20 June 2008

Zimbabwe: Can the Dollar Be Saved?

Harare — AS the country seeks a nominal anchor to the besieged Zimbabwe dollar, an optimal and sustainable exchange rate regime has been difficult to attain.

The fall of the Zimbabwean economy is often traced back to November 14, 1997, a day referred to as "Black Friday" when the Zimbabwe dollar lost 71,5% of its value against the US dollar.

Since then, the Zimbabwean dollar has never really recovered and the country has been thrown into a decade-long downward spiral.

The daily depreciation of the Zimbabwe dollar in recent weeks has been ferocious, but can the Zim dollar be saved?

Since the flotation of the currency back in May, evidence suggests that the dollar has struggled to find a bottom, losing an average of 25% of its value a day.

At the time of writing this article, US$1 was worth $7 billion on the open market and the rate to the pound sterling was at $16 billion.

Exchange rates are expected to have changed by the time the article is published.

Remember that the country slashed 3 zeros off the currency in August 2006.

The accelerated depreciation requires further surgery to lop off at least three more zeros purely for ordinary people to comprehend the arithmetic of buying a loaf of bread together with a box of matches.

The flotation of the Zimbabwe dollar without a macroeconomic support has made the currency defenceless against rampaging inflation, unsustainably low interest rates and high unemployment, resulting in a seriously twisted economic quagmire.

High unemployment has led to reduced productivity, a decimated export potential and the emergence of one of the world's most sophisticated black markets.

The negative side effect of the currency instability has been the shift of resources and energies towards "speculative activities" which can earn the investor quick returns and the much-needed US dollar, at the expense of productive investment and long-term development.

That the Zimbabwe dollar would have been subjected to speculative attacks by economic agents scrambling to find a hedge elsewhere is hardly surprising.

The crash of the dollar after flotation was inevitable.

Several factors are important in predicting currency crashes; these include monetary and fiscal expansions, declining competitiveness, current account deficits and losses in international reserves.

All of which underlines the problems with the Zimbabwean economy.

So what could have been the reasons to float the currency when the macroeconomic outcome was predictable? There could be several reasons for this.

The first was to bait foreign currency into official coffers to fund critical supplies.

The flotation of the Zimbabwe dollar undertaken by the central bank, and more importantly a move towards market-determined exchange rate regimes also resulted initially in a significant narrowing down of premia between "official" and "parallel" exchange rates that had grown significantly due to pressure on fixed rates.

Furthermore, the elimination of cumbersome exchange control measures and administrative machinery for allocating foreign exchange could have resulted in an improvement in the allocation and utilisation of the scarce foreign exchange, although the allocation is still tightly controlled by the central bank.

Lastly, some analysts point towards a more sinister political reason for the liberalisation, having coincided with the much-contested presidential run-off.

Nonetheless, one of the side effects of the flotation has been the increased instability and volatility of the external values of the Zimbabwe dollar.

If the assessment of Zimbabwe's limited capacity for sound policy-making is empirically correct, the foreign currency crisis is set to worsen.

A bloated and unsustainable budget deficit has not been helpful. Despite a low interest rate regime, the government's fiscal record has been dismal.

The Finance minister's prediction of economic growth in 2008 will be an act of magic as is getting diesel from a rock in Chinhoyi.

The problem with exchange rates is that they affect the price of domestic money directly correlating to the rate of inflation. Exchange rates, affects inflation through two common channels.

Firstly, in an open economy, the real exchange rate affects the relative price between domestic and foreign goods, which in turn affects both domestic and foreign demand for domestically produced goods and hence affects aggregate demand and inflation.

There is also a direct channel, in that the exchange rate affects domestic currency prices of imported foreign goods, which enters the consumer price index.

As a result, an attempt to control inflation, is often implemented as one of the choices for a nominal anchor under a floated currency, the second choice is controlling monetary aggregates, an area in which the central bank appears to be fighting a losing battle.

Based on the pricing of most commodities, the Zimbabwe dollar seems to have lost credibility and value as a trading currency, nationals and foreigners have become less willing to transact in the currency leading to an unintended dollarisation of the economy.

This has caused some assets in Zimbabwe to become more expensive in real terms compared to their value anywhere else in the world.

Although it may be too early to empirically measure the impact of the floatation on the Zimbabwean currency.

Important lessons can be learnt from the recent experiences in Zimbabwe's management of foreign exchange markets and exchange rates.

These include, the desirability of determining an optimal and sustainable exchange rate regime within a framework and consistent with broader macroeconomic goals and addressing the challenges of moving from controlled foreign exchange markets and administratively set exchange rates to liberalised markets and market-determined exchange rates; the necessity of establishing the institutional and legal framework needed for efficiently functioning foreign exchange markets and market determined exchange rates; defining specific roles for the various operators in foreign exchange markets (central banks, commercial banks and foreign exchange dealers) in order to ensure the smooth functioning of the markets and to minimise systemic risks; defining the role of the central bank in the liberalised foreign exchange markets and market determined exchange rates; understanding the linkages between exchange rates movements and their impact on the rest of the economy.

The rapid depreciation of the Zimbabwe dollar will most certainly reverse the central bank's attempts at stabilising the economy resulting in internal hemorrhaging.

It is unlikely that the central bank will introduce any monetary policy measures to stabilise the free-fall before the presidential run-off.

The value of a currency in nominal terms reflects people's confidence or lack thereof in the economic policies of a sitting government. The recovery of the Zimbabwe dollar is therefore inextricably linked to the resolution of the political process.

lLance Mambondiani is an investment executive at Coronation Financial plc, an international financial advisory company registered in the UK trading in Southern Africa and the United Kingdom.

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