Parallel exchange rate drivers in Zimbabwe

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Raymond Madombwe

A key question lingering in Zimbabwean minds of late, is what is the parallel market rate of the day?

This rate is important to everyone as prices in shops are benchmarked using this rate to price goods in local RTGS Dollars. The parallel market rate has been experiencing increased volatility with RTGS Dollars falling out of favour, depreciating sharply. Policy makers, are none the wiser, with press reports quoting them echoing a sentiment that current parallel market rates are not justified. This article seeks to answer the question of what is driving the rapid deterioration of Zimbabwe’s local currency?

The Quantity Theory of Money

The Monetarist school of thought in Economics believes that Money directly affects Prices, Output,  Gross Domestic Product (GDP) and Employment in an economy. This school of thought created “the Equation of Exchange which states that:

(M)oney Supply in The Economy*(V)elocity of Circulation = (P)rice Level in the Economy*(Q)uantity of Goods & Services Produced in the Economy in short MV=PQ

Zimbabwe’s Formal Financial System

In an interview in March 2019, the Permanent Secretary in Zimbabwe’s Ministry of Finance unpacked the c.$10 Billion total money in Zimbabwe. $9.2 Billion of those deposits are denominated in local RTGS Dollars, while $700 Million represents United States Dollar deposits. Further breaking it down

➢ $4 Billion of those local deposits have already been lent out by banks,

➢ $3 Billion of the local deposits are placed in Government Treasury Bills

➢ $1 Billion in local deposits are housed in the Reserve Bank of Zimbabwe open market operations and savings bonds.

This leaves Zimbabwe’s formal financial system with $2 Billion free float for their monetary requirements. These requirements include payment for both local as well as foreign goods and services.  Following this logic, if all available cash is used to fund imports, the intrinsic value of Zimbabwe’s local currency can only depreciate to:

$2 Billion/700 Million = RTGS$2.8571 for every United States Dollar

The fatal flaw with this line of thinking is that V as per the Equation of Exchange is assumed to be constant. Zimbabwe recorded a 61.7% growth in transactions in 2018 with a total value of $151.75 billion exchanging hands. V is very significant in any discussion considering that $12.65 billion exchanged hands each month in 2018

Zimbabwe’s Formal Market

Two key policy pronouncements have had an effect on the demand side MV of the Equation of Exchange. Firstly, Zimbabwean banking deposits were devalued through their specification by the Reserve Bank of Zimbabwe as local currency, removal of the 1:1 peg with the United States Dollar, and creation of an interbank market to purchase foreign currency on a willing buyer willing seller basis.

Secondly, a 2% tax was introduced on all transactions to boost revenue inflows for the Government of  Zimbabwe. The interbank market was introduced with an initial rate of RTGS$2.50 for every United States Dollar, in line with the above exchange rate logic. This market has seen only $81 million United States Dollars exchanging hands three months after its introduction. This depressed activity has left business unable to access foreign currency to fund their requirements. Policymakers have responded by securing funding to inject liquidity into the interbank market and allowing the exchange rate to float more freely with the RTGS$ depreciating sharply to RTGS$5.26 for every United States Dollar as at the 31st of May 2019. This effective devaluation has had the effect of reducing the value of (M)oney in the formal financial system in Zimbabwe.

The Government of Zimbabwe also introduced a 2% Intermediated Money Transfer Tax late 2018, to increase tax revenues. This tax is charged at a flat rate of 2% for any transaction above $10, with transactions over $500,000 paying a flat tax of $10,000. Limited transactions are exempt from this tax covering investments, tax payments/refunds, intra-company transfers, transfers to specified trust accounts, intra-Government transfers, foreign currency transfers, inbound and outbound pension fund payments, and petroleum industry payments. This policy action has had the effect of placing a 2% cost for transacting through formal channels. This added cost slows down transactions volumes and the (V)elocity of money circulation on formal channels. On the flip side, the added cost on formal channels promotes illicit cash transactions.

The supply side PQ would ordinarily have to adjust to the new market equilibrium. (P)rice has adjusted upwards with Zimbabwe’s annual official inflation rate reaching 75.86% in April 2019. Q, which represents GDP, would need to adjust downwards to counteract not just the decline in MV, but also the increase in P. This Q adjustment will come either through GDP contraction or the transfer of business activities to the informal market. The recent jump in the parallel market rate exchange calls for more scrutiny of the latter argument.

Zimbabwe’s Informal Market

Zimbabwe’s parallel exchange rate has galloped to new all-time lows for the RTGS$ with quoted rates ranging from $7.50 – $8.60 local dollars for each United States Dollar. This market represents leakages from the formal market and growth of this market segment could be countering the decline of the formal market. The International Monetary Fund Working Paper ‘Shadow Economies Around the World: What Did We Learn Over the Last 20 Years?” placed the size of Zimbabwe’s informal economy as anywhere between 44 – 60% of GDP. This heavy weighting places a significant portion of Zimbabwean (M)oney in informal channels.

The informal market has not been spared from the 75.86% annual inflation rate affecting (P)rices in Zimbabwe. For the sake of simplicity let us assume the informal market output (Q) has remained constant. M and/or V need to adjust upwards to counteract the increase of P being experienced on the supply side. The MV readjustment will also need to further counteract policy decisions in the formal market which are putting downward pressure on MV in that market.

This surge in MV in the informal market will lead to an increase in demand for currency in Zimbabwe. Ordinarily, this uptick will filter back to the formal market as Zimbabweans bank their cash. A confidence deficit has, however, influenced people against holding their cash as local currency in Zimbabwean banks. The net result is an increase in demand for foreign currency for local trade. This increased demand has led to the sharp deterioration of Zimbabwe’s local currency.

Zimbabwean informal market participants are bidding up their price to access foreign currency as competition is increasing for the scarce foreign currency already circulating in the informal market. The formal market is failing to service this growing appetite, necessitating the need for a jump in illicit financial flows. As the black market rate continues to accelerate, new incentives attract more illicit financial flows. Put simply, Zimbabwean local currency is depreciating sharply because Zimbabweans are scrambling to devalue it, in a bid to discover a price that provides sufficient liquidity to meet foreign currency requirements for the informal market.

This evidence of rapid informalization of the Zimbabwean economy, is more damaging to Zimbabwe’s future prospects. These illicit financial flows are being traded in an illiquid foreign exchange informal market with information asymmetry and huge potential for market abuse. These factors have collided to influence
the sharp swings in the informal market exchange rate that Zimbabwe is currently experiencing. The social cost is immense as the same rate is being used to price goods in Zimbabwe’s formal market.

Re-evaluating our assumption of constant (Q), the situation on the ground points to a declining formal market which is being counteracted by a growth in the informal market. Market pundits have pointed out how fuel demand has not tapered off to dispel economic contraction arguments. If this logic holds (MV) in the informal market will need to further adjust upwards to compensate the growth of economic
activity (Q) in the informal market. This would lead to further deterioration of Zimbabwe’s local currency in the informal market as more foreign currency will be demanded to fund informal market activities.

Informal Market Social Cost
The increased informalization in Zimbabwe has massive social costs that outweigh social benefits. Informal market participants do not pay their fair share of tax and social security contributions. Tax administration and enforcement becomes difficult as cash trades do not create a paper trail for tax authorities to sniff out tax evasion. Social services will decline as the Government will increasingly become less capacitated to fund them. The formal economy will ultimately lag in development leading to disintermediation and less efficient allocation of resources.

Zimbabwean policymakers should relook the effects of their policy actions as they indirectly encourage increased informalization of the Zimbabwean economy. The informal market rate is providing a feedback mechanism of the evolution of supply and demand of foreign currency in Zimbabwe.  Resultantly, MV=PQ tells us that the informal market exchange rate is in line to deteriorate further if no corrective measures are implemented. The effects of the current status quo are too dire to ignore the message being communicated by the galloping informal market exchange rate.

This article has been prepared by Raymond Madombwe for information purposes only and does not constitute financial advice. Raymond is a Financial Economist with wide-ranging experience in the financial service industry. This article was prepared with the utmost due care and  consideration for accuracy and factual information; the forecasts, opinions and expectations are deemed to be fair and reasonable. However, there can be no assurance that future results or events will be consistent with any such forecasts, opinions and expectations. The author will therefore not incur any liability for any loss arising from any use of this document or its contents or otherwise arising in connection therewith. The author can be contacted on raymadombwe@gmail.com