When Inflation is Harmful: Economic Recovery Efforts & De-Dollarization.

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Samuel Mapuranga

 “The stakes in choosing the right monetary and fiscal policies are high” Robert Lucas (2003: 3) argued in his presidential address to the American Economic Association. Mistakes at this level cause inflation, distort decisions in labour and capital markets, and might either precipitate or fail to prevent recessions.

Lucas proceeded to calculate the potential welfare gain of improving fiscal and monetary policies to attain an ‘optimal’ stabilisation policy and found that the potential welfare gains from such improvements were orders of magnitude smaller than the potential gains from supply-side policy reforms. Whether this result and the associated policy priorities also hold for Zimbabwe is an empirical question, and this calls for policy makers and researchers to find and contribute towards an answer to the challenges facing the economy today.

All else being equal, a moderate decline in currency generally benefits firms in that country however, when the decline is severe or prolonged, it may be a sign of weaker economic fundamentals. Such a situation may also lead to inflationary pressure and/or government intervention. As a result, movements in key FX markets influence corporate profits and economic values of firms around the world through a number of channels. These FX impacts show up in corporate policies across the spectrum, including import and export costs, cost of capital and relative investment appeal.

When a currency depreciation is sudden and severe, a number of challenges arise for firms operating in such a weak currency environment, as well as for firms from strong currency countries considering investments in these countries. This has been the case for Zimbabwe’s RTGS$ in the past two months. The nation’s year-on-year inflation reached 97.85 percent in May, latest statistics from the Zimbabwe Statistical Agency (ZimStat) revealed on the 17th of June. The annual inflation rate jumped steeply from 75.86 percent the previous month – April, showing how the country’s economic meltdown continues to escalate. Zimbabwe, whose inflation rate is widely ranked as the second highest in the world after Venezuela, is experiencing its worst economic challenges with price increases at a 10-year high. Monday, Zimbabwe’s central bank abolished the use of multicurrency in an effort to curb black market currency trade however, the reintroduction of the Zimbabwean Dollar is a bitter reminder of the 2008 crisis period.  The 2008 economic crisis destroyed savings and forced the Southern African nation to abandon its currency, the Zimbabwe dollar. At the height of the financial crisis, Zimbabwe’s inflation skyrocketed to more than 89-sextillion. In response, the government printed its highest denomination of $100-trillion.

Inflation Crisis and Macroeconomic Instability.

In a dollarized environment, exchange rate changes become more important than interest rate changes in the conduct of monetary policy as a result, price elasticities to monetary shocks are prone to be higher in dollarized countries. Despite the introduction of the interbank market, businesses in Zimbabwe have been pricing their products and services using the parallel market thus giving rise to high prices of goods and services. Thus, high inflation figures for April and May became inevitable as dollarization deepens the impact of the exchange rate channel on the inflation rate.

Indications from a severely depreciating RTGS$ (signals or) can be attributed to a weak or weakening economy. This is often associated with declining economic growth, and possibly even a recession. Furthermore, the weaker currency may lead to inflationary pressures, among others, via more expensive imports. In order to protect the currency, governments often raise interest rates, which may further slow the economy. In such circumstances, policy makers also often consider regulatory intervention and capital controls to protect the currency. These interventions may increase risk for both local and non-local firms. Unique pressures arise for local firms with liabilities in the strong currency (for example, USD) but cash inflows in mostly the local currency. Under financial pressure, these firms may curtail investments, thereby further weakening the local economy.

Developments in inflation and economic growth for Zimbabwe post dollarization.

Zimbabwe experienced high inflation levels since 2000, which culminated into hyperinflation in March 2007. Annual inflation peaked at 231 million percent in July 2008. During the high inflation period the country posted huge negative growth rates, which bottomed out at -14.7 percent in 2008. Resultantly, there is general consensus among industrialists, policy makers and economists that very high inflation has distortional effects on economic growth in Zimbabwe. High inflation has negative effects on the economy through loss of competitiveness, thus adversely impacting Zimbabwe’s balance of payments. Moreso, high inflation also affects investment decisions as it brings about uncertainty on the future value of investment projects and also erodes the real value of tax revenues.

Zimbabwe experienced an outright reversal of high inflation when it realised deflation for 28 consecutive months from October 2014 to January 2017. Annual inflation reached its lowest level of -3.29 percent in October 2015. Under a deflationary spiral, falling prices raise the real value of debt, which undermines borrowers’ balance sheets (statement of financial position). Furthermore, anticipation of further decreases in prices, results in consumers delaying spending, thus negatively impacting on economic growth. Outright deflation is thus harmful to economic recovery and growth. Though economists regard deflation as a major threat to economic recovery, for everyone else, it’s a bitter reminder of years of hyperinflation that destroyed their savings. Thus given hyperinflation memories, money demand is likely to be more sensitive to inflation, even at low levels. The market’s quicker response in adjusting consumption and investment decisions is, therefore, relayed to growth earlier and at lower inflation rates after the crisis than before.

Given the aforementioned conditions, real GDP growth which averaged 10 percent from 2009 to 2012, fell to 3 percent in 2014 and declined further to 0.6 percent in 2016. An examination of Zimbabwe’s deflation shows that this was mainly driven by external factors such as appreciating US dollar, falling international oil and food prices. With seemingly high inflation and huge negative inflation both being detrimental to growth in Zimbabwe, it left so many punitive memories attached to loss of pension savings build over several decades. In order to ensure economic recovery and maximise economic growth, analysts therefore agree on an optimal inflation level for Zimbabwe of around 4.6 percent for multi – currency regime and 8.71 percent with our own currency.

De-dollarization, management of macroeconomic policy and increased financial risk.

Smack in the middle of a war with inflation, finance minister, Government of Zimbabwe faces a grim task as the economy fights de-dollarization. If officials can’t keep inflation in check, will they be able to turn the economic fortunes and convince the nation that the return of local ZimDollar will ease Harare’s economic woes? Compounding the challenge include the country’s power sector plagued by significant and structural operating difficulties, recent severe droughts increasing the nation’s import bill as well as enormous difficulties of entrenched corruption and bureaucracy keeping potential investors away. This adds serious pressure on Zimbabwe’s economy and puts the Southern African nation’s economic recovery efforts in a bit of a pickle. In particular, the nation is facing an economic contraction much faster than what was estimated abating all recovery efforts. Due to adverse consequences of dollarization on macroeconomic stability, monetary policy transmission, and financial sector development and the absence of a unique formula for de-dollarization success, economists believe that credible monetary and exchange rate frameworks, low and stable inflation, as well as deep domestic financial markets are essential ingredients of any de-dollarization strategy. As Zimbabwe’s central bank embarks on a de-dollarization process, policymakers need to consider proper sequencing of policies, effective communication as well as being proactive to risks from potential financial disintermediation and instability, and/or capital flight.

The first step in addressing this challenge would be to recognize the seriousness of production decline, waning public confidence and trust. There’s little evidence Harare has done that and part of the difficulty in the economy have been very large declines in the absolute number of jobs in agriculture and mining. It aggravates the external imbalance thus the sectors that grow (that is, the non-tradables) use up foreign exchange but do not generate it, while those that stagnate are the ones that can potentially improve the external position of the economy. To achieve a stronger external position, Zimbabwe’s economy needs a relative expansion of the tradable sector which implies both more low skilled jobs and an increase in export earnings

Consequently, a strategy for economic recovery and sustainable growth involves the creation of jobs in the tradable sector. Such a pattern of growth is needed in order to create the external resources required to sustain growth. It is also needed to create the kinds of jobs that use the resources that the economy has at its disposal, that is, land. It is clear that the nation is facing acute foreign currency shortages hence a strategy to relax and overcome this constraint is necessary. However, foreign currency constraint is aggravated by the pattern of growth that Zimbabwe is experiencing, and in fact is in large part its result.

Foreign currency constraint is further compounded by Zimbabwe’s poor business environment—with a long history of graft and bureaucracy and operating losses from national projects. It is important to highlight that the economic recovery and sustainable growth strategy followed by the government of Zimbabwe has to be based on the resources that Zimbabwe has, not on the resources that it wished it had. Thus, a strategy based on the relative expansion of the tradable sector represents a better match with the currently under-utilized resources of the economy such as land and human capital. Why is this not happening automatically through the normal operations of the market? There is need to analyze the binding constraints that may be keeping the nation far from its economy recovery prospects and eventually realizing its potential. At the strategic level, it is important to examine and assesses the causes of inflation in the post-dollarized Zimbabwe with the understanding that monetary reforms may not be the only priority needed to turn around the economic fortunes of the nation.

Thus, when looking for binding constraints to economic recovery and sustainable growth it is useful to look at relative performance. Here a metaphor is useful: it is believed that when trying to understand why there are so few animals in the Sahara Desert, it is useful to note that the few animals one does find tend to be camels and not hippos. If the problem is lack of water, the animals that survive are the ones that are particularly good at managing water. In the context of Zimbabwe, it is clear that the sector that has grown less and that has suffered the biggest losses has been the tradable sector: this is expressed in the dismal long term growth in per capita real exports and in the massive job losses in the sector. This sector has some characteristics that make it vulnerable.

The direct and indirect influence of high inflation have caused significant and structural operating difficulties on sectors such as mining and energy, agriculture and manufacturing.  Moreover, the influence on inflation of factors such as imports, consumer expectation about future inflation, exchange rate, output growth and money supply, among others is of paramount importance. Although interest rate has been found to be one of the major determinants of inflation in Zimbabwe during the pre-dollarization period, there has been an insignificant relationship between interest rate and inflation in dollarized Zimbabwe. To this end, there is bountiful evidence that consumer expectations about future inflation, money supply, current exchange rate, and import value are the major factors influencing inflation.

In order to succeed in de-dollarization, there is need for then for policy makers to pursue a targeted menu-of macroeconomic and financial measures. Although there is no single formula for success, credible monetary and exchange rate frameworks, low and stable inflation, and deeper domestic financial markets are essential ingredients of any de-dollarization strategy and for the success of Zimbabwe’s de-dollarization journey. Thus, recommendations include a gradual move toward more flexible exchange rates, measures to make the local currency more attractive and reduce the asymmetry of exchange rate and enhancing financial development. Above all, effective communication and continuous public engagements plays a major role.

Secondly, high inflation expectations would also drive up inflation, while an increase in real output would result in a decrease in inflation. A common view among economists is that dollarization makes monetary policy more complicated and less effective.  Loss of monetary autonomy therefore means that policy makers had no total control over price formation as this became largely dependent on external factors – typified by the lack of exchange rate as a tool at the authorities’ disposal. Thus, at this point, it is important for policy makers to take into account risk from potential financial disintermediation and instability as well as capital flight, while bearing in mind that transparent and effective communication is important to build public trust in the credibility of monetary policy making.

Creating an environment conducive for business is a key factor. This will enable the private sector to increase production and such policy measures will reduce reliance on imported finished goods from neighbouring countries. Domestic consumers will in turn substitute foreign goods for cheaper domestically produced goods thus reducing the public’s propensity to import. As a result, inflationary pressures emanating from imports of finished consumer goods such as cooking oil, soap, beverages and other food items can be significantly reduced. In the long – run, the major challenge remains in the need to attract more investment across all sectors of the economy in order to increase output in order to sustain economic recovery.

Likewise, the need to improve efficiency remains critical if the Zimbabwe’s goods are to maintain their competitiveness in both the domestic and international markets. Accessing external lines of credit at internationally competitive interest rates will also improve the competitiveness of the economy. In essence, the expeditious resolution of the country’s debt overhang remains critical in efforts geared at unlocking affordable credit lines from international capital markets. Relatedly, the meaningful attraction of both debt and non-debt creating capital flows, notably foreign direct investment, requires that supportive measures be adopted pro-actively in Zimbabwe. In this regard, the need for the alignment of the country’s investment laws, implementation of reforms and procedures to international best practices cannot be over-emphasised.

For Zimbabwe, the attraction of foreign direct investment entails the fast track of and implementation of reforms in such a manner that achieves the twin objectives of attracting the much-needed capital and advanced technology. The attraction of foreign direct investment remains the cog that underpins the attainment of efficiency and export competitiveness; the effective plugging of attendant supply gaps; the permanent shedding of import dependency and the diversification of the country’s export basket away from over reliance on primary products to finished products comes all in that order. It is also imperative that the country creates a land market to resuscitate the agricultural sector, which is the backbone of the economy, through its forward and backward linkages with the manufacturing sector.  However, some de-dollarization successful stories have been underpinned through successful initiatives and prudential regulations in such countries. These include holding reserve requirements for foreign currency deposits in local currency, imposing higher reserve requirements on foreign currency deposits, and remunerating the reserve requirement on local currency deposits at a higher rate than for foreign currency deposits.

Conclusion

Conclusively, while it is important to encourage market-based de-dollarization as opposed to forced de-dollarization. Policy measures that force de-dollarization may lead to capital flight, financial disintermediation, and banking sector instability. De-dollarization measures that have failed in the past include the forced conversion of foreign currency deposits and the suspension of access to foreign currency deposits. The central bank should use caution in introducing interest rate or capital controls, policies that place limits on foreign currency borrowing or lending, and requirements to use local currency in domestic transactions. The regulatory burden associated with the de-dollarization process may lead to disintermediation or potentially more risky intermediation. As the Government of Zimbabwe embarks on the de-dollarization strategy and aggressive measures on the monetary front to defend it, it is of paramount importance for the central bank to be attuned to opportunities for regulatory arbitrage.   While the IMF has predicted that the Southern African country’s economy will contract by 2.1 percent owing to macroeconomic imbalances and a poor farming season, de-dollarization may proceed very gradually as policy makers maintain reform momentum.

Samuel Mapuranga writes in his own personal capacity. Feedback: Email – smapuranga15@gmail.com; or Twitter: @Sa_miiM.