Zim’s misaligned exchange rate and inflation debacle

There is a general agreement that there is need to have capacity of the exchange rate to absorb shocks from both domestic and external  factors.

DANIEL NDLELA 

But for this to happen smoothly, there is need to have a supportive macroeconomic environment for exchange rate management, that sets the macroeconomic fundamentals right, in particular the presence of complementary monetary policies and fiscal discipline which are the prerequisites in the success of any exchange rate regime.

Persistence of an overvalued exchange rate, as in the Zimbabwean case should be understood as a major source of exchange rate management problems.

In this regard the relationship between the nominal and real exchange rate plays a central role in influencing the response of agents to any nominal devaluation.

The nominal exchange rate is always a policy instrument under managed floats and other controlled regimes.

A nominal devaluation has at most a transitory effect on the real exchange rate, thus emphasizing that it is the real exchange rate that remains consistent with internal and external balance as a function of exogenous and policy variables.

Short-lived devaluation episodes are quickly followed by nominal appreciations within a relatively short period and the frequent reversal of policies.

Such scenario renders considerable difficulties for productive structures to respond to exchange rate policy.

It is this continued lack of faith in policy consistency that results in exchange rate volatility which in turn leads to a reduction in the responsiveness of productive sectors to policy changes.

Empowering our productive sectors, especially the manufacturing sector requires the need to create faith in the system.

Producers should be able to view policy changes as permanent and stable, not an every other day Radio and TV talk shows.

The success of exchange rate management including devaluation hinges on policy consistency.

It must be done consistently at all levels, to minimise the adverse short-run sectoral impacts.

The general observation reveals that due to uncertainty about policy consistency, very few firms in the manufacturing and agricultural sectors are able to make necessary production adjustments in the event of exchange rate movements, which includes devaluation.

Yes the economy has had some positives, which are noted in industry capacity utilisation recovery, real GDP growth and expansion in economic growth (infrastructure, agriculture, manufacturing and mining), and a questionable and squeezed fiscal surplus.

At the general level, the economy generally made some progress in 2021 buoyed by a record agricultural season with maize production estimated at 2.7 million metric tonnes, higher mineral production and international mineral commodity prices, increased manufacturing production capacity utilisation and a practical approach to managing Covid 19.

The above positives are quickly followed by some notable negatives or downsides, namely: a runaway gap between the auction rate and the parallel market rate now ranging from ZWL220 to ZWL240 per one USD compared to an auction rate of ZWL118; exchange rate volatility (depreciation); currency vulnerability as shown by resentment or flight from the local currency; increasing re-dollarisation and price differentiation’ with discounts for USD payments and steep exchange rate for local currency payments; entrenched high unemployment levels and low salaries in real terms creating hardships for the populace.

In addition, there is a continuous serious brain drain affecting the health and social sectors, senior lecturers from our higher education institutions are migrating in numbers.

This is further exacerbated by incipient inflationary pressure (average monthly inflation remains high at 5.8% leading to growing poverty levels and rising inequality.

The resurgence of inflation follows the widening parallel market premiums compounded by widespread indexation of prices in the parallel market.

Lack of confidence in the economic system also results in exchange rate leakages and strengthening of the parallel market.

At the same time, the parallel market regime involves the rationing of foreign exchange, through the current managed auction system, basically an exchange control system that encourages the development of rent-seeking behaviour even among private entrepreneurs.

Thus under speculative behavior fueled by arbitrage behaviour and uncertainty, the exchange rate over adjusts in response to any monetary stimuli.

Zimbabwe has had its highest foreign currency receipts at US$9.7bn in a long time.

We have to answer the question why these receipts still remain inadequate for our national needs as the bulk of them US$6.194bn have largely come from export receipts which increased by 67% over last year.

Is it not the case that failure to adhere to a plausible exchange rate flexibility or a truly operating Dutch auction system opens the door for these receipts to be either externalised or infiltrate into the parallel market.

Because the Zimbabwe economy has since the early 1990s adjusted to the parallel market, any devaluation will have a limited impact as the parallel market is likely to adjust upwards if the perception about the stability of the economy is not restored.

In other words, whatever auction rates you adopt, renaming of the currency, etc without adjusting the existing macroeconomic and institutional fundamentals will further trigger devaluation spirals with disastrous consequences.

This is contrary to the situation where there are stable institutions such as well-regarded central banks.

In the latter the country is more able to emerge from economic debacle with its reputation intact, which reminds us of the economic theory that good institutions persist and breed prosperity even through crises.

To counteract this adverse speculation, the country needs a different positioning of the central bank, that will focus on good and unquestionable corporate governance, ethically based mechanisms or confidence building programmes.

Overall confidence building requires effective policy implementation, maintaining the proposed expenditure stance for sustained time periods, avoiding frequent policy reversals which has been a contributory factor in undermining confidence in the foreign exchange market, and boldly tackling the unnecessary bulging bureaucracy.

Correction of policy inconsistency can only be achieved through a macro policy matrix that seeks to achieve sustainable internal and external equilibrium, broad balance between aggregate demand and aggregate supply which is necessary to dissipate domestic inflationary pressures, a  sustainable growth path which is characterised by neither upward nor downward price pressures and with no widening current account balance.

Zimbabwe’s current Fiscal and Monetary policy measures are unlikely to achieve much towards the desired currency and exchange rate stability.

The main challenge with the current fiscal and monetary policies is the asymmetry and the underlying lack of consistency which has been an underlying weakness of the macroeconomic policy framework for a long time.

As it is, the framework has limited chance of achieving internal and external balance, a definite prerequisite for achieving currency stability by dissipating inflationary pressures and get the economy on course towards low and stable inflation.

In the short-term this can be done by reining in on money supply growth and mopping excess liquidity, capping RBZ lending to Government of Zimbabwe on statutory limits and maintaining positive interest rates.

It is imperative that as a country we have an optimal monetary policy framework that ensures that the interest and exchange rate policy are designed and synchronised so as to achieve financial markets equilibrium in terms of both the foreign exchange and domestic money market.

For a long time now, Zimbabwe has had no synchrony between exchange rate policy and quantitative reserve money targeting.

This is because, when the authorities target or tighten reserve money, they don’t at the same time synchronize this with exchange rate flexibility, which simultaneously renders a mutually exchange rate and financial stability.

Quantitative tightening and exchange rate flexibility must be an integral part of an effective monetary policy framework, otherwise we will always have the present scenario of randomly tightening on reserve money, while exchange rate is left on its rigid slide.

Dr Daniel Ndlela is an economist and head of Zimconsult, an economic consultancy firm.