HomeBusiness DigestInterest, exchange rates and inflation-pegging

Interest, exchange rates and inflation-pegging

THE changes brought about mainly by the Reserve Bank governor at the beginning of last year brought back sanity to an out-of-control economy, and for most Zimbabweans, were the light at the end of a long, dark tunnel the country entered i

n 1997.


The economy appeared to have stabilised, and was even said to be on the recovery path last year, before faltering towards the end of the year, and coming to a position which looks even worse than 2002-3 as of now.

Interest rates have remained stubbornly punitive, inflation is no longer declining at last year’s fantastic rate, and the country is in the throes of a crippling foreign currency shortage. What has gone wrong?


Raising interest rates to stifle speculation was a step in the right direction. The introduction of the foreign exchange auction was also a positive move, as was the introduction of the Productive Sector Facility to cushion industry and commerce. For some time after these changes, the economy did appear to be recovering.


Trouble started when the exchange rate stopped moving in line with inflation developments. The rationale behind this move seemed to be to accelerate the rate of decline in inflation, albeit at the expense of the exporter and the diasporans. While this worked for some time, the cost has now obviously become too great for these parties as shown by declining inflows from exports and the drying up of official diaspora money. This became increasingly evident from the last quarter of 2004.


Had the Zimbabwe dollar been put on a crawling peg system from that time, where the local currency would be depreciated in line with month-on-month inflation, the gains made from squeezing margins on exporters over the first three quarters of the year would have been crystallised. The decline in inflation would also have been maintained, as the outlook would have continued to be one of high, but receding inflation.


What should also be noted is that while the cost of foreign currency was held constant, those accessing it at the auctions were pricing the goods they bought in line with parallel market rates as they were aware that fewer goods were being imported and therefore they could increase prices without suffering a slowdown in demand. Holding down the exchange rate therefore did not slow down inflation, particularly as there was an absence of foreign currency reserves to continue meeting demand.


Given the acute state of the foreign exchange shortage now and the continued absence of balance of payments support (it also appears this will not be coming anytime soon, given President Mugabe’s speech on Independence Day), nothing short of a massive devaluation would restart meaningful levels of foreign currency inflows.


Unfortunately, once that happens, all prices (including those that have already been adjusted upwards in line with the parallel market rate) will be raised, resulting in the level of prices jumping beyond where they would have been had the currency been on a crawling peg all along. It would, however, mean that we have meaningful inflows once again.


Having effected this one-time devaluation, the monetary authorities would then have to continue to devalue the currency in line with developments in month-on-month inflation, and more importantly, make it known that this will happen. By so doing, the authorities would have created an environment in which all players know the path that the important fundamentals will take. This would also kill off speculative opportunities currently in existence.

For example, if one knows that the Zimbabwe dollar will have declined at the same rate as inflation in a year’s time, and there will not be a parallel market from which to realise higher gains, one would most likely not buy or hold foreign currency. This would be especially so in a positive interest rate environment, as one would realise more from investing on the money market than from holding foreign currency.


On the other hand, trying to hike interest rates again without devaluing and putting the currency on a crawling peg would only result in a higher cost of capital for those struggling companies still in a borrowed position, which would result in inevitable company closures, and greater hardships on the general populace. It would also stifle the already low aggregate demand within our economy, thus impacting negatively on even those companies that are not borrowed, and that are not engaged in speculative activity. In the medium to long-run, high interest rates would also lead to inflation as money is channelled away from productive activities into bank accounts to generate more money when the economy’s output is falling.


High interest rates would not reduce demand for foreign currency significantly as most of this demand currently is for the purchase of inputs and commodities. It is also highly unlikely that there are still people borrowing to buy currency on a speculative basis, as banks’ lending policies have become very stringent, and borrowing rates are still punitive. Moreover, high interest rates would not kill the parallel market as foreign currency shortages would still be there.

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