What is our optimal exchange rate?

FOLLOWING our discussion last week, it appears there are various arguments being put forward with regards to management of the current situation — where we seem to be stalling on the inflation front, the stock market appears to be g

etting out of control, and the foreign currency shortage has become critical.

The most popular solution being put forward is an interest rate hike, because this would halt the stock market rally and discourage speculative borrowing to fund foreign currency parallel market activity.

While the stock market rally would indeed be slowed down by an interest rate hike, this is not the simplest way to achieve this, as this would have negative impacts on other economic activities such as slowing down aggregate demand and accelerating the demise of an already weak industrial sector.

If the RBZ reverts to the 91-day ZTB OMO bills, and keeps them open to the general public, investors could realise above-inflation returns from these.

At the current TB rate of 95% over a 91-day period, investors would realise compounded returns of 135% per annum, which are above inflation. This would instantly solve the “stock market problem”.

As to whether or not there is speculative borrowing to fund parallel market activity, simple arithmetic would suggest this is not the case.

At the current allocation rate of US$11 million per auction, over a year the Reserve Bank would have allocated US$1,144 billion. According to the fourth quarter monetary policy statement, in 1996 (which we shall take as the proxy for a ‘normal’ year) the country’s total foreign currency earnings were US$3,878 billion. Yet in spite of this, the country still needed an additional US$1,062 billion in “grants and other transfers” to balance off the books.

It is thus reasonable to say that this year, given a larger population and more adverse conditions (drought, reduced agricultural and industrial activity etc), the country’s foreign currency requirements would exceed US$5 billion.

That the amount of bids is currently standing at only just over US$200 million is thus actually quite surprising.

Raising the level of interest rates would not result in the country requiring less foreign currency, and could be compared to over-inflating the tyres on a car in the hope that this would re-start a stalled engine.

In any case, borrowing rates on average are currently at between 105 and 125%, which works out to between 174 and 228% on a compounded basis. Given the effort and length of time it now takes to get a loan approved, and the additional time needed to get funds from the auctions, it is hardly likely that there are many people speculating on the foreign currency auction as a means of livelihood.

Given that we do not, and are not likely to have a source of balance of payments support in the short to medium-term, our only hope lies in boosting exports and remittances from the diaspora. Currently, virtually all exporting companies have cut down on export volumes (see this article on our website www.adway.co.zw for details) citing an unviable exchange rate regime.

Their actions are entirely reasonable, given that their export revenues would have grown only about 32% over 2004 ceteris paribus, against input cost increases averaging 132%. They are advocating that the exchange rate should be determined by market forces, as opposed to the controlled auction rate.

Allowing market forces to determine the exchange rate without balance of payments support, and under the current situation where supply far exceeds demand would result in extreme decline of the exchange rate, to such an extent that our currency would become grossly undervalued, which would be an equally undesirable situation.

Consider, on the other hand, pegging the exchange rate to month-on-month inflation after effecting an appropriate devaluation. The exporters would get reasonable value as their costs and revenues are growing in tandem. They would actually benefit from increasing exports as they would be able to retain more foreign currency to fund their operations; the auction system would continue to have more bids than available currency, which would make it the source of last resort.

People remitting from the diaspora would also get good value as their remittances’ purchasing power remains constant over time. Bids would continue to outstrip supply on the auction, but as exports and remittances increase, the gap would gradually decline. When bids and offers eventually become matched, the exchange rate could then be left to the dictates of market forces.

Defending the currency is only effective when done to counteract short-term speculative attacks on the currency, or to smooth out seasonal effects on demand and supply. It also requires foreign currency reserves. In our case, pressure on the currency is emanating from fundamental weaknesses within our economy. — Own Correspondent.