In recent weeks there has been much talk about “fiscal and internal devaluation”.
Ritesh Anand Column
Fiscal devaluation is an attempt to restore competitiveness through changes to the tax system, while internal devaluation is an economic and social policy option whose aim is to restore the international competitiveness of a country mainly by reducing its labour costs — either wages or the indirect costs to employers.
The concept of internal devaluation was first coined at the beginning of the 1990s, when Finland and Sweden were considering the opportunity of joining the euro.
Post the financial crisis, a number of European countries including Lativa, Ireland, Greece and Lithuania adopted internal devaluation policies with mixed results. For the most part internal devaluation policies failed in these countries. So what makes Zimbabwe unique in thinking that we can solve our problems through fiscal and internal devaluation?
Devaluation is often part of the remedy for a country in financial trouble. Devaluation boosts the competitiveness of a country’s exports and curtails imports by making them more costly. Together, the higher exports and the reduced imports generate some of the financial resources needed to help the country get out of trouble.
For countries that belong to — and want to stay in — a currency union, however, devaluation is not an option.
This was the situation facing several euro area economies at the onset of the global financial crisis: capital had been flowing into these countries before the crisis but much of it fled when the crisis hit.
Although not part of a currency union, Zimbabwe, which adopted the multi-currency regime in 2009, faces a similar challenge today.
The country’s implied real effective exchange rate is currently over-valued by an estimated 45%. This largely reflects the progressive appreciation in the US dollar underpinned by strong economic recovery in the United States and accommodative monetary policy measures adopted in most Euro zone countries.
The nominal appreciation of the US dollar against major currencies has had concomitant effects on the real effective exchange rate, a development that has continued to undermine the country’s export competitiveness.
In such circumstances, can fiscal and internal devaluation policies work in Zimbabwe?
Internal devaluation strategies consist of deflationary policies aimed at decreasing production costs and the implementation of structural reforms.
In practice, however, governments have no influence on overall prices and must rely on the propagation of a substantial cut in civil servants’ wages to the private sector’s salaries, and eventually to producer prices.
The process should lead to a shift in investment from the non-tradable towards the tradable sector. Structural reforms should allow for increased productivity.
Significant cuts in civil servants salaries in Zimbabwe would be politically unpalatable. Furthermore, reducing the cost of utilities, especially power would be difficult to fathom given the power crisis the country currently faces.
Earlier this year, Econet cut salaries for all staff by 20% and there are a number of companies operating on flexible working policies in order to cut costs.
Cutting civil servants salaries would certainly reduce government expenditure but it would also depress aggregate demand and lower GDP.
Government needs to find ways to stimulate demand to offset the slack created by internal devaluation policies. In the absence of monetary policy levers like quantitative easing, only changes to economic and investment policies can stimulate growth. Without policy reforms, especially investment and economic policy reforms internal devaluation is likely to fail in Zimbabwe.
The Latvian government adopted an aggressive strategy of internal devaluation in response to the 2008-2009 crisis, adopting pro-cyclical macroeconomic policies in order to increase unemployment and lower unit labour costs.
This strategy had huge economic and social costs, including a record loss of 24% of GDP in two years, soaring unemployment, and massive emigration. These costs are considerably higher than the worst crisis-devaluation experiences of other countries over the last 20 years, and the Latvian recovery has been much slower.
The recovery that Lativa experienced in 2012 had nothing to do with an increase in net exports. Rather, it appears that the recovery resulted from the government not adopting the fiscal tightening for 2010 that was prescribed by the IMF, as well as expansionary monetary policy caused by rising inflation.
The data contradict the notion that Latvia’s experience provides an example of successful internal devaluation.
Latvia received 7,5 billion euros (US$10,2 billion), or about 75% of its annual GDP, in aid commitments for 2008-2011 from Europe and the IMF, and it is also unknown how much of the European and IMF aid would have been provided if Latvia had pursued a different economic strategy.
Unfortunately, given the multi-currency regime, devaluation is not an option for Zimbabwe. Fiscal and internal devaluation is the only option we have at our disposal.
Furthermore, in the absence of monetary policy levers like quantitative easing only changes to economic and investment policies can stimulate growth.
Without policy reforms, especially investment and economic policy reforms fiscal and internal devaluation is likely to fail in Zimbabwe.
There are no easy options and any talk of the return on the Zimbabwe dollar is likely to send shivers down people’s spine.