HomeAnalysisGovt may need to review bond notes framework

Govt may need to review bond notes framework

In November last year, the government, through the Reserve Bank of Zimbabwe (RBZ), introduced the bond notes which it said were backed by a US$200 million facility from Afreximbank. While the market has remained doubting as to whether the bond notes were backed by a facility from the regional bank, there are strong indicators that the notes could indeed be backed by a facility from the bank.

By Daniel Ngwira

Recent comments attributed to the bank’s Afreximbank president Benedict Oramah in the media that “I think the issue of the incentive being increased is under discussion”, suggests confirmation of the existence of a facility.

But the pronouncement by RBZ governor John Mangudya that “as long as the facilities are there to back bond notes, it’s more like a gold standard”, is not accurate. While Mangudya is right in stating that when “you issue an instrument that is backed by something so that it becomes convertible”, the truth of the matter is bond notes are not convertible. So far bond notes have proved to be non-convertible, thus violating the “gold standard”.

When a currency is convertible, it entails that it is a substitute for “good money”. Convertibility, therefore, gives the holder of the “substitute money” (in this case the bond notes), the right to redeem, on demand, value in good money (the United States dollar).

Redemption of value in good money should happen without restriction in order for a currency to be said to be fully convertible. The bond note could have been convertible if it could be traded without government and central bank restrictions. Allowing the free trade of bond notes under the current circumstances could have seen the currency substantially losing its parity level with the greenback given the shortages of the US dollar in the market vis-à-vis the demand. It is illegal for bond notes to be traded outside the government’s desired parity value to the US dollar.

The question is: how does a government ensure convertibility when it artificially fixes the value of its currency? It is difficult to reconcile, more so when a country is going through an exchange crisis which requires it to introduce a priority list that defines which payments qualify to be made first, while others, by virtue of their distance in the priority ladder, have a remote chance of being made.

The current scenario renders bond notes partially convertible at the discretion of the authorities. This is a far cry of what the economic agencies want at this point in time (given the country’s reliance on imports) and short of the implications of having a bond note backing facility of US$200 million and issuing notes in line with that backing.

Full convertibility is usually feared in situations whereby the substitute currency supply overstrips the stock of the “good money”. That is to say, if the government has issued $400 million worth of bond notes when it only has a backing of US$200 million, it entails that the backing currency would be depleted thus eroding market confidence and invoking a market crisis.

The gold standard is the art of pegging a currency and guaranteeing convertibility. In history, Britain, Japan, Germany, the United States and most other major trading nations, were operating the gold standard by 1880. The standard was used as a framework for determining exchange rates in order to facilitate international trade. The US dollar was equivalent to 23,22 grains of pure gold. Thus one ounce of gold cost US$20,67 given that there are 480 grains in an ounce. On one hand, the British pound was equivalent to 113 grains of pure or fine gold making one ounce cost £4,25.

What this meant then, as it should mean today, is that when a holder of US$1 lost trust in the paper currency, or when they decided they did not want to hold the paper currency, they would exchange it for the 23,22 grains of pure gold. The principle and the ease of converting the dollar into fine grains of gold would sum up convertibility. This entails that when a central bank or a government pronounces convertibility and the holders of a token currency which is deemed convertible to a backing instrument, usually a precious mineral or another currency, fails to redeem value, then convertibility is compromised and cannot be deemed to exist or may be deemed to be partial to distinguish it from “blocked” currencies which have no convertibility options built in them.

In today’s parlance, a currency is said to be freely and fully convertible when it can be exchanged into another without any impediments. There are very few currencies which are freely convertible in the global markets and there are some things that are common among them: the economies are robust, stable and open. Further, the prices of convertible currencies tend to be market determined. Moreover, markets have confidence in such currencies. A typical example of a convertible currency is the United States dollar.

Why did countries adopt the gold standard in the past? They did so in order to capture the confidence of economic agents regarding the use of their currencies. In the face of the industrial revolution, international trade soared, leading to the need for a more convenient form of payment other than gold and silver; it became impractical to use gold and silver in paying for international trade as literally these had to be shipped to the country supplying the goods (exporter). It was, therefore, not practical for countries to ship gold and silver to each other in pursuit of trades. So it can be seen that currency convertibility was meant to convince the holders of gold and silver that the piece of paper they were holding was worth something; that would be proven through the execution of the conversion of a paper currency into silver and gold. The failure of a bank to convert the paper currency at the request of the holder would erode the confidence of the holders and thus ignite a run on the banks. This would lead to the collapse of the system.

When one looks at the currency system of bond notes, it would be easy to see that it is a far cry from the convertibility entailed by the gold standard. From the exporters’ point of view, limited conversion is construed in the sense that the bond notes, which they are credited with, can be accounted for as US dollars, but even banks are making a distinction between depositors of dollars and bond notes, hence convertibility is theoretical and limited.

To the rest of the depositors, they are not able to present the bond notes to the bank and obtain dollars at their wish (or on demand).

I have tried it many times and the banks have said that they do not have US dollars. In any event, with the entailed convertibility, there would be no need for the alternative market for US dollars to flourish.

One of the major events that precipitated the collapse of the gold standard was that between 1919 and 1928, when the major trading countries returned to the gold standard, some of them did so at the pre-war levels. For instance, Britain pegged the pound to gold at the pre-war gold parity level of £4,25 despite substantial inflation from the start of the World War I to 1925 when it returned to the gold standard.

This resulted in British goods being priced out of the markets, thereby causing an economic depression. As foreign holders of pounds lost confidence in the British government’s willingness to maintain its external value, they converted the pound into gold. This resulted in reserves being depleted and finally the government gave in to economic dictates and suspended convertibility. What followed was a flurry of competitive devaluations. As there was no winner, by 1939, at the start of World War II, the gold standard was dead.

The level of confidence in the bond note as a convertible currency has been challenged in light of the multiple pricing structures which are favouring the holders of the greenback. This is despite the fact that the RBZ seems to have contained printing of the bond notes in line with the said facility from a regional bank.

What the governments may not have known in the past when they introduced the gold standard was that it cannot be a permanent arrangement in the domestic market; that is, the promise to pay the bearer on demand (in silver and gold) could not be sustained. Currency convertibility cannot work in the long-term as it is subjected to many market pressures. It should therefore be used as a bridge to the next destination.

The statement that “we just can’t issue something out of a thumb suck” by the central bank is meant to justify the erroneous assumption that the bond notes are premised on the gold standard, which they are not. In any event, how many countries in modern economics are running similar convertible systems? If the country’s exports outstrip the imports or improve substantially while government contains its expenditure, then we can easily run our own currency.

Government must therefore work on two issues that can help restore the monetary sanity in the system: boosting production and therefore exports, and the reduction of the costs of governing the country.

It is expensive for a country to run a fully backed currency. Modern economies are run on fiat currencies. These are currencies backed by the government that issued it rather than by physical goods like gold and other currencies. Fiat systems are cheaper for the economy suffice to say that they depend on the robustness of the government that backs it.

The existing framework of bond notes entails that an exporter is given an incentive in a local currency which is called bond notes; they have to queue for foreign currency, which is scarce at banks. They will need this foreign currency to buy spares, consumables and some raw materials from outside the country. When they get a working capital loan from a local bank, they will be credited in local currency and still line up for foreign currency at the bank.

They may not get it if they require using it on items that are not on the priority list. The inefficiency here comes in the sense that the exporter could be better off being awarded an incentive or working capital loan in foreign currency.

The question here is whether the bond note framework is still relevant after having failed to alleviate the cash crisis more than six months on? Are we not better off as a country if the central bank uses the backing facility to provide working capital loans to the manufacturing sector struggling to utilise productive capacity due to lack of funding?

We do not yet know by how much the central bank wants to raise the bond note facility, but let’s suppose they want to raise it to US$600 million, that money would change the face of the economy if it is directed towards the productive sector as opposed to financing pieces of paper. Even the existing US$200 million facility would go a long way in capacitating the local economy bearing in mind that when a country needs US$1 billion to be jump-started, that does not mean it can be injected from day one. Neither does it mean that an absolute US$1 billion will be required.

Economies all operate on the basis of the multiplier factor which enables a unit of currency injected to have an effect greater than that unit.

The desire to finance pieces of paper with the greenback is premised on the wrong assumption that economic agents are shipping out US dollars. Available data shows that this is without any basis. Besides, government can come up with alternative measures to plug the holes should that be the case.

Ngwira is a chartered accountant, former bank treasurer and former university lecturer. He holds finance and business qualifications. — daniel.ngwira@gmail.com/ cell: +267 73 113 161.

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