De-dollarisation recipe for disaster: Lessons from Peru

THE following are the numerous questions that need to be addressed about the Reserve Bank of Zimbabwe (legal tender) Regulations, SI 142.
Has government addressed the fundamentals which lead to the adoption of a multi-currency system? How is the so-called Zimbabwean dollar going to boost confidence in the market? Is it going to work effectively?.

Justice Dzama

What is de-dollarisation?

According to the International Monetary Fund (IMF), successful de-dollarisation makes the local currency more attractive to residents than foreign currency. De-dollarisation entails a mix of macro-economic and micro-economic policies that enhance the attractiveness of the local currency in economic transactions and raise awareness of the exchange risk-related costs of dollarisation, thus providing incentives to economic agents to de-dollarise voluntarily.

It may also include measures to force the use of the domestic currency in tandem with macro-economic stabilisation policies. It is worth mentioning that de-dollarisation by forced administrative means always entails a risk of negative spillover effects to other parts of the economic system.

Successful de-dollarisation requires credible macro-economic stabilisation, complemented by micro-economic measures, according to the IMF.In addition to macro-economic stabilisation, two-way exchange rate volatility, stable and low inflation are key ingredients of de-dollarisation.

Additional policies and measures are often necessary to break persistent dollarisation and encourage the use of the local currency. Therefore, the following measures should be implemented before the national currency returns:

l There is need for macro-economic stabilisation, focusing on the credible reduction and stabilisation of inflation. Stabilisation policies include fiscal consolidation and appropriately tight monetary policy to reduce the inflation rate. Fiscal consolidation lessens the need for government borrowing from the central bank, and a tighter monetary policy reduces credit growth. Both policies restrain aggregate demand, resulting in a drop in inflation and, eventually, the appreciation of the real and/or nominal exchange rate. Credible policies curb inflationary expectations and lower the cost of stabilisation. There is also
need of high real gross domestic product;

l There is need for reforms that are aimed at building confidence and restoring the credibility of the central bank;
l Development of capital markets is also important;

l International relations need to be restored. This involves re-engagement with the World Bank, the IMF, and other potential sources of outside assistance;
l Money supply should be linked to reserves;
l There is need for political stability;

l Investor confidence should be boosted particularly by offering long term licenses in the market;
l There is need to reduce corruption within the economy;

l There is need for unbiased taxation that does not treat income from foreign currency more beneficially than income from local currency so as not to create a bias toward holding foreign currency assets; and

l Parastatal reforms and business capacity utilisation (currently capacity utilisation is at 49%) should be raised.
Lessons from other countries

In the mid-1980s, the Peruvian government decided to combat dollarisation by forced conversion of foreign currency deposits to the local currency. This policy turned out to be counter-productive, provoking financial disintermediation and capital flight.

The inflation rate reached quadruple digits in the 1990s and the Peruvian sol lost its essential functions.

After this painful experiment, government authorities radically changed their de-dollarisation strategy. The new plan focused on achieving macro-economic stability by creating a fiscal surplus, significantly lowering public debt, and stabilising inflation by introducing an inflation targeting regime, which was followed by significant currency appreciation from 2003-2011. The macro stabilisation policy was complemented by prudential regulations to better account for foreign currency risks, and to develop a market for securities with a long maturity in domestic currency.

Chile’s experience shows that indexation introduced to avoid dollarisation may persist even after macro-economic stabilisation has been achieved. Despite the presence of indexation since the 1960s, by the 1990s Chile had successfully stabilised the economy, liberalised the financial sector, and gradually dismantled controls on international capital movements.

Government also undertook a debt conversion scheme to change foreign currency-denominated debt into indexed debt. Although Chile adopted inflation targeting and allowed the peso to float freely in 1999, indexation continued to be prevalent. It was ultimately reduced by targeting a fixed nominal interest rate instead of the inflation indexed “real” interest rate. Subsequently, peso deposits increased and reached 90% of total deposits in 2010.

Egypt de-dollarised its economy in the context of macro-economic stabilisation and bank reform. The share of foreign currency deposits (FCDs) to total deposits declined from 56% in 1991 to 22% in 1999 and further decreased to 18% by 2004.

In 1991, the authorities launched a set of fiscal and monetary reforms to reduce inflation and liberalise the financial system, which was heavily controlled (credit ceilings, interest rate controls, and differential reserve requirements).

The liberalisation of the banking system led to a significant decline in inflation, positive real interest rates, and ultimately to the decline in FCDs. Peru provides a brilliant example of how market driven de-dollarisation defeats dollarisation based on the prudential regulations alone.

Zimdollar impact

The country has retained the option to print its own money, gain its ability to directly influence its economy, including its right to administer monetary policy and any form of exchange rate regime, and the ability to collect “seigniorage”, the profit gained from issuing coinage. The following drawbacks are associated with the return of the Zimbabwean dollar given that the country failed to attain macro-economic stability first:
l The country’s economic climate going forward will become less credible as the possibility of speculative attacks on the local currency and capital market virtually reappears;

l There will be increase in risk of inflation (we are now experiencing it as we speak) and devaluation;
l Return of the Zimdollar is creating negative investor sentiment, almost reigniting speculative attacks on the local currency and the exchange rate;
l Continued operation of the parallel foreign exchange market; and
l Inefficiency in the interbank market (made of only demand).

Way forward

Given that Zimbabwe has introduced the Zimdollar without meeting the necessary conditions of de-dollarisation, it cannot withdraw its policy announcement so as to avoid the problem of policy inconsistency.

Rather, the following raft of stabilisation measures must be put in place to bolster the newly introduced Zimdollar:

l Government should embark on macro-economic stabilisation policies aimed at taming inflation, as done in Israel and Egypt. To blunt exponential price increases, Government finance must change in a credible way so the public believes there is real commitment to eliminating abuses that caused rapid inflation and currency devaluation in the past. Government should respect the importance and impact of expectations to avoid another dark transition;
l Government should embark on full financial liberalisation. This involves freeing banks from administrative controls on the determination of interest rates makes it more likely that domestic real interest rates will be positive (this was done in Estonia, Haiti, and Hungary); and
l Government should ensure that the domestic payments system is in local currency payments at terms which are at least as favorable as those for foreign currency payments.

Dzama, principal economist at National Economic Consultative Forum. These weekly New Perspectives articles are co-ordinated by Lovemore Kadenge, immediate past president of the Zimbabwe Economics Society. — or mobile +263 772 382 852.

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