Inflation risks in the outlook

THE Reserve Bank of Zimbabwe (RBZ) in its 2021 Monetary Policy, targets to control inflation to below 10% by December 2021 in order to support the economic growth rate of 7,4%.

Tafadzwa Bandama
economist

The Bank hopes to achieve this inflation target by consolidating the monetary targeting framework, sustaining the foreign exchange auction system, and maintaining financial sector stability supported by fiscal discipline.

A favourable agricultural season is also expected to boost food production and exert downward pressure on inflation. Increased production, import substitution and export promotion are all expected to render stability to the exchange rate and subsequently inflation.

The RBZ will implement the following measures to reduce inflation, which is currently in the three digit levels annually.  Zimbabwe’s year-on-year inflation rate was 240,6% in March 2021. The RBZ implemented the following policy measures:

The Bank policy rate for overnight accommodation from the current 35% to 40%;

The Medium-term Bank Accommodation (MBA) rate for the productive sector was also hiked from 25% to 30% per annum;

Statutory Reserves were increased from 2,5% to 5% for demand and/or call deposits and maintained 2,5% for time deposits to facilitate long-term lending in the medium-term.

This is meant to curtail speculative borrowing in the economy and at the same time support the productive sector through lower interest rates.

The Reserve Bank has also maintained the monetary targeting framework for the year 2021, which will be achieved by reducing the quarterly reserve money growth from the 25% quarterly target in 2020 to 22,5% per quarter in 2021.

However, there are a number of challenges that should be overcome in order that the economy achieves the envisaged single digit year-on-year inflation rates.

The risk of missing the targeted money supply growth remains elevated. If money supply growth is excessive, this can potentially frustrate the current efforts of attaining single digit inflation levels. The figure below illustrates the relationship between money supply and exchange rate and tells us how sensitive the exchange rate is to money supply growth.

It is important to note that even if the central bank deploys open market instruments to mop up excess liquidity, the damage will have already been done on the exchange rate front. For example if liquidity is injected in the morning, even if it is mopped up later that day, a temporary presence of liquidity in the market can drive the exchange rate. And we know that the exchange rate once having risen is very sticky.

One of the major risks to money supply growth could be from purchases of the maize harvest from farmers. The risk is manageable if money supply is monitored extremely carefully and maize purchase payments are done in small doses linked as closely as possible to offtake from the maize millers.

The increase in money supply has a disproportionate pass through effect on exchange rate depreciation and subsequently price formation in the economy. The figure below shows the widening gap between the official and parallel market exchange rate.

The sustainability of the Auction System – the supply side to the auction is still an issue given that it is currently dominated by the Central Bank. Any challenges to the forex supply chain pose a risk for the sustainability of the auction system, which will cause the parallel market to rise again.

The parallel rates have been firming gradually and are now at US$1 to ZW$130. Many players in the informal sector are not eligible to come to the auction due to lack of supporting import documents and minimum bid amount, but their demand for forex is both real and urgent.

So they continue to rely on the parallel market. While the auction is managing to satisfy the short-term needs of companies, the medium to long-term forex requirements for re-tooling and refurbishing need more long term and affordable external lines of credit, which cannot be obtained through the auction.

Adjustment of statutory obligations fees, rates and taxes at both central government and local government level in line with economic developments is causing cost-push inflation. Examples are Zesa tariffs, municipal rates, import and export taxes, etc. Government agencies are adjusting prices by huge mark ups and this could see inflation creeping upwards as businesses will push these costs to the final consumer.

While this transition might be critical, it will have some push on effect on inflation in the short term. In the long term, it will assist to realign government pricing to market prices and reducing the need to for government to borrow or utilise the overdraft facility with the RBZ.

Imported inflation is a risk emanating from a rise in global crude oil prices. Fuel extends its tentacles to every sector of the economy and a rise in crude oil prices will affect price formation in the economy. A rise in global food prices as has happened with soya crude oil is likely to feed into inflation.

To illustrate the impact of global food prices on the local economy, the recent hike in the price of crude soya bean oil on the global markets affected the prices of stock feed and related meat products to include beef, chicken and pork. Cooking oil prices also had to increase to match adjustments in raw material prices as illustrated in the table.

The use of expensive alternative power sources during electricity shortages pushes prices up. The output gap in terms of local consumption and production has necessitated electricity imports.

Imported inflation is likely to stem from the increase in Eskom energy imports prices from the South African power utility as we import roughly 15% of energy from South Africa. This follows a High Court judgement that has ordered a R10 billion (US$671,5 million) to be added to Eskom’s allowable revenue according to Bloomberg.

This revenue will be collected from customers in the 2021/2022 financial year. This move will result in a 15% increase in electricity prices and Zimbabwe will import this inflation through energy imports.

Once this happens, there will be an all-round effect of prices increases throughout the economy. This electricity import trend is likely to be reversed in the long term given the energy projects that are in the pipeline.

South Africa could experience a general price hike in the economy due to increases in the prices of oil and electricity. South Africa is Zimbabwe’s major trading partner, and any price increases in our Southern neighbour will have a contagion effect on prices in Zimbabwe through imported inflation.Covid-19 and public health response measures will affect prices in future due to logistical constraints in global supply chains. Bottlenecks at international borders might result in shortages of raw materials and finished products, which might result in price hikes to match demand.

This is actually the current case with increases in the prices of stock feed where logistical bottlenecks experienced mainly the Beitbridge boarder post have resulted in price increases. Besides, it may become more expensive to import raw materials from source markets due to regionalisation and nationalisation of some inputs for domestic industries.

The world has experienced this especially in the pharmaceuticals and medical supply sector, where countries have suspended the export of raw materials in order to produce products for domestic use in the fight against Covid-19.

Adverse inflation expectations due to the hyperinflation experience of the first decade of the New Millennium cannot be ruled out as the premium between the official and parallel market exchange rates widens.

Forward looking economic agents will hike prices in anticipation of higher inflation in future. Though the country is expecting a bumper harvest in the current agricultural season, the economy is existing in a low output equilibrium, which dampens disinflation efforts.

Low Capacity Utilisation with an average of 47% in the manufacturing sector in 2020, engenders a high cost environment and supply shortfalls, leading to price increases. This affects the supply side and foreign currency generation capacity of the economy. Wage demands across the public and private sectors, as the economy remains largely indexed to the US dollar are likely to cause inflation in 2021.

Adverse inflation expectations by economic agents, which continue to be sustained by the experiences of the past hyperinflation era also cause inflation. Wage demands in the economy are not necessarily in response to inflation alone, but also to the structural erosion of wages and incomes occasioned by a series of currency and exchange rate reforms since October 2018.

Exchange rate adjustments from 1:1 to 1:3 in October 2018 which was confirmed in Feb 2020 inter-bank; to 57 in June 2020 (first auction); and to current levels of 1:84 represent a real and systematic erosion of the value of wages in the economy.

Recommendations for inflation control include achieving more efficiency on the foreign exchange auction market, so that all businesses (SMEs and large corporates) access foreign exchange on a timely basis.

Staggered adjustments of utility prices and other state owned enterprises should go a long way in controlling inflation. Subsidies, especially for social safety nets should be adequately budgeted for to prevent their destabilising effects on the economy. Government should consider a Subsidies Policy which will assist in reducing the effects of the associated inefficiencies on the economy.

The current rollout of a coronavirus vaccination programme is key for economic growth and dampening inflation expectations by enhancing production and productivity across all sectors of the economy.

Import substitution across major sectors such as agriculture — entrepreneurial initiatives in horticulture and livestock production (increase food production and reduce pressure on foreign currency) noting that major beneficiaries at the Currency Auction are in the food sector.

Investing in infrastructure directly linked to production e.g. Electricity, mechanisation, water harvesting is key. The energy import bill can be reduced by investing in alternative sources of energy.

Since the adjustments of fees, rates and levies by central and local government are inevitable, a gradual adjustment of the realignment process in government fees and levies should help dampen inflation.

Expansion of the economy, as it rises from negative growth rates to take up unutilised capacity, is usually associated with inevitable prices increases. As the country forges ahead with developmental aspirations we should be wary of blind spots risks which may negatively influence the disinflation programme.

Bandama is an Economist by profession and training. She possesses an in-depth knowledge and understanding of Macroeconomics and Real Sector Economics which skills she obtained while working for public and private entities. Her portfolio brief includes economic research, data analytics, policy formulation, analysis and advocacy. She is currently the Chief Economist of the Confederation of Zimbabwe Industries and writes in her own capacity.