What is a Currency Board? What are the main functions of a Central Bank?
For Zimbabwe, how will replacing the later with the former improve or infringe on these functions? Is a Currency Board effective dollarisation and surrender of economic independence and national sovereignty?
Is the Reserve Bank of Zimbabwe’s (RBZ) propensity to practice economics of politics the harbinger of economic afflictions, like high inflation, or is the practice a necessary evil in the face of drying investment, economic sanctions, ebbing local productivity and singular exports of primary un-beneficiated raw products? How is either of the Currency Board or the Central Bank critical in ameliorating the specific adverse macro-economic situation Zimbabwe finds itself in at present? What of the Rand Money Union? Has the RBZ Forex Auction System failed?
What is my considered assessment of the Zimbabwe’s monetary situation? What are my recommendations?
All these questions are answered and expounded at length below.
Zimbabwe is back trending in global news for all the wrong macroeconomic news. Year on year inflation in June 2022 short up to 132% after being recorded at 97% in May 2022. The official exchange for the local currency and the United Stated Dollar (USD) for the same period depreciated from ZWL109.00 to ZWL309.00 to 1USD meaning ZWL lost 65% of its value, or inversely, those holding ZWL could now purchase only 35% of what they could only a few weeks earlier. This phenomenon in itself feeds into inflation expectations worsening the scourge.
There’s high levels of foreign and domestic debt, insufficient infrastructure, policy inconsistencies (the levying and rescission soon after of customs duties on basic commodities imports and the order to ban banks from lending and sudden repeal of that order a few days later come to mind), political instability, corruption, and low capacity utilisation are among the top difficulties facing the economy, according to the BTI-Project research.
Zimbabwe’s economy is primarily informal as a result of its economic troubles, with an estimated 90% of the population working in the informal sector. The forced shut downs necessitated by Covid-19 caused untold haemorrhaging of the economy which is still yet to fully recover.
Public companies (parastatals) are faring no better, if at all, as they are among the poorest performers and have become the hub of rent-seeking activity, with their contribution to the economy falling from roughly 60% to around 2% of GDP, and 70% of parastatals being classified technically bankrupt.
According to the World Bank, the number of people living in severe poverty increased to 6.6 million in 2019, more than double the amount in 2011. Extreme poverty levels reached 40% of the population in 2019, up from 30% in 2017, with urban poverty increasing more (from 4% to 10%) than rural poverty. And it is scary to contemplate that the situation has deteriorated further from then. We await the new numbers.
And the news get worse for Zimbabwe as an upheaval in the global economy due in the main to conflagration in Ukraine will exacerbate an already dire home situation. The war in Ukraine has cut off a key supplier of wheat to Zimbabwe and also reduced supplies of farm chemicals for local crops.
A World Bank report named “Stagflation Risk Rises Amid Sharp Slowdown in Growth” published on the 7th of June 2022 states that global growth is expected to slow from 5.7 percent in 2021 to 2.9 percent in 2022, far less than the 4.1 percent forecast in January. As the war in Ukraine hampers business, investment, and trade in the short term, pent-up demand fades, and fiscal and monetary policy support is reduced, it is likely to linger around that rate in 2023-24.
As a result of the epidemic and the conflict, the level of per capita income in emerging nations will be roughly 5% lower this year than it was before the outbreak. So Zimbabwe as a net importer will catch the cold as global powers sneeze.
The picture is as clear as can be. Predicaments all round. But challenges are there to be surmounted and overcome. The central bank is right smack in the middle of this dilemma and the nation waits with bated breaths as to what monetary pronouncements it will give to help arrest runaway inflation, and ultimately the economic ills alluded to above.
But is it fit for purpose?
Murmurings are now growing that it is not. Some are voicing that the RBZ needs to be strategically and structurally reformed urgently. Yet others are calling for its complete replacement with a “Currency Board” or mortgaging monetary policies to South Africa by joining the Rand Money Union.
What is a Currency Board?
A currency board is a division tasked by a country’s finance ministry to abide by an extreme form of a pegged exchange rate. The nation’s central bank, if allowed to subsist alongside the currency board, is stripped of control over the currency rate and money supply (printing).
Frequently, this monetary authority is given explicit orders to back all local currency units in circulation with foreign money. In such a case the modus operandi is referred as a 100 percent reserve requirement when ALL local currency is backed by the chosen foreign currency used as a peg. A currency board works in the same way as a strong version of the gold standard since it requires 100 percent reserves. Thus, a currency board is often needed to maintain reserves of the underlying foreign currency in addition to a set exchange rate.
Automatic stabilisers will prevent any substantial outflows of foreign money in the case of a “testing of the system,” according to currency board architects. Adjustments in money supply within the currency board country – a contraction in the case of a flight into the anchor currency – lead to interest rate changes, which in turn motivate investors to shift their funds. While this is effectively the same process that functions under a fixed exchange rate, the implied exchange rate guarantee in the currency board regulations assures that the required interest rate fluctuations and the resulting costs to the economy are kept to a minimum.
What are the main functions of a Central Bank?
In another publication I’ve already made I described the functions of a central bank. I quote here from that piece verbatim:
These include, among others, to issue money (notes and coins) and ensure people have faith in notes which are printed like protect against forgery. Printing money is also an important responsibility because this has a direct bearing on inflation, which is the general rise (or decline) of prices over a given period of time.
The central bank should independently be the supervisor in chief of all commercial banks staving them off of malpractice to avert their collapse with depositor funds. It thus becomes a lender of last resort to these banks as well, if need be, when they get into liquidity shortages, maintaining confidence in the banking system.
It is also a lender of last resort to the government, borrowing on the open market through selling bonds and treasury bills (which are simply loans to the central bank at a pre-set interest payable in a pre-set time) to finance government projects and needs. The phrase “of last resort” in both occasions should be emphasised.
A reserve bank does inflation targeting since low inflation helps to create greater economic stability and preserves the value of money and savings. This it does by controlling how much it should print guided by complex macro economic indicator calculations that consider such hard factors as Gross Domestic Product (GDP), productivity, and balance of payment, current national debt, Consumer Price Index (CPI) and the like. To shift spending habits and encourage or tighten these it may increase or decrease money interest rates.
Other abstract factors are considered like national objectives and poverty levels. The ultimate aim is such that there should be just enough money to stimulate and sustain economic growth, therefore improve people’s welfare, achieve national economic targets like growth and unemployment, as well as control money in circulation without negatively affecting productivity such that inflation ensues.
Meanwhile, the number of participants in the Auction System has dropped dramatically, from an average of 450 last year to just 285 this year, tracking the reduced amounts being traded at present. The System is on the bring of complete failure.
For Zimbabwe, how will replacing the later with the former improve or infringe on these functions?
We have a growing number of economic commentators advocating for disbanding of the RBZ because it is incapable of being reformed and needs to be replaced by a Currency Board and Financial Services Regulator. They say, rightly so, that Central Bank cannot be both a player and a referee in the market while also amassing debt at the cost of taxpayers (now at a staggering US$5 billion or 25% of current GDP).
Over that, RBZ has allowed commercial banks to “create” close to 85% of all local money supply (M3). When one uses the RBZ exchange rates, subtracts USD from M3, and then calculates the ratio of local bank loans to local M3, one finds that commercial banks have “printed” over 85% of all local ZWL in circulation in the previous 30 months. This is estimated to be an unsustainable 50 times growth! During the same time global money supply has gone up by under 0.5%.
Surely how did the RBZ have this happen under its watch? More pertinently, how did the abrupt decision to ban banks from issuing out loans help matters? No wonder this was reversed within days. More importantly, all this feeds into the argument for a Currency Board where such could not happen as “printing” is strictly controlled and aligned with reserves of the anchor currency.
Now this is significant. This is the very topic of discussion for this analysis piece. Is replacing the Central Bank with a Currency Board the panacea to Zimbabwe’s monetary woes?
Considered analysis will show that the RBZ, though beset by a multitude of challenges, some self inflicted, is still a better option with reforms than a Currency Board.
Only if the country has enough official foreign exchange reserves to cover the whole narrow money supply can a Currency Board system be considered credible, and in Zimbabwe’s case there isn’t adequate cover. Under the system, financial markets and the general public may be certain that every local currency bill is backed by an equal amount of foreign currency in the government’s treasury.
If this were to be followed then surely we are suggesting sudden shrinking of a US$26 billion to be serviced by under US$200 million M3 USD supply which is in official coffers. There just isn’t enough trust in the system to bring all informal money into the system and form a viable currency reserve. It needs time. Time that Zimbabwe will not have as the numbers are dire. This will therefore be equivalent to adopting an ultra-contractionary monetary policy with similar contractionary implication for the real sector.
Also, a Currency Board might be restrictive, particularly for Zimbabwe with fragile financial systems vulnerable to economic shocks. With a Currency Board in existence there is no central bank to act as an unrestricted lender of last resort to financially distressed institutions. It may, at most, provide loans from an emergency fund put aside at the time the currency board is formed or financed over time using central bank earnings, but the rigidity will soon exacerbate Zimbabwe’s situation than improve it.
So the constant juxtaposition of Zimbabwe to Singapore, where they have a Currency Board in operation and succeeding, fails to acknowledge the massive differences in economic fundamentals between these two countries.
Another cost of a Currency Board in Zimbabwe could be the inability of the government to use financial policies to stimulate the economy, such as interest rate or exchange rate adjustments; instead, under a Currency Board, economic adjustment will have to be made through wage and price adjustments, which can be both slower and more painful.
Because a Currency Board system uses a hard peg of the local currency to a chosen “anchor” currency, and with all but a few who adopt the system choosing to peg against the dollar, it is not hard to see why this system is viewed as dollarisation by another name.
Zimbabwe faced its biggest current account deficit during dollarization, which is a hard peg like a Currency Board, while the non-debt producing side of the financial account remained relatively empty, rendering the balance of payments unsustainable. Additionally, the USD’s global acceptance, combined with local market uncertainty, resulted in net outflows, as investors sought to store their receipts outside of the nation. This will very definitely be the case once more, with the Currency Board depriving local business of reinvestment money until market confidence returns. But, how long will this delay last, and at what cost to the economy?
Admittedly, an immediate and noticeable effect of a Currency Board (read dollarization) will be price stability and reduced inflation in the short term as fundamentals track fundamentals of the anchor currency (the USD or Rand). But, dollarization deprives a government of a potentially strong instrument for financing public spending: the ability to generate money, often known as seigniorage.
Seigniorage, is technically defined as the difference between a currency’s nominal value and its cost of production, and can be seen as an additional source of revenue for the government beyond what can be obtained by taxation or borrowing from domestic or international financial markets. What can’t be paid for through tax collections or borrowed money can, in effect, be paid for seigniorage, which is all lost under Currency Board system.
Is the Reserve Bank of Zimbabwe’s (RBZ) propensity to practice economics of politics the harbinger of economic afflictions, like high inflation, or is the practice a necessary evil in the face of drying investment and economic sanctions?
I have already discussed this very topic in another analysis piece, suffice to recap here for expediency. In there I aver that the RBZ has become very political, predominantly from the tenure of Dr Gideon Gono. In an interview with Alpha Media Publisher Mr Trevor Ncube, he actually said he worked under political instruction. By insinuation, he indicated to Ncube in the discussion that his hands were tied and went on to quote sections of the RBZ Act [Chapter 22:15] and the Finance Act [Chapter 23:04] that gave power to the president to order the fiscal activities.
It is neither here nor there if he had become politically powerful or he was just a docile dependent appendage of politics, the final analysis will always be that him and the RBZ eventually practiced economics of politics as the lack of autonomy (or the political interference, whichever applied) led to wrong decisions which exacerbated Zimbabwe’s dire economic situation.
In the interview Dr Gono suggested that an RBZ governor should be picked by his peers and report to parliament not to the Finance Minister. Though this is well intentioned as its the august house anyway that sets the laws of the land and thus likewise can supervise the land’s purse holder in form of RBZ, I do not see any leader diluting his or her power and allowing parliament to usurp such a central institution from their grasp.
Notwithstanding the fact that the very parliament may not have its sympathies with him or her as it may be made up of opposition party members regardless of their composition or their numbers.
The advent of economic sanctions make the idea hard to sell to politicians to act only directed by economic indicators where they argue being hamstrung by sanctions. Something will have to give. Elsewhere in this opinion piece I advocate for partial privatisation of the Reserve Bank of Zimbabwe as one possible solution.
What of the Rand Money Union?
By adopting the Rand, Zimbabwe would effectively become a member of the Common Monetary Area (CMA), which includes South Africa, Lesotho, Swaziland, and Namibia. The CMA is a legally binding agreement that imposes strict, but reasonable, responsibilities on all parties involved. Given Zimbabwe’s present economic state, two of these commitments are impossible to envisage being met.
Article 2 of the agreement contains the first duty, which requires signatory governments (excluding Swaziland) to back up local currency issues with foreign reserves and prohibits the monetisation of fiscal deficits. And Zimbabwe would relinquish control over its monetary and exchange rate policies while also limiting its fiscal policy options. Zimbabwe would be left with a very limited budgetary room in which to manoeuvre in order to get out of its current predicament. The use of an inflated currency (compared to its condition) would have the immediate impact of reducing the competitiveness of the country’s exports, thereby killing any export-led attempt at growth.
Furthermore, any economy in Zimbabwe’s condition that wishes to begin on an economic recovery programme would be well advised to have access to both fiscal and monetary policy. This is due to the fact that combining the two policies in a single well-coordinated manner is essential for success.
Has the RBZ Forex Auction System failed?
The RBZ Forex Auction System, although it started brightly, is facing a myriad of challenges. I have been one of the staunchest proponents for the system appearing in multiple TV interviews exalting its advantages. However, like any system, it is only as good as how its implemented. It appears these hurdles are not so much structural but self inflicted operational choices.
Case in point is allocation of unavailable foreign currency. At the time of writing, the Central Bank was seating on a backlog of US$135 million. Simply put, the central bank has allocated 135 big Ms which currently have not yet been brought to the auction by sellers. This not only clogs supply chain pipeline as needy importers are starved of the foreign currency to keep the cogs of Zimbabwe industry machinery turning, but also saddles RBZ with an unnecessary debt.
At time of allocation the exchange rate was US$1:ZWL165.99 and today the RBZ “rate” is at US$1:ZWL326.71. What this means is the central bank has now to folk out 21.7 billion ZWL MORE to purchase the same US$135 million and fulfil previously unfulfilled allotments. This means more printing. More inflation pressures!
What is my considered assessment of the Zimbabwe’s monetary situation?
2021 Nominal Gross Domestic Product (GDP) is just above US$26 billion. Current money supply (in percent of GDP) is 24% – 85% of that controversially “created” by banks in loan books. Official exchange rate at time of writing was 1US$:326ZWL with parallel market hovering around 1US$:680ZWL. Exports for 2021 were US$6.6 billion while imports were US$7.1 billion bring a trade deficit of over 7%. Internal debt is at 70% of GDP and external debt is at 66% of GDP for a total debt burden of 136% of GDP.
In a phrase, my considered assessment of the Zimbabwe’s monetary situation is “critical but hopeful.”
What are my Monetary Policy recommendations?
1. Make RBZ apolitical
There is a reason why In April 2016, the International Monetary Fund (IMF) in its conference entitled “Rethinking Macro Policy” the general consensus found that central banks should retain full independence with respect to traditional monetary policy. Technical decisions need technical reasoning hence should remain undiluted as technical processes.
After all, politicians are driven by need to please supporters, with one eye always on remaining in power (plus the ever-tempting desire to line their own pockets at the expense of their citizens’ purchasing power). Their assessment is not always for the economy but for personal survival.
So, ideally, RBZ governors must be nominated by parliament and report to same, not to ministry of finance. Over and above that, some of RBZ’s equity should be sold to private players whose interests are purely economic. Examples of privately owned central banks include the South African Reserve Bank which was privatised from its inception in 1921, the Reserve Bank of New Zealand nationalised in 1935, Bank of France and Bank of England both nationalised in 1946, Bank of Spain1962, Bank of Portugal 1974, National Bank of Angola 1975 and the National Bank of Austria privatised in 2010, among many others.
2. Enable Bureau du Changes to participate
Allow the Bureau du Change system to compete with the street by enabling them to purchase and sell money. This would allow us to observe and track real exchange rates in this market, which should continue to function alongside the official sector represented by the auction;
3. Allow Forex sellers to sell at their asking price
All commercial banks should be required to sell any surplus foreign exchange that their account holders have asked them to sell through an auction at the prices set by their clients. Whoever is asking for too much will not make a sell and adjust accordingly. This allows market price discovery and destroys the parallel market. This also will disclose the size of the demand for hard currency at rates greater than the auction’s weighted average;
4. Move Fidelity Printers gold purchase account funds from RBZ account to Auction System
To assist fulfil demand, ask the Reserve Bank to stop buying gold on its own account and shift funds to the auction. This will free up between $800 and $900 million every year for the auction, increasing currency available by a third;
5. License an Investment Bank
RBZ should license an Investment Bank that’ll make direct infrastructure and programme investments in the country, offer financial guarantees for the nation where it needs to borrow and leverage its resources (a practice which has been banned by the International Monetary Fund – IMF – so countries can not practice it). Thus the Investment Bank can offer that guarantee instead through a very broad range of private sector partners allowing it to work with the market rather than to replace it. In financial terms, this bank will offer collateralised debt obligation, or surety for the nation using vaulted resources. It may even purchase, store, and invest gold, from the central bank or from producers depending on licensing, and then be able to “reserve” this gold with the RBZ.
There is an estimated US$2 billion in cash in people’s hands as they shun the banking system. This Investment Bank can be allowed to take deposits in ZWL against specific gold reserves (allocated deposit) and walk away with serialised deposit certificates linked to specific gold bars. They can redeem their certificates, with notice, at the current gold price at time of amortisation. That way there is no loss of value and confidence is brought into banking along with the “mattress cash.”Over and above that, this system relieves the inflationary pressures even in USD as people chase the greenback for rent seeking purposes and as store of value.
6. Treasury to do Letters of Credit, not RBZ
Transfer the Reserve Bank’s clearing obligation for RBZ Letters of Credit to the Treasury. The Reserve Bank spent $1.2 billion on this in 2019. In the medium run, these Letters of Credit should not be reissued unless there is a genuine emergency. Letters of credit should be handled by the banking sector, with the auction handling the servicing. The central bank’s capacity to fund the auction should be boosted much more as a result.
7. Strengthen the role of Capital Markets
Interestingly, the RBZ and the government have been too concerned about trade balances when it comes to the exchange rate. The concept is to increase exports while reducing imports, resulting in a surplus. When all other variables are in place, there’s nothing wrong with it. Despite continuous trade deficits, several economies have maintained a stable currency. United States of America (-2.3%), United Kingdom (-4.2%), Canada (-3.2%), Mexico (-2.3%), Brazil (-3.6%), and India (-3.6%) are other examples (-2.6 percent ). Although trade balances are crucial for currency policy, they have a limited influence on currency stability. The way to go is to strengthen the role of Capital Markets, which in earnest has sustained the Zimbabwe economy, without whosecovering role, most industries would have failed a long time ago.
Yes I said it.
Trade flows represent for a very small portion of global foreign exchange movements, according to the numbers. To give an idea, US$6.7 trillion on average is how much money is moved in currency markets on a daily basis. Global commerce in other commodities and services, on the other hand, barely scratched $25 trillion in the whole 2021. This clearly shows that the majority of forex flows are capital rather than trade-related.
Zimbabwe ought to be deeply looking at its capital markets policies. What stops the country having long term plans to establish an African currency clearing house for routing African transactions than have them pass through London Currency Market first, as well as a Securities and Precious Metals Exchange right on African soil? Anyone asking why the Victoria Falls Stock Exchange which was meant to be a forex trade post still has only two listed counters a year after inception? Would that still be the case had it been made foreign exchange market with clearing ability?
8. Eliminate arbitrage
The biggest arbitrage affecting fiscal space in Zimbabwe is the artificially depressed exchange rate. It goes without saying that the temptation is huge for a business to apply and be allocated forex which they get at half the parallel market rate and immediately offload it in at a return of a 100% without any importation or production. This ultimately kills industry which should be growing to make exports or substitutes for imports which both ease pressures on the demand for USD. Let the forex exchange rate truly float. Costs have already priced in the parallel replacement rate anyway so it can’t harm the economy any more than is already obtaining.
9. Readjust Interest Rates
The RBZ can match interest rates to inflation. At present we have businesses borrowing cheap money from banks and buying securities for speculative reasons then offloading their returns on the parallel market to convert the easy income into USD, further exacerbating the parallel rate situation. Intentions to borrow should be tied to productivity, not speculation.
10. Additionally
In addition to the aforementioned steps, the bank should progressively transition to just selling what it has available in cash at auction each week, with clearing times reverting to seven days by the end of the year. If there is a true hard currency surplus, the Monetary Policy Committee will have to decide at what level they want exchange rates to settle and begin buying foreign currency for national reserves.
In conclusion, many nations’ Currency Boards have had excellent economic benefits, both in terms of lowering inflation and stabilising expectations after extended periods of hyperinflation. As a result, the advise for Zimbabwe to adopt the same from some circles is not surprising. However, the nation should be wary of such requests for at least three reasons.
First, the success stories mostly represent the experiences of smaller nations with currency boards, which have yet to be adequately shown in bigger countries. And in bigger nations by GDP these nations have had to endure close to minimum four decades of financial pain before effective measurable results. Time Zimbabwe does not have as it already tittering on the precipice.
Second, and perhaps more importantly, the effective installation of a currency board system necessitates time for consensus building as well as careful preparation and implementation of significant legislative and institutional reforms. In short, political agreement. In the absence of which the strict confines on a Currency Board will be hard to adhere to and thus without the cover of a central bank and with a misfiring currency board the results will be worse than having a faltering central bank.
Third, the government has a fragile banking system whichmay need to rehabilitation first before adoption of a Currency Board. Removing the RBZ and its financial cover may expose the few banks still in operation in the country to jeopardy. In Zimbabwe, there are 13 commercial banking institutions, five building societies and the one investment bank went under curatorship. A dollarising country forfeits a formal lender of last resort, since in adopting a foreign currency it also gives up a central bank capable of discounting freely in times of financial crisis. Domestic banks may thus be more exposed to potential liquidity risks. In Zimbabwe’s circumstance, the requirements for creating a Currency Board are too risky time sensitive to do it during a macroeconomic crisis, after all.
We all agree the RBZ is faltering. We all must agree it is still not yet beyond redemption, however. Adopting a Currency Board would be akin to plugging a round hole with a square piece for now. Either way, tough choices have to be made and made now.