The following are pondering notes on what risks and considerations should guide the continued easing in of a local currency
HARARE – (FinX) – The glue to credit based capitalism is confidence. In a global financial system of fiat currencies, the disparity between one currency’s desirability and another’s is largely confidence. Currency confidence refers to three functions as a medium of exchange, store of value, and as a unit of account. Accordingly, when a currency is demonetized in the manner that the Zimbabwean Dollar was after hyperinflation, it would have failed all three uses. As authorities lost monetary control, economic agents impulsively transitioned to a global reserve, the USD. Government announcing a multi-currency regime as legal tender in 2009 merely affirmed confidence in the local currency to be nil.
When introducing a new local currency, like Zimbabwe’s authorities in present time, there should be no implicit agenda to achieve the three currency functions, in their absolute sense, over the US dollar. A nascent local currency should progressively accumulate its own confidence, and not be in deliberate contest with a reserve currency. The nuance here matters two fold; (1) for policymakers and citizens alike to realize that a new Zimbabwean Dollar is not meant to push out the US dollar, and (2) to acknowledge that its predecessor local currency was not pushed out by dollarization!
Local currencies cannot displace reserve currencies, even in their own economies. Domestic currencies can only complement reserve currencies, with these local currencies consistently working to retain their own appropriate confidence! Grasping this perspective helps to cognitively get over the exaggerated impossibility of a country dedollarizing its economy. Not only is this empirically untrue, it creates an incorrect context, one which assumes that reserve currencies are formidable competitors and hindrances to local currencies.
Circumstances in which countries dollarize, or dedollarize, vary around the world. They happen quite frequently too. While in 2009 ten countries were officially dollarized, as per legality of tender, according to the IMF’s International Financial Statistics, 47 countries had foreign currency deposits exceeding 30% of total deposits, which is practically dollarized. But none of these instances are caused by competing dynamics between reserve and local currencies. Actually, as economies dollarize and dedollarize to varying extents, the relevant challenge is the difficulty that authorities face in managing appropriate local credit in their financial systems, and subsequently, the real exchange rates of their local currencies. Consider the following scenarios:
No control over quantity of reserve currency
Dollarization is the measure of the quantity of reserve currency in a country’s financial system, relative to the local currency. In 2008, many eastern European countries inadvertently dollarized prior to their entry into the European Union. Sound economic reforms and growth that preceded the political pathway to the EU promptly built appeal to credit from continental Europe. As foreign currency deposits grew, it effectively dollarized the regions financial sectors preemptive of authorities’ discretion. The inverse also happens. As economies go through steep downturns, de-industrialization and output slumps pose loss of household and enterprise creditworthiness, leaving masses of people desiring to save depreciating value in reserve currency such was the case in Mexico in 1998, Angola in 2001, and Turkey in 2007. Economic agents in these countries impulsively grew their foreign currency deposits (FCDs).
No control over real exchange rates
Dollarization can also affect exchange rates. Sheer flows of reserve currencies, whether inward or outward, can influence the real value of a local currency in a manner which many authorities struggle to control. Due to skepticism in the region’s output potential, in the first six months of 2018 in Latin America, capital inflows fell to USD$46 billion from USD$110 billion the same period in 2017; more than 100% disparity. This dedollarization happened so fast, and sharply depreciated the region’s currencies with blinding speed. Inversely, the Asian financial crisis that came to a head before the turn of the millennium was preceded by tides of capital inflows that flooded Asian financial markets. On the hopes of commodity booms, cheap labour industrialization, and urban modernization, the region attracted significant inflows, effectively dollarizing these economies. But this confidence was overly optimistic, greedy maybe, turning into a bubble that overly wagered on the output capacity of these economies. Accordingly, the regions’ currencies were overvalued. Before authorities could respond, speculators pounced. Authorities took years to re-find sustainable exchange rate equilibriums.
What is going on in these situations? And what, particularly, eludes authorities from having greater control over the fate of their domestic currencies? An admissible presumption is that underlying these forces of foreign exchange markets is credit; specifically, the imbalance between domestic and global credit. So perhaps it would be wise to reflect on what credit variables authorities should strive to manage, so as to have better discretion on the level of dollarization and real exchange rates that a Zimbabwean dollar can sustain.
There’s never money so bad to chase away good money
But before that, a prominent myth must be debunked. Many Zimbabwean commentators are impressionable to Gresham’s law of commodity money that states “bad money drives out good money”. Commodity money emphasized the value of the copper, silver, nickel that minted coins; unlike modern paper notes and digital units of currency that make the commodity value of currency negligible. Sure, in context of rigid merchant economies of the 15th and 16th century, Gresham’s law may have been befitting. In modern credit finance of fiat currencies, a more moderate perspective should articulate that “complementary money makes open economies function, and local currencies cannot drive out reserve currencies”. The good money, which is reserve currency, never goes away. That is the purpose of it being a global reserve. For instance, when Zimbabwean authorities introduced RTGS or bond notes, US dollars were not driven out for reasons different to already occurring outflow trends. This would be the same for a full on Zimbabwean dollar. Flows of good money, tell a story of credit, not of bad money.
Having a pulse on credit
A local currency can only complement a reserve currency when the domestic economy retains sustainable credit levels. Credit is the ability to access capital now, on the promise of the work an individual or economy is expected to do in future. A nation’s credit outlook is likelihood that future productivity can pay back creditors over time. This is fundamentally what the global financial system is all about, allocating capital to appropriate credit outlooks.
Capital invariably comes from already wealthy or productively superior entities to borrowers usually in developing economies. The challenge is that developing economies struggle to balance the credit in their economies with their productivity capacity. This is typically what compromises the confidence of their domestic currencies.
By attracting reserve currency either as debt, equity, remittances, or FDI, developing economies would be in effect taking on credit at highly benchmarked productivity expectations, which they then struggle to sustain. Consider KFC Zimbabwe at the micro-level. It is a franchisee of Country Bird Holdings (CBH), a South African entity listed on the JSE. But, CBH merely has rights from YUM Brands, listed on the NYSE. YUM Brands prices its earnings and yield targets in United States Dollars. This means that to operate profitably and settle its franchise fees, KFC Zimbabwe’s stores are dependent on the domestic economy’s productivity to sustain the benchmark of its foreign creditors. Initially, break even points for KFC Zimbabwe were estimated at USD$5.9 million a year. At the macro-level, the Government of Zimbabwe has to service its foreign debt that is priced in reserve currencies. Just like most developing country governments, it is dependent on domestic tax revenues, priced in local currency, to settle reserve currency coupons. This is basically an act of balancing domestic productivity to global productivity as well.
Granted, this perspective of comparing productive credit perhaps traces just one underlying variable of currency confidence. But, I would suggest it is likely the most significant variable. More popular variables may include the demand and supply of foreign currency to settle international payments. But again, isn’t the ability to make payments, both by households and corporations, dependent on the productivity that determines household and corporate creditworthiness? For instance, a Zimbabwean household may desire to make tuition payments every four months for a university student studying in Florida. Let’s assume both parents are executives at listed manufacturing companies. Sure, their nominal salaries are fixed at, say, ZWL$30,000 a month. But their real income and creditworthiness is determined by the productivity of the domestic economy. When the domestic economy is productive, their real income and creditworthiness goes up. This means their local bank will extend more credit for them to pay the tuition, which the local bank will settle for them through a correspondent bank in Florida. But the inverse is true. Depressed domestic productivity should decrease their real income and creditworthiness. A prudent local bank will not extend as generous loans to the family, or else over time the bank will also be stretched to satisfy international payments. Is this the caution prevalent in Zimbabwe? I would proffer that professional stature, regardless of domestic productivity, influences the credit relations between the banks and their clients.
The wrong response becomes a destructive path
And here is where problems start! Authorities and domestic economic agents often overlook growing productivity disparities between currencies, or they simple do not have effective metrics to guide levers to adjust these disparities! So in the instances where, households such as the executives with a dependent in Florida, businesses like KFC Zimbabwe, or the government itself, all become increasingly strained to settle reserve currency priced credit, the central bank has traditionally been persuaded to either (1) create more domestic credit, or (2) print more local currency. But neither is the appropriate response. In fact, both become more harmful, as they are not backed by improved productivity.
What is a more appropriate response?
A number of IMF working papers have been written exploring what is referred to as an optimal dollarization; an ideal level of reserve currency claims in a local financial system. The purpose of figuring out an optimal dollarization is to better identify global credit manageable by an economy’s productive capacity. Optimal dollarization also avoids overvalued or undervalued exchange rates for a local currency. This applies for households, private businesses, and governments.
Abiding to an optimal dollarization requires managing credit in an economy. But, this seems impossible to do without having an intentional industrial strategy. Debt, equity, remittances, or FDI, are all expectations on an economy’s output and growth. Indeed then to have a better shot of balancing, or at least tapering these expectations, authorities must have some strong levers on industrial output and growth. Do Zimbabwean authorities have such? Monetary and fiscal communications of recent years do not suggest so.
Minutes from the new Monetary Policy Committee, however, offer a glimpse of some hope. In its General Economic Outlook section, point 5, the MPC refers to the country’s potential growth rate (what the economy can produce at its current capacity). Though it does not explicitly mention what that capacity is, a fair assumption is that it is referring to industrial benchmarks such as Confederation of Zimbabwean Industries’ capacity utilization metrics. But how credible are those metrics?
The lack of structural data makes monetary control illusive
Zimbabwe is a highly informalized economy. This suggests that official credit and money supply data are grossly distorted from the productive capacity of real economic activity. One may reasonably assume a large part of the informal economy is involved in trading, with imported commodities and the arbitrage markets of currency representing a large share of this trading. Just these two informal sectors significantly discount the credibility of official credit and money supply data. Consider the situation where businesses under receipt their earnings of foreign currency, and enter the informal currency market with their earnings. The black market margins for most businesses are more profitable than their lines of business.
Let’s interrogate the agricultural, mining, and manufacturing output estimates in official data. Many farmers sell produce to informal markets such as Mbare musika. Miners sell their ores to middlemen without a monetary trace of quantities and pricing. And many manufacturers of consumables sell to tuck shops that do not have business licenses of formal certification. All these transactions are highly liquid to avoid formal traceability. So, do the formal banking records of entities in these sectors truly represent the real monetary outlook of the economy? Effectively, authorities cannot manage the quantity of foreign currency in the financial system (dollarization) with the real productive credit of the economy. This is a problematic hole to be in, and one to expect a nascent local currency to dig itself out of.
Moreover, the interbank market cannot be relied upon as true measure of the real exchange rate of the local currency to reserve currency. Bids and offers in that formal market are just as deceptive as the informal market in reflecting the real productive exchange rate between the ZWL and the USD. Authorities must expediently formalize the economy. It is the only way the economy can give reliable reference of optimal dollarization and real exchange rate guidance.
How do other central banks do it?
Have you ever heard former Bank of England Governor, Mark Carney, give a monetary policy statement? Much of his policies had direct reference and relation to the productive outlook of an economy. The Bank of England to set base interest rates, for instance, in a manner which it can estimate effect of industrial output, real wages, and eventually business and consumer credit. The Reserve Bank of Zimbabwe, and many other developing country central banks, cannot do the same as they have no levers to control the productive capacity of their economies. It is almost impossible with high informalization and poor structural data. The fundamental vulnerability of their local currencies is this poor economic structure. Hopefully, the Government of Zimbabwe can call for capacity building from the OECD, World Bank, and IMF. This isn’t just for the purpose of formalizing the economy, but creating credible and useful economic metrics for productivity.
After creating that structure which allows authorities to assess the productive outlook of the economy, an intentional industrial strategy is needed. Logically, when you know what your real productive outlook is like, you can then manage the economic and business cycles that attract or disincentive reserve currency flows into the domestic economy. The South African Reserve Bank (SARB) probably does this well than any other developing country central bank. This is why the Rand has been a stable currency. By compiling regular domestic household and corporate credit outlooks, the SARB gives global investors a reliable measure of adequate inflows and outflows that are coherent to the economy’s productive capacity. This means the Rand can complement the foreign currency deposits (FCDs) in the South African financial system. Indeed this is why estimates of the real exchange rate between the Rand and reserve currencies are not far off official rates.
Local currencies struggle in poor intermediation environments
What are the chances of a local currency gaining confidence in Zimbabwe? I would guess at this point, very little. Local currencies struggle in poor intermediation environments. The prominence of financial intermediation is a great tell sign of credit in an economy. Two traits presently challenge the Zimbabwean dollar; (1) capital markets are more speculative than allocating of productive credit (2) bank net interest margins contribute very little to revenues. In November 2018, the Zimbabwean Stock Exchange gained over 70% on mere speculation of an impending currency. That suggests that investor funds in capital markets are not aligned to the productivity capacity of listed entities. When banks shy away from pursuing revenues from lending, this implies that an economy’s productive capacity is not competitive for banks themselves to borrow reserve currency capital. Until the productive implications of this outlook changes, a Zimbabwean dollar will struggle to gain confidence, and hold a sustainable exchange rate.