COMMON MARKET FOR EASTERN AND SOUTHERN AFRICA (COMESA)
THE EFFECTIVENESS OF MONETARY POLICY IN ZIMBABWE
Economic Research Division
Reserve Bank of Zimbabwe
80 Samora Machel Avenue
P. O. Box 1283
Telephone:+263 4 703 000 (General Line)
+263 4 702 948 (Direct Line)
+263 772 751 893
- CHAPTER ONE: BACKGROUND TO THE STUDY
Monetary policy in Zimbabwe has gone through a number of distinct phases since the country gained independence in 1980, reflecting fundamental shifts in broad macro-economic policy and developments. The conduct of monetary policy in the 1980s, against the background of broad macro-economic controls, remained passive. Direct controls related to caps on prices, wages, interest rates, credit rationing, a raft of administered prices, as well as stringent exchange control regulations. Although controls helped to keep inflation at artificially low levels, they severely limited the contribution of monetary policy to economic development.
1.1Monetary Policy in the 1980s
The 1980s were also characterised by periodic droughts, which put pressure on the economy in general, and on the fiscus in particular. The high fiscal deficits that ensued, absorbed a disproportionately high level of domestic savings, and limited the contribution of monetary policy to economic growth and development. The resultant decline of investment, with private sector investment contracting from 12.5% of GDP in 1985 to a low level of 7.7% in 1988, led to uneven economic growth which, on average, remained low at close to 3% in real terms, and in some cases negative. With the rate of inflation averaging 12.7% during the decade to end 1989 and short-term interest rates averaging 10%, controls on interest rates effectively led to negative real interest rates, which served only to discourage financial intermediation and savings mobilisation.
1.2Monetary Policy in the 1990s: Monetary Targeting Framework
In the 1990s, however, a more active conduct of monetary policy was witnessed, as most controls on domestic economic activity were removed under a series of macro-economic reforms and liberalisation programmes, including the Economic Structural Adjustment Programme (ESAP) in the early 1990s, and the Zimbabwe Programme for Economic and Social Transformation (ZIMPREST), from 1996 to 2000, among others. The adoption of these phases of economic reforms, which set to liberalise and deregulate the domestic economic environment by increasing the role of market forces in the efficient allocation of resources, dictated that monetary policy assume a more active role. Consequently, the thrust of monetary policy shifted from direct controls in the 1980s to more liberal and market-based instruments of monetary control, during and after the 1990s.
The removal of direct controls also necessitated the introduction and development of indirect instruments of monetary policy. These included secondary trading in treasury bills; the use of Reserve Bank of Zimbabwe bills to complement open market operations; variations in the reserve requirement ratios; and the active use of repurchase agreements (repos) for liquidity management purposes. The rediscount rate was also actively used to project the Central Bank's medium term view of inflation on the one hand, and as a primary rate through which the monetary authorities influenced other interest rates in the economy. This rate was, however, phased out and replaced by the Bank rate, at the end of 1998.
1.3Monetary Policy Between 1997 and 2003: Exchange Rate Controls
In the build-up to the turn of the century, particularly in the 5-year period between 1998 and 2003, a raft of policies characterised the rapidly changing economic landscape. The Central Bank’s monetary policy strategy, which hitherto, was premised on monetary targeting, became unsustainable due to increased monetization of fiscal deficits. Monetization of Government financing shortfalls began firstly in August 1997, when about 60,000 war veterans were granted ZWD50000 (nearly USD3 000 at the time) each, outside the budget (Chitiyo, 2000). This triggered inflation and loss of confidence in the local currency, thus precipitating massive speculative currency attacks, on the money, capital and foreign exchange markets. Faced with limited options on exchange rate adjustments, the Central Bank responded by raising interest rates significantly, through frequent hikes in the Bank rate. This notwithstanding, the exchange rate, however, continued to depreciate, both on the official and parallel markets.
The excessive price build-up, associated with rapid depreciation in the exchange rate, forced Government to re-introduce price controls, which had been abolished at the beginning of the 1990s, as part of the wide-ranging macroeconomic reforms. The controls immediately resulted in shortages of basic commodities in official markets, as goods disappeared from the shelves of supermarkets, thus signalling the beginning of rapid informalization of the economy. The Central Bank responded by trading the local currency within a narrow and overvalued exchange rate band, resulting in significant losses of foreign currency reserves. Notwithstanding this defence of the exchange rate, excessive speculation in a largely open economy resulted in the collapse of the exchange rate, on 14 November 1997, in what has become known as the “Black Friday”. On this day, the exchange rate depreciated by over 40% (Chitiyo, 2000).
Since then, the pass through from depreciation to prices had, however, became so direct and extremely vicious, under the environment of excessive speculation. This price formation was consistent with the findings of Odedokun (1997), who concluded that currency depreciation in the official and parallel markets,monetary growth, and foreign inflation, were the underlying causes of domestic inflation, in a cross-country study of several Sub-Saharan African countries,including Zimbabwe.
Zimbabwe’s participation in the civil war in the Democratic Republic of Congo (DRC), beginning September 1998, under the SADC protocol, further strained Government’s financial position, and according to Dietrich(2000),this fuelled speculation and negative perceptions about fiscal sustainability in the medium term. The Land Reform Programme in 2000, which followed the collapse of talks during 1998 Donor Conference on Land Reform, further damaged confidence in the economy and weakened the currency, with devastating effects on price stability. Armed with dwindling foreign currency reserves, and an ineffective interest rate and exchange rate regimes, the Central Bank resorted to a number of import controls, coupled with financial repression.
From 1997, therefore, the exchange rate policy became more pronounced, and overshadowed the effectiveness of monetary aggregates and interest rates, in transmitting policy messages to the real sectors of the economy. Government also adopted the Millennium Economic Recovery Plan (MERP) in 2001, which was development oriented, and effectively ushered in new challenges, opportunities and threats for monetary policy. Between 2000 and 2001, the monetary targeting framework faced additional institutional and operational challenges, including episodes of fixed exchange rates; explicit announcements of the Bank rate; increased recourse by government to the Central Bank financing of its operations; a manipulated low interest rate environment; and attempts by authoritiesto stimulate economic activity through directed lending, in the form of on-lending facilities backed by statutory reserves held by the Central Bank. The directed lending policies, as well as direct interventions by the Central Bank in the economy, though various on-lend facilities bank-rolled by issuance of currency, were escalated in the period beginning 2004, when the Central Bank embarked a developmental agenda, through the financing of a plethora of quasi fiscal activities.
The cumulative effect of exchange rate controls and escalating inflation led to shortages of both local and foreign currency, which reached a climax in 2003. An acute shortage of Zimbabwean dollar banknotes followed inability of the Central Bank to secure adequate imports of bank note paper, ink and other currency printing materials, due to crippling foreign currency shortages in the official market. In response to the currency shortages, the Central Bank introduced the first series of bearer cheques, as emergency currency notes, which circulated alongside the main currency, from 15 September 2003, until their withdrawal on 21 August 2006. The bearer cheques, also known as Special Traveller's Cheques, were in the denominations of $5 000 and $10 000, while higher denominations of $20 000, $50 000 and $100 000 were later issued. All bearer cheques of this series were, however, demonetised in August 2006, following the first re-denomination of currency.
1.4Monetary Policy Between 2004 and 2008: Hyperinflation
The monetary stance at the beginning of 2004 was, in principle, contractionary monetary targeting framework, aimed at reducing inflation, which had reached just above 600% by December 2003. Under this strategy, a Framework for Liquidity Management was put in place, aimed at containing money supply growth to levels consistent with desired inflation targets. Reserve money, which was fairly and reasonably under the control of the Central Bankat the time, became the operational target, while interest rates(through use of the Bank Rate) were the main instruments of monetary policy. Frequent hikes of the Bank Rate, tightening of Central Bank lending to Government and banks, coupled with reduced inflation expectations, as economic agents initially believed the Central Bank’s declaration of inflation as “enemy number one” in the economy, had some positive impact on macroeconomic variables. Inflation, which had peaked to 623% in January 2004, decelerated sharply from March to around 130% by the end of 2004.
As highlighted above, the Central Bank embarked on an expansionary monetary policy drive, aimed at directly and indirectly financing Government, public enterprises and private entities, in projects meant to prop up economic activity, under an overall development agenda (December 2003 RBZ Monetary Policy Statement). Although the monetary policy strategy was predominantly monetary targeting, active use of exchange rate, multiple interest rates and direct injections of money supply in the economy, diluted the effectiveness of the monetary targeting framework, resulting in severely weakened underlying fundamentals in the economy. The economy, however, initially responded positively to the monetary stimulus packages in the very immediate to short-term, with nominal GDP expanding, and inflation falling from around 600% at the end of 2003 to 124% by end March 2004. This somewhat gave credence to the monetarist view that changes in money supply can result in changes in real variables in the short-term. This was partly because pat of the funds injected into the economy was offset by commercial bank statutory reserves held at the Central Bank – which was some form of directed lending.
The positive output gains were, however, short-lived, and were eventually reversed by the inflationary effects of excessive monetary expansions. Monetary injections would soon exceed the funds held by the RBZ in the form of bank statutory and other reserves, implying that the development agenda of the Bank was now financed directly from printing money. Beginning 2005, the economy embarked on a hyperinflationary journey, which only ended in 2009, with the adoption of dollarization.
As observed by Makochekanwa (2007) and Coorey, et al (2007) hyperinflation in Zimbabwe was basically and predominantly a monetary phenomenon, fuelled largely by excessively monetary expansions, arising from the Central Bank’s quasi-fiscal activities. According to Kairiza (2012), “The quasi-fiscal activities went beyond the operational realm of a normal Central Bank and had the effect of undoing the ephemeral achievements in the inflation battle andfirmly set course for the drive towards hyperinflation”.The sharp decline in domestic production resulted in widespread shortages of basic goods and services, which continuously pushed up prices. Kairiza (2012) also notes that, in addition, rapid and sustained depreciation of the exchange rate, itself largely a consequence of rising inflation, also fuelled inflation via the pass-through effects on prices. It became a vicious cycle. Makochekanwa (2007) modelled the money demand function using an Error Correction Methodology, and concluded that the country’s hyperinflation had been largely driven by excessive liquidity injections from the Central Bank.
As early as the first Quarter of 2005, the Central Bank itself had realized that the development agenda had been the fundamental cause of escalating inflationary pressures in the economy. In a document titled Inflation Drivers in Zimbabwe: Supplement to the First Quarter 2005 Monetary Policy Review Statement, the RBZ noted, “On the demand side, excessive money supply growth was identified as one of the major cause of inflation. Empirical evidence for Zimbabwe has shown that excessive money supply growth, which is not matched by productive economic activity, has adverse effects on inflation”. The Bank noted further that “On the demand side, money supply growth unrelated to economic activity is a major source of inflation in the economy. The Reserve Bank, therefore, created a Frameworkfor Liquidity Management, whose primary objective is to contain money supply growth to levels consistent with inflation targets”.
In document titled “A Synopsis of the Impact of the Central Bank’s Interventions to the Economy from January 2004 to June 2006”, “Extra-Ordinary Interventions by the Reserve Bank of Zimbabwe (2008), and in various other Supplements to Monetary Policy Statements, the RBZ listed the following quasi-fiscal activities (QFAs) as underpinning the development agenda:
- Concessional financing to the productive sectors of the economy, particularly agriculture for both working capital and infrastructure development;
- Farm Mechanization Programme;
- Transport Sector Interventions;
- Revolving Fund for Small to Medium Enterprises (SMEs);
- Gold Development Fund;
- Bio-Diesel Project;
- Maize and Tobacco Support Schemes;
- Basic Commodity Supply Side Interventions (BACOSSI);
- Distressed Companies Fund;
- Funding of country-wide dam construction and rehabilitation;
- Parastatal Re-Orientation Programme (PARP);
- Parastatals and Local Authorities Rehabilitation Programme (PLARP);
- Provision of foreign exchange to some key social Ministries, such as Health and Child Welfare;
- Fund to strengthenthe Judicial System; and
- Payment for other National strategic interests, food imports, including financing of general Government operations, particularly those that required foreign currency.
As a result of these quasi-fiscal interventions, money supply and inflation rose sharply (Munoz, 2007). Broad money supply (M3) growth was continuously on an upward trend, rising from 177.6% in January 2005 to585.8% by December 2005, and further to 1 185% by June 2006, underpinned by the Central Bank quasi-fiscal operations. Faced with this scenario, the Central Bank announced in October 2005, that “the Reserve Bank had moved from the eclectic monetary policy management framework to a monetary targeting framework. In the monetary targeting framework, reserve money is the operational target and inflation is the ultimate target. The Reserve Bank will continue to pursue explicit monetary targeting regime, through rigorous open market operations, as well as other forms of interventions targeted at reducing money supply expansion” (RBZ, 2005).
In line with this policy strategy, the Central Bank announced plans to further tighten monetary policy, in particular, the interest rate policy. “The prevailing high inflationary pressures in the economy require that the Reserve Bank maintains the policy of positive real rates, in line with inflation developments. The Bank’s overnight rates will, therefore, continue to serve as a pre-emptive tool, whose main focus is to realign inflation expectations, as well as the real demand for credit in the economy. On an ongoing basis, therefore, the Bank’s accommodation rates will be revised, consistent with levels deemed to be appropriate, based on projected inflation profiles, at the same time, minimizing the adverse effects of the interest rate instrument to the productive sectors”.
By mid-2006, the high inflation environment had begun to pose technical risks on financial information and accounting systems in the economy, with most information technology (IT) systems failing to cope with the increasing number of digits or zeros. Most systems had fast approached their programmed digital handling capacity ceilings. In view of this challenge, the RBZ announced at the end of July 2006, that it was rebasing the national currency, by knocking off three (3) zeros from the currency. Subsequently, a changeover period of between 1 August 2006 and 21 August 2006, was prescribed for rolling over to the new currency, dubbed “New Family of Bearer Cheques”. The 21-day changeover process was termed “Operation Sunrise – A New Beginning for Zimbabwe”, under which the Central Bank led other national institutions country-wide to “buy-back” old currency with new currency, at a factor of 1 000 (RBZ July 2006 Monetary Policy Statement).
Because the underlying macroeconomic fundamentals had not been corrected, and that monetary injections into the economy continued unabated, the positive impact of currency rebasing did not last for long. The three zeros knocked out of the currency were soon to return – with a vengeance (Kramarenko, et al, 2010). Inflation continued rising, reaching 1 281.1% by December 2006. Money was losing value every hour, as people shuttled between the banking halls and the shops. Currency withdrawn from the banking system had no opportunity of being re-banked, as there was no incentive to save the worthless currency in the banks. In addition, the difficulty of obtaining money from the banks (due to cash withdrawal limits) destroyed the incentive to re-deposit the cash in the first place. All the currency issued by Central Bank was circulating outside the banking system, implying that banks required to order cash from the Central Bank nearly all the time.
With the country’s BOP position worsening rapidly, parallel foreign exchange market activities escalated, and compounded the currency crisis, as these activities were essentially financed by cash movements on either terminal of the transactions. Soon, there was a vicious cycle involving loss of value of currency, escalation in the parallel exchange rates and rising prices of goods and services. The official exchange rate was fixed at grossly overvalued levels, and was only increased by insignificant margins after long periods of fixation. Meanwhile, the parallel exchange rate, which had become the actual exchange rate for over 95% of transactions, was deteriorating at least three times daily.