This is a story about a country led by an African freedom-fighter, who:
Had a history within the South African ANC Opposed the white colonial rulers of his country Jailed for his "terrorist" activities Convincingly elected to lead his country and advocated
reconciliation between blacks and whites "If yesterday I fought you as an enemy, today you have
become a friend (...) If yesterday you hated me, today you cannot avoid the love that binds you to me and me to you."
Was overloaded with international honours (honorary doctorates, Hunger Project Prize, Knighthood by ERII, short-listed for Nobel Peace Prize)
29-30 January 20152
Zimbabwe success story from 1980-1990
High growth ratesHigh school enrolment rates increased from 2% to 70%Literacy rate nearly doubled from 45% to 80%NY Times in 1986: "Zimbabwe under Mr. Mugabe’s
leadership remains one of Africa’s success stories. His sensible economic policies have kept the country’s key agricultural sector healthy. His responsible treatment of the white remnants of colonial Rhodesia has checked the flight of a skilled minority. Even the debilitating relations between black tribes seem to be less tense."
29-30 January 20154
… And Now …
Inflation surpassed 1 billion percent in 2008;About 90% of all Zimbabweans are unemployed
and at least 4,160 companies have closed;more than 25% of citizens have left the country;Male life expectancy was 58 years in 1991 vs. 45
years in 2006; Female life expectancy was 61 years in 1991 vs 34 years in 2006;
Country is no longer food self-sufficient and imports most goods from South Africa (and China)
29-30 January 20155
Zimbabwe presently
unemployment estimated at close to 90%; since 2011,
“And worst of all we can't even grow our own food anymore; in the first six months of 2014 we imported over US$400 million worth of groceries, most from South Africa.”
29-30 January 20156
Zimbabwe Monetary Policy:
From Hyperinflation to
Dollarization
UCT SUMMERSCHOOL
2015
7 29-30 January 2015
8
What is Hyperinflation?
29-30 January 2015
• Generally: Over 100% annual rate of inflation
• Cagan’s definition: month-on-month price increases exceeding 50%
• Hanke & Krus (2012) identify 29 episodes of hyperinflation
Nature of Inflation
Increase in price for the same goods or services, adjusted for quality.
Both a socio-political & economic issue Battle for income shares
The depreciation – inflation spiral
29-30 January 20159
11
Zimbabwe Inflation in Context
29-30 January 2015
Country Start date End-dateMaximum
Monthly Rate--%
Hungary Aug 1945 Jul 1946 4.19 x 1016
Zimbabwe Mar 2007 Nov 2008 7.96 x 1010
Yugoslavia Apr 1992 Jan 1994 3.13 x 108
Republika Srpska Apr 1992 Jan 1994 2.97 x 108
Germany Aug 1922 Dec 1923 29,500
Greece May 1941 Dec 1945 13,800
China Oct 1947 May 1945 5,070
Danzig Aug 1922 Oct 1923 2,440
Armenia Oct 1993 Dec 1994 438
Turkmenistan Jan 1992 Nov 1993 429
Source: Hanke, S and Krus, N (2012), World Hyperinflations, Cato Working Paper No 8.
12
Other Past Hyperinflations
Post-war World War I (Germany) Post world war II (Hungary, Greece, China)
Latin America – as a result of 1980’s financial liberalization (Peru, Bolivia, Chile, Argentina, Brazil)
Former USSR, transition into democracyAfrican cases (Congo Brazzaville & DRC)
29-30 January 2015
Zimbabwe’s Hyperinflation: (Lecture I)
Costs and benefits of inflationHow did it happen?How is money created?How was the exchange rate set?Hyperinflation and Purchasing Power
ParityHyperinflation and the Quantity of
Money Theory29-30 January 201513
Was government leadership ignorant of consequences of policy?
Was government pursuing an alternative strategy that went wrong?
Was policy calculated to benefit only a few?
Hyperinflation and Policy(Lecture I)
29-30 January 201514
15
Hyperinflation Exit Strategy(Lecture II)
Multi-currency dollarization exit strategy Pros and Cons of DollarizationOptimal Currency Area implicationsCurrent policy issues
29-30 January 2015
Costs of High Inflation
• Hurts purchasing power of those on fixed incomes
• Raises real rate of taxation (personal and business)
• Distorts relative prices leading to incorrect decisions by economic agents
• May reduce short-run output and raise output volatility
17 29-30 January 2015
Inflation andthe Interest Rate
• Inflation (or expected inflation) raises the nominal interest rate
Nominal interest rate (R)
= expected inflation (ie ) + constant (r)
• What really counts is the real interest rate
r = R - ie
Or how much above the inflation rate you have have to pay to borrow money.
18
r = real interest rate
29-30 January 2015
Inflation Affects theNominal and Real Interest Rates
• For rising or volatile Expected inflation, the real interest rate premium ( r ) becomes larger.
• R = r + ie
• High (real) interest rates reduce investment, and• Undermine the real value of debt (good for
debtors)
19 29-30 January 2015
Costs of High Inflation
Inflation can create real distortions in economy and affects the real interest rate.
20 29-30 January 2015
Benefits of Inflation
1. Seigniorage – the difference in the value of money created by the government/central bank and the cost of creating that money. Often estimated as the change in central bank base money, or simply the change in the value of notes and coins. Governments like seigniorage.
29-30 January 2015
21
Benefits of Inflation
2. May create money illusion and help real wages adjust downward.
%∆W - i = growth in real wages
29-30 January 2015
22
Benefits of Inflation
3. Inflation allows the possibility of a negative real interest rate (if nominal interest rate is set below the rate of inflation), which can be useful to stimulate the economy.
Nominal interest rate (R) = expected inflation (ie ) + constant (r)
23 29-30 January 2015
Inflation and Money
“All inflation is a monetary phenomena” Must have increased money supply to have inflation
“All inflation is a government phenomena” Government must sanction the increased money
supply.
29-30 January 201524
All Money Is Created by Banks
Central bank creates new money when it makes a loan (to government or a State Owned Enterprise)
The Central bank reduces the money supply when it sells foreign exchange (reduces its foreign reserves)
Commercial banks have a money multiplier for the loans they make (to private sector and government)
29-30 January 201526
Central Bank’s Balance Sheet
Total Central Bank Liabilities = Reserve Money or Base Money or High Powered Money
11-27
Assets Liabilities
Foreign Assets, net (=foreign reserves)
Credit to government (net)
Currency in circulation
Net asset position with banks - Open market operations (OMO)
Banks’ deposits (reserves)
Total Assets Reserve Money
CIC
In banks
29-30 January 2015
Commercial Banks’ Balance Sheet
11-28
Assets Liabilities
Cash (in vault) Demand deposits
Loans to private sector
Loans to Government (bonds)
Savings deposits
Operations with Central Bank (OMO)
Total Assets Money
29-30 January 2015
Money Creation
Purpose
Type of Bank
Government Private sector
Central Bank
Commercial Banks
29-30 January 201529
Central Banks can Control Broad Money through the Money Multiplier
mm = Broad money(M3)/Reserve Money
Increasing Reserve Money raises the money supply by a multiplier effect, which depends on reserve ratio (r) and cash/deposit ratio (c).
29-30 January 201530
31
Zimbabwe: Growth of Reserve Money
29-30 January 2015
1,000
1,000,000
1,000,000,000
1,000,000,000,000
1,000,000,000,000,000
1,000,000,000,000,000,000
1,000,000,000,000,000,000,000
10
100
1,000
Jan-
96Ju
n-96
Nov
-96
Apr-
97Se
p-97
Feb-
98Ju
l-98
Dec
-98
May
-99
Oct
-99
Mar
-00
Aug-
00Ja
n-01
Jun-
01N
ov-0
1Ap
r-02
Sep-
02Fe
b-03
Jul-0
3D
ec-0
3M
ay-0
4O
ct-0
4M
ar-0
5Au
g-05
Jan-
06Ju
n-06
Nov
-06
Apr-
07Se
p-07
Feb'
08Ju
l-08
Dec
-08
1996m1 to 2006m6
2006m7 to 2008m12(right scale)
Background to Zimbabwe’s Inflation
Why the government would want to print money
29-30 January 201532
Background to Zimbabwe’s Inflation
The Congo War (1998) - Unbudgeted
Land Reform-Old problem, shifted approach Farm mechanization
Political Challenge – rise of MDC in 1999
Incentive for government to print money
29-30 January 201533
Structure of Zimbabwe’s Foreign Exchange Markets (>2000)
Multiple Exchange Rates:
1. Official RZB rate (overvalued)
2. Parallel market rate (supply-demand)
3. UN Rate (PPP)
4. Rate for notes differed to rate for deposits
5. “Old Mutual Rate”
29-30 January 201534
35
Official versus Parallel Market
Jan-98 Oct-98 Jul-99 Apr-00 Jan-01 Oct-01 Jul-02 Apr-03 Jan-04 Oct-04 Jul-05 Apr-06 Jan-07 Oct-07 Jul-087E-02
7E+06
7E+14
7E+22
Offical rate
Parallel rate
29-30 January 2015
36
Parallel Market Premium
Jan-98 Sep-98May-99 Jan-00 Sep-00May-01 Jan-02 Sep-02May-03 Jan-04 Sep-04May-05 Jan-06 Sep-06May-07 Jan-08 Sep-081E+00
1E+01
1E+02
1E+03
1E+04
Spread: Parallel/Offi-cial
Log of Parallel Market Exchange Rate Premium( >1 means more depreciated parallel rate)
29-30 January 2015
Hyperinflation and Economic Behaviour
How do economic agents behave in the face of hyperinflation? Do they invest? Do they save? Do they speculate? Do they spend money rapidly?
29-30 January 201537
Exchange Rate Arbitrage
Buying dollars in the official market and selling them in the parallel market
Buying dollars for Z$ cash and selling them for Z$ deposits
Barter may be better than cash
29-30 January 201538
Exchange Rate Arbitrage Winners and Losers
What is the impact of large profits on exchange rate arbitrage if GDP is static?
Would you consider these “rents”?
29-30 January 201539
What Is Money?
Money serves as:1. Means of payment2. Measure of value3. Store of wealth
What happens to country’s money during hyperinflation?
29-30 January 201540
Inflation – Depreciation Spiral
The level of inflation is affected by the exchange-rate-pass-through into prices
The value of the exchange rate is determined (affected) by purchasing power parity (PPP)
29-30 January 201542
Purchasing Power Parity
The purchasing power parity relationship – that prices are equalized across countries – is based on:
The “Law of one price”
P = NER Pf (for a single good)Then for a basket of goods:
NERppp = K P/Pf (aggregate price level)
NERppp is the equilibrium exchange rate
e = local/foreign currency; increase=depreciation29-30 January 201544
Does PPP Hold?
Tends to be a long-run phenomena after taking account of transportation costs and tax/tariff differentials.
Tends to be true for traded goods as opposed to non-traded goods
29-30 January 201545
Dynamic PPP
If PPP holds in terms of levels, NER = K P/Pf
Then it holds in terms of changes:
Δ%NER = Δ%K + Δ%P - Δ%Pf
Δ%NER = 0 + idom - ifor
i.e.
The %change in the exchange rate can be predicted by the inflation differential
29-30 January 201546
The Real Exchange Rate and Relative Prices
The real exchange rate is equivalent to the relative prices between countries adjusted to
one currency RER = (Rand/$*CPI_US)/CPI_SA
= (CPI_US in Rand)/(CPI_SA)
= Pus in lc/Psa
RER = (NER*Pf)/P
= NER*(Pf/P)
4729-30 January 2015
PPP and the RER
NERPPP =K*(P/Pf)
RER = NER*(Pf/P)
If PPP always holds, then the RER is constant (=K)
PPP only tends to hold over the long run, not in the short run
4829-30 January 2015
PPP in Zimbabwe
Did Purchasing Power Parity hold?If PPP holds: then: is constant If the RER is Constant, then PPP holdsTest RER for stationarity
29-30 January 201549
50
Official versus Parallel real XR
29-30 January 2015
Jan-98 Oct-98 Jul-99 Apr-00 Jan-01 Oct-01 Jul-02 Apr-03 Jan-04 Oct-04 Jul-05 Apr-06 Jan-07 Oct-07 Jul-080
500
1,000
1,500
2,000
2,500
3,000
3,500
Real parallel market ex-change rate
Official exchange rate
Official Rate: no unit root, StationaryParallel rate: no unit root, trend Stationary (real depreciation)
PPP and the Z$ Exchange Rate
Official exchange rate is stationary Did government price at PPP?
Parallel market RER is not stationaryHyperinflation caused real
depreciation
29-30 January 201551
The Quantity Theory of Money (QTM)
Mv = PQ
Money*(velocity of circulation)= (Price level)*(Quantity Output)
How Does Money Affect Prices
29-30 January 201552
Mv = PQ In changes: %ΔM + %Δv = %ΔP + %ΔQ
Money must go somewhere:+ %ΔP prices
%ΔM + %ΔQ output
- %Δv speed of circ
The Quantity Theory of Money (QTM)
29-30 January 201553
What Happens When Money Increases
Helicopter money experimentRapid increases in money in a short period
generally increase prices (inflation)Steady consistent rises in money needed for
transactions and investment over the long-runAcceleration of money growth will not result in
accelerating real output
29-30 January 201554
Causality
Y XEconometrics can establish correlations
Causality is a philosophical question
If lagged values of X can help predict Y above and beyond lagged values of Y alone, then X Granger-causes Y
29-30 January 201557
Common Characteristics of Hyperinflation
Increase in velocity of money and shift to cash vs deposits—no savings
Inability to pay foreign debt service leads to default on debt, which eliminates ability to borrow foreign currency in capital markets
Increase in capital controls to prevent capital flight
Expansion of parallel markets
29-30 January 201559
Characteristics of Hyperinflation
Loss of confidence in the banking system, flight to cash, which remains after hyperinflation has been stopped; can’t afford to lend/borrow
Extreme price distortions, as government and SOEs must price at official exchange rate, which leads to losses. e.g.Could buy Air Zimbabwe plane ticket to
Emirates or Johannesburg for equivalent of $US5 changed on parallel market
Resident stop paying utility bills and taxes
29-30 January 201560
Review
Discussed the record size of the Zimbabwe hyperinflation and the conditions that motivated it.
Explained the nature of inflation and ifs relationship with money and the exchange rate: PPP and QTM
29-30 January 201562
What Was the Central Bank Thinking?
Was the RBZ behaving like a Development Bank, trying to provide cheap financing for development?
But doing it with high powered money, which has a large multiplier
29-30 January 201563
Could Zim Policy Have Worked?
Maybe in the early days (before 2006) before the inflation-devaluation spiral
If all RBZ loans went for investment, they might have increased GDP (Q)
[QTM: %ΔM+%Δv = %ΔP + %ΔQ]+ %ΔP prices
%ΔM + %ΔQ output
- %Δv speed of circ
29-30 January 201564
How Do Countries Stop Hyperinflation?
Must stop inflation – devaluation spiralNeed confidence that policies that created
inflation will be stopped.Typically slash government budget deficit
and raise interest rates Need to replenish foreign reserves and
peg exchange rate (or use currency board)Need support from partners like IMF/World
Bank29-30 January 201565
66
Zim Strategy
Several attempts made at currency reform, i.e. taking zeros off of currency, but no serious stabilization effort.
Why was there a lack of effort by senior policy makers for stabilization?
Private sector resorted to Dollarization
29-30 January 2015
What is Dollarization
Economic agents choose to hold a strong, stable foreign currency (e.g. dollars or euros) in place of local currency to protect their wealth, and serve as a means of payment
29-30 January 201567
What Does Dollarization Mean
Country is so small or so dependent on larger partner that there is no benefit of maintaining a separate currency; e.g. Monaco, Costa Rica, British Virgin Islands, Guam,…
Choice to dollarize is admission of government inability to manage monetary and exchange policy
29-30 January 201568
Types of Dollarization
Unofficial dollarization – transacting in the foreign currency is technically illegal but tolerated
Official dollarization – government officially adopts use of foreign currency as the legal tender for the country
29-30 January 201569
Dollarized Countries Using US Dollar
British Virgin Islands Caribbean Netherlands (from 1 January 2011) East Timor (uses its own coins Ecuador (uses its own coins in addition to U.S. coins; Ecuador
adopted the US dollar as its legal tender in 2000.)[
El Salvador Marshall Islands Federated States of Micronesia (Micronesia used the US dollar
since 1944) Palau (Palau adopted the US dollar since 1944) Panama (uses its own coins in addition to U.S. coins. This country
has adopted the US dollar as legal tender since 1904.) Turks and Caicos Islands
29-30 January 201570
Dollarized Countries Using Euro
Andorra (formerly French franc and Spanish peseta since 1278)
Kosovo (formerly German mark and Yugoslav dinar)Monaco (formerly French franc since 1865; issues its
own euro coins)Montenegro (formerly German mark and Yugoslav dinar)San Marino (formerly Italian lira; issues its own euro
coins)Vatican City (formerly Italian lira; issues its own euro
coins)
29-30 January 201571
Dollarized Countries Using the Rand
Lesotho (alonside Meloti)Namibia (alongside Namibian dollar)(Alongside Swazi Lilangeni)Zimbabwe (Alongside the American dollar,
Euro and Botswana pula)
29-30 January 201572
73
Zimbabwe’s Dollarization Exit Strategy
29-30 January 2015
Dollarization was initiated by the private sector to protect itself
Choice of official dollarization was government admission of inability to manage monetary and exchange policy
Government implemented 5-currency dollarization (US$, €, ₤, Pula, ? ; later added Yuan, A$)
US dollar became default (used for accounting)
Has Zimbabwe formed a currency union with the United States?
i.e.Is it like another state of the USA, from an
economic point of view?
29-30 January 201574
How to Create Money in A Dollarized Economy
Run a balance of payments surplus, i.e. inflows > outflows;
Generally means that country need to have an ongoing trade surplus
OrCapital inflows are continuously large enough
to create an overall BOP surplus
29-30 January 201575
What Does the Central Bank Do?
Central bank (RBZ) no longer has its own currency that it can create
Zimbabwe’s Reserve Bank is broke (i.e. liabilities>assets)
RBZ cannot be lender of last resortRBZ cannot make loans to government Central bank still supervises the banking system
29-30 January 201576
There is No Central Bank to Manage Money Supply
Domestic banking system takes over role of creating money based on the banking multiplier (based on reserve ratio of 25%)
Commercial banks take over the role of central bank regarding foreign reserves, which are now held by the private sector
29-30 January 201577
78
Benefits and Costs of Dollarization
Benefits
Less Xrate volatility - good for exports
Inflation falls to level of host country
Enhanced monetary credibility
Increased fiscal discipline Tends to increase
international integration
Costs
Loss of control over monetary policy
Loss of seignorage revenue Loss of lender of last resort
by central bank No exchange rate shock
absorber Need larges amounts of
foreign reserves
29-30 January 2015
Theory of Optimal Currency Areas
Countries with high trade volumes among themselves can benefit from currency union by reduced transactions costs
Countries subject to frequent external shocks can benefit from monetary union (MU)
MU best with geographic proximityHigh degree of labour and capital mobility is
beneficial
29-30 January 201580
Dollarization Currency
Even if benefits did outweigh the costs, the question of what host currency to adopt for dollarization remains.
29-30 January 201581
Optimal Currency Area Theory
Countries with high trade volumes among themselves can benefit from currency union by reduced transactions costs
Countries subject to frequent external shocks can benefit from monetary union (MU)
MU works best with geographic proximity, and
High degree of labour and capital mobility between countries
29-30 January 201582
SADC and CMA Alternative
Potential future SADC monetary unionCMA Rand zone should be interesting to
Zimbabwe (SA is major trading partner)Each member maintains a degree of
monetary autonomy
Should Zimbabwe have joined the CMA Rand zone?
29-30 January 201583
How to Increase the Money Supply
Increasing liquidity requires a balance of payments surplus. Usually achieved through a structural current account surplus, but …
Zimbabwe has trade deficit (25% of GDP)
But a surprising large positive errors and omissions, responsible for
bringing money into the country
29-30 January 201585
What are the Errors and Omissions
The errors and omissions reflect unaccounted inflows, most likely from substantial remittances from Zimbabweans in South Africa
Other dollar cash may be leaving the country unaccounted for and be deposited in Botswana and South Africa.
Capital may have left Zimbabwe as private sector reserves – these will eventually be exhausted
29-30 January 201586
Is the US Dollar Good for Zimbabwe?
Use of US dollar creates US dollar pricing, which may be too high to make Zimbabwe internationally competititve and create jobs.
If inflation is higher in Zimbabwe than USA, then Zimbabwe is becoming increasingly less competitive, i.e. it may be experiencing a real appreciation.
How can Zim be competitive with South Africa outside of mineral exports?
29-30 January 201587
Are Zimbabwe’s US Dollars Real?
Are US dollar deposits created in Zimbabwe the same as real US dollars?
Government proposed to create a US Dollar Treasury Bill market – can it work?
Why are dollar interest rates in Zimbabwe so high (15%+) compared to the USA (2-8%)?
29-30 January 201588
The Investment Challenge
Country needs funds for new investment to increase supply side, but
Domestic residents don’t have sufficient savings to fund needed investment
Government can’t print money for investmentIndigenization Program requires 51% local
ownership, which discourages FDI
29-30 January 201589
Why Indigenization Program Reduces Liquidity
Reduces amount of new investment funds that foreigners are allowed to bring in;
For old investment, transfer of ownership facilitates outflow of capital, e.g. mines and banks
29-30 January 201590
Investment Needs and the Interest Rate
Domestic liquidity is in short supply, but needs rational allocation, thus high interest rates
Lending to Zimbabwe carries high risk premium and thus high interest rate.
So high interest rates reflect time preference?
29-30 January 201591
Zimbabwe’s Debt Constraint
Government would like to initiate large-scale investment projects, but
No one (in OECD) will lend new funds to Zimbabwe government because it is in default on existing debt, amounting to about 150% of GDP.
Government need debt relief package through IMF/World Bank to resolve existing debt, or new lenders.
29-30 January 201592
Can The Angola Model Work
The Angola government borrowed money from China for investment, which was collateralized by pledged oil production
Should (can) Zimbabwe mortgage its untapped natural resources in the same way by the government?
29-30 January 201593
Conclusions - Hyperinflation
Government chose easy strategy of high fiscal spending financed by printing money during 2000s
It disguised excessive fiscal spending using (quasi-fiscal) central bank lending
Multiple exchange rates allowed insiders to earn arbitrage profits
Main losers were those who operated in the Zim-dollar economy
29-30 January 201594
Conclusions - Strategy
The government must have understood the effects of its policies on the exchange rate, but tried to direct the exchange rate arbitrage profits rents to desired people (in ZANU)
29-30 January 201595
Conclusions - Monetary Policy
The government appeared to set the official exchange rate based on PPP, whereas parallel rate showed underlying real depreciation
Evidence (from the Quantity Theory of Money) seems to show that money growth was directly driving the exchange rate depreciation
29-30 January 201596
Conclusions – Dollarization
Dollarization appears to have been done out of default rather than by calculation or on the basis of Optimal Currency Area theory
The rand would appear to a better currency for Zimbabwe than the US$
Policies to address current financial and investment challenges are deficient
A new economic crisis could materialise
29-30 January 201597
Questions
1. Did dollarization produce a positive result for Zimbabwe?
2. Who were the winners and losers in Zimbabwe’s hyperinflation?
3. Should Zimbabwe mortgage its natural resources with China to relaunch its economy? (Angola Model)
4. What did Zimbabwe teach us about capital mobility?
29-30 January 201598