What future for monetary policy in Zimbabwe?

That really is one big question! But Peter Draper and Andreas Freytag ask it in this article, What future for monetary policy in Zimbabwe?, at VoxEU.org.

Draper and Freytag argue that Zimbabwe needs major monetary reform to cure its hyperinflation. That really has to be the understatement of the century so far! They see three options as being on the table – adopting a currency board, the South African Rand, or a crawling peg. Their column argues against a currency board and says that “Randisation” deserves serious consideration – if South Africa will step up to the plate.

Draper and Freytag open by explaining

Zimbabwe is much in the news again with its newly minted unity government. It remains to be seen whether it will cohere and drive a concerted reconstruction process. Zimbabwe’s future monetary policy is of enormous importance, given the country’s infamous inflation rate.

Three monetary reform scenarios are being discussed – an ordinary or crawling peg to a basket of currencies, “Randisation” (adopting the Rand), and a currency board, i.e. a domestic currency with the money base 100% backed by foreign reserves. The latter two would entail Zimbabwe surrendering monetary policy sovereignty – an issue attracting considerable controversy.

First up, what about Dollarisation? Draper and Freytag write

The currency board or “dollarisation” option is closely associated with US scholar Steve Hanke (2008). In Zimbabwe’s case, he refers approvingly to the currency board Southern Rhodesia operated in the 1940s. However, the preconditions were very dissimilar to Zimbabwe today. Regardless of Rhodesian governments’ other failings, their administrative capacity, and therefore the credibility of any new institutions, was far more developed, whilst trade and capital markets were far less integrated than today. Mr Mugabe and his Zanu PF party not only destroyed the economy thereby creating hyperinflation, poverty and starvation– they also eradicated a workable administration. The latest manifestation is the cholera crisis, now reportedly affecting 80,000 people and spreading rapidly into neighbouring countries. Critically, all kinds of economic institutions necessary for a country to develop are now lacking.

Seems a fair point, its hard to believe that there is much in the way of workable government (or private) institutions left in Zimbabwe. What this means is that a currency board or dollarisation may be difficult to implement. For both regimes to work a number of institutional pre-conditions, particularly fiscal stability, openness to trade and capital flows, and market flexibility are needed. And they just aren't there. An additional pre-condition is trust in markets and in state agencies. If the central bank is not to be trusted, and who would trust it given its recent history, why should the ordinary Zimbabwean citizen trust a currency board (unless it is located out of the country)? Draper and Freytag go on

Furthermore, a currency board would require the Zimbabwean government to possess sufficient foreign exchange reserves to finance the monetary base. In January 2008, the date of the latest available data, the Zimbabwean central bank’s foreign assets accounted for approximately 0.1% of the monetary base. Clearly reserves are too small to finance the monetary base in a currency board without recourse to massive foreign capital injections from the donor community. But those are only likely to be forthcoming once Mr Mugabe and his securocrats have decisively left the scene – a prospect we find rather bullish under current political circumstances.

One would hope this last point is right. Draper and Freytag continue

Over time, a currency board system requires the ability to earn the necessary money growth on global markets. Zimbabwe does not have the production structure (even before the meltdown) to generate the exports required nor the human resource capacity to sustain such a high rate of exchange (i.e. the US dollar) through rapid productivity growth, and the high rate of exchange would encourage imports (no bad thing if you have the foreign exchange, which Zimbabwe won’t) whilst discouraging exports. Hence Mr Hanke’s advice could penalise Zimbabwe’s recovery for a long time.

Finally, it is not obvious that the Zimbabwe Reserve Bank should lose its competencies, as the currency board solution would require. Those advocating this path argue that the Zimbabwe Reserve Bank has become so politicised (correct) that it is beyond redemption (debatable). However, the same argument applies to other state institutions used as Zanu PF’s piggy bank. The situation is much worse than it was in Estonia and Lithuania when they adopted currency boards in 1992 and 1994, respectively.

Overall, a currency board may be the least attractive alternative

Next Draper and Freytag look at Randisation.

What about adopting the Rand, as recently suggested by South African President Mr Motlanthe, and rejected by Zimbabwe’s new Finance Minister from the Movement for Democratic Change, Mr Biti? For each South African citizen, 1000 Rands are circulating. Adopting the same ratio in Zimbabwe would require 11 billion Rands. Currently the total cash circulation in South Africa is about 73 billion Rand. An increase of 11 billion Rand would add 15% – a substantial increase.

This solution requires dismantling the central bank’s money-issuing function. Politically, this may be easier than having a crippled central bank. Randisation would more politically insulated than a currency board, as money issuance would require South African approval. Politically, this would be very tricky. On the other hand, Zimbabwe would gain the reputation of the Rand without requiring the backup of foreign reserves.

However, South Africa’s partners in the Common Monetary Area (Namibia, Lesotho, and Swaziland) may not support this path. Moreover, unless South Africa imposes stringent conditionalities on the reconstruction loans it undoubtedly will extend to Zimbabwe, the latter will be enormously tempted – especially in the likely absence of major donor funding – to deviate from the CMA’s strictures using fiscal policy, thereby destabilising regional currency arrangements.

The third possible alternative is a simple (or crawling) peg to a basket of currencies including the rand.

This scenario, coupled with a Zimbabwe Reserve Bank and Finance Ministry with new leadership, seems possible and politically most feasible. It requires less ambitious policy reforms in other policy areas and does not require huge foreign reserves to sustain it. The question is whether Zimbabwean institutions would have the confidence in their people and foreign investors to sustain the peg. Like the other two scenarios, it is unthinkable without a ban on government borrowing at the central bank. This condition must be highlighted, as it is the sine qua non of any sensible monetary reform.

Draper and Freytag conclude

If the government can keep away from the money press, both the peg and the circulation of the Rand are sustainable. Overall, it is not clear to us which is more desirable. On political grounds the peg is more feasible, but if the economy is to be brought back on track, inflation has to be reduced quickly and Randisation proffers that possibility.

• Hanke, Steve H. (2008), How to Kill Zimbabwe’s Hyperinflation, Global Dialogue, Braamfontein, August, pp. 23-25; 35-36.