There’s been a lot of conversation around the idea of Zimbabwe using a currency board as a fix to the foreign currency exchange rate problems the nation has been going through. It has been discussed on the YouTube show Friday Drinks and at business forums. As with anything we need to understand the problem, the proposed solution and why it would (or would not) work. Zimbabwe’s exchange rate difficulties are clear for all to see. Once hailed as the strongest currency in Africa, then the region, the Zimbabwean dollar has been up against it. Now US$1 fetches 700 Zimbabwean dollars on the parallel market and 420 on the Interbank (willing buyer willing seller) market, which is now the official exchange rate for pricing. So, is a currency board the answer?
Zimbabwean dollars have steadily and rapidly depreciated against foreign currencies. This affects people’s livelihoods for two reasons. Firstly, Zimbabwe is an importer of many things and a depreciating Zimbabwean dollar means these things become more expensive to a population that largely earns in Zimbabwean dollars. Secondly, the world is globalised and money should be able to buy anywhere in the world, something Zimbabwean dollars cannot do. The Zimbabwean dollar, therefore, is unpopular with anyone because it fails on important functions of money. It is however a medium of exchange but competes with foreign currencies on this front. So the demand for foreign currencies is great amongst Zimbabweans because they satisfy those other functions. If I buy US dollars with my Zimbabwean dollars I can now buy across the world and my money maintains some sort of value. Now add to the quasi-fiscal activity from the monetary authority, we call it printing in simple terms. Increasing the supply of Zimbabwean dollars on the market and devaluing them steadily. The effects are felt in price increases in Zimbabwean dollar terms. Zimbabwe has foreign currency inflows from exports which exporters surrender part of to the auction system at an unfavourable exchange rate. The auction excludes many economic participants so an Interbank system was set up to buy (and perhaps sell) foreign currency. The parallel market is inclusive and offers sellers favourable exchange rates while offering buyers liquidity, something official channels fail to do. So where does a currency board come in?
A currency board is a form of exchange rate peg. Now I understand those words may leave Zimbabweans already sceptical but hear me out. It is a method of managing an exchange rate through a separate institution. Unlike the fully powered central bank which controls all matters, a currency board concerns itself with just two functions. Firstly the currency board manages the inflow and outflow of foreign currency. This can be done by making local currency the only legal tender and encouraging all exporters to liquidate receipts to local currency. Equally so when citizens need foreign currency the board freely sells the currency. So nobody is trapped with the local currency, it is free-flowing. Secondly, the board has the task of building foreign currency reserves to defend the domestic currency value. Let’s use a hypothetical exporter who receives US$100 000 in proceeds, assuming there is no inflation or exchange rate depreciation to keep things simple. The exporter will convert this to local currency and use it to fund their operations if at some point they need foreign currency to buy some inputs they clearly will not demand all the money they converted hence there’s a surplus and the board builds up reserves through such operations.
The key feature of a currency board that proponents are excited about is that it then sets the tone for local currency issuance. The local currency is only issued to the extent that it is covered by foreign currency reserves. This can also be applied fractionally, so, for example, we could local currency must equal 40 or 50 percent of foreign currency reserves. All other matters of monetary policy are then determined by demand and supply. Interest rates for example will rise if money starts to leave the economy. They will usually work with an exchange rate target or range. You can also use a basket of currencies which would be ideal for Zimbabwe’s multiple trade relationships. If the domestic currency starts to weaken, the board releases foreign currency from reserves to quell demand, easing pressure and vice versa.
The benefits of implementing a currency board include
Visible anti-inflationary policy
It goes beyond talk of fighting inflation and makes necessary sacrifices to work towards curbing inflation.
Easy convertibility of domestic currency
We can relate this as a benefit. Easily and freely change your Zimbabwean dollars to foreign currency and vice versa.
Responsive interest rate regime
Interest rates become a tool for monetary management in the economy not a too little too late measure as the RBZ has used them in the recent past.
It lowers inflation because the exchange rate is now a function of inflow and outflow and not fiscal indiscipline (printing).
As expected, currency boards also present drawbacks
Central bank powers eroded
The Central bank is stripped of much of its power and looking at our central bank governors past and present you get the feeling that they would feel this one.
No lender of last resort
The central bank can no longer act as a lender of last resort to banks or the government. It leaves banks exposed to shocks and requires strong banks.
Loss of Government stimulus power
The government cannot easily use fiscal policy to stimulate the economy without having the money. The RBZ has stepped in to finance government programs but with a currency board in place, they would not be able to do this. The government would have to borrow at real rates.
Economic adjustments through wage and price adjustments
With all other elements off the table, the two tools remaining to balance the economy are wages and prices. I’ve lived in an economy that focused on the wages of workers, keeping them fair. With the government as one of the largest formal employers, this would put a lot of pressure on them or more accurately taxpayers. I think Zimbabweans understand why price controls don’t work but for the benefit of the doubt, you simply cannot control the price of something that you do not control the supply of. So wages are the best tool.
Is this the answer for Zimbabwe?
Well, this is why you’re reading so it’s time to digest the information. We can see why a currency board would make sense for Zimbabwe, our central bank has not covered itself in glory and changing the system there makes sense. We could achieve the results of a currency board by simply changing our rules. If the institution, The RBZ, is our problem what difference would another institution work any better? If the rules would make the difference can we not implement the same rules in the existing infrastructure. In short, currency boards work and I believe a currency board would work in Zimbabwe. That said, many other systems would work too. But as they say, nothing works until you do.