So Finance Minister Mthuli Ncube said we should expect to have a local currency within 12 months. Given the history of the Zimbabwe dollar many would be justified for having an uneasy feeling in their stomachs. Thoughts will undoubtedly go back the hyperinflation of the 2000s which lead to a catastrophic loss of value of savings and was ended by the multi currency system in early 2009.
How currencies work
Just a quick tutorial on how currencies work so we can understand some of the issues involved here. There are two types of money, representative money and fiat money. Representative money is backed by an asset with intrinsic value, say gold. The US dollar for a time followed the gold standard where central banks would pay $35 for an ounce of gold. Fiat money on the other hand draws its value from the confidence participants place on it. So the more a currency is accepted the greater its value. This is clear to see if you consider that the current US dollar is a fiat as is our bond note but the bond note has gradually lost value. This makes sense when you consider that while bond notes were introduced at parity they cannot be used by importers or those who need to make foreign payments but dollars can.
Now exchange rates for fiat currencies are set in two ways; fixed and floating. In a fixed exchange rate setup the reserve bank would dictate the exchange rate with other currencies and be responsible for upholding it. Where the exchange rate floats it is purely determined by market forces; supply (availability of the currency) and demand (for the currency). This can also be easily understood through the currency trouble our currency bond has and how it’s linked to our status as a net importer; we are demanding more dollars and the supply of bonds (and RTGS) is growing.
1st hurdle: the Bond note
There’s a big first hurdle that must be cleared before any process of introducing a local currency; the bond note. The bond note and money tied up in electronic transfers such as RTGS are in circulation. While the physical bond notes were guaranteed by a $200 million facility the electronic bond notes (RTGS) have no such backing and this poses a very important question. One that must be answered prior to discussions about a Zimbabwe dollar return; by whatever name. What do we do with the RTGS balances?
As a surrogate currency it will need to be dealt with to pave the way for a local currency. It may go the way of the Zimbabwean dollar and be officially demonetized. Demonetization of the Zimbabwe dollar was a process not an event and with the size of those balances being over the $9 billion mark we should expect much the same if this route is chosen.
The way the local currency will be introduced and handled will therefore be informed by the route chosen with the bond note. Let’s take a speculative look at how it would play out. The government has long held on to the belief that the bond is at parity with US dollar so to say they would introduce the new local currency at parity is not a stretch. While over time there have been soft admissions of a lack of parity such as the bank directive to separate accounts and the fuel price increase they have held firm.
Officially adopt bond
There’s the option of adopting the bond note as the official currency and this has its advantages and disadvantages which I will touch more on later. The one that screams out is of course the disparity between the $200 million in bond notes and the $9billion in RTGS. This spells two words Zimbabweans have become accustomed to bu would not want to characterize the new currency; cash crisis. So a pure adoption would complicate the process. There are of course ways to introduce cash into the system without increasing the money supply (hence increasing inflation) .
The other problem posed here is of course the existing rate in the parallel market. This would require strong foreign currency reserves for government to be able to hold up this rate. Something we presently do not have with will documented foreign currency shortages. While the finance was answering a question at the town hall meeting where the new currency pronouncement was made he said government is in the process of building foreign currency reserves. So perhaps they may be geared up towards this in time.
At prevailing rates
Adopting the bond as the official currency might prove to be a good idea. In finance the Efficient market hypothesis of Eugene Fama posits that where information flows efficiently in a market the prices of goods reflect all information that is available. In English prices in market consider all the information that is known. So the current parallel market rate for the bond note has taken into consideration all the existing factors. Add to that the ease of adoption and it seems a good idea. However the bond note has had a bad rap prior to its birth and this would obviously affect confidence. It is a currency that has already lost approximately 75% of its value in less than 3 years. This may favour introducing a new currency.
Adopting an altogether new currency means that ultimately the bond note must be demonetized. The rate at which the bond will demonetized can be determined by government and they will essentially buy back bonds from people at a prescribed rate.There is more to consider if this route is chosen, like whether the government will go with a fixed or floating rate.
Introduce at fixed rate
As I alluded to earlier the fixed rate perspective would mean that the reserve ultimately takes responsibility for ensuring the availability of foreign currency at the prescribed rate. Our current position is based on this sort of thinking. The difficulty this places on the reserve bank in a country that is a net importer of goods (a net exporter or money) is clear to see in our current state. It cannot hold forever if at all.
Introduce at floating rate
The majority of developed and developing markets work on a floating rate perspective. In this scenario the government would allow the market participants to decide on the appropriate exchange for the currency to other currencies. As I mentioned before intervention here would be in the form of money supply, controlling the amount of currency available. This is favorable because it allows for shift to expansionary (increase money supply) or contractionary (reduce money supply) when needed.
For Zimbabwe this move would come with a fair bit of uncertainty early on. In contrast to the idea of adopting the bond at floating rates, introducing a new currency may see more volatility as the market will try to settle on a price. The bond for all its ills has a known value in the market. This may be more favorable to all market participants as it will not disrupt markets.
All this said there are a few other issues that would have to be ironed out regardless of which Avenue is chosen for the introduction of a local currency. Government debt for one and it’s conjoined twin government expenditure would need to be handled without prejudice to give the currency a fighting chance. Fiscal discipline is key to stability of the currency. In addition to this programs that foster narrowing of the trade deficit would have to become a top priority. In essence currency value and therefore exchange rate is a metric that simply shows the level of trust market participants have in the issuer of the currency, not in the currency itself.