UCT SUMMERSCHOOL 2015 Monetary Policy: Hyperinflation to Dollarization 1 29-30 January 2015 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) 2 29-30 January 2015 Which One?
3 29-30 January 2015 Zimbabwe success story from 1980-1990 High growth rates High school enrolment rates increased from 2% to 70% Literacy rate nearly doubled from 45% to 80% NY Times in 1986: "Zimbabwe under Mr. Mugabes leadership remains one of Africas success stories. His sensible economic policies have kept the countrys 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."
4 29-30 January 2015 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) 5
29-30 January 2015 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. 6 29-30 January 2015 UCT SUMMERSCHOOL
2015 7 Zimbabwe Monetary Policy: From Hyperinflation to Dollarization 29-30 January 2015 What is Hyperinflation? Generally: Over 100% annual rate of inflation Cagans definition: month-on-month
price increases exceeding 50% Hanke & Krus (2012) identify 29 episodes of hyperinflation 8 29-30 January 2015 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
9 29-30 January 2015 Zimbabwe CPI Inflation (12 month inflation in percent change) 10 29-30 January 2015 Zimbabwe Inflation in Context Maximum Country
Start date End-date 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 Monthly Rate--% Source: Hanke, S and Krus, N (2012), World Hyperinflations, Cato Working Paper No 8. 11 29-30 January 2015 Other Past Hyperinflations Post-war World War I (Germany) Post world war II (Hungary, Greece, China)
Latin America as a result of 1980s financial liberalization (Peru, Bolivia, Chile, Argentina, Brazil) Former USSR, transition into democracy African cases (Congo Brazzaville & DRC) 12 29-30 January 2015 Zimbabwes Hyperinflation: (Lecture I) Costs and benefits of inflation How did it happen? How is money created?
How was the exchange rate set? Hyperinflation and Purchasing Power Parity Hyperinflation and the Quantity of Money Theory 13 29-30 January 2015 Hyperinflation and Policy (Lecture I) 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? 14 29-30 January 2015 Hyperinflation Exit Strategy (Lecture II) Multi-currency dollarization exit strategy Pros and Cons of Dollarization Optimal Currency Area implications Current policy issues 15 29-30 January 2015
Costs and Benefits of Inflation 16 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 and the Interest Rate Inflation (or expected inflation) raises the nominal interest rate Nominal interest rate (R) = expected inflation (ie ) + constant (r) r = real interest rate 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 29-30 January 2015 Inflation Affects the Nominal 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. 21 29-30 Benefits of Inflation 2. May create money illusion and help real wages adjust downward. %W - i = growth in real wages 22
29-30 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. 24 29-30 January 2015 How is Money Created? 25 29-30 January 2015
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) 26 29-30 January 2015 Central Banks Balance Sheet
Assets Liabilities Foreign Assets, net (=foreign reserves) CIC Credit to government (net) Currency in circulation Net asset position with banks - Open market
operations (OMO) Banks deposits (reserves) Total Assets In banks Reserve Money Total Central Bank Liabilities = Reserve Money or Base Money or High Powered Money 11-27 29-30 January 2015
Commercial Banks Balance Sheet Assets Liabilities Cash (in vault) Demand deposits Loans to private sector Loans to Government (bonds) Operations with Central Bank (OMO)
Total Assets 11-28 Savings deposits Money 29-30 January 2015 Money Creation Purpose Government Type of Bank Private sector
Central Bank Commercial Banks 29 29-30 January 2015 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). 30 29-30 January 2015 Zimbabwe: Growth of Reserve Money 1,000 1,000,000,000,000,000,000,000 1,000,000,000,000,000,000 1996m1 to 2006m6
1,000 31 29-30 January 2015 Background to Zimbabwes Inflation Why the government would want to print money 32 29-30 January 2015 Background to Zimbabwes 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 33 29-30 January 2015 Structure of Zimbabwes 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 34 29-30 January 2015 Official versus Parallel Market 7E+22 7E+19 7E+16 7E+13
n Ja Ma Se Ja Ma Se Ja Ma Se Ja Ma Se Ja Ma Se Ja Ma Se Ja Ma Se Ja Ma Se Ja Ma Se Ja Ma Se Ja Ma Se 29-30 January 2015 Parallel Market Premium 1E+04 Log of Parallel Market Exchange Rate Premium ( >1 means more depreciated parallel rate) 1E+03 Spread: Parallel/ Official 1E+02
1E+01 1E+00 36 29-30 January 2015 Hyperinflation and Economic Behaviour How do economic agents behave in the face of hyperinflation?
37 Do they invest? Do they save? Do they speculate? Do they spend money rapidly? 29-30 January 2015 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 38 29-30 January 2015 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? 39 29-30 January 2015 What Is Money?
Money serves as: 1. Means of payment 2. Measure of value 3. Store of wealth What happens to countrys money during hyperinflation? 40 29-30 January 2015 Economic theory behind money, prices and the exchange rate 41 29-30 January 2015
Inflation Depreciation Spiral The level of inflation is affected by the exchangerate-pass-through into prices The value of the exchange rate is determined (affected) by purchasing power parity (PPP) 42 29-30 January 2015 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=depreciation 44 29-30 January 2015 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 45
29-30 January 2015 Dynamic PPP If PPP holds in terms of levels, NER = K P/Pf Then it holds in terms of changes: %NER = %K + %P - %Pf %NER = 0 + idom i.e. - ifor The %change in the exchange rate can be
predicted by the inflation differential 46 29-30 January 2015 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/$*CPI_US)/CPI_SA = (CPI_US in Rand)/(CPI_SA) = Pus in lc/Psa RER = (NER*Pf)/P = NER*(Pf/P) 29-30 47January 2015
PPP and the RER NERPPP =K*(P/Pf) RER = NER*(Pf/P) If PPP always holds, then the RER is constant (=K) PPP only tends to hold over the long run, not in the short run 48 January 2015 29-30 PPP in Zimbabwe Did Purchasing Power Parity hold? If PPP holds:
then: is constant If the RER is Constant, then PPP holds Test RER for stationarity 49 29-30 January 2015 Official versus Parallel real XR 3,500 3,000 Official Rate: no unit root, Stationary Parallel rate: no unit root, trend Stationary (real depreciation) Real parallel market
exchange rate 2,500 2,000 1,500 Official exchange rate 1,000 500 Ja M a
Se Ja M a Se Ja M a Se Ja M a Se Ja M a
Se Ja M a Se Ja M a Se Ja M a Se Ja M a
Se Ja M a Se Ja M a Se 0 50 29-30 January 2015
PPP and the Z$ Exchange Rate Official exchange rate is stationary Did government price at PPP? Parallel market RER is not stationary Hyperinflation caused real depreciation 51 29-30 January 2015 How Does Money Affect Prices The Quantity Theory of Money (QTM) Mv = PQ Money*(velocity of circulation)
= (Price level)*(Quantity Output) 52 29-30 January 2015 The Quantity Theory of Money (QTM) Mv = PQ In changes: %M + %v = %P + %Q Money must go somewhere: + %P prices %M + %Q output - %v speed of circ 53 29-30 January 2015
What Happens When Money Increases Helicopter money experiment Rapid increases in money in a short period generally increase prices (inflation) Steady consistent rises in money needed for transactions and investment over the long-run Acceleration of money growth will not result in accelerating real output 54 29-30 January 2015 What is Causing What?
Money Prices Exchange rate 56 29-30 January 2015 Causality YX Econometrics 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 Grangercauses Y
57 29-30 January 2015 Common Characteristics of Hyperinflation Increase in velocity of money and shift to cash vs depositsno 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 59
29-30 January 2015 Characteristics of Hyperinflation Loss of confidence in the banking system, flight to cash, which remains after hyperinflation has been stopped; cant 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 60
29-30 January 2015 UCT SUMMERSCHOOL 2015 61 Zimbabwe Monetary Policy II: Dollarization 29-30 January 2015 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 62 29-30 January 2015 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 63 29-30 January 2015 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: %M+%v = %P + %Q] + %P prices %M + %Q output - %v speed of circ
64 29-30 January 2015 How Do Countries Stop Hyperinflation? Must stop inflation devaluation spiral Need 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 Bank 65
29-30 January 2015 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 66 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 67 29-30 January 2015 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 68 29-30 January 2015 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 69
29-30 January 2015 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 70 29-30 January 2015 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) 71 29-30 January 2015 Dollarized Countries Using the Rand Lesotho (alonside Meloti) Namibia (alongside Namibian dollar) (Alongside Swazi Lilangeni) Zimbabwe (Alongside the American dollar, Euro and Botswana pula)
72 29-30 January 2015 Zimbabwes Dollarization Exit Strategy 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) 73
29-30 January 2015 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? 74 29-30 January 2015 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 Or Capital inflows are continuously large enough to create an overall BOP surplus 75 29-30 January 2015 What Does the Central Bank Do? Central bank (RBZ) no longer has its own currency that it can create Zimbabwes Reserve Bank is broke (i.e.
liabilities>assets) RBZ cannot be lender of last resort RBZ cannot make loans to government Central bank still supervises the banking system 76 29-30 January 2015 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 77 29-30 January 2015 Benefits and Costs of Dollarization Benefits Costs Less Xrate volatility - good for exports Inflation falls to level of host country
Enhanced monetary credibility Increased fiscal discipline Tends to increase international integration 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 78
29-30 January 2015 When is dollarization beneficial, and what currency should be used? 79 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 proximity High degree of labour and capital mobility is beneficial 80 29-30 January 2015 Dollarization Currency Even if benefits did outweigh the costs, the question of what host currency to adopt for dollarization remains. 81 29-30 January 2015
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 82 29-30 January 2015 SADC and CMA Alternative Potential future SADC monetary union CMA 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? 83 29-30 January 2015 What challenges has (US$) dollarization created for Zimbabwe? 84 29-30 January 2015
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 85 29-30 January 2015 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 86 29-30 January 2015 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? 87 29-30 January 2015 Are Zimbabwes 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%)?
88 29-30 January 2015 The Investment Challenge Country needs funds for new investment to increase supply side, but Domestic residents dont have sufficient savings to fund needed investment Government cant print money for investment Indigenization Program requires 51% local ownership, which discourages FDI 89 29-30 January 2015
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 90 29-30 January 2015 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? 91 29-30 January 2015 Zimbabwes 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. 92 29-30 January 2015 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? 93 29-30 January 2015
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 Zimdollar economy 94 29-30 January 2015 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) 95 29-30 January 2015 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
96 29-30 January 2015 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 97 29-30 January 2015
Questions 1. Did dollarization produce a positive result for Zimbabwe? 2. Who were the winners and losers in Zimbabwes 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? 98 29-30 January 2015
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