The soft peg and local economic stability

Zimbabwe introduced the Dutch inspired foreign exchange auction system on the 23th of June to replace the fixed exchange rate (hard peg) of US$1: ZW$25 that had been in existence since 26 March 2020. It was noted at that time that the authorities had realized the negative impact of a fixed exchange regime and policy interventions were moving towards creating a free market where the exchange rate would be determined by market forces. However the growing spread between the parallel market rate (Now US$1: ZW$120) and the stickiness of the auction rate has confirmed market fears that the economy is back to a pegged rate. For the past 4 months, the local unit has firmed on the Auction Market at between ZW$81 and ZW$82 against the greenback despite the decline in inflation rate, slump in exports and growth in reserve money from ZW$12.65 billion (As of 20 August) to ZW$16 billion (As of 11 December). To achieve this exchange rate stability, the Reserve Bank of Zimbabwe (RBZ) has to continuously borrow a substantial amount of US Dollars to maintain the peg and oil the auction market.

The central bank has not hidden its desire to see the country utilizing a crawling peg since it enables the central bank to manage currency fluctuations and curb the probable devaluation of the Zimbabwean Dollar. However the bank has to continuously increase domestic money supply to satisfy the 30% of foreign currency it retains from all export earnings. This means that the central bank has to pump in Zimbabwean Dollars equivalent of US$90 million into the economy every month. Despite this, the economy is gradually showing signs of stability and improvement in confidence levels due to partial dollarization which has allowed various producers and retailers to price their goods in foreign currency and receive proceeds in cash.
This has reduced pressure on the foreign exchange market even though bulk of the traded foreign currency is not being banked and circulating in the informal economy. The maintenance of soft peg has the following impact on the economy besides the clear increase in central bank‘s foreign debt.

Impact on fuel supply

The local market has witnessed improved supply and stability in the petroleum sector after the government made a deliberate effort to allow the retailing of fuel in foreign currency by authorized DFI service stations on the local market. Motorists (and all fuel consumers alike) could therefore choose to purchase fuel using the local currency or foreign currency since two prices had a small variance based on the auction rate and parallel market rates. However the widening spread (Now over ZW$35 on every US$1) has set the market on a reset and presented arbitrage opportunities to unscrupulous dealers. By obtaining Fuel at ZW$97.44 (Below US$82 cents using the parallel market rate), retailers and informal dealers can sell the commodity at the authorized prize of US$1.19/litre and make huge profits. This variance will bring back the long fuel queues and artificial shortages that characterized the market in 2019 and the first half of 2020. The huge spread also entrenches corruption in Zimbabwe's murkiest sectors.

Impact on corporate incomes

The current re-dollarization wave poses challenges to a number of corporates who have to follow to the regulatory soft peg that prevails on the Auction market while importing raw materials and procuring inputs or restocking using the parallel market rate. This means that such corporates cannot attract foreign currency from their customers and will likely suffer from foreign exchange related losses. A number of consumer goods manufacturers and retailers are caught in this dilemma, and they are losing market share to informal traders who can import and sell various merchandise at discounted prices in foreign currency.

Impact on balance of trade

Zimbabwe is heavily reliant on commodities exports with over 91% of foreign export receipts coming from mining and tobacco exports. The country's manufactured exports have dwindled over the years due to antiquated machinery, liquidity challenges, lack of capital and investment, high inflation rates, high costs of production and economic instability. This means that Zimbabwe is now a net importer of manufactured commodities, which creates perpetual demand for foreign currency to satisfy local consumption. The soft peg on currency acts as a deterrent to export growth (Since 30% of foreign receipts are settled using a pegged rate) while encouraging consumption of finished merchandise through giving cheap foreign currency to importers. The imbalance can only be resolved through a managed floating exchange rate where commercial banks act as match makers between importers and exporters with an efficient foreign exchange rate.

The exchange rate may be volatile in the short term but it will save the central bank from continuously printing money (managing inflation) and redirect foreign currency circulating in the informal sector to the formal economy. The exchange rate spread also discourages Gold mining production from primary producers who retain only 70% of the earnings when Small Scale and Artisanal miners get 100% in foreign currency. This deters production while providing loopholes for smuggling and diversion of Gold to small scale miners for onward side marketing.

Impact on confidence

Market confidence is the most important ingredient in the value of fiat currencies and exchange rate stability in an economy. Exporters and other foreign currency holders have to be confident that they will get a fair value for their hard earned foreign currency in the local financial market, while buyers have to be assured that they can always get foreign currency for their import needs whenever they need it. Players in the market must be happy to hold onto their Zimbabwean Dollar balances with assurance that the local unit will maintain its value in the near future. So far, exporters are still holding onto to over US$1 billion in foreign currency which cannot be traded because the pegged auction rate is divorced from the open market rate.

The balance of payments model of pricing currencies holds that foreign exchange rates are at an equilibrium level if they produce a stable current account balance. Zimbabwe, which runs a persistent trade deficit is experiencing a sustained shortage of foreign currency, which ultimately depreciates the value of its local currency. The soft peg is not sustainable and will not succeed in saving the Zimbabwean Dollar considering the amount of debt the central bank has to contract to stabilize the exchange rate and oil the auction market, which has limited independent sellers at the moment. The bank has to play a balancing act of managing money supply (inflation) while keeping exporters happy by crediting the equivalent local units to the retained foreign currency earnings.

Victor Bhoroma is an economic analyst. He holds an MBA from the University of Zimbabwe (UZ). Feedback: Email vbhoroma@gmail.com or Twitter @VictorBhoroma1.