Pegged exchange rate unsustainable

Zimbabwe's export receipts for the first 9 months of 2021 jumped 38% to US$6.10 billion from US$4.43 billion realized in the same period in 2020. Notable improvements have been realized in international remittances which grew by over 53% and export earnings which grew by 36% buoyed by firming commodity prices.  The growth is expected to take Zimbabwe's official foreign currency earnings to a record figure of about US$8 billion in 2021 (Up from 2020 value of US$6.29 billion). Despite the year on year growth in export earnings, the country is stuck in unrelenting artificial foreign currency shortages. The shortages have created an undesirable system where buying and selling foreign currency has become a big business with a greater yield than most formal businesses. Similarly, the shortages create unhealthy arbitrage opportunities in the market thereby causing price instability. A significant portion of the earned foreign currency is being diverted to the informal market and leaking from the economy through Illicit Financial Flows (IFFs) due to the current foreign exchange market inefficiencies.

Illicit Financial Flows (IFFs)
It is estimated that Zimbabwe loses over US$1.5 billion every year through IFFs that could potentially benefit the country in terms tax revenues and downstream payments in various value chains. The flows manifest through minerals smuggling, foreign currency externalization and tax evasion by local and foreign businesses. Exacerbating this endemic problem is the pegged exchange rate where exporters and traders realize losses if they convert their earnings to local currency through the pegged auction rate. The rate also acts as a tax on foreign currency deposits in the local financial sector.
There is a positive relationship between poor economic governance and illicit financial outflows with export of illicit funds often requiring the use of illegal means that involve systematic corruption.

FCA Balances and lending
US Dollar deposits in Foreign Currency Accounts (FCA) have grown from US$352 million in January 2020 to over US$2.4 billion as of October 2021. The depositors have no incentive to convert these funds using a rate which is lower than the market accepted rate. The funds also remain idle because banks require guarantees (backed by law) that borrowers of foreign currency repay it in hard currency to avoid a repeat of 2009 and 2019 when borrowers repaid foreign currency denominated debts using a depreciated local currency. This would not be the case if the foreign exchange market was market determined through a managed floating mechanism. Therefore, the absence of a market determined foreign exchange market and monetary policy inconsistency is negatively impacting the local credit market. Various sectors of the economy would benefit from the idle funds to ramp up production, retool and meet domestic demand.

Increasing external debt
As a result of the disparity between the pegged formal rate and the free market rate, the central bank and treasury are the biggest, and only suppliers of foreign currency on the auction platform. The central bank has gone to the length of acquiring collaterized lines of credit (external debt) from AfreximBank and other financiers to support the auction allocation mechanism. This would not be necessary if the exchange rate was market determined as it would crowd in private funds from exporters, local businesses, Non-Governmental Organizations (NGOs) and households who benefit from over US$1.3 billion in diaspora remittances. The central bank is also committing millions in foreign currency to dividends repatriation for foreign owned companies and multinational corporations (MNCs) operating in Zimbabwe. This role would be easily performed by commercial banks if the auction system was market determined. Additionally, government would be able to utilize a significant portion of more than a billion in foreign currency tax revenues it earns on paying living wages for its restive civil service to restore normal public service delivery especially in schools and health care. With foreign debt now over US$10.7 billion (excluding central bank debts) before the Global Compensation Deed debt of US$3.5 billion to former commercial farmers is factored in, it is not sustainable for the central bank to incur more external debt to support auction system or subsidize various importers at the expense of exporters and the economy at large.

Pegged rate and Inflation
The central bank has revised its year-end inflation target upwards for the third time to 53%, from the previous forecast of 10% at the beginning of the year and 25%-35% forecast of August 2021. The main source of inflationary pressure on the local market is money supply growth which leads to artificial demand for foreign currency on both the formal and parallel markets. The central bank requires foreign currency to service external debt obligations (among other purposes), hence it is caught in a never ending printing spiral. The central bank has limited interest in letting the auction rate be market driven as that will entail paying more for the 40% in retained export earnings by the bank. Going forward, money supply growth is expected to maintain annual inflation in double digit figures.

Pegged rate and agriculture
Local farmers have started demanding payment for delivered produce in foreign currency due to the serious depreciation of the Zimbabwean Dollar. The government had set high producer prices for the 2020/21 agriculture marketing season to improve productivity and fend off side marketing of grain. However, the spread between the auction rate and parallel rates provides a disincentive to farmers who are rarely paid on the spot. This means agriculture productivity is dependent on an efficient exchange rate that ensures viability for farmers.

Pegged rate and competitiveness
The huge spread between the free market rate and the auction rate means that the government now has import subsidies for various importers and the central bank is also subsidizing citizens to access cheap foreign currency for domestic consumption. This framework is creating an unequal operating environment across various sectors of the economy with exporters (especially miners and tobacco farmers) feeling robbed. For every US$1 of export proceeds, exporters now lose at least 20 cents on surrendering 40% to the central bank under the current export control regulations. This is before various taxes, levies and license fees charged in foreign currency apply to the exporters. This means the pegged exchange rate is acting as a tax on all exports. The exchange control measures are also discouraging exports of manufactured merchandise in a period when Zimbabwe needs to prepare for the Africa Continental Free Trade Area (AfCFTA).

Sustaining the parallel market
So far the auction platform has allocated US$1.9 billion to formal producers and businesspeople in the market since June 2020 versus formal demand for foreign currency exceeding US$5.5 billion in a year. This means that successful bidders only receive 20% to 30% of their foreign currency needs after about 2 months while daily revenues and the parallel market augment the difference. The export figure does not take into account smuggled merchandise which is not declared at customs or merchandise that is under declared for the purpose of paying less duty.

Zimbabwe earns more foreign currency (per capita) than regional peers such as Namibia, Botswana, Malawi, Zambia, Mozambique, Tanzania and Kenya. These countries do not have endemic foreign currency shortages because they have market driven foreign exchange markets. It is worth noting that foreign currency is a scarce resource which needs to be shared in every economy on the global scene, however the sharing can only be efficient if accompanied by a market determined rate where buying and selling margins are very thin to close huge arbitrage opportunities being enjoyed by the elite in Zimbabwe. To address the above inefficiencies, the central bank needs to state beforehand the exact amount of foreign currency available to bidders on auction and commit to settling winning bids within 3 days (T+3). This means the weekly auction should only be carried out if winning bids from the previous week are fully settled. The bank should also weed out producers and retailers (especially petroleum players) who sell their products exclusively in foreign currency and convert proceeds to local currency to place bids again.

The central bank needs to learn from past mistakes where fixing the exchange rate led to market instability and unintended consumption subsidies running into billions of dollars. Exporters and foreign currency holders need to be allowed to trade their foreign currency at market determined rates where the auction market is decentralized from central bank control. The central bank must emulate basic tenets of central bank intervention (open market operations) to mop up excess liquidity in order to manage inflation instead of pegging the exchange rate which has never been a sustainable intervention. Inflation is largely a function of money supply in Zimbabwe and the biggest underwriter to stability is the central bank itself, not a controlled rate. In conclusion, the current foreign currency allocation platform needs to be operated under a true Dutch Auction System to ensure sustainability.

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