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Monetary policy in dollarised economies

The announcement by the Reserve Bank of Zimbabwe of the review of Zimbabwe dollar balances as it moves towards the demonetarisation of the currency is set to mark the end of the Zimbabwe dollar.

Like most central banks in the world, the primary mandate of the RBZ is to regulate money supply and ensure stability and smooth functioning of the banking system. However, the use of a foreign currency has limited the ability of the central bank to effect changes in the monetary base (the amount of money circulating in the economy) primarily to control inflation as well as perform the role of lender of last resort.

Following the dollarisation of the economy, Zimbabwe has adopted as legal tender other countries’ currencies, principally the US dollar. The US dollar has thus taken over all the functions of a domestic currency with policymakers effectively giving up any possibility of monetary and exchange rate policies.

While official dollarisation would be equivalent to pegging the domestic currency to the US dollar, it is different in that it is irreversible. This irreversibility theoretically makes full dollarisation a credible economic policy and a way to avoid currency and balance-of-payments crises, eliminate exchange rate risk, and contribute to the decline of the country risk premium and interest rates, as well as reduce the inflation rate and inflationary expectation.

With its ability to borrow from financial markets limited, government has to maintain fiscal discipline as it will typically only be able to finance its spend out of tax revenues collected. This effectively drowns out an economy such as Zimbabwe’s in which government spending on public services (and particularly health and education) as well as public infrastructure is a key requirement to the recovery of the economy. Failing to achieve this serves to crowd out private sector investment which typically follows government spend. The end result is a downward spiral, making it even more difficult for the government to fund the budget deficit as well as stabilise the economy in difficult times. 

The restriction on the role of the RBZ as lender of last resort is one of the costs of full dollarisation as the bank is limited in its ability to provide loans to banks facing liquidity problems. Printing money is no longer a feasible source of liquidity, and the central bank has had to look for alternative responses to episodes of financial distress. The upside, however, has been that bank runs have become less likely because consumers and businesses may have greater confidence in the domestic banking system, as the dollarisation has reduced the moral hazard arising from the ability to print money at will. As such, the central bank is there to provide guidance and oversight on banks which would have to manage their own solvency and liquidity risks better, taking the respective precautionary measures.

Some economists have argued the relevance of a central bank in an economy that is using an external currency. That economy is somewhat more vulnerable to external shocks. However, policy credibility and economic stability brought on by fiscal and monetary discipline can encourage reforms and promote competitiveness and productivity to overcome such vulnerabilities.

The effectiveness of monetary policy comes down to the ability of the central bank to foster trust and confidence of the financial markets. As such, it is of crucial importance for the leadership of the bank to manage perceptions around policy stability and provide adequate forward guidance. The central bank should strike to achieve the ideal of political independence in effecting its policy decision. While this concept in itself is difficult to conceive given that political interference tends to be hard-wired in the operation of the central banks, a semblance of this ideal can be achieved if government focuses on fiscal matters and does not unduly influence monetary policy actions.

One thing is for certain though, without a well-functioning financial system that is capable of providing liquidity to the markets in times of need, the economic recovery will be a long and hard road to travel. Initiatives such as the Zimbabwe Asset Management Company (Zamco), created by the central bank last August to take over non-performing loans from banks, should theoretically help revive the capacity of banks to provide new loans.

Overall, dollarisation has brought some sanity to a financial system that had approached a precipice and stared down, just managing to avert an absolute calamity. Inflation was brought under control in one fell swoop but the economy is now facing disinflation. The rabbit hole to avoid, however, will be the much-dreaded deflationary environment in which prices in future are expected to be lower than current prices. This is terrible for any economy as it stifles investment and causes individuals and companies to hold back on spending, which continues in a never-ending downward spiral.

Thanks to dollarisation, the weakest and most problematic banks have been removed from the system which has aided stability. However, Zimbabwe has been left with a smaller banking system, in terms of financial penetration. While the dollarisation has to some extent revived the savings culture, the levels of savings in the economy remains too low to support significant growth in credit extension necessary to lift the economy. What we know is that one cannot spend one’s way to prosperity and wealth creation and growth only come out of savings which can thus be directed toward investment. The central bank has to play a role in creating the environment in which this conversion of saving to investment is possible.

In conclusion, however, the long-term sustainability of monetary policy in a dollarised economy with the characteristics such as those reflected by Zimbabwe remains uncertain as significant institutional weaknesses in the economy and banking system continue. Only time will tell.
l Nesbert Ruwo (CFA) and Jotham Makarudze (CFA) are investment professionals based in South Africa. They can be contacted on media@opportunvest.co.za

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