Will exchange rates converge?


It was a small victory for Zimbabwe when the IMF staff made positive comments on local authorities’ efforts to stabilise the local foreign exchange market and lower inflation after their visit between September 12-19 2022. The global financial institution also commended the tightening of monetary policy and the contained budget deficits which were cited as key to the narrowing of the parallel market exchange rate premium. Zimbabwe has been experiencing macroeconomic stability since 2016 when the failure of the bond notes birthed the parallel market. An official rate was introduced in 2019 when the country reverted to the Zimbabwean dollar but low confidence and system inefficiencies, among several other concerns, have seen authorities struggle to close the gap between the official and parallel market rates.

The gap between the two rates averaged 43% in the first 12 months of the ZWL’s return before spiking to an average of 153% in the subsequent three months following the authorities’ move to fix the official rate at 1:25 because of Covid-19 effects. The premium narrowed to an average of 27% in the five months after the introduction of the foreign currency auction system in June 2020, but inefficiencies in the system quickly led to a jump in the premium to an average of 76% between December 2020 and May 2022. A devaluation of the official exchange rate from 1:173 to 1:309 overnight narrowed the premium to an average of 54% between June and October 2022. The increase in interest rates to 200% for corporates, a tight hold on ZWL available for lending, and an overhaul in the government’s procurement process were also instrumental in the narrowing of this premium over this period, which is currently around 23%. 

We hold onto the view that rates convergence will be a major step towards economic stability but whether this can be achieved requires a look at drivers of demand for foreign currency on the parallel market in developing countries. According to a study done by Agènor in 1992, the emergence of the parallel market in developing markets is often underpinned by restrictions on transactions in foreign currency. Only a small group of intermediaries is permitted to engage in currency transactions. Purchases of foreign currencies by domestic agents are, in principle, restricted to uses judged by the authorities to be “essential” for economic development, such as imports of capital goods. Consequently, some of the supply of foreign exchange is diverted and sold illegally at a market price higher than the official price to satisfy the excess demand.

We observe that this holds true in Zimbabwe considering that only a few “qualified” agents can access foreign currency through the Dutch auction system. Given that more than half of the economy is informal and cannot participate in the formal auction system, we can infer that demand for foreign currency for business and personal use is considerably high in the informal sector, and this cements the demand for foreign currency on the parallel market. We also add that fuel, the most critical and basic commodity in any functioning economy, only trades in foreign currency vis-a-vis no allocation on the auction system for local fuel consumption.

In addition, foreign currency in the parallel market comes with less costs and limitations. Transactions in formal channels attract an IMTT of 2% for ZWL and 4% for USD-denominated transactions. This tax was created with the goal of collecting tax from the informal sector but the quick cash-dollarisation of the untamed industry has left formal businesses facing the brunt of the burden. We also add that there are no limits with parallel market transactions, and we identify this as an advantage since USD withdrawal limits in formal channels dwindled from US$10 000 per day in 2013 to US$1 000 in 2022. To top it off, policy inconsistency has resulted in the general population opting to preserve value in hard currency and out of the formal system which abruptly wiped entire bank balances almost instantly on two occasions in the last 15 years.

In light of the above, we opine that convergence is highly unlikely and this carries unsettling expectations over the country’s growth potential and long-term stability prospects. A study done by the IMF that analysed 25 developing countries with active parallel currency markets between 1970 and 2021 revealed a trend of high inflation and poor economic growth. These countries experienced an average contraction of 28% in their economies from their respective peak periods to 2021. These economies also featured prominently among countries with widespread corruption and poor governance, and they had some of the highest inflation rates in 2021.

We also assert that the central bank’s tight hold on ZWL makes the current slowdown in inflation and currency stability temporary and superficial. Local banks’ ZWL liquidity for lending purposes has been cut down from ZWL$14,2 billion in September 2021 to ZWL$0,1 billion in September 2022, and this has choked up the availability of debt capital which is critical for bridge finance in sectors such as agriculture, distribution, and manufacturing.

Mtutu is a research analyst at Morgan & Co. — [email protected] or +263 774 795 854.

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