Re-dollarisation: Is this the right path forward for Zim?

The Reserve Bank of Zimbabwe (RBZ)

ZIMBABWE officially ditched its local currency in 2009 and adopted a multicurrency regime dominated by the United States dollar (USD) — dollarisation reform.

Dollarisation is a generic term used by economists when a country substitutes its currency with foreign currency as a legal tender.

In 2019, authorities reintroduced the Zimbabwean dollar (Zimdollar) as legal tender.

However, by end of 2022, the economy had largely re-dollarised (entrenched US dollar use) despite government de-dollarisation efforts. This piece, the first of a series to come, seeks to highlight the causes, the good and the bad of dollarisation for Zimbabwe.

Status quo

The official statistics show that the economy has largely re-dollarised. The Reserve Bank of Zimbabwe (RBZ) revealed that of the total banking sector deposits, 64,2% are foreign currency accounts (FCA) deposits.

Also, Zimbabwe National Statistics Agency’s (ZimStat) estimates at the Classification of Individual Consumption by Purpose (COICOP) division show that in 2022 , about 76,56% of transactions were done in US dollars with a balance of 23,44% done in Zimdollars.

The surveys by the Confederation of Zimbabwe Industries (CZI), a manufacturing industry body, also established that on average domestic foreign currency sales contributed about 66% of private sector businesses' forex earnings.

By taking into account the unbanked informal sector transacting largely in cash, it is clear that Zimbabwe is now back in a multicurrency regime with the US dollar at the epicentre.

Drivers of dollarisation

Dollarisation can be by a de facto market process or through an official government decree. Historically, nations have dollarised as part of economic reforms to infuse macroeconomic stability - the case for Zimbabwe.

During the height of 2008 hyperinflation, it became so difficult to gauge market prices to an extent that the government stopped publishing official inflation statistics with independent estimates showing monthly inflation hovering above a billion percent.

 Again, re-dollarisation being experienced in the market now is a response to Zimdollar fragility and skyrocketing inflation.

When there is economic instability and high inflation, economic agents (agents hereafter) are forced to diversify and protect their assets from domestic currency devaluation risks.

There are two main reasons behind agents’ demand for foreign currency assets: currency substitution and asset substitution.

Currency substitution means that foreign money is essentially used as both a medium of exchange and a unit of account. Since high inflation or hyperinflation increases the cost of using the domestic currency for transacting purposes, agents will be prompted to be on the lookout for cheap alternatives.

Asset substitution entails agents’ risk and return considerations between domestic and foreign currency-denominated assets. Generally, forex-denominated assets provide insurance against macroeconomic risks.

Benefits of dollarisation

Zimbabwe is experiencing debt distress. Debt distress is when a country faces challenges in paying its creditors and a debt restructuring is required. With over 80% of public debt in foreign currency, the fragility of Zimdollar increases debt servicing costs and propensity to default.

Economic literature posits that the immediate benefit from the elimination of devaluation risk by dollarisation is the reduction in the country's risk premium on foreign borrowing.

In other words, with dollarisation, interest premiums owing to currency devaluation risk will likely disappear. The elimination of the currency risks, however, does not guarantee a substantial reduction in the default risk premium on foreign currency-denominated debt.

Apart from raising borrowing costs, a currency crisis can also wreak havoc on the domestic economy.

In theory, the exchange rate affects inflation, that is, a massive Zimdollar depreciation is likely to cause inflation to increase.

Hard data shows that when the Zimdollar plunged by 12% on average per month in both the official and parallel markets between February 2019 and December 2022, annual headline and monthly  inflation averaged  306% and  12% respectively.

While it is conceivable that dollarisation will not eliminate risks of external crises, it indeed holds the promise of steadier market sentiment.

This is because the elimination of currency risk tends to limit the incidence and size of contagion episodes.

Durable price stability offered by dollarisation also helps clamp deepening poverty and widening income inequalities.

According to the latest World Bank estimates, the unaffordable prices of basic goods in 2022 plunged about 40% of the population into abject poverty.

More so, although dollarisation may make it difficult to insulate the domestic financial sector, it helps establish a sound financial sector while making economic integration of the domestic economy into the global economy much easier.

The use of a common currency propels market integration as it lowers transaction costs and trade restrictions — the use of widely accepted currency reduces volatilities.

All else constant, dollarisation encourages foreign companies to invest for the long-term taking advantage of stable currency, which gives them a stable income stream that is not subject to frequent exchange rate fluctuations.

Risks of dollarisation

The biggest risk posed by dollarisation is the loss of autonomy as the country’s monetary policy will now be dictated by a foreign country.

 A monetary policy is key as it helps the government manage inflation, currency exchange rates, and financial market stability.

As such, losing this policy arm will constrain the government in delivering a goldilocks economy, which is key in the improvement of living standards.

The relegation of monetary policy also means loss of seigniorage revenues. This is a profit a government can earn by issuing currency, especially the difference between the face value of notes and coins and their production costs.

Seigniorage revenue can also relate to the interest rate central bank charges from lending commercial banks money.

Furthermore, although dollarisation can eliminate the banking sector's vulnerability to devaluation risk, it cannot avoid all sources of the banking crisis.

In case of such crises, dollarisation largely impairs the government’s lender-of-last-resort function thus inhibiting RBZ to respond to financial emergencies.

Typically, a central bank is the ultimate guarantor of the stability of payments and financial systems in case of a systemic bank run.

While RBZ may be able to provide short-term liquidity to individual banks in distress, dollarisation can make it lose the ability to deal with a sudden run-on deposit throughout the banking system.

A central bank can only undoubtfully guarantee all claims under any circumstance when it can print currency as needed.

So, once this ability ceases to hold, the lender of last resort function becomes too limited.

Moreover, dollarisation hurts small open developing economies like Zimbabwe by rendering their domestic companies uncompetitive.

The use of a strong currency like the US dollar increases the domestic cost of production since factors of production are priced in the foreign currency against regional counterparts pricing in their relatively weak currency.

The huge exchange rate differentials also make locally manufactured goods expensive in the eyes of foreigners while making foreign-produced goods cheap in the eyes of locals.

This may lead to the importation of non-essential imports leading to unsustainable trade deficits. For instance, ZimStat shows that between 2009-2018, Zimbabwe experienced a huge deficit averaging US$2,5 billion per year.

 In addition, dollarisation in a developing country set up promotes the dumping of cheap foreign goods and the externalisation of forex. Over time, this leads to acute forex shortages in the official channels and loss of employment.

Way forward

The balance of benefits and costs of dollarisation is usually two-handed.

However, by reflecting on the status quo and distinguishing between short-run and long-run periods, one may establish that both dollarisation and a mono-currency regime (de-dollarisation) may be part of the policy package that is needed by Zimbabwe to attain durable stability.

Which proposal then best suits the short-run? Which best suits the long-run? This becomes the gist of next week’s column.

Sibanda is an economic analyst and researcher.He writes in his personal capacity. — [email protected] or Twitter: @bravon96

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