This plan was originally mooted in July 2007 when it was reported that
the South African Development Community was putting together a rescue
plan for the Zimbabwean economy, which would involve effectively
extending the rand monetary area into that country. In the following
article, published on Moneyweb on July 10 2007, David McCarthy analysed
the cause of hyper-inflation in Zimbabwe, as well as the benefits and
potential dangers of the suggested plan both for Zimbabwe and South
Africa. We are republishing the article in light of its renewed
relevance today.Â
Hyperinflation is caused by the government printing money to pay its obligations.
The
value of a currency is determined not by markets but by the government
that issues it. This is because governments have (more or less) the
exclusive right to create money. Most simply, they print banknotes, but
they can also purchase outstanding treasury bills or bonds with
cheques, or create electronic balances that banks can access – for
instance by paying government employees using electronic transfers.
In
all developed countries, and in most developing ones, the government
tries to carefully balance how much currency it removes from the
economy (by collecting taxes and selling bills or bonds) and how much
it injects (by paying wages of civil servants, buying goods from the
private sector and purchasing bills and bonds).
This balance is
performed on a daily – if not hourly – basis to ensure that nothing
strange happens to interest rates, which are the barometer of money
supply and demand. If there is too much money, overnight interest rates
will fall, while if money is tight, they will rise. The overnight
interest rate itself could be used to dictate how much liquidity the
central bank needs to add to or remove from the system, but for various
reasons central banks often prefer to use other techniques.
In
the UK, for instance, the Bank of England apparently tries to track
every government outlay and collection, and matches liquidity to this,
so overnight interest rates sometimes fluctuate a little wildly when
there is a mistake about the timing or amount of a particular payment.
But they very rarely get it wrong over a month, and because the markets
know this and expect stability to continue, monthly interest rates
there are in fact very stable.
Because governments control the
value of currency, when we accept banknotes in exchange for valuable
goods or services we are implicitly trusting that the government won’t
render the value of the paper we hold worthless by printing a whole lot
more of it very suddenly. Of course, we could conceivably only choose
to accept goods or other services in exchange for our own, and if we
lived in a barter economy we would have no other option but to do so,
but money is so convenient that it has been with us in many forms for
thousands of years.
What has happened in Zimbabwe is that the
sense of trust that is essential for paper money to function has broken
down, because the government abandoned its duty to protect its
currency. It began to print money to pay its obligations, without
removing a corresponding amount of money from the economy in tax
receipts (by raising taxes) or issuing treasury bonds (by raising
borrowing). This meant that there was more and more money chasing fewer
goods and so prices began to rise.
Even if the effect is small
and prices rise quite slowly, eventually inflation becomes
self-reinforcing because individuals and businesses become accustomed
to price changes and so increase prices just because they expect that
everyone else will increase their prices too. In this sense, inflation
becomes "entrenched" and is extremely difficult to get rid of. However,
in hyper-inflationary times, the effect is ever so much worse. Here,
pricing becomes a race – each business tries to increase its prices
faster than all the others – and the result is an inflationary
death-spiral.
The mechanism by which individual businesspeople
decide by how much to raise prices each day (or in Zimbabwe, apparently
each hour) is not well understood and is the focus of much research by
macro-economists (they call this the "transmission mechanism"). In
Zimbabwe an obvious source of macro-economic information for individual
businesses is the unofficial or parallel rate of the Zimbabwe dollar
against the US dollar, which I would imagine most business in Zimbabwe
watch fairly closely, even if they do not rely directly on imported
goods.
The origin of the problem in Zimbabwe lay with the
collapse in tax revenues caused by the seizure of white-owned farms.
This meant that the government had suddenly either to borrow, or print,
a lot of money to cover outgoings. Either because the central bank was
incompetent, as the IMF claims, or because they couldn’t borrow enough
on private markets to meet expenditures, they decided to print money.
If
Zimbabwe were to join the rand currency area, key issues would be the
"price" at which it joins the area and on how the switch is structured.
The rate of exchange between (worthless) Zimbabwean dollars and South
African rands is crucial.
For instance, when East Germany joined
West Germany, and DDR marks were exchanged for deutschmarks, the rate
at which the exchange was made was very favourable to the east Germans.
The west Germans, collectively, paid a fortune and many economists
attribute the economic pain Germany suffered after unification partly
to this issue.
According to the CIA factbook, the Zimbabwean
economy is only about 1/25th the size of South Africa’s, so the effect
on individual South Africans could be quite small if the deal were
priced correctly. In aggregate, however, the cost could be huge if the
arrangement were mispriced.
A possible way of structuring the
deal would be for the South African government to lend Zimbabwe
sufficient funds to "rand-ise" their economy. Without adequate
guarantees, say from Western donors, this would expose the South
African taxpayer to the substantial risk of ultimate Zimbabwean
default, which, as I discuss below, is extremely likely.
Of
course, we would also need to worry about precisely how the switch was
administered: we could end up substantially enriching a group of
already extremely wealthy ZANU-PF oligarchs who are ultimately entirely
responsible for the demise of their country’s economy.
Given the
extent of corruption in Zimbabwe and the fact that property rights
there (which are crucial for a prosperous future) have apparently been
almost completely obliterated, this is a critical issue and one which
could derail the entire operation.
A further complication would
be the treatment of the existing stock of Zimbabwean-dollar denominated
government debt. One option might be to allow the economy to "rand-ise"
but not to allow the government to switch its debts into rands –
effectively forcing the Zimbabwean government to default on its
existing debt as a precondition for entry.
If the Zimbabwean
government were allowed to convert its existing debt into rands, and
then defaulted, this would have serious consequences for our own
economy.
The South African Reserve Bank would also need to take
control of the Zimbabwean banking system because private banks –
bizarrely to non-economists – also create money when they write loans
and this would need to be controlled in order to prevent Zimbabwean
banks from becoming a source of inflation for the rand currency area as
a whole.
For Zimbabwe the effect of moving to rands would be
almost instantaneous. Trust in the currency would be restored and
no-one would feel the need to raise prices. The economy would return –
gradually – to normal, assuming that the currency change was
accompanied by a return to the rule of law.
There would probably
still be large price changes – both up and down – as the relative
prices of goods adjusted to normal levels (one of the effects of high
inflation is uncertainty about relative prices) but prices would soon
settle down.
Stockpiles would disappear and people would feel
comfortable selling their goods again. Germans still remark on how,
after the deutschmark was introduced in western Germany in 1948, goods
appeared on the shelves, as if from nowhere, and, more than fifty years
later, many ascribed their reluctance to give up the mark for the euro
to this apparent "miracle".Â
However, even if the Zimbabwean
economy is successfully "rand-ised" it is quite likely that the ZANU-PF
government would soon find itself in a precarious position.
One
can think of the Zimbabwean economy using rands as an economy on the
old gold standard: since even governments cannot manufacture gold there
was a fixed amount of coinage and for every guinea a government spent
it had to collect one in taxes or borrow one from someone else.
The
South African Reserve Bank would still keep a monopoly on printing
rands and the Zimbabweans would no longer be able to print money to pay
their bills. They would need to finance their huge deficit either by
collecting taxes or by issuing explicit debt.
Given the size of
their deficit this would be impossible, and they would end up massively
cutting public spending and/or raising taxes, with serious economic
consequences. The near-inevitability of eventual Zimbabwean default
should be a crucial determinant of the structure and pricing of
"rand-isation" – if it does not prevent it altogether.
Of
course, Zimbabwe is already in an extremely dire position, and because
of this, we ourselves are threatened. The potential economic effects of
a currency union need to be evaluated in this light: no option is easy.
One cannot help feeling that things would have been simpler if our
government had handled this situation with more foresight and diligence
a few years ago when it first arose.
David McCarthy is a senior lecturer in finance at the Tanaka Business School, Imperial College, London
Post published in: Agriculture