UCT-LSE
JULY SCHOOL
2015
Dr. Mark Ellyne
1
Case Study in the
Failure of Economic
Policy: Zimbabwe
29-30 January 2015
Purpose
This is a case study about poorly chosen
economic policies;
This is a story about monetary policy, inflation
and the exchange rate.
This helps us understand the nature of
money, how it is created, and the harm it can
do if not managed properly.
It has applications to developed countries as
well, including the use of quantitative easing.
2
Zimbabwe success story
from 1980-1990
 High growth rates
 High school enrolment rates increased from 2% to 70%
 Literacy rate nearly doubled from 45% to 80%
 NY Times in 1986: "Zimbabwe under Mr. Mugabe’s
leadership remains one of Africa’s success stories. His
sensible economic policies have kept the country’s key
agricultural sector healthy. His responsible treatment of
the white remnants of colonial Rhodesia has checked
the flight of a skilled minority. Even the debilitating
relations between black tribes seem to be less tense."
3
… And Now (2014) …
Inflation surpassed 1 billion percent in 2008;
More than 25% of citizens have left the country;
At least 4,160 companies have closed;
Male life expectancy was 58 years in 1991 vs. 45
years in 2006; Female life expectancy was 61
years in 1991 vs 34 years in 2006;
Country is no longer food self-sufficient and imports
most goods from South Africa (and China); and
Unemployment estimated at close to 90%; since
2011.
4
Nature of Inflation
Increase in price for the same goods or
services, adjusted for quality.
Both a socio-political & economic issue
 Battle for income shares
The depreciation – inflation spiral
5
What is Hyperinflation?
• Generally: Over 100% annual rate
of inflation
• Cagan’s definition: month-on-month
price increases exceeding 50%
• Hanke & Krus (2012) identify 54
episodes of hyperinflation
6
Zimbabwe CPI Inflation
(12 month inflation in percent change)
7
Zimbabwe Inflation in Context
Maximum
Country
Start date
End-date
Hungary
Aug 1945
Jul 1946
4.19 x 1016
Zimbabwe
Mar 2007
Nov 2008
7.96 x 1010
Yugoslavia
Apr 1992
Jan 1994
3.13 x 108
Republika Srpska
Apr 1992
Jan 1994
2.97 x 108
Germany
Aug 1922
Dec 1923
29,500
Greece
May 1941
Dec 1945
13,800
China
Oct 1947
May 1945
5,070
Danzig
Aug 1922
Oct 1923
2,440
Armenia
Oct 1993
Dec 1994
438
Turkmenistan
Jan 1992
Nov 1993
429
Monthly Rate--%
Source: Hanke, S and Krus, N (2012), World Hyperinflations, Cato Working Paper No 8.
8
Other Past Hyperinflations
Post-war
 World War I (Germany)
 Post world war II (Hungary, Greece, China)
Latin America – as a result of 1980’s financial
liberalization (Peru, Bolivia, Chile, Argentina,
Brazil)
Former USSR, transition into democracy
African cases – war and social dissent (Congo
Brazzaville & DRC)
9
Zimbabwe’s Hyperinflation:
(Part I)
Costs and benefits of inflation
How is money created?
Inflation – depreciation spiral
Was government leadership
ignorant of consequences of policy?
How was the exchange rate set?
10
Hyperinflation Exit Strategy
(Part II)
Multi-currency dollarization exit strategy
Pros and Cons of Dollarization
Optimal Currency Area implications
Current policy issues
11
Costs and Benefits of Inflation
Is inflation all bad?
12
Costs of High Inflation
• Hurts purchasing power of those on fixed
incomes
• Raises real rate of taxation (personal and
business)
• Distorts the exchange rate and other relative
prices leading to incorrect decisions by
economic agents
• May reduce short-run output and raise output
volatility
13
Would You Lend Money Me at
Less than the Inflation Rate?
• Inflation (or expected inflation) raises the
nominal interest rate
Nominal interest rate (R)
= expected inflation (ie ) + margin (r)
r = real interest rate
• What really counts is the real interest rate
r = R - ie
Or how much above the inflation rate you have
have to pay to borrow money.
14
Benefits of Inflation for Government
Seigniorage – the difference in the value
of money created by the
government/central bank and the cost of
creating that money. Often measured as
the change in central bank base money,
or simply the change in the value of
notes and coins. Governments like
seigniorage.
15
Money Illusion
May help real wages adjust downward.
%∆W - i = growth in real wages
W = nominal wages
i = inflation
16
Inflation and Money
“All inflation is a monetary phenomena”
 Must have increased money supply to have inflation
“All inflation is a government phenomena”
 Government must sanction the increased money
supply.
17
What Happens
When Money Increases
Helicopter money experiment
Rapid increases in money in a short period
generally increase prices (inflation)
Rise in money should be consistent with rise
in real GDP (volume of transactions),
tempered by interest rate (cost of money)
18
What Is Money?
Money serves as:
1. Means of payment
2. Measure of value
3. Store of wealth
What happens to country’s money during
hyperinflation?
19
How is Money Created?
All Money Is Created by Banks
20
How Central Bank Creates Money
Central bank creates new money when:
1) it makes a loan (to government or a State
Owned Enterprise)
2) it buys foreign exchange and increases its
foreign reserves
21
Central Bank’s Balance Sheet
Assets
Liabilities
Foreign Assets, net
(=foreign reserves)
CIC
Credit to government
(net)
Currency in circulation
Net asset position with
banks - Open market
operations (OMO)
Banks’ deposits (required
reserves)
Total Assets
In banks
Reserve Money
 What causes reserve money to rise?
11-22
How Commercial Banks Create Money
Commercial banks create money via the money
multiplier when:
1) they make loans to the private sector or
2) they make loans to the government
23
Commercial Banks’ Balance Sheet
Assets
Liabilities
Reserves with central bank
Demand deposits
Loans to private sector
Loans to Government
Savings deposits
(bonds)
Open market operations with
Central Bank (OMO)
Total Assets
11-24
Money
Commercial Banks’ Money Multiplier
For each new deposit, a required
minimum amount goes to the central
bank as a reserve requirement (for
prudential purposes) and the remainder
can be lent out to the private sector or
government.
25
Sources of Money Growth
1) Lending to government by banks
a) commercial banks= purchase of treasury bills;
b) central bank = printing money
2) Lending to the private sector by commercial
banks
3) Balance of payments surplus purchased by
central bank raises domestic money supply;
What is difference between electronic money vs
notes and coins?
26
Growth of Reserve Money
from Reserve Bank of Zimbabwe
1,000
1,000,000,000,000,000,000,000
1,000,000,000,000,000,000
1996m1 to
2006m6
100
1,000,000,000,000,000
2006m7 to
2008m12
(right scale)
1,000,000,000,000
1,000,000,000
1,000,000
10
Jan-96
Jun-96
Nov-96
Apr-97
Sep-97
Feb-98
Jul-98
Dec-98
May-99
Oct-99
Mar-00
Aug-00
Jan-01
Jun-01
Nov-01
Apr-02
Sep-02
Feb-03
Jul-03
Dec-03
May-04
Oct-04
Mar-05
Aug-05
Jan-06
Jun-06
Nov-06
Apr-07
Sep-07
Feb'08
Jul-08
Dec-08
1,000
27
Background to Zimbabwe’s Inflation
Why the government would
want to print money
28
Background to Zimbabwe’s Inflation
The Congo War (1998) - Unbudgeted
Land Reform-Old problem, shifted approach
 Farm mechanization
Political Challenge – rise of MDC in 1999
Incentive for government to print money
29
Economic relations between
money, prices and
the exchange rate
30
What is Causing What?
Money
Prices
PPP
Exchange
rate
31
Inflation – Depreciation Spiral
The level of inflation is affected by the
exchange-rate-pass-through into prices
The value of the exchange rate is determined
(affected) by purchasing power parity (PPP)
32
Relationship Between the
Exchange Rate and Prices
Purchasing Power Parity is based on:
The “Law of one price”
P = NER Pf (for a single good)
Then for a basket of goods:
NERppp = K P/Pf (aggregate price level)
 NERppp is the equilibrium exchange rate
e = local/foreign currency; increase=depreciation
33
Dynamic PPP
If PPP holds in terms of levels, NER = K P/Pf
Then it holds in terms of changes:
Δ%NER = Δ%K + Δ%P - Δ%Pf
Δ%NER = 0
+ idom
i.e.
- ifor
The %change in the exchange rate can be
predicted by the inflation differential
34
Does PPP Hold?
 Tends to be a long-run phenomena after
taking account of transportation costs and
tax/tariff differentials.
 Tends to be true for traded goods as opposed
to non-traded goods
35
What If Government Tries to Set an
Arbitrary Exchange Rate
Government would like to set overvalued
exchange rate so importers can obtain imports
cheaply, but
Then, there is high demand for foreign exchange
(at overvalued rate), and
Central bank will lose all of its foreign reserves.
Then private sector creates parallel market
exchange rate since it cannot obtain forex from
central bank at official rate
36
Structure of Zimbabwe’s
Foreign Exchange Markets (>2000)
Multiple Exchange Rates:
1. Official rate set by RBZ, which was
overvalued – why?
2. Why was there a Parallel market rate
(supply-demand)
3. Other rates:
 UN Rate (PPP)
 Rate for notes differed to rate for
deposits
37
Official versus Parallel Market
38
Parallel rate
Offical rate
Jan-98
May…
Sep-…
Jan-99
May…
Sep-…
Jan-00
May…
Sep-…
Jan-01
May…
Sep-…
Jan-02
May…
Sep-…
Jan-03
May…
Sep-…
Jan-04
May…
Sep-…
Jan-05
May…
Sep-…
Jan-06
May…
Sep-…
Jan-07
May…
Sep-…
Jan-08
May…
Sep-…
1.E+22
1.E+21
1.E+20
1.E+19
1.E+18
1.E+17
1.E+16
1.E+15
1.E+14
1.E+13
1.E+12
1.E+11
1.E+10
1.E+09
1.E+08
1.E+07
1.E+06
1.E+05
1.E+04
1.E+03
1.E+02
1.E+01
1.E+00
Jan-98
May-98
Sep-98
Jan-99
May-99
Sep-99
Jan-00
May-00
Sep-00
Jan-01
May-01
Sep-01
Jan-02
May-02
Sep-02
Jan-03
May-03
Sep-03
Jan-04
May-04
Sep-04
Jan-05
May-05
Sep-05
Jan-06
May-06
Sep-06
Jan-07
May-07
Sep-07
Jan-08
May-08
Sep-08
Parallel Market Premium
1.E+04
Log of Parallel Market Exchange Rate Premium
( >1 means more depreciated parallel rate)
1.E+03
Spread: Parallel/Official
1.E+02
1.E+01
1.E+00
1.E-01
1.E-02
39
Hyperinflation and
Economic Behaviour
How do economic agents behave in the face
of hyperinflation?




40
Do they save?
Do they invest?
Do they spend money rapidly?
Do they speculate?
Exchange Rate Speculation and
Arbitrage
Buying dollars in the official market and
selling them in the parallel market
Buying dollars for Z$ cash and selling them
for Z$ deposits
Barter may be better than cash
41
Who Were Winners and Losers
in Zimbabwe Hyperinflation
Those with access to foreign exchange?
Debtors or creditors?
Those on Z$ income without access to
dollars?
Speculators, traders, or workers?
42
Common Characteristics of
Hyperinflation
Increase in velocity of money and shift to
cash vs deposits—no savings
Inability to pay foreign debt service leads to
default on debt, which eliminates ability to
borrow foreign currency in capital markets
Increase in capital controls to prevent
capital flight
Expansion of parallel markets
45
Characteristics of Hyperinflation
Loss of confidence in the banking system, flight
to cash, which remains after hyperinflation has
been stopped; can’t afford to lend/borrow
Extreme price distortions, as government and
SOEs must price at official exchange rate, which
leads to losses.
 e.g.Could buy Air Zimbabwe plane ticket to
Emirates or Johannesburg for equivalent of $US5
changed on parallel market
Resident stop paying utility bills and taxes
46
Zimbabwe Monetary
Policy II:
UCT-LSE
JULY SCHOOL
47
Dollarization
Exit Strategy
How Do Countries Stop Hyperinflation?
Use price controls
Must stop inflation–devaluation spiral
Need confidence that policies that created
inflation will be stopped.
Typically slash government budget deficit and
raise interest rates (to stop source of money
creation)
Need to replenish foreign reserves and peg
exchange rate (or use currency board)
Need support from partners like IMF/World Bank
48
Zimbabwe Strategy
Several attempts made at currency
reform, i.e. taking zeros off of currency,
but no serious stabilization effort.
Why was there a lack of effort by senior
policy makers for stabilization?
Private sector resorted to unofficial
dollarization
49
What to do in Hyperinflation?
Unofficial Dollarization
Economic agents choose to hold a strong,
stable foreign currency (e.g. dollars or
euros) in place of local currency to
 protect their wealth, and
 serve as a means of payment
50
What Does Dollarization Signify
Convenience: Country is so small or so
dependent on larger partner that there is
no benefit of maintaining a separate
currency; e.g. Monaco, Costa Rica, British
Virgin Islands, Guam,…
Desperation: Choice to dollarize is
admission of government inability to
manage monetary and exchange policy
51
Types of Dollarization
Unofficial dollarization – transacting in the
foreign currency is technically illegal but
tolerated. Pricing may be in local currency
but payment accepted in dollars (e.g.,
DRC)
Official dollarization – government officially
adopts use of foreign currency as the legal
tender for the country and pricing is in
dollars (e.g., rand in Namibia)
52
Dollarized Countries Using US Dollar










53
British Virgin Islands
Caribbean Netherlands (from 1 January 2011)
East Timor (uses its own coins
Ecuador (uses its own coins in addition to U.S. coins; Ecuador
adopted the US dollar as its legal tender in 2000.)[
El Salvador
Marshall Islands
Federated States of Micronesia (Micronesia used the US dollar
since 1944)
Palau (Palau adopted the US dollar since 1944)
Panama (uses its own coins in addition to U.S. coins. This country
has adopted the US dollar as legal tender since 1904.)
Turks and Caicos Islands
Dollarized Countries Using Euro
 Andorra (formerly French franc and Spanish peseta
since 1278)
 Kosovo (formerly German mark and Yugoslav dinar)
 Monaco (formerly French franc since 1865; issues its
own euro coins)
 Montenegro (formerly German mark and Yugoslav dinar)
 San Marino (formerly Italian lira; issues its own euro
coins)
 Vatican City (formerly Italian lira; issues its own euro
coins)
54
Dollarized Countries Using the Rand
Lesotho (alonside Meloti)
Namibia (alongside Namibian dollar)
Swaziland (alongside Swazi Lilangeni)
Zimbabwe (alongside the American dollar,
Euro and Botswana pula)
55
Zimbabwe’s Dollarization
Exit Strategy
 Unofficial dollarization was initiated by the
private sector to protect itself
 Choice of official dollarization was government
admission of inability to manage monetary
and exchange policy (Feb 2009)
 Government implemented 5-currency
dollarization (US$, R, €, ₤, Pula; later added
Yuan, A$)
 US dollar became default currency, used for
accounting and pricing.
56
Question?
Has Zimbabwe formed a currency union with
the United States?
i.e.
Is Zimbabwe like another state of the USA
from an economic point of view?
57
How to Create Money
in A Dollarized Economy
Run a balance of payments surplus, i.e.
inflows > outflows;
Generally means that country need to have
an ongoing trade surplus, or
Capital inflows are continuously large enough
to create an overall BOP surplus
58
Money Multiplier
in a Dollarized Economy
Domestic commercial banks create money based on
the banking multiplier (based on reserve ratio of
25%)
Commercial banks also take over the role of
central bank regarding foreign reserves, which
are now private sector foreign reserves
59
Are Zimbabwe’s US Dollars Real?
Are US dollar deposits created in Zimbabwe
the same as real US dollars?
Government proposed to create a US Dollar
Treasury Bill market – can it work?
Why are dollar interest rates in Zimbabwe
so high (15%+) compared to the USA (2 to
8%)?
60
What Does the
RBZ Do?
Central bank (RBZ) no longer has its own currency
that it can create
Zimbabwe’s Reserve Bank was broke (i.e.
liabilities>assets)
RBZ cannot be lender of last resort
RBZ cannot make loans to government
Central bank still supervises the banking system
Recently:
RBZ recapitalised and
Reinstated as government’s banker
61
How to Decide when dollarization
is beneficial, and what currency
should be used?
62
Optimal Currency Area Theory
Countries with high trade volumes among
themselves can benefit from currency union
by reduced transactions costs
Countries subject to frequent external shocks
can benefit from monetary union (MU)
MU works best with geographic proximity,
and
High degree of labour and capital mobility
between countries
63
Alternative to the US$
Potential future SADC monetary union
CMA Rand zone should be interesting to
Zimbabwe, as SA is major trading partner
Zimbabwe looks like SA
Apparent labour mobility
Each CMA member maintains a degree of
monetary autonomy
 Should Zimbabwe have joined the CMA Rand
zone?
64
Benefits and Costs of Dollarization
Benefits
Costs
 Less Xrate volatility - good
for exports
 Inflation falls to level of host
country
 Enhanced monetary
credibility
 Increased fiscal discipline
 Tends to increase
international integration
 Loss of control over
monetary policy
 Loss of seignorage revenue
 Loss of lender of last resort
by central bank
 No exchange rate shock
absorber
 Need larges amounts of
foreign reserves
65
29-30 January 2015
What challenges has (US$)
dollarization created for
Zimbabwe?
66
US Dollar Accounting and Pricing
Can Zimbabwe be competitive with South
Africa outside of mineral exports?
Use of US dollar creates US dollar pricing,
which may be too expensive to make
Zimbabwe internationally competitive and
create jobs.
67
How Can Zim Increase the US$
Money Supply
Increasing liquidity requires a balance of
payments surplus. Usually achieved through
a structural current account surplus, but …
Zimbabwe has trade deficit (25% of GDP)
Country appears to be financing itself through
large positive errors and omissions,
(responsible for inflow of cash into the
country)
68
Loss of Confidence in Banking System
People prefer to hold cash versus electronic
deposits
Persistent shortage of liquidity in system
70
Danger of Banking Crisis
Electronic deposit money is created by
banking sector money multiplier.
Real US$ deposits require notes or dollar
deposits in the US to back local deposits.
If too many electronic deposit dollars are
produced, then they may not be able to be
redeemed in cash or imports, which
Could lead to a banking crisis
71
The Investment Challenge
Country needs funds for new investment to
increase supply side, but
Domestic residents don’t have sufficient
savings to fund needed investment
Government can’t print money for investment
Indigenization Program requires 51% local
ownership, which discourages FDI
72
Why Indigenization Program Reduces
Liquidity
Reduces amount of new investment funds
that foreigners are allowed to bring in;
For old investment, transfer of ownership
facilitates outflow of capital, e.g. mines and
banks
73
Zimbabwe’s Debt Constraint
Government would like to initiate large-scale
investment projects, but
No one (in OECD) will lend new funds to
Zimbabwe government because it is in default
on existing debt, amounting to about 150% of
GDP.
Government needs debt relief package
through IMF/World Bank to resolve existing
debt, or new lenders.
74
Is There a China Option?
The Angola Model
The Angola government borrowed money
from China for investment, which was
collateralized by pledged oil production
Should (can) Zimbabwe mortgage its
untapped natural resources in the same way
by the government?
75
Conclusions - Hyperinflation
Government chose easy strategy of high
fiscal spending financed by printing money
during 2000s
It hid excessive fiscal spending using (quasifiscal) central bank lending
Multiple exchange rates allowed insiders to
earn arbitrage profits
Main losers were those who operated in the
Zim-dollar economy
76
Conclusions - Strategy
The government must have understood the
effects of its policies on the exchange rate,
but tried to direct the exchange rate arbitrage
profits to desired people (in ZANU)
77
Conclusions - Monetary Policy
The government appeared to set the official
exchange rate based on PPP, whereas the
parallel rate showed underlying real
depreciation because the underlying real
economy was so damaged by inflation
{Evidence (from the Quantity Theory of
Money) shows that money growth was
directly driving the exchange rate
depreciation}
78
Conclusions – Dollarization
Dollarization appears to have been done out
of default rather than by calculation or on the
basis of Optimal Currency Area theory
The rand would seem to a better currency for
Zimbabwe than the US$ (based on OCA)
Policies to address current financial and
investment challenges are deficient
A new economic (banking) crisis could
materialise
79
Questions
1. Who were the winners and losers in
Zimbabwe’s hyperinflation?
2. Did dollarization solve Zimbabwe’s
hyperinflation?
3. Should Zimbabwe mortgage its natural
resources with China to relaunch its
economy? (Angola Model)
4. What did Zimbabwe teach us about capital
mobility?
80