·         Bank Policy rate up 10 percentage points

·         Interbank ex rate to be market-determined

·         Auction market to remain active for “price-discovery”

Harare - Following the implementation of economic measures announced on 11 May 2023 and 29 May 2023 respectively, the Central Bank introduced new measures on the 6^th of June, 2023 meant to curtail exchange rate volatility.

In a rather twist of events, the Reserve Bank of Zimbabwe admitted that the volatility is highly driven by demand and supply factors as opposed to behavioural factors as previously claimed by RBZ Governor John Mangudya. Therefore, the Bank sought to address the supply side of foreign currency constraints as well as the demand side.

On the supply side, the government floated the interbank exchange market to allow the exchange rate to be market-determined. This allows the formal exchange market to participate on the currency market competitively against the parallel market by reducing the premium between the two markets and thus encourage economic players to rely on the formal market for buying and selling their foreign currency.

 The government also lifted the 90-day liquidation requirement on export proceeds, a directive that was implemented barely a month ago. While this is reflective of the back-and-forth of monetary policies and the clash between treasury and the Central Bank, the move ensures more foreign currency in the market as exporters can freely dispose the foreign currency at their own discretion and when they deem necessary. To ensure viability of the interbank market, maximum trading limits were reviewed upwards from US$100,000 to US$500,000 while trading margins on foreign exchange transactions will be aligned with international best practices.

To assess the efficiency and effectiveness of these measures, one needs to evaluate and understand what the government could possibly do to fix the supply side of foreign currency exchange in the country while subsequently reducing volatility.

One of the most effective ways for the Central Bank to manage exchange rate volatility on the supply side is by increasing its foreign currency reserves. Foreign currency reserves are assets held by the Central Bank in foreign currencies such as the US dollar. These reserves can be used to stabilize the exchange rate by buying or selling foreign currencies in the market. The main sources of foreign currency reserves are exports, direct purchases, and remittances from abroad. While remittances have been strongly growing over the past decade, the formal banking channels have failed to capitalize on the growth due to a number of factors that include lack of confidence in the regulated channels, as well as increasing imports from either consumers or retailers amid a low production level locally. This has also weighed on the exports part as a source of foreign currency reserves due to loopholes as well as low exports levels comparative to foreign currency demands locally.

Typically, when there is an increase in demand for a particular foreign currency, the Central Bank can use its reserves to supply that currency to the market, thereby stabilizing its value. Similarly, when there is an excess supply of a particular foreign currency, the Central Bank can buy that currency from the market and add it to its reserves. This has been the weakness of the government post-independence as the Central Bank has always rushed to introduce different series of currencies without paying attention to its capacity to ensure the stability of that currency by ensuring a strong foreign currency base. While the removal of the 90-day liquidation period increases supply of foreign currency in the economy, the opportunity cost is to weigh on prospects of raising foreign currency reserves by the RBZ.

The floatation of the exchange rate would, theoretically, lead to reduced activity on the parallel market as the formal channels would be offering the same rates and security to traders. However, the effectiveness of this would rely on the supply of foreign currency on the interbank market. Since the interbank is now supposed to self-finance, it now relies on the confidence of private players to liquidate their foreign currency balances at the bank for the ZWL. Due to the long-drained confidence levels in the country, it would only make sense for the government to intervene in the short-term and ensure supply of foreign currency on the interbank before it self-finances in the long-run, naturally. However, this would also depend on the government’s foreign currency reserves, which are currently very negligible and thus implies that the government doesn’t have capacity to stabilize a local currency nor the preparedness. Low supply of foreign currency on the interbank market in the interim will lead to sustained demand for forex on the parallel market, which will see the parallel rate spiral at a faster pace than the interbank rate, thereby widening the premium and fail to achieve the intended goal by the Central Bank.

On the other hand, the statement from the Central Bank alluded that the Auction market will remain active to meet “smaller requirements for foreign payments and for continuous price discovery”. This seems contradictory to the measures implemented on the interbank market which include the floatation of the exchange rate. The phrase “continuous price discovery” refer to continued exchange rate bands. An exchange rate band is a range within which the value of a currency is allowed to fluctuate against another currency. The Central Bank sets upper and lower limits for the exchange rate band and intervenes in the market when “necessary” to keep the exchange rate within these limits. Theoretically, this aids in stabilizing exchange rates and reduces uncertainty for businesses. However, trends have shown that this only aids in increasing arbitrage opportunities as the parallel market spirals uncontrolled while the formal exchange rate fluctuates within parameters, thereby widening the premium between the two markets and consequently lead to currency and pricing instability.

On the demand side of foreign currency, the government introduced measures that include the increase in Bank policy rate from 140% to 150% per annum, an increase in the Medium-term Bank Accommodation interest rate from 70% to 75% per annum and the increase in Statutory Reserve Requirements on local currency demand and call deposits from 10% to 15%.

By adjusting interest rates from 140% to 150%, the Central Bank can make it more attractive for investors to hold domestic currency. If interest rates are high, investors are more likely to hold domestic currency, which reduces demand for foreign currency and stabilizes exchange rates. Conversely, if interest rates are low, investors may seek higher returns elsewhere, leading to increased demand for foreign currency and exchange rate volatility. However, this is dependent on magnitude. The government reduced the interest rates to 140% when inflation was at 200%, which offered a negligible premium between the two. Currently, ZWL inflation is hovering close to 800%, which renders an inflation rate of 150% negligible when considering arbitrage opportunities. The ZWL has been averaging a monthly depreciation of -20% on the trio of the interbank market, the auction market and the parallel market this year. If someone borrowed from the bank ZWL1 million on the first of January, 2023, which was an equivalent of US$1,000 on the parallel market, and buys the greenback using the loan, then hold for 6-months before converting back to ZWL on the respective currency market, they would be able to pay back the principal amount of ZWL1 million, the accrued interest of almost ZWL750,000 and remain with almost ZWL4.25 million as an arbitrage profit. This is assuming the interest rate of 150% is applicable on the loan. This then reflects how the increase in Bank policy rate is insignificant in curtailing speculative borrowing.

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