Monetary Policy:Hyperinflation

to Dollarization

UCT SUMMERSCHOOL

2015

1 29-30 January 2015

This is a story about a country led by an African freedom-fighter, who:

Had a history within the South African ANC Opposed the white colonial rulers of his country Jailed for his "terrorist" activities Convincingly elected to lead his country and advocated

reconciliation between blacks and whites "If yesterday I fought you as an enemy, today you have

become a friend (...) If yesterday you hated me, today you cannot avoid the love that binds you to me and me to you."

Was overloaded with international honours (honorary doctorates, Hunger Project Prize, Knighthood by ERII, short-listed for Nobel Peace Prize)

29-30 January 20152

Which One?

29-30 January 20153

Zimbabwe success story from 1980-1990

High growth ratesHigh 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."

29-30 January 20154

… And Now …

Inflation surpassed 1 billion percent in 2008;About 90% of all Zimbabweans are unemployed

and at least 4,160 companies have closed;more than 25% of citizens have left the country;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)

29-30 January 20155

Zimbabwe presently

unemployment estimated at close to 90%; since 2011,

“And worst of all we can't even grow our own food anymore; in the first six months of 2014 we imported over US$400 million worth of groceries, most from South Africa.”

29-30 January 20156

Zimbabwe Monetary Policy:

From Hyperinflation to

Dollarization

UCT SUMMERSCHOOL

2015

7 29-30 January 2015

8

What is Hyperinflation?

29-30 January 2015

• Generally: Over 100% annual rate of inflation

• Cagan’s definition: month-on-month price increases exceeding 50%

• Hanke & Krus (2012) identify 29 episodes of hyperinflation

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

29-30 January 20159

Zimbabwe CPI Inflation (12 month inflation in percent change)

29-30 January 201510

11

Zimbabwe Inflation in Context

29-30 January 2015

Country Start date End-dateMaximum

Monthly Rate--%

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

Source: Hanke, S and Krus, N (2012), World Hyperinflations, Cato Working Paper No 8.

12

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 democracyAfrican cases (Congo Brazzaville & DRC)

29-30 January 2015

Zimbabwe’s Hyperinflation: (Lecture I)

Costs and benefits of inflationHow did it happen?How is money created?How was the exchange rate set?Hyperinflation and Purchasing Power

ParityHyperinflation and the Quantity of

Money Theory29-30 January 201513

Was government leadership ignorant of consequences of policy?

Was government pursuing an alternative strategy that went wrong?

Was policy calculated to benefit only a few?

Hyperinflation and Policy(Lecture I)

29-30 January 201514

15

Hyperinflation Exit Strategy(Lecture II)

Multi-currency dollarization exit strategy Pros and Cons of DollarizationOptimal Currency Area implicationsCurrent policy issues

29-30 January 2015

Costs and Benefits of Inflation

29-30 January 201516

Costs of High Inflation

• Hurts purchasing power of those on fixed incomes

• Raises real rate of taxation (personal and business)

• Distorts relative prices leading to incorrect decisions by economic agents

• May reduce short-run output and raise output volatility

17 29-30 January 2015

Inflation andthe Interest Rate

• Inflation (or expected inflation) raises the nominal interest rate

Nominal interest rate (R)

= expected inflation (ie ) + constant (r)

• 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.

18

r = real interest rate

29-30 January 2015

Inflation Affects theNominal and Real Interest Rates

• For rising or volatile Expected inflation, the real interest rate premium ( r ) becomes larger.

• R = r + ie

• High (real) interest rates reduce investment, and• Undermine the real value of debt (good for

debtors)

19 29-30 January 2015

Costs of High Inflation

Inflation can create real distortions in economy and affects the real interest rate.

20 29-30 January 2015

Benefits of Inflation

1. Seigniorage – the difference in the value of money created by the government/central bank and the cost of creating that money. Often estimated as the change in central bank base money, or simply the change in the value of notes and coins. Governments like seigniorage.

29-30 January 2015

21

Benefits of Inflation

2. May create money illusion and help real wages adjust downward.

%∆W - i = growth in real wages

29-30 January 2015

22

Benefits of Inflation

3. Inflation allows the possibility of a negative real interest rate (if nominal interest rate is set below the rate of inflation), which can be useful to stimulate the economy.

Nominal interest rate (R) = expected inflation (ie ) + constant (r)

23 29-30 January 2015

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.

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How is Money Created?

29-30 January 201525

All Money Is Created by Banks

Central bank creates new money when it makes a loan (to government or a State Owned Enterprise)

The Central bank reduces the money supply when it sells foreign exchange (reduces its foreign reserves)

Commercial banks have a money multiplier for the loans they make (to private sector and government)

29-30 January 201526

Central Bank’s Balance Sheet

Total Central Bank Liabilities = Reserve Money or Base Money or High Powered Money

11-27

Assets Liabilities

Foreign Assets, net (=foreign reserves)

Credit to government (net)

Currency in circulation

Net asset position with banks - Open market operations (OMO)

Banks’ deposits (reserves)

Total Assets Reserve Money

CIC

In banks

29-30 January 2015

Commercial Banks’ Balance Sheet

11-28

Assets Liabilities

Cash (in vault) Demand deposits

Loans to private sector

Loans to Government (bonds)

Savings deposits

Operations with Central Bank (OMO)

Total Assets Money

29-30 January 2015

Money Creation

Purpose

Type of Bank

Government Private sector

Central Bank

Commercial Banks

29-30 January 201529

Central Banks can Control Broad Money through the Money Multiplier

mm = Broad money(M3)/Reserve Money

Increasing Reserve Money raises the money supply by a multiplier effect, which depends on reserve ratio (r) and cash/deposit ratio (c).

29-30 January 201530

31

Zimbabwe: Growth of Reserve Money

29-30 January 2015

1,000

1,000,000

1,000,000,000

1,000,000,000,000

1,000,000,000,000,000

1,000,000,000,000,000,000

1,000,000,000,000,000,000,000

10

100

1,000

Jan-

96Ju

n-96

Nov

-96

Apr-

97Se

p-97

Feb-

98Ju

l-98

Dec

-98

May

-99

Oct

-99

Mar

-00

Aug-

00Ja

n-01

Jun-

01N

ov-0

1Ap

r-02

Sep-

02Fe

b-03

Jul-0

3D

ec-0

3M

ay-0

4O

ct-0

4M

ar-0

5Au

g-05

Jan-

06Ju

n-06

Nov

-06

Apr-

07Se

p-07

Feb'

08Ju

l-08

Dec

-08

1996m1 to 2006m6

2006m7 to 2008m12(right scale)

Background to Zimbabwe’s Inflation

Why the government would want to print money

29-30 January 201532

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

29-30 January 201533

Structure of Zimbabwe’s Foreign Exchange Markets (>2000)

Multiple Exchange Rates:

1. Official RZB rate (overvalued)

2. Parallel market rate (supply-demand)

3. UN Rate (PPP)

4. Rate for notes differed to rate for deposits

5. “Old Mutual Rate”

29-30 January 201534

35

Official versus Parallel Market

Jan-98 Oct-98 Jul-99 Apr-00 Jan-01 Oct-01 Jul-02 Apr-03 Jan-04 Oct-04 Jul-05 Apr-06 Jan-07 Oct-07 Jul-087E-02

7E+06

7E+14

7E+22

Offical rate

Parallel rate

29-30 January 2015

36

Parallel Market Premium

Jan-98 Sep-98May-99 Jan-00 Sep-00May-01 Jan-02 Sep-02May-03 Jan-04 Sep-04May-05 Jan-06 Sep-06May-07 Jan-08 Sep-081E+00

1E+01

1E+02

1E+03

1E+04

Spread: Parallel/Offi-cial

Log of Parallel Market Exchange Rate Premium( >1 means more depreciated parallel rate)

29-30 January 2015

Hyperinflation and Economic Behaviour

How do economic agents behave in the face of hyperinflation? Do they invest? Do they save? Do they speculate? Do they spend money rapidly?

29-30 January 201537

Exchange Rate 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

29-30 January 201538

Exchange Rate Arbitrage Winners and Losers

What is the impact of large profits on exchange rate arbitrage if GDP is static?

Would you consider these “rents”?

29-30 January 201539

What Is Money?

Money serves as:1. Means of payment2. Measure of value3. Store of wealth

What happens to country’s money during hyperinflation?

29-30 January 201540

Economic theory behind money, prices and the exchange rate

29-30 January 201541

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)

29-30 January 201542

Purchasing Power Parity

The purchasing power parity relationship – that prices are equalized across countries – 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=depreciation29-30 January 201544

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

29-30 January 201545

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 - ifor

i.e.

The %change in the exchange rate can be predicted by the inflation differential

29-30 January 201546

The Real Exchange Rate and Relative Prices

The real exchange rate is equivalent to the relative prices between countries adjusted to

one currency RER = (Rand/$*CPI_US)/CPI_SA

= (CPI_US in Rand)/(CPI_SA)

= Pus in lc/Psa

RER = (NER*Pf)/P

= NER*(Pf/P)

4729-30 January 2015

PPP and the RER

NERPPP =K*(P/Pf)

RER = NER*(Pf/P)

If PPP always holds, then the RER is constant (=K)

PPP only tends to hold over the long run, not in the short run

4829-30 January 2015

PPP in Zimbabwe

Did Purchasing Power Parity hold?If PPP holds: then: is constant If the RER is Constant, then PPP holdsTest RER for stationarity

29-30 January 201549

50

Official versus Parallel real XR

29-30 January 2015

Jan-98 Oct-98 Jul-99 Apr-00 Jan-01 Oct-01 Jul-02 Apr-03 Jan-04 Oct-04 Jul-05 Apr-06 Jan-07 Oct-07 Jul-080

500

1,000

1,500

2,000

2,500

3,000

3,500

Real parallel market ex-change rate

Official exchange rate

Official Rate: no unit root, StationaryParallel rate: no unit root, trend Stationary (real depreciation)

PPP and the Z$ Exchange Rate

Official exchange rate is stationary Did government price at PPP?

Parallel market RER is not stationaryHyperinflation caused real

depreciation

29-30 January 201551

The Quantity Theory of Money (QTM)

Mv = PQ

Money*(velocity of circulation)= (Price level)*(Quantity Output)

How Does Money Affect Prices

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Mv = PQ In changes: %ΔM + %Δv = %ΔP + %ΔQ

Money must go somewhere:+ %ΔP prices

%ΔM + %ΔQ output

- %Δv speed of circ

The Quantity Theory of Money (QTM)

29-30 January 201553

What Happens When Money Increases

Helicopter money experimentRapid increases in money in a short period

generally increase prices (inflation)Steady consistent rises in money needed for

transactions and investment over the long-runAcceleration of money growth will not result in

accelerating real output

29-30 January 201554

What is Causing What?

29-30 January 201556

Money

Prices

Exchange rate

Causality

Y XEconometrics can establish correlations

Causality is a philosophical question

If lagged values of X can help predict Y above and beyond lagged values of Y alone, then X Granger-causes Y

29-30 January 201557

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

29-30 January 201559

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

29-30 January 201560

Zimbabwe Monetary Policy II:

Dollarization

UCT SUMMERSCHOOL

2015

61 29-30 January 2015

Review

Discussed the record size of the Zimbabwe hyperinflation and the conditions that motivated it.

Explained the nature of inflation and ifs relationship with money and the exchange rate: PPP and QTM

29-30 January 201562

What Was the Central Bank Thinking?

Was the RBZ behaving like a Development Bank, trying to provide cheap financing for development?

But doing it with high powered money, which has a large multiplier

29-30 January 201563

Could Zim Policy Have Worked?

Maybe in the early days (before 2006) before the inflation-devaluation spiral

If all RBZ loans went for investment, they might have increased GDP (Q)

[QTM: %ΔM+%Δv = %ΔP + %ΔQ]+ %ΔP prices

%ΔM + %ΔQ output

- %Δv speed of circ

29-30 January 201564

How Do Countries Stop Hyperinflation?

Must stop inflation – devaluation spiralNeed confidence that policies that created

inflation will be stopped.Typically slash government budget deficit

and raise interest rates Need to replenish foreign reserves and

peg exchange rate (or use currency board)Need support from partners like IMF/World

Bank29-30 January 201565

66

Zim 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 Dollarization

29-30 January 2015

What is 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

29-30 January 201567

What Does Dollarization Mean

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,…

Choice to dollarize is admission of government inability to manage monetary and exchange policy

29-30 January 201568

Types of Dollarization

Unofficial dollarization – transacting in the foreign currency is technically illegal but tolerated

Official dollarization – government officially adopts use of foreign currency as the legal tender for the country

29-30 January 201569

Dollarized Countries Using US Dollar

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

29-30 January 201570

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)

29-30 January 201571

Dollarized Countries Using the Rand

Lesotho (alonside Meloti)Namibia (alongside Namibian dollar)(Alongside Swazi Lilangeni)Zimbabwe (Alongside the American dollar,

Euro and Botswana pula)

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73

Zimbabwe’s Dollarization Exit Strategy

29-30 January 2015

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

Government implemented 5-currency dollarization (US$, €, ₤, Pula, ? ; later added Yuan, A$)

US dollar became default (used for accounting)

Has Zimbabwe formed a currency union with the United States?

i.e.Is it like another state of the USA, from an

economic point of view?

29-30 January 201574

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

OrCapital inflows are continuously large enough

to create an overall BOP surplus

29-30 January 201575

What Does the Central Bank Do?

Central bank (RBZ) no longer has its own currency that it can create

Zimbabwe’s Reserve Bank is broke (i.e. liabilities>assets)

RBZ cannot be lender of last resortRBZ cannot make loans to government Central bank still supervises the banking system

29-30 January 201576

There is No Central Bank to Manage Money Supply

Domestic banking system takes over role of creating money based on the banking multiplier (based on reserve ratio of 25%)

Commercial banks take over the role of central bank regarding foreign reserves, which are now held by the private sector

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78

Benefits and Costs of Dollarization

Benefits

Less Xrate volatility - good for exports

Inflation falls to level of host country

Enhanced monetary credibility

Increased fiscal discipline Tends to increase

international integration

Costs

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

29-30 January 2015

When is dollarization beneficial, and what currency should be

used?

29-30 January 201579

Theory of Optimal Currency Areas

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 best with geographic proximityHigh degree of labour and capital mobility is

beneficial

29-30 January 201580

Dollarization Currency

Even if benefits did outweigh the costs, the question of what host currency to adopt for dollarization remains.

29-30 January 201581

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

29-30 January 201582

SADC and CMA Alternative

Potential future SADC monetary unionCMA Rand zone should be interesting to

Zimbabwe (SA is major trading partner)Each member maintains a degree of

monetary autonomy

Should Zimbabwe have joined the CMA Rand zone?

29-30 January 201583

What challenges has (US$) dollarization created for

Zimbabwe?

29-30 January 201584

How to Increase the 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)

But a surprising large positive errors and omissions, responsible for

bringing money into the country

29-30 January 201585

What are the Errors and Omissions

The errors and omissions reflect unaccounted inflows, most likely from substantial remittances from Zimbabweans in South Africa

Other dollar cash may be leaving the country unaccounted for and be deposited in Botswana and South Africa.

Capital may have left Zimbabwe as private sector reserves – these will eventually be exhausted

29-30 January 201586

Is the US Dollar Good for Zimbabwe?

Use of US dollar creates US dollar pricing, which may be too high to make Zimbabwe internationally competititve and create jobs.

If inflation is higher in Zimbabwe than USA, then Zimbabwe is becoming increasingly less competitive, i.e. it may be experiencing a real appreciation.

How can Zim be competitive with South Africa outside of mineral exports?

29-30 January 201587

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 (2-8%)?

29-30 January 201588

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 investmentIndigenization Program requires 51% local

ownership, which discourages FDI

29-30 January 201589

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

29-30 January 201590

Investment Needs and the Interest Rate

Domestic liquidity is in short supply, but needs rational allocation, thus high interest rates

Lending to Zimbabwe carries high risk premium and thus high interest rate.

So high interest rates reflect time preference?

29-30 January 201591

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 need debt relief package through IMF/World Bank to resolve existing debt, or new lenders.

29-30 January 201592

Can The Angola Model Work

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?

29-30 January 201593

Conclusions - Hyperinflation

Government chose easy strategy of high fiscal spending financed by printing money during 2000s

It disguised excessive fiscal spending using (quasi-fiscal) central bank lending

Multiple exchange rates allowed insiders to earn arbitrage profits

Main losers were those who operated in the Zim-dollar economy

29-30 January 201594

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 rents to desired people (in ZANU)

29-30 January 201595

Conclusions - Monetary Policy

The government appeared to set the official exchange rate based on PPP, whereas parallel rate showed underlying real depreciation

Evidence (from the Quantity Theory of Money) seems to show that money growth was directly driving the exchange rate depreciation

29-30 January 201596

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 appear to a better currency for Zimbabwe than the US$

Policies to address current financial and investment challenges are deficient

A new economic crisis could materialise

29-30 January 201597

Questions

1. Did dollarization produce a positive result for Zimbabwe?

2. Who were the winners and losers in 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?

29-30 January 201598