Zimbabwe Banking Overview 2011

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Special Report - Zimbabwe Banking Sector

April 2006

The Zimbabwean economy and the banking sector as a whole remain difficult to track, given thecomplexity of the environment. As a result, this discussion has been limited to our view of the most

relevant developments and concerns, as outlined below.

Regulatory and Accounting Risk

Concerns stem from a relatively volatile regulatory framework. Movements in statutory reserve

requirements typify the regulatory risk faced by financial institutions. In late 2005, an increase in statutory

reserve requirements removed substantial amounts of market liquidity, causing banks to suffer major

liquidity shortages, at which time banks had to bid for cash from the market at rates of up to 700%.

Within three weeks of the statutory reserves hike, the RBZ held shorter dated treasury bill tenders,

suggesting that the liquidity that had been removed from the market had run out. Because the RBZ was

competing with the banking system for liquidity, it offered rates of 500% for 90-day paper, granting

savers a 120% gain on their money over 90 days.

After declining in early 2006, the reserve requirement has again been hiked, forcing banks to source more

liquidity, which must be paid over to the RBZ at no interest. Shortfalls have to be funded from the

interbank market or directly from the RBZ at 800%. This exposes banks to potentially huge losses and

extends the difficulty of meeting a new US$10m capital requirement by September 2006. In this context,

our expectation is for short-term interest rates to rise further, heightening the possibility of a second-

round “flight to quality”. Amplifying these concerns, 90-day paper offering 500% can now be boughtdirectly from the RBZ, thus attracting much-needed deposits away from the banking system.

Running concurrent to this is what we term accounting risk . Accounting risk is introduced through the IAS

39 convention, which requires institutions to mark-to-market their available-for-sale instruments. In the

current environment, banks’ asset mixes are heavily skewed towards government securities, with large

portions of their Treasury bill portfolios being maintained as available-for-sale securities (in what is known

as their trading book). With uncertainty surrounding rates and tenures offered on Treasury bill issues (the

RBZ is extrapolating an inverted yield curve based on inflationary expectations that are out of sync with

market expectations), banks are finding themselves “out of the money”. As a result, and under IAS 39,

they are required to offset unrealised losses to equity. This phenomenon has further compounded financialinstitutions’ challenge of meeting the minimum paid-up capital requirements by September 2006.

Economic Risk

According to the IMF, Zimbabwe’s economy contracted for the seventh consecutive year in 2005. Economic

growth – particularly within the crucial agricultural sector - continues to be constrained by severe foreign

exchange shortages, which have starved the economy of fuel as well as basic and intermediate goods.

Meagre international reserve levels reflect the absence of foreign direct investment and capital inflows –

symptomatic of international isolation and the prevailing economic distress. The foreign currency shortage

is further compounded by the exchange rate system. In the four months to January 2006, the official rate

depreciated 74% to Z$99,200/US$, where it has since been maintained under the current system. In a

hyperinflationary environment, and under an inflexible exchange rate system, erosion of the domestic



currency’s purchasing power has seen a severe weakening of the Zimbabwean dollar as a unit of account,

store of value and unit of exchange. Exchange rate overvaluation and excess demand for foreign currency

(partly prompted by its desirable property as a store of value), has fuelled a growing diversion between

the official and parallel rate. The parallel rate currently stands at around Z$220,000/US$ and is likely to

weaken substantially going forward.

Inadequate capital inflows and the foreign currency crisis are both a function and an aggravator of the

hyperinflationary environment. The inflation rate has escalated over the last year, recording a year-on-

year rate in excess of 900% during March, with independent analysts projecting the rate to increase to

well over 1000% during the year ahead (against an RBZ expectation for inflation to subside to around

200% by year-end). As with other modern hyperinflationary episodes, expeditious price increases have

been triggered by uncontrolled money supply expansion that, in turn, has been driven by endemic fiscal

imbalances. Accounting for the consolidated deficit of both government and the RBZ (thereby including

quasi-fiscal activities and financing of parastatals that are granting huge subsidies to the private sector),

the IMF report that the public deficit amounts to 60% of GDP. Given the absence of foreign funding, it is

impossible for the domestic savings base to finance the deficit through the issuance of Treasury bills.

Therefore, the gap can only be bridged by monetising the deficit i.e. printing money. Moreover, on top of

this, with Treasury bill maturities at 500% for 90 days (2500% compound) that need to be funded, itappears that continued escalation in the rates of money-supply growth and inflation is inevitable. Empirically, hyperinflations are accompanied by an abrupt reduction in financial intermediation, which

reduces the size of the financial sector (consistent with current trends in Zimbabwe), as well as increasing

systemic risk.

Sovereign Default Risk

International evidence on sovereign debt crises shows that the years preceding a crisis are generally

characterised by widening fiscal deficits, and easy access to market financing that loosen the resolve for

fiscal reforms. As has occurred in Zimbabwe, such an environment leads to an escalation of borrowing

costs which, combined with a shortening of maturities, sets off debt dynamics that soon prove to be

inconsistent with a country’s servicing ability. In addition, the combination of a weak economy and public

finances gives rise to a circular policy dilemma, as high interest rates are necessary to finance budget

deficits, but further dampen economic activity and feed back to weaker budgetary performance. Without

timely recourse to fiscal rectitude, a debt crisis inevitably ensues and government is forced to default or

inflate the debt away, both of which entail large economic and welfare costs.

Empirical studies show that domestic currency defaults have usually been the result of an overthrow of an

old political order or the by-product of dramatic economic adjustment programs aimed at curbinghyperinflation. However, neither of these eventualities appears likely in the short term. A more feasible

outcome in the short term – as garnered from meetings with financial institutions in Zimbabwe - is a

restructuring of government debt. Such a restructuring would potentially involve a compulsorily roll over of

short-dated securities into longer-dated paper at lower yields. Naturally, with banks’ asset bases reflecting

high concentrations in government securities, this possibility introduces considerable pricing risk to the

banking system. This, in conjunction with the central bank’s liquidity mopping-up policy, which involves

the daily sweeping of clearing accounts into two year, untradable Treasury bills offering a reduced fixed

rate (currently standing at 200%), has heightened liquidity risk in the short term, since many banks have

matched large deposits with treasury bill maturities.



Conclusion

Given the factors above, the banking sector is facing a very challenging 2006, with tight liquidity

management and prudent risk management guidelines essential. The key challenge and focus of banks

during 2006 will be the re-capitalisation of their balance sheets, with a view to meeting the new minimum

paid up capital requirement of US$10m for commercial banks, US$7.5m for building societies and

merchant banks, and US$5m for discount houses. The RBZ has stated that enough time has been given

and that it will not be swayed to delay compliance. Furthermore, the RBZ in its last Monetary Policystatement indicated that going forward, banking institutions that cannot be rehabilitated in the normal

course of business would be liquidated immediately, with no prospects for curatorship. Cognisance is,

however, taken of the uncertainty which accompanies the fact that the Reserve Bank initially pegged the

increased capital requirement at Z$100,000/US$ (the exchange rate prevailing at the beginning of 2006).

With inflation having subsequently increased so exponentially, the increased capital requirement would be

significantly reduced in real terms by the end of September 2006. In this regard, the Reserve Bank has

indicated that, if there is a material decline in the official exchange rate by this time, then the minimum

capital requirement position will be reviewed again, with an as yet unspecified time frame for banks to

comply with such amendments.

While GCR views the enlarged capital requirements as a necessary step to improve the stability of the

banking sector as a whole, we are expecting either a fall out in the banking industry or an industry-wide

consolidation. As at 31 December 2005, only five banks had met the new minimum paid up capital

requirement. Institutions that have common shareholders are likely to merge, with capital rationalisation

becoming an increasingly important issue for shareholders. Furthermore, financial groups maintaining

multiple licences, geared to benefit from lower statutory reserve requirements on discount houses and

finance houses, would be forced to consolidate these entities to meet the capital requirement. Banks that

are not strategically well positioned, and/or have limited access to capital, could be particularly vulnerable

in the prevailing circumstances. The RBZ currently supervises 32 financial institutions made up of 14

commercial banks, 6 merchant banks, 6 discount houses, 4 building societies and 2 finance houses

This document is confidential and issued for the information of clients only. It is subject to copyright and may not be reproduced in whole or in part without the written permission of Global Credit Rating Co. (”GCR”). The credit ratings and other opinions contained herein are,and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. No warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitness for any particular purpose of any such rating or other opinion or information is given or made by GCR in any form or manner whatsoever.

Following from the issues raised in this report, all ratings will be closely monitored by GCR. In addition,

due to the breakdown in the traditional links between short and long term ratings, GCR will in future only

accord long term bank ratings in Zimbabwe.

Documents

Zimbabwe Banking Overview 2011