ECONOMIC MUSINGS: ZIMBABWE’S INFLATION CONUNDRUM
STIMULATE ECONOMIC GROWTH OR CONTAIN INFLATION?
Zimbabwe’s economy is projected to contract 2.1% in 2019. With official year-on-year inflation for June 2019 out at 175%, local policymakers find themselves with the unenviable task of having to tame high inflation and economic contraction at the same time. In economic parlance, this dual phenomenon of high inflation and economic stagnation is referred to as stagflation.
It is widely accepted that the genesis of the current high inflation lay in the ultra expansionary fiscal policies of the period 2016 through 2018 when the government ran persistent budget deficits. Whilst government’s objective might have been to spur economic growth – with some modicum of success – this economic growth was purchased at the cost of higher inflation.
Over the period January 2016 through December 2018, money supply grew at an average 29% per annum, with the country’s money stock doubling from circa RTGS$4,7 billion to RTGS$10 billion during the period. This necessitated the later uncoupling of the RTGS$ and US dollar and subsequent liberalization of the exchange rate. No wonder then, that current finance minister, upon assuming office, identified the need to return to fiscal discipline as one of his major policy objectives. This came from the realisation that budget deficits had spurred money supply growth leading to exchange rate instability and higher inflation.
Inflationary pressures from the expansionary fiscal policies of 2016-2018 are still very much embedded in the system and will take a while to unwind. Policymakers do however, have at their disposal, monetary and fiscal policy tools through which they can try to influence economic activity and thereby combat this high inflation and economic contraction.
The major challenge though, is that policy solutions for high inflation and economic contraction are diametrically opposed. What prescription you administer to remedy one, directly exacerbates the other. Deflationary policies that tame inflation invariably choke aggregate demand and hence lead to further economic contraction, while expansionary measures aimed at stimulating economic growth inadvertently fan inflationary pressures. It is analogous to using water to douse flames on a laptop that for one reason or another, has caught fire. There is no just way of extinguishing the fire without wetting the machine!
Local policymakers are therefore faced with the trade-off between containing inflation and stimulating economic growth. Achieving both is nigh impossible. Do they seek to tame inflation and accept further near-term economic contraction, or will it be balls to wall on stimulating economic growth, in which case, high inflation will likely be the unintended consequence?
In view of the required trade-off, let’s analyse current policy and try to form an opinion around which of the two battles, if any, local policymakers have chosen to fight. Recently, the Reserve Bank of Zimbabwe, which is the local custodian of monetary policy, hiked its overnight accommodation rate to 50% per annum (up from 15%). The accommodation rate is the interest rate at which central banks lend money to banks to plug their short-term liquidity shortfalls. Other interest rates in the economy, such as the cost of bank credit as well as the yield on savings deposits, are usually benchmarked to the accommodation rate.
Whenever the central bank ups its key interest rate, this signals a contractionary tilt to monetary policy. A rate hike is designed to lower the level of aggregate spending within an economy by increasing borrowing costs for firms and households, leading to lower investment as well as lower interest-sensitive consumptive spending – the so called “cost of
credit” channel of monetary policy transmission. The ultimate policy objective being to dampen inflationary pressures ascribed to excessive demand for goods and services. A factor that will curtail the effectiveness of the rate hike in reducing aggregate spending is the fact that, unlike most economies in which credit drives consumption at a household level, the Zimbabwean economy generally operates on a “cash” basis. In other countries, households’ expenditure on motor vehicles, houses, household appliances and to an extent, fast-moving-consumer-goods, are generally financed by credit. As such, Zimbabwe’s “cash-driven” household consumption is likely to exhibit significantly less sensitivity to fluctuations in interest rates. Ergo, a rate hike in Zimbabwe is likely to have less impact on this component of aggregate spending than would be the case in other economies in which household spending is driven by credit. A salient point worth noting here is that consumption constitutes the biggest component of aggregate spending within most economies, Zimbabwe included.
So far, RBZ’s rate hike is yet to permeate to the rest of the economy by way of increased borrowing costs and higher interest rates on savings. This is largely due to the fact that daily market liquidity has been in excess of ZWL1,5 billion since the rate adjustment. Banks therefore, haven’t needed to borrow from the central bank through the overnight accommodation window, rendering the rate hike ineffective thus far. The local interest rate environment is largely unchanged from pre-hike levels. In a bid to increase the potency of its rate hike, RBZ recently commenced open market operations aimed at mopping up excess market liquidity through treasury bill auctions. Three auctions have been held so far, two of which were oversubscribed. On the evidence of these auctions, it is likely that RBZ will mop up some of excess liquidity through the open market operations.
A policy instrument that RBZ has decided against using for now is the statutory reserves ratio. One suspects the central bank is keeping its powder dry for now and waiting to see how much traction the open market operations have in draining excess market liquidity before upping the reserves ratio to augment the TB auctions and savings bond issuances.
Local monetary policy, as it stands currently, exhibits a contraction bias, implying that monetary authorities has chosen to contain inflation ahead of the pursuit of near-term economic growth. The contractionary effects of monetary policy are, however yet to fully take root in the real economy.
A look now at the fiscal space. The budget balance, which measures the extent to which government revenue matches expenditure, is an indicator of government’s policy
stance. As a policy tool, budget deficits, where government spends more money than it collects in revenue in a given period, indicate an expansionary tilt to policy and are generally used to spur economic activity through increasing aggregate spending. The reverse is true for budget surpluses.
The chart above shows the extent to which government expenditure has overshot revenue over the past few years. Back in 2014, government ran a balanced budget where expenditure largely matched revenues. At the time, annual inflation averaged -0.1%. In recent years this had given way to budget deficits financed by the issuance of treasury bills and central bank overdrafts. During the period 2016 through 2018, local debt quadrupled from RTGS$2,25 billion to RTGS$9.5 billion. High inflation ensued.
Zimbabwean policymakers have declared their intention to return to fiscal discipline by reducing budget deficits. Austerity was the major theme of the original 2019 budget, with policymakers targeting to restrict the budget deficit to 24% of projected total revenues, down from 54% recorded the previous year. At the time of announcing the initial 2019 budget, official inflation was around 20% whilst the Zimbabwean economy was projected to post real growth of 3.1% in 2019.
Much has changed since the pronouncement of the initial 2019 budget. Supply side shocks of electricity shortages, recalibration of the economy from the multicurrency to a local currency, along with the adjustment in local price levels to the liberalised exchange rate environment have combined to create an economic landscape in which inflation is in triple digits and real growth is projected to be negative 2.1% in 2019.
In this new economic reality, Zimbabwe’s revised 2019 budget projects a fiscal deficit of 32% of revenue, up from 24% in the initial budget. How can one interpret this policy stance in view of the required inflation containment/growth stimulation trade-off? A study of the composition of government spending should shed further light and help us draw inferences on which side of the divide local fiscal policy lay.
The above chart shows the composition of government spending. The revised 2019 budget exhibits a greater emphasis on capital expenditure than the initial budget (38% in revised budget vs 25% in initial budget). Capital expenditure is more discretionary in that if funding constrains dictate, capital projects can be deferred whereas employment costs and other recurrent expenditure are relatively less flexible elements of government expenditure.
Combined with the increased overall projected budget deficit for 2019 (32% vs 24%), the revised budget’s increased emphasis on capital expenditure points to an expansionary bias in fiscal policy and suggests policymakers are prioritising growth over inflation containment. Given the fact that government recorded a ZWL800 million budget surplus during the first half of 2019 and the swing in the budget balance to a projected 32% deficit by yearend, it is difficult to conclude otherwise.
Monetary and fiscal policy don’t quite seem to be in sync. Policy is currently equivocal. Monetary policy certainly has a contractionary bias, even though it might require some augmenting through upward revision of statutory reserve ratios to ensure it is more potent in restricting aggregate spending. Fiscal policy on the other hand, as we interpret it, still exhibits a fairly expansionary feel to it. It could well be the case that through monetary policy, the authorities are targeting inflation containment, whilst looking to boost growth through fiscal policy – a sort of middle-of-the-road approach.
The concern however, is that fiscal policy, through its direct impact on spending within the economy, tends to have a greater short-term impact on economic activity than does the relatively indirect transmission mechanism of monetary policy on the real economy. Therefore, in an environment with inflationary pressures already embedded into the system, the danger of adopting an expansionary fiscal stance is a greater likelihood of stoking inflation.
Our view is that unavoidable economic contraction is a lesser evil than high, unpredictable levels inflation. Business thrives on price stability. The longterm nature of business strategy requires a stable inflationary environment. We believe business can survive cyclical economic contractions as long as there is clear policy commitment to achieve price stability. Using our earlier analogy of the burning laptop, we are of the opinion that it is better to pour water and douse the inflationary flames, accept that the laptop will get wet and be content in the knowledge that we can find the spares to replace damaged parts and get the machine working again. The alternate decision to let the flames ravage on, is clearly untenable.
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