No chances for Zim dollar comeback | The Herald

via No chances for Zim dollar comeback | The Herald December 18, 2013 by Richard Sainsbury

IN the face of a crippling liquidity crunch that has threatened to force the economy back into a recession, it has become apparent more than ever that the multi-currency regime which had stabilised the economy can also be very destructive if stakeholders such as Government and industry are not disciplined in planning and managing their finances.

Against such challenges, there has been a certain amount of warranted suspicion lately in regard to the return of the Zimbabwe dollar, which some purport to be an antidote to the perennial liquidity crunch that has bedevilled the economy. Amidst the speculation, there have been two main options discussed for how it could return; these are, namely, the gold-backed currency and the fiat currency.

The first option which has been discussed is Zimbabwe issuing gold-backed currency. Gold- backed currencies were the standard prior to 1947. The gold standard has since been abolished, with no currency currently in existence using the standard. The world currently uses a new currency standard called fiat money, which is a currency that has no intrinsic value but whose value is derived from the common understanding that it can be traded for goods and services.

In the ruins of the financial crisis in 2008, there has been much debate on the gold standard and its viability in comparison to fiat currencies. Without getting into too much detail, the following basic conclusion can be made on the economic effects of the gold standard in comparison to those of a fiat currently standard; “the gold standard curbs inflation but is prone to deflation and fiat money is prone to inflation but curbs deflation”.

Inflation in moderation is better economically than its proportionate amount in deflation, because deflation generally paves the way for a depression as declining prices lead to a decrease in incomes, and debts and unfunded liabilities become much more expensive to repay. Against this background, we do not think a return to the gold standard is viable.

In addition, it is also certain that no other country will move back to the gold standard because of its many limitations. By examining the option of issuing a gold-backed currency while the rest of the world does not, really highlights the impracticality of this idea. With the recent history of the behaviour of the Reserve Bank, and the memories of the hyperinflation that went with it, there is still distrust in the value of any currency that may be issued by that institution.

Because of such perceptions, if a gold-backed currency were to be introduced in the near future, the value of each gold-backed dollar must be 100 percent backed in value by gold. Any attempt otherwise would see an immediate run on the central bank. It would be more practical to debate about a gold-backed currency if the country had gold reserves at the Reserve Bank to back the currency, but unfortunately the RBZ has been technically bankrupt for a very long time. However, if we were to hypothetically assume that the country’s gold reserves are worth US$500 million and every dollar must be accounted for, the total value of all issued currency must therefore be equivalent of US$500 million. Against these assumptions, if Zimbabwe’s GDP is approximately US$10 billion, then applying the gold standard would effectively shrink the economy from US$10 billion to US$500million, which does not make any sense and also the reason why most countries in the world have abandoned this form of currency. There is no upside to such a currency, let alone the impracticality of any attempt to implement it. In addition, minerals beneath the ground are not commodities and cannot be sold until they are in a position to be sold. What this means is that they are essentially worth nothing until extracted and as a result cannot be leveraged into a currency as well.

The second issue that has arisen recently is that Zimbabwe needs its own currency so that it can implement tools such as monetary policy to stimulate the economy. So let’s explore the viability of Zimbabwe issuing a fiat currency. In our opinion there are so many problems with this but we will explore the two clear ones. Fiat currencies by nature are just notes that are legal tender, meaning that they can be traded in Zimbabwe for their value in goods and services. The value of fiat currencies is therefore derived from the two principle forces, namely, the supply of the currency and demand for the currency.

The central bank, which issues the currency, has complete control over the supply of currency and herein lies the first problem, which is that during the previous decade Zimbabwe went through the worst hyperinflation in history, the Reserve Bank issued/printed too much currency for the same amount or less output. The result of this was that there was too much money chasing too few goods causing inflation. It was compounded by a lack of confidence in the issuer as a result of its increased money printing which decreased effective demand and made the currency even less valuable. This continued until the currency became worthless and Zimbabwe moved to US dollars. Zimbabwe was able to do this because most transactions by this stage were already taking place in US dollars and the local currency didn’t have any value. Those memories are still fresh in many people’s minds; therefore there would be no confidence in the currency if it is reintroduced in the short or medium term, rendering the idea disastrous.

There is also a further problem with a premature reintroduction of a local currency, which would exacerbate the above situation. To explain this we will have to give a brief overview of how banking works. The world uses what’s called fractional reserve banking. Basically what this means is that when a deposit is made to a bank they now have an asset in cash and a liability in deposits. The bank must also have certain requirements of capital reserves. Now, when the bank receives a deposit it puts a proportion of this deposit into reserves and advances the remainder in the form of a loan. Thus the bank has effectively created more money in existence. In theory this money exists, however, the money is not available or liquid until the loan is repaid. This effectively means if everyone went to the bank demanding their money at any one time i.e. a bank run, the bank would not have enough money to pay the depositors their money back.

This situation is not unique to Zimbabwe and occurs everywhere. Another important point to keep in mind is that a large proportion of this money is not in physical notes and coins, it is held in accounts within other banks around the world. This is important because in theory if Zimbabwe issues its own currency, it would require all US dollars to be exchanged for Zimbabwe dollars at a certain exchange rate.

However, Zimbabweans, with recent memories of hyperinflation will more than likely not trust the newly issued currency and will attempt to keep the US dollar notes they already have and will attempt to withdraw their US dollars from the banks causing a bank run which will more than likely bankrupt the financial sector. To avoid this situation, the government would have to freeze all accounts which contain US dollars and convert them to the newly issued currency. This forced exchange will likely lessen the confidence of the newly issued currency, and by association the demand and the currency will collapse from the very moment of its existence.

However, the biggest obstacle if by some miracle Zimbabwe did manage to issue a new currency in the short or medium term is its impact on trade. Zimbabwe perennially struggles from a large trade deficit which has consequently made it difficult for the country to build its foreign currency reserves. A premature return to the Zimbabwe dollar or any new local currency in the absence of adequate foreign currency reserves would also render such a currency useless, as an overwhelming demand to exchange the local currency into foreign currency so as to import goods and services, will destroy the currency’s value over a very short space of time. Therefore, there is no upside to this and the clear lack of viability and benefit acts as the reasoning that there will be no Zimbabwe dollar return in the short to medium term.