SI’s reversal erodes fiscal policy credibility (Part 1)
Published On May 28, 2014 » 3345 Views» By Hildah Lumba » Features
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THE depreciation of the Kwacha nominal exchange rate against major international convertible currencies prompted the revocation of statutory instruments S.I. 33 and S.I. 55. The justification given was that these two instruments had brought about an erosion of investor confidence.
An economic principle based explanation of the link between the Kwacha depreciation and the two statutory instruments was not given, but rather there was emphasis on the vague term” investor perceptions” of what the statutory instruments entailed.
The lack of an economic theory fundamentals based explanation of the connection between the statutory instruments and the depreciation of the Kwacha exchange rate brings into focus issues to do with the credibility of general economic policy management and in particular monetary policy management.
The depreciation of the Kwacha exchange rate had come about against the backdrop of falling copper prices but with increases in production, an expansionary fiscal policy stance evidenced by a widening budget deficit and low foreign exchange reserves.
Herein lay the sources of the Kwacha exchange rate depreciation and solutions and methods employed to arrest the depreciation lay in addressing these issues. Addressing these issues would have gone a long way in allaying investor fears about future economic prospects of the country.
Spokesmen for investors maintained that, the SIs had sent signals of a return of some form of exchange control regime which signalled policy reversals and showed economic policy inconsistency and hence the drop in foreign currency inflows, which had contributed to the depreciation of the Kwacha against major currencies.
The issue at hand here is of one evaluating the validity of such assertions and whether or not they are based on sound economic theory fundamentals and facts or on subjective sentiments of vested interest groups.
The attractiveness of one country’s assets depends partly on the credibility of its economic policy and that is why analysts gauge the credibility of fiscal and monetary policy.
It is also important to note that there is a difference between regulation and control and also to point out that regulation is not incompatible with a market based system, the United States of America financial system being an example of one of the most heavily regulated market in the world and yet it is acknowledged as one of the most efficient market based financial system in the world.
From the reasons advanced and subsequent comments and justifications for revocation of the two SIs from vested interest groups, it would appear that the decision to revoke these instruments was driven more by these wrongly premised sentiments than any solid economic analysis of what was driving the exchange rate movement.
The reaction to the depreciation of the Kwacha bears all symptoms of a decision process overwhelmed by panic. Otherwise, why revoke the two statutory instruments and then talk about further consultations and in any case, with who?
Normal forms of interventions to counter usual volatility trends in financial market prices (the Kwacha exchange rate) taken by Bank of Zambia such as, the raising of reserve requirement to limit credit availability, sell of foreign exchange reserves to dampen pressure on the Kwacha and reduce money supply, assuming it was unsterilised intervention, and an upward adjustment to the  Bank of Zambia policy rate to counter inflationary pressures were not allowed to go through the normal transmission process and time frame, this all pointing to panic.
It is an acknowledged fact that there is a tendency for financial market prices to exhibit excess volatility. Some price movements may simply reflect waves of greed and fear that exaggerate underlying conditions.
It is also important to recognise that price movements, even if apparently unjustified, can feed back into economic decisions, as can the greed driving the price movements.
What signals does this panic reaction to the exchange rate depreciation send to players in the market and what confidence can they have in the efficacy of the decision-making process and policy direction?
It is important that policy reactions to these price fluctuations are based on sound economic principles than the sentiments of vested interest groups, whose interests might be transitory and may not be the same as national interest.
Strong economic analysis, good market information and a proper appreciation of the market psychology are essential for the monetary authorities to make the right choices. Good and accurate market information is what the two instruments were meant to bring to the fore in the decision making process.
It would also be interesting to know what the role of and input of the Bank of Zambia was in the introduction of and revocation of the two statutory instruments was, since it is the implementing agency. What reasons were advanced by Bank of Zambia for the introduction and timing of the revocation of the two statutory instruments?
Answers to the question of the extent of Bank of Zambia involvement in this policy reversal, hinge on the independence of the Central Bank and the credibility of monetary policy.
Credibility in this case being the confidence the central bank commands in terms of matching its deeds to its words. It rests on the revealed principles and objectives which it has followed and pursued over time. It also has to do with the readability of its monetary policy.
Credibility influences market expectations about the future behaviour of the central bank. It is an asset, a catalyst which has a strong bearing on the cost/benefit ratio of monetary policy.
Specifically as regards SI 55, it is important to note that it preceded SI 32 which had more stringent information requirements. Its revocation and replacement with a much diluted SI 55 was a source of serious differences within officials at the Ministry of Finance and Bank of Zambia and partly explains the transfer of some key officials from the ministry, who had strongly objected to manoeuvres to water down SI 32.
It also would appear like to the anti-SI 32 lobby group, the watered down version of SI 32, (SI 55) was not acceptable as well and they were hell bent on continuing with the fight until they achieved their final goal, which was the revocation of SI 55.
The Kwacha exchange rate depreciation seemed to have provided the perfect scenario for furtherance of their ultimate objective which was a return to the status quo of no regulatory framework in which the Bank of Zamia would monitor the balance of payments. Whatever consultations were carried out by the authorities, seem to have been confined to these investor groups.
The content of their objections and rationale for placing the blame on the two statutory instruments for the depreciation of the Kwacha was based on the rather subjective perceptions  of  investors that,  the two statutory instruments represented a move back to exchange controls and that this amounted to economic policy inconsistency.
But such sentiments do not much up with facts nor do they make economic sense in that there is complete convertibility on both current and capital account transactions of balance of payments in Zambia.
The simple fact is that, there were no provisions in SI 55 which introduced inconvertibility on both current and capital account transactions. So how could decisions affecting the level of foreign exchange inflows and outflows and their timing, have been influenced by the statutory instrument.
Section 4. (1) of the Bank of Zambia Act states that, the Bank shall formulate and implement monetary and supervisory policies that will ensure the maintenance of  price and financial systems stability so as to promote balanced macroeconomic development.
Section 4.(2) (a) states  that the bank shall licence, supervise and regulate the activities of banks and financial institutions so as to promote the safe, sound and efficient operations and development of the financial system; (b) promote efficient payment mechanism; (c) issue notes and coins to be in the Republic of Zambia and regulate all matters relating to the currency of the Republic; (e) support the efficient operation of the exchange system and (f) act as adviser to the Government on matters relating to economic and monetary management.
It is light of the above responsibilities of the bank of Zambia that S.I. 33 and SI 55 should be seen when they were introduced in the first place.
Financial markets are the channel through which monetary policy objectives and decisions are transmitted to the real economy and consequently affecting and influencing both the consumption and investment decisions which in turn affect the direction and rate of economic growth.
Financial regulations set the framework through which monetary policy is conducted. The regulations are there to set the parameters in which attainment of monetary policy objectives will be pursued and achieved.
Regulations are not incompatible with operation of market based system. Regulation of financial markets is an integral part of economic management and particularly important in the framework of a market based economic system.
Financial markets are the most regulated sector of the economy even in the most liberal and market based economies like the United States of America.
In the USA, contravention of financial regulations carries with it stiff penalties including imprisonment. Confidence is critical to the stability of the financial system and hence the need for regulations which promote and enhance transparency and uniformity of information on which financial market participants can base their decisions.
Regulations ensure a systematic flow of information in the system that enables the authorities, as well as market participants, to read and appreciate the trend and pattern of economic developments. Both statutory instruments would have been meant to enable bank of Zambia to get data and information in a timely and systematic manner through the banking system.
Accurate and timely data provides a good base for appropriate analysis of what is happening in the economy. The two statutory instruments should be seen in the context of measures meant to improve the efficiency of the financial system.
It is against this background that one should evaluate whether SI 33 and SI 55 were necessary for monetary policy management and whether they were based on solid prudent economic fundamentals.
At the recent extractive industries conference, the ICMM report indicated that publicly available data on the mining sector was scarce and that ambiguities existed in relation to eg production and gross domestic production data.
It further observed that reliable data on production volumes is a critical input in any assessment of the macro contribution from mining, and yet ambiguities exist around what constitutes the ‘right’ numbers.
To emphasise the point, the report gave the example of the disparity in copper production volume figures (200,000 tonnes) between the International Copper Study Group (which is recognised as a premier source of copper market data) and Bank of Zambia data.
It concluded that lack of authoritative and definite domestic data on production reflected a broader problem of capacity weakness. This goes to confirm the problem of getting accurate data which SI 55 was meant to address.
It is ironic that even after identifying and confirming the data and information collection mechanism deficiencies, government could go ahead and cancel SI 55 which would have filled the void in information collection.
SI 55 specified the items to be monitored, the notification process, the time frame in which the notification should take place and penalties for failure to meet information requirements. Nowhere in the provisions of the statutory instrument is control nor requirement for approval provided for.
In any case such a provision would have contradicted regulations which allow for complete convertibility of both current account and capital account transactions in balance of payments. Thus the importance of an efficient data collection system anchored on clear guidelines is emphasised.
In considering whether S.I. 33 and S.I. 55 were necessary, it is important to start by looking at what the monetary policy making process is about. The monetary policy making process is a forecasting process, requiring accurate, relevant and timely data. It is an exercise in financial modelling involving estimating the parameters that define the relationship between economic variables.
It is an exercise with predictive intent. Information and data to use to arrive at internal equilibrium such as the money demand function would be generated from the requirements of SI, 33 that transactions be quoted in Kwacha which is the legal tender.
At the same time, monitoring of balance of payments as specified by SI 55 would ensure adequate flow of information necessary for estimating the external balance.
These two instruments formed the basic and most reliable mechanism of getting accurate data and information on which formulation of monetary policy would be based. The monetary policy process starts with identifying and selecting monetary policy objectives.
It then moves on to selecting the instrument variables to be used to move towards some intermediate target and then finally the ultimate target. In making monetary policy, the central bank looks at a variety of indicators, not ignoring any source of information arising from the complex transmission from policy action to final objective.
Policy instruments are usually adjusted in small increments in response to these indicators that there is some risk that the previous instrument setting might not be producing the desired result.
The monetary policy framework set above operates in well-developed financial markets in which the transmission of policy operates principally via changes in interest rate and exchange rate. Actions taken by the central bank to adjust its balance sheet initially affect short term interest rates, changes later radiate out, on one hand, to other rates of return and the cost of capital and on the other hand, to the exchange rate.
Changes in both interest and exchange rate directly influence the demand for goods and services, and hence output, and changes in output relative to its potential which affects the rate of inflation.
At this point it is important to look at the Bank of Zambia Act and what it says about what the monetary policy objective should be.
Section 4(1) refers to promotion of balanced macroeconomic development which, in macroeconomic balance approach means securing both internal and external balance equilibrium of the economy.
By internal balance is meant, the economy attaining a level of output consistent with both full employment and a low sustainable rate of inflation.
And by external balance is meant, achieving a stable nominal effective exchange rate at a level which is high enough to avoid importing inflation and at the same time low enough to keep the economy internationally competitive .
It is having a current account position that is generated by economic fundamentals of national savings and investment when the economy is in internal balance, with the additional requirement that the resulting path of the net foreign assets is sustainable.
Because the equilibrium exchange rate depends on the position of internal and external balance in the economy, it will change in response to shocks that alter these balances.
Thus, as long as SI 33 and SI 55 facilitated the efficient provision of appropriate and accurate data and information to monetary policy formulation and implementation, they were justifiable and should never have been revoked.
SI 33
In the context of S.I. 33, it is important to start by defining what money is and its role in the economy. It is also important to look at how money is used as an instrument of monetary and fiscal policy.
Money is defined by its functions which are as universally accepted medium of exchange, a unit of account, a store of value as well as means of deferred payments. The motives for holding money are for transaction, speculative and precautionary purposes.
Aggregate demand for money depends positively on gross domestic product, negatively on one or more opportunity cost variables usually nominal interest rate and or inflation rate. It is also accepted that money is essential for the efficient running of the economy on account of it reducing the transaction costs in the exchange of goods and services process.
Thus money as an economic variable is important in the conduct of monetary policy. The money supply process is at the centre of monetary policy and because the central bank is usually the institution mandated to issue currency, that is why, ordinarily, it is the one that manages monetary policy.
The Bank of Zambia Act stipulates the primary objective of the central bank as one as one of maintaining price stability.
This, in actual fact, is not unique to Bank of Zambia but is rather a universal objective of most central banks in market based economies.
Money plays such an important role in the inflationary process that its control must be the overriding responsibility of the central bank. Maintenance of price stability is one of the benchmarks for judging credibility of monetary policy.
Bank of Zambia is the institution entrusted with the issuance of the fiat currency of Zambia. Monetary policy management is basically the management of money or put in other ways, the creation of money and activities closely related to it.
Money is the unit of account in which notes and deposits are denominated, which as a rule is the fiat currency of a national state (The kwacha in the case of Zambia).
Thus when we talk about inflation eroding the value of money, we mean depreciation in terms of goods and services that can be bought with it. In the same vein, trading in foreign exchange markets establishes the relationship between different currency units, the value of one in terms of another. Money is also is the universally accepted means of exchange and a means for deferred payments. Seen in that context then, S.I. 33 was meant to enforce these functions of money.
Demand for currency reflects the transaction needs and its estimation must be based on the currency in circulation and that of bank deposits.
Since the transactions motive is key in demand for money, the currency in which transactions are denominated is critical in determining the money demand function. It would thus be assumed that SI 33 was introduced to make the Kwacha the operative currency to enable accurate determination of the money demand function.
Correct estimation of the money demand function is crucial in the monetary transmission mechanism to attainment of the monetary policy objective of price stability.
Demand for money serves as conduit in the transmission mechanism for both monetary and fiscal policy, so the stability of the money demand function is  critical, if monetary and fiscal policy are to have predictable effects on real output and the price level.
It is at the heart of the issue of monetary policy effectiveness. Allowing transactions to quote in other currencies would distort the money demand function which the Bank of Zambia would be using to estimate required money supply expansion or contraction and expected out turn in interest rates and inflation.
Thus Introduction of SI 33, among other considerations ensured correct estimation of the money demand function and effective monetary policy.
That is a more justifiable reason for its introduction, than its revocation on account of its impact on so called investor sentiments.
The kwacha, which is the currency issued by Bank of Zambia, is the designated sole legal tender for all public and private transactions. Section 33 of the Bank of Zambia Act states that, a tender of payment of money shall be legal tender if it is notes and coins that are made and issued by the Bank under this act.
So SI 33 was only reinforcing Section 33 of the Bank of Zambia Act which people had been ignoring by quoting transactions in other currencies.
From the perspective of monetary policy management this was perfectly justifiable since the quantity of the Kwacha is the only magnitude the Bank of Zambia can control and determine.
For monetary policy effectiveness and attaining of the monetary policy objective of price stability, it is only logical that the central bank uses a variable over which it has control.
The quantity theory of money is basically about the relationship between the volume of money and the price level.
Simply put, the theory stipulates that variations in the stock of money will translate in price level variations given that output is fixed in the short run and velocity of money is stable.
It is on the basis of this theory that central banks use the money supply process to control inflation or in other words, to maintain price stability.
The predictability of monetary policy decisions of Bank of Zambia as regards variations in money supply to affect prices, interest rates, exchange rates and asset prices should be more enhanced by correct estimation of the money demand function which the introduction of SI 33 was meant to promote.
Section 5 of SI 33 which also ensures the convertibility of the Kwacha into any foreign currency, guaranteed the ability of any one engaged in legitimate transactions access to foreign currency to meet any of their legitimate foreign currency obligations.
Any issues to do with the exchange risk due to movements in exchange rate should be left to the normal instruments in financial markets that are used to guard against such risks. In any case it is maintaining the value of the Kwacha through inflation containment that can guarantee exchange rate stability and minimise risk.
Under such a scenario the incentive to quote in foreign currency or hold foreign currency accounts would diminish. One known so called business guru gave the issue of being able to borrow much cheaply from abroad has the reason why it was necessary to revoke SI 33, but it is common economic sense that a reduction in inflation leads to a drop in nominal interest rates and it is through control of money supply that inflationary pressures can be contained which would then lead to a reduction in the cost of borrowing.
Any foreign lender is more concerned about whether there are exchange controls or not, and the convertibility of the local currency.
SI 33 guaranteed the convertibility of the kwacha, so quoting of transactions in kwacha provided no obstacles to ability to borrow cheaply from abroad as long as the proposed venture was viable.
Revocation of SI 33 is a recipe for inviting the Zimbabwean situation  where the local currency is no longer the accepted medium of exchange and the government are no longer in a position to undertake any monetary policy measures to influence inflationary  trends, let alone interest rates.
The central bank has been reduced to a receiving and paying agent for the government. The economy is experiencing deflation but the authorities have no tools to counter it.
All this on account of them allowing other currencies, over which they have no control, run parallel to the Zim dollar. Anybody with the best intentions for the Zambian economy cannot encourage that scenario by supporting the revocation of S.I. 33.
(Look out for Part 2 in tomorrow’s edition)
*The author is former managing director of the Development Bank of Zambia (DBZ). He once served as director of research at the Bank of Zambia and Economist at the IMF.  He holds a BA in Economics (UNZA) and an MBA in Economics and Finance (Aston Business School, Birmingham, UK). He is currently a lecturer in macro-economics, money, banking and financial markets at the University of Lusaka.

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