Excess liquidity drives hyper-inflation

Zimbabwe is one of those countries that continue to validate Milton Friedman’s views on the chief cause of inflation globally. Friedman said, “Inflation is always and everywhere a monetary phenomenon”.

When my countrymen hear about inflation, the first thing to ring in their minds is the central bank, the Reserve Bank of Zimbabwe (RBZ). This is associated with the 2007/8 hyper-inflation period when one banknote denomination was 100 trillion Zimbabwe dollars. Banknotes were now seen in the streets and garbage areas as they became worthless.

Various studies have been done on the causes of the 2008 records shutting inflation level. All of those I have read, there is consensus that it is excessive liquidity (money supply) growth that triggered heavy exchange rate loss and subsequent high inflation. Evidence also exists supporting the view that it is the Bank (RBZ) that influenced liquidity growth. The Bank engaged in massive quasi-fiscal activities.

Fast forward to 2019, prices that had stabilised in 2009 after the adoption of the US dollar as legal tender began to increase. The re-introduced Zimbabwe dollar was also plummeting heavily against the US dollar particularly on the parallel market. The main trigger of exchange rate depreciation post-dollarisation is also excessive liquidity growth in the economy. Generally, liquidity growth should move in tandem with the growth in activity in the real sector.

For starters, by real sector, I mean domestic production.

When money is supplied at a faster rate than the rate companies are producing goods to spend that money on, the prices of existing goods will have to go up. This is what is called the “rationing” function of the price through the operation of market forces of demand and supply.

In 2019, the country experienced a massive energy deficit, acute forex shortages, and a severe drought which affected agriculture, the mainstay of the economy. Consequently, Zimbabwe faced its worst recession with high inflation since 2008.

As I noted earlier, excessive money supply causes inflation. There are various levels of money supply in the economy and of these levels, reserve money is the most troublesome.

Reserve money which is also popularly known as high-powered money or central bank money is the base level of money supply in an economy, made up of currency in circulation plus banking sector deposits at the Bank. To simplify, banking sector deposits at the Bank are made up of required (statutory) reserves, banks’ RTGS balances, and other deposits.

Reserve money (M0) is the most price-sensitive level of money supply because it comprises components that function mostly as the medium of exchange than the store of value. Also, M0 is injected directly and at the discretion of the central bank hence the name central bank money. As such, aiding economic growth is a secondary function of any central bank with the primary function being to control the growth of prices.

I am convinced that the continued sharp depreciation of Zimdollar in the alternative markets and high prices currently prevailing is mainly driven by excessive growth in reserve money. Granular analysis of reserve money statistics shows that when reserve money mounted 169,94% from December 2018 level to close 2019 at ZW$8,8 billion, the Zimdollar lost about 85% of its value on the parallel market.

Yes, there is a wide consensus that parallel markets are driven by speculation. However, for Zimbabwe, it is being largely driven by the government itself. As alluded to earlier, reserve money was surging in 2019 despite plummeting real sector activity and acutely scarce forex. This alone warrants enormous exchange rate depreciation pressure and price growth.

Reserve money balances also maintained a disproportionate growth path in the first seven months of 2020. The balances spiked by 84% to settle at ZW$16,2 billion in July 2020 from a December 2019 level of ZW$8,8 billion. In response, the Zimdollar plunged by 82% in the parallel market from an average of ZW$22:US$1 to ZW$120:US$1 and inflation reached its post-dollarisation high of 837,5% in the month.

The last five months of 2020 however witnessed sharp moderation in reserve money growth. Between July and December, reserve money grew by only 10,8% to close the year at ZW$18,8 billion. This slowdown in reserve money growth supported by about US$539,47 million that exchanged hands on the auction market during the period led to about 9,1% Zimdollar gain in the parallel market as annual inflation nosedived to close 2020 at 348,56%.

In January 2021, reserve money balances surged by a staggering 16,3% relative to a paltry growth of 1,8% realised in the prior month. Consequently, annual inflation reversed its five-month southward movement as it added 14,07 percentage points while monthly outturn mounted 5,43%, the biggest monthly gain since August 2020.

Furthermore, a glance at RBZ statistics shows that liquidity growth pressure has greatly increased since the start of April. This is the month the 2021 agriculture marketing season opened and civil servants were awarded a 25% salary review. The government through the Grain Marketing Board (GMB) is buying grains from farmers and the parastatal is expected to buy about two million tonnes of grains to the tune of ZW$60 billion including 1,8 million tonnes of staple maize. This increased liquidity is hurting the Zimdollar value.Parallel market premiums, the percentage difference between official and alternative exchange rates, is fast approaching the 60% mark. High premiums hurt exporters who are obliged to liquidate 40% of their forex receipts using the overvalued RBZ auction rate.

The Zimbabwean economy is estimated to be 70% informal, of which the informal sector sources forex mainly from the parallel market. Also, because of the reportedly long RBZ forex supply backlog, some in the formal sector are sourcing forex in the parallel market. Consequently, parallel rates are used as a pricing benchmark in both markets. For perspective, since April monthly prices are skyrocketing closing June at 3,88% from 1,58%.

I believe that if the government reverts to sustainable spending to curtail the current upward liquidity growth trajectory (as was the case in the 2HY2020), parallel exchange rate depreciation and price growth will begin to diminish. Conventionally, stability will be sustained if the parallel premiums oscillate at or below the 20% threshold. Also, authorities should craft a clear de-dollarisation roadmap anchored on prudent market-oriented economic policies to increase the use of local currency.

  • Sibanda is an Economic Analyst and this was first published by the Zimbabwe Independent