The Sunday Mail
Cornelius Dube
THE introduction of the Dutch Foreign Currency Auction in Zimbabwe towards the end of June 2020 resulted in a number of positive developments.
Inflation, which was spiralling out of control, took only about a month to be tamed.
After peaking at 837,5 percent in July 2020, inflation decelerated fast to 50,2 percent by August 2021, which was the lowest level ever recorded for more than two years.
Secondly, the parallel market exchange rate, whose trend was steadily going north, began to stabilise in response to the introduction of the auction, as genuine transactions could be accommodated at the auction with no need to go to the parallel market.
The parallel market exchange rate was at $100:US$1 in June 2020 when the auction system was introduced, and decreased slightly to below $100 until around November 2020.
In January 2021, the parallel market rate had increased by only 8 percent over a seven-month period.
Access to foreign currency from official sources was a perennial challenge for business, standing out as a chorus at business forums as well during the annual manufacturing sector surveys conducted by the Confederation of Zimbabwe Industries (CZI).
Following the introduction of the auction, a long period followed without any foreign currency concern being raised, with industry performance showing immediate recovery.
For example, capacity utilisation for the manufacturing sector began to increase; it was 34,7 percent in 2019 and by December 2020 it had increased to 47 percent.
Over the first six months of 2021, capacity utilisation increased by 7 percentage points to 54 percent. The improved performance by business had a cascading effect to the rest of the economy.
For example, the CZI Business and Economic Intelligence Report for the second quarter of 2021 shows that new jobs created as a percentage of total employment was about 12 percent over the three months to June 2021.
However, around April-May 2021, signs began to emerge that the positive gains were now under threat.
The foreign currency auction market became overwhelmed, resulting in business raising concerns about the waiting period between the time they got allotted and the time that they received foreign currency.
Companies waited up to seven weeks on average for their accounts to be settled, while their working capital in Zimbabwe dollars was already tied up to the expected foreign currency. This marked the beginning of an increase in traffic to the parallel market, resulting in the parallel market rate spiralling, which also caused further problems.
Run-away parallel market rate as an outcome as well as part of the problem
The increase in the parallel market rate due to demand from players who would ideally be served by the auction created problems for the economy. It created a huge parallel market premium, which is the excess of the parallel market rate over the official rate.
Trading on the parallel market is risky as it is illegal, but once the return is so high, it would be worthwhile to undertake the activity as the return covers the perceived risk.
By August 2021, the parallel market premium was more than 84 percent.
However, the huge parallel market premium began to de-motivate exporting businesses, as they have to liquidate about 40 percent of the export proceeds at the official exchange rate.
The well-meant foreign currency liquidation policy began to be perceived as a tax by exporting businesses, and given that most of their local obligations would be influenced by the parallel rate, it also had viability implications.
However, the huge premium also created a perception that the auction facilitated access to “cheap” foreign currency, hence there was a scramble to participate, including businesses that would otherwise not have participated.
This further increased the backlog, which led to business, in genuine need of foreign currency, being squeezed out, ending up supplementing using the parallel market.
The use of the parallel market as a source of foreign currency by business at a time when the rate was on an upward trend had an immediate impact on inflation.
The inflation gains were reversed, which was apparent from month on month inflation figures first, before becoming evident on annual inflation.
Where was the problem?
In addition to the general low confidence in the local currency as a store of value due to high inflation, the foreign currency auction system also failed to operate as a proper Dutch Auction System.
By design, a Dutch Foreign Auction is expected to produce a price where foreign currency generators are willing to supply the foreign currency auction.
A Dutch Auction is supposed to be a price discovery process, giving signals to bidders that they face lower chances of getting an allocation by offering to pay less.
However, this can only arise if strict Dutch Auction rules are adhered to, which include:
◆ A known amount to be auctioned on the day of the auction;
◆ Highest bidders being allocated in full first, with only the low bids being subjected to a pro-rata depending on amount available.
However, the auction was selling foreign currency beyond the capacity of the RBZ to settle, resulting in backlogs.
Despite the high demand for foreign currency at the auction, the minimum acceptable bid continued to be lower than the previous week average, which also eroded the incentive to bid higher, as even low bids could still have a chance of getting an allocation which was as high as the high bids.
Has a solution been found now?
Over the past month, there have been efforts across all the critical stakeholders to ensure that the auction rediscovers its price discovery role.
There was a firm commitment that the RBZ would follow the principles of the Dutch Auction to the full, while also ensuring that there is no further accumulation of the backlog, with all bids to be honoured within two weeks.
This had an immediate impact in the economy.
First, the official exchange rate, which had changed only by about 2 percentage points over a year to August 2021, suddenly increased by more than 7 percentage points in two weeks.
However, there is also a noticeable impact on the parallel rate, where the upward pressure has died and there is a visible downward pattern emerging.
The auction is slowly reclaiming its former role in June 2020 when it helped stabilise both the parallel rate and the official rate.
Exchange rate stability is the main issue in terms of the inflationary transmission mechanism. This means that a solution appears to have been found now to the problem.
It is expected that there will be some short-term adjustment as the exchange rate from the foreign currency auction rises to the level where it should have been had the auction been functioning without challenges.
If the foreign currency auction continues to function properly, the parallel market rate will face downward pressure, which will see the impact on prices and inflation in the long run being diluted.
The economy is currently at a false equilibrium, hence correcting the foreign currency challenges will create a true equilibrium which monetary policy will help sustain.
The effectiveness of the current monetary policy thrust to contain money supply growth as a way of managing inflation will become more pronounced now if the auction continues to operate effectively going forward.
◆ Cornelius Dube is an economist with more than 16 years research experience in economic analysis and research. Views expressed are personal opinions and should not be associated with the institution currently affiliated with.
