Abstract

Zimbabwe’s 2008 hyperinflation is said to be the second highest in recorded history, and provides an interesting case study of policy failure. We explore possible motivating factors behind the hyperinflation to understand why it happened and persisted for so long, and who benefited from it.

The paper examines the exchange rate–inflation spiral and explains how a large parallel foreign exchange market generated high profits for some, especially state-owned enterprises and those with insider connections who could arbitrage the dual exchange rate system. The paper explores the determination of the exchange rate, and tests the purchasing power parity hypothesis. It finds that PPP held for the official exchange rate but not the parallel exchange rate, providing evidence of structural change in the economy. It examines the causality among money, prices and the exchange rate using a vector error correction model to better understand the impact of monetary policy. In examining the hyperinflation, this paper uses the “Impossible Trinity Hypothesis” to explore the possibility that Zimbabwe’s policy-makers may have been trying set both the exchange rate and monetary policy.

The paper also examines the “dollarization” exit strategy and post-2008 economic policies. It argues that the choice of using the US dollar as the main currency of the dollarized Zimbabwe was not optimal based on optimal currency area theory. Additionally, subsequent policies to influence domestic liquidity and control investment have created new and serious problems for the country’s economy.

This case study of Zimbabwe’s hyperinflation and subsequent dollarization provides lessons for other developing economies about conducting monetary policy and the impact of full dollarization.

Zimbabwe Monetary Policy 1998-2012:

From Hyperinflation to Dollarization1

By Dr. Mark Ellyne and

Michael Daly2

Keywords: Hyperinflation, Zimbabwe, Dollarization, Impossible Trinity, Capital Controls, Monetary

Policy.

JEL Classification: E42, F31, E5

1 This paper is forthcoming in Economic Management under Hyperinflationary Environment: Lessons from Zimbabwe, Oxford University Press.

2 Mark Ellyne (mark.ellyne@uct.ac.za) is Adjunct Associate Professor of Economics at University of Cape Town, and Michael Daly (dlymic006@myuct.ac.za) is a post-graduate student in the School of Economics.

2

INTRODUCTION

Much work has been done to show that hyperinflation is a government-created and sustained policy

failure that cannot occur without monetary accommodation (Sicklos, 1995). We try to further

examine the factors behind the Zimbabwe event and ask at what level policy-makers considered

what they were doing: (1) Were government leaders ignorant of the impact of their policies? (2)

Were government policy-makers trying to pursue an alternative strategy but inept with the

implementation? or (3) Were government leaders knowingly transferring purchasing power from the

private sector to the public sector? The goal is to better understand how such policy failures occur,

and to learn lessons so that similar disasters do not occur in the future in Zimbabwe or elsewhere.

This paper explores the dual exchange rate markets that existed during the 2000 to 2008 period to

understand how some benefited from the inflation-depreciation. We examine how the parallel and

official exchange rates adjusted during this period and test a monetary model of exchange rate

determination, using cointegration analysis, to determine identify whether purchasing power parity

held during this period..

We explore the possibility that the government was pursuing an alternative monetary and exchange

rate policy prior to 2009, following a Chinese or former Soviet Union (FSU) foreign exchange market

model. The authors use the “Impossible Trinity Hypothesis” (ITH) as a framework to explain the logic

of this model and why it was not optimal for the country.

Alternatively, the poor economic decisions taken by Zimbabwean policy-makers in the lead up to the

economic crisis may have been politically motivated. In this case, an understanding of the potential

winners and losers of this inflationary policy provides further understanding of the phenomenon?

To conclude, we examine the hyperinflation exit strategy in terms of optimal currency area theory

and conclude that official multicurrency dollarization, dominated by the US dollar, may not have

been the optimal long-run policy choice and that moving forward, a regional strategy should be

considered.

Finally, we consider the current economic policy challenges facing the country under dollarization,

including: creating a balance of payments surplus; potential dangers of trying to control monetary

policy, and the strategy to raise investment. We find potential grave crises lurking in all of these

areas. Zimbabwean policy-makers also seem divided on the way forward. Economic policies appear

to reflect short-term political goals as opposed to more rapid improvement of economic welfare;

although this could also represent some social time-preference. Based on these and past policies, we

believe that government has too heavily relied upon monetary policy to support its political agenda,

sometimes at the expense of the general economic welfare.

HYPERINFLATION IN HISTORICAL PERSPECTIVE

Inflation camouflages income redistribution and should be understood as a socio-political battle as

well as an economic issue, because one person’s costs are another’s income. By examining the

source of inflation and the winners and losers in the inflation process, one can begin to understand

this economic phenomenon in social terms. Hyperinflation is often associated with changing political

conditions, war, social unrest, or political mismanagement. It is also true that hyperinflation must be

3

accommodated by printing money and hence the government always bears some role for creating it

as well as the responsibility for resolving it. Inflation may be the process used to re-distribute real

income shares in a hidden manner. Often it is a battle between capital and labour or between the

public and private sectors for shares of the national income. Typically, increasing inflation is

generally linked with the depreciation of the exchange rate which sustains an inflation-depreciation

spiral. Thus, ending hyperinflation is usually linked with the stabilization of the exchange rate.

For the purposes of this paper, we focus on the period beginning in 1998 as the starting point for the

inflationary period that lasted until end-2008. Prior to this, Zimbabwe had been following an IMF

structural adjustment program. The break with the Fund was mainly due to an excessive government

deficit linked to payments to the “war veterans” (of Zimbabwe’s war for independence). Following

an inconclusive IMF mission at end-1997, there was a 70 percent depreciation in the Zimbabwe

dollar exchange rate in 1998 and an outright break with policies agreed with the Fund. RBZ quasi-

fiscal expenditure began after that, and the end-year annual inflation rose from 20 percent at end-

1997 to over 50 percent at end-1999, and accelerated to an estimated 66,200 percent at end-2007.

In Zimbabwe’s case, the hyperinflation arose from rapid growth in central bank reserve money, not

just by lending to the government but by excessive central bank lending to state-owned enterprises

and other private sector entities. Between 1990 and 1997, the fiscal deficit averaged 6 percent of

GDP, and this expanded to 20 percent by 2000 before being inflated away. During the 1998-2008

period, direct lending to the economy by the Reserve Bank of Zimbabwe (RBZ) acted as a means to

avoiding an even more rapidly rising fiscal deficit. This hidden quasi-fiscal activity of the RBZ was

largely directed to State Owned Enterprises (SOEs) in a surreptitious manner. This was a disguised

fiscal deficit financed by printing high-powered money.

According to Hanke and Krus (2012), the Zimbabwe hyperinflation ranks as the second highest in

history, surpassed only by the 1946 hyperinflation in Hungary (Table 1). They identify these

hyperinflations following the definition provided by Cagan (1956), which is when the price-level

increases by at least 50% per month. Similarly, if the inflation rate drops below 50% and remains

below 50% for at least one year, the episode of hyperinflation is said to have ended. Based on this

definition, Hanke and Krus identified just 29 case of hyperinflation in history, the most recent was

Bulgaria in 1997. Of course, for such high levels of inflation, reliable measurement of price data is

problematic.

Hyperinflation only rose to prominence in the early half of the twentieth century when it ravaged

the economies of a number of European nations post-World War 1. This period of European

economic and political instability led to the famous German hyperinflation in 1922, where inflation

rates peaked at 29,500% per month (Table 1). While Germany’s peak inflation rate was drastically

lower than more recent hyperinflations, it was the most severe one experienced at the time. It led to

rapid depreciation of the Reichsmark and a shortage of cash, which prompted the central bank to

increase currency in circulation in order to facilitate transactions at higher prices (Heifferich, 1927).

Analysts have since pointed out that the German hyperinflation was as much a socio-political as an

economic phenomenon. The burden of punitive war reparations imposed at Versailles limited the

government’s room for manoeuvre in economic policy. Modern literature takes the more monetarist

view that the excessive creation of currency drives inflation. In Germany’s case, the increase in the

4

supply of money was accomplished through the increased discounting of commercial and

government bills by the Reichsbank (Burdekin & Burkett).

Table 1. Ten Highest Recorded Hyperinflations

Country Start date End-date Maximum

Monthly Rate--%

Hungary Aug 1945 Jul 1946 4.19 x 1016

Zimbabwe Mar 2007 Nov 2008 7.96 x 1010

Yugoslavia Apr 1992 Jan 1994 3.13 x 108

Republika Srpska Apr 1992 Jan 1994 2.97 x 108

Germany Aug 1922 Dec 1923 29,500

Greece May 1941 Dec 1945 13,800

China Oct 1947 May 1945 5,070

Danzig Aug 1922 Oct 1923 2,440

Armenia Oct 1993 Dec 1994 438

Turkmenistan Jan 1992 Nov 1993 429

Source: Hanke and Krus (2012).

The aftermath of World War 2 brought with it a new batch of hyperinflationary episodes—Hungary,

Greece, Taiwan, Philippians and China. Of these Hungary is the most noted, and is the most severe

hyperinflation on record. During this episode Hungary experienced a peak monthly rate of 4.19x1016

percent and an overall price increase over the 13 month period of 3x1025. Hungary’s inflation was

unique. Bomberger and Makinen (1980) note, that of all the countries that experienced

hyperinflation after World War 1, only Hungary experienced a second hyperinflationary period after

World War 2. Additionally, the looting by the Soviet and German forces during World War 2 left the

country with a greatly depleted level of capital stock, and output of between 40 and 50 percent of

the pre-war level (Bomberger & Makinen). Reparations after the war accounted for 25-50 percent of

the monthly expenditures of the Hungarian government. Central Bank officials repeatedly warned

the Allied Control Commission that the process of discounting treasury bills to finance such a large

deficit would inevitably lead to a repetition of their earlier hyperinflation. The Soviets who

dominated this commission disregarded these warning, leading some to believe that the

hyperinflation was encouraged to achieve a political objective—the destruction of the middle class

(Bomberger & Makinen).

The next wave of hyperinflationary episodes occurred in the 1980’s in the Latin American countries

of Peru, Nicaragua, Argentina, Bolivia and Brazil. Bolivia is interesting as it was the first instance of

hyperinflation in over 30 years, excluding Chile which experienced a very brief hyperinflation in

October of 1973. The Bolivian hyperinflation is particularly notable as it is one of the only

hyperinflations that did not result from war or revolution. The proximate cause of the hyperinflation

was Bolivia’s loss of international creditworthiness in the early 1980’s. During the period of 1975-

1981 the Bolivian government relied heavily on foreign borrowing to finance public expenditures

(Bernholtz, 1988). The combination of increasing international debt, a poor tax system,

macroeconomic mismanagement, and poor export performance prevented the Bolivian government

from procuring further international loans. When foreign capital inflows dried up in early 1982, the

government lacked the political support to raise taxes, so it substituted domestic credit expansion

for foreign capital flows as the means to finance the government (Sachs, 1987). The rapid expansion

of the money supply then set off the inflationary process.

5

In the early 1990’s, the dissolution of the Soviet Union resulted in political and social turmoil setting

off a period of hyperinflations in former Soviet states. The most unique of these was the Yugoslav

hyperinflation, which reached 313 million percent on a monthly basis in January 1994 and was one

of the longest recorded periods of hyperinflation. That hyperinflation was closely associated with the

disintegration of the former Yugoslavia, the ensuing loss of monetary and fiscal control, wars in the

region, and a comprehensive international economic embargo imposed on the country (Bogetic &

Petrovic). As inflation increased, output halved and the fiscal deficit rose to 28 percent of GDP

(Bogetic & Petrovic). In this respect the Yugoslav hyperinflation is similar to that of the Hungarian

hyperinflation of 1945-1946, where a drop in output of between 40 and 50% was experienced. The

dramatic increase in the fiscal deficit was of similar dynamics to those in the early hyperinflations of

Germany and Austria. A significant increase in seignorage preceded the hyperinflation and was used

to finance the growing fiscal deficit. Towards the end of the hyperinflation, the economy

experienced almost complete unofficial dollarization to the Deutsche Mark, which was openly

traded at universally known daily black market exchange rates–very similar to the story that

unfolded in Zimbabwe almost 20 years later.

The 1990’s also saw two African hyperinflations: the Congo (Brazzaville) and the Democratic

Republic of Congo (DRC). As with a number of past hyperinflations, the root of the DRC’s

hyperinflation was primarily political—the collapse of conventional government was coupled with an

explosion in government spending and falling revenue collection (Beaugrand, 1997). This

government spending was financed almost entirely by printing currency. In addition, the political

crisis led to a decrease in external trade and output. In the turmoil that resulted from changing

political dynamics in the country in 1990, the authorities granted government employees large wage

increases that nearly trebled the wage bill in order to thwart growing discontent (Beaugrand, 1997).

At the same time government revenue was falling, largely due to a decrease in mining taxes and

dividends.

The Zimbabwe hyperinflation has many similarities to past hyperinflations, including some elements

of war and fiscal failures. As with the hyperinflations of Hungary and the Democratic Republic of

Congo, the episode in Zimbabwe was preceded by a marked decline in real GDP. Between 1998 and

2008, real GDP in constant (1990) Zimbabwe dollars declined by an estimated 55% from Z$ 10.4

billion to 4.7 billion (Figure 1). Moreover, it may be unique in that it happened during a period of low

international inflation and reflected mainly domestic issues.

6

Figure 1. Zimbabwe: Real GDP

(in constant 1990 Zimbabwe dollars)

Source: RBZ’s GDP for 1990 indexed by the real GDP growth rate recorded by the

IMF’s WEO database.

BACKGROUND TO THE ZIMBABWE HYPERINFLATION

As noted above, hyperinflation is usually a socio-political occurrence as much as a monetary one. In

this respect, we explore several key socio-political events that may have contributed to Zimbabwe’s

hyperinflation, including: (i) gratuities paid to the war veterans, (ii)the government’s participation in

a regional war, (iii) the government’s push for land reform, and (iv) the new political challenge to

President Mugabe’s ZANU-PF party.

Appeasing The War Veterans

In August 1997, Mugabe conceded gratuities and monthly pensions to the politically powerful group

of “war veterans.” The gratuities alone cost the government more than twice the total government

spending on land reform since 1980. (Selby) This dramatic increase in government expenditure had

serious negative consequences for the country’s budget position, which was subsequently

exacerbated by its participation in the Congo war the following year.

The Congo War

The Zimbabwean government’s decision to enter into the Second Congo War in 1998 on the side of

Laurent Kabila started Zimbabwe on “the road to economic ruin” (Noko, 2011). The government had

not budgeted for the war, it turned out to be more expensive than originally anticipated, and the

President could not raise taxes to pay for it. Zimbabwe’s decision to deploy troops to the DRC

conflict was one of the most troublesome for its citizens given that there was no clear rationale for

Zimbabwe to become involved (Maclean, 2002). One commonly cited explanation was that the illicit

7

mineral trade in the DRC offered lucrative possibilities for rewarding those loyal to ZANU (Maclean,

2002). Additionally, it could ensure the allegiance of the strategically important military.

By August 2000, Maclean (2002) estimated that the government had spent more than 10 billion

Zimbabwean dollars (200 million US dollars) in two years in the conflict. This was expenditure the

government could not afford, as real GDP was in decline. In such circumstances, it is understandable

that the government turned to printing money or RBZ financing as an alternative to real adjustment

policies.

Land Reform

The structural inequality of land ownership between white and black Zimbabweans was a social and

political sore point, which ZANU-PF argued would inevitably lead to economic and political

instability. It was frequently cited by Mugabe as a major problem, although little was done to rectify

the problem for two decades after independence. ZANU-PF portrayed the land redistribution as a

basis for economic empowerment, growth and development (Masunungure & Badza, 2010).

Until the land expropriation programme began in 2000, the land reform had been handled under the

premise of “willing buyer—willing seller.” Beginning in 1999/2000, the government-supported war

veterans invaded and forcibly took control of nearly all the 4500 white-owned commercial farms in

Zimbabwe (Noko, 2011). This provided a convenient, low-cost strategy for land redistribution. Under

the fast-track land reform programme many of the commercial farms were simply handed over to

important ZANU-PF members, but some were broken up and given to new farmers.

The land reform process focussed on the numbers of those resettled or needing resettlement, both

in the 1980’s and in the 2000’s, obscuring other vital dimensions such as infrastructure and service

support to make reform sustainable (Sachikonye, 2003). The new farmers had limited access to

financing as banks refused to recognise the transfer of ownership under Zimbabwe’s expropriation

programme. Some estimate that agricultural output may have declined by as much declined by

85.7% between 2002 and 2009, and Zimbabwe shifted from being a net food exporter to a net food

importer (Noko, 2011). This decline was attributable to a combination of the land reform, unsuitable

macroeconomic policies, increasing levels of inflation and a weakening financial system.

Notwithstanding this, quite a number of small-scale tobacco farmers have been successful at earning

a living and keeping the tobacco industry alive.

Noko (2011) cites the financial support for the land redistribution programme as one source of

inflationary policies. Under the “Farm Mechanization Program,” and other similar programs, the

government and the RBZ offered free or concessional financing to new farmers. In mid-2008 the

government authorized the RBZ to print “Special Agro-Cheque” notes to finance farmers. These

programmes added to the inflationary quasi-fiscal activities of the RZB, which were a key

contributing factor to the rampant growth of inflation.

While no complete costing has been done to determine the full cost of Zimbabwe’s land reform

programme, conservative figures from the Commercial Farmers’ Union of Zimbabwe (CFU) estimate

that the destabilization of the agricultural sector between 2000 and 2011 has cost the Zimbabwean

economy US$33 billion (Theron, 2010).Subsequent sanctions imposed by the United States of

8

America and a number of European countries along with IMF restrictions further dampened hopes

of recovery..

Political Challenge

During the first two decade after independence, President Mugabe had been in the comfortable

position of being able to manage the Zimbabwean economy with relatively little political opposition.

During the 1980s, there was opposition from Joshua Nkomo’s ZAPU supporters in the south of the

country. The first real domestic rebellion against Mugabe might be considered the civil unrest of the

‘war veterans,’ who were given a large unbudgeted gratuity in 1997 that destabilized the Structural

Adjustment Program with the IMF at the time. However; with the formation of the first major

opposition party in 1999—the Movement for Democratic Change (MDC)3 under the leadership of

Morgan Tsvangirai—Mugabe faced a tangible political challenge for the first time. This challenge to

ZANU-PF seemed to lead to the use government institutions and policies to maintain ZANU-PF’s

political power.

Nhvira (2012) notes that already in 1999 the government took the step to amend Section 9 of the

Bank of Zimbabwe Act, which had been in force since 1964, to remove the time limit for repayment

of loans advanced to the government. This opened the way for fiscal deficits that didn’t ever have to

be repaid and greatly damaged the well-being of the RBZ.

This growing threat from the opposition MDC and the increasing instability in the Zimbabwean

economy became more apparent after the 2000 election, which Mugabe only won narrowly by a

vote of 47.2% to 45.6% of the electorate (Lodge, Kadima and Pottie, 2002). As support for the MDC

grew following that election, so did the level of ZANU-PF patronage. Prudent fiscal and monetary

management slowly deteriorated.

Simple abuse of the government budget is difficult as fiscal spending is monitored by the Parliament

and the public. More sophisticated means of hiding politically-biased spending usually go through

SOEs, whose accounts are not open to the public and are more easily camouflaged. In Zimbabwe,

the SOEs represented a substantial share of the economy and covered institutions from the public

utilities to the Grain Marketing Board and various industrial corporations. The ruling party developed

a method for funding loss-making SOEs outside of the budget, by using direct loans from the central

bank, which was a hidden form of quasi-fiscal spending. Normally, such policies are not tolerated by

central banks.

A more positive interpretation of the RBZ’s conduct might say that it assumed the behaviour of a

development bank and tried to expand the supply side of the economy by supplying low interest

loans to selective productive sectors. Such a strategy of stimulating the economy through the

creation of high-powered money was a very risky strategy and not well-developed.

As prudent management of the money supply was relaxed, high inflation expectations became

entrenched. According to the RBZ balance sheet, the growth of its reserve money rose from around

60% per annum at end-1999 to about 180% at end-2002, and then to 400% at end 2003. The growth

in this “high powered money” appeared to come from a combination of direct credit to non-

3 MDC later split into two factions: MDC-T and MDC, although we refer to them jointly here as the MDC opposition.

9

government enterprises and the rediscounting of treasury bills. It is particularly notable that the net

foreign assets of the RBZ were negative by end-1997, implying that the central bank had no net

foreign reserves. In short, it appeared that the government (or the ruling party) used the RBZ to fund

and hide quasi-fiscal spending and drove the bank into bankruptcy.

It is noteworthy that the official beginning of hyperinflation began in March 2007, just 1 year before

the March 2008 election. In that election, it was widely believed that ZANU-PF had lost to MDC, but

would not yield power. The election results foreshadowed the peak of the hyperinflationary period

in November 2008, and again seemed to provide evidence that hyperinflation reflects a socio-

political battle.

Winners and Losers from Inflation

Identifying the winners and losers from high inflation may help understand the motivation for

inflationary behaviour. Rising government spending first benefited civil servants receiving

government wages and pensions, like the military and war veterans. Secondly, government and

quasi-fiscal lending of the RBZ benefited the SOEs, which employed large numbers of people. As long

as they received their accelerating wage increases before others, they could benefit from

temporarily improved purchasing power, until eroded by the subsequent rise in inflation. In such a

situation, the government temporarily gains a greater share of domestic purchasing power, at the

expense of the private sector.

In the private sector, those agents who were involved in foreign trade or had access to foreign

exchange at the official rate did not suffer as much from the inflationary environment, as they could

protect their purchasing power by holding foreign exchange (Manyani, 2011). Those working solely

in the Zimbabwe-dollar economy had no way of protecting their saving except to buy real assets as

quickly as possible. The dual foreign exchange market (explained below) allowed many unprofitable

state enterprises, government officials and others with access to the official exchange rate to

prosper, off profits made through arbitrage with the parallel market exchange rate rather than

creating genuine added value. The high inflation environment hit the farming peasantry particularly

hard, as they had little access to foreign exchange at the official rate but pushed up the prices of

farm inputs (Manyani, 2011).

The dual foreign exchange markets created a zero-sum game for creating wealth. Given that the size

of GDP is basically fixed in the short run, creating large profits from short-term speculation without

adding to real productive output creates a zero-sum game, where others must be losing value. The

losers are inevitably the persons working only in the Zimbabwe-dollar sector, whose labour is being

purchased with a rapidly depreciating currency. The losers in this dual exchange rate inflationary

system were primarily the rural peasant workers and unskilled urban labourers who received

Zimbabwe-dollar wages and had no way to protect against their loss of purchasing power.

Direct profits could be made by those with links to the government or SOEs who were able to access

foreign exchange at the official rate and sell it (or use it) at the parallel rate, which allowed them to

generate rents or exploit value added through arbitrage. However, companies that needed imported

raw materials suffered for lack of foreign exchange and many saw their business collapse.

10

Thus we conclude that public sector was the starting point for inflationary pressure, and those

involved in government or public enterprises may have received some benefit of being at the

beginning of the monetary and inflationary spiral. The subsequent inflation-devaluation spiral was

aggravated by the multiple exchange rate markets in existence, which encouraged profiteering by

those who could cross the walls separating them. Agents working in the foreign trade sector

probably fared better because they could protect themselves through hedging in foreign currency or

tradable goods. However, the real losers in this system were those agents that had no access to

foreign exchange but could only sell their labour for a currency that had a declining purchasing

power.

THE INFLATION-DEVALUATION SPIRAL

Zimbabwe had been following an IMF program during the mid-1990s, and we can compare

monetary policy by the growth of reserve money (Figure 2). Despite some period of deterioration

during 1997, monetary policy began to significantly break down in 1999, and seriously collapsed by

end-2001 when the annual growth in reserve money surpassed 100 percent; broad money followed

suit within several months. As one would expect, inflation closely followed the growth of broad

money (Figure 2).

Money and prices

The expansion of the money supply was largely motivated by the growth of reserve money, which

started out as credit to the government, but later expanded to credit to SOEs and the private sector,

as well as large credit expansion to the commercial banks.

Figure 2. Zimbabwe: Reserve Money Growth

(12 month percent change)

Source: RBZ data.

11

Figure 3. Zimbabwe: CPI Inflation

(12 month inflation in percent change)

Source: RBZ data and CPI estimates by Robertson (from June 2005)

Foreign Exchange Markets

The Zimbabwe dollar (Z$) exchange rate has gone through numerous adjustments since

independence, but might be considered to have passed through 3 broad exchange rate regimes.

Initially after independence in 1980, it was pegged to a basket of currencies but subject to periodic

devaluations. Beginning in 1994 the exchange market was liberalised and the basket was replaced

with an independent float, and the exchange underwent regular depreciations. Beginning in 1999

the Zimbabwe-dollar was officially pegged to the US dollar but regularly devalued (Noko, 2011). A

fourth period of official dollarization began in January 2009.

During the inflation period of 1998–2008, domestic output declined so imports became more

important and the pass through of exchange rate depreciation to domestic inflation rose. As the

government took to printing money at an increasing rate, the exchange rate became the symbolic

measure of inflation and created a classic inflation-devaluation spiral.

The Zimbabwe authorities did only moved to an officially pegged exchange rate regime in March

1999, well after they broke off their ESAF (Enhanced Structural Adjustment Fund) Program with the

IMF in early 1998. Owing to the high inflation during this period, the pegged rate quickly became

overvalued and was subsequently devalued—a process that continued to repeat itself. The

overvaluation and the corresponding shortage of foreign exchange led to the emergence of an overt

parallel foreign exchange market by September 1999, where the price of foreign exchange more

accurately reflected its scarcity. This period from 1999 through 2008 was characterised by foreign

exchange shortages, regular official depreciations, and a growing parallel market (Figure 4).

12

Figure 4. Official versus Parallel Market Exchange Rate (Z$/US$, increase is depreciation)

Source: Data from RBZ. Rates adjusted to remove effects of currency reforms in 2006 and 2008.

As the banks and RBZ were unable to meet the demand for foreign exchange at the official rate, a

parallel foreign exchange market developed, where the spread typically ranged between 10 and 100

times the official rate (Figure 5). The officially fixed exchange rate, which was overvalued, remained

constant until pressure forced it to devalue to a level more in line with supply and demand.

Normally, a genuine fixed exchange rate requires the central bank to supply foreign exchange in

unlimited amounts at that rate, but this was impossible owing to the excess demand at the official

rate. As a result there was always a queue for foreign exchange, and often only government agencies

and state owned enterprises could obtain foreign exchange at the official rate, if any was available.

Parastatals that earned foreign exchange would be allowed to keep part of their foreign exchange

but were required to surrender the remainder to the central bank. As the money supply continued

to grow and inflation rose, the official exchange rate quickly became overvalued in real terms and

the devaluation process repeated itself.

1.E+00

1.E+02

1.E+04

1.E+06

1.E+08

1.E+10

1.E+12

1.E+14

1.E+16

1.E+18

1.E+20

1.E+22

Jan

-98

Jul-

98

Jan

-99

Jul-

99

Jan

-00

Jul-

00

Jan

-01

Jul-

01

Jan

-02

Jul-

02

Jan

-03

Jul-

03

Jan

-04

Jul-

04

Jan

-05

Jul-

05

Jan

-06

Jul-

06

Jan

-07

Jul-

07

Jan

-08

Jul-

08

Offical rate

Parallel rate

13

Figure 5. Parallel Market Exchange Rate Premium (ration of parallel to official rate

>1 means a more depreciated parallel rate)

Source: Figure 4.

The data that we show below was supplied by the RBZ as a representative parallel market rate

obtained by survey. Under such conditions, one can understand that multiple parallel market rates

would exist, which raises the question of how such rates become established. One parallel rate was

referred to as the Old Mutual rate, because Old Mutual Insurance was listed on the Zimbabwe stock

exchange as well as the London stock exchange. Thus, the same share could be purchased for

Zimbabwe-dollars and pounds sterling, creating some measure of an implicit exchange rate and

offering arbitragers an opportunity to make money. Such a rate however, necessarily included the

cost of equalising the value of Old Mutual shares in Harare with London. Another parallel exchange

rate was created by the UN for paying local salaries, in order to link its salaries to an underlying US

dollar value. This was used by many international organizations for accounting purposes, and

provides a useful tracking mechanism.

As inflation accelerated, the scarcity of Zimbabwe-dollar bank notes created an additional parallel

rate between transactions done with notes and those done with bank deposits; where the

Zimbabwe-dollar exchange rate was more depreciated when transacting with deposits as opposed

to notes. As a result, a practice, known as “burning dollars” emerged, where arbitrageurs would buy

foreign exchange with Zimbabwe-dollar notes at an appreciated rate and sell those US dollars at a

profit for Zimbabwe-dollar bank deposits. This process could be repeated if one had bank contacts to

obtain more Zimbabwe-dollar notes from your bank deposit. Economic theory tells us that multiple

exchange rates may exist depending upon the reason for their existence, but they tend to converge

if arbitrage is possible.

14

Tests of Purchasing Power Parity (PPP)

We can examine some aspect of market rationality by testing to see if the official and parallel market

exchange rates had any relationship to PPP, or the law of one price. Under the PPP hypothesis, the

exchange should move in response to changes in the relative price levels, for which we use the

consumer price indices (CPI).

(1) NER = k*CPI_Zim/CPI_US

(where the nominal exchange rate (NER) is expressed in Zim$/US$)

This is equivalent to saying that the bilateral real exchange rate (RER) remains constant if PPP holds.

(2) RER = NER*CPI_US/CPI_Zim

Thus, we calculate the official real exchange rate (RER_Off) and parallel market real exchange rate

(RER_Par) versus the US dollar (Figure 6), and test them for stationarity to determine if PPP holds.

The standard Augmented Dickey Fuller (ADF) test shows that the official market rate is stationary,

using one lag (Table 2). We also tested for trend stationarity but found that the trend was not

significant. On the other hand, the real parallel market rate was stationary around a significant

positive trend, which indicates that there was an underlying (trend) real depreciation taking place.

These results might indicate that the government tried to set the official nominal rate in such a way

as to keep the real rate constant over the long run. However, the parallel market rate showed a

significant long-run structural real depreciation indicating that productivity was probably eroding

and the exchange rate required a real depreciation to maintain competitiveness.

Figure 6. Zimbabwe: Real Exchange Rate Zimbabwe dollars per US dollars

(An increase implies real depreciation)

Source: Nominal exchange rate data from RBZ; calculation of real exchange rates by authors.

15

Table 2. Augmented Dickey-Fuller Test for Unit Root For Real Exchange Rate for Zimbabwe

(Excludes last 6 months of data) Null Hypothesis: There is a unit root (series is not stationary)

a) RER—Offical Rate ADF test with constant

Null Hypothesis: RER_OFF has a unit root

Exogenous: Constant, Linear Trend

Lag Length: 1 (Automatic - based on SIC, maxlag=12) t-Statistic Prob.* Augmented Dickey-Fuller test statistic -6.221761 0.0000

Test critical values: 1% level -4.031899

5% level -3.445590

10% level -3.147710 *MacKinnon (1996) one-sided p-values.

Conclusion: There is no unit root, series is stationary

b) RER—Parallel Rate ADF Test with constant and trend

Null Hypothesis: RER_PAR has a unit root

Exogenous: Constant, Linear Trend

Lag Length: 5 (Automatic - based on SIC, maxlag=12) t-Statistic Prob.* Augmented Dickey-Fuller test statistic -3.805903 0.0194

Test critical values: 1% level -4.034356

5% level -3.446765

10% level -3.148399 *MacKinnon (1996) one-sided p-values.

Conclusion: There is no unit root; series in trend stationary. _______________________ Source: Calculation by authors, using Eviews . Real effective exchange rate defined as: Z$/US$*(CPI_USA/CPI_ZIM).

16

Causality

In the hyperinflation process, there is a vicious cycle of money growth (M), inflation (P), and nominal

depreciation (NER) that takes place, which we endeavour to explore further, especially in respect to

the question of causality.

M P NER

We use the Granger Causality test to provide some initial insight on the money-inflation-

depreciation spiral chain of causality.4 The Granger Causality test requires that the tested series be

stationary. Using the ADF test and Phillips-Peron test, we find that CPI, broad money and the parallel

market exchange rate are all I(2) and the official nominal exchange rate is I(1) trend stationary

(Table 3). Series that are I(2) stationary imply that the levels have constant acceleration upward,

whereas I(1) series have constant velocity. These results seem to make sense for the inflation period

under consideration.5

Table 3. Stationarity Tests for all Variables

Zimbabwe Variable

Variable ln(rer_off) ln(rer_par) ln(ner_off) ln(ner_par) ln(m2_zim) Ln(cpi_zim) ln(gdpr_zim))

Test ADF ADF ADF ADF PP ADF ADF

Period 1998q4-2008q2

1998q3-2008q2

1998q3-2008q1

1998q4-2008q3

1998q4-2008q3

1998q4-2007q4

1998q4-2008q4

Freq Q Q Q Q Q Q Q

Order I(1) I(1) I(1) I(2) I(2) I(2) I(1)

Lags 2 1 1 1 1 1 1

Constant Yes Yes Yes Yes Yes No Yes

Trend No No Yes No No No No

Signif level

1% 1% 1% 1% 5% 1% 1%

Other comments

Not I(1) if incl. all of 2008

PP test confirms results

ADF test is significant for 1999-2007

4 Granger causality tells us that the assumed exogenous variable significantly affects the assumed endogenous variable, even after lagged values of the assumed endogenous variable are used on the right hand side of the equation. That is, in the conditional distribution, lagged values of yt add no information to explain movements of xt, beyond that provided by lagged values of xt itself (Greene, 2012). 5 There would be limited difference in interpretation between being I(1) stationary with a trend and I(2).

17

Table 3. (continued) Stationarity Tests for all Variables

USA Variable

Variable ln(m2_usa) Ln(cpi_usa) ln(gdpr_usa))

Test ADF ADF ADF

Period 1998q4-2008q4 1998q4-2008q4 1998q4-2008q4

Freq Q Q Q

Order I(1) I(1) I(1)

Lags 1 1 1

Constant Yes No Yes

Trend No No No

Signif. level 1% 1% 10%

Other comments

Source: Calculations by authors using EViews. See Appendix 2.

The Granger Causality test was run on pairs of the stationary variables, including 4 lags, with the null

hypothesis of: No Granger Causality. The results for the official exchange rate indicate that changes

in broad money growth Granger causes changes in CPI inflation which Granger causes changes in the

growth of the official nominal exchange rate (Box 1). This would support the PPP test above.

Moreover the Granger causality of money on the exchange rate would support a more monetarist

logic based on the Quantity Theory of Money (below). Secondly, change in growth of the official

nominal exchange rate was being Granger caused by the parallel nominal exchange rate. This would

indicate that the official nominal exchange rate was reacting to money, prices and the parallel

market rate. This makes some sense as the government was setting the official rate based on a PPP

strategy, where money growth was driving inflation.

Box 1. Diagrammatic Presentation of Granger Causality Tests (Variables refer to second difference of log of variable)

Notes: Direction of arrow indicates significant causality (at the 5% level) No arrows indicate no significant causality.

Based on results show in Appendix 2- Source: Calculated by authors using EViews. All variable are second the difference of the log of the level of the variable. See Appendix.

Based on the above results, we use the Quantity of Money Theory (QMT) (Equation 3) to examine

the monetarist view that the price level (P) is a function of the level of the money supply (M), the

velocity of money ( ) and output ( ).

(3)

M2 CPI

NER_Off

NER_Par

18

Combining the QTM with PPP (Equation 1) implies that the exchange rate is determined by the

relative levels of money supplies, outputs and velocities

(4)

Then

We can estimate Equation 4 in log form and substitute a trend line for the relative velocity term, as

we might expect velocity in Zimbabwe to be rising relative to the USA owing to financial deepening

(Equation 5). Taking the first differences of (5) yields a dynamic equation based on relative rates of

change (Equation 6).

(5) ( ) [ ] (

) (

)

(6) ( ) (

) (

)

where dl = first difference of the log of the variable, which is the growth rate

We test equation 6 for cointegration and find one cointegrating vector using one lag and a constant

(Appendix Section 4).6 This would substantiate the long-run relationship between the nominal

exchange and relative money growth, based on QTM and PPP. Based on this, we estimate the vector

error correction model for (6) and find the correct sign for the relative inflation variable, with a

highly significant coefficient of about 0.9. This implies that 90 percent of the inflation differential

passes through to the exchange rate. The coefficient on the relative growth term, however, is the

opposite to what was predicted by Equation 6, but not unexpected. According to the quantity

theory, all other things being equal, a decline in output reduces the demand for money, prices fall

and the exchange rate should appreciate (decline), i.e. there should be a negative relationship

between output and the nominal exchange rate. However, if output is collapsing and causing exports

to collapse owing to a range of other factors, while import demand grows, then the exchange rate

will certainly depreciate for balance of payments reasons. In this situation, there would be a positive

relationship between output and the nominal exchange rate. The larger problem for the error

correction model in (6) is the adjustment mechanism of -1.05, meaning full or more than 100

percent adjustment takes place every period, indicating over-adjustment and likely instability. We

have some concerns about the overall stability of the model, but think that the relationship between

money and the exchange rate is being appropriately captured by the model. This would tend to be a

typical characteristic of hyperinflation: printing money flows through to the exchange rate and price

level almost equally.

6 The model is estimated from 1998 to2007q4 because the data in 2008 are partially estimated and of much weaker quality.

19

Table 4. Zimbabwe: Quantity of Money Error Correction Model

Long-Run Cointegrating Equation for dlog(ner_par)

Variable Coefficient t-statistic Significance level

Constant -0.15 3.1 >1%

dlog(cpi_zim/cpi_usa) +0.89 14.2 >1%

dlog(gdpr_zim/dgdpr_usa) +3.40 2.19 >5%

ECM for d2log(ner_par)

Long-run cointegrating equation =Error correction term-α

-1.05 -2.7 >5%

d2lner_par +.22 .83 n.s.

d2lm2_zim_usa -1.22 2.3 1%

d2lgdpr_zim_usa -1.05 -2.7 >5%

R-squared .34

Source: Calculated by authors in EViews, see Appendix Section 4. dlog=first difference of log of

variable; d2log = second difference of log of variable.

THE IMPOSSIBLE TRINITY HYPOTHESIS

Zimbabwe’s economic policy from 1998 to 2008 might look more ingenious if we consider that the

authorities were trying to follow an economic model along the lines of China or the former Soviet

Union (FSU), which can be put into the context of the “Impossible Trinity Hypothesis” (ITH). The ITH

is an outcome of the Mundell-Flemming model of open-economy macroeconomics, which suggests

that an economy cannot maintain a (1) fixed exchange rate, (2) free capital movement, and (3) an

independent monetary policy simultaneously—although any two are possible (Figure 7).

Of the 3 potentially desirable policy goals, the choice is usually understood as being between

monetary policy independence or a fixed exchange rate, given the existence of capital mobility

(Aizenman, et al., 2011). In this normal choice, the free movement of capital prevents a country from

both maintaining a constant exchange rate and freely controlling its interest rates, as deviation of

interest rates from that of its partners causes capital flows that strengthen or weaken the exchange

rate.

20

Figure 7. Impossible Trinity

Capital Mobility

Monetary independence Fixed Exchange Rate Source: Aizenman, Chin and Ito

However, a country might theoretically maintain exchange rate stability and monetary autonomy if it

can exercise full control over capital flows, as is broadly the case in China today (Hung, 2008) or

previously in the former Soviet Union. Even the original Bretton Woods system provided some

monetary autonomy and exchange rate stability by limiting capital mobility. When the capital

account is tightly closed, there is no possibility of foreign exchange escaping, so the exchange rate

and monetary policy can be set largely independently of the rest of the world. Thus, in a situation of

a closed economy, reminiscent of the FSU, the official exchange rate can be completely controlled,

as the government makes decisions based on rationing and shadow prices, with market prices

playing a minor role. Under such autarky, the closed capital account takes on critical importance

within the ITH, and many economic decisions begin to look like rationing.

It would appear that Zimbabwe was trying to pursue a strategy of closing its capital account in order

to control both its monetary and exchange rate policy at the same time. However, simply legally

closing the capital account is insufficient to halt capital flows, as they can fairly easily, albeit illegally,

escape through the current account. The FSU and China were more successful at controlling capital

flows because those governments also controlled a large share of the means of productions,

including the banking system and therefore could limit illegal capital flows. If the government could

halt all unauthorised capital flows and parallel markets, then the domestic interest rate would not

have any impact on capital flows and the exchange rate could be fixed consistent with a desired

current account balance.

There is some evidence to support the hypothesis that Zimbabwe tried to follow such a policy. Using

the Chinn-Ito data on capital account openness (Chinn-Ito, 2008),7 we observe that Zimbabwe

dramatically increased capital account exchange controls in 2003—i.e., they reduced capital account

7 The Chinn-Ito index is a measure of the degree of openness of a country’s capital account. The index ranges from a value of 2.46 which indicates “most financially open” to -1.86, indicating “least financially open”. Zimbabwe’s Chinn-Ito index score ranges from -1.159 (prior to 2003) falling to -1.86 (2003 – 2008), recovering to -1.159 in 2009 and improving even further to -0.1 in 2010. The index is based on binary variables to codify the tabulation of restrictions on cross-border financial transactions reported in the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions.

Closed financial markets And pegged exchange rate;

Floating

exchange

rate regime

Monetary

Union

21

openness (Figure 8). The decline in openness that occurred in 2003 was due to the exchange

controls that were introduced on November 30, 2002, when the government closed all bureaux de

change. This limited licenses to deal in foreign exchange to banks, further affecting the convertibility

of the Zimbabwean dollar (Noko, 2011).

We also note that the capital account was reopened in 2009 after the dollarization of the economy,

signalling an end to the isolationist policy and a re-entry into the world economy. So there was clear

evidence of an attempt to close the capital account as the hyperinflation gained momentum.

Figure 8. Zimbabwe: Chinn-Ito Index of Capital Account Openness (0=closed, 1 = open)8

Source: Chinn-Ito (2008)

The Chinn-Ito data is further re-enforced by data on the overall index of exchange restrictiveness,

compiled by Ellyne and Letete (2012), which show a rising level of exchange control restrictiveness

that peaks in 2007 and subsequently falls rapidly in the dollarization period (Figure 9)

8 Graph is based on the normalised KAOPEN data of the Chinn-Ito index.

22

Figure 9. Zimbabwe Overall Index of Exchange Restrictiveness

The data on exchange and capital controls show that they intensified as the hyperinflation

progressed, in order to protect the official fixed exchange rate. However, this attempt at maintaining

control of the capital account was largely unsuccessful owing to foreign exchange leakages brought

about by the existence of an illegal but widespread parallel exchange rate market and the difficulty

of fully closing the capital account in today’s highly globalized world. Given the historical ties

between Zimbabwe and South Africa and their porous shared border, it is understandable that they

could not effectively stop capital flows of cash with South Africa. The authorities’ inability to regulate

such balance of payments flows is further evidenced in the post-2008 balance of payments data,

which shows extremely large errors and omissions. Thus, the result of the government’s

expansionary monetary policy and failure to effectively close the capital account was capital flight

and a destabilization of the economic system.

The Dollarization Exit Strategy

The Zimbabwe hyperinflation ended painfully and slowly during 2008. Annual (year-over-year)

inflation surpassed [100,000] percent in January 2008 and accelerated to 11 million percent by June,

after which most attempts to measure it become meaningless.9 According to best estimates, the

month-to-month inflation rate first surpassed 100 percent, reaching 135 percent or an annual rate of

1.2 million percent, in October 2007. The month-to-month inflation rate rose to an estimated 2,600

percent in June 2008, and may have peaked at 20,000 in September 2008,10 the equivalent of about

25 percent increase in prices per day (based on 22 working days in the month). One hears stories of

shops raising prices twice a day.

9 Estimates until mid-2008 come from John Robertson. 10 We don’t have the same data from which Hanke and Krus determined the 7.96x10

10 monthly inflation rate

in November.

20.0 25.0 30.0 35.0 40.0 45.0 50.0 55.0 60.0 65.0

2000 2001 2002 2003 2004 2005 2006

2007 2008 2009

2010

Source: Ellyne and Letete (2012)

23

Despite the astronomical hyperinflation, there was a notable lack of a government stabilization plan

to reduce inflationary expectations and restore faith in the domestic currency. The government did

make several attempts at currency reform (removing zeros from the notes),11 but these reforms

were not accompanied by any serious stabilization program to prevent printing more money.

Ultimately, the government simply succumbed to the unofficial dollarization that had been taking

place in the private sector. This may be an indication that senior policy-makers lacked incentive to

alter the economic situation because they were directly benefiting from the hyperinflation and the

multiple foreign exchange markets.

By 2008, the private sector had completely lost confidence in the Zimbabwe-dollar, but it remained

the official legal tender of the country, and as such, all domestic payments were to be made in

Zimbabwe dollars. As previously shown, the premium between the official rate and the parallel

market rate reached as high as 4,000 times the official rate, indicating the extent to which the

official exchange rate was divorced from reality. However, the government and SOEs were still

required to provide public services in Zimbabwe-dollars, priced at the official exchange rate. Many

public enterprises and utilities went bankrupt at official prices because they could not obtain needed

imports at the official exchange rate. As the provision of public services disappeared, the private

sector refused to pay for utilities and taxes, leaving behind wide ranging arrears to many public

utilities. The government exchange rate policy ultimately decimated the public sector as well as the

private sector. As the Zimbabwe-dollar became increasingly meaningless, goods disappeared from

the shops and the formal economy ground to a halt by mid-2008: there were literally no goods in

shops at Zimbabwe-dollar prices.

In desperation, the government permitted the use of foreign currency for domestic payments in

January 2009 and goods started to reappear in shops. By April 2012, 5 foreign currencies were made

legal tender for domestic transactions and use of the Zimbabwe dollar simply stopped.12 This

government decision appears to have come about largely by default and simply followed the

behaviour of the private sector. There is little evidence of any strategic government policy to exit the

hyperinflation, except that another currency reform was done in February 2009, where 12 zeros

were removed from the currency.

At the time of introduction of foreign currency payments, there were large amounts of Zimbabwe-

dollar bank deposits, which remain frozen to date because there is no agreement on what rate to

convert them into foreign currency. The difference in using the official versus the parallel market

rate could be thousands of times different. At the beginning of 2013, there are still wide-ranging

cross debts of the private sector to the public utilities and the banks to its depositors that need to be

resolved following the official dollarization. The final decision of the government to dollarize was an

admission of its inability to manage monetary and exchange rate policy.

The resulting multicurrency dollarization is different from most other dollarization schemes, which

usually restrict the official legal tender to the “dollar” currency alone or else in combination with a

local currency. Although the Zimbabwe scheme technically allows payment in any of 5 currencies,

11 The first currency reform in August 2006 removed 3 zeros; the second currency reform in August 2008 removed 9 zeros; and short-lived currency reform in January 2009 removed 9 zeros. All data in this paper have been adjusted to remove the effect of the currency reform, i.e. go back to pre-August 2006 Z$s. 12 The 5 official currencies are: US dollar, South African rand, Botswana Pula, pound sterling, and the Euro.

24

the government and the banks shifted there accounting systems to US dollars, effectively making it

the official currency. Other currencies, which may be accepted as a means of payment, are then

converted into US dollars at some exchange rate—often at relatively arbitrary rates.13 Slowly

businesses are moving toward a single means of payment; otherwise they stand to incur ongoing

domestic exchange valuation risks by transacting and holding multiple currencies.

Dollarization is the hardest form of a currency peg, as it is leaves no scope for exchange rate

manipulation and implies the formation of currency union with the economy whose currency is

being used. The benefits and costs of dollarization have been widely discussed in the literature

(Honda & Schumacher, 2006). Proponents of dollarization argue that it reduces inflation to that of

the host currency, it boosts exports, and the resulting improvement to confidence and fiscal

credibility results in lower interest rates, increases foreign investment and improves growth.

The above benefits were initially achieved by dollarization, but there are also considerable costs to

dollarization (Table 5). The increased price stability that is gained may come at the expense of

increased output volatility, as the stabilizing effects of monetary policy are lost and only fiscal policy

remains. Seigniorage income, or the government windfall from creating new national money is also

lost. The central bank loses its role as lender of last resort, as it can no longer rescue banks by

printing or loaning unlimited amounts of money. In addition, a dollarized currency is effectively a

fixed exchange rate regime and does not allow for smooth responses to external shocks, which a

flexible exchange rate would better accommodate. The RBZ no longer functions as a central bank

(there are no Zimbabwe dollars) and its foreign liabilities (to the IMF) are larger than its foreign

reserves, creating a negative net worth. Nonetheless, the central bank still continues its role to

supervise the banking system and undertake financial sector surveillance.

Table 5. Summary of Benefits and Costs of Dollarization

Benefits Costs

No exchange rate volatility vs the dollar—may enhance exports

Loss of control over monetary policy; including money supply and interest rates

Inflation generally reduces to that of host currency

Loss of seignorage revenue

Enhanced credibility over monetary and exchange rate policy

Loss of lender of last resort ability by central bank

Increases fiscal discipline Need to keep larger amount of foreign reserves or pay for precautionary international credit lines

May increase international economic integration No exchange rate to act as shock absorber

Source: Compiled by authors

13 For example, private business frequently accepted South African rand at a rate of 10 per US dollar as opposed to the official rate. In 2012, this amounted to a 12% surcharge on use of the rand.

25

CHOICE OF EXCHANGE REGIME

Finally, we briefly review Zimbabwe’s dollarization exit strategy in respect to the theory of optimal

currency areas (OCA). The decision to use a fixed exchange rate or use the currency of another

country is usually linked to a choice about regional integration.14 Most African countries see some

long-run advantage from greater regional integration and have mandated the African Union to move

to a common African currency and monetary union by 2028 (ADM, 2012). Under this strategy, some

5 regional economic communities would be created and then merge together to form an African

Economic Union.15 It is thus peculiar that Zimbabwe has essentially chosen to form a currency union

with the United States of America at this time rather than join the regional Rand zone.

Optimal Currency Area Policy

Traditional “optimal currency area” theory tells us that countries that are highly integrated with

others, i.e., have a large share of their foreign trade together, can benefit from a common currency

(Mundell 1961; McKinnon 1963). In general those benefits are seen as reduced exchange rate

uncertainty and lower transactions costs of foreign trade, reduced price discrimination, greater

liquidity, and larger markets. On the other hand, a common currency means loss of the exchange

rate as a policy instrument.

Is regional integration a good strategy for Zimbabwe? While most African countries see some long-

run advantage from greater regional integration, the process of yielding sovereignty to supra-

national organization is politically difficult and takes considerable time. Smaller countries typically

are international price-takers and must adjust rapidly to international price shocks, especially

commodity producers who suffer from more frequent external shocks. Being part of a larger

monetary union can provide a cushion for them. Additionally, countries that are less well-managed

or have weaker institutional structures will benefit more from a strong monetary union. As part of a

fixed exchange rate bloc, countries may benefit from slower adjustment.

The benefits of a currency union are fairly well documented in the literature. Rose (2000) finds a

large positive effect of a currency union on international trade and a small negative effect of

exchange rate volatility after controlling for a host of features “…trade is over 3 times higher

between common currency countries.” Tsangarides, Ewenczk and Hulej (2006) find that “Countries

belonging to the same currency union trade about 2 times more with each other than do other

comparable countries that do not share a common currency.” Currency unions are associated with

trade creation, trade stability, and increased co-movement of prices. Currency unions also tend to

induce financial integration, which has trade-creating effects

The big question for Zimbabwe is whether multicurrency dollarization (dominated by the US dollar)

was the optimal policy. In this event, Zimbabwe has essentially formed a currency union with the

USA. Yet, Zimbabwe’s largest trading partners are China (for exports) and South Africa (for imports).

One might argue that US dollarization is a pseudo peg to the Chinese yuan, and the gradual

appreciation of the yuan against the US dollar is good for Zimbabwean exports. 14 Regional integration generally progresses from a free trade area (without any necessary exchange rate linkages), to a customs union, to a monetary union (with a common currency and common monetary policy), and finally to an economic union (with free movement of all factors of production). There may be numerous intermediate steps along the way. 15 The 5 RECs include: CoMESA, SADC, ECOWAS, ECCAS, EAC

26

However, traditional OCA theory would argue that monetary unions perform best when member

countries are in close geographical proximity and experience similar economic shocks, thus naturally

supporting a similar economic policy. In addition OCA theory would expect there to be a high degree

of capital mobility–both human and non-human—to support the adjustment process. Zimbabwe

fails to meet these requirements for the US dollar. Why didn’t Zimbabwe try for greater regional

integration in SADC.

SADC Regional Integration and the CMA

Zimbabwe has been a member of SADC since 1980 and has generally been a supporter to SADC

integration despite the criticism SADC has levied on the Zimbabwean political situation. However,

there is no SADC monetary union at present, but next to Zimbabwe there is the Common Monetary

Area (CMA) rand zone, which functions like a hybrid monetary union (ADM, 2012).16

Table 6. Measures of SADC Country Size and Wealth, 2010

Source: World Bank, African Development Indicators.

16 The CMA comprises South Africa, Namibia, Lesotho and Swaziland. It is a free trade area with free movement of capital but not labour mobility.

Current GDP

in millions of

current US

dollars

Real GDP

in millions of

constant 2000 US

dollars

Population

in millions

GDP per capita

in current US

dollars

Liberalised 41,716 13,134 16.3 2,559

Zambia 16,193 5,587 12.9 1,255

Mauritius 9,729 6,631 1.3 7,484

Botswana 14,857 841 2.0 7,429

Seychelles 937 75 0.1 9,370

CMA 382,182 196,215 55.7 6,861

South Africa 363,704 187,234 50.0 7,274

Namibia 12,701 6,089 2.3 5,522

Swaziland 3,645 1,846 1.2 3,038

Lesotho 2,132 1,046 2.2 969

Other Non-Liberalised 151,480 73,677 201.5 752

Tanzania 23,057 19,955 44.8 515

Mozambique 9,586 9,117 23.4 410

Malawi 5,106 2,744 14.9 343

Zimbabwe 7,474 4,082 12.6 593

Madagascar 8,721 5,027 20.7 421

Angola 84,391 25,901 19.1 4,418

DRC 13,145 6,851 66.0 199

TOTAL 575,378 283,026 273.5 2,104

Measures of Size and Income, 2010

27

The CMA is a well-established institution that has worked very well for almost 50 years, despite

political changes, and thus provides policy credibility and institutional depth to any new member.

South Africa manages CMA monetary policy, has a sophisticated financial system, and follows an

inflation targeting regime that has produced relatively low inflation over the past decade. All CMA

member countries converge to the South African inflation rate, which is one of the lowest in the

region. One could say that Johannesburg serves as a “London” financial centre for Africa, which

deepens the financial market and improves availability of capital in the region (at competitive rates).

Additionally, South Africa is also one of Zimbabwe’s largest trading partners, and therefore by

joining the CMA Zimbabwe would benefit from a fixed Rand exchange rate. These factors make it

realistic to begin with the Rand zone as an optimal currency area for Zimbabwe as well as a possible

currency for SADC regional integration.

The CMA model is interesting because it is not a full-fledged monetary union but a hybrid model that

offers certain benefits to members. Every country has its own central bank and its own currency—

key institutions that most countries are reluctant to abandon. The CMA operates more like a hard

peg,17 but has had all the benefits of a monetary union for its members. It is a free trade area with a

common external tariff wall and has free movement of capital with a common set of exchange

controls. The common set of exchange controls provides some desirable level of security against

capital flight and illegal cross-border transactions.

It should not be any different for Zimbabwe to operate in rand than in US dollars. It would mainly

require that the government shift to a policy of single currency dollarization, the rand, and begin

some cooperation with the South African Reserve Bank. Zimbabwe would remain dollarized (in rand)

but might consider minting its own coins in the future. It must establish a credible track record of

economic management before thinking about re-introducing the Zimbabwe-dollar, even within the

context of the CMA. The government might also consider joining the Southern Africa Customs Union

(SACU) to provide obtain some corresponding fiscal integration, although this is not absolutely

necessary to participate in the monetary union.

South Africa is Zimbabwe’s largest supplier of imports, it is geographically close, and is an important

source of worker remittances. Most importantly, Zimbabwe looks more like South Africa from an

economic structural point of view—both countries look like commodity exporters--and it more

closely follows SA’s business cycle. This means that a South African monetary policy and rand

exchange rate would be more appropriate for Zimbabwe than the US dollar and its monetary policy.

OCA theory would support Zimbabwe joining the CMA rand-zone rather than the USA dollar zone. A

South African monetary policy would seem more appropriate for Zimbabwe than US monetary

policy, more liquidity would be available within the CMA, and Zimbabwe would obtain recognition

for following a credible monetary policy as part of the CMA. No doubt there will varying economic

impacts on different sectors of Zimbabwe’s and SA’s economies. It is to be expected that various

sectors of the economy might incur varying benefits and costs. However, joining the rand zone

should provide net benefits by providing lower cost trade, greater liquidity, more investment

resources, and monetary policy credibility.

17 The CMA is also like a currency board that requires more-or-less full foreign currency cover for the local currency in circulation.

28

While the dollarization strategy successfully halted Zimbabwe’s hyperinflation, it is not an ideal long-

term solution for the country, whereas contributing to African regional integration might be a better

long-term strategy. Moreover, Zimbabwe policy-makers are still confronted by several important

economic problems under the multi-currency dollarized system.

CHALLENGES OF DOLLARIZATION

The main constraint to growth cited by most Zimbabwe businesses is the lack of liquidity and finance

for working capital and new investment. It is not surprizing that liquidity management is

problematic, as it is a monetary policy issue and there is no domestic management of monetary

policy under a dollarized system. Investment is similarly linked to monetary policy through the

interest rate, but depends critically on other structural policies, like the indigenization policy, which

appears to be problematic.

Balance of Payments

Creating liquidity in a dollarized economy requires a balance of payments surplus. Thus, the first big

challenge to policy-makers is to create an overall balance of payments surplus,18 which is most

appropriately done by creating a structural current account surplus. However, Zimbabwe’s current

account was officially in deficit in 2010-12, which indicates a fundamental structural problem for a

dollarized economy. If there is a genuine overall balance of payments deficit, then the economy

may, in fact, be deflating.

However, there is some evidence that there are substantial missing current account inflows, possibly

from worker remittances, because the ‘errors and omissions’ is highly positive. Many experts

suspect that large unrecorded remittances from outside the country (mainly South Africa) are

funding imports. Alternatively, there may be large amounts of capital that have already left

Zimbabwe as private sector reserves and these are being used to pay for imports. If so, those

reserves will eventually be exhausted.

The interpretation of the overall balance of payments needs to be redefined in the Zimbabwean

context, because the RBZ is essentially not playing any financial role. In principle, the commercial

banks take over the role of the central bank, and foreign reserves become private foreign reserves.

Thus private capital held offshore will require a capital outflows by the commercial banks. In fact,

when commercial banks hold 25 percent of their deposits as liquid assets, they frequently do that by

holding them in the form of nostro accounts offshore. When dollars are needed for imports, it is the

funds from these accounts that provide the part of the foreign exchange for them.

Monetary Management

The dollarization of the economy has effectively eliminated the role of the RBZ in monetary policy,

as it has no supply of instruments or cash US dollars that can be used for open market operations to

manage the money supply. Because the local currency is the US dollar, the RBZ is no longer the

lender of last resort, as it had been with its own currency. For the most part, the monetary

authorities have no control over domestic liquidity.

18 Normally, this refers to an increase in official reserves, but could equally refer to private bank reserves, as the RBZ is currently not in a position to accumulate reserves.

29

However, there is still a domestic banking system money multiplier; because Zimbabwe operates a

fractional reserve banking system that creates new deposits (i.e. money). Loans for domestic

purchases create a deposit multiplier effect, whereas loans for imports flow out of the country.We

can begin to understand the money creation process from the accounting for the standard money

multiplier for an economy with its own currency. In the traditional case, the money multiplier (mm)

is the ratio of broad money (M2) to reserve money (RM).

(1) mm = M2/RM

Broad money is composed of customer deposits (D) and cash (C) or currency in circulation (2), while

reserve money comprises cash and bank reserves (R) held at the reserve bank (3).

(2) M2 = D + C

(3) RM = C + R

By incorporating the reserve ratio (r=R/D) of required reserves to deposits and the cash ratio (c=C/D)

of cash to deposits, we can obtain a formula for the money multiplier for a local currency, based on

these ratios (4).

(4) mm = (D+cD)/(cD+rD) = (1+c)/(r+c)

For Zimbabwe, the above formula provides the basis for the banking system money multiplier. If we

knew the amount of US dollar notes in circulation we could exactly calculate the money multiplier.

Ignoring the impact of currency in circulation for the moment, as it is unknown, the domestic money

multiplier for banks creating new deposits is simply the inverse of the reserve ratio (5), which is the

liquidity ratio in the Zimbabwe case.

(5) (1/r)

Since the required liquidity ratio is 25 percent, the domestic money multiplier for new deposits

brought into the banking system is 4.

The desire of private agents to hold part of their deposits as cash (the cash/deposit ratio) tends to

reduce the money multiplier. We know that the cash ratio rose from 0.08 in 1999 to 0.33 in 2007 for

the Zimbabwe dollar. Assuming a similar cash/deposit ratio for US dollars, the true money multiplier

might lie between 3.3 (=1.08/.33) and 2.3 (=1.33/.58), based on equation (4). Given the present lack

of confidence in the banking system and the potentially high cash/deposit ratio, the money

multiplier is probably closer the lower end of this range.

The key issue for policy-makers to understand about the Zimbabwe financial system is that bank-

created dollar deposits are not really equivalent to US dollars. If they were, wouldn’t every country

be creating US dollar this way? These US dollar deposits created in Zimbabwe can function perfectly

well for domestic transactions, in the same way a local currency would function. They depend on

confidence in the government and in the domestic financial system. However, one cannot

necessarily use those deposits for imports or for a capital outflow unless they are backed by real US

dollars, which depends on the balance of payments and private foreign reserves. Only dollars earned

through the balance of payments can be used to purchase imports.

30

Thus, there is a potential danger of producing too many US dollar deposits created in Zimbabwe

without sufficient balance of payments earning, because those deposits do not have international

purchasing power. No one can see the difference between US dollars earned through the balance of

payments and those created through banking money multiplier, but only those dollars earned

through the balance of payments can be used for purchase of imports because they are backed by

foreign exchange.

The government’s attempt in 2012 to create of a US dollar treasury bill market19 posed the danger

of either creating too many US dollar deposits through the money multiplier by such domestic bank

lending, or the risk of crowding out private borrowing. Under a dollarized system, the government is

usually obliged to run a balanced budget because it receives no seignorage and cannot print money

to pay its debts. Basically, the government is no longer the risk-free borrower. In fact, lending to the

government may entail similar risk as lending to a large corporation—hence the demand for similar

high interest rates. Of course the government can finance the budget by borrowing dollars on

international credit markets (a balance of payments transaction), but the government cannot pay its

current external debt service and thus is unlikely to find such any foreign lenders.

Other government ideas in 2012, like capping lending rates or confiscating banks’ nostro accounts

are also dangerous initiatives that circumvent real economic progress and development, and risk a

banking crisis in the process. Interest rates are high because the amount of real US dollars available

to borrow is limited to those earned through the balance of payments. If too many domestic dollar

deposits are created through the money multiplier, when private agents try to use those deposits to

pay for imports and there is insufficient backing, there will be a loss of confidence in the banking

system. Any attempt to confiscate the banks’ nostro accounts and use them for government

spending or lending that does not generate export earnings will only accelerate the demise of the

banking system.

Investment

A third major policy challenge facing policy-makers is increasing investment. We have noted that

domestic liquidity is short supply in a dollarized economy, so foreign borrowing and foreign direct

investment should be important sources of investment. In this regard, the impact of the

government’s “indigenization policy,” which requires 51 percent domestic ownership, would

technically reduce the amount of foreign inflows that would otherwise come into the country.

Moreover, the indigenization policy would authorise major capital outflows by mandating domestic

entrepreneurs to purchase 51 percent of foreign-owned enterprises, who would then externalize

that money.20

The indigenization policy would necessarily reduce the net capital inflows in the balance of

payments. A strategy of reducing net capital inflows when more are needed seems strange, but

might be interpreted as a time preference decision by the authorities, whereby they prefer long-run

dividends to stay in the country over increasing short-run investment. The authors do not think that

19 The government’s attempt to create a treasury bill market in November 2012 failed because the banks demanded yields of 12 to 15 percent, which the government regarded as too high, and rejected most of the bids--luckily. 20 ZANU-PF promotes the indigenization policy, MDC does not.

31

this is the right trade-off for the present situation, when domestic investment and liquidity are

desperately needed.

The government also sharply raised the minimum capital required for banks in 2012, from US$[10]

million to US$100 million. This may turn out to be a prudent step for the long run. Some analysts

said that his action was intended to force foreign banks to bring in more capital and expand their

domestic lending. However, a majority of the banks in the country are small domestic banks, who

will not be able to raise such large amounts of capital. They will be forced to consolidate into a

smaller number of domestic banks, or will be bought by foreign banks. As noted earlier, without a

lender of last resort in Zimbabwe, banks must essentially self-insure and this is easier for branches of

foreign banks than for domestic banks.

CONCLUSIONS

Zimbabwe notably achieved the second highest hyperinflation in recorded history. This paper set out

3 possible explanations for the hyperinflation that occurred between 1998 and 2008: (1)

government policy-makers did not understand the full implications of their monetary policy; (2) the

government policy-makers were trying to fix the exchange rate and manage monetary policy under a

closed capital account, which they couldn’t effectively close; or (3) the government understood that

it was benefiting by printing money at an accelerating rate to fund SOEs and the civil service.

Based on the background conditions leading up to the full hyperinflation—including an unfinanced

war, a dysfunctional land reform program, and a new political challenge—the government chose to

take the easier strategy of high fiscal spending financed by printing money. They disguised part of

the excessive fiscal spending through central bank loans to SOEs and private enterprises. The

resulting exponential growth of the money supply coming through the public sector meant that the

private sector was effectively losing purchasing power. This ultimately led to excessive government

debt and a collapse of output—not unlike other cases of hyperinflation in the past.

A unique characteristic of this hyperinflation was the multiple exchange rate markets that allowed

many SOEs and government-connected insiders and to benefit from access to foreign exchange at

the overvalued official rate. Because the parallel exchange rate frequently carried a premium of 10

to 100 times the official rate, anyone able to obtain foreign exchange at the official rate could readily

make a good profit by selling it on the parallel market or purchasing labour cheaply in Zimbabwe-

dollars. However, because there was little or no value-added in this arbitrage process, compared to

the size of the profits being made, there was an implicit zero-sum game whereby some other

economic agents lost value added. This paper identified the main losers as those who operated

solely in the Zimbabwe-dollar sector, as the product of their labour was expropriated at a discount.

The economic agents who had access to foreign exchange could often benefit from the inflation-

depreciation spiral or at least hedge themselves against loss of purchasing power.

As inflation accelerated, the process of dollarization in the private sector increased and the parallel

market expanded. The government could hardly have been ignorant of what was happening, as

official annual inflation broke 100 percent by end-2001, as did growth in the money supply. Yet the

government continued to pursue a fixed exchange rate policy with regular devaluations, without

taking any significant steps at economic stabilization, despite the intensification of the inflation. By

32

early 2007, about a year before elections were to be held, the inflation rate surpassed 50 percent

per month (about 12,900% annualized) along with money growth and depreciation.

We examined the money growth-inflation-depreciation spiral as well as testing the purchasing

power parity hypothesis to try to understand the logic of this spiral. We deduced that the

government appeared to be setting the official exchange rate on a PPP basis, whereas the parallel

market rate was showing an underlying real depreciation that probably reflected the deteriorating

productivity of the economy. In addition to PPP, it appeared to us that the Quantity Theory of

Money hypothesis also held, which indicated that money growth was also directly driving the

exchange rate depreciation. We noted that the decline in output had the impact of reducing export

capacity and raising the demand for imports, thus furthering a real depreciation.

We examined the proposition that the government may have been trying to close the capital

account in an attempt to control both the exchange rate and monetary policy, perhaps trying to

follow the model of the Chinese or the former Soviet Union, where it worked with some success. In

this regard, we examined the “Impossible Trinity Hypothesis.” While it looked like the government

had increase exchange controls in an attempt to close the capital account, it was not able to

effectively do it in Zimbabwe, owing to the developed parallel exchange markets and numerous

escape routes for capital flight. Moreover, too many “insiders” were benefitting from the spread

between the parallel and official exchange markets to truly close that loophole. As a result, the

inflation-depreciation spiral reached astronomic levels and the economy wound further downward.

We observed that the dollarization exit strategy appears to have been done more out of default than

calculation. The decision to have 5 currencies as part of the official dollarization, with the choice of

using the US dollar as the main currency as opposed to the South African rand, appears to show little

consideration of optimal currency area theory. Moreover, the official dollarization policy requires

that the balance of payments should generate an overall surplus in order to increase domestic

liquidity, yet the official balance of payments shows a shockingly high current account deficit of over

25 percent of GDP. Although we noted likely technical reasons explaining the high errors and

omissions, the current account deficit is necessarily a very worrisome factor.

We examined two main economic challenges in the dollarized period: (1) the need for more

investment and (2) the lack of domestic liquidity. In response to the first, the ZANU-PF policy-makers

have promoted an “indigenization policy,” that dampens foreign direct investment and reduces net

capital inflows, which we thought could be counter-productive in the near term.

Policy makers have tried to increase domestic liquidity by prodding the domestic banks to lend

more, which is to say that they are trying to increase the money multiplier for creating domestic US

dollars deposits. There seems to be an idea that the government can increase the growth of the US

dollar money supply through the money multiplier without a corresponding balance of payment

surplus.21 In this regard, policy makers tried to launch a domestic US dollar treasury bill market in

2012, which fortunately did not succeed. This effort to expand liquidity is bit reminiscent of the

earlier inflation period.

21 We explain that US dollar deposits created in Zimbabwe do not have the international purchasing power of genuine US dollars unless they are backed by a balance of payments surplus.

33

In conclusion, we have identified a number of policies that seem to demonstrate that government

policy-makers are still resorting to politically expedient solutions without considering their

underlying economic implications. Thus we fear that the Zimbabwe economic crisis may not be over.

The present current account deficit, the pressure to create faster monetary growth through

domestic dollar deposits, and the indigenization policy as a response to investment needs may

create new crises for Zimbabwe. Under the circumstances, we believe that the one prudent course

of action for Zimbabwe’s economic policy would be to follow a regional integration policy by joining

the CMA rand zone and subjecting itself to the guidance of the South African Reserve Bank.

34

REFERENCES

Aizenman, Joshua, Menzie Chinn, and Hiro Ito (2010). “Assessing the Emerging Global Financial Architecture: Measuring the Trilemma’s Configuration over Time.” NBER Working Paper No. 14533.

Asonuma, Tamo, Xavier Debrun, and Paul Masson (ADM, 2012). Welfare Effects of Monetary Integration: the Common Monetary Area and Beyond. IMF Working Paper WP/12/136.

Beaugrand, Philippe (1997). Zaire’s Hyperinflation, 1990-96. IMF Working Paper WP/97/50.

Bogetic, Z and Petrovic, P (1999). The Yugoslav Hyperinflation of 1992-1994: Causes, Dynamics, and Money Supply Process. Journal of Comparative Economics, Vol 27 , 335-353.

Bomberger, W A and Makinen, G E (1980). Indexation, Inflationary Finance and Hyperinflation: The June 1945 – 1946 Hungarian Experience. Journal of Political Economy, Vol 88 (3), 550-560.

Bomberger, W A and Makinen, G E (1983). The Hungarian Hyperinflation and Stabilization of 1945-1946. Journal of Political Economy, Vol 91 (5), 801-821.

Burdekin, C K R and Burkett, P (1996). Hyperinflation, the real exchange rate and endogenous money: post- World War I Germany revisited. Journal of International Money and Finance, Vol 15 (4), 599-621.

Burdekin, R C K and Burkett P (1992). Money, Credit, and Wages in Hyperinflation: Post- World War I Germany. Economic Inquiry, Vol 30, 479-495.

Bernholz, P (1988). Hyperinflation and Currency Reform in Bolivia: Studied from a General perspective. Journal of Institutional and Theoretical Economics, Vol 144 (5), 747-771.

Chinn, Menzie D. and Hiro Ito (2008). "A New Measure of Financial Openness". Journal of Comparative Policy Analysis, Volume 10, Issue 3, p. 309 – 322 (September).

Ellyne, Mark and Letete, Emmanuel (2012). Study on Exchange Control Liberalisation in SADC and Its Implications on the Free Trade in the SADC Region. Proprietary study for SADC Secretariat, Gaborone.

Hanke, Steve and Nicholas Krus (2012). World Hyperinflations. Cato Working Paper No 8.

Heifferich, Karl (1923). Money, 6th ed. Translated by L. Linfield, Adelphi. New York, 1927.

Horvath, Julius (2003). Optimum currency area theory: A selective review, Bank of Finland Working

Paper No. 15.

Laidler, D E and Stadler, G W (1998). Monetary Explanations of the Weimer Republic’s Hyperinflation: Some Neglected Contributions in Contemporary German Literature, Journal of Money, Credit, and Banking, Vol 30 (4), 816 – 831.

Maclean, S. J. (2002). Mugabe at war: The political economy of conflict in Zimbabwe. Third World Quarterly, 23(3), 513-528.

Manyani, C. (2011). Crisis Does Not Spell The End, The Peasantry During a Decade of Economic Decline in Zimbabwe, A Case of Gwanda South (Ntalale). International Institute of Social Studies.

Masunungure, E. V., & Badza, S. (2010). The Internationalization of the Zimbabwe Crisis: Multiple Actors, Competing Interests. Journal of Developing Societies, 26(2), 207-231.

35

Mundell, Robert (1961). “Theory of Optimum Currency Area”. American Economic Review, Vol. 51

(pp 657-665).

Nhavira, J.D.G. (2012). Monetary Policy Transparency in Sub-Saharan Africa: Evidence and Lessons.

PhD Thesis, Nelson Mandela University.

Noko, J. (2011). Dollarization: The Case of Zimbabwe. Cato Journal, 31(2), 339-365.

Petrovic, P; Bogetic, Z and Vujosevic Z (1999). The Yugoslav Hyperinflation in 1992-1994: Causes,

Dynamics, and Money Supply Process. Journal of Comparative Economics, Vol 27, 335-353.

Sachikonye, L. (2003). From ‘Growth with Equity’ to ‘Fast Track’ Reform: Zimbabwe’s Land Question.

Review of African Political Economy, 30:96, 227-240.

Sachs, Jeffrey. 1987. "The Bolivian Hyperinflation and Stabilization." American Economic Review 77,

no. 2: 279.

Sachs J and Morales J A (1989). “Bolivia’s Economic Crisis,” in Foreign Debt and Economic Performance, National Bureau of Economic Research and University of Chicago Press. (Previously NBER Working Paper 2620.)

Selby, Angus (2006). “Commercial Farmers and the State: Interest Group Politics and Land Reform in

Zimbabwe.” D.Phil Thesis, University of Oxford, 246-255.

Siklos , P. L. editor (1995). Great Inflations of the 20th Century: Theories, Policies and Evidence.

Cornwall: Edward Elgar Publishing.

Southern Africa: Government Activates SADC Investment Protocol, The Herald, 9 August 2012.

Theron, D. (2010, January). Zimbabwe: New wave of violent farm evictions. PRESS STATEMENT: The Commercial Farmers’ Union of Zimbabwe.

Yehoue, Etienne (2005). On the Pattern of Currency Blocs in Africa. IMF Working Paper, WP/05/45.

Appendix I 36

APPENDIX I: EVIEWS TECHNICAL OUTPUT

1. Unit Root Tests

Log(RER_Official) is I(1)) Null Hypothesis: D(LRER_OFF) has a unit root Exogenous: Constant Lag Length: 1 (Automatic - based on SIC, maxlag=9)

t-Statistic Prob.* Augmented Dickey-Fuller test statistic -9.554832 0.0000

Test critical values: 1% level -3.610453 5% level -2.938987 10% level -2.607932 *MacKinnon (1996) one-sided p-values.

Augmented Dickey-Fuller Test Equation Dependent Variable: D(LRER_OFF,2) Method: Least Squares Date: 01/31/13 Time: 11:08 Sample (adjusted): 1998Q4 2008Q2 Included observations: 39 after adjustments

Variable Coefficient Std. Error t-Statistic Prob. D(LRER_OFF(-1)) -2.763624 0.289238 -9.554832 0.0000

D(LRER_OFF(-1),2) 0.968974 0.206511 4.692119 0.0000 C -0.083911 0.151648 -0.553328 0.5835 R-squared 0.759632 Mean dependent var 0.145822

Adjusted R-squared 0.746278 S.D. dependent var 1.861050 S.E. of regression 0.937426 Akaike info criterion 2.782445 Sum squared resid 31.63562 Schwarz criterion 2.910411 Log likelihood -51.25768 Hannan-Quinn criter. 2.828358 F-statistic 56.88519 Durbin-Watson stat 1.470964 Prob(F-statistic) 0.000000

Appendix I 37

Log(RER_Parallel) is I(1)

Null Hypothesis: D(LRER_PAR) has a unit root

Exogenous: Constant

Lag Length: 1 (Fixed) t-Statistic Prob.* Augmented Dickey-Fuller test statistic -5.562379 0.0000

Test critical values: 1% level -3.605593

5% level -2.936942

10% level -2.606857 *MacKinnon (1996) one-sided p-values.

Augmented Dickey-Fuller Test Equation

Dependent Variable: D(LRER_PAR,2)

Method: Least Squares

Date: 01/30/13 Time: 19:40

Sample (adjusted): 1998Q4 2008Q3

Included observations: 40 after adjustments Variable Coefficient Std. Error t-Statistic Prob. D(LRER_PAR(-1)) -1.021100 0.183573 -5.562379 0.0000

D(LRER_PAR(-1),2) 0.384393 0.151067 2.544525 0.0152

C 0.059137 0.044862 1.318205 0.1955 R-squared 0.464192 Mean dependent var -0.001722

Adjusted R-squared 0.435229 S.D. dependent var 0.366125

S.E. of regression 0.275148 Akaike info criterion 0.329022

Sum squared resid 2.801133 Schwarz criterion 0.455688

Log likelihood -3.580432 Hannan-Quinn criter. 0.374820

F-statistic 16.02726 Durbin-Watson stat 1.888879

Prob(F-statistic) 0.000010

Appendix I 38

Log(NER_Official) is I(1)

Null Hypothesis: D(LNER_OFF) has a unit root

Exogenous: Constant, Linear Trend

Lag Length: 1 (Fixed) t-Statistic Prob.* Augmented Dickey-Fuller test statistic -4.991468 0.0004

Test critical values: 1% level -4.034356

5% level -3.446765

10% level -3.148399 *MacKinnon (1996) one-sided p-values.

Augmented Dickey-Fuller Test Equation

Dependent Variable: D(LNER_OFF,2)

Method: Least Squares

Date: 07/31/13 Time: 19:19

Sample (adjusted): 1998M04 2008M06

Included observations: 123 after adjustments Variable Coefficient Std. Error t-Statistic Prob. D(LNER_OFF(-1)) -0.992764 0.198892 -4.991468 0.0000

D(LNER_OFF(-1),2) 0.128650 0.170195 0.755899 0.4512

C -0.191669 0.181146 -1.058090 0.2922

Appendix I 39

Log(NER_Parallel) is I(2)

Null Hypothesis: D2LNER_PAR has a unit root

Exogenous: Constant

Lag Length: 0 (Automatic - based on SIC, maxlag=9) t-Statistic Prob.* Augmented Dickey-Fuller test statistic -5.430229 0.0001

Test critical values: 1% level -3.610453

5% level -2.938987

10% level -2.607932 *MacKinnon (1996) one-sided p-values.

Augmented Dickey-Fuller Test Equation

Dependent Variable: D(D2LNER_PAR)

Method: Least Squares

Date: 01/31/13 Time: 11:27

Sample (adjusted): 1998Q4 2008Q2

Included observations: 39 after adjustments Variable Coefficient Std. Error t-Statistic Prob. D2LNER_PAR(-1) -1.065243 0.196169 -5.430229 0.0000

C 0.121526 0.099137 1.225838 0.2280 R-squared 0.443503 Mean dependent var 0.047663

Adjusted R-squared 0.428463 S.D. dependent var 0.811184

S.E. of regression 0.613256 Akaike info criterion 1.909851

Sum squared resid 13.91506 Schwarz criterion 1.995162

Log likelihood -35.24209 Hannan-Quinn criter. 1.940460

F-statistic 29.48738 Durbin-Watson stat 1.704356

Prob(F-statistic) 0.000004

Appendix I 40

Log(M2_ZIM) is I(2)

Null Hypothesis: D2LM2_ZIM has a unit root

Exogenous: Constant

Lag Length: 1 (Fixed) t-Statistic Prob.* Augmented Dickey-Fuller test statistic -6.254674 0.0000

Test critical values: 1% level -3.626784

5% level -2.945842

10% level -2.611531 *MacKinnon (1996) one-sided p-values.

Augmented Dickey-Fuller Test Equation

Dependent Variable: D(D2LM2_ZIM)

Method: Least Squares

Date: 01/30/13 Time: 19:59

Sample (adjusted): 1999Q1 2007Q4

Included observations: 36 after adjustments Variable Coefficient Std. Error t-Statistic Prob. D2LM2_ZIM(-1) -1.911048 0.305539 -6.254674 0.0000

D(D2LM2_ZIM(-1)) 0.298748 0.196963 1.516771 0.1388

C 0.089075 0.041225 2.160684 0.0381 R-squared 0.744590 Mean dependent var 0.014218

Adjusted R-squared 0.729110 S.D. dependent var 0.443903

S.E. of regression 0.231038 Akaike info criterion -0.012810

Sum squared resid 1.761499 Schwarz criterion 0.119150

Log likelihood 3.230577 Hannan-Quinn criter. 0.033248

F-statistic 48.10195 Durbin-Watson stat 1.726003

Prob(F-statistic) 0.000000

Log(CPI_ZIM) is I(2)

Null Hypothesis: D2LCPI_ZIM has a unit root

Exogenous: None

Lag Length: 0 (Automatic - based on SIC, maxlag=9) t-Statistic Prob.* Augmented Dickey-Fuller test statistic -8.282693 0.0000

Test critical values: 1% level -2.628961

5% level -1.950117

10% level -1.611339 *MacKinnon (1996) one-sided p-values.

Augmented Dickey-Fuller Test Equation

Dependent Variable: D(D2LCPI_ZIM)

Method: Least Squares

Date: 01/31/13 Time: 10:56

Sample (adjusted): 1998Q4 2007Q4

Included observations: 37 after adjustments

Appendix I 41

Variable Coefficient Std. Error t-Statistic Prob. D2LCPI_ZIM(-1) -1.859763 0.224536 -8.282693 0.0000 R-squared 0.652761 Mean dependent var 0.041822

Adjusted R-squared 0.652761 S.D. dependent var 0.448132

S.E. of regression 0.264071 Akaike info criterion 0.201458

Sum squared resid 2.510406 Schwarz criterion 0.244996

Log likelihood -2.726965 Hannan-Quinn criter. 0.216807

Durbin-Watson stat 1.379334

Appendix I 42

Log(GDPRUS$_ZIM) is I(1)

Null Hypothesis: DLGDPRUS$_ZIM has a unit root

Exogenous: Constant

Lag Length: 1 (Automatic - based on SIC, maxlag=9) t-Statistic Prob.* Augmented Dickey-Fuller test statistic -6.445926 0.0000

Test critical values: 1% level -3.600987

5% level -2.935001

10% level -2.605836 *MacKinnon (1996) one-sided p-values.

Augmented Dickey-Fuller Test Equation

Dependent Variable: D(DLGDPRUS$_ZIM)

Method: Least Squares

Date: 01/31/13 Time: 11:04

Sample (adjusted): 1998Q4 2008Q4

Included observations: 41 after adjustments Variable Coefficient Std. Error t-Statistic Prob. DLGDPRUS$_ZIM(-1) -0.225780 0.035027 -6.445926 0.0000

D(DLGDPRUS$_ZIM(-1)) 0.980967 0.084844 11.56203 0.0000

C -0.003800 0.000819 -4.640952 0.0000 R-squared 0.786864 Mean dependent var -0.001084

Adjusted R-squared 0.775646 S.D. dependent var 0.007395

S.E. of regression 0.003503 Akaike info criterion -8.400230

Sum squared resid 0.000466 Schwarz criterion -8.274847

Log likelihood 175.2047 Hannan-Quinn criter. -8.354573

F-statistic 70.14503 Durbin-Watson stat 1.341397

Prob(F-statistic) 0.000000

Appendix I 43

Log(CPI_USA) is I(1)

Null Hypothesis: D(LCPI_USA) has a unit root

Exogenous: Constant

Lag Length: 0 (Automatic - based on SIC, maxlag=12) t-Statistic Prob.* Augmented Dickey-Fuller test statistic -5.947728 0.0000

Test critical values: 1% level -3.481217

5% level -2.883753

10% level -2.578694 *MacKinnon (1996) one-sided p-values.

Augmented Dickey-Fuller Test Equation

Dependent Variable: D(LCPI_USA,2)

Method: Least Squares

Date: 01/27/13 Time: 22:01

Sample (adjusted): 1998M03 2008M12

Included observations: 130 after adjustments Variable Coefficient Std. Error t-Statistic Prob. D(LCPI_USA(-1)) -0.469971 0.079017 -5.947728 0.0000

C 0.000896 0.000357 2.508590 0.0134 R-squared 0.216529 Mean dependent var -9.22E-05

Adjusted R-squared 0.210408 S.D. dependent var 0.004057

S.E. of regression 0.003605 Akaike info criterion -8.397834

Sum squared resid 0.001663 Schwarz criterion -8.353718

Log likelihood 547.8592 Hannan-Quinn criter. -8.379909

F-statistic 35.37547 Durbin-Watson stat 1.884455

Prob(F-statistic) 0.000000

Appendix I 44

Log(M2_USA) is I(1)

Null Hypothesis: D(LM2_USA) has a unit root

Exogenous: Constant

Lag Length: 0 (Automatic - based on SIC, maxlag=9) t-Statistic Prob.* Augmented Dickey-Fuller test statistic -4.127530 0.0024

Test critical values: 1% level -3.596616

5% level -2.933158

10% level -2.604867 *MacKinnon (1996) one-sided p-values.

Augmented Dickey-Fuller Test Equation

Dependent Variable: D(LM2_USA,2)

Method: Least Squares

Date: 02/04/13 Time: 13:47

Sample (adjusted): 1998Q3 2008Q4

Included observations: 42 after adjustments Variable Coefficient Std. Error t-Statistic Prob. D(LM2_USA(-1)) -0.789836 0.191358 -4.127530 0.0002

C 0.012907 0.003194 4.040516 0.0002 R-squared 0.298695 Mean dependent var 0.000641

Adjusted R-squared 0.281162 S.D. dependent var 0.008957

S.E. of regression 0.007594 Akaike info criterion -6.876506

Sum squared resid 0.002307 Schwarz criterion -6.793760

Log likelihood 146.4066 Hannan-Quinn criter. -6.846176

F-statistic 17.03651 Durbin-Watson stat 1.668355

Prob(F-statistic) 0.000181

Appendix I 45

Log(GDPR_USA) is I(1)

Null Hypothesis: D(LGDPR_USA) has a unit root

Exogenous: Constant

Lag Length: 0 (Automatic - based on SIC, maxlag=9) t-Statistic Prob.* Augmented Dickey-Fuller test statistic -2.864212 0.0582

Test critical values: 1% level -3.596616

5% level -2.933158

10% level -2.604867 *MacKinnon (1996) one-sided p-values.

Augmented Dickey-Fuller Test Equation

Dependent Variable: D(LGDPR_USA,2)

Method: Least Squares

Date: 02/04/13 Time: 13:57

Sample (adjusted): 1998Q3 2008Q4

Included observations: 42 after adjustments Variable Coefficient Std. Error t-Statistic Prob. D(LGDPR_USA(-1)) -0.531107 0.185428 -2.864212 0.0066

C 0.002611 0.001599 1.633255 0.1103 R-squared 0.170188 Mean dependent var -0.000767

Adjusted R-squared 0.149443 S.D. dependent var 0.007585

S.E. of regression 0.006995 Akaike info criterion -7.040835

Sum squared resid 0.001957 Schwarz criterion -6.958089

Log likelihood 149.8575 Hannan-Quinn criter. -7.010505

F-statistic 8.203712 Durbin-Watson stat 2.011514

Prob(F-statistic) 0.006628

Appendix I 46

2. Granger Causality Tests

Pairwise Granger Causality Tests

Date: 01/31/13 Time: 13:49

Sample: 1998Q1 2008Q1

Lags: 4 Null Hypothesis: Obs F-Statistic Prob. D2LNER_OFF does not Granger Cause D2LCPI_ZIM 35 2.07257 0.1134

D2LCPI_ZIM does not Granger Cause D2LNER_OFF 3.57034 0.0189 D2LM2_ZIM does not Granger Cause D2LCPI_ZIM 35 10.7270 3.E-05

D2LCPI_ZIM does not Granger Cause D2LM2_ZIM 2.09417 0.1104 D2LNER_PAR does not Granger Cause D2LCPI_ZIM 35 0.67742 0.6138

D2LCPI_ZIM does not Granger Cause D2LNER_PAR 0.37641 0.8233 D2LM2_ZIM does not Granger Cause D2LNER_OFF 35 6.90481 0.0006

D2LNER_OFF does not Granger Cause D2LM2_ZIM 0.71857 0.5870 D2LNER_PAR does not Granger Cause D2LNER_OFF 35 6.49061 0.0009

D2LNER_OFF does not Granger Cause D2LNER_PAR 2.00788 0.1229 D2LNER_PAR does not Granger Cause D2LM2_ZIM 35 2.25719 0.0903

D2LM2_ZIM does not Granger Cause D2LNER_PAR 2.09755 0.1100

Appendix I 47

3. Cointegration Test for Quantity Theory of Money:

Johansen Test for a Cointegrating Equation lcpi_zim_usa = log(cpi_zim/cpi_usa) dlcpi_zim_usa = first difference of lcpi_zim_usa lm2_zim_usa = log(m2_zim/m2_usa) dlm2_zim_usa = first difference of lm2_zim_usa lgdpr_zim_usa = log(gdprus$_zim/gdpr_usa) dlgdpr_zim_usa = first difference of lgdpr_zim_usa

Date: 02/04/13 Time: 14:03

Sample: 1998Q1 2007Q4

Included observations: 37 Series: DLNER_PAR DLCPI_ZIM_USA DLGDPR_ZIM_USA

Lags interval: 1 to 1

Selected (0.05 level*) Number of Cointegrating Relations by Model Data Trend: None None Linear Linear Quadratic

Test Type No Intercept Intercept Intercept Intercept Intercept

No Trend No Trend No Trend Trend Trend

Trace 1 1 1 1 1

Max-Eig 1 1 1 1 1 *Critical values based on MacKinnon-Haug-Michelis (1999)

Information Criteria by Rank and Model Data Trend: None None Linear Linear Quadratic

Rank or No Intercept Intercept Intercept Intercept Intercept

No. of CEs No Trend No Trend No Trend Trend Trend Log Likelihood by Rank (rows) and Model (columns)

0 104.9985 104.9985 107.1517 107.1517 110.4992

1 130.5715 139.2083 140.4643 140.4675 142.5928

2 132.1355 142.3220 143.2687 144.0126 145.6647

3 132.6677 143.8724 143.8724 146.0497 146.0497 Akaike Information Criteria by Rank (rows) and Model (columns)

0 -5.189108 -5.189108 -5.143335 -5.143335 -5.162119

1 -6.247107 -6.659910* -6.619694 -6.565812 -6.572583

2 -6.007327 -6.449838 -6.446956 -6.379060 -6.414310

3 -5.711767 -6.155266 -6.155266 -6.110796 -6.110796 Schwarz Criteria by Rank (rows) and Model (columns)

0 -4.797263 -4.797263 -4.620875 -4.620875 -4.509044

1 -5.594032 -5.963297* -5.836004 -5.738583 -5.658278

2 -5.093022 -5.448457 -5.402036 -5.247063 -5.238775

3 -4.536233 -4.849116 -4.849116 -4.674032 -4.674032

Appendix I 48

4. Estimate of Vector Error Correction Model For Quantity Theory of Money

Vector Error Correction Estimates

Date: 02/04/13 Time: 14:38

Sample (adjusted): 1998Q4 2007Q4

Included observations: 37 after adjustments

Standard errors in ( ) & t-statistics in [ ] Cointegrating Eq: CointEq1 DLNER_PAR(-1) 1.000000

DLM2_ZIM_USA(-1) -0.893439

(0.06305)

[-14.1693]

DLGDPR_ZIM_USA(-1) -3.401794

(1.54986)

[-2.19491]

C -0.150582

(0.04894)

[-3.07690]

Error Correction: D(DLNER_PAR

) D(DLM2_ZIM_U

SA) D(DLGDPR_ZI

M_USA) CointEq1 -1.052874 0.317037 -0.005102

(0.39181) (0.22410) (0.00921)

[-2.68722] [ 1.41470] [-0.55387]

D(DLNER_PAR(-1)) 0.284449 -0.101330 0.009493

(0.26794) (0.15325) (0.00630)

[ 1.06163] [-0.66120] [ 1.50707]

D(DLM2_ZIM_USA(-1)) -0.699463 -0.498006 -0.015010

(0.37701) (0.21564) (0.00886)

[-1.85530] [-2.30946] [-1.69360]

D(DLGDPR_ZIM_USA(-1)) -2.202120 2.355977 0.030305

(7.60711) (4.35104) (0.17883)

[-0.28948] [ 0.54147] [ 0.16946] R-squared 0.341867 0.216358 0.092108

Adj. R-squared 0.282036 0.145118 0.009572

Sum sq. resids 5.883166 1.924678 0.003251

S.E. equation 0.422230 0.241503 0.009926

F-statistic 5.713939 3.037027 1.115973

Log likelihood -18.48250 2.188223 120.2820

Akaike AIC 1.215270 0.097934 -6.285515

Schwarz SC 1.389424 0.272087 -6.111362

Mean dependent 0.039940 0.050246 -0.000463

S.D. dependent 0.498307 0.261197 0.009974 Determinant resid covariance (dof adj.) 2.65E-07

Determinant resid covariance 1.88E-07

Log likelihood 129.0119

Akaike information criterion -6.108750

Schwarz criterion -5.412137

Appendix II 49

Appendix II: Data

1. USA data on money and prices from IMF, International Financial Statistics

CPI: Obtained from the Bureau of Labour Statistics, Consumer Price Index – All Urban

Consumers (US City Average), Series ID: CUUR0000SA0 (1998 – 2008), monthly data

M2 money supply: Obtained from the International Monetary Fund’s International Financial

Statistics database. (1998 -2008), monthly data

Real gross domestic product: Obtained from the International Monetary Fund’s International

Financial Statistics database. (1998 -2008), quarterly data

2. Zimbabwe data:

Reserve money and RBZ balance sheet: from RBZ

Broad money supply and monetary survey: IMF

Consumer Price Index: Monthly data from Zim Stat, IMF, and John Robertson for

hyperinflation period.

Real GDP: Annual data provided by Zim Stat, national statistical agency.

Parallel market Rate: Obtained from the Reserve Bank of Zimbabwe (1998 – 2008), monthly

data

Official exchange rate: Obtained from the Reserve Bank of Zimbabwe (1998 – 2008),

monthly data

3. World Bank development indicators: The dataset is accessible at

http://data.worldbank.org/data-catalog/world-development-indicators

4. Exchange Control data

Chin-ITO index: Dataset of financial openness can be accessed at:

http://web.pdx.edu/~ito/Chinn-Ito_website.htm

Ellyne, Mark and Emmanuel Letete (2012), Exchange Control Liberalization in SADC and Its

Implications for Monetary Union, Mimeo.

Chater, Rachel and Mark Ellyne (2013), Exchange Controls in the Context of SADC Regional

Integration: A New Index for Measuring SADC Restrictiveness, Mimeo

Appendix II 50

Hanke & Krus(2012) table of all known cases of hyperinflation