eBusiness Weekly
Economy Uncensored with Tapiwanashe Mangwiro
This month will come to a close with the Reserve Bank of Zimbabwe (RBZ) Governor having announced the policy for the year through his Monetary Policy Statement (MPS), and everyone is eager to hear about the “structured currency”.
Just as we heard more about the proposal which was as the Business Weekly predicted to be in their last edition, a colleague and I discovered one thing, ‘We tend to reinvent the wheel much to the failure of good policies.’
Zimbabwe is set to adopt the concept of a currency board in order to try and save the Zimbabwe dollar or what is left of it.
This week we look at what a currency board does and where it is being used. We will also look at what happened the last time we reinvented the wheel.
During the week, the Minister of Finance, Economic Development and Investment Promotion, Prof Mthuli Ncube said; “The idea going forward is to make sure that we manage the growth of liquidity which has a high correlation to money supply growth and inflation.
The way to do that is to link the exchange rate to some hard asset such as gold,” said Ncube.
“To do that you have to have some sort of currency board type system in place where the growth of the domestic liquidity is constrained by the value of the asset that is backing the currency.”
The currency board concept
Currency boards are monetary authorities that issue notes and coins fully backed by foreign reserves, typically a stable foreign currency such as the US dollar or the euro and the Rand in our case.
The concept of currency boards originated in the British Empire in the 19th century, with the establishment of the Board of Commissioners of Currency in British Malaya in 1845.
Currency boards were popular in the 20th century, especially in colonial territories and newly independent countries seeking stability in their monetary systems.
However, their popularity declined in the latter half of the 20th century as many countries opted for more flexible exchange rate regimes, such as managed floats or pegs.
Several economists have supported the concept of currency boards as a mechanism for ensuring monetary stability.
Some notable proponents include Milton Friedman the Nobel laureate economist who advocated for currency boards as a means of achieving monetary discipline.
He famously said; “A currency board is a wonderful form of monetary arrangement.”
Lawrence White, an economist specialising in monetary theory and banking history, has written in support of currency boards as a credible commitment mechanism to maintain price stability. White argues that currency boards can provide a credible anchor for monetary policy.
Functioning Dutch auction
A functional Dutch auction for foreign currency is a mechanism used by central banks or monetary authorities to buy or sell foreign currency reserves. In this auction format, the central bank sets a maximum quantity of currency it wishes to buy or sell and announces a minimum acceptable price.
Bidders then submit their bids, indicating the quantity of currency they are willing to buy or sell and the price they are willing to accept.
The auctioneer starts with the highest price and gradually lowers it until the total quantity of currency being bought or sold matches the central bank’s target.
In order for it to work, the central bank announces the maximum quantity of currency it wants to buy or sell and sets a minimum acceptable price.
Bidders submit their bids specifying the quantity of currency they wish to buy or sell and the price they are willing to accept.
Then the auctioneer starts with the highest price and gradually lowers it until the total quantity of currency matches the central bank’s target.
Bids are filled in descending order of price until the target quantity is reached. The clearing price is the lowest price at which the total quantity of currency matches the central bank’s target.
One example of a functional Dutch auction for foreign currency is the Reserve Bank of Australia’s Foreign Exchange Swap Facility auctions, where the central bank provides liquidity to the foreign exchange market by buying Australian dollars from authorised financial institutions.
Proponents of this system also include Milton Friedman who while not specifically advocating for Dutch auctions in foreign exchange markets, he emphasised the importance of market mechanisms in determining exchange rates.
He famously said, “Flexible exchange rates are not a panacea; they are an improvement over fixed rates, not an unmixed blessing.”
Economist Lawrence Summers, the former US Treasury Secretary and economist has supported market-based mechanisms for exchange rate determination.
He stated, “Market-based exchange rates allow for better adjustment to external shocks and a better focus on domestic objectives.”
Paul Krugman, another Nobel laureate economist, argued for the use of flexible exchange rates and market-based mechanisms in managing currency fluctuations.
He stated, “Flexible exchange rates allow for independent monetary policies and help cushion the economy from external shocks.”
These economists generally support market-based mechanisms, such as Dutch auctions, as a way to achieve efficient and flexible exchange rate outcomes. However, the Dutch auction in Zimbabwe platform was set to be supported by the Reuters Forex Trading platform, an electronic system for bank-to-bank trading. However, the central bank withdrew from this arrangement before full implementation.
Following a promising beginning, the auction platform shifted to become an allocation platform, where the exchange rate was loosely tied regardless of factors like money supply growth or other economic changes affecting foreign currency pricing.
This departure from the originally intended Dutch auction principles aimed to establish trust in central bank operations, ensure transparency in foreign currency allocation, and permit some degree of free market price determination in foreign currency trading.
The experiment ended in disaster as the currency has been neglected and 80 percent of our transactions are now dollarised. However, the minister signalled that they might do some tweaking of the original currency board, which makes them face an uphill task of restoring confidence in the banking sector.
Tapiwanashe Mangwiro is a resident economist with the Business Weekly and writes this in his own capacity. @willoe_tee on twitter, [email protected] on email and Tapiwanashe Willoe Mangwiro on LinkedIn
