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WHAT DETERMINES GOOD FINANCIAL HEALTH?
THE CASE FOR A DERIVATIVE MARKET IN ZIMBABWE (PART II)
THE CASE FOR A DERIVATIVE MARKET IN ZIMBABWE
MANAGED OR FLOAT EXCHANGE RATE—WHICH ONE IS THE BEST SUITED FOR OUR ECONOMY?
WHAT THEN? WHEN THE MEDIUM OF EXCHANGE LEAKS VALUE…
IS MARKET TIMING RELEVANT?
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published-Thu 10 Nov 2005

MANAGED OR FLOAT EXCHANGE RATE—WHICH ONE IS THE BEST SUITED FOR OUR ECONOMY?


By: Herbert Chibika

There was excitement in the market when the central bank dropped the Auction System and introduced the Tradable Foreign Currency Balances System (TFCRS) in the Third Quarter Monetary Policy Statement.  This will see exporters retaining 70% of export proceeds in their foreign currency accounts (FCA). If the funds are not utilized by the end of 30 days, the foreign currency will be liquidated at the inter bank rate determined by the inter bank market.  The balance of 30% will be sold at the auction price to be determined and announced from time to time.  In contrast, the auction system was a managed exchange rate where the government, through the central bank was central in dictating the direction of foreign currency price. By and large, the auction was driven by buyers, leaving sellers to take prices as set by those in need of the foreign currency. The system failed to amass the critical mass required by agents of the economy, as exporters proffered to transact in the parallel market, were rates were said to be in conformity with parity dictates. This resulted in shortages of foreign currency in the official market. The new system has been commended, especially given that it gives reprieve to exporters who were facing viability challenges under the auction system.  The inter bank market is expected to harness foreign currency in parallel systems to the mainstream formal market, as it is expected to wipe out arbitrage opportunities in the parallel foreign currency market. With the introduction of such a system the question being asked is whether the exchange rate regime has been transformed from a command to a market determined exchange rate, as widely reported in the papers.

Generally, there are two main exchange rate regimes, namely the flexible regime (that includes freely floating and managed floating regimes) and the fixed regime. The freely floating regime allows laws of demand and supply to dictate the value of a country’s currency without government intervention.  The advantages of such a system is that, there is no need for central banks to value the currency (that is, fix the exchange rate), hence it automatically eliminates balance of payment imbalances.  The disadvantage is that it brings uncertainty in future exchange rates.  Volatile fluctuations in the exchange may have devastating effects on the economy, and strategic planning cannot be done with certainty.  Zimbabwe, as a net importer and net borrower of foreign currency, will suffer from exchange rate risk with such a system. The managed floating exchange rate regime entails government intervention (through the central bank) in the exchange rate determination to smooth out shocks or volatility brought up by speculation or events like drought.

In a fixed exchange rate regime, the central bank pegs the exchange rate to protect the economy from the adverse effects of a flexible regime, to eliminate exchange rate risk.  The problem with such a regime is that there is a constant need to revalue the currency to approximate equilibrium levels. The system also encourages eruption of a parallel market for foreign currency, where market forces and risk premiums will dictate the price of foreign currency.  This transfers huge amounts of foreign currency out of the formal channel, and may result in critical shortages of foreign currency.

Given the above prognosis, one can conclude that the inter bank exchange rate regime recently introduced is not a free float, neither is it a fixed exchange rate.  The fact that 30% of exports are sold at the auction rate determined by the central bank shows that the exchange rate has elements of a fixed exchange rate regime.  After the introduction of the inter bank system, the inter bank market set the exchange rate at Z$60 000/US$ for now.   The inter bank rate is managed to avoid adverse volatility that may bring instability, as opposed to leaving the exchange rate to pure market forces.

In light of the factors above, one can safely conclude that our exchange rate regime as espoused in the third quarter monetary policy is a blend of fixed and managed exchange rate systems. One aspect is whether the new exchange rate is the correct prescription for the economy. To start with, there is no economy world wide with a freely floating exchange rate regime. In Zimbabwe, the free float will subject our foreign debt to exchange rate risk, and cost of imports may choke our production sector on one hand, whilst it will give exporters a life line on the other hand. The move by the central bank to implement a middle of the road approach to strike a balance between the two is commendable. However, the extent of control should allow the exchange rate to adjust to international parity, otherwise the new inter bank rate will fall into the same predicament as was the case with the auction, which stagnated and allowed arbitrage opportunities to prevail. We expect the governor to constantly review the auction which will apply on the 30% of exports to equilibrium levels. In addition, the governor should follow a “crawling peg” on the inter bank market where the central bank will review parameters of the exchange to be in line with parity conditions. This will ensure that our exchange rate is at equilibrium with international parity, hence guard against eruption of black market activities

 

 


 

This article is published for general investment advice and it must be noted that the price of
equities and the income derived from them can rise as well as fall. Neither First Mutual Limited nor the author shall be held liable for any losses as a result of the investment advice
contained in this article. It is important that specific investment advice is sought as each
investor’s investment will be dependent on their circumstances.

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