ZIMBABWEAN HYPERINFLATION CRISIS

Presented by GROUP 6

Abhishek Banerjee Shraddha Chillarige Vivek Hariharan Manisha Kumar Mythri Macherla Kanchan Tiwari

(C004) (C012) (C024) (C036) (C040) (C061)

Contents
THE ZIMBABWEAN SETTING ............................................................................................... 3 INTRODUCTION .................................................................................................................... 3 DECLINE IN GDP .................................................................................................................... 3 ROAD TO INFLATION .............................................................................................................. 5 POST INDEPENDENCE ......................................................................................................... 5 INCREASING PROBLEMS ..................................................................................................... 6 LAND REFORMS AND INFLATION ................................................................................... 7 HYPERINFLATION .................................................................................................................... 9 SETTING IN OF HYPERINFLATION ................................................................................. 9 INTRODUCTION OF THE SECOND DOLLAR ............................................................. 10 DOLLARIZATION AND DEFLATION ................................................................................. 12 CURRENT SITUATION ........................................................................................................... 14

THE ZIMBABWEAN SETTING

INTRODUCTION
At the time of independence in 1980, Zimbabwe had a much more developed economy than most of its sub-Saharan counterparts. At the time, the country had an average growth rate of 4.3% per annum making the country the envy of sub-Saharan Africa. Zimbabwe had a vibrant and diversified economy at the time. The country had the most developed capital market in all of Africa, second only to South Africa. As such, Zimbabwe was a symbol for the rest of the world of what Africa could become. These achievements lead to the conclusion that independent Zimbabwe was a success. Twenty years on since independence, and contrary to expectations Zimbabwe was still a developing country and in the effect of experiencing a decline in development. The economy had collapsed and was in a free fall. Now the economists stated that Zimbabwe is in an economic conundrum, the roots of which are linked to the crash of the Zimbabwean dollar in 1997. This was the same currency which when introduced in 1980 and replaced the Rhodesian dollar at par was worth more than the US dollar. (ZWD 1 = USD 1.47)

DECLINE IN GDP
A quantitative analysis of the situation in Zimbabwe reveals that the real Gross Domestic Product (GDP) fell by almost 30% from 1997 to 2003 and continued to fall through 2008. The figure shows Zimbabwes real GDP growth (percentage) from 1980-2008. Surprisingly, this turn of events in Zimbabwe is occurring when African countries are beginning

to achieve reasonable growth rates. The figure validates this assertion by juxtaposing Zimbabwes real GDP per capita in USD against that of some of the other African nations. An abridgment of these indicators shows how by 2003, the Zimbabwean economy was shrinking

faster than any other economy in the world at 18% per year. Zimbabwes crisis has deepened to levels that have set the country back more than 50 years.

ROAD TO INFLATION
POST INDEPENDENCE
Initially the government followed a corporatist model with government management of the economy. The state already had ownership of utilities and agricultural marketing agencies. The new government added to this by buying out more private companies. The government also extended existing protectionist policies. The government propagated a whole range of new economic policies, introducing a minimum wage and virtually eliminating the right to fire workers. The total spending on education nearly tripled (from Z$227.6 million to Z$628.0 million), as did government spending on healthcare (from Z$66.4 million to Z$188.6 million), between 1979 and 1990. Expenditure on publicsector employment rose by 60% and on the civil service by 12% per annum over the course of the 1980s. Central government expenditure tripled and increased its share from 32.5 percent of GDP in 1979 to 44.6% in 1989. Interest rates were artificially capped. The consequences during this time were rather mixed. Economic inequality within the population decreased and provision of education and healthcare became more widespread. But due to the increase in relative poverty in relation to the surrounding regions there was an exodus of white Zimbabweans, skilled workers during this period. There were several reasons for middling to low performance of the economy. Protection sustained existing high cost companies, but discouraged exports by raising the costs of inputs to exporters, leading to a critical shortage of the foreign exchange needed to acquire imported technology. Foreign companies were not allowed to remit dividends, and new foreign investment was actively discouraged. The need to get permission and licenses for new investment and the dismissal of individual workers imposed heavy time and transaction costs. Repressed interest rates discouraged saving and the states high propensity to borrow reduced the supply of capital to all but favoured borrowers, and also stoked inflation. The regime did not encourage, and even suppressed, the development of independent new African businesses because of the threat they were thought to offer to ZANUs (Zimbabwe African National Union) political monopoly. Public spending skyrocketed, particularly in the areas of civil service employment, spending on social services, drought relief, and subsidies for government owned companies. This in turn generated a chronic budget deficit, a high tax regime, and a rapid increase in public debt - all of which created a drag on the economy. Compounding the problem, all companies were effectively discouraged from employing new workers because of controls over wages and employment.

This had two politically significant consequences. First, it suppressed the emergence of a genuinely entrepreneurial African business class and reduced the political support of those that did make their way despite these problems. Second, it turned unemployment into a major threat to the legitimacy of the regime, especially in urban areas. In real terms, wages declined over the decade.

INCREASING PROBLEMS
By the end of the 1980s there was increasing agreement amongst government elites that new economic policies needed to be implemented for the long term survival of the regime. The new policies set out to encourage job-creating growth by transferring control over prices from the state to the market, improving access to foreign exchange, reducing administrative controls over investment and employment decisions, and by reducing the fiscal deficit. It had wide local support and was introduced before economic problems had gone out of control. A 40 per cent devaluation of the Zimbabwean dollar was allowed to occur and price and wage controls were removed. The austerity plan in Zimbabwe was followed by economic problems of increased severity. Growth, employment, wages, and social service spending contracted sharply, inflation was not reduced, the deficit remained well above target, and many industrial firms, notably in textiles and footwear, closed in response to increased competition and high real interest rates. The incidence of poverty in the country increased during this time. The new policies were undermined by extremely unfavourable conditions. Drought reduced agricultural output, exports, public revenue, and demand for local manufacturing. Growth during three droughtaffected years (1992, 1993, and 1995) averaged 2.6 percent; during three good years (1991, 1994, and 1996) it was 6.5 percent. South Africa canceled its trade agreement with Zimbabwe at this time contributing significantly to deindustrialization. The government's failure to bring the fiscal deficit under control undermined the effectiveness of those elements in the program that were followed through. This led to growth in public borrowing, sharp increases in interest rates, and upward pressure on the exchange rate. The limited cuts that were made concentrated on the social services and led to serious reductions in the quality of health and education. The government's austerity plan coupled with a relatively weak and highly protected economy came far too quickly. Uncompetitive industries were eliminated and over manning was reduced, but in such a sudden and disruptive manner as to cause economic chaos. The last half of 1997 marks a turning point from the relatively disciplined policies that the government had pursued since the attainment of independence in 1980. A string of decisions had the effect of damaging confidence in the local currency, concomitantly exerting pressure on the

Zimbabwean dollar in the currency markets, which fed to inflation. Firstly, in August 1997, approximately 60,000 war veterans were granted ZWD50000 each plus a monthly pension of approximately USD125 per month outside the budget. This increased government spending amounted to almost three percent of GDP at the time and had the immediate effect of inflating the budget deficit at the end of 1997 by 55 percent from the 1996 levels. Concerns were raised pertaining to the financing side of the transaction in view of an already precarious fiscal position, and so the government intended to accommodate the gratuities payment through tax increases in the 1998 budget. But countrywide protests orchestrated by the trade unions forced the government to backpedal and resolve to monetization of the transaction. The second populist decision followed in November 1997 when the president, Mugabe, announced plans to compulsorily acquire white-owned commercial farms, again without elaboration on the financing side of the transaction. This had the immediate effect of giving investors a perception of an ensuing precarious fiscal position and consequently there were spontaneous and concerted runs against the currency and from the money and capital markets. The climax of these events was on 14 November 1997 when the Zimbabwean dollar crashed and lost 75 percent of its value against the USD on a single day, on what is now known as Black Friday in Zimbabwean economic history. The stock market also plummeted and the index was down by 46 percent by day end from the peak August levels. The central bank had to intervene and adopt a tight monetary policy by raising interest rates by six percentage points within that single month. The exchange rate continued to depreciate uncontrollably, thus the 1997 financial and currency turbulence set the stage for a long and potentially long slump in the real economy. In 1998 Mugabe's intervention in the civil war in the Democratic Republic of the Congo, supposedly to protect his personal investments, resulted in suspension of international economic aid for Zimbabwe. This suspension of aid and the millions of dollars spent to intervene in the war further weakened Zimbabwe's already troubled economy.

LAND REFORMS AND INFLATION

The presidents rhetoric on confiscation of white-owned farms was elevated to the next level in early 2000, when war veterans, who were now the paramilitary wing of the ruling ZANU PF party, started invading white-owned farms as part of an elaborate scheme by ZANU PF to terrorise people to vote for it in the parliamentary election in July 2000. 300,000 households and 51,000 black commercial farmers were apportioned the previously white-owned commercial farmers. As a result of the upheavals on the farms, agricultural output fell dramatically from the level of 18 percent of GDP in 2000 to 14 percent of GDP in 2002. Tobacco, the countrys major foreign currency earner was not spared as can be seen from figure.

The consequences of the falling agricultural output were immediate. The government could not service its multilateral debts obligations and as a result in October 2000, the World Bank suspended any extra lending to Zimbabwe due to non-payment of over six months. On the other hand the government could not import essential raw materials and fuel as a result of the declining forex inflow, which further fed into falling production with the result that by 2004, total foreign currency earnings from the export of goods and services had declined to less than half the 1996 peak of USD 3169 million. With the country completely cut off from the donor community, the crisis caused by forex shortages reached a climax in 2003. An acute shortage of Zimbabwean dollar banknotes developed during the first nine months of 2003 as the central bank could not print local currency due to shortage of hard currency to import paper and ink. Reflecting a combination of both demand pull and cost push inflation drivers, the period 2000 to January 2004 saw Zimbabwe registering unprecedented levels of inflation build up. On the demand side, excessive money supply growth was identified as one of the major cause of inflation. Empirical evidence for Zimbabwe has shown that excessive money supply growth, which is not matched by productive economic activity, had adverse effects on inflation. Money supply growth emanates from the actions of both the private sector and Government to the extent of their borrowing from the banking system. The Reserve Bank therefore, created a Framework for Liquidity Management, whose primary objective is to contain money supply growth to levels consistent with inflation targets. On the supply side, the major driver of inflation was the shrinkage in aggregate supply sparked by the fall in the agriculture, which then spread to other sectors of the economy. In Zimbabwe, there are supply bottlenecks, which have been brought about by various factors including natural disasters (drought), shortage of inputs, and structural rigidities including infrastructural deficiencies. These factors have to some extent adversely affected production and have resulted in demand outstripping supply leading to inflationary pressures during the last few years.

HYPERINFLATION
SETTING IN OF HYPERINFLATION
In 2003, the new governor undertook monetary policy strategy and consequently set up a Framework for Liquidity Management, which was to contain money supply growth to levels consistent with inflation targets. The interest rate was the operational target and it was raised acutely in the first quarter of 2004, reaching a peak of 5,242 percent annually in March 2004. Inflation which had soared from about 20 percent in December 1997 to a peak of 623 percent in January 2004 decelerated sharply from March to around 130 percent at the end of 2004. The high interest rates let to a huge liquidity crisis in January 2004. the high real interest rates and an increasingly overvalued official exchange rate was also putting pressure on domestic producers and exporters., In a move sold as though it was to bail out the ailing financial industries, the central bank started engaging in fiscal activities had the effect of undoing the achievements in the inflation battle and firmly set course for the drive towards hyperinflation. The central banks help to the unpopular ruling regime at the expense of the masses went beyond inflation tax but also diversion of the donor funds passing through the central bank to the ZANU PF. In 2008 the central bank siphoned funds from the Global fund meant to fight HIV/AIDS, malaria and tuberculosis to aid ZANU PFs political campaign. In return the government turned a blind eye to the bureaucratic and personal interests at the central bank that were to the detriment of the country. And at that time the general unemployment rate in the country was over 80 percent.

Due to the bottlenecks in the economy, it was observed that there was a decline in the supply. This lead to the leftward shift in the aggregate supply curve as shown in the graph.

To tackle the bottlenecks, the central bank injected more money into the economy by simply printing more notes and therefore increasing the liquidity in the economy. This further lead to increase in demand, the aggregate demand shifted rightward ( as shown).

The above two factors, were the major determinants of the prices in the economy. The equilibrium between the aggregate demand and the aggregate supply curve was attained at a high price level. Hence there was an overall increase in prices.

INTRODUCTION OF THE SECOND DOLLAR

The ravaging inflation standing at over 1000 percent meant that the people had to carry large sums of currency to conduct the simplest of transaction and on 1 August 2006, the Zimbabwean dollar was replaced by a new Zimbabwean dollar exchanging at a ratio of 1000:1 and it was subsequently devalued against the USD. According to the central bank governor, the basis of these reforms was that the removal of three zeros would effectively have positive psychological effect on people's reference points. In other words the governor opined that by simply removing zeros from the currency, people would be confused to think that the Zimbabwean currency was no longer inflationary and hence revise their inflation expectations. Given the superficial nature of the reforms, there was no sign of recess in inflation and Zimbabwe formally entered hyperinflation in March 2007 when month-on-month inflation reached 50.54 percent and year-on-year 2,200 percent. This period thus, marked the countrys

accelerated drive towards hyperinflation fuelled. the characterization of inflation in this period is therefore of a demand pull nature where the major driver of inflation was excess liquidity.

INTRODUCTION OF THIRD AND FOURTH DOLLARS On 30 July 2008, the Governor of the RBZ announced that the Zimbabwe dollar would be redenominated by removing 10 zeroes, with effect from 1 August 2008. ZWD 10 billion became 1 dollar after the redenomination. More banknotes were issued since the governor vowed to continue printing money and the denominations reached $1 trillion by January 2009. In February 2009 a final denomination was implemented, cutting 12 zeroes. The Zimbabwean dollar had become largely irrelevant by this time, with the economy being almost completely dollarized. Even the national postal service, Zimpost, was said to be charging customers postage in US Dollars, even though some of the stamps were in Zimbabwean Dollar denomination. The Zimbabwe dollar was officially abandoned on April 12, 2009.

DOLLARIZATION AND DEFLATION

2008 was to find hyperinflation gaining momentum, reaching 417,823 percent in March. Foreign currencies obtained on the black market floated against the Zimbabwe dollar and they rapidly replaced it. The U.S. dollar, South African rand, Botswana pula, Zambian kwacha, and Mozambican metical all became increasingly popular in Zimbabwe during 2008. By December 2008 the use of foreign currency as a medium of exchange was almost complete albeit unofficially. In a move sold by the central bank as though to help businesses suffering from chronic shortages of foreign currency to import goods and spare parts, it licensed around 1,000 shops to sell goods in foreign currency. This constituted the first conscious recognition of unofficial dollarization in Zimbabwe. In January 2009, a month after the licensing 1,000 shops the minister of finance gave legal tender status to the South African Rand and the US dollar, hence completing official dollarization. Since the abolition of all surrender requirements on foreign exchange proceeds in March 2009, there has not been a functioning foreign exchange market for Zimbabwe dollars. Bank accounts denominated in Zimbabwe dollars, equivalent to about US$6 million at the exchange rate of Z$35 quadrillion per US$1, were dormant. While five foreign currencies had been granted official status, the U.S. dollar became the principal currency. In cash transactions, the U.S. dollar had become the currency of choice. The rand is prevalent in the South of the country and also circulates in the rest of the country, in particular coins. Wider circulation of the rand is prevented by South Africas capital account controls. Currencies other than the U.S. dollar and the rand have limited circulation in Zimbabwe. The role of local currency was relegated for use in small transactions and for change. The institution of official dollarization had the obvious immediate effect of stopping hyperinflation and the country actually entered into deflation with consumer price inflation standing at -2.34 percent and -3.26 percent at the end of January and February respectively. Aid from bilateral donors started trickling into the country and for the first time in over ten years the country forecasted positive growth. Zimbabwe's central bank no longer publishes data on monetary aggregates, except for bank deposits, which amounted to $2.1 billion in November 2010; the Zimbabwe dollar stopped circulating in early 2009; since then, the US dollar and South African rand have been the most frequently used currencies; there are no reliable estimates of the amount of foreign currency circulating in Zimbabwe.

The multicurrency system has provided significant benefits. In particular, it fostered the remonetization of the economy and financial reintermediation, helped enforce fiscal discipline by precluding inflationary financing of the budget, and brought greater transparency in pricing and accounting after a long period of high inflation. As a result, the price level in U.S. dollars declined during 2009, while the economy started to recover.

CURRENT SITUATION
Zimbabwe's economy is presently growing at a brisk pace despite continuing political uncertainty. Following a decade of contraction, Zimbabwe's economy recorded a real growth rate of 9 percent in 2010. The economy is likely to continue its strong recovery in 2011 from a decade of decline, posting GDP growth of 9.4 percent compared with an estimated 9.3 percent this year. The performance will be underpinned by expansion in the finance, mining, tourism, agriculture, manufacturing and transport sectors. Zimbabwe is home to the world's second-biggest deposits of platinum, as well as vast reserves of gold, diamonds and coal and the sector attracted $502 million of investment in 2011. The agriculture sector is also recovering from a slump triggered by Mugabe's seizure about a decade ago of white-owned farms to give to landless blacks. It is expected that 2012 maize production should hit 1.8 million tonnes from 1.45 million this year. That figure is still below the 2 million tonnes analysts say are needed to feed the country's 13 million people. The government of Zimbabwe, however still faces a number of difficult economic problems, including a large external debt burden and insufficient formal employment. Zimbabwe still has the worst performing economy in southern Africa, all because politicians have failed to create a stable political and economic environment. The country currently has the highest unemployment rate in the region at over 80 percent. Zimbabwes budget is sustained by import duty. Agriculture was able to show a few improved output levels in 2010, particularly for tobacco, but food production volumes have remained so low that a large proportion of the rural population is currently in need of assistance from the World Food Program and other aid agencies. However, new ventures include extensions to sugar production and plantations of jatropha trees, both of which are to assist with the production of bio-fuels. While prices and wages are usually agreed and quoted in U.S. dollars, the main trading partner and country of origin of capital inflows for Zimbabwe is South Africa. Movements in the U.S. dollar/rand exchange rate therefore have considerable effects on Zimbabwes competitiveness and international investment position. The shortages of small-denomination U.S. dollar banknotes and coins pose difficulties for retailers. The government considers the multicurrency monetary regime a temporary arrangement until 2012 at least. Despite the remaining challenges, the multicurrency regime could continue to operate with certain improvements until a new regime is chosen. The necessary improvements include aligning legislation, with the prevailing practice of use of multiple currencies, making exchange controls more transparent, and facilitating the supply of coins, possibly with an agreement with South Africa.

Zimbabwe would need a monetary regime that provides an appropriate and credible nominal anchor and reduces the risk of destabilizing speculative attacks. These requirements are particularly important for Zimbabwe, which has monetary and fiscal institutions with low credibility due to a long history of poor governance, weak macroeconomic management, and a recent episode of unprecedented hyperinflation. Fiscal transfers from abroad would mitigate the cost of losing monetary independence. At present, there are no automatic fiscal transfers between South Africa and Zimbabwe. However, Zimbabwe could potentially join SACU, which as an organization has a revenue-sharing formula favouring poorer member countries. SACU revenue sharing could, therefore, mitigate a negative shock to Zimbabwes economy in case of an idiosyncratic shock to its economy. The jump start in growth has so far been consumption-led, but Zimbabwes export sector, in particular mining, could potentially recover quickly and provide much needed fiscal revenues to a cash-strapped government with large external obligations. The economy is registering its first growth in a decade, but will be reliant on further political improvement for greater growth.