Sunday, February 26, 2017

Zimbabwe: Feasibility of a Gold-Backed Currency, 26 FEB

Zimbabwe: Feasibility of a Gold-Backed Currency

2/26/2017 09:43:00 AM  News    Persistence Gwanyanya

IN my February 10 instalment, I argued that using gold to back bond notes could boost confidence in the surrogate currency and, by extension, attract more investments to rebuild the local economy.

Admittedly, this suggestion does not constitute an optimal currency solution, but could be a better option to avoid a currency crisis.

It’s now clear that, in their current form, bond notes and coins would be inadequate to effectively boost exports as well as remedy externalisation.

Thus, there may be need for measures to beef up the current currency regime and build on the progress made so far to avoid a deeper economic crisis.

Suffice to say my proposal is not advocating for the return of the heyday gold standard that operated at the end of the 19th and early 20th century.

This currency regime operated well as a remedy to the inflation scourge and currency depreciation attributable to excessive credit creation and, as such, might not produce the best result in the current deflationary environment, where monetary authorities have limited control over money supply.

An effective currency solution should be rooted in the clear understanding of the country’s currency crisis.

As noted earlier, the cash shortages in Zimbabwe are largely a result of an unbalanced economy characterised by high levels of consumption – funded from imports – and low production.

This economic imbalance, in part, can be attributed to the fixed exchange rate regime with the dollar, which is about 25 percent overvalued. This makes Zimbabwe’s exports uncompetitive in the international market.

However, adopting a gold-backed currency, which entails switching the peg from dollar to gold, may not necessarily improve the country’s competitiveness.

Clearly, the lack of competitiveness can be traced to deep-seated structural challenges such as poor infrastructure deficit, high cost of utilities, scarcity and high cost of capital.

Zimbabwe’s experience with the fixed exchange rate is deflation, rising unemployment and poverty, sluggish growth and budget and trade deficits.

There is no guarantee that these challenges would be addressed by just switching from dollar to gold peg.

Importantly, being a tiny US$14 billion open economy in a more than $80 trillion world, Zimbabwe might not be better placed to lead the gold monetisation of its currency.

The suggestion to gold back the bond currency alone would be difficult to achieve since this currency is interchangeable with the US dollars at a stipulated exchange rate.

If bond notes were to be revalued against gold, it would automatically mean that the rest of the country’s money supply would also have to be valued similarly.

This would be very difficult to achieve given the current and potential production levels of gold, including financial challenges plaguing the economy.

Devoting the country’s full annual production of yellow metal to build the required reserves will not even be enough to support US$6,7 billion in money supply in the economy.

At a price of ZW$40 000 per kg (35 274 ounces),it would take not less than five years to build the 167 tonnes of gold reserves required to back the full money supply in Zimbabwe, assuming potential annual production of 30 tonnes.

The biggest dilemma that the country faces by devoting all its gold production towards building gold reserves is that this would lead to a further deterioration of the balance of payment position.
Annual exports would fall by $1billion to around $2billion as gold exports are redirected towards building reserves.

This would worsen the liquidity and cash crisis, which may lead to the abandonment of the home-grown gold standard before it starts.

The only better alternative is for authorities to completely abandon the current multiple currency regime and make bond notes a different currency from the other multiple currencies.

This would mean that there would be US$300 million of gold-backed bond notes ($200 million) and coins ($50 million), and this currency would be used for domestic transactions only.

This constitutes de-dollarisation, but it would be difficult to achieve in a short space of time.

As such, the gold-backed bond currency would be allowed to initially circulate alongside the multiple currencies, predominantly US dollars, which mean the US dollar value of gold, which varies minute to minute on the international market, would not be the same as bond notes valuation of gold.

Far from ensuring stability, the proposed currency peg would give rise to enormous complexities as well as volatility and unpredictability.

When Zimbabwe dollarized, the price of gold per ounce was US$869, and thereafter rose to US$1664 before falling to US$1 225 per ounce in 2017.

Had the currency been pegged to a fixed amount of gold, its value would have increased over 90 percent and then dropped 26 percent.

That means its value would have risen 40 percent between 2008 and 2017, which is not much different from the extent of Zimbabwe’s currency overvaluation since dollarisation.

This also underscores the assertion that a country’s competitive challenges would not be solved by just switching from US dollar peg to a gold peg.

It is arguable that the current currency regime is facing a number of challenges that are threatening its sustenance.

The cash premium relative to RTGS money, together with the reported bond note discounts and the return of the Old Mutual Implied rate discount of around 25 percent since September 2016, is instructive.

The dollar in RTGS balances or in bond notes or in fungible Old Mutual shares is not the same as cash dollar or US dollar outside Zimbabwe.

This is a major hinderance to capital flows in Zimbabwe, which are expected to continue as Nostro funding challenges continue.

This suggests that an effective currency solution in Zimbabwe should address production challenges and capital flight.

With an estimated US$14 billion to US$20 billion required to close the infrastructure deficit and US$5 billion needed to reindustrialise, there is need to generate and boost confidence in the country’s currency so as to attract meaningful investments.

This could be the sole reason that gave rise to the idea of monetising bond notes with gold.

The challenges to monetise the country’s money supply through gold doesn’t render the idea impracticable.

There may be need to consider monetising a portion of the money supply in the economy, say a tenth.

This would go a long way in improving confidence.


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