RBZ to tighten money supply. What does that mean and how are they trying to achieve it?

Every single Zimbabwean knows more about economics than the average person everywhere else. We might as well do away with the Economics degrees at our colleges. The school of life was our college and hyperinflation our teacher. However, there are still some concepts we need help breaking down. Today, we try to understand what tightening the money supply means.

The RBZ announced money supply tightening as a solution for the depreciation of the local currency. What does that mean?

Depreciation of the Zimbabwe Dollar and inflation

To note is that the problem the Reserve Bank of Zimbabwe and the Ministry of Finance are trying to fix is the loss in value of the Zim Dollar – its depreciation.

We usually measure the value of our currency against other currencies, most commonly the USD. That is why we talk about direct comparisons, called exchange rates.

We have seen the Zim Dollar fall from parity with the USD in 2017 to ZWD$87 being equal to US$1, a rate of 1:85, on the official market. The parallel market sees US$1 being equal to ZWL$170, a rate of 1. As the rate of decline has accelerated in the past few months, the RBZ has increased efforts to counter the forces driving this depreciation.

The reasons for the depreciation of the ZWD

We cannot go through all that has caused the depreciation. The bottom line is that our currency just doesn’t have value because:

1. It is a fiat currency. This means that like most other currencies there is no gold backing the notes in circulation. The Zim Dollar note is just a piece of paper whose value comes from the trustworthiness of its issuer. Therein lies the problem, a lack of trust (justifiably so) in the RBZ and the Zimbabwe government’s monetary discipline.
2. We are not buying more from other countries than we are selling. How it works is that if you want to buy something in South Africa for example, you need their legal tender – the Rand. Our cross-border traders will tell you this, you need to convert whatever currency you have into Rands before you go to S.A to shop. At a larger scale, the country scale, if there were many foreign companies buying from Zimbabwean companies, they would need the Zim Dollar thus driving up demand and therefore the value.
3. Too much money chasing few goods. Every Zimbo who was alive in the hyperinflation-era of the noughties knows this. Today, we have a lot of Zim Dollars chasing few US Dollars. Everyone wants to convert their Zim Dollars into USD as soon as possible. Problem is there aren’t enough USD in the market for this. What happens is that those holding Zim Dollars are bidding more and more to get the USD which will hold value better than the Zim Dollar.

The excessive money in the market leads to high inflation because prices are based on the USD via the parallel market rates. As the Zim Dollar depreciates and the USD gains value, prices also increase, hence the high inflation.

Tightening the money supply

That last cause is the one that the RBZ wants to address. We have a lot of Zim Dollars chasing a few US Dollars. What the RBZ wants to do is reduce the amount of Zim Dollars in the market. This is what tightening the money supply means. You may hear them talk about mopping up excess liquidity. That’s essentially the same thing as tightening the money supply.

The money supply increased by over 3300% from January 2018 to April 2021. The broad money supply growing from about $7.5m to about $262m USD equivalent. That is a lot of Zim Dollars introduced into the market.  

This increase in money supply is chiefly caused by government borrowings from RBZ through the overdraft facility, issuance and repayments of Treasury Bills, which are short term debt obligations backed by the government and RTGS credits by the RBZ which are not backed by any foreign currency reserves.

Now the RBZ wants to mop up some of that money. The idea is that when there are fewer and fewer of us chasing the USD, the value of the USD will fall as compared to the Zim Dollar.

How are they tightening the money supply?

The RBZ is targeting individuals and corporates that have huge RTGS balances in their accounts. As we discussed, no one wants to hold that currency in Zim Dollars and so they are using these huge RTGS balances to seek USD on the black market. This is increasing the demand for forex and therefore weakening the local currency and increasing inflation.

On a side note, the huge RTGS balances are responsible for the increased activity on the stock exchanges. Corporations realise if they can’t convert their RTGS balances into USD, they might as well purchase stocks and preserve value that way.

The RBZ wants to make sure these huge RTGS balances do not make it onto the black market. Instead, corporations are being invited to purchase special government ‘bills’ called….

Exchange rate linked Open Market Operations

The RBZ has used such instruments before, also called Principal Exchange Rate Linked securities. Here is how they are supposed to be attractive to corporations.                               

To note is that for such instruments we talk about the principal and the interest. The principal is the original amount you pay and the interest is a percentage of the principal paid daily, weekly, monthly or annually. So, consider a corporation that purchased a $100,000 bond at 5% interest per annum that matures after one year. After one year, they receive their initial $100,000 and $5,000 interest.

Now in Zimbabwe where the currency will have lost a lot of value, such a bond would not be really attractive to an investor. That’s where the exchange rate linked OMOs come in.

The instrument is linked to the exchange rate. That means the principal will be determined by the exchange rate on the date of maturity. Let’s say the above $100,000 bond is bought today when the rate is about 1:87. Let’s say the rate is 1:97 after one year when it matures. The principal will then be worth 100,000/87*97 = $111,494. That’s before the interest.

In a way, this is similar to purchasing foreign currency. If the Zim Dollar loses value against the USD, the holder of this instrument sees their principal payment increase. So, this instrument should be more attractive to holders of huge RTGS balances than the other bonds and bills on the market.

If corporations take up the exchange-rate linked securities, this will reduce demand for foreign currency. This would help ease the inflationary pressure the high demand for forex has.

Why the OMOs might not work

You’re probably distracted by the elephant in the room. Which exchange rate will be used? I illustrated how the securities work using the official auction rate and that is the one that will most likely be used. The difference between the official rate and the parallel market is huge and widening and so the exchange rate policy on these instruments will be key to their adoption.

The other problem is the trust issue we discussed above. Can the corporations trust that the RBZ will not introduce some new measure before the maturity of the securities that negates all its benefits? No, they cannot fully trust the RBZ.

So that’s it. That is what all this money supply tightening business is all about.