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Lessons on high inflation for Zimbabwe
The Zimbabwe Independent
May 18, 2007

http://allafrica.com/stories/200705180428.html

ZIMBABWE currently has the highest rate of inflation in the world at 3 700%. The high rate of inflation has contributed to the contraction of the economy, which has declined by about 30% since 1999. This IMF paper by Sharmini Coorey, Jens R Clausen, Norbert Funke, Sònia Muñoz, and Bakar Ould-Abdallah examines the stabilisation experience of countries that experienced similar rates of inflation (above 1 000%) during 1980-2005 and draws lessons for Zimbabwe.

Hyperinflations are largely a modern and rare phenomenon generally associated with printing money to finance large fiscal deficits due to wars, revolutions, the end of empires, and the establishment of new states. According to Cagan's definition, hyperinflation begins in the month inflation first exceeds 50% (per month) and ends in the month before the monthly inflation rate drops below 50% for at least a year. Since monthly inflation is still officially under 50%, Zimbabwe currently does not qualify formally as a hyperinflation case by Cagan's definition.

It is worth mentioning, however, that the official CPI in Zimbabwe is likely to substantially understate inflation because about a third of the basket reflects price-controlled items and the consumption weights are outdated. Many in the private sector believe that the true rate of annual inflation was closer to 3 000% in February 2007. Monthly inflation rates in informal private indices - which are more heavily weighted by food - have exceeded 50% for several months.

Another distinct feature of Zimbabwe's economy is the sustained contraction in output. Real GDP is estimated to have declined by about 30% since 1999. While the initial output collapse is widely attributed to the chaotic seizure of commercial farms - the backbone of the economy - other factors have also contributed in recent years:

• Price distortions due to extensive controls and regulation, particularly relating to the exchange rate which is fixed by the Reserve Bank of Zimbabwe at a highly overvalued rate;
• The collapse of investor confidence due to unpredictable policies and lack of respect for property rights, particularly in agriculture and mining; and
• Minimal external financing because of poor relations with creditors and donors and deteriorating economic and social conditions.

Without an immediate stabilisation package and comprehensive medium-term structural reforms, prospects are for Zimbabwe's inflation to continue accelerating and for the economic crisis to deepen.

Do the countries that have gone through similar episodes of high inflation in recent decades have lessons to offer Zimbabwe?

Using a 12-month inflation rate of 1 000% as the threshold for defining a period of high inflation, we identify 30 such inflation episodes in 24 countries between 1980 and 2005.

Accelerating inflation in Zimbabwe has been fuelled by high rates of money growth reflecting rising fiscal and quasi-fiscal deficits. The adjusted overall fiscal deficit or financing requirement, including government and RBZ interest payments, is estimated to have amounted to about 80% of GDP in 2006. These large and rising deficits have been partly financed through money creation, giving rise to accelerating rates of inflation. In fact, money growth and inflation in 2006 would have been even higher without the implicit taxation of the banking system via a lengthening of the maturity of treasury and RBZ bills and payment of highly negative real interest rates on these bills.

The recent announcement by the RBZ that it would create a fully-owned subsidiary called Fiscorp to carry out QFAs, possibly on a transitory basis, would not address the fundamental issue - the massive price and exchange rate distortions and poor governance in the public sector (including public enterprises) that place an unsustainable burden on the public finances.

The international experience suggests that in countries such as Zimbabwe, with high inflation and extensive relative price distortions, strong upfront adjustment through a broad-based policy package is needed to establish credibility and minimise the cost of adjustment. For Zimbabwe, we identify five interrelated elements that would be necessary in an initial stabilisation package:

• Transparent transfer of quasi-fiscal activities to the government budget, as announced by the 2007 budget. No entity outside the budget should undertake any activity of a fiscal nature (including interest payments, subsidised credits etc) without offsetting transfers transparently provided for in the budget;
• Substantial fiscal tightening, including the newly-absorbed QFAs of the RBZ or any other public entity. This tightening could be achieved by reduction in the government wage bill - which is large by regional standards - and capital expenditure - which more than doubled in real terms in 2006 - as well as from cuts in (former) QFAs, particularly subsidies to public enterprises.
• Complementary measures, such as price and exchange rate liberalisation would be needed to ensure that QFAs are durably reduced.
• Fiscal expenditure would need to be prioritised (within a tighter envelope) to ensure food security rehabilitate the collapsing health infrastructure, and provide a targeted social safety net to protect vulnerable groups, including those affected by HIV/Aids and Operation Murambatsvina.
• Liberalising the exchange regime by unifying the exchange rate and removing restrictions on current international payments and transfers. The interbank exchange rate would need to be substantially devalued promptly and all multiple exchange rates eliminated. The interbank rate should then be depreciated steadily toward the parallel market rate (which would appreciate as fiscal and monetary policies are tightened), and the unified exchange rate subsequently floated.
• Deregulating prices and imposing a hard budget constraint on public enterprises.

Establishing a strong money anchor to reduce inflation and inflation expectations. Once exchange rates are unified and the RBZ disengages from QFAs, a broad money anchor and a flexible exchange regime could be established, with reserve money as the operational target. To ensure that monetary policy is effective and reduce liquidity risks in the banking system, interest rates would need to be gradually moved to market determined levels.

Achieving sustained growth in Zimbabwe will require - in addition to stabilisation - comprehensive structural reform and better governance over the medium term.

Public enterprise and civil service reform, central bank reform, as well as public expenditure and tax reform will be important to sustain the fiscal adjustment and stimulate output growth. Improving governance, including by protecting private property rights and increasing policy predictability, will be essential for reinvigorating investor confidence.

Zimbabwe's situation with respect to agriculture - a key sector of the economy - needs to be resolved. At present, commercial bank lending to the sector remains limited in part because existing arrangements, including the recently-introduced 99-year leases, do not provide adequate security of land tenure. A broad-based agreement among stakeholders on land tenure may be needed to achieve sustained growth in agriculture and in the economy.

The lack of external financing is an issue for Zimbabwe, but cross-country evidence does not indicate this is a reason by itself to delay the implementation of a stabilisation programme. Even with limited external support, decisive policy action led to positive stabilisation gains in several cases. However, in almost all these cases there was external support in the form of close policy advice and technical assistance.

For Zimbabwe, strengthening relations with donors and mobilising external financing would ease the burden of the adjustment needed for a strong, upfront reduction in inflation.

If a credible stabilisation package is implemented upfront and followed by reforms to restore investor confidence, Zimbabwe's economy is sufficiently diversified and potentially strong enough to recover.

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