Events Leading to Hyperinflation in Zimbabwe from 2007-2008 - Research Paper Example

Events Leading to Hyperinflation in Zimbabwe from 2007-2008 International monetary theory and policy deals with exchange rates in interdependent economies. It is also concerned with balance of payment issues. With globalization the world has become a global village where goods and services, labor and capital are exchanged freely in the market. Some countries such as European countries have gone further to establish common market or monetary union. Dealings with other countries requires the use of foreign currency hence the importance of exchange rates for the economy. These foreign currencies are traded in the market just like goods and services hence are subject to price volatility requiring proper administration of a country’s monetary policy. Monetary policy in this case refers to the process by which the monetary authority of a country controls the supply of money through interest rates in order to promote economic growth and stability (Eyler 15). Inflation is a monetary phenomenon which if it intensifies leads to hyperinflation like has been experienced in various countries over the years. Hyperinflation was defined by Cagan in 1956 as a “price level increase of at least 50% per month (Eppel et al. 33). It begins when monthly inflation rates exceed 50% and ends in the month before the rate falls below 50% and must remain so for at least a year. For example in Zimbabwe, it started in March 2007 and ended when the country abandoned its currency in February 2009. So what causes this hyperinflation despite there being monetary authorities to monitor the monetary policy? This will be the subject our study and the main focus will be on hyperinflation in Zimbabwe from 2007-2008 especially being the first country in twenty-first century to experience inflation and the second in the world hyperinflation record books (Hanke 2013 n.p). Literature Review Hyperinflation as stated earlier is the period beginning when inflation exceeds 50% and ending the month before inflation falls below 50%. Hyperinflation is not a new phenomenon as it began in France during the French revolution in 1795. During this incident the monthly inflation shot up to 143% (Koech 1). Koech also observed that hyperinflation occurred 28 times in the twentieth century especially due to the two world wars and transition from communism to market-based economies. However, Zimbabwe was the first to experience hyperinflation in the twenty-first century. It was also the 30th occurrence and the continent’s second after Congo in the 1991-1994. Hyperinflation is often attributed to wars, political mismanagement, and transition from command to market-based economies. However, no researcher has ever fully documented any case of hyperinflation due to difficulties in recording and publication of reliable inflation statistics. Most countries do not record such instances to avoid worsening the situation but Hanke did try to develop a Hyperinflation Index for Zimbabwe (HHIZ) based on market based price data (Hanke n.p). Inflation is regarded as general price level increases in the economy caused by a variety of factors but we shall be concerned with the monetary side of the economy. The monetary policy is used by economies to control money supply and money demand hence economic stability. This entails keeping inflation at the lowest as possible through control of interest rates. Monetary policy can either be expansionary or contractionary. Expansionary policy is aimed at lowering interest rates to attract investments thus combat unemployment during recession while contractionary policy is increasing interest rates hence slow inflation (Carbaugh 396). This is not difficult in a domestic economy. The problem comes in an open economy where international transactions are involved. Here, the exchange rate is very vital especially as they are very volatile and also determine balance of payment between nations. The exchange regime in place determines the ability of authorities to control inflation in the country. In a floating exchange regime, exchange rates are determined by market forces of supply and demand hence the country has no control over price of its currency (Carbaugh 390). A country needs foreign currency to pay for imports and in turn gets foreign currency when it exports products. The currency can appreciate or depreciate depending on the demand and supply in the stock market but a country needs to have balanced balance of payments. An increase in demand for imports leads to depreciation of domestic currency in the long-run while increased demand for exports leads to appreciation of the currency in the long-run (Carbaugh 393). The exchange rate in the floating regime is determined by relative interest rates, relative prices and relative income levels among nations. In the fixed exchange rate regime, exchange rate is fixed by the government. It involves pegging a domestic currency against a key currency in the financial market such as the U.S dollar which is widely accepted worldwide. This exchange rate is maintained by the monetary authority, central bank or a currency board especially in developing nations to guard against inflation. In theory, it is possible that a country may peg the local currency to more than one foreign currency; although, in practice this has never happened (Hanke n.p). Besides it would be very complicated to deal with. By use of this regime, the country is able to curb currency fluctuations unlike in a floating rate regime. During hyperinflation, the exchange rates are very volatile and most of the affected countries change exchange rates more than thrice a day. Some countries also resort to printing of currencies to meet their obligations as the domestic currencies continue to lose value and especially if there is a non independent monetary authority (Eppel et al. 41). According to Krugman, exchange rates behave like prices of financial assets as their movement is primarily driven by changes in expectations about future economic fundamentals (363-366). Market fundamentals include: productivity, inflation rates, real interest rates, consumer preferences and government trade policy (Carbaugh 391). Expectations about future market fundamentals and traders opinion about future exchange rates are essential in determining short-run exchange rates. This is the balance of payments approach and depreciation/appreciation occurs for a nation that spends more/less abroad in combined purchases and invests than it acquires from abroad over sustained period of time. In the long-run, exchange rates are determined by relative price levels, relative productivity levels, consumer preferences for domestic or foreign goods and trade barriers (p. 393). If a country imposes barriers, its imports reduces hence its currency appreciates. A study carried out by Cagan in six European countries from 1920-1946 indicated a relationship between money supply and aggregate price levels. The report showed that demand for real money balance reduces as inflation increases leading to hyperinflation (Koech 7). It is thus every essential to control money supply if hyperinflation is to be curbed. Zimbabwe Case Zimbabwe which was once considered the “jewel of Africa” gained independence in 1980. At that time, it was very productive especially in commercial agriculture. Its farms produced 60% of inputs for manufacturing base. It also had a strong banking sector, many dams and low crime rate (Richardson n.p). However, it experienced the worst inflation in 2007 -2008 withy the highest monthly hyperinflation rates in history. The height of it was early 2009 when a 100 trillion dollar was launched. During this time, the Zimbabwe dollar lost more than 99% of value (Hanke 1). At independence, its annual inflation was 5.4% and month-to-month rate of 0.5%. The largest currency at this time was Z$ 20 and the domestic currency Z$ was the most widely used (Koech 3). The rate of exchange was U.S $1 for Z$ 0.647 and the real GDP growth was 14.6%. In 2008 at the height of hyperinflation, the annual inflation rate was 4.89 billion percent and month-to-month rate was 2600.2%. The largest currency had shot up from Z$20 to Z$ 100 trillion. The country did not have a fixed exchange rate as it was using Zimbabwe dollars, U.S dollars, South African Rand, and Botswana Pula (p.3). The exchange rate had moved to US$1 being traded for Z$ 4 million and real GDP was 17% and unemployment rate of 94% (Coltart n.p). This goes to show how serious the hyperinflation was. The table below shows the highest monthly inflation rates in history. Table 1. Highest Monthly Inflation Rates in History Country Month with highest inflation rate Highest monthly inflation rate Equivalent daily inflation rate Time required for prices to double Hungary July 1946 1.30 x 1016% 195% 15.6 hours Zimbabwe Mid-November 2008 (latest measurable) 79,600,000,000% 98.0% 24.7 hours Yugoslavia January 1994 313,000,000% 64.6% 1.4 days Germany October 1923 29,500% 20.9% 3.7 days Greece November 1944 11,300% 17.1% 4.5 days China May 1949 4,210% 13.4% 5.6 days Source: Prof. Steve H. Hanke, February 5, 2009. From the table we can deduce that Zimbabwe had the second largest monthly inflation rate in history the first being Hungary. Table 2 shows the inflation rates for Zimbabwe over the years according to the Reserve Bank of Zimbabwe figures. Table 2. Inflation Rates (2001=100) Year All Items CPI Year On Year Price Increases 1990 29.6 15.5 1991 36.8 24.3 1992 52.3 42.1 1993 66.7 27.5 1994 81.6 22.3 1995 100.0 22.5 1996 121.4 21.7 1997 144.3 18.9 1998 190.1 31.7 1999 301.3 58.5 2000 469.6 55.9 2001 100.0 71.9 2002 233.2 133.2 2003 1084.5 365.0 2004 4880.3 350.0 2005 16486.4 237.8 2006 184101.1 1016.7 2007 12562581.7 6723.7 Inflation was more than 231 million percent in 2008 hence the purchasing power of citizens had been completely eroded. According to the report, prices doubled every few days thus traders were finding it hard to keep output going. This in turn led to food shortages. The government tried to control prices but it did not work it just worsened the situation. Hyperinflation in Zimbabwe can be attributed to land reforms which redefined property rights. It was not as a result of war like previous countries. When Mugabe took over office in 1980, he was against the whites who owned large tracts of commercial farms and thus after 2000 election, he seized their rights to land and subdivided it among his followers and government officials (Eyler 14). These individuals were inexperienced in managing commercial farms and as a result, productivity and output was affected. Combine with drought, agriculture which was the backbone of the economy was destroyed. The country could no longer earn foreign exchange from exports and it had to import a lot leading to depreciation of its currency. The country did not use monetary of fiscal policies to curb the situation. Poor agriculture coupled with debt obligations from IMF and World Bank, the country embarked on printing more money to meet its commitments. Money supply was under control of central bank which was not independent thus was manipulated by the government; 10-100 billion dollars were printed in one year (Hanke & Kwok n.p). The result of increasing money supply without corresponding expansion of real economic activity was increased inflation following the quantity theory of money (Koech 7). Z$ lost value and citizens resulted to using foreign currency such as South African Rand and U.S dollars to buy products. Due to price controls, consumption items were hard to come by and as such items like bread were sold for very high prices and mostly in black markets. Though shops were licensed to issue foreign currency, the citizens had no confidence in the central bank thus opted to exchange currency in black markets at a higher rate. As of early 2009, the highest denomination was 100 trillion dollars and the government abandoned the local currency (Z$) altogether for foreign currency. The country adopted multicurrency but the US dollar remained the principal currency. This dollarization marked the end of hyperinflation. Hyperinflation in Zimbabwe could be avoided if stabilization programmes were put in place. The first measure would be to restore the currency board which had been there when Zimbabwe gained independence in order to control money supply without interference from government (Eppel et al. 35). The currency board would then set a fixed exchange rate whereby local currency in circulation is backed by foreign currency from the anchor nation at a fixed rate. This would prevent the dollar from fluctuations and instill confidence in the market. Speculation of future market fundamentals affects exchange rates and this would be solved through fixed exchange rate. If traders are not sure if exchange rate will rise or decline in future, they set high prices leading to inflation but if rate is fixed, they would have confidence in investing. The country could also adopt optimum currency areas to protect its economy from future inflation. There is a monetary union in Southern Africa that uses the Rand as its single currency and Zimbabwe could join. However, its monetary policy would be subject to monetary policies of other countries in the union. Zimbabwe could also review its dollarization policy to allow legitimization of its local currency alongside a fixed foreign exchange such as the US dollar. It should also curb excessive printing of money as this only leads to higher inflation. Fiscal restraint is also called for to reduce budget deficits and also foreign debts. Conclusion Once considered the “bread basket” of Africa, Zimbabwe was worst hit by hyperinflation from 2007-2008 as it had the second largest monthly inflation rates in history. It was the first country in the twenty-first century to experience hyperinflation and the second behind Congo in the continent. As of November 2008, annual inflation rate was 89.7 sextillion (1021) percent and the highest currency denomination was Zimbabwe Dollars 100 Trillion bank note. Hyperinflation was caused by inefficiency and drought and poor monetary policy management. This was as a result of land reforms and not honoring rule of law by revoking property rights. It led to high unemployment, high prices, high foreign exchange volatility and emergence of black markets which offered goods and foreign currency at a higher price. A combination of currencies was used: US dollars, South African Rand and Z$ although it was abandoned in 2009 leading to dollarization. The significance of this study is that lack of proper management of the monetary policy or control of exchange rate can lead to dire consequences. Exchange rates are very important in international monetary economy if the economy has to stabilize and achieve balance of payments. A fixed exchange regime is also vital for foreign exchange stabilization. But most importantly, an independent and disciplined monetary authority, central bank or currency board if hyperinflation is to be avoided. References Carbaugh Robert. International economics. Cengage learning. 2012. Coltart, David . A Decade of Suffering in Zimbabwe. Cato Institute, 2008. Eppel, Shari., Rudela, Daniel., Raftopoulos, Brian & Rupiya Martin. Developing a Transformational Agenda for Zimbabwe. Idasa, 2009. Eyler, Robert. Money and Banking: An International Text. Abindgton, Oxon: Routledge, 2010. Hanke, Steve H. R.I.P Zimbabwe Dollar. The Cato Institute. http://www.cato.org/Zimbabwe. Hanke, Steve H; Alex KF Kwok. "On the Measurement of Zimbabwe's Hyperinflation". The Cato Journal Koech, John. Hyperinflation in Zimbabwe: Globalization and Monetary Policy Insitute 2011 Report. Federal Reserve Bank of Dallas http://www.dallasfed.org/assets/doc/institute/annual/2011/annual11b.pdf Krugman, Paul F . International Economics; Theory and Policy. Pearson, 2005. Reserve Bank of Zimbabwe. Inflation. Dec 8, 2013. www.rbz.co.zw/about/inflation.asp Richardson, Craig J. How the Loss of Property Rights Caused Zimbabwe’s Collapse. Economic Development Bulletin no. 4. Nov 14, 2005 Web December 8, 2013. http://www.cato.org/publications/economic-development-bulletin/how-loss-property-rights-caused-zimbabwe-to-collapse Read More