Zambian Kwacha/ US Dollar Exchange rate analysis
To say the first quarter of 2014 has been a volatile period for the Zambian Kwacha exchange rate with the US Dollar would be an understatement. It has been a most unpleasant period. By February 2014 the currency of Africa’s biggest copper producer slid to 5.78 per dollar, its lowest level since Bloomberg began compiling records in 1994 (Hill, 2014). The kwacha was at the time the continent’s worst performer after the Gambian dalasi.
History
Before we can explain where we are going we have to understand where we are coming from. This raises the need for a short review of the Forex market in Zambia. The exchange-rate system in Zambia is broadly characterised by both fixed and floating exchange-rate policies. From independence in 1964 to 1982, and from 1987 to 1991, the monetary authorities adopted a fixed exchange-rate regime. This regime was sustained by an occasional adjustment of the exchange-rate system and other measures such as the issuing of import licences instead of official interventions in the exchange-rate market (Maenad 2001). Between 1983 and 1985, the Zambian kwacha was pegged to a basket of its major trading partners’ currencies with a monthly crawl of one per cent. The crawling peg was later revised to one and a half per cent due to the depressed economic conditions at that time. Towards the end of 1985, owing to conventional and political factors, the authorities introduced a floating exchange-rate regime whereby the central bank (Bank of Zambia) auctioned off foreign currency with the aim that the bidding system would guide the exchange rate (Chirpily 2009). In 1992, the authorities abolished this system and a freely floating exchange-rate mechanism was introduced. The new system allowed commercial banks to trade foreign currency with the Bank of Zambia (BOZ) three times a week. This was later amended from three times a week to daily, in order to control the volatility in the exchange rate. Despite all these measures, Zambia, like many other commodity- exporting countries, witnessed an increase in exchange-rate volatility. As a result, a broad-based interbank foreign-exchange market (IFEM) system was introduced in July 2003 to address the weaknesses perceived in the previous exchange-rate regimes (Chirpily 2009). According to the African Development Bank (ADB) (2007), the introduction of IFEM was considered an important step in improving efficiency in the market. This allowed commercial banks and other licensed agents to bid and offer foreign exchange on the interbank market, and corporates and individuals to sell and buy foreign exchange from commercial banks. The Zambian kwacha is freely tradable, and the liberalisation of the financial sector has attracted offshore investors, speculators and other traders.
Exchange Rate Policy Episodes in Zambia: 1964 – 2007:
the Fixed Exchange Rate Regime (1964 – 1982)
The Crawling Peg (1983 – 1985)
The Floating Exchange Rate Regime (1985 – 1987)
The Fixed Exchange Rate Regime Again (1987 – 1991)
Flexible Exchange Rate Again (1992 - 2007)
Prior to 1994, Zambia operated a fixed exchange rate system.In 1994, the foreign exchange market was liberalized to achieve relative stability and prevent overvaluation of the Kwacha (Kalyalya, 2007);
Exchange controls were abolished;
Foreign currency deposits were introduced;
Bureau de change system introduced;
In 1996, both current and capital account restrictions were removed; and
In 2003, the broad –based inter-bank foreign exchange market system was introduced to promote more transparent price discovery and enhance liquidity in the foreign exchange market.
Exchange rate and the allocation of foreign exchange were permitted to be market determined. By March 1993 most foreign exchange controls on current transactions had been removed and in February 1994 the capital account of the foreign payment systems was liberalized (McCulloch, 2000).In 1995, the Bank of Zambia allowed commercial banks to hold foreign currency deposits. In 1996 the final phase of liberalization of the foreign exchange market was implemented with Zambia Consolidated Copper Mines (ZCCM) being allowed to retain all its foreign currency earnings and supply foreign exchange to the market directly (Kani, 1996 ). Prior to this, ZCCM was required to sell an agreed percentage to the Bank of Zambia which then supplied foreign exchange to the commercial banks through the foreign exchange auctions.
Modern Day
Global Economy and Emerging Markets
The worst sell off in emerging-market currencies in five years is beginning to reveal the extent of the fallout from the Federal Reserve’s tapering of monetary stimulus, compounded by political and financial instability (Bloomberg, 2014).
A confluence of factors caused the emerging market panic. The first is the pull-back of stimulus in the U.S. Since September 2012, the Federal Reserve has pumped massive amounts of liquidity ($85 billion at its highest) every month into the global market in what has come to be known as “quantitative easing.” In December 2013, outgoing Fed Chairman Ben Bernanke announced the beginning of tapering – a $10 billion reduction in monthly bond buying. On January 29th, the Fed announced that it would reduce its bond buying an additional $10 billion, to $65 billion a month. As of April 2014; the new chair of the Federal Reserve Janet Yellen continued the tapering. The central bank on April 30 pushed ahead with its plan to gradually wind down its asset-purchase program in spite of news earlier in the day that growth ground to a virtual halt in the first quarter. Saying the economy is rebounding, the Federal Open Market Committee voted unanimously to reduce its bond purchases by another $10 billion a month, to $45 billion.
Much of the capital that the Fed was infusing into the market through its bond buying flowed to emerging markets. With the Fed tapering off quantitative easing, that liquidity is drying up. In simple terms, no more easy money. And that means that growth in emerging markets will, in all likelihood, be both more expensive, and slower (Forbes, 2014).
Both the tapering of stimulus in the U.S. and weakening of emerging market economies lead to currency volatility (clearly), which leads to panic, which leads to more volatility. A vicious cycle.
Zambian Kwacha
The Kwacha recently hit a historical-low against the United States dollar for the first time after the 2008-09 global financial crises, as the foreign exchange market continued to witness low greenback supply. Similarly, Standard Chartered Bank says increased demand for the dollar resulted in the weakening of the Kwacha”. There was a sizeable mismatch between demand streaming mainly from local corporates and real money market players as compared to the current level of supply for the dollar which is likely to see the currency remain under pressure for the time being,” the bank said in its daily brief (Daily Mail, 2014).
Mining companies, the source of almost 80 percent of Zambia’s foreign earnings, are the biggest suppliers of dollars, the currency in which copper is globally traded. Higher demand for the U.S. currency from the manufacturing, telecommunications and energy industries were being countered with lower supply from copper producers.
Bank of Zambia Official Position
In Line with Government policy, The Bank of Zambia (BOZ) indicated it was going to pursue a flexible exchange rate policy.BOZ explained that the depreciation was trend in the exchange rate was due to a combination of domestic and international market developments (Bank of Zambia, 2014).The consistent economic growth that Zambia has recorded over the years led to a steady increase in imports, particularly capital goods critical for sustaining such growth, although exports continued to show impressive growth, demand for imports had relatively been stronger, thereby contributing overtime to the exchange rate depreciation (Bank of Zambia, 2014).
In addition, Zambia’s increased integration with the global economy, achieved through liberalising its external current and capital accounts transactions implied that international developments had a significant impact on the exchange rate.BOZ highlighted the quantitative easing by the US federal Reserve as well as the price of copper, Zambia’s major export earner. The impact was further compounded by slower portfolio investment inflows which played an important role in financing the country’s current account deficit (Bank of Zambia, 2014).
The Bank of Zambia indicated that the exchange rate with respect to the US Dollar was undergoing a “random walk”
Random Walk
Theoretical framework
The Efficient Market Hypothesis (EMH) states that in an efficient market, asset prices fully reflect all available information about the asset, and investors therefore cannot consistently earn abnormal returns (Pierson, Bird, Brown & Howard 1995). In its weak form variant, the EMH implies that prices follow random-walk behaviour in which successive price changes have zero correlation (Trippy & Lee 1996). This weak form variant of the EMH is known as the random-walk hypothesis (Pierson et al. 1995).
Practical Application
The random-walk hypothesis in foreign-exchange rates market is one of the most researched areas, particularly in developed economies. However, emerging markets in sub-Saharan Africa have received little attention in this regard. A study by (D. Mbululu, 2013) applies Lo and Mack inlay’s (1988) conventional variance ratio test and Wright’s (2000) non-parametric ranks- and signs-based variance ratio tests to examine the validity of the random-walk hypothesis in the Zambian foreign-exchange market. The study utilised daily nominal United States dollar/Zambian kwacha (USD/ZMK) exchange-rate returns for data from August 2003 to December 2012. Both types of variance ratio tests reject the random-walk hypothesis over the data span. The implication is that technical and fundamental analysis can help traders and other investors to earn higher-than-average market returns.
According to Ajani and Karameros (1996), evidence against random walk hypothesis provides support for the classical monetary models of exchange rates, which hold Purchasing Power Parity as the long-run equilibrium model. From 2010 onwards, the Zambian foreign- exchange market has received considerable interest from technical analysts. Traders from a number of banks have undergone technical-analysis training to acquire the skills needed to benefit from reading foreign-exchange trade volumes and price movements. The usefulness of this has remained debatable, but evidence lends support to technical analysis. The relatively less-developed foreign-exchange market in Zambia lends support against the random walk hypothesis as it is prone to huge swings and spikes exacerbated by the lack of foreign-exchange controls.
An understanding of exchange-rate behaviour is important in formulating policies aimed at attaining macroeconomic stability in an economy, as exchange- rate uncertainty is certain to disturb set macroeconomic targets. Moreover, currency trading has become a huge source of revenue for the banking sector in Zambia. Understanding exchange-rate movements will therefore not only help in shaping macroeconomic policy, but also affect other foreign-exchange market participants such as currency traders and speculators.
Statutory Instruments
Government put in place Statutory Instrument No. 55 of 2013 and Statutory Instrument No. 33 of 2012. These regulations were passed principally to support the implementation of monetary policy.
SI 33
Finance Minister Alexander Chikwanda signed Statutory Instrument (SI) number 33 of 2012 on May 7, 2012 which came into effect on May 18 2012, prohibiting the quoting and pricing of goods and services in foreign currency.
SI55
Government introduced SI55 in July 2013. It empowered the Bank of Zambia (BOZ) to monitor currency inflows, outflows and international transactions and regulate charges in the financial sector. BoZ worked with financial service providers, ZDA and ZRA to collect specified documents from importers and exporters above a specified threshold. Persons making certain remittances and those contracting external loans were compelled to submit these to ZRA. Periodic monthly returns have had to be submitted by financial service providers to BOZ.
Both Statutory Instruments have since been removed, but let us address some of their benefits as well as some of the challenges incurred in their execution.
The challenge with SI 33 was that it explicitly made trading in Dollars illegal with an imprisonment of 10 years. This proved problematic for several reasons but mainly it removed free will between two parties. If both the buyer and seller agree to trade in Dollars there is no reason to dispute the trade. But if the seller quotes in Dollars and the buyer refuses to buy in Dollars, a sentence of imprisonment is not the best way to go about it.
SI 33 was otherwise a logical instrument but again, it was introduced without stakeholder consultation so from the onset, some stakeholders were against it and were looking to see it fail. Even if the recent Kwacha depreciation was not caused by SI 33, stakeholders were quick to blame it.
One of the challenges of SI 55 was the amount of paperwork and disclosure requirements needed to send money out of the country. The fact that SI 55 was introduced without stakeholder consultation increased the gap in understanding its requirements. To put it simply, SI 55 is a logical instrument but because it was introduced in rash manner and given public perception of certain government policies, some stakeholders were against it from the onset, even if its intentions were sincere. It created an incentive for some stakeholders to circumvent it.
It is here that SI 55 intended to use the high US dollar revenue from the mines to briefly flow through Zambia’s money markets before being externalised. Thus it assumed as observed in SI 33, that the increased US dollar inflows under SI 55, would create a sustainable Kwacha appreciation. However, the reality on the ground saw the Kwacha fall as SI 55 did not automatically transfer the mine US dollar inflows onto the market, but into local commercial bank accounts, owned by the mines, awaiting authorisation, under SI 55, to be exported. Naturally, local commercial banks moonlighted on these growing mountain of US dollars by lending the funds to foreign banks in overnight facilities, against the back drop of a global US dollar shortage as the US Federal Reserve Bank reined in its Quantitative Easing Policy. To this, the Kwacha fell as interest rates domestically failed to move upwards to counteract the value mismatch (Chanda, 2014).
There was also some public opinion that SI 55 prevented the entry of Foreign exchange in the country. I disagree; I am rather inclined to believe investors were withholding their export earnings as protest against SI55.
Foreign Exchange Rate Policy
There is no consensus in the literature on the factors affecting exchange rates and their volatility. This absence of agreement reflects basic difficulties in modelling and predicting exchange rates.
When Zambia liberalised the her markets, it basically transferred the ownership of forex from the State that paid Zambia’s international debts with the funds to the now privatised mines that have no obligation to pay Zambia’s debts, interest or develop the nation, as the Bank of Zambia’s directive allowed for 100 per cent direct retention through exports (Chanda, 2014).
Sadly, the hard reality of Zambia’s so-called liberalised reforms when placed against other liberalised markets of the US, Japan and the European Union (EU) shows that Zambia’s money markets are not liberalised due to structural imbalances in allowing for equal access to US dollar inflows.
The US and EU markets follow SI 33 except it also includes exports, as the US dollar cannot buy directly anything from the EU unless it’s changed into Euro first.
The same applies for the euro buying anything from the US.
This implies that the structure of a true liberalised economy for Zambia is that copper has to be sold in Kwacha, meaning copper buyers with US dollars first have to change the US dollars into Kwacha on Zambia’s money markets and use Kwacha to buy copper. All the US dollar inflows from export first pass through the market, rather than mine bank accounts, so that every firm and person can have equal access to the inflows. If the mines wish to externalise 100 per cent of their Kwacha revenue, they would go onto the market and buy the US dollar just like any other person or firm with no questions asked or restrictions on amounts externalised (Chanda, 2014).
If SI 33 covered exports as well, then a level playing field would occur, but it is up to Zambia’s captains of industry, and not Government to coordinate the buying and selling of Kwacha/US dollars flows in and out of the money market (Chanda, 2014).
Conclusion
SI 33 and 55 were not the cause of the depreciation of the Kwacha directly, their implementation however created a widely supported opinion that they somehow hindered investor optimism. They lacked clarity in execution that left them susceptible to be blamed for currency depreciation. They however revealed bigger structural problems in the foreign exchange rate policy in Zambia.
The Zambia Government no longer owns the Mines. In 1996 the final phase of liberalisation of the foreign exchange market was implemented with Zambia Consolidated Copper Mines (ZCCM) being allowed to retain all its foreign currency earnings and supply foreign exchange to the market directly. ZCCM was then sold to foreign investors. Long story short the Zambian government has little control or even fair access to exchange inflows, yet it has to service debt in foreign currency. The problem is structural but has been compounded by market dynamics of a global nature.
According to the African Development Bank (ADB) (2007), the introduction of the interbank foreign-exchange market was considered an important step in improving efficiency in the market. This allowed commercial banks and other licensed agents to bid and offer foreign exchange on the interbank market, and corporates and individuals to sell and buy foreign exchange from commercial banks. Although this improved efficiency in the market I firmly believe this where the problem lies, in the interbank foreign exchange market. It needs some regulation, there has to be a tightly regulated bid offer spread to reduce volatility. An IMF working paper indicates that countries with a crawling band exchange rate regime appear to have been successful in lowering NEER volatility below the level that would correspond to their macroeconomic developments and degree of openness. Limiting the volatility in the exchange rate may be important due to the adverse effects it can have on sentiment both within financial markets and the economy. Especially, when the management of the exchange rate is the major tool for implementing monetary policy, excessive short-term volatility can erode the market's confidence in the regime.
In December 2012, The Bank of Zambia in CB Circular No: 05/2006 on the Modification to the Broad Based Interbank Foreign Exchange market system announced that it reduced the overnight overall and single foreign currency risk exposure limits from 25% to 20% and 20% of total regulatory capital respectively. A the same time intraday overall and single currency risk exposure limits were reduced from 40% and 30% of total regulatory capital to 30% and 20% of total regulatory capital.
Higher risk exposure is followed by higher profit margins of foreign currency trade and an added incentive to hold even more speculative positions. As research has already indicated the exchange rate in Zambia does not follow a random walk and thus the opportunity for consistent margins is high.
I am of the firm belief that this increased volatility because it allowed Banks to take more risky positions for bid offers. The Government has options, but it has to reduce the foreign currency exposure limits in the interbank foreign exchange market or introduce daily cap on positions banks can take. The former is less direct and my preferred choice of intervention but a reasonable cap on open, unhedged positions is also a viable avenue.
Central Banks across the globe continuously strive to achieve the financial stability in their respective economies. Nearly all the central banks issue guidelines for Risk Management in the commercial banks which they have to follow. These guidelines provides the minimum requirement and procedures to manage risks faced by a commercial bank and focus on establishing Risk Management Committee & Asset Liability Management committee by banks, setting limits for the open positions, measurement & control of risk , independent audit of risk management process and role board of directors & management.
Solutions
SI 33 should apply to exports as well. Copper must be sold in Kwacha and it should be sold in Dollars it should be changed first into Kwacha. This will create a steady supply of Dollars on the Forex market.
SI 55 should be reintroduced in conjunction with stakeholder consultation and a streamlined process of document submission.
SI 55, should include a surcharge of 20 per cent duty on exporters who directly sell their exports in currencies other than Kwacha.
The Government has to reduce the foreign currency exposure limits in the interbank foreign exchange market or introduce daily cap on positions banks can take.
The Government can also introduce a reasonable cap on open, unhedged positions currency positions
References
Bank of Zambia. (2014). Press Statement on the Recent Developments in the Foreign Exchange Market. Lusaka: Bank of Zambia.
Chanda, D. M. (2014, April 15). ‘SI 33,55 EXPOSED DISTORTIONS’. Retrieved May 6, 2014, from Times Of Zambia: http://www.times.co.zm/?p=19176
D. Mbululu, C. A. (2013). Do exchange rates follow random walks? variance ratio test of the Zambian foreign foreign exchange. Southern African Business Review, Southern African Business Review Volume 17 Number 2 2013.
Hill, M. (2014, February 20). Zambia Calls Emergency Meeting as Kwacha Hits Record Low. Retrieved May 6, 2014, from Bloomberg: http://www.bloomberg.com/news/2014-02-19/bank-of-zambia-calls-emergency-meeting-as-kwacha-hits-record-low.html
Kalyalya, D. H. (2007). KEY DEVELOPEMNTS IN THE FINANCIAL SECTOR AND OULOOK FOR THE MEDIUM TERM. LAUNCH OF THE CULTURE REOMDELLING - ECONOMIC INFORMATION EXCHANGE FORUM , (pp. 6-7).
Kani, F. (1996 ). ‘Central Banking and Macroeconomic Stability’. Lusaka : Paper presented at the Bank of Zambia International Conference on Economic Liberalisation.
McCulloch, N. B.-R. (2000). ‘Poverty, Inequality and Growth in Zambia during the 1990s’. International Association for Research in Income and Wealth. Cracow, Poland
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