Advantages of local currency explained

30 Aug, 2019 - 00:08 0 Views
Advantages of local currency explained

eBusiness Weekly

Luke W  Gumbo

The Government on 24 June 2019 reintroduced the Zimbabwe dollar, abolishing the multi-currency regime in lock-step.

Authorities have since then counselled the public that the rapid re-dollarisation of the economy was one of the reasons that moved it to act, as economic players in the formal sector first as a trickle, then a flood moved to pass on the exchange rate risk to consumers by insisting on settlement in hard currency.

The wisdom of government’s response cannot be challenged in the face of our present challenges, but it is perhaps best to advise all, that though a local currency is always a preferred option, it does come with its own set of challenges. What compounds our circumstances is our recent history with a local currency that has embedded certain behaviours that can, at least in the short term compromise the domestic currency regime.

But to begin this discussion it would be instructive to try and understand the advantages of a local currency.

The advantages rest on sound theoretical and institutional foundations. Theoretically, there are arguments on trade, finance, and fiscal management grounds. On the side of trade, the argument is that flexibility to modify the exchange rate allows domestic authorities to shift domestic relative prices by devaluing the domestic currency in such a way that imports are discouraged and exports encouraged.

This, an advantage in itself, also gives countries resilience against external shocks, such as negative turns in the terms of trade and natural disasters.

The arguments are several on the financial side. All are linked to the ability of central banks to print money and change the price of the currency, allowing them to keep their interest rates low even if they are high in the international market.

The ability to print money would also ensure a plentiful supply of credit even if credit is tight abroad. Most importantly, the power to create money turns central banks into lenders of last resort when a crisis threatens the domestic financial system. On the fiscal side, the argument is that having a domestic currency allows the government to charge a tax on demand for money, called seigniorage. Whenever demand for money increases, the government can print it and spend the proceeds.

All these theoretical advantages are lost when a country dollarises. A case in point can be illustrated by circumstances Greece found itself under post the financial depression of 2008, whereupon after a period of fiscal imprudence, possible remedies were constricted by the country’s use of the Euro, a common currency for 23 European countries.

The reintroduction of a local currency, which would have meant Greece exiting the Euro, was one of the options available to the country.

Businesses could plan with a high level of certainty. This is will not be so, at least in the short term as demonstrated by the exchange rate before the formal introduction of the domestic currency.

One of the unfortunate outcomes of our fiscal and monetary past is our economic policy prescriptions and general market behaviour have all been collapsed into our understanding of the exchange rate and its nominal level.

In a large and widely diversified economy, the main impact of currency depreciations on their economic activity is a substitution, not an income, effect. That is, if the dollar depreciates relative to the pound, producers using inputs imported from Britain can replace them with inputs produced in the United States at similar prices and quality.

People can realise this substitution in consumption as well.

For this reason, the inflation rate does not increase with currency depreciations and wages, while reduced in foreign currency terms, remain constant in real terms. Thus, the currency retains its domestic value even if losing it in terms of other currencies for very long periods.

By contrast, developing economies are weak and poorly diversified dominated by primary exports, so their ability to replace imports with local products is very limited. This difference is crucial to understand the monetary behaviour in developing countries like Zimbabwe.

People in diversified countries have two services provided in one single currency—the standard of value and the means of exchange.

In developing countries, these two services are divorced, the first being provided by a foreign currency and the second provided by the domestic currency. Because of this divergence, people think in terms of ratios of domestic to dollars prices and adjust their behaviour to the rates of change of these ratios.

The success of the authorities rest on their ability to reset the public perceptions these services so that economic participants do not differentiate between the two. Under normal circumstances multilateral support and currency reserves in excess of 18 months cover would have been ideal in our circumstances.

In an environment dominated by currency shortages, and shortages of basic goods and services, within a context of historical monetary indiscretions the government has its work cut out.

Luke W Gumbo is an economic and financial analyst. His views are personal and in no way represent any of the institutions he is associated with.


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