A Bevy of Economic Threats Force Bank of Zambia to Raise Interest Rates

Gerald Hamuyayi (FMVA)? , Lusaka, Thursday, 16 May 2024 - A perfect three-pronged storm of economic challenges is brewing for central bankers. The Bank of Zambia is faced with a hat-trick of rising inflation, a depreciating currency, and an increasing overnight interbank lending rate. The economic headwinds pose a serious hurdle for central bankers, necessitating a hawkish policy stance to tame inflation and stabilise the currency. However, a widening divergence between the overnight interbank rate and the policy rate reveals a banking sector struggling with Kwacha shortages and liquidity crunches, complicating monetary policy decisions.

At its second Monetary Policy Committee meeting, the Bank of Zambia (BoZ) raised the benchmark policy rate by 100 basis points to combat rising inflation. Zambia's inflation soared to 13.8% in April 2024, exceeding the bank's 6% to 8% target by a colossal 500 basis points at the very least, as both onshore and offshore inflation expectations rose. The drought crisis, which has affected over 7.5 million Zambians, has exacerbated the inflation surge, with both food and non-food prices rising.

In the first quarter of 2024, the Kwacha depreciated by 10.6% against the US dollar as demand outstripped supply. To mitigate the Kwacha's decline, the Bank of Zambia intervened in the foreign exchange market, supplying $369 million to absorb the excess dollar demand and ease pressure on the currency. However, the dollarisation of the Zambian economy and existing inefficiencies in foreign exchange pricing, resulting from rate negotiations for large dollar transactions, have persistently distorted market efficiency.

Developments in the overnight interbank market have been intriguing. Since the policy rate hike on February 14, from 11% to 12.5%, the interbank interest rate has averaged 18.63%, significantly higher than the benchmark 12.5%, representing a substantial 6.13% average premium charged in the market. Premiums higher than this level were last seen in 2014 and 2016, as illustrated in the 'Benchmark Policy Rate Vs. The Interbank Rates' chart. In response to a question from Financial Insight Zambia on liquidity conditions, BoZ Deputy Governor Chipimo said, “Monetary conditions are significantly tighter than what would be implied by just looking at the policy rate; the rate should pull back within the corridor as the central bank readjusts its balance sheet.”

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Additionally, the chart indicates that policy rate hikes are associated with a sharp increase in the overnight interbank lending interest rate. Furthermore, the graph suggests that the Bank of Zambia has historically adopted a policy of reducing the policy rate when the interbank rate has exceeded the benchmark for a sustained period prior to the Monetary Policy Committee meeting. Given the unfavourable movements in inflation and the exchange rate, the central bank decided to maintain tighter liquidity conditions by raising the rate by 100 basis points. "We have determined that it's necessary to maintain current conditions to address the current challenges," the BoZ Deputy Governor added.

Zambia's economy faces tough times as credit costs rise and lending slows due to tighter liquidity and high interest rates. Like Panadol, a painkiller, the policy rate hike provides short-term relief from the Kwacha's depreciation, but sustaining stability requires economic growth, increased exports, and improved export quality through value addition - a challenging task amid the energy and food crises.