Impacts of 'Kwachalisation' on the Zambian Economy.

"Kwachalisation", we shall need to coin a less mouthful word soon, refers to the process of increasing the use of the Zambian Kwacha (ZMW) as the primary and exclusive currency in domestic transactions, reducing reliance on foreign currencies, particularly the US Dollar (USD) and its hegemony. Foreign exchange shortages, a 15.4% rise in the annual inflation rate as of July 2024, and a depreciating currency has forced the Bank of ?Zambia into considering new monetary policies aimed at stabilizing the economy. This significant policy shift aims to stabilize the economy but carries potential benefits and drawbacks, informed by historical data from other nations like Ghana and Kenya.

These proposed regulations in the Bank of Zambia Foreign Exchange Market Guidelines, Gazette Notice 525 of 2024, stipulate that:

1. All domestic transactions must be conducted in Zambian Kwacha. Thus, existing contracts in foreign currencies must be converted to Kwacha at the Bank of Zambia’s daily average mid-rate.

2. Parties have up to one year from the commencement of these regulations to comply.

Non-compliance with these regulations could result in severe penalties, including fines up to two thousand five hundred penalty units, imprisonment for a term not exceeding two years, or both. Additionally, the Bank of Zambia may impose administrative sanctions on a person for failure to comply with the prescribed guidelines.

Background: The Dollar’s Dominance

The U.S. dollar's role as the de facto global currency was cemented at the Bretton Woods Conference in 1944. The agreement established the dollar as the world's reserve currency, backed by the largest gold reserves. For nearly a century, the dollar has held its status, partly due to the U.S.' dominant economic position in the early 20th century.

Yearly Average Buying and Selling Exchange Rates of the Zambian Kwacha (ZMW) Against the US Dollar (USD) from 2013 to 2023.

The Zambian Kwacha (ZMW) has experienced significant fluctuations against the US Dollar (USD) over the past decade, reflecting various economic challenges and global market conditions. Here's a breakdown of the key trends and their implications.

ZMW/USD Exchange Rate Trends (2013-2023):

2013-2014: The Kwacha started relatively stable, with minor depreciation from 5.38 (buying rate) in 2013 to 6.14 in 2014.

2015-2016: The Kwacha depreciated sharply from 8.69 in 2015 to 14.21 in 2016. This was largely due to the falling global copper prices, Zambia’s leading export, coupled with domestic economic challenges such as rising inflation and fiscal deficits.

2017-2018: The Kwacha experienced some recovery and stabilization, averaging around 9.57 in 2017 and slightly depreciating to 10.45 in 2018, likely due to improving copper prices and adjustments in economic policy.

2019-2020: The Kwacha again depreciated sharply to 18.29 in 2020, driven by a combination of external factors (e.g., COVID-19 pandemic, declining copper output) and internal economic pressures, including high inflation and public debt.

2021-2023: The currency saw further depreciation in 2021, reaching 19.89, before slightly appreciating to 16.88 in 2022 due to the new governments debt restructuring efforts and IMF support. However, the Kwacha weakened again in 2023 to 19.34, reflecting ongoing economic challenges.

Current Economic Challenges:

Food Insecurity: Zambia's food insecurity, exacerbated by drought and power shortages, creates pressure on the import bill as the country needs to import food, leading to higher demand for foreign currency.

Power Outages: The reliance on hydropower, combined with drought conditions, has led to significant power generation deficits. Zambia expects a power generation deficit of 700 megawatts this year, the need to import electricity further increases the demand for foreign exchange, weakening the Kwacha.

Declining Copper Output: With copper being Zambia’s major export and a primary source of foreign exchange, declining output reduces foreign currency inflows, putting further pressure on the Kwacha.

?Impact of De-dollarization:

Exchange Rate Fluctuations: De-dollarization could lead to greater volatility in the Kwacha, especially in an environment of high external economic pressures and domestic challenges. This could exacerbate inflationary pressures, especially on imported goods.

Increased Import Costs: Given the current economic conditions, particularly the need to import electricity and food, de-dollarization may increase the cost of these imports as the Kwacha weakens, leading to higher inflation and further economic strain.

Inflationary Pressures: The de-dollarization process might not be successful if inflation remains high, as the populace and businesses may continue to seek refuge in foreign currencies like the USD.

IMF concerns. Is Eric Lautier right?

The International Monetary Fund (IMF)’s Zambian representative, Eric Lautier, expressed concerns that these "kwachalisation" measures could counteract efforts to contain inflation. Lautier suggested that successful de-dollarization requires low and stable inflation rates and minimal external economic pressures, conditions not presently met in Zambia.

Is he right?

Here is an economic verification to investigate this.

Zambia: Annual Exchange Rate, Inflation (GDP Deflator), Broad Money, and Real Interest Rates (2013-2023)"

• Dependent Variable: Inflation Rate
• Independent Variable: Annual Percentage Change in ZMW/USD (Exchange Rate), Broad Money (BroadmoneycurrentLCU), Real Interest Rate.

In a multiple linear regression with inflation as the dependent variable and three independent variables: the exchange rate (annual percentage change in ZMW/USD), broad money supply (in local currency units), and the real interest rate. We deduce that:?

A 1% depreciation in the ZMW/USD exchange rate is associated with an increase in the inflation rate by approximately 1.82%. This positive and significant relationship suggests that as the Kwacha depreciates, inflation tends to rise, confirming the link between currency depreciation and inflationary pressures.

Coefficient: 1.81599, t-ratio: 3.794, p-value: 0.0192 (significant at 5% level).

• Blue Circles (Actual): Represent the observed (actual) inflation rates corresponding to different exchange rate levels.
• Orange Dots (Fitted): Represent the inflation rates predicted by the regression model for the given exchange rates.

Deduction:

1. Correlation Between Exchange Rate and Inflation: The graph indicates that there is a generally positive relationship between the exchange rate and inflation. As the exchange rate (indicating depreciation of the Kwacha against the Dollar) increases, inflation also tends to increase. This aligns with the economic theory where currency depreciation often leads to higher import costs, driving up inflation.
2. Lautier's concerns are indeed valid. The current economic environment in Zambia, characterized by high inflation and significant external pressures, is not conducive to a successful de-dollarization process. De-dollarization could exacerbate existing inflationary pressures if not managed carefully, as the regression analysis suggests that currency depreciation is a key driver of inflation. Therefore, without first stabilizing the economy and reducing inflation, efforts to de-dollarize could potentially counteract efforts to contain inflation and further destabilize the economy.

Historical Context and Lessons

Ghana: Faced initial challenges with inflation and economic stability but eventually achieved some level of stabilization after a prolonged period of adjustment.

Kenya: Encountered economic turbulence as it reduced dollar dependency, with mixed results over time.

These examples highlight that while de-dollarization can offer long-term benefits by reducing external vulnerabilities and fostering greater economic independence, the transition period is often characterised with difficulties, including inflationary pressures and exchange rate volatility. Zambia’s current economic conditions suggest that it may face similar challenges, and careful management will be crucial to avoid exacerbating existing problems.

*Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of any organisation, company or individual.

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