South Africans often ask how Zimbabwe was able to adopt the dollar as its official currency and, conversely, how it could re-establish its own currency. The answers begin with an understanding of what money actually is.
In modern financial systems, notes and coins make up a very small part of the money stock (just 3% in South Africa). The rest is bank deposits. Bank deposits are converted into notes at an ATM for small-scale spending. But most exchanges are done through the transfer of deposits from spenders’ bank accounts to those of sellers using the internet, debit cards or cheques.
It follows that the money stock increases when bank deposits increase, such as when banks make new net loans to their customers. When a customer successfully applies for a loan, their bank account is credited with the agreed sum. For the bank, the new loan is a new asset that is matched by the new deposit liability — the increased amount deposited in the customer’s account. The customer has a counterbalancing new liability (the loan they must repay) and asset (the deposit). Through its lending, the commercial bank has increased the money stock.
Where did this new deposit come from? In effect, it was created by the bank out of nothing.
To meet this increase in its balance sheet, the bank need only adjust its reserve requirement (in South Africa, a fixed ratio of 2.5% of its deposits) at the Reserve Bank. It does this by borrowing the needed reserves from the Bank at the prevailing central bank lending rate. The commercial bank must also maintain a small amount of capital against its loans. It meets this either from existing excess capital or by raising capital through debt or issuing shares.
To adopt the dollar as its official currency, it was necessary for Zimbabwe first to replace Zimbabwe dollar notes and coins with US dollar notes. This was easy, as hyperinflation had completely destroyed the value of the Zimbabwe dollar and Zimbabweans were already using US dollars and rands to make transactions. These dollars and rands came from remittances from Zimbabweans living abroad and from (dwindling) earnings from tourism and exports.
Zimbabweans had also already been allowed to hold US dollar deposits at the banks. All other deposits could be converted into US dollars by an administrative decision to do so at a given exchange rate. After dollarisation, the interesting thing is what happens when banks create loans. A Zimbabwean bank now credits its customer’s account with US dollars and its assets and liabilities rise by the same amount. The Zimbabwean bank does not physically have these US dollars, yet its customers can now make payments with them. In effect, the Zimbabwean bank has increased the supply of US dollars.
These dollars are, however, useful only for domestic transactions. If a Zimbabwean bank or its customer wishes to buy something from abroad, it can do so only using physical US dollar notes or US dollar deposits abroad. It cannot create these; it has to earn them from exports or borrow them through foreign loans. There are, in effect, two kinds of US dollars in Zimbabwe. They have the same value but one can be used only domestically and the other also for international transactions.
This distinction is important should Zimbabwe wish to revert to its own currency. In principle, this requires only that the central bank orders all US dollar bank accounts be converted to the new Zimbabwean currency and that citizens swap their US dollar banknotes for new Zimbabwean notes at a chosen exchange rate.
But if Zimbabweans — with painful memories of recent hyperinflation — do not trust the new currency, they will be likely to hold on to whatever US dollars they possess. Ahead of the switch to the new currency, they will also attempt to convert all their US dollar bank deposits to cash. However, this is physically impossible because the Zimbabwean banks do not hold nearly enough US dollar banknotes to match the US dollar deposits in the banking system.
The same could be said of all modern banking systems if depositors try simultaneously to convert their deposits into cash. But in other countries, central banks can literally print as many banknotes as their banks require. Zimbabwe has no power to print US dollars, only the US Federal Reserve has this authority.
It is therefore difficult for Zimbabwe to return to its own currency until its citizens believe it will maintain its value to the US dollar. It is unlikely such confidence exists at present. To move to a new currency without the people’s faith in its medium-term value would require freezing all bank accounts to prevent depositors trying to switch into US dollar notes. This would precipitate a panic buying of dollar notes, causing the value of the new currency to collapse at the very moment it is introduced.
BY GAVIN KEETON
Keeton is with the economics department at Rhodes University.
Article Source: Business Day