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Determinants of the Exchange Rate and Policy Implications

this thesis helps in understanding and coming up with policy recommendation for ERPS to domestic prices

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28 views4 pages

Determinants of the Exchange Rate and Policy Implications

this thesis helps in understanding and coming up with policy recommendation for ERPS to domestic prices

Uploaded by

anthony chanda
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Southern African Journal of Policy and Development

Volume 1
Article 8
Number 1 April 2014

Determinants of the Exchange Rate and Policy


Implications
Catalina Michelle Tejada
International Growth Centre

Follow this and additional works at: https://scholarship.law.cornell.edu/sajpd


Part of the African Studies Commons, and the Economics Commons

Recommended Citation
Tejada, Catalina Michelle (2014) "Determinants of the Exchange Rate and Policy Implications," Southern African Journal of Policy and
Development: Vol. 1 : No. 1 , Article 8.
Available at: https://scholarship.law.cornell.edu/sajpd/vol1/iss1/8

This Policy Brief is brought to you for free and open access by Scholarship@Cornell Law: A Digital Repository. It has been accepted for inclusion in
Southern African Journal of Policy and Development by an authorized editor of Scholarship@Cornell Law: A Digital Repository. For more
information, please contact [email protected].
Southern African Journal of Policy and Development Vol.1, No. 1, 2014

Policy Brief

Determinants of the Exchange Rate and Policy Implications

Exchange rate policy in Zambia – as in most countries – excites a certain amount of


controversy. On one side, politicians often want to see a “strong” currency (i.e. where a unit
of the local currency buys more rather than less foreign currency), since imports, especially
those of consumption goods, would then be cheaper. On the other side, many economists
want to see a “competitive” currency (i.e. where a unit of the local currency buys less
foreign currency), since that makes exports and import-substitutes cheaper, enabling local
businesses, especially outside of the traditional mining products, to compete more
effectively and expand their markets under certain circumstances.
Low short-term exchange rate volatility is particularly important for developing
countries where people transacting internationally have little or no access to hedging
mechanisms. An importer of food and intermediate input products, Zambia is not an
exception. In the short-term, volatility affects inflation levels, trade financing and aid
denominated in foreign currency. In the long-run, it has implications for competitiveness,
trade, and market diversification.
When and why does a currency (the Kwacha) appreciate or depreciate; and how has
its behaviour over the past years been determined? What is the impact on the economy and
how should the Bank of Zambia (BoZ) respond?
These questions were examined in a paper commissioned by the International
Growth Centre in Zambia (www.theigc.org) and prepared by Professor John Weeks of the
School of African and Oriental Studies at the University of London. Covering the period
2004-2013, the study tested the statistical relationship between the nominal Kwacha/US
dollar exchange rate, and the trade balance, relative interest rates (i.e. Kwacha vs. US dollar
interest rates), and foreign exchange transactions conducted by the Bank of Zambia, (i.e.
intervention by the central bank aimed at changing the exchange rate).
The volume and value of exports from Zambia are overwhelmingly determined by
mining. Hence mining company policies regarding foreign exchange transactions play a
major role in exchange rate determination, the effect of which becomes evident in capital
account movements. Other factors influencing the value of the Kwacha are other exports,
imports, international reserves, aid, debt service, capital flows and the interest rate spread
between the Kwacha and the benchmark US federal fund rates.
The study found that the variability of the nominal exchange rate against major
currencies has declined over recent years, and that the variability – or instability of the

53
Policy Brief

currency-- is quite low compared to other countries. However, in recent months the
nominal Kwacha has mildly depreciated, consistent with external indicators. The same
conclusion holds for the purchasing power parity (PPP) (i.e. the nominal exchange rate
adjusted for relative price levels in Zambia compared with trading partners). This exchange
rate has been slightly more unstable than the nominal rate. The PPP exchange rate in
recent years has changed little, and has shown no consistent tendency to appreciate.
By contrast, the “real” exchange rate, measured as the ratio of tradable goods prices
(exports and importable goods excluding mining) to non-tradables has moved against the
former since the late 1990s, based on the available data (which could be revised when the
CSO re-bases the national accounts data). Tradables have therefore become relatively less
profitable.
With relative prices highly influenced by policies of the mining companies regarding
their export earnings and international prices, the BoZ has limited room to influence the
Kwacha. Moreover, there is a trade-off between nominal depreciation and domestic
inflation; while measurement bias of real exchange rates and equilibrium prices also plays
a role.
Nevertheless, BoZ intervention to date can be considered reasonably effective
regarding short-to-medium term volatility. The BoZ reduces short-run volatility of the
exchange rate through the purchase and sale of foreign exchange and changes in the
interest rate on public bonds, sterilising the effects on the money supply. If the objective is
to moderate currency appreciation, it sells Kwacha per foreign currency at a cheaper price
than the equilibrium price at the expense of losing international reserves. To moderate
depreciation it must offer more foreign currency per Kwacha inducing traders to sell
Kwacha. During 2005-2007 appreciation was partially mitigated, and since 2008,
depreciation has been slowed by the BoZ with a slightly greater effect. It is estimated that
during 2006-2013 Bank of Zambia operations reduced variation in the Kwacha from 9.2
percent of its quarterly value to 5.5 percent.
The study concludes that exchange rate policy is well managed. While it is not likely
that a policy attempting to manage the long term exchange rate would be effective, it is
possible, though costly in the short-term, to reinforce the current effectiveness of exchange
rate policy to further reduce short-to-medium term volatility. However, limits set by
reserve holdings and inherent instability of mineral prices hinders the Bank’s ability to
achieve a bigger reduction in the volatility of the currency.
The establishment of a sovereign-wealth fund to manage copper revenues should be
considered. It could be used as a counter-cyclical mechanism to stabilise the fiscal balance,
and to accumulate reserves to fund public investment. If well managed, it could become an
important source of output growth, reinforce macroeconomic stability, and provide space
for monetary policy.
While shifting incentives towards non-mining tradables is desirable for long-term
growth, it would require more than better exchange rate management. In Zambia, the

54
Policy Brief

exchange rate is not an effective instrument to foster competitiveness of non-copper


exports. Although it could be part of a diversification strategy, effective developmental
policies at the sectoral level would also be needed.

Catalina Michelle Tejada


(International Growth Centre)

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