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Tuesday, 17 February 2015

Lungu's Kwacha Challenge

President Lungu has assumed power when the Kwacha is again threatening to breach K7 per $1. It is currently trading at K6.95 per $1, having fallen by around 20% over the last 12 months. The current rate is just lower than the historic low of K7.05 per $1 recorded in June 2014.

However,  it seems it is only a matter of time before we reach the $7 levels again given that it briefly broke through K6.80 two weeks ago. Indeed, a longer trend suggests that the Kwacha has actually halved in value against all major developed nations' currencies since Lungu’s predecessor assumed power.

The sustained fall in the Kwacha over the last three years has partly been influenced by external factors. These include the ongoing gradual decline in copper prices (already discussed), tapering of US credit and more recently the gradual strengthening of the US dollar. These have battered other regional and comparable currencies.

The vast bulk of the reasons for the Kwacha's poor performance have been domestic risks since PF came to power. What the IMF has called "home grown risks".  There has been little investor confidence in the Finance Minister Alexander Chikwanda's ability to manage national finances. Indeed there continues to be substantial questions around PF's economic policies in general. Though we are confident that President Lungu is watching things carefully.

Over the last three years we have seen threats to our economic fundamentals, culminating the sharp decline in the early part of 2014 following the Fitch and Standard & Poor downgrades in November 2013. Global credit agencies picked up on the fact that GRZ finances were deteriorating. Spending had substantially overrun in 2013 and 2014 following large public service wage bill, rising infrastructure commitments and  higher debt service obligations.

To make matters worse it appears politically Zambia over the last three years had been run in a chaotic manner.  There has been poor coordination of political and economic decisions. Policy at BOZ and Ministry of a Finance has been nothing short of trial and error. For example we had SI33 and SI55 imposed and then revoked. Then there was the costly Kwacha rebasing that achieved nothing. We also had the fiasco of BOZ depleting foreign reserves to fund the fiscal side.

These challenges were amplified by strong political uncertainty. Since PF took power succession battles rocked government once it became clear than Sata was too unwell to stand in 2016. To make matters worse, with power became more  centralised at State House the more Sata became incapacitated effectively bring the business of government to chaotic equilibrium.

The increase in deportation of investors, confusion on export taxes, constitutional impasse, restriction of political freedoms, lack of consultation and reckless borrowing all contributed to a poor climate that has left the Kwacha on the ropes.

President Lungu has a difficult job. The Kwacha needs to be stabilised sooner rather later. Further depreciation carries risks economic and political risks. A weaker Kwacha may threaten the viability of the current budget vis-a-vis meeting debt repayment and other government costs, and of course the exchange rate risk on oil procurement.

Instability of the Kwacha may also other other effects. For example, high volatility may lead to reduction in foreign reserves if the new BoZ chief decides to intervenes to reduce volatility. It also means GRZ debt repayments will continue to rise.

At the individual level, a weaker  Kwacha translates in higher cost of imports, mostly for consumption purposes, but some significant ones for production as well! The elasticity of imports becomes crucial here, but needless to say, a weak exchange rate means higher domestic production costs for many sectors not least general transportation.

That said, a weaker Kwacha opens a window of competitiveness for non-mining sectors especially agriculture produce. Though questions remain whether the Zambian economy has diversified enough in recent years to take advantage of this window. We have seen some signs of diversification, but in general this remains aspirational.

So how should President Lungu respond? We need a combination of short and medium term solutions.

First, we need to restore policy confidence. Firing Gondwe is a good move but Chikwanda has remained. Given that power lies at the Ministry of Finance it would have been good to get a new person with fresh ideas to have a go at restoring policy and economic credibility. Without a change of personnel at the Ministry of Finance it is hard to see how confidence can be restored in the Kwacha.

This brings us to the second point. As a nation, we need to take forward legislation that will guarantee operational independence of the central bank. This will immediately signal improved policy credibility. It does not require change in constitution. This should also be accompanied by a new Debt Management Bill that gives greater authority to parliament on domestic and external borrowing.

The new BoZ governor has not been appointed through competition and lacks operational independence. He will struggle to have any impact. As the saying goes, it all comes down to the politics.

Thirdly, President Lungu should send a clear signal that the era of unsustainable borrowing and rising fiscal deficits has come to an end. This is really at the heart of our challenge. Many investors and ordinary Zambians do not believe PF understands the scale of the challenges facing the country.

It is therefore important that a new "austerity programme" is instituted that focuses on identifying current public sector waste (e.g. close embassies, reduce size of cabinet, get rid of the new government bank for civil servants, cut CDF spending, halt plans for new stadiums, re-target the roads and rail programmes, etc). No more new excessive spending until the current road and rail infrastructure programme is complete.

Fourthly, prepare Zambians for the benefits of a weak but stable Kwacha. As we have repeatedly noted, the problem is not the level of the Kwacha per se. There are significant competitive benefits to a weaker currency. The problem is stability.

Politically the public has to understand why a weak but stable currency is potentially good for a developing country. This requires President Lungu to avoid the mistakes of his precedessors who have repeatedly wrongly seen a stronger Kwacha as economic success.

Finally, we need a complete rethinking of our economic policy. The President needs to appoint a new independent economic commission that will come up with new policies to guide Zambia forward.

Crucially such a body should be tasked with coming up with a clear policy on mining taxation that is fully consulted on with the public. In the long term the Economic Commission could be given wider remit on other areas e.g. industrialisation.

Good leaders use difficult situations to remodel the country positively and not look to the past. The weakness of the Kwacha has given President Lungu a unique opportunity to use this crisis as a new opportunity to forge ahead. Not look to the past. Failing to act will just continue to leave the country on auto pilot.

In the next post we shall turn to another challenge...

Chola Mukanga
Copyright © Zambian Economist 2015

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