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CENTRAL BANKING INTERVENTIONS – POSSIBLE OUTCOMES

By DARLINGTON CHILUBA


FIRSTLY, should central banks intervene to control the exchange rate? Secondly, what is the point of managing the exchange rate if the price of local goods and services remains unchanged?
Are such interventions political or objectively for economic reasons?
Believe it or not, the answer to the first question is yes, but indirectly. The last two questions require an explanation because central banks are supposed to act in national interest.


Meanwhile, the notion of national interest rarely means mutual agreement and will either be defined by those in power or those with power.
Put simply, national interest will be defined by elected officials, those with financial power or those with temporary power to change the national hierarchy through elections or revolt.
It is a tricky balance this national interest, even tendentious.
The oldest central bank, the Riksbank of Sweden was established in 1668 as banker of the domain to secure and protect public interest.
Modern central banks, like the Bank of Zambia (BoZ), have been anchored on this same idea of safeguarding the national interest. This means avoiding economic collapse through a mechanism called price stability.
Studies show that this is the core function of reserve banks or central banks (See, among others, Christopher Crowe and Ellen E. Meade ‘The Evolution of Central Bank Governance around the World 2007).
Price stability partly involves ensuring the national currency retains value that enables the economy to function and grow. A functioning economy allows local, regional and international trade transfers to flow within it confidently.
Local businesses must trust the currency to have transactional value in the domestic economy. This also means that the currency must be able to transact with other currencies through the foreign exchange mechanism without losing value and deleting profits for businesses.
Therefore, price stability as a function of monetary policy becomes anchored by inflation, the exchange rate and money supply.
Central banks observe these three and will often intervene to correct economic instability by indirectly adjusting factors that affect the value of the currency and thus the integrity of domestic finance. This answers the first question concerning the right to intervene, they have to. It is a matter of risk management.
Are these interventions politically motivated? This is the third question; we’ll resolve the second one afterwards.
Central banks intervene to avoid economic collapse. Whether we disagree on the definition of national interest, we can all agree economic collapse is disastrous for everyone.
By rebranding national interest as protection of the economy, intervention is justified as objective than political. Interestingly, if an economy collapses, social revolt normally directs anger at politicians, not the central bankers in most cases. Politicians, therefore, will have as much interest to keep the economy from collapse as much as central bankers.


This is why central bank independence has become critical in the last 10 or so years to balance expectations of elected officials and managers of economy.


Let’s get to the second question: Why are local prices stagnant when the exchange rate has improved? Three reasons: inflation, the exchange rate and money supply.
Money supply is the sum of notes and coins in the economy at any given time. In the old days, the quantity of notes in circulation was linked directly to gold deposits at the (central) bank so that banks would not issue more notes than gold. If they did, collapse was imminent. Even today, too much money chasing too few goods creates a problem called inflation.


Inflation speaks to the value of a currency over a given period. A K100 for example, will not buy the same goods it could afford during the same period a year ago. The loss in buying power can be explained by inflation. Equally, too much money in circulation creates hyperinflation while too little stifles growth.

The exchange rate is simply the price of one currency against another. Countries have a choice to either fix the exchange rate or allow it to float.
Some propose that a fixed exchange rate system is good because it keeps inflation low and controls the supply of money. Others believe floating the currency promotes productivity and economic contribution on a sectoral basis. Zambia has a floating system introduced in the 1990s.
There is a better link between money supply and inflation. The percentage change in annual money supply typically increases when inflation goes up. For instance, the annual percentage change in money supply increased from 13.65 percent in December 2018 when inflation was 7.9 percent, to 58.4 percent in March 2021 when inflation was now well over 21 percent.
This means that if money supply is high as it is, inflation (the value of money) will not decrease. This is part of the reason local prices have not changed despite the exchange rate improving because supply and inflation are relatively high. We are talking only money supply of the Kwacha.
The link between inflation and the exchange rate is not a straight line. Even when the exchange rate improves, local prices will not change immediately because there are simply too many factors at play – cost push inflation.
These include foreign exchange income (mostly from copper and non-traditional exports for Zambia), total cost of imports which includes oil prices and so on.

In addition, numbers show that the percentage change in money supply of foreign exchange has dropped to 39 percent as of March 2021. This is the same level it was in June 2020 when inflation was going towards 16 percent.
So again, if foreign money supply is reduced then growth linked to that currency will be stagnated. Thus, any benefit from the improved exchange rate is instantly countered by the downward supply or hold of foreign exchange.

The one other change that materialised after the August 12 elections is that the cost of our loans (Eurobonds) has dropped significantly. It means that we may now require less Kwacha to buy dollars needed to pay those loans. But again, if the money supply is not adjusted, inflation will keep prices high and the Kwacha of lean value.
By way of conclusion, inflation, the exchange rate and money supply have not converged to reduce the price of local commodities. We’ll see what interventions will take place for national interest.

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