Article by Kevin Tutani
Foreign reserve assets are foreign currencies and other commodities held by central banks as a means to support economic continuity and growth within an economy. They comprise banks notes, foreign bank deposits, foreign Treasury bills and bonds, IMF Special Drawing Rights (SDRs) and reserve positions, gold and other commodities. For clarity, Special Drawing Rights can be viewed as a generosity of the IMF, which are issued to all its member countries for free, mostly in times of severe crises. Zimbabwe last received SDRs worth $958 million, in 2021, as a means to assist the country after the covid 19 economic downturn. SDRs are only repaid if a country decides to leave the IMF. On the other hand, IMF reserve positions are made up of annual membership subscriptions paid by each country to the organisation, each year. Once more, in a time of crisis a country can request its past annual subscriptions and use them as it deems fit, without being charged an interest.
How Zim acquires its reserves
Before delving into explanations of how reserves work, it should be important to initially set off by describing how they are acquired. In 2021, Zimbabwe generated foreign exchange through exports ($6,4 billion), development aid ($1.1 billion), foreign direct investments ($166 million) and remittances ($1.6 billion). 75% of export receipts were given to the exporting companies in foreign currency, whilst the other 25% was issued to them in Zimbabwe dollars, by the Reserve Bank of Zimbabwe (RBZ). Thus, the RBZ took the 25% foreign currency from exporters, which then became part of the bank’s foreign reserves. This is the typical manner in which foreign reserves are created, anywhere in the world. A strong export-oriented economy therefore, means that a country can have robust foreign reserve assets. It can be that simple. In neighbouring South Africa and other countries, all exporters are given 100% local currency (with a few exceptions), whilst the South African Reserve Bank (SARB) takes all the foreign currency. Later in the article, it will be stated why the SARB has a right to do so and how the RBZ needs to emulate the competence of the South African monetary authorities so that they can also create economic conditions which would make it fair for the bank to collect 100% forex from exporters.
A portion of foreign direct investment and development aid will also end up at the RBZ and be exchanged for domestic currency. However, in Zimbabwe, remittances are unlikely to be part of the bank’s foreign reserves.
Once acquired, foreign exchange reserves are used for various national objectives. They are mostly used to facilitate imports through supplying importers with the essential foreign currency for enabling purchases in foreign countries. This is how some Zimbabwean importers access foreign exchange at the weekly RBZ auctions. According to official records, a total of US$1.97 billion was issued to importers, through the auction, in 2021. Other importers however, are still making use of the parallel market, as the auction has not yet established enough capacity to serve all the prevailing demand. It is crucial to state that, in a normal economy, when importers cannot access funds through the formal banking channels, they will resort to the parallel market, which typically implies that the domestic currency will lose value (depreciate).
Foreign reserves are also kept to prevent the domestic currency from depreciating due to political instability and speculative activity in the economy. When market participants begin to demand increasing amounts of foreign exchange, it is the duty of the central bank to release some of its foreign reserves in order to add the supply of forex in the market so that the domestic currency does not depreciate acutely. Such responses can work when the changes in demand are temporary. If the changes are longer and long-term in their nature, then using central bank foreign reserves will not be able to stop the domestic currency from losing value.
Reserves are also used to enable the country to respond to various global crises. These include, global recessions (such as that of 2007- 2008), depressed commodity prices, pandemics (such as covid-19), geopolitical tensions (such as Russia-Ukraine war), etc. When such global challenges arise, Zimbabwe can expect to have depressed foreign investment, lack of foreign credit, lower government revenue, less forex for importers and reduced demand for exports. Thus, in order to avoid complications arising from such problems, the RBZ is expected to use its foreign reserves to attend to the challenges. For example, in times of global crises, local industries in dire need of foreign credit for their continuation, can find a lender in the RBZ, when all else fails, in the international markets.
Since the Ministry of Finance does not have significant foreign assets capable of generating revenue, it will need US dollars from elsewhere in order to make repayments of the government’s external debts. In this regard, the Ministry can access the required US dollars from the central bank. Depending on circumstances, independence of the central bank and accounting methods applied, the reserves can be passed on in exchange for domestic currency in the government’s bank accounts, as a loan or for free. If the RBZ fails to provide the foreign exchange then the country may end up defaulting on its debt repayments.
Reserves can also be kept as a means of response to unforeseen national disasters, which may include damages due to cyclones, earthquakes, extreme droughts, etc. When a country experiences such tragedies, it will naturally be in need of funds to address the losses and damages from the natural phenomena.
When reserves are significant, the excess can be used to make investments in less-liquid assets. This is typically done through a vehicle such as a Sovereign Wealth Fund (SWF). The SWF can use the extra finances to establish interests in domestic or international infrastructure, stock exchange, real estate or energy investments, etc. It is crucial to state that, a core portion of foreign reserves should always be available for supporting importers, government debt repayments, defending the value of the local currency and attending to global crises. Funds assigned to SWFs, can only be apportioned after the basic expectations or uses for the reserves are met.
The oddity of Zim
Zimbabwe finds itself in a peculiar position where the central bank does not have foreign exchange reserves. Rather, reserve assets are mostly in the hands of the average person in the street and private firms. The country is reported to have between US$3- US$7 billion circulating within its informal sector. In percentage form, this translates to between 15%- 35% of GDP.
It is crucial to understand why average Zimbabweans have resorted to becoming custodians of foreign reserves. A comparison of the inflation figures of South Africa, China and Zimbabwe may betray one of the key reasons why this is so. In May 2023, South Africa, China and Zimbabwe had annual inflation rates (CPI) of 6.3%, 0.2% and 175% (official rate), respectively. This reveals that the RBZ should conclusively deal with inflation, so that households and businesses will not undermine the local currency. A look at the official exchange rates of the three countries (South Africa, China and Zimbabwe) between January and May, this year, also shows another reason why ordinary Zimbabweans are now keeping foreign reserve assets. In January, the exchange rates against the dollar, for South Africa, China and Zimbabwe’s currencies were R17.4, ¥ 6.75 and ZW$796 (official rate), respectively. By the end of May, the rates had become R19.03, ¥7.08 and ZW$1989, respectively. Once more, this points to a need for the RBZ to execute its foundational role of defending the local currency, without which, the general public will continue to undermine it.
The US$3- US$7 billion circulating in the informal sector has much greater economic potential if it were to be channelled into the formal sector. Firstly, using the credit multiplier methodology, the US$3 billion can create additional banking deposits worth US$15 billion, to the local banking sector. With statutory reserve requirements at 15% and 5% for demand and time deposits, respectively, the funds can multiply by five times (or more), if converted to local currency and made part of the domestic financial system. Through credit creation, the funds will grow exponentially. It is noteworthy to state that, this estimation assumes that the public would surrender their US dollars to the RBZ and fetch local currency in return. In such a situation, the RBZ would take the dollars and add them to the country’s foreign reserves. The US$15 billion banking sector, would be a huge jump from the prevailing circumstances, where the local financial sector is currently managing less than US$3 billion in deposits.
Secondly, when the funds start circulating in the formal sector, the government will have more opportunities of taxing the public and earning from their transactions. Currently, the IMTT (Intermediate Money Transfer Tax) is earning around 6% of government revenue. Treasury’s budget will resultantly move from its consistent, unimpressive, US$4 billion value, to around US$8 billion, when informal sector funds are incorporated into the formal system.
Thirdly, as the US$3 billion is added to the RBZ’s foreign reserves, it can then be used for various national objectives, as outlined before. Others may wonder how it is that US dollars can be exchanged for local currency. This can be explained by simply stating that money has no intrinsic value, whether US dollars or Rands or the local currency. Rather, money acts as a token, an invoice for goods and services produced. In other words, money acts as proof that goods or services were produced. However, in order to make the exchange of foreign currencies for Zimbabwe dollars fair, there is need to ensure that inflation and exchange rate stability are similar between Zimbabwe and other strong economies.
Simply put, if the RBZ would retain annual inflation below 5% and maintain a stable exchange rate, the public would not have a justification to perform the other mandate of the reserve bank, which is, to act as the custodian of the nation’s foreign reserves.
Growing reserve assets, going forward
In order to grow the country’s foreign reserve base, it will be crucial to continue maintaining a positive trade-balance. This means that exports of goods and services should be greater than imports. The government should also support the export sector whilst substituting imports, where possible. Introducing import certificates can be a good option. Exporters may be issued with import certificates for every dollar amount which they export. Each certificate can have a redeemable value of 1% of the value of goods or services exported. In-turn, importers will not be allowed to import without purchasing a certificate from exporters, and thereby pay an additional 1% in support of the export sector. Moreover, imports will not be able to outgrow exports in such an arrangement, as there will not be any certificates available for a value which exceeds the country’s total exports.
Non-essential jobs can be exported to other regions of the world, in order to encourage foreign exchange remittances from expatriate workers. In 2021, personal remittances totalled a significant $1.6 billion. As long as Zimbabwean labour is demanded in foreign lands, that will work favourably for the country’s trade balance and foreign reserve position.
Taking a leaf from Switzerland, should also assist towards strengthening the country’s reserve assets. For a country with a population of just below 9 million (8,7 million), the Swiss have the third-highest foreign reserve assets in the world, at US$863 billion, at the end of 2022. The nation is only under the strong export-oriented economies of China and Japan, in terms of reserve assets. Its trade performance is equally as exceptional as the two, with a total of $388 billion in exports (in 2022), for such a small population.
The Swiss Franc is also considered a safe-haven currency by investors and various global market participants. The nation’s strong economy, political stability and long-standing neutrality in geopolitical confrontations, add to the reliability of the Franc. During the past two World Wars, for instance, the country retained neutrality and was able to maintain industrial and financial sector continuity, amidst the global showdown. No country declared war on it, meaning that it did not engage in any of the wars through armed conflict.
Similarly, Zimbabwe can choose to embrace geopolitical neutrality for the benefit of the local currency. Ensuring that local politics is civil and crime is adequately addressed, will also go a long way towards improving the attractiveness of the Zimbabwe dollar as a safe-haven currency. Foreign funds will increasingly flow into Zimbabwe, as direct and portfolio investments.
The Swiss National Bank (SNB) is also exceptional in managing domestic price levels and exchange rate movements. Annual inflation in August 2023, was a modest 2.4%. The large Swiss Financial sector also attracts massive foreign capital. Foreign bank account holders enjoy extreme levels of privacy as their information is not easily disclosed to third parties. Clients’ deposits are secured through robust deposit protection methods, whilst the sector is characterized by extreme stability.
In the same way, adding to the stability of Zimbabwe’s banking sector and improving its quality will draw more foreign funds. Additionally, managing to keep inflation as low as in the advanced economies will have the same positive effect.
Kevin Tutani is a political economy analyst. He can be reached at email@example.com