What could be the true value of bond note?

daniel-ngwira1

The official exchange rate of the bond note since introduction is B$1=US$1. This exchange rate has been met with mixed feelings.

However, there has not been enough momentum on the ground to upset this exchange rate regime partly because of the tight control of the market. Before the introduction of the bond note many analysts voiced concern on the likely impact on inflation, value loss through exchange value depreciation and possible shortage of goods in the shops.

The central bank has not been caught off guard either. This has been necessitated by the discipline of the Mangudya-run central bank and the public pressure which had resisted the notes on account of historical losses in value due to warlike printing of currency in the foregone era.

My well-considered view is that the noise made by analysts and economists in their multitude helped to ensure that the central bank maintained the discipline it had promised even though they could not set up the independent monitoring board as they had indicated.

This still does not entail that, overall, bond notes are good for the economy. They are a response to a crisis just like bearer’s cheques were during their time. Bond notes are a reflection of the fundamental problems the economy is facing.

They demonstrate that policy is reactive and struggles to catch up with the market dynamics. They show market and regulatory failure to convince the public to rely on other exchange mechanisms which are not physical.

Not everyone agrees that the bond note must be priced at par with the greenback. The economic fundamentals of the two economies, the United States and Zimbabwe, are too different to justify that exchange rate.

Zimbabwe has, for several months, been suffering negative inflation which shows, to some extent, the weak aggregate demand in the economy. The argument of the authorities could be that the bond notes are backed by a facility. A look at the RBZ website shows various announcements on bond notes but no evidence of the line backing the bond notes.

How are exchange rates determined and forecast? While there are many ways, we can only look at a few of them. Basic economic theory tells us that a key determinant of exchange rates is the supply and demand of one currency in relation to the supply and demand of the other currency. Looking at the current set up of the Zimbabwean economy, highly characterised by imports outstripping exports, it is conceivable that the dollar is in higher demand relative to the bond note.

The economics behind it is that if the demand for dollars exceeds the supply of the greenback, and if the supply of the bond note is greater than the demand for them, then the dollar-bond note exchange rate would change.

The fact that bond notes are in short supply may be trivial depending on market perception. What is paramount is the relative supply and demand of the currency pair. In a country which relies so much on imports and where the greenback has been the pillar of trading, the exchange rate may not hold firm.

Even if people decide to use rands as opposed to dollars, the effect is the same due to the concept of reverse cross currency. With this concept, the value of a currency pair can be derived from currency pairs in which the currency to be derived is quoted.

The only way the bond can hold onto the exchange rate announced by monetary authorities is through fixation or the reality or perception that the note is backed by a line from the said regional reputable bank. Fixation without any economic basis has its problems in the long run, that is, the promotion of the underground market.

Ideally the price of a currency can be held firm at a desired level through buying and selling of that currency.

This, however, costs the country in the form of reserves which we know the government does not have and is therefore keen to build.

Two fundamental reasons guide the supply and demand for currencies.

Firstly, a currency is desired for what it can buy. In our case, as economic agents desire to import goods from outside to support their businesses, they will demand the appropriate currency desired by the merchants who will be based outside the country. The greenback has been popular thus far. Secondly, speculation drives demand for and supply of currencies. Of the over US$5 trillion traded on the foreign exchange markets daily, a significant part of that is related to speculation.

Let us build the concept of speculation further in order that we put things into proper perspective. George Soros, a well-known financier who has been the principal partner of the Quantum Group, a hedge fund, is famous for moving markets through his well-calculated speculative bets. In 1992, Soros made a move on the British pound based on his well-considered view that the pound was likely to decline in value against the German deutsche mark. The value of the pound stood at DM2,80 at the time. While Britain had an obligation to hold the pound above DM2,77 as per EU agreement on monetary policy, Soros doubted that could happen. As a result, he shorted the pound.

Short selling is a process of placing a speculative bet that the value of an asset will decline and thus an investor would then make a profit from that decline. Say an investor believes that a financial asset will decline in value from its current level of US$20, they then sell the asset which they do not have at US$20 with the hope of buying the asset when the value has gone down say to US$15. They will then return the asset to the party who would have lent it to them. Their profit would be US$5. The risk is that the value of the financial asset may not fall, instead it could rise, and still the investor is obliged to return the financial asset which they would have borrowed.

In this case they would incur a loss. Normally the lender of the financial asset tends to demand collateral security in case things go wrong.

The simultaneous purchase of the mark and sale of the pound by the Quantum Group was so enormous that it drove down the pound against the mark. At the same time as Soros had a reputation of making winning bets, other currency traders made similar moves of short selling the pound against the mark.

The bandwagon effect exerted further pressure on the pound to the extent that on September 16 the Bank of England, on instructions from the government, tried to prop up the pound through a US$20 billion purchase of pounds.

Nonetheless the pound continued on a downward spiral. The next day a decision was made to allow the pound to fall as the pressure exerted on it was so enormous it could gobble a lot in reserves to halt the downward momentum.

Eventually the pound declined to DM2,00. In all, Soros made a US$1 billion in profit in just a month.

If the bond note were to be left to float freely against the dollar, it could have been hit hard by speculators who would have doubted the government’s ability to hold the value at par with the dollar through open market trades given that the country does not have any reserves to support the desired value.

In the absence if a crackdown on informal currency traders, even the underground market could have gone wild as the speculators’ bets would have been premised on the lack of confidence. More so, it is fundamentally incorrect for the bond note to be at par with the dollar, assuming the note is not backed by a line.
A look at the Law of One Price tells us that identical goods must be sold at the same price when they are expressed in a common currency.

This is after discounting freight and tariffs. Say B1=ZAR10, if a television set in South Africa is going for ZAR2 000, then it means in Zimbabwe it must sell for B$200. If the television set is instead selling for B$100 in Zimbabwe, a trader could benefit by arbitraging; buying television sets in Zimbabwe and selling them in South Africa. They would make a profit of B$100.

The increased demand of television sets in Zimbabwe would increase the price while the increase in supply in South Africa would result in a fall in prices. This process would persist until prices in both countries equalised. This entails that the exchange rate cannot remain static.

Validation of the law of one price then implies that the purchasing power parity would hold. In a world of trade barriers and free movement of goods, this entails that a “basket of goods” can sell for almost the same price in each of the countries. This can be tested by looking at the basket of currencies in each country and then deriving the exchange rates from the prices of each basket.

In addition, interest rates determine exchange rates. According to the International Fisher Effect, “for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries.”

To put it in common parlance, what this means is that if interest rates in the US are 4% while they are 15% in Zimbabwe, the value of the bond note against the dollar should decline by 9% against the dollar.
Of course I need to highlight that inflation in Zimbabwe is negative yet rates are very robust, largely driven by short supply of capital.

Irvine Fisher predicted that there was a strong relationship between inflation rates and interest rates.

Using the Fisher Effect, it can be noted that in the absence of capital flow restrictions, any differences in real interest rates would attract movement of capital from destinations of low interest rates to those of higher interest rates in an osmosis-like manner.

The capital flows would persist until the real interest rates equalised. This entails that any differences in interest rates are as a result of differing expectations about inflation. Consequently, the value of a currency associated with higher nominal rates would depreciate by the inflation rate.

Exchange rate determination and forecasting is quite a complex matter. Given that the forecasting techniques are accompanied by many simplifying assumptions, forecasters tend to be frustrated as it is not easy to get exchange rates right. The volatility of currency markets entails that an equilibrium exchange rate may only be reached or attained after so many movements up and down, in which case millions may be gained or lost during the process.

Other techniques of estimating or projecting exchange rates may be employed. Looking at three southern African countries, namely Botswana, South Africa and Malawi, we can be able to estimate the range of exchange rates for a deemed Zimbabwean currency, the bond note to the dollar.

We can do this using the state of the economy, the stability of various macroeconomic variables and the prevailing quoted exchange rates in the active currency markets. Mid rates for March 20 2017, USD1=MWK725,500, USD1=BWP10,25 and USD1=ZAR12,6337 could help illustrate. I have eliminated GDP as it rarely correlates with exchange rates. The cases of Japan versus many major currencies and GBP versus the USD are paramount in this regard.

From the exchange rates quoted above, the bond note is unlikely to be stronger than the Botswana pula, neither is it likely to be stronger than the rand.

Taking into account the inherent weaknesses of the Malawian economy, its lack of potential from a resource endowment point of view and comparing it with the Zimbabwe’s strengths of being rich in natural resources and full of potential, though currently not well managed, the bond note is unlikely to be any weaker than the Malawian kwacha. This may imply that the bond note should range anywhere between USD1 is to 13 and USD1=725.

The range of estimates above assumes a non-USD-backed bond note. If, however, the note is truly supported by a bank line as consistently claimed by the authorities, then it entails that the current exchange rate of par to the dollar is near-correct.

Near-correct in the sense that under normal circumstances exchange rates change so many times in a day due to the differing perceptions of market participants or daily shortages and surpluses and reasons for entering into trades or interpretation of market data. If the note is backed, it becomes the only modern-day currency to have intrinsic value just short of being convertible. Fiat currencies are now universal.

The other reasons that could hold firm the bond note to the USD is that its supply is mathematically controlled.
At the current level of market circulation, the bond note would unlikely depreciate to the extent of its predecessor, the bearer’s cheques.

It is important for the authorities to note that while holding an exchange rate at a higher level than it ought to be may look prestigious, the right or true rate is what matters in that it can contribute to the realignment of the economy in such a way as to solve some known problems. A strong currency makes exports expensive while it promotes imports, ceteris paribus.

Ngwira is a chartered accountant, former bank treasurer and former university lecturer. He holds finance and business qualifications. Contacts: daniel.ngwira@cd, +267 73 113 161.

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