Maravi

Levy's illness and inflation

Levy's illness and inflation
By Editor
Thursday July 10, 2008 [04:00]

If we are not careful, President Levy Mwanawasa's illness may have serious negative impact on our economy. We will be making a big mistake if we drop everything, stop working as we wait for the outcome of President Mwanawasa's illness in Paris. With or without President Mwanawasa, our economy should move on. We should not allow the kwacha to depreciate or our fuel reserves to run dry. These have a serious impact on inflation.

In July 2007, the price of a barrel of oil stood at US$65. The kwacha-dollar exchange rate was around K4,000 per dollar and inflation in Zambia was dipping below double digits to around 9 per cent.

Over the last 12 months, a lot of things have changed. The kwacha appreciated rapidly against the dollar and reached a level of around K3,200 per US$ at the beginning of June, 2008. Most people expected that the rate would continue to appreciate to around K2,500 per US$ by the end of the year.

Although inflation had once again risen to above 10 per cent, the expectation was that the combined effects of the strengthening kwacha, the restriction on maize exports and the new crop harvest would result in our economy being shielded from both food and oil price increases.

On this basis, all the economic forecasts were suggesting that inflation would close out at around 7 per cent this year. The question we must now pose is whether this scenario is realistic given the rapid devaluation of kwacha following the illness of President Mwanawasa.

Perhaps the initial effort should be to estimate what the possible exchange rate shock to the economy would be when combined with the oil price shock. Currently, oil is trading at around $143 per barrel, and all the economic forecasts are suggesting that the high oil prices will continue for the next five years.

So let us assume that oil remains at $143 per barrel then we can pose the question on what the effects of a devaluation in the kwacha would imply for inflation in Zambia. A fairly crude measure would be to start by asking: "How much does the oil price contribute to Zambian inflation?"

Although oil prices rose by about 120 per cent over the last year, the 20 per cent appreciation of the kwacha during the same time meant that in kwacha terms, oil prices only rose by 76 per cent.

Indeed, if the kwacha continues its appreciation to K2,500 per US$ and oil prices remain stable at around $143 per barrel, then this will translate into an oil price rise of only 38 per cent. So from this perspective, we can see that an appreciating kwacha shields us from external shocks. The more important question is whether this is actually good for us or not.

In 2005 when the kwacha started appreciating significantly against the US$, there was a lot of outcry particularly from exporters who felt that they were losing out. The typical argument was that when the kwacha appreciates, exporters who face international competition and therefore cannot dictate prices receive less money for their exports.

This is not quite correct. Assuming prices are stable, they receive the same amount in dollars. However, when they convert their dollars into kwacha they receive less kwacha. Their profitability in kwacha terms therefore depends on their local costs as incurred in kwacha.

The simplest way of looking at the local cost would be to look at the kwacha cost of capital. Basically, it does not make sense to go into business unless the return that one makes is higher than the cost of capital. If we can determine how the cost of capital is arrived at, then we can also answer whether a devaluation is good or bad for the economy at large.

Although there are various definitions of the cost of capital, we can generalise this as being determined by the risk- free rate; this is equivalent to the highest investment return one can get at no risk and is usually associated with investing in government securities.

Economic theory still maintains that it's not possible for a country to default on debt issued in their national currency as the government can simply continue to print money.

Obviously, there are effects of printing money chief of which is rising inflation as experienced in Zimbabwe. It is also being determined by a risk premium - this is an additional return that the investor requires in order to make an investment in securities other than those issued by governments.

The logic here is that unless an investor gets an additional award above the risk-free government rate, it does not make sense for him to invest. This risk premium is a personal choice and depends on a person’s risk appetite. For this reason, we can only say that it is difficult to quantify since personal choice will differ from person to person.

So we can safely say that the only known fact we have is that the rational driver for making an investment decision is the risk-free or government rate. So we can now re-pose our question to read as: "What are the core determinants of the risk-free or government rate?"

Unsurprisingly, this is actually one of the most studied issues in economic literature. The answer to this question is simply: Risk-free rate = Inflation + Spread.

This summary has various academic representations but we can ignore these niceties and focus on its meaning.

The point is that to have real growth, in the economy, the nominal rate of growth must be higher than inflation. If inflation is higher than the nominal growth, then in reality the economy is shrinking. Think of Zambia between 1974 to 1998 and you get an idea of what this means.

So in essence, it all boils down to inflation. Any economic effect that increases inflation will result in higher interest rates and therefore higher cost of capital and lower real growth.

The link to lower real growth is slightly tenuous but it can be easier explained from an investor’s point of view. Basically, an investor will not invest in the real economy, that is into business expansion if he knows or thinks he knows that he can get a higher return from buying government bonds.

The economic uncertainty from higher inflation makes the investor risk averse. Since money is not being used for physical investment purposes, no jobs are created and therefore no value is added and hence there is no real growth.

Quite simply put, the risk-free rate must be higher than inflation if the economy is to preserve its value. So let us now return to the impact of the exchange rate on our economy. More specifically, let us attempt to quantify what the impact of the oil price increase would be under two scenarios.

The first is if the exchange rate returns to K4,000 per US$ and the second is if the kwacha appreciates to K2,500 per US$. To estimate the exchange rate and oil price effect on inflation, we need one additional piece of information.

We need to know how much oil contributes to the inflation basket. Obviously for a transporter or commercial crop farmer, fuel prices impact their operational costs more significantly than for, say, a fast food restaurant. Further, we can observe that since most goods are transported they will be affected to various degrees by increasing oil prices.

Let us assume that oil contributes to about 10 per cent on the inflation basket. This means that if oil prices rise by 100 per cent, then inflation due to oil would contribute 10 per cent to inflation.

A 25 per cent currency devaluation ending next year would add 2.5 per cent to inflation whilst a 22 per cent currency appreciation would reduce inflation by 2.2 per cent. If inflation rises by 2.5 per cent, then the cost of borrowing funds would also rise by 2.5 per cent.

Currently, with bank lending rates at about 19 per cent this would mean lending rates would rise to 21.5 per cent. Alternatively, should the kwacha appreciate then lending rates would drop to below 17 per cent. But perhaps the more critical point relates to the absorption of the fuel price to date.

A 10 per cent oil price effect on inflation suggests that there is 7.6 per cent of additional inflation that the economy has not yet absorbed. The key point is not that inflation should increase by 7.6 per cent. Rather, it is that the economy now has expectations of higher inflation and will start to price this in.

This in turn will start showing as higher lending rates and its associated consequences of reducing economic growth. Clearly, one strategy the government should be adopting is the minimisation of higher inflation expectations.

It will virtually be impossible to contain higher inflation expectations if the kwacha continues to devalue simply because of the current political uncertainty owing to the health of President Mwanawasa. And in case we have forgotten our history, we should all remember that Zambia's economic decline started in 1974 following increases in oil prices.

The Kaunda government proceeded to borrow money to fund oil imports, imposed price and wage controls in the hope of controlling inflation, introduced fuel subsidies funded by borrowed money all at the same time that copper prices in a nationalised industry were collapsing. Although we have not quite reached the stage of price and wage controls, the government has stated that fuel is being subsidised to the tune of US$15 million per month.

Clearly, those tasked with running the affairs of the country in the absence of President Mwanawasa need to pay a lot of attention to all the factors that may push the inflation rate upward, especially the exchange rate and all matters relating to fuel supplies and prices. These cannot be left to wait for President Mwanawasa's recovery.

Actually, President Mwanawasa may make quick recovery in a Zambia with inflation that averages around 7 per cent and not one with inflation over 10 per cent.

Labels: ECONOMY, MWANAWASA

posted by MrK @ 3:22 AM