I recently came across a very interesting and thorough research paper from the IMF on the Zimbabwe hyper-inflation episode. What was quite clear from the document was that the high inflation of the period was the result of very high quasi-fiscal losses by the country’s central bank and not of runaway fiscal deficits. Probably the most important factor was interest costs of open market operations while also subsidies (mainly in the form of free forex to public enterprises) and foreign losses (due to a mismatch between foreign assets and liabilities) played a significant role. The annual flows were enormous, close to 60-80% of GDP which explains why annual inflation quickly reached levels of 600% and 1200%.
The rest of the post contains the relevant parts (and figures) of the paper that explain the hyper-inflation process more clearly:
While central bank losses in most countries have not exceeded 10 percent of GDP, Zimbabwe’s flow of realized central bank quasi-fiscal losses are estimated to have amounted to 75 percent of GDP in 2006. Losses have arisen from a range of activities including monetary operations to mop up liquidity; subsidized credit; foreign exchange losses through subsidized exchange rates for selected government purchases and multiple currency practices; and financial sector restructuring. Quasi-fiscal losses of this sort, rather than conventional monetary or fiscal laxity, have been the mainly responsible for the surge in money supply in Zimbabwe during 2005-7. The power to create money to finance losses quickly run into conflict with any recognized monetary policy objective with official inflation reaching 1,594 percent as of January 2007.
The following are noteworthy features of the balance sheet:
- Nonearning assets are substantial; they amounted to 83 percent of total assets as of October 31, 2006.
- RBZ securities, introduced as a sterilization tool at the beginning of 2004, became the largest liability by the end of that year, overtaking currency in circulation, previously the largest liability.
- Starting in 2004 sharp increases in statutory reserves to finance the concessional credit to favored sectors, such as agriculture, led to a steep climb in required reserves, which are not remunerated.
- Foreign liabilities, largely represented by credits from international financial institutions, have for some time been much larger than foreign assets. In this situation any currency depreciation produces losses.
- The smallest liability is capital and reserves which has been kept constant at a very low level. A central bank increases its capital through seigniorage and reduces it by operating expenses and distribution of profits to the government. Figure 1 shows the evolution of seigniorage since 2001 in Zimbabwe. For the RBZ, seigniorage has fallen from over 5 percent of GDP in 2001 to about 0.1 percent of GDP in 2005 because, given very high rates of inflation, real base money has declined drastically in relation to nominal GDP and the RBZ has invested in assets, including QFAs, with large negative real interest rates. Only the failure to apply a recognized accounting framework keeps the RBZ capital and reserve from being negative.
Most of the RBZ’s quasi-fiscal losses were incurred in connection with activities that go far beyond conventional central banking functions. There were four main sources of the losses:
- Subsidies in terms of free foreign exchange to public enterprises; price supports to exporters to partially compensate them for an overvalued exchange rate; and subsidized credit to troubled banks, farmers, and public enterprises.
- Realized exchange losses stemming mainly from the purchase of foreign exchange from exporters and the public at higher prices than sales of foreign exchange to importers (mainly government and public enterprises); and recognition of previously unrealized exchange losses upon repayment of external debt, including to the Fund.
- Interest payments associated with open market operations to mop up liquidity.
- Unrealized exchange losses reflecting official devaluations because foreign liabilities exceeded foreign assets.
To contain money growth, the RBZ sterilized the impact of the direct injection of liquidity into the economy that the QFAs represented. In January 2004 the RBZ started to issue its own bills at effective interest rates of over 900 percent per annum. These RBZ Financial treasury bills were naturally attractive to the market but too costly to the RBZ, so they were soon abandoned and replaced by Open Market Operation (OMO) bills, introduced in May 2004, and Special RBZ bills, introduced in June 2004. The OMO bills had the same interest rates as the existing government treasury bills but the accounting for them was clearly separated from holdings of government treasury bills since the interest cost was charged to the RBZ. The issuance of these bills escalated beginning in September 2004 after the large-scale financial or “liquidity” support to troubled commercial banks. The Special RBZ bills were introduced to absorb excess bank liquidity at the end of the day. They had a maturity of two years and carried an interest rate that was sharply negative in real terms. The long maturities deferred the monetizing consequences of the high nominal interest rates.
The RBZ has accumulated substantial domestic interest-bearing liabilities through open market operations to absorb liquidity. The vicious circle of rising losses and rising remunerated liabilities has resulted in inflation and increases in the interest rates of the bills, further accelerating the interest cost for the central bank. By 2005 the net interest cost of sterilization equaled 40 percent of GDP. In 2006 the interest cost grew further but its liquidity impact was partly alleviated as the authorities lengthened the maturity of treasury bills, thus deferring interest payments.