Copyright UCT
A study of the factors influencing exchange rates in a small, open economy – the case of
the Zambian economy
A Research Report
Presented to
The Graduate School of Business
University of Cape Town
in partial fulfillment
of the requirements for the
Masters of Business Administration Degree
By
Bedah Salasini
December 2006
Supervisor: Dr Barry Standish
Copyright UCT
2
ABSTRACT
World over, stable and competitive exchange rates continued to be a major
macroeconomic target of most countries over the past decade. But to maintain the
exchange rate at stable and competitive levels requires extensive knowledge on what
factors influence the exchange rate to fluctuate. This paper studied factors influencing the
foreign exchange rate in Zambia, a small open developing economy from 1999 to 2004
whose currency, the Kwacha, generally depreciated over this period against the United
States Dollar. By using the balance of payments approach, the monetary approach as well
as the portfolio balance approach to exchange rate determination, the study found that
appreciation in the Kwacha is positively associated with rising yield on the 91 day treasury
bill, the rising copper prices, improvement in the overall balance of payments, a reduction
in the international reserve change, reduced budget deficits, reduced broad money supply
and lastly reduced total gross national product. Surprisingly, increased financial account
balance and debt relief were found to negatively impact on the kwacha appreciation. This
absurd result, most likely, was caused by the fact that US dollars earned from these
sources were not supplied into the market but must have ended up to build strategic
international reserves which the government can draw upon in times of calamities like
droughts, unprecedented fuel shortages. However, if these US dollars were supplied into
the market, then they only helped the kwacha not to depreciate to the full extent it would
have if the Zambian exchange rate regime were a free floating system. However, the
Zambian exchange rate regime is a dirty floating system.
Copyright UCT
3
DECLARATION
Plagiarism is forbidden, and so I declare that this is my own work and all sources of
information have been cited and referenced.
Signed
Copyright UCT
4
ACKNOWLEDGEMENT
I am greatly indebted to all those people who have assisted me in the various aspects of
this study: Dr Barry Standish for providing supervision and reviewing my work at
different stages of the study. My wife, Charity and our two girls Yongo and Tusankine for
their patience, encouragement and understanding. Joseph Simumba for his invaluable help
in collecting the data and his insight into monetary economic theory.
Copyright UCT
5
TABLE OF CONTENTS
Abstract…………………………………………………………….……….2
Declaration………………………………………………………….………3
Acknowledgements……………………………………………….………...4
1. Introduction………………………………………………….…………..6
2. Overview of Zambia’s economy………………………………………..8
2.1 The first period 1964-1974…………………………………………….8
2.2 The second period 1975-1990………………………………….………9
2.3 The third period, post 1991…………………………………….......…11
3. The nominal exchange rate regime 1964-2006……..............................11
4. Literature review on exchange rate determination…………….….....17
4.1 Traditional or Trade approach…………………………..…….…….18
4.2 Modern approach and theory…………………………….…….….…20
4.2.1 Monetary approach………………………….…………………..….20
4.2.2 The portfolio balance approach…………………….…………..….22
4.3 Empirical evidence: An overview……………………….………...….23
5. Methodology and definition of variables……………………….…......25
6. Description of the data………………………………………….…..…..27
7. Data analysis and discussion of findings.……………………..…….....29
8. Conclusion and policy recommendations……………………..…...….34
Bibliography
Appendices
Copyright UCT
6
1. INTRODUCTION
Zambia, like other small but open developing economies, has struggled to maintain a
stable and competitive exchange rate. A stable and competitive exchange rate continued to
be a major macroeconomic target over the past decade in the national economic plans. The
need for a stable and competitive exchange rate emanates from government realisation that
big swings in the exchange rate do impose real costs on business planning. Anticipated
revenues, production costs, household expenditure, foreign direct investment and the
budget balance of the government can all be adversely affected as the exchange rate
fluctuates.
Every time the currency fluctuates, regardless of direction, one entity in the economy
usually gains while another loses. In the case of domestic currency appreciation, producers
of export commodities lose on revenue whilst consumers of imports including importers
record a rise in their real income. In the case of domestic currency depreciation the
importers as well as the consumers now experience a decline in their real incomes while
the exporters gain extra revenue.
The phenomenon of gains and loses as exchange rate fluctuates does not spare foreign
investors or the government. On the part of government, volatility in the exchange rate
may lead to unforeseen deficit in its budget. Evidently, the recent appreciation in the
Kwacha undoubtedly forced the finance minister to seek parliament’s approval of a
substantial supplementary expenditure bill.
The tendency of one group benefiting and another losing out simultaneously as the
exchange rate fluctuates usually creates conflicts in a nation. To avoid conflict arising
from exchange rate volatility, it is imperative that central banks endeavour to promote a
stable and competitive exchange rate.
Managing a stable and competitive exchange rate is not easy. It requires policy makers and
regulators to effectively understand factors which affect the observed volatility in the
exchange rate. Studying the factors responsible for exchange rates volatility has for long
preoccupied much theoretical and empirical work of international finance. Most
researchers have suggested a wide range of probable factors that determine volatility in the
exchange rate. These factors are discussed and studied at length in the literature review.
Copyright UCT
7
Recent works on exchange rate determination have shown that traditional models of
exchange rate behaviour provide less significant results when applied to an emerging or
small open developing economy. Such studies tend to conclude that some conditions
exclusive to these nations are treated differently in the earlier models. As such there is
increasing desire amongst economists to study the determinants of exchange rates in small
open developing economies.
This paper analysed factors that influence the Kwacha to fluctuate against US dollar over
the period 1999 to 2004. By using annual data while being guided by the balance of
payments, monetary and portfolio balance approach to exchange rate determination, the
study found that appreciation in the Kwacha is positively associated with rising yield on
the 91 day treasury bill, the rising copper prices, improvement in the overall balance of
payments, a reduction in the international reserve change, reduced budget deficits, reduced
broad money supply and lastly reduced total gross national product. Conversely, increased
financial account balance and debt relief were found to negatively impact on the kwacha
appreciation. This result is absurd and contradicts the prediction of the balance of
payments approach. Nonetheless it adds to the evidence that exchange rate determination
in the small open developing economies does not show systematic results which have been
observed in the developed economies.
From the beginning, it should be emphasised that the results of this study are indicative
rather than conclusive. The Pearson product moment correlation method used is not a
robust method. A robust treatment of the data required that the exchange rate should have
been regressed on its determinants. Although, this could have been done using the
ordinary least squares method, this method was deemed inappropriate because variables in
this study were found to be highly correlated, as shown in table 3, such that the errors in
the ordinary least square method would have been serially correlated thereby invalidating
all the results. The other available econometric methods which would have overcome this
problem are beyond the ability of the Author. Alternatively even if the author had the
ability to handle the other econometric models, the data available would have not been
sufficient to guarantee good results. Although monthly data on 91 day treasury bill yield
rates and exchange rates was readily available, monthly data on the balance of payments
proved a challenge.
Copyright UCT
8
2. OVERVIEW OF ZAMBIA’S ECONOMY
Zambia is a landlocked country in southern Africa. It covers a land area of 752614 square
kilometres with an estimated population of 10million. The country gained its
independence in 1964 from the British Rule with most production units bring under being
under foreign ownership. The major economic activity was mining with copper production
and exports dominating the sector and the economy. Since independence copper has
remained as the major export commodity although government has in the recent past
supported diversification to production of Non Traditional exports. The importance of
copper can be seen in table 1 below
Table1: Importance of Copper Mining to the Zambian Economy
1970
1975 1980 1985 1990 1996
Mining and Quarrying as % of GDP 36 14 16 16 7.4 5.9
Mineral Tax as % of Government Revenue 58 13 5 8 0.1 2.3
Copper Exports as % of Total Exports 95 91 85 83 84 52
Mining Employment as % of Total
Employment
17 17 17 16 15 10
Source: IMF: International Financial Statistics, 1997; Mkenda, 2001
Due to challenges faced in the data collection process, this information was only available
up to 1996
To comprehensively understand how Zambia’s economy has evolved, three distinct
periods ought to be noted (Ng’ambi, 2004). These are 1964 to 1974, 1975 to 1990 and
1990 to date.
2.1 The first period: 1964 to 1974
The first period 1964 to about 1975 reflect a period of high copper prices, rapid economic
expansion, growth in public sector and a corresponding rise in government expenditure.
During this period the nation was one of the prosperous in Africa. In 1967/8 the nation
embarked on the mulungushi reforms, a set of policies which aimed at empowering the
indigenous people in the running of the economy. This led to nationalisation of many
Copyright UCT
9
manufacturing and financial services firms. However the revenues obtained from copper
exports still helped the government to continue with its ambitious programme under this
strong command economic structure.
In 1973, the nation was hit by an external shock when OPEC increased oil prices by over
400 percent. (Ng’ambi, 2004:2) writes that following the oil shock, the country’s GDP fell
by 5 percent in 1973.Gross international reserves decreased from US $700 million to
about US $ 200 million by 1974, threatening the country’s ability to import; the current
account balance went into deficit and inflation started to rise steadily. All this was
happening at a time when copper prices at the world market had started to decline
significantly. As can be seen from the table, copper being the largest export commodity
accounting for about 95 percent of total exports with mineral tax averaging between 58
and 13 percent of government revenue, undoubtedly government revenues contracted
tremendously.
Coupled with a huge programme of infrastructure development and human capital
formation, given that the nation had only 168 graduates at independence, with most
existing infrastructure only sufficient for a minority group, the governments budget
balance by 1974 was negative 4.5 percent as a proportion of GDP. As a result government
had to borrow externally to finance its expenditure such that the external debt as a
proportion of GDP stood at 37.3 percent in 1974.
2.2 The second period; 1975 to 1990
During this period, mineral earnings continued to decline as copper prices continued to
sour on the global market. The performance of the economy also continued to deteriorate
resulting into one of the worse depression the country has ever recorded in its economic
history. Although the copper and oil external shocks were key factors in the country’s
economic malaise, the failure by government to respond with favourable macroeconomic
adjustment policy perpetuated the crises. Table 2 below shows selected macroeconomic
indicators 1973 to 1990.
Copyright UCT
10
Table 2: Selected Macroeconomic Indicators; 1975-1990
Variable
Year
ToT1 Reserves2 Current3
Account
Budget4
Balance
GDP5
Growth
Copper6
Prices
1975 126.3 142.0 -726.1 -340.8 -2.4 56.10
1976 139.6 92.7 -132.8 -231.3 4.3 63.64
1977 119.8 66.3 -232.3 -190.3 -4.8 59.41
1978 114.0 51.1 -321.1 -208.8 0.6 61.92
1979 135.9 80.0 4.7 -139.9 -3.0 89.49
1980 125.5 78.2 -544.6 -295.0 3.0 99.12
1981 100.1 56.2 -766.6 -210.2 6.2 79.05
1982 88.9 58.2 -592.6 -276.5 -2.8 67.21
1983 97.8 54.5 -310.0 114.6 -2.0 72.23
1984 Na 54.2 -162.7 -120.1 -0.4 62.66
1985 Na 200.1 -404.1 -232.3 1.6 64.29
1986 Na 70.3 -372.1 -388.1 0.6 62.13
1987 Na 108.8 -256.7 -232.3 -0.2 80.79
1988 Na 134.0 -324.7 -205.2 6.7 117.93
1989 Na 116.2 -292.0 -71.7 -1.1 129.15
1990 Na 193.1 -489.8 -43.8 -0.4 120.72
Notes: 1= terms of trade (1987=100); 2=total reserves minus gold (current US$ million); 3=current
account balance before official transfers (current US$ million); 4=Government budget balance (current
K’mn); 5=annual growth of real GDP (%); 6=London Metal Exchange Prices (US cents/pound)
Source: As tabulated in Ng’ambi (2004) from World Tables and International Financial
Statistics, 1992
Given the structural imbalance and the huge external debt, that the nation in 1983
implemented the first structural reform programme. The government restricted wages, new
public sector employment and the budget deficit with a view to reduce aggregate demand
given the high and rising inflation rate. However in 1987, after the food riots on the
copperbelt and Lusaka provinces, the IMF structural reforms were replaced by the New
Economic Recovery Programme following the broad criticism against them. With a partial
command system at its core, NERP managed to reduce the budget deficit and inflation, at
Copyright UCT
11
the cost of serious commodity shortages, but it too collapsed after the 1991 elections when
the UNIP government lost the elections.
2.3 Third period: post 1991
When the MMD won the 1991 elections, it introduced the economic recovery programme
under the auspice of the IMF and World Bank. Between 1992 and 1995, most parastatal
companies were privatised. A cash budget approach was adopted in 1993 and values
Added Tax as well as user fee arrangement for social services were introduced. The
central Government was downsized through worker retrenchment. Prices and exchange
rates were decontrolled. In this period, GDP growth was volatile especially in the
agriculture sector where the private sector usually failed to absorb output in bumper
harvest years as government had withdrawn from agriculture marketing activities. Another
significant decline was observed on LME mineral prices which had fallen from 94 US
cents/pound in 1990 to 79 in 1994 before bouncing to 100 in 1995 and dropping again to
78 in 1996&97 and 56 in 1998. Data sources used in this study did provide information
subsequent to 1998.
In 2000, Zambia was classified as a highly indebted poor country (HIPC). By virtue of this
status creditors pledged to cancel the Zambia’s debts stock once it met certain bench
marks. The most notable condition was the requirement that government must reduce its
deficit to below 10 percent of gross domestic product. Therefore beginning 2001,
government tightened fiscal and monetary policies with the view to reduce the rising
aggregate demand which had caused inflation to rise while contributing to the depreciation
of the Kwacha. Although the nation failed to meet the conditions at due date, it managed
to qualify later on after the qualification period was extended to 2004. Huge debt
cancellations and restructuring in the post HIPC period have been reported to have a
positive impact on the appreciation of the Kwacha which recently characterised the
economy.
3. THE NOMINAL EXCHANGE RATE REGIMES: 1964 – 2006
Since independence, Zambia’s nominal exchange rate has undergone significant policy
changes. From 1964 to 1982 the country used a fixed exchange rate (to the US$) regime
which was abandoned in favour of the crawling peg which as well just lasted for a two
Copyright UCT
12
year period. In 1985 the country introduced the floating exchange rate regime but it too
was abandoned in 1987 when the nation resorted back to the fixed exchange rate again.
Stringent government controls and decrees among them prosecution of erring player and
possible exclusion from trading in the market enforced the fixed exchange rate system in
the nation.
The major thrust for abandoning the fixed exchange rate regime earlier was caused by the
bullish behaviour the US dollar exhibited against major currencies in the early 1970s when
the International Gold Standard system was pronounced since its re-emergence in 1946
(Encyclopaedia of American History). In 1971 the International Gold Standard Exchange
Rate Regime collapsed after the US treasury department under the administration of
president Richard Nixon announced that it would no longer redeem US dollars for gold in
foreign exchange transactions following the continued deterioration in its balance of
payment position and dwindling gold reserves after past attempts to devalue the dollar
failed (Encyclopaedia Britannica; Encyclopaedia of American History).
In Zambia the bullish US dollar led to an overvalued and misaligned Kwacha which in
addition to the external souring of copper and oil prices deteriorated the current account
balance. However the replacing of the US dollar peg with the Special Drawing Rights later
saw a series of devaluations in the Kwacha.
In July 1983, the fixed exchange rate regime was abandoned and replaced by the crawling
peg after the 20% devaluation of 1983 (Aron and Elbadawi, 1992; Ng’ambi, 2004).
Nonetheless the crawling peg, unlike the fixed peg, was the trade weighted average basket
of currencies for the country’s major trading partners. Under this regime, the Kwacha was
allowed to fluctuate within a narrow band to allow for adjustment unlike in the earlier
cases when no adjustment was made except for occasional devaluations (Mkenda, 2001).
In October 1985, the foreign exchange auction system was adopted in favour of the
crawling peg. Aron and Elbadawi (1992) reports that dissatisfaction with the downward
rate of adjustment and the inefficiencies of accompanying annual exchange allocation led
to the adoption of the foreign exchange auction system. Following the introduction of the
foreign exchange auction system, the Kwacha per US dollar exchange rate on 3rd October
1985, was quoted at K2.2 depreciating (127.7 percent) to K5.01 at the close of the first
week and 8.3 on 11th October 1986 a year later which marked the 53rd weekly auction In
Copyright UCT
13
the week 60 auction, conducted on November 29, the Kwacha recorded a sharp decline
closing at 15.25 representing a depreciation of 86 percent since the introduction of the
system.
On the back of these figures, the rules, regulations and operations of the auction system
had changed notably. The notable changes included the change in documentation
accompanying bids, from the 41st auction, the introduction of the Dutch auction on 2nd
August, 1986 and the three-fold increase in the amount of foreign exchange by the Bank
of Zambia (BoZ).
Looking at the trends in macroeconomic indicators presented in table 2, which reveals a
weak state of the economy at this time, it is not surprising that the Kwacha depreciated
even sharply in most time periods. The depreciation of the domestic currency after
inception of the auction system shows that the Kwacha was simply trying to discover its
true value (equilibrium value) given its demand and its scarcity in the country.
Unfortunately in towards January 1987, the foreign exchange auction system began to
collapse. The system was blamed for having caused the depreciation of the Kwacha and
that it had contributed to the already rising inflation which emanated from rising food
prices after the subsidies on maize meal were abolished. Furthermore the system was
accused perpetuating poverty by worsening the distribution of income in favour of the
minority rich at the expense of the majority poor and lastly the system was mismanaged.
The Bank of Zambia in most cases failed to honour its commitments which were in most
cases above its stock of foreign reserves, such that other market agents lost confidence on
the credibility of the auction system. As the unfilled promises rose, fears on sustainability
of the system also rose obviously resulting into adverse market reactions amongst the
participants whose effects on the stability and value of the Kwacha must have been
disastrous.
The panic must have been much stronger towards January 24, 1987 (68th week of auction)
when the system was temporarily suspended after being an issue of concern in the
December 5th, 1986 Copperbelt and Lusaka riots which were sparked by increased food
prices after maize meal subsidies were abolished as part of government austerity measure.
Copyright UCT
14
On 28th March 1987 the suspension on the system was lifted and the official trading rate
was set at K9.0. Beginning this date, six more auctions were conducted under a two-tier
auction arrangement. The first arrangement, the official window was established with a
fixed official rate of K9.0 and it was restricted to debt service, importation of essential
commodities and receipts of loans and grants, whilst the auction rate was allowed to
fluctuate between the official rate and the K15 upper ceiling only.
The upper limit was abandoned after four weeks such that in the fifth auction, of the six
auctions conducted after the auction resumed, held on the 24th of April, saw the value of
the kwacha fall to its lowest at K21.02/US$. Therefore on 1st may, after the sixth auction
which served to allocate foreign exchange at the K15 rate was done, President Kenneth
Kaunda abolished the auction system when he announced his governments rebuff on the
IMF supported programmes in favour of the New Economic Recovery Programme dubbed
growth from own resources.
From 5th may, the government re-introduced the fixed exchange. The kwacha value was
fixed to the dollar first with the initial value at K8 and later after the dollar was replaced
by the basket of currencies of the country’s major trading partners. However the
government established a Foreign Exchange Management Committee (FEMAC) to guide
all foreign exchange allocations and issuing of import licences. FEMAC operation had a
number of restrictions on the activities agents could engage in and requests for foreign
exchange were filed through commercial banks. Under the FEMAC, exporters of non
traditional commodities were allowed to retain fifty percent of their earnings with free
trade of title to this retained earnings occurring at a premium on the official rate but
required approval from FEMAC. Imports were only permitted if considered essential and
not produced locally or as long as they won’t out-compete local production.
In February, 1990 the FEMAC introduced a dual currency pricing and allocation
mechanism as the two concurrent devaluations of the Kwacha in June and December1989
to K16 and K24 per US dollar respectively. Under the first window, the initial official rate
of K27.8 fixed for Bank of Zambia to sell, under existing FEMAC guidelines of imports,
foreign exchange for imports while simultaneously using it to all the foreign currency
earned by ZCCM. Opposed to the official window, the open general licence (OGL)
window attracted a market rate of K40 per US dollar.
Copyright UCT
15
After the 1991 elections, the foreign exchange market was liberalised with most controls
abolished. This caused the exchange rate to depreciate rapidly. During this liberalisation
period, the retention rate of export proceeds was increased from the previous 50 percent to
100 percent with the government adopting a negative list of imports under the open
general licence window, opposed to the more detailed one under FEMAC. In 1992, the
bureau de change system was authorised while the exchange rate system was unified with
the official rate now determined by the weighted average bureau de change rate. In
December the following year, the foreign exchange auction system was re-established at
Bank of Zambia. By 1994 the currency was fully convertible after most foreign exchange
controls on the current account had been abolished following the suspension of the
Exchange Control Act of 1965. Further attempts to strengthen the foreign exchange
market in this year saw commercial banks being allowed to establish foreign currency
accounts which could even be held on behalf of the non bank public. Increased market
ability to handle foreign exchange made the authorities to abolish the OGL window. After
the abolishment of the OGL window, currency auctions increased from three times a week
to daily although ZCCM continued to be the major supplier of foreign currency dealing as
the non traditional sector was still small.
In 1996, ZCCM was allowed to retain 100% of its earnings when authorities resolved that
the supply of currency in the market emanating outside BoZ official intervention, was
imperative in creating a vibrant market. At this stage, Caroline (2004) reports that at this
stage the BoZ official buying and selling rate were de-linked from the weighted average
dealing rate and linked to commercial banks daily weighted average rates.
After most mines under ZCCM were privatized, monopolistic pricing of foreign currency
in the market emerged after it became evident that new mine owners began dealing with
only a selected faction of commercial banks which consisted of big banks, as they are
usually perceived to be more secured and can finance required mine financial capital. This
led to huge depreciation of the Kwacha the coupled with rising dollarisation in economy, a
situation where business houses illegally price goods and services in US dollars
demanding payment at a predetermined rate (Ng’ambi, 2004). In addition, with low
intermediation process in the market, the foreign currency holding at commercial banks
increased. Figure 1 below shows the exchange rate from 1995 to 2004.
Copyright UCT
Figure 1
QUARTELY FLACTUATION IN THE NOMINAL ZMK/US$ SPOT EXCHANGE RATE: 1995-2005
0
1000
2000
3000
4000
5000
6000
PERIOD (QUARTER ENDING)
ZMK
/US$
Figure 1 show that the kwacha generally depreciated although towards the end of 2003 the
rate of depreciation became low with the currency gaining value from quarter ending
March 2005. Observation on the behaviour of the rate after 2002, show that tight fiscal
conditions under the Highly Indebted Poor Country initiative (HIPC) and subsequent
introduction of the broad based Interbank Foreign Exchange system (IFEM) were key in
stabilising the exchange rate.
The IFEM system was launched on the 23 July 2003 after BoZ abolished the earlier
measures government had instituted to curb speculation in the market and stabilise the
exchange rate in January 2001. In 2001 the government directed all foreign firms to retain
at least 75 percent of their foreign currency earnings within Zambia and only repatriate the
25 percent. In addition BoZ the ruled that suppliers trading at least US$100, 000 per week
should transact through its dealing window. Nonetheless the measure failed to curb
further depreciation of the Kwacha as evidenced by the 20.0 percentage point depreciation
of the kwacha barely six months after the measures were enacted.
16
Copyright UCT
17
With the rationale to foster a transparent and efficient exchange market, the IFEM was
established to enhance availability of liquidity in the market and improve the flow of
information among participants. The major notable difference in the IFEM is that the
market agents are categorically, based on some criteria, classified either as primary dealers
or market makers.
Primary dealers, mainly commercial banks, do quote two- way prices all the time without
disclosing which side of the market they wish to deal thereby transmitting symmetric
information to the market which in the process generates competition. They are ever
present in the market and affirmatively deal on the prices they quote. The Bank of Zambia
deals based on the lowest bid in the market and highest ask such which makes its role
passive in the market without undermining its critical role as the regulator. Therefore the
exchange rate regime in Zambia remains a managed float, opposed to the extreme fixed
and free floating exchange rate regimes.
4. LITERATURE REVIEW ON EXCHANGE RATE DETERMINATION
Developed theory on exchange rate determination stands in two distinct categories, at
least; Traditional and Modern exchange rate theory (Susmel, 1998). The notable difference
is that most part of modern theory view exchange rates from a purely financial
phenomenon. Modern theory, first developed in the late 1960s, does explain much on the
short run volatility of exchange rates and their tendency to overshoot their long run
equilibrium level, as observed over the past two and half decades in the Dornbursh (1976)
exchange rate overshooting model . However it must be born in mind that prediction of
theory may differ depending on whether exchange rate regime under consideration is
fixed, free floating or managed float. Nonetheless space in most models allows for
modification of prediction to reflect ruling exchange rate regime.
This section presents the theoretical models of exchange rate determination although much
focus is on modern thought which is more useful in understanding exchange rate
behaviour today. Nonetheless pertinent issues from the traditional models are emphasised
and noted especially in the long run.
Copyright UCT
4.1 TRADITIONAL OR TRADE APPROACH
The traditional exchange rate determination model is based on the trade flows and the
speed of adjustment depends on how responsive imports and exports are to exchange rate
movements hence traditional model can also be called the trade or elasticity approach
(Salvatore, 2004). This approach treats international private flows as passive responses to
compensate for temporary trade imbalances. Changes in the exchange rate according to
traditional models occur as a result of policies aimed at restoring the BOP equilibrium.
Beginning from a Balance of Payment (BOP) equilibrium position we know that;
0=++++= SDORFAKACABOP 1
Where CA is the current account, KA is the capital account, FA is the Financial, OR the
official Reserve account and SD the usual statistical discrepancy.
Under the flexible exchange rate regime, as long as equation one does not balance
inevitably the exchange rate will move to correct the imbalance. The traditional model
therefore seek to show how exchange rates will move as the nation tries to correct for a
trade imbalance. As mentioned earlier, the model implores the trade flow approach. Let’s
consider a simplified trade balance expression;
( )tfd ryyfMXTB ,,=−= 2
For showing the domestic income, foreign income and the real exchange rate
(ratio of domestic to foreign prices)
dy fy tr
The implication of equation two is that we expect the nominal exchange rate to change as
long as any underlying factor in the TB equation varies. A priori, a rise in domestic prices
and income will create a rise in imports over exports and vice-versa. In effect the
exchange should depreciate, or in its absence, measures to devalue must be instituted to
ensure a balanced position is restored. But to fully understand this model we need to
estimate trade elasticities (price and income). In his International economics text,
Salvatore (2004: 560) while citing empirical studies by Harberger (1957), Houthaker and
Magee(1969), Goldstein and Khan(1985), Marquez (1990) to mention a few, reports that
real world trade elasticities are likely to be much smaller in the short run than in the long
18
Copyright UCT
run. Therefore much of the prediction from the elasticity approach may not hold in the
short run period. This problem is aggravated by the famous J-curve argument, which
postulates that when the domestic currency values depreciates, the trade balance can
actually deteriorate before improving overtime due to the tendency of domestic currency
price of imports to rise faster than export prices after a depreciation or devaluation.
Another way to look at exchange rate behaviour in a traditional way is to use the
absorption method. Introduced by Alexander in 1952, the absorption approach begins with
the income equilibrium condition;
( )MXTGICY −+−++= 3
Where is consumption, C I is investment, G is government spending andT national
taxes. By definition absorption, A = GIC ++
The intuition behind the absorption approach is total domestic spending does not
determine domestic output but spending on domestic goods determines domestic output.
The proportion of domestic spending not spent on domestic output is spent on imports
instead. Therefore the trade balance in here in defined as the difference between output
and domestic absorption (Susmel, 1998).
.
Rearranging equation 3 and introducing the after-tax private savings we obtain;
({ TGISMXTB − )}+−=−= 4
The implication of this model is that it highlights important factors from the actions of
government, independent of the central banks intervention, which can be manipulated to
correct for a trade imbalance whose movements inevitably affect the exchange rate
Traditional approach has over the years failed to explain why some nations with trade
balance deficits have experienced appreciating currencies just like why some trade surplus
nations have seen depreciating currencies. The explanation seem to be the fact that
international private capital flows are much larger than trade flows today such that
exchange rates reflect mostly financial rather than trade flows especially in the short run.
This in fact is the premise upon which modern theory is founded (Salvatore, 2004: 501)
19
Copyright UCT
4.2 MODERN APPROACH AND THEORY
Rather than considering trade flows, modern theory views exchange rates and the balance
of payments as a financial phenomenon. At the core of this approach, is the Purchasing
Power Parity (PPP) theory, as introduced by the Swedish economist Gustav Cassel. In its
absolute form, the PPP postulates that the equilibrium spot exchange rate between two
currencies is equal to the price ratios in the two nations. However given the many
weaknesses of the absolute PPP the much flexible and much useful version is the relative
PPP. According to the relative PPP theory the change in the spot exchange rate over a
period of time should be proportional to the relative change in the prices levels of the two
nations over the same period.
4.2.1 THE MONETARY APPROACH
To show how monetary approach is developed to determine exchange rates, the starting
point is to model the money market. From the famous Irving Fischer (1911) Quantity
theory of money, as commonly modified to exclude double counting, if we let and
be the nominal amounts of money demanded in the domestic and foreign nation
respectively, then;
dM
*dM
kPYM d = and 5 **** YPkM d =
Where is the desired ratio of nominal money balances to nominal national income, k P
is the price level and Y is the real output is both nations respectively.
If we assume equilibrium in the money market, such that = , where is money
supply, substituting for is equation 5 as well as dividing by and then
solving for the domestic-foreign price ratio, we obtain;
dM sM sM
sM dM sM *sM
kYMYkM
PP
S
S*
**
* = 6
20
Copyright UCT
By definition from the PPP theory, *PP is the spot nominal exchange rate quoted as the
number of domestic currency units per unit of foreign currency as long as the PPP holds
continuously.
Equation 6 can be rewritten to reflect growth rates in the underlying variables by assuming
that money velocity does not significantly change in the short run as;
( ) ( )TTTSTSTt YYMMS −+−=+**
, , 7
Equation 7 shows that movements (rise or decline) in the nominal spot exchange over a
given period is equivalent to the sum of relative growth in money supply, a variable
mostly influenced by central banks, and relative growth in the two nations income over the
same period. Therefore fluctuation of the currency can also be explained by the relative
action of central banks involved and the relative growth in incomes between the two
nations.
The monetary model is usually extended to incorporate the effects of future expectations
on exchange rate movement through the interest rate differential, which is the difference
between the home and foreign nation yield rates on bonds (Salvatore, 2004:521).
Exchange rate expectations in this model are viewed from the uncovered interest arbitrage
theory since monetarists perceive foreign and domestic bonds as perfect substitutes hence
additional risk of a foreign bond is ignored. According to the uncovered interest arbitrage
theory, when capital is perfectly mobile between nations, interest rates will always be
equal between them in the long run.
If, instead, yield rates are higher in one nation, investors of the second nation will find it
profitable to invest in the first nation. The implication is that increased demand for the first
nations bonds will raise their prices (a reduction in yield), whilst a reduction in demand for
the second nation’s bonds will reduce their price (a rise in their yield). The arbitrage
process will continue until interest parity is achieved. The buying of foreign bonds where
yield rates are high will cause the currency of the foreign nation to appreciate relative to
the domestic currency hence contributing to the reduction on expected returns. Therefore
the percentage difference in interest rates between nations indicates the percentage change
expected in the currency in the current period.
21
Copyright UCT
22
4.2.2 THE PORTFOLIO BALANCE APPROACH
The portfolio balance approach is a more realistic application of the monetary approach
discussed earlier (Salvatore, 2004). This model treats exchange rates like any other
speculative price. It begins by arguing that money is just one asset in which individuals
and firms hold their wealth. The other assets are domestic and foreign bonds. Unlike the
monetary model, it assumes that foreign and domestic bonds are imperfect substitutes such
that holding a foreign bond comes with additional risk. Portfolio balancing depends on the
returns of each asset.
Holding domestic money is risk free but its cost is the forgone returns if that money was
invested into a bond. A domestic bond has a default risk but in addition to default risk, a
foreign bond face other risks like ban on capital flight, freeze on foreign capital as a result
of political and civil strife to mention a few. However foreign bonds are desirable because
they help diversify country specific risk that is losses on domestic returns may be
compensated by gains in foreign yields.
At any given time, an individual or a firm will hold a portfolio which maximizes his utility
given his preferences, wealth, yields on both domestic and foreign bonds, future value of
foreign currency, relative inflation rate, level of risk aversion and his income.
Equilibrium in assets is attained when its supply is equal to demand. However a change in
any of the underlying factors of any asset will cause the equilibrium level to change. This
is where the exchange rate is now determined. Let us consider an instance where yield
rates on the foreign bond declines. Investors will balance their portfolios by reallocation
their wealth from foreign bonds to domestic bonds keeping money balances constant.
In the foreign exchange markets, investors will be selling the foreign currency and buying
the domestic currency such that the domestic currency will appreciate relative to the
foreign currency. No wonder the model argues that exchange rates are determined in the
process of individuals and firms to balance there portfolios through asset reallocation
hence it is also called the Asset Model.
The interest differential is now equal to the expected appreciation less the risk premium
since foreign bonds are now considered to have additional risks over domestic ones.
Copyright UCT
23
In summary determining exchange rate is rather complex. Various factors act quite
simultaneously and isolating them can sometimes be difficult. However it is generally
agreed that exchange rates today depends so much about the expected future movements
of the rate given all available information. However unevenness in information amongst
market agents has surely created unanticipated movements in the exchange rate making
them more random and difficult to predict with high confidence.
4.3 EMPRICAL EVIDENCE: AN OVERVIEW
Since 1976 after Frenkel published his influential paper which tested the validity of the
monetary model in explaining the German exchange rate during its hyperinflation period
of the 1920’s and which subsequently provided strong evidence favouring the model,
various studies have been conducted overtime to test the exchange rate determination
models although exchange rate volatility still remains a thorny issue to all economies
today.
Studies on exchange rate determination have evolved to estimate or fit models not only to
past data, also called the in-sample estimation, but also to predict the future exchange rate
values also known as out-of-sample estimation.
In their controversial paper, published in the journal of international economics, Meese
and Rogoff (1983) argued that monetary and traditional models failed to forecast exchange
rates well. However researchers like Mark (1994) argued that Meese and Rogoff
mispecified the models during estimation, mainly because they did not consider the effects
of change in economic policy and foreign exchange market arrangements which mostly
differ between countries. Furthermore baskets used to compute the overall price indices as
well as the existence of transaction costs across nations have affected the PPP as well as
exchange rates too. Actually Dornbusch(1987) and Levich(1985) provided evidence that
the PPP had collapsed in the latter part of the 1970s and much of 1980s.
However ten years after the Meese and Rogoff (1983) paper was published, McDonald
and Taylor (1993) examined the Deutsche-Mark to US dollar exchange rate by employing
the monetary model and ruling out price-stickiness effects between 1976 and 1990. They
found evidence that their exists a long run equilibrium between monetary variables and the
exchange rate after it co-integrated with relative money supply, relative income and
relative interest rates using the Johansen(1988) multivariate co-integration method.
Copyright UCT
24
In 1999, when China had just started recording all time high economic growth rates, Wei
Weixian (1999), compared the absorption, the elasticity and the monetary models when he
empirically studied the foreign trade balance in China. His results showed that the trade
balance failed to co-integrate with the exchange rate hence he argued in favour of the
elasticity approach. Furthermore his study reported that a J-curve existed in China and that
devaluations have had significant impact on the trade balance.
With increased variations in the findings from empirical studies, rather than essentially
accepting or rejecting the importance of one variable over the other, emerging new
evidence from research on exchange rate determination, for much of the period beginning
1990, has now concentrated much on methodological issues like the econometric
specification and estimation of the models. For example McDonald et al (2003) reviewed
several non-stationary panel methods which have become popular in the nominal
exchange rate studies today. They included the Kao and Chen (1995) Ordinary Least
Squares (OLS) method, Chiang (2000) dynamic OLS method and Pedroni (2001) fully
modified OLS. Since exchange rates are driven by factors between two nations, at least,
panel data methods do capture not only time series but also cross-sectional properties of
the data which is inevitably lost from ‘pure’ time series models like the vector error
correction and the Johansen method for example.
Nonetheless McDonald et al (2003) provided evidence that augmented monetary model
provided a good description of the exchange rate in a panel of six transition countries
namely the Czech Republic, Hungary, Poland ,Romania, Slovakia and Slovenia.
At the country level unfortunately empirical work on the nominal exchange rate is scanty
and if any, unpublished. Much of the published empirical work on exchange rates in
Zambia is on the Real exchange rates. Empirical evidence on the Real exchange rate in
Zambia can be obtained from the works of Kalinda (1996), Mungule (2000) and Simatele,
(2004).
At the regional level, the work done by Zita and Gupta (2007), modelling and forecasting
the Metical- Rand exchange rate, was reviewed. This paper was insightful because it was
based on the Dornbursch (1976) sticky-price monetary model. Findings from this study
showed that the Metical-Rand exchange rate is best explained by changes in GDP and
Inflation rather than the interest rate differential which was found to have a negligible role.
Copyright UCT
25
Results in this study were obtained by modelling 48 quarterly data points covering the
period 1994 first quarter to 2005 last quarter using the Bayesian Vector Error Correction
Model (BVEC) with a follow-up Johansen method. However during forecasting (out-of-
sample estimation) the vector autoregressive method was introduced and its outcomes
were compared to those obtained under the BVEC.
5. METHODOLOGY AND DEFINITON OF VARIABLES
From the reviewed pieces of research work as presented in the literature review, studying
factors which determine the nominal exchange rate can be seen to have become more
sophisticated such that difficulty in improving the existing methodology and estimation is
inevitable. Exchange rate modelling demands good statistical strength in both time series
and cross sectional data estimation on the part of the Researcher. However from a strict
business manager perspective, the value addition for such level of statistical demand can
be questioned although for an economist or policy maker in the central bank value
addition is obvious.
As such it’s not the preoccupation of this paper to either improve on the existing
econometric modelling methods or employ the existing sophisticated multivariate
estimation methods. Instead this paper just aimed to explore, using simple ratio analysis,
the one-to-one relationship that exists between carefully selected variables as guided by
theory presented in the literature review as well as the easy of data availability. Therefore
the major question addressed in this paper is does the value of the Kwacha appreciate or
depreciate with a given change in a given underlying variable. If yes, is the direction of
change consistent with the prediction of economic theory? As such the question of how
much amount of appreciation or depreciation did occur was beyond the scope of this
study.
In order to study the factors which underlie the movement of the exchange rate, this study
used annual data from 1999 to 2004. Nine independent variables were selected based on
their relative theoretical significance as guided by literature with the nominal Kwacha per
US dollar spot rate as the dependent variable.
The independent variables chosen were as follows;
1. Yield on the 91 day maturity treasury bill, in percentages.
2. London metal exchange copper prices, in US dollars per pound.
Copyright UCT
26
3. Current account balance(C/Acc bal), in million US dollars.
4. The financial (F/Acc bal) balance, in million US dollars.
5. The overall balance of payments figure, in millions US dollars.
6. Net change in international reserves, in millions US dollars
7. Debt relief, in millions US dollars
8. Broad money (M2) in billion Kwacha
9. Total gross domestic product in billions of Kwacha
The nominal Kwacha US dollar spot exchange rate was used because its data was readily
available. Broad money used was M2, which is the sum of currency in circulation, demand
and checkable deposits held by non bank public and time and savings deposits that are
readily issued for money.
The study used annual data because, although monthly data on exchange rate and the
91day treasury bill were available, monthly data on the variables in the balance of
payments proved a challenge. The data used in this study was sourced from the
international monetary fund statistical appendices for Zambia, which is a data pool
reflecting the estimated figures by Fund, Bank of Zambia, Central statistical office and
Ministry of Finance and National planning
The 91 day treasury bill was included to represent the domestic instrument which investors
find desirable to hold with no risk. By implication this means the investors are assumed to
be risk averse. It was also taken to represent the interest rate differential which is cardinal
in indicating which country investors will invest in, as portfolio balance approach
suggests. A further plausible assumption made was that the interest rate differential
remained in favour of Zambia since interest rate on the similar treasury bill in the United
States hardly exceeded was five percent. Therefore we expect a rise in the yield rate to be
associated with appreciation of the Kwacha since Americans will find it more profitable to
invest in the Zambia government treasury bills.
To discover the influence the explanatory variables have on the exchange rate, the study
computed the Pearson product moment correlation coefficient using excel spreadsheet.
The Pearson product moment correlation coefficient shows the nature of a liner
relationship which exists between the explanatory and dependent through the coefficient
sign while the strength of the linear relationship observed is explained through the
absolute value of the coefficient. The Pearson correlation coefficient ranges between
negative one and positive with values close to negative one showing a high inverse linear
Copyright UCT
relationship while zero indicates the absence of the linear relationship. Approaching
positive indicates a high direct linear relationship between variables.
However this method only indicates dependence or variable association and does in no
way explain causality among variables. Therefore all variables in this study are only
explained in relation to their association with the exchange rate. There exists a possibility
that exchange rate can be the one determining some of these variables and not strictly they
determining the exchange rate. In short we can know what is associated with the exchange
rate and not what causes the exchange rate. Causality is exchange rate can be like the
chicken egg spiral paradox. The next section describes the study data visually.
6. DESCRIPTION OF THE DATA
Figure 2 below shows the behaviour of the data over the sample period when plotted on a
line chart.
Figure 2
27
ANNUAL MOVEMENTS IN SELECTED EXCHANGE RATE DETERMINANTS:1995-2004
-2000
-1000
0
1000
2000
3000
4000
5000
6000
7000
1 2 3 4 5 6 7 8 9 10
PERIOD
91 days t/bill copper price exchange rate Bop balance Reserve changeC/A balance F/A balance Debt relief Govt Budget/bal Broad money
Copyright UCT
28
From figure 2 it can be seen that over the sample period except after period 9 which
represents the year 2003, the exchange rate remained above the broad money although it’s
worth noting that units of measurements between them differed. Both broad money and
the exchange rate remained positive throughout the sample period together with the debt
relief and financial (F/A) account balance factor although movements of the later are seen
to be closer to the horizontal axis when compared to the former. The current account
(C/A) balance, the overall BOP balance and the government budget balance remained
below zero throughout the sample period whereas change in international reserves
although predominantly negative after period five at least showed some positive values in
period 1, 3 and 4. Interpretation of international reserves, unlike other factors, a negative
coefficient implies the nation increased it net holdings of reserves such that bigger
negative values translates into increased ability of the nation to defend its currency from
undesired fluctuations.
Over the sample period the price of copper fell significantly from the higher US$1.19 per
pound in period 1 to a low US$0.7 per pound price in period 5 and 9 before closing at
US$1.2 per pound in period 9.
Although a strong visual tool, figure 2 does not explain any meaningful relationship
between the independent variables and the dependent variable. Meaningful results on the
nature of the relationship between the dependent variable and the independent variable
was obtained by computing the Pearson product moment correlation coefficient using
excel spreadsheets. Results from the Pearson product moment correlation method are
presented in the next section.
7. DATA ANALYSIS AND DISCUSSION OF FINDINGS
Results from excel spreadsheets on the nature and strength of the relationships between the
independent and dependent variable are presented in Table 3 below.
Table 3; Findings of the Study
DETERMINANT MEAN STDEV1 PEARSON R2
DEP(EXCH) COUNT3
Yield on 91days t/bill (%) 33.9 14.6 -0.50 10.0
Copper price (US$/pound) 0.9 0.2 -0.18 10.0
Copyright UCT
29
Exchange rate (ZMK/US$) 2818.6 1497.5 Nil 10.0
BOP balance (Million
US$)
-293.6 117.7 -0.49 10.0
Reserve change (Million
US$)
-44.0 135.5 -0.65 10.0
C/Acc balance (Million
US$)
-578.2 107.7 -0.72 10.0
F/Acc balance (Million
US$)
302.5 129.8 0.20 10.0
Debt relief (Million US$) 281.4 145.8 0.61 10.0
Govt Budget/bal (Billion
K’)
-589.7 427.1 -0.79 10.0
Broad money (Billion K’) 2384.8 1785.8 0.96 10.0
Total GDP (Billion K’) 11144.0 7679.7 0.95 10.0
Notes: 1= standard deviation, 2= Pearson correlation coefficients with exchange rate as
dependent variable, 3= total data points used in the analysis
Results from table 3 are indicative rather than a conclusive on the influence explanatory
variables exert on the movement of the exchange rate. The yield on the 91 days to
maturity Treasury bill carried a correct sign as expected from theory even after making the
assumption that its representative of the interest rate differential. As noted earlier the
qualifying argument that yields on the similar debt instrument in the United States over the
sample had remained low was feasible. The negative sign on the Pearson coefficient
shows that when the yield on the Treasury note is declining the exchange rate values are
rising implying local currency depreciation.
This relationship is explained by 50 percent variation in the yield rate. Therefore we can
argue that as the yield rate falls, investors substitute holding of the US dollar for 91 day
Treasury bill. Hence increased demand for the US dollar against a rise in the supply of the
Kwacha arising from their discarding the 91 day Treasury bills leads to the depreciation of
the Kwacha. Over the sample period the average yield rate was 33.9 percent with a
standard deviation of 14.6 against the average exchange rate of 2818.6 Kwacha per US
dollar with a standard deviation of 1497.5. Data points included in this analysis had a total
count of 10.
Copyright UCT
30
Similarly rising copper prices can be seen to have led to declining exchange rate values
implying that as copper prices rose on the London metal exchange, the exchange rate
tended to appreciate. However the strength of this relationship looks to be quite low
considering the coefficient value of 0.18. Nonetheless the sign on the coefficient value is
correct as theory predicts. Therefore we can argue that although rising copper prices lead
to Kwacha appreciation we expect stronger relationship from the total copper revenue
because copper prices can be increasing while production lags behind.
The overall balance of the BOP, as defined earlier in the literature review, carried a correct
negative sign with a 49 percent variation in exchange rate movement being explained by
variation in the overall BOP balance. This is undoubted given the fact that every time
inflows rise more than outflows in a nation’s transaction with the rest of the world, the
balance of payments improves hence the appreciation of the domestic currency. Although
the overall balance remained negative throughout the sample period, periods of its
improvement did coincide with reductions in the exchange rate values implying that the
Kwacha appreciated. The opposite should hold when the overall balance deteriorates.
Another interesting variable in the model is the change in net international reserves.
Countries do hold international reserves as a strategic buff stock which they can draw
upon either to defend their currency from undesired movements or which they can utilize
in the event of a serious shock like unanticipated rise in oil price or import of food in the
event of a drought. A negative value indicates that international reserves increased over
the period under consideration whereas a positive figure shows that international reserves
declined. The average net change in international reserves in the sample period was US$-
44.0 million indicating that on average, Zambia’s reserves rose by US$44 million with a
standard deviation of 135.5.
Its relationship with nominal spot exchange rate under the Pearson product moment
coefficient shows that rising net reserves are associated with rising exchange rate values or
Kwacha depreciation. At first thought this result looks absurd. But systematic thought to it
reveals that if the nation, through the central bank has to build strategic international
reserves in US dollars, this can be achieved by the central bank (Bank of Zambia)
withholding some dollars thereby inducing a relative shortage of the dollar in the market
hence the appreciation of the US dollar and depreciation of the Kwacha.
Copyright UCT
31
Furthermore, the sustained negative overall BOP balance, which is a sum of above the line
elements in the BOP accounting, means that the below the line element, which is the
change in reserves, must always be positive if payments have to balance (sum to zero).
Logically to obtain a zero sum as required from the accounting identity, the change in
international reserves should have been positive implying that the central bank was dis-
saving official reserves to fund the deficit in the above the line items. But evidence from
this study showed that instead the change in reserve account increased by an average
US$44 million. Hence this explains only way equilibrium would have been reached was
through the depreciation in the Kwacha.
The Pearson correlation coefficient sign on the current account (C/Acc) balance shows
that the exchange rate appreciated when the current account balance improved. However
improvement in the current account is known to be highly associated to domestic currency
depreciation. This is because depreciating exchange rate improves the external
competitiveness of exports whereas imports became expensive. But this is true only when
the dependant variable is the current account. Therefore the result provided above can be
viewed to reflect the scenario where the Kwacha appreciates through increased net inflows
in the current account. With the correlation coefficient of 0.72, certainly the observed
relationship is robust. Descriptive statistics on the current account balance over the study
period show the mean value of –US$578.2 million with a standard deviation of 107.7.
The financial (F/Acc) account balance over the study period had an average value of
US$302.5 million with the standard deviation of 129.8. The correlation coefficient
however carried a positive sign implying that increased net financial inflows were
associated with rising exchange rate values (Kwacha depreciation). Although the financial
account was positive throughout the sample period as expected from the balance of
payments accounting identity given a sustained current account deficit, the positive sign
on the correlation coefficient is absurd and demands an explanation when compared with
established theory on the balance of payments.
The positive sign can be interpreted to mean that the nation either dis-saved with the rest
of the world and or borrowed externally to finance the deficit in the current account. As
such the dollar earning from this source most likely was not supplied to the market or if it
did, it must have only helped the Kwacha not to undergo a huge depreciation than what
was observed. This is possible because Zambia uses a dirty float exchange rate regime
which entails that the central bank does intervene to smoothen out undesirable currency
Copyright UCT
32
movements using the official foreign reserve account. Therefore we can argue that,
although positive net financial inflows over the sample period were recorded, certainly
they either must have only helped reduced excessive Kwacha depreciation or were taken
into the strategic international reserve account which recorded an average net change of
US$44 million. Governments through central banks build strategic reserves which they
can draw upon in time calamities like a drought to import food, fuel in times of
unprecedented shortages and/or defend there currency from excessive depreciation.
Like the financial account balance, increased relief on debt, instead of being positively
related to appreciation in the Kwacha as expected, was rather found to be positively
related to Kwacha depreciation. This too looks absurd since we expect increased debt
relief, through an improvement in the supply of US dollar to the local economy, should
influence the Kwacha to appreciate. However the similar argument as in the financial
account holds that inflows from this source may have been inadequate to influence the
appreciation in the local economy although they must have had reduced depreciation
margins of the Kwacha. Similarly it can be argued that increased financial account net
inflows must have been channeled to increase net international reserves which over the
sample period rose quite significantly recording an average increase of US$ 44 million.
Therefore this study concluded that the positive correlation sign meant that savings from
debt relief were used to mitigate would be excessive depreciation in the Kwacha had the
exchange rate been a free floating system. Such would be excessive variations in the
domestic currency value is the most common reason advanced as to why governments
must always regulate and intervene in exchange rate markets
Like established in the literature review, the budget balance of the government plays a
critical role in the determination of the exchange rate of any given economy. Regardless of
its ever being below zero in the sample period, it was found to be negatively related to the
exchange rate implying that reduction in the deficit coincided with appreciation of the
Kwacha. This supports the evidence that reduction in government budget deficit entails
reduced government consumption on foreign goods and services at least thereby leading to
decline in the relative demand of the foreign currency against supply thereby causing the
foreign currency to depreciate whereas the domestic currency appreciates. As can be seen
from the correlation coefficient, variation in this variable explained about 79 percent
variation in exchange rate movement showing that the relationship was strong.
Copyright UCT
33
Alternatively the influence of the reduction in government budget deficit can be seen from
equation 4. In equation 4, it can be seen that a reduction in G-T, for a given level of S and
I, the right hand side of the equation will approach S-I when G-T approaches zero. By
implication the result can be interpreted as an improvement in the current account which
as shown in the model was found to be related to appreciation of the Kwacha.
Of further importance is the role of broad money growth on the exchange rate. Increased
broad money in the economy means that economic agents will increase their volume of
transactions since the medium of exchange has risen. This is consistent with the findings
of this study. The positive linear relationship between broad money growth and exchange
rate depreciation, with 95 percent variation in the exchange rate being explained by the
changes in broad money can be explained in two ways as by applying the motives why
people demand money. Firstly from the transaction money demand motive, increased
broad money meant most Zambians increased their buying of goods and services mainly
from abroad such that more kwacha was supplied in the foreign exchange market against a
simultaneous rise in the demand for US dollar which was used to finance imports. The
second argument from the speculative motive for holding money, implies that when broad
money increases, the marginal utility of holding Kwacha balances by economic agents
reduces such that the rebalance there portfolio through converting the additional Kwacha
into US dollars either for speculative motive or further investment in the foreign countries.
In fact the evolution of exchange rate movements in Zambia as depicted in figure 1 seems
favorable to speculators. From the Pearson coefficient, as well as figure 2, it can be seen
that continuous growth in broad money is related to rising domestic currency figures or
depreciation of the Kwacha with about 95 percent variation in the dependent variable
being explained by the changing broad money.
Finally in the variable list is the influence total gross domestic product (GDP), which was
taken at market prices, exert on the exchange rate. With a good correlation coefficient at
95 percent, the rise in gross domestic product was related to rising values of the Kwacha.
This depreciation is expected from theory since rising incomes amongst individuals will
normally lead to higher consumption of imported goods especially that Zambia’s
manufacturing industry is still in infancy stage. The buying of the US dollar using the
Kwacha leads to more kwacha than the US dollar hence the depreciation of the kwacha.
Lastly in this section it should be emphasised that although the major aim was to study the
influence of some selected notable theoretical factors on the exchange rate, results above
Copyright UCT
34
are not conclusive because amongst the variables themselves there exists reverse
dependence and causation may not strictly exist. However valuable information necessary
for policy can be sourced and need be studied further. The section below highlights a
number of policy implications from the findings of the study together with the conclusion
of the study.
8. CONCLUSION AND POLICY RECOMMENDATIONS
The study aimed at examining which factors influence the exchange rate and establish how
the exchange rate is affected and in which direction the Kwacha goes. To achieve its
objective, the study began by reviewing briefly selected changes in the macroeconomic
environment of the country since independence. It showed that since independence in
1964, the exchange rate regime has significantly evolved. Beginning with episodes of
fixed exchange rate systems, the country now uses the dirty floating system. The study
also explained that deterioration in the economy begun with the declining copper prices
and the oil price shock of the early 1970s.
Various attempts made by the earlier governments to save the economy, including
currency devaluations and exchange controls, failed. Therefore by 1991, with the help of
the International Monetary Fund and the World Bank, the newly formed government
liberalised most aspects of the economy such as exchange rate market, decontrol of prices
and many others. This brought new developments in the exchange rate policy with the role
of the private sector becoming more pivotal in the determination of the exchange rate.
The study showed that most aspects of exchange rate theory do significantly explain
exchange rate movement in Zambia except for the financial account balance and the debt
relief. However it should be understood that, Zambia, as a small and open economy is
prone to adverse external and internal shocks such that it can at times behave contrary to
what established theory predicts.
Furthermore the study emphasised that its results were indicative rather than conclusive.
This arose from the fact that the correlation method used was not a very robust method.
Finally the study through its findings, the study recommends that the Zambian government
should endeavour to pursue policies that will help the manufacturing sector grow. It was
observed that, although rising incomes lead to increased consumer expenditure, a bigger
Copyright UCT
35
proportion of increased income is spent on imports which have an implication on the
stability of the local currency value. Although it’s true that Zambia cannot produce
everything by itself as comparative advantage theory predicts, surely the country can
produce competitively some of the consumer goods that are currently imported given the
right deliberate government institutional policy.
Lastly the Bank of Zambia should continue to regulate the market although its actions
must be credible and transparent. The credibility of the Central bank cannot be
overemphasised. As figure 1 showed, the generally depreciation in the kwacha was
perpetuated by the reduced confidence the public had for the central bank. As a result
unfounded fears amongst market participants generated speculative behaviour such that
banks started to withhold the US dollar for no apparent reason (Ng’ambi, 2004).
Copyright UCT
36
BIBLIOGRAPHY
Ng’ambi, C. (2004), “The Changing Landscape of the Foreign Exchange Market in Zambia Over the Last Forty Years and the Challenges for the Future,” A paper Presented at the Bank of Zambia 40th Anniversary Commemoration Conference: Lusaka, Zambia. Aran, J. and Elbadawi, I. (1992), “Parrallel Markets, the Foreign Exchange Rate and Exchange rate Unification in Zambia,” Working Paper, WPs 909, World Bank. Bank of Zambia, Annual Reports, Various, Lusaka, Zambia. Bigsten, A. and Kayizzi – Mugerwa, S. (2000), “The Political Economy of Policy Failure in Zambia,” Working Papers in Economics, No. 23, Department of Economics, Gothenburg University. Babula, A and Oticer – Robe, I. (2002), “The Evolution of Exchange rate regime since 1990 Evidence from De facto Policies,” Internal Monetary Fund Work Paper, WP/02/155. Mkenda, B. (2001), “Long run and Short run Determinants of Real Exchange Rate in Zambia,” Working Papers in Economics, No. 40, Department of Economics, Gothenburg University. Hall, Brand Taylor, J. (1991), Macroeconomics, New York: W.W. Norton and Company. Meese, R. and Rogoff, K. (1983), “Empirical Exchange Rate Models of the Seventies: Do they fit out of sample?” Journal of International Economics, No. 14, PP. 3-24. Susmel, R. (1998), “Structural Models of Exchange Rate Determination,” URL:http://www.bauer.uh.edu/rsusmel/7386/in4.pdf, pp1-15 (accessed on the 21/11/2006). Ministry of Finance and National Planning, (2006), Macroeconomic Indicators, Modeling and Database Unit, Lusaka Zambia. International Monetary Fund. (2004), “Zambia: Selected Issues and Statistical Appendix,” IMF Country Report, No 04/160 :Washington DC. International Monetary Fund. (2006), “Zambia: Selected Issues and Statistical Appendix,” IMF Country Report, No. 06/118:Washington DC. Allsopp, C., Joshi, V., and Mistry, P. (1989), “Zambia: Exchange Rate Policy,” Studies in Macroeconomic Management, SIDA: Sweeden
Cresp-Cuaresam, J., Fidrmuc, J., and MacDonald, R. (2003), “The monetary approach to
exchange rates; Panel data evidence for selected CEECs.” Focus on transition No.2 of
2003
Copyright UCT
37
Weixian, W. (1999) “An empirical study of the foreign trade balance in China” Applied
economic letters, vol.6, issue 8
MacDonald, R. and Taylor, M.P. (1993) “The monetary approach to the exchange rate”
IMF staff papers No.40
Zita, S. and Gupta, R. (2007) “Modelling and forecasting the Metical-Rand exchange rate”
A University of Pretoria working paper 2007-02
Dornbusch, R. (1976) “The theory of flexible exchange rate regimes and macro-economic
policy” Scandinavian journal of economics Vol.78 No.2
Frenkel, J. (1976) “A monetary approach to the exchange rate: Doctrine aspects and
empirical evidence” Scandinavian journal of economics Vol.78 No.2
Encyclopaedia of American History, “International Gold standard”
www.answers.com/topic/gold-standard (accessed on 20/04/2007)
Encyclopaedia Britannica, “International Gold standard” www.answers.com/topic/gold-
standard (accessed on 20/04/2007)
Salvatore, D. (2004) International Economics, Danvers: John Wiley & Sons inc
Appendix I. Data the study used year 91 days
t/bill copper price
exchange rate
Bop balance
Reserve change
C/A balance
F/A balance
Debt relief
Govt Budget/bal
Broad money
Total GDP
1995 41.5 1.19 873.28 -252 40 -463 43 37 -104 541 3,005 1996 60 0.86 1207.48 -103 -31 -525 296 310 -212 727 3,950 1997 20.3 1 1314.58 -195 49 -471 412 159 -212 901 5,140 1998 33.4 0.72 1861.83 -453 246 -579 285 122 -485 1105 6,028 1999 36.2 0.7 2,387.60 -156 -35 -429 452 443 -298 1428 7,478 2000 34.1 0.82 3,110.80 -420 -155 -622 202 217 -708 2486 10,072 2001 50.5 0.77 3,610.95 -292 -124 -758 466 436 -1056 2754 13,133 2002 32.5 0.7 4,306.80 -414 -225 -652 238 437 -1031 3620 16,260 2003 13.8 0.78 4,734.00 -319 -161 -700 380 389 -1349 4468 20,3772004 16.5 1.2 4778.7 -332 -44 -583 251 264 -442 5818 25,997
Note: All units of measurement as defined in the report
Copyright UCT
Appendix II
91 day Treasury bill Yield rate
0
10
20
30
40
50
60
70
1 2 3 4 5 6 7 8 9 10
Period (1995-2004)
Perc
ent
91 days t/bill
38
Copyright UCT
Appendix III
London Metal Exchange Copper prices:1995-2004
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1 2 3 4 5 6 7 8 9 10
Period
US$
per
Pou
nd
Appendix IV
Annual movements in study variables obatined from the BOP:1995-2004
-1000
-800
-600
-400
-200
0
200
400
600
1 2 3 4 5 6 7 8 9 10
Period
US$
mill
ion(
s)
Bop balance Reserve change C/A balance F/A balance Debt relief
39
Copyright UCT
Appendix V
Study variables that were taken in Kwacha
-2000
-1000
0
1000
2000
3000
4000
5000
6000
7000
1 2 3 4 5 6 7 8 9 10
Period(1995-2004)
Bill
ions
of K
wac
ha
Govt Budget/bal Broad money
Appendix VI
Total Gross Domestic Product: 1995-2004
0
5000
10000
15000
20000
25000
30000
1 2 3 4 5 6 7 8 9 10
Period
Billi
ons
of K
wac
ha
40