The James Bond 007 Note, implications and consequences: unfiltered thoughts[1].

The RBZ has decided to introduce a bond note whose functionalities will be similar to a fully functioning currency except for the fact that it cannot be used for international settlements. The ‘piece of paper’ it seeks to introduce is purported to have the following functions of a currency: unit of account (measuring the worth of goods), medium of exchange (i.e. buying and selling goods), and store of value (its value can be retained over time .i.e. it preserves wealth). However, the central bank concedes that the bond note is not currency but has 1:1 equivalence with the US$ (a reserve currency). It’s confusing, neh?

Along with the bond note, a raft of measures instituted to tackle the liquidity problems currently bedevilling the banking sector include: limiting cash withdrawals, forcing the immediate conversion of USD deposit balances into rand and euro for exporters, restricting international settlements to the currency of the destination country, limiting the amount of cash one is allowed to carry abroad, imposing a priority list on foreign currency uses etc. However, the proposed policy measures are myopic, and are likely to have unintended devastating effects for the banking sector, and the economy as a whole.

Conceptual problems with the bond note proposition

The medium of exchange function of the bond note is questionable. The bond note is essentially useless, the mere fact that it cannot be used to settle international transactions disqualifies it as a medium of exchange in the broader sense of the word. The note can only be used for domestic transactions and has no use nor value outside Zimbabwe’s borders. Although, the central bank promises full and perfect 1:1 convertibility between the USD and the bond note, the two are not equivalent and never will be no matter how the RBZ may sugar coat it. The operational modalities and inefficiencies induced in converting the bond note into a USD balance immediately discount the value of the bond note.

Secondly, the bond note cannot qualify as a store of value as it is founded on a non-existent notion of value (a liability backed by another liability). By design the note is self-depreciating in that it is backed by foreign debt. For as long as the Afreximbank facility is open, the debt underlying the note accrues interest, and the longer interest continues to accumulate, the weaker the value of the note becomes, and the higher the amount that has to be repaid in future. This effects are worse if you are to consider that the notes are not backed by any underlying earning asset or production.[2] What the central bank is doing is the theoretical equivalent of printing money. At the time when the Afreximbank facility expires, the central bank is left facing two types of liabilities (a) The loan facility to Afreximbank plus accrued interest, and (b) upto $200 million face value bond notes with no underlying to back the bond notes[3]. In other words the central bank would have created money out of thin air, unless of course it withdraws the bond notes when the facility expires, in which case the bond notes should carry an expiry date. As to whether the bond notes will be withdrawn upon expiration, your guess is as good as mine.

Furthermore, the bond note is an implicit tax on residents in that the debt underlying the bond note will eventually have to be repaid. And like every external claim on the government, the facility will be settled by taxing residents or reducing expenditure, leading to a leakage of the much needed revenue outside the country. As such, the bond note is a future liability, and an additional burden on the tax payer who should commit work hours and forego leisure to pay the debt. What is worse is that the debt underlying the bond note is not and cannot be deployed in any medium to long term earning assets[4].

More importantly, the value of the note is contingent on: the amount spent printing the note; the extent of the drawdown on the Afreximbank facility; the agreed interest on the facility and the cost of the guarantee, the debt covenant structure, monitoring costs and the value of associated optionality elements. As such it is does not and can never have the purported 1:1 value at the point of issue since all future interest payments, costs of printing  and other implicit costs associated with using the note have to be discounted into the price of the note. Although the RBZ may temporarily provide perfect convertibility, such convertibility cannot be sustained. 

If the claim that the note will have perfect convertibility is true, then every time the note is presented and the bearer of the note demands the greenback underlying the bond note, for the purposes of settling a foreign transaction, this is equivalent to a drawdown on the Afreximbank facility i.e. Nostro balances, though with partial replacement. The drawdown is partially counterbalanced by shifting the nature of claims in the banking sector (replacing a strong claim with a series of weak claims) i.e. when locals require funds for transacting locally, they are issued with the same bond notes that would have been previously presented to the central bank for a claim on the USD in the Nostro accounts. The USD of locals is then used to fund Nostro balances, creating the illusion that the bond note system will self-sustain (at least in the short to medium term). However, what will happen is that bad money (bond notes) will chase good money (usd) out of the formal banking sector into the informal sector. Eventually, when the Afreximbank facility is terminated the bank will face challenges funding its nostro accounts but someone will be left holding a worthless piece of paper.  

Perhaps the only function that the bond not may retain is the unit of account function.

Possible challenges with functionality of the bond notes and associated proposals

What I find more worrisome is the fact that the introduction of the bond notes does not curb the causes of capital outflows and neither does it address the incentives to do so. If anything, forced adoption of the bond note is likely to result in businesses demanding more cash payments, possibly hard currency to settle transactions, and will exacerbate dissaving by households.[5] Bank deposits will be limited to transitory salary inflows and transactionary balances. All speculative and precautionary cash balances will be kept outside the banking sector with the potential to amplify liquidity challenges.

Given that memories of Zimbabwe dollar loses during the hyperinflation phase are still very fresh in the minds of most Zimbabweans, and that confidence in the banking sector has not recovered since 2013, this latest move by the central bank will propel the informalisation of the economy and growth of the underground economy. We are likely to witness a return to dual pricing as firms and households shun card payments and bank transfers in favour of cash transactions. This is likely to be necessitated by the inefficiencies in converting the bond notes to a USD balance, and the high level of distrust between the public and the RBZ, of which much of it is not unwarranted.

A major challenge for business is that the forced conversion of USD to Rands and Euros will induce unnecessary exchange rate risks and will complicate cross border transactions. Consider company A (a net importer) that receives US$300 000 today with the intention of purchasing capital equipment worth $300 000 in a month’s time. At the time of receiving its US$ inflow the funds are by default immediately converted as follows 40% into rand at an exchange rate of say ZAR14.50/$ and 10% into euro at 1.5/$ with the remaining 50% maintained in US$. In a month’s time the ZAR exchange rate weakens to ZAR 16/$ while the euro remains unchanged. The company will have to buy US$ at the prevailing rate from the bank in order to fund the purchase of its equipment, facing an unnecessary loss of $11 250 (or 3.75% of the initial inflow) excluding bank charges and exchange rate spreads.  It is unclear how such losses are to be handled and who will bear these losses and whether such losses will be tax deductible.

As for the reduction of individual balances and increased tightening of the cross border transactions, these measures are likely to see an increase in the liquidity challenges in the banking sector as households rush to withdraw their funds in order to beat the full roll-out of the bond notes. Consequently, some indigenous banks without strong relationships with corresponded banks and with inadequate liquidity reserves may falter. Given that the central bank has limited capacity to inject liquidity in the very short term, further reductions in daily withdrawal limits are expected should the bank runs continue.

Implications for banks

The new policy proposals are going to require significant changes to banks operating systems as multiple account now have to be opened for residents to allow convertibility into rand, euro as well as keeping track of the bond note balances.

On the bright side, these new measure will result in cheap inflows as banks make profits on exchange rate spreads. As a result, the measures induce a forced redistribution of wealth from private residents to banks since banks convert deposits at a profit. However, the forced losses from redistribution will be partially offset by the 5% conditional incentive that will be received by exporters, and will be paid for by the tax payer.

Operational modalities as to when the USD deposit is converted 40% into Rands and 10% into euro, and the exchange rates at which such conversions are to made, are also likely to result in unintended inefficiencies by inducing unnecessary foreign exchange risk and thus an implicit tax on business.

In an environment where use of plastic money is still relatively expensive and POS facilities are not widespread, banks will be forced to: lower charges on plastic money in order to push customers outside the banking halls; and to increase investment in POS facilities. Competition amongst banks in providing the cheapest and the most efficient POS service will likely result in increased customer experience. However, since bank accounts are not easily transferable and switching between banks is not without costs, there are limited incentives for banks to invest in POS infrastructure or to improve POS service costs.

The imposition of the 6 month 5% fixed deposit, although well intentioned and likely to improve the stability of banking sector deposits, will increase costs for the banks. These costs will likely be passed on to the final consumer. Considering that average banking sector cost to income ratios are in excess of 80%, loan losses stand at 10.82%, and prudential liquidity ratios in excess of 45% (figures are based on the 31 December 2015 quarterly banking sector report), and interest rates are capped at 15%; the fixed interest cost on these fixed deposits are likely to be high.

The elephant in the room

I suppose it was convenient for the governor to ignore the fact that the liquidity challenges currently faced by the banking sector are largely a result of the loose talk about indigenisation and forced closures of foreign owned companies that resulted in a number of businesses, some of them undoubtedly Chinese, shifting their cash offshore.

Secondly, the intervention by the RBZ governor in civil service salary payment crisis by providing a guarantee that salaries will be paid has left a number of businesses and household thinking that the RBZ will soon raid their accounts in order to help the Treasury meet its obligations. The assurances by the governor were political and not well thought out. Given that the RBZ as the custodian of the financial sector had since lost its credibility, and that confidence in the financial services sector has been low since 2013, such utterances would only serve to send the wrong signal to the market.

On the macro front, the increasing import bill is testament that the local industry has collapsed and is no longer able to meet domestic demand. Hence, a number of firms have resorted to importing goods that should otherwise be produced in the local markets. Secondly, the import of automobiles and non-durables have further added pressure to the liquidity situation since imports are tantamount to exporting liquidity.

The disciplinary mechanism of the Afreximbank facility, where the Afreximbank acts to monitor the activities of a RBZ, is weak and induces an extra monitoring cost that reduces the face value of the bond note. A small supranational entity such as the Afreximbank has limited tools and powers to act on a sovereign government should it default on its obligations. Furthermore, the current $200 million facility represents approximately 23% of Afreximbank’s 2015 capital and approximately 4% of its $5 billion balance sheet. The mere size of the asset concentration on RBZ likely make the transaction to be costly given that Afreximbank also sources its finance on the international bond markets. As a result, Afreximbank does not have the necessary financial and political tools to act as a credibility anchor for the RBZ.

The central bank has effectively taken the role of a central planner by compulsorily altering private sector portfolios. The decision to force companies to hold pre-specified currency quotas under the guise of managing currency concentration risks is poorly thought out. Private agents as utility and profit maximisers, optimally allocate their currency portfolio holdings to reflect expected changes in the underlying fundamentals. As such, it is not surprising that currency holdings are concentrated in the US$ given the current challenges in the Euro area and the increasing volatility of the rand.

Glaring omissions

It is shocking that while acknowledging that the liquidity challenges are largely a mismatch of the import and export bill, not a single measure was proposed in order to stimulate industry in the medium term. The transmission mechanism through which the bond notes will lead to an increase in export revenue and an increase in local production has not been well explained. The 5% export incentive will be counteracted by the adverse uncertainty effects of imposed currency quotas. It is not clear, whether the RBZ will compensate exporters for foreign exchange losses arising from the forced USD conversion to Rand and Euro. Instead, the governor seemed to be placing blame for the liquidity challenges on some wayward elements that have embarked on externalisation and illicit financial flows; and to have designed the policy measures with the primary intention of stemming these flows. If the liquidity crisis is a result of externalisation and money laundering activities, why were the banks that facilitated the transactions not fined for not having followed the KYC requirements to the letter?

Since 2003 we have been hearing of externalisation by businesses and by individuals, but we have not had a single case where the banks that facilitated payments were brought to book. The Governor and the Minister are not being honest, and are not calling a spade a spade. The $1.8 billion that flowed out was a capital outflow arising from business disinvestments. These flows were not profits from industry that were stashed out to avoid taxation. Neither were they proceeds from drug sales or some money laundering transactions. If they were, how did the money find its way into our borders in the first place?

Not a single proposition is directed at addressing the incentives for the sudden withdrawal of funds and the dwindling or rather stagnated deposit growth. It is a fallacy to suggest that the Zimbabwean economy has become a mopping ground for speculators targeting easy USD pickings and arbitrageurs seeking to exploit temporary price misalignments. Banking costs are expensive in Zimbabwe and people are significantly underpaid. As a result, majority of individual deposits are transitory with near perfect matching recurrent expenditures. And it is primarily these individuals that rely on cash transactions. Secondly, the argument that the USD is now used as a store of value does not hold water. In actual fact, one of the functions of money is to store wealth and to preserve value. A currency that does that is doing exactly what it is supposed to do. Money is not merely a medium of exchange (perhaps the good Dr is forgetting the basics of Banking 101).

While singing praises about the Rand and the Rand based settlement system, the governor and the Minister forgot to mention that the rand has been very volatile in the last year. Affecting the stability of the rand has been the downgrade in the country’s credit ratings owing to weak commodity prices, poor GDP performance against targets, prolonged industrial action etc. And Zimbabwean firms and individuals as profit maximisers, have been shunning the rand for the more stable and stronger US$ thereby reducing the costs of their imports.

Bond coins success

While the bond coins have turned out to be very helpful to the transacting public, is it dishonest to credit their eventual success to a sudden improvement in RBZ credibility. It was a fortuitous coincidence that immediately after the adoption of the bond coins the ZAR depreciated markedly and became increasingly volatile, resulting in market participants shifting to bond coins. Secondly, the bond coins have no significant effects on private sector wealth portfolios since they only represent a very small fraction of household cash holdings. After all, a majority of dollarized economies have their version of these coins.

What can banks do in the short term?

As often happens when banks become inundated with request to withdraw funds, they will institute a number of measures in order to control cash outflows and inflows. Such measures include slowing down lending, calling back loans, capping maximum withdrawals per day, and the immoral ones, can go as far as disabling ATM and VISA functionalities. Legally, a bank is not obliged to provide individuals with cash outside its official banking hours and outside the confines of its banking halls. As such, banks will be operating well within their rights should they decide to disable added services in order to manage liquidity. However, such drastic measures are likely to lower confidence in the bank and lead to a run on deposits.

Conclusions

While the introduction of the bond note and the accompanying policy measures seem like good ideas in the short term, the unintended consequences of the policy moves are likely to be very costly and taxing in the medium term. The forced convertibility of US$ to rand will induce unnecessary foreign exchange rate risks and an implicit tax on businesses, which is likely to be passed onto final consumers. This is likely to increase inflation, induce dual pricing and unnecessary distortions in the economy. Furthermore, the bond notes will likely worsen the informalisation of the economy and push more money outside the banking sector and into the underground economy.

The introduction of the bond note is likely to further dent the credibility of the RBZ, destroying the little reputational capital that the bank has left, if any.

Although the bond note is promised to be convertible, the convertibility of the bond note cannot be sustained without an underlying earning asset or reserve. The interest costs on the loan facility will induce an additional burden on the tax payer and will increase the level of foreign debt. Secondly, these interest costs will deplete the face value of the notes such that the notes cannot be used as a store of value with 1:1 convertibility with the USD since the structure of the liabilities underlying the claim on the RBZ are debts that have to be repaid.

The decision by the central bank to disrupt private sector portfolio holdings will cause unintended losses to the private sector, leading to a reduction in the capital available for productive uses, and may skew managerial effort towards non-core activities and away from productive uses. Affected companies are likely to spend a lot of their time and effort redesigning their cash flows in order to circumvent the effects of the regulations.

Finally the debt disciplinary mechanism of the facility is weak and the Afreximbank has no recourse should the RBZ decide to negate on its responsibilities and not service the debt or decide to issue more bond notes. As such, the attempt to use the Afreximbank to anchor the credibility of the RBZ is unlikely to work.

The bond note is the second bold step in the backdoor reintroduction of the Zimbabwe dollar, and a possible avenue for the government to inflate the economy in order to extinguish it domestic obligations.

Policy recommendations

The RBZ should recant the bond notes heresy, and inject USD into the banking sector while tightening the anti-money laundering laws. In the very short term, liquidity leakages may be a small price to pay in comparison to the adverse effects of dented confidence on the banking sector.

Second, the RBZ should remove the compulsory currency quotas and associated currency utilisation priority list.  

Third, the RBZ should make it easy for customers to switch between banks, in order to foster innovation and competition between banks. Customers should be able to move their deposit accounts from Bank A to Bank B at no cost. Such a move will: create incentives that encourage the use of plastic money as banks seek to improve customer experience, lower bank charges, lead to an improvement and expansion in POS infrastructure.

It is better and less costly for exporters to be incentivised using a tax incentive instead of the more expensive Afreximbank facility. A tax incentive, is sustainable and does not increase foreign debt nor future tax liabilities.

The Treasury, RBZ and the Ministry of Indigenisation and Youth Empowerment should take bold steps to amend, and quickly clarify the indigenisation laws, as well as present a unified position that dispels the uncertainty and ambiguities surrounding the Law.

A Side Note on the Lender of Last Resort Function

One of the key functions of Banks is to transform short term (and possibly transitory) deposits into medium to long term loans. This creates what is generally known as a maturity mismatch in that the liabilities of the bank i.e. deposits are payable on demand while the bank’s assets i.e. loans are contractual claims that only become payable after the agreed period of time has lapsed. Since on any given day the amount of withdrawals made by the public is generally stable and predictable, banks often keep a precautionary balance of cash and liquid assets that they can convert immediately into cash. However, when a bank is faced with a run on its deposits, it must quickly liquidate its short term assets and run down on its cash reserves in order to avert a crisis of confidence and possible collapse.

The reserve bank on the other hand as the ‘gate keeper’, is responsible for maintaining the safety and soundness of the financial system as a whole. It steps in whenever problems in the banking sector threaten to destabilise the financial system for example the collapse of an important market function such as the payments and settlement systems, a contagious collapse of systemically important banks, and in the most recent case, arrest of temporary liquidity shortages.

The implications of system wide withdrawal of deposits, such as the ones currently being witnessed in Zimbabwe is that it threatens to collapse the banking sector through market wide bank runs, disrupts the interbank lending and settlement functions and thus affects the flow of economic transactions. Information asymmetries on the financial standing of counterparties on the interbank market will result in cash rich banks being unwilling to lend short term funds to smooth out temporary liquidity shortages to otherwise solvent banks, thereby compounding the liquidity challenges. 

Traditionally, solvent banks facing temporary liquidity challenges may revert to borrowing on the RBZ lender of last resort facility on a secured or unsecured basis when they have exhausted all options in the interbank market, albeit at high rates. The range of acceptable collateral is usually limited to government securities and high quality commercial paper and discount bills. When approached for funding the central bank will often transfer reserves in exchange for collateral on a repo or discount basis. However, in a dollarized economy funds for settlement are a finite resource, and the central bank is not able to meet every request for funding from banks. This means that central bank is currently not in a position to create bank reserves since the treasury’s capacity to issue bonds and the RBZ capacity to print are hamstrung.[6] Secondly, in the absence of high quality assets which banks can use as collateral when borrowing from the central bank, funding from the central bank is generally expensive. And any lending on the LOLR either on a collateralised or uncollateralised basis is tantamount to taking private sector risks in order to help a market function. And losses on these private sector risks will be borne by the Treasury and the tax payer.

Final remark

Should the current liquidity crisis continue to fester, the RBZ will be unable to contain the liquidity drain from the banking system leading to an eventual collapse of the financial sector. And when that happens, that my friends, will be the beginning of a revolution.

By Tinashe Bvirindi

Tinashe Bvirindi is a holder of a MSc in Finance and has experience in different roles in the banking sector. His research interest include Asset pricing, corporate finance, Macro-finance, monetary policy, Macro prudential policy and systemic risk. He can be reached at tbvirindi@gmail.com.

Please do not circulate without the author's permission

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[1] The purpose of this article is not to ululate the recent efforts by the RBZ in trying to avert the liquidity crisis nor to sing praise but rather to criticise the recent policy efforts. I leave the ululating, and the praise and worship songs for another choir. 

[2] This is unlike the traditional sense where the government prints money and invests the same in the economy through embarking on real projects such that the note issue is backed by real production in the economy and can be settled from future tax revenues. This makes sense since the government is creating employment and stimulating production. In the case of the bond note, there is no underlying activity to the note issuance, there is only a liability sitting in some Nostro account and possibly a sovereign bond on the asset side.

[3] The RBZ has remained ambiguous as to how much of the facility will be used to support the bond notes. For ease of exposition, I make the simplifying assumption that the maximum amount of bond notes to be printed is $200 million.

[4] The RBZ could possibly hold very liquid short term government bonds of another sovereign if the facility allows, but that would also mean RBZ will be assuming some sovereign risk.

[5] Although the RBZ has imposed a 6 month fixed deposit with a 5% annually compounded yield, the measure is likely to be viewed as a smoke screen and to be met with scepticism. 

[6] Although the government previously issued bonds in the domestic market, it has been facing challenges in collecting tax revenues and thus any further debt issues from the government are likely to be met with stern resistance. Secondly, challenges in collecting revenue make it difficult for the government to be able to redeem bonds on short notice.