MONSTER AT BAY

Zambia 2014 | ECONOMY | FOCUS: INFLATION

Inflation targeting by the central bank is looking to keep the inflation monster well in the single digits going forward.

Zambia continues to face challenges when it comes to maintaining price stability. The country has been struggling to contain inflation to single digits and has consistently missed targets since its adoption of policy rates as the main tool of macroeconomic policy. Damaging for investor confidence and consumer welfare, a focus on curbing inflationary pressure has been at the forefront of the activities of the Bank of Zambia (BoZ).

Whilst sustaining annual GDP growth rates of more than 6% over the past decade, inflation in Zambia averaged at 9.43% in the period of 2005 to 2014, reaching a peak of 19.2% in April 2005. The rate of 7.8% recorded in September 2014 was above that of neighboring Mozambique, the Democratic Republic of Congo, and Zimbabwe, which is currently struggling to avoid deflation after years of hyperinflation. The country is likely to miss the 6.5% end-of-year target set by Finance Minister Alexander Chikwanda in October 2013, with inflation expected to be “slightly below" 8% as 2014 draws to a close, according to Francis Chipimo, Assistant Director of Economics at the BoZ.

CONTRIBUTING FACTORS

According to the BoZ, the country's inflationary pressure can be in large part attributed to a rise in food prices. Like in other low-middle income countries, food represents the largest share in the average household budget, and hence is given the largest weight in the basket of goods used to calculate CPI. As a result, food inflation will be reflected in overall prices.

Fiscal adjustments in May 2013 are another factor contributing to higher prices: in a politically difficult move, the government removed fuel subsidies and later also maize subsidies, hiking up the cost of energy and agricultural products.

Finally, the national currency, the Zambian kwacha (ZMW), witnessed a sharp depreciation against other convertible currencies, with the exchange rate reaching a low of ZMW7.04 per US dollar in May 2014. According to the central bank, the decline is explained by a reduction in the supply of dollars to the market, in particular from the mining sector, coupled with lower copper prices. As well as exacerbating inflation, the government worried that a weaker currency would erode investor confidence.

POLICY RESPONSE

The situation prompted action from the BoZ, which embarked on a series of measures aimed at restricting liquidity. In March 2014, the statutory reserve ratio for the banking sector was increased from 8% to 14% and its application extended to government and other deposits not previously subject to it. Later that year, the central bank increased the policy rate by 175 basis points to 12%. Furthermore, the rate for its overnight lending facility (OLF) was increased and access to the OLF restricted to once a week; this forced commercial banks to meet their liquidity needs by borrowing from other sources, with repercussions for the interbank lending rate.

According to the Governor of the BoZ, Michael Gondwe, the tighter monetary stance adopted by the central bank was effective in reducing excess liquidity and raising interest rates (in particular the interbank lending rate), moderating inflationary pressures, and “helping to achieve relative stability in the foreign exchange market." This has allowed the BoZ to once again ease liquidity through open market operations in order to sustain economic growth.

MODERNIZED POLICY FRAMEWORK

Since April 2012, Zambia has moved away from targeting monetary aggregates and introduced the Bank of Zambia Policy Rate as part of a wider modernization of its monetary policy framework. The move was welcomed by the IMF and has allowed the BoZ to increase communication with the public and anchor inflation expectations, with the aim of increasing transparency and improving the effectiveness of monetary policy.

The central bank will continue to focus on maintaining inflation in single digits. It will find itself aided by stable commodity prices and lower volatility in foreign exchange markets. However, a “further deterioration in global economic conditions" could impact copper prices and the demand for Zambian exports, according to John Wakeman-Linn, IMF Mission Chief for Zambia. He also warned against further increases in civil servant wages, which could “intensify existing pressures on private sector wages" and increase pressure on inflation, and well as hinder job creation.

Overall, the BoZ is positive about the country's prospects and strong economic growth is expected to persist in the short to medium term, driven by strong export growth and robust performance beyond the copper sector, including in agriculture, transportation, finance, construction, and manufacturing.

In the longer term, as the country moves towards economic diversification, a reduction in its reliance on copper will facilitate macroeconomic management. Zambia's goal for the medium term is to bring annual inflation rates down to 5%.