Central bank calls for fiscal devaluation to increase competitiveness

The central bank says the United States dollar is overvalued in Zimbabwe, hurting export competitiveness with exports remaining subdued against a huge import bill and urged government to undertake internal devaluation to promote competitiveness.

Zimbabwe, which adopted a basket of currencies in 2009 – dominated by the United States dollar – after its own currency was rendered worthless by hyperinflation, is failing to compete with its regional peers on exports due to the strength of the US dollar.

The greenback has appreciated by close to 45 percent against the South African Rand in the past six years, making South African imports relatively cheaper in Zimbabwe.

“The absence of an exchange rate policy to deal with the overvalued real effective exchange rate, imply that the country has to undertake fiscal and internal devaluation to eliminate the disparity between the current account norm and the underlying current account deficit,” the central bank said in an economic research paper published this week.

The RBZ noted that a fiscal devaluation aims primarily at influencing the competitiveness of a country in the short-term by mimicking the effects of nominal currency devaluation.

A standard fiscal devaluation takes the form of a reduction in taxation of labour, financed by an increase in Value Added Tax.

“Fiscal devaluation can be undertaken through a revenue-neutral shift from taxes on labour to taxes on consumption. By reducing the tax burden on exports and raising that on imports, this policy can help to restore competitiveness,” said the central bank.

It added that the country can increase VAT on imported finished products by the magnitude of the real exchange rate overvaluation.

“By so doing, the government will be levelling the playing field on price competitiveness between the country and its trading partners. This policy stance implies that competition will be based on non-price factors such as quality and product branding,” it said.

“The government can simultaneously reduce taxes on labour, particularly low income earners, by the same potential revenue gain from increases in VAT in a way that ensures a revenue neutral shift. The broad objective of a revenue neutral shift is to boost domestic demand, thereby promoting long-term growth and employment creation.”

Several countries, including Denmark and Germany introduced fiscal devaluations with varying degrees of success.

In 1987, Denmark introduced a wide-ranging tax reform to contain overheating pressures, reduce labour cost and improve cost-competitiveness, while preserving exchange rate stability within the European Exchange Rate Mechanism.

VAT was increased by three percentage points (from 22 to 25 percent). The OECD (1988) estimates that this increased price competitiveness by five percent, as measured by relative export prices.

Germany in 2007 raised the VAT rate from 16 to 19 percent and used about one third of the additional revenues to cut employer contributions to the unemployment insurance scheme. The remaining revenue was used to consolidate the budget.

Recently, there has been extensive research in Europe, on whether fiscal devaluations can help alleviate competitiveness challenges in the absence of a nominal exchange rate devaluation.

Market watchers say the case for fiscal devaluation is particularly strong for Zimbabwe, owing to downward rigidities in nominal wages, amid a highly overvalued real exchange rate and extensive involuntary unemployment.

According to the central bank, internal devaluation policy options include implementing measures that boost productivity to reduce the overall cost of production.

“Zimbabwe can address the competitiveness problems in the absence of a nominal devaluation through fiscal and internal devaluation mechanisms. Both fiscal and internal devaluation mechanisms mimic the external nominal devaluation of an exchange rate process,” the RBZ said.

Last year, a local think tank, the Zimbabwe Economic Policy and Research Unit (ZEPARU), which was commissioned by the Ministry of Industry and Commerce to conduct a study into cost drivers affecting the country’s competitiveness, called for widespread reforms that would amount to what it terms an “internal devaluation.”

ZEPARU urged the government to institute urgent reforms to reduce Zimbabwe’s labour, utility, finance and tax costs, which are considerably higher than those of its regional peers and make it less competitive than its trading partners, a local economic think tank has said.

“Following the adoption of the multi-currency system in 2009, the economy faces increased competition from South African imports, its main trading partner accounting for nearly 75 percent of exports and 48 percent of imports. The Rand has depreciated against the US Dollar…which has in turn made South African imports cheaper. The depreciation of the Rand adversely affects the competitiveness of Zimbabwean companies whose costs are on a stronger currency,” ZEPARU said in the October 2014 report.

“Under the multi-currency system the option of devaluing the national currency to regain competitiveness is foregone. Under these circumstances a combination of increased productivity and reduction in the cost of doing business become viable strategies to enhance competiveness.”

Zimbabwe’s international trade flows, and their composition, point towards a sustained loss of competitiveness. Merchandise imports have risen twice as fast as exports in the last five years. The composition of those exports has changed over that period, as more concentration in minerals and metals is observed while imports of services have grown faster than exports.

Zimbabwe’s trade deficit was $2.9 billion in 2014 and analysts say projections that this could narrow to $2.8 billion this year are optimistic.

“This internal devaluation requires coordinated actions across government as well as commitment at the highest level. In as far as the cost-structures highlighted in this study are central for the competitiveness of Zimbabwean industries, an appropriate role for the Ministry of Industry and Commerce is to highlight them (and their solutions) to other government agencies and become an advocate for reform within government.”

ZEPARU identifies labour costs as one of the factors affecting Zimbabwe’s competitiveness, with the country’s minimum wage level indicating higher labour costs compared to Zambia, Botswana and Mozambique. Zimbabwe does enjoy labour costs advantage when compared to South Africa, the report says.

“The trend observed in the last five years reveals large increases that do not appear to be justified by increased economic growth or productivity, at a time when the economy faces increased regional competition from devaluation in neighbouring countries,” the report says.

“To remain competitive, wage increases in a given economy need to be aligned with productivity levels; however the current labour code and practices translate into salary increases expected and upheld by law for all employees regardless of their performance and productivity. Large wage increases (in particular in central government, which is the largest formal employer) observed indicate the need to review the mechanisms through which they are set.”

At the time, ZEPARU said redundancy dismissals were lengthy and prohibitively expensive in Zimbabwe, with severance payments averaging 69.2 weeks of wages, nearly three times as high as the neighbouring country average of 25.4 weeks.

However, Zimbabwe passed amendments to its labour law in August, which dramatically reduced the cost of redundancy.-The Source

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