Bova, Elva

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SOAS Research Online

The contents of this Development Viewpoint re! ect the views of the author(s) and not necessarily those of CDPR or SOAS.Centre for Development Policy and ResearchSOAS, University of LondonThornhaugh Street, Russell Square, London WC1H www. soas.ac.uk/cdprTelephone: +44 (0)207 898 4496Centre for Development Policy and ResearchSchool of Oriental and African Studies    Exchange Rate Management for Commodity Booms:                   Examining Zambia’s Copper Exports        by Elva Bova, Department of Economics, SOASThe ‘Resource Curse’ literature often links a boom in commodity exports with appreciation of a country’s real exchange rate as a result of an in! ux of foreign exchange. This leads to a loss of international competitiveness and hampers diversi" cation of the economy. So adopting the right exchange-rate regime is extremely important for commodity-exporting countries. The real exchange rate is determined by both the relative value of currencies and relative prices. If the exchange rate is allowed to freely ! oat, the greater supply of foreign exchange from an export boom will appreciate the domestic currency in nominal terms as its value rises relative to that of foreign currency. If the exchange rate is " xed, the central bank is obliged to sell domestic currency in return for foreign exchange. This will increase the supply of domestic currency, which will boost domestic demand for goods and services and drive up their prices. This will cause real appreciation since the ratio of domestic prices to foreign prices will rise.The relevance of the exchange rate regimeHence, central banks confront a ‘trade-o# ’ between nominal appreciation if they allow ! exible exchange rates and domestic in! ation if they maintain " xed exchange rates. But in both instances the ultimate result is the same: an appreciation of the real exchange rate, whether through a change in the relative values of currencies or the ratio of domestic to international prices. Economists who favour in! ation-targeting recommend ! exible exchange rates because they would be more conductive, they argue, to domestic price stability. However, we prioritise exchange-rate management as a more e# ective tool to combat commodity-induced appreciation. One reason is that the link between the money supply and domestic prices is often weak because of extensive excess capacity in developing countries. Since under-used factors, such as labour, will be mobilised to increase production when aggregate demand increases, prices will tend to remain stable.Another reason is that food prices account for a large share of the Consumer Price Index. And they are heavily in! uenced by supply conditions. So an increase in domestic demand for food, because of an increased money supply, might not signi" cantly a# ect the CPI.Exchange rate management of the copper boom The recent copper boom in Zambia provides a concrete basis to evaluateexchange-rate regimes. The Zambia boom elicited an in! ux of foreign exchange that, together with speculative capital in! ows and debt relief, sharply appreciated the Kwacha, " rst in November 2005 and then during mid-2007 to mid-2008 (see " gure). However, because the Bank of Zambia was committed to using foreign exchange interventions only to smooth volatility in the exchange rate, it did not undertake any concerted e# orts to counteract the appreciation, especially during the sharp upturn of 2005.  As a result, Zambia’s non-traditional exporters of tobacco, cotton, co# ee and horticulture experienced a 30 per cent decrease in their      No. 19  Novermber, 2008 earnings in domestic currency terms, and thus contracted their production in 2006-2007. This drop in production had dramatic consequences for employment since these sectors accounted for almost 70 per cent of the total workforce while the copper mines accounted for only 10 per cent. The Impact on In! ationWhat could have happened if the Bank of Zambia had managed the exchange rate? What would have been the respective impact on in! ation of the money supply and the exchange rate,? What would have been this impact both in the short run and the long term?To test these hypotheses, we utilised a cointegrated Vector Auto-Regressive (VAR) model for both food and non-food prices during the period 1994-2008. This disaggregation of prices is important because food prices account for almost 70 per cent of Zambia’s CPI. We found that in the short run the CPI was not very responsive to changes in either the money supply or the exchange rate. Food in! ation, though sensitive to the exchange rate in the long run, adjusted mainly to its own previous values in the short run. Moreover, though non-food in! ation was sensitive to changes in the money supply in the short run, it generated only modest in! ationary pressures because it did not account for a large share of the CPI. Under these conditions, we argue that the Central Bank could have opted for managing the exchange rate since this could have forestalled a real appreciation without having had a major impact on domestic prices. Our research tends to support the general proposition that in developing countries such as Zambia, a managed exchange rate could prove to be an e# ective tool for safeguarding international competitiveness without inducing excessive in! ationary pressures in the domestic economy.Reference:Elva Bova (2008). ‘The in! ation-appreciation trade-o#  revisited: the monetary management of the Zambian copper boom’. Paper presented at the AERC Conference on Natural Resource Management and Climate Change, 15-17th of September, Nairobi.* A lower value of the exchange rate denotes an appreciationSource: IMF-IFSCopper prices and nominal exchange rate*01000200030004000500060002000m012001m012002m012003m012004m012005m012006m012007m012008m01Kwache per US$0200040006000800010000US$ per metric tons

Exchange Rate Management for Commodity Booms: Examining Zambia’s Copper Exports

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