Toward the end of 1999, the central bank (Reserve Bank) in Zimbabwe stabilized the Zimbabwe dollar, the Zim for short, at Z$38/USD and privately instructed the banks to maintain that rate

Question

In response, at the end of 1999, an illegal market developed wherein the Zim traded at Z$44/USD. Are you surprised at rumors that claim corporations in Zimbabwe were "hoarding" USD200 million? Explain.

Answer 1

The existence of an illegal exchange market indicates that the Zim is incorrectly valued at Z$38/USD. Clearly, the Zim is over-valued at the official rate (See Exhibit 5.10 for an example of such a situation). At this "artificial" exchange rate everybody wants to turn in Zim to the central bank, receive foreign currency and invest them abroad. To maintain the overvalued rate without losing all its international reserves, the government must control the use of foreign exchange (impose exchange controls). It likely forces exporters to convert their foreign exchange at the official rate, which is too low. Given this situation, hoarding foreign exchange is a rational response. Anyone who earns foreign exchange has an incentive to hold on to the foreign exchange until the Zim is valued correctly, i.e. after it is devalued. Moreover, given high inflation in Zimbabwe and a highly unstable political regime, U.S. dollars are a better store of value than Zimbabwe dollars. The situation in Zimbabwe subsequently deteriorated into hyperinflation, and the abandonment of the Zim.