XLRI Jamshedpur

2014

A Comparative Study of Hyperinflationary Episodes in Asia,

Africa and South America

MTP PROJECT

By Karan Chabra B14149 Mihir Talnikar B14155 Rohit Patnaik B14166 Santosh Kanbargi B14171 Siddhanth Garg B14173

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INTRODUCTION Philip Cagan defined a hyperinflationary episode as starting in the month that the monthly inflation rate exceeds 50%, and as ending when the monthly inflation rate drops below 50% and stays that way for at least a year. Hyperinflation is often the result of the interplay between geo-politics of the region and the economic policies of the country. The objective of this study is to understand the circumstances underlying the beginning of hyperinflationary episodes in countries. For this study we classify hyperinflationary episodes into two categories as proposed by Kiguel and Liviatan:-

a. Classical hyperinflation: These are cases similar to post-war Germany, Austria, Greece etc. Classical hyperinflation has clear causes - exceptionally large budget deficits financed by money creation, and in most cases can be brought to a sudden end, through a comprehensive stabilization program.

b. Recent hyperinflation: These are relatively recent cases seen in Brazil, Argentina, Peru etc. in the late 1980s and the early 90s. Here, hyperinflation is the final stage of a long process of high and increasing rates of inflation and is seen in countries with a long history of high inflation.

Generally there are three fundamental aspects of the rise of hyperinflation.

1. First, there is a cutoff in international lending and the increase in international interest rates.

2. The second important characteristic of the inflation dynamics is that the recourse to seigniorage (i.e., the inflation tax) jumps as the net international resource transfer turns negative, with seigniorage fluctuating around a new ,high plateau.

Seigniorage Laffer Curve: Seigniorage Laffer curve shows the relationship between steady inflation rate and seigniorage revenue. It indicates that seigniorage revenue must rise for a while and then fall again as inflation rises. There is an inflation rate that produces the maximum amount of seigniorage with a stable rate of inflation. Above the steady state inflation rate it is possible to collect more seignorage than SEmax but only if the inflation rate is constantly increasing. This is the essence of hyperinflation.

3. The increasing inflation leads to Olivera-Tanzi effect and causes the tax system to collapse.

Olivera-Tanzi Effect: During any period of high inflation, governments’ upkeep costs for everything rises. However, since inflation hurts both trade and diminishes buying power of the consumer, business revenues fall. The actual real tax proceeds gathered by the government, after adjusting for inflation, will be less than in a period of normal inflation,

Seigniorage Laffer curve

20Source: Amadou Dem, Gabriela Mihailovici, Hui Gao

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due to both increased operating costs and decreased tax revenues from businesses. This reaches extreme levels in hyperinflationary episodes as any lag in tax collection leads to a drastic drop in the real monetary value of the taxes collected. The general causes of hyperinflation are known to be:

1. Fiat money: Hyperinflation is systemic to a fiat base monetary system and is not possible under the gold standard

2. Taxation system breaks down/external borrowing becomes difficult 3. Wars/civil war: Large deficits, mostly from civil wars, revolutions, deep social and

political unrest are monetised through seigniorage 4. Weak government/coalitions: Government may not be able to raise taxes,

implement budgetary reforms 5. External shocks: Lead to increased budget deficits and cause debt crises (as seen in

the case of Latin America) Amadou Dem, Gabriela Mihailovici, Hui Gao posit: ‘Increasing the inflation rate beyond its steady state level can allow an increase of seigniorage revenue even when the economy is on the wrong side of the Laffer curve. The reason is that there are lags in the adjustments of prices to new money creation i.e. inflationary expectations tend to lag behind actual price increases. The dynamic of hyperinflation relies on these lagged inflationary expectations. As households realise that inflation rate is rising they revise upward their inflationary expectations and therefore their real money balances holding, reducing the seigniorage revenue that was collected previously. In order to face the reduction of revenue, the government has to increase the rate of money creation. Once the rate of inflation is beyond the peak of the Laffer curve, the government is forced to continue to increase the rate of monetary growth simply in order to maintain the same level of seigniorage revenue. The inflation rate rises without bound resulting eventually in hyperinflation.’ Stopping hyperinflation as per Fischer/Marco involves:

(1) Fundamentals: to restore internal and external balance. Permanent budget balance, upfront devaluation, bolster central bank independence, external finance, social safety net

(2) Multiple nominal anchors: to achieve rapid synchronized disinflation. Initial exchange rate peg, money and/or credit ceilings, wage freeze through social contract, temporary/partial price controls

(3) Extra nuts and bolts: to facilitate quick move to new macro equilibrium. E.g. interest rate conversion rules for nominal assets; de-indexation or de-dollarization of liquid assets; internal debt rescheduling between firms, banks and governments.

(4) Structural reforms: to remove micro-distortions (and tackle structural links with inflationary processes) Liberalization and deregulation; fiscal reforms; financial sector reform; Stimulating real growth, cutting government expenditure, improving tax collection system, increase net external flow/ default on external debt

(5) Political reforms (where necessary). Consolidation of a fully-fledged democracy.

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BOLIVIAN HYPERINFLATION 1984-85 The case of Bolivian hyperinflation is unique in the sense that it was not triggered by any kind of war or political revolution. South American countries like Brazil, Peru, Argentina and Bolivia were struck by external shocks in 1980-81 namely rise in world interest rates and cutoff in lending from international capital markets. But the extent of economic collapse in Bolivia point to internal factors majorly the turbulent political situation and large reliance on select commodity exports like tin and natural gas. As a result, the annualized inflation rate touched a maximum of 60000% from April 1984 to September 1985, preceded by a period of high inflation.

CAUSES:

Bolivia, like any country, had four major avenues to finance its activities

1. Borrowing from foreign investors

2. Raise taxes

3. Diversify and increase exports

4. Inflation tax (print more money)

Bolivia has historically had an unstable central government. Bolivia was under a military regime from

1964 until 1978, 1971-78 under General Hugo Banzer Suarez (Banzer). A period of political chaos

followed during 1978-82 with rapid alternation of military and civilian rule – military rule being anti-

populist and anti-labor while civilian rule being populist. This kind of alternation was common in

Latin American countries but was particularly sharp in Bolivia. Governments of the left generally paid

for higher public salaries through printing money (i.e., the inflation tax) or through foreign

borrowing, since they were forestalled from raising taxes. Governments on the right, on the other

hand, rejected higher taxes outright and subsidized favoured industries, and instead sought to

finance the government through a reduction of public-sector wages (often with overt repression of

labor), and also through foreign borrowing.

Since both the leftist and the rightist government relied heavily on external borrowing, till 1981

Bolivia had built up a big pile of external debt which had to be serviced – debt had increased from

46.2% of GNP in 1975 to 102.6% of GNP in 1982. Bolivia’s external debt rose dramatically in the

1970s, mostly during the Banzer era. Bolivia’s rapid accumulation of external debt in the 1970s

reflected three forces at work. One, part of the foreign borrowing financed a plausible attempt to

generate a more diversified export base through various investment projects. Two, the government

did not attempt to raise taxes (and indeed rejected a detailed tax reform proposal of the Musgrave

Commission). And three, some of the foreign borrowing had the purpose and effect of enriching a

narrow set of private interests via the public sector’s access to foreign loans.

Bolivian exports have always been dominated by commodities mainly mining – silver in the colonial

period followed by tin starting from the 1900s. Tin and Natural gas accounted for close to 70% of the

total Bolivian exports during the 1980s. Any fluctuation in international prices of these commodities

had a big impact on the current account deficit and hence the fiscal deficit of the country. Cocaine

was one of the major illegal exports from Bolivia. Conservative estimates gave about the same value

for cocaine exports as for legal exports. Cocaine producers were major suppliers of foreign exchange

to the crucial black market.

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In 1977 and 1978, General Banzer faced growing pressure from the Carter administration for a

return to democracy and was ousted in a coup. There ensued a four year period of intense political

instability, with several interim presidents, coups, and deadlocked elections, producing in all nine

different heads of state between Banzer and Siles. Bolivia reached its political nadir in 1980 and

1981, under the Garcia Meza regime which was deeply implicated in the burgeoning cocaine

industry, and therefore never received international support, except for the backing from the

similarly corrupt and violent military regime in Argentina. Capital flight reached new highs in the

period, with errors and omissions in the balance of payments in 1980 and 1981 totalling $590

million, or about 10 percent of 1980 GNP. The commercial banks stopped all lending, and negotiated

an emergency rescheduling agreement which was soon defaulted upon. The rest of the international

community also ceased new lending.

The transitory nature of the governments from 1978-81 ensured that no government had the

political backing to raise taxes or implement economic austerity. Commodity prices started to slide

in 1981 and interest rates on existing loans soared. This left only option open for the government –

seignorage or inflation taxing i.e. printing money to service the foreign debt.

Seignorage per quarter (percentage of annual GNP)

*Source: Developing Country Debt and the World Economy by Jeffrey D. Sachs, 1987

HYPERINFLATION

The hyperinflation under Siles was not so much a result of an explosion of new spending as the

inability to restrain spending in the face of falling foreign loans, falling tax revenues, and higher debt

service payments abroad. A coalition government implied that neither taxes were raised nor

spending was cut.

Government revenues in Bolivia in the early 1980s relied heavily on three main forms of taxes:

internal taxes (mainly sales, property, and income taxes); taxes on trade (mainly tariff collections);

and taxes on hydrocarbons and minerals (mainly paid by COMIBOL and YPFB, the state owned tin

and natural gas companies). Overall, revenues of the central administration fell from more than 9

percent of GNP in 1980 to just 1.3 percent of GNP in the first nine months of 1985. This combined

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with the Olivera-Tanzi effect ensured that simple lags in collection reduced the real value of

collections almost to nothing by 1985.

The official exchange rate was overvalued relative to the black market rate. This encouraged

smuggling, on which tariffs are typically not collected. Even when goods were imported legally,

however, the tariff in pesos was collected on the basis of the official exchange rate, and therefore

the real value of the tariff collections was substantially reduced. The taxes on mining and

hydrocarbons were similarly squeezed. The overvalued exchange rate reduced the profitability of

the state enterprises in these sectors, and reduced tax receipts further.

STABILIZATION

The successful stabilization program was carried out by the newly elected center-right government

of Paz Estenssoro. The fiscal part of the program was to operate on four fundamental bases:

1. A stable unified exchange rate backed by tight fiscal and monetary policies

2. Increased public-sector revenues, via tax reform and improved public sector prices especially

an increase in domestic oil prices

3. A reduced public-sector wage bill, through reductions of employment in state enterprises

(particularly COMIBOL) and reduced rates of real compensation

4. A resumption of concessional foreign financial assistance, from foreign governments and the

multilateral institutions – signing of an IMF standby agreement.

There was a fifth implicit part - an effective elimination of debt servicing, through a combination of

rescheduling with official creditors, and a unilateral suspension of payments to private creditors until

a more fundamental debt settlement could be arranged.

The rise in public sector prices had the biggest short term impact and raised government revenue

considerably. In fact, with the combination of the five points above the central government did not

have to rely on fiscal credit from the central bank at all during the final months of 1985. Within ten

days the inflation was halted, and prices actually began to fall. In December 1985 and January 1986,

prices rose by just 9 percent.

Thomas Sargent argued that such a dramatic change in price inflation results from a sudden and

drastic change in the public's expectations of future government policies, essentially requiring a

regime change as a necessary condition. In Bolivia’s case, the peso had already foregone two of the

three classic roles of money - the unit of account and the store of value to the US dollar. Prices were

set in US dollars but transactions were done in Bolivian pesos converted at spot exchange rates.

Therefore, by stabilizing the exchange rate, domestic inflation could be made to revert immediately

to the U.S. dollar inflation rate. But stabilizing the exchange rate did not by itself lead to return of

confidence. Exchange rate stabilization brought short term relief which was followed by fiscal

balance through a revamped fiscal policy.

Thus, the Bolivian authorities employed an orthodox approach of exchange rate stabilization to reign

in hyperinflation.

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HYPERINFLATION IN BRAZIL INTRODUCTION:

Inflation is a problem that was plaguing the Brazil economy for a long time. In the 1980s, its

economy went through one of its worst phases with inflation touching astronomical heights

becoming hyperinflation and it lasted for 14 years until 1994. The Brazilian Government had

resorted to deficit spending in order to boost the economy. This increased the debt burden. The

government continued to obtain loans despite not being able to raise money from tax revenues. As

the risk factor for the creditors increased, they demanded higher interest rates making it difficult for

the Brazilian Government to repay the loans. In this scenario, the Government resorted to printing

money and thereby increasing the money supply in the economy. The situation subsequently

worsened due to lack of adequate controls and inflation became hyperinflation. In 1990, the

inflation rate was about 3000%. The Plano Real was implemented by the government in 1993 and

subsequently the hyper-inflation was controlled. The Brazilian hyperinflation was comparatively

short-lived when we take a look at the classical hyperinflation. In this paper, we discuss the causes

that led to the hyperinflation and the remedial measures taken the by the government in Brazil to

bring it back under control.

EVENTS LEADING UP TO THE HYPERINFLATIONARY PHASE:

From the mid-sixties to the years leading up to the crisis, the Brazilian economy was experiencing a

healthy phase. Growth was strong and inflation was well within control. The government decided to

go for expansion by taking on debts. Subsequently, the Brazil started running a fiscal deficit. Inflation

had reached 50% in the seventies and had entered three digits in the early eighties. Below chart

explains the scenario that was present.

The demand for public debt increased and in the late sixties, the demand for public debts was more

than the financial needs of the government. This led to an increase in the spending capacity of the

government and led to institutionalised mechanisms which helped local governments increase their

spending capacity too. Brazil saw growth rates which were above 10%. Private savings were

channelled into public investments which led to a string mechanism and the idea that public debt is

necessary to fuel investments. In 1973, the oil crisis hit the world and Brazil maintained its strategy

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of ballooning public debt to maintain its pace of growth. The increasing public debt mechanism was

based on factors like the growth in wealth of private institutions/people and the way the debt,

which ultimately were private savings, was used by the government. According to a study, the

increase in inflation in mid to late seventies was not associated with an increase in seigniorage. The

increase in inflation found its roots in devaluation which in turn was based on easy money and wage

indexation. The relatively stable seigniorage made the Brazil story quite perplexing. During the later

part on the seventies decade, growth dipped and inflation rose even more. Interest rates started to

show an increase and which partly was a result of interest rate ceilings being removed. The

government then, in an effort to contain the inflationary pressures, started with reducing the real

value of public bond debts.

Inflation had been rising steadily until 1985 partly because of the second oil shock and increase in

frequency of wage readjustment and partly because of the devaluation of the national currency by

30%. Despite this, the government was largely focussed reducing imbalances than on containing

inflation. The macroeconomic policy of 1981 and 1982 was more inclined towards reducing

dependence on foreign capital. In case of Brazil, some stabilization plans were implemented this

resulted in causing more imbalances and letting inflation spiral out of control.

Cruzado Plan (1983):

This plan involved changing the currency from cruzeiro to cruzado. The plan relied on wage controls

and price control. Interest rate conversion schedule was set for fixed interest rates. All nominal

interest rates were based on inflation expectation of 0.45% a day. The Cruzado Plan initially saw

success by helping curb inflation. However, there were clear indications of overheating and

equilibrium prices themselves were increasing. Interest rates were kept low despite still high

inflation. Scarcity of products increased prompting the government to resort to measures like

compulsory “loans” on fuel, vehicle purchases, international airline tickets and forex sales. The small

measures introduced by the government had the exactly opposite effect than desired. Due to high

demand, imports kept on increasing and exports were already falling. Due to rumours of devaluation

the future, exports were put on hold. In February 1987, the government stopped all payments of

interest on external debt leading to a default. Their aim was to renegotiate the debt.

Bresser Plan (1987):

It was a sort of a hybrid plan which integrated fiscal and monetary policies with the aim of

containing inflation. It proposed price freezing just like the Cruzado Plan. An automatic trigger was

incorporated for wage-setting in case inflation rose up to a certain level. In the short term, real

interest rates were positive. Rather than going for zero-inflation, it aimed at only reducing it which

was a departure from the previous plan. This plan also failed to meet its expectations with inflation

showing no signs of going down.

Summer Plan (1989):

This plan again involved price freezing. Here the focus was to curb inflation with by reduction in

public debt, reducing public expenditure and increase revenues. This plan incorporated almost

everything that the previous plans lacked. However, the government did not have enough political

power to carry through with the plan. This led to reforms not being implemented.

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THE REAL PLAN: A new currency was created under this plan called the Real. It was valued at 2750 Cruzeiros Reais.

The IMF however, did not approve of the plan. The plan was based on the inflow of foreign capital

which had resumed with the long-drawn renegotiations coming to an end and Brazil getting back on

good terms with other countries. The Plan created an index named URV, which was pegged at 1:1

with the US dollar. Prices continued to rise in Cruzeiros Reais but since the URV was pegged to the

dollar, it had very low variation. On 1st July 1994, Brazil transitioned completely to the URV which

became the Real and Cruzeiros Reais was discarded.

The Real Plan reduced the inflation but the core issue of budget deficit was yet to be addressed. As it

was pegged at 1-to-1 with the US dollar, the Real increased in value as the US dollar increased,

making Brazil suddenly expensive for foreign markets leading to a fall in demand for Brazillian goods

and services. Due to exodus of capital out of the country, further reforms were initiated which led to

Real becoming a free-floating currency. This change led to devaluation of Real and thereby reducing

the value which made Brazillian goods and services cheaper and more appealing to international

investors.

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HYPERINFLATION IN ZIMBABWE One hundred trillion dollars—that’s 100,000,000,000,000—is the largest denomination of currency

ever issued. The Zimbabwean government issued the Z$100 trillion bill in early 2009, among the last

in a series of ever higher denominations distributed as inflation eroded purchasing power. When

Zimbabwe attained independence in 1980, Z$2, Z$5, Z$10 and Z$20 denominations circulated,

replaced three decades later by bills in the thousands and ultimately in the millions and trillions as

the government sought to prop up a weakening economy amid spiralling inflation. Shortly after the

Z$100 trillion note began circulating, the Zimbabwean dollar was officially abandoned in favour of

foreign currencies. Post-independence the value of one Zimbabwe dollar was equal to US$1.54.

From 2007 to 2008, the local legal tender lost more than 99.9 percent of its value.

CAUSES:

The last half of 1997 marks a turning point from the relatively disciplined policies that the

government had pursued since the attainment of independence in 1980. A string of decisions largely

to shore the government’s waning political support and appease powerful disgruntled groups

through the transfer of economic resources in that period inexorably set in motion a rollercoaster of

events that resulted in the economic collapse of the country. These decisions had the effect of

damaging confidence in the local currency, exerting pressure on the Zimbabwean dollar in the

currency markets, which fed to inflation via a pass-through from more expensive imported goods.

Firstly, in August 1997, approximately 60,000 war veterans were granted ZWD50,000 each

(approximately USD3,000 at the time) plus a monthly pension of approximately USD125 per month

outside the budget. The pay-outs amounted to almost three percent of GDP at the time and this had

the immediate effect of inflating the budget deficit at the end of 1997 by 55 percent from the 1996

levels.

The second populist decision followed in November 1997 when the president, Mugabe,

announced plans to compulsorily acquire white-owned commercial farms, again without elaboration

on the financing side of the transaction. This had the immediate effect of giving investors a

perception of an ensuing precarious fiscal position and consequently there were spontaneous and

concerted runs against the currency and from the money and capital markets. The climax of these

events was on 14 November 1997 when the Zimbabwean dollar crashed and lost 75 percent of its

value against the USD on a single day, on what is now known as “Black Friday” in Zimbabwean

economic history. The stock market also plummeted and the index was down by 46 percent by day

end from the peak August levels. The central bank, had to intervene and raise interest rates by six

percentage points within that single month. Thenceforward the exchange rate continued to

depreciate uncontrollably, thus the 1997 financial and currency turbulence set the stage for a long

and potentially long slump in the real economy. The crash of the Zimbabwean dollar in the foreign

exchange markets was immediately mirrored by its loss of value on the domestic markets, as in

January 1998 there was an upsurge in consumer prices of 25 percent. In response to the attendant

fall in real wages, the Zimbabwe Congress of Trade Unions organized protests which paralysed the

whole country for two days, dangerously threatening the government’s grip on political power. In an

effort to assuage the masses, the government reintroduced price controls and simultaneously

attempted to deflect negative public sentiment by shifting its rhetoric against industry, whom it

blamed for excessive profiteering by charging exorbitant prices. The immediate consequence of

these price controls was widespread shortages of basic commodities in official markets and the

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genesis of the in-formalization of Zimbabwe’s economy, which was to eventually spread to financial

markets due to government submarket controls on the forex rates. Paradoxically, the government’s

price controls, via the informal economy fuelled prices higher further eroding living standards and

further alienating the masses.

The economic crisis the country endured as a consequence of the maladroit expenditure

management persisted, and to add harm to injury, in September 1998 the president agreed to send

11,000 troops under the SADC protocol, to the Democratic Republic of Congo (DRC) to back the

discredited leader, Kabila, who was under attack by Rwandan and Ugandan backed rebels. This was

simply the utilization of national military by the political elite for private financial gain as it emerged

that the Zanu PF bigwigs had been promised mineral concession in the DRC. The precise costs of the

ensuing war are open to speculation, as the government was tight-fisted with casualty and financial

information pertaining thereto. A letter written by the finance ministry to the IMF seeking funds

puts the funds to finance the war at USD1.3 million per month in 1998 or 0.4 percent of GDP and in

1999 when additional troops were deployed at USD3 million per month or at 0.6 percent of GDP

(IMF, 1999). However on the basis of a leaked memorandum from the ministry, it can be stated that

the costs were at least ten times the official figures. The situation, be that as it was, the country

could not spare forex outlays of such magnitude and this consequently weakened the currency,

again with pernicious effect on price stability. There was intense pressure on the currency and in a

bid to increase the flows of foreign currency which were dwindling at precariously low levels, the

central bank reintroduced widespread import controls and banned foreign currency accounts. This

dirigisme was futile as in the first quarter of 1999 the central bank, had to devalue the currency by

50 percent to trade at USD1: ZWD38 from USD1: ZWD25.

The president’s rhetoric on confiscation of white-owned farms was elevated to the next level

in early 2000, when war veterans, who courtesy of the gratuities, were now the paramilitary wing of

the ruling Zanu PF party, started invading white-owned farms as part of an elaborate scheme by

Zanu PF to terrorise people to vote for it in the parliamentary election in July 2000. Terror

notwithstanding, the newly formed MDC party went on to secure almost half of the contested

parliamentary seats. As a result of the upheavals on the farms, agricultural output was to fall

dramatically from the level of 18 percent of GDP in 2000 to 14 percent of GDP in 2002 (World Bank,

2008). Tobacco, the country’s major foreign currency earner was not spared. Export proceeds from

tobacco declined from USD612 million in 1999 to USD321 million in 2003. The consequences of the

falling agricultural output were as immediate as they were harmful. The government could not

service its multilateral debts obligations and as a result in October 2000, the World Bank suspended

any extra lending to Zimbabwe due to non-payment of over six months. This marked the closure of

the country’s relations with the World Bank to date and paved way for, on a political front, the

government’s isolationist stance and, on the economic front, free-fall of the unsupported currency.

On the other hand the government could not import essential raw materials and fuel as a result of

the declining forex inflow, which further fed into falling production with the result that by 2004,

total foreign currency earnings from the export of goods and services had declined to less than half

the 1996 peak of USD3,169 million.

On 1 December 2003 a new governor, Gono, was appointed to head the central bank. The

battle against inflation, which now stood at 263 percent on a year on year basis at the end of 2003,

became Gono’s sole objective. He undertook money-targeting framework as the monetary policy

strategy and consequently set up a ‘Framework for Liquidity Management’, which was to contain

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money supply growth to levels consistent with inflation targets. The interest rate was the

operational target and it was raised acutely in the first quarter of 2004, reaching a peak of 5,242

percent annually in March 2004. Inflation which had soared from about 20 percent in December

1997 to a peak of 623 percent in January 2004, decelerated sharply from March to around 130

percent at the end of 2004. Consequent to the high interest rates, financial institutions could not

utilize the central bank accommodation window sparking a huge liquidity crisis in January 2004

which resulted in the collapse of Century Discount House on 3 January. Century Discount House was

a subsidiary of asset management companies. Its collapse was triggered by the fact that it could not

raise depositors’ funds totaling ZWD61 billion. The fall of Century Discount House triggered a

contagion as too many financial institutions were exposed to ENG, thus triggering a liquidity crisis to

mostly indigenously owned banks. In the light of this crisis, which threatened monetary stability, the

central bank came to the rescue of the ailing institutions in the form of the Troubled Bank Fund

(TBF). The TBF was not a free lunch as onerous conditions were attached thereto, such as change of

organizational structure in the affected banks, change in management and directors had to step

down. Moving on with the same issue, the high real interest rates and an increasingly overvalued

official exchange rate was also putting pressure on domestic producers and exporters, and in a move

sold as though it was to bail out the ailing industries, the central bank started engaging in quasi-fiscal

activities. The quasi-fiscal activities went beyond the operational realm of a normal central bank and

had the effect of undoing the ephemeral achievements in the inflation battle and firmly set course

for the drive towards hyperinflation.

By December 2008 the use of foreign currency as a medium of exchange was now almost

complete albeit unofficially and in a move sold by the central bank as though to help businesses

suffering from chronic shortages of foreign currency to import goods and spare parts, it licensed

around 1,000 shops to sell goods in foreign currency. This constituted the first conscious recognition

of unofficial dollarization in Zimbabwe. The institution of official dollarization underlined by the

political accommodation had the obvious immediate effect of stopping hyperinflation and the

country actually entered into deflation with consumer price inflation standing at -2.34 percent and -

3.26 percent at the end of January and February respectively.

There are three approaches, or a combination thereof, that Zimbabwe could adopt in the

event that it does indeed, decides to dedollarize and reintroduce a national currency. The first

approach is market-based, that is the pursuance of macroeconomic policies that give the national

currency stability on both the internal and external markets. The second alternative is non-market

based approach in the form of regulatory reforms. These would aim to change the incentive

structure of holding a portfolio of currencies in favour of the envisaged national currency. The third

approach would be to employ another non-market means which is administrative enforcement.

Basically, this is simply to outlaw totally or limit by law, the use of foreign currency in the country.

CONCLUSION:

The issues at the core of Zimbabwe’s hyperinflation predate the fast-track land reform programme.

The first impetus to the cataclysm lie in the string of policies aimed at pacifying certain disgruntled

social groups through the transfer of economic resources in order to retain political power. The

combined effects of these measures were to give a perception of fiscal instability to investors which

led to currency depreciation hence inflation. In the latter part of the Zimbabwe’s case, the quasi-

fiscal activities of the central bank were responsible for the growth in money supply which fed to

inflation.

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HYPERINFLATION ZAIRE (Rep. Congo) Since 1990, Zaire has experienced an extraordinary period of very high inflation-among the longest

on record. From 56 % in 1989, the annual increase in consumer prices surged to 256 % in 1990,

2,500-4,500 % during 1991-93, and 10,000 % in 1994, before returning to 370 % in 1995 and 657 %

in 1996.

Zaire's hyperinflation experience in the 1990s is typical in many respects. The country's predicament

was brought about by a prolonged political crisis, which led to an explosion of government spending

financed almost entirely by printing currency, an extended period of very high inflation, and a

dramatic contraction of external trade and output. The case is also relatively simple to analyse, in so

far as Zaire's financial system has remained largely underdeveloped- without any market for

government bonds, in particular.

FROM HIGH INFLATION TO HYPERINFLATION

In the 1970s, Zaire's currency-the Zaïre-was pegged to the SDR. Under the fixed peg, supported by

trade restrictions, expansionary financial policies yielded high inflation and a steady appreciation of

the currency in real effective terms. The SDR peg was abandoned in September 1983, with a sharp

devaluation of the currency (78 % in nominal effective terms) and the introduction of a market-

determined exchange rate system. However, the authorities interfered recurrently with the

operation of the new system, and there was a thriving parallel market for foreign exchange. Annual

inflation averaged 62 % in the second half of the 1970s, 44 % in the first half of the 1980s, and 69 %

in the second half of the 1980s. Throughout the 1980s, the velocity of circulation of money in Zaire

remained very high (albeit lower than in the 1970s), which testified to the widespread use of foreign

currency for domestic transaction.

In 1990, Zaire entered a protracted period of political transition, and inflation accelerated to 265 %.

During 1991-94, the political and economic situations worsened in parallel: as the one-party state

crumbled, inflation surged to 3,000-4,500% in 1991-93, and 9,800% in 1994 (or nearly 50 % a month

on average). By end-1993, the traditional forms of government had ceased operating, and monthly

inflation peaked at 225 % during November 1993-January 1994. Over the 12 months ending in

September 1994, broad money growth was 12,850%; currency depreciation, 99.9%; and annual

inflation reached a record 90,000%. Inflation slowed markedly in 1995, to 370%, but rose to 657% in

1996, thus remaining in the vicinity of hyperinflation level.

THE GENESIS OF HYPERINFLATION

A series of events in 1990 set the stage for the gradual disintegration of the political system and the

loss of control over economic and financial management.

First, on April 24, 1990, President Mobutu announced an upcoming process of

democratization and the establishment of a multi-party system within a 12-month period.

Second, political opposition gathered forces and organized widespread demonstrations to

demand an acceleration of the democratization process.

Third, with a view to appeasing demonstrators, the authorities awarded unsustainably large

increases in government wages.

Fourth, the government's financial difficulties were compounded by a drop in mining sector

revenue.

The period from 1990 to 1994 was marked by strong discontent between President Mobutu and the

then Prime Minister Tshisekedi.

13

Steady Hyperinflation, 1994-96

From 1989 to 1994, the Zairian economy contracted cumulatively by some 40 %, and consumer

prices rose by a factor of 21 million; government revenue collections fell from nearly US$900 million

in the late 1980s to US$138 million in 1994. During 1995-96, the contraction in economic activity

bottomed out, and even showed some signs of reversal, while prices rose by a factor of about 35. By

end-1996, Zaire's infrastructure had fallen into disrepair: most roads, railways, and rivers had

become impracticable; the government had all but stopped providing health and education services;

and many public enterprises had ceased operating. The informal sector showed an amazing

resilience, which partly buffeted the plummeting activity in the formal economy. But the

development of "survival reflexes'-with greater autonomy of provinces and generalized self-

subsistence, in particular-also translated into "non-civic" behaviour, including the extension of

corruption and the ransacking of the population by unpaid soldiers. Hyperinflation in Zaire in the

1990s thus left a trail of deleterious consequences on the fabric of society, which will take many

years to remedy.

THE TANZI EFFECT

The Tanzi effect refers to the erosion of the tax base by inflation. There is unavoidably a lag between

the time tax payments are assessed and the time they are collected by the Treasury. In the case of

indirect, domestically based taxes (such as turnover taxes), the collection lag is generally four to six

weeks; for direct taxes, the lag is much longer, and may reach well over a year for personal income

taxes. Even in the case of customs duties, where the assessed base is denominated in foreign

currency, taxpayers are generally allowed several weeks to make payments to the Treasury. As

regards nontax revenue such as licenses and fees, the amounts due are normally set in local

currency terms, which tend to make their value insignificant under conditions of hyperinflation.

In Zaire, where the bulk of government revenue consists of indirect taxes, the average collection lag

may be on the order of one to three months. The Tanzi effect on government revenue is thus quite

large: with inflation running at 10 % a month, real revenue collection drops by 9.1 % if the collection

lag is one month, or 17.4 % if the lag is two months (relative to the case with no inflation). As

inflation reaches 50 % a month, the drop in real revenue collection amounts to 33.3 % or 55.6 %,

respectively. Under such circumstances, taxpayers will always endeavour to delay the settlement of

tax obligations; moreover, tax and customs agents will often use their prerogatives to allow delayed

payments and share some of the taxpayers' gains.

STOPPING HYPERINFLATION

Stopping hyperinflation is no easy task. To reverse its root cause, the government must live within its

means, which is precisely what it has been utterly unable to do to start with. Even if a political

consensus could emerge, and all parties agreed to join efforts to mobilize government revenue and

control expenditure, the constraints might well be such that available means and needs may not be

balanced without exceptional measures and/or external assistance.

Zaire's predicament during 1995-96 illustrates the difficulty. Major efforts aimed at securing a

minimum level of government revenue succeeded in doubling tax revenue collections; expenditure

controls were strengthened at the Treasury; and the disorderly issuance of currency was halted.

14

HYPERINFLATION IN CHINA

The Chinese Hyperinflation period lasted, with several breaks, from a period of Early July, 1943 to

Mid-1949. In June 1937, 3.41 yuan traded for one USD. By December 1941, on the black-market

18.93 yuan could be exchanged for a USD. At the end of 1945, the yuan had fallen to 1,222 Yuan for

a Dollar. By May 1949, one USD fetched 23,280,000 yuan. During the peak of Hyperinflation,

Inflation rate was an incredible 5070%, with prices in yuan doubling every 5.4 days.

The Chinese Hyperinflation episode is a Classic example of War-driven inflation. It started out with

the Chinese Government’s attempts to raise money for the Sino-Japanese War back-firing upon

them , loss of confidence of the people in the Government & the Banks as well as the recession

brought about by the War itself. The incident was also influenced by War-time activities in other

nations such as the US- demonstrating how recessionary & inflationary tendencies in one nation can

quickly spread to another through trade- and affect badly-managed economies very quickly.

FROM HIGH INFLATION TO HYPERINFLATION

Till 1927, the Chinese banking sector was dominated by informal moneylenders as well as private

banks operating autonomously in different parts of the country. Most banks printed their own notes

which were backed by Silver, the traditional medium of exchange in China. These notes were

accepted by both the Government and among other banks.

Given the problems in maintaining a string tax base in China, the escalation of conflicts & growing

Civil unrest had compelled the Chinese Government (led by Chiang Kai-Shek) to depend heavily on

these Private banks for loans. According to the Currency System of China, 1980, these loans

accounted for as much as 49% of the Government’s revenue by 1928. Concerns over the

government’s ability to repay the loans led to the establishment of the Central Bank of China- china’s

first centralized National Bank. The Central Bank offered the private banks large quantities of bonds

guaranteed and backed by government revenue from custom taxes that carried high rates of

interest. These bonds did not fix the financial situation, in fact they made it much greater, but they

did delay the repayment time.

Unfortunately for the Chinese, losses in the War had affected their industrial output as well as

confidence among investors. The economy, already suffering due to corruption & mismanagement,

went into recession. By 1934, the Chinese GDP had fell by 26%.

As the Great Depression in the US arose, the US Government started the Silver Purchase Act which

enabled the US Treasury to purchase Silver. Massive amounts of Silver went out of China- thus

intensifying a Deflationary inflation; this helped appreciate the Yuan a little but increased burden of

debt & decreased industrial output. Despite export controls on Silver, problems increased. When

Private Banks started selling off their holdings of Government bonds at a loss, Chinese government

started taking over them. In 1935, The Central Bank of China announced the Currency Decree and

officially took the country off the silver standard and placed the country on a fiat currency called fai-

pai or Chinese National Yuan.

While this allowed China to monetize its debt & stabilize the economy- just helping it in the War, it

increased inflation rates & damaged the economy & Savings of the Public.

15

THE GENESIS OF HYPERINFLATION

Hyperinflation in China was sparked off by a series of avoidable as well as unavoidable events in

1941.

First, the World War & the Chinese Civil War had necessitated the printing of vast amounts

of currency. The monetary expansion was so severe that the Government had to import

money printed in England.

Second, Civil & Foreign War had virtually destroyed China’s industrial capacity and the

Middle Class. The Government was unable to either collect taxes or manage the economy

properly.

Third, vast amounts of Gold & Silver were being transported to Taiwan for fears of Civil War.

Hyperinflation, 1943-1949

Between 1941 and 1948, the Money supply grew over 2000 times. Both the Government & the

Revolting Communists printed their own currencies to fund the War. The figures for increase in

quantity of money in circulation was:-

1937:- 3.6 Billion Yuan.

1941:- 22.8 billion Yuan.

1942:- 50 billion Yuan. (Hyperinflation starts)

1943:-100.2 billion Yuan.

1944:- 275 billion Yuan.

1945:- 1506.6 billion Yuan.

1946:- 9181.6 billion Yuan.

1947:- 60965.5 billion Yuan.

1948:-399091.6 billion Yuan.

Ebeling writes: -

‘The value of China’s paper money on the foreign-exchange market reflected this huge depreciation

of the currency. In June 1937, 3.41 yuan traded for one U.S. dollar. By December 1941, on the black

market 18.93 yuan exchanged for a dollar. At the end of 1945, the yuan had fallen to 1,222 to the

dollar. And by May 1949, one dollar traded for 23,280,000 yuan’.

The Hyperinflationary episode in China also coincided with massive loss of tax base (called the Tanza

Effect); there was massive Capital Flight to countries like Taiwan & the US- sparking off economic

problems in Taiwan in the 1940s too.

The situation stabilized by late 1950, and was mostly over by 1952.

16

STOPPING HYPERINFLATION

The Communist government took several steps to stop Hyperinflation.

A new Yuan- pegged at 3 million fai-pi to 1 new Yuan was introduced. Price controls & Austerity

measures were introduced & dependence on Deficit financing was curbed. Alternately, the

Communist Government also started an (technically illegal) program of acquiring properties of the

defeated former Government in order to fund its reconstruction & welfare programs. Tax collection

& Land redistribution systems were reformed.

Chinese reconstruction was also financed partly by American & Soviet grants for War

Reconstruction. Soviet Engineers were also instrumental in restoring the country’s industrial centres

in Manchuria as part of their aid program. Printing of new Money was curbed until the problem

gradually resolved over the next 5-10 years.

17

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Demands in Chinese Hyperinflation (2003) 3. Richard C Burdekin, Hsin-hui White, Exporting Hyperinflation (2001) 4. http://goldsilver.com/article/hyperinflation-the-chinese-tale/ 5. Philippe Beaugrand, Zaire's Hyperinflation, 1990-96, Authorized for distribution by Paul A.

Acquah, INTERNATIONAL MONETARY FUND, African Department 6. Jean−Claude Maswana, Assessing the Money, Exchange Rate, Price Links during

Hyperinflationary Episodes in the Democratic Republic of the Congo, Graduate School of Economics, Kyoto University

7. Tom De Herdt , Democracy &the Money Machine in Zaire, Review of African Political Economy, Vol. 29, No. 93/94, State Failure in the Congo

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17. Developing Country Debt and the World Economy by Jeffrey D. Sachs, 1987 18. The Bolivian Hyperinflation and Stabilization by Jeffrey D. Sachs, 1987 19. Inflation Stabilization in Bolivia by Juan Antonio Morales, 1987 20. Inflation and hyperinflation in the 20th century by Amadou Dem, Gabriela Mihailovici, Hui

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