This Selected Issues paper analyzes sources of growth in Zambia. It assesses domestic debt dynamics and expenditure composition under two scenarios: first, the execution of the fiscal adjustment envisaged in the 2004 budget and in the medium-term framework; and second, the continuation of recent trends. The paper assesses movements in the external value of the kwacha using a number of different approaches. It also looks at developments in the real exchange rate and in differentials in rates of return on financial assets in Zambia and key financial centers.

Abstract

This Selected Issues paper analyzes sources of growth in Zambia. It assesses domestic debt dynamics and expenditure composition under two scenarios: first, the execution of the fiscal adjustment envisaged in the 2004 budget and in the medium-term framework; and second, the continuation of recent trends. The paper assesses movements in the external value of the kwacha using a number of different approaches. It also looks at developments in the real exchange rate and in differentials in rates of return on financial assets in Zambia and key financial centers.

III. The External Value Of The Kwacha15

37. This section assesses movements in the external value of the kwacha, using a number of different approaches. First, the section looks at developments in the real exchange rate and in differentials in rates of return on financial assets in Zambia and key financial centers. The section then considers developments in the external trade sector and the implications of Zambia’s reliance on external assistance.

A. The Real Effective Exchange Rate

38. The real effective exchange rate (REER) provides a trade-weighted index of the official value of the kwacha against the currencies of Zambia’s trading partners, adjusted for movements in prices in Zambia and its trading partners. To capture relative movements in production costs, the REER should ideally be calculated using, for example, data on unit labor costs. However, the only economy-wide price series available for Zambia is the consumer price index (CPI). This has the disadvantage that its movements may reflect short-term shifts in demand and supply, rather than trends in costs. Moreover, because of the significant component of imported goods in the index, movements in the CPI may not be independent of the exchange rate.

39. The choice of the base year (when the index of the REER takes the value 100—in this case, 1990) is essentially arbitrary. Hence, a value above 100 does not necessarily indicate that the real value of the kwacha is too high. However, this base period provides a convenient benchmark against which to evaluate subsequent developments in the REER because the exchange regime was liberalized and unified in the early 1990s.16 Before liberalization, the value of the REER—calculated at the more appreciated official exchange rate—is likely to have been biased upward; the sharp fall in the REER in the late 1980s reflected the impact of unification.

40. Since the early 1990s, the REER has generally remained within a band of 15 percent. However, there was a modest tendency of appreciation of about 1 percent per year through the 1990s. Zambia’s high inflation, compared to its trading partners, has been only partially offset by a depreciation of the kwacha against the U.S. dollar; while U.S. inflation has averaged 3 percent, the U.S. dollar value of the Zambian CPI has increased by about 4 percent per year since 1990. The appreciation of the REER continued into the early 2000s and was particularly pronounced in 2001 when it peaked at 15 percent above its level of 1990. The REER has since declined and, in 2003, it fell to only 6 percent above its level of 1990.

B. Bilateral Real Exchange Rates and Real Rates of Return

41. An alternative approach assesses the value of the kwacha using the interest rate parity condition. After allowing for a risk premium for investing in Zambian assets, the real rate of return on a financial asset in Zambia, adjusted for exchange rate movements, would be expected, on average, to equal the return available elsewhere. This risk premium is, however, not directly observable and may be significantly volatile over time. The exchange rate-adjusted net rate of return is here calculated ex post using the three-month treasury-bill rate, the CPI inflation rate, and the actual real exchange rate (as an imperfect proxy for the expected rate).

42. For all three financial markets covered here (the United States, the United Kingdom, and South Africa), the evolution of adjusted returns has closely paralleled the evolution of inflation in Zambia, though differentials were also distorted until the early 1990s by exchange rate controls and the use of the official exchange rate. As inflation accelerated through the 1980s and early 1990s, differentials were increasingly negative for all three markets, and the average (negative) differential peaked at over 20 percent in the early 1990s, as inflation reached its peak of 183 percent in 1993.

43. Following the liberalization of the exchange rate and with the decline in inflation, differentials in all three markets turned marginally positive, averaging 1 percent from 1994 to 1999. Efforts to contain and further reduce inflation in 2001 were accompanied by a sharp increase in nominal as well as real interest rates. As a result, differentials in all three markets also increased sharply in 2001 to average almost 30 percent—an increase that was consistent with the increase in the REER that year. The subsequent moderation in nominal and real interest rates (especially at the end of 2003), as well as in the REER, was also reflected in a moderation of differentials, which fell to an average of 3 percent in 2003.

44. Aside from the upward spike in adjusted net returns in 2001 (and to a lesser extent in 2002), differentials have averaged about 4 percent since exchange rate liberalization and the start of disinflation in 1994. This would seem to be reasonable, given the higher risk associated with investing in Zambian financial assets, and does not suggest a significant persistent misalignment in the exchange rate. The evolution of interest rate differentials has been consistent with the evolution of the real exchange rate, and there is little systematic evidence from these differentials that the external value of the kwacha is currently misaligned.

C. The External Trade Sector

45. There was a steady deterioration in the trade balance on goods and services, from a small surplus in the late 1980s to a deficit of over 16 percent of GDP in 2001. Exports declined as a percent of GDP, while import penetration increased. Although these trends began to be reversed in 2001, the sustained widening in the trade deficit through 2001 raises concerns of a secular deterioration in Zambia’s external competitiveness, possibly stemming from the steady appreciation in the real exchange rate noted above. However, there are other factors that need to be taken into account.

46. There have been significant changes in the structure of trade. Metal exports (mostly copper) declined from 90 percent of merchandise exports in 1990s to 61 percent in 2002. This was in part due to lower copper prices, which fell almost 30 percent between 1995 and 2002, but also reflected declines in output. The sector started to recover in 2000 following privatization, and this recovery was strengthened in 2003 by the recovery of copper prices. Despite the appreciation of the REER, nonmetal exports increased threefold in real terms since the early 1990s. This expansion has been prompted by improved access to industrial markets, as well as the greater regional integration with COMESA and SADC.17 These two developments have also resulted in a marked shift away from trade with industrial countries, especially the European Union, toward trade with other developing countries, especially in Africa.

47. Regional conflicts this past decade have also taken their toll, especially because of Zambia’s reliance on neighboring countries for access to the sea. The conflict in Mozambique ended in the early 1990s, but conflict broke out in the Democratic Republic of the Congo later in the decade, and the conflict in Angola has only recently ended. Zambia’s trade flows have also been affected by the recent disturbances in Zimbabwe.18 It is difficult to estimate the impact of these conflicts on Zambia’s external trade, but a study of the spillover effects from conflict has concluded that, for sub-Saharan Africa, a conflict in a neighboring country reduces real per capita growth by up to 0.5 percentage point.19

48. This picture of the trade sector needs to be further qualified by taking into account the large amount of imports related to external aid. The import content of project aid is difficult to estimate. Assuming an import content of 85 percent,20 excluding these aid-related imports significantly reduces the level of the trade deficit but not the deterioration of the trade balance. The adjusted trade deficit was near balance through most of the 1990s, but rose to about 8 percent of GDP in 2001 before falling back to about 5 percent of GDP in 2003.21 A larger part of this increase in the adjusted trade deficit can be attributed to the increase in capital imports, especially in the mining sector, following privatization. To a lesser extent, the temporary increase in imports relating to the recent drought and to the depreciation of the Zimbabwean currency also played a part.

D. External Assistance

49. Zambia’s reliance on high levels of external assistance might be expected to exert an upward pressure on the exchange rate, leading to some measure of “dutch disease.” For example, it has been estimated that a doubling of Overseas Development Assistance (ODA) flows causes a real appreciation of up to 4 percent at impact, increasing to about 18 percent after five years, and that sterilization policy can be quite effective in preventing this real appreciation.22 A corollary is that high levels of external support can also introduce a risk of exchange rate depreciation, should this level of support be reduced.

50. In gross terms, the level of external assistance to Zambia has averaged about 17 percent of GDP over the past two decades, with a standard deviation almost as large. However, apart from a period of low support in the early 1980s and a period of high support in the late 1990s (mostly due to a large PRGF disbursement following the clearing of arrears to the IMF) there is no evident trend. Net of debt service, official resource inflows have also been very volatile and have also increased since the late 1980s in both absolute dollar terms and relative to GDP. Thus, net official resource inflows over 2000-03 averaged 10 percent of GDP, double the level in the early 1990s, with a large part of this increase due to debt relief under the HIPC Initiative.

51. Although measured net resource inflows have been large, their impact on the balance of payments and the exchange rate has been moderated by two factors. First, a portion of these inflows has been used to accumulate international reserves. Second, a large part of the aid has financed imports. Subtracting these two components yields a measure of the net balance of payments support that could directly influence the exchange rate. Using this estimate, net balance of payments support has increased steadily since the mid-1980s but was generally negative until the late 1990s. It turned positive in the 2000s (averaging 1.1 percent of GDP), reaching a peak of about 2 percent of GDP in 2001, but has declined to almost zero in 2003 in the absence of a new PRGF arrangement. Although net balance of payments support has only recently turned positive, the direction of change is consistent with the steady appreciation of the REER over the 1990s and its reversal since 2001. The magnitude of support in recent years would appear to have been too modest to have a direct impact on the exchange rate.

E. Conclusion

52. This section has looked at the external value of the kwacha from four different perspectives. There was a small but persistent tendency for the real exchange rate to appreciate throughout the 1990s. The real exchange rate spiked upward in 2001, but this has since been largely reversed. This evolution of the real exchange rate was consistent with the evolution of interest rate differentials in key financing markets, the trade balance, and external assistance. Overall, the data provide little indication that the external value of the kwacha is currently misaligned.

Table III.1.

Zambia: Summary Table: External Value of the Kwacha, 1980-2003

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Sources: WEO, and staff estimates.

Financial data for 2003 show the average through October, while trade data for 2003 shows projections for the calendar year.

Includes gross disbursements from the IMF under the successor arrangement following the clearance of arrears in 1995.

Includes the clearance of arrears to the IMF in 1995.

Gross disbursements less debt service.

Net resource inflows less reserve accumulation and aid-related imports.

STATISTICAL APPENDIX

Table 1.

Zambia: Gross Domestic Product by Sector of Origin at Constant Prices, 1995-2003

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Source: Central Statistical Office.

Based on the first two quarters of 2003; likely to undergo revision.

Includes public administration, defense, sanitary services, education, health, recreation, and personal services.

Table 2.

Zambia: Gross Domestic Product by Sector of Origin at Current Prices, 1995-2003

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Source: Central Statistical Office.

Based on the first two quarters of 2003; likely to undergo revision.

Includes public administration, defense, sanitary services, education, health, recreation, and personal services.

Table 3.

Zambia: Gross Domestic Product by Type of Expenditure, 1995-2003 1/

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Source: Central Statistical Office.

The methodology for estimating saving and investment is different from that used by Fund staff.

Based on the first two quarters of 2003; likely to undergo revision.

Total revenue (excluding grants) minus government consumption.

Gross domestic savings plus net factor income and net current transfers from abroad.

Table 4.

Zambia: Index of Industrial Production, 1995-2003

(2000 = 100)

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Source: Central Statistical Office.
Table 5.

Zambia: Volume of Mineral Production, 1995-2003

(In thousands of metric tons)

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Sources: Central Statistical Office; and Bank of Zambia.
Table 6.

Zambia: Marketed Production of Selected Agricultural Crops, 1995/96-2002/03 1/

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Source: Central Statistical Office.

Crop years run from May 1 to April 30.

Provisional—likely to undergo revision.

Table 7.

Zambia: Area Under Cultivation for Selected Crops, 1995/96-2002/03 1/

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Sources: Ministry of Agriculture and Co-operatives; and Central Statistical Office.

Crop years run from May 1 to April 30. Data are based on Post Harvest Survey results.

2003 data based on the Final Crop Forecasting Survey for 2003.

Table 8.

Zambia: Paid Employment by Economic Sector, 1995-2003

(In number of employees)

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Source: Central Statistical Office.

Based on first two quarters of 2003; likely to undergo revision.

Table 9.

Zambia: Annual Composite Index of Retail Prices, 1995-2003

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Source: Central Statistical Office.

Composite index consists of food and nonfood indices; alternatively, it consists of metropolitan high and low incomes, and nonmetropolitan indices.

Table 10.

Zambia: Monthly Composite Index of Retail Prices, 2002-2003

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Source: Central Statistical Office.

Composite index consists of food and nonfood indices; alternatively, it consists of metropolitan high and low incomes, and nonmetropolitan indices.