Zambia: Selected Issues
Author: International Monetary Fund
Publication Date:
24 Jan 2008
eISBN:
9781451841329
ISBN:
9781451841329
Language:
English
Keywords:
ISCR; CR; Zambia; government; ZESCO; Zambia's reserve; risk of a terms of trade shock; current account risk; B. reserve adequacy; opportunity cost; Reserve positions; Current account; Imports; Terms of trade
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This paper analyzes the efforts taken to create fiscal space for the implementation of the fifth national development plan and the risk associated with it, examines the role of monetary policy in determining inflation, and discusses policy options to achieve low inflation. It also identifies areas where reform strategy needs more attention and suggests that reforms of financial system regulation need to be accelerated to ensure stability of the system. It analyzes traditional reserve adequacy measures, and finds looming power crisis as an obstacle to growth.

Abstract

This paper analyzes the efforts taken to create fiscal space for the implementation of the fifth national development plan and the risk associated with it, examines the role of monetary policy in determining inflation, and discusses policy options to achieve low inflation. It also identifies areas where reform strategy needs more attention and suggests that reforms of financial system regulation need to be accelerated to ensure stability of the system. It analyzes traditional reserve adequacy measures, and finds looming power crisis as an obstacle to growth.

IV. Zambia: Assessing Reserve Adequacy1

A. Introduction

1. Zambia has gradually increased its gross official reserves over the past few years. Reserves reached about US$600 million (2.2 months of import coverage) in 2006, from about US$110 million (1.0 month of import coverage) in 2000. By September 2007, reserves stood at about US$900 million (2.5 months of import coverage). The authorities consider 3 months of import coverage, the so-called “rule of thumb,” to be the goal for the medium term. They are building up reserves to insure themselves against a shock, but whether 3 months is enough reserves for Zambia to cope with external shocks needs to be assessed.

2. The main reasons for holding reserves are to enable central banks to reduce exchange rate volatility and to create a buffer against external shocks that could affect domestic welfare. Reserves mitigate the impact on welfare of balance of payments crises by reducing the fall in domestic output and by diffusing the impact on domestic absorption (Jeanne, 2007). Reserves give the authorities time to put in place the necessary corrective policies. Moreover, higher reserves may themselves reduce the probability of a crisis. However, because building up reserves has a cost, it is necessary to understand the probability and the likely size of shocks.

3. Two approaches are used in this paper to assess reserve adequacy in Zambia. Section II discusses traditional reserve adequacy measures (rules of thumb), such as reserves-to-imports, reserves-to-short-term external debt, and reserves-to-money. Section III presents the results of applying the cost-benefit approach to the optimal level of reserves proposed in Jeanne (2007). Section IV draws conclusions. The analysis suggests that Zambia would benefit from further strengthening its reserves.

B. Reserve Adequacy Measures for Zambia

4. Reserve adequacy needs to be assessed broadly. The assessment should take into account macroeconomic policies, institutional conditions, and factors that affect the probability and magnitude of external shocks. Thus, we present below some stylized facts before discussing reserve adequacy measures for Zambia.

Macroeconomic policies

5. The Zambian authorities continue to pursue sound economic policies. These policies together with a favorable external environment and extensive debt relief have brought sustained economic growth, lower inflation, a stronger current account, and reserve accumulation. One of the most important ways to protect against balance-of-payments shocks is to implement sound macroeconomic policies. Policies of particular relevance to reserve adequacy are:

  • Exchange rate policy: Zambia’s exchange rate is flexible and market-determined. The central bank intervenes in the foreign exchange market only to maintain market conditions orderly. The real effective exchange rate has appreciated since the early 2000s (in line with the rise in the price of copper); the nominal exchange rate has been highly volatile. While a more flexible exchange rate has been found to reduce demand for reserves (Frenkel, 1983), the impact of exchange rate volatility is not clearly defined.

  • Public debt policy: Zambia is at low risk of external debt distress and overall its public debt is sustainable.2 Extensive HIPC and MDRI debt relief has substantially improved the debt outlook. As of 2006, external debt amounted to about 9 percent of GDP, down from 86 percent in 2005. The external debt service-to-export ratio, which has also drastically declined, is expected to hold at about 1 percent over the medium term. Furthermore, the Zambian government issues treasury bills and bonds denominated in local currency only. As of 2006 the value of government securities had reached K 5.1 trillion (about 13 percent of GDP). While the debt sustainability analysis considers this to be domestic debt, it is estimated that nonresidents hold 13 percent (about US$155 million or 1½ percent of GDP) of government securities, 67 percent of which are short-term debt. This suggests that the possibility of pressure on reserves because of a change in sentiment by foreign investors is moderate.

Institutions

6. Zambia has been making efforts to build its institutions. Public debt as a whole is low, and domestic public debt, which is about 68 percent of the total, is fully denominated in domestic currency. Public external debt is mostly long-term. The government has been trying to lengthen the maturity of its securities and has not been granting guarantees to the private sector or to public enterprises. Moreover, it is committed to borrowing from abroad mainly on concessional terms. To manage its debt better, the government is finalizing a public debt strategy. Although banks are well-capitalized and liquid, the authorities are planning to further enhance banking supervision and central bank independence. Capital transactions in Zambia are free of controls. Sound institutional arrangements and practices have been found to reduce pressures on reserves.

Possible shocks

7. The most common shocks for developing countries are terms of trade shocks, sudden stops in capital inflows (including grants), global interest rate hikes, and oil price hikes (Becker et al., 2007). To determine the frequency and nature of the shocks that Zambia is exposed to, we take into account its specific characteristics by focusing on the first two types of shocks:

  • Terms of trade shocks. Zambia’s exports (about 38 percent of GDP) are highly concentrated in copper (about 78 percent of export receipts), the price of which is volatile (Figure 1). Copper prices are projected to decline sharply over the next three years (WEO, September 2007 forecasts). However, large investments in copper mines are expected to raise production substantially, largely offsetting the projected decline in prices. The baseline scenario assumes that during 2008–10, copper export volumes will grow at an average annual rate of about 16 percent, while copper prices will fall at an annual average rate of about 20 percent. Receipts from copper exports are projected to increase by 4 percent in 2008 in nominal terms. However, if the projected increase in volume does not materialize, receipts could decline by 12 percent and the current account deficit could widen by 2¼ percent of GDP. Zambia’s risk of a terms of trade shock is therefore high.

  • Sudden stops in capital inflows: To assess this risk, it is necessary to understand the composition of Zambia’s capital inflows. Here we analyze inflows for 2000–06.

  • Annual average foreign direct investment (FDI), which is mainly in the mining sector, is estimated to have been about US$300 million (5¾ percent of GDP), and is expected to increase because large new mining projects are now getting underway. FDI is projected to total US$810 million in 2007 (7.2 percent of GDP).

  • Annual average grant inflows, including current transfers, were about US$300 million. While the standard deviation for grants is lower than for loans and FDI, the inability to predict when these inflows will arrive within a given year could affect the build-up of reserves.

  • Annual average loan disbursements held steady at about US$160 million.

  • Foreign investment in government securities began in early 2005, after Zambia reached its HIPC completion point. The estimated stock of government securities in the hands of foreigners has increased from about US$150 million at the end of 2005 to about US$200 million by the end of September 2007. Annual average portfolio inflows have been only about US$70 million for 2005–07.

Figure 1.
Figure 1.

Copper Price 1

(Spot; U.S. cents per pound)

Citation: IMF Staff Country Reports 2008, 029; 10.5089/9781451841329.002.A004

1 Annual average from 2002-2004, quarterly average in 2005, daily prices in 2006-07.

Becker et al. (2007) recommend that countries adopt a less debt-intensive structure of external finance to reduce the risk of a crisis. Further, FDI has been found to be more stable than other capital inflows. Zambia’s increasing dependence on FDI in recent years, therefore, suggests it is at low risk to sudden stops in capital flows.

Measures of reserve adequacy

8. Traditional reserve adequacy measures are useful, but are only a starting point for further analysis. We compare Zambia’s position to that of a sample of selected African countries, “mature stabilizers” that have gone from a PRGF arrangement to a PSI or are expect to do so (Table 1).3 All selected countries are low-income countries, except for Cape Verde (a lower-middle-income country) and six of them have benefited from HIPC and MDRI relief.

Table 1.

Comparison of Reserves in Selected African Countries

article image
Source: IMF, World Economic Outlook.

9. The traditional reserve adequacy approach looks at four measures:

  • Reserve-to-imports: This is particularly relevant for countries that are exposed to terms of trade shocks but do not have significant access to international capital markets. It represents the number of months a country can support its level of imports after all inflows stop. Reserves equivalent to 3 months of imports is the rule of thumb most commonly used (Wijnholds, 2001). While there is no theoretical basis for this rule, in many cases it is justified by the need to meet unexpected external shocks with reserves to avoid a sudden stop in essential imports. On this measure, Zambia was the only country among those analyzed that did not have adequate reserves at the end of 2006; even though its import coverage had doubled since 2000, it had only 2.2 months of coverage. The average for the countries compared, was 4.1 in 2006 (Figure 2).

  • Reserves-to-short-term external debt by remaining maturity: This measure is useful for countries that have significant access to international capital markets and are therefore vulnerable to a capital account crisis. Countries can benefit by holding enough reserves to cover all obligations falling due within the coming year. The Guidotti-Greenspan rule recommends that reserves be at least equal to short-term debt, thus the threshold for this measure is 1. Of the eight countries, seven had ratios higher than the threshold. Although Zambia’s reserve-to-short-term debt ratio has increased from 0.3 to 0.5, it is still below both the threshold and the average recorded by the countries analyzed (Figure 3). On this measure, Zambia does not have enough reserves.

  • Reserves-to-M2: This is relevant for countries facing a risk of capital flight and is particularly appropriate for countries with a pegged exchange rate. However, even countries with flexible exchange rates must be concerned about the possibility of a run on their currency, because contagion can affect their economies. The usual benchmark range for this measure is 5%–20% (Wijnholds, 2001). Countries with more flexible exchange rates can hold a lower ratio. On this measure all countries considered, including Zambia, score above the upper bound of the suggested threshold (Figure 4).

  • Reserves-to-GDP: While there is no threshold for this measure, it allows for cross-country comparison by other means. By this measure, Zambia’s reserves are only about 1/3 of the average recorded by the selected countries (Figure 5), but has strengthened over time. As of 2006, Zambia’s reserves had reached 5.5 percent of GDP, though that is still well below the average of about 14 percent of GDP registered by the comparison countries.

Figure 2:
Figure 2:

Reserves in Months of Imports of Selected African Countries

Citation: IMF Staff Country Reports 2008, 029; 10.5089/9781451841329.002.A004

Figure 3.
Figure 3.

Reserves-to-Short-Term Debt of Selected African Countries

Citation: IMF Staff Country Reports 2008, 029; 10.5089/9781451841329.002.A004

Figure 4.
Figure 4.

Reserves-to-M2 of Selected African Countries

Citation: IMF Staff Country Reports 2008, 029; 10.5089/9781451841329.002.A004

Figure 5.
Figure 5.

Stock of Reserves of Selected African Countries

(Percent of GDP)

Citation: IMF Staff Country Reports 2008, 029; 10.5089/9781451841329.002.A004

10. Zambia’s current account risks suggest a need for it to increase reserves. Given that the current account is the main factor behind the balance of payments instability in low-income countries, we consider it useful to assess the reserve adequacy against a possible current account shock. Thus, besides reviewing the traditional measures, we have quantified the import coverage required to face an external shock. The analysis assumes that the shock will be fully absorbed by a change in reserves. Moreover, since Zambia’s reserves are still below the suggested 3-month threshold and the risk of a terms of trade shock is high, we also quantify the level of reserves that will allow Zambia to face a current account shock (Table 2).

Table 2.

Implied Reserve Need for Selected African Countries

article image

Standard deviation (percent of GDP), 1990-2006.

Reserve coverage in months of imports needed to cover a two-standard deviation shock.

Reserves in months of imports.

11. We calculate the standard deviation of the current account as a share of GDP and assess the import coverage necessary to face a two-standard-deviation move in the current account. By this measure, the import coverage required for Zambia is 3 months, right at the threshold. Zambia is moving in the right direction; by September 2007, it had reached 2.5 months of imports. If the assessment were based on the standard deviation of export receipts as a percent of GDP, the import coverage required would be 2.3 months, below what is required based on a current account shock. Thus the analysis shows that at the end of 2006 Zambia’s reserves, though adequate for facing an export shock, were below what is needed to face a current account shock. Zambia would benefit from building up reserves further.

12. The analysis of implied reserve needs suggests that most of the countries analyzed have more reserves than they need. Of the eight countries, six have more reserves than they need to face a current account shock—four have accumulated more than 150 percent of the estimated need. With an average of 4 months of import coverage, the eight countries seem to have reserves in excess of the implied need of 3.2 months.

C. Assessing the Optimal Reserve Level for Zambia

13. An alternative approach to assessing reserve adequacy compares the costs and benefits of holding reserves. The model developed by Jeanne (2007) is used to estimate the optimal level of international reserves for Zambia.

Model and Assumptions

14. The model assumes a small open economy, with one single homogeneous good, that is subject to crises, defined as a loss of access to external credit associated with a fall in output. The representative consumer who populates the economy benefits from the country accumulating reserves in two ways: (i) lower probability of a crisis, and (ii) lower welfare cost of a crisis.

The full insurance level of reserves is the level that allows the consumer to continue consuming at the desired level in a crisis:

R=L+ΔY,

where R is the level of reserves, L the level of short-term debt, and ΔY the output loss in a crisis, each expressed as a percent of GDP.

The optimal level of reserves minimizes the loss function:

Loss=δR+πf(R,L,ΔY,σ),

where δ is the opportunity cost of accumulating reserves; π is the probability of a crisis; and f(.) is the welfare cost, which depends on R, L, ΔY, and the risk aversion of the consumer, σ. It is equal to:

R=L+ΔY−(1−(1+δ/π)−1/σ),

that is, the optimal level of reserves is equal to the full insurance level minus a term reflecting the opportunity cost of holding reserves. It increases with the probability of a crisis and consumer risk aversion but decreases with the opportunity cost of holding reserves.

Estimated model for Zambia

15. It is assumed that Zambia is subject to crises associated with terms-of-trade shocks that reduce its output. The calibration is based on the following assumptions:

  • A crisis is caused by a terms of trade shock, which is defined as a 10 percent deterioration in the terms of trade.

  • Zambia’s output loss is assumed to be 3.7 percent of GDP, which is the level estimated for the 44 sub-Saharan African countries for 1980 through 2006 (Sub-Saharan Africa Regional Economic Outlook—October 2007).

  • The probability of a terms-of-trade crisis, defined as the frequency of a worsening of the terms of trade by 10 percent or more that results in a loss of output, is assumed to be 5 percent (Sub-Saharan Africa Regional Economic Outlook—October 2007).

  • The value of the opportunity cost of accumulating reserves (0.3 percent of GDP) is estimated based on the spread between the interest rate on Zambia’s treasury bills and the return on reserves. In 2006 the return on reserves was lower than the interest rate.

  • The benchmark value of relative risk aversion is set to 2, in line with the lower bound of the range assumed by Jeanne (2007).

16. With these assumptions we estimate that the optimal level of reserves is below the 2006 year-end level. Since the optimal level of reserves is sensitive to the assumptions on output cost, probability of a crisis, and degree of risk aversion, we perform sensitivity analyses by re-estimating the model, modifying one parameter at a time. Changes in the output cost have a linear one-to-one impact on the optimal level of reserves. If the output cost is increased by one percentage point f GDP, the optimal level of reserves increases by one percentage point from 2 percent of GDP (baseline) to 3.2 percent of GDP (alternative scenario 1). If the probability of a crisis is doubled to 10 percent, the estimate of optimal reserves increases to 4.5 percent of GDP (alternative scenario 2). Moreover, the optimal level of reserves increases to 5.1 percent of GDP if we assume that risk aversion also doubles (alternative scenario 3). As we increase the output cost, the probability of a crisis and the degree of risk aversion, the optimal level moves closer to the level held by Zambia at the end of 2006.

Table 3.

Zambia: Application of Jeanne’s Model

article image

Expressed in percent of GDP.

Assumes estimates calculated for 44 Sub-Saharan African countries for 1980 through 2006 (www.imf.org).

Assumes an output loss equivalent to the cumulative median loss observed in periods t, t+1, and t+2.

Jeanne estimates that risk aversion ranges from 1 to 10 percent.

D. Conclusions

17. The analysis of traditional reserve adequacy measures suggests that Zambia would benefit from further building up its reserves. In spite of recent increases, the ratios of reserves-to imports and reserves-to-short-term debt are still below the thresholds. However, the reserves-to-M2 measure suggests reserves are adequate. We have also used the thresholds of certain other countries as a yardstick. Zambia’s reserves are below the average for the sample of comparator African countries that have already adopted PSI arrangements or plan to do so, but the reserves of most of the countries selected may be more than is necessary. This comparison, however, does not take into account the macroeconomic and institutional framework of each country. Furthermore, the analysis of the implied reserves needed to cover a two-standard-deviation current account shock suggests that Zambia needs to increase its reserves.

18. Application of the cost-benefit approach proposed by Jeanne can justify higher reserves for Zambia. While application of the model to baseline assumptions results in an optimal level of reserves that is lower than the level attained in 2006, a higher output cost, probability of a crisis, and risk aversion would argue for a higher level of reserves.

References

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  • Becker, Torbjorn, and others, 2007, Country Insurance—The Role of Domestic Policies, IMF Occasional Paper No. 254 (Washington: International Monetary Fund).

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  • International Monetary Fund, 2001, “Issues in Reserve Adequacy and Management” (Washington, October 15).

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1

Prepared by Cecilia Mongrut (PDR).

2

See the 2007 Debt Sustainability Analysis (to be published, www.imf.org)

3

Nigeria is not included because as an oil producer it significantly differs from the other selected countries.

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Cover IMF Staff Country Reports
Zambia: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2008: Issue 029
Publisher:
International Monetary Fund
ISBN:
9781451841329
ISSN:
1934-7685
Pages:
60
DOI:
https://doi.org/10.5089/9781451841329.002

Copper Price 1

(Spot; U.S. cents per pound)

Reserves in Months of Imports of Selected African Countries

Reserves-to-Short-Term Debt of Selected African Countries

Reserves-to-M2 of Selected African Countries

Stock of Reserves of Selected African Countries

(Percent of GDP)