In October 1985 Zambia adopted a significant package of market-oriented reforms. These reforms included a reduction in controls on consumer prices and interest rates, a reduction in consumer subsidies, particularly on maize, an "own funded" import scheme that legalized certain transactions for Zambians illegally holding foreign exchange, and the introduction of an auction for foreign exchange. While major users and earners of foreign exchange were not allowed to participate in the auction, and only 22% of foreign exchange was sold through the auction in 1986, the auction played a crucial role in making a legal market for foreign exchange. Moreover, the auction price was used as the basis for the government allocation of non-auctioned foreign exchange. The foreign exchange auction thus imposed market discipline on the price used in the administrative allocation of foreign exchange.
The reform package had some obvious, immediate effects. The kwacha, the Zambian currency, quickly depreciated from K2.2/dollar to K6/dollar. To some this depreciation was a sign of economic weakness. On the other hand, the auction made it possible to purchase easily foreign exchange at the prevailing rate, while prior to the reforms access to foreign exchange depended on government favor.
Another immediate effect of the reform package was that consumer prices rose. The government sharply increased prices, formerly heavily subsidized, of publicly provided services such as transport and communication services, housing, schooling, and utilities. While such price increases were directly apparent to consumers, an important benefit was to reduce the government's need to impose taxes to pay for the subsidies, and to allow private entrepreneurs, who did not have government subsidies, to compete to serve consumer needs in these areas.
Other consumer prices also rose sharply. On an annualized basis consumer price inflation averaged 93% over the six months following the reforms, in contrast to an average rate 30% in the preceding year. A large part of this price rise can be explained by a one-time consumer adjustment in response to a shift from a price-controlled, shortage economy to a market-clearing economy. With price controls and shortages, consumers need to retain sufficient money balances to be able to purchases goods immediately when they become available. With price liberalization and market clearing, goods are always available at the market price, and consumers tend to hold lower money balances. Thus the shift from a shortage economy to a market economy reduces money demand and causes a subsequent one-time increase in prices.
The reform also increased the prominence of luxury consumption. Prior to the reform, purchases of luxury goods were made discreetly through access to privileged government channels or through illegal markets. With market liberalization traders began to display and advertise luxury goods openly for those with the means to purchase them. Such open trade in luxuries caused resentment among those without the means to purchase luxuries.
In April 1986 the President of Zambia changed his economic policy team in response to criticisms of the reform program. The new leader for economic policy was an economist trained in one of the centrally planned economies in Eastern Europe. This economist argued that rising costs caused inflation, and he sought to reduce inflation by appreciating the exchange rate. One of his policy initiatives was to increase sales of foreign exchange in an attempt to drive down the auction price for foreign currency. Not unlike the situation that develop with respect to consumer durables in centrally planned economies, the sales of foreign exchange turned into forward sales, since the government was not able to immediately provide the foreign exchange. Eventually a ten-week queue of foreign exchange deliveries developed.
The forward sales made economic policy highly vulnerable to a credibility crisis. If domestic traders felt that the government's policy to appreciate the exchange rate was credible, then they would sell foreign exchange and they would be no need for the government to undertake additional sales and build up a queue of outstanding foreign exchange deliveries. On the other hand, as the queue of outstanding foreign exchange deliveries grew, domestic traders had increasing reason to suspect the sustainability of government policy. In particular, with a large queue of outstanding foreign exchange liabilities, the government's financial position was highly vulnerable to an exchange rate depreciation. Moreover, given the change in the economic team, there was good reason to fear a policy reversal and the re-imposition of foreign exchange controls. The rational action given such a fear was to purchase foreign exchange immediately.
In fact, domestic traders did not believe that government policy could or would be sustained, and the result was a dramatic exchange rate depreciation and a large trading loss by the Central Bank. While the policy intent was to sell foreign exchange so as to cause an exchange rate appreciation, the government's policy shift caused a sharp increase in demand for foreign currency and a massive depreciation of the exchange rate. While the exchange rate was roughly constant for the first eight months of the currency auction, over the next year it depreciated from K7/dollar to K21/dollar. This depreciation meant that by the time the Central Bank delivered foreign exchange to purchasers, it was worth significantly more than the price it was originally sold for. The result was a Central Bank loss of about one billion kwachas between July 1986 and March 1987.
The exchange rate depreciation and Central Bank trading losses spurred inflation and a growth in the public sector deficit. In response to the ensuing economic crises, in May, 1987, the government re-imposed controls on the markets for commodities, credit, and foreign exchange.
The above case summary is based largely on Robert H. Bates and Paul Collier, "The Politics and Economics of Policy Reform in Zambia." This paper provides additional analysis of political and economic factors.
Policy Credibility Learning Module