Unraveling Zambia's Fiscal-Liquidity Nexus: The Imperative for Another Aggressive SRR Hike Amidst Policy Complexities

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The stability and health of the Zambian economy heavily rely on the strategic decisions of the Bank of Zambia (BOZ). This analysis focuses on Zambia's current financial market environment, with a particular emphasis on the foreign exchange (FX) rate, market liquidity, upcoming government financial obligations, and the intricate implications these have on the Statutory Reserve Ratio (SRR) set by the Bank of Zambia.

The Zambian Kwacha is trading at its all-time nadir of 23.085/23.135. In parallel, the offshore FX rate currently stands at around 23.700, a noticeable decrease from earlier in the week when it was hovering around 24.000. This decline is primarily attributable to tighter Kwacha liquidity conditions in offshore markets. Nevertheless, the overall current money market liquidity level is still elevated at around ZMW 4.3 billion.

The calendar for November includes Treasury bill and bond maturities, coupled with bond coupon payments, amounting to roughly ZMW 4.5 billion. December follows a similar trajectory, with T-bill maturities pegged at ZMW 4.5 billion and bond maturities and coupon payments at approximately ZMW 3.2 billion. When we aggregate these figures, this implies a staggering ZMW 12.1 billion in maturities and coupon payments by year-end.

Conversely, an FX sale by the BOZ of $ 19.5 million at an average rate of 23.018 will likely drain the money market of around ZMW 0.4 billion today. Moreover, yesterday’s T-bill auction indicates a withdrawal of ZMW 1.5 billion from the market. In sum, these movements suggest a withdrawal of approximately ZMW 1.9 billion from the market in the immediate term. This figure, when juxtaposed against the totality of security maturities from T-bills and bonds, along with coupon payments, places the net injection to the market at around ZMW 10.2 billion by year-end (excluding government-related expenditures and VAT refunds) – a pivotal number that forms the crux of our liquidity assessment.

To manage its financial obligations, the Government of the Republic of Zambia (GRZ) schedules security auctions comprising both Treasury bills and bonds. In the forthcoming period to year-end, three Treasury bill auctions and two bond auctions are on the horizon, where GRZ aims to raise ZMW 11.0 billion.

The scenarios that unfold from these auctions are critical in determining the liquidity landscape to year-end. Let us consider the possibilities: if GRZ succeeds in raising none of its target amounts, the net liquidity will swell to approximately ZMW 14.5 billion. Under such circumstances, to fully drain liquidity, the BOZ would need to contemplate a substantial hike in the SRR by 18.8%. In a scenario where GRZ meets 25% of the funding target, the net liquidity over this period is estimated at ZMW 11.8 billion, necessitating an SRR increase of 15.2% to mop all Kwacha liquidity effectively. If the funding achievement hits the 50% mark, the net liquidity will rise to around ZMW 9.0 billion, implying an SRR hike of 11.7% to drain liquidity fully. Achieving 75% funding translates to net liquidity of ZMW 6.3 billion, requiring an SRR increase of 8.1% to mop up liquidity thoroughly. In an optimistic scenario where the government successfully raises the entire ZMW 11.0 billion, the net liquidity drops to ZMW 3.5 billion, indicating an SRR hike of 4.6% would be sufficient to drain all liquidity.

As earlier alluded, it is imperative to consider that these projections do not account for potential influxes in money market liquidity from government-related expenditures and Zambia Revenue Authority (ZRA) VAT refunds. Such variables could significantly alter the liquidity landscape, further complicating the BOZ’s decision-making process and underscoring why we continually highlight the need for better coordination between the BOZ and GRZ regarding managing these influxes into the money market.

Another crucial aspect to consider is GRZ’s funding shortfall. As of the end of August 2023, the shortfall in net external financing stood at ZMW 2.5 billion, while the gap in net domestic financing was ZMW 8.4 billion. The latter culminates in a total net financing shortfall of ZMW 11.0 billion. This shortfall, understandably, injects a degree of caution into the BOZ’s approach towards aggressive monetary tightening measures. The apprehension stems from a concern that an aggressive tightening of liquidity conditions might severely constrain the government's ability to meet its FY2023 financing targets.

There is a glimmer of hope with the expected disbursement from the International Monetary Fund (IMF) of around $180 million before year-end. This influx will alleviate the government's financing pressures by approximately ZMW 4.2 billion at the current exchange rate. This development, while positive, is set against the backdrop of ongoing debt restructuring conversations between the Zambian government and its commercial creditors. The outcome of these negotiations, aimed at reaching a deal "acceptable" to the IMF and the official creditor committee (OCC), remains critical. Notably, we do not see the IMF withholding these funds from GRZ, as there is clear progress in the discussions.

As aforementioned, the ongoing dialogue about potential hikes in the Statutory Reserve Ratio (SRR) presents a spectrum of scenarios. On one end, we contemplate a hike of 4.6%. At the same time, we consider a more substantial hike of up to 18.8%. Both considerations aim to fully drain Kwacha liquidity from the money market depending on GRZ’s funding achievements to year-end.

Indeed, the effectiveness of the recent SRR hike is a topic of debate among financial market enthusiasts and market players, particularly banks. The current confidence in the banking sector regarding the limited impact of the recent SRR 3% hike stems from the fact that the upcoming maturities in November and December are substantial enough to offset the prevailing liquidity withdrawal. This anticipated influx from maturities has created an environment where banks are relatively comfortable with liquidity, showing little concern for the current tightening. They are right to be, of course. Even after implementing the 3% SRR hike, Kwacha money market liquidity remains elevated at ZMW 4.3 billion. This liquidity situation is certainly ominous for the Kwacha's stability in the near term.

Certainly, there are other channels at the disposal of the BOZ, to manage liquidity, such as FX sales. Typically, when the central bank sells dollars, it effectively withdraws Kwacha from the system. However, Zambia’s limited dollar reserves currently constrain the utilization of this mechanism. As of the end of July 2023, FX reserves stood at around ZMW 2.8 billion, which equates to only three months of import cover. This limited FX reserve capacity restricts the BOZ’s ability to influence Kwacha liquidity through FX sales significantly and substantially reduces its capacity to alleviate FX pressure through this channel. It also limits the ability of the central bank to utilize one direction of FX swaps to mop up Kwacha liquidity. In the latter, the BOZ would be looking to lend dollars and borrow Kwacha, effectively draining Kwacha from the money market. In fact, given the FX reserves position, the BOZ would be driven to use FX swaps in the opposite direction to bolster the FX reserves position by borrowing dollars from the financial sector and lending Kwacha. Unfortunately, this would also exacerbate the current liquidity conundrum unless the BOZ were to enforce a mechanism where the Kwacha lent to the financial sector would have to be placed back with them or with the GRZ at a rate suitable to financial market players rather than a rate set by the BOZ or GRZ.

Open market operations (OMO) present yet another avenue for liquidity management. In recent times, the BOZ has modified its approach to OMOs. Where market players were previously allowed to bid at their preferred rates, the central bank has now shifted to a mechanism where it sets the rates upfront in the OMO window. This change aimed to address issues related to expensive OMO rates and to correct the previously observed anomaly of an inverted yield curve between the overnight and 90-day periods. However, given the current levels of market liquidity and the impact of security maturities and coupon payments yet to manifest, this revised mechanism may need to be more effective. If the central bank intends to drain liquidity from the market significantly, the current OMO strategy might fail to achieve the desired impact. The BOZ should consider reverting to the previous approach.

So, the BOZ is at a crossroads. The central bank can certainly not hike the SRR by as much as 18.8%, at least not immediately. Meanwhile, a further SRR hike of 4.6%, which assumes a rosy 100% funding achievement for GRZ, will likely not be sufficient over this period. Somewhere between an 11.25% and a 12.25% SRR hike on Kwacha deposits, which would take the SRR rate on Kwacha deposits to between 25.75% and 26.75%, may be a more apt recommendation in the immediate future.

The BOZ will deliver an MPC announcement next Wednesday, November 22nd. The BOZ will likely maintain a hawkish bias, and we expect another Basis Policy Rate (BPR) increase of at least 1%. In this period leading to the MPC announcement, or at the announcement itself, the BOZ should consider delivering a further aggressive SRR hike to complement the likely increase in the BPR. Even then, as covered in our Monday 13th November Issue, Continuing the Dialogue: Navigating the Dynamics of Kwacha Stability Amidst SRR Adjustments and Economic Challenges, we maintain that in the immediate term, the BOZ should also extend its focus to the levels of foreign currency (FCY) deposits in commercial banks, which we believe demand thorough examination and possible intervention.

Of course, the strategies outlined above will likely come with their own set of implications and effectiveness. The choice of tools would depend on the central bank's assessment of the prevailing economic and financial stability situation and the BOZ's policy objectives for price stability and growth. We maintain that price stability and inflation should be a higher priority.

When exchange rate fluctuations primarily drive inflation, prioritizing price stability over growth becomes crucial for any central bank, particularly when inflation exceeds targeted ranges for an extended period. Unchecked inflation erodes socioeconomic stability over time by increasing business costs and output prices (which often remain sticky) and reducing real disposable incomes (as wages rarely rise to match or outpace inflation), further straining weakened economic growth and constraining credit extension. In such a context, not promptly addressing inflation may compel the central bank to implement more drastic and disruptive measures later, further undermining economic stability and growth prospects. We broadly covered this in our October 23rd Issue, Time to Aggressively Adjust the Statutory Reserve Ratio: A Tactical Prescription for the Bank of Zambia to Stabilize the Kwacha.

Tracing the Roots of Zambia’s Kwacha Liquidity Scenario

Understanding the current money market liquidity situation necessitates a look back at the historical patterns of government borrowing and spending. This retrospective analysis reveals the cyclical nature of government finances and how this has shaped the current landscape.

The crux of Zambia's liquidity is traceable to the government's net domestic financing activities. Over the years, there has been a noticeable trend: significant domestic borrowings in one fiscal year lead to substantial domestic maturities in the subsequent years. This pattern has resulted in a perpetual cycle of borrowing and maturing debts, creating waves of material Kwacha liquidity injections into the money market. The borrowings in previous years, notably before FY2022 (specifically FY2020 and FY2021), set the stage for the significant maturities we observe today. Each year, as the government seeks to finance its obligations, it enters the market for fresh borrowings, thereby increasing the net issuance. This cyclical pattern has not only sustained but also exacerbated the liquidity situation.

The scale of government expenditures is a crucial factor behind the need for increased domestic financing. In the recent past, elevated levels of GRZ spending have necessitated substantial domestic borrowing to bridge the financing gap. Of course, constrained net external financing has also been a critical driver of GRZ's reliance on net domestic financing. Post debt restructuring, particularly after the IMF Extended Credit Facility (ECF) lapses, we expect a gradual realignment to underpin less GRZ reliance on domestic borrowing. 

Nevertheless, government expenditures materially escalated despite opportunities to curtail domestic borrowing, especially in pre-FY2022. For example, from FY2016 to FY2021, GRZ expenditures increased 21.8% per annum on average, notwithstanding clear warning signs that GRZ’s fiscal posture was becoming unsustainable. The 2022 and 2023 GRZ fiscal years, while opportunities to address this issue, remain consistent with the established pattern of high domestic market borrowings, especially since net external financing remains somewhat constrained, thereby limiting GRZ’s ability to impose a sufficient dent to domestic borrowing.

Looking ahead to the 2024 fiscal year, based on current projections, the net issuance for the upcoming financial year will likely increase to at least ZMW6.9 billion, or as much as ZMW 7.5 billion, given that there are five more auctions left to year-end, which would underpin increased Treasury bill maturities and bond coupon payments next year. This increase will elevate the monthly net issuance above the current issuance target of ZMW 6.5 billion per month. Unless net external financing overperforms in FY2024, such an escalation will only further entrench the cycle of Kwacha borrowing and liquidity influx, posing continued challenges for monetary policy management. Otherwise, to mitigate deeper entrenchment, GRZ will need to materially underperform on targeted expenditures, which would thereafter reduce targeted net domestic financing in FY2024 and underscore reduced domestic borrowing requirements in the subsequent fiscal year of FY2025.

The multifaceted challenges faced by the BOZ in steering monetary policy amidst intricate fiscal dynamics are emblematic of the delicate balance required in macroeconomic management. The precarious position of the Kwacha, compounded by substantial government obligations and a constrained capacity for FX intervention, underscores the urgent need for more aggressive monetary policy interventions. The decisions ahead for the BOZ, particularly concerning the Statutory Reserve Ratio and other monetary tools, are not mere window-dressing technical adjustments but are crucial for maintaining macroeconomic stability. Ultimately, the BOZ's policy choices' effectiveness is measurable in terms of short-term market stabilization and their ability to lay a foundation for long-term economic resilience.

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Dean N Onyambu is the Executive Head of Trading at Opportunik Global Fund (OGF), a CIMA-licensed fund for Africans and diasporans (Opportunik), and is a co-author of Unlocking African Prosperity. Passion and mentorship have fueled his 15-year journey in financial markets. He is a proud former VP of ACI Zambia FMA (@ACIZambiaFMA) and founder of mentorship programs that have shaped and continue to shape 63 financial pros and counting! When he is not knee-deep in charts, he is all about rugby. His motto is exceeding limits, abounding in opportunities, and achieving greatness. #ExceedAboundAchieve

For more insights from Dean, you can follow him on LinkedIn @DeanNOnyambu,  X @InfinitelyDean, or Facebook @DeanNathanielOnyambu.