Is internal devaluation the answer?

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Taurai Togarepi
There have been calls by several industry representatives to institute a macro-economic policy aimed at enhancing production efficiency. These calls point towards internal devaluation. It is imperative to define internal devaluation before critically looking at issues surrounding this topical issue.

In general, internal devaluation refers to strategies aimed at lowering the production costs, especially labour costs; through lowering wages or other indirect costs of employers.

Recently Government reduced the exercise duty on diesel and petrol by $0,07/l and $0,065/l respectively in a bid to lower the price of fuel in the country.

The idea is that a reduction in the price of fuel will translate into a positive impact on the overall production cost structures.

Empirical evidence, especially the success story of Latvia and Eurozone will help to unpack the merits and demerits of such a policy.

Latvia lost 24 percent of its output in two years whilst unemployment rose from 5,3 percent in 2007 to 20,5 percent in 2010.

The Latvian government with the help of International Monetary Fund (IMF) instituted pro-cyclical fiscal policies.

The Eurozone economies pursued a similar approach in a bid to enhance competitiveness, push economic growth and increase employment through reduction of labour costs.

The case of Argentina may help to analyse the cost of devaluation under a multi-currency system. Argentina’s financial system was highly dollarised when they adopted internal devaluation.

If households’ income is denominated in local currency whilst their debt or financial obligations are denominated in foreign currency, it will have balance sheet effects. If due care is not taken, it will result in the collapse of the financial sector as economic agents may default on their financial obligations.

In the initial stages of internal devaluation, the country may experience an increase in unemployment and loss of output. Recovery will be depended on many factors hence; it does not necessarily follow that internal devaluation works in every country.

In Zimbabwe, labour costs constitute a greater portion in the production process. Salaries and wages in neighbouring countries such as South Africa are relatively lower meaning they enjoy an absolute advantage when it comes to production.

One would be persuaded to recommend reduction in wages and salaries to lower production costs in line with regional standards.

However, it is critical to understand that real effective demand is a function of purchasing power and if prices remain somewhat stable whilst wages are falling it may cause a decline in aggregate demand and ultimately declining revenues in the short term.

This therefore requires that a wage decrease be accompanied by a commensurate decline in prices of goods and services. If wages fall whilst prices remain the same or increase over the same period, consumer spending will be eroded.

In Zimbabwe, as long as the gap between the physical cash and electronic money remains huge it is very difficult to stabilise prices hence internal devaluation targeted at wages and salaries may be costly to the nation.

Government gets most of its income from pay as you earn and value added tax. Internal devaluation will result in a decline in the contribution of VAT and PAYE to government coffers.

In order to avoid such a scenario, the Government needs to have a sustainable funding model to cover for the possible decline in revenues.

Looking at the above discussion, before the Government pursue internal devaluation, there is need to critical look at ways to mitigate the anomalies it may cause, as most countries who once adopted this macroeconomic policy did not achieve the intended results.

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