Root out market distortions

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Clive Mphambela
Market distortions are not only a source of vulnerability for the economy, but they are a hindrance to growth. The existence of a plethora of financial market distortions across the Zimbabwean economy should be a cause for concern for policy.

As we progress to put in place an economic revival plan for Zimbabwe, in line with the President Mnangagwa’s vision 2030, we must bring into sharp focus the issues around financial markets and their stability in the new dispensation.

The upheaval in the markets that manifested itself last year largely as a surge in stock market prices and a dislocation in the foreign exchange market, which has spilled into the real goods market in the form of multi tier pricing, must be tackled head on if we are to put the economy on a sustainable path to recovery.

We have seen a rapid decline in real asset valuations in the property markets, we have seen the contraction of private sector credit and we have seen some resurgence of inflation, all being signs that things are not as good as they can be.

The financial services sector plays a central role in the economy through resource mobilisation and allocation. In addition to the intermediation process, the financial sector also facilitates risk transfer and management, performance monitoring of the corporate sector, facilitating trade through providing payment platforms and acting as payment intermediaries and reducing transaction costs.

Financial markets players are a critical element in driving economic development as they act as the link through which funds are transmitted between surplus units and deficit units in the economy.

Financial sector also facilitates savings for future consumption, enabling the economic agents to defer current expenditure through savings. Another key functions of the financial markets is the facilitation of price discovery in the market, provision of liquidity and enhancement of efficiency through information dissemination.

An efficient financial market is one that ensures that participants do not spend too much time sourcing information as it should be readily available.

Financial market distortions interfere with some if not all of the above functions of the financial system. Whilst there is no single agreed definition of what constitutes a “financial market distortion”, it is generally understood that:
A market distortion is as an economic scenario that occurs when there is an intervention by a governing or regulatory body (in the market), resulting in a market failure or enhancement of the welfare of a society .

Examples of such interference in the markets are: price ceilings, price floors, or tax subsidies that are instituted in a specific market by a governing/regulatory body. The WTO defines a market distortion as a situation when prices and production are at higher or lower levels than would ordinarily exist in a competitive market.

In neoclassical economics, a market distortion is any event in which a market reaches a market clearing price for a good or service, that is substantially different from the price that a market would achieve, while operating under conditions of perfect competition and state enforcement of legal contracts and the unhindered ownership of private property.
The ability of financial markets to accurately value, manage and transfer risk is central to economic growth and stability. Growth and economic well-being are inhibited if financial markets are unable to transfer financial resources efficiently from the suppliers of liquidity to deserving entrepreneurs.

This proper functioning of financial markets has often been distorted by levels of intervention that, whilst well intentioned, result in the unintended consequences such as price volatility considerably in excess of limits the would be implied by market fundamentals.

As a consequence, the financial markets have often undergone dramatic crashes and displayed severe speculative bubbles, where market prices are far removed from their natural equilibrium values.

There are myriad sources of market distortions. These range from direct institutional interventions by regulatory authorities or the Government, collateral constraints, informational asymmetries or natural search frictions. Other economic events, actions, policies, or beliefs can also bring about financial market distortions.

These can include asymmetric information or uncertainty among market participants, any policy or action that restricts information flows critical to the proper function of markets, leading to illiquidity (lack of buyers, sellers, product, or money), mass non-rational behaviour by market participants, price supports or subsidies, failure to provide a stable currency, failure to protect property rights, failure to regulate non-competitive market behaviour, and natural factors that impede competition between firms. Financial Market distortions are not only a source of vulnerability for the economy but they are a hindrance to economic growth.

The reason market distortions become topical is very simple. When prices of financial and real assets exhibit very high variability, it also means that the returns for investors in those asset classes also are very variable.

This is the essential definition of risk in the economy. When prices are changing rapidly, whether up or down, that usually indicates fundamental problems in the market.
In trying to understand the causes of observed market distortions, we need to do a bit of root cause analysis to answer the question: what are some of the causes or sources of the various market distortions?

The adoption of the multi currency system (dollarisation) was a natural response to hyperinflation. From February 2009, the economy enjoyed stability engendered by the advent of dollarisation.

Inflation disappeared overnight and in fact for the better part of three or four years the economy enjoyed very low if not negative inflation.

However, dollaristaion brought with it a few chunky challenges, such as the lack of a Lender of Last Resort in a banking system, which is characterized by Liquidity Silos. About 70 to 80 percent of banking sector liquidity is held by 20 to 30 percent of banking institutions.

The other source of distortions in the financial system is the multiple tier pricing of Treasury bills issues by the central bank. There are many distinct classes of Treasury Bills that have been issued. Some are non tradeable TBs, which is a bit of a misnomer because TBs are supposed to be liquid assets. Some TBs are issued as capitalisation or lending instruments, while others are issued as marketable securities. These factors have contributed to the absence of a vibrant secondary market in the instruments. It is difficult in a market without a visible yield curve to accurately price such instruments.

Bond Notes
Backed by Afreximbank but can banks get Forex on demand on the back of the Backing? The same distortion has been carried forward to clients who cannot get access to cash on demand. One to one exchange rate between bond note and US dollars is a distortion. Gershams Law clearly says that you cannot circulate two fiat currencies of same face value when the intrinsic values are different. The currency with higher intrinsic value will be mopped up and will disappear from circulation.

There are shortages of currency (both local and hard currency) from the formal market, but there is plenty of cash in USD and Bond notes in the informal sector. Why? This is because in those informal markets, market forces and the rules of supply and demand are in play.
Prices are fluctuating daily between cash notes Bond and dollars and RTGS depending on the interplay between supply and demand. Informal markets have established clear trading rules that are respected by everyone. This is critical to understand.
There is no one interfering with that market and it is working perfectly. We need to learn from it.

Directed interest rates
Directed interest rates are also contributing to price distortions, particularly on bank lending portfolio. Interest rate caps have tempered with the risk versus return trade off. When such interest rates caps are imposed there will be credit rationing.

This is because banks price their loans at the margin and as bank margins get squeezed to unsustainable levels banks will begin to seek to lend only to higher quality borrowers.
Marginal clients become too risky as banks are unable to recoup potential losses at lower rates so they stop giving credit to those borrowers perceived to be of higher risk.

That is why there is an apparent credit squeeze. I have argued in my past writings that the apparent decline in lending by banks over the last two or three years is not a result of crowding out per se but a result of these pricing distortions being imposed by persuasive regulation. Interest rate caps are a form of financial repression and are not good for the markets.

Whilst government and the monetary authorities should intervene in the financial markets in their legitimate efforts aimed at correcting various forms of market failure, it is notable that occasionally these interventions will introduce unfavourable distortions in the market. Economists therefore, advocate for very little or no government intervention in the markets.

The writer is an economist. The views expressed in this article are his personal opinions and should in no way be interpreted to represent the views of any organizations that the writer is associated with.

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