A variety of conflicting signals from Zambia in recent weeks demands a closer look at what's driving its economic policy and the implications for Global X Copper Miners ETF (COPX), First Trust ISE Global Copper Index Fund (CU) and Market Vectors Africa (AFK).
The confusion kicked off with an announcement from President Michael Sata's government that a plan to rebase the currency by three decimal places has since been put on hold. Meanwhile, it has outlawed the use of foreign currency in domestic goods and services transactions, with penalties for transgression that include up to 10 years in prison. The immediate upshot of this measure was a short-term appreciation for the kwacha as Zambians rushed to sell dollars through official channels.
Next up were policy measures forcing companies to repatriate export earnings back into Zambia, adding another impetus to a rising kwacha. Shortly thereafter, a Zambian government agency report claimed the country is on track to become the world's fifth largest copper producer by 2015 with projected production of 1.5 million tons a year, or double today's output.
The end of last week brought everything to a fever pitch as disagreement surfaced over just how much copper Zambia produced last year (Zambia Reports provides a nice summary of the competing views here). Meanwhile, the IMF projected Zambia's 2012 real GDP growth at 7.7% with 23% growth in the mining sector, but the Economist Intelligence Unit forecasted the same figures at 6% and 2.8%, respectively. U.S. Geological Survey figures currently put Zambia as the sixth-largest copper producer in the world:
Which numbers should we trust?
Until we have more clarity on the data, there are certain unassailable economic realities that hold, regardless of which of the above figures, if any, are the right ones:
- Copper accounts for some 80 percent of Zambia's exports.
- China is the world's biggest single consumer of copper and represents a growing proportion of Zambia's export market, as illustrated in the following chart (Source: Economist Intelligence Unit).(click to enlarge)
- Rebasing or redenominating the currency, should the Sata Administration ever resume this plan, is nothing more than a surface makeover at best. Recasting a 1,000 kwacha note as a 1 kwacha note and recalibrating the exchange rate from 4,800 per US dollar to 4.8 solves absolutely nothing. It is the equivalent of outlawing the use of the number "6" while mandating everyone to instead use the phrase, "half a dozen."
- Dollarization is a phenomenon that can result from a number of different factors, but any economy that overwhelmingly leans on commodity exports priced in dollars is going to have a natural affinity to dollar hoarding, making it all the more difficult to enforce a ban designed to counteract exactly that.
- Anytime a government "bans" something people have demonstrated an organic desire for, nobody should be surprised to find a black market for that thing close behind (Venezuela and Argentina are the most contemporary examples of this as applied to the FX world).
- Given the systemic distortion that accompanies both de facto dollarization of an economy as well as its forced prohibition, we still have no clear view on just what an equilibrium level of money supply even means in the Zambian context. But borrowing costs are sure to be higher in kwacha than in dollars and it is only a matter of time before these higher costs are passed through to mining and production.
- Aside from an appreciating kwacha, another result of the foreign currency ban is an excess supply of kwacha in circulation. Zambia's forthcoming treasury auction later this week will no doubt bring a lot of that liquidity back into government coffers at what appears likely to be a lower-than-normal yield. To the extent that this is simply a reaction to the foreign currency ban, it should go without saying that this is a one-off solution to kwacha depreciation as banning foreign currency use is not a recurring activity and presumably the bulk of Zambians hoarding dollars have already sold them.
- Closely related to the previous point, lower treasury yields this time around are clearly more a function of market crowding than of lower risk as the Sata Administration has done nothing in the meantime to improve the soundness of its fiscal management.
Of all the above points, the final two have the most profound implications for where Zambia and global copper are heading. If the Zambian government should succeed in achieving its short-term objectives with this week's treasury auction, it may give the temporary appearance of having stumbled onto a solution that can loosely be summed up by the following steps:
- Print more local currency to accommodate forced repatriation of US dollar-denominated export revenues;
- Outlaw the use of foreign currency in domestic transactions as an extra measure to bolster (1);
- Pre-empt the specter of inflation resulting from excess local currency liquidity by issuing short-term treasury bills - a "sterilization" of sorts;
- Lather, rinse, repeat: Prepare to replicate and extend these steps as new export revenues accrue and the existing short-term debt stock rolls over.
By now, any macro analysts reading this should notice an eerie resemblance these steps have to the basic template of China's money supply management cycle. Unfortunately for Zambia, the country itself does not possess the requisite global footprint to sustain this cycle for nearly as long as China has, and even if it did, the current administration has yet to demonstrate it has either the discipline or the vision to effectively steer such an agenda.
For the quickest evidence of how problematic this scheme can become, look no further than the fact that no matter how low kwacha yields clear at this week's auction, they won't come anywhere close to the near-zero interest the Zambian government will collect on its US dollar holdings. This puts the Zambian government on what is effectively the money-losing end of a carry trade that perversely becomes a break-even proposition for the government only if the kwacha undergoes a depreciation of crisis proportions. Otherwise, how wide this yield difference winds up being will necessarily drive the pace at which Zambia's fiscal deficit proceeds.
Regardless, Zambia is still excessively beholden to China's economic outlook. So whether due to internal forces or to fallout from what Michael Pettis recently detailed as "Inverted Balance Sheets", an economic backlash looks likely to arrive in Zambia one way or another. Desperate times do indeed call for desperate measures, and Zambia is far from the only country entering unfamiliar territory right now. But one doesn't need a full view of what's ahead to know that pursuing solutions ranging from short-sighted to misguided will inevitably wear thin while the challenges facing Zambia remain as formidable as ever.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.