Special Report - Zimbabwe Banking Sector

April 2006
The Zimbabwean economy and the banking sector as a whole remain difficult to track, given the complexity of the environment. As a result, this discussion has been limited to our view of the most relevant developments and concerns, as outlined below.

Regulatory and Accounting Risk

Concerns stem from a relatively volatile regulatory framework. Movements in statutory reserve requirements typify the regulatory risk faced by financial institutions. In late 2005, an increase in statutory reserve requirements removed substantial amounts of market liquidity, causing banks to suffer major liquidity shortages, at which time banks had to bid for cash from the market at rates of up to 700%. Within three weeks of the statutory reserves hike, the RBZ held shorter dated treasury bill tenders, suggesting that the liquidity that had been removed from the market had run out. Because the RBZ was competing with the banking system for liquidity, it offered rates of 500% for 90-day paper, granting savers a 120% gain on their money over 90 days. After declining in early 2006, the reserve requirement has again been hiked, forcing banks to source more liquidity, which must be paid over to the RBZ at no interest. Shortfalls have to be funded from the interbank market or directly from the RBZ at 800%. This exposes banks to potentially huge losses and extends the difficulty of meeting a new US$10m capital requirement by September 2006. In this context, our expectation is for short-term interest rates to rise further, heightening the possibility of a secondround flight to quality. Amplifying these concerns, 90-day paper offering 500% can now be bought directly from the RBZ, thus attracting much-needed deposits away from the banking system. Running concurrent to this is what we term accounting risk. Accounting risk is introduced through the IAS 39 convention, which requires institutions to mark-to-market their available-for-sale instruments. In the current environment, banks asset mixes are heavily skewed towards government securities, with large portions of their Treasury bill portfolios being maintained as available-for-sale securities (in what is known as their trading book). With uncertainty surrounding rates and tenures offered on Treasury bill issues (the RBZ is extrapolating an inverted yield curve based on inflationary expectations that are out of sync with market expectations), banks are finding themselves out of the money. As a result, and under IAS 39, they are required to offset unrealised losses to equity. This phenomenon has further compounded financial institutions challenge of meeting the minimum paid-up capital requirements by September 2006.

Economic Risk
According to the IMF, Zimbabwes economy contracted for the seventh consecutive year in 2005. Economic growth particularly within the crucial agricultural sector - continues to be constrained by severe foreign exchange shortages, which have starved the economy of fuel as well as basic and intermediate goods. Meagre international reserve levels reflect the absence of foreign direct investment and capital inflows symptomatic of international isolation and the prevailing economic distress. The foreign currency shortage is further compounded by the exchange rate system. In the four months to January 2006, the official rate depreciated 74% to Z$99,200/US$, where it has since been maintained under the current system. In a hyperinflationary environment, and under an inflexible exchange rate system, erosion of the domestic

currencys purchasing power has seen a severe weakening of the Zimbabwean dollar as a unit of account, store of value and unit of exchange. Exchange rate overvaluation and excess demand for foreign currency (partly prompted by its desirable property as a store of value), has fuelled a growing diversion between the official and parallel rate. The parallel rate currently stands at around Z$220,000/US$ and is likely to weaken substantially going forward. Inadequate capital inflows and the foreign currency crisis are both a function and an aggravator of the hyperinflationary environment. The inflation rate has escalated over the last year, recording a year-onyear rate in excess of 900% during March, with independent analysts projecting the rate to increase to well over 1000% during the year ahead (against an RBZ expectation for inflation to subside to around 200% by year-end). As with other modern hyperinflationary episodes, expeditious price increases have been triggered by uncontrolled money supply expansion that, in turn, has been driven by endemic fiscal imbalances. Accounting for the consolidated deficit of both government and the RBZ (thereby including quasi-fiscal activities and financing of parastatals that are granting huge subsidies to the private sector), the IMF report that the public deficit amounts to 60% of GDP. Given the absence of foreign funding, it is impossible for the domestic savings base to finance the deficit through the issuance of Treasury bills. Therefore, the gap can only be bridged by monetising the deficit i.e. printing money. Moreover, on top of this, with Treasury bill maturities at 500% for 90 days (2500% compound) that need to be funded, it appears that continued escalation in the rates of money-supply growth and inflation is inevitable. Empirically, hyperinflations are accompanied by an abrupt reduction in financial intermediation, which reduces the size of the financial sector (consistent with current trends in Zimbabwe), as well as increasing systemic risk.

Sovereign Default Risk

International evidence on sovereign debt crises shows that the years preceding a crisis are generally characterised by widening fiscal deficits, and easy access to market financing that loosen the resolve for fiscal reforms. As has occurred in Zimbabwe, such an environment leads to an escalation of borrowing costs which, combined with a shortening of maturities, sets off debt dynamics that soon prove to be inconsistent with a countrys servicing ability. In addition, the combination of a weak economy and public finances gives rise to a circular policy dilemma, as high interest rates are necessary to finance budget deficits, but further dampen economic activity and feed back to weaker budgetary performance. Without timely recourse to fiscal rectitude, a debt crisis inevitably ensues and government is forced to default or inflate the debt away, both of which entail large economic and welfare costs. Empirical studies show that domestic currency defaults have usually been the result of an overthrow of an old political order or the by-product of dramatic economic adjustment programs aimed at curbing hyperinflation. However, neither of these eventualities appears likely in the short term. A more feasible outcome in the short term as garnered from meetings with financial institutions in Zimbabwe - is a restructuring of government debt. Such a restructuring would potentially involve a compulsorily roll over of short-dated securities into longer-dated paper at lower yields. Naturally, with banks asset bases reflecting high concentrations in government securities, this possibility introduces considerable pricing risk to the banking system. This, in conjunction with the central banks liquidity mopping-up policy, which involves the daily sweeping of clearing accounts into two year, untradable Treasury bills offering a reduced fixed rate (currently standing at 200%), has heightened liquidity risk in the short term, since many banks have matched large deposits with treasury bill maturities.

Conclusion
Given the factors above, the banking sector is facing a very challenging 2006, with tight liquidity management and prudent risk management guidelines essential. The key challenge and focus of banks during 2006 will be the re-capitalisation of their balance sheets, with a view to meeting the new minimum paid up capital requirement of US$10m for commercial banks, US$7.5m for building societies and merchant banks, and US$5m for discount houses. The RBZ has stated that enough time has been given and that it will not be swayed to delay compliance. Furthermore, the RBZ in its last Monetary Policy statement indicated that going forward, banking institutions that cannot be rehabilitated in the normal course of business would be liquidated immediately, with no prospects for curatorship. Cognisance is, however, taken of the uncertainty which accompanies the fact that the Reserve Bank initially pegged the increased capital requirement at Z$100,000/US$ (the exchange rate prevailing at the beginning of 2006). With inflation having subsequently increased so exponentially, the increased capital requirement would be significantly reduced in real terms by the end of September 2006. In this regard, the Reserve Bank has indicated that, if there is a material decline in the official exchange rate by this time, then the minimum capital requirement position will be reviewed again, with an as yet unspecified time frame for banks to comply with such amendments. While GCR views the enlarged capital requirements as a necessary step to improve the stability of the banking sector as a whole, we are expecting either a fall out in the banking industry or an industry-wide consolidation. As at 31 December 2005, only five banks had met the new minimum paid up capital requirement. Institutions that have common shareholders are likely to merge, with capital rationalisation becoming an increasingly important issue for shareholders. Furthermore, financial groups maintaining multiple licences, geared to benefit from lower statutory reserve requirements on discount houses and finance houses, would be forced to consolidate these entities to meet the capital requirement. Banks that are not strategically well positioned, and/or have limited access to capital, could be particularly vulnerable in the prevailing circumstances. The RBZ currently supervises 32 financial institutions made up of 14 commercial banks, 6 merchant banks, 6 discount houses, 4 building societies and 2 finance houses Following from the issues raised in this report, all ratings will be closely monitored by GCR. In addition, due to the breakdown in the traditional links between short and long term ratings, GCR will in future only accord long term bank ratings in Zimbabwe.

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