Demonetising a currency

Adopting another currency or introducing a new currency does not solve the economic crises, unless it is followed by massive corrections in the macroeconomic fundamentals.

 The Central Bank of Zimbabwe announced that it would officially demonetise the Zimbabwean dollar with effect from 15th June 2015. Any bank account in the country which holds between zero and 175 quadrillion Zimbabwean dollars will get a flat amount of US $5. This, in effect sets the exchange rate at US$1 = Z$ 35,000,000,000,000,000

Demonetisation is the process whereby a currency of a country officially loses its status as legal tender. The Zimbabwean dollar’s usage was effectively abandoned in April 2009 itself, but was still recognised as legal tender. Legal tender or fiat money is the official status given to a currency by the central bank, whereby all citizens of that country are obliged to accept it as a means of exchange.

Demonetisation has often happened in the past. Germany has demonetised at least thrice in recent history – from Papiermark to RentenMark; from Reichsmark to Deutchemark to finally from Deutchemark to the Euro.

The process of demonetisation was seen when several European countries abandoned their national currencies to be replaced by the Euro. The other big event of demonetisation process happened with regard to gold, when the US officially closed the gold window in 1973, thereby ending the decades long gold exchange standard/Bretton Woods system.

Apart from these one-off occurrences, the process of demonetisation usually happens after a country goes through a process of hyperinflation and the currency becomes worthless. Zimbabwe’s episode of hyperinflation in 2008, where inflation rates were as high as 231 million percent, caused the Zimbabwean dollar to collapse in value. It was impossible for normal trade to occur with the national currency, as a loaf of bread cost Z$1.6 trillion at one point. As a result, currencies such as the US dollar, the South African rand and the euro were widely circulated and used in Zimbabwe.

HundredTrillionDollar

A hundred trillion Zimbabwean dollar note

 

Demonetistion is usually the last step in the fight against hyperinflation. It is the official acceptance from the central bank and the government that its currency is of little or no value and acknowledgements of its failure. Thus, demonetisation is undertaken only at severely extenuating circumstances. Countries usually try to redenominate the currency first. Redenomination is the fixing of a new value for the existing currency. Operationally, it is the equivalent of knocking of a few zeroes from the value of the currency. For example, Zimbabwe tried redenomination four times since 2006. In the first redenomination Zimbabwe removed three zeroes from the value, 13 zeroes in the second redenomination and a further 12 zeroes in the third redenomination. However, bad macroeconomic fundamentals and a bad fiscal and monetary policy framework ensured Zimbabwe’s journey further into hyperinflation.

Once a currency is demonetized, the country has two options left: 1) Dollarization/Adoption of a foreign currency – This is when the country adopts the currency of another country as its own, which effectively translates into abandoning independence in monetary policy. The monetary policy of the adopted currency become applicable and binding on the country adopting it. Usually, the dollar is adopted, but not necessarily so always. 2) Introduction of a new currency – Eventually, the country might choose to introduce another of its own currency and have a preset exchange rate with the old currency/dollars. This is done to regain independence in monetary policy.

In the final analysis, adopting another currency or introducing a new currency does not solve the economic crises, unless it is followed by large scale corrections in the macroeconomic fundamentals.

Anupam Manur is a Policy Analyst at Takshashila Institution. He tweets @anupammanur

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