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Friday, 29 April 2011

Monetary meltdown

Monetary meltdown


The monetary economy (the total real value of a fiat money supply) can disappear completely. It happened three times during three months towards the end of hyperinflation in Yugoslavia. It happened at the end of hyperinflation in Zimbabwe in 2008, terminating hyperinflation in that country. Zimbabwe did not try hyperinflation again like Yugoslavia which has the distinction of having wiped out the real value of their entire monetary economy three times in three months. In Zimbabwe the economy dollarized spontaneously after a decision by the Reserve Bank of Zimbabwe to close the Zimbabwe Stock Exchange which stopped the Old Mutual Implied Rate being the final exchange rate of the Zimbabwe Dollar with a foreign currency – the British Pound. The Zimbabwean economy dollarized spontaneously after that because it was a sufficiently open economy right next to the stable South African and Botswana and other stable economies in the Southern African region. Those stable economies supplied the Zimbabwean economy with essential goods and services. Zimbabwe then had the opportunity to slowly recover from total monetary meltdown and the devastating effect of implementing the very erosive stable measuring unit assumption – the Historical Cost Accounting model - during hyperinflation as authorized in International Financial Reporting Standards and supported by Big Four accounting firms like PricewaterhouseCoopers. Zimbabwe spontaneously adopted a multi-currency dollarization model using the US Dollar, the Euro, the SA Rand, the British Pound and the Botswana Pula as relatively stable foreign currencies in the Zimbabwean economy.

The variable real value non-monetary item economy (property, plant, equipment, inventory, etc) cannot disappear because of wrong monetary policies. Inflation is always and everywhere a monetary phenomenon. Inflation and hyperinflation have no effect on the real value of non-monetary items. After monetary meltdown in Zimbabwe the properties, plant, equipment, raw materials, finished goods, etc., were still there. The variable item economy can be destroyed by natural disasters like earth quakes and tsunamis and by man-made events like war.

The constant item economy (shareholders´ equity, trade debtors, trade creditors, salaries, wages, rentals, etc.) also cannot be eroded by inflation and hyperinflation because inflation and hyperinflation have no effect on the real value of non-monetary items: both variable and constant real value non-monetary items. However, the stable measuring unit assumption (i.e. the Historical Cost Accounting model or financial capital maintenance in nominal monetary units per se during inflation and hyperinflation) erodes the constant real non-monetary value of constant items not maintained constant during inflation and hyperinflation, e.g. trade debtors, trade creditors, salaries, wages, rentals, that portion of shareholder´s equity never maintained constant as a result of insufficient revaluable fixed assets (revalued or not), all other non-monetary payables and receivables, etc., at a rate equal to the annual rate of inflation or hyperinflation.

Equity is equal to net assets; i.e., the constant real non-monetary value of shareholders´ equity is equal to the constant real value of net assets. Under Constant Item Purchasing Power Accounting (CIPPA) the constant real non-monetary value of equity is automatically maintained constant in all entities that at least break even for an unlimited period of time (forever) during low inflation and deflation whether these entities own any revaluable fixed assets or not.

Only capital maintenance in units of constant purchasing power in terms of the daily US Dollar or other hard currency parallel rate or a daily Brazilian-style index under Constant Purchasing Power Accounting (CPPA) will automatically maintain the constant real value of constant items constant for an indefinite period of time in all entities that at least break even during hyperinflation. This includes shareholders´ equity whether these entities own any revaluable fixed assets or not.

The monetary economy can be totally eroded like in the case of the Zimbabwe Dollar, not simply as a result of hyperinflation, but, as a result of a monetary meltdown after a period of severe hyperinflation. Hyperinflation is defined by Cagan as 50% monthly inflation and in International Financial Reporting Standards as cumulative inflation approaching or equal to 100% over three years; i.e. 26% annual inflation for three years in a row. The IFRS definition is followed in this book. Severe hyperinflation is normally the final stage of a devastating hyperinflationary spiral with a continuously super-increasing rate of hyperinflation when hyperinflation reaches millions of percent per annum. Exchangeability of the monetary unit, under those conditions, becomes limited to very few or just one single foreign currency like in the case of the Zimbabwe where the Zimbabwe Dollar only had exchangeability with the British Pound via the Old Mutual Implied Rate as derived from continued trade in Old Mutual shares on the Zimbabwe Stock Exchange even during severe hyperinflation. A monetary meltdown takes place when a monetary unit stops having exchangeability with all foreign currencies normally after, first, a period of hyperinflation and then a period of severe hyperinflation.

Hyperinflation only erodes the real value of the monetary unit extremely rapidly. Hyperinflation has no effect on the real value of non-monetary items. All non-monetary items (variable and constant items) maintain their real values during hyperinflation when they are updated (measured in units of constant purchasing power) daily in terms of a daily parallel rate (a black market or street rate) normally the daily unofficial US Dollar or other hard currency exchange rate or a daily non-monetary index normally almost totally based on the daily US Dollar exchange rate as Brazil did during 30 years of very high and hyperinflation.

The stable measuring unit assumption (Historical Cost Accounting) – not hyperinflation – unknowingly, unnecessarily and unintentionally erodes the real value of constant real value non-monetary items, e.g. salaries, wages, rents, shareholders´ equity, trade debtors, trade creditors, etc. not maintained constant as fast as hyperinflation erodes the real value of the local currency and other monetary items, e.g. loans stated in the local currency. A monetary meltdown erodes all real value only in the monetary economy; i.e. in the local currency money supply.

Hyperinflation is not always stopped with first a period of severe hyperinflation in the final stage and then a complete monetary meltdown. Hyperinflation was successfully overcome by various countries, e.g. Turkey, Brazil and Angola, without dollarization or a monetary meltdown. However, severe hyperinflation (hyperinflation at millions of per cent per annum) would normally lead to a complete monetary meltdown as happened in Zimbabwe in 2008.

Brazil actually grew their non-monetary economy in real value during 30 years of very high and hyperinflation of up to 2000 per cent per annum from 1964 to 1994 and never had severe hyperinflation followed by a complete monetary meltdown at the end. Brazil managed to have positive GDP growth during 30 years of very high and hyperinflation because the various governments during those three decades supplied the population with a daily non-monetary index based almost entirely on the daily US Dollar exchange rate with their monetary unit which was used to update all non-monetary items (variable and constant real value non-monetary items), e.g. goods, services, equity, trade debtors, trade creditors, salaries, wages, taxes, etc., in the economy daily.

Brazil would not have been able to do that if they had applied the IASB´s IAS 29 Financial Reporting in Hyperinflationary Economies simply because IAS 29 does not provide for continuous daily updating of all non-monetary items during hyperinflation. IAS 29 was authorized in 1989. IAS 29 does not provide for continuous daily updating in terms of the US Dollar parallel rate or a Brazilian-style daily index rate. IAS 29 simply requires restatement of Historical Cost and Current Cost financial statements during hyperinflation applying the monthly Consumer Price Index at the end of the reporting period (monthly, quarterly, six monthly or annual) - generally available a month or two months after the current month - to make these financial statements more useful. It is not the intention of IAS 29 to, and in its current form it cannot, stop the continuous daily rapid erosion of the real value of constant real value non-monetary items as Brazil did for 30 years of high and hyperinflation generating positive economic growth.

This daily very rapid erosion of constant items is caused, not by hyperinflation, but, by the implementation of the stable measuring unit assumption (HCA) during hyperinflation. Applying the monthly CPI a month or two months after the current month is very ineffective during hyperinflation as far as the constant real value of salaries, wages, rentals, equity, trade debtors, trade creditors, positive economic growth, economic stability, the maintenance of internal demand and the continuous daily maintenance of the constant real value of these items are concerned. All non-monetary items (variable and constant items) have to be updated daily in terms of the parallel US Dollar rate or a Brazilian-style daily index rate in order to maintain the real economy relatively stable during hyperinflation in the monetary unit. That is financial capital maintenance in units of constant purchasing power during hyperinflation as originally authorized in IFRS in the Framework (1989), Par 104 (a).

The Framework (1989), Par. 104 (a) states:

Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.

The original Framework (1989), Par 104 (a) authorizes financial capital maintenance in units of constant purchasing power during low inflation and deflation (Constant Item Purchasing Power Accounting - CIPPA) under which only constant real value non-monetary items (not variable real value non-monetary items) are measured in units of constant purchasing power by applying the monthly change in the annual CPI during low inflation and deflation. It is also applicable during hyperinflation (Constant Purchasing Power Accounting - CPPA) where under all non-monetary items - constant and variable real value non-monetary items - are updated daily in terms of the US Dollar parallel rate or a Brazilian-style daily index rate. IFRS authorize financial capital maintenance in units of constant purchasing power at all levels of inflation and deflation.

The stable measuring unit assumption (HCA or financial capital maintenance in nominal monetary units, also originally authorized in IFRS in the Framework (1989), Par 104 a ) assumes, in principle, that there was, is and never ever will be inflation, deflation or hyperinflation as far as the valuation of constant real value non-monetary items never maintained constant are concerned. The stable measuring unit assumption (HCA) assumes, in principle, that money was forever in the past, is and will always in the future be perfectly stable under all levels of inflation, hyperinflation and deflation.

Various authoritative commentators in the accounting profession are requesting a fundamental revision of IAS 29.

Severe hyperinflation is defined as a period at the end of completely uncontrolled hyperinflation when exchangeability between the hyperinflationary monetary unit and most relatively stable foreign currencies does not exist. However, at least one exchangeability has to exist for prices to be established in the hyperinflationary monetary unit; i.e. for hyperinflation to exist. Severe hyperinflation is only possible when there is exchangeability with at least one relatively stable foreign currency in order for prices to continue to be set in the hyperinflationary monetary unit in terms of this final exchangeability. The one exchange rate that lasted till the end of hyperinflation in Zimbabwe was the Old Mutual Implied Rate (OMIR).

The ratio of the Old Mutual share price in Harare to that in London equals the Zimbabwe dollar/sterling exchange rate. p8 1

Severe hyperinflation stops the moment exchangeability between the currency and all foreign currencies does not exist.

Zimbabwe’s hyperinflation came to an abrupt halt. The trigger was an intervention by the Reserve Bank of Zimbabwe. On November 20, 2008, the Reserve Bank’s governor, Dr. Gideon Gono, stated that the entire economy was “being priced via the Old Mutual rate whose share price movements had no relationship with economic fundamentals, let alone actual corporate performance of Old Mutual itself” (Gono 2008: 7–8). In consequence, the Reserve Bank issued regulations that forced the Zimbabwe Stock Exchange to shut down. This event rapidly cascaded into a termination of all forms of non-cash foreign exchange trading and an accelerated death spiral for the Zimbabwe dollar. Within weeks the entire economy spontaneously “dollarized” and prices stabilized. p 9-10 2

There was severe hyperinflation in Zimbabwe while there was exchangeability (prices could still be set in the ZimDollar) with at least one relatively stable foreign currency – the British Pound in this case as it was made possible via the OMIR. When this last exchangeability stopped it was not possible to set prices in the ZimDollar anymore and severe hyperinflation stopped: no exchangeability means no hyperinflation. That was a monetary meltdown. The entire ZimDollar money supply had no value as from that moment. Monetary items expressed in the ZimDollar had no value as from that moment. All variable real value non-monetary items maintained their real values despite the monetary meltdown. The IASB authorized an addition to IAS 1 in 2011 to allow for the fair value valuation of all non-monetary items in the opening balance sheet of companies after severe hyperinflation and a monetary meltdown. Inflation and hyperinflation have no effect on the real value of non-monetary items.

No exchangeability with all relatively stable foreign currencies means no exchange rates which means no severe hyperinflation (no prices being set in the local currency) and vice versa: no exchange rate with any relatively stable foreign currency means no exchangeability which means no hyperinflation (no prices being set in the local currency).

No prices being set in the local currency means monetary meltdown: the total money supply and all money and other monetary items stated in the local currency have no value.

The real or non-monetary economy (houses, properties, buildings, infrastructure, inventories, finished goods, consumer goods, trademarks, goodwill, logos, copyright, trade debtors, trade creditors, royalties payable, royalties receivable, taxes payable, taxes receivable, all other non-monetary payables, all other non-monetary receivables, etc,) cannot be eroded by hyperinflation or a total monetary meltdown: inflation is always and everywhere a monetary phenomenon. Inflation and hyperinflation have no effect on the real value of non-monetary items.


Nicolaas Smith

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