Mozambique’s Unexpected Exchange Rate Stability: A Look into Policy and Market Dynamics

Mozambique’s currency stability since 2021 is driven by a mix of central bank policies, export structures, and market regulations that limit volatility despite a floating exchange rate. Planned updates to market mechanisms may gradually introduce more flexibility while maintaining economic stability.

A recent working paper from the International Monetary Fund (IMF), authored by Samuel Mann and Alexis Meyer-Cirkel, delves into Mozambique’s surprising currency stability, examining the factors that have kept the metical stable against the US dollar since mid-2021 despite significant challenges. The study, presented in “Identifying Determinants of FX Stability in Mozambique,” investigates a mix of structural, market, and policy factors contributing to this unique exchange rate environment. Historically, Mozambique’s metical has shown fluctuations against the US dollar, but since early 2021, the currency has settled into a stable range, a phenomenon made even more intriguing given that Mozambique operates under a de jure floating exchange rate system. This unusual trend is of particular interest in a country with an import-dependent economy vulnerable to climate shocks, insurgencies, and price volatility in the extractive sectors.

Export Structure Limits Currency Volatility

The IMF researchers identify a range of interwoven factors contributing to this currency stability. Mozambique’s economy relies heavily on exports from a few dominant sectors, including coal, aluminum, and electricity, which together account for most foreign exchange earnings. These sectors operate with unique economic structures that lessen their sensitivity to exchange rate shifts. For example, many of the country’s largest exporters, such as coal mining companies and energy producers, price their exports in foreign currencies, usually in U.S. dollars, and often manage their operational costs through offshore accounts. As a result, these companies are relatively shielded from fluctuations in the metical exchange rate, which stabilizes demand for foreign currency in the local market. Additionally, with most major export transactions settled offshore, local exchange rate volatility has limited direct impact on large export-driven companies, reinforcing stability within the foreign exchange market.

Strategic Central Bank Policies Support Stability

The policy decisions of the Bank of Mozambique have played a substantial role in managing the exchange rate, despite the floating regime. In 2021, the Bank implemented critical supervisory measures, such as suspending Standard Bank from foreign exchange activities over regulatory violations, which included alleged manipulation of the exchange rate. This action, along with increased supervision across other banks, significantly affected market behavior, creating an environment of cautious adherence to official rates. Furthermore, the Bank’s high reserve requirements and hawkish stance on interest rates have directly impacted inflation and demand for foreign currency, indirectly supporting the metical’s value. Mozambique’s central bank has maintained some of the highest real interest rates globally, reaching over 10 percent, to mitigate imported inflation. This focus on controlling inflation by supporting the exchange rate has been critical, given Mozambique’s high sensitivity to exchange rate changes, which can rapidly impact consumer prices due to its heavy reliance on imports for goods such as fuel, machinery, and consumer products.

Artificially Stable Reference Rate Calms the Market

Another noteworthy factor is the methodology used by the Bank of Mozambique for calculating the daily exchange rate, which relies on quotes submitted by banks rather than actual transaction rates. This approach results in an unusually stable reference rate since banks often base their submissions on the previous day’s rate, minimizing daily fluctuations. While this does not entirely reflect real-time market activity, it has led to a consistently stable reference rate, reinforcing Mozambique’s de facto stabilized exchange rate arrangement. The reference rate's stability is expected to evolve, however, as the Bank of Mozambique plans to incorporate actual transaction data in the methodology later in 2024, potentially increasing the rate's responsiveness to market conditions.

Market Structure and Parallel Markets Maintain Balance

Mozambique’s market structure also influences its currency stability. Import demand is driven significantly by capital-intensive megaprojects in sectors like natural gas and aluminum, which are largely funded by foreign direct investment. Consequently, these projects generate limited additional demand for foreign currency. Smaller importers, who primarily bring in consumer goods, are generally the main demand source in the FX market. However, the concentration of FX supply among a few large exporters, combined with restrictions on exchange rate shopping, contributes to a relatively shallow FX market with limited volatility. The research also examines the parallel foreign exchange market in Mozambique, which remains relatively small and cash-based, primarily serving curb market transactions with minimal influence on the official exchange rate. While some demand exists on the parallel market, it has not significantly diverged from the official rate, indicating that the current exchange rate is not far from its equilibrium level. A significant parallel market premium, often a sign of underlying pressure on the currency, has not developed to any disruptive degree, with the premium hovering at manageable levels, even as demand for foreign currency occasionally spikes.

Preparing for a Potentially Floating Future

Looking ahead, Mozambique may gradually transition toward a more dynamic floating rate as it enhances its market mechanisms. The planned reference rate methodology update is expected to reflect more realistic transaction volatility, which may introduce some flexibility to the current arrangement. Moreover, increasing opportunities for financial instruments, such as hedging, could provide additional means for exporters and importers to manage currency risks. Efforts to diversify exports may also reduce Mozambique’s dependence on a few sectors, easing pressure on the exchange rate and enabling a more organic floating system over time. The Bank of Mozambique will likely play a crucial role in this transition, carefully balancing intervention to ensure a smooth shift without triggering abrupt volatility.

The IMF report offers valuable insights into how an economy like Mozambique, which faces structural challenges and economic vulnerabilities, has managed to maintain a de facto stable currency under a floating regime. While the report acknowledges that the current arrangement may not hold indefinitely, it highlights the delicate balance achieved through a mix of central bank policy, market structure, and economic dynamics, which has so far enabled Mozambique to keep its currency relatively steady amid potentially destabilizing forces. As the country pursues gradual market improvements, it will be critical for policymakers to navigate this transition carefully, keeping a close watch on evolving market pressures and global economic conditions.