Whenever I meet with clients and investors, the one discussion I always have, regardless of market conditions, is on currency markets.
There are often strong views on why the direction of domestic policy or the price of major tradable goods or services causes one’s own currency to strengthen or weaken. However, the discussion that we don’t have often enough is the overly impact that the movements of the US dollar can have on emerging market countries and whether there is a way to mitigate this over time.
While policy and trade are usually the main drivers of major currencies, I often point out that currencies and their drivers are relative, not absolute. Therefore, any discussion of an economy’s policies or external balances matters, but primarily with regard to the policies or external balances of the economy’s major trading partners.
However, when it is the US dollar itself that is moving, the impact is magnified due to the significant share of global fuel and food priced in US dollars.
This was highlighted in 2022 when the US dollar appreciated significantly against most global currencies. The US Federal Reserve raised interest rates at a record pace to address US inflation that spiked on the back of global fuel and food price increases following the Russian invasion of Ukraine.
This “double whammy” of higher US interest rates and surging global inflation caused huge headaches for central banks everywhere. For most, the unpalatable choices were either to raise interest rates even faster than the US to prop up their currency, or to allow the currency to depreciate, making already more expensive food and fuel even more expensive to import.
Many countries instituted fuel or food subsidies to help mitigate the impact on their citizens, but this typically increased budget deficits, driving up debt at a time when financing that debt had suddenly become much more expensive.
As if the situation wasn’t difficult enough, most African countries still rely on US dollar debt to help finance their economies. The United Nations trade body UNCTAD estimates that Africa’s external debt grew rapidly to $466 billion by mid-2022 through bilateral loans, syndicated loans and bonds. As local currencies devalue, dollar debt repayments become more expensive, pushing more countries toward a future potential debt crisis.
Across Africa, this deluge of geopolitical and macroeconomic shocks has weighed heavily on many currencies. For net fuel and food importers, this has resulted in both the strongest currency depreciations and the highest levels of inflation. This macroeconomic backdrop, combined with government policies and central bank missteps, has pushed some currencies to historic lows.
Countries that did better tend to have one of two things in common. They are either net fuel exporters or have implemented quasi or actual capital controls to limit the devaluation of their currency.
But while limiting capital outflows may give the illusion of control to a struggling central bank, it has two very negative implications for the real economy.
First, the ability for importers to access US dollars becomes very difficult. This leads either to the formation of a parallel currency market, to access to essential imported goods becoming problematic, or to both. Hardly anyone had heard about Sri Lanka’s financial problems until they ran out of dollars to buy fuel.
Two, existing investors who want to receive dividends etc. or potential future investors are deterred from investing in that country for fear of not being able to repatriate capital. This affects the long-term growth potential of an economy, with insufficient investment capital available to get to work.
Some might argue that the stronger dollar should be seen as an opportunity for Africa, as it means inward investment into the continent is cheaper for US investors, and dollar-based African exports become relatively more competitive. However, the rush to emerging markets will not happen if foreign investors remain nervous about the continued local currency devaluation and its impact on local currency returns once they are converted back to dollars.
Mark Price, Regional Head of Financial Markets – AME, Standard Chartered Bank
Fortunately for most of Africa, the US dollar peaked last October and has since fallen by more than 10 percent against most major currencies. This happened despite the US Federal Reserve continuing to raise interest rates. This has given some much-needed relief to the hardest-hit countries, but leads me to ask the question: Is it possible to mitigate the impact of future US dollar swings on their economies?
An obvious option is to cover much more of their financing needs in local currency. Apart from South Africa and Nigeria, governments have not yet done enough to develop capital markets that would have enabled them to raise more money in their own currencies. This requires both investments in the infrastructure of the capital market itself and the presence of strong local financial institutions, so that they can be less dependent on external investors.
Kenya has an ambitious program to introduce a repo market in 2023, supported by a local central securities depository. This should improve the liquidity of the underlying bonds, reducing the level of local currency debt issuance. This initiative is to be welcomed and I would like other African countries to follow suit.
But countries also need strong local financial players to help absorb the debt issued. One area policymakers should consider is improving (or creating) their country’s pension funds and insurance companies. Africa has one of the lowest wealth-to-GDP ratios of pension funds in the world,(1) similar to the assets held by insurance companies. Policies that lead to greater inflows among such long-term investors create willing buyers of local government debt that can be held for their long-term obligations.
But not every country has the resources or scale to achieve this on its own – could a regional or pan-African approach be more effective? The West African Economic Monetary Union (WAEMU) was established to promote economic integration between eight West African countries.
Member States share a common currency, the CFA franc, managed by a single central bank and live within a set of fiscal constraints similar to those for the euro. Being part of the region allows each country to manage its own local debt issuance in CFA, while gaining a broader inter-regional pool of African investors to sell to.
Improving local debt financing capacities to reduce reliance on US dollar foreign debt will clearly be helpful in managing future fluctuations in the US dollar. However, it does not solve the problems caused by the fact that most of the world’s major fuel and food commodities are priced in US dollars. So, how can African countries better protect themselves against a dollar rampant in the future?
It is very unlikely that we will see a material shift from commodities priced in dollars. That leaves several possible options for African countries to consider implementing.
For those blessed with oil and gas reserves, increasing domestic oil and gas production is an obvious step. But to maximize the amount of USD earned from sales, it is necessary to increase the level of refined products.
However, the need to refine more products onshore in Africa is not just about oil and gas. Selling unrefined commodities such as palm oil, cocoa, etc. means that the value the producer brings in is only a small percentage of the final value of the product (~10-15%). In general, the more Africa can do to move up the manufacturing value chain, both for raw materials and manufacturing in general, the better.
But not every country has oil or gas reserves or can afford this level of investment. A regional cooperative model could be developed to spread investment risk and future benefits more broadly across the continent. Africa has a very young population that needs work. Playing a greater role in the production process solves both improving USD inflows and providing higher quantity and quality of employment.
Improving food security should also be a priority for those countries that traditionally rely heavily on imported grain, rice, etc. Egypt was particularly vulnerable when Russia invaded Ukraine, as it was forced to pay vastly higher prices in US dollars, at the time that the Egyptian The pound fell rapidly.
Increasing the productivity of African arable land – perhaps by producing fertilizer on the continent rather than importing it. Improving the distribution infrastructure so that perishable goods survive long enough to reach the consumer. Switching to other crops that can be grown and consumed in Africa. All this will help improve food security and ease the pressure to get dollars.
In short, Africa is overexposed to the US dollar. The constituent countries must either work independently to mitigate that risk or work collectively to do so. Periods of dollar strength are cyclical, so hopefully there will be time to act before the next one arrives. Hope is not a strategy. But I really hope that the elected officials in Africa have recognized the damage done over the past 12 months and are working on their strategy.
Article by Mark Price, Regional Head of Financial Markets – AME, Standard Chartered Bank
