Press Room

Future Outlook for Africa Currencies A Major Concern

In 2007, Tullow Oil made an announcement that uplifted a whole nation. The company had discovered 1.5bn barrels of oil in the Jubilee oil field off the Ghanaian coast.  By December 2010, the company was producing 25,000 barrels per day (bpd) and targeting 100,000bpd by 2014. In the first three years of production, the government had earned an average of $469million per annum in royalties. Given that the country also exports gold and cocoa, the economic prospects looked promising and investors began scouting for opportunities across the economy.

Although the economic fundamentals looked sound, the depreciation of the Ghanaian Cedi in 2014 has led investors to re-examine the country’s outlook. At the beginning of 2014, the Cedi was trading at 2.35/US dollar (USD) but by August it had fallen by a stunning 64% to trade at 3.85/USD. This story is not limited to Ghana. Several other African currencies struggled in 2014; with the other notable mention being the Kenyan Shilling and Nigerian Naira, which have needed Central Bank support to retain its value.

Significance of Currencies

Supply and demand determines exchange rates.  The change in a currency’s supply and demand is driven by either: changes in the business cycle, changes in preference which impact foreign trade, changes in capital flows, differences in inflation and changes in the price of traded goods.  In today’s integrated global economy, where international trade is a necessity, exchange rates can enhance or diminish a country’s competitiveness and make investments in the country more or less attractive.

The accounts of the balance of payments (BOP), which record the flows of money between a country and the rest of the world, aid in the understanding of exchange rate movements. The BOP is made up of three accounts: current account (exports/imports), financial/capital account (flow of funds for investment) and the official reserve account. The official reserve account, which records transactions made by the Central Bank, largely does not move year-on-year which leaves the current and financial account for closer examination. 

Whether the strengthening or weakening of a currency is a good or bad thing depends on one’s perspective. When a currency increases in value, importers flourish as they can buy more goods and services. A depreciating currency has the opposite effect with exporters selling more goods and services.

Custodians of currency value

Central banks have multiple mandates that may conflict at times. These include: price stability, protecting the value of the currency and pursuing balanced, sustainable economic growth. Central banks can achieve their objectives by attempting to control the money supply. This can be done in variety of ways such as: buying and selling of government bonds, changing the reserve requirements for banks, and more popularly, changing interest rates.  By lowering interest rates, there is increased money supply, which leads to increased imports and ultimately currency depreciation. 

Government spending and policy initiatives will also have an impact on the direction of the currency. Effective policies that promote import substitution will lead to current account surpluses with the resulting effect of currency appreciation. Other methods include the imposition of trade barriers and restrictions/allowance of capital flows.

On the Ground

The chart above illustrates the performance of selected currencies since the beginning of 2014. The Ghanaian Cedi’s disastrous performance has brought the discussion of currency risk centre stage. Other African economies have also performed poorly against the dollar in recent times. Given that each country’s economy is unique and to better understand the forces driving this, we will closely examine Ghana, Nigeria and Kenya. 

The key exports for Ghana, Nigeria and Kenya are: gold, oil and cocoa for Ghana, oil for Nigeria and tea, coffee, flowers and tourism for Kenya. Ghana and Kenya operate current account deficits (Imports > Exports), while Nigeria runs a current account surplus. Although Ghana produces oil, it is a net oil and gas importer as it imports gas for power generation. Kenya has had a difficult year as terrorist attacks have crippled the hospitality industry and the oversupply of tea has resulted in a 44% decline in tea prices. 96% of Nigerian export revenue is derived from oil proceeds and with crude prices tumbling; the Naira has come under pressure. All three of these markets are similar in that they are over reliant on a few economic sectors for foreign exchange.

In 2014, the Ghanaian current account deficit is forecast to be 12.4% and Kenya 11.2% of GDP. Nigeria’s current account surplus is forecast to remain at 4.1% but will gradually decline if lower oil prices persist. To restore the current account balance, currency depreciation is needed or a positive financial account movement through foreign investment is necessary.

Short-term response by policy makers

There has been a varied monetary and fiscal response to the currency crisis in each country. The timing of the appetite for emerging market fixed income securities has been a blessing as governments have taken advantage of the opportunity to attract foreign exchange. Kenya’s sovereign bond issue was a resounding success for the government and has also been beneficial to the Central Bank of Kenya (CBK). CBK bought the dollar proceeds from the government and has subsequently used it to support the shilling.

Reliance on the financial account to support the currency should be viewed as a short-term measure. Firstly, equity flows into the country especially in emerging markets can be short-term in nature given that most countries have limited exchange controls, which are part of incentives to attract investments. Thus investors are free to enter and exit as they wish.  The Asian financial crisis illustrates the short-term nature of equity flows in emerging markets, which are also subject to contagion. Thus, governments turn to the relatively stable source of hard currency by issuing sovereign bonds.

Ghana too has taken advantage of global appetite for African sovereign debt and has hinted at issuing its third Eurobond. Although offering an attractive return to investors, investment risk will continue to grow as debt-to-GDP levels rise, rendering continued issuance of sovereign bonds unsustainable.

The Nigerian government has been more forceful in protecting the value of the Naira. Its initial response has been supporting the Naira through open market operations. All three governments have pursued this strategy to some degree. Open market operations entail buying local currency and selling the dollar to support the price of the local currency. The sustainability of this strategy depends on the foreign-currency reserves held by the central bank. The foreign-currency reserves of Nigeria, Kenya and Ghana stood at $39.5billion, $7.4billion, $4.4billion respectively. These relatively low reserves limit the ability of the Central Bank to halt the currency decline especially with market speculators involved.

Long-term response by policy makers

The long-term solution to address the current account imbalance is to rethink trade policies, which unfortunately take time to design and actualise. Recent investments by some of these countries seem to suggest that policy makers are actively redressing trade imbalances.

Although Ghana is an oil producer, the World Bank reports that it spends $1 million per day on crude oil imports for use in its power plants. To reduce this need for foreign currency, the government commissioned the Atuabo gas plant - described by Ghana’s President John Mahama as a ‘game-changer’. The plant will utilise gas from the local oil fields thus eliminating the need to import crude oil.  The Ghanaian government has forecast that the country will save $500 million annually in crude imports and reduce the cost of power to businesses. However, analysts forecast that gas supplies to the plant from the oil fields will only be guaranteed in 2017 when two new oil fields come online.

Kenya has also made strides in improving its current account deficit. The new government’s push to produce 5,000MW of power by 2017 is yielding results. By December 2014, the government projects that the total power output will have risen by 800MW from 1,600MW to 2,400MW. The majority of this new power produced is from geothermal sources, which is expected to be used as base-load, electricity available at all times, that will replace the expensive thermal power. Thermal power is reliant on crude oil and Kenya expects to save $325 million per annum through these changes.  

The biggest challenge to Nigeria’s economic future is its reliance on oil. Crude oil revenues account for 80% of total government revenues and 96% of foreign currency derived from exports. High oil prices have contributed positively to the country, enabling it to achieve current account surpluses. However, falling and unstable oil prices pose significant challenges. Economic diversification with emphasis on manufacturing and agribusiness has been part of the economic agenda. The government’s objective is to improve the business environment by lowering the cost of doing business. Specific initiatives are centred on lowering the cost of energy and building more transport infrastructure.  Out of the 35,000km of federal highways in Nigeria, 25,000km are motorable an increase of 20,500km in the last three years. There is a sense of urgency given the recent sharp drop in oil prices and the quantity of exported oil declining.

Successful Investment Results

The search for returns has led investors to the African continent. The key determinants on an investment producing a real return to shareholders are driven by both macro and micro factors. Macroeconomic factors such as: inflation, tax rates, currency and political risk are largely left to policy makers with investors focusing on more controllable factors such as business-level operating performance.

There are some risk-mitigating strategies available to investors to protect against macro factors. These include: diversifying investments across markets, structuring investments appropriately, obtaining political risk insurance and purchasing financial instruments to hedge against exchange rate risk. The twin challenges facing investors seeking to hedge currency risk are exchange controls and a lack of liquidity, which impose additional risks such as counter-party risk. In the larger economies on the continent, hedging instruments are available that can assist in managing the risk. However, the excessive volatility of currency risk makes risk elimination impossible. 

For investors, good business performance could be illusory with significant currency depreciation. Yes, attempting to mitigate currency risk is wise but in the longer term some faith must be placed in the governments’ commitments to address investors’ concerns. Governments are looking for more investors and investors, in turn, are seeking governments that understand and are proactive in finding ways to address challenges. Ghana’s currency crisis has raised much needed awareness and with interests aligned, policy makers have to find ways to remedy the situation.

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