Africa FX special report: Getting the regime right
Fixed or floating? Managed or not? The argument continues to rage within Sub-Saharan African central banks about how best to run and oversee a currency.
As an investor, would you rather invest in a country with a floating exchange rate or a tight peg to a hard currency, or where a tender is secured to a hard currency with a looser peg, and which is ‘managed’ by the local central bank using a wide range of flexible financial tools? The issue matters deeply: it may be the most important decision facing corporates and investors when deciding whether or not to put capital to work in the region.
Many central banks across Sub-Saharan Africa choose the latter route, allowing their currency to fluctuate within a tight trading band against a hard currency, usually the US dollar or, in western Africa, the euro. Others bind their currency to a stronger regional peer: the Namibian dollar, for instance, is pegged at par to the South African rand.
To many authorities, the managed route is the most sensible option. “Most countries in Africa don’t have a flexible exchange-rate regime, as their economies are structured to withstand shocks, so they run a managed peg where currencies can fluctuate within a tight band, allowing the central bank to interject sporadically to manage the peg,” says Gaimin Nonyane, senior macro-economist at pan-African lender Ecobank. “This allows companies to manage shocks, and to avoid big swings in the FX market, which would lead to foreign investors incurring major losses. Managed pegs help to reduce that exposure.”
A few sovereigns opt for a floating-rate mechanism – Ghana, where Access Bank has a thriving domestic business, springs to mind, as does South Africa. These are historically strong and diversified economies (accepting that global gyrations have in recent times affected both countries) with open capital accounts. In theory, corporates and investors can put their money to work in either market whenever and however they like, safe in the knowledge that they can re-appropriate that capital any time.
Each approach has its proponents and critics. Floating rate mechanisms are attractive to foreign investors but could leave the host nation struggling if a currency tumbles in value against the likes of the US dollar, as has been the case through much of 2015. If a government then reacts by imposing sudden capital account restrictions, it would dent its image in the eyes of foreign investors. This outcome in one or more economies, given the global threat to local currency stability, is far from improbable.
Central banks need
some wiggle room within which to work
In a July 2015 report, Renaissance Capital warned that several regional currencies were under “significant pressure”, due to dollar strength and localized macroeconomic imbalances, notably the Kenyan shilling and the Nigerian naira. Conversely, it noted that the Ghanaian cedi and the Tanzanian shilling were undervalued. “In East Africa, we have seen most currencies depreciating at a faster pace in recent years,” says Jean Claude Karayenzi, managing director at Access Bank in the central African state of Rwanda. “Foreign currency inflows into the region have been affected negatively by the low prices of mineral and other essential commodities. On the other hand, we have seen a high demand for imported products, thus putting pressure on most local currencies and on our trade deficit.”
Managed currencies have their own detractors. They typically exist in immature or underdeveloped markets, and can get expensive if a local currency slips sharply in value against the tender to which it is pegged. The fixed or floating debate will rage for years if not decades to come. What makes the argument relevant right now for Sub-Saharan Africa countries is that bilateral US dollar exchange rates have become the nominal anchor for expectations about inflation and a host of economic variables. “This creates a special role for central banks in terms of managing the value of their currencies against the dollar, regardless of where they may be trending in real effective terms,” says Alan Cameron, chief Africa economist at London-based boutique investment bank Exotix. “With the deepening of markets over the last decade or so, the debate is not just about trade flows: in many of these countries, cross-border capital flows have become equal if not larger than the trade flows, and therefore are just as important in the determination of ‘fair value’ exchange rates.”
The pressure on currencies across the region forces corporates and investors to give serious thought to whom they want to manage their foreign exchange needs. Local lenders might offer specific, small-scale solutions, but it’s the big regional lenders, such as Access Bank, that offer a range of services that fit each market, and can aid an institution seeking regional solutions to its regional currency needs and demands.
The problem is most acute in major economies heavily dependent on oil revenues. (Nigeria for instance sources 98% of its export earnings from the sale of oil and gas.) “Over the past year, a lot of African currencies have come under pressure, especially oil dependent countries due to the continuing decline in oil prices,” says Adedapo Olagunju, group treasurer at Access Bank. “Consequently, these countries’ central banks have resorted to regulation to protect their respective currencies. To this end, regulation more than market forces has been the major determinant of the value of these currencies.”
A case in point is Nigeria’s central bank. Its governor, Godwin Emefiele, has rejected calls to devalue the naira, as fears rise about the economic and fiscal challenges facing Africa’s largest economy. Emefiele’s plan, which involves restricting imports of food, cement and other goods in an attempt to boost local production, aims to raise the value of the naira and boost the country’s dwindling foreign reserves, which have fallen more than 20% since mid-2014, and are set to decline further. Nigeria’s FX reserves slipped to $31.3 billion at end-August 2015, according to data from the Central Bank of Nigeria, offering the country only five months of import cover.
“The central bank has been under a lot of pressure to devalue the currency,” notes Access Bank’s Olagunju. “This has increased the anxiety of FX users both internationally and locally, thus increasing the request for FX hedging products from our clients.”
The big picture here is that most of the region’s major economies either run a floating-rate mechanism, or opt for a variation on Nigeria’s ‘enhanced’ or ‘demand’ management strategy, which helps the country, to quote central bank chief Emefiele, “manage what we have and live with what we have”, while cutting its dependency on US capital flows.
Hard pegs to soft pegs
But no single view on currency management or strategy is likely to win the day. A 14-year-old treatise on exchange rate regimes, penned by the current vice chairman of the US Federal Reserve board of governors, Stanley Fischer, continues to resonate today. Fischer wrote that nations would continue to modify and adapt their exchange rate regimes, moving from crisis-prone soft pegs to hard pegs or floating regimes, and predicted a continuation of that trend “particularly among emerging market countries”.
He was right. Those who say hard pegs do not work often point to the countries that have laboured under them while riven by crisis (the list includes Mexico in 1994 and Turkey in 2001) as well as emerging markets that dodged trouble by avoiding or removing a pegged rate (notably South Africa in 1998). For those nations fully or mostly open to international capital flows (South Africa again springs to mind here, as does Ghana), pegs are “not sustainable unless they are very hard indeed”, Fischer cautioned. He added that a wide variety of flexible rate arrangements (and a good modern-day example here is Nigeria’s demand-management strategy) was “possible”.
Nigeria needs to make stronger policy decisions,
Angus Downie, Ecobank
Roosevelt Ogbonna, executive director, commercial banking, at Access Bank, believes that, over the long term, pegged exchange rates “won’t work in Africa. Central banks need some wiggle room within which to work, and that is why in Nigeria, we are focused on maintaining a managed float. I strongly believe that managed currencies will be a strong focus across the region for the time being.”
Angus Downie, chief economist and head of economic research at Ecobank, believes that while floating-rate mechanisms are “better”, countries “still need strong management from their central banks, including in many cases a peg to the euro or the US dollar, a situation that we have in place across western Africa”. But he also predicts that as the situation improves – as the price of oil rises and a more coherent picture of the precise timing and nature of US interest-rate policy emerges - “Nigeria will begin to move to something more free-floating with the naira”. This, though, will take time: the country remains too dependent on income from energy exports, while being undermined by a struggling power sector and an incoherent tax regime. “Nigeria needs to make stronger policy decisions, which are in the long-term interests of the economy,” Downie adds.
So the fixed-or-floating argument will continue to rage. While a floating regime may be the best option for economies aiming to attract investment capital, it may remain unpalatable to many if not most emerging and frontier markets. “The erratic nature of short-term portfolio flows may be devastating to such economies, especially when such countries have not been able to accrue enough reserves to support the resultant volatility in their currencies,” says Access Bank’s Olagunju. “Each country should consider the peculiarities affecting their economy to determine how best to manage it.”