Why Africa's dependency on the U.S. dollar is a big deal
"Local" currency lending and its impact
The BRICS bank conducted its first-ever bond sale denominated in South African rand. You may wonder why this is noteworthy?
If you only have 1 min, here’s a summary of the key points:
Local currency lending: Borrowers and lenders use the borrower's home currency.
Sub-Saharan African countries are over-exposed to the USD (in the median country, 84% of exports, 67% of imports, and 60% of external debt are priced in US dollars)
African currencies have on average lost 8% in value relative to the USD since January 2022, after sudden interest rate increases by the Fed
This leads to higher prices, larger debt and weaker trade balance in the short-term
Local currency lending contributes to stability for borrowers, the development of local financial markets and reduces foreign exchange cost
Instruments like long-term currency swaps, exchange rate insurances and anchor investors for local currency corporate bonds help foster local currency lending
You have more time? Let's break it down:
Local vs. Foreign Currency Lending
Local currency lending: Loans in the borrower's own currency. Both parties use native currency.
Foreign currency lending: Loans in a different currency. Example: South Africans getting loans in USD, not Rand.
Sub-Saharan African countries are highly reliant on debt denominated in USD
African countries are highly reliant on the US dollar and the US-denominated financial system for trade invoicing and external debt.
A total of 84% of exports, 67% of imports, and 60% of external debt are priced in US dollars for the median country - IMF (April 2023)
This makes their economies over-exposed to movements in the dollar exchange rate.
After a long period of around zero interest rates, the US Fed suddenly and strongly increased the federal funds rate from 0.25% to 5.5% during the past 1,5 years. This increased the costs of borrowing money and boosted the USD exchange rate.
African currencies have lost about 8% of their value since January 2022
Recently, currencies in most African countries have been getting weaker compared to the US dollar.
On average, African currencies have lost about 8% of their value since January 2022. Some countries, like Ghana and Sierra Leone, have seen their currencies drop by over 45%.
This leads to
Higher prices: 1% increase in the rate of depreciation against the USD leads, on average for the region, to an increase in inflation of 0.22 pp within the first year (Source: IMF)
Larger debt: Exchange rate depreciations increased public debt in sub-Saharan Africa by 10 pp in 2020 - 2022, holding all else equal (Source: IMF)
Weaker trade balance in the short-term: Goods are usually priced in US dollars. Exporters need time to adapt production, even with more profits, while consumers struggle to find local alternatives for imports. In the medium-term the balance improves.
Local currency lending contributes to stability, the development of local financial markets and lower cost
Advantages of increased local currency lending include
Stability for Borrowers: No fretting over currency fluctuations like the USD. Easier loan planning and repayment.
Growing Local Financial Markets: Boost financial sophistication by promoting local currency bond issuance. This helps local businesses get more capital, expand, and boost economic development.
Reduced Foreign Exchange Costs: Borrowing in foreign currency often means extra expenses for currency conversion. With local currency loans, these costs are sidestepped.
Instruments that can foster local currency lending
Long-term currency swaps are hedging products that provide security for lenders while letting borrowers repay their debts in their local currency. Players like TCX can hedge more than 100 currencies across emerging markets.
African Local Currency Bond Fund: Conceived by the German KfW development bank, the fund acts as an anchor investor to foster corporate bonds in local African currencies.
Currency Exchange Rate Insurance: For example, the African Trade & Investment Development Insurance offers coverage against losses due to exchange rate fluctuations for businesses and investors in Africa.
More alternative approaches to hedging include denominating debt in a blended mix of currencies, investing in proxy assets such as land or “borrow-and-lend” where the borrower deposits the hard-currency with a domestic bank using it as a security for a loan in local money.
Sources to learn more
If you’re interested in who lends to Africa and how, then check out the Africa debt database (a research project by the Kiel Institute, free download) covering 7000 individual loans and bonds with a total volume of nearly 800bn USD including financial terms.
IMF Note on Managing Exchange Rate Pressures in Sub-Saharan Africa (April 2023)