As of 9th September 2014, the Ghana cedi had depreciated well over 47.54% against the dollar, a little over 38.30% against the euro and 44.28% against the pound sterling since start of the year, according to the data provided by the Central Bank of Ghana.
Since the 1990’s there have been many cases around the globe where investors, especially currency investors, have been caught off-guard -- which led to runs on currencies and capital flight. What really triggers investors, traders and financiers to take actions like this?
What are the key economic fundamentals and technical analysis they consider? Or do they simply go by their gut-instinct? Hold on, we will examine currency volatility and expose what its foundations really are.
A currency crisis is a situation in which there is a serious doubt as to whether a country’s central bank has enough foreign exchange reserves to maintain the country’s fixed exchange rate.
This is brought on by a decline in the value of a country’s currency. The weakening in value adversely affects an economy by creating unwarranted volatilities in exchange rates. This means that one unit of the currency no longer buys as much as it used to in another.
When confronted with currency crisis, central bankers in a fixed exchange rate economy can attempt to maintain the exchange rate by dipping into the country’s foreign reserves or push for exchange rate swings.
Now, reaching into the foreign reserves becomes a very practical solution when the market experts a downward trend. This pressure placed on the currency can be quickly offset by an increase in interest rate.
To be able to increase the rate, the central bank has to shrink the local currency supply, which with in turn increase the demand. By selling off foreign reserves, the central bank creates a capital outflow from which it must hold the domestic currency it receives out of circulation as an asset.
Sustaining the exchange rate is an arduous task and cannot last forever both in terms of a decline in foreign reserves and holding back domestic currencies. As an import-led economy, our reserves could not hold onto the pressure well enough, so the money the central bank released could not offset the deficits even though the interest rates went up. So, the situation had to be let loose -- and this is the result we see today.
Devaluing the currency by increasing the fixed exchange rate results in domestic goods being cheaper than foreign goods, which increases demand for workers and increases output. As said earlier, in the short-run devaluation also increases interest rates, which must be offset by the Central Bank through an increase in the money supply and an increase in foreign reserves.
Propping-up a fixed exchange rate can eat through a country’s reserves very quickly. The rate of the devaluation of our currency should deplete our foreign reserves but that is not the case at the moment. I believe the Central Bank is either holding onto the reserves or there is none at all. This option has rather led to releasing more of the domestic currency into the economy, surging the foreign currencies higher.
Ghana’s parliament has approved US$1.5 billion for the borrowing of the Eurobond this year, a billion to support the budget and US$500 to retire the matured bonds secured in 2007.
This move is a timely but temporary measure to curb the cedi’s devaluation: to get cheaper rates for the bonds, government should consider certain hedging strategies such as taking positions in interest rate futures and forwards to offset risk in the delays and high interest rates which might be encountered on the international bond market.
Now let’s examine the anatomy of the crisis. Investors’ confidence in the stability of the economy eroded as result of the 2012 election dispute, heavy borrowings, uncertainty about government’s actions -- just to mention a few that made investors jittery.
Some investors got their monies out of the country, which is referred to as capital flight. Once investors have sold their domestic currency-denominated investments, they convert those investments to foreign currency. This exchange even causes forex rates to get worse, resulting in a run on the currency that can make it difficult for the country to finance its spending.
Forecasting when a nation will go into a currency crisis involves the breakdown of a diverse and complex set of variables; let’s now see the Latin American crisis of 1994.
On December 20, 1994, the Mexican peso was devalued. The Mexican economy had improved greatly since 1982, when it last experienced upheaval, and interest rates were at positive levels. These are the factors that contributed to their subsequent crisis.
• Economic reforms from the late 1980’s, which were designed to limit the country’s rampant inflation, began to crack as the economy weakened.
• The assassination of a presidential candidate in March 1994 sparked fears of currency sell-off.
• The Central Bank was sitting on an estimated US$28billion in foreign reserves, which was expected to keep the peso stable. In less than a year, the reserves were gone.
• The Central Bank began converting short-term debt, denominated in peso, into dollar-denominated bonds. The conversion resulted in a decrease of foreign reserves and an increase in debt.
• A self-fulfilling crisis resulted when investors feared a default on debt by the government.
In the process of devaluing the peso in December 1994, the Central Bank made major mistakes. The valuation was not done by a large amount, which showed that while still following the pegging policy it was unwilling to take the necessary painful steps.
This led investors lose confidence in the peso and pushed the rate radically low -- which forced the government to increase domestic interest rate to nearly 80%. This had a major impact on other economic indicators such as inflation and GDP. The crisis was finally relieved by an emergency loan from the USA.
There are several key lessons to be learnt to forestall future occurrences.
• An economy can be initially solvent and still succumb to a crisis. Having a low amount of debt is not enough to keep policies functioning, let alone having huge deficits.
• Trade surpluses and low inflation rates can diminish the extent to which a crisis impacts an economy; but in case of a financial contagion, speculation limits options in the short-run.
• Governments will often be forced to provide liquidity to private banks, which can invest in short-term debt that will require new term of payments. If the government also invests in short -- term debt, it is possible for it to run through foreign reserves quickly.
• Maintaining the fixed-exchange rate does not make a Central Bank’s policy work simply on face value. While trying to maintain the peg, investors will ultimately look at the Central Banks’ ability to maintain the policy.
Our economy experienced a rapid positive growth but didn't make us immune to this crisis. This is so because growth rates that are too rapid can create instability and a higher chance of capital flight and runs on the domestic currency. Efficient Central Bank management can help, but foretelling the steps an economy can ultimately take to reverse such crisis is a tough one to map out.
By Henry Obeng Tawiah
The writer Senior Analyst, Morgans Investors Service
[email protected]
Facebook
Twitter
Pinterest
Instagram
Google+
YouTube
LinkedIn
RSS