HEDGING AFRICAN CURRENCIES
JANUARY 2016
AFRICAN CURRENCIES
Seeiso
Both 2014 and 2015 served
as stern reminders of the
volatility inherent in African
markets.
Globally
we
witnessed a general decline
in commodity prices, not
least of which was the
spectacular crash in oil
prices that dealt a Tyson-like
blow to the budgets of all oil
exporting economies.
Matlanyane
In Europe economic growth
dwindled so much that the
ECB turned to quantitative
easing in a bid to jump start those economies. In
the East we saw a slowdown in China’s resource
intensive economic growth, leading to significantly
lower demand for African resources. Towards the
West the US dollar has been increasingly
strengthening on the back of a stronger domestic
economy which has allowed the Federal Reserve
to increase rates by 25 basis points in December
2015, the first US rate hike in almost 10 years.
Additionally, as if to compound these effects, this
all comes amidst heightened security and political
threats from terrorist groups such as Boko Haram,
Al-Shabaab and Islamic State. The aggregate
effect, in line with this risk off scenario that is
playing out, has been the reallocation of capital
from developing and emerging markets towards
the safer, and increasingly attractive developed
economies.
Research
Analyst
pace of currency depreciation in the face of a
rampant dollar. However, due to a limited amount
of foreign currency reserves and the negative
knock on effects of restrictive monetary policy
measures, authorities face constant difficulties. As
a result, African currencies have taken centre
stage in investors’ concerns when investing in
these markets. To put this in context consider
recent developments in two of the continents more
prominent investment destinations, Nigeria and
Kenya.
Nigeria
Since the dramatic price decline of crude oil in mid2014 the Central Bank of Nigeria (CBN) has
implemented a cocktail of policies as part of its
efforts to stabilise domestic inflation and the
Nigerian Naira (NGN). In addition to a 8.4%
devaluation of the local currency and a 100 basis
point (bps) Monetary Policy Rate (MPR) hike to
13% in late 2014, the CBN further carried out a de
facto devaluation of the NGN by abandoning the
Dutch Auction Systems and moving to an order
based system that effectively allowed the CBN to
supply dollars at a managed rate of c.200 naira to
the dollar. This was a move that the bank stated
“was to limit speculative trading on the currency”
which was allegedly a key cause of the stress on
the naira.
In this prevailing scenario, where African
economies face slower growth rates and upward
inflationary pressures in the short to medium term,
the continent’s currencies continue to come under
increasingly
greater
pressure.
Monetary
authorities have tried their utmost to slow the rapid
Figure 1: Naira exchange rate, Nigerian foreign reserves and price of oil.
Source: Bloomberg
Seeiso Matlanyane, Research Analyst
These measures evidently did not achieve their
objective as eventually, given the subsequent
relentless pressure on the currency and rapidly
falling foreign exchange reserves (illustrated in
Figure 1), the CBN turned towards capital controls
by implementing a ban on sourcing foreign
currency for a list of 40 specific products ranging
from toothpicks to private jets. Ultimately, by
essentially removing USD liquidity from the market
and helped by a briefly stabilising oil price at c.60
dollars per barrel, the CBN managed to artificially
keep the local currency at c.200 against the dollar
for most of 2015. But keeping the naira at this level
comes at an increasingly greater cost. Since
September 2015 the oil price has continued its
slide, followed closely by the country’s Foreign
Reserves which are down 15% compared to what
they were just a year earlier. This implies further
pressure on the local currency, the key difference
this time around being that the authorities have
significantly less ammunition to defend the current
exchange rate level.
Kenya
Despite Kenya’s favourable position to a lower oil
price as a net oil importer, the Kenyan shilling has
certainly not been immune to the rest of the
pressures faced by other currencies on the
continent. The tourism sector’s collapse after
security threats coupled with a worsening current
account deficit placed a substantial burden on the
local currency. By May 2015, the shilling had
depreciated 7.8% against the USD and inflation
was hovering close of the upper end of the
government’s target at c.7%.
Figure 2: Kenya exchange rate, interest rate and inflation. Source:
Bloomberg, CBK
This prompted the Central Bank of Kenya (CBK)
to react quite aggressively by increasing the
Central Bank Rate (CBR) by 300bps over two legs
by August 2015. While subsequent movements in
the KES suggest that these rate hikes have
managed to somewhat arrest the slide in the
currency and return inflation to comfortable levels,
large
planned
capital
expenditures
on
infrastructure and worsening climate conditions
point towards the country continuing to operate
with twin deficits for the foreseeable future. This
coupled with over hanging threats of sporadic
attacks from terrorist group Al-Shabaab is likely to
keep the tourism sector depressed and keep
pressure on the shilling.
With the looming possibility of further pain to come
for the continent’s currencies and monetary
authorities being significantly limited in their
abilities to bring stability against a formidable
dollar, there are some methods to protect against
adverse currency movements that can be
considered. The caveat here of course being that
hedging currency risk in itself is not without risk.
Currency hedging
The rudimentary idea behind hedging currency
exposure is as follows; foreign investors that are
invested in the local markets naturally have a long
position in the domestic currency. This simply
means that the investors are due to receive cash
flows in the local currency at some time in the
future. The risk that the investor is implicitly taking
on is that the local currency depreciates between
now and when the cash flows are due to be
received. In order to protect against this, the
investor needs to ensure that when they
eventually receive the cash flows, they can
convert these cash flows to hard currency at a
favourable predetermined rate. Even for our two
case study countries, Nigeria and Kenya, which
are among the more sophisticated and fluid
financial markets in our universe, investors are
quite limited in the types of instruments that are
available. Futures and Non-deliverable Forwards
(NDF’s) are the most widely used instruments that
allow investors to hedge their currency exposure.
These contracts allow investors to lock in a
specific pre-determined exchange rate at a future
date.
Seeiso Matlanyane, Research Analyst
To evaluate the implications of using these
contracts, we consider an observed set of market
quotes and then compare this to the expected
future exchange rate implied by fundamental
differences between the countries. The results
essentially give an indication of how far a currency
needs to depreciate beyond what can be
considered the fair value exchange rate before the
hedge becomes profitable.
The risk is that the currency does not move to the
levels that would make the hedge profitable and in
this case the investor stands to lose considerably.
To put this in context consider various payoffs for
a hypothetical investor with a USD 100 000
notional amount invested in either country looking
to protect this exposure for different exchange rate
scenarios in one year’s time.
Kenya
For the Kenyan shilling the NDF market is pricing
in a depreciation to 117.4 KES against the dollar
in one year from the time of writing. When
considering the difference in one year interest
rates between Kenya and the US, it indicates that
the KES should roughly depreciate to 117.7 per
USD one year on.
KES per
USD
KES
Movement
(%)
Return on
Nominal
98
100
102
104
106
108
110
112
114
116
118
120
122
124
126
128
130
-3.9%
-2.0%
0.0%
2.0%
3.9%
5.9%
7.8%
9.8%
11.8%
13.7%
15.7%
17.6%
19.6%
21.6%
23.5%
25.5%
27.5%
-19.7%
-17.4%
-15.0%
-12.8%
-10.7%
-8.7%
-6.7%
-4.8%
-2.9%
-1.2%
0.6%
2.2%
3.8%
5.4%
6.9%
8.3%
9.7%
Figure 3: Different return scenarios for different
levels of KES. Source: Bloomberg, Prescient
With the current spot price at c.102.2, the market
is pricing in depreciation roughly in line with what
is indicated by fundamental factors. If one then
considers locking in this exchange rate by selling
KES forward, the expected payoff profile for
different levels of the KES in one year is given in
Figure 3 above.
The return scenarios show that a hypothetical
investor hedging using NDF’s risks losing as much
as c.15% of their notional amount if the shilling
remains at the current level of c.102 to the US
dollar. The key consideration therefore becomes
whether the investor’s conviction is that the shilling
will depreciate past the break-even rate of c.118
by the time the contracts expires in one year, as
any depreciation below that will leave the investor
out of pocket.
Nigeria
The findings in Nigeria are considerably more
dramatic with a market expected local currency
depreciation of c.42.5% which is approximately
five times more than what the interest rate
differential implies.
NGN per
USD
NGN
Movement
(%)
Return on
Nominal
195
200
205
210
215
220
225
230
235
240
245
250
255
260
265
270
275
280
285
290
295
300
305
310
315
-2.5%
0.0%
2.5%
5.0%
7.5%
10.0%
12.5%
15.0%
17.5%
20.0%
22.5%
25.0%
27.5%
30.0%
32.5%
35.0%
37.5%
40.0%
42.5%
45.0%
47.5%
50.0%
52.5%
55.0%
57.5%
-45.1%
-41.5%
-38.0%
-34.7%
-31.6%
-28.6%
-25.8%
-23.0%
-20.4%
-17.9%
-15.5%
-13.2%
-11.0%
-8.8%
-6.8%
-4.8%
-2.9%
-1.1%
0.7%
2.4%
4.1%
5.7%
7.2%
8.7%
10.2%
Figure 4: Different return scenarios for different
levels of NGN. Source: Bloomberg, Prescient
This means that investors hedging using this
method are obligated to buy dollars one year from
now at c.283 NGN per dollar while the CBN
controlled rate currently is 199. Despite Nigeria’s
higher risk profile and the diminishing Central
Bank’s ability to maintain the official exchange rate
at this current level, a depreciation of this
magnitude is painful to lock in. This is probably a
Seeiso Matlanyane, Research Analyst
contributing factor to the extreme market sell-off
observed recently. International investors would
rather liquidate equity positions and attempt to
repatriate US dollars at the current rate than
remain invested and face a devaluation of the
Naira.
Our return scenarios show that a hypothetical
investor stands to lose as much as c.42% of their
notional amount if they enter into the hedge trade
and the central bank somehow manages to keep
the exchange rate at this c.200 level over the next
twelve months. Even when the CBN inevitably
allows the naira to depreciate, the likelihood of that
depreciation being greater than 43%, which is
priced into the market, should be a big
consideration for investors.
Given the current depreciation that is being priced
into the markets, regardless of how the African
currencies seem inevitably poised for a
depreciation, the decision to enter into a hedging
trade is not straight forward. Investors need to
carefully assess both the likelihood as well as the
magnitude of a currency depreciation over a given
time frame. The nature of currency futures and
NDF contracts is such that parties looking to
hedge their exposure can end up losing
significantly if the depreciation that is priced into
the market is not realised. This loss is larger if the
currency actually appreciates against expectation.
Therefore, in the quest to eliminate risk, investors
can end up being exposed to additional
unanticipated risks.
MEET THE FUND MANAGERS
Johan Steyn (MCom, CFA)
Johan has been managing funds in listed African equity markets since 2013. He joined Prescient in
2012 in a technical support role for the Retail Business Development team, after spending two years
abroad working in financial services in London. Johan is a CFA charter holder and has a Master’s
degree in Investment Management from Stellenbosch University.
Seeiso Matlanyane (BBusSci)
Seeiso joined Prescient in February 2015 where he is responsible for research and assisting with the
management of Africa equity portfolios. Previously he worked for Bloomberg as a Fundamentals
Analyst in the Global Data department where he conducted market and data analysis for Sub
Saharan African Markets.
Seeiso Matlanyane, Research Analyst