Several nations in Africa have also experienced an inflation rise, posing an economic crisis exacerbated in some instances by fiscal dominance resulting from significant levels of public debt.
- Imports and exports have a significant impact on a country’s economy.
- Currency fluctuations are unavoidable due to floating exchange rates, which are the norm in most major economies.
- Since African economies are mainly import-oriented, currency devaluation has manifested in “imported” inflation.
Many African countries are today confronted with significant monetary policy issues. The epidemic slowed economic development, and the recovery will likely fall short of pre-crisis levels this year. Several nations in Africa have also experienced an inflation rise, posing a financial crisis exacerbated in some instances by fiscal dominance resulting from significant levels of public debt.
Many of these economies may experience capital outflows as major central banks in developed economies eliminate policy stimulus and hike interest rates in the coming months. The economic impact of Ukraine’s conflict, notably the accompanying rapid spike in oil and food costs, is expected to exacerbate the issues.
Currency fluctuations and exchange rate considerations
Currency fluctuations are unavoidable due to floating exchange rates, which are the norm in most major economies. Various variables influence exchange rates, including a country’s economic performance, inflation expectations, interest rate differentials, and capital flows. The stability or inefficiency of the underlying economy often determines the exchange rate of a currency. As a result, the value of a currency might change from one moment to the next.
Allowing currencies to adapt while focusing monetary policy on domestic objectives benefits countries with regulated or free-floating exchange rate regimes.
Many Sub-Saharan African nations with floating exchange rate regimes exhibit traits and vulnerabilities that restrict the benefits of entirely flexible rates. For example, dominant currency pricing (i.e., fixed export prices in US dollar terms) might undermine the advantageous trade adjustments linked to flexible rates.
Furthermore, shallow markets (those with insufficient liquidity) can accentuate exchange rate swings and produce excessive volatility. Many nations in the area have shallow foreign currency markets, as shown by significant gaps between the bid and ask prices.
High foreign-currency obligations are also a significant risk in many economies. Exchange rate depreciation can jeopardise individual and corporate financial health when there are substantial currency mismatches on balance sheets. Furthermore, insufficient central bank confidence might cause currency rate movements to have a greater impact on inflation. Currency mismatches and significant passthrough can drive production and inflation to shift in opposing directions during shocks, exacerbating policymakers’ decisions.
It remains evident that currency rate passthrough is significantly higher in low-income African nations than in more developed economies. This creates a particular concern considering the often-heavy reliance on energy and food imports.
The far-reaching consequences of currency levels and exchange rates fluctuations
Many individuals are unconcerned about currency exchange rates since they rarely need to be. The average individual conducts their everyday life in their local currency. Exchange rates are only relevant in rare cases, such as international travel, import payments, or foreign remittances.
An overseas traveller may desire a stable native currency since it would make travel abroad more affordable. However, a strong currency may severely drag the economy in the long run, rendering entire industries uncompetitive and resulting in the loss of thousands of jobs. While some people like solid currencies, a weak currency might provide more economic advantages.
When central banks formulate monetary policy, they consider the value of the local currency in the foreign exchange market. Currency levels influence the interest rate people pay on their mortgage, the profits on their investment portfolio, the price of food at a local grocery, and even employment prospects.
The slowdown in economic growth
Imports and exports have a significant impact on a country’s economy. A weaker currency generally makes imports more expensive while increasing exports by making them more affordable to foreign buyers. Over time, a weak or strong currency can contribute to a country’s trade surplus or deficit.
On the other hand, a stronger currency might diminish export competitiveness, making imports cheaper, causing the trade imbalance to expand further and weakening the currency in a self-adjusting mechanism. However, before this occurs, export-dependent companies may be harmed by a too strong currency.
Major African currencies have lately hit new lows against the world’s major controlling currencies, like the USD. Currency devaluation will have ramifications, including an increase in African export competitiveness and a reduction in the countries’ capacity to import. Most African countries, however, continue to rely on imports. As a result, because net exports have an inverse relationship with the local currency’s strength, currency depreciation in African countries entails lower import value and hence slower GDP growth.
Foreign capital is more likely to flow into nations with strong governments, vibrant economies, and stable currencies. A generally stable currency is required for a country to draw capital from foreign investors. The possibility of exchange-rate losses caused by currency devaluation will prevent foreign investors from investing in Africa.
Foreign direct investment (FDI) involves foreign investors purchasing interests in existing African enterprises or establishing new facilities in the destination market. The oil-rich countries will benefit from FDI amid Africa’s present economic turmoil. Many European countries, particularly Germany, have made it plain that they want to look to Africa as an alternative to Russian oil and gas. Thus, Europe’s interest in the African gas sector will stimulate FDI.
African governments often prefer FDI over foreign investment portfolios since it symbolises hot money that departs countries quickly when conditions deteriorate. This impact, however, is known as capital flight, and it can be triggered by any adverse event, such as currency depreciation.
Since African economies are mainly import-oriented, currency devaluation has manifested in “imported” inflation. This inflationary pressure is unlike any other that African countries have faced. As consumption continues to outpace production levels throughout the continent, the pressure is morphing into a possible pandemic, reinforcing the need for more efficient economies.
For example, the Kenyan shilling has continued to fall versus major global currencies, reaching an all-time high of 117.57 shillings per US dollar.
The Kenyan shilling has been rapidly declining in the last year. The decline results from the demand for dollars from the energy industry outstripping the supply from exports and remittances. The Kenyan central bank also warns that global inflationary pressures would most certainly intensify due to the rapid pace of monetary policy tightening by major central bankers.
Regarding monetary policy, most central banks continue to prioritise exchange rates. A robust local currency drags on the economy in the same way that tighter monetary policy does (i.e. higher interest rates). Furthermore, tightening monetary policy when the local currency is strong may aggravate the situation. The move would draw hot capital from external investors looking for higher-yielding assets. This would further strengthen the domestic currency.
Africa has reached a point where central banks are looking for fast fixes to combat inflation. To attain a favourable real rate and mobilise savings for investment, African governments have had to boost interest rates above the level of inflation.
However, the most significant concern is Africa’s susceptibility to growing inflation in developed and developing economies, given the continent’s reliance on imports. As a result of rising interest rates, many governments’ debt burdens currently remain exacerbated by higher borrowing costs.
Rising food costs and currency instability resulted in Nigeria’s inflation rate climbing to 17.71 per cent in May. In its decision to raise the policy interest rate by 150 basis points to 13.0 per cent earlier that month, the Monetary Policy Committee recognised the limitations of monetary policy in tackling inflation concerns, given structural challenges hurting domestic output in the nation.
Possible solutions for currency and monetary policy challenges in Africa
First, it is critical to continue to eliminate vulnerabilities over time. Reduce balance-sheet discrepancies; strengthen money and foreign currency markets, and reduce exchange rate passthrough by increasing monetary policy effectiveness.
However, vulnerabilities keep rising in the short term. Deploying extra instruments may assist relieve short-term policy trade-offs whenever shocks such as the Ukrainian crisis strike. Foreign currency intervention, macroprudential policy controls, and capital flow controls can increase monetary policy independence. Further, the intervention would improve financial and price sustainability. A decrease in output volatility would result if reserves are enough and these instruments remain available.
Various economies face a sharp tightening of global financial conditions and other adverse external financial shocks. African countries with such vulnerabilities can improve immediate economic outcomes by using foreign exchange intervention to limit exchange rate depreciation. Consequently, the government would limit the inflationary impact and reduce negative balance sheet effects. As a result, production would get significant, and inflation lower than it would without the deployment of the extra policy tool.
A few crucial qualifications remain necessary for central banks considering such programs. The instruments should not be used to keep an overvalued or undervalued currency. Furthermore, while new tools might assist mitigate short-term trade-offs, this advantage must be carefully balanced against possible long-term costs. Reduced incentives for market development and effective risk management in the private sector are examples of such costs.
Communicating about the collaborative use of various instruments in a more complicated framework can also be difficult. Furthermore, broadening the variety of policy alternatives may expose central banks to political pressures. As a result, central banks will have to evaluate the benefits against the possible adverse effects on their openness and credibility. The evaluation remains crucial mainly when policy frameworks are not firmly established.