Managing currency depreciation remains crucial to reducing risk perception and boosting access to African trade finance.
- African central banks have implemented foreign exchange controls and rationing to address foreign exchange deficits.
- Access to trade finance has significantly strained African trade, exacerbated by foreign currency, dependence, especially the US dollar.
- Any disruptions to hard currency liquidity negatively impact trade finance availability in areas with high trade potential.
Access to trade finance has significantly strained African trade, exacerbated by foreign currency, dependence, especially the US dollar. African countries have long experienced liquidity constraints and recurrent crises in the balance of payment. Moreover, the excess reliance on the dollar exposes African countries to foreign exchange risks.
Approximately 80 per cent of all international trade is facilitated by financing or credit insurance. Financial institutions including banks act as intermediaries between buyers and sellers. They manage the risks occasioned by gaps between payment and delivery of goods. Reliable trade finance helps sellers mitigate payment risks, and buyers reduce delivery risks during shipment.
Africa has a significant regional trade finance gap. Consequently, African companies have significantly struggled with access to affordable trade finance and integrating it into the global supply chain. Typically, African trade finance is characterized by short-term, low-risk, and high-collateral loans. Default rates remain significantly lower than banks’ non-performing loan ratios. The main obstacle for trade finance is a lack of foreign exchange liquidity, currency and credit risk, and a general perception of increased regional risk. Thus, managing currency depreciation can boost African trade finance.
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Access to foreign exchange liquidity
Many exports are invoiced in dollars, even when shipped to other African countries or Asia. Any disruptions to hard currency liquidity negatively impact trade finance availability in areas with high trade potential. Access to hard currency liquidity is crucial. But domestic private companies in Africa have limited access to foreign exchange liquidity and long-term deposits in their currencies. Adequate foreign exchange reserves should be considered an essential part of a country’s self-insurance. This will help protect against currency depreciation, particularly in low-income countries.
According to the Bank of International Settlements, Africa’s private sector holds few foreign assets or none that can be quickly repatriated in challenging economic times. Even in non-pandemic times, most African banks cite inadequate foreign exchange liquidity. Foreign correspondent banks are also unavailable to increase the supply of trade finance.
Macroeconomic instability, including sovereign and political risk, can cause the value of local currencies to decrease in relation to hard currencies. The decline of foreign counterparties for many African regions further compounds the decline of foreign counterparties for many African regions, making accessing US dollars and clearing dollar transactions increasingly challenging.
African governments have tried managing currency depreciation. For instance, African central banks have implemented foreign exchange controls and rationing to address foreign exchange deficits. They use hard currency reserves to trade goods deemed essential to their economy, resulting in the increased cost of non-essential goods. In cases of limited liquidity, banks and governments tend to prioritize larger clients or companies over small and medium enterprises, and rationing further exacerbates the imbalance in the distribution of trade finance to smaller companies.
US dollar domination of African trade finance
Companies in countries with developed financial markets can use their domestic banking systems to finance trade. However, letters of credit issued by African commercial banks often need confirmation by global banks or institutions in the destination countries.
Lack of proper currency risk management can lead to negative consequences for those receiving trade finance from global banks and their affiliates due to the combination of limited credit availability and changes in exchange rates.
Currency depreciation and rising interest rates
The local currency depreciating against the US dollar and increasing floating interest rates make existing loans more costly. Additionally, convertibility and transfer risk can occur when the local currency becomes too weak to convert to another currency, either due to changes in its value or government controls on capital and exchange rates.
In addition to currency volatility risk, trading partners face indirect credit risk from currency conversion when they agree to future dollar transactions. African exporters who take out dollar loans and earn dollar revenue have a natural hedge on their balance sheets, but importers who obtain dollar trade finance and earn local currency revenue have an imbalance on their balance sheets.
During the current global financial instability and the prevailing exchange rate fluctuations, importers could find it challenging to meet dollar-denominated payment obligations due to a significant devaluation of local currencies on liquidity constraints when monetary authorities ration access to dollars.
Moreover, adverse credit conditions combined with exchange rate fluctuations reduce the availability of new trade finance loans and increase financing costs. Research has shown that trade finance flow correlates negatively with the US dollar index.
In recent times of stress associated with the strong performance of the dollar, the ‘flight to safety’ effect has led banks and companies in importing countries to cut exposure and credit to particular countries that they perceive as riskier. Hence, managing currency depreciation remains a priority.
Addressing currency risks
Managing currency depreciation remains crucial to reducing risk perception and boosting access to African trade finance. There are several approaches to enhance the management of currency risk and the liquidity of trade finance.
First, deepening trade and financial integration will likely promote the use of local currencies and reduce the cost of borrowing. Second, developing national secondary currency markets will help de-risk foreign exchange transactions. Third, experimenting with innovative financial instruments – such as synthetic local currency trade finance instruments – can begin as trade integration deepens and local secondary markets develop.
Regional systems eliminate the need for an intermediary foreign correspondent bank for faster payment processing and at lower costs across borders. The transaction volume of the dollar-denominated remains high. However, there is evidence that regional integration has steadily increased local currency transactions.
According to SWIFT, African regions with strong integration increasingly use local currencies as against hard currencies including the US dollar. For instance, the use of the West African franc by the eight countries in the WAEMU region has overtaken the South African rand and the British West African pound.
This implies that boosting the use of regional currencies will shield the African trade market from adverse global conditions associated with the performance of US dollars. However, further regional coordination remains necessary. This will build a continental payment system that encourages the use of local correspondent banks and local currencies. Such moves can help in managing currency depreciation to boost African trade finance.
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