EAZ advises how Zambia can mitigate ‘credit risk’ effects of a strong dollar

Stock market ticker board blurred at edges
  • Zambia urged to strengthen manufacturing capabilities to decrease import inflation
  • EAZ lauds recent MOU for Mwinilunga honey to sell in China

Rating agency Moody’s Investor Service earlier said a strengthened United States (US) dollar meant an increase in the credit risk of several emerging markets due to currency depreciation. A Moody’s report said a strong dollar would also lead to a drop in foreign exchange reserves of countries such as Argentina, Ghana, Mongolia, Pakistan, Sri Lanka, Turkey and Zambia.

“Countries with large current account deficits, high external debt repayments and substantial foreign-currency government debt are most exposed to the impact of a stronger US dollar,” Moody’s Global Managing Director of the Sovereign Risk Group Alastair Wilson said.

Brazil, China, India, Mexico and Russia are the least vulnerable as they are less dependent on external capital inflows, the report said.

From the above what does this entail for Zambia?

The United States dollar has rallied to a 13 – month high of 96.7 amidst speculation fueled by the trade wars between the world’s top two economies namely US and China. Surely when elephants fight, the grass suffers, so emerging markets have taken a ‘knock’ with currencies coming under pressure from stronger dollar strength. Post Trumps election the US economy has undergone a series of intense macroeconomic interventions and monetary policy tightening which has given the greenback parity strength that has made dollar denominated assets such as treasuries and stocks, very attractive causing asset sell – off ripple effects in emerging markets to include African nations (A sell-off is the rapid selling of securities such as stocks, bonds, ETFs, commodities or currencies). A stronger dollar fundamentally entails, commodities coming under pressure to wane the demand for assets such as copper, crude, gold, platinum and other industrial commodities. Because emerging market economies are ‘Dutch diseased’ (Over-dependence on one or two commodities for export revenues), export proceeds then decline. The autopsy of a plummet in proceeds of export revenues then translates to insufficient cover for fiscal programs manifesting in budget deficits which African nations choose to plug with external borrowing to bridge the gap.  Another consequence of low export revenues due to a decline in commodity prices is a weak build-up of foreign exchange reserves for import cover purposes.

The case of Zambia

Africa’s second largest copper producer, Zambia, depends on the red metal for over 75% of its export revenues. A stronger dollar would entail a lower copper price that would have the net effect of impacting the exchange rate because the mines will not realise sufficient dollar proceeds from copper exports which could, to some extent, stifle conversions (dollar to kwacha to meet local currency obligations such as wage bills or tax payments). It must be borne in mind that the mines are the largest suppliers on the currency market to the extent that the playout in the industrial commodities market manifests in currency volatility (appreciation or depreciation swings). An economy can have all the dollars in the world but exchange rate is only a function of the portion converted to the dollar –  kwacha rate is the price at which conversion takes place. Copper had a bullish run in the first half (H1:2018) flirting with highs of USD7,250 a metric ton as news of the electric car hit the market. Electric cars need copper wiring to transmit electric charge. However, uncertainty then gripped the metals market after the US and China roiled into a trade war that saw the dollar strengthen, forcing investors to offload risky assets to replace them with dollar denominated assets. As a consequence, copper has shaved off significant value to trade at near 1 – month lows of USD5,926 a metric ton. For Zambia, this means lower proceeds from copper exports. Because copper is a barometer for global economic growth, a lower price will signal weaker growth prospects for Zambia which then prices into copper producers’ dollar assets (Eurobonds) to widen credit default spreads to push yields higher.

(Credit default spreads measure the credit risk of a counterparty such that wider spreads signal deteriorating position and narrow spreads reflect stronger positive credit position).

It has been technically proven that Eurobond yields correlate negatively with underlying commodity prices. (Zambian dollar bonds will correlate with copper prices; Angola, Nigeria and Gabonese Eurobonds will correlate with crude oil prices etc.). Depending on the mechanics of each nation, lower commodity prices (due to stronger dollar) then ideally should translate into weak build-up of foreign exchange reserves and as such import cover is jeopardized. Nigeria and Angola lost most of their foreign exchange reserves when the price of crude plummeted significantly from highs of USD110/bbl. to just under the teens at USD32/bbl. This was in part the reason why the oil dependent nations issued Eurobonds. Why this is a source of concern is because reserves are viewed as financial ammunition to balance currency stability when an economy is exposed to vulnerabilities such as external shocks. However, burning reserves is very costly. Zambia is sitting on USD1.82-billion of foreign reserves and any external shocks would threaten stability of this cover thus far.

What can Zambia do to mitigate the effects?

Much as the effects of dollar strength is systemic to emerging markets and African nations, diversification through building manufacturing capabilities is strongly advised. The biggest challenge is to start building this capability with foresight of a rainy day so as to be hedged from external shocks. The impact of global markets however tends to hit economies that are more positively integrated into the global financial system such as South Africa, Kenya, Nigeria and Ghana which supposedly have duel listings in capital markets in addition to having more liquid assets such as bonds that are listed on international indexes such as the JP Morgan emerging market bond index – EMBI’s etc. These nations easily catch flue when the west coughs. Illiquidity has proven to be a natural hedge against global turbulence benefiting nations like Zambia. However, manufacturing capabilities then tend to promote local industries to the extent that imports are reduced thereby curbing import inflation. If Toyotas were manufactured in Zambia and sold in Kwacha, there would be no need to buy dollars to import these brands from Japan. But because manufacturing capabilities are weak in Zambia, dollar demand will remain high as citizens continue to import goods from outside. Excess dollar demand is the sole reason for pressure on the Kwacha. Zambia needs more exports of products to earn foreign exchange to compensate potential loss of export proceeds from copper. This has been the biggest hurdle for the Ministry of Commerce and Trade in failing to close tangible deals that would foster forward trade between Zambia and its peers or globally. It is for this reason that trade balances are negatively widening. The recent MOU to allow Mwinilunga honey to sell on Chinese shelves is a welcome move but we need more than just honey out there.

(Forward integrated trade refers to getting Zambian products on international shelves).

Proceeds could be maximized through value addition of metal processing which is a solution that has been on the table for decades. The likes of Neelkanth cables have smelt the coffee and have started to add value to copper by manufacturing wires.

Other considerations include hedging through short dated (3-months to 6-months) forward exchange contracts for businesses that would like to secure dollars in a currency volatile environment. These will allow for locking in of exchange rates in advance for transactions to happen in the future. However, it is a dry point of construction that the Zambian market has a limited array of derivative instruments to manage currency risk due to either restrictive central bank licenses or lack of technical expertise to manage currency and interest rate risk through interest rate swaps, contracts for exchange or exotic products.

From a credit perspective, lending may need proper matching with cash flows, i.e. dollar loans must be matched with homogenous cash flows or kwacha loans should be absorbed by local currency cash flows to mitigate currency risk concerns. Cross currency asset – liability mixes must be carefully thought out with residual risk appropriately hedged.

Mutisunge Zulu is an Economist and currently National Secretary for the Economics Association of Zambia.