Will cedi depreciation mean higher interest rates?

For much of this year the cedi has been under pressure from a surging US dollar. Ghana may be forced to raise interest rates to stem further local currency depreciation

The conventional wisdom is that the United States’ central bank, the Federal Reserve will raise the benchmark federal funds rates further this month. If indeed this happens as is overwhelmingly likely, the effects will be felt in Accra, as the Bank of Ghana will come under increasing pressure to increase its own benchmark interest rates in an effort to keep cedi denominated financial assets competitive.

The competitiveness of cedi denominated investment securities against US dollar denominated counterparts has become essential, following the opening up of Ghana’s securitized public debt market to foreign investors a decade ago, who now hold nearly one third of government’s debt securities currently in issuance.  When Ghana first began allowing foreign investors to buy into its cedi denominated public debt securities back in 2008, US Federal Fund rates were at an all time low of 0.25% as America’s central bank used loose monetary policy to make cheap money readily available in an effort to stimulate economic activity and thereby overcome the economic recession brought about by the global financial crisis of that time. This monetary policy strategy, known as “monetary easing” enabled emerging market economies such as Ghana to attract international financial portfolio investors to buy into local currency denominated sovereign bonds because they offered relatively high yields – in Ghana’s case of up to a peak of nearly 25% – at a time US bond yields were insignificantly low. The wide interest rate differential gave such international investors enough confidence to take on the large currency exchange rate risks inevitable in such investments.

Over the past decade Ghana has become addicted to foreign investment in cedi denominated bonds for several reasons. One is that foreign investors are willing to invest in far longer tenured securities than their local counterparts; even local institutional investors in Ghana are unwilling to put a significant proportion of their respective investment portfolios in bond with tenors of more than two or three years. Indeed, it is foreign participation that has enabled the Government of Ghana regularly issue medium to long term bonds with tenors of up to 10 years.

Secondly, foreign investors are willing to accept lower coupon interest rates than their local counterparts and this has lowered government’s public debt servicing costs. It is instructive that more often than not, government has been able to keep its annual public debt servicing outlays below budget, by increasing the proportion of debt securities sold to foreign investors relative to the proportion subscribed by local investors.

Thirdly, foreign investors, although subscribing to cedi denominated instruments, do so by bringing in direly needed foreign exchange which has been used to prop up the country’s foreign reserves, which in turn has helped stabilize the cedi, ultimately reducing the forex risk suffered by those foreign investors. This has kept everyone happy, persuading the foreign investors to roll over their investments on maturity, which stems outflows when the bonds mature.

However this happy merry go around is now under threat from the gradual retreat from monetary easing by America’s Federal Reserve Bank.  Over the past couple of years, interest rates have been gradually hiked and Federal Funds Rates now hover at between 1.75% and 2.0%, four times where they stood as recently as 2016.

Resultantly, international portfolio investors are now flocking back to dollar denominated bonds issued by western hemisphere governments and major corporations alike. With further interest rate hikes by the Fed being expected, this trend is likely to intensify further over the coming months.

Inevitably therefore, investors are reducing their exposures in emerging markets to finance bigger bond purchases in developed markets. To be sure, while Ghana has been a major victim from this trend – the cedi has lost some 5% against the dollar so far this year – it is still far better off than countries such as Argentina and Turkey which have seen their domestic currencies fall by some 50% against the dollar since the beginning of the year.

Unsurprisingly, led by squabbling politicians from both sides of the political divide, all sorts of reasons have been proffered for the cedi’s fragility and just as expectedly, the Bank of Ghana’s explanation as to the effect of monetary tightening in the US is largely falling on deaf ears.

Part of the reason  for this however is that a leading option to put the cedi back on an even keel would be to increase interest rates so as to make cedi denominated securities more internationally competitive again, but this is a strategy few stakeholders even want to consider.

To be sure, Ghana’s fiscal and monetary policy makers both, have worked hard at lowering interest rates over the past two years from their peaks reached by the middle of this decade, when bank lending rates approached an average of well over 40% per annum. Since late 2016, the BoG has lowered its key Monetary Policy Rate from a peak of 26% to 17.50% currently. Similarly, benchmark coupon rates on short term treasury bills have been lowered from close to 25% to barely 13%.

However, effective lending rates have not fallen by nearly as fast and about half of the banks in the country still maintain base lending rates of over 25% and average effective lending rates of over 30%. Unsurprisingly, the formal private sector, which traditionally relies heavily on credit for its working capital wants interest rates to fall further and government itself, desperate to accelerate economic growth and create direly needed new jobs, agrees with this desire. Thus, selling the idea of an interest rate hike would be difficult, even if is to stabilize the cedi, another key macro-economic performance parameter.

Opponents of such a hike point out that if cedi denominated securities are no longer competitive even though they still offer yields that are between seven and ten times those offered by their US counterparts, then it is unlikely that even a 10% increase in domestic yields could possibly make a difference. They point out that the problem is not so much the narrowing interest rate differential between cedi and dollar denominated securities, but the fact that yields on dollar denominated instruments are now rising to absolute levels that can satisfy international investors.

Whether this argument is true or not may not matter; the fact is that higher interest rates do not fit in with government’s economic management strategies and the BoG itself wants to support government’s strategies, moreso if differing would make it the scapegoat before a dissatisfied private sector.

This means there will be increasing pressure on the cedi’s exchange power going forward, although this itself is fortunately being dampened by Ghana’s ongoing merchandize trade surplus.

By Onajite Sefia