Cedi Volatility: Speculators Thrive on Weak Economic Fundamentals

Cedi Volatility: Speculators Thrive on Weak Economic Fundamentals

“In a flexible exchange rate regime, changes in the value of a domestic currency is a barometer for the strength of the

country’s economic fundamentals ” – Courage Kingsley Martey

Since the adoption of a flexible exchange rate regime under the Financial Sector Adjustment Program (FINSAP) in 1987, the Ghana Cedi has recorded annual depreciation with varying degrees of volatility.

While the Cedi recorded relatively mild depreciation between 2003 and 2007 on account of the Highly Indebted Poor Country Initiative which unlocked multi-lateral debt relief, a combination of election-related excesses and persistent energy crisis have undermined Ghana’s economic fundamentals over the years.

The fiscal discipline and improved economic fundamentals which were achieved under the 3-year IMF program between 2009 and 2012 were invariably sacrificed on the altar of the 2012 elections as central bank financing of the budget deficit (22.47% of the previous year’s tax revenue) exceeded the 10% ceiling.

The average budget deficit recorded from 2012 – 2014 (10.6%) was 380bps higher than average for the period under the immediate past IMF program (2009 – 2011) with the highest deficit of 12.1% recorded in 2012 (an election year) against a target of 6.7% for the year. – Courage Kingsley Martey

Since the adoption of a flexible exchange rate regime under the Financial Sector Adjustment Program (FINSAP) in 1987, the Ghana Cedi has recorded annual depreciation with varying degrees of volatility.

While the Cedi recorded relatively mild depreciation between 2003 and 2007 on account of the Highly Indebted Poor Country Initiative which unlocked multi-lateral debt relief, a combination of election-related excesses and persistent energy crisis have undermined Ghana’s economic fundamentals over the years.

The fiscal discipline and improved economic fundamentals which were achieved under the 3-year IMF program between 2009 and 2012 were invariably sacrificed on the altar of the 2012 elections as central bank financing of the budget deficit (22.47% of the previous year’s tax revenue) exceeded the 10% ceiling.

The average budget deficit recorded from 2012 – 2014 (10.6%) was 380bps higher than average for the period under the immediate past IMF program (2009 – 2011) with the highest deficit of 12.1% recorded in 2012 (an election year) against a target of 6.7% for the year.

Ghana’s electricity supply deteriorated in 2012 mainly on account of interruptions in gas supply from the West African Gas Pipeline Company (WAGPCo) and the frequent downtime of the country’s thermal plants.

The delay in the completion of the country’s gas processing plant, the Atuabo gas plant (completed in late 2014) implied the lack of an alternative to WAGPCo as a source of gas supply. The erratic electricity supply restrained economic activity and private investment during the year, resulting in a sharp slowdown in Ghana’s GDP growth from 15% in 2011 to 8.8% in 2012 (4.0% in 2014).

The demand pressures triggered by the high deficit financing from the central bank and the slowdown in GDP growth combined to significantly weaken Ghana’s balance of payments (BOP) position. The overall BOP recorded a deficit of $1.2 billion at the end of 2012, completely reversing the surplus of $546.5 million recorded in 2011.

Although fiscal consolidation was initiated in 2013 to rein in the budget deficit, the substantial damage to Ghana’s economic fundamentals and the recurrent power supply challenges have significantly dented investor confidence. Ghana’s weak economic fundamentals consequently provided a fertile ground for speculative currency transactions as rational economic agents moved into safe-haven assets (in this case, foreign currencies) to preserve the value of their financial assets.

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Although a significant part of the cedi’s volatility can be attributed to the speculative activity of investors, speculative attacks on a currency is mainly a reflection of weak fundamentals of an economy which speculators customarily flag as posing a high risk to a stable outlook.

Ghana’s inevitable return to a 3-year IMF program (which commenced in Apr-2015) and a positive review from the first assessment in Jun-2015 triggered a change in sentiments in foreign exchange transactions.

The Bank of Ghana (using FX swap with banks) capitalized on the changing sentiments to ramp up daily FX supply to $20 million in order to quell speculations about a possible shortage of foreign currency on the market. The desired result was achieved as a strong rebound in the cedi’s value culminated in a 34% appreciation against the US dollar on the interbank market during the first three (3) weeks of Jul-2015.

The relentless speculative demand reversed with a substantial reduction in the hoarding of foreign currencies which were unleashed unto the FX market. But alas! The strong recovery could not be sustained with the weak economic fundamentals as speculation re-emerged on the FX market, causing renewed depreciation which gradually wiped out the gains made in Jul-2015.

The Way Forward

Ultimately, rebuilding Ghana’s weak economic fundamentals is the surest way to restore investor confidence in the Cedi and avert the significant volatility resulting from speculation. It begins with the implementation of fiscal policy that would be consistent with a monetary policy whose main objective is price stability (including exchange rate stability).

In other words, it is important for the government of Ghana to remain committed to the fiscal adjustments under the IMF program in order to cut the fiscal deficit to sustainable levels. As was presented by the finance minister in mid-July 2015, the reduction in fiscal deficit from 9.5% in 2014 to a projected 7.3% by the end of 2015 requires great commitment from the government.

The government’s projected revenue has taken a major hit mainly due to the slump in the international prices of Ghana’s primary commodities (gold, crude oil, and cocoa).

It is therefore critical to front-load the expenditure adjustments in order to contain the exogenous shocks to revenue. The substantial allocation to recurrent expenditures which are quite rigid in nature makes it difficult for the government to quickly calibrate expenditure to contain unexpected shortfalls in revenue.

These rigid components of recurrent expenditure include employee compensation, interest payments and statutory allocations which must necessarily be paid as they fall due. Total employee compensation and interest payments on loans together accounted for ~85% of tax revenue in 1HY-2015, a commitment that allows for a very low degree of freedom for expenditure adjustments.

In light of the efforts to rid the public sector wage bill of “ghost names”, through the implementation of Electronic Salary Payment Vouchers (E-SPV), automation of the public financial management system and ongoing rationalization of the civil service, the percentage of tax revenue allocated for employee compensation is expected to decline.

It is expected that the percentage of tax revenue allocated to wages and salaries would decline to 35% by 2017 (from the current 44%), consistent with the ECOWAS convergence criteria. These measures should help reduce the fiscal deficit to sustainable levels by the end of 2017 (although the 2016 election poses another risk), thereby reducing the inflationary effect of central bank financing as well as restraining government borrowing to ease the upward pressure on interest rates.

The government would, however, have to reach a consensus with the various labor groups negotiating for conditions of service as the protracted negotiations in Aug-2015 would have consequences for the 2016 budget preparation.

Any deal reached would be executed through the 2016 budget, which would pose a risk to a substantial cut in the budget deficit in 2016 (NB: there are indications of relatively less restrictive IMF measures for 2016).

At this juncture, it is worth recounting a profound statement by the IMF team following the first review of Ghana’s 3-year program in Jul-2015:

“The success of the program critically hinges on continued spending moderation, in particular, the wage bill with stricter control of the payroll being put in place, and renewed efforts to improve revenue collection. Making public the strategy for the 2016 budget and wage negotiations consistent with this framework will go a long way in restoring market confidence and lowering financing costs”.

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Our analysis of Ghana’s budget deficit revealed an average increase of 3.6% in an election year since the 2000 election mainly due to spending overruns, emphasizing the need for expenditure moderation especially in election years.

Rebuilding Ghana’s economic fundamentals also hinges critically on increased productivity in the real sector of the economy: agriculture, services, and industrial sectors.

Raising productivity in the public sector would ensure that the government’s expenditure on wage bill is matched by higher output and tax revenue. Boosting productivity in the export sector would also help increase foreign exchange earnings and correct the balance of payment deficit which is a major trigger for cedi volatility.

Export diversification and value-added production would be critical ingredients in the strategies to improve the country’s earning potentials and reduce vulnerabilities to the “boom and bust” cycle associated with primary commodities.

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BoG Governor, Dr. Henry Kofi Wampa

The anticipated issue of another Eurobond ($1.5 billion), cocoa loan syndication ($1.8 billion), the resumption of donor support (~$500 million) and opening the weekly auction of Ghana’s 2-year Note to foreign investors should help provide the much-needed FX inflows in the Q4-2015.

The substantial inflows would help erase the balance of payments deficit in the short term and restore the much-needed confidence in the Ghana Cedi but only for a limited period or for the rest of 2015.

Sustaining the cedi’s stability for a much longer-term would require a marked improvement in Ghana’s economic fundamentals by correcting the structural imbalances in the economy.

A commitment to the fiscal consolidation program under the IMF over the next 3 years is a necessary condition, but maintaining the fiscal discipline after the adjustment program is critical for sustaining strong fundamentals and investor confidence. This is the only means to anchor exchange rate expectations and sustain the cedi’s stability.

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