Background
The excess demand for the US dollar over supply remains inevitable, even in times of COVID-19 where rate of imports has declined. One of the recent Forex Forward Rates (FFR) auction in 2020 registered about 62.62% of banks’ excess bid over the accepted amount with a bid cover ratio of 2.71x, which is contrary to an expected trend in the midst of the pandemic. The interbank forex rates has started risingindicating a depreciation of the cedi in the forex market. The dominance of the dollar in international financial transactions,underscore the importance of considering the dollar as the currency towhich the cedi should be anchored and managed to minimize extreme unexpected depreciation should external shocks occur. Furthermore, assumptions underlying domestic financial policies, which pertain totransfer of funds across borders need to be reviewed to ensure the effectiveness of the anchoring policy.
Effect of COVID-19 on international financial markets is one of the factors currently affecting the strength of the cedi. Industries are having liquidity challenges compelling them to sell the most secured and liquid assets, and resulting in lower asset’s price and higher interest rate. Hence, the U.S. Fed conscious attempt to purchase bondsto increase liquidity to the firms at a stabilized interest rate. The Fed’s monetary policy measures to mitigate the appreciation of the dollar to make U.S. industry’s products competitive suggests that eventual depreciation of the cedi will stimulate inflation in Ghana. Thus changes in prices of bonds in the international bond market, its effect on the domestic exchange rate and associated inflationary pressures have implications on the domestic interest rates, which when not addressed will continue to weaken the cedi whenever interest rates on bonds rise in the international market.
Decision to hold foreign or domestic assets greatly determinesexchange rates in the short run than exports and imports demand. This is because expected returns on Ghanaian banks’ deposits denominated in domestic currency, and that expressed in terms of deposits denominated in foreign currency of which exports and imports transactions constitute a smaller percentage, indicate the decision to hold foreign or domestic assets. In other words, in terms of the cedi, the relative expected return on U.S. dollar deposits, to a greater extent, determines the exchange rate. Thus foreigners and domestic residents desire to hold more dollar deposits and fewer cedi deposits when the relative expected return on dollar deposits increases.
Moreover, increase in money supply and its potential role in fuelingshort run depreciation of the cedi cannot be ignored. The central bank’s COVID-19 stimulus packages, such as reduction of the policy rate, reserve requirement, CCB among others, to ensure financial stability could contribute to further depreciation of the cedi. This is because the real money supply will increase in the short run as percentage rise in price equalizes the percentage increase in nominal money supply in the long run. The short run increase in real money supply causes interest rates to further decrease and reduces the expected return on cedi deposits in terms of the dollar, thereby causing depreciation of the cedi in the short run. Hence, investments denominated in dollars would become more attractive than that in cedis, all other things being equal.
In the long run where increase in money supply has been accompanied by a corresponding increase in price levels, real variables such as the real interest rate remains unchanged with a reduced impact relative to the short run. Though this causes the long run effect of the cedi’s depreciation, emanating from increase in money supply, to be less felt, the cedi eventually depreciates. Thus expected exchange rate (cedis per dollar in the next period) would be relatively better (lower) than current exchange rate (spot cedis per dollar). Hence, increasing money supply has potential consequences of a declined appreciation of the cedi.
Interest rate band and hedging
One of the ways to manage the stabilization of short run exchange rate is to provide interest rate band for banks whose assets are denominated in cedi to account for its depreciation in terms of the dollar. Thus, should the cedi depreciate, the margin of interest between the actualinterest (spot interest rate) and ceiling of the band (expected interest rate) would account for it. Alternatively, the excess demand of the forex forward auction can be given the interest rate band that accounts for the risk emanating from possible depreciation of the cedi, then the central bank hedges against the interest rate risk component within the band which emanates from the depreciation.
This in a way would discourage the willingness of foreigners and domestic residents to hold assets denominated in dollars, thereby reducing its demand in the short run. Though it might cost the central bank to hedge, the opportunity cost could be lower relative toavalanche assets that gets denominated in dollars as the cedi depreciates. The central bank can finance the cost of hedging by an‘exchange rate stabilization fund’ where banks are encouraged to contribute. Another way is to let all banks to hedge interest rate risks emanating from depreciation of the cedi and finance it from a zero or very low interest (determined by weekly average depreciation rate of the cedi) funds borrowed from the ‘exchange rate stabilization fund’.
In addition to the above, a stakeholders’ consultation with international traders in some selected business districts of Kumasi and Accra suggested that the Bank of Ghana mandates specific commercialbanks to open international agencies/branches in the top ten most importing/exporting countries like China and India. This will enabletraders to withdraw monies in Chinese Yuan, in the case of China, upon arrival to transact any business intended for the trip without necessarily demanding US dollars. For instance, a Ghanaian bank in China will have traders opened foreign currency accounts denominated in Ghanaian cedi. This will enable Ghanaian businessmen to transfer funds in cedi into their accounts in China and then withdraw funds in Chinese Yuan when they arrive in China for business transactions. These businessmen will have foreign currency and foreign exchange accounts in these Ghanaian banks in Ghana, to enable funds generated from exports to be transferred to Ghana. These measures, when carefully planned, would reduce the increasing demand for the dollarfrom the trader’s perspective and eventually reduce imported inflation emanating from the appreciation of the US dollar against the cedi.
Potential effect of interest rate band and hedging
The implementation of the above policy measures can reduce the demand for assets denominated in dollars when domestic interest rates are structured to account for possible depreciation of the cedi. In pursuance of the interest rate band and hedging policies, expected exchange rates (cedis per dollar in the next period) could be less than current exchange rates (spot cedis per dollar), which could increase the expected return on assets denominated in cedi deposits in terms of dollar in the short run, and attract more investments to strengthen the cedi. This is because as the current exchange rate rises above equilibrium rate (analogous to an expected exchange rate where investments denominated in cedi are desirous as one in dollar, making investors indifferent in their investment decisions, due to prudentimplementation of the policy) the expected dollar return on cedi deposits will rise. For instance, given the expected return on cedi deposits in terms of the dollar, , equal Ghana’s interest rate minus the expected appreciation of the dollar (, where is 10% ; current exchange rate is GHc1 per dollar; and the expected exchange rate is 1 cedi per dollar (equilibrium rate as explained above). The expected dollar return on cedi deposits will be 10% because expected appreciation of the dollar is zero. However, if the current exchange rate is GHc1.50 per dollar, all other things being equal, the expected change in thevalue of the dollar becomes –33.33%. Hence, becomes 43.33% [10% – (-33.33%)], which can attract more investments to further strengthen the cedi on yearly basis. Thus, given the 91-day treasury rate of 14.76% in June 2020, and that same period’s exchange rate of GHc5.6707 per US$, if the implementation of the policy results in a decline in the expected exchange rate to GHc3.05 per US$ in December 2020, then the expected return in terms of the dollar will be 60.97% [14.76-(-46.21)]
The preceding example depicts the importance of the policy to potential increase in nominal interest rate which emanates from increase in real interest rate, rather than from inflation, and its effect on the exchange rate. Increase in nominal interest rate stemming from increase in real interest rate leads to appreciation of the cedi, while increase in the rate which emanates from increase in expected inflation depreciates the value of the cedi. In Figure 1 below a persistent decline in the real interest rate is associated with a rising cedi price of the dollar, denoting depreciation of the cedi. In other words, banks prefer to invest in assets denominated in dollars than lending to other banks. This results in increasing demand for the dollar, and hence depreciation of the cedi.
Source: Author’s construct, 2020 | Bank of Ghana
Conclusion
Implementing interest rate band policy that enables domestic interest rate to automatically adjust upward to account for depreciation of the cedi will result in the appreciation of the domestic currency (cedi) until it is appropriate to review the policy when the effect turn out to be undesirable on the economy. Moreover, the band can minimize deviations from future expected exchange rates, which when kept fairly constant enables expected future return on assets denominated in cedi to increase, if the current exchange rate is relatively greater. This is because investors of assets denominated in cedi are optimistic of getting an expected future return in terms of the dollar, hence the anxiety involved in buying dollars and selling cedis is minimized.
About Author:
Dr. Kwame Acheampong, Economist and Consultant. Email:[email protected]
