CHAPTER 4 Conclusions
- Stella Kaendera, S. V. S. Dixit, and Nabil Ben Ltaifa
- Published Date:
- December 2009
The evolution of exchange rates in sub-Saharan Africa has reflected the impact of both external developments and distinct policy choices. The fall in export demand, commodity prices, and private capital inflows contributed to currency depreciation, which some authorities opted to counter through increased intervention while others chose to let market forces play. Given above-trend inflation, the currencies of countries that intervened generally appreciated in real terms.
The new external environment has raised costs for both floating and managed currencies. Countries with managed exchange rates have to face sterilization costs (to stem an appreciation) and external financing costs (to stem a depreciation). Their real exchange rates appreciated by a wider margin compared to the other countries. Such an outcome could harm competitiveness and undermine long-term sustainability over time if the real effective exchange rate significantly deviates from its equilibrium. Countries with floating currencies faced increased exchange rate and price volatility, which can also deter long-term investment.
African economies can expect exchange rate pressures and volatility to persist for some time. Shifts in commodity prices as well as in portfolio and other private capital flows are likely to continue given the highly uncertain trajectory of the global recovery, the geographic rebalancing of trade flows, and volatility in the exchange rate of the main currencies.
The prospect of continued exchange rate volatility raises particular challenges for those countries seeking to enhance their integration with international capital markets. Financial integration is generally expected to act as a catalyst for growth in Africa, facilitating more rapid investment in infrastructure and private sector development, enhancing competition, and encouraging foreign direct investment and technology transfer. However, exchange rate volatility could hinder progress with financial integration, skewing capital flows toward short-term options at the expense of longer-term investment.
Deepening domestic financial markets is key to enhancing their capacity to handle external financial volatility over the long term. As mentioned, interbank, capital, and foreign exchange markets are still shallow in most sub-Saharan African economies. Stronger regulatory and supervisory frameworks could help reduce inefficiencies and enhance competition. There is also scope for reforms to encourage the development of stock markets by putting in place frameworks that will allow better risk assessment, reduce market uncertainty, and improve transparency. Broader bond markets will allow diversification into longer-term investment instruments—important for long-term investors. Developing forward hedging instruments would also generate some stability in the foreign exchange market by reducing forward settlement risks.
Additional measures could be explored to mitigate the impact of external volatility in the short-term.
Intervention on foreign exchange markets has been used with different degrees of success. Intervention has costs both if used to stem appreciation (sterilization costs) or to stem depreciation (external financing costs). Thus, to be successful, intervention must be limited in time and backed by credible monetary and fiscal policies.
Capital controls are attracting renewed interest, either through outright limitations of foreign purchases of certain financial instruments or through price-based measures like taxes on selected inflows. It is difficult to judge the effectiveness of capital restrictions in countries where they exist and the extent to which they reduce the cost and frequency of intervention. Price-based controls such as capital transaction taxes entail significant requirements in terms of enforcement capacity and sizable risks of domestic disintermediation, which makes them a challenging option at best for most sub-Saharan African economies.
Increased regional trade could reduce the adverse impact of volatility in the rest of the world. The elimination of intraregional tariff and non-tariff barriers would help broaden demand at a time when traditional markets are expected to show only subdued growth. However, trade integration would also need to be supported by a gradual harmonization of exchange rate policies within the region, which may be challenging given the diverging preferences shown across countries since the onset of the global crisis.