Currency futures will hedge FX risks

The often volatile nature of many African economies is working against increased FDI into the continent and imposing constraints on businesses. Our guest writers, Prasad Dalavai* and Dharmeshsingh Mohadewo*, argue that Africa needs a continent-wide futures exchange to manage FX risk.

Like most markets, the currency market is prone to periods of instability and readjustment. Large swings have the most, and obvious, impact when talking about big sums of money. Certain key African currencies’ annual volatility is in double-digit numbers.

All organisations that invest, sell or source from economies which have a currency other than their domestic currency will be exposed to foreign currency (FX) risk.

Therefore increased participation in global trade by African firms requires suitable forex risk management and effective hedging tools. Many firms within the continent are exposed to foreign exchange risk and its implications. As a result, forex risk is passed on by producers in the form of higher prices, curtailing the competitiveness of African companies in the global market.

Further, inadequate coverage against forex risk also limits the extent and rate of financing of their businesses by financial institutions. Even banks and financial institutions are exposed to forex risk either directly or indirectly depending upon their role in the value chain from production to export of finished goods.

Africa is fast becoming an alternative market, especially with investors in the stagnated US and European markets looking to shift their investments elsewhere. Increase in Africa’s share of global FDI in the recent past indicates the same. Thus businessmen, African firms, banks and financial institutions and the investor fraternity who have exposure to forex risk desperately need proper hedging instruments, such as currency futures.

Efficient management of forex risk certainly enhances the scope of operations of African firms from domestic to regional and even global. Currently, forward markets exist for a few of the currencies, while currency futures are restricted to only four currencies – the Mauritian rupee, South African rand, Botswana pula – and the latest addition, the Zambian kwacha.

There are only three operational derivatives exchanges in Africa – Bourse Africa based in Mauritius; the JSE, based in South Africa; and Zambia’s Bond and Derivatives Exchange (BADEX), which has just become operational. USD/MUR and rand/USD currency futures contracts are traded on the Bourse Africa platform; USD/rand and pula/rand are traded on the JSE; while kwacha/USD is traded on BADEX.

A pan-African derivatives exchange would be better placed to offer an economical and efficient platform enabling stakeholders to hedge forex risk and thereby become more competitive in the global market.

A pan-African exchange would assist in the sustainability of the exchange as it then becomes cost competitive.

The timely availability of trade information and trade finance are equally important for unleashing the potential of trade within Africa. Therefore, a multi-asset pan-African exchange such as Bourse Africa could address certain challenges faced by African firms as Africa’s requirements for complex financial instruments grow amid global trade and volatile commodity prices. The stakeholders can even hedge commodity price risk in addition to forex risk.  

There is no doubt that economic reforms have unleashed entrepreneurial innovation in the continent. However, entrepreneurial innovation and spirit has to be sustained through effective forex risk management to unlock Africa’s potential.

For this, there is a need for a well-established, pan-African derivatives exchange to cater for the requirements of the stakeholders of Africa’s global trade.

While the opportunity for development and greater contribution to the global economy does exist for Africa, the continent needs to create a conducive business environment to exploit the opportunity.

Rapid global  integration required
Currently, Africa contributes only 4% of global GDP. Africa’s share of global trade has been sustained in the range of 3.6% to 4% over the last 10 years. On an annual average basis, the region’s share of global foreign direct investment (FDI) inflows was a mere 1.9% for 1990–1999 though it improved to 3.2% for 2000–2009.

Africa’s FDI and GDP moved in tandem to an extent; the correlation coefficient between the two over the last 30 years (1981 to 2012) has been reasonably good at 0.75. In fact, the correlation between FDI and GDP, with a one-year lag for the period, was highest, indicating the lag effect of FDI, hence higher FDI is followed by a greater GDP growth rate.

Indeed, it is widely recognised that FDI acts as a driver of employment, boosts technological progress, improves productivity and brings economic growth. However, Africa has never been a major recipient of FDI inflows and lags behind other regions of the world. The average of Africa’s share of global FDI is a weak 2.3% over the last three decades.    

In the 1980s, Africa’s average share of global exports and imports was of 3.8% and 4% respectively, while it was only 2.8% and 2.6% respectively in the first decade of the millennium.

The decreased share in international trade indicates that Africa struggled to adapt to globalisation, hence it is necessary for African nations to renew themselves to succeed in the dynamic global business environment.

More sophisticated hedging instruments such as currency futures will go a long way towards increasing FDI flows.

* Prasad Dalavai is the Manager and Dharmeshsingh Mohadewo is the Assistant Manager of the Research & Product Development Team at Bourse Africa, the first international multi-asset-class exchange from Mauritius.