The Ghanaian cedi (GHC) has been in the global spotlight recently, with Bloomberg reporting that the currency is the second worst performing currency in the World in 2022 –
After the Sri Lankan rupee. Notably, Cordros Research highlight that while the Ghanaian cedi depreciated by 26.3% YTD against the US dollar in the interbank market (19 August 2022), it weakened by 34.6% YTD in the FX Bureau market (BDCs) during the same review period. The recently increased pressure reflects an increase in FX demand emanating from genuine and speculative demand amid capital repatriation pressure due to sovereign credit rating downgrades. In this report, we assess how the exchange rate premium breached the IMF’s benchmark and the factors responsible for the lingering currency pressures. We also evaluated the fair value of the local currency using the Ordinary Least Squares regression (OLS) based on the interest rate and inflation differentials with the United States. Lastly, we update our views on where we expect the currency by the end of the year.
FX Pressures: Exchange Rate Premium Breaches IMF’s Benchmark
Prior to November 2021, the GHC/USD exchange rate depreciated at a slower pace, and the exchange rate gap between the official market (interbank) and FX Bureau markets (BDCs) was within the IMF’s +/-2.0% gap in cases where there are recognized markets that serve the retail end. Precisely, we highlight that the average FX Bureau premium over the interbank market exchange rate was 1.9% between January and October 2021. However, as concerns about the government’s finances increased after the presentation of the 2022FY budget estimates, the FX premium averaged 9.2% between November 2021 and July 2022, with the premium rising to as high as 11.6% in May 2022. Our view aligns with the Bank of Ghana (BOG) that the current exchange rate pressures are driven by negative sentiments arising from (1) sovereign credit rating downgrades, (2) loss of gross FX reserve buffers, and (3) foreigners’ divestments of local currency bonds, amid the challenge of financing the budget from both domestic and external sources. Additionally, the preceding factors have led to an increase in speculative demand for the US dollar, further weakening the already pressured GHC amid higher outflows from genuine demand for imports. Consequently, as stated earlier, the Ghanaian cedis depreciated by 26.3% year-to-date against the US dollar at the interbank market as of 19 August. At the FX Bureau markets, the local currency depreciated by 34.6% YTD against the USD during the same review period.
GHC/USD: Fairly Valued at the Interbank but Under-Valued at the FX Bureau
Our model follows the theory of the International Fisher Effect, which states that the expected change in exchange rates is given by the difference in nominal interest rates across countries. In other words, the difference between the nominal interest rates in two countries is directly proportional to the changes in the exchange rate of their currencies at any given time. In our regression model, we define fair value as a function of interest rate differential (364-day Treasury bill rate minus 1-year US treasury yield) and inflation rate differential (domestic inflation rate – United States inflation rate). Our formula for estimating the currency’s fair value:
GHC/USD = β0 + β1 (INTR) + β2 (INFL), where β1 and β2 represent the coefficient of interest rate and inflation rate differentials, respectively.
Findings from the model showed that 76.9% of the variation in the exchange rate is explained by the two independent variables included in the model.
In our analysis of currency data from January 2020 to July 2022, we note that the fair value estimates have mirrored the interbank market exchange rate movement and recently deviated largely in the FX Bureau markets. Accordingly, our model suggests that the local currency is trading close to its fair value (the 12-month average differential between the forecasted and actual rates is near 0.0%). Based on the preceding, we believe the exchange rate is undervalued by c.10.7% (figure 2) at the FX bureau markets, suggesting that the recent sell-off might have been overdone. Notably, our fair value estimate settled at an average of GHC7.29/USD in July. At the same time, the local currency exchanged for an average of GHC8.16/USD in the FX Bureau markets.
Does the Local Currency Tread Water from Here?
Our model suggests that the local currency could depreciate further but at a much slower pace for the remainder of the year. Overall, we forecast the local currency’s exchange rate with the US Dollar will average GHC8.12/USD by year-end (July average: GHC7.39/USD), primarily driven by a higher interest rate differential as the monetary authority embarks on a more aggressive tightening cycle relative to the US Fed. A 15.0% premium translates to an estimated GHC9.34/USD in the FX Bureau market by year-end (July average: GHC8.16/USD). As of writing (23 August), the Ghanaian cedi traded at 9.80/USD at the FX Bureau market. Notwithstanding, we highlight some measures that could provide short-term respite for the gross FX reserves. Notably, the Ghanaian Parliament approved a USD1.30 billion Cocoa Board (COCOBOD) loan on 28 July. Going by historical precedence, we think the loan could come through by the end of September. Simultaneously, the government expects a USD750.00 million term loan from the African Export-Import Bank and USD250.00 million syndicated loans from international commercial banks.
Over the medium term, we believe the gross FX reserves would be bolstered by the expected inflows from the IMF (USD3.00 billion) if a deal is finally agreed on with the government, which could drive foreign inflows to the economy. Thus, an agreement reached in line with the expected timeline (on or before Q1-23) could improve investors’ sentiments, serving as a tailwind for the local currency. However, in a situation where the IMF deal is delayed, we would expect the local currency to weaken further against the USD as weak sentiments become more severe.
Overall, we expect the domestic currency’s exchange rate to average GHC8.12/USD by December – 0.9% and 20.7% appreciation compared with the interbank (GHC8.19/USD) and FX Bureau market (GHC9.80/USD) rates, respectively, as of the time of writing.