Fiscal deception, external financing and monetary policy credibility

In the past, the stability of the cedi depended largely on exogenous factors such as commodity price shocks, uncertainty in the financial markets, global financing conditions, energy shocks, crude oil imports, as well as other fiscal pressures.

In the current circumstances, however, where the cedi is recording its worst performance since 2016, the pressures appear to be largely self-inflicted and coming from deliberate fiscal under-reporting and reliance on external financing coupled with monetary policy inertia. Although other Frontier Emerging Market countries may be experiencing pressures, ours is peculiar considering that Ghana’s sovereign risk is projected to deteriorate further given the current levels of borrowing as well as the political risk in a typical election year.

Theoretically, several factors determine exchange rates in most economies. Some of the short-term determinants include interest rate arbitrage (exchange rates react to changes in relative interest rates between nations), speculation (currency traders trade on projected interest rate movements), and unforeseen events (uncertainty from political instability, natural catastrophe, terrorist attacks, etc).

The medium-term determinants include money growth, (a nation with a higher monetary growth will experience a depreciating exchange rate), real income growth (if domestic income growth goes up relative to other nations, demand for imports will rise and hence the currency will depreciate), and trade balance (when a country’s trade deficit worsens, its currency depreciates).

Finally, the long-term determinants include interest parity condition (this describes the relationship between short-term interest rates, spot exchange rates, and forward exchange rates), and purchasing power parity (exchange rate should equal the ratio of prices of a fixed basket).

Whereas the government is to blame for the fiscal issues and the financing thereof, the Bank of Ghana appears also to be under-estimating the problem and attributing the phenomenon to a number of untenable reasons. For instance, in a recent interview the Central bank said it was due to an adjustment in its reference rate (under a supposed floating regime), and also pressures from the government’s revenue mobilization and expenditure choices. The central bank further said the pressures were coming from payment of some energy-related debts which had forex components. Again, this raises questions as to whether the Bank of Ghana did not capture these in its 2019 forex cashflow projections as it should.

From best practices in other central banks, when there is a currency crisis as we have now, there are three options to deal with the situation and all three choices must be crafted into a well-thought-out strategy. The first is to allow the currency to depreciate and adjust to the shock while the floating regime automatically facilitates a return to equilibrium.

The second is where the central bank simply uses more of its reserves to intervene in the foreign exchange markets to limit the pressures. The third option is where the Central bank increases the policy rate to stem capital flow reversals that could be destabilizing.

These three options are not mutually exclusive, and in practice, many Central banks use a combination of all three (3) to prevent currency crises from transiting into full scale financial and economic crises.

For example, instead of policy tightening at the last MPC meeting, the Central bank continued to use the second option by intervening in the markets. Indeed, the seven months between March 2019 and October 2019, for example, saw significant drawdowns in reserves by nearly ?2 billion. This has been the strategy throughout 2019 as the policy rate has been kept unchanged while international reserves declined.

Sadly, these reserves were procured from the recent Eurobonds in March 2019, which have been channelled mostly into consumption rather than investment. It has become a pyramid scheme where Eurobonds have become the only way a supposedly fast-growing economy and a solid one for that matter, could survive.

However, it is just a matter of time when the pyramid scheme will crumble, if we continue this approach of economic management. We even celebrate it with kenkey parties, with hysteria.

Although the World Bank and the International Monetary Fund (IMF) have maintained since April this year that Ghana was at a high risk of debt distress after their assessments found that public debt levels had breached three of their debt sustainability criteria, the Governor of the Bank of Ghana declared in a subsequent interview that Ghana’s public debt stock was sustainable but the large foreign investor component made the economy vulnerable. Interestingly, the Economic Commission for Africa (ECA) had also made the same assessment as the IMF/World Bank as it listed Ghana among 11 countries in the sub-region that were at high risk of debt distress.

While we continue to operate this ‘pyramid’ scheme, we must remember that the ratio of short term private capital inflows to net international reserves has risen to over two times above the standard benchmark. This means that there is a real prospect of payment default, which could be triggered by any shock to external financing conditions.

For example, the ongoing trade tensions in the advanced countries could trigger capital flow reversals across the frontier and emerging market countries including Ghana. Already, data from the Bank of Ghana shows that there are significant capital flow reversals ongoing while foreign participation in domestic bonds has been on the decline.

To address the current pressures on the cedi effectively, the first solution is for government to become transparent about the true fiscal situation while the Bank of Ghana works on its 2020 foreign exchange cashflow to effectively capture all projected payments. This will guide its market intervention strategy going forward.

These measures should be coupled with drastic fiscal adjustment that involves expenditure rationalization and revenue-enhancing efforts to stem the fiscal pressures. Third, excessive dependence on external financing should be curtailed and the stock of external debt actually reduced using the Sinking Fund.

Fourth, the Bank of Ghana (BoG) must stop playing the ostrich and instead change its stance to policy tightening while allowing more flexibility for the cedi and to preserve the level of international reserves. Indeed, these points were raised in the recent IMF statement on the 2019 Article IV Consultations.

The fact that current levels of short term private capital in relation to net international reserves is far more than twice above the benchmark, is no laughing matter. This is a red flag for our external payments and our vulnerability in that regard. The least change in external financial conditions will lead to a deep currency crisis.