Managing exchange rate pressures in Sub-Saharan Africa—adapting to new realities
Most currencies weakened in 2022 against the US dollar—the dominant currency for trade invoicing and external debt. Official exchange rates in non-pegged countries, where the exchange rate is not fixed to another currency on a de jure basis, depreciated 7 percent on average year over year by the end of 2022, exceeding 20 percent in some cases. There were large exchange rate spreads in parallel markets in some countries (Burundi, Ethiopia, Nigeria)—at times, reaching 90 percent. Pegged countries—where the exchange rate is fixed (mostly to the euro or the South African rand)—also saw their currencies weaken against the US dollar. The exchange rate pressures also manifested in the depletion of reserve assets, as foreign exchange inflows slowed, and central banks used their reserves to finance imports and repay foreign debt.
An index—combining depreciation against the US dollar and reserve depletion—shows that exchange rate pressures were at a six-year peak in 2022, on average, and were higher in pegged regimes and non-resource-intensive countries. While this note focuses primarily on developments in 2022, pressures against the US dollar have persisted in the first months of 2023 in many countries.
Exchange rate pressures stem from both global and domestic factors. The combination of monetary policy tightening in advanced economies and greater global risk aversion decreased net foreign exchange inflows to the region and priced out frontier economies from the international capital market.
Higher interest rates in the United States pushed the trade-weighted US dollar index, a broad-based measure of US dollar strength, to a 20-year high in October 2022. Weak external demand related to monetary policy tightening and economic slowdown in major economies (euro area and China) created headwinds for exports, while higher oil and food prices, partly due to the war in Ukraine, pushed up import costs for net importers.
On the domestic side, fiscal deficits also contributed to external imbalances in some countries. About half of the countries in the region had deficits exceeding 5 percent of GDP in 2022, and countries with larger fiscal deficits tended to face higher exchange rate pressures. In some countries deficits were monetized leading to higher inflation, which in turn, weakened currencies further. Weaker currencies lead to higher inflation, larger debt, and a weaker trade balance in the near term Sub-Saharan African economies—particularly non-pegged countries—display a high exchange rate pass-through to inflation.
For the region as a whole, a 1 percentage point increase in the rate of depreciation against the US dollar leads, on average, to an increase in inflation of 0.22 percentage points within the first year, which is higher than in emerging Asia (0.15) and Latin America (0.18). The pass-through is 0.28 for non-pegged countries in the region, about four times stronger than in pegged countries where trade is mostly invoiced in the peg currency. In the WAEMU, for example, about 72 percent of trade is invoiced in euro (Boz and others 2020), which makes imports and consumer prices less responsive to US dollar changes.
Large depreciations are associated with considerable risks of inflation de-anchoring, especially in non-pegged regimes. The size of the depreciation matters. When depreciations are modest, the increase in inflation occurs mostly in the first year after the shock. However, at higher levels of depreciation, the percentage increase in inflation is not only disproportionately larger in the first year; it continues to be high well into the second year after the shock. Moreover, there is evidence that exchange rate pass-through to inflation is asymmetric; during episodes of depreciation, pass-through is estimated to be eight times stronger than during periods of appreciation, suggesting inflationary pressures may not come down quickly when the local currencies strengthen against the US dollar.
Currency depreciation pushes up the public debt stock. About 40 percent of the region’s public debt is external. Since the beginning of the COVID-19 pandemic, exchange rate depreciations increased public debt in sub-Saharan Africa by 10 percentage points on average by the end of 2022, holding all else equal Figure 3. Exchange Rate Pass-Through to
Inflation in Sub-Saharan African Countries with
Non-Pegged Regime.
Finally, exchange rate depreciation is associated with a deterioration of trade balance in the near term in the region. In the near term, trade is slow to respond to exchange rate depreciation as goods are invoiced mostly in US dollars and exporters require time to adjust their production despite higher profits while consumers face difficulties finding local substitutes for imports (Figure 5). Over the medium term, the trade balance improves as countries adjust to new relative prices. However, in sub-Saharan Africa, structural impediments, including a weak business environment and greater share of trade in commodities and agriculture which tend to be less responsive to changes in relative prices, undermine sustained improvements in the trade balance.
In 2022, countries raised interest rates, intervened in foreign exchange markets, and resorted to administrative measures to resist depreciations
Most countries tightened monetary policy. The median interest rate hike was 260 basis points in the region in 2022 as countries sought to fight inflation, which also helped to support their currencies. However, the median rate hike was lower by 90 basis points compared to the median in emerging market and developing economies outside the region.
A number of countries also intervened in foreign exchange markets to resist exchange rate pressures, in part to address the cost-of-living crisis from higher prices. The median depletion of reserves in months of imports was twice as high in sub-Saharan Africa than in other emerging market and developing economies over the course of 2022. With reserves significantly lower—below three months of imports in about 40 percent of non-pegged countries on average during 2022—the degree of intervention slowed down over the course of the year.
With reserve buffers running low, many countries also applied administrative measures to control foreign exchange flows. These measures include multiple currency practices (Nigeria), foreign exchange rationing (Ethiopia, Nigeria), price control through moral suasion or punitive measures in interbank markets, and banning foreign currency transactions for local businesses (Ethiopia). Some countries also resorted to unconventional measures such as buying oil with gold (Ghana).
Exchange rate pressures are difficult to resist for long and call for policy adjustment. Pegged regimes in the region suffered less from the surge in the value of the US dollar in 2022 given their lower share of trade and debt in US dollars. However, many of them lost significant international reserves over the course of the year.
As their monetary policy is not fully independent, they need to tighten with the peg country to minimize the risk-adjusted interest rate differential. Fiscal consolidation is also warranted in many of them to adjust external imbalances and to rebuild reserve buffers.
As for non-pegged regimes, in most countries, letting the exchange rate depreciate is necessary to facilitate adjustment to external shocks that are durable, such as changes in terms of trade and higher interest rates in advanced economies.
Exchange rate adjustments provide price signals that help all agents in the economy, including the government, to adapt to new external realities. For example, exchange rate depreciations can persuade consumers to switch consumption toward more domestically produced goods and urge governments to prioritize their foreign-exchange-related spending and investors to invest more in export-oriented businesses.
However, there are adjustment costs in terms of higher inflation and public debt. In countries where reserve buffers are low, currency depreciation and its associated costs are unavoidable. Policymakers can take several steps to mitigate the adverse impact and contain exchange rate pressures.
These include: Tighter monetary policy that can keep inflation expectations in check and reduce exchange rate pressure through attracting capital from abroad and stem outflows. Fiscal consolidation that will keep public debt sustainable and rein in external imbalances, particularly in countries where fiscal imbalances are key drivers of exchange rate pressures.
Cutting government expenditures that directly or indirectly affect imports can be particularly helpful to lower the demand for foreign exchange—for instance, eliminating fuel subsidies can reduce fuel imports. Strengthening the social safety net through well-targeted measures will support the poor, who are more adversely affected by the rise in prices.
Countries with sufficient reserve buffers—very few—could consider foreign exchange interventions to lean against exchange rate pressures if there is significant risk of inflation de-anchoring in the presence of weak monetary framework or shallow foreign exchange market. However, reserves can be depleted quickly if exchange rate pressures are elevated and driven by fundamental forces. Policymakers will need to carefully calibrate their response to ensure that adequate external buffers remain to manage short-term volatility including sudden surges in foreign exchange demand (Gopinath and Gourinchas 2022). These interventions should not be used as a temporary fix in lieu of necessary fiscal and monetary policy adjustments.
In both pegged and non-pegged regimes: The use of distortive policies should be minimized. Administrative measures such as foreign exchange rationing, price controls, and multiple currency practices can lead to market distortions and misallocation of resources and create opportunities for corruption. They also may not mitigate the adverse impact. For example, parallel market spreads may emerge or widen that then can be passed through to domestic inflation.
Support from international financial institutions (including the IMF) can help ease exchange rate pressures. The support not only provides valuable foreign exchange, it also demonstrates policymakers’ commitment to economic reforms that will help restore market confidence.