THE KWACHA’S PERFORMANCE
7th September 2015
By Austin Chijikwa
IMPORTANT NOTE: The authors views are entirely his own and do not necessarily represent the views of his employer. This is only for information purposes and does not constitute advice. The author is not liable for any actions taken based on the contents of this report.
The Kwacha has generally shown a declining trend over the last five years although its depreciation has accelerated in the last two years. From 2010 to early 2015 the local currency has floated between K4.500 and K5.500 before breaking above the K5.500 and signalling the onset of a more tumultuous period for the Kwacha.
Figure 1 Kwacha Performance for past 5 years (Reuters)
The Kwacha’s first rapid depreciation occurred in the second quarter of 2014 as the local unit plummeted to a then all-time low of 7.3 against the greenback. The depreciation at that time was attributed to several factors including
- Fiscal Deficit: The government according to the IMF in 2013 significantly overshot their budget deficit projections of 4.1% of the country GDP to about 8.6% instead. Almost all spending deviated significantly from budgeted levels e.g.:
– Wages increased in September 2013 by 45% versus the planned 9.1% with the full effects expected to be felt in 2014.
– Spending on subsidies reached 4% of the budget against a planned 0.7%
To finance the deficit government increased borrowing through Treasury Bills as well as part of the 2012 Eurobond proceeds given to state-owned enterprises but had not yet been spent (IMF).
- Policy Uncertainty: Frequent regulatory changes appeared to have had a negative effect on the business environment and particularly the introduction of Statutory Instrument No. 33 which restricted the pricing of goods to Kwacha and Statutory Instrument 55 of 2013 which introduced new measures to enhance monitoring of Balance of Payment -BOP (the flow of funds, good and services in and out of the country). The two regulations had an easily observable impact on the exchange rates with their introduction preceding an appreciation of the Kwacha. However, stricter BOP controls and related restrictions on VAT refunds appear to have had to a greater extent affected the mining sector which contributes around two-thirds of Zambia’s foreign exchange earnings. In what looked like a stand-off, supply of foreign exchange from the mines withered putting pressure on the Kwacha.
- Low Copper Prices: A sharp drop in copper prices precipitated by concerns of slowing growth in China appears to have triggered the sharp drop in the Kwacha. Copper prices dropped the most in one day on 6 Mar 2014 since December 2011 and to their lowest in two years after a Chinese solar company became the first company to default on a bond traded in mainland China according to the Wall Street Journal. Chinese copper accounts for about 40% of global refined copper demand explaining the sensitivity of copper prices to events in China.
To curb the Kwacha’s sharp drop the Central Bank took several measures to arrest the fall and reduce volatility in the markets. Implemented measures include
- Raising monetary policy rates
- Raising reserve ratio for commercial banks
- Direct intervention in the foreign exchange markets
- Revocation of Statutory Instruments 33 and 55
The policy measures appear to have worked as the local currency appreciated strongly to trade within a K6.000 to K6.600 range through the third and fourth quarters of 2014. However these measures were seen as short term with the following comments from ETM Analytics indicating that a broader set of negative fundamentals would prevail over the long term.
“In other words, although the re-dollarisation of the economy following the removal of SI33 and SI55 is a bullish fundamental to the kwacha, there are still a bigger set of bearish fundamentals for the currency that remain in place, and have not showed signs of diminishing, yet. This therefore leads us to hold the view that even as the removal of SI33 and SI55 can help stabilize the kwacha in the short-term (i.e. next three to six months) around the 5.75-6.25 mark against the dollar, it does not by itself lead to a medium- to longer-term strengthening trend of the kwacha.”
The next rapid drop in the Kwacha followed at the beginning of 2015 when the Kwacha broke through the K6.6 barrier. This drop coincided with a steep drop in the prices of oil and copper again.
Figure 2 Copper hits fresh lows – January 2015 (Bloomberg)
Whereas the steep drop in the Kwacha appeared to have been triggered by the sharp copper decline an underlying widening fiscal deficit continued to be a point of concern. In addition a stand-off between the government and mining companies concerning the payment of value added tax constrained the supply of foreign currency to the market. The IMF calculated in May 2015 that VAT refunds had grown from 1% of GDP to 3% or about ZMW5.5 billion (USD743m using a rate ZMW7.4).
The Central Bank was in a weaker position to contain the depreciation this time around. It’s foreign reserves had significantly declined from around USD3,500m in Q4 2014 to around USD2,800 at this time. Further interest rates were already close to two year highs and the Central Bank was wary about increasing them further.
Figure 3 One Year Treasury Bill Performance for Past 2 years (Reuters)
The absence of a direct intervention may perhaps explain the weaker reversal as the Kwacha appreciated to K7.000 from a low of K7.75 but it was still weaker than K6.6 at the beginning of the move.
The next and most recent fall was precipitated by a 25% drop in the Chinese stock market and unprecedented 6% devaluation of the Yuan by the Chinese Central Bank. This event sent a shockwave through global markets as stocks from the US to Japan dropped as well as commodities. Copper fell to six year lows to reach USD4885 with other commodities also adversely hit. Commodity-linked currencies consequently suffered losses with the Kwacha breaching the K8 barrier and reaching K8.500 within three days before proceeding to over K10 to a dollar. Other frontier/emerging currencies suffered heavy losses as well as shown below.
Figure 4 Africa Currency Ranker – 1 Month Returns (Bloomberg 5 September 2015)
The drop in Chinese stocks markets and actions taken by the Chinese government to devalue the yuan as well as purchasing of share to shore up its stock market was taken as signal that growth was indeed slowing in the world’s second largest economy. Over the past decade almost half of global GDP growth is attributed to growth in China and poor news from there added to a general negative outlook in other markets such as the Eurozone (e.g. Greece). Portfolio flows out of perceived risky countries therefore weakened their currencies as investors flew to safe-haven assets such as the United States dollar.
WHERE TO FROM HERE
In the medium to long term the following factors are expected to be key drivers for the Kwacha’s direction as they have continued to drive performance over the past 18 months:
1. COPPER PRICES AND PRODUCTION.
The copper mining industry in Zambia is very important due to contribution to forex earnings (about 70%) and total tax contribution.
- Threats to Kwacha Performance
• Dipping copper prices: Data from China has in the recent past more consistently pointed a slowdown in its growth and copper prices continue to reflect this showing a steady decline over the last two years.
• Power Shortage: Reduced power generation due to water problems at the Kariba North Bank power plant will severely affect the mines and force cuts in production. In addition to low copper prices this will negatively impact the value of the country’s exports of which copper accounts for about 70%.
• Regulatory Challenges: The mines have had significant regulatory challenges which has reduced additional investment and general confidence in the sector. Many of these issues have been recently resolved but the after effects will continue to linger while government will probably continue to look for ways to extract revenue from the mines.
- Support to Kwacha Performance
• China slowdown may have been exaggerated: Some analysts whilst acknowledging a slowdown in China GDP growth feel that growth will still remain strong. Capital Economics points at seasonally adjusted numbers that show at a recovery in trade growth from last year. In addition, stronger for China’s trading partners such as the US will further support demand for China’s exports.
• Several analysts predict a recovery in copper prices over the long term. Analysts surveyed by Bloomberg show consensus for an increases in copper prices over the next 5 years with estimates or prices returning to over USD6,000 over the next three year. This is expected to provide some long term support for the Kwacha.
Copper factors supporting the Kwacha are likely to be outweighed in the short term i.e. probably over the next six months to a year by the threats whose solutions require a longer time frame to implement.
2. PUBLIC SPENDING/PUBLIC DEFICIT
The government’s domestic and international debt has grown over the last two years and stands at approximately 34% percent of GDP. While this remains within a 45% threshold suggested by the IMF for debt sustainability, worries about the exchange rate and reduced government revenue have still raised concerns.
- Threats to Kwacha Performance
• High government expenditure: The government for the past three years has consistently missed spending targets and according to the IMF accumulated domestic arrears equalled 2.5% of GDP (about K4.6bn) in 2014. The upcoming general elections is expected to put more pressure on expenditure and test the fiscal discipline of government.
• Threatened revenue collection due to reduced economic activity (mines and power cuts): The government has struggled to raise budgeted revenue e.g. the revision of mineral royalties bringing into question the ability of government to pay its debts. Poor revenue collection through taxes is expected to extend other sectors whose productions is expected to be reduced by current power shortages. In July 2015 Zesco announced plans to increase power load-shedding hours which they further increased in August. This situation is expected to continue through to the end of the first quarter of 2016 given good rainfall and the commissioning of the Maamba coal-powered plant currently under construction.
• Weaker kwacha and external debt: Whilst a wide public deficit is expected to weigh on the Kwacha, in cyclical fashion a sharp drop in the Kwacha significantly raises the cost of repaying foreign debt. The government’s interest repayments a year add up to around USD190m demand for dollar a year putting further pressure on the Kwacha. A fast depreciating Kwacha further reduces the government’s ability to repay its foreign debt and the currency depreciates further as a result
- Support to Kwacha Performance
• Coming online of new generators will reduce power outages: The commissioning of the 300MW Maamba Power Plant is expected to erase the current power deficit next year and may lead to a resumption of normal production.
• Strong growth potential: According to the IMF, foreign direct investments from recent years is expected to pay off through increased mine output and they project GDP growth of between 6-7% in the medium term. Government has also committed to them to try to reduce the fiscal deficit in upcoming in the year.
Again the threats to the currency look they will prevail over the medium to long term and point towards a weaker Kwacha over that period.
Technical analysis uses the study of past price action to draw conclusions regarding the likely direction and magnitude of future price movements. Technical analysis is usually used for short term positioning ranging from intraday to a weekly basis (Rosenberg and Baker).
Technical indications are mixed but as at midday 7th September 2015, indicators supporting the Kwacha include the Relative Strength Index and Momentum Indicators which show that the Kwacha is oversold and has commenced a change of direction. It looks therefore that the Kwacha is due for a correction at least in the near term after a sharp depreciation. Based on Fibonacci retracements the ZMW may retreat as far as K9.5 which forms the next resistance level. A failure to break through this level may lead to further depreciation whilst a close below this level could take the Kwacha to the next resistance level of around K9.1.
The Moving Average Convergence Divergence (MACD) shows more upward momentum as it trading above the zero line and there is wide divergence between the short and long term moving average lines. This indicator is less conclusive but contradicts the aforementioned indicators and points more to a maintenance of the status quo – a weak Kwacha.
Technical indicators, therefore, to an extent point towards an appreciation in the Kwacha in the near term. However the magnitude and timing are difficult to predict and it should be noted that the structure of the local currency markets does not render this market well for the reliance on technical analysis.
Overall factors weakening the Kwacha appear to be the dominant influences in the long term which may go out as far as three years. The currency and economy remain vulnerable to external shocks such as drops in copper prices. Internally a fiscal adjustment is required to contain the growing fiscal deficit but may be difficult to implement without a temporary contraction in GDP growth.
The new equibilirium trading level for the Kwacha is difficult to establish due to the Kwacha’s susceptibility to external shocks but in my estimation should range between K9.5 to 11 over the next two quarters. Going into 2016 a higher range of between K12 to K13 maybe reached.