(Ecofin Agency) - A recent report reveals that 69% of African banks consider themselves significantly exposed to currency risk, stemming mainly from the imbalance created by securing funds in strong foreign currencies while issuing loans in local currencies.

Around 60% of African banks view financial products designed to mitigate exposure to exchange rate fluctuations, such as forward contracts and currency swaps, as costly, according to a report released on April 23 by the Making Finance Work for Africa Partnership (MFW4A). The latter is an initiative launched in 2007 by the G8 to support the development of financial systems in Africa.

Titled "FX Risk in the African Banking Sector: Survey Report," the study is based on a survey conducted between July and December 2023 involving 31 banks and 5 non-banking financial institutions (NBFIs) across various sub-regions of the continent (19 in West Africa, 7 in Southern Africa, 6 in East Africa, 3 in North Africa, and 1 in Central Africa).

Of these institutions, 69% acknowledge significant exposure to currency risk, primarily stemming from the asymmetry created by securing funds in strong foreign currencies while issuing loans in local currencies.

These banks procure funds in US dollars and/or euros from international investors, multilateral financial institutions, or development finance institutions (DFIs), while their loans are primarily denominated in local currencies.

The majority of surveyed institutions (58%) extend loans denominated in both local and foreign currencies, while 36% lend exclusively in local currency and 6% only in foreign currencies. The latter operate in countries where the economy is heavily "dollarized," such as South Sudan and Somalia.

However, 65% of banks and NBFIs lending in foreign currencies report that less than 25% of their loan portfolios are denominated in those currencies.

On the liability side, over a third of surveyed institutions state that 50% or more of their funds and deposits are denominated in strong currencies, with one-fifth indicating that between 25 and 50% of their holdings are in foreign currencies. Consequently, the proportion of funds and deposits collected in strong currencies exceeds that of loans denominated in foreign currencies, resulting in a significant gap between foreign currency assets and liabilities. As a result, funds obtained in strong currencies are primarily converted into loans in local currencies.

Solvency Concerns

Developed in collaboration with the Currency Exchange Fund (TCX), a fund established in 2007 by several development finance institutions and donor countries to provide its members and their clients with hedging solutions against exchange rate risk inherent in operations in developing countries, the report indicates that using funds raised in strong currencies to issue loans in local currencies may negatively impact the solvency of African banks. They could face repayment difficulties due to the appreciation of the strong currencies in which they have mobilized a large part of their resources, compared with local currencies.

Of the 36 African financial institutions covered by the survey, 22 saw the currency of the country in which they operate depreciate against strong currencies in recent years, and 18 encountered difficulties in repaying debts denominated in foreign currencies.

The primary tools used by African banks to monitor their currency risk are tracking systems and market analysis software. They also conduct regular evaluations and tests of their currency risk. Only 25% of banks and NBFIs manage currency risk using hedging strategies, which involve using hedging instruments against the negative effects of expected currency fluctuations, including forward contracts, currency options, and currency swaps.

The main reason for the low use of these instruments remains their high cost, which leads most banks to attempt to manage currency risk internally.

To assist these institutions in managing currency risk more effectively, the report recommends that regulators and policymakers take initiatives to promote an environment conducive to the growth of African capital markets and establish new prudential rules regarding limits on commercial banks' open net positions (ONP) as well as ceilings on loans and holdings in strong currencies.

International investors, multilateral financial institutions, and development finance institutions are called upon to improve offerings of financing in local currency to African banks, which should in turn strengthen their internal capacities by investing in training programs and participating in collaboration platforms.