Time to strengthen our capital markets to tame forex risks

Columnists Time to Strengthen Our Capital Markets to Tame Forex Risk Friday October 28, 2022


Of the six pillars that make up the Absa Africa Financial Markets Index; access to foreign exchange, market transparency, fiscal and regulatory environment, legal standards, capacity of local investors and market depth, the last two being the most crucial.

So it’s a bit disappointing that Absa’s latest research shows that these are the only pillars that Kenya scores below average. That raises a lot of concerns.

How will a weak local market close this gap as China’s bilateral lending and outward foreign direct investment decline? Is the new government raising its hopes too high by relying on local markets?

How are we going to fund our infrastructure projects if our savings rate (12 percent) is among the lowest in the world?

To begin with, let’s take a look at why we need a well-functioning local capital market. A; it increases access to financing in local currency and thereby helps to better manage currency risk and inflation. This is a valuable advantage, especially in today’s high inflation and strong dollar environment.

Two; a lively local market will contribute to greater stability in the financial market. Lessons learned from the Asian crisis of 1998, when sudden capital outflows caused a lot of misery. It’s worth noting that research from the World Bank shows that emerging markets were better able to cope with the global financial crisis of 2008, averting major economic disruptions. Three; it provides benefits at the macroeconomic level by supporting the transmission of monetary policy, which is facilitated by liquid securities markets.

To achieve these benefits, we will urgently need to accelerate from where we are now. First, we need to increase our savings rate. Foreign savings can never be a good substitute for domestic savings. They cannot be the basis for our domestic investments. Such an arrangement does not end well in the long run (think of Sri Lanka). We can also borrow a leaf from our neighbors.

The savings rate of Tanzania and Uganda is above 20 percent, Africa is at 17 percent, while the world average is 24 percent. Two is to embrace innovation. What about the introduction of local currency bonds or bonds indexed to the exchange rate? There are plenty of international investors with hundreds of billions of dollars looking for higher returns. Three is to create an inviting economic environment. If foreign investors see a reckless fiscal and/or monetary policy, they would vote with their money. Sound economic policies generally attract more inflows from portfolios to a country.

Achieving these goals is also crucial for the economy. Research by the World Bank shows a high correlation between fundamentals (read: gross domestic capital markets and income per capita) and the level of development of the local capital markets. This largely explains why capital markets are generally at an embryonic stage in smaller and low-income countries.

One more thing, as capital markets development is best done gradually, it therefore means that in the short term tapping into international markets for Kenya will remain a viable option for the foreseeable future. That door must remain open for the time being.

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