Concessionary FX hedges and when they make sense - An Open Letter on Angola

Currency risk is the EM investor's Boogeyman.

Hedging is expensive. In many African countries, currency depreciation is systemic because of reliance on USD imports and the lack of an export base.

Angola is an acute example where a subsized hedge makes a lot of sense. And it could provide a case study for other African markets.

For starters, I love Angola ??????

Anglophone investors don’t talk about the country, but it has lots of opportunities across tourism, food processing, industrials, etc.?

The is also a vibrancy ?? to the country— We’re at the end of a lost decade: first rating upgrade since 2014, growth in import substitution, banks are turning focus on the real economy.

People are hungry to build.

For real investment to take off, there is a need for a subsidized currency hedge created by a central bank or DFI, to reduce the currency risk of investing in the SME sector and real economy.

ie: allow investors to place USD as collateral to borrow local currency at single digit interest rates.

The currency problem in Angola is unique.?

Angola’s central bank restricts Angolan companies from earning in USD except for oil giants. Others must transact in local currency. Big contrast to markets like Nigeria, Kenya, Ghana, etc where USD revenues are common across exporters, tourism industry, and service providers.?Tanzania is somewhat similar in her currency problem (more on that in a later article).

This artificially inflates the local currency (Kwanza) by forcing its use. So, so even though Kwanza is down 40% YTD, the slide has good odds to continue. At the Luanda airport today, there are dozens of informal traders who will buy USD, very happily, at the exchange rate listed on Google, picking up an arbitrage in the parallel market.

This parallel rate prevents price discovery for any prospective investor. Every investment in the country begins "out of the money" on a currency basis because the depreciation is locked in.

Put simply: until the market can freely trade currency, no one can know how much their business is worth and what interest rates make sense.

The fear has been that if USD is allowed to freely trade, 80% of the country will shift to USD and the central bank will lose control of local rates making inflation out of control, especially given the heavy import reliance.

This is a fair concern— “will the medicine kill the patient?”

A subsidized currency hedge is a great middle ground. Allow institutions to apply to place USD with the central bank and borrow in local currency against that collateral, 1-to-1, at 7.5% (the same cost as the new subsidised Agriculture loan programme). The result would attract USD into the central bank reserves (supporting sovereign debt sustainability) while channeling investment into the real economy by creating a corridor for USD investors to participate despite the currency mis-pricing. Further initiatives could require that such hedges are used for Small-and-medium-enterprise investments; strengthening the case for the subsidy.

I believe this solution may, in some ways, be better than free-floating currency— further investment into local businesses is needed before an export sector could grow strong enough to benefit from the weak currency.

This solution could be created in other African markets, with great benefit, but would be more market-distorting than in Angola, because the currency is already mis-priced by central bank regulation. We must avoid a situation where a currency hedge allows USD investors to outcompete banks. In Angola, though, the banks are hungry for international investors to invest alongside them-- international investor participation is very limited.

This is not a silver bullet, but would definitely help make it easier to invest in Angola to greater and greater measures.

Angola is awesome. We’ll be back.

Credit to Alastair Herbertson for raising the idea in a conversation with Aum Thacker and Rui Oliveira of BFA Asset Management .