The high cost Making cross-border payments on the African continent has prompted the continent’s governments to look for options to settle trade and other transactions in local currencies. This has given birth to the Pan African Payment and Settlement System scheduled for release in 2024 under Kenya leadership.
Development economist Christopher Adamwho has studied the exchange rate policies of African countries, answers some key questions.
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Why are African countries exposed to the international foreign exchange market?
Three main reasons. First, African economies are small and as such are highly dependent on trade with the rest of the world. They dominate their exports primary commodities including oil and gas agriculture, minerals and cash. On the import side, they buy a whole range of products β from basic products not produced at home, such as food, drugs and medicinesto capital goods and energy. A large percentage of them come from China and other major economies of the global North. But because African countries are small relative to their trading partners, they rarely have the power to set import and export prices. They are “price takers” in global markets. And with world prices pegged to the world’s major reserve currencies (the US dollar, the euro, the yen and the renminbi), African countries are exposed to movements in those world prices.
Second, ‘intra-Africa’ trade is still a relatively small proportion of the total trade of African countries.
Finally, since the currencies of African countries are mostly not directly exchangeable in international transactions, the dollar remains the most widely used currency in trade, even among African countries.
What is required to get the system off the ground?
The basic idea of ββthe system is to be able to settle trade between African countries without having to use the US dollar.
There are two big challenges with this. First, intra-African trade represents less than 15% of Africa’s exports at present (although proponents of the African Continental Free Trade Area expect this to increase significantly in the coming decades). Therefore, the African payment system does not completely eliminate the role of the dollar (or other foreign currencies) in the settlement of trade.
The second issue is this trade it is not balanced among African countries. For example, Kenya exports a greater total value of goods to Ethiopia than it imports from Ethiopia. If Ethiopia paid in its own currency, Kenya would end up with Ethiopian currency it didn’t need. Some form of settlement currency that is acceptable to all is required β most likely the US dollar.
What are the challenges and potential risks?
Since trade rarely happens instantaneously, some institution in the trade finance chain bears the exchange rate risk. Because of the gap between the order for imports and their receipt for sale in the local economy, there is a risk that the value of the local currency will change relative to the currency in which the import is denominated.
In the “old” system, this risk is borne by the merchant because everything is priced in dollars. The value of export income in local currency or the cost of imports in local currency will change with movements between the local currency and the dollar, but banks and dollar-quoting counterparties are protected.
Under the new system, the same distribution of risk will remain in “foreign trade”. This exchange rate risk also exists for intra-African trade.
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An important question for the new African payment system is: who bears the exchange rate risk if one African currency depreciates against another? Should the importer or exporter bear the risk? Can and should the African payments system carry the risk of exchange rate fluctuations itself? Where both currencies are volatile, traders may prefer the relative stability of settlement through the US dollar.
The success of this system also depends on scale. The more transaction settlement is channeled through it, the easier it will be to settle in local currencies. Large currency imbalances will be less frequent. However, until the system reaches this scale, the African payments system will need a strong balance sheet so that merchants and participants have confidence that settlement will be fast and risk-free. It is currently unclear how this will be achieved.
What is the best case scenario?
If the system can address the problem of trade imbalance, provide clarity on risk management and scale of approach, it could be very successful. But all of this will be driven by underlying financial performance. Improved regulation will help, but what really drives it is the structure of trade. The more African economies can develop intra-African trade and the less they depend on extra-African trade, the less reliance on the dollar will be in trade. This growth of trade depends to some extent on trade settlement and trade finance, but much more on production, consumption, trade policy and fiscal policy.
Christopher Adam is a professor of Development Economics at University of Oxford.
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