By Frances Coppola
These days, outright default is rare. More often, distressed countries seek help from the International Monetary Fund (IMF). Broadly speaking, the IMF provides short-term lending in response to actual or potential crises. It lent to several countries hit hard by the 2008 financial crisis, including Ireland, Iceland, and Latvia, and supported Greece, Portugal, and Cyprus in the eurozone crisis of 2012-13.2
In August 2016, the Bank for International Settlements (BIS) said that corporate debt in developing economies had nearly doubled since 2009, from 60 percent of GDP to 110 percent of GDP.3 In September 2015, the United Nations Conference on Trade and Development (UNCTAD) similarly warned that corporate debt service ratios in developing countries were “on a steep upward trend that threatened to undermine wider debt sustainability.”4
The combination of high corporate debt levels in developing countries with shrinking international trade and slowing global growth usually causes trade finance turbulence and sharp declines in currency exchange rates.5 Investors are concerned that if businesses (and the banks that fund them) become unable to service their debts, governments may be forced to bail them out to preserve trade and jobs, sharply increasing government debt in relation to GDP and raising the prospect of a sovereign debt crisis. As UNCTAD says, “unsustainable corporate debt has a habit of ending up on public balance sheets when corporate bankruptcies threaten to undermine macroeconomic stability.”6
Oil exporting countries in sub-Saharan Africa are particularly vulnerable: the IMF estimates that the terms-of-trade shock caused by falling oil prices since mid-2014 has caused them an income loss of about 20 percent of GDP, which the IMF says “typically shaves annual growth by some 3 to 3½ percentage points for several years.” The IMF is currently lending to 17 countries in sub-Saharan Africa and in discussion with several more.7 Even the continent’s largest economy is not immune: Kenya agreed to a $1.5 billion precautionary loan in March 2016.8 The IMF observes that although many developing countries, especially commodity exporters affected by falling prices since 2014, have protected themselves from foreign exchange crises by allowing their currencies to float against the dollar, “some may be running out of room to maneuver.”9
After IMF intervention, the exchange rate usually stabilizes and inflation falls, improving the conditions for international trade and trade finance. But for some governments, the IMF’s insistence on structural reform is too much: Angola backed out of negotiations in July 2016 when it became clear that the IMF would expect greater transparency from its state-owned oil company Sonangol.10
High exchange rate volatility can cause severe difficulties for businesses involved in international trade, since the value of business invoices can vary considerably between supply and settlement. Additionally, businesses in countries whose currency exchange rates are very volatile can have difficulty raising trade finance, since banks can be reluctant to lend foreign currency when the cost of obtaining it is uncertain.11
These difficulties mean that international trade and finance tend to shrink as currency exchange rates become more volatile. Unfortunately, this reduces still further the prospects for economic growth, making debt even less sustainable and increasing exchange rate volatility even more. At its worst, this feedback loop can develop into complete currency collapse and hyperinflation, as is currently being experienced by Venezuela.12
Sometimes, doing business with a country whose currency is hyperinflating is all but impossible. The other side of hyperinflation is a crippling shortage of foreign currency, so countries experiencing foreign currency shortages usually impose capital and/or exchange controls to prevent foreign currency leaving the country. Unfortunately, this renders local businesses unable to pay their international debts and prevents foreign businesses from repatriating earned profits. Consequently, international trade comes to an abrupt stop, causing widespread shortages and price increases, which further feeds inflation.13
For exporters to developing countries, invoicing in their own currency can help to protect against exchange rate volatility. For example, an Australian company doing B2B sales in Kenya might invoice in Australian dollars (AUD). This preserves the AUD value of their own cash flow. However, it raises the risk of late payment or default, since a sharp fall in the exchange rate of the Kenyan shilling versus AUD would considerably increase import costs for the Kenyan business and may even threaten its solvency, especially if foreign currency is hard to come by. Businesses exporting to developing countries with volatile exchange rates might find economic indicators such as sovereign debt yields and credit default swap (CDS) spreads helpful when evaluating business risk.
Importers from developing countries may prefer to use FX hedging techniques.14 For example, a U.K. company paying its Nigerian supplier in naira might use an FX option to enable them to benefit from the naira’s exchange rate fall versus the British pound, while limiting the risk of losses should the naira rise. However, hedging products can be expensive for volatile currencies.
Since businesses in developing countries with volatile currency exchange rates typically find it difficult to obtain trade finance in foreign currency, the Nigerian exporter may decide to invoice the U.K. company in British pounds in order to build up FX reserves. This eliminates FX risk at both ends of the trade, preventing the U.K. importer from benefiting from the falling naira exchange rate.
International businesses with production facilities or branches in countries with very volatile currency exchange rates may find their import costs rising sharply in relation to their earnings. They may also find it difficult to convert local currency earnings into foreign currency, since banks may be unwilling to provide the necessary funds and there may be capital or exchange controls. There is little a business can do to protect itself against these effects: some businesses choose to cease production when a country is in FX crisis.
Rising corporate and sovereign debt in some developing countries is increasing currency exchange rate volatility due to investor worries about the possibility of debt crisis. Businesses that trade with such countries may consider FX hedging techniques to protect themselves from currency volatility.
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. Capital Flows and Capital-Market Crises: the Simple Economics of Sudden Stops, Guillermo Calvo; http://www.columbia.edu/~gc2286/documents/ciecpp5.pdf
2. IMF Crisis Lending, IMF Factsheet; http://www.imf.org/en/About/Factsheets/Sheets/2016/08/01/18/48/Crisis-Lending
3. International capital flows and financial vulnerabilities in emerging market economies: analysis and data gaps, Bank for International Settlements; http://www.bis.org/publ/othp25.pdf
4. "Alarm bells over corporate debt in emerging economies", UNCTAD; http://debt-and-finance.unctad.org/Pages/Alarm-bells-over-corporate-debt-in-emerging-economies_02.aspx
5. International capital flows and financial vulnerabilities in emerging market economies: analysis and data gaps, BIS; http://www.bis.org/publ/othp25.pdf
6. "Alarm bells over corporate debt in emerging economies", UNCTAD; http://debt-and-finance.unctad.org/Pages/Alarm-bells-over-corporate-debt-in-emerging-economies_02.aspx
7. "IMF Lending Arrangements as of December 31, 2016", International Monetary Fund; http://www.imf.org/external/np/fin/tad/extarr11.aspx?memberKey1=ZZZZ&date1key=2020-02-28
8. "Kenya secures $1.5bn IMF loan", The Wall Street Journal Online; http://www.wsj.com/articles/kenya-secures-1-5-billion-imf-loan-1458024460
9. Financial Stability Challenges In A Low-Growth, Low-Rate Era, IMF; https://www.imf.org/external/pubs/ft/gfsr/2016/02/pdf/c1.pdf
10. "Angola has fired its finance minister after talks with the IMF stalled", Quartz; https://qz.com/774391/angola-has-fired-its-finance-minister-after-talks-with-the-imf-stalled/
11. "The Implications of the Strong Dollar For International Trade", American Express FXIP Blog; https://www.americanexpress.com/us/foreign-exchange/articles/implications-of-strong-dollar-on-global-trade/
12. "Venezuela’s currency is so devalued it no longer fits in ordinary wallets", Washington Post; https://www.washingtonpost.com/news/worldviews/wp/2016/11/27/venezuelas-currency-is-so-devalued-it-no-longer-fits-in-ordinary-wallets/?utm_term=.964bf1f145e3
13. "What Is Hyperinflation? Its Causes, Effects and Examples", The Balance; https://www.thebalance.com/what-is-hyperinflation-definition-causes-and-examples-3306097
14. "Simple Exchange Rate Hedging For SMEs", American Express FXIP Blog; https://www.americanexpress.com/uk/content/foreign-exchange/articles/exchange-rate-risk-hedging-for-smes/
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