“And it never failed that during the dry years the people forgot about the rich years, and during the wet years they lost all memory of the dry years. It was always that way.”
As author John Steinbeck reminds us in his masterpiece “East of Eden,” human nature is such that we forget quickly, but it should not and does not have to be that way when managing an economy. African economies in particular are significantly affected by booms and busts, which are created by fluctuations in commodity prices, exchange rates, and interest rates. Can we afford to forget about the impact an oil price over $100 per barrel has on oil-consuming economies in Africa and only focus on oil-producing countries who are benefiting? Can we afford to forget about the impact an oil price below $30 per barrel has on oil-producing countries in Africa and only care about the oil-consuming economies who are benefiting? Given the susceptibility of African economies to these major shifts, this human tendency towards forgetfulness must, instead, become one of education and lessons learned.
These same questions apply in the fixed income market (FX and interest rates) and the impact its volatility has on African economies. As Amadou Sy, director of the Brookings Africa Growth Initiative, pointed out early last year, it is not yet time to sound the alarm on the foreign exchange risk of African sovereign bonds, even if my view is that African sovereigns get very little independent advice on how to effectively mitigate the financial risks of external financing (a significant issue in and of itself). However, it is not only time to sound the alarm on commodity price volatility and its impact on African economies, but for African economies to take charge and protect their economies by fully embracing sound risk management principles.
According to the International Monetary Fund (IMF), Africa’s growth rate fell from 5 percent in 2014 to 3.75 percent in 2015; its lowest in 17 years according to Brookings’ latest Foresight Africa report. Clearly, many African economies have been hit hard by the volatility of commodity prices, which is a recurring problem. The question now is what can be done about it?
First, I recommend that every African country development plan include a detailed financial risk analysis for the medium and long term. That analysis should clearly identify the major risks to which a given economy is subject. Once identified, these risks now have to be quantified as much as possible. This risk quantification step is key because, in commodity-producing countries, for example, just looking at their daily production figures and equating that to their commodity risk exposure is just not accurate. Nigeria is a case in point where the federal government only retains a portion of oil revenues under its various production agreements. In addition, Nigeria is the largest oil products importer in sub-Saharan Africa, and therefore quantifying oil risk exposures for Nigeria requires some attention to detail. The quantification of risks should be followed by a deep analysis of risk tolerance. In the case of oil-producing countries, a risk tolerance analysis could mean finding out at what oil price level, by how much, and for how long does the economy hurt. It could also mean finding out at what oil price level the economy stops generating enough dollar revenues, which could then lead to external debt servicing problems. In the case of oil-importing countries, where oil subsidies are still in place, the question could be, “At what price level do subsidies become unsustainable for the yearly government budget?”
The concept of risk tolerance is one that has been implemented with some level of success by the private sector, especially international banks. I strongly believe that African governments could benefit tremendously from integrating risk tolerance analyses into their macroeconomic studies. These analyses should help a given country know exactly what kind of shocks it can sustain or not. The shocks deemed unbearable should be the ones that lead to the formulation and implementation of a detailed risk management strategy.
Some may argue that for some economies, going through the steps above is now a bit too late. I disagree. In fact, for oil-producing countries, the above analyses should at least encourage getting a strategy in place now and implementing it as soon as oil prices recover to reasonable (in accordance with risk tolerance figures) levels. Moreover, for oil-consuming countries, it is absolutely crucial that they put these measures in place now and actually implement a hedging strategy that will lock in these low oil price levels for the medium term. There were many experts who expected $100 oil to be the norm; and now we are hearing that prices should stay around $30 for a prolonged period. But who knows? Indeed, in a 2001 IMF paper titled, “Hedging Government Oil Price Risk” by James Daniel, a Mexican government official states, “We said, listen, given the uncertainty and given the volatility, it can go to $40 (a barrel) or it can drop to $10. We have a budget here, a budget that we have to cover […] We didn’t do it to be ahead. The government does not speculate in that sense. Doing nothing is speculative. It does look good now that we are ahead compared to doing nothing. Some days we do not do as well. But we sleep well.” Mexico is well-known for arguably having the best oil risk management program in the world. The words above are in fact full of wisdom for African economies exposed to commodity price risk. Some of them have in fact put in place successful sovereign commodity risk management programs. Ghana, Malawi, and Morocco are great examples of African nations that have understood the need to buy insurance to insulate their economies against commodity price volatility, but there needs to be more.
Last, but not least, I am not advocating that African countries just focus on hedging/buying insurance alone to manage their risks. What is advisable is that African governments use a diverse set of tools to manage risks. For example, hedging and diversification away from oil for oil-producing countries (which unfortunately cannot happen overnight) are two sets of strategies that are readily available in the risk management toolkit. We have now seen the damage commodity price volatility inflicts to African economies. As a result, governments cannot sit idly by and not insulate their economies against commodity price risk. It does not have to be that way.
This blog reflects the views of the author only and does not reflect the views of the Africa Growth Initiative.
Mansour Sy is the chief strategy officer of Taleveras Group. He has previously worked in commodities business development, and spent a combined 12 years in commodities market risk, and hedge funds risk at both Goldman Sachs and Morgan Stanley.