Currency pandemics: How the pula is becoming worthless

• BOB set pula to lose value faster compared to last year
• US and South African markets pass-through effects expected to drive pula movement
• FX reserve decline could affect pegged rate – economists
• Falling FX reserves could warrant another downward crawl adjustment – FNBB experts
• Fitch says Pula Fund has missed strong growth in local currency and failed long-term value creation
• Fitch says Pula Fund is used for politically-motivated spending, calls into question its governance

Before that particular day, countries fixed their currencies against the US Dollar, the reserve currency, which was tied to gold at the price of 35 dollars per ounce. So countries could trade the US Dollar, which was then exchanged for gold, meaning that all currencies were backed by the valuable commodity.

To cut a long history short, that system is no longer in place after then US president Richard Nixon suspended the convertibility of the dollar into gold amidst anxiety that the US was printing more money than could be backed by gold deposits. Now purported ‘money’ is backed by nothing but confidence, what is known as Fiat Currency. Perceived value of money is only measured in relation to each other. This triggered currency wars; the devaluing of their currencies to make them tradable and competitive with partners or the dollar.

Pula Basket

The currency weights in the pula basket are ZAR: 45 percent and SDR: 55 percent. Over the past couple of years, the weights within the basket have remained unchanged. The rate of crawl has, however, been adjusted to maintain stability of the real effective exchange rate. “This objective was largely met in 2020, thwarting the need for any changes to the exchange rate mechanism in 2021,” Gomolemo Basele, the Quant Analyst at the First National Bank of Botswana (FNBB) explained to this publication. “That being said, the rand will continue to be the dominant factor in the pula outlook, accounting for most of the volatility observed in the pula against major crosses.”

The Bank of Botswana disclosed that the nominal effective exchange rate (NEER) of the pula depreciated by 2.1 percent in the 12 months to November 2020, which was consistent with the transition from an annual upward rate crawl of 0.3 percent implemented in 2019 to annual downward rates of crawl of 1.51 percent.

Government sets pula to lose value

Each year, the crawling band exchange rate regime is adjusted upwards or downwards. Early January, the finance ministry, though the Bank of Botswana as the custodian of the monetary policy, decided set the pula currency to lose value at a faster rate of 2.87 percent this year after diamond sales were impacted by Covid-19 in 2020. Available statistics show that in the first nine months of 2020, sales dropped 42 percent to $1.49 billion while production slumped 29 percent. Economic growth for the first three quarters of 2020 averaged negative 9.1 percent.

Wilfred Mandlebe, Permanent Secretary at the finance ministry, explained: “The downward rate of crawl reflects the need to contribute to the easing of real monetary conditions while supporting the domestic industry’s competitiveness in the absence of significant inflationary pressures in the economy.” At FNBB, they argue that the pula movements will continue to be driven by pass-through effects from the political and economic events in the US and South African markets. The bank forecast BWP/USD and BWP/ZAR rates to average 11.38 and 1.44 respectively in 2021.

In general, Basele says the crawling peg exchange rate systems provide a degree of stability between trading partners – as represented by the currencies the pula is pegged to, in the case of Botswana. “In the event that there are large shocks in the markets of the currencies in the peg, the home currency can be adjusted to avert the same shocks playing out domestically,” he says, adding that in the case of the pula peg, this can be done by adjusting either the weights of the constituent currencies, or the rate of crawl or a combination of both.

FX reserves decline

The foreign exchange reserves and the Government Investment Account (GIA) are the main financial buffers and have in the past played an important role in absorbing the impact of shocks. Diamond reserves have served as the basis for Botswana’s sovereign wealth fund. Since 1994, a portion of foreign exchange reserves, swelled by diamond exports, has been devoted to the Pula Fund. However, the reserves have been on a gradual decline and a much faster decline through the pandemic. Fitch Solutions points out that consistent low diamond prices and eventual depletion of reserves, coupled with draw-downs for budgetary support, have raised serious questions about the fund’s ability to smooth the country’s transition to a non-commodity economy.

The GIA, which is money owned by government (P6 billion balance as at October 2020), contains funds raised through fiscal surpluses which are generated chiefly through the budgetary rule that spending must not exceed 40 percent of GDP and a Sustainable Budget Index, which is a ratio of recurrent spending to non-mineral revenues. In addition to assets held at the IMF, the liquidity portfolio, which represents the remainder of foreign reserves allocations, contains excess reserves, defined as more than six months of import cover.

According to the report by Fitch, the Pula Fund is guided by an allocation strategy that has, over recent years, devoted around 60-65 percent of assets under management to long-term fixed income and 35-40 percent to equities. In terms of fixed income assets, reserves can only be invested in investment-grade sovereign debt, with fixed income following the allocations the IMF uses for the SDR currency basket. Accordingly, equity investments are made in a range of countries according to their weight in the MSCI Index. The central bank’s financial markets department manages 50 percent of the fund and nine foreign fund managers take care of the other 50 percent, according to the report that adds that the Pula Fund is prevented from investing in Botswana to avoid the fund from being subjected to diamond market trends, which influence the performance of the rest of the country’s economy.

Failure to diversify portfolio for value creation

According to Fitch, the relatively risk-averse approach of investing overwhelmingly in developed markets, particularly in US equities and US dollar-denominated securities, has ensured fund stability, but also tepid fund growth. “The fund has missed strong growth in local currency emerging markets sovereigns and holds assets with relatively subdued yields. The lack of investment in alternative asset classes, such as real estate and private equity, also indicates that the Pula Fund has failed to follow other sovereign wealth funds in diversifying portfolios to ensure greater long-term value creation,” Fitch wrote. In May 2019, BoB widened the scope of the fund’s permitted investments, adding more currencies and equities as a means to take advantage of more attractive investment returns.

While it faces lower potential in terms of asset growth, Fitch observed that the Pula Fund has suffered the effects of lower diamond prices as well as declining domestic diamond reserves. In 2017, the fund’s value was estimated at around P58bn (USD5.6bn) and has seen sluggish growth over recent years. The fund also reportedly suffered heavy losses due to global market volatility in late 2018, though some of these were recovered in a subsequent rally during Q119. As at October 2020, reserves fell by P16 billion.

Impact to pegged exchange rate

There is fear that falling reserves could eventually affect the ability to have a pegged exchange rate for the pula. If Botswana’s foreign exchange reserves continue to fall, Basele says this could warrant further downward adjustments to the rate of crawl in order to increase foreign exchange inflows, as well as increase the competitiveness of Botswana’s exports.

Of conservative Pula Fund and political expediency

Managed by the Bank of Botswana (BoB) and designated asset managers, the Pula Fund is ostensibly a future generations savings fund. However, Fitch says its objective under the Bank of Botswana Act is unclear. In reality, the agency says it is increasingly used for politically-motivated spending. “Draw-downs have undermined asset growth, while a conservative approach to asset management has undermined value creation,” Fitch wrote in a Q4 2020 report for Botswana. “Since 2000, there have been six years of significant draw-downs from the GIA for various purposes, muddying the fund’s objectives.”

Fitch notes that some withdrawals have included financing public pensions and the budget deficits, but the government has also tapped into funds to avoid politically sensitive decisions such as raising taxes, introducing school fees or capping the rise in civil servants’ wages. “Withdrawals call into question the fund’s governance. While Botswana has been a signatory to the Santiago Principles since 2008, the Pula Fund has low levels of transparency and gaps in regulation, with a lack of clear oversight rules,” Fitch says. “It lacks a constitutive charter or legislative framework that guides withdrawals and spending, enabling the government to use the fund to finance the budget, although it is unable to use the fund to finance off-budget expenditure or withdraw more than the GIA’s share of the fund.”

According to reports by CTGN Africa, in July 2020 BoB was seeking legislation to limit assets to withdrawals from the Pula Fund, which has reported a recent fall in reserves, which are equivalent to around 7 percent of GDP as of May 2020, which is down from 20 percent as of 2011. Previously, Econsult, an independent think tank, explained that rebuilding them requires the following: balance of payment surpluses (more exports, more inward FDI), and government budget surpluses (reduced spending, increased revenues).

Fiscal pressures

Botswana’s fiscal pressures escalated due to the increased funding needs required to combat the effects of the pandemic. Unlike most of its peers, Basele says Botswana has some levers to pull regarding funding options – local bond issuance as there is still capital market appetite for paper and debt-to-GDP levels remain way below thresholds; and options for foreign currency debt from different Development Funding Institutions as the sovereign remains the highest rated in sub-Saharan Africa, despite the negative outlook by ratings agencies.

Towards the end of 2020, the government, through the Ministry of Finance and Economic Development (MFED), approached the World Bank for budgetary support in light of the constraints to government revenues as a result of the disruption caused by the pandemic. Although discussions are still at a preliminary stage, Basele expects details of the proposed financing solution to be published in 2021. Experts will be eager to hear what the Minister of Finance Dr. Thapelo Matsheka has packed in his brief case this coming week during the budget speech in the course of his most challenging period.

Parliament has approved the MFED’s proposal to increase the government note programme from P15 billion to P30bn, along with the frequency of auctions to help fund the expected higher deficits in the medium-term. “In our view, these initiatives were pursued with the view of relieving pressure on the country’s FX reserves as a primary source of funding the economic shock occasioned by the COVID-19,” Basele says.