It’s a myth; US dollar loans are not cheap!
Ghana has had a somewhat liberal foreign exchange regime for decades. This has among other things allowed residents to freely transact in foreign currency, mostly the US Dollar (USD), for both international and local transactions.
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Indeed under our current foreign exchange regulations resident firms can contract either local or foreign currency denominated loans from banks regardless of currency of their revenues.
As a finance professional often involved in the structuring and negotiation of loans to corporates, I have witnessed an increasing number of businesses (and sometimes even individuals) in Ghana opting for USD denominated loans instead of the local currency loans. The key motivation has been that local currency interest rates are too high and cedi borrowings are therefore relatively expensive.
This perception is widespread to the extent that even local currency earners with no USD revenues have insisted on borrowing in USD—a phenomenon described as currency mismatching, a form of wrong way risk. It turns out in fact that local currency loans over the medium to long term are cheaper than US Dollar denominated loans by as much as 70 per cent.
Risk professionals who often advise against currency mismatching have usually argued that the practice creates (a) currency depreciation risks to local currency earners where such borrowers end up incurring foreign exchange losses if the local currency depreciates, and (b) foreign currency liquidity risk where local currency earners are not able to service USD debt obligations on time because of unavailability of physical USD currency for purchase—typically described as convertibility risk.
For offshore lenders the additional risk that regulatory changes could restrict foreign currency transfers out of the country to meet debt service (currency transfer risk) often lingers although people have long argued that this risk in Ghana is relatively remote.
Theoretically, (covered) interest rate parity hypothesis predicts that it should not make any difference, returns (or cost)-wise, whether a business is investing (borrowing) in local or foreign currency. The end result should be the same in a reference currency—currency depreciation should exactly offset any difference in interest rates. However due to market inefficiencies that pertain in reality, we are far from a zero-arbitrage world.
It is interesting to note that even during the brief period of restriction on USD borrowing by the Bank of Ghana in 2014 and the resulting high cedi depreciation during that period, appetite for foreign currency debt remained high. Indeed some borrowers insisted on exploiting a window in the regulation which allowed foreign banks to still lend in USD to local entities regardless of the currency of their revenues.
Surprisingly, the notion that local currency debt is expensive has not really been interrogated empirically. If that is so, then the question is whether the notion is based on actual evidence or it is an exaggerated perception capable of defying palpable evidence? At least optically, interest rates and cost on cedi loans appear high compared to interest rates quoted for USD loans but the costs go beyond just interest service. Indeed many have argued that the view that cedi loans are expensive has not properly taken into account the persistent depreciation of the local currency, at least not in recent times.
Against this background, this article analyses the cost of local currency and USD debt over the last eight years, roughly since Ghana re-denominated its currency. The analysis compares equivalent amounts of USD and Ghana Cedi (“GHS”) debts priced for an “average” corporate (large SME) borrower in Ghana.
The main finding is that contrary to the perception of USD loans being cheaper, local currency debt has been shown to be cumulatively cheaper by up to nearly 35 per cent for floating-rate borrowing and up to about 70 per cent for fixed-rate borrowing for term loans with tenors between January 2008 and December 2015. The result is consistent across different time periods and loan pricing scenarios.
The rest of this article details the analysis comprising the assumptions for a hypothetical base case, the results and some key conclusions.
Results
The results for the Base Case analysis are tabulated below and indicate that under a floating rate scenario the FCY Borrower would have paid a total amount of GH¢26m to fully retire the floating rate loan, 35 per cent higher than GH¢19.4m paid by the LCY Borrower. On the other hand, debt service under the fixed rate loans shows that the FCY Borrower would have paid a total of GH¢27.4m, compared to a total of GH¢16.2m paid by the LCY borrower (68 per cent higher for the FCY Borrower), to fully retire the loan.
The interest service under the floating-rate FCY loan is 40 per cent lower than that under the LCY loan. This observation shows the widely held perception that LCY interest costs are high, compared to FCY. However, interest cost is just one part of the story, as borrowers are obliged to repay capital as well. Indeed in some instances lenders are more concerned about the return of, rather than on, their capital. Table 2 shows that capital repayment under the FCY loan (in cedi terms) is much higher than that under the LCY loan by almost 110 per cent. This makes the total debt service under the floating-rate FCY loan higher than the LCY loan by as much as 35 per cent.
Similarly the total debt service under the fixed-rate FCY loan is 68 per cent higher than the LCY loan. It is even higher than the over payments under the floating-rate loan. In this specific instance the fixed-rate resulted in lower interest payments under the LCY loan. Under the floating-rate the FCY loan “benefitted” from adverse movements in T-bill, which is absent under the fixed-rate scenario. Again the capital repayment contributed hugely to the higher payments under the FCY loan. Thus the devil is not in the interest but rather in the capital repayment.
Summary of base case assumptions
In order to compare cost of borrowing in local currency to cost in foreign currency, I assume that in January 2008 two hypothetical firms contracted two loans each from a hypothetical bank in Ghana. One of the firms, the “LCY Borrower”, borrowed in local currency (the “LCY loan”) in both floating and fixed interest rates whiles the other firm, the “FCY Borrower”, borrowed the foreign currency equivalent amount in USD (the “FCY loan”) also under floating and fixed rates. The goal is to find out which of these two firms would have incurred higher total debt service (i.e. interest and principal payments) and under what type of interest arrangements (i.e. fixed or floating). The key terms of these hypothetical loan facilities are summarized in the Table 1 blow as Option I and Option II, together the Base Case.
Why these outcomes?
(1) Floating-rate loans
Fig. 1 shows trends in quarterly debt services split into interest and capital payments over the tenor while Fig. 2 displays these on cumulative basis. The irregular interest service curves reflect changes in outstanding exposures as well as changes in the respective base rates over time.
It is worthy of note that whereas the local currency capital instalment curve is linear and flat, that for the foreign is rather irregular and generally upward sloping, mirroring the effects of cedi depreciation against the USD (see Fig. 7 below). Fig. 1 therefore shows that the cost of the USD loan (in cedi equivalent) comes mainly from capital repayments.
The higher costs can be approximated by the area between the FCY capital repayment curve and that of the LCY capital repayment curve. The increase in the amount of cedis required to meet the same USD capital instalment repayment – from an initial cedi equivalent of GH¢305,625.00 in March 2008 to GH¢1,185,937.50 in December 2015 – is 288 per cent more than offsets any gains from the low USD interest service. Whereas the gap between FCY and LCY interest payment curves has narrowed over the tenor, that between the capital repayment curves has increased as the exchange rate increases.
On a cumulative basis total debt service for the FCY loan remained lower than the LCY loan debt service until about June 2013 under the floating-rate scenario and thereafter continues to be higher and increasing at a faster rate (see Fig 2). Again this latter trend reflects the rate of depreciation, which increased from 12 per cent p.a. on average between Jan 2008 – June 2013 to an average of 24 per cent between Jun 2013 and Dec 2015.
2) Fixed-rate loan
The picture under a fixed-rate loan scenario is broadly similar to that of floating-rate in that the trend in capital repayments under both FCY and LCY loans are the same—the LCY capital repayments are the same on quarterly basis but the FCY loan repayments escalate in line with the depreciation of the cedi (see Fig 3). The difference lies with the interest service curves, which more or less reduce linearly in line with reducing outstanding exposures under both loans.
However, the benefits to the LCY loan (lower debt payments) come much earlier in 2009, see Fig 4, as the adverse impact of the increased T-bill rate to the LCY loan is absent in this scenario. You would notice that the initial big gap between the interest service curves under the floating-rate scenario is absent under the fixed-rate scenario. Thus the off-setting effect of the interest savings under the FCY loan is absent.