Exploring Currency Hedging in Zambia

By Micheil Banoub, Director of Programs, Kuo Sharper Initiative (KSI)

At Kuo Sharper Initiative (KSI), an impact investing fund committed to supporting small and medium-sized enterprises (SMEs) across Africa through debt finance, we are constantly exploring innovative solutions to address the challenges of operating in volatile markets. Earlier this year, KSI collaborated with the Legatum Center for Development and Entrepreneurship at MIT to host an FX Innovation Workshop focused on tackling currency risks in African economies.

When KSI decided to explore small business lending in Zambia, I used the opportunity to immerse myself in the market and explore practical applications of the FX hedging strategies discussed during the workshop. With a one-way ticket to Lusaka and some 20-dollar bills (because cash is king when traveling), I arrived in Zambia with two hypotheses:

1. Borrowing in local currency against a USD time deposit would be with low interest rates.
2. The primary concern for SMEs is the prohibitively high borrowing cost—often exceeding 30% per annum.

Both assumptions turned out to be incorrect. In this blog, I’ll focus on the first hypothesis and the exploration of FX hedging options. A second blog will delve into the broader implications of lending costs for Zambian entrepreneurs.

 The Big Picture

Zambia's economy faces significant macroeconomic challenges that complicate the business environment. As of October 2024, the annual inflation rate rose to 15.7%. According to the Bank of Zambia, the key drivers of inflation were low supply of maize grain, fish and vegetables; increased demand for solid fuels due to electricity load management, and depreciation of the Kwacha against major currencies.

Zambia relies on hydropower for 80% of its electricity. Unfortunately, the country is experiencing a severe drought that affected hydropower and led to power loss for up to 16 hours a day (when I was there in November). The drought also negatively affected the agriculture sector which employs almost 50% of the population. The Zambian kwacha experienced depreciated by almost 15% against the U.S. dollar from November 2023 to November 2024. In addition, 70% of Zambia’s exports are copper. Fluctuations in the price of copper affect the supply of hard currency and the exchange rates.

On the Ground in Lusaka

After settling in Kabulonga, a district of Lusaka, and trying the nshima, a staple food of Zambia, I arranged for 23 meetings in almost a week. These included discussions with banks, microfinance institutions (MFIs), and SME leaders, all aimed at uncovering actionable solutions for currency hedging and better understanding the SMEs and their concerns.

Challenges with Secured Loans

My first round of meetings was with commercial banks to evaluate options for secured loans. The initial concept was straightforward: deposit USD funds as a time deposit and use it as collateral to borrow in Zambian kwacha. In theory, this approach eliminates credit risk for banks, leading to low borrowing costs. However, two significant hurdles emerged:

1.  Central Bank Reserve Requirements: The Bank of Zambia mandates a reserve ratio of 26%, meaning that for every 100 kwacha loaned, 26 kwacha must be held in reserve. This adds a substantial cost, which is passed on to borrowers through higher interest rates.
2. Internal Bank Structures: In many banks, the lending and treasury desks operate independently, each with separate quotas. While the lending desk sees the secured loan structure as low-risk, but they have no quota to attract USD or hard currencies, limiting its appeal.

Treasury Products: FX and Currency Swaps

I then explored treasury products, guided by discussions with financial experts. Two solutions stood out:

• FX Swaps: This involves a spot exchange rate to convert USD to kwacha, paired with a future rate (far leg) for reversing the transaction.
• Currency Swaps: Beyond the exchange of currencies, this product involves quarterly interest payments. For instance, a USD-kwacha swap would see the bank pay SOFR-based USD interest while the borrower pays interest on the kwacha. However, currency swaps expose borrowers to interest rate fluctuations, as demonstrated during my visit when the Bank of Zambia raised its policy rate by 50 basis points, unexpectedly increasing hedging costs.

Both FX swaps and currency swaps are calculated using the same method of interest rate differential. I would describe them as the same product presented in two different manners.

 Non-Deliverable Forwards (NDFs)

International entities like MFX offer NDFs, a hedging tool that differs from traditional swaps by not requiring an upfront exchange of funds. Instead, the transaction is settled based on interest differentials. While NDFs mitigate currency risk, they do not provide the liquidity needs of local markets, which is a core priority for KSI as we remain committed to local currency lending.

The Verdict: FX Swaps (for now)

After comparing the available options, FX swaps emerged as the most practical solution. They provide both liquidity and hedging at a relatively lower cost, aligning with our mission to support SMEs in volatile markets.

I say for now as we are looking into other ways of financing using local currency, specifically by tapping into local pension funds. This would mitigate the FX risk where both debt source and business proceeds will be in the same local currency. More about that later.

Our journey in Zambia has underscored the complexities of currency risk management and the need for tailored financial tools in emerging markets. Stay tuned for my next blog, where I’ll explore whether high borrowing costs are the main concern for entrepreneurs in Zambia. 

(Spoiler: they are not!)