Banks increased their issuance of loans in foreign currency amid the recent local forex market dysfunction, the International Monetary Fund (IMF) has disclosed.
In addition, the banking sector deposits and other liabilities rose to heighten the industry’s exposure to forex risks.
The build-up in foreign currency loans is largely attributable to commercial banks seeking to hedge against currency risks which were defined by forex access difficulties in the domestic market.
According to the IMF, banks’ shares of FX loans, deposits and liabilities stood at 30, 25.6 and 31.5 percent, respectively, at the end of 2022, compared to 28.5, 24.5 and 29 percent, respectively at the end of 2021.The build-up in FX positions for instance saw larger on-balance sheet net short forex open positions where the foreign currency asset-to-deposit ratio was less than 100 percent.
The exposure was, however, partly offset by off-balance sheet net long positions, the majority of which consisted of currency swaps between banks and clients.
Larger short FX positions mean that banking clients were bearish of the country’s forex exchange direction and would largely expect the local currency to depreciate significantly in the short run while the inverse points to a bullish position where clients expected the local exchange rate to improve over the long-term.
The IMF warns the build-up of banks’ FX exposures has increased the industry’s vulnerability to exchange shocks even as it notes positive recent action to resolve the foreign exchange market dysfunction.
In 2022, the real effective exchange rate appreciated according to the IMF but yielded dollar shortages at the start of 2023 with widening spreads between the interbank forex market and the rate at which banks transact with their clients (and within the bank client market).
In essence, forex exchange, particularly dollars, could not be purchased from banks at the prevailing exchange rate while banks were limited in forex dealings among themselves.
In late March, the CBK took steps to restart the dealings (interbank forex market), including the issuance of a forex code for market participants, bringing two inter-dealer brokers and increasing engagement with market participants.
“The CBK started holding more regularly scheduled meetings with market participants to increase two-way communication and transparency, and provided verbal clarifications on banking circulars (Circulars 10 and 11 issued in 2015) that interbank transactions need not be limited to, and can be smaller than, the standard ticket size and that the spread limits only apply to the indicative quotes for the standard ticket size.”
Data provided by the IMF shows interbank forex trading volumes for all currencies have improved and rose to around four percent of all transacted volumes from volumes of less than two percent for the most part of 2022.
Earlier this week, the CBK said activity had returned to the Forex interbank market even as more improvements are expected.
“We have actually seen the interbank market working a bit more than it was before. There is still some way to go but this is an area where we do not need to engage more with commercial banks to increase activity. It’s an area we are working on but can see some success for instance when you look at the spread between the CBK rate and the retail rate, which is not as high as it was before,” CBK Governor Kamau Thugge said.
During the height of the forex dysfunction, clients seeking dollars largely deployed currency swaps where a customer could deposit a lump sum in local currency and obtain a comparable supply of dollars but would have to pay for the difference in the exchange rate at the maturity of the contract handing FX gains to commercial banks.
Across 2022 and in the opening quarter of 2023, commercial banks multiplied earnings from foreign exchange trading by leveraging the crisis.
Similarly, foreign currency deposits have continued to soar and reached Sh1.075 trillion as of April from Sh834.5 billion at the same time last year.
The rise in foreign currency deposits is nevertheless partly masked by a weaker local exchange rate and holdings by commercial banks in regional subsidiaries where foreign currencies are more prevalent.
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