How countries get into currency crises (Ghana edition)
The playbook for how this happens to developing countries
We hear the term “economic crisis” but it is important to note that there are many types of crises: America has a “housing crisis”, the Eurozone is in a recession, Turkey is suffering 40% inflation in May 2023, and China currently suffers from 20% youth unemployment. I am not talking about those “crises” (well I will talk about inflation). But today, I am mainly going to talk about a balance of payments crisis.
A balance of payments crisis is colloquially referred to as a situation where a country on the verge of bankruptcy or has already experienced a sovereign default. Whenever a government can’t raise enough money through taxes the government will issue bonds to borrow from other governments, investors, institutions, and banks. For bonds, they typically pay an interest payment every period, and when the bond matures, the government needs to pay the principal of the bond. A sovereign default simply means a country missed a scheduled payment to lenders & credit investors. ( This happened in Zambia in 2020, Sri Lanka in 2022, and Ghana in 2023.
A country enters a balance of payments crisis when the country is deemed to be “poorly managed under unfavorable economic conditions”. But what does that mean? Let’s use Ghana as an example because it is in a currency crisis (I’m also Ghanaian so a bit of a bias).
In the 1980s to 2000s, Ghana underwent two phenomena.
1) Ghana suffered the mass erosion of living standards through two decade long, the African Debt Crisis. Commodity prices fell and Ghana’s top commodities like cocoa plummeted in price every year from $4500 per ton in 1977 to $816 by 1993. Gold also dropped from $2675 per ounce in 1980 to $500 per ounce in 1999. The result of this drop made Ghana unable to pay off its external debts and receive 8 IMF bailouts during this period. Inflation was massive, inequality increased, and most living standards went below independence levels, inflation adjusted.
2) Ghana transitioned from military rule to democratic rule in 1992 due to IMF mandate.
Post 2000s, Ghana was an star of Sub-Saharan Africa:
In 2002 Ghana’s total ~$4B debt was wiped clean from the IMF
In 2007, Ghana discovered 3B barrels of oil in the Jubilee field in 2007 and exporting millions of it starting in 2010.
Ghana then quickly graduated from the World Bank’s ranking from low income to lower-middle income again by 2010-2011 (a big achievement since roughly half of Sub-Saharan Africa is low income status.)
Ghana has a human development index (composite score of education, life expectancy, and income per person) at 63.2%, a medium level of development, which is the second highest in West Africa (losing only to the small island, Cabo Verde) and #12 on the entire continent.
Ghana has the second highest access of electricity on Mainland Sub-Saharan Africa, beating South Africa, losing only to Gabon on the mainland and small African islands.
Despite these successes, Ghana has in total went to the International Monetary Fund (IMF) 16 times as a result of currency & debt crises since independence. In fact, it is about to secure its 17th IMF emergency funding for a $3B bailout to be distributed over 3 years.. This raises the question: Why does Ghana repeatedly encounter theses crises, especially considering its abundant resources?
To be in a currency crisis, the following must be occurring:
1 - Your country depends on imports:
The country needs to import food, machines, cars medicine, fuel: gasoline, diesel from abroad instead of producing the goods themselves. Let’s examine Ghana’s trade.
For example, in 2021, Ghana exported $14B worth of goods to the world. Its top three exports to the world were $5.3B in gold, $3.6B crude oil, and $1.5B in cocoa beans, and many other goods. Not bad.
But Ghana also imported $20B worth of goods that same year. This makes Ghana run up a account deficit which is financed by borrowing. Ghana buys $3.7B worth of machines (construction vehicles & excavation machines from China), $3.5B in food (like rice from Thailand), $1B refined petroleum( gasoline, kerosene, diesel) mainly from the European Union. For a few examples. For other examples, Ghana also $450M in medicine & vaccines from the EU, America, & India. Ghana continued this trend in 2022.
As a result, Ghana spends way more money to buy goods from the rest of the world (especially for important imports like food, fuel, and transportation vehicles) than it sells to the rest of the world.
2 - Your nation has a persistent budget and current account deficit.
Since 2004, Ghana has always spent more money than receiving money in taxes. As a result of Ghana’s budget deficit, Ghana had to issue bonds to lenders to make up the difference.
But also, since 2004, Ghana has been running a current account deficit, which is an accounting of how much money comes into Ghana verses leaving Ghana (Exports- Imports + net income made from abroad - net expenses transferred abroad. Income in this sense means: interest payments, rent, dividends, wages, foreign aid, remittances made from abroad).
In 2021 for Ghana: (Granted Trusting Ghana’s government data isn’t perfect and there are discrepancies but this is what is reported):
Net Trade in Goods& Services: -$2.1B (Ghana buys more from abroad then sells)
Net Primary Income: -$3.83B (Ghana pays more wages, salaries, interest income & dividends to the world than it takes in)
Net Secondary Income: $3.4B (Ghana receives over $3B in remittances payments from the Ghana diaspora)
Add this together and it means Ghana ran up the current account deficit balance with another $2.5B. The only way to finance this is by borrowing $2.5B in that year. This means Ghana imports more goods from the world than exports goods to the world and it has been doing so since 2004. Ghana has borrowed in foreign currency to buy more goods from the world. 2022 was another year of $1.61B in borrowing.
3 - You have a pegged exchange rate to artificially raise your nation’s living standards.
Your country anchors their currency to the dollar/other foreign currency, and your country pegs the currency way too high which artificially raises your country’s standard of living (paying 6 cedis to buy a dollar worth of goods is cheaper than paying 12 cedis to buy a dollar of goods). However, your nation doesn’t export enough goods and generate sufficient export earnings, to maintain your currency’s elevated value. As a result, your central bank would have to sell your foreign exchange at your preferred rate to maintain your currency’s value.
Ghana maintained a “crawling peg” as a currency anchor where the country gradually lets their currency adjust their exchange rate (against the dollar usually) at a certain range. China and Argentina also have crawling pegs.
Since Ghana runs consistent current account deficits, Ghana’s currency should be devaluing fast, but during March 2020 to Feb 2022, Ghana purposely sold dollars and buys back its currency, cedis, to control the rate the Ghana’s currency weakening. In other words, Ghana sells its dollars to maintain the strength of Ghana’s currency so importing rice, gasoline, medicine, and etc. won’t be rapidly increasing in price and becoming more expensive. China had a ~$1.4T trade surplus in 2021, China sells more than it buys, giving China a war chest of dollars. Meanwhile Ghana was depleting its war chest.
A currency peg is good for artificially increasing the standard of living for your people, but the problem with a currency peg is that speculators and traders will try to undermine your peg. Between March 2020 to Feb 2022, Ghana’s central bank is selling dollar for around 6 cedis.
However, traders who analyzed Ghana’s economic data could deduce that Ghana was importing more than it exports and it is selling its precious foreign currency to maintain it’s currencies strength. This is not sustainable, leading some traders to buy at the market price. So traders may trade millions of currency at 12 cedis for a dollar, which weakens the currency sold (cedis) and strengthens the demanded currency (dollars). When this happens, Ghana’s central bank will have to intervene and sell millions of dollars to buy cedis for at a rate of 1 dollar to 6 cedis. The central bank of Ghana does this to reverse what the traders are doing by making cedis in demand & stronger and weaken the dollar. As a result, Ghana was hemorrhaging its foreign currency to defend its currency, the cedi. By 2023, Ghana only had $5B left of foreign reserves. To put in perspective how low that is, Ghana imports $20B in 2021! If Ghana decided to use its reserves instead of borrowing, Ghana would have ran out of money. So Ghana tried to borrow, but unfortunately no one would lend to Ghana anymore. As a result of being cash strapped and locked out of borrowing, Ghana chose to default and go to the “lender of last resort” the IMF. But I spoke about default too soon, let’s analyze the borrowing part more so we can understand more.
Because Ghana spent its dollars defending the cedi. That prevented Ghana from investing more in its sovereign wealth funds. Ghana has three funds, and combined the value of the three is ~$1.2B, which is roughly $36 assets per person. In comparison, Botswana’s SWF has nearly $1600 assets per citizen.
4 - Your nation borrows a lot of money in foreign currency like dollars.
If your country doesn’t have enough domestic investors in banks, investment funds, & pension funds, you need to borrow in a foreign currency like dollars or euros to meet the import needs of your country. As of 2021, Ghana’s total domestic savings from government, people, and firms is 20% of its GDP or $15B, roughly the same as Ghana’s domestic debt levels, but Ghana’s external, dollar denominated debt was ~$30B. The fact that external financing exceeds domestic financing means Ghana doesn’t have a big enough middle class or enough rich people with deep pockets in Ghanaian bank accounts to meet Ghana’s financing needs. Hence Ghana borrows in US dollars from abroad. If Ghana’s cedi depreciates, the dollar denominated debt gets more expensive. Ghana receives tax revenue in cedis but has to pay its external debt in dollars. If the cedi weakens, interest payments become unbearable.
5 -Your nation if suffering from capital flight.
America raised interest rates, as a way to curb inflation. U.S. Treasuries are giving juicer returns. As a result, investors are selling emerging market currencies and buying dollars/euros putting downward pressure on Ghana’s currency.
During COVID uncertainty and U.S. interest rate hikes, investors as a result sell your nation’s stocks/bonds (portfolio investment) which in Ghana they have been selling over $2B worth in 2021. Or they sell big stake in a project/business/factory (foreign direct investment), this was down -2.4B in 2021. Investors have been taking their money out of Ghana.
Ghana is running out of foreign currency to maintain your currency peg, so your central bank can’t sell dollars to prop up your currency, making your nation’s currency depreciate fast. Ghana’s Cedi peaked at 14.5 cedis to 1. This made Ghana’s debt more expensive.
6- Massive inflation due to currency devaluation.
Because your country imports a lot of goods (food, medicine, cars, fuel) the moment your currency declines, all those imported goods get automatically more expensive, causing rampant inflation.
7 - Sovereign default or brink of default
You either default on debt or you get an IMF loan before you default. (getting an IMF loan requires structural changes to your economy)
8 - The IMF loans you money but the government needs to tighten it budget.
Firstly the debt has to be restructured & refinancing - changing the structure of the debt to make it easier for Ghana to pay off (extend the period of time payments can be made or lowering the interest rate) and/or the bondholders take a “haircut”, when the principal debt is reduced to investors (aka investors & lenders take a loss). For example, four South African banks took a $400M loss.
The IMF will make the government will cut government expenses (civil servant wages, education spending, highway spending), cut government subsides (fuel subsides - subsides that reduce the cost of fuel for your citizens), sell bankrupt government owned enterprises to investors, and increase taxes (increase VAT tax, a consumption tax that affects poor people more)
The way to escape the sovereign debt crisis —> IMF borrowing —> austerity pattern is very difficult. The country needs to do the following:
The country needs to not run large persistent deficits (either by the country producing more goods to export or by reducing food imports, which will probably starve your country, leave them without medicine, or no electricity. Ideally the country needs to increase farming productivity which may/may not involve land rights reform.)
The country needs to reduce borrowing in US dollars/Euros/Pounds. This is hard because that means the country needs a larger middle class or more rich investors with deep pockets who keep their money in their nation’s banks. More deep pockets will increase the domestic savings rate which means banks will have more money to lend. If people are not putting their money in domestic banks, then the gross savings rate won’t rise and the county will need to depend on foreign borrowing for its food/medicine/electricity needs.
The country needs to stop anchoring its exchange rate so high. It’s very tempting for governments to anchor the currency high because a stronger currency means the country can buy more food/medicine/cars/energy. This works well short term but hurts long term. The currency anchor can’t be maintained long term if the country runs out of foreign currency due to consistently bleeding out one’s foreign exchange just to maintain a strong currency to import way more than one exports. By the time the country runs out of foreign exchange, the currency rate skyrockets and the whole country loses.
The only true way out of the crisis cycle is for the country to produce more goods that the world wants so the nation can have plenty of foreign exchange. A nation can get more foreign exchange either through winning the oil & gas resource lottery or being a manufacturing powerhouse.
Resource Lottery winner: Saudi Arabia, Qatar, and UAE got out of poverty, pearl diving, goat herding, and farming by winning the important resource lottery with having oil and/or gas, which is more valuable than most resources. (Crude Oil is ~$1T market, Cobalt is a ~$8B market. DRC may have cobalt, but oil is way more in demand.) That’s why manufacturing is so key for development.
Manufacturing Powerhouse: Japan, South Korea, Taiwan, and China. All four of these places were occupied and/or colonies of Japan before WW2 ended. Japan got rich first by being an industrial power, and used South Korea & Taiwan for cheap labor as Japan built its industrial titans: Sony, Toyota, Toshiba, Mitsubishi. Then South Korea and Taiwan used China for cheap labor as they built their industrial titans. (Kia, LG, Hyundai, & Samsung) and (TSMC & Foxconn). Now China is on the verge of being a high income country, using Vietnam as its source of cheap labor.
Become an agricultural Powerhouse: (Obtainable! in near term)
Japan, Taiwan, South Korea, and China initially prioritized agriculture before transitioning into manufacturing. In the 1950s and 60s, Japan, South Korea, and Taiwan redistributed land from landlords to peasants, leading to increased yields. This resulted in higher savings and domestic consumption. China followed a similar path after Mao's era, with Deng Xiaoping's economic reforms in the 1980s.India, once comparable to Africa in agricultural productivity, has no surpassed the “Low Income Food Deficit Country” Classifier. Ghana needs to make more of its own food. Ghana had $5B reserves in 2023 but imports to the tune of $3.62B of food yearly.
By enhancing agricultural output, Ghana can bolster farmer incomes, stimulate local consumption, and encourage savings, ultimately raising the country's savings rate for farmers beyond subsistence levels. Furthermore, surplus food production could open avenues for food exports, augmenting foreign currency inflow. Ghana recently surpassed the "Net Food Importing Developing Country" classifier, but must further boost yields to ensure sustained progress.
All links are underlined!