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Prof. Ian Giddy

Tel 212-998-0426; Fax 212-995-4233

E-mail: ian.giddy@nyu.edu Web: http://giddy.org

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Worries at Cap des Biches

 

 "Will the CFA franc devalue again? And if so, when? And what can we do to protect ourselves?" asked Michel Maddoux, Treasurer of GFI-Dakar, a power company near Dakar in Senegal. Maddoux was discussing the advisability of hedging the US dollar debt that GFI had incurred several years earlier.

The project, GTI-Dakar, consisted of a 56-MW, oil-fired plant located about 20 kilometers east of Dakar at Cap des Biches. The IPP (Independent Power Producer) plant uses naphtha fuel produced at the SAR refinery. The consortium developing the project included General Electric's Structured Finance Group, The World Bank's International Finance Corporation and the Italian utility Sondel. The project was started in 1999 and completed in 2002.

Of the $65 million financing for the project, $30 million was US dollar-denominated debt. The debt, in the form of a floating-rate bank loan, had six years left before it had to be repaid. A long-term sales contract with Senelec (Senegal National Electric Power Co.) gave banks confidence that the debt would be repaid, but the recent decline in the Euro and the possibility of a devaluation of the CFA franc against the Euro made Maddoux wonder whether he should do something to protect against a possible loss. Among his alternatives were to renegotiate the debt to convert it to Euros, to enter into a dollar-Euro currency swap, or to use short-term forward contracts. The last was the only hedging instrument available in CFA francs.

There were problems with all three possibilities. Renegotiating the loans would be costly and time-consuming because of the number of banks involved. A currency swap would involve arranging a line of credit with a major bank, since the swap involved counterparty risk. Also, while either technique could protect GTI against a depreciation of the Euro against the dollar, this would do nothing to protect GTI in the event of a devaluation of the CFA franc.

 

"What dare we do?" replied his deputy, David Lane. "I know our first  responsibility is to GFI's shareholders, but if it becomes known that we are shorting the CFA franc we may  find ourselves branded as unpatriotic speculators. Look at Tuesday's Dakar Presse. Do we want to be accused of 'putting jobs at risk in the pursuit of a quick profit'? 

"With the unemployment rate at 20% and rising, it seems that jobs are being lost because of the BCEAO's unwillingness to allow the CFA franc to devalue," said Maddoux. "Thirty percent of Senegal's trade is with France, and with the CFA franc tied to the Euro, we suffer exchange risk on our debt every time the Euro falls against the US dollar. We would be doubly hurt if the CFA franc were to devalue agianst the Euro, as happened in 1994."

 

"My friends in the banks are telling me that some sort  of relief for the export sector is imperative," said Lane. "Some are talking about a subsidy to agricultural producers, but currency dealers seem to have concluded that such an increase is politically impossible and that the regional central bank, BCEAO, would devalue before they would allow it to happen. The big banks' hands are tied, for the Central Bank has cut off their access to the discount window whenever Central feels that the funds would be used to sell CFA francs and buy foreign currencies. As you recall, the credit squeeze wrought by the Central Bank has forced some institutions to pay high rates for overnight money to cover their short positions in recent weeks."

 

"High short term interest rates and the fact that the CFA franc has been pushing against the Euro link are certainly indications that the currency has problems. Coffee, cocoa, rubber and other prices are falling, and travel scares have kept many tourists away. Political and civil war problems in some member countries have not helped. In recent months the other West African currencies have all undergone similar pressures and most have eventually been forced to devalue."

 

"I agree it's touch and go," his colleague responded. "Yet pressures may be easing as one after the other the speculators, having been burned, are dropping out. They've had to  pay exorbitant interest rates day after day to short the CFA franc, else they've sold CFA francs in the forward market at a tremendous discount. In either case they lose money when the authorities succeed in resisting a devaluation. The financial community in West Africa is small and the number of players willing to stake big money and jeopardize their relationship with the Central Bank is diminishing. Moreover the fundamentals, such as Senegal's positive trade balance, seem much more favorable to the CFA franc than, say, the currencies of Ghana or Nigeria."

 

"Clearly it's of great importance to us to determine whether or not the CFA franc will devalue within the next three months, and also what could happen to the dollar-Euro relationship. We should look at the evidence and views on spot and forward exchange rates, on interest rates, inflation and other economic variables and decide what will happen. In particular, what's the probability of a devaluation in the next three months, and how much? Then we must decide whether it's worth covering our dollar exposure, and how it should be done."

Assignment

1. What drives the relationship between currencies? What factors caused the 1994 devaluation of the CFA franc against the French franc, and could it happen again?

2. What is the difference, from the point of view of a company, between a "fixed rate system" (like the CFA franc) and a "floating rate system" (Like the US dollar-Euro relationship).

3. Consider the following possibilities. Please explain how each of them would work, and how it would help protect the company. What action would you recommend for GTI-Dakar?

• Renegotiate the $30 million loan, replacing it with a loan denominated in Euros
• Keep the USD loan in place, but enter into a 6-year currency swap to effectively convert GTI's payments into Euros.
• Hedge the dollar-Euro risk by buying dollars forward, with rolling 3-month forward contracts
• Hedge against a possible devaluation of the CFA franc, by selling francs in the 3-month forward market.
• Leave the dollar loan unhedged, and pass the cost of any foreign exchange losses on to Senelac, the buyer of GTI's power
• Do nothing now but watch the situation carefully and hedge if the risk becomes too great.
  

 

 

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