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Shock hits the Shilling

FINANCIAL STANDARD
By | Jun 22nd 2010 | 4 min read
By | June 22nd 2010
FINANCIAL STANDARD

By Morris Aron

The shilling has been on a losing streak, sliding to a six-year low against the dollar, following news that Europe could be sailing into a financial crisis, a situation bound to slow recovery of the global economy.

But to comfort the business community Central Bank Governor Njuguna Ndung’u made a curious statement — a week ago — that could have passed as just any other pronouncement.

He advised firms to put their hedging instruments in place as a cushion against the effects of the volatility, saying causes of the weakening shilling were exogenous — caused by forces whose origin are not within the country.

But at a time when the situation is expected not to ease soon, the statement, analysts say, points to a bigger picture: the need of using hedging as a financial tool to shield against currency volatility, especially for companies that import commodities in bulk.

For almost three weeks, the local unit has been volatile since news of rising debt levels in Greece emerged and sparked concerns over a possible financial crisis in Europe and dampened hopes of a faster global economic recovery.

economic rules

Statistics indicate the Greek budget deficit had risen to 13.6 per cent of its gross domestic output last year, and was more than four times the limit of Eurozone economic rules.

Following the news, the shilling hit a six-year low against the dollar early this month and has remained above the Sh80 mark, with analysts saying it may remain at that level up to December before it strengthens again.

"The Euro crisis is still predominant in the next two to three months but I don’t see the shilling selling at less than Sh70 against the dollar soon," said David Cowan, the chief economist for CitiBank Africa.

The shilling’s volatility is bad news to traders as it makes imports more expensive, with the immediate casualty being oil.

Though oil prices have dropped significantly since the record prices of $145 in July 2008, analysts say prices might rise should the global economy show signs of recovery.

Experts say uncertainty over the direction oil prices take and volatility in foreign exchange rates is seeing companies turn to hedging in a bid to forestall increases in production costs and boost profitability.

"Companies which have foreign currency dominated loans or buy oil in bulk normally turn to hedging as financial tool to shield against market uncertainties," said analysts with NIC Capital, who asked not to be quoted.

Hedging is a risk management strategy used in limiting or offsetting probability of loss from fluctuations in the prices of commodities, currencies or securities.

The benefits of hedging as a financial tool was demonstrated recently when Kenya Airways (KA) announced results for the financial year ended March 31. A year ago, the airline experienced the financial instrument’s ugly side.

positive gains

Kenya Airways posted a pre-tax profit of Sh2.6 billion for the year ended March 31, 2010, compared to a Sh5.6 billion loss recorded in the previous financial year.

KA Managing Director Titus Naikuni attributed the performance to positive gains made from its fuel hedging policy and favourable exchange rates.

The profit was despite KA’s core business performing dismally with revenues from operations dipping and operation costs rising as a result of the decision by the airline to add more routes and an increase in manpower costs.

Positive hedging and "a drop in international oil prices from a peak two years ago" boosted the income statement by more than Sh6 billion in what could have otherwise been a Sh3.5 billion loss.

The inclusion of the hedging benefits resulted in a Sh2.7 billion profit courtesy of international accounting standards guideline on how to report hedging gains or losses.

The previous year, KA reported a loss of Sh5.6 billion after its fuel hedge policy boomeranged, returning a loss of Sh1.37 billion from fuel derivatives and an unrealised hedge loss of Sh7.5 billion.

Cement manufacturer East Africa Portland Cement Company recently announced plans to issue a convertible bond to raise funds for hedging a yen-dominated loan eating up its earnings.

Portland Cement Managing Director John Nyambok said the firm has opted for hedging as a solution to high costs that the company incurs as a result of the shilling volatility that has made the loan repayment too expensive as the local currency appreciates against the yen and eliminate the circle of repayment.

"We want to hedge 100 per cent of the loan because we have paid a lot, but it is like chasing the wind," said Nyambok in a past interview.

Portland Cement secured a Sh1.7 billion yen-dominated loan in 1996 to expand its production capacity, but due to strengthening of the yen, the loan ballooned to Sh4 billion by 2005.

Last year, costs of servicing the loan saw the company to post a 36 per cent decline in pre-tax profit to Sh715 million against Sh1.1 billion in 2007.

Though over the years the company has been trying to retire the loan to mitigate losses, even contemplating a one-off repayment, it has been impossible because it was a government-to-government arranged facility.

accounting policies

But perhaps the most interesting saga as a result of hedging was a spat between KenGen, Institute of Certified Public Accountants of Kenya (ICPAK) and Capital Markets Authority over the manner in which the power company reported its results last year.

The spat stemmed from a decision by KenGen to change the company’s accounting policies, by not charging all exchange losses resulting from foreign currency denominated transactions in the income statement.

ICPAK faulted KenGen’s decision to recognise foreign exchange losses of Sh5.3 billion incurred in 2009 in a special foreign currency revaluation reserve account in the company’s statement of changes in equity. The company would have reported a pre-tax loss of Sh894.6 million.

The development resulted in a 278.6 per cent increase in profitability from the previous year’s figure of Sh1.4 billion.

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