Currency Crunch: USD Loan Repayments and Shilling Conversions in Kenya's FX Turmoil
Dean N Onyambu
Picture Source: https://biznakenya.com/kenya-shilling-fall-against-us-dollar/
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A recent report from Business Daily highlights a pressing issue in Kenya's banking sector: a rise in 'non-performing loans' (NPLs), particularly those in US dollars. NPLs are loans where repayments have become complicated, which, in this case, stems from challenges with loans denominated in US dollars amidst a shortage of this currency in Kenya.
However, Kenya's situation is not unique. Argentina, Turkey, Nigeria, and Zambia face similar challenges reflecting a common problem in emerging economies: managing loans in foreign currencies like the US dollar, especially when the local currency is unstable or weak. This trend points to a broader global issue affecting the financial stability of emerging markets.
The Business Daily article, informative as it is, needs to be clarified about the practices of repaying loans. This confusion highlights the need for a clearer understanding. Take a borrower in Kenya, for instance, who has taken a US dollar loan but earns in Kenyan shillings. They face unique challenges, especially when repaying their loan. The main challenge lies in the fluctuating exchange rate between the dollar and the shilling. This fluctuation often occurs when the Federal Reserve, the central bank of the United States, increases its interest rates. Such a rate hike can increase the dollar's strength against the shilling, making it more costly for the borrower to repay their dollar loan.
A borrower in this situation has several options. If their US dollar loan has an interest rate that varies, they can opt to fix this rate. Fixing the rate means that even if the Federal Reserve changes its rates, the interest on the loan remains unchanged. Another strategy is to convert their loan from US dollars to Kenyan shillings (USD-to-KES loan conversion). This move can be particularly beneficial if the borrower wants to avoid the risk of the dollar strengthening significantly against the shilling. By converting their loan to Kenyan shillings, they align their repayment obligations with their income, making it easier to manage their debt amidst these economic changes.
When a borrower decides to switch from a variable to a fixed interest rate on their dollar loan or changes their loan from US dollars to Kenyan shillings, it is crucial to understand that this is not a default. A default typically occurs when a borrower fails to meet the loan repayment terms. In contrast, what we are seeing here is a strategic financial adaptation. It is similar to choosing an alternate route home to avoid traffic. In this case, the borrower is still committed to reaching their goal – which is paying off the loan. They choose a different, perhaps more convenient, or cost-effective path to achieve this. Both companies and individuals frequently use these strategies to manage their risks or to benefit from more favorable interest rate conditions.
Adding to the complexity is Kenya's foreign exchange (FX) market, where US dollars are currently scarce. This scarcity highlights a significant mismatch: borrowers have taken US dollars (USD) loans but earn their income in Kenyan shillings (KES). This mismatch can lead to difficulties in meeting loan obligations in USD. In this challenging environment, borrowers often find a third option. They might offer to pay in KES if they cannot access enough USD for their payments. It is essential to understand that while this situation is presentable as a technical default, it is not a traditional loan default. Usually, a default happens when a borrower does not make scheduled payments in the agreed currency and on time. However, if a borrower arranges with their bank to pay in KES, and the bank can quickly convert these payments to USD, the repayment schedule can still be met. As such, this is not a failure to meet loan obligations; it is more like a strategic adaptation to the challenges of currency availability. It is similar to the borrower giving the bank an order to exchange KES for USD, ensuring they can still repay their USD on time.
However, the scarcity of US dollars in Kenya complicates this situation further. Often, banks can only meet some requests for currency conversion due to this scarcity. As a result, borrowers might be unable to make their US dollar repayments on time, even though they have enough Kenyan shillings. This scenario leads to what we define as an actual default: failing to service the USD loan as per the agreed schedule. The borrower has the means (the shillings) but cannot obtain US dollars due to market scarcity or the bank's inability to accept KES as repayment. This missed or late payment can seriously affect their creditworthiness and requires immediate action to rectify.
This risk, caused by an inability to access US dollars in the FX market, is known as transfer and convertibility risk. In such situations, a likely solution for the borrower is to convert their loan from USD to KES. Once they convert their loan to Kenyan shillings and address any missed USD payments, their loan moves out of default status. They can then continue servicing their restructured debt in a more accessible and manageable currency, which is KES. This approach effectively addresses both the initial currency mismatch and the challenges arising from the subsequent default.
Banks should ideally be cautious about issuing loans in currencies that do not match the borrower's income, especially in markets with difficult currency conversions. This caution helps avoid situations where borrowers cannot meet loan obligations due to currency mismatches and liquidity issues. However, there are times when risk standards might unintentionally drop, particularly during periods of high dollar prevalence.
An interesting scenario unfolds when many borrowers in Kenya choose to convert their USD loans to KES. This conversion is a complex process for banks. They must first 'close out' the dollar loan and then issue a new loan in shillings. To complete this, banks need to find enough dollars in the market to settle the original dollar loans. Imagine a grocery store experiencing a regular flow of customers buying various items. Now, picture that store suddenly facing a rush of customers all wanting to buy the same product – this is akin to the sudden, increased demand for US dollars in the market due to mass loan conversions. While not a default, this mass conversion represents a collective adaptation to the challenges of dollar scarcity.
This large-scale conversion puts significant pressure on the FX market, similar to the grocery store struggling to meet the unexpected surge in demand. This scenario can cause a backlog of US dollars in the Kenyan FX market. Additionally, as more people try to convert their shillings into dollars, it can lead to the shilling's depreciation, making it even more costly to obtain dollars. This situation creates a challenging feedback loop for banks: they must manage the high demand for conversions while also dealing with broader market impacts like currency depreciation and exacerbating dollar scarcity.
As such, banks are currently facing a dual challenge. On the one hand, they must manage the immediate, increased demand for US dollars. On the other, they have to restructure their financial strategies to address the long-term effects of many borrowers switching their loans from USD to KES. Despite the complexity of this situation, such restructuring can be a proactive approach to improve financial stability and resilience in fluctuating FX market conditions. This process can lead to positive outcomes. For instance, banks can strengthen the health of their financial portfolios by reducing the number of non-performing loans and aligning the terms of loans with the currencies in which borrowers earn their income. This strategic response benefits borrowers, too, helping them manage their debts more effectively. In the long run, these actions contribute to Kenya's financial ecosystem's stability and health.
Banks' proactive approach in these challenging times goes beyond just converting currencies; it leads to deeper engagement with their clients. By working closely with borrowers, banks can better understand each client's unique financial situation and provide tailored responses. A clear example is a Kenyan bank's collaboration with a property company that charges its rent in US dollars. While the property company may seem to have a stable income in USD, the reality is more complex. The tenants, earning in Kenyan shillings, face the challenge of buying USD in the currency market to pay their rent, which exposes the property company to risks associated with currency conversion and cross-border fund transfers, also known as 'transfer and convertibility risk.' In response, the bank helps the property owner convert their loan to KES, easing the repayment burden under dollar scarcity conditions. This kind of partnership is more than just a financial transaction; it is a strategic alliance. It enhances the bank's insight into market needs and individual client situations. Such collaborative efforts are vital in managing currency fluctuations and maintaining the overall stability of the FX market.
In conclusion, the current economic landscape, marked by challenges in foreign currency loans and the fluctuating FX market, demands proactive and adaptive strategies from both banks and borrowers. We have seen that the critical issue is not just about taking out loans in US dollars but about how borrowers manage these loans when their income is in a different currency. Changing a loan's terms – from a variable to a fixed interest rate or USD to KES – is not a default. It is a strategic move to cope with changing economic conditions. A default, in the true sense, occurs only when a borrower fails to meet their repayment obligations as per the original terms. This understanding is crucial for banks and borrowers in Kenya and elsewhere as they navigate the complexities of loan management and currency mismatches. By aligning loan terms with borrowers' income currencies, banks can reduce the risk of actual defaults and contribute to the financial stability and resilience of individuals and the broader economy. As we move forward, these thoughtful financial practices pave the way toward sustainable financial health in a globalized economy.
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Dean N Onyambu is the Executive Head of Trading at Opportunik Global Fund (OGF), a CIMA-licensed fund for Africans and diasporans (Opportunik), and is a co-author of Unlocking African Prosperity. Passion and mentorship have fueled his 15-year journey in financial markets. He is a proud former VP of ACI Zambia FMA (@ACIZambiaFMA) and founder of mentorship programs that have shaped and continue to shape 63 financial pros and counting! When he is not knee-deep in charts, he is all about rugby. His motto is exceeding limits, abounding in opportunities, and achieving greatness. #ExceedAboundAchieve
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