With a strengthening US dollar and depreciating local currencies, dollar-denominated debt of low-income countries suddenly becomes much more expensive to repay. TCX has developed the HEAR ratio to show the impact of currency risk on sovereign budgets for health and education in Africa.
The HEAR ratio expresses a country’s currency risk in terms of its average annual budget for health and education. The ratio shows a country’s open currency exposure as a multiple of its average budget for health and education. This indicates how much a country’s dollar-denominated debt would increase following a currency depreciation of 1% versus the US dollar, expressed in terms of the annual budget for these sectors.
Example: the HEAR ratio of country XYZ is -7. This means that the country’s open currency exposure (in local currency) is 7 times bigger than the average annual budget for health and education. It follows that country XYZ’s dollar-denominated debt would increase by an amount equivalent to 7% of its average annual national budget for health and education, should its currency depreciate by 1% versus the US dollar.
We divide a country’s open currency exposure, expressed in local currency, by a typical average budget for health and education (also in local currency):
HEAR ratio = (notional open FX position expressed in LCY) / [(education budget + health budget)/2]
HEAR visualization
The map below shows the HEAR ratios for African countries. The redder a country, the more its (local currency) budget for health and education is at risk. It is immediately clear that many African countries run very sizable risks, as they run open currency exposures that are large, or even huge, compared to their government expenditures on health and education.
Note: IMF and World Bank data; OGR calculations. CMR, TZA and UGA based on 2018 data. No HEAR ratio available for countries colored in grey.
HEAR test
If the currency of country XYZ (with a -7 HEAR ratio) would depreciate by 10% in a given year, its dollar-denominated debt would increase by a massive 70% of its average annual budget for health and education. This what we call the ‘HEAR test‘ which shows how much a country’s external (dollar-denominated) debt would balloon in case of an annual depreciation of 10%. Unfortunately, a 10% depreciation is not uncommon at all for emerging and frontier market currencies.
HEAR damage
A third related concept is what we call ‘HEAR damage‘. Given a country’s HEAR ratio and the currency depreciation in the past calendar year, what is the actual ‘damage’ done – through its open currency exposure – expressed in units equal to its average annual budget for health and education?
Synthetic local-currency finance should always be a borrowing option
TCX believes that borrowing countries should be given a choice to borrow in (synthetic) local currency as this results in predictable interest and debt (re)payments. However, the current common practice of borrowing in hard currency while not hedging currency risk often leads to ballooning debt. This could have serious consequences for government expenditures on, among other things, healthcare and education, which are crucial sectors for development.
For questions or comments, please contact us at info@tcxfund.com.
To calculate the HEAR ratio, we have used the following sources:
Health care, education budgets: The World Bank
GDP: International Monetary Fund, World Economic Outlook Database, April 2022
International reserves: International Monetary Fund, IFS Database
External debt: The World Bank, International Debt Statistics
Exchange rate, annual average: International Monetary Fund, IFS Database
WAEMO countries international reserves: Central Bank of West African States (BCEAO), Statistical Yearbooks
HEAR ratio = (Notional open FX position expressed in LCY) / [(education budget + health budget)/2] .
The FX position is calculated as FX reserves minus External debt, expressed in LCY
Health and education budget used in a given year is the weighted average of the previous 3 years health and education budgets.
How to handle monetary unions’ (WAEMO, CEMAC) reserves?
WAEMO: For WAEMO countries we treat each country individually, taking as FX reserves only the part of FX reserves which is clearly indicated on the respective national CB’ balance sheet, while ignoring the union-wide CB reserves.
CEMAC: For CEMAC countries we treat each country individually, clear country-level reserves are available.
Missing data
Data for CMR, TZA, UGA is from 2018, as 2019 data is not yet available.