Hedging Currency Risk
One of the risks we get most asked about and spend time finding mitigation strategies for is the exchange rate risk. I wanted to provide a short intro to how we think about it.
In general, hedging currency risk in Tanzania’s poorly developed capital markets is challenging. First of all, there are no publicly traded options for the Tanzanian Shilling. Buying options directly from banks is expensive as the currency is fairly volatile and as there isn’t significant competition among the existing issuers. We would also have to bear the counterparty risk which outside of the few global banks that operate there (like Citi) may be substantial. Moreover, the Tanzanian exchange market is both small and inefficient (monthly USD sales volumes are at $100m+) and consequently the interest rate parity doesn’t hold. This makes money market hedges and forward contracts resemble private bets more than anything else.
Our business faces two types of currency risks. First, as our inputs come from China, Europe and the U.S. and as our revenues are realized in Tanzania, the Shilling’s depreciation hurts our margins. Second, as we fund our operations from the U.S., a depreciating Shilling makes it difficult to repatriate earnings or to pay back loans.
To mitigate the first risk, we seek battery and charging equipment manufacturers within Tanzania and in neighboring countries (the correlation between East African currencies is surprisingly high), so that both inputs and outputs are in the same currency. Luckily, the price of our main competitor, kerosene, follows oil price, which, in turn, is dollar based. Thus, as the Shilling depreciates, both the cost of kerosene and that of our inputs increase. As a result, the prices of all the products in the market increase, and we may be able to have the end-customer share some of the increased costs.
The most efficient way to mitigate currency risk associated with the repatriation of money is to expand internationally. Instead of being dependent on the Shilling-US dollar relationship, we will then have a portfolio of currencies to work with. Although our position is, in this case, hurt by the correlation between currencies, rapid international expansion remains the best way to go.
What is the magnitude of EGG-energy’s currency risk? A depreciating event that with current volatility happens once in 20 years would eat 40% of our full-scale profits. Luckily there is no indication that the Shilling is grossly mispriced at the moment and no extensive correction is expected.
Shilling volatility: Five year trend – TZs vs. USD
Jukka