Are some local banks over-risking in the Eurodollar market?

The magnitude of their exposure to dollar-denominated instruments is a real concern in the current environment. PHOTO | SHUTTERSTOCK

On Tuesday, the Central Bank of Kenya (CBK) quoted the shilling at 161.35 against the US dollar, a sharp drop from the 156.46 exchange rate at the end of December last year.

While some of the factors (both external and internal) behind this depreciation are well known, one gets a bad rap: the Eurodollar market – a misleading term referring to US dollars deposited in banks outside the United States and which are not subject to US banking regulations.

Are (some) players stockpiling dollars in anticipation that the local unit would lose further ground against the greenback and other major world currencies? I believe so.

The latest data from the Central Bank of Kenya (CBK) shows foreign currency deposits increasing at a faster pace than before. Total deposits reached Sh1.2 trillion at the end of June 2023, up 32 percent from Sh 891.5 billion as of June 2022.

Specifically, corporate bodies accumulated slightly over Sh800 billion in absolute foreign currency deposits by mid-last year compared to Sh592 Billion in the year prior. Similarly, household foreign currency deposits climbed by 26 percent to stand at Sh373 billion as at the end of June 2023 compared to a year prior.

Now, we can assume that, since corporations account for about 70 percent of the dollar deposits, these holdings are purely for international trade reasons. While that may be true, it’s highly probable some players see the market as a window to long the dollar as a way to hedge against the fast-depreciating shilling.

Furthermore, with Eurodollar deposits offering attractive rates over domestic deposit rates, the trade is a no-brainer – fueling this rate premium is the fact that the Eurodollar market operates with minimal regulatory constraints, which in theory, should allow for higher deposit rates.

That said, concerns are being raised over the expanding short-term forex maturities within the banking system. Rising Eurodollars deposits, sourced as term deposits maturing at near terms (weeks to several months), although deemed low risk, pose a huge risk with the key question being: in a prolonged dollar-shortage scenario, where will banks get dollars to fill the dollar-funding gap?

Typically, these gaps should be funded by interbank forex loans, borrowing from central banks, currency swaps, etc. However, all these markets are in a tight bind because of risk and liquidity concerns. So, in a doomsday scenario, if a particularly important bank or series of banks in the Eurodollar market were to default, this could trigger damaging bank runs.

Even if a bank is sufficiently capitalised, large Eurodollar obligations are likely to undermine liquidity. Given these risks, the rapid growth of the Eurodollar market should not go unnoticed.

Although it provides an alternate channel of financing for banks to load up their balance sheets with Eurodollar liabilities, the potentially dire consequences with respect to dollar funding gaps is a major concern and needs to be monitored.

The magnitude of their exposure to dollar-denominated instruments is a real concern in the current environment.

Mwanyasi is MD, Canaan Capital