US embassy cable - 05GABORONE745

UNCLAS SECTION 01 OF 03 GABORONE 000745 
 
SIPDIS 
 
JOHANNESBURG PLEASE PASS TO FCS 
DEPARTMENT PLEASE PASS TO OPIC, JIM POLAN 
DEPARTMENT PLEASE PASS TO USTDA, NED CABOT 
DEPARTMENT PLEASE PASS TO USTR 
DEPARTMENT PLEASE PASS TO AF/EPS, CYNTHIA AKUETTEH 
AND ADA ADLER 
 
E.O. 12958: N/A 
TAGS: ECON, BEXP, EFIN, ETRD, BC, Economy, TRADE 
SUBJECT: BOTSWANA DEVALUES CURRENCY 
 
 
1.  Summary: The Ministry of Finance and Development 
Planning (MOF) announced a 12 percent devaluation of 
the Pula on May 29 as well as a restructured formula 
for calculating the exchange rate.  The Pula is 
currently pegged to a basket of currencies, 
including the U.S. Dollar, the Yen, the Euro, the 
Rand and the British Pound.  While the peg to this 
basket of currencies will not be affected by the 
restructuring, the new system will allow for 
continuous adjustments through what is known as a 
crawling peg as well as a widening of the margin 
between the buy and sell rates for currencies quoted 
by the Bank of Botswana (BOB).  The rationale 
presented by the MOF for the devaluation and 
restructuring was to enhance the competitive 
position of domestic producers and exporters, 
encourage the development of a local inter-bank 
foreign exchange market, and provide reassurance to 
foreign direct investors based on a stable 
competitive real effective exchange rate.  This 
devaluation could be the first step towards 
converting to a floating exchange rate system and 
may enhance its export competitiveness, but the 
timing of the move has raised eyebrows among members 
of the financial sector in Botswana as the decision 
comes two days before the BOB is due to pay out on 
several long-term bonds.  End Summary. 
 
2. While the devaluation is being sold as a means of 
ensuring the future stability of the real exchange 
rate, the abrupt devaluation and restructuring will 
have several short to medium term consequences on 
inflation, the budget, the bond market and investor 
confidence, and ultimately the type of exchange rate 
system employed by Botswana. 
 
Importing Inflation 
------------------- 
 
3. Devaluing the currency will put immediate upward 
inflationary pressure on the economy as the vast 
majority of products sold in Botswana are imported, 
primarily from South Africa.  Dr. Keith Jefferies, 
former deputy governor of the BOB, told EconOff that 
inflationary pressure will surely rise, possibly by 
as much as 5 or 6 percent to between 10 or 12 
percent on a per annum basis for a year or so.  Dr. 
Jefferies also said, "The BOB may adjust its 
inflation band (Note: The BOB sets an annual 
inflation target band, which is currently between 3- 
6 percent for the 2005/6 fiscal year), but only 
temporarily as the inflationary bulge should be 
short-lived, just as it was for the last 
devaluation."  The MOF last devalued the currency by 
7.5 percent in February 2004.  Finally, the 
inflationary pressure created by the devaluation 
means there are no more foreseeable cuts in interest 
rates, which remain extremely high at a 14 percent 
prime rate that stifles local investment. 
 
Budgetary Impact 
---------------- 
 
4. There is no getting around the obvious impact 
this move has on the GOB's fiscal standing, adding 
an immediate boon to its revenue generation, 
particularly from diamond sales, which are dollar- 
denominated and account for nearly 50 percent of 
government revenue.  Over the course of the past 
couple of years, the GOB has been holding its purse 
strings tightly following three consecutive budget 
deficits.  But the devaluation will free up a 
substantial amount of money, potentially $300 
million, to spend on much needed infrastructure 
development projects, many of which have stalled. 
 
5. However, given the potential for driving up 
inflation even further if it acts too quickly, the 
MOF's press statement wisely indicates that the new 
exchange rate system "will be supported by ongoing 
fiscal and monetary prudence."  This suggests that 
the GOB does not intend to spend the additional cash 
raised by the devaluation immediately, but rather 
spread over a period of time.  Either way, this 
devaluation will obviously help what was predicted 
to be another deficit year. 
 
Investor Confidence and the Bond Market 
--------------------------------------- 
 
6. Despite the stated objective of reassuring 
foreign investors, the move is likely to have the 
opposite impact of shaking their confidence, at 
least in the short term, following the second major 
devaluation of the Pula in just 16 months.  The 
previous devaluation of 7.5 percent was done in 
February 2004, and had the benefit of nearly 
balancing the 2003/2004 fiscal year books.  Former 
Governor of the BOB, Mr. Quill Hermans, told 
EconOff, that despite the fact that the devaluation 
was needed and had been predicted, it constituted a 
"body blow to investor confidence."  Martin 
Makgathle, CEO of Motswedi securities concurred, 
saying he believes it has "shaken investor 
confidence" and is worried about sustaining the 
perception of Botswana as a stable economic country. 
 
7. The biggest losers in the devaluation are 
bondholders.  Given the immediate maturity of its 
850 million Pula BW001 bond on June 1, its first 
ever bond issuance, the additional revenue raised by 
the devaluation comes at a very convenient moment 
for the GOB, which must repay these debts.  Ms. 
Kathy O'Connell, CEO of Legae Investors Mutual Fund, 
told EconOff, "It could have been worse. The 
Government could have defaulted or extended 
repayment of the BW001 maturity, and imagine the 
rating agencies would have had a field day with that 
one."  However, it remains to be seen how the rating 
agencies will see this exchange rate restructuring, 
considering the impact it has on the Government's 
debt obligations, and whether Botswana will retain 
its investment-grade sovereign credit ratings. 
 
8. For foreign bondholders, in particular, the 
devaluation will have an immediate negative impact 
if their returns are converted into foreign 
exchange.  Given the lack of any rollover or new 
bond issuances to coincide with the BW001 maturity, 
there will be a lot of excess liquidity flooding the 
Botswana capital market this week.  With nothing to 
put their money into, Botswana Treasury bond yields 
should drop as money is shifted into Bank of 
Botswana Certificates, and a significant proportion 
is likely to be repatriated overseas. 
 
9. Portfolio investors will also be negatively 
impacted as the value of their investments falls 
correspondingly to the devaluation.  Dr. Tebogo 
Matome, CEO of the Botswana Stock Exchange, told 
EconOff that the devaluation will clearly cost 
portfolio investors money, and it will take time to 
bring them back to this market.  In addition, Dr. 
Matome noted that portfolio investment typically 
leads the way for foreign direct investments (FDI), 
so the negative impact on portfolio investments 
could stem the flow of FDI, with a correspondingly 
negative impact on the GOB's efforts at diversifying 
the economy. 
 
10. Mr. Brian Alexander, Managing Director of Andisa 
Capital, a financial services company incorporated 
under the Botswana International Financial Services 
Center (IFSC), told EconOff that the restructuring 
of the exchange rate system is "definitely positive" 
for investment in that we won't see large scale 
revaluations in the future, which should add 
stability to the market.  He also said, as an IFSC 
company that earns money only in foreign exchange, 
the move would boost profits.  Mr. Wayne Osterberg, 
CEO of Stockbrokers Botswana, told EconOff that he 
agreed the restructuring is a good idea, but 
lamented that the decision to devalue the currency 
was done immediately in a single move, rather than 
incrementally under the newly established system. 
 
Moving Towards a Free Float? 
--------------------------- 
 
11. Dr. Jefferies, who departed the BOB only 
recently, told EconOff that the restructuring of the 
exchange rate mechanism signals a first step towards 
establishing a floating exchange rate in Botswana. 
In addition to the continuous adjustments described 
in the new policy, the Bank of Botswana has also 
increased the margin between the buy and sell rates 
for currencies quoted by the Bank to plus or minus 
0.5 percent from the preexisting 0.125 percent. 
This move should, as the MOF suggests, catalyze the 
development of a market-based inter-bank foreign 
exchange market in Botswana, which could in turn set 
the benchmark for converting to a floating system. 
The MOF's press release explicitly states, "As the 
foreign exchange market among the primary dealers 
develops, further increases in the width of the band 
around the central rate will be announced."  This is 
a clear indication of the BOB's attempt at letting 
the market determine the real exchange rate and 
bring a greater level of stability to the system. 
 
12. EconOff asked Mr. Osterberg about a potential 
shift to a floating system, and he noted that a 
crawling peg system served as a "useful 
steppingstone for converting to floating systems in 
Chile, Israel and Colombia," and could likely do the 
same for Botswana. 
 
Conclusion 
---------- 
 
13. Assuming the immediate negative inflationary and 
investor confidence impacts are short-lived, the 
GOB's decision to shift to a crawling peg system 
should bring greater stability to both Botswana's 
fiscal circumstances and its burgeoning capital 
markets. 
 
HUGGINS