Kenya's central bank cut its overnight lending rate to 6.25 percent on Tuesday but imposed restrictions on borrowing from the discount window, saying it was being used for regular supply rather than a last resort.
Tuesday's surprise move came less than two weeks after the central bank unexpectedly raised the discount window rate to 8.00 percent from 6.25 percent in a bid to tighten monetary policy and prevent banks from undermining the shilling.
The cut in the overnight rate brings it back in line with the bank's benchmark Central Bank Rate (CBR), an interest rate it ditched as a reference for overnight borrowing on June 29.
"The CBK is concerned that recently, commercial banks have not been using the discount window as a last resort, but as a permanent supply of liquidity," the Central Bank of Kenya (CBK) said in a circular to bank executives.
The central bank said any commercial bank lending to others on the interbank market would henceforth be denied access to funds from the discount window on the same day. The amount banks can borrow in any given week will also be capped.
Some analysts said the new restrictions on borrowing meant Tuesday's announcement taken as a whole signaled a further tightening of monetary policy by the central bank -- a response to the fact the June move had not stopped shilling weakness.
"There is no question that by restricting the amount that banks can borrow from the discount window -- on any one day and over the course of the week -- the CBK has effected a real tightening of policy," said Razia Khan, Africa economist at Standard Chartered Bank in London.
"However, there is still an element of 'mixed messages' that the market will have to resolve," she said.
Traders said the initial shilling decline on the rate cut could be short-lived as the market was now digesting exactly what impact the discount window borrowing restrictions might have on long dollar positions.
By 0800 GMT, the shilling was trading at 90.55 to the dollar, weaker than 90.30 on Monday.
"In the near term, we anticipate a reversal of the knee-jerk sell-off in the KES in response to this news. The interbank market should tighten further, with banks becoming much more cautious about liquidity management," said Khan.
The central bank said commercial banks should consider selling government securities or closing out foreign exchange positions -- before resorting to the discount window.
At the time of the June increase, the regulator said one reason for the move was to stop banks using the window to fund foreign exchange positions against the shilling, which hit a record low against the dollar on June 22.
But while the shilling strengthened following the June 29 rise, it has since started to weakened again and Tuesday's decline was the third in a row.
Some traders said they were shocked by the central bank's continued tinkering with market policies in a bid to defend a currency that has been partly undermined by surging inflation at home and higher import bills.
They said offshore investors interested in buying Kenyan government securities in a search for higher yields could be put off by the central bank's policies -- and that banks would always find other ways to take short shilling positions.
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