Overvalued shilling may hit 110 to US dollar by year end

The Kenyan shilling is overvalued by a fifth, analysts at investment bank Renaissance Capital (Rencap) say.

This is putting pressure on the local unit to depreciate further at a time of decreased financial inflows and a strengthening dollar.

Rencap economist Yvonne Mhango said in the investment bank’s July update on African economies that Kenya’s real effective exchange rate (REER) is 20 per cent overvalued and forecasted that the currency is headed for 110 units to the dollar by the end of the year.

The REER takes into account the value of trade between countries and their inflation levels.

According to the economist, the Kenyan shilling remains one of the most vulnerable to a significant depreciation compared to peers in sub-Saharan Africa considering the deviation of its REER from the 10-year average of the region, and the fact that its depreciation has been smaller than the euro/dollar depreciation.

“The shilling’s vulnerability explains the 300 basis points rate increase in recent weeks by Kenya’s central bank… policy tightening will slow the depreciation, but it will not halt it because weak exports, growing imports and a slowdown in financial inflows will weigh on the currency; as will US rate increase that is due in the short term,” said Ms Mhango.

The position is similar to that taken by other experts, including those at the World Bank office in Nairobi, who have said that the unit had accumulated overvaluation of 36 per cent between 2000 and 2013. With the recent weakening, the unit has however reduced some of the overvaluation.

“We believe ongoing monetary tightening will keep the Kenya shilling from hitting 120 units to the dollar. We thus revise our 2015 shilling forecast to 109 units to the dollar versus 100.7 to the dollar previously,” said Rencap.

The real exchange rate of a currency is determined by comparing the cost of equivalent goods across countries and adjusting for inflation.

READ: Kenyan shilling not too overvalued, says CBK insider

Kenya’s main trading partners, including East African countries, the EU, India and China have seen their currencies fare worse against the dollar over the past year.

A strong currency in real terms hinders the growth of the economy by discouraging local production of goods. It also encourages imports, which become cheaper.

This year, the shilling is down about 13 per cent to the dollar, with the pressure coming from the slump in tourism that has reduced dollar inflows, a wide current account deficit, and a globally stronger dollar that has come as a result of the recovery of the US economy and the expectation that the quantitative easing is to be wound down.

Economic analysts at CfC Stanbic bank also pointed out last month that the shilling is overvalued in real terms, cautioning that policy makers should not solely concern themselves with addressing the nominal exchange rate while ignoring the real or underlying exchange rate.

CfC regional head of macroeconomic research Phumelele Mbayo said that the shilling’s relative strength in real exchange rate terms makes it cheaper for Kenyans to import goods that could be produced locally.

“Considering that the underlying macroeconomic factors are stable, there is no need for concern over the nominal (one-on-one) exchange rate. The strong shilling in real terms on the other hand will eventually affect the growth ambitions of Kenya,” said Mr Mbayo.