Why CBK’s interest rate increase may not be so bad

Borrowers with variable rate debt groaned a collective disgruntled sigh at the Central Bank of Kenya’s action last week when it raised the benchmark interest rate to 10 per cent.

Debtors of all stripes seeking mortgage, automobile, business, or other financing all must pay more for any loan tied to CBK’s benchmark rate.

Further, university classrooms across the nation buzzed with student questions regarding the expected effects of the interest rate increase: why do central banks typically raise interest rates?

So in honour of lender cheers and borrower agony, let us postpone the Business Talk mini-series on job hunting and interviews to focus on CBK rates.

In unpretentious terms, central bank roles usually encompass four main functions, among many ancillary responsibilities.

First, governments usually task central banks to promote economic growth. Second, control inflation. Third, cultivate a robust banking sector. Fourth, foster a stable exchange rate.

When a central bank raises its benchmark interest rate, it often desires one or both of two of the above mentioned primary affects: lower inflation and strengthen the currency.

Since Kenya’s inflation rate does not alarmingly exceed historical levels at the moment, we investigate together two critical questions: should Kenyans feel overly concerned about the shilling’s depreciation and does the CBK rate increase help or hurt the situation?

Many Kenyans fear that the shilling may cross the psychological boundary of 100 units to the dollar like it did in 2011. The fact that our shilling fluctuated 13.2 per cent in its value against the US dollar during the previous 12 months with its strongest value at 87.38 and its weakest point hitting 98.92 bothers much of the population.

However, we first must investigate whether the shilling’s depreciation exists as an isolated event.

In fact, most of the world’s currencies depreciated against the dollar over the past 12 months. Kenya does not subsist as an outlier.

So if global currencies depreciate against the US dollar, why must we in Kenya feel scorn at the CBK and the government when the issue revolves more on the strength of America’s economic recovery rather than any problems here at home with our typical economic fundamentals?

The euro, Canadian dollar, the yen, British pound, as well as the Ugandan and Tanzanian shillings have all depreciated markedly against the US dollar over the past 12 months.

So, Kenya is not alone. The story is about the dollar, not really about the Kenyan shilling.

Kenya actually fared well as our currency appreciated against the euro, Canadian dollar, Japanese yen, Ugandan shilling and the Tanzanian shilling while coming in fairly even with the British pound.

Despite Kenya’s economic power at the moment as one of the top five growth economies in the world, the CBK clearly seems to understand the citizenry’s anxiety over exchange rates.

So in a move plausibly more for the psychological benefit of our citizens, CBK’s rate increase helps prevent, but certainly cannot stop on its own, the Kenyan shilling from reaching 100 units to the dollar.

As interest rates rise in Kenya, investors from East Africa and across the world desire to put their money here in order to earn higher returns on savings accounts, fixed term deposits, Treasury bills and bonds, among others.

When the world demands more goods, services, or accounts denominated in the Kenya shilling, then the value of our currency goes up. People demand more of the currency in order to buy shilling-based products.

When the Russian ruble depreciated dramatically as a result of the oil price drop and Western sanctions, its central bank nearly doubled its benchmark rate in December 2014 to 17 per cent.

The increase alongside gradually stabilising oil prices impacted positively on the ruble. So, the Central Bank of the Russian Federation succeeded in its goal and has since gradually lowered its interest rate, even again this week, and its benchmark rate now stands at 11.5 per cent.

However, sometimes central banks overreact to inflation or currency worries by raising rates too high for their respective markets.

In the three years preceding the global financial crash in 2008, the United States’ Federal Reserve Bank quickly increased benchmark interest rates over 500 per cent in order to curb inflation, but then rapidly dropped them to only 0.25 per cent in just six months to try to ward off the impending recession.

However, the action came too late. Combined with the high oil prices of early 2008, the high interest rates caused a 79 per cent surge in mortgage delinquency in less than 12 months and partially contributed to an economic collapse.

Conversely, central banks, like the Bank of Japan, try to lower interest rates in order to stimulate economic growth. Borrowers spend in stores and shop when they pay less on their loans. Higher disposable income boosts economic growth. Japan oscillated its monetary policy by holding its benchmark rate between 0 per cent and 0.5 per cent for the past 20 years.

While Kenya’s benchmark rate stands significantly higher than the less than three per cent found in many OECD countries, the rate stands in the middle of our continental brethren. Our 10 per cent rate is more than Botswana, Angola, DRC, Namibia, and South Africa, but we actually compare considerably better than Ghana, Malawi, Nigeria, and Uganda.

So why do investors put their money here when they could reap more returns from investing in Uganda or Nigeria? Kenya offers unparalleled regional economic stability.

Due to the perceptions about our financial steadiness, CBK is banking on investors flooding into the Kenyan market without us having to pay top continental rates on deposits and Treasury bills. One would then expect the Kenyan shilling to appreciate as more of our currency is demanded.

So, how did the market react over a week into the CBK’s rate increase? The currency appreciated slightly, though not dramatically, against the US dollar, Ugandan shilling, and Tanzanian shilling.

Unless the US economy continues to strengthen or if oil prices raise drastically, then the CBK’s move may keep the shilling from passing the 100 psychological mark against the US dollar.

Discuss how the interest rate increase may affect you personally with other Business Daily readers on Twitter through #KenyanEconomy.

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Prof Scott serves as the director of the New Economy Venture Accelerator (NEVA) at USIU’s Chandaria School of Business, www.ScottProfessor.com, and may be reached on: [email protected] or follow on Twitter: @ScottProfessor