Weak shilling sends CBK back to the drawing board

The Central Bank of Kenya’s monetary policy committee (MPC) has announced plans to hold its fourth meeting in as many months as it grapples with continued depreciation of the shilling after last week’s action.

The calling of yet another unscheduled MPC meeting is seen to reflect the CBK’s concern at the possible effect of the shilling’s depreciation on inflation, which climbed to 7.3 per cent in June from 6.9 per cent in May largely on account of a weakening currency.

“Inflation rate is a policy target of the CBK set at a range of five per cent plus or minus 2.5 percentage points, unlike the exchange rate which is not a policy target,” a senior treasury official at a local commercial bank said of the decision to call the meeting.

“Monetary policy manoeuvres have a limitation as a tool to control the exchange rate. There is a fiscal policy side to it as well that might require us to reduce public spending, and maybe introduce taxation measures, however unpopular, to reduce the appetite for imported goods.”

Persistent turbulence in the forex market is seen to be a signal that the shilling’s weakness cannot be tackled using monetary actions alone but needs to be backed by fiscal policy actions targeting the underlying causes of the shilling’s depreciation.

Kenya’s current account deficit (import-export gap) has grown to nearly 10 per cent of GDP, and in nominal terms stood at Sh101.5 billion at the end of the first quarter of the year, increasing the shilling’s exposure.

READ: Steep price rises loom as shilling defies CBK action

The deficit has rapidly expanded in the past couple of years as Kenya increased its intake of capital goods to develop infrastructure and households increased their appetite for imported consumer goods.

Standard Chartered head of research for Africa Razia Khan said there are concerns that pass-through from a weaker forex rate may increase inflationary pressure in the coming months.

“This is despite the CBK reiterating its healthy level of forex reserves (at $6.62 billion or 4.2 months of import cover) backed by a precautionary financing facility from the International Monetary Fund to calm market sentiment,” said Ms Khan. 

Kenya is required to maintain at least four months of import cover but recent interventions in support of the shilling, repayments of foreign debt and exchange rate revaluations have seen the reserves drop from $7.51 billion (4.9 months cover) at the beginning of the year to 4.2 months cover.

A further drop in reserves may force the country to make the first drawdown of the IMF precautionary facility.

August may, however, be too soon for the CBK to increase the policy rate (CBR), given the need to allow for the pass-through of the June and July increments.

Some market watchers reckon that the mismatch between yields on government securities and interest rates is part of the problem.

There has been a realisation that government securities yields were behind the market curve, and that the rates on the Treasury bills should have been allowed to go up in tandem with the CBR to attract foreign investor inflows.

Dealers have indicated that investors are looking at yields of at least 13 per cent on the one-year T-Bills, whose latest auction stood at 11.1 per cent. 

The Treasury is, however, selling a five-year bond that seeks to raise Sh15 billion at a fixed rate of 13.19 per cent.

The primary securities auctions are seen as an important tool of mopping up liquidity in the market and at the same time bringing in much-needed foreign exchange, thus boosting the shilling against the dollar.

The MPC, which usually meets once every two months, hit the market with a surprise 150 basis points CBR increase to 11.5 per cent during its last meeting held on July 7, while at the same time raising the cost of loans by reviewing the Kenya Banks Reference Rate (KBRR) to 9.87 per cent from 8.54 per cent.

This followed the 150 basis points increase in June that pushed the policy rate to 10 per cent, the first time in more than two years that the MPC changed the benchmark rate.

The committee — which is chaired by CBK governor Patrick Njoroge — expressed concern over the prevailing inflation, and said that the need to anchor inflationary expectations was the main driver of the interest rate increase.

“The committee noted elevated risks to the inflation outlook mainly attributed to the pressures on the exchange rate over the past few months. The market perceptions survey of June 2015 showed that private sector firms expected inflation to rise mainly on account of pass-through effects of past exchange rate movements and increases in fuel prices,” said the MPC.

In particular, the committee noted the need to closely monitor liquidity conditions in the market, in turn putting in place a new three-day repo, which will augment liquidity mop-up efforts in the money market.

The CBK has been employing various tools to manage exchange rate volatility, including near constant liquidity mop-ups and occasional direct sales of dollars to the market.

The bank sold a substantial amount of dollars in consecutive trading sessions (Monday and Tuesday) to stem volatility in the currency exchange rate after the shilling hit a new trading low of 103.85 to the dollar.

The dollar sales helped firm up the currency back to 102.10/20 levels by Tuesday afternoon, although with underlying fundamentals remaining unchanged there remains an expectation in the market that further weakening is on the way.