Why Central Bank had uphill task in stabilising the shilling
In a March closed-door meeting with fund managers on the decision by the Monetary Policy Committee to raise the central bank rate to six per cent, CBK governor Njuguna Ndung’u talked at length on why there was no need for worry over movements of the exchange rate since it is “an automatic stabiliser” to the economy.
Then, the shilling to dollar rate was at about Sh85, which was considered a significant depreciation because the exchange rate had hovered around Sh77-81 for the better of the previous 12 months.
The “automatic stabiliser” thesis derives from the observation that a currency tends to depreciate when a country increases imports, but when importers realise how expensive it is they begin to cut on goods that are not important.
Simultaneously, the weaker exchange rate encourages more exports which have a tendency to push a currency up.
In this manner, the current account deficit — showing more imports than exports — in the balance of payment is automatically corrected over time by the exchange rate itself without any active intervention by authorities.
Mark Mobius, executive chairman of Templeton Emerging Markets Group who was visiting Kenya recently, holds the same position.
Dr Mobius pointed out that any attempt to intervene, beyond the mere smoothening of temporary imbalances, is likely to cause more problems than it would solve as witnessed in Thailand when the country faced a currency crisis in mid 1997.
The Thailand crisis began with depreciation of the currency at which point the central bank decided to pump dollars into financial markets.
But savvy global speculators, mainly hedge funds, bought the entire amounts. The same crisis hit Argentina in 2001 to 2002 and speculators struck again causing the country to run out of forex.
These countries provide practical lessons and explain why Kenyan monetary authorities have been reluctant to engage in an all-out war through pumping money into the forex market.
“The central bank should do nothing about the currency unless it is merely smoothening short-term fluctuations in the market.
“People know how to adjust so the central bank shouldn’t do anything that amounts to intervention. You can get into trouble by attempting to control currency values,” said Dr Mobius.
This is to say that in the long run, the exchange rate will return to its equilibrium such that where the shilling depreciates, export demand rises while import demand declines due to high prices. It amounts to an automatic correction of the current account deficit.
Has there been any semblance of this automatic stabilisation in the Kenyan case during a year in which the shilling has depreciated by more than 20 per cent?
There is scanty evidence so far. The Kenya National Bureau of Statistics’ (KNBS) Leading Economic Indicators for August show that the total value of exports between June and July increased by 1.5 per cent while the value of imports declined by 1.3 per cent over the same period.
Prof Ndung’u said there was reduction in imports of goods intended for consumption but an increase in those intended for the productive sectors of the economy.
The point of contention was that the reduction in imports was minimal as the current account deficit remained high and had limited impact on the currency that is currently hovering at Sh95 to Sh96 to the dollar, far from the Sh81 level at the beginning of the year.
Apparently convinced that matters would settle, the CBK first hesitated to act strongly to tighten the Central Bank Rate (CBR) until the September data showed that prices had risen by 17.32 per cent — indicating that the weaker exchange rate had passed through to inflation.
The monetary authority drastically raised the CBR to 16.5 per cent in two consecutive sessions totalling 9.5 percentage points within one month.
Overall, CBK has tightened the rate by 1075 basis points (an equivalent of 10.75 percentage points) since March.
CBK also wanted to trade dollars directly with exporters and importers, bypassing banks — a policy pronouncement that never took off given the commitment to liberalisation of the exchange rate regime that has been in existence since 1994.
Not surprisingly, when the International Monetary Fund (IMF) came to Nairobi recently it insisted on a free-floating exchange rate regime.
This is something that is clearly stated in one of the articles of the Bretton Woods institution to which Kenya has subscribed and would not have wanted to appear to be flouting at a time it was desperate for the IMF’s hard currency.
The intention to bypass banks was not taken well by the industry.
One MP accused the government of letting Equity Bank buy dollars from the market using the cash it receives from government — apparently a reference to the SME, youth, and women’s funds that have been distributed by a number of banks and microfinance institutions including Equity. Analysts and dealers also began to tell stories of how chief executives were receiving letters from CBK warning them of dire consequences if their media comments were seen to be inflaming market sentiments.
This seemed to confirm the claim made in Parliament that Mr Ndung’u did not have a good working relationship with banks.
And yet the governor is a well-respected economist who spent most of his career as a researcher and academic. As an economist, with a doctorate from Sweden and original research work published in respected journals, Prof Ndung’u is considered one of the Kenya’s best economists.
In the practical world of central banking, however, Prof Ndung’u has made decisions that he would probably find unpalatable as a scholar in economics.
Such decisions include “criminalisation” of emergency borrowing where banks are now subjected to investigation and possible punitive action if they borrows more than twice in a week at the discount window. The decision has led to misalignment of short-term interest rates because it is now more expensive to borrow from another bank through the interbank market than from the central bank — which was not the case previously.
CBK’s attempt to trade in forex directly with importers and exporters has also been seen as a retreat into the era of foreign exchange controls.
Prof Ndung’u is on record for saying that some banks with foreign links had moved forex out of the country in order to cause scarcity and sink the value of the shilling.
Purchasing power
However, the governor did not name the banks. Even when Finance minister Uhuru Kenyatta was hard-pressed by Parliament to name the banks, he offered no concrete answers other than the excuse that CBK did not make the names available to Treasury.
Experts say that inflation is a major contributor to the depreciation of the shilling.
This is in line with the purchasing power parity principle, recently explained by economist Joy Kiru of the University of Nairobi.
The principle states that the exchange rate between one currency and another changes in order to equalise the domestic purchasing power of trading partners. This means that if the price level is high, as has been the case for Kenya, but is lower in trading partners — as is the case in European and North American countries that have experienced deflation — then the value of the domestic currency must fall in order for the two to be in equilibrium when trading takes place.
The fact that Kenya’s inflation stands at 18.91 per cent and the Eurozone one at three per cent means that the Kenyan currency has to depreciate against the Euro to bring about parity (or equilibrium) in prices since about a quarter of Kenya’s trade is with Europe.
A question was put to Prof Ndung’u during one of his press briefings on whether he thought fiscal policies (relating to government spending and taxation) were well synchronised with monetary policy to curb the turbulence in the currency market.
Treasury’s intervention
He responded, though a bit vaguely, that they were synchronised. However, he later dropped the stance stating that he had done his part and the remaining task required Treasury’s intervention.
“There are two forces pulling the shilling, supply and demand. We have done our part in managing the demand side by raising the cost of borrowing. The remaining part is for Treasury and other Government bodies that deal with fiscal policies,” said Prof Ndung’u at the height of the outcry for intervention in currency market.
The problems facing Kenya’s monetary authorities are not unique. In Uganda inflation stands at 30.5 per cent and its central bank rate is at 23 per cent.
In a report, JP Morgan lists South Africa, Kenya, and Uganda as among countries with the highest currency depreciation rates this year.
The Central Bank of Nigeria (CBN) was also been struggling with a weaker currency and rising interest rates. Despite the country’s huge oil exports, as at the end of October, the naira has lost six per cent of its value since June.
Nigeria has $32 billion worth of forex reserves, which is about seven months of import cover, but this is only half of the 2008 level ($62 billion), according to an analysis by Razia Khan, head of research at StanChart in London.
CBN noted that “there is, however, need for more fiscal prudence to safeguard the external reserves from further depletion.”
Fiscal prudence is an issue that appears to have been ignored for long. Only recently, Treasury attempted to address the matter by cutting spending during this financial year after realising the pressure it was putting on interest rates, the value of the shilling, and inflation.
Citigroup economist for Africa David Cowan has been categorical that Kenya’s currency problems relate mainly to the huge current account and fiscal deficit. Some economists, including those at the IMF, have pointed out that there has been high government spending and rapid expansion of credit from banks to households contributing to increased money supply. Cash injected into an economy, which is not matched by production, floats around thereby tending to raise overall demand which pushes up prices of goods.
The increased money supply has a tendency to reduce the value of the same currency. Some analysts argue that the expected deficit of Sh236 billion for this financial year (about 7.5 per cent of the gross domestic product) is above what would be prudent in a situation where aggregate demand appears adequate and there is no need for a fiscal stimulus.
Underlying this argument on excess aggregate demand is that this can only cause inflation which soared to 18.91 per cent in October. The 10-month annualised average inflation is 12.9 per cent, indicating that it will probably average the same for the entire year.
At an average of 13 per cent, fixed-income assets must attract a higher rate so that the real return is positive.
But Kenya is seen as having been slow to react to the changes taking place from an inflation and exchange rate point of view.
According to an analysis by JP Morgan, a comparison of the situation in Kenya with Nigeria shows that investors prefer the Nigerian case.
“We continue to favour Nigeria over Kenya given Nigeria’s stronger economic positioning and we highlight Kenya’s delayed policy actions,” said the JP Morgan report.
The same sentiments were expressed in a report by Citigroup. “Fortunately, some central banks are belatedly seeing the light and restoring tighter monetary policy,” the bank said in reference to Kenya and the recent tightening of CBR to 16.5 per cent.
Drastic measures
In a recent analysis, Dr Mbui Wagacha, a consultant economist and director at CBK, said it was necessary to take decisive action in the manner that Paul Volcker, a former US Federal Reserve chairman, did in the early 1980s.
Volcker’s drastic tightening of monetary policy and Treasury’s fiscal prudence led to low inflation and economic growth that lasted more than a decade.
Right now interest rates are so high that some banks have raised not only base rates, but also deposit rates are also on the rise.
Some banks are charging a base rate of as high as 25 per cent. But for investors focusing on fixed-income securities, it is boom time.
“The overriding thing driving the market is the rising interest rates. People are moving into the fixed-income market because returns are good and assured,” said Einstein Kihanda, an investment manager at ICEA Asset Management.
