Kenya needs vibrant foreign exchange market that limits CBK interventions

The currency debate is inviting any other day and that is why in the recent past analysts and policy mandarins have been tackling what the weakening Kenyan Shilling means for the economy.

The other day an article by Abdillahi Abdirahman in the Business Daily on April 5, 2011 titled “How Poor Policy has led to weakening of the Kenya Shilling”, caught my attention.

It should not go unchallenged.

The author blames the Central Bank of Kenya’s (CBK) “poor” policies for the weakened shilling.

Apparently, he is faulting three policy positions: the low reserve levels; the expansionary monetary policy (which he calls a loose monetary policy) and the CBK’s non interventionist policy in the forex market.

Before we look more closely into each, I wish to point out certain key points that could have been confused.

The title gives the impression that the author’s position is that a weak shilling is bad but ends up saying he “prefers any measures that help our exports at the expense of imports”.

That is what a weak Shilling does. It makes exports more attractive and imports more expensive.

Common misconception

The monetary policies mentioned — expansionary monetary policy and non-interventionist policies — lead to appreciation of the exchange rates, not depreciation.

Because the author dwelt on why the currency should not be allowed to appreciate so much, let me digress and discuss a common misconception that appreciation is always bad.

A strong Shilling makes imports cheaper and therefore may lead to reduced costs of production depending on the composition of domestic production input matrix.

If imported input costs constitute the bigger proportion of the total input cost then cheaper imports will lead to reduced cost of production, which may in turn lead to higher exports.

This is because exports will now be cheaper internationally due to reduced production cost.

Think about a case where oil prices were to come down by half, what would that do to the competitiveness of our exports?

And is it not imports that constitute a bigger share of Kenya’s production input basket?

Back to the three policies being faulted. From the CBK Weekly Bulletin of March 25, 2011, the usable official foreign exchange reserves held by the Central Bank stood at US dollar 3,935 million (equivalent to 3.90 months of imports) as at March 24, 2011.

This is the highest level in terms of months’ worth of import cover since March, 2008.

This means two things: that the CBK has been building up the reserve level after the 2007/2008 crisis and if you were to buy the author’s argument that low reserves caused the Shilling to be weak, you would expect that between March 2008 and August 2008 when Kenya’s import cover was lowest, the exchange rate to the dollar would be weakest.

But the rates were strongest in this period peaking at 61.89 in May 2008.

This means that it is not entirely the import cover that is depreciating the exchange rates.

The exchange rates may weaken when the cover is low because the speculators know that the monetary authority has no ability to intervene.

Before we drastically push import cover to six months, it is important to reflect why the cover reduced in the first place and whether it would have been prudent to increase it in the face of the menacing Global Financial Crisis (GFC), post-election shock and severe drought in the late 2007 and early 2008.

During that period, capital flows including donor flows reduced as donor countries implemented stimulus packages in their own countries.

With reduced inflows, reserves reduced. The only option the CBK had was to replenish it by purchasing foreign currency in the domestic market, which would have wreaked further havoc on exchange rates since no inflows were coming in.

This would have had more serious implications than just running the reserves down.

Now having reduced and the 2007/2008 shocks behind us, can CBK build it up it overnight? No, because that would also hurt exchange rates.

This is a floating market meaning the gradual replenishment of the reserves is a better policy.

The author also argues that an expansionary monetary policy aggravated trade deficits by encouraging consumption of second hand imports.

An expansionary monetary policy has the effect of reducing the cost of loanable funds (interest rates).

This will increase investments and production including the production of exportable goods.

While some small borrowers may use the loans to buy imports, a good portion of this segment of the market use the loans for investments in buying a matatu, building residential houses, expanding their small businesses and so on.

At the end, majority of the small borrowers use the loans to create jobs and wealth increasing output while the bigger producers use the loans to increase their export capacity.

Another perspective to look at the effect of a loose monetary policy is through international flows.

The reduction in the domestic rates resulting from a loose policy will reduce capital inflows.

When this happens, the exchange rates will depreciate making exports more attractive than imports.

If you follow this argument, it then implies that a loose monetary policy is in fact good for exports and bad for imports.

The challenge

Asking the CBK to intervene in the forex market is also a mixed-up.

The CBK can intervene in the short-run to smoothen out temporary shocks in the economy (except for temporary speculative attacks) but this intervention must not be a long term monetary policy.

The challenge is for the market players to develop a vibrant future foreign exchange market in Kenya to avoid over-reliance on the spot rate and not to intervene.

With a floating exchange rate regime, an open capital account and an independent monetary policy, the CBK cannot successfully intervene in the forex market in the long term without breaking down monetary policy.

If it does, an independent monetary policy will be no more.

Dr Oduor is an economics lecturer at Kenyatta University and expert on Monetary Policy at Kippra.