Why you should care about forex reserves


Former Central Bank of Kenya Governor Patrick Njoroge on December 1, 2022. PHOTO | LUCY WANJIRU | NMG

The erosion of Kenya’s official forex reserves below the statutory threshold of an equivalent four months of import cover has heightened concerns over the country’s weakening buffer in the event of external shocks.

The depletion has left the Kenyan shilling exposed to further depreciation after reserves last week fell to their lowest level in nearly a decade to stand at Sh870 billion ($6.939 billion).

This can now just cover 3.88 months’ worth of Kenya’s imports before a crisis.

But why do forex reserves matter? Below are answers to what would be frequently asked questions on the reserves held at the Central Bank of Kenya (CBK).

What are forex reserves?

Reserves describe a store of foreign currencies held by the CBK which may be in the form of banknotes, deposits, bonds, Treasury Bills and other government securities.

The assets are in any other currency other than own/home unit implying that Kenya would not hold shilling-denominated currency in its reserves.

The reserves are, however, primarily held in US dollars, which serves as the world’s reserve currency given its hold as the most traded currency in the world.

What role do the reserves play?

According to the CBK, forex reserves are a safeguard which ensures the availability of foreign exchange to meet the country’s external obligations including foreign debt payments and imports with the primary requirement in managing the reserves being capital preservation.

How much in reserves is enough?

While there is no upper limit on forex reserves, the CBK Act requires the lender of last resort to maintain official foreign exchange reserves equivalent to the value of four months’ imports and manage them.

CBK reserves management policy cover safety, liquidity and maximisation of total returns. The bank invests the reserves to earn ‘reasonable’ returns while maintaining adequate liquidity.

What happens when the reserves fall below the four months’ import cover?

CBK Governor, Dr Patrick Njoroge, says the erosion of reserves does not necessarily trigger an event or crisis even as the bank works to replenish the cover.

Nevertheless, the erosion of the reserves is a psychological significance given that the size of official reserves signals confidence to potential investors in the country, action by ratings agencies and foreigners considering withdrawing their capital from the country.

Analysts for instance have stated the depletion of reserves would lower investor confidence in the country’s ability to meet unforeseen external shocks including a spike in external debt service or volatility in the local currency.

Why have the reserves fallen below the lower limit now?

Depletion of the reserves has to be understood largely from how the cover is funded in the first place. For instance, disbursements from external borrowing are a significant contributor to the forex reserves.

With Kenya having been largely locked out from accessing the international capital markets in 2022 which could have seen issuances of instruments such as the Eurobond or syndicated loans, the country thereby saw constrained inflows of hard currency narrowing the inlet to fund reserves.

Equally, the sharp rise in interest rates across the year led to bloated external debt repayments further thinning the forex reserves which had stood at a record high in mid-2021.

The combination of reduced hard currency inflows mainly from external debt funding and greater outflows from external debt service has therefore left thinner reserves.

How can the CBK rebuild the reserves?

The low-hanging fruit for the CBK in rebuilding the reserves is through Kenya’s renewed access to foreign financing.

The government has already set the wheels for Kenya’s return into the international capital markets in motion by planning the issuance of Sh112.8 million ($900 million) syndicated loan by June this year.

The syndicated loan is expected to be complemented by programmed loans from the International Monetary Fund and the World Bank, with the latter for instance set to disburse a Sh94 billion ($750 million) loan to Kenya by June.

The CBK usually receives monies from foreign funding in its accounts after which it keeps the hard currency before wiring to the exchequer, the equivalent financing in local currency.

Forex reserves have previously seen a lift-off from fresh external financing disbursements.

Alternatively, CBK can influence flow of foreign currency into the country through monetary policy, in particular, additional tightening of monetary policy which would incentivize new investments by foreigners who would bring with them hard currency.

Monetary policy tightening is nevertheless a double-edged sword as it would also have the effect of raising yields on government security instruments resulting in higher debt service costs which would take away from CBK’s function of prudent reserves management.

Does the value of the shilling relate to the level of reserves?

According to the CBK, Kenya currently pursues a free-floating exchange rate system implying no predetermined rate at which the shilling exchanges with other currencies nor a direct link to instruments such as forex reserves.

However, the CBK deploys reserves by selling hard currency from its holdings to even out extreme or undesirable fluctuations in the local exchange rate including upsurges in demand and supply.

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