Capital Markets

Debt spiral, import hold shilling hostage

The Central Bank of Kenya. FILE PHOTO | NMG
The Central Bank of Kenya. FILE PHOTO | NMG 

Many times, analysts have associated the volatility of the Kenyan shilling with the big gap between the values of the country’s imports and exports, the huge external debt as well as inflation. Even then, the extent to which these factors are linked to the movement in the value of the currency have been largely unknown.

Business Daily has unearthed the link with analysis of data stretching back to 10 years revealing that the import-export value gap and external debt have been more strongly linked with the volatility in the currency more than is the case for inflation.

That is to say that as the difference in the two rises, the shilling depreciates further by almost the same margin. In more technical terms, there is a positive correlation of 0.8 (which is nearly one-for-one change) between the increase in shilling depreciation and the current account deficit.

The gap is usually referred to current account deficit and is broadly defined as the sum of the balance of trade (exports minus imports), net factor income such as interest and dividends, and net transfer payments such as foreign aid.

As at end of April 2017 Kenya posted a current account deficit of $4.55 billion (Sh460 billion), showing that we are spending more on imports than the revenue we receive from exports causing the shilling to depreciate. This deficit has however been a constant feature of the Kenyan economy due to the limited export base.

One positive thing is that the deficit has fallen to single digits as a proportion of the national income from the double-digit levels in times of huge shilling volatility in 2015 and 2011.

The IMF has been warning countries of the risk of huge current account deficits noting it can lead to private financing withdrawing. The global money lender is normally called upon by countries experiencing financial distress especially in times of huge currency depreciation.

“(Big deficits) can be highly disruptive because private consumption, investment, and government expenditure must be curtailed abruptly when foreign financing is no longer available and, indeed, a country is forced to run large surpluses to repay in short order what it borrowed in the past.

This suggests that—regardless of why a country has a current account deficit (and even if the deficit reflects desirable underlying trends)—large and persistent deficits call for caution, lest a country experience an abrupt and painful reversal of financing,” the IMF research department says in one of its publications.

Early this year, the IMF noted that Kenya’s current account improved last year.

“The current account deficit has continued to narrow in 2016, with the 12-month current account deficit falling to 5.2 per cent of GDP in September (compared to a projected eight per cent for the year as a whole under the programme.”

The National Treasury promised to go easy on overall spending as part of reducing imports—given that the state is the largest importer - to keep the current account deficit stable.

“Continuing fiscal consolidation over the medium term to reduce the burden on monetary policy in demand management, maintain public debt sustainability, and support a reduction in the current account deficit while protecting high-priority public investment and social spending,” said National Treasury Secretary Henry Rotich in response to IMF review.

The other outcome of BD research is that the local unit weakness increases with the rise in external debt. The co-efficient of correlation between the two is 0.8, indicating that the two move nearly in lock step. From the data, Kenya’s foreign debt has been rising to stand at about Sh2 trillion, which is about half of the total public debt.

Servicing of external debt is done in US dollars and mostly by revenue from exports. A high level of external debt means more revenue from exports will be used to service the external debt.

“(IMF) staff urges the authorities to resolutely implement their fiscal strategy to maintain public debt sustainability and support inclusive growth,” warned the Kenyan government early this year. The link between the value of the currency and inflation is slightly weaker for inflation with the co-efficient at 0.7.

In relation to interest rates, the correlation is weak at only 0.3, meaning that a unit upward change in the rate only relates to 0.3 units of similar change in the value of the currency. That means that upward changes in interest rates have not affected the value of the currency in the past 10 years in any major way.

If this were to be applied to policy, it would mean that major actors in the economy would need to reduce imports and debt to reduce volatility of the currency. Given that government is the single largest spender or consumer in the economy, it would mean it reduces imports and public debt.

In recent years, the shilling has been weakest in September 2015 when it reached 106.15 units to the dollar and in October 2011 when it hit nearly 107 to the greenback. But 10 years ago, it was not even Sh70 to the dollar.

Political stability or instability, though difficult to measure, also affects currency as a country with a high risk of political turmoil is less attractive to foreign investors. As a result, limited foreign capital flows can lead to depreciation in the value of the currency.