Stabilising the shilling without risking reserves

The recent tightening of foreign exchange flows through forex bureaus such as the ones pictured, as part of counter-terrorism efforts, also comes into play in the shilling’s volatility. PHOTO | SULEIMAN MBATIAH |

What you need to know:

  • Record oil imports will intensify pressures on the shilling despite high diaspora remittances
  • Volatility of the local currency stems from the global financial crisis, worsened by the shilling’s turmoil domestically in 2011, insecurity and closing down of several forex bureaus. Recovery lies in avoiding excessive turbulence and minimising the negative impacts on investor opportunities and risks, write Dr Mbui Wagacha and Dr Eric Aligula

Three key factors determine a country’s exchange rate: the relative purchasing power of its currency; its investment opportunities and risks; and its demand for goods and services.

Against this background there is reason to ponder the recent depreciation of the Kenyan shilling. This year, it has shed approximately 5.1 per cent of its value against the US dollar, compared with annual declines of 4.8 per cent, 0.27 per cent, 1.1 per cent, 5.29 per cent, and 6.48 per cent for 2014, 2013, 2012, 2011 and 2010, respectively.

The current global exchange rate scene is rooted in the financial turbulence of 2007/2008, the management of the ensuing economic contractions (deflation), and the impacts of policy choices made in major economies to fight the great recession.

The US chose its policies wisely. It implemented expansionary but “unconventional” central banking policies combined with an expansionary fiscal stimulus to address financial stability and stimulate the economy by restoring private spending.

The policy mix cut interest rates to historic lows but caused capital “spillovers” abroad, especially in the so-called “carry trade”. The policy mix worked to reverse a plunging economy. It yielded a strong recovery and created or saved millions of jobs. The success has also strengthened the dollar and revived US interest rates.

The Eurozone imposed austerity — now recognised as a bad policy that deepened the recession in most of Europe. It avoided deficit spending, slashed spending and raised taxes in depressed economies looking to fiscal probity to boost confidence.

In some countries, notably Portugal, Ireland, Greece and Spain, this inflicted great suffering. Economic contractions, indebtedness and financial sector turmoil followed, risking a Eurozone breakup.

Real per capita GDP in 2015 is 10 per cent lower than expected, and below 2007 levels. Early this year, the zone adopted America’s policy-mix framework including quantitative easing. Unsurprisingly, in March 2015, business optimism had resumed.

The interim consequences of these policies include the massive and positive “spillovers” of capital to emerging economies in search of better returns. Kenya’s relatively attractive interest rates, earnings on equities, securities and bonds led to inflows, especially to the NSE. Over 2009-2015 this helped finance our current account deficits that averaged 13 per cent of GDP over 2010-2015.

Recovery in the major economies with rising interest rates has sparked dollar-led outflows of capital from emerging economies in a flight to quality. The NSE has shed some 429.6 million dollars on the foreign counter since the beginning of this year.

The recent volatility and depreciation of the shilling tracks this context of the financial crisis, worsened by the unusual turmoil the shilling experienced domestically in 2011 as well as the impact of Kenya’s security challenges in 2013, 2014 and 2015.

The recent tightening of foreign exchange flows through forex bureaus as part of counter-terrorism efforts also comes into play. Yet a deeper understanding of drivers of the shilling’s movement is essential in developing an appropriate policy framework.

A leading focus is the credibility of monetary policy to avoid excessive turbulence and volatility like that seen in 2011. In the 2009/10 budget Uhuru Kenyatta, as Deputy Prime Minister and Minister for Finance, provided resources for a much-needed stimulus to support demand and stronger output growth. The key objective was to return the economy to its Vision 2030 growth path. This spurred real GDP growth sharply: 0.2 per cent, 3.3 per cent and 8.4 per cent for 2008, 2009, and 2010, respectively.

Nevertheless, growth faltered, notably after 2011, when Central Bank of Kenya monetary authorities kept the CBR at an unrealistic 7 per cent and sent the shilling into a spin. The shilling is in practice a managed float. Policy should focus on minimising negative impacts on investor opportunities and risks.

Prior to the latest Monetary Policy Committee meeting on May 6, 2015, market sentiment expected stabilisation and a tightening stance to stem perceived renewed pressures on the shilling. Unexpectedly, the MPC retained the key Central Bank Rate (CBR) at 8.5 per cent and named it a tightening by virtue of CBK preparedness to use its reserves and IMF precautionary resources in monetary operations, rather than changing the key rate or using other instruments.

It argued that the weakening shilling was a result of seasonal demand related to earnings remittances to foreign investors.

Interestingly, the MPC hoped for a continued decline in the oil import bill to ease foreign exchange pressures on the shilling. Yet, Reuters was projecting record oil imports for Kenya — a third higher than in May 2014.

The 2015 volume of oil imports may reach four times the 2013 level. This will intensify pressures on the shilling despite diaspora remittances averaging $121.38 million a month in the first quarter of 2015.

Significantly, movements in the shilling need not yet trigger alarm. Depreciation against the dollar is not significantly repeated for other major currencies. The euro and the South African rand show stability or have depreciated against the shilling; the pound replicates the appreciation of the US dollar.

These observations suggest short-to medium-term lessons on the shilling if the pressure persists. By law, CBK is required to hold foreign reserves to cover a minimum of four months of imports.

This statutory position limits the degree to which CBK can rely on stabilisation by participating in the foreign exchange markets to influence the exchange rate.

Fortunately, studies at the Central Bank of Kenya and elsewhere show that prudent participation in the market does significantly cause successful directional changes.

So-called “leaning against the wind” — acting to slow or correct excessive trends in the exchange rate as the case may require — works.

A loose policy stance accompanied by foreign exchange “purchases” tends to depreciate the shilling while tight policy accompanied by sales results in appreciation.

To insulate the shilling, we must recognise that Kenya’s open capital account and a managed float do not eradicate opportunities for persisting speculative attacks. The monetary authorities have some options. They could let the shilling slide gradually instead of the unfettered use of reserves or recourse to borrowed money. Otherwise, curious speculators could test particular levels which could exhaust reserves and would be wasteful on valuation losses. Monetary authorities could also raise the key CBR interest rate to defeat the attackers while selecting other tools to ease interest rates for domestic investors.

Raising the tenor of outward remittances on short-term capital flows is also an option. Above all, confidence in the professional capabilities of CBK leadership is vital.

In a discussion titled, “From The Art of War to the Science of Economics”, in June 2013, Matt McCaffery likens military and economic strategy. When lacking infinite amounts of resources, it is wise to strategise and leverage markets to generate those goods and services we require without exhausting our limited resources. The lesson is that not all measures at CBK require overt interventions with reserves. Alternative and innovative policy choices and instruments work, as the major world economies clearly revealed after the 2007/08 turmoil.

Bearing in mind that the government’s principal concern is the maintenance of a stable macro-economic environment supportive of growth and job creation, the slide of the shilling presents a challenge to the extent it constrains the realisation of these goals, especially the cost of productive imports needed to spur growth. We see a number of interventions that would be prudent under the current circumstances.

PRE-EMPTIVE TRACKING

First, monetary authorities need to be more technically skilled and vigilant in monitoring trends in the economy. A prudent and pre-emptive tracking and reading of negative factors, including official as well as private short, medium and long-term flows and the volumes of exports financing imports, is critical. This to ensure CBK is able to respond in a timely manner, using appropriate instruments, for exchange rate predictability and stability. Monetary policy should smooth macroeconomic conditions and not adopt the stop-go approaches of 2011.

Second, let us leverage the advantage of declining imported fuel prices in a framework facilitating conservation of foreign exchange while diverting the windfall to productive effects in the economy.

A proposed sequence of measures would involve, inter alia, raising the fuel levy and creaming off the surplus to create a stabilisation fund. This would lower demand and conserve some of the sharply increasing forex uses on oil imports. The fund would be utilised, in turn for stabilising oil prices domestically, spurring investment for rapid improvements in public transport, and increasing access of agricultural produce to markets by expanding rural roads and inter-county transport networks.

Implementation of initiatives such as the Nairobi Mass Rapid Transit Programme should be hastened. These efforts would prop up GDP, fight food price inflation, reduce the demand for oil imports and reduce the cost of doing business all at once. Such a package of measures should be a focused effort with clear and tight timelines and results over a three-year period.

Third, our exports need rebuilding. The cover ratio, our exports’ ability to finance imports, had fallen from 43.3 per cent in 2010 to 33.2 per cent in 2014. Reworking our exports is critical. The development of bankable projects and leveraging them in the upcoming international meetings in Kenya to secure increased investment will be critical.

Finally, issues of macroeconomic stability should be escalated in dialogues with the counties to reduce pressures from external indebtedness, foreign exchange-absorbing travel and imports of goods and services that could negatively influence the value of the shilling without counterpart gains for Kenya.

The writers are senior economic adviser, and economic adviser, Executive Office of the President.