Sinking feeling: The slide of the shilling and what not to do about it
The slide of the shilling is the subject of considerable debate and concern. Two of my professional colleagues, Dr Mbui Wagacha and Dr Eric Aligula, have recently weighed in on the debate (“Stabilising the shilling without risking reserves”, Sunday Nation, May 24).
The gentlemen signed off the article as Senior Economic Advisor and Economic Advisor, Executive Office of the President. The President’s advisor offering guidance on monetary policy is cause for concern. I will come back to this issue.
Beyond that, the article cannot be described as an exemplar of clarity. Granted, monetary economics is not a straightforward subject, but my colleagues could have done a better job of making it more palatable. I will try and do that. This in my view requires answers to two questions. First, what is the cause? Second, what should the government do about it?
What is the cause? A currency is a medium of exchange and an asset. Currency movements therefore have a trade and investment dimension.
EXPORT BANANAS
Let us say a bunch of bananas is USh1,000 in Uganda and the exchange rate is USh10/KSh1, which translates to KSh100 for a bunch of Uganda bananas. The price of a bunch of bananas in Kenya is KSh120. It is profitable to import bananas from Uganda. Suppose the price of bananas in Uganda goes up to USh1,200, while both the prices in Kenya and the exchange rate remains the same? It is no longer profitable for Uganda to export bananas to Kenya.
Uganda will only be able to export bananas to Kenya if its currency depreciates to USh12 /KSh1 so that KSh100 still buys a bunch of bananas in Kampala that can be sold in Nairobi for KSh120. If the price of bananas in Kampala reaches USh1,500 and the exchange rate remains at USh10/KSh1, the banana trade will turn the other way round since a bunch of bananas costing KSh120 in Nairobi will now fetch KSh150 in Kampala.
The principle here is that to maintain competitiveness, a country’s currency will adjust to the inflation difference between its rate of inflation and that of its trading partners.
Moving on to investment, suppose the interest on Kenya Treasury bonds is 10 per cent, while the return on US Treasuries is 2 per cent. An investor who expects the shilling/dollar exchange rate to remain the same over the year will see this as an opportunity to make $8 more for every $100 invested in Kenyan Treasury bonds than holding US Treasuries.
EXCHANGE RATE
Foreign money will flow into Kenyan Treasuries. This will have two effects, raising the price of bonds (which lowers the return) and strengthening the currency until the “excess” return on Kenyan treasuries is finished — “arbitraged” away in financial parlance.
This already points to a relationship between the exchange rate and interest rates. The principal here is that exchange rates adjust to the differential between domestic and global interest rates. High risk domestic interest rates relative to global interest rates will attract capital inflows and strengthen the shilling and vice versa.
Currencies are also assets which are traded in their own right. Suppose you had anticipated at the beginning of the year that the shilling would depreciate as it has from KSh90 to 98. You could have made yourself a 9 per cent return in five months by simply buying dollars and holding, which translates to a 21 per cent annual return.
CURRENCY MOVEMENT
The large scale speculative trading that drives currency markets is more sophisticated. A speculator who had the same prediction would have borrowed Sh90 million from the bank at 12 per cent interest, bought a million dollars, using the same dollars as collateral. She’d have sold the dollars for KSh9 million profit and paid interest of KSh4.5 million making a cool KSh3.5 million, which assuming a 10 per cent cash cover (called a “margin cover”) for the loan, works out to a 105 per cent annual return. Of course the shilling could have failed to depreciate or even strengthened in which case the speculator would have lost an equally tidy sum.
Two observations.
First, expectations of currency movements are self-fulfilling. Second, misaligned currencies are vulnerable to speculative attacks. The import of this is that currency prices are more volatile than is warranted by market fundamentals. If people anticipate the shilling will depreciate against the dollar, they rush to buy dollars, causing the shilling to “overshoot” the expected depreciation.
Which of these factors are responsible for weakening of the shilling?
LONG HAUL
First, over the long haul our rate of inflation is higher than our trading partners. We should expect the shilling to be weakening over time.
Second, the US economy is on the mend. The Federal Reserve’s (US Central Bank) quantitative easing (money printing) is winding down. There is anticipation that US interest rates will soon rise. In addition, petroleum prices have tumbled, there will not be as much “petrodollar” sloshing around the globe looking for yield. These two developments translate to expected returns moving against emerging markets currencies.
In our case, these developments are compounded by a weakening economy in general and of exports in particular. We have recently reported weak economic growth, well short of the 6.5 per cent promised to Eurobond investors. Key export earning sectors — manufacturing, tea and tourism — are struggling. Prospects for quick oil bounty have dimmed.
In the meantime, we’ve been stocking up expensive foreign currency debt like we have a winning lottery ticket in the pocket. The Eurobond alone has more than doubled our interest payments on foreign debt. It will not be lost to the market that some, perhaps most of this money is going into inflated projects of doubtful value.
BEARISH MARKET
It should not surprise if the market goes bearish on the shilling. The value of the shilling is analogous to the share price of a company. The shilling slide is telling us that the market has revised the prospects of Kenya Inc. downwards.
The next question is what the Government can do to stem the slide of the shilling. There are two types of interventions, monetary and structural.
I will first dispense with structural policies. Structural policies are those that would address the underlying drivers of inflation, turn around the weakening export sectors, and address lack of productivity growth in the economy. Although these are long term, evidence of credible strategies would of itself influence market sentiment. More prudent public investment would also help. It should be readily apparent that structural interventions are important in their own right; they ought to be pursued regardless of exchange rate movements.
Monetary policy offers two options, selling dollars and raising interest rates. Selling dollars only makes sense if the Central Bank is certain that the shilling fundamentals are sound and the slide is essentially excess volatility.
FUNDAMENTAL QUESTIONS
The interest rate option raises more fundamental questions. We claim to pursue an inflation targeting monetary policy regime. In an inflation targeting regime, the Government sets an inflation target and leaves the Central Bank to determine how to best to achieve it. The Central Bank in turn builds a monetary policy model. The model has two parts. One part forecasts inflation. The forecasting model may or may not include the exchange rate. The other part relates changes in interest rates to inflation.
Based on the model, the Central Bank establishes a policy rule. The rule says if inflation forecast is Y then we will adjust interest rates by X. This makes monetary policy transparent and predictable, meaning that given the same information set, different group of experts would in most cases arrive at the same decision. This is the essence of Central Bank independence.
The purpose of Central Bank independence is to insulate monetary policy from political objectives of the government of the day, such as stimulating the economy in the short run, or supporting the currency as the CBK is being pressured to do now. I should point out here that an inflation-targeting monetary regime relies on the flexibility of the exchange rate to absorb external shocks.
WEAKKENING SHILLING
This then brings us back to my beef with my colleagues Dr Wagacha and Dr Aligula. Given their stated positions as the President’s economic advisors, their foray into the subject of the weakening of the shilling was inappropriate. They propose for instance, that the CBK “could raise the key CBR interest rate to defeat the attackers while selecting other tools to ease interest rates for domestic investors.”
The President’s men are saying that in the event that raising interest rates becomes necessary, the Central Bank should find means of holding market rates down so that the regime does not become unpopular. They want to have their cake and eat it too.
This is precisely the sort of political meddling with monetary policy that Central Bank independence is meant to cure. We saw its consequences in the very hard landing of the economy in 2011 as a result of the Central Bank’s accommodation of the Economic Stimulus Programme during the current president’s tenure in Treasury.
STIMULUS PACKAGE
The President’s men are unsurprisingly all praise for the stimulus package. They instead attempt to pass the buck for the hard landing to the Central Bank for maintaining the Central Bank Rate (CBR) at an “unrealistic 7 per cent.” It’s unclear whether they think 7 per cent was too high or too low, but it does not matter because the prognosis is plain wrong.
It’s wrong because the CBR was and is still largely disconnected with the money market. While the CBR was at 7 per cent, the “real” money market rates — the interbank and 90 day Treasury Bill rates — were below 2.5 per cent for most of 2010 and early 2011. This was a perfect set up for a speculative attack on the shilling.
I do not mean to say that the President’s men should be gagged. As observed earlier, the Central Bank’s independence is limited to operation of monetary policy. The policy regime itself and the policy goals is the Government’s prerogative. If as it seems, the Government is inclined to a monetary policy regime that pursues multiple goals, it is in order for the President’s men to introduce such a debate. In the meantime, they should play by the rules.
David Ndii is managing director of Africa Economics [email protected]
