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 (top) and Dr Eric Aligula (bottom)

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.

Source: reelforge

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