It is no secret that the Kenya shilling has been tanking, nearing 106 to the US dollar last week. Bear in mind that this is not the lowest the shilling has ever reached; KES reach USD 107 in October 2011. However, conditions now are different and have informed the anxiety about the depreciation of the shilling. Not only does Kenyaâ€™s Current Account Deficit remain substantial, the country is racking up foreign denominated debt. As of March 2015, Kenyaâ€™s public debt stood at KES 2.5 trn, about KES1.3 trillion (52%) from domestic sources, with the remainder of KES1.2 trillion in foreign borrowing (48%). Yet total public debt is expected to go up to 2.9trn by end year. How much of this will be foreign denominated? This question becomes important when analysing the KES value issue as it adds to the problem of a scarcity of dollars.
The factors that are causing KES depreciation are numerous and include high liquidity in the market after the government released payments to state-linked entities and ministries, a strengthening of the US dollar, Kenya’s high current account deficit which has led to a scarcity of dollars, high imports, and poor tourism inflows the last of which is an important forex earner. Finally, foreign investors have been exiting the Nairobi Securities Exchange taking dollars along with them. So what can and what has the CBK been doing to address these pressures on the shilling?
Well firstly is the direct sale of foreign exchange. However, such a strategy is constrained by two factors. Firstly, Kenya is an import economy, thus by definition, forex is scarce. Yes, the government currently has Foreign Exchange reserves of about $6.4 billion as well as a precautionary facility from the IMF, but these options are limited. Not only must dollars be drained from the economy to may trade payments, lower exports and the poor performance of tourism add a further burden on the CBKâ€™s ability to throw dollars at the depreciation problem. Further, high dollar denominated debt means that the government has to start saving dollars in order to make the repayments that are maturing on this type of debt.
Secondly, the CBK can address the depreciation problem by fiddling with interest rates; and it has. CBK raised the Central Bank Rate (CBR) to 10.0 percent in June 2015 from 8.50 percent, which had been stable since May 2013. CBK then again raised CBR from 10% to 11.5% in July 2015. But there are several problems with raising interest rates to influence the performance of the shilling. Firstly, it often has the effect of slowing economic growth due to reduced investments and consumption. The conundrum here is that the performance of the Kenyan economy will be negatively affected by a hike on interest rates; yet the Treasuryâ€™s rosy growth projection of up to seven per cent this year was based on interest rates remaining stable at around the May 2013 levels. Remember that the Kenyan economy is already performing at the subpar level of 4.9% GDP growth in first quarter. Yet interest rates hikes make the prospects of the rates of future GDP growth even grimmer. However high GDP growth performance was based on lower interest rates, the very same lower interest rates government had hoped to rely on to generate the type of economic growth to generate funds that can be used to accumulate revenue as well as build up forex reserves. Thus the irony is that the interest rate increases CBK is using to try and control KES depreciation may constrain GDP growth and thus the governmentâ€™s ability to accumulate the funds needed to give it wiggle room in controlling interest rates in the future. Difficult conundrum indeed.
Finally, the CBK can reduce the amount of shillings in circulation to control KES depreciation. Indeed, the CBK has sought to drain excess liquidity from the market by offering Sh6 billion in repurchase agreements. But again the CBK is constrained, mainly by political considerations. It is well known that Kenya has a very high recurrent public expenditure bill and thus the government is in a situation where more KES are regularly being released into the market than had been the case for previous administrations, pushing KES liquidity in the market up at regular intervals. But there is no way, as of now, that that public expenditure bill will be reduced; such steps would be too politically acrimonious. Add to this the fact that Kenyan teachers just secured a pay increase. That hike, if calculated up to 2017, will be Sh99.8 billion incurred on teachersâ€™ pay alone. It is also likely that payments to police and other civil servants will rise; thus the public recurrent expenditure is on the rise. Sadly, governmentâ€™s options in creating the funds to make such payments possible will, again, affect governmentâ€™s ability to control the depreciation of the KES. How can government pay an ever increasing public expenditure? One by raising taxes which reduce investment and consumption and reduce GDP growth, or additional borrowing by government in domestic markets which crowds out private sector, or foreign borrowing which adds to the problem of additional foreign denominated debt. Thus here, again, CBKâ€™s impact in lowering KES circulation via draining excess liquidity is limited given all these political considerations. Indeed in addressing all these wage demands, government again will be put in the difficult position of very high liquidity in local markets, coupled with taking actions that may dampen GDP growth while also potentially accruing more foreign denominated debt. Again, a difficult conundrum indeed.
Given all these factors, it is clear that the CBK is in a very tight position with regard to the monetary policy options at its disposal to control the depreciation of the shilling. It will be interesting to see the action the CBK takes in coming months in addressing what is truly a difficult problem.
This article first appeared in my column with the Business Daily on September 13, 2015