Watching Arsene Wenger recently when Barcelona thrashed Arsenal 3-1, I sympathised with him... in his belief that his team was resilient and would overcome the shock and awe Barca displayed.

By Friday of last week, the Central Bank seemed to take the cue from Arsene by reassuring Kenyans that the shocks buffeting the shilling were “temporary side shocks but the fundamentals were okay.”

Unfortunately, Arsenal is out of the Champions League. For the Kenyan shilling, it is floating and has to continue receiving the battering in the forex market.

In recent weeks, the foreign exchange market has been very jittery driven both by domestic events and external events.

The Kenya shilling has lost 7 per cent of its value — depreciating from 80.57 in December to Ksh86 to the US dollar.

The market is looking for information to guide it. The Central Bank seems to be wobbling in its duty to steady the market.

Its messages to the market are creating more confusion instead of reassurance.

Nobody is calling for the Central Bank of Kenya to sell the little forex exchange reserves at its disposal to reverse the sharp depreciation of the shilling – its $5 billion is like a drop of water in the ocean.

What Kenyans want to see is a Central Bank using the instruments at its disposal to mitigate the sharp depreciation seen last week.

That is why it has a Monetary Policy Committee and a research department. To hear the Central Bank say it will do nothing reminded me of “going with the flow.” Only dead fish go with the flow.

What is happening?

There are several recent events that have made the foreign exchange market jittery. On the domestic front, the ICC decision on the “Ocampo six” has led to uncertainty on Kenya’s political climate.

Secondly, there were reports that drought in tea growing regions was affecting production which had already plummeted significantly.

Additionally, the meteorological department’s forecast that this year’s rainfall is likely to be inadequate created further uncertainly for market analysts.

Thirdly, inflation has steadily risen from 3.22 per cent in August last year to 6.54 per cent in February 2011.

Fourthly, that Kenya’s account deficit is wide is causing uncertainty on how it will be financed.

Lastly, the just released IMF board papers argue that Kenya’s debt levels, which now stand at about 50 per cent of GDP, ought to be reduced to 45 per cent by 2013, for macroeconomic stability and creating fiscal space for future growth.

On the foreign front, a number of events have created uncertainty. First, the turmoil in North Africa and the Middle East has caused uncertainly in the international oil market.

Prices have risen to over $100 per barrel. IMF World Economic Outlook forecasts for 2011 were $85.50 per barrel.

Oil imports constitute over 25 per cent of Kenya’s current account. To make it worse, the Energy Regulatory Commission has steadily adjusted prices of oil upwards to Ksh102 ($1.19) per litre for unleaded petrol In March 2011.

Secondly, given the difficulty Africa’s investors are facing withdrawing their portfolio on the Egyptian money and capital market due to the political turmoil there, and Kenya’s being among the few markets on the continent with an open capital account, foreign investors are liquidating their positions on the Nairobi Stock Exchange to cater for the increased demand for the US dollar.

The NSE has lost 446 points since January 2011 — about 10 per cent.

There are speculations both on the domestic and international markets. There is nothing wrong with speculation.

Forex dealers are in the market to trade and speculate. That is how they make money. When you buy a stock on the NSE, you speculate that it will make capital gains or at worst you will receive dividends by holding that share.

It is not a bad thing to speculate. Secondly, If one is saving to import a Toyota from Japan in two months, instead of holding and waiting for two months to convert your savings into forex, you will prefer to buy the dollar at 80 rather than at 85.

With the knowledge that the shilling will depreciate, one is better off buying the dollar now rather than wait when it value sinks further.

Importers seem to have decided to hold to their dollars for their near term imports. This is a rational decision.

These are the fundamentals which are causing jitters on the foreign exchange market.

The problem is that the CBK has refused to acknowledge the facts and has instead dismissed them as short term in nature or supply side shocks. The ground is changing very fast below the CBK’s feet.

Previous policy response

Credit must be given to the Central Bank for maintaining that it will not intervene in the forex market by selling its forex reserves which now stand at just over $5 billion to support the shilling.

This amount is small change for forex market. It should be remembered that when the CBK tried to support the shilling in October 2008 by injecting $100 million, it turned out to be a laughable joke.

It had no impact on the shilling. Its value to the dollar continued dropping from Ksh62 to just over Ksh80.

Forex reserves dwindled to below four months of import cover. The CBK cannot allow itself to repeat that mistake. It will be a butt of all jokes if it succumbed to that pressure.

The CBK however, has instruments at its disposal that can mitigate the free-fall of the shilling. But before we go into that, the background to this argument will be helpful.

The policy response to the global financial crisis of 2008 was both monetary and fiscal.

Treasury implemented the Economic stimulus Programme (ESP) while the Central Bank implemented an accommodative monetary policy.

Under ESP, the government borrowed more domestically and front loaded its borrowing programme.

By February 2010, CBK had already met almost 90 per cent of the 2009/10 borrowing target. For continuity purposes, the remaining 10 per cent was spread across four months.

At a time when the market was liquid, what the CBK was offering for auction could not satisfy the market appetite from March 2009 to June 2010.

The end result of this is that interest rate on Treasury- Bills and T-Bonds fell drastically.

This was a win for treasury because it was able to finance the ESP by borrowing domestically with interest rates below inflation levels.

On the monetary policy front, the Monetary Policy Committee complimented the Treasury fiscal policy by gradually reducing the CBK from 9.75 per cent in November 2008 to 5.75 per cent in January 2011.

The reduction in CBR coordinated movements in the short term rates (the Repo and interbank market) and the rates in government securities.

Though it is important to have in mind that interest rates on Treasury-Bills and T-Bonds reflect government appetite on funds and nothing else (not even monetary policy).

Putting these together, the policies implemented since 2008 to cushion Kenya from the quadruple shocks in that year (political, oil, drought and the global financial crisis) allowed Kenya to wither them and GDP growth increased from 1.6 per cent in 2008 to an estimated 5 per cent in 2010.

Even though, CBK’s primary mandate is price stability. Its main pre-occupation since 2008 was on supporting economic growth which is its secondary objective.

That was the correct decision since inflation was falling and was below the 5 per cent target. As such, inflation was not an issue for policy.

Changing environment

The economic environment has since changed and the Central Bank has to do things differently. Inflation is on an upward trajectory, current account deficit is at 6 per cent of GDP and increasing.

Prices of oil imports that constitute 25 per cent of the current account have hit over $100 per barrel.

The supply side of foreign exchange are threatened by drought in tea growing areas and higher air fares as a result of increasing oil prices, meaning tourism will also be affected this year.

The argument that a depreciated Kenya shilling is good for exports is tenuous since 50 per cent of Kenyan exports to the Comesa region currencies have depreciated even more.

This means the depreciation dividend for Kenyan exports in the region will be nil if not negative (we sell our goods in Uganda, Tanzania and elsewhere outside Kenya in US dollars not in Kenyan shillings).

Kenyan goods have become more expensive in Uganda and Tanzania. The exports to the rest of the world are mainly in Coffee, tea and horticulture.

Will Kenyan farmers start growing more coffee and tea now so as to benefit from the weaker shilling?

I doubt it. Of course they will get more shillings for the volume they have now. The biggest benefactors will be those in the horticultural sector as they can quickly turn around their produce.

Supply side shocks

It is true that the monetary policy does not amend itself neatly with supply side shocks.

But let us face it, the supply side shocks caused by drought or some thugs blocking roads to the markets in Nairobi and other cities are different from those caused by political uprising in the Middle East and North Africa and thus need to be treated differently.

Temporary shock

It is true that the shocks are truly temporary and may be short run in nature. But how short is short run? Monetary policy has an impact in the short run and neutral in the long run.

Increasing interest rates now will choke economic growth. It is true that higher interest rate is deleterious to economic growth. However, that is not what analysts are saying.

Commercial banks have long argued that they have long term contracts with borrowers and they have always called for more time to adjust lending rates to movements in CBR.

In addition, the interest rate relevant for exchange rate is not the commercial bank lending rate but rather it is the rates on government securities which tends to attract foreign capital.

What CBK can do

The central bank needs to prioritise its objectives. The CBK statute identifies price stability as the primary objective.

Keeping inflation low should be its focus. Nobody would ever credit the CBK for making Kenya grow. That is the role of Treasury.

Secondly, the CBK has a very strong research department which can inform the MPC rate and the extent of exchange rate pass through to domestic prices.

That work needs to be done and if it is available it should be shared so that the public can do its own analysis based on the research output.

Thirdly, economic analysis argues that when a currency depreciates, interest rates will have to increase to ease pressure on the exchange rate.

A volatile exchange rate can be a source of broader economic volatility.

Moreover, a stable rate makes it easier for household and businesses to engage the rest of the world and plan for the future.

The current system where the Central Bank of Kenya is stifling interest rates on domestic financial assets from rising is similar to capital controls.

With a weak shilling, domestic assets (read government securities) have become cheaper to international investors but they are unattractive because the central bank refused to let the lid off the pressure cooker (the interest rate on government securities). The central bank cannot have its cake and eat it.

Fourthly, if the rumours are true that analytical work at the CBK research department had forecast higher inflation as early as November 2010 and MPC had taken no action, that would be a scandal of enormous proportions.

The independence of CBK requires that it listens to its own internal research.

Fifthly, there might be sympathies with the fact that CBK needs to wait for signs of second round effects before taking actions.

Wage negotiations incorporating higher inflation expectations would be good signals. Those are good theoretical arguments.

The counter arguments are there for all to see. It costs more to transport goods to Nairobi from the hinterland now than in December last year; Kenyans are paying more for their matatu fare today than they did then.

Civil servants and teachers want more pay now than they were receiving last year.

What other second round effects are economists at the CBK looking for?

With a large informal economy and high unemployment, what wage negotiations is one waiting to see?

Lastly, doing nothing is not what technocrats at the CBK are employed to do.

They should learn to be humble enough to assure Kenyans that the CBK will do everything possible within its power to ensure that the best policy will be taken to solve its worries.

That includes giving it a placebo.

Mureithi Muruiki is a practising economist.