There has been a growing debate in the media regarding the exchange rate and the performance of the Kenyan shilling. Discussions on this topic have centred on the recent weakening of the shilling suggesting that this is bad for the economy.
Some of these discussions have implied that the Shilling should always strengthen.
This perception requires to be clarified so that the market is not misled by some commentators focusing, indirectly, on their portfolio returns where the exchange rate plays a vital role.
A competitive exchange rate ensures that the interests of both exporters and importers are balanced. In this regard, movements in the exchange rate serve to correct any imbalances in the market.
CBK policy to exchange rate?
The proper context of this discussion must be premised on the understanding of the CBK’s mandate of overall price stability and within the framework of a floating exchange rate regime and a liberalised capital account.
This policy setting means that the exchange rate adjusts — it weakens or strengthens — in line with economic factors including trade, production and investment in the economy.
The CBK therefore provides the policy environment for the exchange rate and does not target a particular level or direction of change of the exchange rate.
It participates in the foreign exchange market as and when it is necessary to stem excessive volatility emanating from external shocks, or to cover a short-term shortage of foreign exchange liquidity in the market, or to effect government external payments obligations, and when it is building its foreign exchange reserves to improve the months of import cover position.
The Central Bank’s participation in the market is therefore not aimed at defending a particular level or direction of change of the exchange rate.
Moreover, whenever the Monetary Policy Committee (MPC) holds its bi-monthly meetings, it considers development in the exchange rate market among other factors when deciding on the monetary policy stance to be adopted to deliver its price stability objective as well as macroeconomic stability.
To put this matter in a different context, the financial market in Kenya currently transacts between $350 and $500 million a day that translates to between $12 and $15 billion a month. The Central Bank endeavours to keep foreign exchange reserves equivalent to four months of import cover, currently slightly over $4 billion.
This therefore means that were the CBK to intervene in an attempt to hold the exchange rate at a particular level or move it towards a certain direction, its holdings of reserves would not last even for a week.
There is a negative implication when the Kenya Shilling depreciates as it implies a higher cost of financing imports. However, there is also a positive side to a weak shilling as it means lower foreign prices for our exports; this increases the country’s competitiveness in the world market, which improves our balance of trade position.
Further, a weak shilling promotes domestic investments that create employment and also discourages final consumption of luxury imports. All these are necessary to improve the current account balance and support economic growth.
For instance, in 2011, there was a large current account deficit of about 11 per cent of GDP; the exchange rate had to depreciate significantly to correct for this imbalance in the economy.
However, for a small, open developing economy like Kenya that has a huge oil import bill, a protracted weakening of the shilling may eventually cause inflationary pressures through knock-on effects on energy prices via consumption and production processes, although this is not the case now.
A strong Kenya shilling reduces the competitiveness of our exports, which could dampen economic growth. Kenyan exports become expensive abroad and imports become cheaper, thereby discouraging domestic competitive industries as the share of foreign goods in our domestic market increases.
Furthermore, a strong shilling can discourage domestic investments as the cost of domestic borrowing is implicitly high, which in turn impacts negatively on economic growth and employment.
An appreciating currency is like a tax hike, which increases the burden on manufacturers of domestic goods while making imports cheaper domestically. This can lead to a recession as excess capacity can trigger layoffs.
As the economy goes into a recession there would be a weak effective demand and the National Treasury would collect less tax revenue, which would undermine the activities of the government.
What then is the desirable rate of exchange of the Shilling to the US dollar?
From a broader perspective, depreciation or appreciation of a currency is an adjustment process in response to the underlying fundamentals.
Economists generally agree that a desirable exchange rate should be at a level that makes our export of goods and services competitive in the world market.
A large proportion of the discussion on the exchange rate in the media has been at the level of discovering if the currency is misaligned — that is whether it is overvalued or undervalued.
A recent analysis by the MPC over the years has shown that the exchange rate is never misaligned beyond a range of about five per cent and so we expect the exchange rate will move to correct any imbalances in the long run.
The Kenyan economy is likely to pick up well given the public investments made so far, the private sector investment response.
But there are several threats. The food supply situation influences inflation in the short run. But this may be diminished with the short rains in September.
Fuel prices are always a concern; so far they are stable. The Egyptian crisis and its impact on tea exports is providing a challenge for dollar flows in the tea sector.
But there is a lot of optimism and public investment to open up production potential and reduce transactions costs — cost of doing business. This will spur private investment.
Increasing investment opportunities will support a reduction of lending rates. The planned Eurobond will add to this optimism as it finances further public investments to spur domestic production and growth capacity and potential. This is what we expect by the end of this year given the above caveats.
Prof Ndung’u is the Governor of the Central Bank of Kenya.