Is the shilling overvalued against the dollar?

The shilling on Friday touched a low of 97.35 against the dollar, a sign the local currency could be headed for the worst drop in three-and-a-half years.

Analysts say the local unit could come under more pressure in coming days as importers buy more of the US currency in anticipation of end-month demand. Some analysts see the shilling likely crossing 100 mark against the dollar.

“The shilling still has room to weaken further,” Bobby Otieno, Ecobank Kenya’s country treasurer, said. But this time round, he added, the shilling is not expected to hit the 2011 levels of 107 units to the dollar.

Mohamed Wehliye, a senior vice president at Saudi Arabia’s Riyadh Bank, said the country’s widening current account deficit would adversely impact the value of shilling, with the local currency likely being dumped by foreign investors in the wake of a weakening trade balance, slowing economic growth and security concerns.

“It’s quite possible the shilling could tumble further in coming months, given the numerous risks surrounding the economy. But I don’t think it will hit the 107 low of 2011,” Mr Wehliye said.

Bridging the gap

But it would be important to understand some underlying factors in the currency markets that have hit the shilling.

Kenya runs a big current account deficit, which inflows into the capital account — money from foreigners investing in Kenya, including direct and portfolio investments — helps compensate for.

The current account deficit measures the difference between the value of goods and services a country imports and the value of goods and services it exports.

In recent times, this deficit has widened and capital flows have not bridged the gap. As a result, demand for dollars is high, yet the supply remains low — this means that it now takes more shillings to buy the US currency. As per the laws of economics, if the demand for dollars in a country exceeds its supply, then the currency’s worth increases.

“It may be that importers are the major entities in need of the dollar for making their payments, or seasonal factors like corporates paying dividends to foreign investors,” said Wehliye.

He added that there are also signs foreign institutional investors are withdrawing their investments in the country and taking them elsewhere, creating a shortfall in dollar supply.

Further, the worth of the dollar has increased globally, which is another major reason for the shilling’s recent depreciation.

The US Federal Reserve has hinted it will start raising short-term interest rates before the end of the year, a move that has begun to draw investors looking for good returns in a low-risk market back to the US.

Speculative demand

A stronger dollar automatically means all currencies start taking a hit, the shilling included.

Two weeks ago, Central Bank of Kenya Deputy Governor Haron Sirima hinted that the troubles facing the shilling might be due to speculative activity and not fundamentals.

“Kenya’s central bank has seen some speculation on the shilling and will scale up its open market operations to stem market volatility,” Dr Sirima said.

To calm the market, he hinted that CBK may use an International Monetary Fund credit facility.

However, Mr Otieno does not believe the shilling is under speculative attack by currency dealers.

“To the best of my knowledge, there has been no manipulation of the shilling at all,” he said

Otieno’s sentiments were echoed by investment analyst Aly-Khan Satchu, who said: “I do not think it’s a cynical case of manipulation.”

Although it is normally hard to detect currency speculation, analysts say normal corporate demand for the dollar could be used by commercial banks to create speculative demand for the greenback in offshore markets, which can weaken the shilling.

While CBK cannot influence speculative demand easily, it can contain corporate demand for dollars within the country by having commercial banks meet their needs locally instead of in offshore markets.

When corporate demand for the US currency is covered offshore, speculators can use the opportunity to buy more dollars, which weakens the shilling.

“You need to make sure corporates’ commercial-related foreign exchange requirements are met by the local banking system without resorting to the offshore markets. CBK can act as the clearing house and as the buyer/seller of last resort should the current shilling situation worsen,” Wehliye said.

The advantages of undertaking such a measure is that corporate demand for the dollar will not lead to speculative demand for it in offshore markets, as it will be contained within local forex markets.

“Currency speculators don’t cause a currency to depreciate. Like vultures, they attack the currency when it is naturally weak and make the situation worse,” Wehliye added.

Value correction

Adding another angle to the debate, Otieno believes the shilling is overvalued.

“For a while, the shilling has been overvalued; hence, there is no reason for panic,” he said, adding that the shilling has been very resilient even as other African currencies weaken over the dollar’s strength.

He said the weakening of the shilling has been a correction of its value.

Mr Satchu also attributed the current pressure on the shilling to the recent closure of 13 Somali remittance firms, better known as hawalas.

“I estimate $1billion to $2 billion (Sh97.4 billion to Sh194.8 billion) in Somali flight money has exited the last few weeks after the hawala crackdown,” he said.

But CBK has dismissed the idea that the shutdown of hawalas was behind the depreciation of the shilling. Sirima said the bank had not seen any evidence that there was a decline in foreign exchange remittances.

However, Wehliye said closing hawalas deprives the market of liquidity, which impacts on the shilling’s value.

“My estimation is the numbers would be down between 5 per cent and 10 per cent. I don’t think we can discount the impact of hawala closures when it comes to the supply and demand for the dollar, which in turn impacts on the value of the shilling,” he said.

The economy of Somalia is virtually run from Nairobi and hawalas are a major link between the two, playing a key role in the movement of capital between Nairobi and Somalia.

It is estimated that hawalas inject between $5 billion and $7 billion (Sh487.5 billion and Sh681.1 billion) into the market.

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