Over the last month or two, the exchange rate has come back as a topic of national economic discussion. This time, though, it is not over its appreciation against the major foreign currencies (an issue exporters had complained about), but its depreciation.

In the last two years, the export sectors (mainly tourism and agriculture) have been clamouring for intervention by the Central Bank of Kenya (CBK) to influence a reversal of the appreciation of the shilling. Some had even gone as far as calling for the re-introduction of a pegging regime (partially if not wholly).

However, CBK has largely left the determination of the exchange rate to market forces.

Now these market forces seem to have heeded the exporters’ plea: They have tilted the shilling’s value on a downward trend. From a mean rate of around Sh68 to the US Dollar at the beginning of September, the shilling has steadily lost value to the current mean rate of around Sh80 to the greenback. This is a rate last seen over four years ago and should be good news to the exporting sectors. But it is bad news for all others. However, as the country’s exports become competitive, the depreciation is stoking fears of yet another spell of price increases on petroleum and other consumer products. Consequently, this is likely to bring about fresh inflationary pressures.

The shilling’s downward spiral (especially against the dollar, the main currency denomination for our imports) is already pushing up commodity prices. Prices of imported second-hand vehicles and spare parts, for instance, have risen to an all-time peak.

We should also brace for another increase in the cost of electricity, as fuel (oil) is a major factor in its production.

A weaker shilling impacts on nearly every aspect of the country’s economy. In addition to basic commodities such as foodstuffs, many imported products could also experience price hikes. In addition, increased production costs also affects the competitiveness of Kenya’s exports.

This trend could go further to erode the country’s balance of payments position.

It seems, therefore, that the gains made from the recent drop in international oil prices could be lost to a weakening shilling. Kenyans hoped for a break from havoc caused by high crude oil prices that have since dropped from a historic high of over $140 per barrel to around $70 currently. The local currency losing value could throw the rest of the economy into chaos.

SPECULATION

It calls, therefore, for urgent but sustainable measures to ensure market forces do not run amok to the long term detriment of the economy.

As much as acting Finance Minister John Michuki and CBK Governor Njuguna Ndung’u seem to be blaming the depreciation on speculation in the banking sector, as custodians and managers of monetary and fiscal policy they need to manage the issue competently.

Getting exchange rate management right is key for economic stability and growth in the long term. Any exchange rate regime, especially a flexible or liberalised one like ours, requires complementary policies to increase its chances of success. These include enhanced prudential regulation of the financial system and a counter-cyclical fiscal policy.

On prudential regulation, it is often noted that weak banks can be a main constraint for monetary and exchange-rate policy.

Only when banks are reasonably healthy can policy be used freely, without the fear that interest or exchange-rate fluctuations will bring the banking system tumbling down. Hence, identifying and tackling the sources of financial fragility is crucial.

On fiscal policy, it has been noted by researchers that excessively pro-cyclical fiscal policies are the inevitable consequence of weak and deficit-prone fiscal institutions.

A simple and first step forward, therefore, is to reduce the levels of public indebtedness. With expected decline in foreign capital inflows due to the international financial crisis, it is imperative, therefore, that the government learns to live within its means.