Why Central Bank is right on value of the shilling, not IMF

Central Bank of Kenya governor Patrick Njoroge.

The International Monetary Fund says the shilling has been overvalued by 17.5 per cent. Currently, Sh104 is equivalent to one US dollar. 

However, the IMF says it should be Sh122.20 to the dollar. Nevertheless, knowing how difficult it is to explain exchange rates, I wonder how the IMF is sure about 17.5 per cent overvaluation of the shilling.

This is a serious debate because we export less and import a lot.

If the depreciated shilling does not induce additional exports, our balance of payments position and foreign reserves will worsen.

IMF asserts that the government and the Central Bank of Kenya (CBK) are actively managing the value of Kenya’s shilling against major currencies such as the Euro, Dollar, Yen and the Pound Sterling.

The Central Bank can do this through the monetary policy or official reserves. Why would the IMF raise this issue? There are advantages and disadvantages to a managed exchange rate.

In a managed exchange rate system, the rate is kept within a desired range so that there is controlled volatility.

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Investors like a predictable exchange rate and this explains why some countries opted for a fixed exchange rate policy.

Managing the exchange rate happens a lot among nations.

As an example, from 2011 to 2015, the Switzerland Government and National Bank managed her currency, the Swiss Franc, against the Euro. This was to protect their exports against a strong currency.

When there is a financial crisis, CBK must manage the exchange to bring it to order.

Currency depreciation

If CBK has to use monetary policy, then the likely target will be interest rates.  The theory tells us that low interest rates reduce demand for currency - inducing its depreciation - resulting in devaluation, and vice versa.

That is, if interest rates in Kenya fall relative to rates in foreign countries, the demand for our assets will fall and so will be a fall in demand for the shilling.

Unfortunately, up to late this year, the interest rate in Kenya was regulated, and so it might have not been possible to fix it. However, a central bank can use its reserves to buy or sell its currency to devalue or revalue the currency.

To devalue a currency, the central bank buys foreign currencies, thus making the forex more expensive relative to the local currency.

Selling the shilling increases the supply of the local currency. It means that Central Bank will sell the foreign currency to revalue the Kenyan shilling.

However, given a large number of factors that impact on the exchange rate,  the effect of monetary policy on the exchange rate might not be visible.

The Chinese limit their investment in other nations and investment in China by foreigners to protect their exchange rates.

However, the CBK does not want to hear about a managed exchange rate. Why? First, it is possible CBK is not managing the exchange rate. Secondly, no central bank would want to be associated with the printing of local currency.

To manage the dollar or any other foreign currency, CBK would have to print lots of Kenya shillings. This can be inflationary, thus undermining the role of CBK to manage price levels.

The expectation is that Kenya’s shilling will depreciate if inflation rates are high to a level in which it translates into a decline in purchasing power.

Multinational payments

The IMF is concerned because Kenya is a member and is required to follow a system of multinational payments.

Besides, the IMF suggested that inflation is high; therefore, the shilling, in response, should depreciate.

The theory on exchange rate determination tells us that when there is an increase in imports and a decrease in exports, the shilling depreciates because the demand for foreign currency is higher.

In Kenya, we have both fiscal deficits and balance of payments deficits, coupled with large external loans that expose us to the foreign exchange resource crisis.

What might be saving us from a crisis might not be actions of CBK but remittances of foreign currency by Kenyans living and working abroad.

The high interest rates in Kenya, compared to, say, those in US and UK attract investors, and Kenyans are better off investing here because the assets are cheaper.

The danger with foreign-currency inflows is that it might boost imports at the expense of exports.

Who between IMF and CBK is right? It is difficult to know.

But the answer is in the data and the model each party uses to locate the true exchange rate.

In monetary issues, there are different perceptions as to why the exchange rate between the dollar or Sterling Pound, and the Kenya shilling is where it is. The IMF’s position might be that our current account deficits and external borrowing put enough pressure to depreciate the Kenya shilling.

However, there are many tradeoffs when it comes to exchange rate determination such that it is difficult zeroing on one or two factors as drivers of the exchange rate. There are even speculators whose activities hurt the real economy.

-The writer teaches at the University of Nairobi

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Central Bank governor Patrick Njoroge.Central Bank of Kenya