How the foreign exchange market works

Central Bank of Kenya head office in Nairobi. [Jonah Onyango, Standard]

Remarks by Deputy President Rigathi Gachagua that the Central Bank of Kenya (CBK) did not have enough foreign exchange reserves (forex) to be used by oil importers has generated debate on how exactly the foreign exchange market works.

CBK, the financial regulator, even came out to school the former Mathira MP on how trading in foreign currencies works, insisting that as a regulator it is not an active player in the forex market.

Generally, CBK is responsible for formulating monetary policy to achieve and maintain price stability and issuing currency. It also formulates and implements foreign exchange policies and manages foreign exchange reserves.

The foreign exchange (also known as FX or forex) market is a global marketplace for exchanging national currencies against one another.

Now, as a regulator, CBK, is one of the participants in the forex market.

Never mind that it had close to $7.424 billion of forex reserves by last Friday. This is known as official reserves. Commercial banks had $3. 954 billion worth of foreign exchange reserves by end of July, according to CBK data.

So, does it mean that CBK does not engage directly in selling and buying foreign currencies such as the US dollar, British pound, Japanese yen, and euro?

Not necessarily. As the banker for Government, CBK also keeps forex reserves on behalf of the former. These reserves are mostly used for the government's external obligations such as paying foreign debts.

Now, if as a trader, you want dollars to, for example, buy petroleum products, you will not go to CBK because CBK is not your banker. You will probably go to a commercial bank, another player in the forex market.

You could also go to a forex bureau, particularly if you are not dealing with huge sums of money.

To this extent, CBK was right to note that oil importers get their foreign exchange reserves (forex) from commercial banks and not the regulator. Anyway, amidst talk of dollar shortages by commercial banks and forex bureaus, there has been push for CBK to avail dollars to forex traders.

Well, as part of its role of ensuring stability in the forex market, CBK can intervene by selling or buying dollars from banks to ensure the market operates efficiently.

In this case, it basically gets into the market. But, it will not deal directly with traders, it will only trade with banks.

Currently, for example, there has been a push for CBK to avail dollars to banks that can then sell them to importers.

But CBK is not falling for this. Instead, the financial regulator, heeding the advice of the International monetary fund (IMF), wants to let the exchange rate act as a shock absorber by letting the shilling depreciate.

The expectation is that the expensive imports due to a weaker shilling will be counter-balanced by cheaper exports, and thus more dollar revenue.

So, where do all these foreign currencies come from?

When you export goods or services, you are paid in foreign currencies. Also, when foreigners visit for leisure or business, they come with critical foreign currencies that they exchange into Kenya shillings at the prevailing rate in the forex market.

Moreover, when the government borrows, for example, from the International Monetary Fund (IMF), it is given the money in foreign currencies.

These dollars will then be available to those who need them such as oil importers. However, the outflow of dollars from the reserves of commercial banks has outpaced the inflows, resulting in a crisis of dollar shortage.

The situation has been aggravated by the reduced inflow of dollars and other foreign currencies due to poor tourism and export earnings.

Due to the lingering effects of Covid, the number of foreign visitors, though improving, is yet to return to the pre-pandemic levels, said the World Bank in its latest Kenya Economic Update.

The US is currently exchanging at an average of Sh120.6 at authorised dealers such as commercial banks and forex bureaus, CBK data shows. However, there have been talks of an emerging parallel foreign exchange market with traders quoting a higher rate compared to the prices they are giving CBK.

The drop in the country's forex - assets held on reserve by a central bank in foreign currencies - has put the country in a precarious position in case of a sudden surge in external obligations.

With little reserves, the country can find itself struggling to meet some of its obligations including servicing foreign debts and importing critical supplies such as fuel, fertiliser, food, drugs and machinery.

This year, the highest reserves of foreign currency were on January 13, at $8.764 billion (Sh1.06 trillion). However, this dropped to a low of $7.346 billion (Sh885.56 billion) on September 8, which means that forex levels dropped by Sh171 billion in this period.

CBK Governor Patrick Njoroge, in an interview with Bloomberg TV, expressed his fears over the rapid increase in interest rates in advanced economies, saying this is likely to hurt Kenya's external position.