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Shilling woes undermine economic recovery efforts

By | June 21st 2011
By | June 21st 2011

By Odhiambo Ocholla

Last week, the shillings almost hit a low of Sh90 to the dollar fuelled by demand from the oil import bill and reaction that the Central Bank of Kenya (CBK) will take no action to influence its strength.

CBK’s typically responds to the weakening currency values by using combinations of higher domestic interest rates and foreign exchange market intervention.

However, there are concerns over the effects of the new round of ‘quantitative tightening’ in which CBK has raised policy-lending rate by 0.25 percentage points and cash reserve ratio by 25 basis points.

This will tighten liquidity in the market, which would increase long-term interest rates and thus contribute to slow economic growth. But this will probably also have two other effects. It will strengthen the shilling against the dollar and stem inflationary pressure.

A currency that is not well managed and subject to continual depreciation is not likely to find its resistance level soon. New policies and models are called for, that include measures to stabilize the shilling.

Fuel prices

More seriously for the long term, the falling shilling may add to an upward worrying trend of inflation, which currently stands at a high of 12.95 per cent against the Government’s inflation target of 5 per cent.

The weak shilling would escalate some of the impact of rising imported fuel prices, which had hampered the country’s industrial sector thus exacerbating the country’s unemployment rate, currently estimated at over 40 per cent.

We want as a country to boost our manufacturing capability and competitiveness, which will also have an impact on the job creation. New emphasis should be about jobs, jobs and jobs. There is a mismatch between economic conditions and CBK’s monetary policy.

Policy stance

CBK needs to smoothen volatility in the currency markets and ensure fair valuations in the market. In practice, a higher interest rate defense of the currency is often part of a broader monetary policy framework, which also includes some amount of intervention. CBK’s decision not to intervene could be a deliberate measure at creating room for self-correction in the currency market but there is some cause for worry with this policy stance. 

Clearly, a policy decision need to be made on the extent to which a higher interest rate and or intervention would be used to prevent further shilling depreciations.

More generally, the choice of how much to intervene and or raise interest rates in response to negative shocks that tend to weaken the domestic currency is related to the optimal choice of the exchange rate regime – while it has been empirically observed that in practice most countries with floating rate intervene quite heavily in foreign exchange markets.

Though CBK has insisted that they would not intervene I believe they have to take some monetary policy measures and intervention to restore the value of the Kenya shilling.

Local exporters

The only benefit of shilling depreciation is a slight increase in exports, but then inflation will come along.  The weak shilling has made it increasingly easy for local exporters to compete, has increased their competitiveness and would increase the propensity of manufacturers to create more jobs.

However, while a weaker currency should benefit our exporters and may have a positive short-term impact on growth, there is the fear of a weak unit also exacerbating inflation concerns.

With the down trend of the shilling against the dollar, Kenyans will bear the brunt as commodity prices are expected to hike to unimaginable levels, while exports such as tea and horticultural producers smile all the way to the bank.

Further, those employees and expatriates working for international organisations like UN, World Bank, among who are paid in dollars are literally minting money as the shillings depreciates.

The exchange rate depreciation coupled with rising inflation risks could see an increase in long-term debt yields. Even some commercial banks have responded to the same by raising their base lending rates.

Ultimately, the shilling depreciation cannot salvage our economy because we are net importers. The current monetary policies are not powerful enough to cushion the economy and another round of quantitative tightening is necessary.

Ocholla is an Investment Banker. Email: [email protected]

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