Foreign exchange reserves are held by the central banks, mostly in USD, and the main purpose is to make international payments and hedge against exchange rate risks. The reserves are used to back the nation's liabilities and support and maintain confidence in the policies for monetary and exchange rate management. Additionally, the reserves serve to limit external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis or when access to borrowing is curtailed.
In a floating exchange rate system such as ours, market forces determine the value of a currency, based on its demand and supply arising mainly from international trade. An increase in exports, tourism, diaspora remittances and foreign direct investment (FDI) inflows increase the supply side.
On the other hand, an increase in crude oil prices and prices of industrial raw materials increase our demand for the dollar. When demand outstrips supply, there is a shortage of the dollar, and the value of the local currency falls. This is why central banks intervene in the market by supplying foreign currency in support of the national currency. Stronger foreign currency reserves will allow central banks to "buffer their currencies against sharp declines by supplying USD to the market" at times of volatility.
A dollar shortage occurs when a country's net outflows of USD outweigh its net inflows. This can happen when it has to pay more USD for its imports and international obligations than it receives for its exports. When the balance of trade is favourable, it receives more USD for exported goods and services compared to USD spent on imports, and vice versa.
Our exports have been on the decline in recent years. However, our imports increased substantially due to higher prices of raw materials and crude oil prices. On average, our imports have been at least three times our exports. In addition, our international obligations such as payment of external debts increased significantly. This created an increased demand for the USD which resulted in the devaluation of the shilling by 20 per cent, from Sh100 to Sh120.88 since 2013.
On April 24 this year, the CBK directed commercial banks to ration dollars following a shortage of the currency. Consequently, banks imposed a daily cap on dollar purchases and businesses struggled to obtain adequate foreign exchange (Forex) to meet their obligations.
Various business organisations such as the Kenya Private Sector Alliance and Kenya Association of Manufacturers publicly complained that the lack of adequate hard currency was "negatively affecting their ability to settle obligations to overseas suppliers in a timely manner". It also created "strained relations with suppliers, at a time competition for raw materials has intensified globally due to rising demand amid lingering supply chain constraints."
In June, the National Treasury insisted there were enough dollars even as traders demanded more of the currency to import products such as palm oil, wheat, fertiliser, and refined petroleum products whose prices had shot up globally. But as the dollar shortage in commercial banks continued to bite, businesses that required millions of dollars weekly for imports were forced to cut production or even shut down. Businessmen had to shuttle between banks and forex bureaus daily to meet their demands.
CBK insists that it has adequate forex reserves, but its failure to supply forex to the market has resulted not only in a USD shortage but also in a parallel forex rate. While its indicative exchange rate rose to Sh120 last week, the commercial banks sell at between Sh125 to Sh127 to importers, creating a dual exchange rate in the country for the first time since liberalisation of foreign currency. But why is the CBK unable to intervene in the market as mandated by law? Let me explain.
The CBK is worried about the government's debt obligations and needs both the dollars it can get and the lower exchange rate. The government requires $3.28 billion in external debt repayments for the 2022/23 financial year, nearly half the forex reserves at CBK. With an external loan portfolio of $35 billion, a one-shilling drop in the forex rate will add an additional Sh35 billion to public debt. This explains why CBK literally "fixed" the interbank rates at Sh116-118, and directed banks not to buy dollars above that rate.
Simply put, commercial banks buy the dollars at Sh116-118 from customers but sell at between Sh124-127. Exporters opted to keep their USD rather than sell at Sh116. This is the reason banks could not provide dollars to their customers.
If the CBK allows commercial banks to price the USD at the market rate, the shortage will end as customers will be inclined to offer them to the banks. Instead, it prefers to bury its head in the sand and pretend all is well. The shortage continues while CBK can happily issue a misleading statement, tongue-in-cheek!
If it persists, we may end up going the Sri Lanka way. In June last year, the Sri Lanka central bank told banks not to request dollars from its depleted foreign currency reserves as the country faced a major scarcity of dollars in the forex market.
Commercial banks dealing in the interbank foreign exchange market were restricted in managing foreign exchange liquidity within the banking system. This created a shortage of dollars for transactions as exporters were not converting their foreign currencies till they got higher deposit rates in dollars. What followed is in the public domain.
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