Silver lining in economic storm cloud this year

Global economics tend to determine the path banking outlook takes, and given that credit cycles tend to dovetail economic cycles; looking at the drivers of the global economy is a reasonable starting point in attempting to illuminate the banking outlook. The global economy faces certain downside risk factors in 2019, three of which are, first; the emerging and potential China-US trade war with Trump and Xi in discussions to meet halfway on trade matters by March 1, 2019, second; Brexit with the unfolding events in Westminster and Brussels, and third; the US monetary policy stance on ‘where-next?’ post the normalization cycle started by Janet Yellen and continued by the new Fed chair, Jerome Powell.

Financial markets are likely to only fully price these risks overtime as they crystallise, but it seems the global banking industry has begun to hedge itself of these risks, if to go by the continuing balance sheet restructuring and structural adjustment actions that we saw in the latter part of 2018 by major global banks.

Closer home, buy side investors seem cautious but optimistic by tanking valuations in emerging markets as we enter 2019, and with global equities having shed off $5 trillion in 2018 and emerging markets asset classes, outside equities, doing relatively well, there’s a willingness by investors to take on more frontier risk. The capital re-allocation out of the emerging markets seen in 2018 as US rates normalised is likely to have largely settled, we are seeing signs of excess global liquidity and with a more predictable US rates path, we are likely to see funds flow into frontier markets driven by increased investor risk appetite for EM’s.

To refinance

I remain optimistic of a positive transmission to EM’s from the macro activity in global markets, if only to go by the personal experience I had in the fourth quarter of 2018. I had never seen such a flurry of London and New York based fund managers seeking meetings in an attempt to build investment thesis for the Kenyan asset class.

For instance, in equities, with approximately 17 per cent or Sh420 billion of wealth wiped off the NSE in 2018, and with capital flight having led the NSE to touch a 10-year low in October 2018, the bear market seems to provide a re-entry point for foreign capital. Kenya’s equity markets are likely to rally in 2019. But this is only one side of the emerging story. Looking at EM economies more closely, however, and analyzing the idiosyncratic factors underpinning the imagined economic outlook, one is left to wonder whether a consensus exists on any economic upside in the short term.

Kenya, in particular, is going to face some mixed economic performance with a potential deceleration going into the medium term. Kenya has to refinance up to Sh900 billion of debt in 2019; of which, Sh400 billion is domestic debt. Returns from the prior debt-led investment cycle are yet to fully come on-stream, and whilst debt to GDP ratio remains conservative and debatable, it is the structure of Kenya’s debt repayments and how much of revenue collected goes to repaying debt, subject to yield, tenure and currency depreciation given the amount of debt held in foreign exchange (FX) - that may be a cause of concern.

Supply side fiscal policy will come under pressure as Kenya manages the debt refi and repayment schedules. It’s either we generate revenue faster from the underlying economic and investment activities or raise taxes or cut expenditure. And this is not simply about a debate around debt from China or whether we are comparable to other debt-led economies, it’s simply a unique economic structural problem that Kenya has to deal with at this cycle of a debt driven economic expansion. That’s on the public side.

On the private side, credit supply improved from around 2 percent to around above 4 percent in 2018, but this number remains relatively weak given the 20 percent levels in 2015. And with the effectiveness of monetary policy actions curtailed by the persisting interest rate cap, credit expansion remains very much in the woods.

These, among other broad-based factors, are going to create distributional consequences and a storm cloud for the economy and financial markets in 2019. What we do with monetary policy, in particular repeal of the interest rate cap, remains the silver lining.

In July 2017, I published an in-depth analysis on interest rate cap elaborating on the complexity of operating a free market economy with some form of price controls in place. Simply put, in free market economics, existence of price controls of any form on one side of the market has material unintended consequences on the broad economy. The continuing existence of rate cap makes it ineffective for monetary policy actions to be transmitted to the real economy.

Twin deficits

When you control interest rates, you indirectly control the currency holding it at artificial levels. Managing inflation pressure becomes complex as the normal understood relationship between rates and inflation doesn’t hold. Banks can’t effectively price, for risk and credit expansion slows in the most vulnerable sectors of the economy. Bank deposits move to government paper as the government borrows at artificially low rates on the more passive side to manage the twin deficits as the case of Kenya. With required foreign exchange reserves to manage the balance of payments like Kenya’s case, this means nominal stability remains artificial.

Banks are going to have to navigate an environment where even assuming a predictable and an aggressive forward guided monetary policy, with rate cap, the length of time it would take for these macro factors to re-balance will be unpredictable. For the central bank to deliver its mandate effectively, the interest rate cap has to be repealed. The MPC cannot keep its most important tool, the CBR, on a near autopilot mode when we have a market system where every other economic factor is free floating. Something will have to give in eventually between currency, rates, and/or inflation. With any form of price controls in a free market economy, policy setting institutions, including central banks, loose their independence and impact to markets.

Mr Muthui is a former Wall Street Investment Banker and current Director of Strategy at Barclays