Nairobi: Can it happen again? Will it happen again? For good reason, these are likely to be the first questions that come to mind when considering the outlook for the Kenyan shilling over the coming year. 2011 will be imprinted in most Kenyan’s minds as the year that the extent of the shilling’s volatility surprised almost everyone. Yes, Kenya has seen exchange rate volatility in the past. But the macroeconomic context back in the 1990s – the last comparable experience of forex volatility perhaps – was entirely different.
What distinguished 2011 was the speed with which a seemingly stable economic backdrop – low inflation to begin with, low interest rates, success with financial deepening even during the global crisis, a steadily recovering economy – could all suddenly be put to test. What was surprising was how the stability that had long been taken for granted could so easily and so quickly come unhinged.
For some time now, Kenya’s forex regime has been among the most liberalised in Africa. With no capital or current account controls – until the latest emergency measures to stabilise the currency by restricting the provision of Kenya shilling liquidity to offshore counterparties in tenure less than a year – the Kenyan shilling had become the second most liquid (read, most easily traded) currency in Sub Saharan Africa, after the South African rand.
The South African rand, much more a barometer of global risk appetite, and more greatly influenced by global rather than local factors, is notoriously volatile. When risk appetite is on the ascent, foreign investors buy South African equities and bonds, and the rand benefits. When risk appetite wanes, investors sell their South African assets, and the rand weakens.
Recent developments in Kenya have revealed interesting similarities, with Kenya’s financial markets becoming more open and portfolio investment – especially in Kenya’s equity markets – rising in importance. A widening current account deficit – the financing of which increases reliance on foreign inflows – was also observed. Finally, the sovereign debt crisis in the euro area, an important trading partner to both Kenya and South Africa, weighed heavily.
South Africa was more fortunate in many respects. Bond yields that were still considered favourable relative to peer emerging markets, the likelihood that the South African Reserve Bank (SARB) might cut interest rates again in response to economic weakness, and robust gains in gold, all helped to shield the South African rand from more pronounced volatility – until around September 2011 that is.
Kenya, with the worst regional drought in 60 years taking its toll, was less fortunate, and therefore more susceptible to any turn in sentiment stemming from the European debt crisis. While domestic monetary policy and the belated response to the inflation shock are often blamed for the Kenyan shilling’s troubles in 2011, such analysis ignores an important dimension - the fundamental drivers of the crisis.
First, Kenya was by no means isolated – the inflation shock that was to precede Kenyan shilling weakness hit much of East Africa. Ethiopian inflation peaked at over 40 per cent, Ugandan inflation at over 30 per cent. Even inflation in Tanzania – known for its relative price stability– climbed rapidly to double digits. Demand for food imports rose regionwide. Events related to the Arab Spring were to drive oil prices dramatically higher, despite other OPEC producers stepping in to compensate for the absence of Libyan oil production. Indeed, even given current global risks, the oil market remains relatively tight, and prices are still elevated. The oil price surge spelled bad news for any oil importer, especially in East Africa where the impact of the drought on traditional hydroelectricity production, and a generally-sound growth backdrop, had both pushed oil import demand higher.
Yet the Kenyan shilling weakened more than most. In part, this was because of market disappointment that more tightening was not forthcoming any earlier, as well as the market’s interpretation of the relative absence of any public verbal or actual intervention to prop up the shilling early on in its weakening trajectory, in marked contrast to East African neighbours such as Uganda.
What happens now?
Adding to the perfect storm, the coincidence of sizeable corporate demand for dollars (much more a one-off than bearing any relation to excessive credit growth – as is sometimes argued) no doubt also played a role in influencing market sentiment.
However, it is difficult to separate the Kenyan shilling’s performance from the fact of its greater tradability. Given its status as the second most liquid currency in Sub Saharan Africa, the surprising feature is that the Kenyan shilling had not – in fact – succumbed even more to external shocks prior to 2011.
Events of 2011 will no doubt create much debate over the optimal forex regime for a country in Kenya’s situation. To our minds, attempts to put in place lasting controls would be a step in the wrong direction. If an economy is likely to be subject to frequent shocks, better that a nominal variable – such as the exchange rate – takes the hit, rather than real, underlying economic activity. Any amount of Kenyan shilling overshooting – with a strong likelihood of recovery as we have seen since – is preferable to the real economic drag that might result from a less-liberalised forex regime, and the distortions caused by foreign currency shortages. A flawed policy response might easily prolong the impact of any shock.
The same would also apply to any attempt to impose controls on loan rates, in the erroneous belief that this might encourage more lending. A vast body of economic literature suggests that when banks cannot price adequately for risk relative to their cost of funds, the impact is likely to be credit rationing rather than further credit extension. Kenya is unlikely to prove the exception to this well-established economic rule. The decision by the Bankers Association to extend the tenure of existing loans, rather than pass on the full impact of higher interest rates is a sound response to the reality of higher interest rates, which should blunt its overall impact on real economic activity. But any attempt to put in place curbs on interest rate spreads would risk undoing a lot of Kenya’s recent success with financial inclusion, perhaps permanently.
For now, Kenya is in a relatively good place. Policy interest rates have been raised 1100 bps in recent months, CRR tightening has exerted even more of an effect on market liquidity, and the Kenyan shilling, finally responding to these policy moves, has regained much of its earlier losses. Inflation – which has not yet reflected adequately the impact of Kenyan shilling appreciation, should start to do so in the coming months. We forecast that by June (or perhaps even earlier), the CBK will be in a position to cut interest rates again with the likelihood that the CBR is cut at least 400 basis points over the course of 2012, with more easing to come as inflation drops decisively back to single digits, in 2013.
As difficult as the financing of the government’s budget deficit is now, with secondary market trading in Kenyan government securities grinding to a halt, the likelihood of a multi-year easing in Kenyan interest rates should create new demand for bonds, provided other macroeconomic risks are in check and the effort to contain the primary deficit continues.
None of this would have been possible in the absence of the authorities’ tightening response in recent months. Indeed, had the authorities not tightened interest rates forcefully, the risk is that there would have been a vicious cycle of rising price expectations, further foreign exchange weakness, and even higher inflation. All would have lost out, with the poor the hardest hit. Acting forcefully to achieve Kenyan shilling appreciation was the right thing to do.
Will FX risks recur? For now tight liquidity and an improvement in regional fundamentals are helping the Kenyan shilling. Over time, it is likely that the forex market measures put in place to stabilise the shilling will be reversed. But by then, the hope is that inflation will be on a clear downtrend, and foreign investors – attracted by Kenya’s high yields and the prospect of capital appreciation – will be buying heavily into Kenya’s bond market. 2012 presents risks of its own – Kenya faces elections, the euro area crisis is by no means resolved. Nonetheless, with a more proactive policy response already demonstrated, the hope is that the worst of the storm has passed.
- Razia Khan is the Standard Chartered Bank head of research for Africa region.