The IMF has commended the steps taken by the CBK to prop up the weakening shilling
The International Monetary Fund is pleased in the fashion in which the Central Bank of Kenya (CBK) has responded to the weakening Kenyan Shilling. CBK has increased benchmark lending rates severally this year to mop up excess liquidity and give the shilling a boost. This comes at a time when the Shilling has weakened considerably against the dollar, dropping to levels not seen in four years.
“Recent decisive steps by the central bank to tighten monetary policy are appropriate. These steps will help contain the impact of the recent shilling depreciation on domestic prices and anchor inflationary expectations,” said IMF Deputy Managing Director Min Zhu. The international moneylender says that Kenya’s economy is still on track despite what it describes as “headwinds from rising global market volatility and local security challenges.”
Global market volatility is greatly linked to the fact that the U.S. dollar is strengthening against the backdrop of general weakness across other major economies. As a result, many currencies, not just the Shilling, have significantly depreciated against the dollar. The Euro, for instance, has lost more than 20 percent against the dollar since the beginning of the year.
Whereas the IMF is happy about the CBK’s move to increase interest rates, and the strengthening effect it will have on the Shilling, businesses across the country are understandably not. Kenya, like many emerging economies, has a high interest rate environment. Last year, before the interest rate hikes, the average interest rate was 15.7 percent. With the rate hikes, average interest rates will go much higher, possibly in the 18-21 percent region. This will force businesses with existing loans to dole out larger interest payments, negatively affecting their cash flows. Businesses will also shy away from taking new loans, affecting the overall growth of business in Kenya.
Higher interest rates present a boon for banks in the near-term. They will be able to collect more from existing loans. In the long-term, however, banks stand out to lose from lower appetite for loans. There is also the risk that as interest rates rise, bad loans will increase, compelling banks to increase their provisions for bad debt.
As things stand, non-performing loans in the country’s banking sector have already increased, pointing to the effect of rising interest rates on businesses’ ability to service debt. As at June 2015, non-performing loans (NPLs) stood at Sh124.6 billion, compared with Sh104 billion at the beginning of the year.
Lending is still a principal business for banks. The increase in NPLs and lower appetite for credit is therefore likely to affect overall growth in the industry. This will compel banks to look to other business segments to grow non-interest income. There is likely to be increased pressure on the CBK and the country’s economic planners to stop the Shilling’s downfall.
CBK under pressure to contain Shilling’s freefall
Although the strengthening dollar remains the primary cause of the Shilling’s weakness, there are some underlying problems in the Kenyan economy that have also greatly contributed to the Shilling’s freefall. Earnings from tourism have declined substantially over the past three years due to security concerns. Similarly, imports have increased significantly due to infrastructure projects. This has caused the current account deficit to widen, putting more pressure on the Shilling.
Current account deficit
The gap between imports and exports widened by Sh37.7 billion, a 59 percent increase, in the first three months of the year, the Kenya National Bureau of Statistics reported. This builds on to a steady trend that has seen imports grow as exports stagnate. “The deterioration in the current account balance was mainly occasioned by the increase in the import bill and the decline in the value of total exports in the same period,” KNBS said.
To plug the trade deficit, Kenya will need to increase exports and cut back on imports. This, however, is easier said than done. Growing exports will need the full support of the government in terms of diplomatic engagement with trade partners. It also needs political will and full cooperation from trade partners, which is something that is always hoped for but never guaranteed.
Increase in imports while exports stagnate to weaken shilling further
Cutting back imports, on the other hand, is not an option, at least not now. One has to simply look at the fastest growing sectors of the Kenyan economy to know that imports will not slow down any time soon. IT and construction are the fastest growing sectors of the Kenyan economy, with both having recorded double digit growth in the past year and poised to grow even faster in coming years. Both IT and construction require costly imports which are not produced domestically in sufficient volumes. This suggests that both the volume and value of Kenyan imports will increase.
With imports set to expand and exports set to stagnate, things don’t look good for the Shilling. Furthermore, these developments are taking place amid a strengthening dollar. The role of the CBK in strengthening the Shilling will therefore come into greater focus in the near-term. It is likely that the recent rate hikes from the CBK are not the last we are seeing.