Introduction
Currency crises are well known phenomena with investors being caught guard leading to possible capital flights. Notable real times from the 90s include South American crisis of 1994 and the Asian Crisis of 1997. What really makes currency investors in money markets behave like this? Investors, like wildebeests, always yearn for greener pastures, and event, hurt everyone that stands in their way. In this paper, we take a closer look at the 2011 Kenyan shilling instability against the dollar, uncovering the possible causes. We will also touch on its corrective mechanism by the Central Bank of Kenya via the interest rate channel.
Possible Causes of the Currency Crisis
A currency crisis steams from a decline in the value of a country’s currency relative to selected foreign currencies. For instance, the period 2008-2011 saw a steady decline in the value of the Kenyan shilling against the dollar from 78 to 107 per dollar. Such a decline negatively affected the Kenyan economy since it created instable rates of exchange (Velasco, 2000). This meant that present value of the shilling could no longer purchase as much as it used to in US dollars.
Varied views, both from experts and non experts, were put across to address this situation. One rising star, a professional blogger, termed the shilling as one of the worst performing of the worlds’ currencies. She went on to blame the current global crisis for the severe beating the Kenyan shilling took, she writes “…after all, even the Euro zone is stuck between rock and a hard place...” , she suggested a mere spillover effect from developed to developing economies.
As if triggered by her words, one commentator cites four additional sources of this wild volatile characteristic. First, the speculative behavior of major financial institutions prompted them to issue loans to currency investors who in turn defaulted. Second, Kenya is solely dependent on expensive finished-products imports such as oil, cars, and heavy machinery. Since the dollar in an internationally accepted unit of payment, it put so much pressure on the shilling thus devaluing it. Third, since 2012 is a politically charged year, fear of possible instability caused a mass investor panic negativity impacting on shilling value (Mathenge, March 2, 2012).
Key public figures shared the same views about the causes of this crisis. Deputy Prime Minister, then minister of Finance, Uhuru Kenyatta blamed this fall on a miscommunication between CBK and Kenyan commercial banks. On the other hand, CBK boss Professor Njuguna Ndung’u struck at five key banks and dollar-shilling currency investors for being notorious speculative traders. Other financial analysts poked their fingers into helpless monetary policy tools and mixed central bank signals which were causing investor and bank panic (Mathenge, March 2, 2012). After all, hadn’t they learnt of the weaknesses and limitations of monetary policy many less developed and emerging economies?
More recently, house committee on depreciating shilling through its chairman, Mr. Adan Keynan found evidence to put the blame on CBK. The committee claims that the government bank knowingly allowed financial institutions to make a killing by trading in cheap money publicly borrowed. The report further showed that these institutions had borrowed a total of 600 billion shillings in 2011 -up from 11 billion in 2010- at a CBR of 10 percent and later lent it bank at 26 percent rates through IOUs (Mathenge, March 2, 2012).
Measures Taken to Tame the Wild Volatile Shilling
When combating currency crisis, central banks of economies with fixed exchange rates such as The Republic of China and Ethiopia either use their foreign reserves or fix them at a fluctuated rates. However, Kenya is markets fuelled state that relies on forces of demand and supply which little central bank intervention to act as a guide. Additionally, Kenya has had a history with rather unstable foreign exchange reserves. To take care of this, Mr. Kenyatta proposed seeking of additional funding from International Monetary Fund under its newly created credit facilities to help boast foreign reserves (Sanger, Jan 25, 2005).
So why did he see the need to tap into Kenya’s foreign reserves? During the depreciation, downward market pressures placed on the shilling could only be offset by an increase in the interest rate. In order to increase the rate, the central bank of Kenya had to shrink the money supply, which in turn increased demand for the for the shilling relative to the rogue US dollar. His understanding of the issue was for the government bank to sell off its foreign reserves to creating a much desired capital outflow (Chang, 2001). When a central bank sells a portion of its foreign reserves, it receives payment in the form of the domestic currency, which it holds out of circulation as an asset.
Secondly, the CBK came up with the decision to directly sell US dollars to willing currency investors. This decision temporarily displayed some signs of stability from 107 to 102 shilling against the dollar. This was a move aimed at limiting the freedom of commercial banks as currency traders. In addition, it cut by half the amount of active foreign currency – form 20% to 10% - commercial banks could hold for trading purposes. This move was meant to limit commercial bank ability to hoard US dollars at the expense of the shilling (Velasco, 2000).
Changes in exchange rate in turn changes amounts of foreign reserves as well as political and economic factors, balances of trade and payment, inflation rates and unemployment levels. A devalued Kenyan shilling relative to the dollar through an increase in exchange rate resulted in cheaper domestic goods relative to foreign goods. In bid to help curtail this, the central bank of Kenya increased the Central Bank Rates from 7- 11 percent and further increases towards the current 16 percent hence discouraging borrowing (Mathenge, March 2, 2012).
In response to this rise, top commercial banks increased their lending rates, for instance ABC now gave out loans at 7.75 percent. Other players such as I&M bank, Commercial Bank of Africa, Standard Chartered, Barclays, and Development Bank of Africa to levels up to 17 percent. The increase in credit cost and reduction in credit availability meant that borrowing from commercial banks would be discouraged and a further dollar demand reduced (Chang, 2001). Higher domestic interest rates would mean reduced foreign currency investors and Kenyan foreign investments, further reducing the fall in shilling value.
Unfortunately for domestic commercial banks, foreign currency investors become aware of central bank strategies and can use such information to create an expectation advantage. If they expect the central banks to increase interest rates, which would decline the exchange rate, the objectives are not achieved since they turn back to their governments for loans (Chang, 2001). It is advisable, therefore, for central bank to use its reserves to shrink the money supply, which increases the domestic interest rate.
Future Policy Recommendations
Since changes investor confidence cause capital instabilities, the creation of exchange rate stability closely monitored by qualified policy makers should be encouraged. The creation of sound money market and banking institutions is needed to mobilize savings for capital formation (Sanger, Jan 25, 2005). Lastly, sound relationships between fiscal and monetary policy implementers, in this case CBK and the Treasurery, should be encouraged. Predicting the possibility of Kenya running into future currency crises is also fundamental. Common characteristics that should have been visible include heavy borrowings which increased current account deficits, track record currency volatility since late 2007, and political instabilities which sent the wrong signals to currency investors.
References
Chang, R. (2001). A Model of Currency Crises in Emerging Markets. Quarterly Journal of Economics 116(2) , 487-517.
Mathenge, O. (March 2, 2012). Shilling Debate Put off as MPs Clash. Daily Nation , 10.
Sanger, D. (Jan 25, 2005). US Faces More Tension Abroad as Dollar Slides. The New York Times , 23.
Velasco, A. (2000). Financial Fragility and the Exchange Rate Regime . Journal of Economic Theory 92 ,, 1-34.
LIONEL INZAHULI SAVAGE
No comments:
Post a Comment