Future Capital Kenya

To understand the current exchange rate dynamics, it is easier to consider a useful analogy. This blog has developed an uncanny reputation for creating wacky analogies over time, but I think they've been useful with regards to getting the message across.

Now everyone, well at least most people, have been in a relationship. These relationships were sometimes built on what romantics would call "real reasons", such as; respect, admiration, compatibility and a pure and warm understanding of each other, telepathy if you will. Others have been built on what pragmatists would also consider to be real reasons, such as; money, a well connected father in law, a nice figure or maybe just pure convenience a "why not?" relationship. Depending on which side you fall on, some of these reasons may be appalling and some may even be disgusting, but it cant be denied that all of them are real. 

Now imagine two people who are dating, Mr. X and Ms. Y. Mr. X through his obvious swagger and charm convinces Ms. Y to be his girlfriend. Ms. Y was in a difficult situation in her life and was helpless as Mr. X swooned to win her over. Six months down the line, after the conveyor belt of roses and chocolates starts to chug along slower, it hits Ms. Y that maybe Mr. X wasn't the man for her all along. In retrospect, it may not have been the smartest of choices, in fact "he always used to stare at other girls" and "whenever he hugged my friend Z, the hugs would last a few seconds too long". The tipping point comes when the two lovers decide to meet up for lunch at their favourite restaurant. Ms. Y arrives on time and as has been the case for the last three months, has to wait for longer than is necessary for Mr.X to arrive. In this 45 minute wait for Mr. X, the doubts about their relationship grow stronger and stronger, and in this escalation she decides that enough is enough. Their relationship can no longer work, it's time to call it quits.

Dear readers, this situation as removed as it may be, to a great extent represents the reality with investments and capital flows. Generally they are driven by fundamentals and sometimes they are driven by sentiment. However, as much as this sentiment may seem speculative, it usually is a "starry-eyed" person's awakening to the fundamentals. 

Having a weak currency has one major adverse implication for Kenya, with a high urban population, imports become expensive and thus inflation pressures mount. From a national security perspective, this is extremely dangerous. Note that the prices of crude oil have eased off their April high's of $116 per barrel, but your fuel costs haven't adjusted. This is simply down to a weak currency.

Exchange rates are driven by three major factors which are listed below;

1. Trade Balances - When Kenya imports oil for instance, it has to buy dollars as oil prices are quoted as $/barrel. Alternately, when a foreigner buys Kenyan tea, he has to buy Shillings as the price of tea is quoted in shillings. Therefore, by simple deduction, imports result in shilling outflows and exports result in foreign currency inflows. If exports exceed imports, the country has a positive trade balance and thus there is more demand for its currency resulting in a stronger currency. The alternate is true when imports exceed exports. In Kenya's case, imports exceed imports by a whopping Kshs 537 billion (USD 6 billion) or almost a fifth of GDP. In fact, the trade deficit has hovered at around 15% of GDP for the last twenty years. You can now automatically tell that our currency from a trade perspective faces enormous pressures.

2. Capital Flows/Interest Rates - In response to the currency crises that emerged not only in Kenya, but generally in East Africa, heads of EA Central Bank's led by Prof. Ndung'u raised interest rates. The CBK did it by raising the CBR rate (now called the discount rate) from 6.5% to 8.00%. The thinking behind this is that, if you raise rates in Kenya, foreign capital will flow into the country seeking higher yields. Given that the interest bearing instruments are denominated in shillings, the foreigners will have to purchase shillings thus strengthening the currency. Therefore capital flows, through the interest rate mechanism do have a bearing on currency movements.

However, this was not the best of moves. Rising interest rates in an inflationary environment such as ours could kill the economy. Hiking interest rates due to demand-pull inflation works well, however when inflation is cost push such as ours, rising interest rates choke the economy of credit and lead to lower aggregate demand. Major banks have increased their lending rates and they can easily justify this by saying that the Central Bank's rates are much higher than they were this time last year. In macro-economics, such a situation is called a trilemma, where Central Banks can either focus on exchange rates or interest rates and inflation through their Monetary Policy, by trying to affect the exchange rates, the CBK is actually worsening the interest rate/inflation environment.

Moreover, this policy move would work well, if foreigners thought highly of Kenyan debt. Kenyan debt obligations from the Treasury are rated B+ by S&P. This is a whole four grades below the minimum investment grade that dictates global fund manager's investment decisions. Therefore, our structural problems are influencing our macro objectives. For more information about credit ratings look here.

3. Psychological Factors - This feeds back into our analogy, and to a great extent explains our current currency issue. Sentiment does affect the markets and often overlooks the two main fundamentals listed above. If economic agents and owners of capital become wary of the shilling, their actions could lead to a weakening of the shilling. Just like the girl, sentiment could lead to a realisation that the fundamentals are flawed and that this "relationship" is not worth it. In a recent blog post, I identified some flawed fundamentals and suggested that the shilling is bound to get weaker. Indeed it did. All the economic actors took short positions against the shilling and their actions exacerbated the already dire situation.

To surmise, investment decisions, just like relationships reflect both sentiment and fundamentals. Like a lady smitten, sometimes investors and other economic agents may decide to over-look the fundamentals and just ride on sentiment. However, often, in a state of hubris, the man's actions will lead to the lady realising that she is in the wrong relationship. The 45 minute delay will lead to angst and sentiment will turn against the man. He will lose his girlfriend. In Kenya, high inflation, increased political uncertainty and other such factors turned the sentiment against us. This resulted in a currency appreciation that lead to the Kenyan shilling reaching all time lows against the dollar.

Prof Ndung'u once wrote that;

These remarks can easily be translated to "Kenya will only achieve success, if it focuses on its fundamentals". The CBK's actions were a stop-gap solution, but the country will have to improve its productivity and international standing to reduce the chances of future speculative imbalances that weaken the currency.