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Why has the Kenyan Shilling declined so sharply?

Wolfgang Fengler's picture

How would you feel if, after a normal take-off, you noticed one of the engines on your plane wasn’t working properly? What if you then found out the other engine was overheating? Now suppose the captain announces that you should buckle-up because the plane is about to meet an approaching hurricane?

This is what Kenya’s economy is currently going through. The country is in the middle of a perfect storm, and the declining Shilling is the most visible manifestation of Kenya’s economic woes. Why has the Shilling been falling so much and so unpredictably?

The main reason is that Kenya’s economy is increasingly imbalanced: the country is importing too much and exporting too little. This makes it vulnerable to shocks.  The gap between imports and exports needs to be financed by financial inflows other than export earnings. In 2011, imports have soared (mainly due to higher oil and food costs), while exports remained stagnant. The gap between imports and exports, also called current account deficit, now stands at above 10% of GDP – one of the highest in the world! Today, Kenya’s main exports don’t even earn enough to pay for its oil imports, not to mention other imports beyond oil (figure)!  The money to pay for any additional imports needs to come from somewhere.

Figure – Since February 2011, Kenya’s top exports can’t pay anymore for its oil imports (click on figure to see it larger)
 
Source: Simulations by Jane Kiringai and John Randa, Kenya PREM; Data points reflect 12 months moving averages

The money won’t come from manufacturing exports:  that is Kenya’s weak engine. Manufacturing stagnated a long time ago in Kenya, though it has been the driving force of other successful emerging economies. Ten years ago, manufacturing accounted for 11 percent of Kenya’s economy–and it is the same today, despite a decline in the share of agriculture from 30 percent to 25 percent. Kenya’s growth has been in services, particularly transport and telecommunications, reflecting the resurgence of Kenya Airways and Kenya’s telecom revolution.

If you import a lot, you need enough dollars to pay for these imports.  Ideally, exports will give you everything you need. When exports aren’t enough—which is the situation in Kenya today-- the gap needs to be filled through other financial inflows, including remittances, private investment, and support from development partners. In Kenya, over the last six months, the share of short-term flows has increased substantially. This “footloose capital” makes Kenya even more vulnerable to shocks. It often just takes a single event – even if it is completely unrelated to Kenya – to prompt these short-term flows to leave the country as quickly as they came in.  This is Kenya’s overheating engine.

A weakening Shilling is not necessarily bad for Kenya’s economy. It can help to rebalance Kenya’s economy in the medium term, by making imports more expensive and exports more competitive in the countries where those exports are bought, thus adding to export earnings. Unfortunately, in Kenya, high inflation has been eating away some of the benefits that it would get from a weaker exchange rate, thus creating additional pressure on the Shilling. If investors, local and international, think their money will lose its value in Kenya very quickly – which happens when inflation is high – they tend to move it to countries where it will hold its value over the medium-term. If policy makers are not careful, Kenya could well end-up in a vicious cycle where high food and fuel prices lead to higher inflation, which in turn weakens the exchange rate, which raises the cost of imports, which further increases inflation.  This would be a bad outcome for Kenya.  Even if international food and fuel prices decline – which they did since August – inflation can still go up: indeed, it reached a new peak at 17.3 percent in September.

The economic storm which was already brewing in the first half of 2011 has now reached full force and has accentuated Kenya’s structural weaknesses. The turbulence in Egypt meant fewer tea exports to one of Kenya’s main markets. The subsequent struggle in Libya increased global oil prices and the import bill. Now, the next storm is approaching and it could become a hurricane, not just for Kenya: the Euro crisis and the apparent helplessness of European policy makers to deal with it, is having repercussions across the world, including Africa. Two of Kenya’s key exports and foreign exchange earners, tourism and horticulture, still depend largely on European markets. Flowers and vacations are luxury goods, and are among the first purchases that Europeans will cut-off if they go into a full-fledged economic crisis.

What should the pilot do if one engine is failing, the other one is overheating, with the plane tilting, and a hurricane is approaching?  Here’s what not to do: adopting strategies that have demonstrably not worked in the past, such as adopting price controls or establishing parallel currency markets, which have proven to be disastrous in many countries—including here in Kenya—and we need to avoid these proven mistakes this time around.  If I were in that plane, I would want the pilot to bring it down quickly and safely. While on the ground, the engines could be repaired and adjusted, as the hurricane passes by; it will take you longer to get home, but you will live to reunite with your family.

There are many measures that the government can take to get Kenya’s “economic plane” safely on the ground. One of them has been taken by the Central Bank last week when it increased benchmark interest rates from 7 to 11 percent.  This can contribute to controlling inflation and the next weeks will tell if this measure was sufficient. The risk is that it will also cool the economy. While unpopular, such measures are needed to reestablish Kenya’s macroeconomic credibility and help the economy in the medium-term. This is the price to pay in order to retain investments and avoid a crash. 

Comments

Submitted by jaymz on
food prices have continued rising steadily because there is more population increase and declining land productivity. when the effect of dry weather compounds this issue, more people become vulnerable to the disastrous slide of the shilling. Kenya exports some of the produce but the major decline caused by dry weather makes it more unsustainable. Kenya needs to increase its forest cover to mitigate on water catchment base requirement. in addition to building more dams and initiating irrigation programs, Kenya needs to train its farmers on the correct farming technology including post harvest issues to ensure adequate household food safety. it is important to ensure farmers have access to adequate affordable seeds and fertilizers. the cost of inputs sometimes is so high that farmers cannot afford the cost of carrying out the proper farming for optimum yields. a fertilizer plant establishment would be a better priority since the country can also sell to the neighbors before the idle talk of getting nuclear energy and space craft.

Submitted by KenyanButNotAnEconomist on
After such analysis Wolfgang the only solution you offer is what already the CBK is doing? Also, how come you have not mentioned anything to do with the IMF and whether the $750 bn they are offering in two years will be sufficient or not? How come you have not provided any new ideas on what is wrong with the shilling in the first place? Could the anti-laundering measures implemented have anything to do with the shillings drop as now billions of dollars are unable to enter the country? Will CBK reducing banks foreign exposure limit help that much? These are the issues you should address when providing analysis and I look forward to your response.

Submitted by Wolfgang on
Dear friend, You have lots of good questions. Please note that all my blogs have a standard format (about 900 words and one defining charts; also because they are published in the Saturday Nation and need to be limited). Our Economic Reports have more in-depth analysis and you can find them under www.worldbanmk.org/kenya/keu. We will launch the next report early December. Here some quick reactions: 1. General economic challenges in Kenya: There is not one silver bullet to get the Shilling back into stable waters, also because the reasons for the decline was a combination of factors: structural current account deficit, dramatic increase of imports, especially when oil prices were above $100, volatility in global financial flows since deepening of Euro crisis 2. IMF: The IMF’s financing will help to stabilize the Shilling, especially if it is coupled with other measures, such as higher interest rates 3. What’s wrong with the Shilling? The current Account deficit (too many imports, too little exports) or an economy “flying on one engine” (see the blog and our economic report) 4. Anti-Money Laundering: Unlikely that it is connected to the drop of the Shilling. Tighter Anti-Money laundering may actually help the Shilling if Kenya would attract more “credible” international investment. Also, some of the illicit financial flows to Kenya have been overstated. The basic problem is very simple: Imports are too large, exports too little. Kenya needs to export more and start its “manufacturing engine” then the economic parameters will change Hope this helps Wolfgang

Submitted by Jimnford Kebira on
During the period 1991-1997 the Russian rubble lost its value by almost 150%. Their foreign exchange policy at the time of raising interest rates on government debt to attract foreign funds to plug the gaping budget deficit further complicated the problem. This can be said of Kenya too, last week the Central Bank raised interest rates most likely to attract short-term investiments from foreigners. While this might cool the raging weaker shilling, it is a short-term control which postpones a problem but doesnt address it. The last government budget for the first time hit a trillion mark, this would make sense if the government had more revenues coming into her coffers, far from it. Given this Kenya's budget deficit is balooning year by year. This is another area the government should address, it should be strigent in its expenditures.

Submitted by Scubidu on
I believe your theme “importing too much and exporting too little” is quite informative. Though I’d like to address the moral hazard I believe exists in the energy sector that's a consequence of Kenya’s Guaranteed Loans Act, CAP 467. I have read in today’s paper (The Business Daily) that Parliament has approved a Treasury guarantee for an international loan for additional public power generators. Granted that these debts are financed largely in Yen it shouldn’t have that big an effect on the over BOP position. However, according to information I have available to me the current account deficit has virtually doubled over the last year due to slowing exports and service receipts. My main concern is don’t these guaranteed loans distort aggregate demand raising imports of machinery and by extension creating demand for oil (particularly due to the recent investments in thermal energy)? According to KenGen, under their current Power Purchase Agreement they’re not exposed to foreign currency translation exposure so their balance sheet includes recoverable foreign exchange adjustments amounting to Kenya shillings 13 billion in 2011 from Kenya shillings 4 billion in 2009. This means that the company has no exposure to currency mismatches, which is a scenario other private companies are finding difficult to cope with. The secondary effect of this is that these losses with have to be recovered from either taxpayers or electricity consumers (the general public). I believe this creates an unhealthy situation where a publicly held company contributes to further depreciation of our already overvalued currency, while its management are not being held accountable for their decisions. I would appreciate your views on this matter. Thank you.

Submitted by kimken on
After taking all the above into consideration:-To fix inflation, reduce interest rates and spark economic growth we need to; 1. Obtain a loan to cushion world oil prices in the long term and short term. 2. Price subsidies on oil inorder to lower manufacturing costs which will result in reduced final product prices. 3. Price controls, that will ensure manufacturers' only edge is quality. Benefits:-Increased disposable income which will result in increased savings and investments.Growth in deposits will force Bank interest rates down. Subsequent large lending should only be directed to projects that enhance economic growth. Any surplus monies thereof, the Government can use to build infra-structure that will further enhance economic growth in all viable sectors.(This should be outsourced inorder to curb cyclic inflation). Resultant low cost products will effectively compete in the export market hence closing our current account deficit. This should be sustained until our exports far exceed our imports.

Submitted by Wolfgang on
Be careful with large-scale subsidies and price controls. They have almost always gone wrong, hurt the poor and increased corruption. Here is a piece on price controls by our Country Director John Zutt: http://www.nation.co.ke/oped/Opinion/Capping+bank+interest+rates+will+do+more+harm+than+good/-/440808/1328244/-/xhwlv7/-/index.html

Submitted by Caesar on
Good insight. I predict some tough economic times for Kenya's next President. the current coalition government has been in a spending spree, in recurrent spending, public works, the public are also over leveraged, and large defense spending in the war in Somalia, exports have also remained flat. except for an increased productivity in cement mining I cannot see anything current and in the radar that will sustain growth.

Submitted by Ronny on

Am wondering if the government is a wear of what is happening , and if they are what are they doing?

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