The falling shilling

The falling shilling / 1 - 5

The feel good factor arising from the adoption of the 2010 Kenyan constitution and the promise it holds for reducing poverty and creating an equitable and harmonious society may be rapidly eroding as the Kenyan economy and society face a battering of negative forces.

Whilst the steep decline in the value of the Shilling (the steepest for decades) is the focus of the public debate and public policy responses, the Shilling's fall is happening side by side with one of the steepest rise in inflation (especially in the prices of those goods and services consumed by the poor) for over a decade; a steep decline in stock market value, wiping billions off the value of assets and making the Nairobi Stock Exchange (NSE) one of the worst performing in the world at the moment; and, a concomitant decline in the real estate sector, the main absorber of liquidity. The already anemic size of Kenya's reserves (averaging less than 3 months of imports since 2004) is further depleted and the chronic deficits in the trade and fiscal accounts are worsening. Public indebtedness is escalating and is increasingly dominated by short-term debt.

On top of these, Kenyans have suffered one of the worst episodes of hunger for years which remains unresolved, and the country is engaged in full scale military hostilities in Somalia. These factors can worsen the already dire poverty and inequality situation, and roll-back the modest gains made in achieving the Millennium Development Goals (MDGs) if not properly handled. A proper handling would begin with the diagnoses of the immediate and underlying causes of these converging problems. The pronouncements and measures taken by the managers of the economy, leave a sense of short-termism, the cost of which is likely to be borne disproportionately by the poor, whilst leaving the underlying vulnerabilities and fragilities largely untouched. This paper argues that four main factors fundamentally underpin these fragilities:

(1) the way capital flows are managed and the level of deregulation of the financial sector

(2)the underlying structure of the economy, mainly excessive importation and dependence on primary commodities exports, as well as a bulging underground economy,

(3) Underlying inequalities and poverty and inadequate steps to address them

(4) Regulatory problems due, in particular, to conflict of interest.

The falling shilling - 2 - Official Explanation

The falling shilling - 3 - Capital transfer regime

We are told that the weakening of the shilling is not driven by weak economic fundamentals as "the economy remains sound". Rather, the decline is mainly due to external shocks which have caused the demand and supply of foreign exchange to misalign. These shocks include: drought that has affected the food supply, thus necessitating higher imports and exerting pressure on inflation; and, the sovereign debt crisis in Southern Europe which has led to the strengthening of the dollar, making the dollar relatively more expensive. Monetary policy played a role through the injection of cheap credit by the Central Bank of Kenya (CBK) through the banking system both in terms of short-term and longer term lending, thereby creating a scenario of too many shillings chasing after too few dollars as well as goods and services. The Central Bank Governor's position that the sharp collapse may also be attributed to speculation and the hoarding of dollars for speculative purposes was dismissed out of hand. The surge in global energy prices is also a significant external contribution to domestic inflation. The falling stock market is attributed to investors playing safe by selling their securities to buy government bonds which are considered a safer haven.

The policy responses arising from such an analysis are predictable and perhaps short-sighted. All that is necessary, it seems, are modest steps to put more dollars in the market e.g. by reducing the amount of foreign exchange banks are allowed to hold as part of their capital requirements; additional borrowing from the International Monetary Fund (IMF) to soar up reserves; tightening credit in the economy by raising the interest rates; cutting down government expenditure to reduce inflation; and mopping up extra liquidity through CBK sale of short-term securities. Structural measures are in the form of encouraging better cooperation between the CBK, commercial banks and currency dealers. Unfortunately, these measures will not only do little to address the underlying fragilities and minimize future crisis, but they also risk deepening poverty by shrinking growth and reducing investments in basic services. These can in turn feed into worsening trade and fiscal imbalances through reduced exports and government revenues. Essentially the proffered responses are "pro-cyclical" in nature i.e. they will squeeze economic growth in order to achieve short-term stability.

I will argue that what Kenya is experiencing is a combination of currency, balance of payments and financial crisis which reflect in high and rising interest rates, inflation and deteriorating asset portfolios (increasing share of bad loans in total lending) and the falling value of the shilling. These suggest firstly, that there are significant credit, assets and investment bubbles in the economy.

Secondly, external liabilities relative to reserves (debt obligations) are perceived as unsustainable especially when the current account is chronically in deficit and rising against a rising short-term debt.

Thirdly, liabilities are highly liquid, meaning that non-residents can freely move their capital round from bond-markets, to equities to government securities.

Fourthly, vulnerabilities arising from the latter point are higher the more extensive the nature of foreign participation is in local financial markets. This increases market volatility and raises exposure to spill-over from financial instabilities abroad. Finally, rather than insure itself against capital reversals, Kenya has started to routinely depend on the IMF's financial help and policy advise.

What underlies the bubbles in the economy? It will seem that the boom year of 2010 was not driven by productivity growth but by ample liquidity pumped into the system by the CBK; low interest rates that fueled speculative lending to unproductive sectors such as high-end real estate and car loans. This real estate market got a further boost through an ample injection of short-term portfolio capital seeking short-term gains through anticipated interest rate rise, equity market gains and gains from the over-valued Shilling at the time. Short-term portfolio capital (flows of foreign capital into equities and bond markets) constituted the bulk of external capital inflows into Kenya in 2009 and 2010. These inflows into equity markets, together with the attendant liquidly it injects may have been both the cause and effect of the sharp increases in the stock prices in 2010. Its withdrawal equally accounts for the sharp drop in equities in the NSE. The sharp increases in the earnings rate of equities reflect bubbles in the asset market (mainly real estate) rather than economic fundamentals. One manifestation of these bubbles is the fact that housing loans have expanded faster than other types of lending and is a major source of household indebtedness.

Rising inequalities contribute to crisis in many ways. Inequalities concentrate the effective demand in the luxury sector, such as high-end real estate. This contributes to the bubble, amplifying the potential for financial crisis and social instability whilst denying investments to the productive sector and small and medium economies where the most jobs can be created and incomes distributed or investment in health and education to create opportunities for future employment. The literature is converging on the conclusion that more inequalities are associated with less sustained growth. Inequality may also make it harder for governments to regulate the economy to benefit the population if the wealthy have disproportionate influence on political choice. Financial liberalization on the other hand can contribute to higher inequality and poverty through skewed allocation of resources, household indebtedness, and by facilitating tax evasion and avoidance and illicit capital flight. A 2009 World Bank study shows that inequalities are steep and rising and disparities among geographic regions are wide.

The core issue here is the liberalization of the capital account and financial deregulation which allows for hot money to flow freely into the economy and around financial markets and out again. Capital Account Liberalisation (CAL) entails allowing not only foreign direct investment (FDI) but also capital inflows to bond and equity markets and to the banking sector. Financial deregulation includes CAL and involves the changes in the freedoms of domestic banks to engage in foreign transactions and foreign banks to enter the domestic market. Kenya's official policy favors full financial liberalization. To complete its liberalization process, Kenya is working towards making Nairobi an International Financial Centre

The falling shilling - 4 - Why the nose-dive

There is a demand and supply problem – Kenya is simply not earning enough foreign exchange to match the high extent of her imports. The country simply lacks sufficient reserves to defend its currency when under attack or in adverse times. More-over, currency is significantly more exposed when the financial sector is excessively liberalized as is the case in Kenya. In liberalized financial markets and capital account regimes (with high freedom of capital to move in and out and into various markets), the main source of volatility is not the current account (trade imbalances) but the capital account. In these regimes, the adequacy of the reserves is determined not only by import needs, but also debt servicing as well as inflationary expectations and political factors. Kenya's economy is suffering a combination of these factors. Perceptions of political instability facilitate capital exit. It is suggested that the spike in the shilling's fall some time in April/May 2011 may have resulted from politically exposed wealthy persons transferring foreign currency abroad. In addition to food and fuel import pressure, Kenya is also facing significant debt servicing pressures since most of the debt – public and private – is increasingly short-term in nature having been raised from bond markets. This exposes the Shilling to speculative attacks and capital flight..

Other factors that drive speculative attacks include:

(1) an ability to engage in international electronic trading in currencies;

(2) current account deficits above 3% of GDP;

(3) eliminating conditions and restraints for the purchase and transfer abroad of foreign currencies by residents;

(4) permitting financial institutions to conduct offshore business in foreign currencies without establishing business in the country;

(5) eliminating conditions mandating the identification of natural persons behind numbered accounts and corporate entities.

These factors facilitate the rapid transfer of foreign currencies abroad for varied purposes such as risk mitigation, speculation or wealth concealment for tax avoidance and illicit wealth transfer. Illicit capital flight is rampant in Kenya and recent estimates suggest that as much as $3bn may have been illicitly transferred abroad by wealthy individuals and companies seeking protective havens for their wealth or in order to avoid, evade or minimize their tax obligations.

Currency speculation is a recognized lucrative business in Kenya, made possible by the deregulation of finance, including capital account liberalization and the freedom to engage in international electronic trading. The CBK Governor could not have been engaging in idle talk when he accused (without revealing) some commercial banks of hoarding dollars for speculative purposes or to drive down the value of the shilling in order to make a quick killing.

Kenya's speculative trade also thrives through the so-called 'underground economy'. Variously defined, this economy involves the small jua kali sector as well as the big time criminals engaged in narcotics and arms trade, money laundering and the piracy industry. Some estimates suggest that the size of this economy may be as big as 25% of Kenya's GDP. If income distribution in this sector is as skewed as the national picture, then perhaps as few as 10% of the players in this economy may well command as much as 15% of GDP of cash outside the formal economy. This means large volumes of cash – shillings and foreign exchange – including counterfeit notes are floating around the country. Banking industry players speak of people visiting their banks in East Leigh with sack loads of currency. Such players have a capability to influence the volume of foreign exchange traded.

Some analysts also suggest that there is a convergence of three economies: the formal financial; the illegal financial and the political/financial ones. If there is some truth to this assertion, it is hard to see how the financial sector can be effectively regulated through conventional tools of monetary policy, reserves policy and regulating the inter-bank trading of foreign exchange. It is hard to curtail the flow of criminal money if it is relatively easy to move it around, clean it up and ship it abroad and back in.

In all these cases, at the heart of the instability is the excessively liberalized financial markets and capital account regime. Kenya's experience closely mirrors Thailand's policy environment in period leading to the 1997 financial crisis. Therefore, Kenya could be sleep walking into a disaster worse than Thailand as it apes all that Thailand and South-East Asia have learnt and largely reformed. For example, nothing could be more disastrous than the planned International Financial Centre modeled alongside the Thai one which is partly blamed for the crisis but also for facilitating corruption, tax evasion and money laundering.

The falling shilling - 5 - Conflicts of interest

The Thailand case also has resonance in terms of political regimes. In Thailand just as in Kenya, there is a conflict of roles and interests. Those with the political responsibility to regulate the financial system for efficiency and equitable growth also have interests in the banking sector and personally benefit from the freedom to move capital in and out. Stringent regulation would be tantamount to attacking their own interests. In Thailand, dubious involvement of politicians in certain financial institutions and shady deals for personal gain set in motion a chain of events that ultimately led to a fall in confidence in the Central bank and its regulatory integrity. Watching the Kenyan scene one cannot but feel a sense of pity for the Central Bank Governor as he battles to bring some order to the financial markets and the currency, whilst being contradicted.

I will conclude as follows. The degree of capital account liberalization and financial deregulation of the Kenyan economy has something to do with the declining shilling and asset and stock markets. The liberalization has succeeded in sucking in hot money (not FDI) seeking quick profits. This hot money went into the housing sector and banking stocks, in search of interest rate differentials. It also found its way into government bonds, making a few rich, and leaving the the majority behind and the government more indebted. It created growth without distribution or productive capacity, thereby increasing inequality. The bubbles burst when inflationary expectations, increased perception of risk occasioned by increased debt servicing burden, declining reserves and political factors led the hot money to flee along side illicit capital flight and speculation on the shilling or simply hoarding of the dollar, leading to a combined collapse in the shilling, stocks and real estate. The core of the crisis lies in the rules governing the management of capital flows and not just demand and supply.

Sadly, the need to rethink the rules governing the capital account appears to have been ruled out. However, at the very least, the issue should be debated as is required by the constitution. This is because financial liberalization not only brings benefits but as we have shown in the above analysis does occasion also, significant costs in the form of volatilities, deepening inequalities and poverty.

The long run stabilization of the shilling and inflation requires that Kenya produces more of what it needs (especially food), sells more of those goods that add value significantly; separates the private and public domains and addresses poverty and inequality. To do so, implementing the constitution in word and spirit is critical.