Kenya’s shilling management is flirting with disaster
Many emerging market currencies have had a wild ride over the last year, yet Kenya's shilling has remained largely stable.
The IMF last year reclassified the shilling as a managed rather than a floating currency, leading to protests from the authorities who insist that the currency is fairly valued and that the only interventions are to reduce volatility.
The difference amounts to much more than word play, according to Reginald Kadzutu, chief investment officer at Amana Capital in Nairobi, in research published this month. The Kenyan shilling has lost 50% of its purchasing power since 2009, yet the exchange rate has declined by only 20%, the report argues. That implies a shilling overvaluation of 30%, Kadzutu argues: “It is a glaring picture that shows a mismatch in the national statistics.”
Kenya needs dollars to service its foreign debt and pay for imports. The trade deficit grew by 26% from 2013 to 2018, but the resulting demand for dollars is not accurately reflected in the exchange rate. “The country has been operating a managed shilling rather than a free float currency,” he says.
- An overvalued shilling, Kadzutu argues, will make the country’s exports uncompetitive.
- “The current account deficit will not go anywhere until the Kenya shilling goes to the level it is supposed to be.”
- The deficit will be compounded by drought, meaning more grains imports, and the decline of the domestic industry, meaning more sugar imports, Kadzutu says.
Kenya’s restrictive interest-rate regime has prevented banks from lending to the private sector as they cannot balance risk and return, Kadzutu argues. This has starved the private sector of credit growth. Kadzutu says that private-sector credit is growing at 4% instead of the required 12%, meaning the prospect of reduced tax revenue and higher debt.
Johnson Nderi, corporate finance manager at ABC Capital in Nairobi, does not agree that the shilling is being artificially supported. He says the stability is due to low inflation and remittances.
- Nderi accepts that fiscal policy is a key weakness in a context of growing debt-service costs.
- Recurrent expenditure is perennially above tax-revenue collection and one out of four tax shillings collected goes to paying interest, he says.
Kadzutu sees an economy that is “waiting for a spark” before imploding. The current framework will be able to sustain slow growth for the next three to five years, he argues. In the long run, he predicts a “drastic drop” in the level of the shilling that will cause the economy to collapse. A falling shilling, he argues, will lead to panic demand for the dollar, pushing the shilling further down and leading to a temporary withdrawal of foreign funds from the capital markets. The central bank will be unable to deal with the resulting supply-side inflation. Corporate defaults will increase, as will the number of non-performing loans held by banks.
To avoid such a scenario, Kadzutu says, Kenya should carry out a “controlled devaluation” of the shilling to allow it to reach its true market value. Businesses should reduce risks by cutting foreign-denominated debt.
Secretly managed currencies usually get heavily punished in the end, with Turkey being a recent example. Kenya urgently needs to allow the shilling to find its true value.