Kenya: Why Kenya's Central Bank Is Likely to Retain Base Lending Rate At 9%

Nairobi — The Central Bank of Kenya's decision making organ- Monetary Policy Committee (MPC) is set to meet on Tuesday November 27, 2018.

This will be the last sitting in 2018 by the CBK's top decision making entity which meets at least once every two months, to review the country's macro-economic conditions and make a decision on the direction of the Central Bank Rate (CBR).

During the previous meeting held on September 25, the committee maintained the CBR at 9.0% after cutting it from 9.5 per cent in July.

The decision was based on the country's macroeconomic fundamentals which it termed stable, as well as sustained optimism on the economic growth prospects.

This was pegged on inflation expectations, which were well anchored within the target range, having fell to 4.0 per cent in August from 4.4 per cent in July, following decreases in food prices that offset the increase in energy prices, including the increase in the price of charcoal.

The MPC noted that the overall inflation was expected to remain within the government target range of 2.5 per cent to 7.5 per cent despite upward pressure from rising fuel prices due to a rise in global oil prices and the impact of excise duty on some of the Consumer Price Index (CPI) items.

Expectations of declining food prices due to favorable weather conditions was expected to mitigate the upward inflationary pressure.

Additionally, the MPC noted that private sector credit grew 4.3 per cent year-on-year in August, with the highest growth in lending being recorded in the building and construction, manufacturing, consumer durables and trade sectors at 14.9 per cent, 13.3 per cent, 11.5 per cent and 7.0 per cent over the same period respectively.

Private Sector Market Perception Survey conducted in May 2018 had earlier indicated that the private sector was optimistic about local economic prospects in 2018.

This was mainly attributed to a rebound in agriculture, pick-up in private sector economic activity, strong forward hotel bookings, renewed business confidence due to the ongoing war against corruption, and a stable macroeconomic environment.

The current account deficit narrowed to 5.3 per cent in the 12 months to July 2018 from 5.6 per cent in June 2018, and was expected to narrow further to 5.4 per cent of GDP in 2018 supported by strong growth of agricultural exports particularly tea and horticulture, improved diaspora remittances and tourism receipts.

The petroleum products import bill was however expected to increase due to higher international oil prices and expected front-loading of imports with respect to the ongoing Standard Gauge Railway (SGR) project, but the effects on the current account were expected to be mitigated by lower imports of food in 2018.

As the committee meets to evaluate the prevailing macro-economic conditions, experts at Cytonn Asset Managers Limited, an Affiliate of Cytonn Investments Management Plc have predicted the base lending rate will be retained at 9.0 per cent, a similar prediction which came to pass in the previous meeting.

The asset managers have analysed the macro-economic indicators trend since the September 2018 MPC meeting, and how they are likely to affect next week's MPC decision on the direction of the CBR.

Of the six factors that Cytonn tracks, one is negative, two are neutral, and three are positive, with no change since the last MPC meeting.

These factors are government borrowing (positive), inflation (positive), currency-Kenya Shilling to US Dollar (neutral), GDP growth (positive), Private Sector Credit Growth(negative) and liquidity which has been given a neutral score.

"We believe that the MPC should adopt a wait and see approach, given the macro-economic environment is relatively stable. We therefore expect the MPC to hold the CBR at 9.0 per cent," Cytonn Asset Managers Limited says in its MPC note.

According to Cytonn, the decision will come on the back of a stable inflation, despite expectations of inflationary pressure in the remainder of the year as the effects of the various tax policy measures introduced through the Finance Bill 2018 continue to be felt.

"We do not believe that the pressure is high enough to warrant a policy shift. Inflationary pressure has further been mitigated by the declining food prices due to the improved weather conditions and as such, inflation is expected to be within the government set target of 2.5 per cent to 7.5 per cent," the asset managers note.

Inflation has averaged 4.5 per cent in the first 10 months of 2018 compared to 8.7 per cent experienced in a similar period in 2017. The year-on-year inflation rate for October recorded a decline to 5.5 per cent from 5.7 per cent in September.

The decline was attributed to a 1.8 per cent and 0.9 per cent decline in the food and non-alcoholic beverages index and the transport index, respectively.

Inflation in the remaining part of the year is expected to experience upward pressure due to the various tax amendments as per the Finance Bill 2018, but at a lower rate than earlier anticipated following the reduction of the VAT charge on fuel to 8.0 per cent from 16.0 per cent effective September 21.

This, Cytonn says, affirms expectations on inflation for the year averaging within the government's set target.

Another factor is a stable currency. Despite the recent depreciation of the Kenyan Shilling against the US dollar, the experts note that the local currency has remained relatively stable, reflecting a more stable economic environment.

The Shilling has lost by 2.2 per cent since the last meeting, mainly driven by levels of dollar inflows failing to meet the demand mainly from oil importers, which has also seen the oil import bill rise.

It is however expected to remain stable supported by dollar reserves hence a neutral score.

Volatility of the Kenyan shilling has mainly been cushioned by Central Bank's activities which has seen the forex reserves decline by 4.4 per cent to US$8.1 billion from US$8.4 billion since the last MPC meeting, but still remain high and above the optimal level of reserves for Kenya as per the IMF's set at 3.5 months of imports.

According to Cytonn, the ongoing prospects of the Treasury issuing another Eurobond could also eliminate the need for tightening the monetary policy, as it will enhance the forex reserves thus cushioning the shilling.

Private sector credit growth has remained unchanged at 4.3 per cent for the three months to September, since the lowering of the CBR to 9.0 per cent in July, higher than the 3.3 per cent average for the nine months to September 2018.

This is also higher than the 2017 average of 2.5 per cent but is still below the 5-year average of 12.6 per cent.

"Key concern however remains the effectiveness of monetary policy with the interest rate cap still in place. The Central Bank Rate) has lost its signalling role as interest rate controls have weakened the link between the CBR and bank lending and deposit rates," Cytonn's asset managers say in their note.

"Prior to introduction of interest rate controls, the CBK had been changing the CBR with respect to developments in inflation and growth. However, since the implementation of the rate cap, the impact of the CBR cuts has not been clear," they added.

Government borrowing however remains positive according to the Financial Year 2018-19 budget, another factor which is likely to influence the committee's decision.

Total borrowing target for the current financial year is Ksh558.9 billion down from Ksh620.8 billion in the 2017-2018 financial year ended July.

It has been under no pressure to borrow as evidenced by the declining yield curve as the government continues to reject expensive bids.

"We expect the government to be under no pressure to borrow in the domestic market. With the rate cap still in place, the government is expected to continue accessing domestic debt at lower yields due to reduced competition from the private sector coupled with improved liquidity," the experts at Cytonn note.

Total borrowing requirement to plug in the fiscal deficit in the 2018-2019 is also expected to decline to Ksh558.9 billion from Ksh620.8 billion, with domestic borrowing estimated at Ksh 271.9 billion, 8.6 per cent lower than the Ksh297.6 billion target in previous year. This hence reduces the pressure further.

Gross Domestic product (GDP) growth, a key factor in MPC's decision, is projected to come in at between 5.4 per cent and 5.6 per cent, driven by recovery in the agriculture sector, continued growth in the tourism, real estate and construction sectors, and growth in the manufacturing sector.

The economy expanded by 6.3 per cent in the second quarter of 2018, higher than 4.7 per cent in quarter two (Q2'2017) supported by recovery in agriculture as a result of improved weather conditions.

Improved business and consumer confidence, increased output in the manufacturing, electricity and water supply sectors which grew by 3.1 per cent and 8.6 per cent respectively also supported growth.

The CBR will also be based on private sector credit growth which is expected to remain low, below the 5-year average of 13.0 per cent.

Latest CBK data indicates that private sector credit growth has remained unchanged at 4.3 per cent since July.

This has however been the highest growth rate since December 2016, pointing to a recovery though still way below the 13 per cent five -year average.

Low credit growth will be occasioned by the interest rate cap, which has made banks adopt a more stringent credit risk assessment framework thus limiting lending to riskier borrowers.

With the prevailing CBR at 9%, banks can lend with interests up to 13 per cent as the law puts the ceiling at four percentage points above the central bank rate.

Liquidity is expected to remain high with the heavy maturities of short-term domestic debt in the 2018-2019 financial year currently comprising of Ksh629.3 billionT-bill and Ksh155.4 billion worth of T-bond maturities, as well as continued government spending through the various infrastructure investments.

"Liquidity levels in the money markets have continued to improve as indicated by the declined average interbank rate to 3.6 per cent in October from 4.5 per cent in September. There has however been a concern that the increased liquidity in the inter-bank market could further weigh down the shilling," Cytonn notes.

With these factors, Cytonn managers strongly believe the CBR will remain unchanged and as the MPC meets this week, the market will be keenly following to know the new rates.

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