Shortly after Kenya's 2022 elections, the shilling depreciated rapidly against the US dollar - the country's main currency for international transactions - fuelling a wave of political discontent.
More than a year later, the Central Bank of Kenya, taking its cue from the International Monetary Fund, said that the run on the shilling was a market correction for a currency that had been overvalued by between 20% and 25%.
By early this year, the shilling recovered. Finance scholar Odongo Kodongo answers our questions about Kenya's exchange rate fluctuations.
How is the shilling's exchange rates determined?
Kenya operates a floating exchange rate regime. This means that the value of the shilling is, in principle, determined by market demand and supply. Market demand and supply are affected by movements of money across national borders.
Movements of money into the country are driven by forces such as the value of exports and transfers from abroad (such as diaspora remittances), and the value of investments from abroad. For example, if Kenya exports more goods at higher prices, this increases the shilling's demand as Kenyan exporters convert their dollar receipts to shillings. The shilling appreciates, all else equal.
On the supply side are the value of imports and outbound transfers (like pensions of retired expatriates), and the value of investments abroad. For example, to buy shares abroad, Kenyans must sell shillings to buy foreign currencies. This increases the shilling's supply, causing it to depreciate, all else equal.
The drivers of international money flows are, in turn, affected by economic factors (called fundamentals) such as interest rates, inflation, and income. For example, a fall in interest rates in Kenya may encourage businesses to borrow to finance their investment opportunities, increasing Kenya's economic production.
The rise in economic production generates more goods to be sold in Kenya and abroad. Sales abroad increase the value of exports, which causes the shilling to appreciate. Contrarily, an increase in government borrowing from abroad initially causes a shilling appreciation as Kenya's foreign currency reserves grow. However, it also raises the expectation that Kenya will henceforth pay more to foreign creditors, which may elicit some reversal in the initial appreciation.
Why does the exchange change rate matter?
The exchange rate matters for several reasons.
First, it may drive domestic inflation. For example, if one barrel of oil trades for US$100 and the exchange rate is KES 120/US dollar, we pay KES 12,000 per barrel. Should the shilling depreciate to KES 150/dollar, we would now pay more: KES 15,000 per barrel. Because oil is used in the manufacture of goods and provision of services (such as transport), a higher oil bill makes those goods and services more expensive.
Second, the exchange rate also affects how much we earn from exports. For example, exports worth US$1,000 would fetch us more shillings (KES 150,000) at KES 150/dollar exchange rate rather than only KES 120,000 at KES 120/dollar.
However, economic sectors are not affected the same way by exchange rate changes. Sectors that do not export or import goods and those that do not compete with imported goods are hardly affected by exchange rates.
What role does Kenya's central bank play in the foreign exchange market?
In a market-driven exchange rate system such as Kenya's, the central bank's responsibility is fairly straightforward. It is to ensure exchange rate stability to facilitate planning by businesses and households and to maintain confidence in the currency. It does this by intervening in the market whenever necessitated by exchange rate fluctuations.
For example, on 5 December 2023, the central bank's monetary policy committee intervened by increasing the policy interest rate from 10.5% to 12.5% on the argument that the shilling had depreciated "more than necessary to reestablish equilibrium". An increment in the interest rate is expected to attract foreign investors, creating a demand for the shilling and causing it to appreciate.
However, this action did not alter the market's expectations. The shilling continued falling, and, by 25 February 2024, the shilling had depreciated to 163/US$. This is probably because there were other reasons keeping the shilling weak, such as investors' fears about a possible default on Kenya's maturing eurobond debt.
In mid-January 2024, Kenya sought to refinance its US$2 billion maturing eurobond obligation. On being approached, two multilateral institutions, the International Monetary Fund and Trade and Development Bank, committed close to US$ 1 billion in new loans.
This "success" induced the initial change of tide in the value of the shilling. Later, nudged by Cote d'Ivoire's success, Kenya issued a US$1.5 billion seven-year note in the eurobond market, the success of which triggered a strong rally in the shilling's value: by 10 April 2024, it had strengthened to about 129/US$.
Is the current shilling's appreciation sustainable?
Like many market-driven currencies, the shilling is not floating freely. As explained, the central bank often intervenes in the currency market to achieve objectives such as, to smooth fluctuations (reduce the speed of transition from one rate to another), or to stem further fluctuations.
Related to this is that currency values may change in response to sentiment. For example, when Kenya recently paid off part of its eurobond debt, media reports suggested that the shilling was thereafter unlikely to suffer a strain from a possible sovereign default (which the market had already priced into the shilling's value). The positive sentiment conveyed by such reports likely informed the shilling's initial euphoric appreciation.
However, currency value changes induced by sentiment or intervention are not sustainable. If Kenya wants to keep the shilling's value artificially high, for example, it will soon realise that foreign currency reserves, used for intervention, are not limitless.
An appreciable depletion in reserves causes expectations of a shilling decline, which induces capital flight. Capital flight then increases the shilling's supply causing it to depreciate. Thus, to keep the strong shilling sustainable requires strong economic fundamentals.
Have Kenya's economic fundamentals improved?
The short answer is, "no". Let's examine some factors. First, as explained, the country recently borrowed almost US$2.5 billion abroad to refinance a US$2 billion debt. The result was a net growth of almost US$500 million in external debt. This will further increase the proportion of public revenue committed to debt servicing (called the debt burden).
As of first quarter 2023, debt servicing was gobbling up about 67.5% of Kenya's tax revenues, leaving very little money for development spending: during 2023, development expenditure constituted only 16.5% of revenues (excluding grants). Reduced development spending imperils economic performance, and weakens the shilling in the long run.
Second, Kenya's trade balance (value of exports minus value of imports) has been negative. Of concern is that the negative balance has been growing: from 4.9% of GDP in 1975 to 9.3% in 2022. This situation is not expected to change soon. The growing negative trade balance is consistent with a long run shilling depreciation.
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Third, in its February 2024 review, the central bank raised the policy interest rate to 13%. This has pushed up the cost of money, with central bank's discount window (the rate at which central bank lends money to banks experiencing short-term liquidity shortfalls) rising to 16%.
The higher cost of money discourages private sector investments and lowers economic production. Low economic production reduces exports and increases imports, leading to currency depreciation.
Further, the high interest rates have raised yields on assets such as the benchmark 10-year government bond. This has attracted hot money (speculative foreign capital seeking high asset returns) which has partly driven the shilling's appreciation. Gains from short term investments often dissipate quickly when interest rates begin to fall as the recent Treasury bills auction shows. With gains diminishing, the hot money will flee, pulling down the shilling's value with it.
Finally, because of its role in organisation of production and labour productivity, human capital plays a critical role in economic performance. Higher human capital development is associated with higher levels of innovation and risk taking, which help to expand economic activities (economic and export diversification) and to improve production efficiency. Kenya's human capital development index has remained largely weak, growing from 0.52 in 2017 to 0.54 in 2020, which is not good for export diversification and portends long run shilling depreciation.
Odongo Kodongo, Associate professor, Finance, University of the Witwatersrand
