How Vulnerable is the Kenyan Economy? Interest Rates

Interest Rates


The increase in Interest rates from 5.75% in March 2011 to 18% in December 2011 . This measure came along with increasing the cash reserve ratio from 4.75% to 5.25% over May to November 2011. Both these measures had the effect of squeezing the money supply in the economy in a bid to stem inflation which still remains in the higher teens.

The effects of these measures have been;

• A slowdown in economic growth due to expensive credit in the market. Currently, credit for both corporate entities and individual clients ranges between 20% to 35%
• A shift in investment from listed equities to Fixed income securities due to perceived better returns notwithstanding the fact that election years have traditionally meant poor performance in the stock market.

There has also been hue and cry regarding the egregiousness of spreads between the risk free rate of interest (the CBR rate which is around 18%) and the rate at which banks loan clients currently at around 30%. This has led to a move to curb these rates by parliament the introduction of interest rate caps. This would mean that a bank cannot charge more than a particular percentage over the Central Bank Rate. This has been met with resistance from the Banking fraternity and the treasury who say this is over-regulation and would adversely affect the banking sector.

Both sides of the divide have valid points but the approach has to be balanced. On one hand, capping of interest rates would stifle access to finance due to the fact that only highly creditworthy persons would be able to access loans. The rest would be given a wide berth by the banks. On the other hand, it is unjustifiable that banks continue to make double-digit growth in profit while the economy suffers. There is a sense that they have a disproportionate advantage in comparison with other industries in terms of passing on risk to its clientele. This can only be curbed by increasing competition within the financial services sector to 'force' banks to reduce their margins. This could also be done by encouraging other forms of financing for business via vehicles such as private equity firms, SACCOS and Venture capital funds which would increase choice of financing for entrepreneurs. Also, the CBK can institute regulation capping the portion of capital banks can use for trading securities and currencies so as to skew the capital towards the credit market. 

 

How Vulnerable is the Kenyan Economy? Exchange Rates

Exchange Rates 
The sudden decline of the Kenya Shilling in the second half of 2011 was most alarming. Kenya became the worst performing currency in the world against the US Dollar with 30% loss in value. The question that arises is whether this drop was due to an sudden increase in fundamental demand for currency or was it speculator driven. Recently, the Central Bank Governor has been on the firing line for the perceived slow response to this crisis and the probe by the parliamentary committee on finance has revealed a lot of the behind-the-scenes happenings during that time. Key highlights includes:

• Demand for explanation by the Central Bank Governor from three leading Banks on  their activities in the currency market during this period.
• Parliamentary Task force set to investigate the fall of the shilling. ( Read Parliamentary Report)
• Recommendation by the Parliamentary Select committee that the Central Bank Governor resigns in taking responsibility for the Shilling's fall.

This report provides an insight on the the vulnerability of the shilling against major currencies. The highlights include:

• The Country's ever increasing current account deficit. The CBK Governor indicated this during the testimony by saying between September 2011 to October 2011 this deficit widened by  $116 Million which is about  20% increase. A lot of this is blamed on Kenya's increasing appetite for imports and a lack of focus on exports. However, the increase in the deficit over 2011 was abnormal by any standards  with an almost five fold increase over the second half of the year. ( See Chart) This alludes to the fact that this increase in deficit is not solely based on fundamental changes in import/export patterns. Which brings me to my second point...
• There is also a regulatory gap as attested by the CBK Governor's confession that electronic trading systems are difficult to monitor. He is referring to systems such as Reuters and Bloomberg which financial industry players use to communicate. Due to this, deals that would have once taken months to complete are completed in a matter of minutes. This allows for capital to flow faster in between markets which, on the negative side, exacerbates flight of capital. 
•  Kenya has an open capital account and a floating exchange rate.This means that there are no restrictions to flow of Forex within the Kenyan Market. Whereas it is an important mechanism in making the economy competitive, it makes the country more susceptible to economic shocks locally and internationally. It is no coincidence that as the European debt crisis was coming to the forefront, the shilling began its steep decline. It also opens the door for speculators with access to large chunks of Forex to 'attack' the Shilling by shorting the shilling against the dollar.
•  Kenya's Forex reserves are in urgent need of boosting. This was made clear as the CBK could not adequately defend the shilling by selling dollars as it had meager reserves. Also, at the time of the crisis, the CBK was in the process of building import cover of about 6 months. This could have been among the reasons a supply of dollars from CBK was not forthcoming as the steep decline began.

These highlights above are by no means exhaustive but give an indication as to main the sources of vulnerability. The calls for the Governor's resignation have merit but will not address the issues at the core of the problem. The country's addiction to imports has to be reined but this will take time and should not be at the of expense economic growth. This means that shilling will remain fundamentally weak over the time period it will take to the economy to structurally shift from an import driven one to being export based. The possible solutions for this include; 

• Decreasing our dependency on oil imports buy investing on our own energy infrastructure and importing oil from regional Uganda or Tanzania.
• Encouraging growth of local manufacturing , agriculture and tourism with aim of satisfying local and export demand for goods and services and decreasing need for Forex.
• Smarter regulation of currency markets with impetus placed on regulation that discourages speculative trading. The Central Bank should also build its Forex reserves for sufficient import cover and also aim to diversify its main reserve currencies to reflect our ever increasing need for Chinese imports.   

How Vulnerable is the Kenyan Economy? Inflation

The second half of 2011 was a tumultuous season in the Kenyan financial Sector. We saw the Kenyan Shilling capitulate almost overnight by around 30% against the US Dollar to 107 KES/USD . In a bid to curb this dollar demand, interest rates soared in reaction to the Central Bank setting  the benchmark Central Bank Rate higher. This made the cost of credit for business reach levels last seen in the 90s when the economy was in the doldrums. As this was cooking, inflation rates were soaring hitting over 20% on a month on month basis on the back of higher food and oil prices. These three factors: Inflation, Exchange Rates and Interest Rates, being all significantly negative, formed the ingredients of the perfect economic storm.

So, How vulnerable is the Kenyan Economy? We can try to get to the root of this by dissecting each of these factors.

Inflation 
Inflation is a double edged sword. Too much of it diminishes your purchasing power, too little/ or lack of it indicates low economic growth ( read Japan's Lost Decades)  A common sense approach to define a good inflation rate is one that does not outstrip the rate of GDP growth. Currently (February 2012) , inflation stands at around 18% while projected economic growth for the year is 4-5% depending on who you ask.

Therein lies the problem, our common tab for goods we buy keeps on increasing at a higher rate than our common wealth. The simple solution is to either increase our rate of economic growth to 18+% ( which is means almost quadrupling our productivity....not very plausible) or reducing our rate of inflation to less than 5% ( which can and had been done)

Following this course of action requires that the country at ensure it has food security for at least two years. This requires that agriculture be modernized in terms of production, marketing and storage. Malawi is a great example of how food security can be achieved in a short time with targeted subsidies to smallholder farmers and efforts to use higher yielding and drought resistant seeds.(read Malawi's food security success) There is also need to localize storage for farmers to enable all year long supply of grain. It would also make the farmer less vulnerable to middle-men if farmers can get credit using grain receipts as collateral. Also, there has to be conscious effort to commercialize agriculture.This is the only way food security can be assured in the long run.

Oil is also a major component in the inflation equation with far-reaching effects on the cost of production of most goods and services. Our major handicap is that we have no local production. Nevertheless, we still can institute measures to curb variance in supply and price. In the short term, we can curb our inefficiencies in the oil industry along the supply chain. From outdated infrastructure at the country's sole refinery  to transport issues within the oil pipeline, the supply chain is riddled with shortcomings that are mainly due to poor management over the years. The industry is in need of reform to manage this resource. There also has to be infusion of competition in the industry which is controlled by a few companies. The recent moves to regulate the oil prices is also long overdue. The use of derivatives to manage the variation in pricing while sourcing oil  also needs to be explored. In the long run, Kenya needs to develop its own energy resources: Oil and alternative energy resources. There also has to be an effort to source oil cheaply within the region from either Uganda or Sudan and Natural Gas from Tanzania. There is need for creating strategic reserves to curb interruptions in the importation of oil. Currently, Kenya buys oil with a months lag for downstream distribution. This exposes us to adverse geopolitical events in the Gulf region and attacks on shipping lanes by pirates.

The Biggest Reason why Warren Buffet is a Winner

This morning, I came across an adaptation Warren Buffet's annual Letter to Berkshire Hathaway Shareholders. In case you are Martian, he happens to be the World's most successful Investor with a track record spanning over five decades. I happen to be a big fan for his common sense approach to investing, his down-to-earth lifestyle and lately his political views as President Obama's unofficial economic adviser. This 81-year old is showing no signs of slowing down.

Reading this letter  gives me insights to his way of thinking and is a free education for any aspiring investor. In this letter, Warren Buffet speaks of the folly of Beta. Beta is what Investment Gurus the world over use to quantify the risk involved in investing in a particular asset. Simply put, the higher the Beta, the higher the risk. Beta is part of the Capital Asset Pricing Model created and perfected by revered economists, three of whom received the the Nobel Prize for economics. The problem Warren Buffet has with Beta is the underlying assumption behind it chiefly, that assets with more volatile prices tend to be riskier than assets with less volatile prices. This makes Stocks appear more risky than Bonds. The little problem that no one appear to mention is that currencies to lose purchasing power over time. Thus, if your investment is currency based like Bonds are, you will suffer the inevitable loss of purchasing power due to the simple fact that  money supply increases over time. A stock represents a share of a business, an entity whose primary goal is to increase value for its shareholders. Thus, depending on price you buy the business at and its ability to increase its value( or as Warren Buffet puts it more elegantly,'the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power' ) you are more likely to get better returns over time than a bond investor.

This brings me to what, in my humble opinion, makes Warren Buffet successful: His independence of thought. He questions conventional wisdom, regardless of whom its from. Be it Nobel Laureates or your financial adviser. As long something passes his common sense test, it does not matter what the world thinks. As he puts it, so long as the man in the mirror is ok with it, then he's fine with it. 

You can get more of his letters to shareholders at http://www.berkshirehathaway.com/letters/letters.html . An adaptation of his latest letter by Forbes can be found here