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.