The Discount Window:CBK's Gift or Curse?

The debate regarding the fall of the shilling  in 2011 rages on in parliament. What is being exposed by both sides of the divide is a lack appreciation of the other side's view. This is expected of politicians as each has an agenda they are pushing. On one hand, the MPs allied to the CBK Governor,led by the finance minister have chosen to blame the shilling's fall on the Eurozone crisis. On the other hand, MPs pushing for the adoption of the parliamentary select committee  report are blaming it on the banks. The charges include the hoarding of Forex and the abuse of the 'Discount Window' by the CBK.

This 'Discount window' has been the subject of discussion and would be the best place to start to unravel this controversy. Banks need money from time to time meet client cash withdrawals. They can access this in several ways:

• Selling of Assets such bonds 
• Borrowing from another bank (Interbank Market)
• Borrowing from the CBK ( Discount Window)

Banks usually use the Interbank market or sell bonds and reserve the Discount window as a last resort for funding. However, according to the PSC committee report, this appears to have drastically changed in 2011.  According to the report, cumulative borrowing over 2011 through the discount window was around Kshs. 600 Billion. This was driven by the discount window offering lower rates than the inter-bank market, which provided an arbitrage opportunity for banks borrowing from the discount window and lending on the inter-bank market.

This, in the face of a currency crisis in the country, was, and still remains a source of grave concern. How can such an anomaly remain unchecked? It points to loss of touch by the CBK of the market. Which begs the question, why haven't any heads rolled at the CBK?

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.