Jul 19, 2015

Emerging market currencies have been under pressure during the year because of the US Federal Reserve’s announcement of an intention to raise interest rates. The expectation of a rate hike by the Fed has sent capital flowing out of emerging markets, causing a depreciation of most currencies. Additionally, the possibility of a “Grexit” is exacerbating the need for investors to invest in safer regions, such as the US. As expected, the impact of this on the currencies differs from country to country depending on the strength of the country’s macroeconomic fundamentals, with countries that have weaker fundamentals experiencing higher currency volatility.

The Kenya Shilling has witnessed a downward pressure against the dollar since the beginning of the year, losing 13.0% YTD to close at 102.5 as of Friday 17^th July from a rate of 90.6 at the start of the year. The depreciation of the shilling can be attributed to a number of factors, namely:

• The strengthening US Dollar in the global markets due to a possible rate increase, given the improvements in economic performance in the US;
• Insecurity situation in Kenya, which has led to delayed investments into the country. Also, this came with the President’s directive to shut down some money transfer companies that handled money transactions into the region;
• The fact that the Central Bank stayed for sometime without a substantive governor led to uncertainty in the market;
• Reduced foreign inflows from tourism and agriculture. These are two of Kenya’s key exports and foreign exchange earners. Tourism as a sector in Kenya has suffered given the insecurity situation towards the end of last year, with agriculture suffering from the inadequate rainfall experienced in the country in the first quarter and also volatile commodity prices in the global markets;
• A widening current account deficit at 9% of GDP for FY2015/2016, up from 7.3% the previous year. This is on the back of a rising import bill especially on capital goods necessary for the increased infrastructure development. Data from the KNBS shows that the current account balance recorded a deficit of Kshs 101.5 bn in Q1’2015 compared to a deficit of Kshs 63.8 bn in Q1’2014, and;
• The growing fiscal deficit, currently at 5% of GDP, will lead to increased government borrowing both from the domestic and international markets. Increased borrowing from international markets will open up the country to shocks, leading to increased currency volatility.

The situation is actually replicated across the larger East African region and in Africa, where most currencies have depreciated against the dollar, with the exception of the Malawian Kwacha. In East Africa, the Tanzania Shilling has lost 24% YTD to the dollar, while the Uganda Shilling has lost 16% YTD to the dollar. Uganda’s current account deficit is projected to widen to 10.3% of GDP in FY2015/2016, from 8.4% in FY2014/2015, on the back of higher infrastructure related imports and weaker exports owing to subdued global commodity prices. Tanzania, on the other hand, has a current account deficit of 11.1% for FY2015/2016. Compared to Kenya’s 13% depreciation YTD, it is clear that the larger the current account deficit, the more the currency is vulnerable to external shocks.

In the recent months, we have seen the Monetary Policy Committee aggressively raise interest rates to curb further depreciation of the shilling. In our view, the benefits derived from the aggressive rate increases could be minimal since most of the issues we are facing are structural, rather than a result of interest rates parity issues. Comparing this with what happened in 2011, the rate increases were more effective because the inflation rates were really high, peaking at 19.7% in November 2011; the rate increase then helped reduce money supply, which was more inflationary. However, the current situation is different. At the moment the inflation rate is at 7.0%, and though we expect it to increase, it could be gradual. The sudden rate increases will stifle the already fragile economic growth, and in our view the effects would be significant. Last week, we saw the Uganda Monetary Policy Committee raise the CBR to 14%, leading to a strengthening of the currency. In our view, the Kenya shilling is not reacting to the rate increases because the MPC’s actions are anticipated, hence already priced in by the market.

Despite the school of thought that the currency is over valued, the rate of currency depreciation is what is of key concern for any investor. We would have expected a more gradually depreciation of the shilling. In our view, the Central Bank and the government at large could take the following measures to curb significant further depreciation in the future:

• To avoid panic buying and speculation on the currency, rates should be moderately raised while allowing for the impact of the presiding increases to take effect. Any sudden increases should be well explained and understood by the market;
• Involve market participants while coming up with the policies, as they have positive contributions that may add value to policy makers and policy direction;
• Reduce the rate at which the country’s budget is growing. Balancing between current consumption and expenditure for future benefits remains a delicate balancing act; and could be achieved;
• Diversification of the economy to avoid over-reliance on agriculture and tourism. A good example is Mauritius, which is primarily a financial hub and benefits greatly from that. Kenya’s brand, location and skilled workforce uniquely positions the country to be financial hub, but we will have to fundamentally rethink our capital markets infrastructure and regulatory frameworks;
• Continue with the good initiatives of youth empowerment as it increases economic activity and may lead to increased exports. In addition, there is need to continue supporting entrepreneurial activities through the ways we identified in the Cytonn Weekly Report # 27. We won’t be able to sustainably address currency depreciation if we do not manufacture more locally in order to reduce importation;
• Work with the private sector to encourage Kenyan’s living abroad to invest back in the country. Despite the fact that the remittances have increased, there is potential for much more to come into the country if we develop and implement an active diaspora investment strategy and engagement plan;
• Diversification of the reserve holding from only USD based to a pool of other currencies to avoid significant reliance on the US economic performance.

In conclusion, our view is that the performance of the currency will be largely dependent on the performance of the USD. Since the rate of expected Fed increases is already priced in the market, we might not see a lot of further dollar strengthening. We expect to see the recovery of the tourism sector given the semblance of calm on the security side. With the many infrastructural projects ongoing in the country, we are seeing global capital flowing in, and if well matched with the expected infrastructural expenditure, it might alleviate further pressure on the currency. The activity of the Central Bank will be key, but of note is that forex reserves have really declined to 4.14 months of import cover, from 4.90 months at the start of the year, and the minimum target is 4 months of import cover. We should see CBK drawdown on the USD 700 mn financing facility approved in February by IMF to support the shilling. The declining oil prices in the international market will also help support the shilling as it reduces the level of imports in USD terms. In our opinion, we expect to see stability in the currency in the coming months, but we reiterate that the country needs to come up with a long-term plan to reduce importation by spurring local manufacturing.