The shilling has been on a depreciation streak having lost 5.4%, year to date, ending May at Sh106.8 on average due to reduction in diaspora remittances due to Coronavirus pandemic, a flight to safety by foreign investors, increased demand from importers as they stock up dollars and dwindling forex reserves
Over the past five years, the Kenya Shilling has been relatively stable against the Dollar, as the Central bank has continuously maintained high forex reserves at above the statutory target of 4.0 – months import cover, having averaged $6.7b equivalent to 4.6 months average import cover.
The shilling has been on a depreciation streak having lost 5.4%, year to date, ending the month of May at Sh106.8 on average. The recent depreciation has raised concerns, with the International Monetary Fund (IMF) indicating that Kenya’s debt structure increases the currency’s vulnerability to external shocks. In the past 5 months, forex reserves have declined by 3.4% to $8.5b (5.1-months import cover) from $8.8b (5.4-months imports cover) in January 2020.
The depreciation has mainly been attributed to: A 6.3% reduction in diaspora remittances to $228.8m in March this year from $244.8m recorded in December 2019 attributable to Coronavirus pandemic; A decline in demand for Kenya’s exports due to lockdowns in major markets; A flight to safety by foreign investors; Increased demand from importers as they stock up dollars, and; The dwindling forex reserves exerting pressure on the shilling, causing a depreciation of the currency.
However, the Sh78.7b disbursement from the IMF will assist in cushioning the shilling from external volatility.
Evolution
Interest rates in Kenya witnessed high volatility in 2011 and 2015 as seen by the significant increase in yields in the government papers, which largely follow what is happening in the economy. In times of expected high borrowing, lending rates tend to shoot up as was seen in September 2015 where the yields on the 91-day papers increased to 18.6%, a 4-year high from the last recorded high yields of 20.9% in 2011. The high borrowing target in the high cost of credit environment saw the government offer attractive rates on its papers.
Over the last 5 years, the rates on government papers have remained relatively stable despite the continuous high budget deficit. The capping of the interest rate through the Banking Amendment Bill (2016) saw banks not keen to lending to the private sector as the regulation limited their credit pricing, and so most of the cash was channeled towards government debt, which offered better returns on a risk adjusted return basis.
With the expected economic slowdown we expect to see more borrowing locally as the governments seeks to plunge in the budget deficit brought about by the slow-down in revenue collections. It shall also be difficult and expensive to raise funds from the international markets.
To address the Coronavirus pandemic that has dampened economic activities leading to significant revenue underperformance, the National Assembly on April 22 approved the supplementary budget for the fiscal year 2019/20, paving the way to a Sh9.7b decline in the gross total supplementary budget. Despite the Sh9.7b reduction, the overall fiscal deficit has increased to an estimate of 7.8% of GDP from the earlier estimated deficit of 6.3% of GDP for FY 2019/20. The table below illustrates the allocation of the Supplementary Budget 2019/20, showing how much has been collected:
As seen above, the Government has been able to raise 65.7% (Sh1, 841.1b) of its total budget (Sh2, 803.1b). With less than two months to the end of the fiscal year, the Government will be under pressure to borrow domestically.
For the Government to ease pressure on the interest rate, they should, one, consider seeking for debt restructuring to reduce the debt serving cost. In 2019, the debt to service ratio stood at 45.2% above the 30.0% recommended threshold; relook at the budget and consider shelving some of the projects that are not very urgent. Despite the Sh9.7b decline in the gross total supplementary budget for 2019/2020, the fiscal deficit remains high at an estimate of 7.8% of GDP, and; consider negotiating for a temporary debt stand still as well as look for concessional loans that will provide additional liquidity and serve as a bridge special purpose vehicle for commercial debt servicing.
What will drive currency performance?
Balance of payments: According to the Economic Survey 2020 by the Kenya National Bureau of Statistics, the current account deficit grew by 10.9% to Sh567b in 2019 from Sh511.3b recorded in 2018, attributed to a 2.9% decline in the value of exports despite 2.3% increase in the value of imports.
The export sector has continued to suffer significant losses (it is estimated that the floriculture sector will lose Sh60b by the end of 2020) due to reduced demand for Kenyan exports and the decline of global commodity prices.
Despite the easing of the lockdown measures in Kenya’s trading partners, we expect the business environment to have a sluggish growth towards the end of 2020. The tourism sector, one of the key foreign exchange earners, has suffered significant losses due to the ban on international travel. In March 2020, Kenya Airways announced a Sh8m revenue loss following the travel restrictions.
On the plus side, however, Kenya could be facing a lower import bill on account of the reduced oil prices as well as the reduction in the imports of goods and services as many firms have scaled down their operations in light of the Coronavirus. The low import bill will however not be able to offset the current account deficit thereby and as such, we expect continued pressure on the shilling due to the high dollar demand.
Government debt: Kenya’s debt stands at Sh6.3tn comprising of Sh3.2tn in external debt and Sh3.1tn in domestic debt as highlighted in the chart below:
In the recently approved Supplementary Budget II Estimates for the fiscal year 2019/20, Kenya is scheduled to pay a total of Sh253.4b comprising of Sh121.5b in external debt redemptions and Sh131.9b in external debt interest payments. In the 2018/19 fiscal year, the debt service to export earnings ratio came in at 30.2%, an increase from the 20% recorded the previous fiscal year, an indicator of increased pressure on the foreign exchange receipts that are being redirected to service debt. Given the poor performance in the export sector, we expect the debt service to export earnings ratio to continue rising this year due to the underperformance on the denominator side, which will in the essence put more pressure on the forex reserves as the country meets external debt obligations.
Forex reserves: Kenya’s Forex Reserves have been declining in 2020. So far they have witnessed a 3.4% decline to $8.5b (5.1-months import cover) in May 2020, from $8.8b (5.4-months imports cover) in January 2020. The decline is due to low inflows amidst increased dollar demand. There shall be continued pressure on the reserves due to low exports of goods and lower diaspora remittances amidst increases in demand for dollars to service Kenya debt and as foreign investors flee to safer havens.
On the positive side, the IMF recently disbursed Sh78.7b ($739.0m) to help the country address the impact of Coronavirus pandemic. These funds will be used to provide budget-financing needs and allow the government to maintain an adequate level of foreign reserves to support the economy as well as cover the balance of payment gaps. Despite this, we still expect forex reserves to continue declining with our sentiments being on the back of reduced diaspora remittances, continued investor capital outflows in the money market, and increased foreign debt repayments.
Monetary policy: Central Banks play an instrumental role in determining price stability and economic growth of a country. Depending on the economic cycle, Central Banks can either adopt an accommodative or a tight monetary policy.
Given the current economic environment that has greatly been affected by the Coronavirus pandemic, the MPC implemented an accommodative policy by lowering the CBR by 25 bps to 7.00% from 7.25%. As a result, domestic investment activities will decline as Kenya’s financial and capital assets become less appealing to investors on account of their lower real rate of return.
Consequently, the shilling will continue to depreciate as the demand for the dollar increases. We do not expect the CBK to increase the rates as it is mainly focused on reviving the economy. Given that the Inflation rates have remained within the government’s target of 2.5% – 7.5% supported by the lower fuel prices and favorable weather conditions, the Central Bank will not be under pressure to increase the rates on this front, and as such, the shilling will continue to weaken.
Underlying factors expected to drive the Interest Rate environment
Fiscal policies: In the recently approved Tax Amendment Bill 2020, the Government reduced its expenditure by %9.7b and forfeited an estimated Sh122b of the earlier expected revenue due to the current constrained economic conditions, and as such increasing the fiscal deficit to an estimate of 7.8% of GDP from the earlier estimated deficit of 6.3% of GDP for FY 2019/20. This saw the domestic borrowing target adjusted upwards to Sh404.4b from the earlier approved Sh300.3b to plug in the fiscal deficit.
The Government is currently 28.1% behind its domestic borrowing target of Sh404.4b having borrowed Sh290.9b against a prorated target of Sh357.7b. With less than two months remaining to the end of the FY’2019/20, we do not believe the Government will be able to meet this target as it is also burdened by high levels of debt maturities currently standing at Sh148.9b (Sh117.9b in T-Bill maturities and Sh31b in T-bond maturities) and as such, it may resort to accepting expensive bids and destabilize the interest rates in the process.
To relieve the burden of debt maturities, the Government is seeking to restructure the maturities of the Treasury Bills by switching T-bill investors to the June Infrastructure bond. Given that the 364-day T-bill will be maturing on June 1st 2020, investors have the option of rolling over their maturities or investing their proceeds to the June Infrastructure Bond. Due to the revenue side constraints given the current reduced economic activity as evidenced by the declining PMI to 34.8 from the 37.5 seen in March, we foresee the Government increasing its borrowing activities in the local market with a bias towards an upward adjustment of the yields to incentivize investors thus putting pressure on interest rates.
Liquidity: In the March sitting, the MPC lowered the Cash Reserve to Ratio (CRR) to 4.25% from 5.25% and increased the maximum tenor of Repurchase Agreements (Repos) from 28 days enabling banks to access long-term liquidity secured in their holdings in government papers. The CBK also availed Sh35.2b to commercial banks, which would be used to support borrowers affected by the Coronavirus pandemic.
Consequently, this move has led to ample liquidity in the money market as evidenced by the low interbank rates of 4.1% recorded during the week. In an ideal situation, the ample liquidity in the money market, the lowering of commercial banks’ lending, and deposit rates would lead to increased money supply in the economy and an increase in consumers’ purchasing power.
The lowering of the CRR will contribute towards increasing liquidity in the short term. According to the CBK, the reduction of the CRR in March had by the end of April freed Sh17.6b, which was granted to 11 commercial banks and one microfinance bank to be used for onward lending to distressed borrowers.
As the effects of the Coronavirus continue to be felt in the economy, we believe banks will find it difficult to lend to businesses and individuals as the risk levels have increased as such a large proportions. These funds may be channeled to government securities offering some reprieve on the Government yields due to reduced credit competition from the private sector.
Monetary policy: In the April sitting, the MPC cut the CBR rate by 25 bps to 7.00% from 7.25% in order to support economic growth, stabilize the financial markets and mitigate the economic and financial disruptions brought about by the virus. Of the Sh32.5b availed by the CBK to the Commercial Banks in March, 43.5% of the funds were utilized with the tourism, real estate, and agricultural sector being the major beneficiaries. As a result of the adoption of the accommodative policy in 2020, commercial banks’ lending rates declined to 12.2% in February 2020 from 12.3% seen in December 2019. In our view, should the MPC continue to pursue an accommodative monetary policy in this tough operating environment, lending rates may remain constant on account of the bank’s credit pricing models, therefore, locking out borrowers from accessing credit.
Due to the low credit risk associated with government securities, the value of their stream of future cash payments is simply a function of the investors required return based on the inflation expectations as inflation erodes the purchasing power of a bond’s future cash flows. Put simply, the higher the current rate of inflation and the higher the (expected) future rates of inflation, the higher the yields will rise across the yield curve, as investors will demand this higher yield to compensate for inflation risk. Inflation in the country is expected to remain stable and within the government target of 2.5% – 7.5% and as such this might aid in mitigating the upwards readjustment of government securities as investors will not be attaching a higher premium to meet their required real rate of return.
Going forward
Based on the foregoing and factoring in the adverse effects the ongoing Coronavirus pandemic on the economy, two scenarios are likely to unfold. One, the shilling is likely to depreciate by 5.5% by the end of the year on a YTD basis on account of reduced exports earning due to the lockdown measures; declining diaspora remittances that have been brought about by reduced economic activity, the decline in disposable income, and the increasing cost of goods will see the forex decline. In turn, the shilling will be exposed to foreign exchange shocks due to lowered forex exchange reserves, and, high level of government debt that has widened Kenya’s fiscal deficit, making it hard for the Government to access foreign debt as investors attach a high-risk premium on the country.
Two, there is likely to be a slight upward readjustment on the yield curve. These sentiments are on the back of increased pressure on the government to plunge in the budget deficit by meeting its increased domestic borrowing. There is a probability that the government will accept expensive bids and in turn destabilize the interest rate environment; investors will attach a high-risk premium to meet their required real rate of return, and, banks will not be willing to lend to the private sector, and as such, the excess liquidity will be channeled back to government securities. (Cytonn)
