… and the causes of dollar demand-supply mismatch
By Ephraim Njega
The talk about dollar shortages has been with us for some time now, with fuel and oil importers saying that the deep in supply of the US currency is crippling their business – a debate as to whether the shortage is real, or it is due to market manipulation is still on-going.
There are both fundamental and sentimental issues which can affect the supply of dollars. When the Covid-19 happened, prices of commodities in the global markets rose sharply. This meant that we needed more dollars to import the same quantities of goods we were importing before the pandemic. At the same time, the pandemic adversely impacted the country’s sources of dollars such as exports, foreign direct investment, and even tourism inflows.
We also have a huge portfolio of external debt which needs servicing hence faster depletion of forex reserves. The prolonged drought has increased the need to import food while depressing our agricultural exports.
After the pandemic was brought under control, inflation rose rapidly in developed countries, and the authorities responded by raising interest rates. As a result, the dollar strengthened at the expense of other global currencies. High interest rates also resulted in capital flight from emerging markets. Investors are attracted by the high returns at home hence see less need to invest in riskier markets abroad.
Foreign investors have been exiting the Nairobi Securities Exchange (NSE) for several months. This is also contributing to the depreciation of the shilling. The dollar shortage also adds to the capital flight woes. Foreign investors are concerned that if the shortage worsens, they wouldn’t manage to repatriate the proceeds of share sales.
The high-interest rates have also made it hard for the country to borrow from the international markets. In the past, we would build our forex reserves through loans. The high inflation in developed countries might adversely impact diaspora remittances which are a major source of foreign currencies in the country. This can aggravate the forex crisis.
The interbank forex market has not been functioning properly. Ordinarily, a bank with dollar shortage would buy them from another bank. But this has hardly been the case, with lenders relying on buying dollars from their customers. The dysfunction in the interbank forex market has been blamed on the hawkish regulatory stance by the Central Bank of Kenya (CBK) – so the banks are less willing to trade dollars amongst themselves for fear of market manipulation accusations.
The dysfunction in the interbank forex market is also likely to cause poor price discovery as far as the exchange rate for the shilling is concerned. The subsequent speculative activities in the forex market can cause volatility, a scenario that can encourage hoarding of dollars resulting in an artificial shortage.
The weakening of the Kenyan shilling against the US currency is, therefore, caused by external economic shocks (pandemic, rising interest rates in developed countries, Russia-Ukraine conflict) and internal economic shocks (drought, political instability). It is also caused by fundamental issues (actual dollar demand and supply mismatch) as well as sentimental issues (mainly speculation, hoarding, fear, and information asymmetry). There are also structural issues such as a high trade deficit and significant external debt.
Status of Foreign Currencies in the Country
The amount of foreign currencies in the country includes official forex reserves held by CBK and foreign currency deposits held by commercial banks. There are also foreign currencies outside banks but getting data on that is impossible since such currencies aren’t centrally issued or monitored.
As of March 24, 2023, CBK had forex reserves amounting to $6.55 billion equivalent to 3.66 months of import cover. It is worth noting that this falls below the legally mandated four months of import cover. It is also below the 4.5 months’ worth of import cover required under the East African Community (EAC) monetary union convergence criteria.
On the other hand, as at December 31, 2022, commercial banks had foreign currency deposits amounting to Sh921 billion. This is equivalent to $7 billion at current exchange rate. The deposits represent 3.9 months’ worth of import cover. Both the CBK’s reserves and commercial banks foreign currency deposits total to 7.56 months of import cover. Why then is there a shortage of dollars if these are the actual figures?
The official forex reserves are usually used for servicing debt and financing government imports. They can also be used to stabilise the market in case of volatility. However, CBK’s ability to intervene in the forex market is limited by the fact that its dollar reserves are below the statutory requirement. This exposes the shilling to speculative onslaught as there is no fear of CBK’s response.
The dollar deposits held in commercial banks can only be available if the customers sell them. With the shilling depreciating fast, customers are likely to hold onto their dollars as they enjoy the forex gains. Even business customers will be unwilling to offload their dollars for fear that they might be unable to buy them when they need them for future transactions.
Impact of Shilling’s Depreciation on the Economy
As an import dependent country, a weakening currency has many negative consequences on the economy. The most obvious being the rising prices of imported goods. If the dollar scarcity worsens, it could reach a point where we can’t import essential commodities such as fuel and medicine. This can cause serious economic slowdown and even be a threat to life.
Most Kenyans are employed in retail trade where they deal mostly in imported stuff. Inability to import goods can lead to massive job losses. Consumers would be greatly inconvenienced as they would face empty shelves in supermarkets. Manufacturers who cannot import raw materials would also close shop leading to job losses.
Lack of forex can lead to inability to service external debt. The subsequent default would affect the country’s creditworthiness thus shutting us out of the international debt markets. We would therefore be unable to finance our budget using external funds. This would also worsen the dollar scarcity.
The rapid depreciation of the shilling is increasing our external debt without us borrowing extra money. From the beginning of the financial year to March 24, 2023, it has added Sh508 billion to our external debt without us borrowing an additional shilling. If this continues, it will wipe out the country’s borrowing capacity. The Sh10 trillion debt ceiling will be quickly exceeded leaving the government without the legal authority to borrow.
Way Forward
The efforts to jumpstart the interbank forex markets should be expedited. This will ensure shortages of dollars occasioned by non-fundamental issues are addressed.
The high spreads (profit margins) enjoyed by forex traders especially banks need to be checked. Spreads of more than ten shillings can turn the shilling into a commodity. The excessive trading in the shilling could lead to faster depreciation and volatility.
Recently, the government started importing fuel on credit in order to temporarily ease the pressure on dollar demand. It is however, unclear as to what will happen when the payments are due and we need to raise dollars for settlement. This would amount to postponing the problem which doesn’t solve anything.
As a temporary measure, the government needs to source for dollars through concessional borrowing. It should enter into talks with the multilateral lenders to secure loans in significant amounts which can buy us time as we wait for the markets to cool down. This will also ease concerns about our ability to service the $2 billion of worth of Eurobonds which are due by June next year.
In the long-run, we need to grow our sources of dollars while limiting unnecessary imports. Most of the food we import can be produced locally. We can also achieve energy security by refining the Turkana oil for domestic use or by electrification of our transportation systems. We need to invest heavily in tourism promotion. We also need policies which encourage Kenyans in diaspora to invest home including issuing diaspora bonds. We need to diversify our exports to avoid overreliance on agricultural exports which are under immense pressure due to climate change.
The regional integration process should be fast-tracked so that we reach the goal of a monetary union. Initially, this was supposed to happen by 2024. It has since been postponed to 2031. Having a single currency for the region will end the need for trading in foreign currencies.
The government should also explore other bilateral arrangements to allow us to trade in our own currency with other countries. For instance, there is a deal for EAC countries to trade with India using the Rupee and each country’s respective currency. This however can only work smoothly if there is a healthy balance of trade between the partners.
Though the fundamental issues causing the shilling to depreciate can’t be resolved overnight, providing clarity on the actions being taken will send positive signals to the markets. The feeling that nothing is being done or that things are beyond the control of the government strikes fear and encourages irrational market behaviour. In the end, you can get into a situation where the true value of the shilling will be impossible to establish. This can result in wild speculation and massive depreciation which cannot be accounted for by fundamental issues. That is the outcome we need to avoid by all means.
Writer is a business and development consultant, and an economic analyst. He holds an MBA Degree from the University of Nairobi.
