The Monetary Policy Direction is Ruinous
The Central Bank of Kenya, in an apparent bid to curb runaway inflation and shore up a weak shilling, has pursued a policy of increasing interest rates and tightening liquidity resulting in a dramatic increase in interest rates. The current environment is reminiscent of the 90's when interest rates touched 40 per cent and beyond and which resulted in a lost economic decade. The Monetary Policy Committee (MPC) has advanced a number of reasons for the policy stance they have taken. The first is the need to reduce inflation, the second is to dampen demand for imports and therefore ease pressure on the exchange rate and the third is to reduce private sector credit and cool down the economy. In my view, the reasons advanced by the MPC are highly debatable and it is doubtful if the objectives are valid and where they are valid it is uncertain if the measures will achieve the desired outcomes.
Let’s consider the effectiveness of increasing interest rates to reduce inflation. Low interest rates may fuel inflation if they create demand that cannot be matched by existing supply leading to an unsustainable increase in the price of goods and services. The theory is that, in times of high inflation the price of money should be increased so at to reduce the demand for goods and services and therefore reduce prices. For the theory to work, the goods should be those whose demand increases or decreases with income. There are however certain goods, whose demand does not increase or decrease in line with incomes. These goods are known as necessity goods, which are goods that we cannot live without and which consumers are unlikely to cut back even when times are tough. Examples of necessity goods are food, power, fuel, water, housing, and basic transport. In calculating inflation the Kenya National Bureau of Statistics (KNBS) uses a basket of goods and services. Within the basket used by the KNBS necessity goods such as food, fuel, housing and transport account for 63 per cent of the basket. KNBS reported that inflation in the month of November was at 19.72 per cent. Of that figure, the contribution of inflation by necessity goods, specifically food, fuel and transport, was 14.86 per cent or 75 per cent of total inflation. It is an established economic fact that the more necessary a good is, the lower the demand will be impacted by the price, as people will attempt to buy it no matter the price. Given that 75% of our inflation is directly attributable to goods that are completely essential and another 5% - 10% is indirectly driven by the price levels of those necessary goods, It is intriguing how the MPC concluded that by increasing interest rates, people will somehow consume less food and fuel and therefore driven down prices.
If the issue is inflation, let us address the root causes of inflation. Taking food as an example, agriculture accounts for 22 per cent of GDP and employs at least 70 per cent of the work force. The contradiction is that for an agricultural country we are a net food importer. Consider the case of oil and electricity, a significant volume of oil imports goes towards powering diesel powered oil generators yet we have very significant reserves of geothermal and other renewable sources of power.
The second reason advanced by the MPC is the need to strengthen the domestic currency. It is true that since the Central Bank began its policy of increasing interest rates the domestic currency has strengthened against the major currencies. The strengthening of the domestic currency has been as a result of two principal reasons. The most significant one in my view, is the increase in the holding cost of any other asset except the Kenya Shilling, forcing the market to liquidate other assets including foreign currency holdings and shares and hold their assets in Kenya Shilling. The attraction of the shilling is due to the fact that the Kenya Shilling interest rate is very attractive. Commercial Banks are willing to pay as much as 30% on fixed deposit. The increased demand for Kenya Shillings and consequent reduced demand for foreign currency has led to a strengthening of the Kenya Shilling. The second reason cited by the MPC for the strengthening of the Kenya Shilling is the reduced demand for imports due to the high cost of money. The bulk (68 per cent) of our imports are oil, machinery and transport mainly related to the ongoing infrastructure development and manufactured goods, primarily intermediate goods. I have not seen evidence of a reduction in the volumes of imported oil or the slowing down of infrastructure development and so I am inclined to believe that the primary reason the Kenya Shilling has strengthen is the first reason, which is the flight to local currency in pursuit of a high yield. It is therefore logical to conclude that unless we address the deep underlying causes of our weak currency then the current levels of the Kenya Shilling can only be sustained if interest rates remain high.
The forces of demand and supply determine the value of a currency. Exports create demand for the domestic currency while imports increase the demand for foreign currencies and therefore increase supply of local currency to purchase the foreign currency. The weakening of the Kenya Shilling is a function of these forces and is driven by the following factors. The first is that our imports are way larger than our exports and imports are growing faster than our exports. Our exports are 40% of our imports and this ratio is shrinking. In the year to June 2011, imports grew by 21% while exports expanded by 12%. The growth in imports is a function of the significant investment in infrastructure and the increase in the price of oil. The growth in imports is not a bad thing as such because it is necessary if we are to make the necessary investment in infrastructure. The deficit between what a country imports and exports (current account deficit) is funded by either foreign inflows of capital or the foreign reserves that a country holds. The crises in Europe, which is Africa’s largest source of foreign direct investment, has trigged a global flight to liquidity and the capital in-flows have diminished and in certain instances reversed putting pressure on the currencies and reserves of emerging markets across the globe. To the extent that imports remain larger than exports and risks to the global economy persist it is fair to conclude that fundamentally the Kenya Shilling remains under pressure and it is being artificially supported by the high interest rates. The consequence is that when prices are artificially distorted they create the wrong incentives. I am of the opinion that it may have been preferable to let the Kenya Shilling find its true level and in that way create incentives for the export sector and reduce non-essential imports by making them more expensive. By artificially supporting the local currency we are imposing a tax on exports and a subsidy on imports. We are in essence taxing a Kenyan farmer who would wish to export and subsidizing a middle class YUPPIE importing a used Range Rover Sport. What is worse, is the heavy toll the economy is taking offers inly temporary support to the currency.
The third reason advanced for increasing interest rates is that there has been a rapid expansion of private sector credit, which has led to the economy overheating. These are the facts, the average economic growth for Sub- Sahara Africa (SSA) is approximately 5.5 per cent. The average economic growth for Kenya over the last 5 years has been 3.3 per cent and it is only in 2010 that economic growth was at 5.5 per cent which is the Africa average. The second fact is that average population growth over the last five years has been 2.55%, implying that real per capita incomes have been growing at less than 1% over the last 5 years.
There is also a view that private sector credit is expanding at an unsustainable rate. It is true that private sector credit has expanded by 93 per cent since 2007 to Kshs 1,076 billion. But it is also true that private sector deposits have also increased by 65 per cent to Kshs 1,442 billion. The expansion in private sector loans is therefore funded by an expansion in private sector savings. At 75 per cent the loan to deposit ratio in Kenya is extremely conservative when compared to the 100 per cent plus loan to deposit ratios in the developed world. There is also a perception that consumer borrowing is the primary driver of growth in credit. In July 2011, credit to private households as a proportion to total credit was only 11 per cent, which is a decline from 14.7 per cent in July 2008. The building and construction sector has also taken some flak. These sector accounts for a paltry 3.3 per cent of total credit and has also declined from 4.9 per cent in July 2008. Lending to real estate, which is largely mortgages has increased from 3.8 per cent of total credit in 2008 to 8.8 per cent in July 2011. This is understandable when one takes into consideration the low level of home ownership in the country and the demographics where the rate of new household formation is very high. The high rate of credit growth has in reality been to the productive sectors of the economy. In the year to July 2011 the average credit growth was at 27 per cent. The sectors that grew above this average were, agriculture, manufacturing, building and construction and finance and insurance. If you take this point and tie it to the fact that we are facing a supply driven inflation it is fair to conclude that we require more capital into these crucial sectors so as to expand productive capacity and reduce the rate of inflation.
The current monetary policy is in my view undermining our economic growth and has distorted economic incentives which will only make the situation worse. To illustrate my point, there is little reason to invest in the real economy when the government and commercial banks are offering such high interest rates for passive capital. Investors are therefore being rewarded not to invest and expand the productive capacity of the economy, which is the solution to our inflation problem. Those who have been unfortunate to have invested are facing a harsh punishment. There cost of borrowing has been increased to unbearable levels and there is a real possibility that this may trigger loan defaults which I hope will not cascade into a banking crises. The local currency has been artificially propped up and therefore creating incentives for importers and punishing exporters, which is not the way to reduce the current account deficit.
An economic crisis of extraordinary proportions is unfolding in the global economy. This is not the time to create uncertainty and conduct monetary experiments. We need stability and we must ensure that our domestic economy remains robust. It is time to move from economic theory to the practical realities of the current environment.