Prof. Njuguna Ndung’u, CBS Governor, Central Bank of Kenya DEVELOPMENTS IN THE EXCHANGE RATE AND ACTIONS THE CENTRAL BANK IS TAKING A Media Briefing by Prof. Njuguna Ndung’u, CBS Governor, Central Bank of Kenya June 23, 2011

Outline Introduction The Exchange Rate Policy. Supply and Demand for Foreign Exchange Normal requirements Speculation/Arbitrage Market Outcomes International events including impact on neighbouring countries Oil prices Cross Rates The CBK Actions and Policy Response

1. Introduction Food and fuel crisis affect domestic inflation while currency depreciation is an addition. The crisis in the Euro Area is having an impact on currencies and money markets around the world. However, with the tight monetary policy stance, depreciation cannot affect inflation given that money supply growth is constrained. Central Bank analyses indicates that intervening in the current environment through injections of foreign currency will only lead to loss of foreign reserves without solving the problem. We need a sustainable solution. Analyses conducted at the CBK show that the current level of the shilling is being exacerbated by arbitrage and speculation on the future value of the shilling as well as the current level of reserves together with expectations on the food and fuel supply. Consequently, the current level of the shilling does not reflect the true value of the Kenya shilling, so it will still recoup its true value once the crisis is over. Despite the shocks on the exchange rate, private sector confidence in the economy remains high.

2. The Exchange Rate Policy In a floating exchange rate regime, monetary policy is independent and will affect relative prices including the exchange rate. It allows for a continuous adjustment of the exchange rate in line with the demand and supply conditions of foreign exchange in the economy. In addition, the market adjusts through the exchange rate movements rather than the level of foreign reserves changing. Consequently, external shocks and internal imbalances are reflected in exchange rate movements rather than reserve movements. For this reason, the exchange rate is an automatic stabilizer.

3. Supply and Demand for Foreign Exchange: There is adequate supply of forex in the market Foreign Reserves and Trade Statistics (USD Million)   Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Average Total Forex Holding 4,907.1 4,878.6 5,296.4 5,238.4 5,232.0 5,248.0 5,133.4 Central Bank 3,786.3 3,808.1 3,932.9 3,921.9 3,991.4 3,985.2 3,904.3 Commercial Banks 1,120.8 1,070.5 1,363.5 1,316.5 1,240.6 1,262.8 1,229.1 Total Forex Trade 2,142.7 1,916.8 1,912.8 2,216.0 1,878.4 2,013.3 Exports - Goods & Services 860.9 704.6 762.6 814.0 749.8 778.4 Imports - Goods & Services 1,281.9 1,212.2 1,150.2 1,402.0 1,128.6 1,235.0 Oil Import Bill 275.7 336.0 287.3 365.2 280.8 309.0 Oil as % of Total Imports 12.9 17.5 15.0 16.5 15.4 Commercial Bank Forex transactions 1,933.9 1,851.3 1,787.7 2,030.8 1,766.8 1,874.1 Oil as % of Bank Transactions 14.3 18.1 16.1 18.0 15.9 Forex holdings averaged USD 5.133 Billion in the last six months. CBK is holding on average USD 3.904 Billion and Commercial banks are holding on average US $ 1.229 billion. Forex holdings are even much higher than during the global financial crisis. This shows that the impact of the current crisis is being exaggerated.

3. Supply and Demand for Foreign Exchange: Current account balance improving on account increasing forex inflows… Improving current account balance expected to ease pressure on the exchange rate.

3. Supply and Demand for Foreign Exchange: Normal requirements of foreign exchange… The normal demand for foreign exchange is steady: Outflows of forex are minimal; Heavy imports of machinery will come down, but is stable.

3. Supply and Demand for Foreign Exchange: Arbitrage in the Forex Market… Over the week, 9th to 16th June 2011, five banks exported over USD 260 million. We are updating the data on a regular basis. During the same period, the volume of borrowing from the Central Bank by strong banks went up – suggesting arbitrage opportunities. Speculation comes in when at the same time they drive the bids in the domestic currency market. This is what we have observed as well.

These positions do not seem to reflect trading fundamentals. 3. Supply and Demand for Foreign Exchange: Arbitrage in the Forex Market… Four large banks have been noted to be holding very large overseas positions. These positions do not seem to reflect trading fundamentals. This type of exposure will put pressure on the exchange rate. Their positions are largely associated with their group companies overseas. We will restrict them from any arbitrage using the domestic currency.

4. Market Outcome: Exchange rate weakening experienced in main EAC countries Daily Normalised Exchange Rates to the US Dollar for the Kenya Shilling and Neighbouring Comparators (1st Jan 2010=1) On a broader level, other countries in the EAC region have been experiencing similar difficulties, hence there is need for a coordinated policy response. However, South Africa, with a comparably higher foreign reserves level has maintained a strong currency.

4. Market Outcome: Easing of world oil prices expected to reduce pressure on the exchange rate… The decline in world oil prices since May 2011 expected to ease oil import bill. Import bill on oil will respond and so will demand for forex to finance the imports.

4. Market Outcome: Flight into other strong currencies… The second round Greek crisis has caused flight into other currencies such as the Swiss Franc, and Australian and Canadian dollars – indicates diversification of portfolios..

5. The CBK Actions and Policy Response There is adequate foreign exchange reserves in the market. The Bank is continuously analysing exchange rate volatility but can only intervene to stem volatility but not to defend a level or direction of the exchange rate. Consider further tightening of monetary policy to tame future inflation and stabilise the exchange rate. In future, allow all institutions licensed to trade in foreign exchange to make bids when CBK is buying or selling – this will remove the dominance in the market and make forex trading competitive. Take appropriate and corrective action to make sure the forex interbank market is truly driven by market events and fundamentals as should be the case and as the Euro crisis seem to be getting closer to resolutions.