The Exchange Rate & the Performance of the Kenya Shilling – Key Points to note

There has been an increasing debate in the media regarding the exchange rate and the performance of the Kenya Shilling. Discussions on this topic have centered on the recent weakening of the Kenya Shilling suggesting that this is a bad outcome for the economy.

The depreciation of the Kenyan shilling has accelerated over the past year, losing almost 24% of its value against the dollar. This depreciation is making imports more expensive and increasing Kenya’s debt, which stood at more than Ksh 10,100 billion (64.4 billion euros) at the end of June, according to Treasury figures, or around two-thirds of gross domestic product.

A competitive exchange rate ensures that the interests of both exporters and importers are balanced. In this regard, movements in the exchange rate serve to correct any imbalances in the market. The movement of the exchange rate cannot therefore be classified as good or bad if it is adjusting to economic factors.

There is a negative implication when the Kenya Shilling depreciates as this implies a higher cost in Shillings to finance imports. However, there is also a positive side to a weak Shilling as it means lower foreign prices for our exports; this increases the country’s competitiveness in the world market, which improves our balance of trade position. Further, a weak Shilling promotes domestic investments that create employment and also discourages final consumption of luxury imports.

All these are necessary to improve the current account balance and support economic growth. For instance, in 2011 there was a large current account deficit of about 11 percent of GDP, the exchange rate had to depreciate significantly to correct this imbalance in the economy.

However, for a small, open, developing economy like Kenya that has a huge oil import bill, a protracted weakening of the Shilling may eventually cause inflationary pressures by knock-on effects through energy prices via consumption and production processes. This is not the case currently.

On the other hand, a strong Kenya Shilling reduces the competitiveness of our exports which could dampen economic growth. Kenyan exports become expensive abroad and imports become cheaper thereby discouraging domestic competitive industries as the share of foreign goods in our domestic market increases.

Furthermore, a high interest rate which discourages domestic investment, which in turn impacts negatively on economic growth and employment, is generally associated with short-term inflows of foreign exchange which strengthens the Shilling.

Strengthening the Shilling by short-term foreign exchange inflows increases the risk of exchange rate instability since these can be easily reversed. An appreciating currency is like a tax hike. It increases the burden on manufacturers of domestic goods while making imports cheaper domestically.

This can lead to a recession as excess capacity can trigger layoffs. As the economy goes into a recession there would be a weak effective demand and the National Treasury would collect less tax revenue which would undermine the activities of the Government.

On a broader perspective with respect to this subject, a depreciation or appreciation of a currency is an adjustment process in response to the underlying fundamentals. Economists generally agree that a desirable exchange rate should be at a level that makes a country’s export of goods and services competitive in the world market.

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