To understand the current exchange rate dynamics, it is easier to consider a useful analogy. This blog has developed an uncanny reputation for creating wacky analogies over time, but I think they've been useful with regards to getting the message across.
Having a weak currency has one major adverse implication for Kenya, with a high urban population, imports become expensive and thus inflation pressures mount. From a national security perspective, this is extremely dangerous. Note that the prices of crude oil have eased off their April high's of $116 per barrel, but your fuel costs haven't adjusted. This is simply down to a weak currency.
Exchange rates are driven by three major factors which are listed below;
1. Trade Balances - When Kenya imports oil for instance, it has to buy dollars as oil prices are quoted as $/barrel. Alternately, when a foreigner buys Kenyan tea, he has to buy Shillings as the price of tea is quoted in shillings. Therefore, by simple deduction, imports result in shilling outflows and exports result in foreign currency inflows. If exports exceed imports, the country has a positive trade balance and thus there is more demand for its currency resulting in a stronger currency. The alternate is true when imports exceed exports. In Kenya's case, imports exceed imports by a whopping Kshs 537 billion (USD 6 billion) or almost a fifth of GDP. In fact, the trade deficit has hovered at around 15% of GDP for the last twenty years. You can now automatically tell that our currency from a trade perspective faces enormous pressures.
2. Capital Flows/Interest Rates - In response to the currency crises that emerged not only in Kenya, but generally in East Africa, heads of EA Central Bank's led by Prof. Ndung'u raised interest rates. The CBK did it by raising the CBR rate (now called the discount rate) from 6.5% to 8.00%. The thinking behind this is that, if you raise rates in Kenya, foreign capital will flow into the country seeking higher yields. Given that the interest bearing instruments are denominated in shillings, the foreigners will have to purchase shillings thus strengthening the currency. Therefore capital flows, through the interest rate mechanism do have a bearing on currency movements.
3. Psychological Factors - This feeds back into our analogy, and to a great extent explains our current currency issue. Sentiment does affect the markets and often overlooks the two main fundamentals listed above. If economic agents and owners of capital become wary of the shilling, their actions could lead to a weakening of the shilling. Just like the girl, sentiment could lead to a realisation that the fundamentals are flawed and that this "relationship" is not worth it. In a recent blog post, I identified some flawed fundamentals and suggested that the shilling is bound to get weaker. Indeed it did. All the economic actors took short positions against the shilling and their actions exacerbated the already dire situation.
Prof Ndung'u once wrote that;
"The policy instruments that matter most for export success lie outside the realm of monetary policy. These include the reliable provision of productivity-enhancing public inputs and the protection of private economic returns from investments"
These remarks can easily be translated to "Kenya will only achieve success, if it focuses on its fundamentals". The CBK's actions were a stop-gap solution, but the country will have to improve its productivity and international standing to reduce the chances of future speculative imbalances that weaken the currency.