Cost of money rises steeply as Kenya bows to IMF demands

The Central Bank of Kenya on Tuesday raised its policy rate by the highest margin ever, in a surprise move that marked the IMF’s return to the centre of Kenya’s monetary policy.

A statement released by the bank at the end of the Monetary Policy Committee meeting said the Central Bank Rate (CBR) – the principal instrument that the CBK uses to transmit its decisions – is to rise by 5.5 percentage points, marking a steep tightening of monetary policy to reduce inflationary pressure and stabilise the shilling.

(Also read CBK’s war on inflation sets stage for rise in cost of loans )

Njuguna Ndung’u, the Central Bank governor, also said the Cash Reserve Ratio (CRR) or the money that commercial banks must keep with the Central Bank as a bulwark against their operations would rise to 5.25 per cent in another measure aimed at limiting the amount of money in circulation.

The twin decisions marked the greatest influence that the International Monetary Fund (IMF) has had over Kenya’s domestic policy in nearly 10 years and came after the country’s recent engagement with the Bretton Woods institution for foreign exchange support.

The MPC’s decisions were a carbon copy of the IMF’s recommendations made public a day earlier and which rooted for a tightening of monetary policy to limit credit to the private sector and to stop further slide of the shilling.

“Monetary policy will be tightened to bring down the rate of expansion of credit to the private sector to levels that can be sustained and to reduce the demand for foreign exchange,” the IMF said in a statement released at the end of its mission in Kenya on Monday.

A rise in interest rates was one of the key conditions that the IMF gave Kenya for access to a new foreign exchange support loan that Nairobi had asked for to stabilise its besieged currency.

In agreeing to take the IMF medicine, Kenya appears to have given up its pursuit of growth in favour of inflation control and currency stability – the twin factors that are seen to make the economy unattractive to foreign investors because of their negative impact on the value of investment.

A rise in the CBR – the rate at which commercial banks borrow from the central bank as the lender of last resort -- by 5.5 percentage points means the rise in lending rates that began in earnest with last month’s increase of the CBR to 11 per cent will intensify, taking the average base lending rate above 22 per cent from the current 19 per cent.

The IMF expects that at this level, the interest rates will discourage private sector borrowing, reduce demand for foreign exchange and restore stability to the shilling.

“Kenya needs to reduce the pace of the growth of private sector credit that is fuelling the rise in demand-pull inflation,” said Domenico Fanizza the head of the IMF mission that ended on Monday.

In September alone, private sector credit grew by 36 per cent compared to the same month last year a development Mr Fanizza said was not sustainable.

“Consistent with the monetary policy stance taken by the last MPC meeting, there is therefore a need for further tightening of monetary policy to tame these inflationary pressures and stabilise the exchange rate,” Prof Ndung’u, who chairs the MPC, said in a statement.

MPC had last month promised to gradually tighten the policy rate to curb inflationary pressures from exchange rate turbulence. As a further measure to tighten demand-driven inflation, the IMF expects the Treasury to reduce government spending in the next couple of years.

In the 2011/12 national Budget, the Treasury raised spending by 15 per cent over the previous year’s figure to Sh1.15 trillion.

Less state expenditure should also lower public debt – technically called fiscal consolidation – to less than the recommended 45 per cent of the gross domestic product in two years.

“Credit growth has definitively been given a back seat by the MPC, and fighting inflation returned to the fore.

This bold policy move is positive for the shilling which should retrace when the market opens tomorrow (this morning), and sends a positive signal that the CBK is now finally boldly fighting inflation,” said Yvonne Mhango, a South Africa-based Sub-Saharan Africa economist at Renaissance Capital.

Ms Mhango said that the real impact of the move is to significantly increase the real policy rate to less than -2.0 per cent from -7.9 per cent previously.

“The bad news is that the likelihood of a hard landing for banks as credit growth collapses is significantly higher,” said Ms Mhango.
If the government carried out the agreed measures, inflation should come down to 17 per cent by the end of this year from nearly 19 per cent currently and to seven per cent by the end of next year.

“The implementation of tight monetary and fiscal policies to contain domestic demand pressure should also allow for a steady decline in inflation to 7.00 per cent by end-2012,” said Mr Fanizza.

Even before the IMF arrived in Nairobi on October 13 for the mission, Finance minister Uhuru Kenyatta had directed line ministries to cut spending.
This would reduce the amount that will be borrowed through the domestic market and thereby mitigate a rise in interest rates but it also had the impact of reducing demand-driven inflationary pressures.

The major constraints to a more rapid increase in interest rate will be the tight liquidity in the market.

The discount window rate, for example, continued to rise and was at 22 per cent yesterday from just about 10 per cent two weeks ago.

The tightness is a result of the ongoing mop-up of cash in circulation by the CBK and the concentration of liquidity in four banks that are supposed to distribute the tea bonus payments to farmers.

“The committee’s analysis of data and assessment of events showed that the banking sector remained robust. However, the information provided to the committee showed that both inflationary pressures resulting from accelerating growth of private sector credit and exchange rate volatility threaten the economic recovery and macroeconomic stability,” said Prof Ndung’u.

He said the MPC Market Perceptions Survey conducted in October showed that the private sector continues to expect high inflation to persis.

“Going forward, monetary policy has to reverse these expectations through further tightening that will bring inflation and inflationary expectations under control and stabilise the exchange rate to protect the economic growth base,” said the governor.

Source: www.businessdailyafrica.com

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