March 8, 2023/Cordros Report
While the Kenyan Shillings (KSH) did not depreciate much against the US dollar (USD) in 2022FY despite the fundamentals suggesting steeper depreciation, we highlight that the KSH has been in the spotlight recently given how shortages of US dollars have led to a wider spread between interbank FX rates and the bank-client rates. As of 6 March, the FX rates at the bank-client market were quoted as high as c. KSH138.00/USD relative to the interbank FX rate of KSH127.86/USD – representing a 7.9% premium. In this report, we cast our spotlight on the (1) driving forces behind the depreciation of the KSH against the USD, (2) the deteriorating external accounts, and (3) expectations for the local currency based on the Current Account (CA) model of the External Balance Assessment.
The country’s official FX reserves settled at USD6.61 billion as of 3 March (-11.2% vs December 2022: USD7.44 billion) – the lowest print in more than nine years. The preceding represents 3.7 months of import cover, below the Central Bank of Kenya’s (CBK) statutory requirement of at least four months of import cover. The persistent decline in the country’s usable FX reserves reflects the synchronous impact of (1) CBK’s FX intervention to slow the KSH’s depreciation against the USD, (2) large commercial and bilateral debt repayment obligations, and (3) relatively lower commodities prices. Thus, the lower FX reserves are reducing investors’ confidence and have made it difficult for market players to source dollars in the local market, contributing to the recent currency depreciation.
Other factors that have contributed to the local currency’s depreciation include (1) the strengthening of the US dollar against other currencies, (2) tight external financing conditions, (3) elevated global uncertainties, and (4) deteriorating external accounts. We discussed the latest development in the external sector account in the next section.
Q3-22 External Account Leaves Little to Cheer
The Current Account (CA) balance remained in a deficit position, settling at USD1.53 billion as of Q3-22 (Q2-22: USD1.66 billion). To wit, total exports moderated by 2.5% q/q primarily due to the lower earnings from coffee (-31.9% q/q), tea (-2.6% q/q), and horticulture (-16.0% q/q). Likewise, aggregate imports settled lower by 1.7% q/q despite an increase in petroleum products imports (+5.5% q/q | 32.8% of total imports) amid higher crude oil prices. Consequently, the trade balance declined by 1.2% q/q to USD3.13 billion. Elsewhere, the surplus in the services account rose by 33.9% q/q as international travel continued to improve. Moreover, the primary account balance increased by 2.7% q/q to a deficit of USD418.00 million on account of higher interest-related payments on other investments. Finally, the secondary income balance reduced slightly by 0.8% q/q, likely due to lower remittances in the review period.
Over 2023FY, we expect the CA deficit to settle at USD5.33 billion or 5.3% of GDP (2022E: USD6.10 billion or 5.7% of GDP) on account of our expectations of (1) moderation in trade balance deficit, (2) slowdown in the primary income balance, and (3) higher services and current transfers. Notably, while we expect export receipts to decline by 4.2% y/y because of lower commodities prices than the prior year, we believe the lingering currency depreciation will induce a lower demand for imported goods, combining with low crude oil prices to slow down aggregate imports (-3.7% y/y).
Wide REER Gap Suggests KSH/USD has More Room to Depreciate
We used the CA model of the external balance assessment to determine how overvalued the KSH is, providing a leading indicator of how much depreciation is needed to restore the external balance, other things being equal. After accounting for our expected GDP, inflation and Net Foreign Asset (NFA) benchmark for 2023, our model established a 0.06% CA norm as a percentage of GDP in 2023.
Furthermore, our preliminary adjusted CA balance settled at -5.29% for 2023, leading to a corresponding CA gap of -5.35% of GDP. Based on the IMF’s external sector assessment for Kenyan peers, we note that the current account elasticity to the real exchange rate is -0.2%. Adjusting the current account elasticity with the CA gap, we arrived at a REER overvaluation of 26.8%, suggesting that the local currency still has more room to depreciate towards KSH156.52/USD. The FX futures contracts also paint a picture around this, with the 6-month and 1-year contracts at KSH144.63/USD and KSH155.40/USD, respectively, as of 6 March compared to the spot price of KSH127.86/USD as of the same date.
Nonetheless, the estimates are subject to statistical uncertainties, including (1) balance of payment errors and omissions and (2) structural factors affecting the CA, which the model does not capture. Meanwhile, it is pertinent to note that currencies hardly trade at their fair value estimates in the short term due to varying fundamental issues and interventions by monetary authorities, posing further downside risks to our estimates.
Overall, two major factors we identified that could prop up the official FX reserves in the short term are (1) recovery in the tourism sector and (2) disbursements from the World Bank and IMF. On (2), the Central Bank governor stated that Kenya is expected to receive USD300.00 million from the IMF when it completes a program review scheduled for June. At the same time, the World Bank is also expected to disburse USD400.00 million to the country in the same period. However, the 2023 redemptions are likely to neuter this impact. Notably, Kenya has KSH622.47 billion or USD4.86 billion in external debt services (redemption + interest payments) for the 2023/2024 fiscal year, including the maturity of a USD2.00 billion Eurobond in June 2024.
