By MUNA WAHOME, mwahome@ke.nationmedia.com  (email the author)

Posted  Wednesday, October 5  2011 at  22:05

Central Bank of Kenya governor, Njuguna Ndung’u

Central Bank of Kenya governor, Njuguna Ndung’u. CBK has raised lending rate to tame inflation and stabilise the shilling.

 

The Central Bank of Kenya on Wednesday sharply increased the key lending rate, giving the clearest signal that the battle against inflation and exchange rate turbulence will inform monetary policy in the medium term.

A statement issued at the end of the special Monetary Policy Committee (MPC) meeting said the Central Bank Rate — the key policy rate that the CBK uses to signal the direction of lending rates — will rise by four percentage points to 11 per cent. (Also read : Banks deepen shilling’s losses with large piles of foreign cash)

This is the highest single increase since the rate was formulated in June, 2006.

It is also nominally the highest ever cost of Central Bank lending to commercial banks.

Fixing the CBR at 11 per cent means that the MPC is setting the economy up for a tighter monetary environment that should result in some measure of macroeconomic stability but also sets the stage for a painful rise in lending rates and a further slowdown in growth.

Its impact is to increase the cost of borrowing, cut back on the amount of money in circulation and slow down the rate of inflation.

The pain for the common man will come in when the banks restrict lending.

Credit squeeze is one of the time-tested methods of fighting inflation whose simplest definition is “too much money chasing a few goods”.
“In the short run we have to tighten our belts,” said Njuguna Ndung’u the CBK governor.

Analysts said that although it came too late, the CBK had made the right decision by focussing on managing inflation and restoring exchange rate stability even if it hurts growth in the short-term.

“This is a show of much stronger resolve in tackling the inflation problem,” said Razia Khan, an economist with Standard Chartered Bank in London. “Markets should react positively because this a good move, in reaction to the clear evidence that inflation is threatening to become a more generalised problem.”

The MPC said the decision to raise the policy rate by such a wide margin was informed by the realisation that decisive and immediate action was required to stem inflationary pressures, stabilise the exchange rate and re-establish a healthy economic base.

Central Bank has been under pressure to stop the shilling’s slide, culminating in formation of an inter-agency committee by Prime

Minister Raila Odinga and the appearance of Prof Ndung’u before the President and the PM on Tuesday and Wednesday respectively.

Yesterday, the Monetary Policy Committee admitted that its gradualist approach to a tighter monetary environment had failed partly because of the persistent supply side problems (high oil and food prices).

It is now expected that the local currency will claw back some lost ground as investors respond to high interest rates and lower inflation expectations.

“The shilling is likely to retrace to the late 90s/$1 region, but we are unlikely to see a return to the 85/$1 due to fundamentals,” said South Africa-based Renaissance Capital economist Yvonne Mhango.

The Kenyan currency edged up to trade at Sh101.60 to the dollar reflecting a 40 cent change in yesterday’s trading.

Most analysts were generally agreed that it had become necessary to tighten monetary policy in view of inflationary pressure and currency volatility that left quarter two growth at 4.1 per cent.

“This shows the CBK has taken on board criticism about its slow reaction. I do not think you can criticise this one; it is a strong signal,” said Robert Shaw, an economic commentator.

Other analysts were cautiously optimistic of the action but insisted that it was long overdue.

CBK has in the past been reluctant to increase interest rates in fear of affecting the economic growth and it remains to be seen how the latest move works.

“It could cushion the economy against inflation and the shilling from volatility in the long term but in the short term it may upset the market,” said Ecobank managing director Tony Oknapachi.

Joseph Kieyah, a senior analyst with the Kenya Institute of Public Policy Analysis — a quasi-government think-tank — said the measures are not guaranteed to bear immediate fruit.

“First, the increase in interest rates may hinder growth but bring inflation down. But inflation might remain the same or fall depending on whether the monetary policy is working,” Prof Kieyah said.

In the past, the International Monetary Fund has advocated for restriction in growth of the so-called net domestic assets, which CBK has finally heeded through what amounts to a shock therapy.Mr Oknapachi said banks will be forced to shrink their margins as they may not be able to pass the whole four percentage points to their customers.

In recent weeks, banks have been raising their rates to reflect the 75 per cent rise in CBR mid last month and a progressive increase in the rate on government paper that saw the 91-day Treasury Bill ascend to over 13 per cent.

“There is a risk of default if banks increase lending rates to more than banks can cover in their operating costs. Banks have to be more careful,” Mr Oknapachi said.

Kenyan banks have in the last decade recorded gradual decrease in the default rates to 5.9 per cent in April as the economy improved and corruption in the Judiciary declined.

Many of them would be keen to prevent a reversion to the Moi era situation where up to a third of the debts were defaulted.

Trade-offs

Among the negative trade-offs of the new monetary policy measure is the fact that the government will pay a substantial price as the interest rates go up.

Already struggling with a huge payment of external liabilities due to the decline of the shilling, the domestic debt burden is also set to rise although recovery of the local currency will help ease the foreign debt liability. Total public debt has hit Sh1.4 trillion courtesy of the shilling’s decline.

“Debt repayment has to be another cost. As economists say, there is nothing like free lunch; every move has a cost and benefit to it,” said Prof Kieyah.

The CBK move follows that of Bank of Uganda to raise its policy rate this month by a similar margin.

Uganda is suffering an inflation rate of 26 per cent. Like Kenya, it has been battling the twin evils of high oil and food prices, but also state extravagance in a recent general election. Both countries have seen their trade and Budget deficits widen.

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