CHAPTER THREE MONETARY POLICY AND ECONOMIC PERFORMANCE IN KENYA
This chapter provides an overview of Kenya’s economic, monetary and financial reforms – since its independence in 1963. It explores the economic and monetary performance over the years; and highlights the challenges facing the conduct of monetary policy. In particular, the chapter assesses the respective monetary policy frameworks, and the associated economic performance from 1963 to 2014. The chapter also explores a number of challenges that the current policy framework faces; in particular the intricacies associated with financial innovations, the under developed financial markets, pursuance of multiple objectives at times competing and recent rising trend of domestic debt.
The chapter is divided into six (6) sections. Section 3.2 outlines the main features of Kenya’s monetary regime and the associated economic performance from 1963 to 1985. Section 3.3 explores the monetary policy environment from 1986 to 2014. The associated economic and financial performance, including the financial structure, is presented in Section 3.4. Section 3.5 highlights the challenges to the effective conduct of monetary policy in Kenya, and finally Section concludes the chapter.
Monetary Policy Regime and Economic Performance in Kenya (1963-1985)
Kenya, which attained its independence in 1963, has historically been and remains the largest economy in the East Africa Community in terms of its GDP size (World Bank, 2015). Post-independence has been associated with significant economic and financial reforms, which in part explain the momentous levels of economic and financial development, manifested in higher levels of economic growth, low and stable inflation, positive trade balances and significant growth in money supply and private sector credit as shares of GDP (Kinyua, 2001).
Post-independence monetary policy was controlled by the East Africa Currency Board (EACB) that also served Uganda and Tanzania. It was until 1966 that the EACB broke down, leading to the creation of the Central Bank of Kenya (CBK) by the Act of Parliament – the Central Bank Act (CAP 481) – and was mandated to execute all functions of the Central Bank (Kinyua, 2001). Further Kinyua (2001) notes that monetary policy, thereafter, was conducted through direct controls; and that domestic credit was the intermediate target, and the minimum reserve requirement was fixed at 12.5% of the commercial banks deposit liabilities in 1969.
Interest rates were controlled, exchange rates fixed and the CBK held the significant shares of the foreign exchange since it took over the custody of the foreign exchange in 1967 (Killick and Mwega, 1990). Also, Killick and Mwega (1990) indicate that positive real interest rates were recorded at an average of 1.9% between 1966 and19970. Statutory limits higher than EACB limit were instituted on the government borrowing from banks. While the increasing fiscal deficits were recorded from 1965 through the remaining part of 1960s, limited borrowing from central bank and printing of money was observed. In addition, the Treasury bills were significantly held by CBK. The exchange rate encountered episodes of devaluation following the first post-independence balance of payments test in 1967 and another in 1969 (Kinyua, 2001).
Moderate financial repression was observed, CBK held a direct significant influence over the behaviour of the banks and non-banking institutions, also known as moral suasion. At independence, the banking sector in Kenya was comprised of nine foreign commercial banks, dominated by few London based banks, in particular, the Barclays, Standard Chartered and National and Grindlays, along with a few other financial institutions such as the Post Office Savings Bank and several Non-bank Financial Institutions (NBFIs) and Development Finance Institutions (Brownbridge, 1996b). Table 3.1 shows the selected economic indicators for Kenya over the period from 1960 to 1970.
Table 3.1 illustrates that Kenya experienced strong macro-economic performance, exhibited by high growth rates, positive balance of payments and low inflation in the 1960s. Despite recording negative real GDP growth rate in 1970, real GDP averaged 4.7% between 1963 and 1970, inflation was stable and low at an average of 2 %, and balance of payments surplus were recorded except in 1967 and 1969, also shown in Table 3.1. Further, Table 3.1 shows that the high growth rates were associated with high savings rates and high investments coupled with significant national expenditure-an average of 99% of GDP in the 1960s. Despite Inflation rates being low and stable, money and quasi money (M2) as percentage of GDP grew from 3.9% in 1961 to 30.6% in 1970 (see Table 3.1).
In the 1970s, however, the economy faced a number of shocks, some of which were: The collapse of the Bretton Woods system of fixed exchange rates in 1971; the oil shock in 1973/74; the drought in 1979; and the positive boom of high coffee price in 1975 (Killick and Mwega, 1990). These shocks – except the coffee price boom – had far-reaching effects on the economy that manifested in worsening balance of payments, dwindling real GDP growth rate, and double digits inflation (Killick and Mwega, 1990). Table 3.2 shows selected economic indicators for Kenya between 1971 and 1980.
As shown in Table 3.2, the levels of inflation seemed to have had a positive co-movement with the increased share of M2 as share of GDP and the persistent high share of national expenditure as % of GDP – over 100 %. Due to the oil crisis, the terms of trade deteriorated by 22% between 1972 and 1975, however the terms of trade – following the coffee – tea boom improved thereafter by 53% between 1975and 1977 (Swamy, 1994). Real GDP growth rate that was 22% reduced in 1971 to 5.6% in 1980 while the M2/GDP ratio remained virtually unchanged during the 1970s, despite increasing marginally by 4% between 1977 and 1979 (see Table 3.2). The large government borrowing and growing fiscal deficits over the same period were funded through domestic borrowing (Kinyua, 2001).
A number of measures were undertaken in the early 1970s. Monetary policy that was largely inactive in the 1960s was then subject to a number of changes. The liquidity ratio requirement was changed a couple of times in the 1970s, starting with the liquidity ratio being raised to 15% in 1972 – on top of removing the cash ratio. The 15% liquidity ratio requirement was further extended to cover the NBFIS in 1974; and the Treasury bill was increased from nearly 0% to 6% (Kinyua, 2001). Moral suasion was also used an instrument subjecting commercial banks to reduce their lending to the import sector and foreign owned firms. There was also a shift from Kenya shilling alignment to the US dollar to the Special Drawing Rights (SDR) in 1975; and this marked the first step of engaging with IMF to reverse the economic trend and mitigate domestic and external shocks (Kinyua, 2001).
Interest rates remained controlled. Elements of moderate financial repression remained exhibited by continued fixing of the exchange rate, increased government borrowing from the commercial banks, and moral suasion practice. In addition to increased control of the bank sector, government’s own bank, Kenya Commercial Bank, was established in 1970 (Killick and Mwega, 1990). Interest rate spread averaged 5.1% annually in the 1970s, way below the annual average inflation rate of 12.1% leading to negative rates of return. The real interest rates were negative through the 1970s averaging 7.45% between 1971 and 1980. According to Killick and Mwega (1990), this in part discouraged the development of the banking sector.
The number of commercial banks that were eleven (eight foreign and three domestic banks) in 1971 reduced to four by 1980 and were all foreign-owned. On the contrary, the NBFIs that were six nearly doubled to eleven over the same period and eight were locally and privately owned. This was partly explained by the regulatory differences for the two institutions coupled with the negative interest rates on both loans and deposits, especially for commercial banks (Brownbridge, 1996b).
From 1978 through to 1982, the economy deteriorated, in part explained by severe drought of 1978/79, the second oil crisis and normalisation of the world prices of coffee and tea in the early 1980s. These shocks further deteriorated the economy as exhibited by deteriorating balance of payments and double-digit inflation (Kinyua, 2001). A number of measures were undertaken to counter and stabilise the economy. These measures included but were not limited to: Raising of the liquidity reserve ratio and the discount rate; the re-introduction of the cash ratio; limiting credit to the private sector to only 18%; and the institution of more controls on exchange rate (Kinyua, 2001).
In 1979, the IMF and Kenya agreed on the first structural adjustment loan but no actual disbursements were made until 1980 when balance of payments support was necessary to mitigate any related consequences of the second oil shock (Swamy, 1994). The respective structural reforms aimed at removing controls on prices, trade and credit, while also driving structural reforms to address the supply side shocks. The reforms also targeted fiscal and monetary policy including rationalisation of expenditure, adopting flexible exchange rate and reducing controls on trade and credit (Swamy, 1994).
These measures did not have a lasting effect, as fiscal deficits averaged 8% annually compared to the 3-4% of the early 1970s. Principally borrowing from the domestic market continued – averaging 8% annually and the debt service ratio had increased to 13.2% in 1980 from under 4% in 1977 (Killick and Mwega, 1990).
At the dawn of 1980s, most of the economic indicators were discouraging especially when compared to the post-independence decade’s economic performance. In particular, the 1981 and 1983 period encountered poor economic performance. The current deficit as share of GDP was 12.5% in 1981, inflation increased to over 20% in 1982, real GDP declined to 1.3% in 1983 and debt service ratio increased to over 25 % (Swarmy, 1994). Additionally Swarmy, (2014) notes that this prompted Kenya to approach the IMF for a second adjustment loan in 1982.
As part of the IMF adjustment programme in 1982, it was agreed to increase the controlled interest rates to ensure that the positive or near positive real interest rates go forward. The interest rate spread was also reduced to 2.3% in 1982 from the average of 4.8 % in 1980. From 1982, a crawling peg exchange rate system anchored to a basket of currencies was adopted (Swarmy, 1994). Monetary policy continued to operate through the direct measures, in particular using credit restrictions, fixed cash ratios, and liquid asset ratios as well as setting minimum deposit and maximum lending rates. Regulatory parity and interest rate parity between commercial banks and NBFIs was ultimately established in the mid-1980s. The interest rates before 1980, were set attractively for NBFIs than banks, attracting a significant share of the deposits and loan portfolio. Government borrowing from the banking system was also significantly reduced. The growth in commercial banks remained subdued, some banks closing between 1980 and 1985, while the growth of NBFIs continued, the number growing to 19 in 1985 (Brownbridge, 1996b). Table 3.3 shows selected economic performance indicators for Kenya between 1980 and 1985.
Economic performance between 1982 and 1984, as portrayed in Table 3.3, was sluggish. Inflation stayed in double digits; economic growth remained between 1-2%; growth in domestic credit as share of GDP hardly increased; interest rate spread marginally improved; money supply as share of GDP remained stagnant at 28-29%; and real interest rates remained negative. As further illustrated in Table 3.3, the official exchange rate (Kenyan shilling per US$, period average) appreciated by over 100% between 1980 and 1985 and the levels of Foreign Direct Investment (FDI) as share of GDP reduced by 50%. The dismal economic performance is partly attributed to the attempted military takeover of the government in 1982 as well as the recurring drought in 1984 and dwindling investment (Killick and Mwega, 1990).
The post-independence period leading to 1985 was characterised largely by an ineffective monetary policy that was subservient to fiscal policy. It was passive in the first decade after independence since inflation was low, and thereafter was dominated by the fiscal policy due to increased expenditure pressure in the late 1970s and early 1980s (Kinyua, 2001). The main monetary tools were credit controls and imposition of ceilings particularly on commercial banks. The weak monetary policy coupled with expansionary fiscal policy, periodic droughts and oil crisis, in part, led to inflationary pressures over the years. The interest rates remained administered and negative in real terms over the period and the exchange rate was fixed until the early 1980s (Killick and Mwega, 1990).
Despite sustained financial repression over the corresponding period, there were increased levels of financial deepening. Money supply (M2) as share of GDP increased from just 4% at independence to 27% in 1985, although it had reached 30% in late 1970s (Kinyua, 2001). The rapid growth in NBFIs is attributed to favourable differential requirements and regulation in comparison to the commercial banks, prompting the latter to own significant shares in NBFIs. The first adjustment programme of the IMF agreed in early 1980s was not successful in reversing economic trends, prompting further structural adjustments in the mid-1980s until the 1990s (Kinyua, 2001).
Monetary Policy Reforms and Economic Performance in Kenya (1986-2014)
The year 1986 heralded the dawn of major reforms agreed under the new Structural Adjustment Programmes (SAPs) integrated into the macroeconomic management policies. The SAPs aimed mainly at reducing inflation, increasing sectorial efficiency and restoring the sustainable balance of payments (Rono, 2002). In particular, Rono, (2002) highlights that the SAP reforms inter alia, included the liberalisation of prices and marketing systems; financial sector policy reforms; international trade regulation reforms; restoration of fiscal discipline; divestiture and privatisation of parastatals and civil service reforms.
The financial sector policy reforms aimed in part, at increasing the competition in the financial sector, and at increasing the range of financial instruments through an expanded financial infrastructure. It also targeted the deregulation of interest rates, improving the overall process of financial intermediation, mobilisation, and the allocation of resources (Rono, 2002).Further in 1986, Treasury bonds were introduced, the cash ratio was re-introduced, at the rate of 6%, and the liquidity ratio was raised to 20% (Nyamwogo and Ndirangu, 2013).
Between 1986 and 1990, a couple of structural adjustment facilities were agreed with the IMF and the World Bank. In 1988, two facilities were agreed; the first aimed at reducing overseas borrowing, budget deficits as share of the GDP, and maintaining positive real interest rates while the second aimed at reducing trade tariffs and controls. Further in 1989, an Enhanced Structural Adjustment Facility (ESAF) was agreed to reinforce the objectives of price de-control and reducing fiscal deficits (Rono, 2002). In addition, a financial sector reform aimed at financial liberalisation while reinforcing the central bank’s regulatory capacity through review of the Banking Act was done in 1989 (Gertz, 2009).
Figure 3.1 shows selected economic indicators for Kenya for the period from 1986 and 1995.
While 1986 is regarded as the crucial point for the key reforms, it was associated with a financial crisis – with a couple of NBFIs defaulting on their obligations (Kinyua, 2001).
Figure 3.1 shows that inflation, which had eased to just 2.5% in 1986, increased again to double digits in 1986, and continued to rise through to the mid-1990s while growth continued to slow reaching negative rates in 1992. The high inflation rates rendered the real interest rates negative, despite the attempt to raise the interest rates (Kinyua, 2001). Further, also shown in Figure 3.1, the raising of the savings rate to 12.5% and 15% in 1989 and 1990, respectively, was not enough to attain positive real interest rates. Economic growth, however, picked up in 1993, and started to grow, at positive rates (Kinyua, 2001).
Figure 3.2 shows selected financial depth indicators for Kenya 1986 to 1995.
Figure 3.2 shows that, levels of financial deepening continued into the mid-1990s. This progress was impressive against the backdrop of financial repression from the early 1960s being sustained through to the mid-1990s (Kinyua, 2001).
The 1990s became the true era of key reforms actualisation. Initial important steps to liberalise the foreign exchange market begun in 1990, adopting a dual exchange rate which entailed tracking the official exchange rate and the market rate available. This was done through creation of a legal free market for foreign exchange and the government issued foreign exchange bearer certificates. Complete liberalization of the exchange rate was achieved in October 1993, when the exchange rate was allowed to be market determined (Maehle et al., 2013).
In 1991, Capital Markets Authority (CMA), the supervisory body in-charge of capital market developments in, Kenya was set up. Further steps were undertaken in 1994, with the relaxation of all the restrictions on current account transactions including the removal of all export taxes and allowing exporters to retain 100% of their foreign exchange proceeds in foreign exchange accounts (O’Connell et al., 2010). In addition, O’Connell et al. (2010) underscore that restrictions on outward investments and inward investments were removed in 1994 and 1995 respectively, marking the complete removal of the quantitative controls on the capital account controls.
The era of the liberalisation of the exchange rate and capital account between 1993 and 1995 was associated with a significant surge in both foreign exchange outflows in 1993 and inflows in 1994/95 (Maehle et al., 2013). The Kenyan shilling suffered sizeable weakening owing to foreign outflows and the stagnant growth of exports for the period 1990-92. In response, government adopted the third export promotion policy that entailed fully refunding the import taxes paid on inputs used in the production of exports (Maehle et al., 2013). Subsequently, Kenya started to experience large inflows of foreign exchange in part, explained by the high interest rates associated with increased liquidity mop up through issuance of large volumes of treasury bills and the interest rate differentials were in favour of the Kenyan shilling (Maehle et al., 2013).
The liberalisation reforms were continued into the 1990s, and the lending rate and the maximum interest rate spread were fully harmonized by 1990 for both banks and NBFIs. Liquidity ratios were harmonized later in July 1995 at 25%. In 1991, the first step in liberalising the interest rates was implemented – with the first auctioning of treasury bills in the primary market (Kinyua, 2001). The method of Treasury bid auctioning was reformed further in 1993, with the volumes to be sold in the primary market auctions contingent upon the Central Bank’s determination of fiscal needs and the prevailing monetary circumstances.The CBK determined the volumes on the weekly auctions (Kinyua, 2001).
Following the increased government borrowing associated with government expenditure related to the elections in 1992, large quantities of Treasury bills were issued to curb the inflationary spiral – subsequently leading to high interest rates and the associated negative impact on private investments (Kinyua, 2001). Fiscal costs associated with sale of the treasury bills rose rapidly, the domestic interest payments accounting for 93% and 90% of end period for 1992/93 and 1993/94 respectively (IMF, 1995).
Domestic credit to the private sector, as a share of GDP, started to weaken in 1992 (see Figure 3.2). The lowering of maturities restricted eligible securities, as collateral for overnight loans such as treasury bills and bonds. Treasury bills maturity halved; while the Treasury bonds terms were reduced to 45 days or less (Ngugi, 2001).
The cash ratio was re-activated in 1993 and sequentially increased to 20% in March 1994 to mop up the excess liquidity including the wave foreign exchange surge inflows. Commercial banks and NBFIs that failed to meet the cash ratio requirements were subjected to penalties (Ngugi, 2001).
These measures supported by the tight fiscal policy adopted (budget rationalization attempts) in 1994 were only effective to reduce money supply but not sufficient to curb inflation, as inflation was largely caused by the drought and the 1992/93 election bound fiscal deficits (Kinyua, 2001). Economic performance between 1992 and 1994 remained gloomy. Real interest rates were negative despite the nominal interest rates being high, and fiscal deficits worsened as result of expansionary fiscal policy and inflation rose to 30% (Kinyua, 2001).
Prior to 1996, monetary policy had multiple objectives, which were often inconsistent with the sustenance of low and stable inflation. Thereafter, the CBK Act was amended, clearly defining the narrowed mandate of the monetary policy as well empowering the central bank with more autonomy. Prior to 1996, the Minister for Finance had exclusive authority over CBK Board of Directors and could overrule monetary policy without restraint. Price stability was defined as the primary objective with the ultimate aim of promoting the long-term goal of economic growth. The other objectives included: promotion of liquidity, exchange rate stability and ensuring financial stability (Kinyua, 2001). The Minister of Finance was mandated to provide six months Monetary Policy Committee (MPC) reports to Parliament; detailing the monetary policy performance, future annual targets and annual policy strategy (Kinyua, 2001).
The amendment of the act also mandated CBK to shift from targeting broad money (M3) to targeting broader money (M3X and MXT)4 as the intermediate target; and the actual transition to broader aggregates happened in 1998. In addition, the reserve money consisting of currency in circulation and bank reserves kept at CBK served as an operating target (Kinyua, 2001). The Open Market Operations (OMO), cash ratio and reserve requirement, rediscount facilities and lender of last resort facility were used as monetary instruments (Kinyua, 2001).
The dejure monetary targeting remained in place until 2011. Faced with the inflation spiral in 2011, CBK in September that year moved to adopt the short-term interest rates as the main operational target, while maintaining the monetary targeting framework (Andre et al., 2013). The current monetary framework is regarded as flexible monetary targeting, which targets both the quantity (reserve money) and prices (interest rates), with the primary objective of attaining the inflation targets while the secondary objective is to support economic growth and employment creation as well as financial stability (CBK, 2010). The quantities are targeted through targeting the reserve money, where its targets serve as the operational target, while targeting prices by using the Central Bank Rate (CBR) to signal the monetary policy stance (Andrle et al., 2013).
The Central Bank Rate (CBR) is used as a reference rate for pricing monetary policy operations. It is set and announced monthly by CBK’s monetary policy committee. The CBR serves as a reference for interbank rates and repo rates. Previously it served as reference for interest rate for CBK overnight lending facility. A number of other monetary instruments including: the open market operations (OMO), standing facilities (as a lender of the last resort), required reserves, foreign market operations, licensing and supervision of commercial banks and communication of bank decisions are used to achieve the monetary stance (Berg et al., 2013). Table 3.4 shows the monetary policy and exchange rate regime in Kenya.
TABLE OF CONTENTS
TABLE OF CONTENTS
LIST OF TABLES
LIST OF FIGURES
1.1 Background to the Study
1.2 Statement of the Problem
1.3 Objectives of the Study
1.4 Hypotheses of the Study
1.5 Significance of the Study
2. MONETARY POLICY AND ECONOMIC PERFORMANCE IN UGANDA
2.2 Monetary Policy Regime and Economic Performance in Uganda (1962-1986)
2.3 Monetary Policy Reforms and Economic Performance in Uganda (1986-2014)
2.4 Financial and Economic Structure of Uganda
2.5 Challenges Facing Monetary Policy Effectiveness in Uganda
3. MONETARY POLICY AND ECONOMIC PERFORMANCE IN KENYA
3.2 Monetary Policy Regime and Economic Performance in Kenya (1963-1985)
3.3 Monetary Policy Reforms and Economic Performance in Kenya (1986-2014)
3.4 Financial and Economic Structure of Kenya
3.5 Challenges Facing Monetary Policy Effectiveness in Kenya
4. MONETARY POLICY AND ECONOMIC PERFORMANCE IN TANZANIA
4.2 Monetary Policy Regime and Economic Performance in Tanzania (1961-1986)
4.3 Monetary Policy Reforms and Economic Performance in Tanzania (1986-2014)
4.4 Financial and Economic Structure of Tanzania
4.5 Challenges Facing Monetary Policy Effectiveness in Tanzania
5. LITERATURE REVIEW
5.2 Monetary Policy and Economic Growth: A Theoretical Framework
5.3 Monetary Transmission Mechanisms
5.4 Monetary Policy and Economic Growth: A Review of Empirical Literature
6. ESTIMATION TECHNIQUES AND EMPIRICAL MODEL SPECIFICATION
6.2 Empirical Model Specification
6.3 Estimation Techniques
6.4 Data Source and Definition of Variables
7. EMPIRICAL FINDINGS
7.2 Empirical Findings for Uganda
7.3 Empirical Findings for Kenya
7.4 Empirical Findings for Tanzania
8. CONCLUSION AND POLICY RECOMMENDATIONS
8.2 Summary of the Study
8.3 Summary of the Empirical Findings, Conclusions and Policy Implications
8.4 Limitations of the Study and Areas for Further Research
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