How commercial banks led to rapid decline of shilling

During the month of October when the shilling depreciated steeply against the dollar in more than a decade, both banks and their clients net foreign currency holdings rose by a dramatic Sh45 billion ($449 million).

It was as if the banks and some of their customers who regularly buy forex were preparing for a battle of their lives in the hard currency market. As speculators and traders, it turned out that they were right because it was in October that the average value of the shilling, at Sh101.27 to the dollar, was the lowest since the local unit was floated in the mid 1990s.
Kenya had finally come face-to-face with speculators ranging from banks to their clients as they tried to build an arsenal for the battle, fearing the demand might become overwhelming in the weeks and months that followed.

The banks’ net foreign assets more than doubled during the month to Sh41 billion ($405 million), an extra Sh22 billion or $218 million on the basis of the average dollar rate of the time, according to data from the Central Bank of Kenya.

The clients of the bank accumulated in their accounts an extra Sh23 billion ($231 million) to stand at Sh274.8 billion in October.

To them, it was the best time to make a killing from the depreciating shilling.

Just two months earlier, banks had accumulated foreign exchange by $174 million as tea earnings entered their accounts – just ahead of the Sh30 billion-plus tea bonus payment – but, which was withdrawn or converted into local currency by the following month.
This was happening amid accusations that some foreign banks had shipped out hundreds of millions of dollars abroad.

With this exit of currency and banks holding an extra $449 million in a climate of limited forex reserves, Central Bank’s activities in the market had minimal impact as the authority itself would later tell the MPs in the parliamentary committee investigating the fall of shilling.

“The CBK injected $118.25 million in the market between July and November 22, 2011.

Given that the Bank (CBK) also bought foreign currency from the markets amounting to $95.8 million, the net injection was small and could not have reversed the direction of the Kenya shilling. The intervention through the sale of foreign exchange was limited by the amount of reserves available in Kenya,” the committee wrote in its report.

Kenya Bankers Association CEO, Habil Olaka, told the same committee that clients “went into panic buying of foreign currencies for their future needs in anticipation of a weakened shilling. Speculators also came into the market creating a shortage of foreign currencies.”

But was the business purely speculative on the shilling? Most authorities say that most of the global currency trade is actually speculative and there is therefore nothing odd about banks having speculated.

“It is true that most of the forex banking transactions are carried out for speculative purposes to make income for a commercial bank and there is nothing unusual about that for an institution that is in business,” a banking consultant who has held key management roles in banks said on condition of anonymity.

A foreign exchange trader said that it takes as much as Sh1 million to train a dealer who then comes under pressure to show results and a return on the investment for banks that trains one.

“An institution is not going to invest one million shillings in a person and not expect results from those handling forex with aim of increasing income from this stream,” said a forex dealer who spoke on condition of anonymity because the training information is an internal affair.

The banking consultant said that it was true that it could take as much Sh1 million to train a dealer in the treasury department of a bank, although other staff are also trained at a relatively lower cost.

The point that the dealer was making was that banks collect the forex deposits with a view to using it for forex-related lending or other income-generating transactions and not for the sake of it.

They were, therefore, holding forex knowing that it would become lucrative to resell it. Not surprisingly, CBK finally realised that most of the banks it had accused of hoarding forex were actually only doing business.

According to CBK data, the top five banks with the largest forex holdings totalling 56 per cent of the entire industry holdings last September were CFC Stanbic, Kenya Commercial Bank, StanChart, Citibank Kenya and Barclays.

The banking consultant said that banks would continue to make good money from the foreign exchange trading going by the third quarter bank results because the exchange rate volatility of last year provided the perfect opportunity for dealers to make money.

“When the forex market is volatile, the dealers can earn their companies good income by making calculated bets,” said the consultant.

“So we will continue to see banks releasing results that show high earnings from forex trading as we saw with the third quarter results.”

The former banking executive said that it was not only Kenyan banks that speculated on currency but it was also a global practice done as part of their business.

A key point to note for the Kenya shilling, the consultant said, is that it is freely traded in both local and international markets, thereby exposing it to predictable and unpredictable sentiments of international speculators.

Given the billions of dollars they hold, the international financial players could trigger changes in the value of the local currency, as long as the fundamentals show it is vulnerable.

The fundamentals are still seen as not favouring the shilling. For example, the current account deficit – which shows that imports far exceed exports – is still wide having risen to about 10 per cent by the end of last year from five per cent of Gross Domestic Product in 2010.

Investor appetite

At the same time, the capital and financial account – which shows hard currency flows into or outflows out of Kenya – has also been under pressure due to the crisis in Europe where investors’ appetite for emerging and frontier markets assets has taken a beating.

Even with the bailout package for Greece having been agreed upon, uncertainty looms because both analysts and the International Monetary Fund have predicted the area will face a recession of at least 0.5 per cent contraction in GDP growth this year.

The other fundamental being considered is that of the official foreign exchange reserves being largely flat since the CBK cannot enter the market to buy dollars without causing depreciation of the shilling.

“We don’t expect the shilling to remain at current levels given what fundamentals are telling us, which is that the current account is still wide and forex reserves are flat. As such, we expect the shilling to weaken from current levels before it stabilises,” said Yvonne Mhango, a sub-Saharan Africa economist at Renaissance Capital.

But are international speculators and hedge funds – known to take aggressive or risky position on assets – involved in currency speculation in Kenya as they have been known to be in other countries facing currency depreciation?

Financial crisis

For a long time, former Malaysian leader Mahathir Mohamad accused billionaire hedge fund owner George Soros of having triggered the Asian financial crisis in the late 1990s through currency speculation and driving Malaysia to near ruin.

It is the same Soros whose most enduring reputation is that of the investor who betted on the British pound in September 1992 and pocketed over a billion dollars in a single transaction, and as a result became famously known as “the man who broke the Bank of England”.

For Mr Soros was said to have made a large bet against the Thai baht – and consequently Thailand became the epicentre of the Asian economic turbulence between 1997 and 1998 during which billions of dollars exited the continent’s markets exacerbating the financial crisis.

Argentina also has had several currency crises, some of which were due to the pegging of its unit to the dollar – a situation that caused it default on the International Monetary Fund and other loans in 2002.

Argentina had mismanaged its macroeconomic fundamentals including incurring huge fiscal deficits from year-to-year, uncompetitive export trade aggravated by capital outflows in excess of $20 billion in 2001 alone against a recession that had been going on for four years before its now-famous default.

With the weak fundamentals, speculators waited with bated breath to pounce knowing that the currency was bound to fall, practically a one-way bet.

As the shilling depreciated rapidly in September-October period of last year, a somewhat similar accusation was made against banks by Prof Njuguna Ndung’u, the CBK governor.

It turned out that most of the currency activities of the banks were within the law even if they were speculative. Knowing that fundamentals are dicey, speculators only need a trigger.

And that is what may have happened in the Kenyan case as the escalation of the eurozone crisis served as the last straw that broke the camel’s back.

During the proceedings before the parliamentary committee investigating the fall of the shilling economist David Ndii said the spark for the shilling rapid depreciation was the European crisis that saw people hold on to the dollar in anticipation that the euro was going down, with the knowledge that the basic problems had been building pressure over time.

“The instability of the shilling had two drivers, the underlying causes and the trigger. The underlying causes were to do with fiscal and monetary policies and the trigger was the eurozone crisis,” said Dr Ndii.

In a presentation at a recent conference called by the African Development Bank to discuss inflation in east Africa, Prof Ndung’u noted that the “depreciation in the exchange rate between April and October 2011 was exacerbated by the currency wars”. He said: “The sudden steep weakening of the shilling in September to October 11, is consistent with the sudden strengthening of the US dollar in the global financial markets.”

The ground for the global events to play into the local markets had been laid by the fiscal deficits, which had been rising for several years causing an increase in money supply, rising current account deficit as well as stagnation in the level of foreign exchange reserves.

Attractive proposition

Since the fundamentals have not changed even though the shilling is stronger than last year, the currency still faces the prospect of a rapid depreciation should a similar trigger such as an opening of a new front of the eurozone crisis through Portugal — quickly becoming “the new sick man of Europe” — suddenly emerge even as the Greek one seemed to be coming to a close with the agreement on how to resolve it.

“Any global event that would spur risk aversion such as a default within eurozone or heightened geo-political risk (such as in Iran) will see the ‘hot money’ pulling out of Kenya and into safe-haven destinations to the detriment of the shilling,” said Renaldo Desouza, an analyst at Nairobi-based Genghis Capital.

The speculators are watching closely because the local unit is always an attractive proposition to them. Analysts at Standard Chartered have in the past noted that the shilling along with the South African rand is among the most liquid – easily traded and cashed — in Africa thereby explaining the currencies volatility relative to the hard currencies.

However, some authorities actually say that speculators, including the aggressive hedge funds, are good for markets and economies because they impose discipline, especially on governments that may be tempted to be irresponsible with public finances.

World Bank chief economist for Africa, Shantayanan Devarajan, said towards the end of last year that speculators and hedge funds normally exploited macroeconomic conditions.

“I wouldn’t blame speculators or hedge funds, because that is the business they do, but I would see depreciation as reflecting underlying problems in an economy,” said Mr Devarajan. “If the bond markets, for example, show a high premium for the eurozone countries, it is because they reflect the risk of possible default.

The hedge funds, therefore, keep governments focused on what they are supposed to do because the hedge funds will come in if a government fails.”

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