RECENT ECONOMIC DEVELOPMENTS AND OUTLOOK For Sharing with the National Economic and Social Council By Prof. Njuguna Ndung’u, CBS Governor, Central Bank of Kenya June 24, 2011

Outline Introduction Inflation Developments Balance of Payments Pressures Exchange Rate Movements Central Bank of Kenya Monetary Policy Responses to Inflation Outlook

1. Introduction Economic recovery in Kenya stronger with a growth of 5.6 percent realised in 2010. The banking sector remains strong with increasing access to financial services across the country. In addition, credit supply to productive sectors of the economy has remained strong. Inflationary pressures attributed to recent increases in food and fuel prices pose a risk to this strong economic recovery. Shocks to the exchange rate mainly due to Euro fears and food/fuel prices internationally, and does not reflect Kenya’s economic fundamentals. However, private sector confidence in the economy has been sustained. In addition, World Bank CPIA rating for Kenya increased from 3.7 in 2009 to 3.8 in 2010 confirming the success of Kenya's institutional and structural reform efforts. A strong policy response to supply shocks being implemented to ring-fence this confidence. We anticipated balance of payments pressures due to imports from the energy sector and private sector response to public investment – expect USD 509 million IMF ECF support.

2. Inflation Developments: Food and Transport Costs Driving Inflation Upper inflation target bound (7%) Lower inflation target bound (3%) Overall inflation has been above the upper target bound of 7 percent since March 2011 due to escalation of food and transport costs. However, the rate of increase in overall inflation slowed down significantly in May 2011.

2. Inflation Developments: Food, Transport and Housing Costs contributing for 87.9 percent of inflation… For May 2011, the main categories in the CPI basket contributed 87.9 percent of the inflation (i.e. 11.38 percent of the 12.95 percent)

2. Inflation Developments: Inflation has been rising in the region due to increasing food and fuel costs… Inflation in Uganda and Tanzania increased much faster than in Kenya in May 2011. Overall inflation in Uganda much higher than in Kenya while moderation in food prices in Rwanda resulted in a decline in overall inflation in May 2011.

2. Inflation Developments: Easing of world oil prices expected to lower transport costs… The decline in world oil prices since May 2011 already being factored in fuel prices. Fuel enters in both final consumption and production cost configurations thus pushing domestic prices upward i.e. cost push pressure.

2. Inflation Developments: Improved rains expected to ease inflationary pressures… Between January and May, 2011, average rainfall in the food basket areas was near the long term mean for the main food basket areas – this is expected to ease pressure on food prices

3. Balance of Payments Pressures: Widening current account balance exerting pressure on the exchange rate A widening current account deficit due to increasing imports has put pressure on the exchange rate. However there has been an overall surplus of the BOP driven by the capital and financial account which improved to 10.3 percent of GDP in April 2011. Diaspora remittances averaged about USD 70 million between March and April 2011.

3. Balance of Payments Pressures: Imports are mainly capital and intermediate goods which are good for growth… A higher proportion of imported goods is in capital and intermediate goods which are directed towards investment which is growth enhancing.

3. Balance of Payments Pressures: Imports are mainly capital and intermediate goods which are good for growth… The proportion of crude petroleum imports is about 10 percent of total imports. Consequently, the impact of oil imports on the exchange rate should be minimal in the absence of speculative forces in the market.

4. Exchange Rate Movements In a floating exchange rate regime, monetary policy will have an impact on the exchange rate. The adjustment to shocks is usually shared between movements in foreign exchange reserves and the exchange rate. Sources of exchange rate pressure: Current account balance: our merchandise (trade) account has accumulated deficit for some time now rising from a 12-month cumulative deficit of USD -6.0 billion (17.7% of GDP) in April 2010 to USD -7.8 billion (24.7% of GDP) in April 2011.

4. Exchange Rate Movements … External influence: manifested through international exchange rates: especially the pressure from the “reserve currencies”. Holding one currency instead of another shows the investors’ risk appetite: right now investors are offloading the Euro denominated assets and searching for a safer currency: Consequently, the US Dollar has gained and strengthened globally – thereby weakening the Kenya Shilling. Foreign exchange demand and supply in the domestic market. Other internal factors: GDP growth, economic activity, inflation and relation with other international partners – gives credit to domestic policy environment and certainty.

4. Exchange Rate Movements: Exchange rate movements reflect domestic and international events… High crude oil prices following the political crisis in the Middle East and North Africa, debt crisis in the Euro Area, domestic demand and speculation by some local foreign exchange dealers explain the recent depreciation in the Shilling.

4. Exchange Rate Movements: Exchange rate weakening experienced in main EAC countries… Daily Normalised Exchange Rates to the US Dollar for the Kenya Shilling and Neighbouring Comparators (1st Jan 2010=1) Other countries in the EAC region have been experiencing similar difficulties, hence there is need for a coordinated policy response. However, South Africa, with a comparably higher foreign reserves level has maintained a strong currency.

5. Central Bank of Kenya Policy Responses to Inflation: Tight monetary policy stance adopted CBK has adopted a tight monetary policy stance in order to tame inflation and inflation expectations and enhance exchange rate stability. The stance is also expected to tame any demand driven inflationary pressures which could ensue. The Monetary Policy Committee (MPC) increased the Central Bank Rate (CBR) from 5.75% to 6.00% on 22nd March, 2011. This slowed down the rise in the inflation rate from 9.19% to 12.05% to 12.95% in March, April and May 2011, respectively. Inflation rates increased at a comparably higher rate in Uganda and Tanzania in May 2011. On 31st May, 2011, the MPC raised the cash reserve ratio by 25 basis points to 4.75% and raised the CBR by 25 basis points to 6.25% - to further enhance the fight against inflation. The Bank is also reviewing the use of other tools to further enhance the effectiveness of monetary policy and liquidity management – like the liquidity ratio. CBK’s monetary policy measures to fight inflation will be complemented by the impact of recent Government measures to address the supply side factors which have been affecting inflation.

5. Central Bank of Kenya Policy Responses to Inflation: Tight monetary policy stance adopted… As expected, short term interest rates have increased following tightening of monetary policy through raising of the CBR – this is expected to reduce domestic demand and consequently, demand driven inflationary pressures. Tightening monetary policy will affect domestic prices and the exchange rate and prevent money supply growth – this will ratify supply constraint pressures on domestic prices.

5. Central Bank of Kenya Policy Responses to Inflation: Gradual monetary policy stance to ensure credit growth… The monetary policy stance has been a gradual tightening in order to ensure that lending rates do not rise to affect credit expansion that has been supporting economic growth. Credit growth was Ksh.25 billion in April 2011.

6. Outlook Given the sustained confidence in the economy, the growth outlook remains strong despite the recent inflation and exchange rate shocks. CBK is balancing policies for fighting inflation while at the same time implementing measures to facilitate credit expansion which is key to supporting growth – A gradual tightening of monetary policy. The tight monetary policy stance has stopped the ratification of inflationary expectations. A turn around in inflation is expected in July 2011 driven by: The impact of the tight monetary policy stance on domestic prices. Government actions to lower or eliminate taxes on key food and fuel items expected to lower food and fuel prices. Food imports also expected to increase supply. Declining world oil prices. Expected improvement in food supply following the recent rains which were near normal in the food basket areas.

6. Outlook… There is adequate foreign exchange in the market. Total forex holding in Kenya stands on average up to now USD 5.133 Billion: of which CBK is holding on average USD 3.904 Billion and Commercial Banks are holding on average USD 1,229 billion. This is higher than the levels held during the global financial crisis. The exchange rate is expected to stabilise by July 2011 on account of: The foreign exchange reserves position (Currently at USD 3.9 billion) will be enhanced by the expected USD 100 million BOP support from the IMF in July 2011. Increased foreign exchange inflows through tourism earnings expected from July 2011 coupled with rising Diaspora remittances. Increase in short term interest rates expected to attract short term capital inflows. Efforts by major European countries to address the debt crisis in the Euro Area. The recent depreciation in the exchange rate could ease BOP pressures from rising imports.

6. Outlook… Consequently, the impact of the shocks from inflation and exchange rates is expected to ease from the third quarter of 2011. However, the crisis in the Middle East and North Africa still pose a risk on crude oil prices and inflation. The Bank will continue to monitor both domestic and international developments which could have implications on price stability and will take appropriate policy actions.