BACKGROUND TO THE MPC DECISIONS ON 11TH JANUARY AND 1ST FEBRUARY, 2012 AND FOLLOW-UP A Presentation to the Kenya Bankers Association Governing Council Prof. Njuguna Ndung’u, CBS Governor, Central Bank of Kenya February 15, 2012

Outline Background to the MPC decisions: Key Message from the MPC Meetings Economic and Financial Indicators Expectations on Key Economic Indicators – December 2011 Market Survey. Impact of measures announced by KBA in December 2011 to cushion borrowers from high interest rates.

1a. Key Message from MPC Meetings The MPC retained the CBR at 18.0 percent at its meetings on 11th January, 2012 and 1st February, 2012 – to allow time for previous policy measures to have their full impact on inflation. Monetary policy measures in place are working: Overall inflation continued to decline; it stood at 18.31 percent in January 2012 from 19.71 percent in November 2011 – slow but declining. Exchange rate continued to appreciate, hence supporting easing in fuel prices and energy prices; Private sector credit growth continued to slowdown signalling easing demand driven inflationary pressure. Slowdown in credit growth to finance imports also dampened pressure on the exchange rate. Banking sector remain stable with a limited threat of loan defaults reflecting: The impact of recent measures taken by KBA to cushion borrowers from high interest rates. The planned USD 600 million GOK external commercial financing to finance part of its domestic borrowing will dampen upward pressure on interest rates. But there is political pressure due to the current level of interest rates?

1a. Key Message from MPC Meetings.. Confidence in the economy has been sustained: Kenya’s credit rating re-affirmed at “B+ with stable outlook” by both Standards and Poor’s and Fitch Ratings. GOK request for augmentation of support under the Extended Credit Facility programme approved by IMF – this will boost foreign exchange reserves. December 2011 MPC Market Survey showed that private sector firms expect inflation to decline, exchange rate to strengthen, and economy to remain resilient in 2012. Continued increase in diaspora remittances which have now reached USD 85 million in a month. However, balance of payment pressures, uncertainty in the global financial markets due to eurozone debt crisis, projected dry spell in most parts of the country, and demand pressures from higher credit expansion remain major risks to the inflation and exchange rate outlook. A tight monetary policy has therefore been maintained in view of these risks to ensure a continued decline in inflation, and exchange rate stability.

1b. Economic and Financial Indicators: Inflation declining with tight monetary policy Overall inflation has been declining since December 2011 reflecting the impact of the tight monetary policy stance and falling food and fuel prices supported by the appreciation in the exchange rate. Demand driven inflation pressures have eased slightly. However, non food non fuel inflation edged upward slightly in January 2012 on account of seasonal increases in school fees, text books and house rents .

1b. Economic and Financial Indicators: Exchange Rate Responding to Policy Measures.. Normalised Exchange Rates of the Kenya Shilling Against Major Currencies (1st Sept 2011 = 1) The Kenya Shilling exchange rate has appreciated significantly against the US Dollar since September 2011 in response to the tight monetary policy and regulatory measures put in place by CBK since mid 2011.

1b. Economic and Financial Indicators: Slowdown in private sector credit growth easing demand pressures.. Private Sector Credit to Finance imports (Ksh Mn) Quarterly Credit Expansion (Ksh Bn) Credit expansion in the fourth quarter of 2011 was Ksh 14.0 billion compared with Ksh 45.5 billion over a similar period in 2010 – the reduction reflects success of a tight monetary policy stance. The monetary policy stance has slowed borrowing to finance imports which is expected to partly ease pressure on the current account with positive effects on the exchange rate.

1b. Economic and Financial Indicators: Credit risk has remained low.. Analysis of NPLs & Loans from May 2011 to December 2011   May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Gross NPLs (Ksh. B) 60 58.3 57.6 57.5 57.7 60.7 55.1 53.1 % Change (Monthly) N/A (2.8%) (1.2%) (0.2%) 0.3% 5.2% (9.2%) (3.6%) Gross Loans (Ksh. B) 1,046.9 1,083.1 1,118.3 1,137.8 1,192.5 1,213.5 1,201.4 1,205.5 Monthly Loans Growth (Ksh. B) 36.2 35.2 19.5 54.7 21.0 (12.1) 4.1 3.5% 3.2% 1.7% 4.8% 1.8% (1.0%) Gross NPLs/Gross Loans (%) 5.7% 5.4% 5.1% 5.0% 4.6% 4.4% Net NPLs (Ksh. B)* 22.6 20.8 20.3 20.5 19.6 22.2 17.5 18.4 Net NPLs/Gross Loans (%) 2.2% 1.9% 1.6% 1.5% *Gross NPLs less Interest in Suspense and Specific Provisions Net NPLs ratio has declined to 1.5% in December 2011 from 1.8% in October 2011. This indicates adequate provisioning and minimal risks on loan defaults.

1b. Economic and Financial Indicators: Cost of funds has increased rapidly with tight liquidity conditions.. Minimum and Maximum Deposit Rates Across banks (%)   November 2011 December 2011 Minimum Maximum 1 Overall 0.00 29.50 32.00 2 By Market Segment Corporate Personal 25.00 3 By Bank Size Small Medium 29.00 Large 28.00 4 By Maturity Demand 0-3 Months 0.10 28.50 4-11 Months 27.00 1 - 2 Years 26.25 3 - 5 Years 14.00 11.57 Over 5 Years 7.00 12.00 4.50 The cost of funds increased across market segments and by maturity due to increased competition for deposits. Some banks were paying deposit rates in the range of 29-32 percent to some corporate depositors in December 2011. However, a case of an inverted yield curve with shorter tenor deposits attracting higher rates. We need to invest in surveys to assess expectations as well as leading indicators for inflation expectations.

Interest rates Spreads 1b. Economic and Financial Indicators: KBA measures expected to ease the rising lending rates and spreads.. Interest Rates and Spreads by Bank Category (%)   Lending rates Deposit rates Interest rates Spreads All banks Small banks Medium banks Large Banks Jan-11 14.03 14.61 14.20 14.93 3.43 4.96 3.50 2.00 10.60 9.65 10.71 12.94 Feb-11 13.92 14.82 13.85 14.66 3.41 4.91 3.34 2.07 10.51 9.92 10.50 12.59 Mar-11 14.47 14.11 3.47 4.46 3.33 2.10 10.45 10.01 10.78 12.84 Apr-11 14.34 13.99 15.01 4.50 3.37 9.84 10.63 12.90 May-11 13.88 14.37 14.06 14.97 3.57 4.45 3.76 2.12 10.31 10.30 12.86 Jun-11 13.91 14.27 14.02 3.68 4.55 3.84 2.09 10.23 9.72 10.19 Jul-11 14.14 14.35 14.58 15.08 3.85 4.59 4.20 2.32 10.29 9.76 10.38 12.76 Aug-11 14.32 14.85 15.07 4.07 4.65 4.36 2.62 10.25 9.96 12.45 Sep-11 14.79 14.78 15.13 15.51 4.21 4.69 2.43 10.58 9.88 10.44 13.08 Oct-11 15.21 15.17 15.52 15.95 4.83 5.14 5.29 3.04 10.39 10.03 10.24 12.91 Nov-11 18.48 17.57 19.37 18.82 5.75 6.66 6.41 2.99 12.73 10.90 12.96 15.83 Dec-11 20.04 19.12 20.59 20.95 6.99 7.24 7.54 3.63 13.05 11.88 17.32 Interest rate spreads increased between October and December 2011 on account of large banks. Small banks, with lowest lending rates, maintained competitive deposit rates – they had lower spreads.

1c. Changes in Inflation Perceptions/Expectations (% of firms) Inflation – Banks Inflation – Non-bank firms Increase Remain at the same level Decline July-2010 25 62 14 28 44 Sep-2010 38 18 42 32 26 Nov - 2010 46 12 35 36 29 Jan-2011 89 4 7 56 20 24 Mar -2011 100 74 2 May -2011 91 6 3 July -2011 75 11 66 21 13 Oct -2011 82 16 10 Dec-2011 9 63 50 Inflation expected to decline in 2012 on account of: CBK actions to tighten monetary policy expected to ease demand for credit; lower energy costs; improved food supply across the country; and appreciation in the exchange rate of the Kenya Shilling to USD. Uncertainty in the resolution of the eurozone debt crisis could result in exchange rate volatility with pass-through effects to inflation

1c.Changes in Exchange Rate Perceptions/Expectations(% of firms) Banks Ksh/USD Exchange rate Non-Banks Strengthen Remain the same Weaken July-2010 21 28 51 26 48 Sep-2010 68 9 23 42 32 Nov - 2010 61 33 6 Jan-2011 25 54 20 Mar -2011 16 8 76 71 May -2011 88 14 63 July -2011 34 11 55 30 19 Oct -2011 53 39 45 Dec-2011 60 10 Exchange rate expected to strengthen in 2012 due to: reduced demand for foreign exchange by importers due to higher interest rates; increase in short term capital inflows due to higher interest rates; improved foreign exchange inflows from donors and NGOs; regular interventions by CBK; increased flows from tourism; less pressure from food imports due to improved rains. Risks on exchange rate stability mainly uncertainty in the resolution of the eurozone debt crisis

1c. Changes in Lending Rates Perceptions/Expectations(% of Banks) Decline by More than 2 % 1-2 % Remain the same Increase by 1-2% July-2010 14 75 7 4 Sep-2010 6 59 26 9 Nov-2010 33 58 Jan-2011 32 39 29 Mar-2011 12 60 28 May-2011 49 July-2011 3 93 Oct-2011 100 Dec-2011 23 22 19 36 The December 2011 survey shows that unlike October 2011, only just over a third of banks expect a rise in lending rates in 2012. Lending rates expected to remain high in the short term but to decline with inflation – we need to watch non-performing loans in the short term.

1c. Changes in Credit Growth Perceptions/Expectations(% of firms) Banks Growth in Credit Supply Non-banks growth in credit demand Decrease Remain the same Increase by 1-10% Increase by 10—20% Increase by above 20% July-2010 7 33 20 27 Sep-2010 3 56 32 6 47 46 Nov-2010 9 24 15 23 8 Jan-2011 34 31 5 48 Mar-2011 28 40 12 29 May-2011 18 22 41 17 July-2011 21 39 4 Oct-2011 26 37 38 19 Dec-2011 10 65 Private sector credit growth expected to slowdown in 2012 due to high interest rates and cost of funds – this will ease demand driven inflationary pressures.

2. Impact of measures announced by KBA to cushion borrowers from high lending rates The threat of accumulating NPLs negligible – decline in net NPLs observed. Notable progress made by banks towards cushioning borrowers from high interest rates. A survey by KBA for 35 banks shows that since December 2011: The tenors of 440,267 loans valued at Ksh 98.9 billion were extended. Interest rates on 7,426 loans valued at Ksh 51.9 billion were capped. Charges on 56 loans valued at Ksh 1.4 billion were phased out. Interest on 1,210 loans valued at Ksh 237.9 million was waived. In addition, 1,273 loans totalling Ksh 879.4 million did not attract interest under the in Duplum rule. Need for all banks to respond to the survey in order to provide a complete picture. But there is scope for banks to do more to protect borrowers and their investment.