BACKGROUND TO THE MPC DECISION of March 22, 2011 A Presentation to the Media by Prof. Njuguna Ndung’u, CBS Governor, Central Bank of Kenya March 28, 2011

1. Key Messages from the MPC Meeting The MPC tightened the monetary policy stance on 22nd March, 2011 by raising the CBR to 6 percent: inflation beginning to be persistent and likely to have permanent effects on domestic prices; Instability of the exchange rate due to political events in Middle East and North Africa. Policy stance expected to protect economic activity by controlling inflation and stabilizing the exchange rate. Despite these shocks, there is sustained confidence in the economy supported by results of the March 2011 Market Perception Survey and continued decline in credit risk.

Key Messages from the MPC Meeting… A new monetary programme under the Extended Credit Facility is in place – targets are consistent with the current monetary policy stance. Foreign exchange disbursements expected to dampen pressure on the exchange rate. Continuation of strong performance of the banking industry with significant increase in number of loan accounts and growth in credit – however, the interest rate spread remains high.

2a. Drivers of Inflation : Food, oil prices and transport costs increasing Inflation has been pushed up by food, fuel and transport costs. Some of these pressures could be shed off in the coming months. The impact of the dry spell and political crises in North Africa and Middle East countries have exerted pressure on food and oil prices, respectively.

2b. Contribution to Overall CPI Inflation Contribution of food inflation rising (accounts for 56 percent of inflation). Transport and Housing (including electricity and fuel costs) account for 33 percent of inflation. Communication pulling down the index by about 1 percentage point.

2c. Global Food Prices: Food Inflation a Global Phenomenon High food prices a global phenomenon: world food inflation accelerated to 34 percent in February 2011 from 25 percent in December 2010 due to rising prices of oil and cereals. Domestic dry weather conditions worsened the food price increases that would have otherwise been recorded due to increases in international food prices.

2d. Exchange Rate Policy: The Exchange Rate is An Automatic Stabilizer The foreign exchange policy and foreign exchange management: It is good to re-state the policy and the benefits that accrue; several benefits accrue to the Kenyan economy with a floating exchange rate regime It allows for a continuous adjustment of the exchange rate in line with the demand and supply conditions of foreign exchange in the economy The market equilibrates or adjusts through the exchange rate movements rather than the level of reserves changing

2d. Exchange Rate Policy: The Exchange Rate is An Automatic Stabilizer ... It allows the CBK to pursue an independent monetary policy to address the core mandate - fighting inflation - without being overly concerned about the balance of payments effects → these effects are balanced by the exchange rate movements External shocks and internal imbalances are reflected in exchange rate movements rather than reserve movements or calls for CBK intervention to control the adjustment process For this reason, the exchange rate is an automatic stabilizer.

2d. Normalised Daily Exchange Rates (15th Sep. 2008 = 1) The exchange rate is an automatic stabiliser – shocks are absorbed and adjustments made through it. This provides the economy with an appropriate adjustment tool. Since late 2007, we identify seven shocks of differing magnitudes which are explained by different events. But the exchange rate also has the ability to return to its long-run mean.

2e. Exchange Rates: Kenya Shilling More Stable in the Region Kenya Shilling exchange rate has been relatively more stable against the USD compared with the Uganda and Tanzania Shillings.

2f. Growth in Credit: Credit Expansion Financing Growth 41.3 Bn Credit grew in January and February 2011 by Ksh.41.3 billion even when the dry spell was prevailing. This is consistent with the stance taken then and the commensurate demand for credit from the private sector.

2g. Net Non-Performing Loans/Total Loans: Credit Risk Declining Net NPLs/Total Loans (%) Loan Weighted Sector NPLs/Loans Dec-09 Dec-10 Feb-11 Comment Agriculture 0.71 0.50 0.49 improved Manufacturing 1.10 0.76 0.72 Building and Construction 0.16 0.15 Stable Mining and Quarrying 0.01 stable Energy and Water 0.04 0.02 Trade 1.75 1.35 1.27 Tourism, Restaurant and Hotels 0.23 0.22 Transport & Communication 0.39 0.38 Real Estate 0.95 0.70 0.7 Financial Services 0.18 Personal/Household 2.23 1.97 Total 7.94 6.25 6.09 Credit risk has generally declined across all the sectors implying increased confidence in the economy.

2h. Credit: Increasing Credit Expansion as Indicated by Growing Number of Loan Accounts Sectors Dec' 09 Dec’ 10 Feb' 11 Change Dec’ 10/Feb’11 Agriculture 110,798 117,371 123,532 5.2% Manufacturing 11,518 18,936 20,084 6.1% Building and construction 5,668 7,923 8,674 9.5% Mining and Quarrying 1,022 1,294 26.6% Energy and Water 4,825 4,896 5,133 4.8% Trade 262,988 285,763 255,587 (10.6%) Tourism, Restaurant and Hotels 4,913 5,364 5,232 (2.5%) Transport and Communication 23,587 23,521 24,462 4.0% Real Estate 14,060 14,495 15,534 7.2% Financial Services 27,151 29,683 35,490 19.6% Personal/Household 1,206,434 1,284,690 1,359,998 5.9% Grand 1,672,964 1,793,664 1,855,020 3.4% Most sectors continue to register growth in loan accounts. There was an increase of 61,356 loan accounts between December 2010 and February 2011.

2i. Average Commercial Banks Lending Rates Category of Bank (Size) Average Base Rate Change in Base Rate Feb-11/ May 2010 Average Lending Rate Change in average lending rate Feb-11/ Dec 2010 Jan 2011 Feb 2011 All Banks 14.59 14.24 -0.35 14.44 13.87 14.03 13.92 -0.52 Small Banks 14.80 14.52 -0.27 14.83 14.61 14.82 -0.01 Medium Size Banks 14.04 -0.57 14.46 14.20 13.85 -0.61 Large Banks 13.96 13.67 -0.29 15.43 14.95 14.93 14.66 -0.77 Average lending rates and base rates responded to MPC signals with declines between May 2010 and February 2011. All categories of banks reduced their average lending rates between May 2010 and February 2011. Medium banks were charging the lowest rate, on average, by February 2011.

2j. Interest Rates Spread Remains High   Lending rates   Deposit rates   Interest Rate Spreads All Banks Small Banks Medium Size Banks Large Banks May-10 14.44 14.83 14.46 15.43 4.62 5.11 4.79 3.22 9.82 9.72 9.67 12.21 Jun-10 14.39 15.29 14.30 15.19 4.45 4.59 4.47 3.23 9.94 10.70 9.83 11.96 Sep-10 13.98 14.54 14.10 15.10 3.53 4.43 3.67 2.45 10.45 10.11 10.44 12.64 Dec-10 13.87 14.20 14.95 3.59 3.46 2.19 10.28 9.42 10.74 12.76 Jan-11 14.03 14.61 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 The average spread increased by 69 basis points between May 2010 and February 2011 due to a faster decline in the average deposit rates. Large banks trading on their market power by offering the lowest deposit rate and maintaining the highest spread.

Non-Bank Private Sector Firms 2k. Economic Growth: Sustained Optimism by Banks and Non-Bank Firms for Higher Economic Growth in 2011 (%) Commercial Banks 2-3 3-4.4 4.5-5 5 5-5.6 5.7-6 Above 6 Sep -2009 68 24 Nov-2009 56 22 Jan- 2010 41 59 Mar-2010 40 60 May-2010 76 July-2010 17 69 14 Sep-2010 9 82 Nov - 2010 3 12 39 46 Jan 2011 28.6 60.7 10.7 Mar 2011 4 36 Non-Bank Private Sector Firms 2-3 3-4.4 4.5-5 5 5-5.6 5.7-6 Above 6 68 24 90 10 73 27 86 14 53 33 9 17 66 16 21 63 19 50 31 28 40 29 59 12