The irony of a strong shilling
A man counts money. A depreciating shilling presents favourable condition for inflows, including Foreign Direct Investment and remittances.
Since the successful sale of a fresh $1.5 billion Eurobond last month, the Kenyan shilling has staged a remarkable rally against the US dollar. Not only did the receipt of these funds prevent the country from defaulting on its $2 billion Eurobond issued in 2024, but it also arrested and subsequently reversed the shilling's depreciation trend.
From its peak against the greenback on January 25 at 163.50, the shilling is presently trading at 133.00. This development has garnered praise from the Kenya Kwanza government, who view it as a testament to the effectiveness of their economic policies.
Typically, a nation’s currency strength correlates with favorable economic indicators like low inflation, steady growth, and fiscal responsibility evidenced by a balanced budget. A robust currency signifies confidence in the economy, attracting foreign investment, enhancing domestic purchasing power, and alleviating the sovereign debt load.
Yet, this apparent strength may obscure underlying weaknesses, including diminished remittances and diaspora investments, and pose hurdles for export-driven sectors. Additionally, a strong currency might erode competitiveness in global markets thereby impeding tourism, export earnings, and trade equilibrium.
The irony of a robust shilling reveals itself vividly in its impact on trade dynamics. While it may reduce the cost of imported goods like petroleum products, consequently contributing to lower inflation rates, it also raises the price of exports for foreign buyers. This can result in a decrease in export competitiveness and a widening trade deficit, which ultimately threatens the economy's long-term sustainability.
One of the most significant repercussions of a stronger shilling would be felt keenly by thousands of tea and coffee farmers, who would experience substantial reductions in their earnings and bonuses. These key commodities, tea, and coffee, would become relatively more expensive compared to those of neighboring countries, potentially prompting buyers to shift their preferences to countries like Rwanda, Burundi, Uganda, Tanzania, or Ethiopia.
Moreover, a robust shilling might diminish the incentives for export-oriented industries to innovate and improve productivity, exacerbating trade imbalances and hindering the nation’s pursuit of industrialisation. In Kenya, diaspora remittances play a crucial and multifaceted role in supporting economic stability, poverty alleviation, investment, development, foreign exchange reserves, consumption, and financial inclusion. These remittance flows serve as a vital link between migrants and their home country, contributing significantly to both individual welfare and national economic growth.
Last year, diaspora remittances surpassed $4 billion for the second consecutive year, highlighting their substantial impact. In contrast, Foreign Direct Investment net inflows were comparatively modest, estimated at just $393 million in 2022 according to the World Bank. Although there may have been a slight increase in FDI in 2023, it undoubtedly remained significantly lower than remittance levels.
A depreciating shilling presents favourable conditions for inflows, including Foreign Direct Investment (FDI) and remittances. Conversely, as the shilling strengthens, the purchasing power of the diaspora community diminishes, potentially leading to a reduction in remittances.
Kenyans residing in the US have voiced concerns over losing out due to foreign exchange dynamics, coupled with the sluggish downward adjustment of average prices. Moreover, some individuals have opted to suspend their projects back home until their dollars regain their purchasing power, reflecting the significant impact of currency fluctuations on diaspora contributions to the Kenyan economy.
But there is an upside to a strong shilling, such as an accumulation of foreign exchange reserves due to investors flocking to the currency, in search of stability and returns. While ample reserves can provide a buffer against external shocks and currency volatility, they also pose challenges in terms of monetary policy management.
The Central Bank of Kenya would ultimately face a dilemma that it would need to address — balancing exchange rate stability or maintaining price competitiveness and supporting export-led growth. Interventions to weaken the currency, such as foreign exchange market interventions or interest rate adjustments, carry risks of inflationary pressures and capital flight. Conversely, allowing the currency to appreciate unchecked may lead to adverse effects on export-oriented sectors and employment.
Regrettably, the sole tangible advantage of a strong shilling, namely the ability to repay and retire the country’s external debt, may not materialise as expected. Despite the favourable exchange rate, which would have facilitated debt repayment, Kenya opted to refinance a comparatively cheaper Eurobond with new debt.
The decision involved selling new seven-year bonds with a higher coupon and yield, offering rates of 9.75 per cent and 10.375 per cent, respectively, compared to the existing bond’s 6.875 per cent. This strategy not only deferred the financial strain but also exacerbated the situation by locking in higher borrowing costs. Instead of focusing on the favourable exchange rate today, the refinancing approach adopted by the government has potentially heightened the financial burden in the long run.
