A concept called the Idiots Curve recently flashed on my LinkedIn pages, thanks to Dr Lucy Muthoni, a mathematician. In summary, you will feel dumber before you get smarter on a new assignment, no matter how well-informed or experienced you might be.
The next leadership of the Central Bank of Kenya must ponder and wade through the assignment to sharpen their deliverables, given the worsening economic conditions and a tradition of bank balance sheets tight-fisted with loans.
What a difference compared to March 2015, when as Acting Chairman of the CBK Board, I kick-started the shortlisting process for the current CBK leadership. We had a newly minted Constitution, Article 231 to boot, s well as a newly amended CBK Act to implement.
The outlook is more daunting than in 2015. IMF’s Global Stability Report paints a perilous phase, at least since 1990, after banks and businesses failed to prepare for the current phase of rising interest rates.
In low-income countries, excessive indebtedness, high cost of failures to tackle fiscal, monetary and debt cracks, as well as a decline in global demand for their exports, are on the plate, and especially for Africa.
Listening to a House Committee Chair fumbling a week ago on subsidies to address hunger, I thought to prefix this piece with snapshots: Kenya’s many failing policies compared to governments of quality we’ve had in the past, such as the Kibaki era. The government teems with experts in metaphoric talk as the economy plummets to the edge of the cliff of debt default.
One prank by a PS for Labour interprets his job as to roll out a bizarre and simplistic economic fallacy: educate Kenya’s skilled workers (at taxpayers’ expense – because Kenya boasts 86 per cent of the labour force with post-secondary education, above the regional average of 72 per cent) and use more taxpayer money to migrate that labour to the Middle East (can he, with the macabre deaths there?) not to the domestic economy.
We could cite many policies of shame. Stay with the subject of the day – rebuilding our premier macroeconomic institutions and constructing a return to the growth path that Kibaki bequeathed the nation over a decade ago. Kenya’s acknowledged growth potentials still shine.
US Ambassador Meg Whitman summarised them most recently and brilliantly: Kenya leads as a regional hub for finance and logistics, and is the leading destination for FDI. And with the US as the lead export market, its economic conditions can be reshaped to improve our fortunes.
Lessons from a banking crisis
Among Kenya’s regulators in the financial sector, few match the capacity embedded in the CBK as I attested in my time, when we added to the CBK regulatory function of price stability the oversight of financial stability, installing a matching Board sub-committee. But challenges in Central Bank/fiscal policy interplay have since intensified as I warned in WR Issue No.17, Pulling Apart, and WR Issue No 30, Banking Crisis Raises Red Flag. Kenya needs to step things up.
Following the recent stock market rout, deposit flight and exodus from US and European banks starting with Silicon Valley Bank (SVB), the resulting failures brought tectonic shifts, placing central banks in a quandary on two mismatched objectives: fighting stubbornly high inflation, while maintaining financial sector stability.
The reasons why recent collapses and systemic dangers were obvious in hindsight but unanticipated by policymakers is that central banks did not raise the alarm when regulatory floodgates were opened, revealing some banks swimming naked. Repeal of the Dodd-Frank Act (thanks to the Donald Trump regime) played a part. After the 2008 crisis, the Act mended bank regulations for holdings of elevated shares in assets.
The never-say-die economy
Now, a high probability of global recession is predicted from the banking fallout. Singularly in G7, the UK economy sinks to a contraction of 0.3 per cent in 2023 forecasts. Yet, while US banks failed to try to purr the US economy with corporate lending on the assets side, Kenya’s banks fail to support real economic potentials by sticking to securities and keeping the rest of deposits mainly as liquidity, shunning the work of credit assessments.
Banks which by regulations should hold a minimum of 20 per cent liquidity ratio, sometimes have held 88 per cent, piling up holdings in Treasury Bills and bonds called fiscal dominance.
To promote growth and productivity, Kenya would have to venture into more complicated math, drawing down liquidities and raising loan portfolios, for the following reasons.
First, as banks fight stubborn inflation with higher interest rates, dispensing with Covid-era lower interest rates, it was inevitable that bonds and share prices would fall, and yields rise, with pressures to control post-Covid era inflation as a priority.
This drives instability in stocks and bonds markets. Massive unrealised losses have occurred, with banks teetering on insolvencies. Yet, relenting on interest rates as a trade-off to help lower bond yields and stave off the haemorrhage of ‘unrealised losses’ in banks, associated with loan books, as well as values of stocks and bonds, has never looked more contradictory.
Central banks like the FED and ECB insist on fixing inflation first, over the losses and interests of financial markets. Second, in Kenya, with the potentials cited above, banking for corresponding opportunities is thematically a private sector arena in which to grow Kenya’s socio-economic opportunities.
Yet, our banks tread on tiptoe to pin assets in the private sector, putting the asset category firmly on the back burner, which holds back financial intermediation, economic activity and growth.
Third, in an emerging market, policy and National Treasury/CBK decisions, even when wrong, are cut differently for domestic and foreign investors and stakeholders.
While interest rates, for example, affect capital flows in both portfolio and FDI, increases or cuts affect domestic and foreign players differently. With increases, our business investors’ and households’ access to credit retreats. Capital flows in contrast increase, especially portfolio flows, in search of interest margins.
The reverse is the case when we lower interest rates and are faced with bouts of capital flight. The macro-policy stance at present is a typical example of our dilemma. Rising interest rates and fiscal austerity run concurrently. This can only contract domestic investor opportunities with reduced access to credit to grow out of the slump, while external capital benefits. Indeed, the Purchasing Managers Price Index (PMI), trending below 50 per cent shows contracting private sector business activity in manufacturing, retail agriculture, services and construction.
Austerity, deflation and economic contraction are associated with this erroneous policy mix.
The strategy we need
In the contest between the two central banking objectives cited, National Treasury’s spending and adjustments mainly drive the aggregate supply in targeted areas of the economy but can spill inflation and macro-instability.
CBK’s monetary policy, while sluggish, influences access to credit through interest rates but cannot influence the supply side.
The CBK modulates aggregated demand to align it with supply, using monetary instruments to address overheating when spending or monetary excesses spill into inflation targeted at the 2.5 percent to 7.5 per cent band.
The recent banking crisis exposed Kenya’s lending weakness in the private sector as if it was a virtue, mainly because “unrealised” losses were relatively low. Paradoxically, muted losses were incurred by Kenyan banks already enjoying comfortable margins, compared to major banks in the US and European capitals.
In the latter zones, exemplified by SVB, banks piled their large cash deposits to Treasury bonds, long-dated private sector debt and related wealth assets, on the assets side of their balance sheets.
These bank operations generate strong corporate lending and securities that drive economic activity and growth.
Kenyan banks, however, keep a tradition on the liabilities side of their balance sheets (mostly customer deposits), translating them into a risk-averse mode – mainly treasury bills, bonds and only muted private sector lending (especially loans) on the assets side.
A variety of portfolio hedges are used – lending and repayments in forex for example or minimising ‘unrealised’ losses from securities by segmenting holdings into a tradable segment (marked to market), a segment for sales to gain from market positions, and a segment held to maturity. I focus on the failure of credit in Kenya’s macro-economy because, if businesses cannot access it, growth is restrained.
Tighter credit subscribes to that restraint but pointedly contracts the economy when tightened together with fiscal contraction as is happening presently.
Even worse, our broken credit markets restrain both short-term employment and recovery and productivity. As redress, a CBK leadership is needed that will align with Kenya’s domestic and regional and global opportunities cited above, by engineering trust or coverage of real or perceived lending risks to borrowers in the private sector.
Subjected to special regulations
In the Reserve Bank of India (RBI) for example, the Willful Defaulter Law lowers risks and strengthens confidence, with loan collection in favour of banks. On regulation, CBK could also pioneer a position that banks holding assets above a certain level would be subjected to special regulations – a quasiDodd-Frank Act.
Some general outcomes bear out some of the disconnects on the recent banking crisis’ impact in Kenya and abroad. In the US, high commercial private-sector lending powers private sector as an engine of economic growth and policy management.
Although the impact of deflated values of stocks and bonds spilt over into Kenya, there is a stark contrast in heightened ‘unrealised losses’ in the US, compared to Kenya. SVB sold some of its investments on the assets side, clocking losses of US$1.8 billion. Losses for banks in the US reached US$620 billion, about 28 per cent of their total capital, but the banks’ exposure to other assets like the long-dated loan-book portfolios are much higher.
Contrast this with Kenya, where banks have traditionally shunned private sector lending on the proverbial risks of (especially local) domestic clients. Kenyan banks’ unrealised losses at end of 2022 were only about nine per cent of core capital. The US ‘loan book’ losses from the inverse rule on stocks and bond prices versus yields raised unrealised losses to $1.75 trillion, or 80 percent of their capital.
Why the vast difference? Kenyan banks’ tepid exposure to private sector lending, vis-a-vis US exposure to both loan books and domestic sovereign risks, is part of the reason. The highest unrealised losses to hit a Kenyan Tier 1 bank showed a paper loss of Sh29.01 billion in 2022, compared with Sh7.09 billion in 2021.
This is linked to a strategy of raising exposure to holding sovereign debt instruments – TBs and bonds – while shunning asset holdings in the loan book. Kenyan shareholders need to ask hard questions about how this loss will be managed, given the shareholder dividend payout amounts to only Sh15 billion.
In sum, Kenya’s highly profitable banks escaped SVB-like fallout not by virtue, but thanks to a conservative tradition of avoiding powering and enlarging private sector loan books.
The CBK and National Treasury have homework to do in strengthening their policy intents to referee the appropriate macro-framework for growth in accordance with our potentials over business cycles.
Dr Wagacha, an economist, is a former chairman of the Central Bank of Kenya and advisor to the Presidency.
The story was first published in the Weekly Review