Kenya’s economic experience in 2011 is worth watching in the context of larger peers such as Turkey and India. In all three countries, currencies have come under great weakening pressure.
In all three, inflation has risen strongly. In all three, the central banks suffered criticism. But only in Kenya has policy changed so dramatically that 2012 is likely to be a quite different story.
What do Turkey, India and Kenya share? First, a dependency on energy imports. The Arab spring pushed oil prices to an average near $110 in 2011 and this has benefited some like Russia, Nigeria and Angola, but caused considerable economic pain to those who import oil.
Second, food prices have been volatile and this has particularly hurt Kenya due to the poor rains in 2011. Third, low interest rates as each country exited the 2008-09 crisis, has encouraged very high credit growth in each of the three. This proved to be something which central banks were reluctant to crush.
High credit growth can help drive economic growth; push up government budget revenues; reduce the budget deficit and generally make life better. Unfortunately, it can also lead to excessive spending on imported goods; a widening gap in what Kenya (or India or Turkey) buys from abroad and what it can sell abroad, and a rise in asset prices that become hard to justify over the medium to long-term. Eventually that puts currencies under great pressure to weaken.
Each country has taken a different response to these pressures. India started a cycle of gradually raising interest rates through 2010-11 which has only just ended. The process was too slow to please the market and the Indian rupee has recently hit extremely weak levels. In Turkey the central bank was reluctant to raise interest rates at all, and has now embarked on a policy of very wide interest rate bands (from 5.75-12.5pc at the time of writing) in a bid to stop currency depreciation whilst not killing growth. Again the market has not been impressed, and the currency has been under great pressure.
Kenya has taken a different stance. A brave change of heart in October 2011 saw interest rates soar. This has had a radical effect on the currency. From extreme weakness, the shilling has strengthened dramatically. What will happen in 2012 as a result? First, inflation will be brought back under control. Second, credit growth will slow sharply. Import growth should slow. In addition we expect oil prices to weaken in early 2012 which should reduce the import bill too. The gap between exports and imports, “the current account deficit”, should shrink which will help the shilling to stay strong if that’s needed.
From large rises in asset prices such as land, we might start to fear falls in 2012, and growth may slow to four percent with risks of something lower still.
The question for the central bank now is when they should cut rates? In our view, the currency is now too strong. Kenya needs to build a broader more competitive export economy and the experience of many countries suggests that weaker currencies (for example closer to Sh100 to the dollar) rather than overly strong currencies (such as Sh85 versus the dollar) help most. A sharp slowdown in the economy can also scare the markets, as India is now demonstrating. Cuts in rates in 2012 if they are early enough and done at a measured pace should allow the central bank to manage the currency, while experiencing the benefits of low inflation, a better current account position, without risking a crash in Gross Domestic Product (GDP).
It will not be an easy process to manage. Externally the global economy is not in great shape. The eurozone crisis may ease in coming months (at least we hope so), but there are now fears of a hard landing in China. Kenya cannot rely on foreign demand to help its economy in 2012. Also Kenya like many emerging markets has a high dependence on the weather being well behaved to ensure food price stability. But the central bank has given itself credibility and we believe it can manage the difficult challenges of 2012.
Robertson is the Global Chief Economist at Renaissance Capital