East Africa's currencies will remain under pressure unless interest rates rise to a level where real returns can attract capital flows into largely import-dependent economies suffering from high inflation rates.
The currencies in Kenya, Tanzania and Uganda all fell to record lows against the dollar on Tuesday. The Kenyan shilling has led the way this year and hit a low of 91.68 against the dollar, a fall of 13.9 per cent since the end of 2010.
While the slides have fuelled some speculative positions which have exacerbated moves, analysts say the economic backdrop points to further currency declines unless short-term interest rates jump, inflation slows dramatically – or all three central banks intervene in a robust and co-ordinated fashion.
All three economies depend on oil imports, their economies rely on rain-fed agriculture for domestic food production and some power generation – and all three stepped up budget spending to sustain growth in the fiscal year starting in July.
At the same time, rising food and fuel prices have sent inflation rates this year to reach 13 per cent in Kenya in May, 16 per cent in Uganda and 9.75 per cent in Tanzania.
Analysts say the Kenyan monetary policy response to inflation was initially too slow: The central bank cut its benchmark lending rate by 25 basis points in January only to reverse the move in March as inflation neared 10 per cent.
The bank raised rates in May by 25 basis points and has been sucking liquidity out of the money market, but analysts say the muted response to inflation, coupled with higher spending is undermining confidence in the shilling.
"Earlier this year we saw a policy mistake where the central bank cut rates and then within a couple of months had to raise them," said Stuart Culverhouse, chief economist at frontier markets brokerage Exotix.
"The second issue is the concern that we have had for a couple of years, and was confirmed in the budget statement two weeks back, that fiscal policy is overly loose. The budget deficit looks entrenched and there seems to be no intention of reining it in," he said.
Budget spending in Kenya in 2011/12 is set to rise 15 per cent, pushing the deficit to 7.4 per cent of gross domestic product while spending in Tanzania will rise 16 per cent.
"The whole of East Africa will remain under pressure as they all suffer the same disease: high inflation and dependency on importation. So unless they are willing to let rates go up to attract investment above inflation levels, the currencies will keep suffering," said a foreign exchange trader in Nairobi.
The Kenyan central bank has stressed that inflation is largely driven by temporary supply-side shocks and has pointed to an easing in domestic fuel prices in May, which should also help tame food price rises.
The central bank has also stressed that it and commercial banks have ample foreign currency holdings that are far higher than when the global financial crisis hit – so the current shilling weakness is inevitably temporary.
Nevertheless, foreign exchange traders say the Kenyan market is betting on further declines in the shilling. Banks and exporters are hanging on to dollars at a time hard currency is needed for crucial oil and maize imports.
And the central bank is also lending billions of shillings to banks through its overnight window, which traders say can then be used to fund long dollar positions.
"There are a couple of issues driving the value of the shilling, one is high commodity prices, which means there is foreign exchange demand from Kenyan oil importers and those who are then exporting to East Africa, much of which is landlocked," said Angus Downie, fixed income and currency strategist at Ecobank Capital.
"There is no longer a tax on the importing of maize because there is not enough domestic maize, there is a lot of foreign exchange demand for these imports," he said.
"Kenya is facing a textbook situation in which it should raise rates, that would boost demand for the shilling."
Culverhouse at Exotix said he reckoned the central bank would have to raise rates by 200 basis points to stop the rot.
"Unless we see signs the authorities recognize the situation, it's only going to get worse," he said.
Central banks in Uganda and Tanzania have been more proactive in selling dollars to stem shilling declines. The Ugandan shilling has fallen 6.1 per cent this year while the Tanzanian currency is down 8.0 per cent.
But neither has been able to curb the downward trend and analysts said the Kenyan shilling should continue to determine their overall direction because of regional trade links.
"The biggest factor driving the [Ugandan] shilling down is regional depreciation. Kenya is our biggest trading partner and most of our inflows come from there, so when their currency suffers, so does ours," said Mark Bitarabeho, head of sales at Standard Chartered Bank in Uganda.
In Tanzania, traders said there was also a perception the Bank of Tanzania was not too worried about the shilling's decline because it made exports more competitive.
But they were still surprised the central bank did not step in on Tuesday when the shilling hit 1,600 for the first time.
"We don't see any further economic fundamentals to support the shilling. The central bank says a weaker shilling is good for exports, so they haven't been doing anything much to give the local currency a boost," said Bruno Ngooh, a trader at Standard Chartered Bank Tanzania.
Nairobi-based independent analyst Aly Khan Satchu said the central banks in the region needed to act fast.
"This 'see no evil hear no evil' strategy is essentially a giant come on to the short sellers," he said.
"I would jack up short-term money until I found the pain level and I would get on with it before things fall apart – these are disorderly markets that need a firm hand."