Kenya's central bank has managed to cool sky-high money market interest rates with its latest policy adjustment, but analysts say it still faces a struggle to restore market confidence and stem weakness of the Kenyan shilling.
Policy makers have been on the defensive since January when the central bank cut its benchmark lending rate in a bid to keep interest rates down – just as inflation started to surge.
Eight months and two smaller-than-expected interest rate rises later, inflation is running at 16.7 per cent, the shilling has hit a record low against the dollar, bond yields have rocketed and private analysts' economic growth forecasts for 2011 are being trimmed.
The central bank's latest move – changing the way it calculates the rate at its discount window, used to lend to banks in emergencies – has caused that rate to plunge to 19.8 per cent from 31.4 per cent seen on Friday, when the change was announced.
This promises to ease a funding crunch in the money market. Average interbank lending rates, which fell about 1 percentage point to around 27.7 per cent on Monday, are expected to fall sharply to below the new level of the discount rate. Bond yields have also started to ease, with two-year yields down between 50 and 70 basis points this week.
But analysts worry that the root of the markets' volatility, a crisis of confidence in policymaking in a country which has traditionally been viewed as one of Africa's most stable and sophisticated economies, has not been fully addressed.
"In the last couple of weeks it seems like the central bank has been either taking measures to suck up domestic liquidity or tighten monetary conditions without hiking rates and sending a wider tightening signal," said Stuart Culverhouse, head of research at frontier markets brokerage Exotix.
"The effect may be bringing some stability but it is failing to recognize the wider confidence crisis about the currency and the central bank."
To stem the slide of the shilling, which hit an all-time low of 95.10 to the U.S. dollar on Aug. 9, the central bank sucked liquidity out of the domestic money market in an effort to stop traders taking positions against the currency.
But a byproduct of that policy was a surge of interbank lending rates to crippling highs above 30 per cent last week, prompting the finance minister to urge the central bank publicly to restore stability to monetary policy.
Last Friday, the central bank responded by adjusting the way it calculates the discount window rate and by giving banks more flexibility to meet cash reserve ratios – its fifth adjustment to the discount rate or lending rules since June 29.
Finance Ministry and central bank officials have been meeting this week to come up with further policy responses. Some official sources said it was possible the central bank would resume injecting liquidity into the money market through reverse repurchase agreements.
"Unpredictable and inconsistent monetary policy has negatively impacted foreign investors' perceptions of Kenya," said Matthew Searle, sub-Sahara Africa analyst at Business Monitor International.
"At a time when sub-Saharan Africa is increasingly on international investors' radar screens, doubts over shilling stability will reduce the attractiveness of Kenyan assets in foreign currency terms – whether that foreign currency is dollars, euro, yen or renminbi."
One upshot of the currency weakness and rising bond yields is that foreign investors have largely steered clear of Kenyan Treasury debt auctions – last week's bond sale fell short by nearly two-thirds. This has left Kenyan banks saddled with government debt.
Another consequence of the unpredictability of policymaking, brokers say, is that some foreign investors are now snubbing the Kenyan stock market. The benchmark NSE 20 index was the second-best performer in Africa in 2010 but hit a 20-month low last week.
The central bank has won some sympathy in the markets for its argument that ramping up benchmark interest rates to fight inflation would be counterproductive, given that food and fuel price rises are expected to be temporary.
But analysts say the bank's image has been tarnished by not following orthodox policies. In particular, confusion over its policy may risk importing more inflation by weakening the shilling.
"I understand that the central bank has a paramount pro-growth bias but we are a frontier market and the margin for manoeuvre and an unorthodox strategy does not exist in the real world," said Nairobi-based independent analyst Aly Khan Satchu.
"The recent sharp run-up in the overnight rate gave the shilling very little succour, and that's essentially a consequence of an erosion of our monetary policy bona fides, right there."
Some other emerging market economies such as Turkey have also rejected conventional policymaking this year, by refraining from hiking benchmark interest rates and instead fiddling with banks' reserve ratios in the face of an inflation threat.
In recent weeks, Turkey's policy has been partially vindicated by the global economic slowdown. Nevertheless, Turkey is a stronger and more diversified economy than Kenya, and it is able to cope more easily with weakness of its currency.
Some company executives in Kenya are starting to worry that unless inflation is tackled fast, the outlook for the economy and the currency in the long term will not improve.
"All these three issues will have different tools that can be applied and you can win on one or two but you can never win all three at the same time," Adan Mohamed, managing director for Barclays Bank in east and west Africa, told Reuters on Tuesday.
"As far as I am concerned, we must deal with inflation and deal with it quick. It's a virus. If we deal with that, I think the others may have to give in temporarily. Economic growth might be low, but in the long term once you sort that out, the others will hopefully come back on track."