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DEVELOPMENTS IN THE EXCHANGE RATE AND ACTIONS THE CENTRAL BANK IS TAKING

Outline . IntroductionThe Exchange Rate Policy.Supply and Demand for Foreign ExchangeNormal requirementsSpeculation/Arbitrage Market Outcomes International events including impact on neighbouring countriesOil pricesCross Rates The CBK Actions and Policy Response. 2. 1. Introduction. Food

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DEVELOPMENTS IN THE EXCHANGE RATE AND ACTIONS THE CENTRAL BANK IS TAKING

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    1. DEVELOPMENTS IN THE EXCHANGE RATE AND ACTIONS THE CENTRAL BANK IS TAKING A Media Briefing by Prof. Njuguna Ndung’u, CBS Governor, Central Bank of Kenya June 23, 2011

    2. Outline Introduction The Exchange Rate Policy. Supply and Demand for Foreign Exchange Normal requirements Speculation/Arbitrage Market Outcomes International events including impact on neighbouring countries Oil prices Cross Rates The CBK Actions and Policy Response 2

    3. 1. Introduction Food and fuel crisis affect domestic inflation while currency depreciation is an addition. The crisis in the Euro Area is having an impact on currencies and money markets around the world. However, with the tight monetary policy stance, depreciation cannot affect inflation given that money supply growth is constrained. Central Bank analyses indicates that intervening in the current environment through injections of foreign currency will only lead to loss of foreign reserves without solving the problem. We need a sustainable solution. Analyses conducted at the CBK show that the current level of the shilling is being exacerbated by arbitrage and speculation on the future value of the shilling as well as the current level of reserves together with expectations on the food and fuel supply. Consequently, the current level of the shilling does not reflect the true value of the Kenya shilling, so it will still recoup its true value once the crisis is over. Despite the shocks on the exchange rate, private sector confidence in the economy remains high. 3

    4. 2. The Exchange Rate Policy In a floating exchange rate regime, monetary policy is independent and will affect relative prices including the exchange rate. It allows for a continuous adjustment of the exchange rate in line with the demand and supply conditions of foreign exchange in the economy. In addition, the market adjusts through the exchange rate movements rather than the level of foreign reserves changing. Consequently, external shocks and internal imbalances are reflected in exchange rate movements rather than reserve movements. For this reason, the exchange rate is an automatic stabilizer. 4

    5. 3. Supply and Demand for Foreign Exchange: There is adequate supply of forex in the market 5

    6. 3. Supply and Demand for Foreign Exchange: Current account balance improving on account increasing forex inflows… 6

    7. 3. Supply and Demand for Foreign Exchange: Normal requirements of foreign exchange… 7

    8. 3. Supply and Demand for Foreign Exchange: Arbitrage in the Forex Market… Over the week, 9th to 16th June 2011, five banks exported over USD 260 million. We are updating the data on a regular basis. During the same period, the volume of borrowing from the Central Bank by strong banks went up – suggesting arbitrage opportunities. Speculation comes in when at the same time they drive the bids in the domestic currency market. This is what we have observed as well. 8

    9. 3. Supply and Demand for Foreign Exchange: Arbitrage in the Forex Market… Four large banks have been noted to be holding very large overseas positions. These positions do not seem to reflect trading fundamentals. This type of exposure will put pressure on the exchange rate. Their positions are largely associated with their group companies overseas. We will restrict them from any arbitrage using the domestic currency. 9

    10. 4. Market Outcome: Exchange rate weakening experienced in main EAC countries 10

    11. 11 4. Market Outcome: Easing of world oil prices expected to reduce pressure on the exchange rate…

    12. 12 4. Market Outcome: Flight into other strong currencies…

    13. 5. The CBK Actions and Policy Response There is adequate foreign exchange reserves in the market. The Bank is continuously analysing exchange rate volatility but can only intervene to stem volatility but not to defend a level or direction of the exchange rate. Consider further tightening of monetary policy to tame future inflation and stabilise the exchange rate. In future, allow all institutions licensed to trade in foreign exchange to make bids when CBK is buying or selling – this will remove the dominance in the market and make forex trading competitive. Take appropriate and corrective action to make sure the forex interbank market is truly driven by market events and fundamentals as should be the case and as the Euro crisis seem to be getting closer to resolutions. 13

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