CBK: Shilling has largely been undervalued

The Central Bank of Kenya (CBK) has reignited its tiff with the International Monetary Fund (IMF) by disapproving the institution’s stance of the shilling over valuation.

In its fresh report- An Assessment of Exchange Rate Misalignment in Kenya, which was published at the end of last week, the reserve bank challenges IMF’s assumption maintaining the local unit’s exchange rate alignment to prevailing fundamentals.

CBK Governor Patrick Njoroge had previously hit back at the multilateral lender’s suggestion of the shilling’s misalignment to insist of the bank’s non-intervention to the effective exchange rate.

The new retaliation is however an empirical documentation of the local currency historical misalignment where the CBK employs the Behavioural Equilibrium Exchange Rate (BEER) formula which in large part encompasses the movement of the nominal exchange rate to changes in commodity prices while holding cyclical perverse outcomes at constant.

From its findings which track the shilling’s value between 2014 and 2017, the CBK determines the exchange rate has held widely within the fundamentals with the only counts of deviations remaining close to the equilibrium.

The findings are then put under microscope by being compared to alternative measures of deviations to include purchasing power parity (PPP), trade elasticity and macro-economic balance.

In all instances CBK’s review largely matches up to the alternatives with observed deviations sticking to a five percent band.

Nevertheless, the shillings is by far undervalued over the review period but for periods of overvaluations, a deviation above five percent, in a factor attributed mainly to instances of external shocks such as the financial crisis of 2008 and the Euro zone debt crisis between 2010 and 2012.

Game of theories

The CBK assessment of the country’s exchange rate misalignment is however one in many methodologies of valuing the shilling, there being no one widely accepted method of determination.

As such, the CBK recognizes the multiple approaches to assessing the shilling’s true value whose outcome is largely dependent on inputted variables.

“The study reiterates the need for sensitivity in the assessment of exchange rate misalignment since the magnitude of misalignment could vary across methodologies, owing to a set of built in assumptions in each approach,” reads part of the report.

In October last year, the IMF suggested the local unit was overvalued by up to 17.5 percent after overhauling its inputted variables to separate fundamentals into policy, non-policy and cyclical variables.

Termed as the External Balance Assessment (EBA) and the EBA Lite approach, the method looks at existing structural and policy gaps to move away from the traditional preoccupation in exchange rate misalignment.

Nevertheless, the methodology has been found wanting in its recorded differences between the exchange rate of countries with dominant special sector such as oil exporters and smaller economies which are mainly dependent on services.

IMF own studies have too observed large regression residuals which equate to high Forex misalignment to reduce the reliability in countries with large productivity differentials.

In its 2018 External Sector Report, the IMF board suggested future presentations of EBA be presented in ranges and intervals to resolve the pervasive results.

Game on

The assessment of the shilling misalignment to fundamentals is expected to raffle more feathers between the IMF and CBK on the shilling’s true value even as Kenya’s readies itself for a new round of talks on the capture of a new Standby Credit Facility (SCF)

In the aftermath of IMF’s overvaluation claims, the country has observed a stagnation in the rate of foreign investment attraction to mirror concerns of the reported rigidity in the Forex rate.

The pair will likely fail to conclusively resolve the difference in currency stance as the CBK holds its end of none-intrusive interventions to the exchange rate.

World over, States have routinely intervened to stem volatility in the valuation of their respective currencies,

Nevertheless, central banks hardly disclose of the reported intervention to leave the door open for the casting of doubts.

“With a soft peg currency with no specific exchange rate level, it becomes difficult to ascertain whether it is overvalued or not. In addition to the Kenya case, the CBK does not make public its intervention activities in terms of quantum as it periodically ‘smooths out volatility’,” Genghis Capital Senior Research Analyst Churchill Ogutu told Citizen Digital in May.