There are distinct aspects that make it difficult to predict local currency trend over specific time duration. For instance the market does not have large enough number of participants, is not an international currency and its rate is often managed by the central bank through interventions. Despite this, I still hold my contention that the present downtrend is likely to persist over the medium-term especially with the widening twin deficits (budget and current account deficits) and high inflation (and inflation expectations). In the long-run unless there is significant changes made on the fundamental factors(boosting tradable goods sector), any interventions will tend to not only aggravate situations but postphone volatility. The longer strong exchange rate persist, the more speculative capital accumulates and the more the speculative capital accumulates, the worse the volatility that accompanies peaks of such currency strengths when ‘fundamentals’ (not motivated by total return) and speculative capital move in the same direction.
It is generally accepted by central banks that speculative capital flows have an inherent exchange rate destabilizing effect (exchange rate fails to reflect prevailing ‘fundamentals’) and there is enough evidence to support the same. Markets cannot be relied upon in establishing their own equilibrium. Some central bank tends to mitigate that risk through capital controls and interventions on the basis that it is much easier to control capital when it is moving into an economy that when it is moving out (Philippine central bank collapsed while trying to defend the currency).
The data I have is unreliable at the moment and much of my views are impressionistic and partly based on conjectures. Commodity prices have been falling and are expected to continue trading at low prices in the medium term. The past few weeks have had a large Tobacco exporter close shop alongside a fluorspar mining company both of which cited low prices as being largely to blame for the exit. Although they represent a smaller fraction of the exports sector, it could be indicative of the likely stress the tradable goods sectors will undergo. The government is trying to slow rising trade balance by restricting sourcing of materials in government projects to local businesses. It is not clear whether it is possible to enforce this rule in practice and on whether the local spending in actual effect will result in further imports to support demand created by the rise in incomes.
The shilling strengthened slightly on nominal (not adjusted for inflation) basis against the dollar immediately after the central bank raised interest rates but has since resumed downtrend albeit at a much slower pace than before the rate hike. The government is still maintaining its aggressive spending stance and running a possible large budget deficit relative to GDP as per the last budget reading. It is also likely to push banks into lending to fund infrastructure development, a money creation process that could result in inflation and further exchange rate depreciation especially if the tradable goods sector is not supported and funds are invested inefficiently. It is also not clear whether government investments will attract much needed longterm capital investments with ongoing allegations of misappropriation of funds and inefficient non-transparent costs investments.
At the moment the economy is experiencing a widening current account deficit that could continue pressuring the shilling. Stronger shilling would have been okay with inflation differential advantage, but inflation at the moment remains higher than in its trading partner economies (whose exchange rates are also depreciating) making it a vicious cycle of high inflation leading to weaker exchange rate and weaker exchange rate leading to high inflation.
External shock risk
At the time of writing, the world’s gaze is focused on the events unfolding in Europe as Greece negotiates with its creditors on a last minute bid to avoid default. Greek default presents a significant market risk in the immediate future alongside possible US rate hike within the year.
In the event of an external market shocks such as Greek exit or US rate hike, international markets are likely to respond indiscriminately towards frontier and emerging market economies that benefited from low interest rates and QE, this could trigger acceleration in loss of shilling against the dollar. Yellen remindee Asset managers that she had already warned them of possible risk in rate hike, they are particularly prone to herd behavior and would be predictable that they could reduce capital investments in these markets. After the initial market shock, differentiation is likely to come on the basis of for instance economic strength judged on fundamentals presented in each economy. Economies with low inflation, strong external and fiscal accounts, more reserves and sound financial sectors are likely to experience less market reactions. At the moment, the country’s biggest advantage lies in predicted high growth rates on fiscal stimulus. Holding adequate reserves is particularly important because interventions will be critical in dealing with the temporary bouts of volatility that will likely arise.
Based on my hypotheses, shilling is likely slide towards 2011 lows on RER and nominal basis in the near future especially with anticipated dollar rally from US rate hike. It would be better for regulators to err on the side of caution in inspiring investor confidence and preparing markets for possible shocks.