Last updated: 10:07 / Thursday, 29 December 2016
Analysis by Global Evolution

Challenges in Frontier Markets: Kenya

Challenges in Frontier Markets: Kenya

Global Evolution's, team visited Kenya in early Dec 16 in order to gauge the degree of likely policy slippage going into mid-2017 elections. The frontier markets experts met with various economic stakeholders including representatives from the Central Bank of Kenya (CBK) and the Finance Ministry. The visit reiterated their extremely constructive longer-term outlook for the economy, but highlighted some potential short-term vulnerabilities:

Growth outlook

Kenya is at an interesting inflection point: the combination of the new SGR railway between Mombasa and Nairobi and improved energy production should enable the development of an industrial corridor along its route. A shift into light manufacturing will have a major
impact on the structure of the economy. Meanwhile, GDP growth was around 6.2% y/y in Q2:16 compared to 5.9% y/y in Q2:15

Political risk

Kenya has elections on 8 Aug 17 and it is likely that the government’s focus will increasingly look towards political gain rather than policy changes in the interim. It is likely that Kenyatta and his National Alliance will win the elections unless the so called National Super Alliance (NASA) which is being spearheaded by ANC leader Musalia Mudavadi is successful in getting agreement between Mudavadi and ODM leader Raila Odinga as to who will lead the party. They suspect an Odinga leadership is unlikely to unseat Kenyatta: a Mudavadi leadership just might.

As with the previous election, which saw limited security issues, the sense is that politicians will be more constrained in whipping up violent ethnic sentiment for political gain during the campaigning for next year’s elections.

The election is becoming more of a focus for policy decisions. In particular, the private members legislation on fixing interest rates, which was unanimously supported in parliament despite being opposed by the executive, is unlikely to be overturned or amended prior to the elections.

Monetary policy

The CBK has a problem. In late Aug 16 parliament unanimously passed a bill capping the spread on interest rates around the CBKs policy rate with a maximum spread of 700 bps. As with all such populist legislation, the rule has created some unwelcome influences. First, it has added to the liquidity pressure being faced by the lower tier banks following the collapse of 3 of them earlier in the year.

Second, it has reduced credit to the private sector as the government is presently financing above the cap intended for private lending. We met several private banks who suggested that once the administration and risk premium is added to private sector clients there was limited value in lending to them, rather than the government.

Third, in order to keep the lower tier banks solvent, the CBK is extending liquidity to them as the interbank market will not at present. This is pulling down the short end of the money market curve and placing upwards pressure on USDKES. Making it relatively cheap to short the KES into an election is always a very dangerous monetary policy move.

To some extent the CBK is between a rock and a hard place, as it balances the needs of banking sector and currency stability. The result has been a reduction in FX reserves to around USD7.33bn in late Nov 16 from USD7.78bn in late Oct 16. The upwards pressure on USDKES has also drawn the attention of a very maternal CBK who is attempting to micro-manage the FX trading of the major banks. Not surprisingly, most of the banks we spoke with believed that USDKES would grind higher into next year’s elections, although none saw an extended or aggressive sell-off.

Inflation appears to have found a bit of a bottom around 5.0% y/y in Q2:16 and has been drifted up again to 6.7% y/y in Nov 16. With a 3-6% inflation range target the move limits the room for the CBK to further cut rates, at least for now.
Interestingly, despite policy rates likely remaining on hold, the bid from commercial banks for government paper created by the new interest rate spread legislation will keep fixed income well bid in coming months.

Global Evolution, an asset management firm specialized in emerging and frontier markets sovereign debt, is represented by Capital Strategies in the Americas Region.