Challenges of Monetary Policy making in Kenya

1. Challenges of Monetary Policy making in Kenya A Presentation at Conference on Central Banking, Financial Stability and Growth: Celebrating 50th Anniversary of Central Bank of Nigeria Njuguna Ndung’u Governor Central Bank of Kenya April 04, 2009

2. Outline Introduction Monetary Policy Framework in Kenya Financial Market and its Structure Market Incompleteness Challenges of Monetary Policy and Uncertainity Resolving the Challenges Conclusions

3. Introduction • Monetary Policy contribution to economic activity and growth is largely indirect, through a stable macroeconomic environment. • A stable macroeconomic environment is a necessary but not sufficient condition for economic growth. • Goal of Central Bank (of Kenya) • To formulate and implement monetary policy directed to achieving and maintaining stability in the general level of prices • How is this done? Control money supply? • Other goals; 1) Supervise commercial banks 2) National payments systems, etc

4. Monetary policy framework • Monetary policy formulated on a Monetary Targeting Framework. • The Framework ensures that monetary policy targets are consistent with the Government economic policy strategy. • Key Assumptions of Framework under a Flexible Exchange Rate Regime • There is a predictable relationship between money and nominal GDP. • The targeted monetary aggregates are under the control of the Central Bank. • There is no trade-off between inflation and output in the long run.

5. Financial Markets • Efficiency of Financial markets determines the effectiveness of monetary policy: Efficient markets assist the transmission mechanism • A well functioning financial market are central to sustained economic growth, by facilitating the smooth exchange and provision of credit • In financial repression system (McKinnon-Shaw type),the transmission mechanism channels are dependent on the regulatory environment. • In liberalized bank dominated financial system • the transmission channels work through credit supply; • the endogenous credit rationing is via the price effect, facilitated by the openness of financial markets.

6. Financial markets (cont) • In developed financial system, • banks and markets for securities are well functioning • the transmission is through prices: (interest rate, asset values and real exchange rate). • Financial markets determine channels through which monetary policy stimuli is transmitted to the rest of the economy • Dysfunctional financial markets will undermine monetary policy transmission • Distortions/multiple pricing/arbitrage • Controls • Information asymmetry-between banks themselves and banks and their clients • Lack of supporting institutions • Segmented markets – difficult to communicate across segments

7. Asymmetric information • Different layers of banks- different information processing • Borrowers are less transparent when • they lack well established reputations (no credit reference bureaus), • accounting and disclosures are lax and poorly enforced (e.g. in Kenya, since banks do not share customer information, there is a tendency for customers hopping from one bank to the other taking loans with no intention of paying). • Opportunistic behavior • borrowers have a stronger incentive to behave opportunistically when they possess limited collateralisable net worth relative to the size of their loans • rural lands title deeds - collateral cannot be realized • Political loans • Sector loans (e.g. loans advanced to farmers) • Adverse selection among banks themselves- in different segments

8. Market structure in Kenya • Small Open Economy with large informal/Agricultural (subsistence) sector • A traditional non-monetary sector and a large informal sector • Impact of Monetary Policy is weak and the direction uncertain • Segmented markets • Large banks vs small banks (no credit lines between them) • Large banks able to access interbank markets, have credit lines with others – price of that credit? • Small banks keep large excess reserves, since no access to interbank-inefficiency. • MFIs and SACCOs - operating mainly in rural areas. • Financial Deepening? – weak despite policy initiatives: • Narrowly defined instruments • Few players: Dominance of a few large banks – adverse selection between banks • Information Asymmetry - No private agent to break this asymmetry (information capital should be a public good)

9. An Example: Structure of banks in Kenya The Five large banks: Multinationals/publicly quoted banks – large capital base (US$ 1 billion and above) The next tier - medium banks, medium capital base The small family banks at the bottom– trade with each other and a few individuals, service family companies, low capital base (between US$ 5 - 60 million) Adverse selection is actually based on this market structure This structure also defines financial product pricing behaviour – responsive to CBK signals or the wider market.

10. MARKET INCOMPLETENESS Lack of forward and futures market Lack of forward foreign exchange markets (no price, no cover) Weakens policy transmission mechanisms Presence of a larger informal sector Operates with currency outside the banking sector Informal financing (e.g. shylocks) Presence of segmented structure banks Each segment has its own market structure Target own niche market Pricing depends on client bank relationship Presence of “family” banks with a pre-defined niche Do not respond to price signals in the market

11. INCOMPLETE MARKETS & WEAKENED MONETARY POLICY TRANSMISSION Uncertainty about the effect/impact of monetary policy Markets rely on price and that price should ‘clear’ the market- that is the price is known Narrowly defined instruments which only affect few market players and sectors of the economy Few players: Dominance of a few large banks operating in the interbank market . Majority of banks do not participate in interbank or Repo market – monetary policy signals are missed Information Asymmetry –between markets segments and across the market Lack of supporting institutions like credit reference bureaus- to create information capital Reliance on social network not prices in the market

12. The Challenges of Monetary Policy Incomplete markets makes monetary policy transmission uncertain (and weak) Monetary policy is ineffective/does not meet the intended objective – for some segments or all the market Traditional channels of transmission are weakened Credit market segmentation (which is a function of the state of financial development) has consequences on transmission of monetary policy The signalling of CBK Monetary Policy may reach only a small segment of the market that may not coordinate the whole market This affects not only information flow but also information processing

13. MONETARY POLICY UNCERTAINT OUTCOMES: EXAMPLES Large banks (between 5-8) trade in the interbank market every day. The rate is important for CBK The trading tells CBK on a daily basis whether there is credit crunch or not But what about the other 35 banks left out? What price do they use, is the interbank rate relevant? Informal markets (shylocks) what prices do they use and how do they set it Interest rate is an important instrument for monetary policy – but segments of the market may not be responsive - so are some agents But also the collateral technology used enforces severe costs prevents large flow of bank loans and credits Creates room for social networks to determine credit allocation? Large informal sector using informal finance and currency outside the banking system.

14. CBK attempts to resolve these Challenges • Segmented Markets: • Horizontal Repos for banks to trade with each other • Force banks to open credit lines (example;during Safaricom IPO) • Reduction of threshold in short term securities (from Ksh1 million (US$12,500) to Ksh100,000 (US$1,250) • Reduction of requirements to open CDS accounts • Raise minimum capital to encourage consolidation • Credit Reference Bureaus – to reduce information asymmetry (sharing of both positive and negative information) • Disclosure issues (introduce APR for loans) • Financial Reforms to increase intermediation • Focus on Price instead of Quantity in Monetary Policy to send clear signal to the market. • Research to inform and improve policy • The world of monetary policy is uncertain right now- but for countries like Kenya, the market and economic structures makes it very uncertain.

15. CONCLUSION Monetary policy and its targeted outcome uncertain due to the structure of the domestic market Banks dominate the market The stock market is active but has a weak base The bond market has relied on government guaranteed bonds Monetary policy transmission mechanism use the price effects – but some segments of the market look at other variables-like quantity Most agents (households) and even informal firms do not look at interest rate as a guide Collateral technology keeps away potential market participants

16. CONCLUSION (contd) Deposit rates in Kenya have remained low on average around 5%, and a spread of 9.5% yet deposits have almost doubled in the last 3 years But this has followed the accounts: 4.7m accounts in December 2007 with 43 banks competing for them Currently 6.8m accounts with 45 banks competing for them and 900bn shillings of deposit The main motive – safe haven for saving The global outcome may be uncertain, but the domestic market structure has more uncertainty.