Executive Summary
Kenyan interest rates have been on a declining pattern since December 2008, and reached a low during the month of July 2010. Since then rates there has been a mild upward correction in rates.
It is our view that interest rates are now at an inflexion point, and we are likely to see sharply higher rates for the rest of the year. The principal factors that will drive the rate higher are:
- Substantial borrowing requirements from the domestic market during January – June 2011.
- Change in the direction and implementation of Monetary Policy
- Increase in inflation beyond CBK’s medium-term target of 5%.
Pattern of Interest Rates
Market interest rates have been on a pattern of decline from a peak in December 2008. These rates include yields on Treasury Bills (91-day, 182-day and 364-day), inter-bank interest rates, as well as yield on Treasury bonds of various maturities. Other rates that have also declined are the Central Bank Rate (CBR), bank deposit rates and Minimum Lending Rates (MLR) of banks. However, these are not market determined rates, and therefore outside the scope of this paper. In this paper, we have generally focused on the yield of the 91-day Treasury Bill, as a proxy for the movement in interest rates across all tenors.
Yields on the 91-day Treasury Bill climbed through 2008, reaching a peak of 8.59% in December 2008. From then, rates slid gradually through 2009, falling to 6.82% by December 2009. Rates then plunged in the first half of 2010, reaching a low of 1.63% in July 2010. Since then, rates have been on a mildly upward slope, reaching 2.36% in December 2010.
Government Borrowing – Financial year 2010-2011
In the annual Budget presentation, the Finance Minister projected a Fiscal deficit for Financial Year 2010-2011 of KSH 188 bn (6.8% of GDP). The Fiscal deficit was projected to be fully financed through borrowings as under:
Domestic Borrowing KSH 105 bn
External Financing KSH 83 bn
In a recent communication to the IMF (February 2011), the Government has advised that the Fiscal deficit for the financial year is projected to increase to 7.5% of the GDP. This represents an increase in the deficit by approximately KSH 20 bn.
The performance on the financing side also shows a considerable slippage. The actual financing during the period June to December 2010 was under:
- Domestic Borrowing – KSH 55 bn (53% of annual requirement) against targeted borrowing during the period of KSH 90 bn (86% of annual requirement)
- External Financing – KSH 12 bn (14% of annual requirement)
- Total Financing - KSH 67 bn (35% of annual requirement)
Historically, the Central Bank has aimed to raise a substantial portion of the Government’s borrowing requirement in the first half of the financial year, and largely rollover maturing debt in the second half of the year. This year the position is substantially different
- Balance of budgeted borrowing requirement in second half (Jan – June 2011) – KSH 121 bn.
- Increase in borrowing requirement due to projected increase in fiscal deficit – KSH 20 bn
- IMF loan to Kenya was approved in Jan 2011 – USD 508 mn (KSH 41 bn), of which the initial disbursement is USD 101 mn. This will meet a significant portion of the External Financing gap.
- Assuming there is no gap/surplus in the external financing, the borrowing requirement from the domestic market in the period January – June 2011 is KSH 76 bn.
It is our view that this level of borrowing requirement in the second half of the financial year can only be filled by the Central Bank paying substantially higher rates on Treasury Bonds and Bills floated during this period.
Monetary Policy
The current monetary policy stance of the CBK was adopted in 2009 following the slowdown in the economy caused by the post-election violence and compounded by the global financial crisis. The key objectives of the Monetary Policy for January - June 2009 were:
- Maintain price stability
- Foster liquidity, solvency and proper functioning of a stable market based financial system.
- Support economic policy on growth and unemployment
- Formulate and implement foreign exchange policy
- Promote the establishment, regulation and supervision of efficient and effective payment, clearing and settlement systems.
The objectives laid out in this Monetary Policy have broadly been followed by the CBK in the subsequent half-yearly Policy statements.
The various steps taken by the CBK since 2009 in support of this monetary policy stance are:
- Reduction of the CBR in 8 steps from 9.00% to 5.75%
- Abstaining from the Repo market, which is used to withdraw excess liquidity from the banking system. The last Repo transaction was undertaken by CBK in May 2009.
- Actively using Reverse Repos since early 2009 to inject liquidity into the banking system
- Stabilization of exchange rates and building up of exchange reserves
- Improvement in payment systems and monitoring the use of mobile phone money transfer
An explanation of Repos and Reverse Repos is given in Annexure 1.
The outcomes of the Monetary Policy adopted by the CBK over this period have largely met the desired objectives, including the following:
- Revival in economic growth, with growth of 5.6% in 2010, and expected growth of 6% in 2011.
- Inflation, as measured by the new CPI Index launched in February 2010, as well as new method of computation adopted, has stayed within the policy target of 5% until December 2010.
- Reduction in, and significant stabilization of short-term interest rates
- Increase in the pace of financial inclusion, through expansion of banking channels as well as financial innovations based on mobile phone technology.
Change in the Direction of Monetary Policy
We believe that a change in the direction of Monetary Policy by the CBK is imminent. This is driven by the following considerations
- The need for the new Monetary Policy program to be approved by the IMF (CBK Press Release dated 27th January 2011)
- The stance of the IMF with respect to Monetary Policy is laid out in IMF’s announcement of the approval of the USD 508.7 million loan. This includes:
- CBK will focus on its medium-term inflation target of 5 percent, taking into consideration the impact of rapid progress on financial inclusion and financial sector deepening
- Enhance coordination of monetary and fiscal policy to minimize liquidity volatility
- Tighten monetary policy promptly if the inflation target is threatened by the eventual lagged impact of increased liquidity on consumer prices.
- The objective of supporting economic policy on growth and unemployment will not be an objective under the revised Monetary Policy. As per the IMF, this will need to be tackled by the Government through tax reforms and expenditure control.
- Bottoming of the CBR at the current level of 5.75%, with the next move to be towards tightening i.e. increase in the CBR.
- Open Market Operations of the CBK to be weighted much more towards Repos, for removing excess liquidity from the banking system and significant reduction in use of Reverse Repos, which have been used to add liquidity to the banking system.
- The Open Market Operations will thus put a floor on the short-term interest rate, and we expect this floor to be at a level higher than current interbank interest rates. A more detailed discussion on expectations in regard to Open Market Operations is given in Annexure 2.
Inflation
Inflation in January 2011 climbed above the CBK’s medium-term target of 5.00%. All indicators locally and globally are for the inflation to be on an upward trend at least for the first half of 2011. Conventionally, the response from the Central Bank to an increase in inflation would be to tighten Monetary Policy.
One of the early measures that we expect from the CBK on this front is the adoption of a new inflation index – this will be the third significant change since October 2009 in how inflation is measured in Kenya. Nevertheless, we believe that the CBK will have to undertake monetary tightening in order to prevent inflation once again returning to double digit levels.
Interest Rate Outlook
Overall, we believe that the interest rate cycle has bottomed out. We have already seen the 91-day Treasury Bill increase from a low of 1.63% in July 2010 to a level of 2.5% currently. We believe that the 91-day Treasury bill will increase above 5.00% in the next few months. Along with this, there will be a significant upward movement in the yield curve across all maturities.
Strategy for upcoming Treasury Bond issues
CBK is offering two bond issues next week with 2 year and a 30 year maturities. Our views on the issues are:
2-year Bond FXD1/2011/2: We expect there to be heavy interest on this bond, with a weighted average of about 4.50%. In light of our interest rate views, we would recommend this paper for trading portfolios to be bid in the range of 4.5% to 5.00%, with an exit shortly after it begins trading. We do not recommend this paper for clients looking to hold the paper to maturity.
30-year Bond SDB1/2011/30: The CBK has labelled this bond a “Savings Development Bond”. However, other than the lengthened maturity, it is no different from the various FXD series of bonds issued by the CBK. We recommend this bond only for investors who are prepared to hold till maturity – namely, Pension Funds and Life Funds, at rates above 14.50%. For other categories of investors, we would recommend giving this bond a miss. Corporate and High Net Worth investors will be better served by buying the existing Infrastructure Bonds in the secondary market, or waiting for the next primary issue of IFBs.
Though these bonds have a lower nominal yield, the interest is free from income tax, and average maturity is relatively shorter due to the repayment of the principle in instalments.
Secondary Market Trading Outlook
Investors with trading portfolios should look to reduce portfolio durations over the next few weeks, by selling long maturity papers. We recommend that investors take profits where they are available and do not be shy of booking a small loss now, to avoid bigger losses later.
Annexure 1
Open Market Operations
Open Market Operations (OMO) refers to actions by the Central Bank to vary the amount of commercial banks deposits held in relation to the statutory requirement. Changes in these deposits impact on the rate of interest at which credit is provided which in turn affects the growth of deposits held with commercial banks which is dominant component of money supply) and ultimately domestic prices. [Central Bank of Kenya – Monetary Policy Statement June 2010]
The two main instruments of OMO used the CBK are Repurchase Agreements (Repos) and Reverse Repurchase Agreements (Reverse Repos)
Repurchase Agreement (Repo)
In a Repo transaction, the CBK sells securities to commercial banks, with an agreement to buy them back after a fixed period of time (usually 1 week). A Repo transaction conducted by the CBK has the effect of reducing liquidity in the banking system, by transferring excess funds from commercial banks to the CBK, in exchange for securities. Repo transactions conducted by the CBK have an indirect effect of putting a floor on short-term interest rates, and can be used as a signalling tool by the CBK for higher interest rates.
Reverse Repurchase Agreement (Reverse Repos)
In a Reverse Repo, the CBK buys securities (Treasury Bills, Treasury Bonds) from commercial banks, with an agreement to sell back the securities after a fixed period of time. A Reverse Repo transaction conducted by the CBK has the effect of increasing liquidity in the banking system, by providing funds to banks in exchange for securities. Reverse Repo transactions have an indirect effect of putting a ceiling on short-term interest rates and can be used as a signalling tool by the CBK for lowering interest rates.
Annexure 2
Expectations in regard to Open Market Operations (OMO) by the CBK – January-June 2010
The CBK conducts OMO in order to achieve a desired level of bank reserves. Prior to the introduction of the Monetary Policy for the first half of 2009 (January – June 2009), CBK was generally seen to be more active in undertaking Repos, in order to mop up excess level of reserves in the banking system.
There was a significant slowdown in the economy during 2008, firstly due to the post-election violence, and then due to the global financial crisis. During this period, the level of bank reserves was in general lower than the target or desired level set by the CBK.
In response to this, the CBK frequently injected liquidity in the banking system through the use of Reverse Repos. From May 2009 CBK also significantly reduced the Reverse Repo rate at which it lent funds to banks, thereby leading to an overall decline in market interest rates. CBK has also abstained from undertaking any Repo transaction since May 2009.
However, since June 2010, the actual reserves in the banking system have consistently been above CBK’s target of reserve money. The classical Monetary Policy response to this, and which the CBK consistently practiced until 2008, is to remove liquidity from the banking system by use of Repos. However, CBK has continued to abstain from the use of Repos, and has continued to use Reverse Repos in the second half of 2010 to increase the level of reserves further.
With a new Monetary Policy to be adopted shortly, with the approval of the IMF, we expect the CBK to return to more conventional behaviour in its OMO, and therefore forecast the return of Repos by the CBK to mop up excess liquidity.
Conversely, there will be a significant reduction in the use of Reverse Repos by CBK, except in times of liquidity imbalance. Further, we expect the CBK to maintain a positive interest spread between Reverse Repo and Repo rates i.e. CBK will inject liquidity into the system (lend to Banks) at a rate higher than which it will mop liquidity from the system (borrow from Banks), and possible linkage of these rates to the CBR.
