Overview of the Kenyan Market 2007
US dollar/Kenyan shilling (US$/KES) broke through a multi-year trend line around 67.9 and then broke further support at 67.3 without much problem. The technical price action opens up a fairly clear run for 65 on a multi-month basis. The short US$/KES position continues to be supported by a combination of a positive balance of payment position and CBK policy, to allow the market to broadly determine the exchange rate given FX reserve levels that meet prudential requirement.
The current account registered a deficit of US$1.078bn in the year to February 2007 – a slight deterioration on a US$974m deficit at end-2006 and a more modest US$360m deficit in the year to February 2006. Nevertheless, the depreciation of the US dollar against Kenyan shilling means that Kenyan GDP in US dollar terms has grown strongly. The result is a current account to GDP ratio of around 4.4% of GDP (we assume nominal GDP at around KES1.625 trillion). Although substantial, such ratios are still reasonably easily financed in a bullish investment environment.
The root of the current account deterioration remains the trade balance. Since the pick up in economic activity in 2005, there has been a siege in imports, which remains ongoing. Imports in the year to February were up US$1.75bn to US$7.73bn. Around half of the increase is additional transport and machinery, which clearly has something of an investment bias. The growth in imports is dwarfing export growth, which is running around 12.1% year-on-year, albeit off a base of US$3.6bn, which is less than half that of imports. Auspiciously, the production of tea, Kenya’s main commodity export (around 19% of merchandised exports) was up 119% year-on-year in Q1 2007, according to Kenya’s Tea Board. The improved rains are also assisting agricultural production more widely. The deteriorating trade deficit is being partially offset by a growing services surplus, which was up US$311m to US$1.46bn in the year to February 2007. Part of the story is the return on increased marketing of Kenyan tourism.
March 2007 was the most profitable month on record for the sector according to the Kenya Tourist Board. Moreover, Kenya is making good progress in the lucrative US market, with US arrivals up some 20.7% in Q1 2007. The other part of the services story is transport, where the high growth being experienced by Kenya’s landlocked neighbours is boosting Kenya’s transport services.
Source: ReutersThe income balance is more or less flat. Interestingly, although not itemised in the balance of payments, an increasing source of income inflows, which is offsetting interest payments on previous borrowing, is coming from the CBK’s FX reserves. The CBK suggests interest on FX reserves was around US$262m in the year to March 2007. Importantly, these interest earnings go straight back into FX reserves.
Transfers are the other net positive contributors to the current account. In contrast to most of its neighbours, Kenya receives no grant assistance on the current account. The net positive transfers, which were up US$364m to US$1.623bn in the year to February 2007 were private transfers. While these figures include some NGO inflows, the bulk is private remittances from Kenya’s diaspora.
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Figure 2: Kenya’s current account by contribution
 Sources: CBK, Standard Bank Group |
Figure 3: Nairobi Stock Market Prices
 Sources: Bloomberg Standard Bank Group |
The financial account, meanwhile, registered a surplus of around US$1.735bn in the year to February 2007, up US$859m. Capital grants were around US$163m down US$31m on the year, while official borrowing was a negative US$173m. Net private inflows of a longer-term nature registered a surplus of US$121m. However, as ever, the large residual came from short-term inflows, which includes portfolio and deposit inflows. These were US$1.62bn up US$1.157bn on the year. As with the private remittance inflows, these investment flows indicate the growing confidence by both resident and non-resident investors.
The result of a financial balance surplus that outstripped the C/A deficit, enabled the CBK to build reserves to by the end of March 2007 up US$609 on the year. Interestingly, despite the sharp growth in imports, the ratio of FX reserves to imports of goods and services increased to 4.5 months from 4.2 months in March 2006.
The CBK is legally bound to keep the ratio above 4.0 months based on a 36-month average of import of goods and services. The ratio based on current imports, as opposed to historic levels, was around 3.7 months in March 2007. The latest figure for CBK reserves for 10 May is a modest decline to US$2.56m. Interestingly, there also continued to be a build up in commercial bank FX holdings. These rose US$243m to US$980m in the year to end March 2007. Most of these assets (US$800m) are held as balances with banks abroad.
Similarly, there is limited de-dollarisation in the formal sector. Resident FX deposit holdings actually increased to US$1.47bn in March 2007 from US$1.2bn a year earlier. It would appear that despite the sustained downside in US$/KES over the last year, the low interest rates on KES deposits continues to make the relative risk rewards of holding KES over US$ unappealing.
The data appears to suggest that the public sector (including the CBK), the commercial banks and the resident retail sectors are all still positioned long US$. Such positioning bodes well for flow driven US$/KES downside. Importantly, the US$/KES downside to date has not been due to foreign investors positioning for the carry. A short US$/KES trade is thus not particularly vulnerable to any downside in interest rates. Indeed, we suspect this also applies to the bond market where foreign participation has also been relatively modest. While there has been more foreign investors in the equity market, we still believe the positioning is relatively light with the Q4 2006 boom in equity prices mostly a product of local retail activity.
Headline inflation has fallen back to core levels around 5.5 – 6.0% year-on-year in the last couple of months. With continued solid food disinflation, headline disinflation is set to continue in the coming months. We are also reasonably confident that core will remain capped by 6.0% throughout the remainder of 2007. In such an environment the CBK’s reference rate is set to remain stable. Meanwhile, the operational interbank rate is set to drift very modestly higher as it has since August 2006 in line with growing economic activity. Stronger growth, contained fiscal expansion and controlled inflation has fostered growing confidence in the long end of the Kenya bond curve and in conjunction with the higher money market rates we have started to see a bullish rotation in the yield curve. We see this continuing on a multi-month basis possibly adding some price appreciation to the yield pick up offered by the longer-dated bonds.
Perhaps the key risk to our bullish currency and rate outlook is the December 2007 election. At present, noise is relatively limited and fiscal expansion is broadly in line with budgeted amounts. However, there is likely to be increased noise in Q3 as the coalition building consolidates in time for the polls. At present, our core scenario is that President Kabaki will succeed in coalescing a sufficient political base to remain in power, but the political situation does remain highly fluid at present.
Our short US$/KES exposure via the three-year bond is working nicely and we have extended our multi-month US$/KES target down to 65, where we will reconsider the situation. We are also reasonably happy that we will see some further rotation in the yield curve with longer-dated yields continuing to quietly move south, adding some bond price appreciation to the currency appreciation and the positive interest rate carry.