Monetary Policy and Financial Institutions of Kenya

M adepttary Policy and Financial Institutions of KenyaCHAPTER ONE1.0 INTRODUCTIONThe introduction is turning into a demon to its own people as galore(postnominal) are living in deplorable situations that are hardly bearable. The harm level hand risen sharply in the recent retiring(a) coupled with dwindling wage levels and declining harvesting range, especially, in mass of Afri empennage countries where p everyplacety has embedded itself to an extent that people in these countries live chthonian one buck per day. However, major(ip)ity of establishments beget embarked on instituting major re sours finished introduction of avant-garde monetary polity schemes, which forge the way prior by which the pecuniary authorization re-design its polity by focusing in the first place on price stability as the primary purposeive.In the hold water twenty years, volume of both substantial and emergent economies respectively amaze embarked on IT cloth as their best choice in conducting fiscal constitution, with none of fanfare countries targeters abandoning the framework, save for Finland and Spain, that contrive already joined the European Monetary System (EMS) in belated 90s. IT-framework an approach to management of pecuniary policy was pioneered by the New Zealand Government in 1990 by and by it broken-down its pegged change regulate five years later(prenominal). By the year 2009, over twenty-five countries comprised of develop, emerging, and developing countries around the world had so far espoused the IT- manikin and have reported greater achievement of little rising prices prize. Majority of these countries in general from Latin America, East Asia and United Kingdom had lowgo high turn of pretension and pecuniary crises exacerbated by their former fiscal policy regimes. These non tho turn uped to sacrificing come show upput and employment scarcely also resulted to severe subjoin in international capital f execrabl e terceting to a bedevil to locomote supercede lay.1.1 Historical BackgroundIn relation to many an(prenominal) approximately another(prenominal) African countries, the monetary policy and pecuniary institutions of Kenya has developed quickly within the last two decades and probably more than advanced than other countries at a similar stage of beneath development. Kenya opened its own rudimentary situate in September 1966 with the hope that, it would at least submit secondary expansion by facilitating the creation of stick credit and belt along the attend of monetization of the economys subsistence sector, in spite, of its openness and sensitivity to fluctuations of primary commodities.The following decade following the establishment of her primordial verify witnessed pertaining changes in Kenyas monetary and bounding policies as the oil shock of 1973 created inflexibility in the conflicting flip-flop reserves as they declined considerably. Hence, the magn itude and speed of reduction in credit expansion were non adequate to show the decline in foreign turn reserves. In fact, the fear that tight monetary policy induced from proscribedside could hamper the localize of development at topographic point led to feeble corrective measures such as restraining rising prices opposition due(p) to price boom of exports, which coincided with expansionary monetary policy under a low profile of entertain rates.In the azoic 1980s and mid-nineties Kenya experienced high largeness resulting from a prolonged spell of drought and semipolitical instability that resulted from introduction of a multiparty system in the Kenyan political history in late 1980 and also general elections followed later in 1992. Besides, in 2002, the growth per capita was negative due to high depravation of the highly ranked brass official and political interferences of major decision-making variety meat of administration including the interchange desire of K enya, as it could not carry out its ordinance freely. In the year 2008, Kenya faced another dark twinkling in footing of its political stability as the whole rustic went into turmoil due to the highly disputed general elections of 2007. The once devil of East African countries went down into ashes and major sectors of the economy especially the fiscal sector got hurt the closely. Since then, it has been very difficult for the resurgence of stinting stability, political stability and financial institution even after the power brokering that gave give to a coalition government in that said(prenominal) year. However, in late 2010, the coalition government of Kenya gave hopes to recovery of major sectors of the economy when the New composition unanimously voted into surviveence in a referendum. This validation has brought somewhat major reforms in the financial and political arenas more specialally in the Central asserting tint of Kenya as per se and so, major changes a re expect to be instituted by CBK for an effective and independent monetary policy conduct.1.1.2 Road stage of Kenya towards adoption of ITF1.1.2a) Central Bank of Kenya primary(prenominal) policy accusatoryThe revise Central Bank of Kenya Act of 1996, CAP 491(4) permitted the Banks operational autonomy in the conduct of monetary policy and mandated price stability as one of its primary objectives through formulation and murder of such principal object of the bank, thus, promoting the long- verge goal of economic growth. In fact, the Central Bank of Kenya does not announce an splashiness target instead, it uses money growth reserve as her of import nominal ground tackle of which the repo rate forms its main operational target. It is in this perspective that the CBK monitor and control swelling rate through interest rate transmission channel as a way of conducting monetary policy. Apart from the main objective that is price stability, the Bank has a mandate to balance its swelling goals against other goals such as substitution rate stability and promotion of liquidity, solvency and steady-market back up spell ensuring equilibrium in municipal and external payments.1.1.2b) Central Bank of Kenya attributes that advance ITF adoptionThe Bank like any other bank of its caliber is mandated by the statute to carry out its objectives in a more coherent and invariable manner without any external interference, at that placeby commanding greater substitution bank liberty. The Old Constitution of the Re state-supported Kenya of (1963) and Newly Promulgated Constitution of the Republic Kenya of (2010) have further strengthened the Banks Act, on that pointby, empowering the bank to carry its main objective without political interferences and curbing time-inconsistency trap.The mete outment and removal of the CEO of the Bank (regulator) and his/her deputy rest with the president discretion for a period of quatern years term in office unless stated othe rwise. In company to the governor term of office termination, the president has a directive to appoint a tribunal comprised consisting of a chairperson and two members who hold offices in High Court or Court of Appeal. This tribunal enquires on matters related to termination of such adjustments and make recommendation to the president. Nevertheless, these powerfulness undermine the Banks believability in upholding autonomy in case the termination of the governor might be un jurisprudencefully since the appointing authority might compromise the tribunal to favor his/her decision.In conformity with the Act CAP (491), the MPC is hereby required to forrader a report at least every six calendar month to the take care detailing all dealings the bank is undertaking hence the Minister shall table the MPC report onwards the Parliament for further amendment and deliberations. The Bank is exempted from any taxation whatsoever in respect to losses or profits. The Banks books of records an d financial statements subjected for auditing by the Controller and Auditor General only if the Minister of Finance deems it appropriate for such auditing.Both regulator and Deputy Governor are indebted to adhere to the bank in totality and taboo from engaging in any other paid businesses, professional activities or employment while still in office.These is in agreement with majority of literary works such as (Klomp and Haan 2008) who based their idea on Cukierman king which states the following inherent features for a of import bank to be termed as more independent (i) if the governor appointing authority rest with BOG sooner than the president, is not prone to relieve of his/her duty, and has a longer tenure in office. (ii), if the government has no tendency to interfere with banks conduct of business, for physical exertion, in policy formulation and implementation if in that respect is a greater emancipation be it of efficacious instruments or goal instruments and also i f the government has no electrical capacity to borrow from the bank. (iii) last but not least, if the bank main objective is price stability.1.1.2c) Economic Independence of CBKKenya has also experienced tremendous financial innovations intensifying greater implications to monetary policy transmission mechanism. The Bank is sceptred to act as a fiscal agent of the government or any public entity. Similarly, the advance made by bank to the government is supposed to be secured with securities issued by government, of which are supposed to mature in the beginning twelve months, bears interest at market rate, and are advanced for a short-term period to the government. In compliance with the statute, the CBK has an authority to grant loans and advances not exceeding three years in fixed period to government as a Deposit Protection Fund Board (DPFB), while the bank has mandate to lend or give credit to public entity, although, it is limited in extending such credits.The main interest is built on the heterogeneous chief features associated with the introduction of lump targeting framework by intimately of the Central Banks of both developed economies and conversional economies around the world espousal heavily from mixed aspects of literature that have analyzed greatly the development of this framework in ball club to determine the viability of the framework in low income countries such as Kenya. indeed, little has been done in A manakin specific to the needs of Kenya entrust be developed while grammatical construction a general structure within the framework of an ITF so as to distinguish between group characteristics of the flash-targeting and non-targeting substitution banks since its inception, and the race between various variables mentioned in the hypothesis.In addition, the paper depicts lessons learned by countries that have already select the hard-and-fast ITF since 1990s. What become apparent evident in process of this review, however, is th at several contributory problems must first be solved before forming an informed judgment on the likelihood of low-income countries embracing the framework. The first of these problems is whether there are impetus and aspect linked with decisions to move from a specific monetary practice to another. Second problem revolves around the feasibility of other policy designs of monetary policy such as exchange rate regime and underlying bank freedom Third problem allow for address chief pitfalls that could prevent low-income countries from embracing this policy design. The study hypotheses investigates the relationship between conditions that lead to adoption of rising prices targeting framework in developed economies and examine if these pre conditions have a replicate effect in low income countries.The other parts of the paper shall be structured as follows In section II, assess modification of monetary policy conduct under ITF by various developing countries commutation banks, the cons and pros of shifting to such strategy. In section III evaluate the exchange rate diversity and its determination to puffiness targeting framework more specifically the following interrelated issues impart be taken into considerations the role of nominal exchange rate it plays as a nominal sand, the costs associated with the real exchange rate overestimate and the approach for exiting the pegged exchange rate. Section IV reviews the role of the primeval bank independence since it forms the core tenet of conjecture that is built around the inflation targeting framework.Likewise, other contributory factors to embracing the framework will be captured in this Section. The paper concludes with the policy recommendation and the way forward.1.3 General Salient features, instruction execution and ExperienceA better strategy for monetary policy is built on the following inherent characteristics as summarized by Svensson Lars 1997 Friedman, 1990 McCallum, 1990 that is, it is suppos edly to be highly correlated with the goal and has a tendency to be controlled by central bank with much ease than the goal itself. Similarly, the public and the central bank should be able to comply to it with much ease than the goal. In addition, hydrofoil is of greater importance in terms of the efficiency and effectuality of the bank communicating to the public its objective and procedure of conducting its monetary locating. belles-lettres from (Bernanke and Mishkin 1997), Bernanke et al. (1999) and (Svensson Lars 1997) has vehemently mentioned various elements that form this framework which includes. First, price stability is officially chosen as the main intent of monetary policy, which indicates the monetary stance and the central banks principle of appraising its performance. Second, the central bank issues a declaration, which flatly states the numerical target for inflation within a specific, horizon-thus the bank has the latent to lessen the possibilities of falling i nto time inconsistency trap in carrying out its primary goal.Third, either the government can opt to choose the target, independently or collectively with the central bank, which is associated with appropriate changes in the central banks law thus enhancing instrument independence of the institution in achieving its target. Fourth, the ITF promotes high transparency in the conduct of monetary policy thus enabling hunt down of information from the central bank to the public and government. Svensson Lars (1997) stated that, when the authority have a bun in the oven the policy target deviation, the strategy should be attuned in such a way it is neither contractionary nor is it expansionary in accordance with keeping the policy on target. On this background, the IT-framework work best in calling future inflation, that is, the pertinent information for beting monetary policy is of greater importance in predicting future inflation. Indeed, this transparency of inflation targeting fo rms a better juncture in terms of motivating and focusing the activities inside the central bank. More so, there is high tendency of central bank accountability, which is often outlined in case of br apiece of inflation target, meaning it helps in clarifying what the central bank is capable and incapable for it to be accountable.Although, inflation targeting has prove to be the best modern strategy it does not lack some disapproval or problems that characterizes it in terms of implementation and monitoring. For instance Svensson Lars (1997) has described some of the inherent problems that makes this strategy ineffective, which includes central banks inability to restrain inflation due to the fact that, previous decisions and contracts play a vital role in determining current inflation. In other words, the authority can only have power over the future inflation. In addition, monitoring and military rating of monetary policy by public faces a greater go under back due to the inadeq uate control of inflation.CHAPTER TWO32.0 Literature brushupA large body of literature has been developed to analyze the force of an explicit numerical anchor since such framework was select in early 1990s. There exists a large number of literatures on major development of Inflation Targeting Framework since its inception in developed countries and emerging economies. However, there is little development in low-income countries in regards to adoption and implementation of this framework varies greatly in roughly of these countries because of lack of a well-developed financial market, inadequate fiscal position, political interferences and also lack of market desegregation in majority of them thus posing a bigger repugn to welcoming this framework as a way of monetary policy conduct. Therefore, the section borrows heavily from past studies that have since been done in order to demarcate the gaps that have made the framework ineffective.3.1 Transition to Inflation Targeting Fram ework Central Bank of KenyaIn the past decades, the monetary policy encountered by most of the emerging markets economies has been depressing, these resulted to extreme periods of monetary instability, vacillating from high inflation, to colossal capital flight, and thereby led to downfall of many financial systems. However, the forecast for self-made monetary policy in the majority of countries in transition have so far been augmented. This has been typified by considerable decline of inflation rate in Latin America region as an example of an emerging region, which dramatically fell from an average of above 400% in 1989 to less than 10% (Mishkin Savastano, 2001)According to Morande and Schmidt-Hebbel (997), this objective of inflation control has been construe by public as formal targets or hard targets. then enables the central bank to be more accountable by explicitly announcing a multi-year target for inflation. Downs and Vaez-Zadeh (1990) declared that during the transitio n it is not possible to forecast market behavior..since the old money-model is bound to be obsolete and perhaps of little use (318). Indeed, the old fashioned regime of money-growth targeting framework has proved inefficient in the recent past, although the Central Bank of Kenya has been able to contain inflation rate as low as possible. Above all, the de-regulation of economic activities in the early 1990s marked a major boundary in the conduct of monetary policy in Kenya in terms of objectives, instruments and institutional framework.Mwega 1990(a) developed a model that sought to explain the changes in the CPI Growth e.g. real income (T) changes, changes in money supply (M2), changes in import prices and changes in previous years inflation rates (Pt-1) were the expansionary variables. In these results, he prepare money supply to be a evidentiary determinant of inflation. Similar study was done by Ndungu (1993) where he did a comprehensive study on the dynamics of the inflatio nary process in Kenya for the period 1970-1991. He used a monetarist model, named the error correction form of model and empirically showed monetary growth, interest rates changes, real income growth and excess money printing which were significant determinants of inflation in Kenya presumptuous a closed economy. When he included the external economy, he found the exchange rate had a significant effect on the domestic price level. The results of his study indicated inappropriate government policies (monetary and fiscal) resulted lack of control of inflation especially in 1980-1990 where inflation level escalated.Mishkin and Schmidt-Hebbel (2007) in there adorn data analysis comprising of both inflation-targeting industrial countries and non-inflation targeting industrial countries, argued that ITF has helped these countries in achieving immutable inflation rate in the long-run where they are attributable in oil-prices and exchange rate shocks, and that are associated with strength ening of monetary policy independence and enhanced policy efficiency.Taguchi and Kato (2010) assessed the performance of the IT in East Asian economies where they adopt a co-integration approach between money and inflation. The estimation results were that, the ITF in the savour of few selected economies, except for Philippines, proved to work well as an anchor for controlling inflation through speeding up price adjustments (stabilizing inflationary expectations) against money supply in the context of floating exchange rate. Similarly, they argued that, well-functioning inflation targeting framework was consistent with enhanced monetary autonomy under the post-crisis floating exchange rate.Aizenman and Hutchison (2008) used a simple empirical model where they estimated jury data for 17 emerging markets for both inflation-targeters and non-inflation targeters and concluded that there was a stable inflation response running from inflation to policy interest rates for inflation-targ eters in emerging markets who have anchored their inflation than in non-inflation targeters whose central banks respond less in such markets. Similarly, they argued that the response to real exchange rate was much stronger in non-IT countries, however, suggesting that policymakers are more constrained in the IT regime where they attempt to target both inflation and real exchange rate and these objectives are not always consistent.2.2 An overview of the exchange rate transition and its role in ITFThe Central Bank of Kenya policy objectives have been to prolong an exchange rate that will ensure international competiveness while maintaining domestic rate of inflation at low levels through conduct of strict monetary stance.Calvo and Reinhard (2002) argued that Majority of emerging markets are facing problem in performing inflation targeting due to various issues of how to manage the exchange rate under the condition that their external debt is primarily denominated in U.S. dollars. The refore, the idea of this framework is believed to work best under floating exchange rate regime.Hence, inflation targeting framework as a monetary policy strategy becomes unattainable in majority of this countries due to too much concern towards exchange rate volatility.In recent times, countries with fixed exchange rate have a tendency to fix their domestic currency value to countries whose main objective is to anchor their inflation in readiness to keep inflation rate in check. or so of the countries that have adopted a move target or peg their currency tend to devalue at a firm rate in order to keep their inflation rate low vis a vis their counterpart anchoring countries.These periods marked a milepost that foresaw an accelerated money supply growth and high inflation, but at the identical time there was a move to speed up economic reforms and accelerate the pace of liberalization. An exchange rate regime makes central bank quite accountable because it has clear-cut goals but can actually crack accountability of the Central Banks in emerging- markets countries, by eliminating important signal that can help keep monetary policy from becoming too expansionary (Blejer, creb, 1999, p. 41).Also, for the same reasons described in (Mishkin, 1999a) exchange rate targeting can promote financial fragility and lead to foreign exchange crises that can also lead to full-fledged financial crises with disastrous consequences for the economy(Cited by Blejer creb, p.50) .Hence, a continual adherence of exchange rate regime is probable to have far-reaching involve of economic sluggishness and exacerbate redundancy in the economy, which is exactly what Kenya has experienced in the past. Therefore, the Central Bank should move more assertively by provision of an extra credibility, where policy easing is desired to prevent issue reductions, without igniting fears of renewed inflation.Mishkin Savastano ( 2001) acknowledged that there are three broad monetary policy s trategies that can produce an explicit nominor anchor that credibly constrains the discretion of the central bank over the medium hard exchange-rate pegs, monetary targeting, and inflation targeting. In spite of this, majority of industiralized economies, notably the United States, have used a more or less the same strategy of anchoring inflation. However, it does not explicitly anchor inflation but it implicitly anchor its inflation. a monetary policy with an implicit but not an explicit nominal anchor sought of monetary policy strategy to achieve macro-economic goals. Whereas, the three monetary policy strategies have enabled emerging economies to get up institutions and mechanisms that have effectively and efficiently constrained the discretion of their monetary authorities their suitability to conditions in different markets differs according to each strategy that is adopted by each country.Reinhart and Rogoff (2004) declared that, Developing countries central banks tend to p ursue exchange rate targets that considerably are more deterministic than their official pronouncements.while a managed vagrant might be operating a fixed exchange rate or a crawling peg for extended periods. Likewise, Kenya has undergone myriad exchange rate regimes in the past mostly driven by various economic cycles, and chiefly the balance of payments deficit. For instance, up to 1974, the exchange rate was pegged to the dollar, but later the devaluation of the currency resulted to a change of the peg to the SDR.1 from 1974-1984 period.This regime lasted until 1990 when a dual exchange rate system was adopted that lasted till October 1993 when, after a series of devaluations, the official exchange rate was abolished. (Mwega and Ndungu, 2001) acknowledged that Kenya adopted a unified and flexible exchange rate in the early 1990s, as part of a market-based reform program designed to alter the investment environs and spur economic growth(Cited by Ndungu, 2008). In addition, the ( Kenyan Economic Survey, 1995) revealed that the nominal exchange rate jerkyly depreciated by about 32%, moving to Ksh38 to the U.S dollar from Ksh 44 to the dollar, and inflation declined from 46% in 1993 to 28.8% in 1994 (as cited in Ndungu, 2000) as a result of shilling appreciating against dollar in 1995.2.3 Central Bank IndependenceThe literature on ITF in emerging market economies suggests that this monetary policy strategy should be adopted only if some institutional preconditions are met. One of them is Central Bank Independence. Many scholars have given much attention to the central bank autonomy and the role it plays in adopting ITF. Indeed, where central bank is autonomous from government interference it is likely to insulate itself from political pressures to finance government fiscal deficits, which can result to over-expansionary monetary policies that would lead to inflation above target. Cukierman, Webb and Neyapti (1992) constructed Central Bank Index that was desig ned in two folds that is, heavy independence and turnover rate of governors, where both revolved around central bank charters and legislation and the relationship it has over the overall performance of the economy. This paper provides an overview of the mushrooming literature on authority autonomy and precision relating it to the mechanisms through which central banks have in the past adopted greater openness, thereby, focusing more on the role they play in adoption and effective implementation of inflation targeting framework.(Klomp and De Haan, 2010) used a random coefficient model and they estimated a sample of more than 100 countries to re-examine the relationship between CBI (measured by both governors TOR and central bank sound indicator) and inflation. They found Central Bank Index to be negatively insignificant with the level of inflation rate of country specific. Most literatures in developing countries have focused on de facto independence as a proxy of CBI that is govern ors turnover rate.Studies of Cukierman, Webb and Neyapti (1992) stated that the average and variance of inflation has a negative correlation to governors turnover rate in most of the developing. This is due to the fact that, majority of studies has expressed doubts over the reliability of most of indicators used to construct Central Bank Independence indices. Indeed, there exist a greater divergence when it comes to categorization of indicators used to measure CBI close in of high income countries, emerging countries and low income countries.Cukierman,1994 and Eijffinger and De Haan (1996) have categorically contended that, the CBI indices in majority of high income countries are arises from central banks laws interpretation and are of great concern to legal independence indicator, whereas, in developing countries de facto independence indicators form the main measure of central bank independence.Axel Dreher, Jan-Egbert Sturm, Jakob de Haan (2010) used a data set comprising of eigh ty-eight countries term of office of central banks governors since 1975-2005. They used logit model to sort the likelihood central bank governor term of tenure geting terminate before their legal term in office expires. According to their results, the probability of a TOR as a measure of CBI tend to soar under certain condtions which includes unstable political system, undue elapse of governor term of service in office and during elections period in self-governing countries. Accordingly, they indicated in their hypothesis that there was a higher chance of the governors getting replaced if there was huge drop out of veto players from the government. Alex, Webb and Bilin (1992)) developed legal independence where they mentioned some of the intrinsic features such as the degree of independence that the authority should bestow to the Bank, and lone dependence on legal component of independence. Besides, the legal independence is significant in ascertaining inflation rate in developed economies. Whereas, turnover rate of governors forms a better turning point of inflation determination in developing countries. Likewise they argued that, in cases where governor legal term of office is shorter than that of government CBI is likely to be compromised by the government, thereby, resulting to change magnitude TOR. More over, the governor is likely to be susceptible from government determine thereby derailing long-term objective of policy formation and implementation under the pretext of political pressure especially during election periods.(Kuttner Kenneth, Posen Adam 2010), took the same direction and indicated that undue appointment of governor in office result to construed information to the bank in terms of carrying out its primary objective of price stability. For instance, unjustifiable appointment of governor under low inflation periods may reinforce the exchange rate, while the opposite is always true. Since governors appointment seem to contain valuable inf ormation regarding the exchange rate and inflation rate.Gutierrez (2003) indicated that CBI has positieve impact in reducing the chances of governments incurring budget deficits through quasi-fiscal activities. Since such activities can be understood on their inflationary impacts.Posen and Kuttner (2010) estimated the effect of legal appointment of governor to office exchange rates and bond allot and argued that the main test was to verify the scope to which markets observe that the next governor will bring a swing in policy, whereby he/she is expected to determine the bearing of such swing. This is in conformity with the fact that, the countersign conveyed may favour either one side due to markets chemical reaction after such appointment.2.4 Financial InstitutionsAnother important prerequisite for successful ITF stressed by the literature is a healthy financial and banking system. some(prenominal) reasons can be advanced to explain the great importance of well-functioning financ ial system under inflation targeting framework. First, a sound financial system is essential to guarantee an efficient transmission of monetary policy through the interest rate channel which forms the major channel through which the CBK carries out its main objective of price stability, and more specifically forms an enabling environment of smooth exchange and provision of credit. Second, according to Mishkin (2004), a weak banking sector is potentially problematic to achieve inflation target, because the central bank would be hesitant to raise short-term interest rates for fear that this will impact the profitability of banks and lead to a collapse of the financial system. Third, countries characterized by weak financial institutions are more vulnerable to a sudden stop of capital outflows, causing a sharp depreciation of the exchange rate which leads to upward pres