How banks are manipulating shilling to gain

The shilling has been the subject of a “financial terrorists” attack, causing it to depreciate against the major global currencies.

Central Bank of Kenya (CBK) governor Prof Njuguna Ndung’u blames four unnamed banks for exerting speculative pressures on the exchange rate.

Currency manipulation is a serious matter that is no different to any other terrorist attack that could cause a lot of suffering to Kenyans. The 1997 Asia financial crisis which impoverished millions of people was caused by institutional currency speculators deliberately manipulating the market. After the Malaysian government froze trading in the ringgit in September 1998, the then Prime Minister Dr Mohammad Mahathir described the currency speculators as “gangrenous leg” that should be chopped off”. Currency speculators take advantage of the flaws inherent in the global financial system.

Know their game

They are very knowledgeable about financial markets and they use this knowledge to “attack” currencies so as to bring its value down and make huge profits. When they collude as these banks are alleged to have done, they can cause a lot of damage to an economy.

While the CBK could counter such attacks to keep exchange rates within reasonable levels, a continuous attack can be difficult for the central bank to match. This is because speculators can take on huge leveraged positions while the central bank would need large amounts of its foreign reserves to counter this. Inability to match the speculators would only cause the exchange rate to plunge further.

So how do they do it? The whole process starts with what is commonly referred to as “shorting a currency”. Shorting means borrowing and selling currencies that you do not own. In contrast with going long-term, you profit in a short trade if the price of a pair gets cheaper.

Here, you buy back the currencies that you initially sold at a lower price. You then return these to the person you had borrowed from. The difference between the price sold and how much you bought the back for is your profit. Confused? Here is a practical example.

Let us assume an initial exchange rate between three currencies, say, the shilling, dollar and euro as follows; Shilling exchange rate is 90 and 128 to one dollar and euro respectively. The euro/dollar cross currency exchange rate is thus 1.4222 (128/90).These exchange rates are in equilibrium since no one can make profit by just trading between the three currencies. If one starts with a dollar, exchanges it into euro, then changes the euro into shilling and then back into US dollar, he would end up with exactly a dollar again.

Now assume that the “shorting” of the shilling by the speculators pushes the exchange rate to Sh 95 per US dollar. By attacking the currency this way, the traders will make two types of profits: first speculative and second arbitrage profits.

Speculative profit comes from betting that a currency would appreciate or depreciate. In our example above, speculative profit is made as follows. First, the traders or the commercial banks sell short Sh90 million at the initial exchange rate of 90 per dollar. This equals $1 million and would be credited to their account. Assume now that the “sell attack” caused the shilling to depreciate to 95 per dollar. Now at this new exchange rate the Sh90 million is worth only $0.947 million. Because this attack caused the shilling to depreciate, it would only require $0.947 million and not $1 million for them to buy back the Sh90 million. They would therefore close their position by buying back the Sh90 million at this new rate and makes a handsome profit of $52,631.58. The profit does not end there though. There is another profit to be made — the arbitrage profit.

Earning profits

Arbitrage profit is made from the mispricing among the exchange rates. An arbitrageur buys currency B spending A, then buys C spending B and lastly returns to A selling C, earning a profit in the process. The chance of profit is maximised by trading with higher amounts. This mispricing happened when the speculators moved the shilling’s exchange rate from Sh90 to Sh95 to the US dollar. In the above example, this is how the arbitrage profit would be made:

First, the trader will borrow $1 million and exchange it into Sh95 million at the new prevailing exchange rate of Sh95 per US dollar. Second, the trader will exchange the Sh95 million into 742,187.50 euros (at the exchange rate of Sh128 per euro). Third, the trader will then exchange the 742,187.50 euros into $1,055,555.56 (at the exchange rate of $1.4222 per euro) and finally they will return back the loan of $1 million, and keep the remaining $55,555.56 as arbitrage profit.

The total speculative and arbitrage profits from nowhere will thus equal 52,631.58 + 55,555.56 = $108,187.13. Although I have used small amounts to simplify the process, currency traders, however, trade in billions of shillings. You can imagine the amount of profits they made during the week 9-16 June in which according to CBK there had been an outflow of $237 million.

A low interest rate regime can help boost the Kenyan economy

As the Word Bank predicts, Kenya may have to navigate through another economic storm this year. Real gross domestic product (GDP) growth projections for 2011 have been revised downwards from 5.7 per cent to 4.2 per cent by the Finance minister and from 5.3 per cent to 4.8 per cent by the World Bank.

Real GDP growth rates through the global economic downturn to date demonstrate the Kenyan economy’s resilience against global economic trends. However, a drought resilient economy would be something. The Kenyan economy is highly dependent on agriculture and there is uncertainty as to the levels of rainfall expected this year.

The consumer price index rose by 10.1 points from 109.38 at the end of 2010 to 119.48 at the end of May 2011. During the same period, inflation went up from 4.08 per cent to over 12 per cent, mainly driven up by rising fuel and food prices. This had a significant negative impact on the purchasing power of the spending middle class.

During the same period, the average yield rate for the 91-day Treasury bills, which is a benchmark for the general trend of interest rates, rose from 2.276 per cent to 6.409 per cent. This upward trend is an indication of the government’s need for cash and is the only way to attract domestic funds.

This may be aimed at reducing money supply, reducing effective demand and thereby curbing inflation, but it may not work because it does not address the factors driving the cost push inflation like high cost of manufacturing due to high electricity costs, very high fuel prices etc. We should, therefore, have a low interest rate regime as this will increase disposable income and expand trade.

High cost

The shilling also reached a new low against the US dollar. This will adversely affect trade by making imports, some of them inputs into production, very expensive and further pushing up retail prices.

Further, we are approaching an election year in 2012 and as usual, there is a high degree of political uncertainty. If the past is anything to go by, we can assume that it is around that time when foreign investors refrain and even divest, demand for the Kenya shilling goes down and it worsens against the major currencies, supply and trade contract and the business community generally grows tense.

From lack of funding, lack of rainfall, political uncertainty and instability leading to post-election violence, the global economic downturn, high cost of electricity, rising oil prices, costly imports, packed technology and such like, there seems to be too many loose ends which frustrate this strategy, resulting in a zig zag, start stop trend in growth.

It is a delicate balance that needs to be carefully watched because for the economy to expand consistently at a high rate, government spending must continue in infrastructure, energy, healthcare, education and agriculture, and all the while maintaining macro-economic stability.