Group Assignment.

Daystar University

ECO 419A : ADVANCED MACROECONOMICS

Submitted to Lecturer Celine Mutie

Submitted by :

Diana Terry Aloo, 20-0882

Clare Becklynn Wanjiku, 20-1057

Moffat Ngonde Mutia, 20-1323

School Of Business And Economics

Economics Department

12th February 2024

a) Considering the unfortunate COVID-19 pandemic, most of the developing countries found

themselves at the receiving end whereby most of the economic and social activities stagnated.

Using Kenya as a case study, elucidate four methods through which the Central Bank of Kenya

contributed to remedying this situation, with relevant examples.

1) Provision of regulatory relief : During this time Financial institutions received

regulatory relief from Central Bank Of Kenya in the form of; extended filing deadlines.

The strain on banks and other financial institutions was lessened as a result. As an

illustration, the Central Bank Of Kenya permitted banks to re-organise loans to

pandemic-affected clients without having an adverse effect on their capital adequacy

ratios.For instance banks provided relief on personal loans by reviewing requests from

borrowers for extension of their loan for a period of up to one year. As at end December,

loans amounting to KSh 1.63 trillion had been restructured (54.3 percent of the total

banking sector loan book) while KSh 32.6 billion (92.7 percent of the KSh 35.2 billion

freed from the reduction in CRR) had been used to assist borrowers affected by COVID-

19. A significant increase in mobile money usage was also noted, with the monthly

volume of person-to-person transactions increasing by 87 percent between February and

October 2020 while the volume of transactions below KSh 1,000 increased by 114

percent. Other relief measures included was moving payments to electronic channels to

keep the economy running during lockdowns, consulting with players in the payments

arena.

2) Monetary policy adjustments: Monetary policy during the period aimed at maintaining

inflation within the target range of 2.5 percent on either side of the 5 percent medium
 term target. For example in November 2019, the Monetary Policy Committtee adopted an

accommodative monetary policy and lowered the Central Bank Rate (CBR) to 8.50

percent from 9.00 percent. They augmented the accomodative stance by lowering the

CBR further to 8.25 percent in its January 2020 meeting to support economic activity.

The Monetary Policy Committtee also lowered the CBR to 7.25 percent in March and

further to 7.00 percent in April in order to support economic activity. Additionally, they

reduced the Cash Reserve Ratio (CRR) to 4.25 percent from 5.25 percent releasing an

additional liquidity of Ksh 35.2 billion used to directly support distressed borrowers as a

result of COVID-19. Additionally, the MPC extended the maximum tenor of Reverse

Repurchase Agreements (REPOs) from 28 to 91 days. This provided flexibility on

liquidity management facilities provided to banks by CBK by enabling banks access

longer term liquidity secured on their holdings of government securities without having

to discount them. The MPC also held monthly meetings in March and April to ensure

closer monitoring of the impact of these policy measures on the economy, as well as the

evolution of the pandemic. These measures augmented other emergency measures

announced by CBK and the Government to contain the spread of the pandemic and to

cushion the economy, households and businesses against its effects. Inflation remained

anchored within the target range during the period, supported by lower food and fuel

prices, and muted demand pressures in the economy. Overall inflation stood at 6.0

percent in April 2020 compared to 6.3 percent in October 2019. Non-food-non-fuel

(NFNF) inflation remained low and stable

3) Strengthening Foreign Exchange Reserves and Exchange Rate Stability: The foreign

exchange market remained relatively stable, despite continued uncertainties in the global
 financial markets due to the impact of COVID-19 pandemic. This Central Bank Of

Kenya supported this stability by a narrowing in the current account deficit and an

adequate reserve buffer. For example the current account deficit narrowed to 4.7 percent

of GDP in the 12-months to November 2020 from 5.4 percent of GDP in a similar period

in 2019, reflecting lower merchandise imports attributed to lower oil imports, improved

tea exports, a rebound of horticulture exports and resilient remittances. The CBK foreign

exchange reserves, which stood at USD 7,750.5 million (4.76 months of import cover) at

the end of December 2020, continued to provide an adequate buffer against short-term

shocks in the foreign exchange market.

4) Credit Relief Measures: The CBK introduced credit relief measures to alleviate the

financial strain on borrowers, particularly individuals and businesses affected by the

pandemic. For example, it allowed banks to offer loan restructuring and moratoriums on

loan repayments to affected borrowers. This provided temporary relief by reducing

immediate financial burdens and helping businesses stay afloat during the economic

downturn. Additionally, the CBK encouraged banks to provide emergency loans or credit

facilities to support sectors most affected by the pandemic, such as small and medium-

sized enterprises (SMEs) and the hospitality industry. The Private sector credit grew by

9.0 percent in the 12 months to April, with strong growth in credit observed in

manufacturing, trade, transport and communication, building and construction, and

consumer durables.
b) Kenya has been experiencing persistent balance of payment deficits. Suppose that you have

been recruited as a policy analyst, critically explain using clear illustrations and examples

how the balance of payment deficit can be solved under the following assumptions:

i) Perfect Capital Mobility. (6 Marks)

ii) Imperfect Capital Mobility. (6 Marks)

i) Perfect Capital Mobility:

In a situation of perfect capital mobility, capital flows freely in and out of the country

without any restrictions. Under these conditions, the balance of payment deficit can be

addressed through adjustments in the exchange rate . The depreciation of the nation's

currency is necessary to correct this imbalance. When the exchange rate declines, imports

become more costly for consumers in the country of origin and exports become less

expensive for consumers elsewhere. Customers are encouraged to purchase more goods

and services produced domestically as a result of this shift in relative prices, which also

increases exports' competitiveness in global markets. For example ,the government took

up a Eurobound worth $ 1.5 billion recently. This move made the Kenya Shillings

apprciate against the dollar making imports cheaper and our exports are more competitive

in the international market , cheaper imports will reduce amount of money spent on

imports while competitive exports will improve the income generated from the exports

thus fixing the deficit.

Further, the government may consider floating foreign currency denominated bonds

locally to mitigate against currency vulnerabilities. Bonds are typically used to broaden

the range of debt instruments they employ. However, the cost of serving international
 capital market (Eurobond) is quite expensive and it usually puts pressure on the local

currency; often it causes a downward spiral on currency if the debt service weighs on the

currency. Kenya made its first debut in 2014 when it issued the Eurobond. The

government was able to raise approximately US$ 2 billion and additionally of US$ 2.1

billion in 2018. If foreign dominated bonds are floated locally, then a number benefits

may ensue. The bond will lead to additional foreign currency inflows, which will

automatically support the Kenyan shilling; additionally it will solidify Kenya position as

international financial market and ensure the country has adequate cover to cushion

against short-term shocks in the foreign exchange market. Issuing offshore local currency

bond to raise funds in international capital market without exposing the shilling to foreign

exchange volatility can also be an alternative

ii) Imperfect Capital Mobility

In a scenario of imperfect capital mobility, capital flows are restricted or subject to

government controls. Under these conditions, addressing the balance of payment

deficit requires a combination of policies beyond exchange rate adjustments.

a) Exchange Rate Adjustments with Capital Controls:

Similar to the case of perfect capital mobility, adjusting the exchange rate can still be a useful

tool in addressing the balance of payment deficit. However, in the presence of capital controls,

the effectiveness of exchange rate adjustments may be limited.Governments may use capital

controls to regulate the flow of funds into and out of the country, thereby influencing the

exchange rate dynamics and reducing speculation in currency markets.By combining exchange

rate adjustments with capital controls, authorities can have more control over the pace and
magnitude of currency depreciation, which can help manage the balance of payment deficit more

effectively.

b) Domestic Policy Interventions:

In addition to exchange rate adjustments, governments may implement domestic policies to

address structural imbalances contributing to the balance of payment deficit.These policies may

include measures to boost domestic production and exports, such as investment in infrastructure,

technology, and export promotion programs.By improving the competitiveness of domestic

industries and increasing export capacity, countries can reduce their reliance on imports and

generate higher export revenues, thereby improving the balance of payments.

Suppose Kenya is facing a balance of payment deficit due to structural issues such as low

productivity and limited export diversity. In addition to allowing the exchange rate to depreciate,

the Kenyan government implements policies to promote export-oriented industries.These

policies may include providing subsidies or tax incentives to exporters, investing in

infrastructure to improve logistics and transportation, and facilitating access to credit for export-

oriented businesses.By addressing structural constraints and promoting export-led growth, Kenya

can reduce its reliance on imports and increase export earnings, leading to an improvement in the

balance of payments over the long term.

In summary, In cases of imperfect capital mobility, governments may need to implement a

combination of exchange rate policies, capital controls, and domestic interventions to address

underlying structural imbalances and achieve sustainable improvement in the balance of

payments.
QUESTION TWO

b) While having coffee with your friends, a casual discussion on the topic of “exchange rates” is

tabled; and one of your peers says, “I think a real devaluation of the Kenyan shilling against the

currencies of trading partners will harm the country’s trade balance and the economy at large”.

Provide an expert opinion to justify your friend’s view, by outlining FOUR valid arguments. (5

Marks)

Decreased foreign investment

Changes in exchange rates between countries have an effect on the performance of their local

currencies with regards to direct foreign investment. Devaluation of the Kenyan shilling against

the currencies of trading partners will weaken local currency which discourages direct foreign

investment. This is because it becomes expensive to acquire the currency of the foreign state into

which investment can be done. A weaker local currency fosters a negative balance of trade

between trading partner countries because of the reduced and unfavorable conditions of doing

the direct foreign investment.

Impact on import costs

A real devaluation of the Kenyan shilling implies a decrease in value relative to other currencies.

This makes it expensive to import products which are used for industrial production purposes.

This in turn raises the production costs whose effects are passed on to consumers in form of

costly prices. Costly priced goods cannot compete favorably in the foreign markets. This

discourages marketability of domestic products on foreign markets.

Inflation
Devaluation often leads to higher inflation as imports become more expensive causing cost push

inflation. With exports become cheaper, manufacturers may have less incentive to cut costs and

become more efficient; thus overtime costs may increase. This can erode the purchasing power

of consumers reducing the domestic demand for goods and services.

Increased cost of borrowing and debt burden

Depreciation of the exchange rate causes an upward revision in external interest. This

depreciation increases the real cost of servicing the existing debts as more local currency is

required to make the same debt payments. This leaves little cash for industrial development and

job creation. This could cause a strain to the country’s fiscal resources.