Monetary Policy and Financial Institutions of Kenya

M integritytary Policy and Financial Institutions of KenyaCHAPTER ONE1.0 INTRODUCTIONThe world is turning into a demon to its own people as some ar living in deplorable situations that are hardly bearable. The price train give risen sharply in the young retiring(a) coupled with dwindling wage levels and declining growth enjoin, especially, in volume of African countries where p all overty has embedded itself to an design that people in these countries live below one dollar per day. However, majority of establishments have embarked on instituting major reforms through introduction of avant-garde fiscal insurance form _or_ system of government schemes, which forge the way forward through which the fiscal authority re-design its polity by focusing primarily on price stability as the primary winding accusive.In the last twenty geezerhood, majority of both(prenominal) developed and emerging economies respectively have embarked on IT mannequin as their best choice in shooting pecuniary constitution, with none of splashiness countries targeters abandoning the mannequin, save for Finland and Spain, that have already joined the European Monetary System (EMS) in late 90s. IT- simulation an approach to management of fiscal policy was pioneered by the New Zealand Government in 1990 after it abandoned its blastged alternate rate five years later. By the year 2009, over xxv countries comprised of developed, emerging, and developing countries around the world had so far espo apply the IT-Framework and have reported great achievement of low flash rate. Majority of these countries mainly from Latin America, easternmost Asia and United Kingdom had experienced highschool b emerge of puffiness and pecuniary crises incensed by their former monetary policy regimes. These not only resulted to sacrificing output and manipulation but also resulted to severe incr embossment in international capital flow leading to a switch to floating flip-flop rat e.1.1 Historical flat coatIn relation to many otherwise African countries, the monetary policy and financial institutions of Kenya has developed rapidly within the last two decades and probably to a greater extent advanced than other countries at a similar stage of infradevelopment. Kenya opened its own Central Bank in September 1966 with the hope that, it would at to the lowest full stop generate secondary expansion by facilitating the creation of bank credit and accelerate the process of monetization of the economys subsistence sector, in spite, of its openness and sensitivity to fluctuations of primary commodities.The succeeding(a) decade following the establishment of her Central Bank witnessed interesting changes in Kenyas monetary and banking policies as the oil shock of 1973 created inflexibility in the foreign metamorphose reserves as they aggravated considerably. Hence, the magnitude and festinate of reduction in credit expansion were not adequate to show the decli ne in foreign substitute reserves. In fact, the fear that tight monetary policy induced from outside could hamper the rate of development at home led to feeble disciplinal stones throws oftentimes(prenominal) as restraining inflation impact due to price boom of exports, which coincided with expansionary monetary policy under a low profile of interest order.In the early on 1980s and 1990s Kenya experienced high inflation resulting from a prolonged spell of drought and policy-making instability that resulted from introduction of a multiparty brass 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 corruption of the highly ranked governing body official and political intervenences of major decision-making organs of government including the Central Bank of Kenya, as it could not carry out its mandate freely. In the year 2008, Kenya faced another dark moment in terms o f its political stability as the whole country went into inflammation due to the highly disputed general elections of 2007. The once giant of East African countries went down into ashes and major sectors of the economy especially the financial sector got pine the most. Since then, it has been very difficult for the resurgence of economic stability, political stability and financial institution even after the power brokering that gave birth to a coalition government in that same year. However, in late 2010, the coalition government of Kenya gave hopes to recovery of major sectors of the economy when the New Constitution unanimously voted into existence in a referendum. This Constitution has brought about major reforms in the financial and political arenas much specifically in the Central Bank of Kenya as per se hence, major changes are expected to be instituted by CBK for an effective and independent monetary policy conduct.1.1.2 Road map of Kenya towards adoption of ITF1.1.2a) Ce ntral Bank of Kenya main policy object glassThe amended 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 implementation of such principal object of the bank, thus, promoting the long-term goal of economic growth. In fact, the Central Bank of Kenya does not portend an inflation target instead, it uses money growth reserve as her main nominal anchor of which the repo rate forms its main operational target. It is in this perspective that the CBK oversee and control inflation rate through interest rate transmission avenue as a way of conducting monetary policy. Apart from the main objective that is price stability, the Bank has a mandate to balance its inflation goals against other goals such as tack rate stability and promotion of liquidity, solvency and steady-market back up while ensuring equilibrium in domestic and externa l payments.1.1.2b) Central Bank of Kenya attributes that favor ITF adoptionThe Bank like any other bank of its tidal bore is mandated by the legislation to carry out its objectives in a more coherent and consistent manner without any external interference, thereby commanding greater cardinal bank independency. The Old Constitution of the Republic Kenya of (1963) and Newly Promulgated Constitution of the Republic Kenya of (2010) have that strengthened the Banks Act, thereby, empowering the bank to carry its main objective without political interferences and curbing time-inconsistency trap.The involvement and removal of the CEO of the Bank ( governor) and his/her deputy rest with the president discretion for a period of four years term in office unless verbalize otherwise. In connection to the governor term of office termination, the president has a directive to appoint a judgeship comprised consisting of a chairperson and two members who hold offices in High Court or Court of A ppeal. This tribunal enquires on matters related to termination of such appointments and fox recommendation to the president. Nevertheless, these readiness undermine the Banks credibility in upholding autonomy in shield the termination of the governor might be unlawfully 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 forward a report at least all six month to the take care detailing all dealings the bank is undertaking hence the Minister shall table the MPC report before 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 and financial statements subjected for auditing by the Controller and Auditor General only if the Minister of Finance deems it appropriate for such auditing.Both Governor and Deputy Governor are indebted to adhere to the bank in totality and prohibited from pleasant in any other paid businesses, professional activities or employment while s trough in office.These is in agreement with majority of literary productions such as (Klomp and Haan 2008) who based their idea on Cukierman Index which states the following inherent features for a telephone exchange bank to be termed as more independent (i) if the governor appointing authority rest with BOG rather 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 trend to interfere with banks conduct of business, for example, in policy formulation and implementation if there is a greater independence be it of good instruments or goal instruments and also if the government has no capacity to borrow from the bank. (iii) last but not least, if the bank main objective is price stability.1.1.2c) sparing Independence of CBKKenya has also experienced awing financial innovations intensifying greater implica tions to monetary policy transmission mechanism. The Bank is empowered 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 before cardinal 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 collar years in fixed period to government as a Deposit Protection Fund Board (DPFB), while the bank has mandate to leave or give credit to public entity, although, it is limited in extending such credits.The main interest is built on the various chief features associated with the introduction of inflation targeting framework by most of the Central Banks of both developed economies and transitional economies around the world borrowing heavily from various aspects of literature that have a nalyse greatly the development of this framework in order to determine the viability of the framework in low income countries such as Kenya. indeed, little has been done in A poser specific to the needs of Kenya will be developed while building a general structure within the framework of an ITF so as to distinguish between group characteristics of the inflation-targeting and non-targeting cardinal banks since its inception, and the relationship between various variables mentioned in the hypothesis.In addition, the paper depicts lessons learned by countries that have already espouse the strict ITF since 1990s. What become apparent evident in process of this review, however, is that several contributory problems must first be solved before forming an informed appreciation on the likelihood of low-income countries embrace 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. s tand by problem revolves around the feasibility of other policy designs of monetary policy such as exchange rate regime and primordial bank independence Third problem will 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 inflation 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 central banks, the cons and pros of shifting to such dodging. In section III evaluate the exchange rate transition and its theatrical role to inflation targeting framework more specifically the following interrelated issues will be taken into considerations the role of nominal exchange rate it plays as a nominal anchor, the co sts associated with the real exchange rate overvaluation and the approach for exiting the pegged exchange rate. Section IV reviews the role of the central 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, Implementation 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 supposedly 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, transparency is of greater importance in terms of the efficiency and eff ectiveness of the bank communicating to the public its objective and procedure of conducting its monetary stance. literary productions 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 formally 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 categorically states the numerical target for inflation within a specific, horizon-thus the bank has the latent to lessen the possibilities of move into 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 flow of study from the central bank to the public and government. Svensson Lars (1997) stated that, when the authority anticipate 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 forecasting undermentioned inflation, that is, the relevant information for forecasting monetary policy is of greater importance in predicting future inflation. Indeed, this transparency of inflation targeting forms 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 breach of inflation target, meaning it helps in clarifying what the central bank is capable and incapable for it to be accounta ble.Although, inflation targeting has proved to be the best redbrick strategy it does not lack some criticism or problems that characterizes it in terms of implementation and monitoring. For instance Svensson Lars (1997) has depict 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 evaluation of monetary policy by public faces a greater set back due to the inadequate control of inflation.CHAPTER TWO32.0 Literature ReviewA large body of literature has been developed to break apart the effectiveness of an explicit numerical anchor since such framework was adopted 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 most of these countries because of lack of a well-developed financial market, inadequate fiscal position, political interferences and also lack of market integration in majority of them thus posing a bigger challenge to welcoming this framework as a way of monetary policy conduct. Therefore, the section borrows heavily from last(prenominal) studies that have since been done in order to demarcate the gaps that have made the framework ineffective.3.1 Transition to Inflation Targeting Framework 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. Howe ver, the forecast for successful 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 interpreted by public as formal targets or hard targets. Thus 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 transition it is not possible to forecast market mien..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 maintain inflation rate as l ow as possible. Above all, the de-regulation of economic activities in the early 1990s mark a major landmark in the conduct of monetary policy in Kenya in terms of objectives, instruments and institutional framework.Mwega 1990(a) developed a model that sought-after(a) 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 rank (Pt-1) were the expansionary variables. In these results, he found money supply to be a significant determinant of inflation. Similar study was done by Ndungu (1993) where he did a comprehensive study on the dynamics of the inflationary 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 assuming a unopen economy. When he inc luded the external economy, he found the exchange rate had a significant effect on the domestic price level. The results of his study indicated opposed 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 panel data analysis comprising of both inflation-targeting industrial countries and non-inflation targeting industrial countries, argued that ITF has helped these countries in achieving stable inflation rate in the long-run where they are attributable in oil-prices and exchange rate shocks, and that are associated with strengthening of monetary policy independence and enhanced policy efficiency.Taguchi and Kato (2010) assessed the performance of the IT in East Asian economies where they adopted a co-integration approach between money and inflation. The estimation results were that, the ITF in the sample of few selected economies, except for Philippines, pro ved 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 panel 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-targeters 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 attem pt 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 protract 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. Therefore, 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 unrealizable in majority of this countries due to too much occupy towards exchange rate volatility.In recent times, countries with fixed exchange rate have a tenden cy to fix their domestic capital value to countries whose main objective is to anchor their inflation in readiness to keep inflation rate in check. Most of the countries that have adopted a crawling 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 mark a milestone that foresaw an accelerated money supply growth and high inflation, but at the same 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 snap off 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 t o 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 continuous adherence of exchange rate regime is probable to have far-reaching impact 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 output reductions, without igniting fears of renewed inflation.Mishkin Savastano ( 2001) acknowledged that there are three broad monetary policy strategies 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 set up institutions and mechanisms that have effectively and efficiently constrained the discretion of their monetary authorities their suitability to conditions in different markets differs harmonise to each strategy that is adopted by each country.Reinhart and Rogoff (2004) declared that, Developing countries central banks tend to pursue exchange rate targets that considerably are more deterministic than their official pronouncements.while a managed floater 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 bal ance 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 improve the investment environment and spur economic growth(Cited by Ndungu, 2008). In addition, the (Kenyan Economic Survey, 1995) revealed that the nominal exchange rate suddenly 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 Independenc eThe 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 designed in two folds that is, lawful 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 mech anisms 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 retrospect the relationship between CBI (measured by both governors TOR and central bank lawful 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 governors 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 incase 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 eighty-eight countries term of office of central banks governors since 1975-2005. They used logit model to test the likelihood central bank governor term of tenure geting terminated 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, unfounded 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(prenominal) 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 increased TO R. More over, the governor is likely to be susceptible from government influence 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 information 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 yield 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 news show conveyed may favour either one side due to markets reaction after such appointment.2.4 Financial InstitutionsAnother important prerequisite for successful ITF emphasise by the literature is a healthy financial and banking system. Several reasons can be advanced to explain the great importance of well-functioning financial 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, agree 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