Muscles of Central Banking: Analysing Tools of Monetary Policy in Kenya

By gatuyu t.j


Central banks wear many caps. They formulate, and implement, monetary policies of their countries. They ensure stability in general level of prices. It is their mandate, to foster a stable, market-based, financial system. They will often be called by their governments’ to support efforts of actualising economic growth and employment creation.

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Central Bank of Kenya Logo

In executing these diverse mandates, more as masters of the monetary policy, central banks have on their backs, strapped, a quiver of instruments.

Whereas central banks in the west have over the years significantly improvised and innovated on these tools, their counterparts in Africa have remained conservative. Like others, the Central Bank of Kenya (CBK) is the custodian of the country’s monetary policy.

Headaches of Inflation

One of the unenviable roles of central bank is to cure inflation, and in rare circumstances, deflation, in the economy. Inflation ought to be tamed to be within allowable margins. The allowable margin in Kenya is on a target prescribed by National Treasury in annual budget statement. Currently, the prescribed inflation target is 5%. It has been so for nearly a decade. The allowable margin is plus or minus 2.5%.

Thus, CBK is supposed to ensure inflation is at 5% plus or minus 2.5% margin. In such a case, it could be 7.5% in the upper side. It slide trend up 2.5% in the lower side, and be okay, falling below which the country would be on deflation.

On this inflation fighting battle, the CBK has experienced marginal success. As per the Kenya National Bureau of Statistics, Kenyan inflation as measured through Consumer Price Index averages at 11% normally and 8% for NFNF (Non-fuel non-food).

Why then, has keeping inflation tamed become such a fuss? You will note. It will be noted. Low and stable inflation, liquidity in the market, ensures higher levels of domestic savings. It facilitates private investment. This results into improved economic growth, where people are able to have higher real incomes, and employment opportunities increased.

There is another flipside. A government that fails to tame inflation may cook its geese. Meet President Nicholas Maduro, of Venezuela. He has been unable to tame the hyperinflation in his country. On this account we are able to predict meme mene tekel has been inscribed on his wall.  His days are numbered. But he may survive. Mugabe, a despot who created a hyperinflationary economy in Zimbabwe, has survived.

You will now decipher. Central banks do not seek to control inflation and keep tap on monetary policy as matter of aesthetics. At stake, includes stability of the government.

Just like other African countries, CBK monetary tools are retrieved from the book of the conservative. The main instruments, being approximately six of them, are as described.

  1. Open Market Operations (OMO)

Open Market Operations are the bedrock of monetary policy instruments. They are CBK actions for regulating money supply and credit conditions. OMO involves stabilising of short term interest through sale and purchase of eligible securities.

When a Central Bank buys securities in the open market, it increases reserves available to commercial banks, for it pumps money to them. This makes it possible for banks to expand their loans. Money supply to the economy is increased. OMO tools that the CBK applies include various variations of Repurchase agreements and Term Auction deposits. What are these?

a) Repurchase Agreements (Repos)

They include vertical Repos, reverse Repos and horizontal Repos.

Vertical Repos is where the CBK sells, through auction, of eligible securities to commercial banks. CBK is compelled to take such action when there the supply of money is high and there is need to reduce liquidity by taking out excess money. Such sale ensures CBK has reduced commercial banks deposits held at the CBK. Repos have fixed tenors. They range between 3 and 7 working days.

There may be instances when money supply in the economy is low. Liquidity needs to be improved. In such a case, CBK applies the Reverse Repo. This is where the CBK purchases securities from commercial banks. In such purchase it supplies them with money. The current tenors for Reverse Repos are either 7, 14, 21, and 28 days.

Lastly, there is the Horizontal Repos. This is not a typical monetary policy instrument. It is more of a mode of improving liquidity distribution between commercial banks under the supervision of the CBK. Commercial banks agree to lend to each other on short term basis on negotiated tenors and yields. They generally use government securities as collateral.

A bank in short of deposit required to be kept overnight at the CBK will borrow from others with excess deposits, mostly on an overnight basis. The CBK monitors, but rarely intervenes, in the overnight interbank borrowing. However, where there is tightness or slackness in horizontal repo, CBK will intervene through other tools at disposal.

b. Term Auction Deposit.

We have seen that Repos are short term instruments. There are times, when securities held by the CBK for Repo purposes are exhausted. Further, certain market conditions may compel the CBK to offer long tenor options of more than a week or up to one month. Instead of vertical repos, the CBK will seek to acquire deposits of commercial banks. These are the term auction deposit. At maturity, they revert to respective commercial banks.

  1. Central Bank Rate (CBR)

Central Bank Rate is the most visible and the key monetary policy instrument. It is the base for all monetary policy operations. The Monetary Policy Committee (MPC), a specialised arm of the CBK, is tasked with setting and reviewing the CBR. The MPC reviews the CBR at least every two months.

Movements in the CBR, both in direction and magnitude, signal the monetary policy stance. We will illustrate.

When CBK is injecting or withdrawing liquidity through reverse and vertical Repos, the CBR, is the interest rate applicable in buying or auctioning bids. Only on Term Auction Deposits, where we have exceptions, for in practice, we have seen CBK offer rates higher than the CBR on term auction deposits.

The CBR is the base rate for commercial banks’ lending interest rates and deposit rates banks should offer on interest earning accounts. This edict was introduced by the Banking (Amendment) Act, 2016, which came in force on September 14, 2016. The amendment set commercial bank interest rate on lending to customers at CBR+4%.

Before the Banking Amendment Act, banks’ lending interest rate was pegged on Kenya Banks’ Reference Rate (KBRR) + k. Banks were left with the onus of allocating constant K, according to their estimation of credit worthiness rating of the borrowers. Mired in greed and walloped by myopia, banks abused the discretion by skyrocketing interest rates in chase of supernormal profits. The formula was statutorily discontinued.

But then, the history of Kenya’s CBR is mixed. Once upon a time, that being the year 1992 or thereabouts, CBR was as the high of almost 76%. The economy was on the verge of collapse after Goldenberg looting. CBR will again run amok during the tenor of Njuguna Nd’ungu as the CBK chief.  It was set at the high of 18%. At the date of this article, CBR is at 10%, where it has stabilised for months.

A reduction of the CBR signals easing of monetary policy. It shows a desire for market interest rates to move downwards. Lower interest rates encourage economic activity. It stirs growth. When interest rates declines, it promotes credit creation.

  1. Overnight Discount Window Facilities

There is a requirement, that commercial banks must ensure certain amount of their deposits “sleeps” at the CBK, every day. A times, banks may not have sufficient deposit to ensure compliance. They could borrow from other banks in horizontal repo. What if they are unable to raise deposit through this repo?

CBK is the lender of last resort. It will come in to provide secured loans to such a commercial bank on an overnight basis. The facility is referred to as the Discount Window. This lending will be at a penal rate over the CBR. Discount window could be traced from the Bagehot’s rule. Bagehot called that in times of financial crisis in a banking institution, central banks should move quickly to “lend without limit, to solvent firms, against good collateral, at high rates.”

CBK reviews rules for access to the discount window from time to time. Banks that make use of this facility more than twice in a week are closely scrutinized and supervisory action may be taken. It is no surprise therefore; banks ordinarily prefer horizontal repos to discount window facilities.

  1. The Cash Reserves Ratio (CRR)

The CBK Prudential Guidelines require commercial banks to maintain certain cash reserves. These are maintained as deposits with the CBK at no interest. The reserves are in proportion to a commercial bank’s total deposit liabilities.

Currently, CRR is 5.25% of the total of a bank’s domestic and foreign currency deposit liabilities. CBK, recently, changed its policy. It now requires commercial banks to maintain their CRR based on a daily average level from the 15th of the previous month to the 14th of the current month. However, it should not to fall below a CRR of 3% on any day.

The banking industry is undergoing changes especially when the Basel III standards on bank regulation are adopted. Basel III is comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision.

Their aim is to strengthen the regulation, supervision and risk management of the banking sector. Their adoption will necessitate the review of CRR requirement, as CBK will move to enforce more of risk based supervisory mechanisms such as requirements for constant stress tests.

  1. Foreign Exchange Market Operations:

CBK may inject or withdraw liquidity from the banking system through foreign exchange transactions. For instance, a sale of foreign exchange to banks withdraws liquidity from the system, as the central bank takes local currency from banks.  On the other hand, a purchase of foreign exchange injects liquidity into the system.

Why would the CBK participate in the foreign exchange market?

A domineering motivation is usually the need to acquire foreign exchange to service official debts. Further, central banks need to build-up foreign exchange reserves in line with statutory requirement. The CBK, in practice, strives to maintain foreign reserves equivalent to four months’ of cover. This is as recorded and averaged for the last three preceding years.

Foreign exchange reserves in Kenya have averaged $4089.54 million between 1995 and 2017. The reserve as at the date of this article is at highest of $11,143.76 million four months of cover.  But there was a time that was in November 1995 when the reserve was at a low of $853 million. The trigger was political climate at the time that led the country being starved of donor aid.

Once in a while, you will see the CBK intervening in the exchange market to stabilize it in cases of excess volatility. As a matter of practice though, and Kenya being a market economy, the CBK does not defend any particular position in shilling trading.

To support the stability of the exchange rate, Prudential Guidelines have offered CBK various arsenals of regulating the Forex market. These are:

  1. The tenor of swaps and Kenya Shilling borrowing where offshore bank is involved is limited to a tenor of not less than one year.
  2. CBK limits the tenor of swaps between residents to not less than seven days.
  3. Requirement that reduction of the foreign exchange exposure ratio of core capital from 20% to 10%. Further, the foreign exchange limits should not exceed the 10% overall limit at any time during any day.
  4. Lastly, there is a requirement that local banks must obtain supporting documents for all transactions in the Nostro accounts of offshore banks.

Forex trading, in recent years, has moved to online platforms. The online traders have for long been unregulated. The Capital Markets Authority (CMA) has taken up the licensing and regulating role of the foreign online Forex traders.

It is not clear why the CMA had to take up this role. It is true currency swaps and options are derivatives instruments classifiable as capital market instruments. Nevertheless, currency trading is generally a money market arena, of which it ought to have been the CBK to prefect.

  1. Other CBK Monetary policy Roles

CBK has other roles which influences the monetary policy.

It licenses financial institutions. It uses this licensing and supervision tools to ensure stability and efficiency. This includes vetting potential managers for suitability, both with respect to qualifications and character, before they take up managerial positions with the banks. In fact, Prudential Guidelines have made it mandatory for vetting of directors of commercial banks to ascertain their suitability.

CBK is the regulator of the National Payments System. Since the enactment of the National Payment Act 2014, Kenya has kept on modernising the National Payments System. This has led to lowered transaction costs. It has further improved the effectiveness of monetary policy instruments. It is the CBK that ensures these payment systems operate without major disruptions and in line with the specified regulatory legal framework.

CBK controls communication in the banking sector. Chase Bank (in receivership), was brought down by amongst other things, social media negative frenzy that triggered a bank run. In the spearheading of communication role, the CBK ensures dissemination of monetary policy decisions and background data.

This increases the efficiency of information transmission and managing expectations.  Patrick Njoroge, the current governor, has been holding regular governor’s Press Conferences on monetary policy decisions. The CBK website is fairly well maintained with constant updated.


In conclusion, Kenya’s monetary policy tools are conservative. Elsewhere, central banks have adopted some other unorthodox instruments such as helicopter money. We shall look at some of these in our next monetary policy paper.

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