Within its financial markets role, the Central Bank of Kenya implements monetary policy decisions, manages the country’s foreign exchange reserves and manages the government’s domestic debt.
Monetary Policy Implementation
Central Bank implements monetary policy using several instruments which include open market operations. For more information, click HERE.
Monetary Policy Implementation
Open Market Operations
The principal objective of Open Market Operations (OMO) is to maintain optimal liquidity in the domestic market guided by the prescribed monetary policy stance. The Central Bank of Kenya implements OMO through two main instruments, namely Repurchase Agreements (Repo and Reverse Repo) and Term Auction Deposit (TAD).
Repo and TAD are for liquidity absorption while Reverse Repo is for liquidity injection. These instruments are open to commercial banks only.
REPO (Sale of Securities)
Repurchase Agreements (Repo) are conducted whenever the CBK is mopping up liquidity from the domestic market to achieve the desired level of liquidity. The Repo transactions will involve sale of Government securities to the counterparty lending funds to the Central Bank.
OMO unit may conduct two Repo Sessions as and when necessary.
Term Auction Deposit (TAD)
TAD is an additional instrument to mop up liquidity from the Banking system. The facility is for tenors of 14, 21 and 28 days.
Reverse Repo (Purchase of securities)
Reverse Repo is for injecting liquidity into the Banking system in line with the deviations or shortfall of set monetary targets or as approved by the Monetary Policy Management Committee. Reverse Repo transactions involve purchase of Government securities by the Central Bank from commercial banks. Haircuts are however applied on securities to guard against any risks arising out of market and price movements.
Foreign Exchange Reserves
Foreign Exchange reserves held by the Central Bank of Kenya (CBK) are a national asset held as a safeguard to ensure availability of foreign exchange to meet the country’s external obligations, including imports and external debt service. The primary objective in the management of these reserves is therefore capital preservation.
The CBK Act requires the Bank to maintain adequate official foreign exchange reserves equivalent to the value of four months imports and manage them prudently.
The reserves are used for:
• Servicing government external debt and non-debt government external obligations.
• Intervention when deemed necessary to smoothen erratic movements of the exchange rates and CBK external payments.
• Acts as a cushion against external crises.
The size of official reserves serves as a confidence signal to potential investors, rating agencies and those contemplating capital flight.
To ensure prudence in the management of reserves, the objectives of CBK reserves management policy are: Safety, Liquidity and Maximisation of Total Returns.
The primary objective in the management of these reserves is capital preservation. With respect to income, the Department invests the reserves to earn reasonable returns while maintaining adequate liquidity.
Foreign Exchange Policy
The country currently pursues a free-floating exchange rate system. This implies that there is no predetermined rate at which the shilling exchanges with other currencies. Like the prices of other goods and services that are decontrolled, the forces of supply and demand determine the value of the shilling. The Central Bank may only step in to even out extreme and undesirable fluctuations in the shilling’s trading rate. Such volatilities may occur due to speculative activities in the market or when the market is not able to clear seasonal upsurges on either demand or supply.
The Central Bank of Kenya compiles indicative foreign exchange rates daily for use by the general public. These rates reflect the average buying and selling rates of the major participants in the foreign exchange market at the open of trade every day, thus providing a good indicator for any interested party on the value of the shilling on any particular day.
It is noteworthy that the rates provided by the central bank are only indicative and that forex dealers, i.e. commercial banks and forex bureaus, may apply varying rates on their forex transactions. It is expected that competition among the dealers will lead to reasonable/competitive margins being applied to forex transactions with customers.
Forex bureaus are licensed to cater specifically for the retail end of the forex market, meaning buyers and sellers of small amounts of forex, mainly in cash. Bureaus therefore often have favourable rates for this market segment when compared to commercial banks’ cash rates.
The commercial banks are more competitive when dealing with larger amounts of forex that are settled via telegraphic transfers using correspondent accounts abroad, and therefore tend provide finer rates for this market segment. Nevertheless, all forex deals are transacted on a willing buyer willing seller basis and are subject to negotiation between the forex dealers and their customers.
Government Domestic Debt
On behalf of The National Treasury, the Central Bank auctions and manages Government’s domestic debt. At the beginning of each fiscal year, the National Treasury determines the budgetary gap to be financed from the domestic market. The Central Bank then comes up with a borrowing plan which it implements through auctions of Treasury bills and bonds. In addition, the Central Bank manages the registry (Central Securities Depository) and maintains the database for domestic debt and contributes to the development of the secondary market for government securities. Commercial banks, pension funds, insurance companies and corporate entities, individuals or retail market also invests.
Treasury bills are short-term government securities which are purchased at a discount and mature over a specified period. Government of Kenya, through Central Bank of Kenya, issues (sells) treasury bills for 91, 182 and 364 days. Purchasing at a discount means that an investor pays less than the bill’s face value, then receives that face value after on the specified maturity date. For example, if an investor wants to purchase a 364-day Treasury bill with a face value of Kes. 100,000 at a yield of 10% per annum attracting a 15% withholding tax, he or she would pay Kes. 92,292.20 and upon maturity after 364 days, that investor would receive the full face (par) value of Kes. 100,000. Currently, the minimum amount one needs to have to buy treasury bills is Kes.100,000 and any amount above the minimum should be in multiples of Kes.50,000.
The 91 Day, 182 Day and 364 Day Treasury Bills are debt obligations issued by the Central Bank of Kenya, on behalf of the Kenya Government, for 3, 6 or 12 months at either a discount or face value, at a competitive auction on a weekly basis. At a discount means the instrument is sold to an investor at below the face value and then redeemed at maturity at the full face value. The difference between the discounted price and the face value determines the yield/interest earned. The yield on 91-day, 182-day and 364-day Treasury bills are the average 91-day, 182-day and 364-day discount rates.
Lenders use these average rates to adjust interest rates on loans and corporate bonds as economic conditions change. They then add a certain number of percentage points, called a margin, which doesn’t vary, to it to establish the interest rate you must pay or will earn in the case of a corporate bond. When the rate goes up, interest rates on any loans or corporate bonds tied to it also go up.
Over the Counter Trading Guidelines (OTC) for Treasury Bills
Treasury bills are not listed securities and thus the trading volume has been very low mainly due to the tedious manual process involved. To address this situation and create vibrancy in this market segment, the Bank embarked on an automation process for trading bills on a Deliver Versus Payment (DvP) model using the Over the Counter (OTC) platform.
In Kenya, treasury bonds are medium to long-term government securities with different maturity periods above 1 year. Investors buying Treasury bonds are loaning the government money for a specified period of time, which is the bond’s maturity period. With most bonds, investors receive fixed interest payments (coupons) every six months throughout that period of time, and at the end of that period they receive back the face value amount that they had invested. If you would like to purchase a Treasury bond, you must have a minimum of Kes. 50,000.
The types of Treasury bonds may be defined by the purpose, interest rate structure, maturity structure, and even by issuer. So far, the government has issued Fixed Coupon/Rate Bonds, Zero Coupon Bonds, Floating Rate Bonds, Infrastructure (Project Specific) Bonds, Restructuring/Special Bonds, and Amortized and Savings Development Bonds. The most commonly issued bonds are fixed coupon bonds, which have huge investor demand. Treasury bonds are issued monthly.
Fixed coupon Treasury bonds – Bear predetermined or market derived fixed coupon (interest), which is paid semiannually on the face value held during the life of the bond. When bought at a discount (required yield higher than coupon), investors benefit from discount (capital gain), which is critical for secondary market trading and regular interest payment.
Infrastructure Bonds – Proceeds are used to fund specific infrastructure projects specified in the prospectus.
Floating Rate Bonds – Pay semiannual interest based on a benchmark rate, for example average rate of 91-day or 182-day Treasury bills, plus some margin. They are on high demand in a high inflationary environment. The Government has not issued this type of bond since 2001, though most corporate bodies issue them.
Zero Coupon Bonds – Do not have fixed interest and investor’s return is only the discount amount equivalent to the yield quoted. Mostly short term and most taken up by commercial banks.
The term ‘yield’ in the context of debt markets refers to the annualised percentage increase in the value of a debt instrument. The percentage depends on the time of the instrument remaining to maturity such that for a bond t years to maturity, yield is represented as Y(t). For instance, a bond whose value increases by 10% p.a. is said to have a 10% yield.
A yield curve is a relationship between the interest rate and the time to maturity of the debt instrument denominated in a given currency. For the issuer, an interest rate is the cost of borrowing, while for the investor the rate represents a measure of return from investment.
The Kenya Government securities yield curve is derived from the relation between interest rates of Treasury bills/bonds and the time to maturities of bonds of different tenors. The interest rates for Treasury bills are the prevailing weighted average rates for 91-day, 182-day and 364-day papers, while interest rates for Treasury bonds are the average prevailing secondary market yields for bonds based on years to maturity. In a developing market, the estimation of the yield curve entails use of only a few known yields for certain maturities while yields for other maturities are estimated by interpolation.
For the investor, a yield curve is useful for understanding conditions in the financial markets with an aim to seeking trading opportunities, measuring expected returns on bonds and acting as an indicator for interest rates and inflation expectations. For issuers, the yield curve acts as a benchmark for pricing other financial instruments in the market as well as predicting the yield/prices of future government issuances.