PROJECT GROUP 2

CHAPTER 1
1.1 BACKGROUND
The strength of the Kenyan shilling vs the United States dollar has always been of great
importance and interest to policymakers, investors, economists and even the general local
population. The government of Kenya usually implements policies that greatly affects the
exchange rate between the two currencies.
A country’s exchange rate is greatly influenced by the policies adopted by its
government. Other than fiscal policy, monetary policy adopted by its Central Bank
greatly affects the home currency strength vs foreign currencies. This is done mainly by
adjusting interest rates and managing of foreign exchange reserves. In Kenya, the Central
Bank of Kenya (CBK) is the entity responsible for managing monetary policy. In 1993,
the CBK introduced the Managed Floating Exchange rate system. This system allowed
for market forces of supply and demand to determine the exchange rate with occasional
interventions when necessary to prevent extreme fluctuations. This move was aimed at
enhancing market efficiency and attract foreign investment but the downside was that it
exposed the strength of the shilling to external shocks such as changes in global financial
conditions and commodity prices.
In 1995 the government of Kenya implemented the liberalization of forex controls. This
policy removed restrictions on foreign currency transactions locally allowing for
individuals and businesses to freely buy and sell foreign currencies such as the US dollar,
the euro and the yen. This move aimed to promote trade and investment by simplifying
forex transactions but unfortunately it made the shilling more susceptible to speculative
attacks, capital flight and lower demand outside its borders.
In the recent past, the government of Kenya has also enacted fiscal policies that have
greatly affected the strength of the home currency. In 2018, the government introduced
value added tax, VAT, on petroleum products with the hope of increasing revenue and
reduce the huge deficits in the budget. This instead ended up destabilizing the economy
temporarily, increase in fuel prices, high inflation and high cost of living. This led to
lower investor confidence in foreign investors which put pressure on the exchange rate.
Talking about trade policies, the government over the years has implemented policies that
promote exports while reducing imports aimed at improving the balance of trade and
reduce reliance on imports. Measures such as export promotion programs, import
substitution policies and introduction of tax incentives for export-oriented industries have
been put in place to boost exports. By doing this, the government aimed to increase forex
inflows and strengthen the shilling.
Governance, the current regime and political stability are other major factors that affect
the strength of any nation’s currency. Kenya usually experiences periods of political
instability during election season. One particular case in the recent past of extreme
political instability is the 2007-2008 post-election violence which led to a sharp
depreciation of the Kenyan shilling at the time. Periods of political stability generally
result in favorable exchange rates.

Fiscal policy and the exchange rate

Fiscal policy is a critical tool in managing the economy of any country. It is the
government’s use of taxation and spending to influence economic activity. It can be
expansionary, increase in spending and reduction in taxes, when the government wants to
boost economic activity or contractionary, reduction in spending and increase in taxes,
when it wants to slow down or lower economic activity.
Fiscal policy greatly affects the strength of a country’s home currency vs foreign ones. In
Kenya, policy adopted by the government greatly affects the strength of the shilling as it
may either increase or reduce demand for the Kenyan shilling abroad.
In 2018, the government introduced a tax amnesty program aimed at encouraging
taxpayers to declare their income and assets. This was part of the government’s efforts to
boost revenue collection and reduce deficits in the budget. The program had a positive
effect on investor sentiment and stimulated confidence in the country’s system of
governance and economy. This move stimulated some strength in the shilling vs the
dollar due to the enhanced investor sentiment.
Still in 2018, value added tax (VAT) on petroleum products was introduced which led to
an increase in fuel prices, higher inflation and higher cost of living. This change triggered
some depreciation of the shilling against major currencies including the US dollar.
The 2023 Finance Act in Kenya has ushered in notable shifts in the levying of a variety
of taxes, encompassing value-added tax, income tax, excise tax, fines, and charges, as
well as broad tax compliance stipulations. Among the new amendments in the act
include, removal of limitations on deductions for interest expenses on domestic debt,
creation of favorable tax framework for eligible property and intellectual income and the
debut of new income tax exemptions. Another key feature of the act is the introduction of
a three percent tax on revenue generated from the trade or exchange of digital assets
including cryptocurrencies and non-fungible tokens (NFTs). Withholding taxes have also
been imposed on rental income and services relating to sales promotion, marketing and
advertising. The value-added tax has experienced multiple alterations, including raised
rates on specific goods, exemptions for certain products, zero rating for specific supplies,
and a modified timeline for tax submission. In a similar vein, the excise tax has been
updated with changes in submission deadlines for certain excise duties, raised rates on
specific goods, and rate modifications for certain services. To bolster tax administration,
the Act rolls out a new digital system for tax invoices, penalizing non-compliance.
Additionally, a tax amnesty initiative has been launched to provide relief on penalties and
interest tied to outstanding main tax obligations before December 31, 2022.
However, the implementation of the Finance Act, 2023 had been temporarily halted by
Conservatory Orders issued by the High Court of Kenya on June 30, 2023. As a result,
the impact of these changes on the exchange rate remained uncertain at the time.

In the current year, 2023, aggressive taxation policy by the government has reportedly
scared away investors. Investors who would have invested in the country and others who
had already invested in the country are now selling their assets to fund investments in
neighboring countries such as Tanzania. This investor behavior has been one of the major
factors that have resulted in depreciation of the home currency against the US dollar by
over 17% so far this year.
While this is not a direct fiscal policy change, it's worth noting that external factors can
also influence the exchange rate. In 2022, the Kenyan shilling depreciated by 9% against
the US dollar. This was driven by high global crude oil prices and increased dollar
demand by importers.
Monetary policy and the exchange rate
Monetary policy involves management of money supply and interest rates aimed at
meeting macroeconomic goals of economic growth, stable and low inflation and full
employment. In Kenya the Central Bank of Kenya (CBK) is in charge of setting the
country’s monetary policy.

The CBK adopted the Managed floating exchange rate regime in1993 to manage the
value of the shilling against other currencies. A fixed exchange rate would have led to a
stable currency at the cost of flexibility of monetary policy. On the other hand the
floating exchange rate regime allowed for more flexibility in monetary policy but the
exchange rates of the shilling have been very volatile.
In 2015 the shilling was trading at Sh105.29 vs the US dollar in September which was the
first time the USD/KES rate had crossed the 100 mark. The CBK intervened to try and
stabilize the shilling against the fluctuations. However, despite its efforts, stabilizing the
exchange rate was still a challenge as the rate still hovered around 100 till the end of that
year.
The IMF in 2018 released a report stating that the shilling was overvalued by 17.5%. The
report claimed that this overvaluation was partly due to Kenya’s central bank periodic
interventions in the forex market which limited the shilling’s depreciation.
In July 2022 the CBK surprised markets by not raising the Central bank rate and
maintaining it at 7.50% after a half percentage point increase in May. Many analysts
expected further weakness of the shilling following this decision and true to their
analysis, for the whole of 2022, the shilling depreciated greatly against the dollar, it fell
by 9% to close at Sh123.4 per dollar, compared to Sh113.1 at the end of 2021.
The Central Bank of Kenya has also been preparing further reforms to its monetary
policy. The reforms aim to improve economic modelling, boost the interbank market and
develop education of monetary policy among interested members of the population. The
end goal with the proposed reforms is to foster economic growth, improve financial
market functioning and enhance effectiveness of monetary policy. Moreover, this could
improve attractiveness of Kenya as a destination for foreign investors hence boosting
demand for the shilling thus strengthening it.
In 2023, the CBK has made significant changes to its monetary policy stance. After going
up three times in 2022, the Central bank rate was hiked again in March 2023 to 9.50%.
This came after inflation remained stubborn and the CBK showed their commitment to
using a data driven approach to keep inflation expectations anchored. This series of
interest rate hikes, and the promise to do more, if necessary, are expected to lead to some
increased demand for the shilling since that would attract foreign investments into the
country if inflation expectations remain anchored. These policy changes however, it is
not possible to measure their exact impact on the exchange rate as there are other factors
at play that are affecting the exchange rate simultaneously.
1.2 PROBLEM STATEMENT
The US dollar vs Kenyan shilling exchange rate has experienced major fluctuations
within the past five years. Throughout most of 2018, the Kenyan Shilling showed
resilience against the US Dollar, with the exchange rate stabilizing at around 102 KES
per dollar (Guzman et al., 2018). This was majorly due to factors such as increased forex
reserves and improved economic and political stability in the country and mostly the
interest rates were low thus achieving exchange rate stability.
In 2020, the Covid pandemic on top of destabilizing global markets, mostly the economy,
the forex market was also not spared. The USD to KES exchange rate experienced
volatility during this period, reaching a peak of around 108.57 KES per 1 USD in
October 2020 (Feng et al., 2021). As the global economy started recovering from the
pandemic over the following two years, the exchange rate fluctuated yet again.
In May 2023, the exchange rate was around 137 KES per 1 USD, and it peaked at around
150.50 KES per 1 USD in October 2023 (Exchange-rates.org, 2023). Factors such as
economic indicators, inflation rates, and market sentiment influenced these fluctuations.
This factor devalued the dollar currency (Kartal et al., 2021). In April 2022 the CBK
(Central Bank of Kenya) issued a directive that ordered commercial banks to ration their
purchases of the US dollar following scarcity of the dollar in Kenya as a result
of disruptions in global supply chains. However, this strategy is not only ineffective but
also unsustainable in the long-term (Kiilu, 2018). Analysts at Cytonn, a prominent
Kenyan asset management firm, in their 2022 October USD/KES forecast wrote that they
“expect the shilling to remain under pressure in 2022”, “as a result of high global crude
oil prices, a persistent Kenyan current account deficit and rising government debt”
The aim of this research is to analyze the impact of government policies on the USD/KES
exchange rate in Kenya and to provide recommendations for mitigating the negative
effects of currency depreciation on the economy.
1.3 PURPOSE OF THE STUDY
The purpose of studying the impact of government policies on the exchange rate in
Kenya is to understand how governmental policies, which are the fiscal policy, monetary
policy, Trade policies, and exchange rate policies, influence the value of the country’s
currency in the foreign exchange market and enable businesses and policymakers make
informed decisions to manage and deal with political economic challenges related to the
exchange rate which plays a role in stabilizing the economy of Kenya.
1.4 RESEARCH OBJECTIVES.

a) To analyse the effect of monetary policies on the exchange rate.

b) To examine the role of fiscal policies on the exchange rates in Kenya.
c) To assess the impact of trade policies in the foreign exchange market.
d) To evaluate the influence of exchange rate policies on the foreign exchange.

1.5RESEARCH QUESTIONS.

a) How do different monetary policies, such as money supply management and interest
rates impact the exchange rate dynamics in Kenya?
b) How does the implementation of fiscal policies, including government spending and
taxation, influence economic signals and economic stability within a specific geostrategic
and economic context?
c) What is the impact of trade policies in the foreign exchange rates and how do these
trade policies influence economic variables such as balances of trade and stability in the
economy?
d) How do exchange rate policies, including fixed or flexible exchange rate regimes,
currency pegs, and managed floats, influence economic growth in a given country or
region, considering factors such as balances of trade, foreign direct investment (FDI), and
national economic stability?
1.6 Justification of study
Consider the following elements to assess the basis for researching the influence of government
actions on Kenyan foreign exchange:
1. Government policies have a big influence on the foreign exchange market, which makes the
issue relevant. Policymakers, companies, and investors may all benefit from knowing how
government actions impact Kenya's foreign currency rates.
2. A nation's economy is greatly influenced by its foreign exchange rates. Exchange rate
fluctuations can have an impact on inflation, interest rates, import and export costs, and general
economic stability. Evaluating how Kenyan government policies affect foreign exchange earnings
can be useful in determining how well these policies work to achieve the country's economic
objectives.
3. Examining how government actions affect foreign exchange may give decision-makers fact-
based knowledge to help them create sensible policies. It can assist in determining the
advantages and disadvantages of current policies and serve as a roadmap for the creation of
new ones that will support a competitive and stable foreign exchange market.
4.Foreign currency rates have an impact on investment choices, particularly for companies that
trade internationally. Businesses may make well-informed decisions about currency hedging,
pricing strategies, and market entry or departure by having a thorough understanding of how
government policies impact foreign exchange rates in Kenya.
5Studies on how Kenyan government policies affect foreign exchange can add to the amount of
information already available in the discipline of economics. It can offer factual data and
insightful analysis that policymakers, economists, and other scholars can utilize to better
comprehend the workings of the foreign exchange market.
1.7 SCOPE OF THE STUDY
This study will focus on the USD/KES fluctuations of over the past 5 years, from 2018 to
current, 2023. Instances and events that have led to significant fluctuations in earlier
years may also be mentioned for context, historical and comparison purposes.
This study will mainly focus on the effect of Kenya government policies on the
USD/KES exchange rate. Other factors affecting the exchange rate such as global
economic conditions and market forces may be mentioned but emphasis will be the local
government policies.
1.8 OPERATIONAL DEFINITION of TERMS
1.8.1 Foreign Exchange Rate
The Foreign exchange rate is the value of a country’s currency measured in another
currency, a foreign one.
1.8.2 Government Policies
Principles or laws set by a government to manage a country’s population and its
economy.
1.8.3 Balance of Payments
The balance of payments is a summary of a country’s transactions with the rest of the
world.
1.8.4 Foreign Exchange Market
The market where currencies are traded.
1.8.5 International Trade
The exchange of goods and services between countries.