Beware of the bliss from capital flows

Generous monetary stimuli from central banks around the world following the global financial crisis have made financial markets flush with liquidity.

Frontier economies such as ours are experiencing large inflows of capital that has in most cases led to inflated asset prices and driven up exchange rates in some countries.

There is no doubt aggregate capital flows to Kenya are set to increase in the years ahead. The International Monetary Fund (IMF) has forecast net foreign direct investment (FDI) to Kenya will rise steadily in the next few years and hit $2 billion annually by June 2019.

Apart from the more permanent FDI, we are also attracting a lot of capital in the form of short-term portfolio flows. The challenge with a large presence of foreign portfolio investors in our capital market is the heightened risk of market reversal should these portfolio investors have any reason to exit the market.

A reversal of short-term capital inflows, in case of central banks in developed nations gradually moving away from their unprecedented accommodative policies, could lead to a sharp sell-off in equities, currency and bonds and cause a sharp liquidity crunch.

A portfolio reversal would lead to significant devaluation of the shilling as we try to stave off limited reserves and fight off speculators. As a country with a large import sector, a sharp devaluation in the shilling would create inflationary pressures. It would also make it difficult for us to service our foreign currency denominated debts including the recently issued Eurobond.

Short-term capital inflows, if left unchecked, can also make us prone to financial instability. Hot money flowing into the economy pushes up asset values. These assets are then used as collateral for loans.

The danger in this is that, without effective measures to quarantine these excessive portfolio investment inflows, they could easily hit our banking sector with the sudden pullout of money from our capital market, creating financial instability.

That is why we need a sound national policy to govern the entry, operations and exit of portfolio investments. There is no doubt that managing risks arising from a reversal of hot money requires adequate macroeconomic policies and sound financial supervision. In some circumstances, however, these alone are simply not adequate. We would need to deploy some form of controls to manage the flow of speculative capital so that it does not disrupt our long-run development prospects.

We should not forget what hot money did in the past to economies in Latin America, East Asia and Central and Eastern Europe. Capital flows are the biggest single cause of financial instability.

Even the IMF has had an ideological shift and now accepts the use of direct controls to calm volatile cross-border capital flows. The Fund now regards capital account regulations as part of the broader menu of macro-prudential measures that countries should be free to use to prevent economic and financial instability.

We should restrain vigorous inflow of short-term capital by making it harder for foreigners to play our stock market during these times of excess global liquidity. We need to review foreign holding limits and set minimum holding periods for assets.

To encourage long-term flows, investment by foreign portfolio investors (FPIs) in government securities, for example, should be allowed only in dated securities of residual maturity periods of at least three years with an overall limit for FPI investments in these securities set at levels we are comfortable with.

When capital flows abruptly reverses, we can then ease these equity and debt market limits and restrictions.

We should also consider other measures that will make our capital market less reliant on hot money for its growth. We need policies that will help encourage our own citizens abroad, for example, to channel money to the economy.

The Central Bank of Kenya (CBK) should consider exempting local banks from cash reserve rules for foreign-currency deposits from Kenyans in the diaspora.

Banks accepting non-shilling deposits from Kenyans living abroad should not be required to keep a certain percent of these deposits in cash reserves as is usually the case for other deposits.

These deposits should also be exempted from the Central Bank liquidity rules. In which case part of the deposit has to be invested in Government-approved securities and other high quality liquid assets.

This will encourage Kenyans abroad to channel capital that will be invested in productive sectors of the economy. We can also look at ways in which we can direct major part of pension and insurance money in the country into our capital market.

Pension funds such as those under NSSF and money from insurance can help deepen our capital market. They need to review the policies that restricts them to investing only a small percentage of their funds in equities. Targeted capital controls does not in any way mean we discourage investments.

It means we can discriminate between long-term capital that will help to deliver jobs and sustainable growth for us and the current short-term tsunami of speculative finance that has in the past wreaked havoc in other developing economies.