Navigating High Exchange Rates

Published on 12th October 2010

The currency war between China and USA provides an opportunity for us to rethink our currency- the Kenya shilling. While USA was busy fighting in Iraq and Afghanistan, China was busy buying US treasury bills and bonds among others. As of July 2010 report, China has over US dollar 2.1 trillions (Ksh 168 trillions) in these fixed markets.

Any more provocation to China may result in China opting to easily dump those US bills and bonds. This will create the largest economic disaster in the world. But it won’t take that path because its economy is export based hence a lot of care will be taken. 

Changes in the exchange rate can have a powerful effect on the economy. These effects however take time to show. There are time lags between a rise or fall in the exchange rate, and changes in variables such as inflation, GDP, exports and imports.

A high shilling value leads to lower import prices. This boosts the real living standards of consumers at least in the short run - for example an increase in the real purchasing power of Kenyans when traveling overseas for business trips, leisure, buying foreign goods and services.
 
When the shilling is strong, it is cheaper to import raw materials, components and capital inputs. This is good news for businesses that import components or wish to increase investment in new technology from overseas countries. Such businesses include the Kenya Power and Lighting Company (KPLC), Bidco, Kengen, and airlines.

A strong exchange rate helps to control inflation. Domestic producers face stiff international competition from cheaper imports and will look to cut their costs accordingly. Although cheaper prices of imported foodstuffs have a negative effect on the rate of consumer price inflation, cheaper imports lead to rising import penetration and larger trade deficit. A case example is the Kshs 20bn trade deficit in goods in the late 80s that saw firms such as Kisumu Cotton Mills (KICOMI) and Rift Valley Textiles (Rivatex) go belly up.
 
When exporters lose price competitiveness and market share, this damages profits and employment in some sectors – notably in the manufacturing industry. A fall in exports has a negative impact on economic growth.

It should however be noted that business can adapt to a high exchange rate. There are ways in which industries can adjust to the competitive pressures that a strong shilling will impose. Some of the options include:  
 
* Cutting export prices (lower profit margins) to maintain competitiveness and market share

*  Seeking productivity/efficiency gains to keep unit labour costs under control

*  Investing resources in new product lines where both domestic and overseas demand is more price inelastic and less sensitive to exchange rate fluctuations. This involves producing products with a higher income elasticity of demand, where non-price factors are more important in securing orders and moving production in areas that are assumed to have low labour costs.

By Gibson Amenya
Enigma Consultants (Kenya) Limited.


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