CENTRAL BANK OF KENYA

MESSAGE FROM
HIS EXCELLENCY THE HON. DANIEL T. ARAP MOI, C.G.H., M.P.,
PRESIDENT OF THE, REPUBLIC OF KENYA
AND COMMANDER-IN-CHIEF OF THE ARMED FORCES

The Central Bank of Kenya commenced operations on 14th September, 1966. Its establishment was a major step towards our independence in monetary affairs. Since that time, the Bank has expanded troth in staff anal in the diversity of its functions. Today, it is one of the vital institutions in the management of our national economy.

On this occasion of its Twentieth Anniversary I want to thank the Bank's management and staff for their devotion to service which has enabled the Central Bank of Kenya to make such a significant contribution to the economic growth and stability of our country.

D. T. ARAP MOI,

THE PRESIDENT,
REPUBLIC OF KENYA.

State House,
Nairobi.
September, 1986.

MESSAGE FROM
THE MINISTER FOR FINANCE
HON. PROFESSOR GEORGE SAITOTI, E.G.H., M.P.

The Twentieth Anniversary of the Central Barlk of Kenya is a significant occasion in the history of Kenya's economic development. In the last twenty the Central Bank of Kenya, in collaboration with the Treasury, has played a major role in the formulation and conduct of Kenva's monetary policy and overall management. The Bank will continue to play an even more prominent role in the future as the demands of the economy and the financial sector in particular become more complex and diversified.

On this happy occasion of its Twentieth Anniversary I would like, therefore, to congratulate the directors and staff of the Central Bank of Kenya for the efficient manner in which they have discharged their responsibilities.

MINISTER OF FINANCE

THE TREASURY,
SEPTEMBER, 1986.

PREFACE

Since its establishment in September, 1966, the Central Bank of Kenya has carried out its policy and administrative functions, in addition to acting as the national centre for collection of data and general information in the field of money and banking with steadily increasing competence. The Bank has disseminated information on its policies and activities all a regular basis through its Annual Reports, the Quarterly Economic Review, and the Central Bank of Kenya Staff Papers.

The evolution of the Central Bank over the years has created a need to improve further public understanding of the objectives, functions, and operations of the Bank and the manner in which they have been carried out during the past twenty years of its existence. I have much pleasure, therefore, on the occasion of the Bank' s Twentieth Anniversary, to release to the public this special book which describes the functions and operations of the Bank in various fields since its establishment in 1966.

During the first twenty years of the existence of the Bank, a comprehensive structure of financial organizations has been established and continues to develop, thereby contributing to the growth of Kenya's economy. As can be expected in any country, there are bound to be some inadequacies as well as weaknesses in the financial structure but these are problems of youth and growths they are issues to be tackled in the years ahead.

I hope that the financial community and the genes al public will find this book useful.

PHILIP NDEGWA,
GOVERNOR

CENTRAL BANK OF KENYA
September, 1986.

INTRODUCTION

As we celebrate the 20th anniversary ofthe Central Bank of Kenya, we also mark the 23rd year of Kenya's independence as a nation. However, these milestones do not mean that we have now come-of-age or reached maturity. Both the nation and the Central Bank are in fact still relatively young, and while we have certainly cut our teeth on some difficult issues, much growth, development and learning still lie ahead.

This book describes the objectives and operations of the Central Bank. The Bank, like other central hanks around the world, is an institution like no other in the country. It is a creation of government with unique functions, such as managing the currency issue. Some of its responsibilities have a formal legal basis, while others have been acquired in a de facto way; and the ways in which it has exercised its powers have evolved and changed over the years, in some cases substantially, because of changes in the economy itself and in the approaches to public administration. To do its job effectively, the Bank needs to keep in close touch with developments in all sectors of the economy, and considerable resources are devoted to monitoring and analyzing these. This also means that the Bank is well placed to provide informed public commentary on economic developments, and continual efforts are therefore made to improve and extend the Bank's publications to help enhance public understanding. The most recent innovation in this respect has heen the introduction of the ' Staff Papers" series of publications.

This book continues that approach. It aims to describe both the role and the operations of the Central Bank, and how these have evolved over the last 20 years. The objective is to provide the general reader with some insights into what the Bank does, and why; and thereby to help to dispel some of the mystique which surrounds it. The Bank, is dedicated to pursuing the national interest, and it is important that its operations should be widely understood and, where necessary, debated.

However, the book is a short one: its aim is to be informative rather that authoritative. Inevitably the coverage of developments in Kenya and within the Central Bank is selective and not comprehensive. Other sources should be consulted for a fuller discussion of many of the topics: a bibliography of some of the main references on Kenya and the Central Bank is included in the book .

Kenya's economic experience prior to independence was not dissimilar to that of other colonies: production activities were rather narrowly based and had a strong agricultural bias, with the choice of specific commodities dictated by local conditions, the demands of the colonizing power, and the preferences of the settlers concerned. Infrastructural and human development were generally given little more than the minimum attention required to achieve the rather narrow objective of producing these commodities and sending them to the developed world.

To some extent. the winds of economic change had started to blow before ( or in anticipation of) independence. The change to self-government generally involved accelerating trends which had already started to emerge, and altering the emphasis given to different objectives, but there were few radical changes in the approach to economic changes in the approach to economic policy. Kenya is still, in fact, substantially dependent on the same small range of primary commodity exports as it used to be. Significant growth has occurred in the manufacturing, distribution and service sectors, but this has not led to any great diversification of the export mix. It has, in some cases, involved significant import substitution, but not always efficient import substitution.

Development of the financial sector has been particularly marked. The financial system plays a key role in the development process, through facilitating the efficient conduct and settlement of economic transactions, through the provision of advice and specialized financial services to businesses and individuals, and through mobilizing savings and directing these to profitable investment areas. Broadly speaking, there have been two phases in this development since indepencence: the 1960s were a period of rapidly increasing monetization of the economy (reflected in a strong rise in the ratio of the money supply to G.D.P.) and increased use of financial intermediation (shown by a rapid decline in the proportion of the money supply accounted for by the currency issue). In the 1970s these ratios stabilized, although the share of the non-monetary economy in G.D.P. continued to decline significantly. The most notable feature of the 1970s and 1980s has been the considerable diversification of the financial system particularly in the latter part of the period. In particular, there has been rapid growth in the number of institutions (both banks and non-banks, domestic and foreign), significant improvements in the branch penetration of the institutions, (in particular into the rural areas), some broadening of the range of financial services available, and presumably-increased competition. Considerable progress has also been make by financial institutions in achieving the aim of Kenyanization (both in ownership and staffing), although some local manpower skills are still in short supply.

Studies have noted that this institution-builing has given Kenya a high degree of depth in its financial system for its stage of development and it is certainly true that for all areas of the economy both access to and the quality of financial services have improved significantly. However, an important qualification is that the institution development process has not been matched by corresponding development in financial system will not reach true maturity until there are active primary and secondary markets for government and private debt securities, and also for equity securities. The government and the Central Bank are increasingly turning their attention to the best means to facilitate this third phase of market development, and a number of changes, both regulatory and institutional, will be necessary.

Perhaps, the largest growth and development has occurred in the government sector. In part, this has reflected the much greater emphasis being given to improvements in, for example, the health and education systems. However, it also resulted from the belief that the government's economic objectives could best be pursued by a substantial amount of direct involvement in investment and infrastructural development, in production of goods and services. Associated with this was the aim of building up a large, professional, and well-educated public service. However, the emphasis is now starting to change in this area, away from direct involvement and more towards creating the right environment for private sector activities to flourish. This is a major underlying theme of the government's Sessional Paper No . 1 of 1986 on Economic Management for Renewed Growth. In addition, the government has made it very clear that it will be increasingly scrutinizing the activities of government departments and parastatals to ensure that. it is getting good value for money from them.

Underlying these changes to the orientation of economic policy, which are now gaining momentum, is the growing realization throughout the nation that the economic environment is likely to remain difficult for the foreseeable future. The first decade of independence was marked by strong growth in real output, albeit from a very low base, but since 1973 the pattern has been more uneven. In fact, per capita real output has declined in all but two of the last seven years, and in 1985 was little more than 2 per cent above the 1973 level. The main conslraint on growth in recent years, as in most other developing countries, has been the balance of payments, which has shown a weakening trend due to deteriorating terms of trade and stagnant or declining export volumes, only partly offset by significant reductions in import volumes. The ultimate sources of this weakness can be partly attributed to unfavourable developments in overseas markets for primary commodities, developments which owe a good deal to restrictive trade policy actions by developed countries as well as to changes in the structures of both demand and supply for these commodities. These developments may be of a long-term nature. However, domestic conditions have also contributed to the deterioration in the balance of payments, and it is now vital that some dynamism be restored to production activities in general, and to export production and efficient import substitution in particular. The changes in the policy environment ale recognition that the welfare of the general population can be noticeably improved only through a resumption of rapid but sustainable economic growth.

Against this background, the role of the Central Bank has evolved considerably over its first 20 years. Its essential objectives have not changedÑthese are to maintain the external and internal value of the currency and to maintain stability in the financial system. Nor has there been any significant change in its relationship with the governmentÑ while the Central Bank of Kenya Act gives the Bank considerable formal independence, in practice in Kenya (as in many other countries) it has been accepted that the design and implementation of financial policies are best achieved through continual consultation and co-ordination amongst the different arms of government.

What has changed over the years is the choice of techniques to implement monetary policy, and the increasing complexity involved in achieving satisfactory monitoring and supervision of financial institutions in order to help ensure their stability.

These developments are discussed more fully in later chapters. However, some essential features of the monetary policy framework can be drawn out as an overview. For most of its history the Bank has relied on direct controls of one sort or another to influence the behaviour of financial institutions. The most important controls have been "price" controlsÑin particular, the exchange rate and (minimum/maximum) interest rates. These "price" controls however, were revised only infrequently as economic conditions changed. The ability of the Bank to exercise firm control over the quantities of money and credit was therefore significantly constrained. As a result there have been extremely large fluctuations in money and credit growth rates over the years, with consequent effects on inflation, real activity and the balance of payments. It is impossible to control money and credit aggregates, as well as interest rates and the exchange rate, for any more than a short period. The Bank nevertheless made efforts to achieve quantitative monetary control, through supplementary instruments such as liquidity and cash ratios, import deposits and direct controls on credit growth. These measures have, predictably, been only partly successful, and they have also had an uneven impact on the financial system and other sectors of the economy.

The situation is now changing. The exchange rate has progressively been administered more flexibly as time has passed, hut both exchange control and various trade policy measures are still required to support exchange rate policy, and the Central Bank is still the residual supplier of foreign exchange to the market. Movements in the balance of payments can therefore still have a substantial domestic monetary impact.

Increased flexibility in interest rates has been foreshadowed, and this is necessary, in particular, to give the Bank a greater ability to offset any unwanted monetary influences arising from developments in the balance of payments or the budget through market operations of one sort or another. Greater flexibility in interest rates will help to ensure the success of such operations, will contribute substantially to the development of the financial markets required to implement them, and will ensure that the effects of monetary policies are spread quickly and equitably throughout the financial system, rather than being concentrated at particular points. There should now tie sufficient competition in the financial system to ensure that financial institutions will not be able to use increased interest rate flexibility to take undue advantage of their customers.

These are developments for the future, and while the changing approach will need to be studied carefully and implemented cautiously, it will also need to proceed with determination if the fruits are to be realized.

CHAPTER 1 - OVERVIEW OF ECONOMIC DEVELOPMENTS IN KENYA

During the past twenty years, the economy of Kenya enjoyed satisfactory performance. Growth in real output averaged 5.0 per cent, substantially higher than the 2.2 per cent average for African developing countries. Population rose at an annual average rate 3.9 per cent, and consumer prices at an average rate of 10.1 per cent. Investment, as a per cent of G.D.P., fluctuated in a range of 18 to 30 per cent. Savings, as a percentage of G.D.P., remained stable at an average rate of 18.9 per cent. On the external front, the current account deficit of the balance of payments averaged around 6.5 per cent of G.D.P. varying with movements in both the volume and the terms of trade. The money supply grew at an average annual rate of 16 per cent between 1970 and 1985, although there were some marked fluctuations in growth rates during the period. Trends in the international economic environment, together with variations in domestic weather conditions, dictated, to a large extent, the tempo of activity during the review period. Charts 1-8 in addition to Tables 1-4 in the appendix provide statistical information on the major economic developments during the period.

Agriculture

Growth in real output was spearheaded by developments in the agricultural sector whose share in G.D.P. averaged 33 per cent between 1970 and 1985. Agricultural output reached a record level of 41 per cent of G.D.P. in 1977 following an upsurge in coffee and tea prices which encouraged production. Since that time, however, the share of agricultural output has followed a downward trend, moving from 36 per cent of G.D.P. in 1978 to 30 per cent by the end of 1985.

The decline was especially sharp in fiscal year 1979/80 and again in 1984 due to severe drought and unfavourable developments in the international prices for agricultural commodities. Real growth rates in agriculture, forestry and fishing did, however, remain positive except in 1979 and 1980 when they were negative, reflecting the devastating effect of drought during those years.

Although there has been increases in agricultural producer prices, the prices of agricultural inputs increased at a faster rate than agricultural cornmodity prices between 1980 and 1984. As a result the terms of trade of agriculture declined during the period. The volume of agricultural exports grew by 4.5 per cent per year with tea and coffee volumes growing at average rates of 7 and 4.3 per cent per year respectively. The livestock sector was heavily influenced by drought conditions and the intake of the Kenya Meat Commission thus tended to stagnate. In order to promote maize and wheat production, the government established, in early 1980, the Seasonal Credit Scheme under which farmers with at least four hectares of maize and wheat under cultivation would receive loans at concessional rates through government financed institutions for purchase of material inputs. In May, 1986, the Seasonal Credit Scheme was replaced by the Guaranteed Minimum Return (G.M.R.) scheme.

The government's efforts in supporting agriculture were focussed on the streamlining of marketing and pricing policies for agricultural. products and on the provision of adequate storage facilities. Incentives in the agricultural sector were maintained in the context of yearly reviews of producer prices. Producer prices for maize and wheat. for example, were raised by 82 and 64 per cent respectively in the four years ended in 1984. The increases helped provide crop surpluses in 1982 and 1983, allowing for some exports and the build-up of a strategic grain reserve.

Manufacturing

The manufacturing sector which accounts for 13 per cent of G.D.P. and about 14 per cent of total wage employment, grew at an annual average rate of 7 per cent between i966 and 1985, with the fastest growth occuring during the 1970 through 1980 period. There was a marked slow-down in growth after this period, stemming from increased oil prices and the consequent costlier imported inputs, and from drought which increased the cost of domestic raw materials. In addition, the collapse of the East African Community in the mid-1970s resulted in a loss of market for manufactured products, causing a slow-down in output. Despite the drought effects of 1979/80 and 1984/85, the manufacturing sector grew at an annual rate 4.4 per cent between 1980 and 1985. Manufacturing activity was dominated by food processing, petroleum refining, metal,transportation and beverage indtlstries. Though production in the manufacturing sector was generally influenced by import-substitution policies, there was a policy re-orientation during the period towards elimination of inefficient import substitution through increased trade liberalization and reduced tariff protection.

Domestic Investment

Domestic investment averaged 26.3 per cent of G.D.P. between 1967 and 1985. Due to favourable investment conditions, the period 1975 through 1980 experienced healthy growth in investment, rising from 18.2 per cent of G.D.P. to 30.1 per cent in 1980. After 1980, however, gross investment tended to decline, reaching 18.5 per cent of G.D.P. by 1985. This decline was occasioned by a general growth in domestic consumption which increased at an annual growth rate of 10.9 per cent. Domestic consumption increased by 24 per cent in 1985 alone; Investment activity was concentrated on rehabilitation and expansion of existing plants rather than on new investment.

Wage Employment

Wage employment grew at 3.4 per cent per year on average between 1967 and 1985, rising from 596,400 persons in 1967 to 1,174,400 persons in 1985. Public sector employment grew faster at 5.4 per cent per year while private sector employment grew at 2.1 per cent per year.

The more rapid growth in the public sector arose mainly from employment in public corporations which in 1980 rose by 28 per cent. In 1985 private sector employment increased by 4 per cent while public sector employment grew by 6 per cent. The government continued to pursue a cautious stance in permitting wage increases in private sector. The wage guidelines formulated aimed at containment of inflationary pressures, and minimizing disincentives to employment creation.

Consumer Prices

Prior to 1981, Kenya maintained specific price controls on 23 basic consumer items, and discretionary price controls on other items which required that manufacturers and traders obtain approval from the price controller prior to adjusting their prices. In spite of the controls, however, consumer price inflation rose steadily from 1.6 per cent in 1967 to 12.6 per cent in 1981. In 1982 prices escalated further in line with-increases in energy costs, to reach a peak: inflation rate of 27.3 per cent. There was also a general increase in food prices during that year. Between 1983 and 1985, the government followed a restrained monetary policy stance which resulted in a decline in the inflation rate to 14.5 per cent in 1983 and 10.7 per cent in 1985.

Budgetary Developments The budget deficit, as a per cent of G.D.P., averaged 5.5 per cent for the central government and 5.7 per cent for the general government between 1972 and 1983. However, due to improved revenue collection and strict expenditure controls, the budget dew ficit has declined in recent years falling from a peak of 9.5 per cent of G.D.P. in 1980/81 to 5.1 per cent of G.D.P. in 1984/85. Between 1972 and 1982, total revenue for the general government was steady at an average of 22.9 per cent of G.D.P. while total expenditure minus repayments rose from 27 per cent of Ci.D.P. to 34 per cent. The Revel of grants remained persistently low at an average of 0.6 per cent of G.D.P. In 1979/80, total revenue increased from shs 1Z,603m to shs 22,018m in 1984/85 (see 'TaElle 2). There was a sharp glowth in the level of external grants between 1983/ 84 and 1984/85 due to increased donor support following the devasting drought effects of 1984. In spite of the growth in revenue during 1984185, however, the budget deficit increased by 35 per cent to shs 4,638m due to substantial increase in 't1 capital expenditure by the government. This large deficit was financed by shs 939m from extertial sources and by shs 3,649m from domestic sources. As well as making efforts to reduce budgetary deficits, the government financed a greater portion of the budget through the relatively less inflationary non-bank credit. Between 1980/81 and 1984/85, government sales of Treasury bills to non- banks increased substan tially. AS a result the share of QOnbank financing of the 'bUer cent. In 1985, central government external debt amounted to shs :30,85Cim of which I.M.F. debt was shs 7,391m. Multilateral lenders accounted for 48 per cent of total external debt in 1984 compared with just 30 per cent in 1980. At the same ti ne, there was reduction in exposure to international cornEnercial banks as the level of coma mercial borrowing declined from 3() per cent of total external debt in 1981 to 17 per cent, reflecting the repayments of two Euro- currency loans tetalling IJS 8315m which were contracted in 1979 and 1981. ache level of bilateral titans fell from 48 per cent in 198Q to 29 per cent szf total external debt in 1984. 'Rhe bulk of the eountr.y,'s debt was Contracted on concessionary terms. There was a steady growth in private non-guaranteed debt which rose from shs 625m in 1970 to shs 6,616m in 1983. Domestic Debt Outstanding domestic debt, excluding short-term borrowings, grew at an average annual rate of 15.3 per cent, rising from shs 1,760m in 1972 to shs 12,840m in 1985. Reflecting a sharp increase in the government deficits, domestic debt increased sharply by 36 per cent in 1978 and by 49 per cent in 1983. The large deficits during these years were occasioned by a sharp increase in government expenditure. There was also an increase in nondefence expenditure associated with higher petroleum costs, and emergency expenditure related to the importation and distribution of maize and wheat fo'r drought relieve during 1979/ 81. After 1983, the entire increase in domestic deficit financing took the form of Treasury bills. As a result the proportion of long-term domestic debt to total debt fell from 45 per cent in 1980 to 30 per cent in 1985. Balance of Payments Since 1967, Kenya's external position has exhibited sharp fluctuations, caused mainly by movements in the terms of trade. A combination of other factors have also been at work, among them extreme climatic variations, severe external shocks, unstable export prices, and a growing debt service burden accompanied by a general~~decline in concessional capital inflows. Adjustment programmes'were therefore undertaken from time to time to eliminate payments disequilibria and restore external viability. The measures taken invariably included pursuit of domestic price stabil ity to improve the climate for investment, control of budget deficits to curb inflationary pressures and to ensure that more productive resources were channelled into the private sector, maintenance of realistic exchange and interest rates to improve the allocation of resources and promote growth, and continual review ot government expenditure, both current and capital, to ensure that resources were productively employed. Between 1967 and 1985, the current account deficit of the balance of payments averaged 6.5 per cent of G.D.P. The deficits were sustainable up to 1969 as they could be financed by capital inflows during the period. However, after 1970, several balance of payments crises emerged. The first major balance of payments difficulty surfaced in 1974 following the first round of sharp increases in the price of crude oil. There was a large deterioration in the terms of trade with import prices rising by 61 per cent over 1973 while export prices rose by only 30 per cent. The current account deficit worsened from shs 934m in 1973 to shs 2,240m in 1974, reflecting substantially higher import values. As a result, the overall balance moved from a surplus of shs 234m in 1973 to a deficit of shs 442m in 1974, as shown in Table 3. In reponse to the large deterioration in the balance of payments in 1974, the government instituted measures to restrain import demand and, in 1975, the current account improved substantially. Subsequently, an improvement in the terms of trade led by sharply rising prices in the world markets for coffee and tea, the balance of payments improved further in 1976 and 1977 registering a record surplus of shs 2,249m in 1977. 12 The second major balance of payments difficulty occurred in 1978. During this year, world coffee and tea prices fell sharply and there was a large increase in import demand resulting from the export boom of 1976/ 77. Consequently, the terms of trade deteriorated by 25 per cent, leading to a massive deficit on the current account. This deficit, partly offset by a large increase in government longterm borrowing, resulted in an overall balance of payments deficit of shs 1,558m. The introduction of an advance import deposit scheme and the subsequent fall in import demand, offset a further deterioration in the terms of trade in 1978. The current account deficit therefore improved from 12.4 per cent of G.D.P. in 1978 to 8.2 per cent of G.D.P. in 1979. There was, consequently, an improvement in the overall balance of payments to a surplus of shs 1,431m. The improvement in 1979 was also attributed to higher long-term and short-ter'm capital inflows as importers of certain goods were required to negotiate 91}-180 days credit from their foreign suppliersb In 1980, the country suffered severe balance of payments difficulties: the terms of trade deteriorated by 9 per cent owing to steep rise in oil prices and to a further declined in coffee and tea prices; and export volumes den dined due to the effect of drought which reduced agricultural output. In addition, foreign exchange reserves declined sharply due to heavy import payments following the relaxation of the import deposit scheme. As a result, the basic balance recorded a large deficit of shs 2,512m. In view of a precipitous decline in the level of foreign exchange reserves following these developments, the 15 (Sentral Bank slowed down the approvals of foreign exchange allocations in late 1980 through a new import system which was introduced to facilitate licensing of imports on a priority basis. Further, as part of the strategy to increase non- traditional exports, ' the government decided with effect from July, 1980 to revise the Export Compensation Scheme which had been in existence since 197S, by raising the rate of compensation from 1() to 20 per cent. There was also an attempt to increase the competitiveness of Kenya exports through the depreciation of the Kenya shilling in February, 1981, from Kshs 9.66 to the S.D.R. to Kshs 10.15 to the S.D.R. In 1981, the current account deficit of the balance of payments declined to 11.1 per cent of G.D.P. from 12.5 per cent of &.D.P. in 1980. The improver ment, resulting from a substantial reduction in the value of imports, occurred despite a further deterioration in the terms of trade. The decline in import values refle&ted substantially lower government imports and a decline in import demand as domestic stocks were reduced. The volume of merchandise exports also declined reflecting a ' sharply lower volume of petroleum exports and a decline or stagnation in tea and other exports. The terms of trade worsened further through a 3 per cent increase in export prices against an 11 per cent rise in import prices. There was also a decline in all categories of capital inflows resulting from lower disbursement of public longterm loans, a sharp drop in suppliers' credits, and tine absence of drawings from the structural adjustment loan which had bolstered capital inflows in 1980. As 'a result, the balance of payments deficit stood at shs 1,985rn in 1981, of which shs 275m was financed by net purchases from the I.M.F. Gross official reserves declined to shs 2,575m, equivalent to six weeks of imports. In 1982, the country faced difficult balance of payments problems exacerbated by global recession. The economy suffered from a weak export sector and a highly restrictive import system. The growth of agricultural output remained below its trend level in part because of the difficult weather conditions in the early 1980s. The terms of trade worsened further by 4 per cent. There was, nevertheless, an improvement in the basic balance from a deficit of shs 2,844m in 1981 to a deficit of shs 2,480m. During the period 1983/84, the country experienced balance of payments surpluses which boosted official reserves from the equivalent of about 1.5 months of imports in 1981/82 to about 3 months of imports by the end of 1984. These developments were attributed to strengthened export performance arising from an increase in tea exports and from strong gains in receipts from non- traditional exports. The domestic and external policies in place during 1983/84 allowed for the liberalization of the import regime and the external payments system. They also allowed for the withdrawal of the advance import deposit scheme in January, 1983. Further, the payment of outstanding external remittances of profits, dividends and fees for 1981 and 1982 were effected. In June, 1983, a new import system was put in place to facilitate the easy flow of imports. The new Five-year Development Plan, which was announced for imple mentation beginning with the 1984/85 fiscal year provided the necessary impetus and success prospects for the adjustment efforts made in 1983/84. The plan aimed at a viable balance of payments position in the medium term, strengthening export performance and gradually improving the growth of real G.D.P. The plan also recognized the need to generate additional domestic resources for development and to maintain the overall budget deficit at a sustainable level, while ensuring adequate domestic financing for the rest of the economy. The growth prospects envisaged in early 1984, however, suffered a major set- back with the emergence of a serious drought in mid-1984. The "long-rains" failed to come and agricultural output collapsed. In addition to the sharp decline in grain, tea and coffee output, the livestock herd was decimated and dairy production severely disrupted. There was, consequently, enormous pressure on the budget and on the balance of payments. The government responded swiftly to the crisis by seeking increased donor support and by borrowing on commercial terms. As a result of the imports requirements for drought relief, the current account deficit of.the balance of payments rose from 2.3 per cent of G.D.P. in 1983 to 3.6 per cent in 1984. In 1985, the current account deficit of the balance of payments worsened in absolute terms but remained unchanged in relation to G.D.P. at 3.6 per cent. This reflected, in part, the sharp increase in food imports following the drought in 1984 and the decline in tea and petroleum exports which resulted from a fall in world prices for the two commodities. There was, in 1981, of which shs 275m was financed by net purchases Tom the I.M.F. Gross official reserves declined to shs 2,575m, equivalent to six weeks of imports. In 1982, the country faced difficult balance of payments problems exacerbated by global recession. The economy suffered from a weak export sector and a highly restrictive import system. The growth of agricultural output remained below its trend level in part because of the difficult weather conditions in the early 1980s. The terms of trade worsened further by 4 per cent. There was, nevertheless, an improvement in the basic balance from a deficit of shs 2,844m in 1981 to a deficit of shs 2,480m. During the period 1983/84, the country experienced balance of payments surpluses which boosted official reserves from the equivalent of about 1.5 months of imports in 1981/82 to about 3 months of imports by the end of 1984. These developments were attributed to strengthened export performance arising from an increase in tea exports and from strong gains in receipts from non- traditional exports. The domestic and external policies in place during 1983/84 allowed for the liberalization of the import regime and the external payments system. They also allowed for the withdrawal of the advance import deposit scheme in January, 1983. Further, the payment of outstanding external remittances of profits, dividends and fees for 1981 and 1982 were effected. In June, 1983, a new import system was put in place to facilitate the easy flow of imports. The new Five-year Development Plan, which was announced for imple mentation beginning with the 1984/85 fiscal year provided the necessary impetus and success prospects for the adjustment efforts made in 1983/84. The plan aimed at a viable balance of payments position in the medium term, strengthening export performance and gradually improving the growth of real G.D.P. The plan also recognized the need to generate additional domestic resources for development and to maintain the overall budget deficit at a sustainable level, while ensuring adequate domestic financing for the rest of the economy. The growth prospects envisaged in early 1984, however, suffered a major set- back with the emergence of a serious drought in mid-1984. The "long-rains" failed to come and agricultural output collapsed. In addition to the sharp decline in grain, tea and coffee output, the livestock herd was decimated and dairy production severely disrupted. There was, consequently, enormous pressure on the budget and on the balance of payments. The government responded swiftly to the crisis by seeking increased donor support and by borrowing on commercial terms. As a result of the imports requirements for drought relief, the current account deficit of.the balance of payments rose from 2.3 per cent of G.D.P. in 1983 to 3.6 per cent in 1984. In 1985, the current account deficit of the balance of payments worsened in absolute terms but remained unchanged in relation to G.D.P. at 3.6 per cent. This reflected, in part, the sharp increase in food imports following the drought in 1984 and the decline in tea and petroleum exports which resulted from a fall in world prices for the two commodities. There was, in addition, a decline in total capital inflows. Although the economy enjoyed a recovery in the service sector with tourism, transportation and inflows of official grants offsetting some of the current account deficit, there was, nevertheless, an overall balance of payments deficit of shs 1,719m. The adjustment programme for 1985 aimed at providing balance of payments support within a framework designed to maintain the underlying monetary and budgetary deficit at sustainable levels in the medium term. The programme aimed at reducing the fiscal and external current deficits to about 4 per cent of G.D.P. in 1986. It also provided for a real growth rate of about 5 per cent in 1986 rising to 6 per cent by 1990, The inflation rate was to be contained within 6-7 per cent per year throughout this period while domestic credit policies were to be adjusted in accordance with these objectives. The balance of payments outlook for 1986 is for a further narrowing of the current account deficit as the terms of trade are expected to swing in Kenya's favour. The value of petroleum imports is expected to fall substantially due to lower prices while coffee export receipts are expected to increase substantially over those of 1984 due to the increase in world coffee prices. Though the increases in receipts appear to be less marked than those in the 1976/77 coffee boom, there will nevertheless be significant short-term benefits for the balance of payments and also for the economy as a whole. Money and Banking The principal instruments of monetary and credit control used by the monetary authorities in Kenya^, were minimum cash and liquidity ratios, quantitative ceilings on the overall credit expansions of commercial banks, and guidelines for the sectoral allocation of credit. Limitations on the amount of domestic borrowing allowed to foreign- controlled companies were also used. Beginning in early 1979, the Bank also used advance import deposits which by Septe.~~mber, 1979, were equivalent to 5 per cent of the stock of money and quasi- money at the start of the year. The import deposit scheme was withdrawn in 1983. When compared to other developing countries, the Kenyan economy is well monetized in relation to its level of development. At the end of 1985, total financial assets which include currency outside banks, deposits of the banking system and government securities were 67 per cent of G.N.P. This reflects financial depth greater than that prevailing in many countries with higher levels of per capita income. Growth in banking system deposits has on average been slower than that of non- banks' deposits. Between 1967-85, banking system deposits grew at an average annual rate of 16.0 per cent while non-bank financial institutions deposits recorded a higher growth rate of 25.8 per cent. This was largely due to the interest rates differential between banks and nonbanks which enabled non-bank financial institutions to offer higher interest rates on deposits than banks. The financial system continued to expand with the opening of new private banks and non-bank financial institutions. At the end of June, 1986, the system consisted of the Central Banks 24 commercial banks with a network of 419 branches. Non-bank financial institutions stood at 50 with a network of 89 branches. The system also includes 32 building societies, 52 insurance companies, 64 hire purchase companies, a post office savings bank, 10 development finance institutions, private pension plans and over 900 savings and credit co- operative societies. Most of this growth in the financial system has occurred in the period 198>1985, when 9 banks and 31 non-bank financial institutions were licensed. Morley and Quasi-money Between 1967 and 1985, the growth in money and quasi-money averaged 15.8 per cent per year reflecting, in part, continued expansion and diversification of the financial system. The most rapid growth since the 1977 "coffee boom" was in 1982 when the money supply increased from shs 18,364m in December, 1981 to shs 21,324m in December, 1982, thereby contributing to the record increase in consumer prices of 22.3 per cent during that year. After 1982, growth in the money supply was reduced to more prudent levels through ceilings on overall credit expansion. Between December, 1982 and the end of 1985 the annual average growth sate was only 8.1 per cent per year. The low rate of growth in the money supply helped to limit the growth in inflation, notwithstanding the rapid growth in credit expansion (see Table 4). Much of the expansion in the money stock was in the quasi-money component which grew at an average annual rate of 18.0 per cent per year between 1967 and 1985. (currency outside banks plus demand deposits grew at a more moderate rate of 14.8 per cent. In 1985, quasi-meney grew by 12.6 per cent while demand deposits and currency outside banks, which had expanded by 9.8 per cent in 1984, grew by only 2.9 per cent. Domestic Credit Domestic credit grew rapidly, rising from shs 1.268m in 1967 to shs 31,380m in 1985. (government credit policy encouraged lending to priority sectors such as agriculture and manufacturing. Credit from non-tsaPk finan cial institutions expanded mere rapidly than that provided by commercial banks. Lending by non-bank financial institutions which stood at shs 242.m in 1967, grew on average at the rate of 24.3 per cent per annum to stand at shs 12,0941n in 1985. In comparison, commercial bank lending grew at a slower annual rate of 16.4 per cent from shs 1,360m in 1967 to shs 7,0,900m in 1985. As a result the share of non-bank financial institutions' lending rose from 15.1 per cent in 1967 to 3657 per cent in 1985. As indicated in Table 4, the government continued to receive budgetary support from the banking system particularly the Central Bank. At the end of 1985, bank credit to the government as a proportion of total domestic credit was 30.5 per cent compared to 1.6 per cent in 1969. Outstanding banks credit to the government in 1985 stood at shs 9,750m, out of which the Central Bank lent 84.5 per cent. Since 1982, there has been a slow-down in bank credit to government. The slow growth in recent years reflects the cautious stance in fiscal policy of limiting aggregate demand in order to reduce internal sslltl eAl{lnal psrssules while at the s.:tmk thile allofiAUing sufficient crc(lit to the l)l lvLile sector. lnterest Rates Up to 1980, the Central Bank's policy on interest rates aimed at keeping interest rates as stable as possible. However, because of the spiralling inflation which followed the 1973/74 oil price increases, interest rates became negative in real terms. In 1981, the Bank adjusted interest rates Upwards by about 2.5-2.5 percentage points in a bid to bring tne rates to positive real levels. This action raised the discount rate to l 2.5 percent during that year while the Treasury bill rates and the lending rate averaged 7.6 and 12.8 percent respectively. By end of 1985. the discount and lending rates rose to 13.9 and 14.0 percent respectively from their 1981 levels. Deposit and lending rates charged by non-hank financial institutions have traditionally been higher than those quoted by commercial banks and this is reflected in the differential in the Central Bank's interest rate controls. In 1983, the Central Bank began to re-inforce its surveillance over financial institutions, especially non-banks, with the aim of securing closer compliance with monetary policy requirements, in particular the methods used in computing interest charges. At the end of June, 1985, the Central Bank's minimum lending rate was l l percent. The discount rate was 12.5 per cent with advances against Kenya government securities being charged 12 per cent. The maximum lending rate chargeable by the commercial banks and the non-bank financial institutions was 14 and 19 per cent, respectively and the minimum deposit rate for both the commercial banks and the non-bank financial institutions was l l per cent. While the interest rate differential between banks and nonbank financial institutions was kept under review to ensure competition on equitable terms, the policy intention was to move towards interest rates determined by market forces. CHANTER 2 - OBJECTIVES AND FUNCTIONS OF THE CENTRAL BANK OF KENYA The objectives and functions of the Central Bank of Kenya are set out in the Central Bank of Kenya Act of 1966. The Act prescribes that the principal objects of the Bank shall be to regulate the issue of notes and coins, to assist in the development and maintenance of a sound monetary, credit and banking system in Kenya conducive to the orderly and balanced economic development of the country and the external stability of the currency, and to serve as banker and financial adviser to the government. The specific functions of the Central Bank of Kenya may be summarized as follows: the first function concerns the provision of banking services to the government and commercial banks and includes the issue of currency. The second function deals with services rendered to the government as fiscal agent, i.e. financing of budgetary deficits and managing the government debt. It also deals with services rendered to commercial banks, i.e. shortterm loans, advances, and rediscounting of bills. The third function concerns the external financing services rendered by the Central Bank which include the management of foreign reserves, administration of exchange controls, carrying out transactions with international monetary institutions, and managing the exchange rate of the Kenya shilling. The fourth function involves the supervision of commercial banks and non- bank financial institutions; and the fifth function is concerned with the role played by the Central Bank in management of the economy. These functions will be considered in that order in this and the subsequent chapters of this book. Provision of Banking Services to Cornmercial Banks A principal responsibility of any central bank is to supply bank-notes and coin to the economy. To discharge this responsibility satisfactorily. a central banlc ensures that there are always adequate stocks of notes and coins and that there is a satisfactory distribution system. the first stage in these arrangements is for a central bank to estimate the demand for the various denominations of currency notes and coin. This involves making forecasts of requirements for notes and coins and ordering supplies in good time before the existing stocks are exhausted. The next stage is the actual printing of the currencyÑa task undertaken using skills that make it very difficult for others to reproduce it accurately. This means that the materials used, the designs, and the actual manufacture of the currency require special expertise, sophisticated machinery and a high level of security. The Central Bank has the sole right to issue notes and coin in Kenya. The first major task the Central Bank had to face when it was established was therefore the issue of the new Kenyan currency notes and coin to the general public on the 14th September, l966. The task required careful planning and preparation for the new currency, design, description and denominations. The services of a number of financial intermediaries were used, and strict security arrangements were necessary to ensure orderly exchange. It was vital to secure the confidence of the public in the new currency. Initial issues of the new currency notes were made to all commercial banks well in advance of 14th September, 1966 at Nairobi, Mombasa and Kisumu. To assist the banks during the early period of exchange, the initial drawings were made on suspense accounts subject to their liquidation within two months of the formal date of issue. The new currency notes comprised the following denominations: shs 5, shs 10, shs 20, shs 50 and shs 100. The new notes were issued through the commercial banks against the exchange of the East African Board currency notes. By 30th June, 1967, the Central Bank had exchanged shs 300 million of the East African currency notes, whilst its own notes in circulation amounted to shs 360 million. The new national coinage of Kenya was released to the general public on the 10th April, 1967, in denominations of 5 cents, 10 cents, 25 cents, 50 cents, shs 1 and shs 2. The 25 cents and shs 2 pieces were new denominations and did not prove to be popular as had been hoped. They were subsequently withdrawn from circulation. In order to save the public any inconvenience, the East African Currency Board notes were allowed to remain legal tender until the 14th September, 1967 and coins until the 1st April, 1969 after which they ceased to be legal tender. However, they continued to be exchanged at the bank at par until 31st December, 1972, when they were finally demonetized. From 1967 to 1985 the structure of the Kenya currency remained virtually unchanged, except that between 1973 and 1980 there were no issues of shs 5() note. Over time, however, the purchasing power of all denominations became eroded by inflation to the extent that the present highest denomination note of shs 1()() is no longer of sufficient value for some transactions. This development led to a substantial increase in the turnover of shs 5 and shs l00 notes and a reduction in their average lifespan. In order to reduce the costs of replacing worn out and torn notes, the bank introduced a new shs 5 coin in October, 1985 to gradually replace the existing shs 5 note. Arrangements were also being made to introduce before the end of 1986 shs 200 note to take over some of the transactions performed by the shs 100 note. Most of the movements of currency from the Central Bank to the public and vice-versa take place through commercial banks. Currency flows from the commercial banks to the public when for example the government and other employers pay wages and salaries to their workers, and the marketing boards and other traders buy farm produce from farmers. The commercial banks obtain the currency they need from the Central Bank by either drawing down their deposits or by selling some of their monetary assets like Treasury bills to it. Later on, when farmers and workers use the cash to buy the goods they need from traders, the currency returns to the commercial banks when traders repay the loans they might have taken from commercial banks to stock up goods in their shops earlier, or when they deposit the currency in their commercial bank accounts. Similarly, when farmers and workers deposit their savings in their commercial bank accounts, there is a return flow of currency to commercial banks. The commercial banks return to the Central Bank any excess amount of currency which they do not required and thus build up their deposits. In this process, new or clean notes and coin go out from the Central Bank and dirty and worn out currency returns to it. In practice these inflows and outflows are all going on at the same time and, although there are fluctuations, the amount of currency in circulation tends to he fairly stable, around a steadily growing trend because of growth in volume of transactions resulting from real growth in tile economy, monetization of the economy and price increases. The amount of currency in circulation increasedfrom shs 48l m in December, 1967 to about shs 6000 m in June, 1986. Direct movements of currency between the Central Bank and the public also take place when those who receive payments by cheques from the government come to the Central Bank to cash them or those who have to make payments to the government towards taxes or other revenue pay them to the Central Bank. Since notes and coins are deposited in bulk by commercial banks, the central Bank maintains notes and coin counters whose duty is to count all the deposited notes or coins as declared by the commercial banks at the time of depositing. After checking, the notes are sorted into clean and unserviceable, and bundles of each category are then made. 'The clean notes are reissued while the others are destroyed. Apart from operating current accounts for the commercial banks, the Central Bank also provides them with other important facilities. One of these facilities is giving credit to commercial banks in time of need in accordance with the provisions of sections 35 and 36 of the Central Bank of Kenya Act. The Bank extends credit to commercial banks in two ways: first, by rediscounting, i.e. purchasing at less than face value bills of exchange, promissory notes or other eligible instruments; and secondly, by granting loans or advances against collateral of credit instruments referred to or negotiable security issued or guaranteed by the government. The Bank is specifically authoriztd to extend short-term credit to commercial banks in order to provide them with cash for three main purposes, namely (i) when they need such credit as a result of their having financed the export or import of goods or their transportation within Keny. (ii) Storage of non-perishable goods and products which are duly insured or deposited under conditions assuring their presevation in authorized warehouses or in other places approve by the Batik, all(l (iii) whell they need it because of thch len(iilig tor agriculttlral or industrial pro(ll.lctioll. 'I'he maturity period of the credit histru-melits from the thile they are purctlase(i by tile Bank and the fixc(i periods of the loans arl(l a(lv,lnces generally calin()t excoc(l () molitils. However, if the Bank finds it to be hl the hiterest of national econoinys it may accept cle(lit instruments Eating to agricultural arid industrial pro(ilictioll with m,ltilrity period of up to 9 months. Before a commercial leaslk is granted any credit facility by the C'cntral Bank it must deinolistr-ate that the liquidity shortage facing it is of a temporary nature and not a stalctul-al problem Which may arise due to under-capitalization For this purpose, the Bank. generally does not extend credit to commercial hank hi excess of its capital and unimpaired reserves. Furthermore, for a loan to be ex tended, a 10 per cent margin hetweeP the arnoulit of loan applied for arl(l value of fhiancial instrument securing the loan is required. Other factors that the Bank considers include the general financial condition of the commercial bank and the factors that led to the liquidity shortage. Unlike credit to government, credit extended to commercial banks Is not subject to any ceilings in tale Am tl~~lle reason is that the amount of such cre(lit, all(l the terms and conditions On which it is given, are important instmlments of monetary policy and hence are m(3ttcrs to be determined by the ( e ntlai caulk tram thne to time in the light at the needs of the particular situ;ltiell that exists and at the time. l he provisions in the sections relating to clctlit operations are, therefore, of all enabling mature i.e. they state the rmmner in which different types of credit can be given, leaving it entirely to the t entral Bank to determine the genes al tel- llls and conditions under which it extends credit to commercial banks anti the rates of interest it will charge thelll. These rates form an hlteglal p art of the interest rate policy of the ( entral Bank. ,Nnotllel important service rendered by the ( ertral Bank to commercial banks is the rllnllillg of the Clearing I I OllSC meclulllisln . T he Nairobi Bankers bleating House which is located in the promises of the l entry Bank is not a (lepartllle nt ot the ( entral Bank: it is a conrlmoll facility of the member banks. It was established to provide a COllVellient ImeClilJIlI for presentation anti settlenlellt of financial instruments such ,IS che(lues, drafts, payment orders drawn on Or payable to other members Before the Clearing l-louse was cstahlishecl banks ha Nairobi were settling their net receipts or payments once a month through courier service. l~he ( c ntral Rank took over the running ol the C healing l louse in Nairobi on 16tl} November, 1')66. A simihlr arrangement also exists in Mombasa, where the branch of the Central Bank has been operating the Clearing House tor the main branches of commercial banks in Mombasa and coast region shlce .lalluary, 1977. Membership of the Cleating House is open to ally bank which abides by the established rules of the Clearing House. Membership may be withdrawn if in the opinion of the Central Bank a member has not acted in the best interests of the Clearing House or in accordance with the established rules. Every member of the Clearing House is required to maintain sufficient funds in its account with the Central Bank to meet the net amount due to other members. When a member's account has insufficient funds, settlement with other members is rendered impossible and the membership to the Clearing House, inevitably, has to be suspended until sufficient funds are available in the account. The Clearing House is presided over by an inspector appointed by the Central Bank assisted by a representative elected by member banks. Provision of Banking Services to Government The Central Bank is by law required to serve as banker to the government and to act as its fiscal agent. In these capacities, the Central Bank is required, amongst other things, to perfonn the following dutiesÑ ((X) to be the official financial depository of the government, i.e. to accept deposits and effect payments on behalf of the government; (ll) to maintain and operate special accounts for the government; (c) as agent of the government, to administer the public debt, i.e. to effect the issuance, payment of interest on, and redemption of bonds and other securities of the government; (d) to pay, remit, collect or accept for deposit or custody, funds in Kenya or abroad on behalf of the government; (e) to purchase, sell, transfer or accept for custody, cheques, 25 bills and other securities for the government; (it) to purchase, sell, transfer or accept for custody gold or foreign exchange on behalf of the government. To discharge its responsibilities under these provisions, the Central Bank mahltains. on behalf of the Treasury, the Exchequer Account, into which all revenue is deposited, and the Paymaster- General Account, out of which all payments are made. The annual budget of the government is essentially a forecast of the revenues which the government expects to receive during the financial year and the expenditures it will incur on normal administration as well as in carrying out various development activities. There are many items in the budget which can be forecast quite accurately. But there are a number of others where the actual performance can differ from the budget forecast in varying degrees due to factors beyond the control or foresight of the government. Consequently, the final budget outturn may be quite different from the forecast and where, as happens frefiuently, unexpected expenditure exceeds revenues, it sometimes becomes necessary for the Central Bank to provide the finance for the excess. Apart from this overall problem for the budget over the financial year as a whole, temporary deficits or surpluses also arise during the financial year itself, because of the different timing of revenue and expenditure flows. Imbalances of both types are reflected immediately in the government's account at the Central Bank and so it is in a position to draw the attention of the Treasury to them. For this pur pose, there are five types of government accounts namely, Recurrent Revenue, Development Revenue, Recurrent Expenditure, Development Expenditure, and certain miscellaneous deposits and expenditures for special funds created in the budget. All ministries and government departments have Recurrent and Development Expenditure Accounts. As regards revenue, all receipts due to the government of Kenya are paid into a Consolidated Fund which forms the credit side of the Exchequer Account and from which no monies are drawn except when authorized by an Act of Parliament or by a Vote on account passed by the National Assembly. When the Treasury releases funds to the various spending units according to the votes sanctioned for them, the Exchequer Account is debited and the account of the ministry, or department concerned in the Paymaster- General Account is credited with the funds released to it. The Paymaster-General Accoutis debited when expenditures are made by the respective ministries or departments. The Central Bank can then watch the expenditures by these organizations and warn them as well as the Treasury in good time before the funds are exhausted. The Central Bank works out every day the overall position of the government by totalling the credits and debits recorded in all government accounts during the day. If the net result is a surplus it is added to the previous day's position, and if it is a deficit, it is subtracted from the position. The daily position is notified to the Treasury as soon as it is established. Lending by the Central Bank to the government is governed by a special set of r, rovisaons hl.>CiiUSC 01' tht hnpol talit w;wys nl v>~~hicil SUCtl Ientling tan ililIUt llC(' thc IllOnt'y supply. l tlcse arovisions ;wilow thc (:entroll 173;ltik to tyivt t() tilt gove I IllTlcrit .111 tylrcs of crc(hts i.e. short-tctm, (is weil as IflC(liUIll- ilt)d lon~~~,-tel m. l I(lWt'Vt'I, hol:h thc torms hl which cretlil tail hc givt.~~n all(l thc txtcat of cretilt hl thcse forilis al-c subject to ceiling,x lili(l (down in tht st;ltute. i',hort-lt rm tr~~.dit to th.t' gOVt rilNlbilt Cilil be m two ioril-ts, i.e. diiect iltlVancts, all(l purchis'e of'l'r(olsurv bills with ;.i matulity of l~~-ss thiill l' niorittis trom tht d,lt,: of issue Mcddiril an(i lorig-ttrill (rtdit t'im only Ie hl the form ol ncg,oti.ll)lt seculitics., i.c. those scturitic-s whicll t'.lil ht) h(!Ut'llt a,id sold hs a m.ll-ket iillkl wEllch mallllc later than I 9 montils troll) thc dolte ot losue. ()ther foi rns ot credit ¥ucil as ttilJl 1();^1ls 'kI(~~ Il()t ,llI¢>wt{{. Ilae: undtIlyin,~~ Idc a is that the ('eutral lialik ShOUl(9 lit' d!/lt to C'OlidllCt Op('ll market op; r ttioris hy using thcse st euritit s m ordel to infint n( t the rtlollcy StlPlli) - hc~~-lcc th. re(luircllBcllt that thc secllril.it s should t!(] neftoli;lble if thty .Ir~~ isstl(zi \ry tils fyoVv<¤vIIlitsilt an(l ncgotiolt)lt antt gtlaro,laltetll hy thc goverrilneilt it issue(l by publie antilol itics. IClo othcr type ol crc{lit carl h( fsiven lzy ttl,~~ ('vIlil-;~~l i3.1115~~ t~~) 81wt ~~,overrlllltnt citlu l- dil-cctly /51 indlrt ctly. I'htie .1l~~~ Ctwit:lill lil-viits regfil(lillyl credit from the C'tntrcil Bank to ,~~~ovtrnrncllt. In thC orig,inal C~~ross rccurrent revelilit of the frovtrnmerit as shown in tht Al)propriation Aecotints for the latest year for whie h such accounts h;.lv. heeil audited hy the Controller arl(l Au(litol-C:ien(} ll 1'11c Recurrent Rcvt lllle of thc ft(!Vt rnlltellt is defined to h1( IU(IC revt nllc Irorll taxes, cust<.!ms. tx(is(, tAxIrt)t-l (tal(i other duties, fee~~-, reilts. pr~~~fits and ineoine from ally invesill-lm-lt ol nn¢.lertsiking hut to t xchldz protb #. (.ls rl 0ns g1,l arlts or loans~~ ol any toinl t~~l horrowingn whether sholt or 101l,.v tclln. Managerlaent (,1' lhe Public l)ebt As t'iSC.Il a~~~,~~:*lit '~~7or tile ,goverilmerit, thte ('ciltial l'iank has the rc sponsit ility of mallil~~~illg the d¢.,lil(stic ptlblie deFt hy whi(.ll Is rnc.lut the (Ieht the fJoven~~mcnt has ineurr((l lo(~~ally hz the form ol' milikcial)lc (i e sicgotielble) securitit s. 'l'ht ('elitral B.lnk is not Ic(luired to hafidlc other lol-lils ot horiowing by tht govcrnane~~~t, sucil ts throtigh dirt ct loolils ft/)m priviltc poirties. 'lthcst ar-c lookc(l al'tot hy rilc 'T-reasufy. Mams,z,tmznt of the public debt involv~~.s issuirig govcrtilncalt securities, makiln~~. pcliodit p;lynltnts of interest 0'1 tht nl, r-cgiste rblg transfers, and rolling over and re(lecnling the securities. ln ad(litioll, thc ('cntral Bank milmigCS "Siliking funds" on behalf of thc 'I'rcolsul y . 'l''hc sinkilig l'unds are el-e.ttt(i hy the Treastlry t'or the purl)osc ot mecting re(itmption expenses at luaturity ot' some of thc stocks. The molley for these funds is contributed by thc l'rt asury scmi- >lililually and the C'entral Bank in lurn invests it in iltj!~~l;:~~l->; iiltlN ~~,t~~,(.0f.s (<:)1 <:X>tliei- lrolp<+l ) to s nat)ie the Iv~~it tile tilile <~~f t eCitalBltti()ll (4f- lhe sto(-ks l 90s?Crl1111ent sf zurities ;SS)Ie d 13Y tht ( 'criti-al i3ank eim t,e yl olil)e(t uncieltE'() i?l'(:)iI i catagories: short-teim. andt zxle (li;lill ot itill~~>-tet-nl. s~~E(wtilitivbs. SrI()U\- tt[I11 SCCU';t;j.''} (<)i1S;St ~~)f' fre~~~surx l~~i!,s U!StI1 ll1aRllID jt jeS (!; UT) tt) (3() >~~vs. ;u-,(l t~~~x l(.SCIV(' (Crt) jlC(itCS IhC rt~~irli)lluiTl l-Xe,I(thn.l I~~~r zui in~~~cslor in 'Iteasulv lDlils ,s shs llsl).,0()ii l'hc ( ciltrdl Bslilh erss El es t il~~tt tint (sinxlunts (~~l' 'Ti~letistlly lrillS (>,-It Ii (.t i'<,l tender (lse subscrihc(l af re;~~s~~)llalblt rates (~~f diseoulit. 1 he (~'eritt-;ll F'nl til( se intendirlL! to purell~~)sc tllf sc I,isls ancJ ail(wts theril tt~~ {flC ill, h.st hi(ldei .. '1't-~~is rneti-X~~)zi ensuies til.ucxcl- then hiivc t)cen ~~-;]!ller inslLtulli(;lllt in tcl-rll~~. Of voll.lllle Illl(t \ ;sIvIc As regards metliunl (A~~-M(.l i()n~~^- tern securities the masialgemSerit: ~~~f ,~~~overilr,ent st~~~ek wols tahen (~~ver i~~~ the Cc ntrill Bank In i')()() Thc ( 'elltral 9.X B ia?k. un(iertook to l-l;lildle (:ln hell.ilf e;~~f~ the 't~reiesury. neu sunseriptions keep the r(t~~ister eaf rioldels all(i servicc thc issucs. Suhse(~~lielltly. ii-le (~~entr.li Bank t~~~ok ovCI the task ot servieing, atl lrrevious issues ot' the govern lTiC'[lit . l-lie issumgr iin(f rcdeemillo of ~~,ovtrnlucllt st~~~cks is a continuous proc~~Ss Isstits AIr~~> nliltit ~~~htil fl,ll(is olr~~ lecl~~.llr(>(l Irsy lhc -I Ic;isury. (uld l't'(iClp~~? tI()lis v)r c()ll~~/elsi()lls f;iGl oll til. (1~~lte s~~/il~~~rl stocks Il;ltvTr~~> ~i~h~~> Elilil)villG of fisl;illdz tlic 00V't'1'111'l1t'114 (ltsii-cs to i'sAiSC ttnougil lhc is9uc ot securities is w()rkC(J out ;lt thc'time (u' pr<[raiinr tht imllu;~~l buuSct, 't tl. m;i jor inxes torh sucil as thc lNur)()li 1l ;< w (Xn kc eI out ~I'he C'cnlrosl lS;~~nh (~~d\ iscs thc ~f~l.as~~.Il-~~; er1l t}1v Ill;¢l:tllities ilit() wllich tlle t~~rt.~~l omu~~unt shoui(t hc split anci the ..tIlilFe84)liel1v i)ltz'lt".t I.ltt'S t(~~l tlle Ill;itUliliCS (iCllCr;llIV. tilreC ftlettUlltiCS .Irc .~~tl'ci-e(t: u^-) te) Acals: hetwccil > (~~>ltl !X! xe~~l~~t.: titl(l t)\t'r 1(} \'CillA. 'rhO ('cnlr.ll Btink ;~~ctivcls wneches tilc pse~~~^ rv~~Ss ¢~~t' tilv isstlcs t(X) ¥nsxJlc tliat the hilctpet cx^~~cctaltiolis ill c tulfilled as f;11 R()l OPERATIONS OF THE ('F,NTR AL BA!alli The foreign exchange and exchange control operations of the Central Bank of Kenya are activities designed to enable the Central Bank carry out its responsibilities of maintaining an adequate level of external assets; administering laws relating to controls on imports, exports, foreign exchange transactions and administering payments agreements between Kenva and other countries. Foreign Exchange Operations Historically, central banks have held reserves of external assets in order to safeguard the value of their currency Statutes of many central banks require them to hold reserves of such external assets at least equal in value to some fixed percentage of total currency issued by them or to aim at a certain target of foreign currency ha relation to a country's imports. Central banks hold these reserves to act as a buffer against adverse movements in the country's balance of payments with the rest of the world, and to maintain confidence of external solvency. All central banks hasc tnus to pay careful attention to both the composition and the overall level of their reserves. l ransactiolis in foreign excil.lnge take place throughout the year. Business houses alid marketing boards engage(l in agriculture, industry and trade as well as private individuals sell goods anti services to people overseas an(l also buy from thenl. All this involves receipts or payments which may be immediate or accruing at some future date. These transactions take place through the banking system. The transactions relating to the general public are carried out by commercial banks anal thz)sc ol the ~~~~ovt,rnlllelli by the (cntrdl 13JI1k IhT\\l \t1 S{}l11C thlles commcl t lJi h.~~nl~~s ills Alamo <.~~llcd UPOn tO eYeCU{K S(811U '()\ LllU1ECI1~~ transactions lol reasons ,)1 (;lsn~~~~ l X ~~A. ; i~~~,0 ilil)t' 't:st~~Ptl',~~ 8:uf llwis stz'l'.l[)4'q'll~~v'til fi ...s-; i..4i .,. 1N,~~:~~ i!''s~~)i?!'ti'ilt (.(311t{1 tititl'.' i;- .t, ~~B~~ ;;~~ ';1.E?' ~~,; ~~.- 81 ?41 z .i gOVCUllmCilt l.U LIt~~'t.ii-gUh'.l'' d l¤ali' lli.'?8 lities in ordtr ~~t} lri+s~~X(lw heruidlt t'intllsc~~~ z* .~~l3.lnsioll il) ilklzSlllLltio tfat'ie asl(l i41V~~>;Ixw<-lit, .iflel st totle!, tilt WilIiriglAr'ss v)1' COlililrlv s) ~~N jtlX [).tlttil(:z' of pa)ments su^-lilus to .1<:4 u;liljL:.Ilg dollars as l't SttNi .issCis. ('OlIllLt!t-h wish p4- rsistent h.llLilttct 0e t).i)'lilt'ntS det'icits werc sulrilosedi to Isa~~~lse nl.Xct< ,cconorlie adjustm4 nts withol!a ih.iliging tL:eir ex~~.hLIlzfe r.itt-s. '1~'slesl z01l4.1it.I(]~~lS ci)til~~l 1lv,l: b. suslairl4 d i'~~)l i~~~li~~.~~,. By latt ] 9i,(15 the.-e was growirig realization that t41ii' tun(:tiollirir ol' vitie par valuc systenl W(IS thrO.)le[1edS E)Y two problems: t'irsl, Litrempts l)y the majos industrial coulttries to use d'''mand maslagel-nenr silaclo-t Ceil0111i4 policies failed to sohZe their i?.ll~~~llt4 ot' payments prolzie ms. .S,,cond, therc was demand fele interniili~~:~~n.ll 1i4tjidity, whicsl ¥loultt 1lol bC saiisl'i( (? h)! ;iciumui.ition oJ i iS dc,l:l.ar- li.~~hilil.e~~. iq'UrtherlnOI'e Ct)lditFif>> Wilh ');Itsil)Ct ot' paymerll SUfPtUS t)ecgi!ne incl-c.~~slrl~~.l 1wt W,17'9' (Jt' ac~~wtllYl*t~~, di5tlt! eAoll;;tr 1'~~.'selves, an(l ,..lesiret.l arl asstt lll.+r w:ri Iree ftonl nzonetalv !n~~)licie<. oi. .*not]ler coufltry. 1)1 ordi r to reso'lve tllis issue discusslons began in S.-ptenll!er. 1t?63 but it was not until April, 1468 tlkat a final agreement was l eached on a scheme to create Spe. ial D~~.lw)nj~~> Rights (S IJ} R S). The l'irst alloc;it:iz)tl of S.D.K.s ur.eier the new sclieme involved S.D.R t),3 billioll (>ver the three years 197(}77. Kenva recci~~/c(l S.D.R. ]5.(. nlillic)rl. The secolld 3~~3 ^l!it3c.:z~~.~~on ot about i.i'}. te. 13.3 billion (f)t8k. r)l.lce ()vewr 1')7'?-- '51, Y.,xl-,y,>. .lg} iht t(?t.'tl curilTntllLitive ;llI()catiol) tt} X 1) ~~t. :).'-..g 14ll11a(~~l,. Ii'lle (iiStX'il5Lili oi X.i').R.s i<. hK,sedi 0n mt tfti:fi^ rs n1.l(:1w;ls ill tise F~~~il.i. tz O.I).S it[t. Il(n tfln~~.~~ibli t~~-sonev iilqt '.t'10 . Or ( z)in. f t8kXV {li(S tl ()e)s r:ltl.rl,, % T0 ,,:!. Il;i.it'' wi,XtlBiAlEli,l)t l)(. t\ NEts' Bl i)ilI't!U'i,i li: n ' ~~-;^A-(^>V~~. ts ot s i~~>i I' ~~-)1 tr.snsa(, Il(ins .A' i\Nt't.'il 111;.'11y' !,. ', :' 'fi'V! j'( ,: \ 'tl,{4 'il' )tillltwfl/{xti ttlS!tllil~~;¥I:.. .. NN'owl(i lg:i!-ll~~. Ai'i-i~~.tn i)~~vi iopnttnt Ri.iXli. {\ti. . t i-l(. .).T).Is tx 211' (.' ~~N'!t1'::!t ~~~s,>};l ,% ,{ ,,c,,] A,,~~ .|t w5stlil~~ I:l ill''';l!" 1.t!5, ".tti::l,lt li' ,llSi,ttl,)l'i., l),~~4.,,~~s,z,? .)i llY i-asi ji Ilx t stiztLsiLity whez] e iEI-<;t! {X ( (i t( W i)ltlt l (:tit 5 C!lCit s . When the first .)ilocation ot S.D Tt.s took pla~~ e in 1.97(). the value ol' S.D.3-< . was set to a fixe(l quansitv ot' ,gold c-&> lilal to the par valtse of {he tJA doilar. I~~'ollowiIlg thc devaluat~~o!l of the IJS e:ltrl3.¢1- in 1971, t{A. parits ,:)f ehe S.l::).P~~. and die doll.Ir ended as thr S I).R. lppit 4 iated against the tlolhir. Aster lt)7 t pal v;i~~Lles w re n() ;t~~Il~~~ffel (!hSerwe(l tnd the dolhkf aS w~~>elNS itl1(i Sil'lCC the shilling was linkcd to the efollar, iIS exch,trtgeb r,:~~t,. foll(:)\A,ed satit. itl Ordef tO glVe ttle S 1').Tw>. t RleuSt.}I''.] {Vrf l-elative stabilits t31at was l..sclrinf in othel currcncies. thf. I un(i deciJJc~~.l ar~~~ith efreCt frolil Ist July 1974 to vlid3tle ..hz '. D.R. orl [he basis ol a slandald haskeR vf 16 CUrrenCieS 'rhe currencies wl re selec:ted frottl cotln.tries whose internationa3 trade averaged 1.I) per .. nt of w~~V>rld trade over the perit)d 1')68-72. 'T'hcse were, rhe 1,1S dollal, deutschemark. pound sterling. I-~ri nch f'r3nc, Japallese sqcn, C'anae.lian tfol,ar-. Italian lira, Netheriands guilder, Be3gium franc, Swe.lish krona, Australt.ln dollar Spanish peseta, Norwegian krona, Danish krona, Austrian schilling and South African sand In 137X, the Danish krona and the South At'rican rand were replaced with the Saudi Arabian riyal aria the Iranian real Effective from Ist lalitiary, 1t3E31 the number of currencies in the S. D R. basket was reduced to five, i e the l)S dollar, deutschemark, pound sterling, Japanese yen and the French franc, Until October, 1975. the Central Bank retained the rclatioli between the shilling and the LIS dolh-tr with marginal variations from time to time However, as time progressed this was found unsuitable because of a sharp upward movement in the exchange rates between the US dollar and other currencies Pence in October, 1975 the S. D R. was chosen as the basis for determining the value of the shilling in terms of other currencie s 'I'o fix the shilling value in tel Ins of othel currencies, the Central Bilrik obtains daily the US $/S D R. rates from the International Monetary Fund and the rates between the US dolhir and other currencies from the Federal Reset ve Bank of New York Forward Exchange Cover Since the exchange rates between currencies fluctuate, Banyan businessmen who expect to receive or pay foreign exchange at some future date and who do not wish to take the risk of exchange loss (or gain) can safeguard their position by obtaining forward cover for future transactions The cover is ha the form of a contract between a businessman and a commercial batik The contract stipulates that a commercial bank would buy or sell a certain amount in foreign currency against shillings from or to a businessman on the stated date at an exchange rate 34 tixe(i at the time of making the contra(t In niaking such contracts commerci.ll b anks have to be very careful ti'Ult tht y themselves are not placed in .1 posilsoll where they might sustain a heavy loss because of unfavourable niovemcnts hl exchange rates betwecil th,i time the contract is signed and its date of' selticrmcilt If demand from hill)ol-ters btlying foreign cuircilcy it a future date equals the supply at the CUI rcncy by exporters at that date then there is no risk for commercial hanks because they e.m set off their forward sales against their forward purchases l iowevcr. this ocidol-ll happens The commercial banks therefore need a safeguard against such contingencies art(J obtain cover from the Ce ntral Bank on lines shnilar to what the banks provide to their customers The forward foreign exchange market in Kenya commenced on I Ith December, 19(i7 Initially, the Central Bank dealt cxcilisively in sterling in spot and forward markets, but the US dollar was hlcluded in the forward foreign exchange dealings in September, 1')6X Since then, the deutschernark has been added to the currencies in which the Central Bank deals forwards and the maximum contract period has been extended to six months from the initial three months Forward deals hl other currencies can be arranged in other foreign exchange markets against a forward purchase of US dollars, pound sterling or deuts~~ chemarks from the Central Bank of Kenya As the exchange risk in foreign transactions with clients is taken over by the Central Bank, it is, of course, necessary that the Central Bank should be compensated for assuming t z ! the risk. 'I his CC)lilpOnSatiOn takes the.> forlrl (of Li [)r(0.8miU{II or (ii%~~i)\lljl \;V('i the ruling spot rate ot exchanger I'lil rates ot premiums oi discount which al C let lll1*CallY qUOtt (l lay the Central Bank FIS forward Inarglas", are based on international market con(iitio>~~s (icl)el1ding on such factors as the forces ot derriand arid supply for the currelicics concerned the differentials in ruling interest rates, inflation rates, and the general political and economic conditions in the countries hivolved. Interest rate differentials are, however, the most dominant single factor in detern- iining forward margins . Relations with International Financial Institutions In its role as manager of foreign exchange reserves, the ventral Bank of ICenya maintains correspondent re-lations with foreign central banks and commercial hanks in those financial centres where. warranted by the volume of business and the financial services availabic. Thc Central Bank opens accounts with reputable hanks and o perates current accounts for dayto-day settlements and receipts, and securities accounts for investments such as short-term deposits, government Treasury hills. and other longterm paper. The Central Bank also maintains accounts of international institutions such as the International Monetary Fund, the World Bank Group, the European Economic Community Dcvelopment Fund, and other aid agencies. On a regional basis, the Central Bank maintains accounts with regional central banks for operating reciprocal banking facilities. The reciprocal banking arrangements are to be taken over by the clearing house based in flarare, Zimbabwe (recently established as part of the Preferential Trade Area institutions) where the Central Bank of Kenya maintains a settlement account to cater for regional trade. Reexchange Control Operations of the Central Bank l Under section 3() of the Central Bank of Kenya Act, the Central Bank is required to administer any law relating to exchange control that may be in force at any time in Kenya. The Exchange Control Act provides that the Minister for Finance retains the overall supervisory powers. Restrictions of some kind or another on foreign e xchange transactions by Kenya residents have been in cxistence for over half a century. In the early 192()s, there were quite restrictive exchange control rules regarding transactions between Kenya, which was then a part of the sterling area, and the rest of the world. Transactions within the sterling area were, however, free from restrictions. Since in those days people in Kenya had very few transactions outside the sterling area, the stringency of these restrictions was not felt by many people or businesses. Local legislation providing specifically for exchange control was introduced in 1951 and the main provision of the current Exchange Control Act have been inherited from it. Again, the 1951 statute controlled transactions with non- sterling countries only. By leaving remittances to sterling area free of control, Kenya began to experience strong pressure on its reserves after independence in 1963. A number of people at that time decided to take out all their assets or transfer large amounts of funds to other sterling area 35 (s)untiles like lhe lJnitc.l lkingdolil, ('ilildEi.-l, AustritiiiJ, I lidid 8 Pi:lkiStall, etc. I'he impersdilt£g h:-eak-lip ot the East AtricalIl C'urrelicy Boal~~.i in 1965 greatly hicft ase(i such iictivity twccal.ls( ot feaTs al out file new currel?cies 5n .llirit 1965. it bccafne nveessally to impose exchelnge (~~ontrol 011 tl.avlsil~~t:ions wittn sterling are.l countirt s otilf W than 'i'anzallia ancl UE,;:uzda . wint h ..X14 ( > t< ~~ok snrlil2l- action. It:.x.h;?mie {f:nttr4)l [eStr;Ct;OnS WOlF eXte[j.{F (E 1(\ tE1t. ;\\iR, t1£ jGl1bOUring CO{lT!ti jCS ;li .zX ligilSt 1t)77 aXtel- tI1#.- (t)I*.XPSV #}} t'97( ! El<.t Afrlcan (:'(.nilnlunny. i I'lt ,r Y,.'l.,lilS,tiC I villtl-O?? ,\(:'t :Itill t?lt' subsidiary le^-~~istash()n (ltid l'UiC'S .Uld reeguiations nl ulf u.lidel- it totgei:sler form one ol the most imgAortattt ml.~~otns (or ecoriorFlic manage}-lle nt in Kellya. l"ne Act provides tnat lill trailsact:is)ris involvillg foreil?>ll .'!'S''ffll,?!lgl: ;11t' plohl l~~i?ed rJFlless perillitte>(l (lit-ectl\/ by t?l" (tre cilannf lled through the comrnercial banks ahich ret~~~in C~~:ip~~t'S of these formsb tl-ie originai one behl~~-" lvieased to the exporter l's)r the purpos. of cle lring the goods Witil the CUStOnlS aut-horities. One of the copies is sent to the Central Bank by the ex}rorter's bank to give the Central Balik notice t)t an impendirig exporl. When the go()ds have been cleared tilrou:~~he cus toms tht- custom's (opy is sent t.o rhe C'entral Hank. Whe-~~ll the + ~~l-oc<:e(is of ihe sale of th,-> -.~~oods aFe r eceived a certificateX to ithax e1fett i.s prepare(:l by the exporter7s 1)3nk ar).ci again dis patciled to the i'entral Bank. 'I'he three documents are then matciled and retained as a record of satist'actory exlrort performallce. Tlle Central Banic also ches ks to ensur-e that not only does the coulitry get a f'air return for the goods but in particulal that the nioney is actually received within a reasonable time. A Under the exchange control law, no resident, be it an individual or a private or public institution, can borrow foreign currency without the consent of the Central Bank. While borrowing by the government does not require exchange control consent, the Central Bank is duly informed of it; borrowing by other parties requires the express prior approval of the Central Bank. Borrowing by government corporations require Treasury s approval. The main concern of the Central Bank in this area is to satisfy itself about the purpose for which the loan is being raised and other tasks and conditions of the loan including the interest rate that is being charged, and the repayment periods. One of the major considerations in foreign borrowing is to spread the repayment period of the loans over as long a period as possible. Residents who, in one way or another, become entitled to foreign exchange cannot retain it themselves, but are required to sell it to authorized dealers and receive shillings in return. Non-residents visiting Kenya are required to pay their hotel and other bills in foreign exchange. The appropriate ministries in the government determine the desirability of foreign investment to be allowed in the areas of economic activity they are concerned with. The Central Bank then ensures that the investment is made by the foreign parties in an approved manner, e.g. cash or new machinery. Borrowing from local banks by resident companies with foreign ownership beyond certain levels require prior approval by the Central Bank. The bulk of foreign exchange pay ments are made in respect of imports of goods. The total amount to be spent on imports in any financial year and the broad priorities for imports of different categories of goods are decided by the government. The Central Bank is entrusted with the task of allocating foreign exchange to import licences. To give effect to these decisions, and under current arrangements exchange control procedures are devised by the Central Bank to ensure not only that the goods so authorized for importation come into the country, but also that the price paid for them is in accordance with market prices for such goods in international markets. In order to ensure that contractual requirements in price, quantity and quality are met, the Central Bank, in consultation with the government, has made arrangements with the General Superintendence Company (S.G.S.) to check and make comparisons. S.G.S. is charged with the responsibility of conducting price comparisons as well as quality and quantity inspection before certain range of goods are shipped to Kenya. When these requirements are met, a "Clean Report of Findings" is issued which enables local banks in Kenya to effect payment to the suppliers abroad. When a "NonNegotiable Report of Findings" (N.N.R.F.) is issued, commercial banks cannot effect payment as the report is not negotiable. A resident wishing to engage the services of a non-resident individual or institution must get prior approval of the exchange control before entering into an agreement to pay for the services. Such services include management, consultancy, and technical services. Dividends due to nonresident investors are freely remitted 37 to them provided they arise out of foreign investment which came in by an approved manner and accrue from trading profits. Applications for foreign exchange for all other purposes are examined by the Central Bank to establish the purpose and the amounts involved and decisions are taken in the light of the prescribed criteria. In 1965 the Exchange Control Investigations Branch was established for the purpose of enforcing the Exchange Control Act (Cap. 113 Laws of Kenya). Since then the branch has established offices in Mombasa, 38 expanded considerably and it has now A4aimdi and Kisumu. The investigations branch ensures that funds due from abroad are properly received without delay and also enforces restrictions imposed by the Act in relation to gold, foreign currency, imports and exports procedures. Officers attached to the branch monitor activities along the borders with a view to gathering intelligence information relating to smuggling of foreign currency and local currency. Also, the officers inspect all tourist hotels and lodges and check on their mode of accepting and disposing foreign currency. CHAPI li:R SUPERVISORY FUNCTION OF THE CENTRAL BANK OF KENY A The supervisory powers conferred on the Central Bank of Kenya are contained in the Banking Act which came into effect on 3rd June, 1969 replacing the Banking Act of 1956. As indicated in Chapter 5 the Banking Act has been amended several times in order to meet the needs of monetary authorities in the conduct of monetary policy and to give the Central Bank legal powers in performance of its various functions. The Banking Act is, however, mainly designed to help safeguard customers' deposits in commercial banks and other financial institutions for a number of inter-related reasons. First, many people who carry out financial transactions through a bank maintain a deposit account which means that they assume the role of bank creditors and become linked with the fortunes of their bank. This contrasts with most other retail business, where customers simply pay for goods or services and never become creditors of the firms. Secondly, deposit safety is related to such factors as the capital in a bank and the condition and market value of its assets, including loans and securities. Investigation of these factors is too complex and costly for individual depositors. Moreover. even if it was possible to establish that a bank's assets relative to its liabilities were adequate the condition could change quickly because many bank assets and liabilities are highly liquid. Since banks continually add new creditors, the relative amount of capital and other factors protecting depositors do fluctuate. A third reason for depositor protection is that much of the information needed to evaluate the condition of a bank is confidential and urtavailable to the public. Bank depositors thus have greater difficulty in protecting their interests than creditors of other types of businesses. While depositors could conceivably combine their efforts in evaluating banks and other financial institutions, the task would still be difficult and costly. The difficulty faced by the ordinary depositor in establishing whether his money is safe or not is one reason why banks and other financial institutions are particularly vulnerable to crises of confidence. These crises have occurred in a number of countries, and have shown that, once depositors lose confidence in the safety of their deposits because of facts, rumours, or any other reason, a "run" on the institution concerned can develop very quickly. The difficulties involved in bank crisis management have led most countries to look for preventive measures which attempt to ensure that "run" on banks do not arise. In Kenya, preventive measures have two dimensions: first, the Central Bank super vises banks and other institutions, in order to identify problems of management or financial condition so that they can be remedied before they reach the point of crisis. Secondly, a deposit protection scheme has been introduced, so that individual depositOIS do not have to fear for the ultimate safety of their deposits even if a crisis of some sort does emerge. oThere are also procedures for orderly management of bank faihires. These 39 measures should be understood as intended to prevent systemic failure of the whole financial system (which would have serious consequences for the operation of the economy) and to protect mdividual depositors. They should not be understood as guaranteeing against the failure of individual banks or other institutions. Neither are they intended to protect the management. shareholders or creditors (other than depositors) of those institutinns. The fact that the Central Bank does supervise an institution does not limit in any way the duties of shareholders. directors and managers to ensure that prudent procedures and appropriate management practices are followed. Scrutiny by the Central Bank is a complement to these, not a substitute for therm And. as hlternational experience has shown. it cannot be assumed that < 'entl-ai Bank supervision sA;ill always identify potential faiF lul es before they occur, particularly when fraud IS jnVOIVed I he Central Bank discharges its supervisory responsibilities for depositor protection through a programme of on- site inspections, and by periodic monitoring of the capital. profit and loss, as well as the liquidity, of conlmercial banks and other financial h~~stitutions. Amlual audit reports on licensed banks and financial institu tions are also submitted to the Central Bank for review. Bank Inspections The power of the Central Bank to conduct on-site inspections of licensed banks and financial institutions is spelt out in section 19 of the Banking Act. The purpose of these inspections is to ascertain that operations are safe and sound with due regard to the interests of depositors, and to determine conforrnity with the relevant laws. rules and regulations governing these operations. A comprehensive written report is prepared by the Central Bank during each inspection for submission to the directors of the institutions under inspection. A close tollow-up is conducted to ensure that any needed corrections identified during an inspectiOn are initiated as deemed necessary by the Central Bank. The inspections carried out by the Central Bank are based on actual on-site visits to the banking pren-lises of the respective institutions as stipulated in the Act. During an on-site visit. Central Bank inspectors review and comment on the organizational set-up of each institution visited, the delegation of functions, the roles of policy and operating staff and management controls. The inspection exercise focuses on the board of directors, its composition and functions, the frequency of board meetings, the nature of business discussed and the records kept. Inspectors look for possible conflict between the board and the day-today management, how authority is exercised at the board level, and for lower managements and whether the activities are coordinated. The general qualification of the board members and their knowledge of the institution's financial matters are noted. Areas of weakness are pointed out. Commmittees of the institution and their activities are looked into to determine their usefulness and performance in the various functions for which they are responsible. The chief executive officer's experience in banking is examined, along with his incumbency, terms of appointment, discretionary powers and how effectively they are discharged. His capability to co ordinate the various activities is appraised. Otilt I executives' relationship with the chiet executive is examined be Interviewillz Ihem. ()ther areas exanlinec! are the assignments and fulictioris of executive staff. an(a their capabilities and experience Manpower developlnellt. recruitment, training and development of staff in relation to their experience and qualifications are examined in detail Efforts on Kenyanization, etc. are areas that are looked into and7 where shortcolililigs exist. these are pointed out to ttle management. 'inanciai C-londiti(!n tsf the l,icelised Banks and Financial Institutions During an inspection tour., ('cntl-al Bank inspectors ascertain tile COllSOli- dated condition of the institulioll. in terms of assets aIld liabilities as COnl-pared With the last inspection carl-ie{t out. The growth Ol' itenis such aS capital and reserves, deposits, advances and profits is examine(i over a period of sav three years to indicate whether theic tlaS been iSnpT'OVtNlent or dechilc. Inipoltant operational ratios are cxamiried. including the percenta_t^ of (apital reserves to deposits; percentage of investments in tioverJlnierit At ligations to deposits tmd also to total investments; the adVatlCtS/deposit ratios an(i provisions for ba(i anal doubtful debts t>+ capita! an I reserves. tithe ratios are assessed with a view to determining in which direction a bank or a financial institution is going. Tile ratios assist the inspectors to make a proper assessment of the financial health of the institution con cerned . Capital structtlre Capital adequacy is im~~~ortimt to the 41 banking industry arid, in this connection. the Centrili Bank inspectors appraise tile pai(l up capital or assigned capital in re lation to total deposit liabilitic.. -I-his examination serves several purposes. In the first instance, the law re(iutres maintenance of capital at a minin-lum of 1.- per cent of deposits. Secondly, the law stipulates that loans to t no F erson or institution should not exceed l(iIi per cent of capital or S per cent of deposit liabilities. Ttlis limitation is based on the principle that it is prudent to diversify lending risks. capital Sti-tI+.:ture is therefore examined to deternzint compliance with the law A listing of ownership is also examined anti details as to how the capital is employed ill the husilless. I)e~~~osit l,iabilities t:')e posits of' the institution are exarminetl by (central Bank inspectors to detcrmilic the sources. and the increases (X1' decreases over a period of sav five yc.ars. V( velopmelits in terms (if cust.olllel service improvements. new branches interest rates paid and other tenets bud studisss:l. A t real (:lown art a: ciroSits and tiler til.lturities is examined hillCC deposits are indicators tii tile mslitutioIl's (~~,liewth orientation alibi it is no c( ssaiy to determine nhelt,c) an institution is relying on narle!~~v sources for deposits, since the spread ol deposits across maturities dcteiriliiles the stability of the deposits, it is an area that inspectors also look al closely. Borrowillgs, Profit and l,oss f30l-rowing from the Central Bank. local and external banks. financial institutions and the money market is cxarmilled in terms of frequency. au thority for- such borrowings records, and/or the purposes for these borrowings. The profit and loss accounts are also examined in order to identify profits and losses since the last inspection and to work out the profit to capital ratio. Details of returns and expenditure performances are examined to detect any deviation from the laid down procedures. The budgeting procedures, controls and variations are appraised and comments made as to dividend payments. The trend of the income/expenditure account is examined in detail in order to establish the trends, identify factors that are responsible for the behaviour of profits and bring out any weaknesses such as loose controls on expenditure, heavy loads of debts, indulgence in uneconomic practices, losses suffered on account of frauds, theft or malpractices by dubious book-keeping methods. Examination is also carried out on profits arising out of the sale or revaluation of assets. Cash and Bank Balances An inspection is carried opt to establish the adequacy of cash, the adequacy of security arrangements, cash limits, insurance of cash in vaults and cash in transit and reconciliation of cash accounts. Other related examinations deal with the cash ratio and inter-bank lending. Investments and Advances Inspectors devote close attention to the investment portfolio of a bank or a financial institution. Section 10 of the Banking Act places some limits on investments, and conformity with the law is checked. The yield of the investment portfolio is examined and ratios worked out. A complete breakdown analysis is done as to the interest rate, cost, book value, market value, appreciation/depreciation in value and maturity distribution of the various investments. Various categories of advances are examined. These include bills purchased and discounted by amounts and maturities. Direct advances are examined in terms of appraisal of loan applications, sanctioning procedures for new loans and renewals, discretionary powers, borrowings by foreign controlled companies, etc. Loans examination is done so that prescribed limits as stipulated in the Act are adhered to. The distribution pattern is also examined in terms of credit extended to the priority sectors of the economy u namely agriculture, exports, tourism, eta Concentration of lending to a few borrowers is viewed as a dangerous practice and the examiners are required to look at this aspect very closely. Loans to directors and their related interests are listed and examined to see that they are all secured. Other areas examined in advances are disbursement supervision, periodic reviews and credit reports, security offered, security documentation, and insurance cover on securities. Bad and Doubtful Debts Any loans that are considered as bad or doubtful get special attention during inspections. Comments on the adverse features of these loans are made and appropriate provisions recommended. Classification is done, and a special mention of them is made in the reports. Foreign Exchange Business and Exchange Control Inspectors examine the institution's I awareness of its role as an authorized dealer in foreign exchange. Correspondent bank accounts are examined and remittances checked against exchange control approvals in order to detect any remittances made without exchange control authority. Savings remittances by non-residents are examined to check whether they conform to the regulations. External accounts authorities are checked and any irregular remittances and doubtful dealings are sighted and reported as necessary. Foreign exchange business involving bills, drafts, import payments, purchases and sales of foreign currency and export receipts are examined as necessary to establish conformity with the rules and regulations. Banking Operations Areas of operations that are examined include accounting systems and controls, book- keeping, general ledgers and subsidiary balancing and reconciliation of all records. and updating. Opening and closing of accounts, dormant accounts staff accounts, cash controls, cash limits, rules of access to restricted areas and adherance to them, customer services, space, cleanliness and other physical conveniences are all looked at, and commented on, as appropriate. Reports and Returns Licensed banks and financial institutions are required to submit to the Central Bank liquidity returns as at the 10th, 20th and the last day of each month. Other returns required by the Central Bank include those relating to capital, profit and loss, and the level of lending to the agricultural sector. Additionally, commercial banks and financial institutions are required to 43 submit a monthly statement of assets and liabilities to the Centrai Bank. With recent computerization in the Central Bank, it has become possible to speed up the tabulation and integration of the various returns so that irregular patterns are quickly detected and immediate attention paid to them. This off-site review supplements the detailed work of field inspectors which is normally done on a staggered lvasis, often once a year or every other year. Il)uring such extended periods hetween inspections, many things could happen, often without detection by Ol notice to the Central Bank. With off-site reviews based upon more frequent reports and returns. the C entral Bank is able to maintain a current profile on the various institutions. Other Supervisory roots In extreme cases, the Minister may revoke a licence if the licensee ceases to carry on business in Kenya or goes into liquidation or is wound up or otherwise dissolved: or if it fails to comply with the Banking Act. the Central Bank of Kenya Act or the Exchange Control Act, Ol any rules, regulations, orders or directions Issued under any of those Acts. Besides possible revocation of a licence by the Minister for Finance, the Banking Act also gives the Central Bank authority to commission external audit firms which meet certain standards to carry out an audit and upon completion of their audit to certify as to the institution's compliance with laws, rules and regulations. CHAPTER 5Ñ DEVELOPMENTS The financial sector in Kenya is guided by five principal Acts of Parliament: the Companies Act, the Hire Purchase Act, the Building Societies Act, the Banking Act and the Central Bank of Kenya Act. The Companies Act is relevant in so far as businesses need to register their names with the Registrar of Companies before they start to operate. After registration each business enterprise is required to apply for a licence as specified in the Act controlling or regulating the type of financial business intended to be operated. In recent years, the distinction between the types of business performed by various financial institutions has tended to disappear, particularly the activities of building societies, the non- bank financial institutions and banks. Banks have expanded their services while other financial institutions have made inroads into activities that were primarily being performed by banks. Despite this development, the Central Bank of Kenya Act and the Banking Act remain the legal basis of the financial sector. The banking business differs from other business activities in that its prosperity depends on public confidence. Whereas, a failure of ordinary business can be filled by another businessman, the failure of a bank has far more reaching consequences. It does not only cause problems for the failed bank and its depositors, but can also cause problems for other banks. Monetary authorities have therefore found it necessary to amend banking legislation in order to regulate the activities of banks and maintain the delicate public trust in the financial system. i' 44 IN BANKING LEGISTLATION The Banking Ordinance, 1910 The Banking Ordinance of 1910 was the first legislation enacted in Kenya to regulate activities of banks which existed at that time. Although the ordinance was not very elaborate when compared to the present legislation, it contained the basic provisions which form the basis of current banking law filch as licensing of banks? inspection and disclosure of certain information to the public. In particular, banks were required to deposit with the Governor of the Protectorate Settlement deeds, memorandum and articles of association before they could commence business. The Governor was also given legal powers to order an inspection of a bank if asked by a shareholder with more than 25 per cent of shares or a depositor holding more than 50 per cent of deposits, and to approve external auditors appointed by the banks. Banks were required to publish their halfyearly statement of assets and liabilities at close of business on 30th June, and 31st December, each year. In addition they were required within 30 days (60 days for banks with head office outside the Protectorate) after 31st December, each year, to file in the Office of Registrar of Companies a list of shareholders their chairing and directors. This information was accessible to the public by paying a small fee. The Banking Ordinance, 1956 After 1910, the banking industry expanded slowly, but steadily. By 1958 there were 9 banks and 3 non-bank financial institutions. In 1916 the National Bank of South Africa, started operations. It amalgamated with two other banks in 1926 to form the Bar t clays Bank (D.C.O.). Other banks that followed were Nederlandsche Handel- Maatschappij (now A.B.N.) in 1951; Bank of India and Bank of Baroda in 1953; Habib Bank (Overseas) Ltd. in 1956; and the Ottoman Bank and the Commercial Bank of Africa in 1958. The earliest non- bank financial institutions to be established were Diamond Trust Company in 1946, Credit Finance Corporation in 1955 and National Industrial Credit in 1959. Savings and Loans (Kenya) was established in 1949 to do the business of mortgage lending. It was followed in the same business by East African Building Society in 1959. The non-bank financial institutions operated generally under the Money Lenders Ordinance of 1933. In order to cope with the increased number of banks and the emerging non-bank financial institutions, Banking Ordinance, 1910 was repealed and the Banking Ordinance, 1956 enacted. Opportunity was also taken to enact the Building Societies Act, 1956. Among the main provisions of the revised legislation was first, the creation of an office of the Registrar of Banks. The Registrar of Banks was given powers to license a bank or to revoke its licence if in his opinion, the conduct of the bank was not in public interest. Those banks that were in operation before the commencement of the Banking Ordinance, 1956 were automatically granted licences. Broadly, the registrar assumed the functions that previously were performed by the Governor of the Protectorate such as licensing and ordering of regular inspection of banks. Other provisions that represented major departures from the previous legislation were: first, introduction under section 4 of the rninimum capital re~~quired to open a bank. The registrar was allowed to grant banking licences only to companies that had paid-up capital of more than shs 2 million; the second provision was creation of a reserve fund. Banks incorporated in the colony and outside the colony (unless in the opinion of the Registrar the aggregate of reserves of such a bank were adequate) were required to maintain a reserve fund and transfer to the fund, every year, not less than 25 per cent of their net profits until the amount of the reserve fund was equal to the paid up capital. In order to protect ale integrity of a bank's management, the new law prohibited appointment as a director or involvement in the management of a bank any person who became bankrupt, or was involved as a director or in the management of a bank that had failed. Persons who had been convicted to a term of imprisonment for an offence related to moral turpitude were also prohibited from holding office in a bank. Contravention of that provision was an offense punishable by imprisonment for a term not exceeding three years or a fine not exceeding shs 10,000 or both such fine and imprisonment. The Central Bank of Kenya Act, 1966 After independence in the early 1960s each East African country desired accelerated development for its people. This also meant a need to have a responsive and active monetary policy to supplement other economic policies. The East African Currency Board, which to a lesser extent had performed the role of monetary authority, suffered serious deficiencies that made its operations incompatible with needs of the newly independent nations. In particular, the Currency Board was passive to external shocks, and lacked discretionary powers to influence or regulate the activities of commercial banks and non-bank financial institutions such as expansion of credit. As the weaknesses of the Currency Board became increasingly apparent, a debate was taking place as to whether a common central bank was the suitable replacement for the Currency Board or whether each of the three East African countries should establish its own central bank. In the end, the desire to have independent monetary and financial policies favoured establishment of separate central banks in Kenya, Uganda and Tanzania. The Act of Parliament establishing the Central Bank of Kenya obtained Presidential assent on 24th March, 1966, but it was not until 14th September, 1966 that Central Bank formally opened for business. The Banking Act, 1968 Following the establishment of the Central Bank of Kenya, with powers to regulate the lending activities of banks and financial institutions it became necessary to revise the provisions of the Banking Act in order to harmonize it with the Central Bank of Kenya Act, and to lay down a foundation for future expansion of the banking industry. This was achieved through enactment of the Banking Act, 1968 which came into force on 3rd June, 1969. First,the Banking Act abolished the office of the Registrar Qf Banks and transferred the functions previously 46 performed by the registrar to the Minister for-Finance and the Central Bank. The responsibility to license banks and financial institutions including the revocation of such licences was according to sections 4, 5 and 6 vested on the Minister. Under sections 19 and 20 the Central Bank was allocated the responsibility of inspecting banks and financial institutions including issuing of directions to a bank or a financial institution. whose affairs were found during an inspection to be detrimental to the interests of depositors or the institution. Another function that was transferred to the Central Bank was approval of auditors appointed by the banks and financial institutions. The Banking Act, 1968, introduced some new provisions not covered by the previous legislation. A distinction was made in section 2 between a bank and a financial institution for the first time. In addition, the minimum capital requirements to open a financial institution were made more liberal than for banks. Whereas the minimum capital to start a locally incorporated bank was maintained at shs 2 million, the requirement for a financial institution was specified at shs 500d000. Another new provision which represented a major development in banking legislation under sections 10, 11 and 12 was prohibition of banks and financial institutions from lending to any single person or institution more than 5 per cent of its deposit liabilities or I00 per- cent of the sum of its paid-up capital and unimpaired reserves. Both banks and financial institutions were barred from lending against security of its shares and to allow any credit to be outstanding in respect of their employees without adequate security. Under sections It + and 12 banks were further restricted in their trading activities and lending against immovable property. In particular banks were not permitted to engage in their account in wholesale or retail trade including import and export trade. These restrictions did not apply to financial institutions. Finally the Banking Act, 1968 required both banks.and financial institutions to maintain a minimum holding of liquid assets to be determined by the Central Bank from time to time. At that time liquid assets were defined as (i) Kenyan notes and coin, (ii) balances held at Central Bank, (iii) net balances with banks in Kenya, (iv) net balances with banks abroad, (v) Kenya Treasury bills, or (vi) such other assets as the Minister may determine. This requirement provided the Central Bank with additional instrument of monetary control. Amendments to the Banking Legislation 197>1984 In the period 1972 to 1984, the Banking Legislation was revised a number of times. The most important changes made included the amendment of section 48 of the Central Bank of Kenya Act in 1972 which enabled the Central Bank lending to the government to be flexibly determined. The previous fixed limit of shs 240 million proved inadequate to finance an expanding government budget. The amendment raised the limit of government borrowing from the Central Bank to 25 per cent of its gross recurrent revenue. Thefnext major amendment to the banking legislation was in 1980 via the Finance Act and Miscellaneous Amendment Act No. 10. The amend 47 ment to the Banking Act raised the minimum capital required to open a locally incorporated bank from shs 2 million to shs 5 million and a financial institution from shs 0.5 million to shs 1.0 million. In case of a bank and a financial institution incorporated outside Kenya the minimum capital requirements were respectively raised from shs 10 million to shs 50 million and froni shs 1.5 million to shs 5.0 million. The Central Bank of Kenya Act was also amended on several parts including addition to the power of the President to vary or suspend the par value of the shilling. In 1982, the Banking Act was amended by raising the minimum capital required to open a bank or financial institution. For a locally incorporated bank and financial institution~~ the minimum paid- up by capital were raised to shs 10 million and shs 5 million respectively. Those incorporated outside Kenya had their minimum capital raised to shs 100 million for a bank and shs 50 million in case of a financial institution. This revision in capital requirements was necessitated by increase in number of banks and financial institutions which had began to emerge. The other two major amendments to banking legislation occured in 1984. Previously, building societies were exempted from the provisions of the Banking Act. Over time, however, their business operations had extended to activities traditionally performed by banks. The Central Bank Act was therefore amended in section 39A to empower the Central Bank to determine interest rates charged by the building societies and to inspect them. In December, 1984, Presidential assent was given to amendment Qf the Banking Act to enable the Central Bank to remove and appoint managers of a bank or financial insti