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 institution whose affairs were not being conducted in the interest of depositors or the institution. The 1985 Amendments to the Banking Act The 1985 amendments to the Banking Act were the most comprehensive since the Banking Act came into force in 1969. Those amendments were designed to remove weaknesses in the previous legislation, and to give more legal powers to the monetary authorities and to broaden the responsibilities and the coverage of institutions under the revised legislation. The main areas covered in the amendments of 1985 are discussed below. Licensing of Banks and Financial Institutions Before the amendments, persons wanting to start a bank or a non-bank financial institution or to open a branch, applied for a licence directly to the Minister for Fi,nance. This procedure was found unsatisfactory. The new amendment requires an application to open a branch or to start a new institution to be channelled to the Minister through the Central Bank. She introduction of this amendment became necessary because the Central Bank is well-equipped to advise the Minister regarding the requirements listed in section 5 of the Banking Act. In particular, the Central Bank has access to the inspection reports, liquidity and other returns, and due to its daily contact with the financial system, it is in a better position to gauge the convenience and needs of the public to be served. The change was also necessary in order to institutionalize application procedures and to make it A, I possible to call for uniform information in all cases. The new procedure of applying through the Central Bank would among other things expedite the consultation process specified in section 24 of the Banking Act. Capital Requirements Two considerations influenced the decision to raise capital requirements in 1985. First, capital levels in Kenya were low when compared to other countries. Second, the low level of capital required to open a bank or non-bank financial institution was considered to be partly responsible for the rapid increase in the number of financial institutions. Monetary authorities felt that more adequate capital was necessary in any growing business and particularly so in banking business. Adequate capitalization was also regarded useful as a safeguard against mismanagement of an institution. In order to maxc the directors and shareholders of banks and non-bank financial institutions carry risk proportionate to that borne by depositors and creditors, section 7 of the Banking. Act was amended in 1985 to incorporate three main provisions. One of the main changes was the raising of minimum capital required to start a bank or a non-bank financial institution. For a locally incorporated bank the minimum capital was raised to shs 15 million and shs 150 million in case of a bank incorporated outside Kenya. Similarly, the paid-up capital required to start a non-bank financial institution was raised to shs 7.5 million for local institutions and shs 75 million for those incorporated outside Kenya. This amendment ensures that those wishing to do banking business have adequate capital of their own. Both banks and financial institutions were given up to An= S 16th May, 1987 to increase their paidup or assigned capital. . . In order to ensure that adequate capitalization was maintained at all times, and also adjusted automatically proportionate to the increase in deposits, gearing ratio was raised from 5 to 7.5 per cent. Institutions were given up to 16th May, 1988 to build-up their capital and reserves. After that date it will be an offence for a bank or financial institution to operate with a lower gearing ratio. In addition to this provision the Central Bank, in consultation with the Minister, was empowered to prescribe minimum ratios that banks and financial institutions should maintain between paid-up capital and unimpaired reserves on one hand and their assets on the other. The other important provision to strengthen the capital base of banks and financial institutions was reintroduction o f a statutory reserve fund. The reserve fund was to be built-up from net profits. As long as the reserve fund was less than paid-up capital, institutions were required to transfer 12.5 per cent of their net profits each year to the reserve fund. After the level of the statutory reserves was equal to the paid-up capital, institutions were required to transfer each year not less than 10 per cent of their net profit to the reserve fund. This requirement was necessitated by the fact that a number of institutions were declaring dividends or issuing bonus shares even where real profits had not been made. Furthermore a number of institutions were also declaring dividends without making adequate provisions for bad and doubtful debts. This situation was dangerous because without adequate provisions for bad debts, one large or a few loan defaults could precipitate a 49 financial crisis for the involved institutions. In order to minimize the possibility of capital erosion through improper declaration of profits, and inadequate provision for bad and doubtful debts, the amendments to the Banking Act specifically provided for investment of all moneys belonging to the statutory reserves fund into government securities or other securities authorized by the Central Bank not later than six months after the end of the financial year. Profits or losses will not be declared before adequate provision for bad and doubtful debts was made. Finally, auditors appointed by banks and financial institutions were required to ascertain compliance with the provisions of the Banking Act and the Central Bank of Kenya Act. Prohibited Business Section 10 of the Banking Act prohibits banks and non-bank financial institutions from granting unsecured advances and credit facilities to its employees or their relatives more than shs 10,000. Previously, this restriction was not sufficiently explicit about the status of the directors of the institutions and their related interests. In order to protect the interest of depositors and creditors, the law was amended to explicitly prohibit directors of banks and non-bank financial institutions from granting themselves, their relatives and their associated businesses unsecured advances and credit facilities. In addition subsection 10 (4) was added to make all directors of such institutions to be liable jointly and severally to idemnify the bank or financial institution against any loss arising from granting advancest loans or credit facilities which are unsecured or not fully secured. Furthermore it is now a criminal offence for an institution to contravene these Ieqtlirenlents. This provision was important to guard against abuses by directors, who failed to honoul their obligations, particularl) in cases where thev ceased to be directors making it necessary for banks and financial institutions to make huge provisions for bad and doubtful debts. Befo!e the 1985 amendment to the Banking Act . section 11 of the Ball k ing Act, on the prohibition of investment in immovable property OI lending against security of imEnov.lble property, coukl onlv be applied to banks. The purpose of pr$)hilnting banks from ttndertak.ing ce1 lain businesses was ttl ensure safetv or customers deposits against speculative investments. cince there WAS little ret trlctis)n on trade rig activities of non bank financial i!3st!tutions, they used the opportunity to engage in speculative investments Thereby putting at risk the customers' deposits entrusted with them. The 1985 amendments to the Banking Act therefore closed this loophole by restricting the trading activities of non- bank financial institutions as well. Specifically, the non-bank financial institutions were barred from acquiring, or holding any part tAf Share capital or have direct interest in a financial, commercial, industrial or other undertakings where the value of the financial institutions' interest would exceed 25 per cent of the sum of its paid-up capital and unimpaired reserves, except shareholding in a corporation established for the purpose of promoting development and approved by the Minister and also in the case where the financial institutions took interest in satisfaction of a debt due to it. In such a situation, the financial 50 institution will be expected to dispose of the interest within a period determined by the Central Esank. Financial institutions were also barred from acquiring immovable property such as land, except for the purpose of development of their own premises or staff houses. This restriction was necessary to prevent customers deposits being tied in non- liquid investrr ents. Anothet development which necessitated the 1985 amendments to the Ranking Act was vertical ownership in financial enterprises, i.e. an institution owned another fmancial institutions or had controlling interest, and in nearly all cases, had the same directors. In those financial enterprises which initially started as non-banks, they began to set-up their own banks. Partly, this development was to enable them access to the interest free current account deposits as non-banks are not permitted to operate chequeing accounts. Whereas there is nothing sinister about this situation, inspection reports revealed that parent companies had a tendency of incurring large unsecured overdrafts with their subsidiary banks. In addition, these activities also complicated management of monetary policy. The law was therefore amended by introducing section 11B which prohibit a licensed financial institution in Kenya from owning directly or indirectly equity shares in a bank. Financial institutions which were in this situation before the amendment were given up to 16th May, 1988 to liquidate their holdings in banks or to reverse these arrangements in order to comply with the amendments in law. Deposit Protection Fund The most fundamental change in banking environment Brought about by the 1985 amendments was the provision for establishment of a Deposit Protection Fund to strengthen the banking industry. The rapid increase-in the member of institutions in the industry brought with it increased risks of failure, and therefore potential loss to depositors. The fund aims at protecting the interest of depositors, particularly small depositors who may be unable to evaluate the financial condition of an institution. The other objectives of the fund are: (i) to promote public confidence in the banking system by limiting runs on banks, and; (ii) to set a mechanism for liquidating the assets and paying off the liabilities of failed banks and financial institutions. All deposit taking banks and financial institutions licensed to carry on banking in Kenya are required to contribute to the fund, by paying an appropriate amount annually which is deemed to be adequate for the successful operations of the fund. Building societies which accept deposits are also to be contributors to the fund. The rate of contributions to the fund is notuexpected to exceed 0.4 per cenPt of the average of the bank's or financial institution's total deposit liabilities. The revised Banking Act provides that the assessment rate may be increased for any bank or financial institution whose affairs are conducted in a manner detrimental to its own interests or those of its depositors. The maximum deposits to be covered by the fund will be shslO0,000 and will consist of the aggregate credit balance of any accounts maintained by a customer at a bank or financial institution, less any liability of the customer to the bank or financial institution. The fund is tD he run by a board responsible for for 51 mutation of policy and for management and control of the fund. The board consists of the (governor of the Central Bank as chairman, and the Permanent Secretary to the Treasury as one of the members. Other Amendments Two other amendments were made in 198S: first to deal with maintenance of necessary information and records and secondly to streamline the operations of representative offices of foreign banks and financial institutions. In the past, the Central Bank had faced problems in trying to investigate the activities of some banks and financial institutions because information was not readily available or records were not maintained. This situation undermined the effectiveness of the (Central Bank in its inspections and supervisory function. The 1985 amendments therefore empowered the Central Bank to order a bank or financial institution to maintain books, records or information as may be considered necessary, in-addition to those currently being maintained. Previously, the representative offices of foreign banks and financial institutions operated without any cons trod After the 198S amendments, these representative offices will now be required to be licensed by the Minister for Finance. In addition, the Minister may require these offices to furnish hint with such information as he may direct. Further, the Minister may order a representative office closed if in his opinion the representative office has engaged in banking or financial business corittrary to the terms of its licence. CItIMTER ROLE OF THE CENTRAL BANK IN THE MANAGEMENT OF THIC ECONOMY The Central Bank of Kenya participates actively in genera] economic management of the country. However, its role is more specific in the determination and management of monetary policy. Monetary policy in Kenya covers all actions by the Central Bank and the government which influence the quantity, cost, and availability of money and credit in the economy. The aims of the Central Bank in conducting monetary policy are compatible with those of the government. Both the Central Bank and the government seek to promote economic well-being of the country by striving to achieve high econo.nic growth and employment, relative stability in the domestic price level, and a viable balance of payments position. In an overall sense, the Central Bank's conduct of monetary policy endeavours to ensure that the money supply is adequate to support growth of productive activities while at the same time, administering the supply of money in a way that minimizes inflationary pressures and balance of payments diffictllties. The powers conferred on the Central Bank to discharge monetary policy and the manner in which it operates in supplying the ultimate means of pays rnents to the economy have been described in Chapter 2 of this book. This chapter is devoted to a discussion of the manner in which the Central Bank carries out its responsibility of promoting the achievement of credit and Excllallge conditions condu(ive to the rapid btlt non- inflationary growth of the Kenyan economy. e 4 of the Central Ban& f hich enjoins the {'elltra! Bank to endeavour to maintain "a sound monetary credit and banking system conducive to the orderly and balanced economic development of the country"Ñ- and to ensure "external stability of the currency" provides the basis for monetary policy. Thus, in formulating and pursuing monetary policy, the Central Bank ensures that the level of credit obtaining in the economy does not impose excessive strains on available resources. At the same time, the Central Bank ensures that monetary policy provides general environment in which savings can be accumulated to the maximum extent possible and utilized to support productive investment. The Bank also seeks to promote an environment that makes foreign investment in Kenya attractive. in order to fulfil the requirement of maintaining a sound monetary and credit system, the Central Bank must devise practical criteria by which it can readily establish whether monetary stability is being reasonably mamtained or not, so that remedial action can be taken whenever necessary. The practice adopted by the Central Bank is to set targets for the increase in domestic credit of the banking system and to contain growth in the money supply to a level consistent with the attainment of credit targets. While the maintenance of a sound monetary and credit system is directly related to the attainment of external stability of the currency, there are certain independent considerations that. make the latter a fundamental requirement for orderly economic development. The most important element of the ntral Banks role in vS2 external stability of the currency is to formulate and maintain an appropriate exchange rate for the Kenya shilling. Unless foreigners have confidence in the domestic value of the shilling, they cannot be expected to save large amounts and hold their savings in the form of.financial assets in Kenya. Local business also need assurance that the external value of the shilling is realistic, and will be kept reasonably stable, so that they can make their long-term production and investment decisions in confidence. The maintenance, both of an appropriate level of the exchange rate and external stability of the currency value, have therefore been among the Central Bank's objectives in the field of domestic monetary policy since its inception. A supplementary measure applied by the Central Bank to help maintain external stability of the currency is to manage the country's external receipts-- such as loans, grants, and export receiptsÑand payments made for exchange of goods and services with the rest of the world, and ensure that these are broadly in balance. In this regard, the Central Bank takes action to ensure, in particular, that there is no excessive downward pressure on the country's foreign reserves Targets of Monetary Policy In the implementation of monetary policy the Central Bank makes extensive use of quantitative monetary targets as objectives of policy. There are advantages in using this approach. One of them is that the targets give the public a clear idea of what to expect. Secondly, the best way of giving a clear indication of thrust of monetary policy is to state quantitative aims for the rate of expansion of one or more of 53 the monetary aggregates. The growth of monetary aggregates. properly related to the circumstances of the time, is perhaps the best indication of monetary conditions, and targets set in terms of monetary aggregates are useful in providing checkpoints against which current developments can be compared and monitored. Several factors affect desirable monetary targets. Some of these concern the pace of inflation and the state of the balance of payments, and how these might influence the rate of monetary expansion. One purpose of announcing monetary targets is to serve notice that excessive increases in domestic costs are bound to come up against resistance. If people believe that the money supply is going to be expanded to accommodate any rise in costs and prices, however fast, inflationary fears are likely to be increased. If, on the other hand, people are convinced that the rate of growth of the money supply will be held within well-defined limits, this helps to reduce inflationary expectations. In the process of implementing monetary policy, the Central Bank usually states monetary aims for the period immediately ahead, normally a year, in the form of targets for the domestic component of credit expansion. There are two good reasons for choosing a domestic credit expansion target rather than a money supply one in the Kenyan context. First, an excessive growth of donnestic credit is usually associated with a worsening balance of payments, both directly, if liquidity leaks abroad, and indirectly, if the excessive growth undermines extel-rlal confidence. T he second consideration is that it is the domestic element of credit expansion that is most directly under the.control of the Central Bank. To focus attention on domestic credit expansion as a control variable is the best means of ensuring that the domestic financial situation is kept under the proper degree of restraint, especially when the balance of payments is in serious deficit. Instruments of Monetary Control The Central Bank has a number of . instruments of monetary control which it has employed on various occasions, as conditions have indicated, since its establishment in 1966. The most important of these instruments is the minimum liquid assets ratio which is stipulated in section 18 of the Banking Act. It was first imposed on commercial banks at 12/2 per cent in December, 1969, and extended to other financial institutions in June, 19741 (Liquid assets are defined as cash in the tills of banks, balances of hanks with the Central Ballk, Treasury hills and net inter- bank balances in Kenya and abroad). The minimum liquidity ratio has been altered several times since 1972, mainly to influence lending hehaviour, and has loeen 20 per cent since January, 1983. The Central flank may also require commercial hanks to maintain mininum cash balances with it against their total deposit liabilities though the maximum prescribed balances may not exceed 20 per cent of total deposit liabilities. This stipulation is contained in section 38 of the Central Bank of Kenya Act. he first use of this instrument by the Central Bank was made in late 1971 when comnnercial banks were required to deposit at the Central Bank S per cent of their net deposit liabilities. The primary objective was to reduce the banks' free cash base and hence curb their capacity to give loans s4 nd advances. l-his measure was cinded in early February, 1972 after demonstrating its powerful impact. he Instrument ¥vas used again by th Bank from 1978 to April 1981 (the ratio was 4 per cent until July, 1978 en it was reduced to 3 per cent)' Another instrument is that of seSective credit control Since its establishment, the Central Bank has devot d much effort towards qualitative credit nt~~rol in order to encourage th areas of economic activity consi(iere(i essential or of high priority ve3pecially agriculture)> and to discourage those which are of lower priority. The Central Bank has effected this policy by issuing special directives in respect of loans, advances or investments made by commercial banks. The Central nk is authorized under its statute t p mits on any category of loans dvances or investments made by mercial banks. Interest rates can be used in various ways, e.g. raising deposit rates to encourage savers to place their savings with banks and other institutions, raising interest rates on bank loans to discourage their use for purposes which have a low return Of are Oi1traIy to national economic polic as well as controlling the growth of the money supply, and reducing rates to encourage the use of bank loans for purposes of a high priority. I[t had been officiai policy in Kenya since independence to follow a "low interest rate policy" in order to encourage investment, and to protect the small borrower. In addition, the Central Bank held the view that stability in interest rates was an important factor in promoting development. It was felt that frequent changes in interest rates would lead to uncertainty in repayments7 which could discourage new investment and add to confusion in the credit market. The Central Bank maintained that interest rates were not to be given too much emphasis in the demand management of the economy. In the Kenyan context? allocation schemes seemed to work much better and faster in supplementing instruments of monetary control such as liquidity and cash ratios. Certain rigidities seemed to exist within the Ke nyan banking system whic h tended to hinder tbe s2noc~~+.1l operation of the interest rate mechanism lithe above considerations do not imply that interest rates were not used at all as a monetary policy tool in Kenya. Changes in interest rates were made at appropriate times not only for purposes of monetary control but also to protect savers and borrowers alike. Fr-olr, the inception of the Central Bank, interest rates were not altered until rnid-1974 when the minimum rate on time and savings deposits was raised from 3 to 5 per cent and the lending rate raised from 7 to 8 per cent Since 1983, the role assigned to interest rates within the monetary policy framework has been significantly modified. Interest rates are now considered to be one of the main instrlsments of controlling tnonetary conditiorls in the country, and greater ins terest rate flexibility can help to achieve monetary control and an appropriate allocation of financial resources in a wav which is considerably more efficient and equitable than could be achieved using the complex set of regulations which have been in force in the past. As a result, there has .5.S been a general increase in interest rates since 1983 and most interest rates are now positive in real terms, i.e. the'y exceed the rate of inflation. The SSentra! Bank has initiated this upward movement in interest rates in order to contain inflationary pressures, to promote savings, rationalize use of credit and indirectly assist in managernent of balance of payrnents. The Bank expects to continue te maintain positive real interest rates as Oven as using interest rats policy mote actively to promote monetary stability and economic growth. Exchange Rate Policy The use of the exchange rate as an instrument of monetary policy has been controversial since the inception of the (SentIal E3ank. While the issues involved in the debate hassle at tildes not been clearly spelt out, it should suffice to note that exchange rate policy seeks to ensure balance of payments equilibrt!lrn in the sense that the demand for imports is met through exports and the inflow of foreign capital. Whenever thete are persistent differences between foreign receipts and payments over a long period, it is obvious that the exchange rate and domestic policies are not, compatible with developments in tile external sector. She situation then calls for changes in either or both types of policies. The exact details of the corrective actions required differ from case to case depending upon the causes of such a disequilibrium The discussion below gives examples of various situations which called for changes in the exchange rate. In November 1967, the pound sterle ing to which the shining had always been pegged in the past was devalued by 14 per cent against the US dollar. The monetary authorities in Kenya decided not to follow the pound sterling. There are also two important points to be made about this policy action. The first is that it was taken in conjunction with the monetary authorities of Tanzania and Uganda. A uniform exchange rate policy was in practice considered to be an important feature of the East African Community, since exchange rates within the region could thereby be kept stable, and trade conducted in confidence. Indeed, as the years passed the exchange rate came to be the only common element of policy in the community and hence a matter of increasing symbolic importance. Second, it was felt that devaluation would lead to an undesirable increase in domestic prices at a time when the healthy balance of payments situation in Kenya, in 1966 and the early part of 1967, did not provide positive arguments in favour of a devaluation. But it.was also recognized that an appreciation of the shilling would have harmful effects upon the earnings of the agricultural sector and perhaps also upon the level of economic activity. After November, 1967, the effective exchange rate of the Kenyan shilling remained almost exactly constant until the middle of 1971. This interlude of calm was to be brought to an end, once again, by events outside Kenya's borders. In August, 1971, the tension between the relative values of the world's major trading currencies which had been increasingly^apparent since 1967 came to a head. Concerned about a persistent loss of gold reserves, the United States suspended the convertibility of its dollar into gold, imposed a 10 per cent surcharge upon imports, 56 and demanded a realignment of the exchange rates of the major trading currencies. For a time, these currencies, including the sterling, were allowed to "float" against the dollar and inevitably most of them floated upwards. The Central Bank, at first, maintained the parity of the shilling with sterling which contributed to an appreciation of the shilling's effective exchange rate by about I per cent in the third quarter of 1971. Ihe Tanzanian authorities decided in August, 1971 to maintain the value of their currency in terms of the dollar rather than sterling. The East African shillings were therefore no longer at par, and an important symbol of unity between the three countries of East Africa was in danger of disappearing. There followed urgent consultations between the authorities of the three countries, as a result of which the Kenya and Uganda shillings were also pegged to the US dollar rather than sterling. In October, 1975, the exchange rate of the shilling was again changed, and the arrangement for fixing it was again modified. The peg was switched from the US dollar to the S. D. R. at the rate of shs 9.66 per 1 S.D.R. from the existing rate of shs 8.61675 per 1 S.D.R. The S.D.R. was considered to be a more stable alignment than any single currency unit. The exchange rate of the shilling was further changed in 1981 when it was devalued twice, by 5 per cent in February, 1981 and 15 per cent in September, 1981 when it was fixed at shs 11.95 per 1 S.D.R. In December, 1982, it was decided to adopt a flexible exchange rate policy aimed at maintaining a competitive value of the shilling, by pegging the shilling to a standard basket of curlencies which are important in Kenya s external trade. I hese currencies included the tJS dollar, pound sterling, deutschemark, Japanese yen, and the French franc. This decision was based on the fact that in the current regime of floating exchange rates, the value of other currencies in terms of the shilling fluctuates on a daily basis due to changes in trends in economic activity in both Kenya and its trading partners, as well as to sizeable changes in the value of major foreign currencies. The adoption of the basket was designed to reduce the undesirable appreciations or depreciations of the shilling exchange rate in terms of specified currencies. In adopting an appropriate basket of currencies, it was decided to use trade weights which reflected the bulk of Kenya's trade mix. Traded goods and tourist receipts were added together to obtain the trade share of the currencies which were included in the basket. A basket representing a complete country trade mix would in some ways have been preferred, but the advantages would have been relatively modest and did not appear to outweigh the administrative disadvantages. Accordingly, a short list of countries that capture the bulk of the volume of Kenya's trade was adopted for use. The trade weights are adjusted on a regular basis as need arises. External Assets Policy The Central Bank is required by section 26 of the Central Bank of Kenya Act to do its best to maintain a reserve of external assets, of an aggregate amount not less than the value of four months' imports, as recorded and averaged for the last three preceeding years. 57 The maintenance of adequate international reserves by the Central Bank is considered as an essential part of monetary policy because reserves provide the means to ensure continued and uninterrupted flow of development illpUtS such as imported raw materials, spare parts, and capital equipment. If international reserves fall below a certain level, the Central Bank usually adopts policies of restraint to ensure a return to a target level. If, on the other hand, they rise above a certain level, it is usually recognized that they represent investment in foreign financial assets that are likely to be less productive than some domestic investments. Examples of external assets policy actions since the inception of the Central Bank have been as follows: the first period was immediately following the devaluation of the pound sterling in November, 1967; the second period comprised most of 1971 and 1972; the third period commenced from the quadrupling of oil prices in December, 1973 and ran to the middle of 1975, while the fourth phase comprised 1978 through 1980. In all these phases excessive credit creation caused heavy outflows of foreign exchange largely through imports. To stem the foreign exchange drain in the first period, commercial banks were directed in November, 1267 to borrow from their head offices before they resorted to the Central Bank. Inter-bank lending was prohibited, and facilities for forward cover for foreign exchange were introduced for the first time in the country's history. During the second phase covering 1971 and 1972, selective credit controls were imposed in July, 1971 upon bank ~~ PurChdsC By the clear tl ' It hec tOplace iper Cen > , quidity ratiO from ~~21/2 Y inlrntlrn lnmdi per Cent 'rhis n caSure pla 69d t¡ Ptivate qeCtor t~~l an abrupt end BUtht Scvdit i reSttictlons iV te faZlill e nevv establisted ; V aS leSS We ef 19 t~~ltrl'l¡ e, It waS clear bV th suffj i - r Would reserves f21ting to th pes, etit e.reSgn level, bec2use th ! e mlnlmllm target t in motiOn hy t+R ,had ary budgets of 1970/74 (' expanSI0X3 momentum Th was still gaining wnel7eta-~~y restAictiOn vvore aggregate p rtS, foreign e } - on ef for trarlsactions onXC lange pUrchases rlade subiect to 1~~ unt e YarietSy of imP¡rtS upon a had been allo ved to reach 58 sVas restricted to n I d¡rneStiC credit, I97s It wa Pehriod June 1974art~~ 12 per the credit need,s OferShstipUwated that for ind trial raU, ared -reViOUSty liquidity ratlO wh 15 hkarlks was Peplied Only to cornrnerC.d fr¡rn 7 to 81e BtaXimum lenCIt¡ S per lightened dnd Pstep procedtt eS were pnCj¡Urage foreign COntrO]l d en to mXttn rate of t , Ahe ¡mpanies t(t rais to finance at rateS , e overseas fr) D 9 g WaS n.r.~~ SC I panies With over 15 ing r.estrl.cted t-PartifCiP2ti¡n WaS further turlngS Sutc12 aS agriCulture mE) Sofnt,> remittance of d to per d acc9unts only, th . gainst COn titlued Vidends Oversea emtttance the peri d¡lsth phase svhich cOvered mbo~~t; nty~~ Ilerefundu 100 per cent of the cost and freight value depending upon the c ategory of imports. Certain items were exempted from these requirements including raw materials, machinery, and government imports. Originally the scheme covered about half of Kenya s imports, but the coverage was later reduced to about a quarter of imports. Restrictions were also imposed on dividend remittances: companies with equity held by non-residellts were not allowed to remit dividend of more than l() per cent of equity capital and/or reserves. Sales of tickets to Kenya residents for non-government travel abroad were made subject to prior approval of the Central Bank. Originally ticket applications had to bc accompanied by a cheque of shs 2 ()()() in the case of air travel and shs l ,()()() in case of travel by sea. Later, these fees, which were to be returned if the applications were not approved, were changed to l() and 5 per cent of the values of the tickets respectively. I he fee required did not apply to students and residents travelling for medical reasons. The import deposit scheme was an emergency measure aimed at discouraging luxury imports and reducing stocks in the economy. The scheme was liberalized substantially in November, 1979 when the import deposit requirement of l()() per cent was reduced to 5() per cent and that of 25 per cent to 1() per cent, except for imports of passenger motor-cars and textiles. The scheme was abolished in January. 19X3. Retrospect and Prospect It will be clear from the description of past events that, even in the short 59 span of 2() years. there has been a good deal of change and development in the approach to monetary policy, even though the basic objectives have not changed. These developments have been caused by a number of factorsÑ notably the growing size, penetration, sophistication and diversity of the domestic financial system, and the great changes which have occurred in the field of international trade and finance. The pace of change and development is unlikelv to slacken in the forcsecahle future, and the challenge now is built on past experience in a way which ensures that monetary policy contim1es to make the best possible contribution to economic growth and stability . In this process, it will be important not to lose sight of some fundamental interrelationships and constrains, all of which can be illustrated from the Central Bank's first 2() years. First, monetary policy cannot be used to achieve a number of incompatible goals. In particular, it is necessary that target for the exchange rate, the level of interest rates. the balance of payments position, and the rate of domestic monetary expansion should he mutually consistent. If they are not, then it will only be possible to achieve one goal (it the expense of another. For example, in periods where interest rates are fixed at too low a level, there will be a tendency for monetary and credit growth to he unduly rapid and for the balance of payments position to deteriorate, eventually forcing a review of the exchange r ate. Secondly, it is clear that the growing diversity and sophistication of the financial system will have a number of implicati(:ms for the conduct of monetary policy. For example, there are signs that direct controls such as ratio requirements, interest rate controls, exchange controls and lending guidelines are gradually becoming less effective as policy instruments. The greater complexity of the economy means that they are more easy to avoid or evade, and successive attempts to modify them to close loopholes generally have only limited success, and it also means that the controls quickly become difficult to understand. The judgements required by bureaucrats in administering controls fairly and in the national interest are becoming increasingly difficult, and it can be hard to change the policy stance quickly to meet changing circumstances. It seems inevitable that Kenya, like many other countries, will move towards placing less reliance on such instruments, moving instead towards more market based intervention to achieve policy goals. A number of moves along these lines were foreshadowed in Sessional Paper Now l of 1986, where they were integrated with similar policy proposals in other sectors. The Bank looks forward to playing an active part in implementing this framework within its own areas of responsibility. Thirdly, it must be recognized that there is always likely to be a conflict between growth and stability objectives in the short-term. On a number of occasions in the past, stringent monetary policy actions have been 60 used to help restore a sustainable balance of payments position or to rein potentially explosive inflation. These actions have constrained domestic growth for a period, but it has to be understood that there can be no prospect of rapid economic growth in the long-term in an environment of galloping inflation and/or the chronic accumulation of external debt. Accordingly, such periods of restraint are sometimes essential in spite of their shortterm costs. Such costs can best be kept to a minimum by ensuring that policy instrument settings do not get seriously out-of-line with the fundamental forces facing the economy, and by taking remedial action at the first sign of trouble rather than waiting until it is too late. Good analysis and research are vital in order to do this successfully, and the Central Bank is very conscious of its responsibilities in this respect. Clearly, the Central Bank cannot be complacent about its conduct of monetary policy over the first 20 years. The international environment is a challenging one, and the domestic environment is also changing both rapidly and radically as the economy matures. Monetary policy will need to continually adapt as this process continues, but the fundamental objectives of maintaining a sound financial system and stability in the value of the currency will not alter. CHAPTER 7ÑDEVELOPMENTS IN THE STRUCTURE AND CAPITAL OF THE CENTRAL BANK OF KENYA The Central Bank of Kenya was legally established on 24th March, 1966 when the Central Bank of Kenya Act received Presidential assent. It was not, however. until 14th September, 1966 that the Central Bank was officially opened by the late President, Mzee Jomo Kenyatta and the first Kenya currency notes released for circulation to the public. The Central Bank began its operations in a modest building, the former Army Records Office on Lt. Tumbo Avenue, now known as Herufi l louse. It took over the functions hitherto performed by the East African Currency Board, in addition to the new responsibilities specified in the Central Bank of.Kenya Act. At that time, it had 60 staff members composed of 38 Kenyans and 22 expatriates. The first Governor, Dr. Leon Baranski, was seconded to the Central Bank by the International Monetary Fund. The appointments of Mr. D. N. INdegwa, as Governor designate, and Mr. A. Abdallah, as Deputy Governor, were made in December, 1966, Mr. Abdallah took up his appointment in January, 1967, while Mr. Sdegwa became the first African Governor in May, 1967. By the end of the first year, staff had increased to 148, of whom 24 were expatriates. The ranid expansion in the Stabs lishment reflected the inevitable growth of the Central Bank's functions and responsibilities. As early as November, 1966, the Central Bank took over the Bankers Clearing House and Kenya Government Accounts from the National and Grindlays Bank. In March, 1967, the Bank took over the management and control of foreign exchange from the Treasury and sixteen months later, on 1st July, 1968, it took over responsibility for the issue and management of Kenya Government Treasury bills, the administration of government funded debt and the management of the sinking fund. Around the same period. an inspection office was set up to enable the Central Bank to exercise its powers of surveillance and supervision over thecountry's financial system, as provided under the Banking Act of 1968. Organizational structure of the Central Bank. After a few years of operation, it became evident that Herufi House could not adequately cater for the needs of the Central Bank. Consequently, a plot was acquired for construction of bigger premises and moves initiated to plan a new headquarters building commensurate with the Central Bank's physical and functional expansion. Construction work on the new headquarters building commenced in August, 1970 and was completed in September, 1972. The building was officially opened by the late President, Mzee Jomo Kenyatta on 1st December, 1972. By that time the total staff had grown to 222 and the organizational structure that had evolved up to that time was composed of the following departments: Office of the Governor.ÑResearch Department, Foreign Department and Internal Audit. Chief Banking Manager's Department.Ñ Banking Office, Currency Office and National Debt Registry. 61 Exchange Control Departments--- Ex change Control Office and Banks Inspection Office. Secretary's Departrnent.-ÑAccounts Office, Estates Office and Administration/Staff Training Office. In September. 1973, the annual meetings of the I.M.F./I.B.R.D and their affiliates were held in Nairobi, the first time for such meetings to be held in Africa. The Bank joined hands with other institutions of the government in organizing the meetings and ensuring that they were a success. On 12th December, of the same year, Kenya celebrated her Tenth Anniversary of Independence. To commemorate the historic event, the Bank issued a special coin of shs 5. 14th September, 1976 was the Central Bank's tenth anniversary. However, celebrations marking this important event were held during Jarnhuri week in December, 1976 to coincide with the country's independence celebrations. The highlight of the celebration was a presentation by the Governor to the late President, Mzee Jomo Kenyatta. a silver die of Kenya notes representing all the four denominations. As early as 196X, the Central Bank had purchased a plot on State House Crescent to construct flats for middle management staff. Construction of the flats began in January, 1975 and they were ready for occupation in July, 1976, in time for official opening as part of the Central Bank's tenth anniversary celebrationsWOf the original 60 employees who joined the Bank at inception, 24 still remained in service: 20 men and 4 women. Special certificates of services were issued to all of them as pioneers (:>f central banking in Kenya. To mark the occasion, a special booklet entitled "The First Ten Years" was published for circulation to the public. As the e.coIlomy contn-lued to grow at an impressive pace, it was cvusidered necessary to establish a branch of the Central Bank outside Nairobi. Mombasa was selected as the most appropriate site. partly as the second largest urban sentry but mainly because of its importance as the country's gateway for the bulk of external trade. Construction of the branch building began in February, l(97.S and was completed in March, 1977. By 30th June, 1977 the branch. with a complement of 12() staff members, had taken over the functions formerly entrusted to the Kenya Commercial Bank. Other matters handled by the branch included exchange control with supporting services from Accounts, Audit, Estates and Administration Sections. The broad supervision of the branch was entrusted to the chief banking manager with the branch manager in charge of the day-tc;-day operations. Mombasa branch building was officially opened by the late President, Mzee Jomo Kenyatta on 12th January, 197X. By early 197X, the structure of the Bank was re-organized as follows: Office of the Gol ernor.--Resealch L)epartment, Foreign Department and Inspection Office. Chief Banking Manager s Depurtment.-ÑBanking Office, Currency Offices General Office and National Debt Registry. 62 Elxc11mge Control Oepartnu?.nt.---lmports C)ffice, Exports Office, Investments Office, General Office and Audit Secretaries Department. and hdminstration Office. In response to a shortage of housing in Mombasa, 1 he Central Bank acquired a plot in Mombasa for accommodation of middle rmallagemellt staff. Construction work at the Tudor Estate began in October, 1978 and was completed by September, 1979, when the high class flats were ready for occupation. 'I'he official opening of the flats was performed by the Governor in November, I979. On 12th October, 1979, the Central Bank was honoured by the visit of H.E. the President, Hon. Daniel T. arap Moi . During this occasion, l l . E . the. President was presented with special golden and silver coins issued by r he Central Bank to commemorate the first anniversary of his installation as President and Commander-in-Chief of the Armed Forces of the Republic of Kenya. During the same month, the local banking community launched the Kenya Institute of Bankers. The Governor of the Central Bank was appointed patron of the institute while the Deputy Governor was elected its first Chairman. in May, 148(), the Central Bank hosted the first teaching seminar mounted by the African Centre for Monetary Studies on "Foreign Exchange Management" The seminar was attended by senior staff drown from 22 member central banks out of 31 members of the Association of African Central Banks. 63 On 1st April? 1981, the Bank took over the operation of the Kisumu Currency Centre which had hitherto been administered on an agency basis by the Kenya Commercial Bank. An initial complement of 38 staff was posted to the centre. The centre is housed in leased premises belonging to the Kenya Commercial Bank but by February I986, plans were at an advanced stage to open a branch in Kisumu to cater for the growing needs of central banking services in western Kenya. On 24th July, 1981, the Governor, accompanied by the Deputy Governor and all board members, called on H.E. the President at State House, Nairobi to present the Nyayo bank-notes for shs 5 10, and 20 before they were released for circulation to the public alongside the existing issues. The new notes bore the portrait of H.E. the President and were released for circulation on 30th July, 1981. The Nyayo coins had been released earlier. By the time the Central Bank celebrated its t5th anniversary in September, 1981, the staff establishment was 1,286, with 1,083 staff at head office, 164 in Mombasa branch, and 39 at Kisumu Currency Centre. Of this number, 60 members of staff who had joined the Bank at inception still remained in service. At the end of December, 1982, Mr. D. N. Ndegwa, who had been Governor of the Central Bank since May, 1967 retired after 16 years of service. Mr. Philip Ndegwa was appointed as the new Governor. Two years later, Mr. Ahmed Abdallah, who had served the Central Bank as.Deputy Governor for I 8 years retired to take up an appointment as Alternate Executive Director of the International Monetary Fund. Mr. E. C. Kotut, formerly the Managing Director of the Kenya National Trading Corporation, was appointed Deputy Governor. A major re-organization in the structure of the Central Bank took place in July, 1984, and resulted in the creation of a number of new departments and divisions. Following the 1986 amendments to the Banking Act, a Deposit Protection Division was created in the Banks Supervision Department to administer the newlyestablished Deposit Protection Fund. The Central Bank also decided to computerize its operations and a Computer Services Unit was set up to hasten the process. The library services of the Central Bank were brought under the umbrella of the Research Department. The organizational structure of the Bank in July, l 986 was then as follows: Office oJf the Cioverrlor.ÑLegal Division, Board Secretariat, Security Division, Internal Avidit Division, Information Processing and Public Information. A dministration Department.ÑPersonnel Management Division, Staff Training and Development Division, Estates Management Division and Purchasing and Supplies Division. Banking Department.ÑNational Debt Registry, Banking Division, Development Division. Banks Supervision Department.Ñ Deposit Protection Division, Inspection and Supervision Division. Currency Department.ÑCurrency Division, and Branch Administration Division. Exchange Control Department.ÑImports Division, Exports Division, Investments Division, General Division and Exchange Control Audit Division. Finance and Planning Department.Ñ Accounts Division, Salaries Division, Budget and Budgetary Control Division and Organization and Methods (O&M) Division. Foreign Department.-ÑPlanning Division, Operations Division. Research DepartingÑDomestic Economy Division, External Finance Division, Statistics Division and Library Services Section. Another important development in the internal management of the Central Bank was the establishment in 1983 of a number of committees to run its affairs on a day-to-day basis. The committees, chaired by the Deputy Governor and advisory to the Governor, include the following: the Appointments, Promotion and Disciplinary Committee; Capital Projects Committee; Computer Steering Committee; Staff Housing Loans Cornmittee; Investments of Foreign Currency Committee; Training Committee; and Tender Committee. Staff Development and Training During the early period of its operations, the Central Bank relied heavily on in-service training provided with the assistance of a training officer from the International Monetary Fund, while at the same time utilizing other appropriate training opportunities both locally and overseas. Today, with a fully fledged Training Division, the Central Bank sponsors more than 150 members of staff for training annually to both local and overseas institutions. Since 1970, many senior officers have attended- a variety of specialized courses offered by the l.M.F. Institute in Washington D.C., and commercial and central banking courses in India, Pakistan, Britain, Italy, Switzerland, the United States and other countries. In addition, the Central Bank is closely associated with other central banks and international (financial) institutions in Africa and elsewhere where staff members are sent for seminars and attachments in specialized areas. A number of staff have also been sponsored overseas for specialized postgraduate training in universities aabroad so as to acquire the management techniques needed in a changing environment. As far as local training is concerned, the Central Bank has continued to sponsor staff for supervisory, administrative and management courses organized by local institutions such as the Kenya Institute of Administration and the Kenya Institute of Management, as well as to other inter-regional training institutions, particularly the Eastern and Southern African Management Institute in Arusha, Tanzania. Lately, the Central Bank has started organizing in-house courses for supervisory and other cadres and refresher courses for secretarial staff. The Central Bank has also encouraged staff to improve themselves in every way they can by introducing an incentive scheme whereby staff members are refunded half the tuition fees incurred in pursuing recognized professional courses, in addition to awarding in cremental credits on completion of such courses. More recently, the Central Bank has been engaged in an exercise designed towards promoting professionalism in providing its services to the public. The aim of training has thus been geared towards giving staff adequate motivation to acquire additional technical skills, professional qualifications and improve their proficiency in clischarging their duties. In this connection, the Central Bank introduced a new promotion criteria in May, 1985 as part-of its terms of service which specified the minimum requirements to be met before a member of staff could be promoted from one grade to another. The criteria specified the minimum age and period in the grade, the training courses which should be attended white in the grade, as well as the desireable working crossexperience needed while working within the relevant departments in the Central Bank. In addition, the Bank introduced in March, 1986, the publicationÑ"Central Bank of KenyaÑStaff Papers". The aims of the publication are to make available on ad hoc basis some of the work and thinking of the Bank staff on monetary and financial matters. The publication will also give staff opportunity to develop their literary qualities. In order to inform staff of their rights and obligations as Central Bank employees, a booklet containing the staff rules and regulations was compiled and issued to all members of staff in May, 1981. In addition, the Pension sScheme of the Central Bank is fully operational with 13 pensioners and 9 dependent families enjoying benefits from the fund. The fund is administered by the Central Bank under the 65 general direction of the Board of Trustees. The Central Bank remains committed to providing medical facilities to its employees and their registered families and has one of the best Medical Benefit Scheme in the country The Bank runs a fully-fledged medical clinic for welfare of its staff members . Management of the Central Bank Responsibility for determining the policy of the Central Bank is given by the Central Bank of Kenya Act to the Board of Directors The Board consists of seven membersÑthe Governor, who is also its Chairman. the Deputy Governor, who is deputy chairman, the Permanent Secretary to the Treasury, and four other directors All members are appointed by the President to hold office for a term of four years and are eligible for reappointment The present board members are the Governor, Mr. Philip Ndegwa, the Deputy Governor, Mr Eric C Kotut. the Chief Secretary and Head of the Civil Service, Mr S Nyachae, the Permanent Secretary to the Treasury, Mr. H. M. Mule, and Messrs M. K. Cheserem, T. C. J. Ramtu and T. Kaloki. The board is required by law to meet not less than once in every two months. According to section 13 of the Central Bank of Kenya Act the Governor shall be the chief executive officer of the Bank and, subject to the general policy decisions of the Board, shall be responsible for the management of the Bank, including the organization, appointment and dismissal of the staff in accordance with the general terms and conditions of service established by the Board. The Governor is also authorized to incur expenditure for the Bank within the administrative budget ~~6 approved by the Board. He is also the Bank's principal representative and spokesman . Capital, Reserves and Accounts of the Central Bank The authorized capital of the Central Bank is shs 26m fully subscribed and held entirely by the Permanent Secretary to the Treasury on behalf of the Kenya Government. The Central Bank is also required to establish and maintain a general Reserve Fund into which is paid. at the end of each financial year, one- fourth of annual profits of the Central Bank, as long as the fund is less than the authorized capital of the Central Bank. That requirement was fulfilled at the end of the 197()/71 financial year when the balance of the General Reserve Fund was shs 26m, the same as the authorized capital. The Act was amended in 1978 to allow for a variable proportion of the annual profits of the Central Bank to be transferred to the General Reserve Fund, the exact size being determined by the Board of Directors in consultation with the Minister for Finance . There is also a special account called the Revaluation Account which holds profits or losses that arise from changes in the exchange rate between the Kenya shilling and other foreign currencies in which the Central Bank holds its foreign assets or liabilities and also changes in the shilling price of gold if gold is included in either of them. These changes can occur as a result either of Kenya altering the exchange rate for the shilling or other countries altering the rates for their currencies. The purpose of having a special account for holding the profits or losses dine to these changes is to isol,atc tilcn) fronl thc ( entra! lSalih's igcll(nal nle~~hts all(l their (listllbution Shlcf ¥xchaller ratcs call nlovc cit!-~~cr Es:.l\. tlle trtllalilUt ill llt \.lll,({ti,)l] ;^^a:'C$)lUlt l'luctuoltes fronl tinlc {lM 7imc .u u is gcncrally of a l';lirlv snu lllEll'llitLl(le. 'I'hc ^'ill.ln(kll ywar ot' thc Ballk is thc SilltltB slS 1!1r. t'ON't'RIl!llCtlt S fisc~~ll ytEll. Withul thrcc morltlls attcr thc closc of 1ll~~ fhltlllcial year. i.c. .It RI)tll Scptcmhc:, thc f3ank is rciluirc(l lo sublllit to t7lc Ministcr for I h1anCC a rclroll 011 thc Ballh's ol~~erations througllout that yeat-. together with thc halall(c shect an(l profit all(l loss accounts (crtificd I)y au(litors appointc(l i)V thc Ballk alld alrprovcd lDy thc Mhlistel- i'or l'hlallc( 'I'hc anmloll l'('l)OI't (0nt;lills Fl l'CVi('W 0i' filulllci;ll arl(l ccononlic situation hl tht country ,19 well FIS lrolicy challges an(l olzeraiions I?Ursuc(I (lurillg th. yval. Aftcr sublllissioll to thc Mhliste:l, thc rclrort iN thercal'tcr lrublislle(l. In ad(litiOIl to thc amlu.ll Iclrort alld accoullts. the 13allk is als0 rcquircd to lrublish a statemcllt ol' its iISSCtS all(l liahilitics cvcry molltll ;tlld a colry submitted to thc Ministe l for Finance. F'7lrtller References 1. 'I'he C'entral Bank of Kenya Act, l (Je)(~~. 2. 'I hc B.lllkillg Act, 19( S. .A. Antlual RelrortsÑ--Ccntral Bank of lRclsy.l. 4. Slafi' I'alzers-ÑC'cntral Ballk ol' KCIlyel 5. Econortlic Sulveys~~'entral Bureau of statistics. 6. Statistical Abstracts{:entral Bureau of statistics. 7. I)cvelo^~~mcnt PlansÑ-C,overnmcnt l'rintcr. S. Scssional l'alrcr No. I ol' 1 9Xf~~ I4.conomic Management for Renewed CJrowth. Govemment Printcr, July. 19X6.