THE LAW ON CENTRAL BANKS

1.      CENTRAL BANKS

The banking system of a country can work systematically and in coordinated manner only if there is an apex institution to direct the activities of the banks. Such apex institution is popularly known as CENTRAL BANK.

DEFINITION OF CENTRAL BANK

There is no standard terminology for the name of Central Bank generally.

Many countries use the form, for example,

-      Bank of England;

-      Bank of Canada;

-      Bank of Russia;

Some are styled as national banks, for example

-      National Bank of Ukraine.

Some countries may incorporate the word “central” for example,

-      The European Central Bank and

-      Central Bank of Ireland

In many countries there may be private banks that incorporate the term national.

Some counties have State-owned banks or other quasi – government entities that have entirely separate functions, such as financing imports and exports.

In some countries, the term national bank may be used to indicate both the monetary authority and the leading banking entity, such as the Russia’s Gosbank.

In other countries, the term may be used to indicate that the central bank’s goals are broader than monetary stability, such as

-      full employment,

-      industrial development and other goals.

The word “reserve” also is used, primarily in USA, Australia, New Zealand, South Africa and India

A Central Bank by definition is a commercial bank (financial institution) which is responsible for maintenance of economic stability and financial soundness of a government economy.

A Central bank has been defined in terms of its functions. The following are some of the definitions give by economists:

1.      According to B.D. Smith (2000) central banking is primarily a banking system in which a single bank has either complete control or a residuary monopoly of note issue;

2.      H.A. Shaw (1918) defies a Central Bank as “the bank whose main function is control of credit”.

3.      In the words of Hawtrey “A Central Bank is that which is the lender of the last resort is”

4.      According to P.A. Samuelson (1966-86) “A Central Bank is a bank of bankers. Its duty is to control the monetary base and through control of high-powered money to control community’s supply of money”

This means that Central Bank must be responsible for the financial soundness of the economy by identifying gaps in the financial market and looking for solutions to these goals so as to ensure a sound financial market in a given economy.

As a commercial bank which its second objective, the Central Bank must make profits on different services it offers to different parties. 

The Central Bank of a country is an autonomous institution entrusted with powers of

1.      CONTROL;

2.      SUPERVISION of the monetary and banking systems of a country.

DISTINCTIONS BETWEEN CENTRAL BANK AND COMMERCIAL BANKS

The Central Bank is different from the Commercial banks in the following respects:

1.      The Central Bank is the apex institution of the monetary and banking system of the country. A commercial bank is only a constituent unit of the banking system and is subordinate to the Central Bank.

2.      While the Central Bank possesses the monopoly of note issue, commercial banks do not have this right

3.      The Central Bank is not a profit- making institution. Its aim is to promote the general economic policy of the government. But, the primary objective of the commercial banks is to earn profit for their shareholders.

4.      The Central Bank maintains the foreign exchange reserves of the country. The Commercial banks only in foreign exchange under the directions of the Central Bank.

5.      The Central Bank is an organ of the government and acts as its banker and the financial advisor, where as the commercial banks act as advisors and bakers to the general public only.

RESPONSIBILITIES OF CENTRAL BANK:

1.      Its primary responsibility is to maintain stability of the national currency and money supply;

2.      Additionally, its active duties include controlling subsidized loan interest rates as bankers’ bank and custodian of foreign currency reserves and government treasury;

3.      It may have supervisory powers to ensure that banks and other financial institutions do not behave recklessly or fraudulently.

After World War I, the Internationally Monetary Conference held at Brussels in 1929 recommended the setting up of a Central Bank in every country. In most countries, the Central Bank is State-owned and has minimal degree of autonomy, which allows for the possibility of government intervening in monetary policy. In some countries such as India the Central Banks are “independent” which operate under rules designed to prevent political interference.

ESTABLISHMENT OF THE CENTRAL BANK OF KENYA

The Central Bank of Kenya was established in 1966 after abolition of the East African Currency Board, which was as of them serving as a Central Bank for the three East African countries – Kenya, Uganda and Tanzania. The Board was abolished because there were imbalances of development of the three countries, and as such this board could not treat the three countries equally, in particular from the view of financial management of their economies, as they were endowed with different natural resources which could not allow them to be matched from the economic point of view. For this reason it was necessary that each country set up each own Central Bank to ensure economic stability and be responsible for the financial soundness of each country’s economy. The Central Bank of Kenya was consequently set up by the Central Bank Act of 1966 which gave it powers of maintaining economic stability and financial soundness of Kenya’s economy.

In 1968, the Central Bank of Kenya was allowed to be governed by the Banking Act of the same year. This Act allowed it earn profits as a Commercial Bank.

THE STRUCTURE OF THE CENTRAL BANK OF KENYA

The Central Bank of Kenya is organized in such a way that there is

1.      A governor

2.      A deputy governor and

3.      A Board of Directors, all of whom are appointed by the government.

In this regard the Governor acts as the Chief Executive of the Central Bank and has been an appointee of the President of the Republic of Kenya.

ROLES PLAYED BY THE CENTRAL BANK OF KENYA

The roles of the Central Bank of Kenya are outlined by the Central Bank Act of 1966 and the Banking Act of 1968. The Central Bank Act of 1966 gives it roles which are aimed at ensuring the financial soundness of the economy such as

-      issue of currency and

-      control of money supply

whereas the Banking Act of 1968 allows it

-      to operate on a commercial basis counting securities

from commercial banks etc.

FUNCTIONS OF CENTRAL BANKS

The main functions of Central Banks are common over the world. But the scope and the content of policy objectives may vary

1.      with respect to the country of origin,

2.      the period and

3.      depending on the country’s  economic situation.

Generally, all Central Banks aim at achieving economic stability along with a high growth rate and a favorable external payment position though property monetary management.

There most common functions are as indicated below:

1.      Issuing currency or note issue and control of money supply

4. Advisor to the Government
5. Banker to the Government
6. Management of Public Debt
7. Banker to commercial banks
8. Financial controller to commercial banks
9. Lender of Last Resort
10. Clearing function and credit control
11. Creation of Financial Institutions
12. Custodian and Control of foreign Exchange reserves and administration:

a)      Areas that fall under Foreign Exchange Control

(i)                                         Regulations aimed at encouraging inflow of foreign exchange into the country

(ii)                           Rate of exchange of currency

(iii)                         Computations of rates of exchange

(iv)                         Special Drawing rights ( SDR’s) and Foreign Exchange

(v)                                       Problems that have upset the use of SDR’s as a means of solving International Liquidity Problems / Limitations to their use.

(vi)                         Factors that affect the rate of exchange of a country’s currency

b)     Types of Exchange rates

(i)                                         Advantages of using fixed exchange rates

(ii)                           Floating exchange rate:

(ii.)                         Dangers of floating rates of exchange to the economy

(iii.)                        

c)                        Objectives of foreign exchange rate

                  control

d)                        Ways of controlling foreign exchange

e)                        Methods of maintaining stable currency

(i)                             Methods for overcoming problems of falling foreign reserves ( Deficits)

f)                         Credit control

g)                        Increasing bank lending capacity

h)                       Main objectives of monetary tools:

(i)                             Limitations of using monetary tools to control credit by the central banks

(ii)                           Solutions to the problems

13.  Interest rate interventions

14.  Implementation of Monetary policy

15.  

NOTES ISSUE AND ISSUING CURRENCY AND CONTROL OF MONEY SUPPLY

Notes Issue

The issue of paper money is the most important function of a Central Bank. Central Bank is the authority to issue currency for circulation, which is a legal tender money .Its Issue Department has the responsibility to issue notes and coins for commercial banks.

The Central Bank regulates the credit and currency according to the economic situation of the country. In the methods of notes issue, the Bank is required to keep certain amount or fixed proportion of gold and foreign securities against total notes issued.

ADVANTAGES DUE TO MONOPOLY ON NOTES AND ISSUE AND CURRENCY CONTROL

Having the monopoly of note issue, the Central Bank gains the following advantages:

1.      Ensuring of the notes issued and proper control over the supply of money can be expected;

2.      Bring stability in the monetary system and creates confidence trust;

3.      Government is able to earn profits from printing currencies.

Notes issue and currency control is the most important role of the Central Bank of Kenya is charged with and it is a role that calls for the highest degree of efficiency and trust on the part of the Central Bank.

The Central Bank is allowed to print money to match the resources accumulated by different sectors in the economy which means that money printed as a strong correlation with the resources the country has at any given point in time. This printing of money must be done in such a way that it is kept as secret as possible to avoid speculation in money supply which can spark off inflation. The Central Bank of Kenya must also maintain optimum quantities of money in circulation – neither too little nor too much – such that the economy will have the right amount in circulation to allow smooth operations.

All money in circulation in Kenya is a legal tender, i.e. it is legally handed over by the debtor to a creditor for the settlement of a debt. Nevertheless, the Central Bank of Kenya keeps some resources to back the Kenyan currency.

These reserves are kept in the form of:

1.      Gold

2.      Silver;

3.      Approved currencies e.g. Sterling Pounds and US Dollars to which the Kenya currency pegged;

4.      Special Drawing Rights (SDR’s)

The part of the Kenyan currency and not backed by the above reserved is known as fiduciary issue and this forms the larger part of the currency. The change in monetary supply in Kenya is very effective and effective and influenced by such factors as:

1.      The government transactions, such as borrowing from the public commercial banks;

2.      Balance of Payment surplus;

3.      Credit and foreign exchange transaction;

All in all the money supply in Kenya at any given point in the time depends mainly on the judgments of the Central Bank of Kenya’s credit needs, but the most important objective to this end is for the Central Bank to maintain  a balance between accumulated resources in the country and supply of money in the community.

The objectives of issuing currency and control of money supply are as follows:

1.      To ensure smooth financial operations in the economy;

2.      To maintain stable prices by keeping inflation at reasonable rates

3.       To avail reasonable credit to the whole economy

4.      To maintain a strong value of Kenya shilling vis  - a – vis other foreign currencies.

Central Bank is an Advisor or banker to the Government 

The Central Bank of the country acts as

1.      the banker,

2.      fiscal agent and

3.      advisor to the government.

As a banker, it keeps the deposit of the Central and S… Governments and makes payments on behalf of them. It buys and sells foreign currency on behalf of the government. Central Bank keeps the stock of gold of the country.

As a fiscal agent, the bank makes short-term loans to the government for a period not exceeding 90 days. It loans and advances to the state governments and local bodies. It manages the entire public debt on behalf of the government.

As an advisor, the bank gives useful advice to the governments on important monetary and economic problems such as

1.      devaluation,

2.      foreign exchange policy and

3.      budgetary policy.

            As advisor to the government the Central Bank of   Kenya must be able to give advice on:

1.      Economic policies which are necessary at any given one point in time to stimulate economic development of various sectors;

2.      Ways of raising finance i.e. the best source of finance at any given point in time and the best course of interest to be paid on which finance, in which case the Central Bank of Kenya becomes the most important financial consultant optional to the government.

3.      The beast means of managing the private sector from the financial management option of view. In particular, it will give evidence to the government as to which projects the private sector should finance and which ones the government should finance.

4.      Ways and means of controlling inflation and a boosting the purchase power of the Kenya shillings so as to improve the living standards of nationals.

CENTRAL BANKS IS A BANKER TO THE GOVERNMENT

The relationship of a Central Bank to a government is not simply that of banker and customer. A Central bank may perform a variety of tasks for government which vary in kind from the ordinary relationship. For example, the Central Bank may manage the public debt – issuing, servicing and redeeming it. Under National Debt Act of 1870 the Ban of England acted in this capacity by advising the government on the issue of its securities (called “gilts” and Treasury bill in Britain). The Bank was not typical in this regard in Europe; debt management is usually performed elsewhere such as by the Ministry of Finance. In 1998 the Debt Management Office, which is an executive agency of the Treasury, assumed responsibility for carrying out the government’s debt management policy.”

A central bank is typically a government’s banker. In other words the central bank performs for the government the services a bank ordinarily provides for a customer with a current account, notably, receiving and making payments and advising and assisting in operation of the account.

IN ENGLAND the Exchequer (which is the central account of the government) is kept by the treasury at the Bank of England, along with National Loan Funds (which is the account of the Treasury at the Bank used for loans and advances by the government) and various subsidiary accounts. Government departments and agencies may also keep accounts at the commercial banks to facilitate payments to and from the public without breaching the statutory provisions establishing the accounts with the Bank.

Government accounts with the commercial banks lessen the impact on their liquidity requirements on the large and unpredictable payments from and to the government by the central banks, and hence in and out of the banking sector. This in turn reduces the need for open- market operations.

But the relationship of a central bank to government is not simply that of banker customer. A central bank may perform a variety of tasks for government which vary in kind from the ordinary relationship. For example, the central bank may manage the public debt – issuing, servicing and redeeming it. Under the National Debt Act of 1870 the Bank England acted in this capacity by advising the government on the issue of its securities (called “gilts” and the Treasury bills in Britain)> The bank was not typical in this regard in Europe; debt management is usually performed elsewhere such as by the ministry of finance. In 1998 the Debt Management Office, which is an executive agency of the Treasury, assumed responsibility for carrying out the government’s management policy.

In relation to foreign exchange the central bank may be the source of rules:

1.      it might license foreign exchange dealers,

2.      administer foreign exchange controls and

3.      be the compulsory depository of the foreign exchange earnings of residents.

More importantly, these days a central bank will be subject to rules, albeit fairly minimal, as it engages in foreign exchange transactions, either on its own account or as agent of government. For example the Bank of England holds the exchange equalization account on behalf of the Treasury; it is through this that the government could act in the foreign exchange markets to try to manage the exchange rate of sterling.

The most important role of a central bank vis –a - vis government is in giving advice on national economic policy and, significantly, conducting one aspect of it, monetary policy. (The particular prism through which the role of the Central Bank of giving advice on the government monetary policy is viewed is the conventional wisdom that the Central Bank independence is a prerequisite to the sound monetary policy.)

In Kenya the Central Bank serves as a banker to the government in the following ways:

1.      It undertakes all government transactions e.g. different government ministries will draw cheques on it as payment for different goods and services these ministries have purchased.

2.      It receives various finances on behalf of the government from such sources as:

a)      Taxes

b)      Foreign grants, foreign loans

c)      Foreign aid

At the same time the Central Bank will undertake to manage these on behalf of the government.

3.      The Central Bank repays foreign loans and this reason will have to keep reserves in foreign exchange to serve such loans.

4.      It advances loans to the government, both on short and long term basis to finance different government projects.

FINANCING GOVERNMENT

Limiting the extent to which a Central Bank can finance the government acts as a brake on the governments’ budgetary policies, and encourages economic rectitude. In terms of such financing are more favorable than those available on domestic or foreign markets, this implies a lower cost for the government in funding its budget but a burden (perhaps losses) for the Central Bank. Easier finance for government may lead to financial imprudence on its part. Moreover, a Central Bank which must finance government will be tempted to do so by printing money There is an obvious inflationary potential in doing so.

Legal controls on  Central bank financing the government are thus common feature of banking and finance Law . For example, Central bank purchase government securities may have the same economic effect as lending government the money, although , a matter of law, it has a quite different character, However, purchasing government securities may be an aspect of open market operations. Rather than to fund government. Limits on the former may therefore be expressed to exclude open market operations. To the extent that the law limits a central bank financing government through cash advances or the purchase of its securities, the bank’s independence is enhanced. Its financial position is more secure and it is able to pursue monetary policy more independently of fiscal policy.

The strictest limit on a central bank financing government is an absolute prohibition; it is incorporated in Article 101.1 of the EC Treaty for the European Central Bank (the ECB)

:
“Overdraft facilities or any other type of credit facility with the ECB or with the Central Banks of the Member sates (hereinafter referred to as “national central banks” in favor of Community institutions or bodies, central government, regional, local or other public authorities , other bodies governed by public law, or public undertakings of member states shall be prohibited , as shall the purchase directly from them by the ECB OR NATIONAL CENTRAL BANKS of debt instruments”

The use of “directly ” in this Article is designed to exempt open market operation. Unfortunately, this was not done explicitly, for as it is expressed one can easily conceive of schemes which, while in breach of its spirit, would not be in breach of its letter ( for example, warehousing a purchase by central bank through a commercial bank).

At the other end of the spectrum are laws which impose few, if any, limits (although as a matter of practice there may be quite definite limits). At one time loans by the Bank of England to the Crown required the authority of Parliament, but under section 12 of the National Loans ACT OF 1968 the bank may lend the Treasury any sums which the latter has power to borrow. If Britain moves to the third stage of European Monetary Union then, consistently with Article 101 of the EC Treaty, the government will have to abandon this possibility.

Intermediate between these two positions are those laws which permit a central bank to advance cash to, or purchase the securities of government, but impose limits on amount, maturity, or conditions. Explicit limits on the amount advanced can be expressed variously as a proportion of the central bank’s own capital or liabilities or as a percentage of government expenditure or ( most commonly) revenues. The Federal Reserve system in the United States provides an illustration of how maturity conditions can be controlled: unless they are purchased on the open market, a federal reserve bank cannot purchase US government securities Having a maturity from the date of purchase exceeding 6 months. Among the important conditions attached to advances to a government is whether it must pay market rates 

Instruments of Monetary policy

Even if a Central Bank lacks goal independence – they have their goal of price stability set for them in which they may apply flexibility in setting the requisite targets and might have a choice of avenues available to reach instrument independence, where the trend has been to move away from regulatory to market instruments

Regulatory instruments can be characterized as direct or indirect.

1.      Direct regulation seems to control directly the amount of money and credit provided through banking system, thus , in the past, for example, the Bank of England, required the banks to adopt particular deposit-taking and lending policies. Quantitative requirements were used at one time  - that a bank’s rate of growth for interest –bearing deposits should not exceed a maximum, or that a bank’s new lending over the next 6 months ( say ) should not exceed a specified amount, whatever the increase in the bank’s deposit base.

Qualitative directives have also been used, advising the banks to lend to some sectors of the economy rather than others. Direct regulation is transparent and quickly effective, although it will soon lead to distortions.

2.      Reserve requirements are indirect regulatory instruments: the banks must maintain minimum reserves, notably in cash and liquid assets with the Central Bank, which the Central Bank can vary in the light of monetary conditions. The size of the reserves clearly determines the value of money in circulation and the even to which banks can itself extend credit to its customers. In England, the legal basis for minimum reserves as with direct regulation lies in the power of the government under section 4(3) of the 1946 Act to approve the issue of directives supporting recommendations made by the Bank of England to bankers. In fact no order has ever been made defining banker for the purposes of the section and no directive issued. Nonetheless, banks have complied when the bank has laid down reserve ratios.  Elsewhere the law is much more explicit in endowing Central Banks with the power to set minimum reserves, for example as a ration of designated liabilities. Non-Compliance is visited by the levying a penalty interest rates and other sanctions. Although the European Central Bank has the potential to use minimum reserves as an instrument of monetary policy once the Council of Ministers has defined the basis for doing so, indicative of the current trend is that the Reserve Bank of New Zealand Act has been shorn of the power to use them Certainly reserve requirements cannot regularly be varied because of the disruption which would be caused to banks, and they can also lead to distortions: for example, a bank may book deposits in its branches in jurisdictions with lower or no reserve requirements his was one reason that the Euromarkets developed, to avoid US reserve requirements.

Contract provides the legal basis for the primary methods used these days in most developed countries to implement monetary policy (these methods are less effective in countries without developed financial institutions).

MANAGEMENT OF PUBLIC DEBT

Public debt by definition is that finance which the government borrows from its citizens through Government securities Treasury bond (short – term finance to the government) or stocks (long-term finance to the government.

Finance from these securities is received n the Central Bank of Kenya on behalf of the government to finance different activities. For this reason, as part of its role in the management of public debt, the Central Bank of Kenya will

not only receive finance from the sale of the above securities but also will undertake to pay interest and to repay the principal debt, the Central Bank of Kenya will:

(i)                             Advise the government as to what rates of interest these securities should carry;

(ii)                           Advise the government under what conditions it would be ideal to sell either treasury bills or government stocks. Treasury bills or bonds are usually sold in a bid to curb inflation in case there is high liquidity in the economy whereas stocks are sold to finance either long – term government projects of long-term budget deficits. 

BANKER TO COMMERCIAL BANKS

The Commercial banks are required to keep a certain percentage of cash reserves with the Central Bank. On the basis of these reserves, the Central Bank transfer funds from one bank to another to facilitate the clearing of cheques.

There are various dimensions to this aspect:

1.      The first is that in exceptional cases the Central Bank acts as the lender of last resort to banks.  This happens when particular institution faces difficulties the Central banks may rescue it. Another aspect of a Central Bank acting as a lender of last resort is where there is a shock to the system as a whole, and cash is withdrawn from a range of banks which is not re-deposited with other banks ( a “flight to cash”). Such widespread loss of confidence is rare, but if it occurs the Central Bank will provide extra reserves to the banks to avoid collapse of the system.

2.      Secondly, banks or at least the leading banks, need to have operational accounts with the carnal bank because, part from their use o has (which is impractical) this is the only acceptable way of settling certain obligations. One such obligations is if a bank needs to make payments to government (e.g. for it or its customer tax bills) and government has its account at the central bank. This involves a flow from the banking sector and this a movement on the accounts which banks have with the central bank.

Another example, is if a bank after betting payments due to other banks against those due to itself, still owes the other banks. Again only settlement by adjustments to the accounts which banks have with the central banks is acceptable. That the banks have accounts with the central bank for this purpose provides an avenue, as we shall see, for it to administer monetary policy.

3.      Banks use central bank as ordinary customer uses their banks, as a worse of notes and coins. Indeed the most basic function of a central banks is the issue of currency. Generally, the central banks will have the sol right to issue banknotes, although in Britain for historical reasons certain banks in Scotland and Northern Ireland  still have a limited right to do so. The right to issue cons may be entrusted to the central bank, or as in Britain, to another body, (the mint) .

European Central Bank has the exclusive right to authorize the issue of banknotes although both the bank and the national central banks may actually issue the notes – and only such notes have the status of legal tender within the Euro zone. ‘Member states of the community may issue coins subject to approval of the European Central Bank as to volume. A Central Bank makes a profit (siegniorage) on the issue of the currency because government deposits securities with the bank to back the issue (hence the usage of the term “fiduciary issue”. ( In Britain all such profits of the Bank of England go to the Treasury under the Currency and bank Notes Act of 1928 by section 2 of the Act there are some limits on the fiduciary note issue although these can be varied by a Treasury  directive and ultimately a statutory instrument). These days “printing money” is a function of the public need for a certain amount of currency, either a source of revenue for the government nor an instrument of monetary policy. Nonetheless a currency is a potent symbol of a poity’s unity, integrity and perhaps strength. Governments interfere with it at their peril.

ROLES OF THE CENTRAL BANK OF KENYA

The Central Bank of Kenya undertakes the following roles:

1.      Acts as clearing house (inter- banking clearing facility whereby it will act as middleman in the settlement of any debts by or any commercial banks in Keya. Through acceptance of cheques by different customers to other parties with other banks, the volume of cheques to parties with other bank , the volume of cheques issued and received are cleared with the aid of the Central Bank of Kenya mediating in such inter-cheques transfer.

2.      The Central Bank acts as a “clearing house” for other banks and mutual obligations are settled through clearing system. Since the bank holds cash reserves of commercial banks, it is easier for it to act as a clearing house.

3.      It is the sole custodian of reserves and deposits which by , law commercial banks are required to deposit with the Central Bank/ These are kept safely although the yd do not earn interest.

4.      It acts as a source of short term finance to commercial banks, in particular where some commercial banks are face with liquidity problems. However, these loans are not supposed to exceed to a term of 6 months

5.      It usually acts as an arbitrator in disputes which may arise among different commercial banks in such matters as financial and expansion disputes.

6.      It is authorized by commercial banks to sell or discusses promissory notes. But sale or exchange or any other documentary credit maturating within 180 days. This service is offered to avail finance for such activities to improper export trade, industry, agriculture production or water, housing.

7.      It acts as a financial controller to commercial banks in as much as it will periodically inspect the activities commercial banks etc. Credit creation, credit control measure, areas of their lending etc,

FINANCIAL CONTROLLER TO COMMERCIAL BANKS

Commercial Banks are required to be guided in all their activities, financial or otherwise by the Central Bank and the Central Bank is highlighted by both  the Central Bank Act of 1966 and the Commercial Banks Act ( Banking Act ) of 1968.

According to the Acts the Central Bank is required to control the commercial banks in the following areas:

1.      It will direct the commercial banks as to which areas of investments are a priority  to the government development plans

2.      It will require he commercial banks to submit periodic reports from which important statistics, which are used to gauge the financial soundness of the economy are prepared e.g. the sums accumulated in a given period, investment made in a given period.

3.      It usually gives advice to the commercial banks in matters of financial planning

4.      It usually gives advice to commercial banks in their process of credit creation

5.      It will advice commercial banks in matters of expansion where and when to open a new branch

6.      Controls the credit creation power of commercial banks in order to inflationary and deflationary pressures within the economy. For this purpose, it adopts quantitative and qualitative (selective) methods.

Quantitative methods

These methods aim at controlling the cost and quantity of credit by adopting:

1.      Bank rate policy

2.      Open market operations

3.      Variations in reserve ratios of commercial banks

Bank rate (or ) discount rate policy

The rate of interest of every Central Bank is known as bank rate. It is also known as the discount rate. At this rate, the Central Bank rediscounts hill of exchange and government securities held by the commercial banks. When the cash reserves of the commercial banks tend to fall below the legal minimum, the banks may obtain additional cash from the Central Bank either by rediscounting bills with the Central Bank or by borrowing from it against legible securities.

The Central Bank charges interest for this service. It control credit by making variations in the bank rate. A rise in the bank rate makes borrowing from the Central Bank cost. So commercial banks borrow less and they in turn raise their lending rates to customers. This discourages business activity, thereby there is decrease in demand for goods and services , and ultimately fall in the price level. The bank rates therefore raised to control inflation. In the opposite case, lower the bank rate offsets deflationary tendencies.

Open market operations

Direct buying and selling of securities, bills and bonds of government and private financial institutions by the Central Bank on its own initiative is called open market operations. In periods of inflation, the Central Bank sells in the money market first class bill. Buyers of this bill, say commercial banks, make payments to the Central Bank. It reduces the size of the cash reserves held by the commercial bank with the Central Bank. Some banks are forced to decrease lending. Thus, business activities based on bank loans and which are responsible for boom conditions are curtailed. In times of depression, the Central Bank buys bills and securities from the commercial banks paying cash to them for such purchases. It increases the cash reserves of the commercial banks. Thereby the banks expand their loans resulting in the expansion of investment, employment, production and price. Thus, the Central Bank, through its open market operations, influences business activity and economic conditions of the country.

 A Central Bank influences the money supply in an economy directly through open market operations. It raises the money supply each time it buys securities, exchanging money for the security. Conversely, selling of securities lowers the money supply. Buying of securities, thus, amounts to printing new money while lowering supply of the specific security.

The main open market operations are:

1.      Temporary lending of money for collateral securities. It is carried out on a regular basis, where fixed maturity loans are auctioned off;

2.      Buying or selling securities on ad-hoc basis

3.      Foreign exchange operations such as forex swaps.

All these interventions cal also influence the foreign exchange market and, thus, the exchange rate.

Variable reserve ratio

Every commercial bank is required by law to maintain a minimum percentage of its time and demand deposits with the Central Bank. The excess money that remains with the commercial banks over and above these minimum reserves is known as the excess reserves. The commercial banks create credit only based on the excess reserves. The Central Bank may bring changes in reserve requirements which consequently will affect the amount of reserves that commercial bank must maintain as well as the amounts available for lending or investing. For instance, when the Central Bank fixes the reserve requirements as 10 %  , a commercial bank will have to maintain a cash reserve of 100 shilling for every deposit of 1,000 shilling and hence, it can lend only up 900 shillings. To check inflation, the Central Bank may raise the cash reserve ratio from 10 % to 15 percent. This will force the commercial banks to deposit additional 5 % by reducing its amount available for lending. On the other hand, to check deflation, the Central Bank may reduce the reserve ratio from 10 % to 7 % , This will raise the excess cash with the commercial banks, consequently, credit be expanded.

Qualitative or Selective Credit controls

Qualitative methods of credit control mean the regulation and control of supply of credit among its possible user’s Their aim is to channelize the flow of bank credit from speculative and other undesirable purposes to socially desirable and economically useful schemes. The important selective credit controls are the following:

1.      Margin requirements

2.      Regulation of consumer credit

3.      Direct Action

4.      Moral suasion Publicity

Margin requirements

These aim to prevent excessive use of credit to purchase securities by speculators. The Central Bank fixes minimum margin requirements on loans for purchasing securities. Suppose the CENRAL Bank fixes 30 % as margin requirements, then for Kshs.1,000/= worth of security, the commercial bank may keep Kshs.300/= as mark and the remaining Kshs.700/= may be used for lending. If he Central Bank want to curb speculative activities, it will raise the margin requirements. On the other hand, if it wants to expand credit, it reduces the margin requirements.

Regulation of consumer Credit

Under this instrument, the Central Bank regulations the use of bank credit by consumers in order to buyer durable consumer goods in installments. To achieve this, it adopts two devices: minimum down payment and maximum periods of repayment.

Rationing of credit

It is employed to control and regulate the purpose for which credit is granted by the commercial banks.

Credit rationing takes two forms:

1.      Variable portfolio ceilings where the Central Bank fixes ceiling on the aggregate portfolios of the commercial banks. They cannot advance loans beyond this ceiling.

2.      Variable capital assets ration wherein the Central Bank fixes ceiling in relation to the capital of a commercial bank to its total assets.

Direct action

It refers to the “directives” of the Central Bank to enforce the commercial banks to follow a particular policy. The Central Bank gives such directions in respect of : lending, policies, the purpose for which advances may be made, and the margins to be maintained in respect of secured loans.

Moral suasion

It implies persuasion and request made by the Central Bank to the commercial banks to follow the general monetary policy in the context of the current economic situation

Publicity

The Central Bank publishes weekly, monthly or quarterly statements of the assets and liabilities of the commercial banks for the information of the public. It also publishes statistical data relating to money supply prices, production, employment and of capital and money market. Etc.

The quantitative credit control methods are used to expand or contract the total volume of credit in the banking system for example, the Reserve Bank of India presumes that the safe limit for bank credit is 50,000 RS. Core. Suppose , at a particular time the actual bank credit is Rs. 75,ooo core, RBI may now use bank rate as a weapon to reduce the volume of credit by RS. 25,000 core .

As such the volume of bank credit is reduced in the country. On the other hand, the qualitative credit control methods are used o control and regulate the flow of credit into particular industries or businesses depending on the economic priorities set by the government.

Suppose that KCB believes that the inflationary pressure in Kenya is due o the commercial banks; loan to speculators and hoarders who have managed to control the supply of inflation-sensitive foods and thus have pushed the prive level. Now it may direct the commercial banks not to lend to speculators and boarders. This analysis  shows that the qualitative controls are indirect , while qualitative controls are direct.

Interest rate intervention

A Central Bank controls certain types of short – term interest rates. These influence the stock and bond markets as well as mortgage and to the interest rates. The European Central Bank (ECB) bond market as well as mortgage and other interest rates. The European Bank (ECB), for example, announces its interest rate at the meeting of the Governing Council. Both the US Federal Reserve System 9 USFRS) and  ( ECB0 are composed of one or more central bodies that are responsible for the main decisions about interest rates, the size and type of open market operations, and several branches to execute their policies. In the case of USFRS, the central bodies are the local Federal Reserve Banks, and for the ECB, they are the National Central Banks.

Contrary to popular perceptions, the Central Banks, are not all – powerful and they have limited powers to put their policies into effect. Most importantly, although the Central Bank controls some or all interest rates and currency rates, economic theory shows that it is impossible to do both at once in an open economy. Even when targeting interest rates, most Central Banks have limited ability to influence the rates actually paid by private individuals and companies.

Policy Instruments

The main monetary policy instruments available to central banks are

1.      Open Market operation

2.       Bank reserve requirement

3.      Interest-rate policy

4.      Re-lending and re-discount and

5.      Credit  policy

While capital adequacy is important, it is defined and regulated by the Central Banks for International Settlement and, in practice, they generally do not apply stricter rules.

To enable open market operation, a Central Bank must hold foreign exchange reserves and official gold reserves. It will often have some influence over any official or mandated exchange rates – some exchange rates are managed, some are market based and many are somewhere in between.

Interest rates

By far the most visible and obvious power of many modern Central Banks is to influence market interest rates. Contrary to the popular belief, they rarely “set’ the rates to a fixed number. Although the mechanism differs from country to country, most use a similar mechanism based on the central bank’s ability to create as much fiat money as required

The mechanisms to move the market towards a “target rate” is generally to lend money or borrow money in theoretically unlimited quantities, until the targeted market rate is sufficiently close to the target. The Central Bank may do so by lending money to and borrowing money from a limited number of qualified banks, or by purchasing and selling bonds.

A typical Central Bank has several interest rates or monetary policy tools it can set to influence markets. The important among them are:

1.      Marginal Lending rate – a fixed rate fro institutions to borrow money from the Central bank;

2.      Main refinancing rate – This is the publicly visible interest rate the Central Bank announces. It is also known as the minimum bid rate and serves ad bidding floor for refinancing loans

3.      Deposit rate – the rate parties receive for deposits at the Central Bank.

These rates directly affect the rates in the money market for deposits at the Central Bank

Capital Requirements

All banks are required to hold a certain percentage of their assets as capital, a rate which may be established by the Central Bank or the banking supervisor. For international banks, including the 55 member Central Banks of the Bank International Settlements, the threshold is 8 % of re-adjusted assets, whereby certain assets are considered to have lower risk and are either partially or fully excluded from total assets for the purpose of calculating capital adequacy. Partly done to concerns about asset inflation and term repurchase agreements, capital requirements may be considered more effective than deposit/reserve requirements in preventing indefinite lending: when at the threshold, a bank cannot extend another loan without acquiring further capital on its balance sheet.

Reserve requirements

Another significant power that the Central Banks hold is the ability to establish reserve requirements for other banks. By requiring that a percentage of liabilities be held as cash or deposited with the Central Bank (or the agency), limits are set on the money supply.

In practice, many banks are required to hold percentage of their deposits as reserves. Such legal reserve requirements were introduced in the 19^th century to reduce the risk of banks over extending themselves and suffering from bank runs, as this could lead to knock- on efforts on other banks. At the early twentieth century gold standard and late 20^th century dollar hegemony evolved, and as banks proliferated and engaged in more complex transactions were able to profit from dealings globally on the moment’s notice, these practices became mandatory if only to ensure that there was some limit on the ballooning of money supply .Such limits have become harder to enforce.

Even if reserves were not a legal requirements, prudence would ensure that banks would hold a certain percentage of their assets in the form of cash reserves. In common to thin for commercial banks as passive receivers of deposits from their customers and, for many purposes this is still an accurate view.

This passive view of bank activity is misleading when it comes to considering what determines the nation’s money supply and credit. The loan activity by banks pals a fundamental role in determining the money supply. The money deposited by commercial banks at the Central bank is the real money in the banking system: other versions of what is commonly through of as money are merely promises to pay the real money .These promises are circulatory multiplies of the real money. For general purposes, people perceive money as the amount shown in financial transactions or in their bank accounts But bank accounts both credit and debits that cancel each other. Only the remaining Central Bank after aggregate settlement – the final money can take one of two forms:

1.      The physical cash, which is rarely used in wholesale financial markets;

2.      The Central Bank money

The currency of the money supply is far smaller than the deposit component. The currency and bank reserves together make up the monetary based called M1 and M2.

Exchange requirements

To influence the money supply, some Central Banks require that some or all foreign exchange receipts be exchanged for the local currency. The rate that is used to purchase local currency may be market-based or arbitrarily set by the Central Bank. This tool is generally used in countries with non – convertible or partially convertible – currencies. The recipient of the local currency may allowed

                                                                                     

(i)                             To freely dispose of the funds required to hold the funds with the Central Bank for some period of time;

(ii)                           To use the funds subject to certain restrictions.

In other case, the ability to hold the use the foreign exchange may be otherwise limited

In this method, the Central Bank, increases money supply when it purchases the foreign currency by issuing (selling) the local currency. The Central Bank may, subsequently, reduce the money supply by various means, including selling bonds or by foreign exchange interventions.

Margin requirements

In some countries, the Central Banks may have other tools that work indirectly to limit lending practices or otherwise restrict or regulate capital markets. For example,  a Central bank may regulate margin lending, whereby individuals or companies may borrow against pledged securities. The margin requirement establishes a minimum ration of the value of the securities to the amount borrowed.

The Central Banks often have requirements for the quality of assets that may be held by financial institutions. These requirements may act as a limit on the amount of risk and leverage created by the financial system. These may be direct such as requiring certain assets to bear certain minimum credit ratings or indirect, by the Central Bank lending to counterparties only when securities of a certain quality is pledged as collateral.

BANKING SUPERVISION

In some countries, the Central Bank through their subsidiaries control and monitor the banking sector. A Central Bank examines the bank’s balance sheets, and behavior and policies towards customers Apart from refinancing. It also provides banks with services such as transfer of funds, bank notes, coins, or foreign currency. Thus, it is often described as the “bank of banks”.

In some countries, banking supervision is carried out by a government department, or an independent government agency. In some other countries, monitoring and controlling of the banking sector is done through different agencies and for different purposes although there is usually significant cooperation between these agencies. For example, many central banks, deposit- taking institutions, and other types of financial institutions may be subject  to different regulations. Some types of banking regulation may be delegated to other levels of the government such as State or provincial governments

Any cartel of banks is particularly closely watched and controlled. Most countries control banks mergers and are wary of concentration in this industry doe to the danger of groupthink and away lending bubbles based on a single point of failure – the credit culture of the few large banks. In finance, generally diversification reduces financial loss, including diversity of point in view.

INDEPENDENCE OF THE CENTRAL BANK

Advocates of independence of the Central Bank argue that a Central Bank which is too susceptible to political direction or pressure ma y encourage economic cycle ,as politicians may be tempted to boost economic activity in advance of an election to the detriment of the long-term health of the economy and the country . In this context independence is usually defined as the Central Bank’s operational and management independence from the government, On the other hand, an independence, privately owned “Central Bank” can, and has been proved in the past to have done as such, create a boom and bust scenario for the profit of the owners and shareholder of the Bank itself.

In addition, it is argued that an independent Central bank can run a more credible monetary policy, making market expectations more responsive to signals from the bank. Recently, both the Bank of England and the European Central Banks have been made independent and follow a set of pushed inflation targets so that markets know what to expect.

Governments generally have some degree of influence over even “independent” Central Banks. The aim of independence is primary to prevent short-term interference

International organizations such as the World Bank, BIS and IMF are strong supports of Central Bank independence. This results, in part, from a belief in the intrinsic merits of increase independence, and in part the support for independence from the international organization derived from the connection between increased independence for the Central Bank and increased transparency in policy – making process 

There was a decision that the Central Bank be separate from the government. The reason why that there was the time inconsistency syndrome. Politicians were short term in their perspective and their decisions and place were short term. This terms were dictated by the election cycles. Because they were short sighted, they encouraged boom and burst cycle i.e. going into election would encourage a boom period by printing money in spite of low input rate and the result would be that everyone would be happy but for the short term. After the election, the monetary policy will be tighter so as not have inflation and that will lead to a burst, which will mean money will be in short supply.

The economy wouldn’t function if subjected to the boom and burst situation. So in order to prevent this you separate the monetary policy from the fiscal policy.

The monetary policy function was given to the central bank and the government was allowed to retain the fiscal policy and cushion the central bank from control by politics through the government of the day. Therefore people will have confidence in monetary policy whether there is a boom or a burst you can know its not politicians around

ELEMENTS OF THE CENTRAL BANK INDEPENDENCE

There are many. To be truly independent, the central bank must have:

1.        Institutional independence

2.        Functional Independence

3.        Financial Independence

4.        Personal Independence

5.        Style independence

6.        Instrumental Independence

Institutional Independence

The Central Bank should be independent from the government as an institution. Specific legislation should establish the Central bank as an institution and not a government department. It must have decisions independence of the finance ministry.

Functional Independence

The Central Bank must be independent to be able to carry out its functions, although there should be some degree of consultation but no interference. Otherwise the monetary policy will conflict with the fiscal policy.

Financial Independence or Economic independence

The Central Bank should be free to utilize whatever monetary policy institutions and instruments it chooses. It is not for the government to say lower the interest rates etc, the Central Bank should have freedom to decide. It should have independence to get money directly from the consolidated fund. Its budget is not to be abject the to the Minister for Finance

Personal Independence

Personal independence the ideology tied to it regards monetary issues (conservative – does not function, risk taker) on the part of the central bank governor how is he appointed? If he is a government appointee, he cannot be independent. It should be well remunerated (over side, you can see a guarantee).

Style independence

What’s the specific obligation of the central bank? Specific objective sometimes must be outlined in the statute, other time they will be outlined broadly. Other times expressly stated in specific terms e.g. central bank has the role to maintain the inflation rate at below a certain point3% .No room for maneuver.

Instrumental independence:

This type of independence is tied with financial independence. Central Bank should have full discretion and power to employ and utilize whatever instrument of monetary policy it needs to achieve its goal. There are different capital requirements on deposit money - 8% total capacity of bank – 12 % (shareholder’s equity).

                                                                         

Additional Functions of Central Bank

Besides the above functions, the Central Bank performs many additional functions. It has to study all problems relating to:

-      Credit,

-      Fluctuations in price level, ‘fluctuations in foreign exchange value

-      It has to collect monetary and fiscal statistics,

-      Conduct research and provide information

-      Look after the matters relating to IMF and the World Bank

All in all, the Central Bank is the financial and monetary guardian of the nation.

Qualitative methods

Lender of Last Resort

There are various dimensions to this. The first is that in exceptional cases the central banks acts as the lender of the last resort to the banks. One aspect of which is that where a particular institution faces difficulties the central bank may rescue it. Another aspect of a central bank acting as lender of last resort is where there is a shock to the system as a whole, and cash is withdrawn from a range of banks which is not re-deposited with other banks ( a flight cash”) Such widespread loss confidence is rare, but if it occurs the central bank will provide extra reserves to the banks to avoid a collapse of the system.

Although the Central Bank has not acted as such, nevertheless, if circumstances warrant, the Central Bank of Kenya will act as lender of last resort in the following circumstances:

(i)                             Under high inflationary situations where the general public usually loses confidence in money which loses value due to inflation and as such they prefer to invest in the real estate. Such a situation usually sparks off a rush for deposits which will have to be withdrawn from commercial banks to finance these fixed assets. Commercial banks, however, may not able to stand such a rush for withdrawals as they invest large parts of deposits with drawn from the public and they will have no alternative but to run to the Central Bank of Kenya to borrow. The central bank is bound to lend such money to commercial banks so as to maintain the confidence of the public in keeping deposits in the banks.

(ii)                           In other circumstances the commercial banks will fail to raise the finance necessary to undertake given investment either because the capital injection is too enormous for it or because of liquidity constraints. For this reason the commercial banks will turn to the Central Bank to raise such enormous finance. In all for the Central Bank lend as the last resort, it charges a high rate of integers to discourage use of this finance, of other sources can available at lower cost.

In other words, the Central Bank acts as the lender of the last resort by giving accommodation in the form of re-discounts and collateral advances to commercial banks, bill brokers and their financial institutions. It lends to such institutions when they are faced with difficult situations so as to have the financial structure of the country from collapse.

Creation of Financial Institutions

The Central Bank of Kenya is charged with the duty to establish a full spectrum of financial service to meet the requirements of the economy in a bid to ensure financial soundness. In this regard it encourages the development of capital markets, which are aimed at availing long- term finance for development purposes. In this connection the Central Bank of Kenyans has encouraged and licensed such financial institutions as:

-      Building Societies

-      Mortgage Finance institutions and

-      Finance development companies.

Also, the Central Bank of Kenya has motivated the growth of money markets through the establishment of procedures aimed at encouraging short – term funds. In all, the Central Bank of Kenya is responsible for bridging any ago in the country’s financial system through the licensing of new financial institutions aimed at filling such gap.

Control of foreign Exchange

Foreign exchange means the finance that a given country earns through the sale of goods and services to foreign country. This finance is usually in the form of money such as:

(i)                             Dollars

(ii)                           Deutsche marks

(iii)                         French Francs’ British Sterling Bound and

(iv)                         Japanese yen

These are the lending give currencies in international and at the same time the only currencies that make up the Special Drawing Rights (SDR). The process of management of foreign exchange is aimed at ensuring that there is a balance between the inflows from aboard (receipts) and outflows abroad (payments). For this reason, in a bid to control foreign exchange, the Central Bank of Keya will allow as little money in foreign exchange to leave the country as possible. Thus, only necessities of life can warrant the allocation of such money, but this limitation is done such that it will not damage the economy of the country. In its control of foreign exchange, the Central Bank of Kenya is the sole seller of foreign currencies in Kenya and commercial banks can only do this with the approval of the Central Bank. On the other hand there many buyers of foreign currencies commonly known as Bureu de Change which are scattered throughout the countries e.g.:

-      Commercial banks, tour companies, hotels and

-      small tourist service companies.

These buy foreign currencies on behalf of central bank of Kenya are paid a commission for such a service. They are supposed to submit reports to the Central Bank which are used to compile statistics regarding the balance of payments position of the country and such statistics are useful in the international trade decision making process. In all, the control foreign exchange has been a major policy instrument aimed at conserving foreign reserves and at obtaining a balance of payments in favor of the country.

Further, in relation to foreign exchange the Central Bank may be the source of rules:

-      it might license foreign – exchange dealers,

-      administer foreign exchange controls and

-      be compulsory depository of the foreign exchange earnings of residents (Camdex International Ltd. V, Bank of Zambia [1998] Q.B. 22

More importantly, these days a Central Bank will be subject to rules, albeit minimal as it engages in foreign exchange transactions, either on its own account or as an agent of the government. For example, the Central Bank of England holds the exchange equalization account on behalf of the treasury. It is through this that the government could act in the foreign exchange markets to try to manage the exchange rate of sterling.  (Exchange Equalization Account Act 1979 section 1).

As a custodian of foreign exchange reserves, the Central Bank keeps and manages the foreign exchange reserves of the country It fixes the exchange rates of the domestic currency in terms of foreign currencies, If there are any fluctuations in the foreign exchange rates, it may have to buy and sell foreign currencies in order to minimize the instability of exchange rates.

Areas that fall under Foreign Exchange Control OF Kenya’s Central Bank

1.      Dealing in foreign currencies – this is controlled such that the Central Bank can sell foreign currencies for approved reasons whereas the buying of these currencies is done by approved dealers;

2.      Immigration treatment for residents (citizens) – Kenyans immigrating aboard can be allocated foreign exchange in particular for purposes of maintenance aboard e.g. student’s allowances, tuition, and also those who go for treatment of deceases that cannot be treated locally. This control also applies to residents who are not Kenyans who have been working for some time and want to repatriate their savings. Such can be approved as long as the resident can submit tax returns indicating the source of such finance/income.

3.      Travel aboard- this is limited to few areas, such as official trips, business trips, and organizations attending meetings abroad. Ordinary citizens may be allowed to travel abroad once in two years and will be allocated foreign exchange of around 10,000 equivalent.

4.      Payment for imports – imports into the country must have the approval of the Central Bank of Kenya, thus must fall in the list of times that qualify for foreign exchange allocation. This means that these payments an only be made in the goods / services imported are essential and cannot be produced locally.

5.      Remittances of savings by non – residents – this may be allowed with prior arrangements with the Central Bank although resident expatriates can only be allowed to repatriate 1/3 of their net earnings.

6.      Payments of dividends and profits to non – residents – non-residents who have invested in Kenya can be allowed to repatriate their dividends and profits subject to the availability of foreign exchange.

Regulations aimed at encouraging inflow of foreign exchange into the country

1.      Payments for exports – by the standing regulations of the Central Bank, these must be remitted to Kenya within a period of 3 months, from the export date. For this reason the Central Bank has a follow up machinery which ensures the remittance of such money back home and businesses which do not comply with such regulations may have their export license withdrawn or fined heavily for such a delay of it is intentional.

2.      Foreign exchange capital injection – The Central Bank freely approves and encourages investments by foreigners, in particularly equity capital to companies quoted in Kenya. This foreign capital , if brought in for investment purpose, can only be approved if it is to be invested in areas specified by the Foreign Investment Act.

3.      Non- resident private investment - the Central Bank encourages non residents to invest in Kenya on condition that a reasonable proportion of such investments are raised from aboard, and in this respect non-residents cannot raise finance on local financial markets except with the approval of the exchange control board. These no –residents are allowed to repatriate their capital and profits but the repatriation guarantee is subject to those investment such have been made in areas specified in the Foreign Investment Protection Act of 1964;

4.      Local Financing – non- residents who require loans and overdrafts from local money markets can obtain these with the approval of the exchange control board. However, these finances are available for a period not exceeding two years on condition that the company raising such short-term finance is directly engage in such activities as:

-      Manufacturing

-      Tourism

-      Agricultural production.

5.      Payment of profits and dividends – the Central Bank is the sole body authorized to approve the payment of profits and dividends to non-residents. These can only be approved by the Central Bank of Kenya for investment and even then such approval does not take immediate effect and will be made only if the country has sufficient foreign exchange.

Rate of Exchange of a Currency

The term “rate of exchange” can be defined as the rate at which the country’s local currency s equated to other currencies or gauged in relationship to other currencies. The rate of exchange of a country’s currency varies from time to time and is determined by the forces of demand and supply for currency, although in most case it could be determined by forces external to the country such as imported inflation. These rates of exchange of a currency can be pegged to either S.D.R. or the U.S. Dollar. Kenya’s currency is currently pegged to the latter.

Factors that affect the rate of exchange of a country’s currency:

1.      Economic performance of the country – if a country produces a number of goods and services these will be utilized locally and may be exported. These goods and services produced will contribute to the well – being of the citizens of the country concerned and will influence their confidence in their economy and thus in their currency, which they will not sell in favor of other currencies as their needs are met by local production. Moreover, the value of a currency is influenced by changes in terms of trade of a country, In particular, the increase in its foreign reserves will have a profound influence on the value of its currency For instance, if a country’s currency value increases steadily, it means that its exports have been growing at a reasonable rate. Those countries importing its goods will have a higher demand for exporting countries’ currency with which to settle their obligations. Thus, the importing country’s currency will lose value in comparison to the exporting country’s currency. In all, the country’s natural resources, which dictate what a given country can produce, will in most case influence the value of its currency especially if such a country has developed appropriate technology which it can use to process its natural resources to meet domestic demand and have surplus for export.

2.      Political atmosphere prevailing in a country – under conditions of political upheavals or tribulations the citizens will opt to hold their assets in other currencies in which they have more confidence due to political stability of the country whose currency is in demand. Thus the rates of exchange of a country with political instability will fall as compared to those of politically stable countries. If a country is facing political uncertainties as a result of anticipated change in leadership his will lead to negative attitudes by citizens of such a country as regards their future at home. Such a situation will lead to loss of confidence in their country’s currency in the short – run, thus lessening in value as the citizens will opt for other stable currencies in which to keep their assets.

3.      Interest rates - if interest rates on savings or fixed deposits are high this will attract investment, particularly, foreign investments, and since these must be made in the local currency the demand for such a currency will increase and so will its value in the short run. These interest rates can be manipulated to boost the value of a country’s currency in particular where the currency concerned is easily convertible.

4.      Movement in capital - when a country obtains foreign loans, the debtor will have a higher demand for the creditor country’s currency and due to this increase in demand, the creditor country’s currency will gain in value against the debtor’s country’s currency. This oveent in capital from some country to another influences the date of exchange of the country concerned whereby a net debtor will experience lower rates of exchange of its currency  than a net creditor and vice versa;

5.      Inflation  - under high inflationary situation caused by excessive liquidity , prices of every commodity will increase tremendously if the demand for such commodities continues to increase without a corresponding supply, this usually leads to shortages in some commodities die to hoarding of these essential commodities which may not be available in the country affected This will mean that the citizens of such a country will purchase these goods from other countries through dubious means which will influence the demand of the currency where these goods are purchased and thus the rate of exchange of such currency will be higher as compared to that of the country with inflation. In addition, inflation, usually leads to loss of confidence in the country’s currency which will be sold in large quantities so as to avoid persistent loss in the value of such currencies. This will reduce its rate of exchange vis-a-vis other currencies.

6.      Devaluation – devaluation it is mean the decrease of the value of the country’s currency vis- a- vis other currencies. And this is usually done with the aim of boosting exports. Devaluation will not only lower the value of the local currency but also it might lead to inflation as imports will be more expensive after devaluation (due to cost push inflation). Consistent devaluation of currency can create a loss in confidence of citizens of the country in question who might sell their local currency in a bid to keep their wealth in stable currencies and this will reduce the value of the local currency vis –a- vis other currencies.

7.      Speculations – these may be economic speculations in a country which may increase the value of the currency e.g. if a country has prospects of discovering a valuable natural resource such as oil, precious minerals such as gold, diamonds etc. in large quantities. Investors gain confidence in such a country and there may be an artificial demand for the country’s currency which may increase its value. If such natural resources are discovered the currency will gain in real terms due to the demand of such natural resources by other countries and thus the currency of the country concerned.

8.      Activities in stock exchange in big stock exchanges such as Wall Street of New York, London Stock Exchange and Stock Exchange of Tokyo, the dealing in shares has major effects on the rate of exchange of the currency the buyer will have a higher demand for the currency with which t pay for the shares and this will increase the value of the currency concerned vis–a-vis the buyer country’s currency. This is particularly so where shares are purchased in large quantities for investment or speculative purposes whereby buyers will assess which country’s shares may gain due to the performance of the economy and companies operating in it.

TYPES OF EXCHANGE RATES

1.      Fixed Exchange rate

This is that rate at which the value of currency remains stable vis–a-vis other currencies for a long period of tie. These rates of exchange are fixed by the Central Bank through the process of pegging the currency concerned - Kenya Shilling is currently pegged to the American Dollar, meaning its exchange rate is fixed to the value of the dollar and will move with movement in the value of the dollar.

Advantages of using fixed exchange rate

a)      It stabilizes the export proceeds and as such it may stimulate exports for the period in which it is fixed;

b)      Foreign investors gauge the return on their investments in local currency vis–a-vis their own currencies. A fixed exchange rate will assure these investors of a stable return on their investment which may induce foreign investors, thus increasing the inflow of foreign exchange to the country.

c)      It enables the government to meet its development plans whose budgets are set in local currencies but may be financed by freeing loans and aid;

d)     It may keep inflation under control because the parties of the imported goods will remain stable as long as the exchange rate is fixed. This is particularly true for imported inflation;

e)      This fixed exchange rate will boost confidence of nationals in their currency which will not only stimulate local investments but also increase spavins and cut-down inflation;

f)       Long- terms investment or long term plans can be worked out with substantial accuracy and this may minimize budget deficits with their negative effects.

2.      Floating Exchange rate

a)      This can be defined as that rate of exchange to which there is no formal parity vis–a-vis other currencies. This means that when the rate of exchange of a currency is floating it is left to move in response to different forces, in particular balance of payment. Floating rates of exchange are left to be determined by forces of demand and supply of foreign currencies. In a given country and as such has equilibrium either per day, per week or any other short time all depending on the balance of payments position. Floating rates of exchange frustrate trade and investment and in extreme cases increase inflation in a country. These rates are usually introduced by the Central Banks of the countries concerned. This usually takes place in extreme economic difficulties where the country’s foreign reserve have fallen to such low levels as cannot allow the usual importations of goods into the country and as such a few existing reserves are auctioned at a price determined by the Central Banks of the countries concerned, which in most cases is equivalent to the market price of the currencies.

Dangers of floating rates of exchange to the economy

a)      It discourages investment in particular by foreign investors as they are uncertain about the return to be earned on investments made under floating rates of exchange.

b)      It may discourage trade in particular export trade because exporters may be uncertain about what revenue they will expect to earn when their foreign earnings are repatriated. This can make pricing of exports difficult or impossible

c)      When a country floats its currency, the citizens of such a country may lose confidence in their currency and may opt to hold their wealth on other forms either  in their local currency which may discourage local savings and thus investment and this may lead to slow development. This can also create political problems as the citizens may lose confidence in the country’s leadership due to hardships caused by the floating currency.

d)     Floating rates of exchange will increase (imported) inflation due to the rising cost of imported goods which will lead to hardships among the citizens of the country concerned as this will lower their standards of living.

e)      A country with floating rates of exchange will not be able to attract credit finance from foreign donor and multi-lateral and bi-lateral lenders as these will face uncertainty over the value of the loans and interest repayments and consequent utilization.

3.      Main objectives of monetary tools

The above monetary tools are used to achieve following objectives:

a)      To contain inflation such that the country maintains price stability so as to boost the standard of living in Kenya;

b)      To increase the rate of economic growth which is achieved through investments resulting from savings made by Kenyans;

c)      Creating employment through boosting investments which are aimed at this objective

d)     To ensure exchange stability which means to control foreign exchange outflows and inflows …… it at desirable levels and also to boost exports.

e)      To increase capital accumulation in investment both by the private and public sectors of the economy.

4.      Limitations of using monetary tools to control credit by the Central bank

a)      Not all money supply in the economy can be found with the commercial banks because quite large sums of money are either kept at home or hoarded by various people for different reasons e.g. fear of high taxation, ignorance of advantages of saving with a bank etc.

b)      There may be lack of cooperation between commercial banks and the Central Bank in that Commercial Banks may not give honest feedback of their activities to the Central Bank and this lack of information may limit the Central banks ability to control money supply

c)      Some of the monetary tools used by the Central Bank may not work in the interest of commercial banks because commercial banks, being profit making organizations, will try to avoid risk and invest their money in the most profitable ventures. For instance, a tool like selective credit control which will usually directs commercial banks to invest in agro based industries, may not be in the interest of commercial banks  because such businesses are not only highly risky but also yield low returns. This will mean reluctance of commercial banks to lend money to such sectors.

d)     Financial Institutions in Kenya may not be under full control of the Central Bank and in some cases undertake financial activities which may be contrary to their objectives and also may not adhere to the Central Bank Objectives, in particular where the objectives conflict – building societies may invest in the major industries of the economy instead o building estates or financing such estates.

e)      The Central Bank of Kenya usually does not lend to commercial banks and as such the increase in bank rates may not affect the rates charged by commercial banks if their finance is raised elsewhere. Moreover, some commercial banks in Kenya charge different rates from those approved by the Central Bank of Kenya which may frustrate this role of credit control.

f)       There other finances available from institutions other than commercial banks e.g. trade credit, credit cards, debentures and issue of shares all of which may affect the supply of money in the economy and yet the Central Bank may not have direct control over these finances. This may fail to exercise restrain over their supply.

g)      There lack of information regarding exactly what money is in circulation, particularly that held by financial institutions such as Building societies and thus the Central Bank’s ability to control this fiancé will be limited by lack of information.

h)      The general public particularly people in rural areas, are ignorant about the need for saving with banks and as such there could be a lot of money in circulation with farmers, businessmen, etc., over which the Central Bank may not have control;

i)        Of late, developments in East African economies have affected the value of Kenya Shilling tremendously which has appreciated more than currencies of neighboring countries this has led to huge amounts of Kenya currency being held in those countries and such money is not under the controls of the Central Bank and as such may affect money in circulation;

j)        The Central Bank of Kenya has not been able to undertake strict inspection of the activities of financial institutions due to lack of personnel and this has made most financial institutions a bit indignant in giving full cooperation to the Central Bank in their day to day activities. This has limited the Central Bank’s ability to use its monetary tools effectively.

k)      Some commercial banks operate subsidiary financial institutions through which they channel the deposits of their customers into various investments. This money may not be well traced by the Central Bank as some of these financial institutions may not be under strict control of the Central Bank.

5.      SOLUTIONS TO THE PROBLEMS

1.      The Central Bank should intensify its inspection of operations of the various commercial banks and financial institutions in Kenya

2.      The Central Bank should watch over all financial institutions operating in Kenya so that it can use the above tools to influence the economy more flexibly.

3.      There should be mass education of the public, particularly in the rural areas, which should be aimed at enlightening the rural savers as to the need and benefit of saving with banks. This will allow the Central Bank to have access to such money which is otherwise kept in tins, pillows, hotels etc.

4.      A law, restraining commercial banks from establishing subsidiary financial institutions should be passed to ensure that commercial banks do not channel some of their deposits into their subsidiaries thus eluding the possibility of the Central Bank controlling such deposits channeled to subsidiaries.

5.      The Central Bank should offer reasonable rates in interest on Treasury Bills so as to make them attractive to most of the investing public. This will boost open market operations.

6.      Also, the Central Bank should reduce the par value of Treasury Bills so as t o make then affordable to the general public to boost open market operations

7.      The Central Bank should also look into ways of withdrawing or relaxing selective credit control, in particular those affecting indigenous business enterprises so as to induce balanced growth in the economy because the country’s economy in agro-based and manufacturing sectors are interdependent and the problems in one sector will equally affect the other

8.      Formalities should be removed by commercial banks e.g. those for opening up savings and current accounts. These formalities have discouraged the- would be savers from opening accounts with banks. Such formalities have discouraged the-would be savers from opening accounts with banks. Such formalities include:

(i)                             Minimum deposit of Kshs. 1,000/=

(ii)                           Guarantors

(iii)                         limit on number of withdrawals

(iv)                         be limited company and not an individual

9.      The Central Bank should encourage commercial banks to open up branches in most of the rural areas to tap the savings from the public being closer to them

10.  The Central Bank should undertake a vigorous campaign to educate most of the commercial banks, in particular private and foreign owned banks, to adhere to its rules and regulations governing the management of the economy and stiff penalties should be imposed to those commercial banks which flout the Central Bank guidelines.

Even if central banks lack goal independence – the banks such as the Central Bank have their goal or price stability set for them,

Implementation of Monetary Policy

A central Bank implements the country’s chosen monetary policy. At the most basic level, this involves establishing the form of currency the country may have, whether a flat currency, a gold-backed currency, a currency board or a currency union. When a country has its own national currency, this involves the issue of some form of standardized currency, which is essentially a form of promissory note – a promise to exchange the note for “money” under certain circumstances. Historically, this was often a promise to exchange the money for precious metals in some fixed amount, Now, when many currencies are fiat money the “promise to pay” consists of nothing more than a promise to pay the same sum in the same currency.

Many Central Banks are “” banks” in the sense that they hold assets and liabilities. A Central Bank’s primary liabilities are the currency outstanding, and these liabilities are backed by assets the bank owns. Unusually, however, Central Banks in jurisdiction with fiat currencies such as US, may “create” new money to back its own liabilities to theoretically unlimited amounts.

In many countries, the Central Bank may use another currency either directly or indirectly, bys is using a currency board. In the latter case, local currency is directly backed by the Central Banks’ holdings of a foreign currency in a fixed – ratio. This mechanism is used m notably, in Hong Kong and Estonia. In countries with fiat money, monetary policy may be used as a short hand for the interest rate targets and other active measures undertaken by the monetary authority.

              

a)    Exchange banks

b)    Industrial banks

c)    Cooperative banks

d)   Savings banks

e)     Investment banks (though falling outside the ambit of this course)