The International Monetary Fund (IMF) has backed central banks’ interventions in the foreign exchange market to address fluctuations emerging from financial shocks like increased global volatility and broad US dollar strength.
The multilateral guidance comes amid continued focus on the Central Bank of Kenya (CBK) role in the foreign exchange market as the Kenya shilling marks prolonged resilience even under increased external pressures like the US-Israel war on Iran and a reversal in developed economies’ policies where both the US and the EU central banks have raised benchmark rates.
A staff team at the IMF has recommended that arbitration by central banks be restricted to financial shocks rather than fundamental causes of currency weakness like changes in economic output/productivity or monetary policy adjustments.
The Kenya shilling has held steady against the US dollar amidst evolving global shocks and has traded in a narrow-bound range of between 128 and 130 since August 2024.
CBK does not describe factors driving its interventionist policy in the foreign exchange market, but it says its interference is limited to stamping out volatility.
The apex bank mainly intervenes in the foreign exchange market by selling currencies in the event of a sharp currency depreciation but buys other currencies like the US dollar when the shilling appreciates sharply.
‘A key consideration for policy makers is distinguishing exchange rate movements driven by shifts in macroeconomic fundamentals from those reflecting changes in financial conditions that affect currency risk premia and market functioning,’ the IMF says in staff discussion notes that aim to elicit debate on the implications of foreign exchange intervention.
‘This distinction is critical for policy strategy; in the former case, exchange rates should typically be allowed to adjust to facilitate macroeconomic adjustment, while forex intervention may potentially be justified in the latter case.’
The IMF staff discussions notes state that determining when to intervene in forex markets remains a major policy challenge for central banks in emerging markets and developing economies (EMDEs), amid heightened global volatility.
The IMF lists three cases that warrant forex interventions including smoothing destabilising risk premia –a phenomenon that describes a fluctuation in the premium demanded by investors to hold risky assets in a way that results in greater market volatility and economic instability.
Central banks can also intervene to address financial stability risks from forex mismatches and to support price stability.
The phenomenon is exacerbated in the event of financial shocks like a financial crisis or when the US dollar and other major currencies strengthen considerably against EMDE counterparts.
Financial shocks are revealed in currency markets through imbalances between currency demand and supply and when market liquidity dries up quickly.
IMF has created a tool to help central banks separate currency fluctuations resulting from shocks and those that occur from fundamentals, employing 10 pointers including interest rate differentials, inflation, net capital inflows, net purchase of foreign currencies and the monetary policy rate.
CBK does not publicly disclose when it makes interventions in the forex market, but analysts have mostly tracked the movement of foreign exchange reserves balances to determine instances of arbitration.
CBK Governor Kamau Thugge previously attributed the relative strength of the Kenya shilling to adequate foreign reserves buffers in response to queries on the currency stability amid evolving global risks.
‘I know a lot of people wonder how we’ve been able to maintain a stable exchange rate for such a long time,’ Thugge told an audience at the 23rd East African Banking School Conference in July.
‘We still expect a fairly strong balance of payments position this year, notwithstanding what is happening in the Middle East, and therefore, we expect the exchange rate to remain relatively stable.’