Liberalization of the foreign exchange market in Kenya and the short-term capital flows problem

The paper analyses the relationship between real exchange rate movements and real interest rate differential on the one hand, and the impact of short-term (speculative) private capital flows and domestic and external shocks on the real exchange rate on the other. This has been analysed in two stages. First, it is expected that a purchasing power parity cannot hold and so the nominal exchange rate is shown to deviate from the perceived long-run equilibrium level determined by the purchasing power parity relationship and these deviations are governed by interest rate differential. It is shown that domestic inflation will rise with a real exchange rate depreciation and that the influence of foreign inflation will decrease with exchange rate appreciation. In the second stage of the analysis, a vector autoregressive (VAR) model is estimated with private short-term capital flows entering the model in levels and in their volatility form. The results confirm that domestic as well external shocks influence the movements of real exchange rate and real interest rate differential, thereby directly affecting or triggering capital flows. The policy lessons relate to the interest rate structure and the effects on the real exchange rate. Interventions to stem adverse movements in the nominal exchange rate seem to lead to high interest rates. This is one of the aspects of policy dilemma argued in the paper. Closing the gap in the real interest rate differential (that is lowering the domestic interest rate) will be consistent with a depreciation of the exchange rate. Perhaps the optimal approach is to limit intervention in the foreign exchange market and thus allow capital flows to be stabilized by the exchange rate movements in the medium to long term. This will remove the effects on the interest rate structure.