The Kenya shilling has rallied to a six-month high against the dollar following intervention by the Central Bank of Kenya (CBK). The unit is now trading at about 129.5 per US greenback a shift from the lows experienced in the post Covid-19 pandemic period.
The CBK’s net dollar sales have helped stabilise the exchange rate, signaling improved confidence in the foreign exchange market.
While a stronger currency is often perceived as positive, its actual impact on the economy is more complex.
Looking keenly at Kenya’s trade structure, inflation trends, and fiscal position, it becomes clear that exchange rate movements alone do not determine economic resilience.
On one hand, appreciation cuts the cost of imports in local currency terms, easing inflationary pressures and lowering the burden of servicing foreign-denominated debt, while on the other hand, it has direct implications for customs revenue, trade competitiveness, and broader fiscal policy.
Limited impact of currency strength
A common expectation is that a stronger currency makes imports cheaper, thereby boosting import volumes. However, looking at Kenya’s import composition, this effect is minimal.
Over the years, essential imports—including fuel, machinery, and food—have consistently accounted for nearly half of total imports. These goods are price inelastic, meaning that their demand does not significantly change even when prices fluctuate. As a result, even with a stronger shilling, the quantity of imports remains largely static.
Additionally, importers often factor in long-term currency trends when making decisions, meaning that short-term exchange rate movements do not necessarily drive immediate changes in trade volumes.
Instead, the primary effect of appreciation is felt through valuation—imports become cheaper in shilling terms, reducing the taxable value of imported goods.
This has direct consequences for customs revenue, as import duties and VAT are charged based on the cost, insurance, and freight) value of imports.
Customs revenue, exchange rate, and valuation effect
While appreciation of the shilling reduces the cost of imports, it does not necessarily increase import volumes. Instead, it primarily lowers the valuation of imports, leading to a decline in customs revenue.
Historically, Kenya has relied on import duties and VAT as a significant component of tax revenue. During periods of currency depreciation, customs revenue tends to rise because higher import prices translate to higher tax collections.
However, when the currency appreciates, the opposite occurs—imports become cheaper in local currency terms, reducing tax revenue.
Looking keenly at recent trends, it is evident that customs revenue gains have often been valuation-driven rather than volume-driven. In other words, revenue growth has been more linked to rising import prices rather than an actual increase in trade activity.
With appreciation now reversing this trend, the government faces the challenge of maintaining tax revenue without relying on exchange rate-driven valuation effects.
Real vs nominal exchange rate: Why it matters
Beyond the immediate impact of exchange rate appreciation, it is crucial to distinguish between the nominal exchange rate (NER) and the real exchange rate (RER). While former represents the direct exchange value of the shilling against foreign currencies, the latter adjusts for inflation differences between Kenya and its trading partners.
This distinction is critical in understanding the true competitiveness of Kenya’s trade sector.
If domestic inflation rises faster than global inflation, RER appreciates even when NER remains stable or depreciates. This is particularly relevant in Kenya, where inflationary pressures have persisted, particularly in energy, transport, and food prices.
As a result, while the nominal exchange rate suggests a stronger shilling, the real exchange rate may still reflect an appreciating trend, making Kenyan exports relatively more expensive in global markets.
In addition, the divergence between NER and RER explains why real imports remain stable despite fluctuations in the nominal exchange rate. While NER affects the valuation of imports, RER has a stronger influence on actual trade flows.
This reinforces the argument that focusing solely on NER movements can be misleading when analysing trade performance and revenue implications.
Debt and fiscal implications of exchange rate movements
Another critical impact of currency appreciation is on debt servicing. Since a significant portion of Kenya’s public debt is denominated in foreign currency, a stronger shilling reduces the local currency cost of external debt repayments.
This improves the debt-to-GDP ratio, easing short-term fiscal pressure. However, while this provides temporary relief, the broader fiscal outlook remains uncertain.
While appreciation reduces the cost of servicing external debt, it also erodes customs revenue, creating a fiscal challenge. Kenya’s reliance on trade taxes means that any reduction in the valuation of imports directly affects government revenue.
Additionally, if inflation remains elevated, domestic debt servicing costs could rise, offsetting the gains from a stronger shilling. A sustainable debt strategy must therefore consider both exchange rate movements and broader macroeconomic factors, including inflation control and revenue diversification.
Way forward: Strengthening fiscal and trade resilience
Given the complexities of exchange rate dynamics, Kenya needs a more strategic approach to managing its economic outlook. Instead of relying on exchange rate-driven revenue gains, the government should prioritise revenue diversification through enhanced domestic taxation and improved tax compliance.
This would reduce over-dependence on customs revenue, ensuring greater fiscal stability even during periods of currency appreciation.
Additionally, structural reforms aimed at reducing import dependence can help cushion the economy from exchange rate fluctuations.
Expanding domestic production in key sectors such as energy, manufacturing, and agriculture would enhance Kenya’s trade resilience, reducing reliance on imported goods.
Furthermore, regional trade integration within the East African Community (EAC) and the African Continental Free Trade Area (AfCFTA) offers opportunities to boost exports, mitigating the negative effects of exchange rate appreciation on trade competitiveness.
Conclusion
While Kenya’s recent exchange rate appreciation has provided short-term relief in external debt servicing and currency stability, its impact on trade and revenue is more nuanced. The limited responsiveness of import volumes to currency movements means that customs revenue is primarily affected through valuation effects rather than increased trade activity.
Additionally, inflationary pressures continue to shape the real exchange rate, influencing trade competitiveness in ways that nominal exchange rate movements do not fully capture.
To navigate these challenges, Kenya must adopt a balanced macroeconomic strategy that prioritises trade facilitation, revenue diversification, and inflation control.
A stronger shilling alone is not a sufficient indicator of economic resilience; instead, sustainable fiscal policies, enhanced domestic production, and regional trade integration will be key in ensuring long-term economic stability.
The writer is research macroeconomist at KRA. Email: [email protected]
