This article first appeared in my weekly column with the Business Daily on January 25, 2015
Oil prices have fallen by more than half from the mid-2014 peak. Most look at this as a positive development for Kenya, but they are missing an important point; there is a link between low oil prices and a strong US dollar.
Analysts have long observed the correlation between low crude prices and a strong dollar.
Why does this happen? The answer is unclear. But one explanation is that when there is plenty of global liquidity and returns from traditional financial assets are low, large amounts of money are shifted to commodity markets and the oil market in particular, thus oil prices go up.
In the inverse case, when the prospect of returns from traditional financial assets is elevated, money is shifted out of commodity markets such as oil, leading to a decline in price.
The US is on the mend as will be discussed below, and this raises prospects of good returns from traditional financial assets and this may be a factor that explains how a strong dollar puts downward pressure on oil prices.
The inverse relationship between crude prices and the dollar will have an impact on the Kenyan economy, but which will carry the day?
According to an analyst interviewed by Reuters, the negative effect of the stronger dollar on global liquidity outweighs the positives from falling oil prices by a ratio of 10 to 1.
Let’s look at the effect lower oil prices can have on Kenya’s economy. Inflation should fall and so should the Current Account Deficit (CAD).
Additionally, lower oil prices are associated with stock surges in the country and portfolio investors targeting Africa are now focusing more on oil-importing countries such as Kenya and looking away from oil-exporting countries.
But Kenyans should also look at the other side of the equation; a strong dollar.
Behind the rise of the dollar are important related factors. Firstly, the US economy is recovering with positive growth prospects while forecasts for other developed economies in particular are being revised down.
The US GDP (annualised) grew 4.6 per cent in Q2 and 3.5 in Q3 while there are concerns about deflation in Europe for example.
There is also a reported improvement in the US current account deficit and some argue that more tension between and Ukraine and Russia could not only further dampen growth in Europe, but this uncertainty could make the Euro even more unattractive for investors pushing them to US dollars.
Kenya faces numerous problems if the trend of the strong dollar continues. To begin with the strong dollar is rising in the context of a weakening Kenya shilling due to low demand for shilling-backed investments (bad for stocks and local debt issues).
Additionally, some imports will become more expensive for Kenya, which is an import economy, thereby placing upward inflationary pressure on the economy (which may counter the deflationary power of low oil prices).
On top the strong dollar will strain the CBK’s capacity to continue injecting dollars into the economy without running down its own foreign exchange reserves.
Finally, Kenya’s dollar denominated debt will be more expensive to service and paying back a strong currency in a weak one is a sombre combination.
Thus although low oil prices are a welcome development, the association with a strong dollar has an ominous undertone for the economy of which Kenyans should be aware.