Beyond dollar rate: IMF identifies hidden warning signs CBK can use to spot shilling stress

Kenya's currency market may be revealing hidden signs of stress that are not apparent from the headline exchange rate, according to new International Monetary Fund (IMF) research. This research offers a framework for central banks to identify whether currency movements are driven by economic fundamentals or financial-market stress.

President William Ruto emphasized the need to translate Kenya's macroeconomic stability into more affordable credit for households and businesses during the CBK's 60th anniversary celebrations. While the country has made progress on economic stability, the benefits have not yet fully reached borrowers. The IMF study, published in September 2026, examined 15 years of monthly data from 25 emerging market and developing economies.

The research indicates that a currency's movement does not always indicate the reason behind the change. Exchange-rate fluctuations can be caused by shifts in economic fundamentals or financial shocks that disrupt currency markets. This distinction is crucial for countries like Kenya, where the shilling's performance impacts import costs, external debt servicing, inflation, and business financing conditions.

One key indicator from the IMF framework is the uncovered interest parity (UIP) premium, which reveals investor compensation for currency risk and can indicate stress in foreign-exchange markets. Other signals include bid-ask spreads, capital flows, interest-rate differentials, and broader funding conditions. A widening bid-ask spread suggests deteriorating liquidity and difficulty matching buyers and sellers.

The IMF study found that financial shock-driven episodes account for about one-third of UIP premium fluctuations in countries like Brazil and Chile, often correlating with significant contractions in economic activity. This challenges the assumption that every currency movement should automatically signal a deteriorating economy.

The research does not determine if Kenya is currently facing a financial shock but provides a framework for policymakers to distinguish between currency movements caused by economic fundamentals and those linked to financial-market dysfunction. The Central Bank of Kenya (CBK) operates a market-determined exchange-rate system, where the shilling's value is determined by supply and demand.

CBK can intervene to mitigate excessive volatility rather than targeting a specific exchange-rate level. As of September 17, the shilling was listed at Ksh129.62 against the US dollar, with the CBK rate at 8.75 per cent, while the average commercial bank lending rate was 14.39 per cent in July. President Ruto's pressure on lenders to reduce credit costs comes amid these concerns.

The IMF research suggests that policymakers should determine the source of exchange-rate pressure before deciding on intervention. Not every spike in currency risk premia requires action, as fundamental economic shocks can also produce similar movements. For CBK, the headline rate is just one piece of the puzzle. More revealing signals may emerge from liquidity conditions, investor risk premiums, capital movements, and foreign-currency funding costs.

This timely report adds another layer to Kenya's debate on translating monetary and financial stability into stronger economic activity.