Background to Augusts Inflation Inflation maintained its downward trend in the latest KNBS publication.

The CPI for August declined 0.31% to 131.51 from Julys stand of 131.92. In August, Year-on-Year inflation stood at 6.09%. Inflation hit a high of 19.72% in November 2011 with the downward trend commencing the following month. This is the 9th month that inflation has maintained this trend. A milestone was achieved as well with inflation finally breaking the MPCs Medium Term target of 9%. The key drivers of the CPI are Food and Non-Alcoholic Drinks (36.04%) and Housing, Water, Electricity, Gas and other Fuels (18.30%). Inflation in August declined mainly due to the following; Kenya imports the ADNOC MURBAN crude oil that traded at USD 97.35 per barrel in June, the lowest level in the year. The downward pressure on Oil prices in July was maintained due to less than favorable economic data from China, US and European worries. China is the second largest consumer of the black gold after the US indicating a significant market loss for OPEC. Furthermore the Eurozone crisis prices even further with Brent crude oil trading at USD 96 per barrel touching the lowest level since January 2011. This came as a relief to Kenya since Oil is its largest component of the import bill. The ERC passed on this benefit to pump price consumers. Further relief on the Food and Non-Alcoholic component was witnessed in the month as better than expected harvests boosted supply driving down prices on foods tomatoes, potatoes, maize flour, cabbage and carrots. The Western highlands, lake Victoria Basin and parts of Rift Valley (bread basket of Kenya) received near-normal rainfall informing the improved harvest as well as increase dairy produce (milk) due to suitable pasture lands. The Kenya Shilling remained stable within a tight band of 83.50-84.50 vs. USD (this was resonated across the other currency pairs). By end of August 2012 the KES was +0.87% Year to Date and +9.93% Year on Year. The consequences of a stable currency are reduced import bill (declining oil prices aided as well) and an increased purchasing power.

What Factors inform the Decision? The MPC will be sitting on 5th September 2012 on the back of a 150bps decline to 16.50% in their last meeting in June. At the same meeting the MPC decided to be convening bi-monthly from the recently adopted monthly frequency. The implication of this move indicates that the MPC are willing to tread cautiously when it comes to rate cuts, if any. The variables considered are; Inflation Currently stands at 6.09% way below their medium term target of 9%. Please note that the initial medium term target was 5%. The increase to 9% was done in Q1 2012 when inflation was averaging 16% and exposed the MPCs doubt of the 5% target to be met in the year. Interest rates are an indicator of inflation with the 91-Day T-Bill depressed from highs of 22% earlier this year to the current levels of 8.12%. Interbank rates have declined from highs of 18% to 7.41% as of yesterday.

KES Stability The USD 600Mn syndicated loan received in May-June has provided enough ST cover for the CBK. The KES has been extremely stable with the regulator willing to sell FOREX directly to Commercial Banks if and when needed. External Shocks The Eurozone crisis and oil price volatility is out of our hands. The Eurozone is Kenyas largest export market and any negative influence will have a direct impact on our current account. Oil is the largest component in our import bill it is very sensitive to any on-goings in the Middle East.

Pre-Empt of the MPC Decision The tightening policy has achieved the desired objectives informing the industrys stance of a rate cut in tomorrows meeting. The question is the size of the cut and we at Genghis Capital believe a maximum cut of 200bps is sufficient. We believe in tomorrows meeting, the MPC will focus more on External Shock factors as majority of the internal ones have been attained. Our decision is informed by; Stability at the pump? - Diesel and Kerosene down Kes.8, Super Petrol down Kes.9.21 and Regular Petrol down Kes.11.70 all from the previous monthwhich necessitated a reduction in transport prices and brought a decline in the CPI transport component for the month. Kerosene is the most utilised cooking fuel amongst Kenyan households thus the decline was a welcome relief to users. The fuel adjustment portion of Electricity bills rose with Kenya Power announcing an upward adjustment in electricity tariffs Fuel Levy up 27 cents to Kes.5.66 per unit and Foreign Exchange Levy from 76cents to Kes.2.80 (note that the foreign exchange levy was not increased due to volatility in the KES but rather to service impending loan premiums for KenGen). The recent Iran Sanctions by the USA, geopolitics especially in Syria, Hurricane Isaac and weak economic data from US and China all negatively affected oil prices pushing them to over USD 112 for the Brent Crude oil. There are reports of increasing supply to the region of 60Mn barrels to ease the price appreciation but OPEC havent confirmed yet. Declining regional inflation - The inflation rate has been on a downward trajectory across all EA members with all Central Banks in the region cutting their benchmark rates for instance the UG central bank cut its rate by 100 basis points consecutively for two months and with a further cut (probably 150bps) is expected in todays MPC meeting. Taking this into account (as UG and TZ face similar economic problems), a 200bps cut would be in order as a radical 400bps cut (consensus estimate) would result in an immediate influx in liquidity into the economy resulting in aggressive mop-up exercises by the Central bank majorly done via repos and TADs. Euro zone crisis - The prolonged euro crisis portends a squeezed market for Kenyan agricultural exports mainly horticultural stock leading for decline in foreign earnings that might put pressure on the Kenyan shilling going forward thus necessitating the need to look at newer markets for our commodities. This would suggest a cautionary approach (200 bps) to shield the currency from external shocks even evidenced by the Central banker directing that banks must have a minimum core capital of Kes. 1Bn (latest legislation) as we wait the crisis to ease out.

Tourism A vital sector and critical source of the countrys FOREX, is set to record lower earnings compared to the previous period last quarter due to booking cancellations that were as a result of the riots witnessed at the end of last month and a South African airline withdrawing from the Mombasa route. This will tend to impact on the countrys foreign exchange reserves (USD 5.12 BN) that currently covers 4.3 months of import. Too much of a cut will risk short term shilling stability implying a surge in imports not to mention the anticipated shilling volatility that will occur nearing the election period. Cereal prices - Grain prices especially that of maize are expected to be fairly stable in the next six months due to bumper harvests - a surplus of 9.8 million bags inclusive of a perennial 15% post-harvest loss, reported in the countrys food basket regions with NCPB offering Kshs 3000 for a 90kg bag of maize that is expected to entice farmers to sell their produce rather than hoard it in hope of higher prices. Wheat though not a major component of Kenyan household budgets is expected to register a price increase brought about by a severe drought that hit the USA expectedly putting pressure on supply of the commodity worldwide.

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