|Kenya's capital and financial account balance displays a sharp shift in external financing from official assistance to private capital
transfers in the 1990s. Whereas the capital account of the balance of payment reflects a surplus, the current account balance shows a huge deficit, which is increasing over time. Foreign exchange reserve, on the other hand, is building up. This paper examines the relationship between short-term private capital flow and real exchange rate in Kenya. Using Vector Error Correction Model (VECM), the analysis reveals that a long-run relationship exists between real exchange rate and its fundamentals. Furthermore, short-term private capital flows are associated with exchange rate appreciation, such that a 10 per cent increase in short-term private capital flows will appreciate the real exchange rate by 0.5 per cent. Other macroeconomic variables
are also identified as having negative effects on the real exchange rate. The study reveals that real exchange rate appreciation leads to a loss of external competitiveness, which hurts exports, and that sterilization through sale of government securities to mop-up excess liquidity seems a sub-optimal option since interest rates are affected in the process. An important policy intervention is that of reducing domestic interest rate to close the gap in real interest differential. This may lead to a reduction in short-term private capital flows and eventual weakening of the shilling.