The local currency has lost 16 percent against the dollar this year, battered by falling appetite for riskier currencies in frontier markets like east Africa and a perception that the country's monetary policymakers have fallen behind the curve.

Central Bank head Njuguna Ndung'u said commercial banks had been given plenty of leeway in the amount of funds they could hold in foreign currencies as a percentage of core capital, and this might be reviewed.

"In Kenya it is set at 20 percent. This is what has given commercial banks massive room to speculate and drive the market beyond what the fundamentals are showing," Ndung'u told Reuters in a statement.

Traders said the effectiveness of any move to cut the percentage would depend on underlying dollar demand, adding that it might spawn a parallel options market of non-deliverable forwards.

"The central bank is still convinced that this (shilling weakening) is driven by speculation. By restricting trading, they want to cool off the volatility," said a trader with a leading commercial bank.

"But if there is underlying dollar demand, it won't help much."

The shilling closed at 93.40-60 against the dollar on Monday, weaker than Friday's close of 92.80-90.

Ndung'u said inflation could not be blamed for the volatility in the exchange rate.

"The daily volatility cannot be driven by the inflation differential between Kenya and its trading partners. So this must be speculation, but by who? The banks themselves," he said.

Ndung'u said the option of reviewing the amount banks are allowed to hold in foreign exchange as a percentage of their core capital fits in well with the regulator's analysis of market behaviour and will therefore define the next course of action.

"If the fire burns so wildly, you get the meat away from the fire. Similarly we need to protect the market from itself," Ndung'u said.

Aly Khan Satchu, an independent analyst said the move was in keeping with the tradition of policymakers the world over to blame speculators when a currency weakens sharply.

"The issue at hand is the differential between inflation at 15.5 percent and the central bank rate of 6.25 percent. Confidence in policymaking at the central bank is low," Satchu said.

Copyright Reuters, 2010