Anchoring High Growth Can Manufacturing Contribute More?

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized December 2014 Edition No. 11 Anchoring High Growth Can Manufacturing Contribute More?

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3 Anchoring High Growth Can Manufacturing Contribute More?

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5 TABLE OF CONTENTS ABBREVIATIONS AND ACRONYMS... FOREWORD... ACKNOWLEDGEMENTS... MAIN MESSAGES AND KEY RECOMMENDATIONS... EXECUTIVE SUMMARY... THE STATE OF KENYA S ECONOMY Economic Performance in Rebasing reveals that Kenya s economy is larger than previously estimated Kenya s economy is strong Fiscal policy was expansionary, increasing the deficit and the debt burden The Central Bank s monetary policy stance supported growth Kenya s external balance deteriorated in 2014 but is set to improve in 2015, thanks to falling oil prices Growth Outlook for Kenya s growth prospects are favorable in the near to medium term Risks have diminished, although they remain significant SPECIAL FOCUS: Why is manufacturing important? Introduction The contribution of manufacturing to GDP and exports has been stagnant Allocative inefficiency is low and hinders job creation A good business environment allows firms to grow and create jobs What obstacles and constraints do firms face? Evidence from Enterprise Surveys What can policy makers do to spur manufacturing? REFERENCES ANNEXES List of Figures Figure 1: Kenya s economy is larger than previously estimated and among the fastest-growing in the region v Figure 2: Kenya s growth compares favorably with its peers... v Figure 3: Value added per worker in Kenya s manufacturing sector is a fraction of what it was 30 years ago x Figure 1.1: Kenya s economy is larger than previously estimated... 2 Figure 1.2: Rebasing GDP revealed that Kenya grew more rapidly than previously estimated... 2 Figure 1.3: Kenya s now has the ninth-largest economy in Africa... 4 Figure 1.4: GDP rebasing increased the contribution of some sectors and decreased the contribution of others 4 Figure 1.5: Growth was robust... 5 Figure 1.6: Tea production remained constant and prices declined significantly... 6 Figure 1.7: Other industry saw the fastest growth... 6 Figure 1.8: Generation of electricity rose, and geothermal generation became the largest source of energy 7 i ii iii iv v

6 Figure 1.9: Growth in the services sector slowed... 7 Figure 1.10: Mobile money payments continued to soar... 8 Figure 1.11: Inflation was low albeit higher than in Figure 1.12: Gasoline prices fell but by much less than international crude oil prices... 9 Figure 1.13: Kenya s fiscal deficit has increased since 2006/ Figure 1.14: Total government spending rose, but spending by the central government fell Figure 1.15: Public debt has been rising but remains sustainable Figure 1.16: Kenya s debt position is below the average of its middle-income peers Figure 1.17: All types of tax revenues rose Figure 1.18: Budget execution of ministerial expenditure varied widely across sectors Figure 1.19: County budget execution in 2013/14 was weak Figure 1.20: The lion s share of county spending went to recurrent expenditures, not development Figure 1.21: Revenue collection varied widely across counties Figure 1.22: In cross-county comparisons, low budget execution is associated with poor revenue collection 16 Figure 1.23: Both short- and long-term rates declined Figure 1.24: The growth of monetary aggregates boosted private sector credit Figure 1.25: Credit to the private sector was brisk Figure 1.26: Kenya s stock market underperformed the Dow Figure 1.27: Kenya s external sector remains out of balance, with exports failing to keep up with imports.. 18 Figure 1.28: Short-term flows dominated the capital and financial account Figure 1.29: The export coverage ratio has declined since Figure 1.30: The shilling demonstrated mixed performance Figure 1.31: The real exchange rate shows the shilling has appreciated significantly since Figure 1.32: Remittances reached an all-time high Figure 2.1: The outlook for economic growth in Kenya is strong Figure 2.2: The current account balance is projected to improve significantly as a result of lower oil prices 23 Figure 2.3: Foreign direct investment in Kenya is much lower than in peer countries Figure 3.1: Value added per worker in Kenya s manufacturing sector is a fraction of what it was 30 years ago 26 Figure 3.2: Manufacturing growth trailed overall economic growth in Kenya between 2010 and Figure 3.3: Manufacturing growth in comparator countries was more rapid than in Kenya Figure 3.4: The manufacturing sector s contribution to Kenya s GDP was similar to that of comparator countries in 2013, but sector growth was much slower Figure 3.5: The East African Community reduced its imports from Kenya in Figure 3.6: Kenya s share of imports of chemicals, plastics, and paper by the East African Community has been falling Figure 3.7: Labor productivity (log of value added per worker-lva_l) varies widely across Figure 3.8: manufacturing subsectors In many subsectors in Kenya, lower-productivity firms employ more workers than higher-productivity firms Figure 3.9: Old firms in the United States create twice as much employment as old firms in Kenya Figure 3.10: The strongest aspects of Kenya s business environment are starting a business, obtaining construction permits, and paying taxes Figure 3.11: Manufacturing firms perceptions of obstacles to doing business changed between 2007 and Figure 3.12: Average change in perceived obstacles by manufacturing subsector ( ) Figure 3.13: Average change in de facto obstacles by manufacturing subsector Figure 3.14: Kenya s business environment first stagnated and then deteriorated, while conditions in most of its peer countries improved... 44

7 List of Tables Table 1.1: Selected indicators before and after GDP rebasing... 3 Table 1.2: Policy implications of GDP rebasing for macroeconomic indicators (percent of GDP)... 5 Table 1.3: Both recurrent and development spending rose in 2013/14 (percent of GDP) Table 1.4: County governments registered a surplus in 2013/14 (millions of KSh) Table 3.1: Growth rates and shares of manufacturing subsectors in Kenya, 2013 (percent) Table 3.2: Kenya s top 10 manufacturing exports and top 2 export destinations, Table 3.3: Labor productivity in Kenya, by manufacturing subsector, Table 3.4: Correlation between productivity growth and firm size in Kenya, by sector Table 3.5: Severity of obstacles to firm performance in the manufacturing sector, 2007 and Table 3.6: Perceived obstacles and their de facto counterparts in Enterprise survey Table 3.7: Most important obstacles to doing business in selected comparator countries (all sectors) Table 3.8: Most important obstacles to doing business in selected comparator countries (manufacturing sector) List of Boxes Box 1.1: Why rebase GDP?... 3 Box 3.1: Data used in the analysis... 27

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9 ABBREVIATIONS AND ACRONYMS AGOA African Growth and Opportunity Act CBK Central Bank of Kenya CBR Central Bank Rate COMESA Common Market for East and South Africa EAC East African Community esws Electronic Single Window System FDI Foreign Direct Investment FLSTAP Financial and Legal Sector Technical Assistance Project FY Fiscal Year GDP Gross Domestic Product GNI Gross National Income ICT Information Communication and Technology IFMIS Integrated Financial Management Information System IMF International Monetary Fund ITC International Trade Center KSh Kenyan Shilling kbrr Kenya Banks Reference Rate KNBS Kenya National Bureau of Statistics KPMG Klynveld Peat Main Goerdeler (a professional services company) KWh Kilowatt-hour L Labor Lao PDR Lao People s Democratic Republic LAPSSET Lamu Port-South Sudan-Ethiopia-Transport MTPII Second Medium Term Plan NEO Net Errors and Omissions NSE Nairobi Securities Exchange NTBs Non-Tariff Barriers OECD The Organization for Economic Co-operation and Development OP Olley-Pakes PAYE Pay As You Earn PFM Public Finance Management SADC Southern Africa Development Community SGR Standard Gauge Railway SMEs Small and Medium Enterprises SSA Sub-Saharan Africa Tbill Treasury Bill TFP Total Factor Productivity U.S United States U.S Fed United States Federal Reserve UK United Kingdom UN United Nations UN COMTRADE United Nations Commodity Trade Statistics Database UNCTAD United Nations Conference on Trade and Development VA Variance VAT Value Added Tax WDI World Development Indicators WTO World Trade Organization December 2014 Edition No. 11 i

10 FOREWORD It is my pleasure to present the 11 th edition of the Kenya Economic Update. Kenya begins 2015 in a sound economic position. It is experiencing solid growth, driven by sustained infrastructure investments, strong growth in other industry sector, and strong agricultural production. At last Kenya is emerging as one of East Africa s growth centers. Kenya s macroeconomic policies have laid a strong foundation for future growth. Its expansive fiscal policy allowed it to finance infrastructure projects without putting excessive pressure on domestic financial markets while keeping public debt within the 50 percent threshold. Its accommodative monetary policy stance has supported economic activities without triggering inflation or putting pressure on the exchange rate. This overall positive outlook is, however, not without risks. The tourist sector has been hobbled through reports and concerns about security that has hit economic activities at the coast especially hard. This Economic Update (KEU edition 11) has three main messages. First, Kenya is poised to be among the fastest-growing economies in the region in the next three years, with growth projections of 6.0 percent in 2015, 6.6 percent in 2016, and 7.0 percent in External and internal balances are expected to improve significantly, thanks to falling oil prices, and public investment, mainly in infrastructure (energy and the standard gauge railway), is expected to firm up growth in the medium term. Second, the external sector remains vulnerable, as import growth continue to outpace export growth and short-term flows finance the current account deficit. Sluggish external demand for exports and declining production for export is widening the current account deficit. These trends point toward underlying structural weaknesses that need to be addressed. Third, Kenya needs to increase the competitiveness of the manufacturing sector so that it contributes more to growth and employment. Over a long period, the relative size of the sector has been stagnant, it has lost market share abroad, and it is struggling with structural inefficiencies. Low overall productivity and large productivity differences in firms across subsectors point to lack of competition; a more efficient sector would do a better job of allocating resources from low-to high-productivity firms, allowing them to grow faster and hire more employees. As in the past, we are proud to have worked with many Kenyan stakeholders during the preparation of this Kenya Economic Update. We hope that it will contribute to their discussions of policy issues that will contribute to helping Kenya grow, permanently reduce poverty, and bring shared prosperity to all Kenyans. Diariétou Gaye Country Director for Kenya World Bank ii December 2014 Edition No. 11

11 ACKNOWLEDGEMENTS This Eleventh edition of the Kenya Economic Update was prepared by a team led by John Randa and Maria Paulina Mogollon supervised by Apurva Sanghi. The core team consisted of Xavier Cirera, Penelope Fidas, Nikola Kojucharov, Kennedy Opala, Angélique Umutesi, Gerard Kambou, Barbara Karni, and Anne Khatimba. The team acknowledges contributions from Georgia Dowdall and Robert Waiharo. The report benefitted from the insights of several peer reviewers including Yutaka Yoshino, Ravi Ruparel, Prof. Terry Ryan, Alvaro Gonzalez and Jane W. Kiringai who provided insightful comments. The team also received overall guidance from Albert Zeufack (Practice Manager, Macroeconomic and Fiscal Management), Thomas O Brien (Country Program Coordinator for Kenya, Rwanda and Eritrea) and Diarietou Gaye (Country Director for Kenya, Rwanda and Eritrea). Partnership with key Kenyan policy makers was instrumental in the production of this report. On February 24, 2015, a draft of the report was presented at the 17 th Quarterly Economic Roundtable. The meeting was attended by senior officials from the Ministry of Devolution and Planning, the Central Bank of Kenya, the Kenya School of Monetary Studies, the Kenya Vision 2030, the Kenya Institute of Public Policy Research and Analysis, the International Monetary Fund, the Kenya National Bureau of Statistics and the Ministry of Industrialization and Enterprise Development. December 2014 Edition No. 11 iii

12 MAIN MESSAGES AND KEY RECOMMENDATIONS Main messages Kenya begins 2015 in a sound economic position. After growing an estimated 5.4 percent in 2014, its economy is poised to be among the fastest growing in the region, with growth projected at 6.0 percent in 2015, 6.6 percent in 2016, and 7.0 percent in External and internal balances are expected to improve significantly, thanks to falling oil prices, and public investment, mainly in infrastructure (energy and the standard gauge railway), is expected to firm up growth in the medium term. The external sector remains weak and vulnerable, as import growth continue to outpace export growth and shortterm flows finance the current account deficit. Sluggish external demand for exports, especially from the Euro area and emerging economies, has contributed to the widening of the current account deficit in the recent past. The large deficit points to underlying structural weaknesses in Kenya s economy, which need to be addressed. Kenya needs to increase the competitiveness of the manufacturing sector so that it can grow, export, and create much-needed jobs. As a share of GDP, Kenya s manufacturing sector has been stagnant in recent years, and it has lost international market share. Low overall productivity and large productivity differences in firms across subsectors point to lack of competition (which allows low-productivity firms to remain in business). The weak business environment is a key constraint for the manufacturing sector. Obstacles to doing business affect this sector more than many others because manufacturing needs access to capital for investments, infrastructure to import inputs and export and distribute finished products, affordable and reliable electricity to produce, labor to man operations, and fair and streamlined regulations and trade policies that allow firms to compete. Several policy actions could help anchor growth and galvanize the manufacturing sector: Key recommendations to anchor and sustain growth at high level 1. To anchor and sustain growth, Kenya needs to boost productivity and regain its competitiveness to encourage production of exports. To maintain high growth rates, Kenya needs to continue investing in infrastructure and human capital, improve the business and regulatory environment, and diversify exports. Increasing exports, is crucial for creating the thousands of low-skilled jobs needed to reduce high unemployment, particularly among young people, unemployment among whom poses a threat to social stability. 2. Address the risks associated with fiscal expansion, and rebuild policy buffers in the short to medium term to address fiscal sustainability. Recent public investment initiatives have started to generate a virtuous cycle between economic growth and debt sustainability. But the reduced fiscal space has left the economy vulnerable to exogenous shocks. In a similar way, the recent Eurobond issue helped integrate Kenya into global markets but increased its vulnerability to external shocks. To protect against such vulnerabilities and be in a position to handle adverse shocks, the government needs to preserve and rebuild fiscal policy buffers. Key recommendations for increasing the contribution of the manufacturing sector 3. Adopt cross-sectoral policies, such as removing market distortions and implementing industry-wide productivity policies, to complement sector-specific approaches. Policies should address inefficiencies in the capacity of the economy to allocate resources from low- to high-productivity firms. This means that trade policy, business regulatory frameworks, labor market laws, and access to finance should facilitate and enable firms to compete, both domestically and internationally. 4. Support the manufacturing sector, by: Helping raise firm productivity growth by facilitating the stock and flow of skills, technology, and information among firms; Levelling the playing field between formal and informal firms, by reducing and streamlining regulation, and ensuring their even and fair application; Decreasing the cost of doing business by addressing critical issues related to energy, access to finance, and cross-border trade (both cargo clearance and non-tariff barriers), as well as devolution and counties revenue-raising business levies Streamlining the process for starting a business and simplifying the insolvency framework iv December 2014 Edition No. 11

13 EXECUTIVE SUMMARY Kenya may be emerging as one of East Africa s growth centers. It is experiencing solid growth, driven by sustained infrastructure investments, buoyant manufacturing and other industry sectors, and strong agricultural production. Buoyed by declines in the price of crude oil, annual growth is projected to pick up from an estimated 5.4 percent in 2014 to percent in , making Kenya one of the fastest-growing economies in Sub-Saharan Africa. There is a challenge to ensure that most Kenyans benefit from this high growth as poverty rates and inequality remained high. To ensure that Kenya s growth momentum is sustainable in the medium term, key steps for Kenya to take include fully implementing the business reform agenda, completing reforms at the port of Mombasa, improving the efficiency of its massive infrastructural projects, strengthening governance, and continuing to maintain macroeconomic stability. Kenya s economy is larger and growing faster than previously estimated. Rebasing of its GDP reveals that Kenya s economy is the ninth largest in Africa and fifth largest in Sub-Saharan Africa (after Nigeria, South Africa, Angola, and Sudan). GDP is estimated at US$55.2 billion (up from US$44.1 billion before rebasing) see Figure 1, with GDP per capita standing at US$1,246 (up from US$994). Kenya is now a lower-middle-income country, according to the World Bank classification, with gross national income (GNI) per capita of US$1,160 in The economy is estimated to have grown 5.4 percent in 2014 and is poised to be among the fastest-growing economies in the region in the next three years (Figure 2). GDP (billions of US$) Figure 1: Kenya s economy is larger than previously estimated and among the fastest-growing in the region GDP in Kenya under old and new basing, GDP (old) Source: Kenya National Bureau of Statistics. GDP (new) Figure 2: Kenya s growth compares favorably with its peers Annual growth (percent) Average annual growth in selected countries in East Africa, Rwanda Tanzania Kenya Uganda SSA (excl. ZAF) 4.1 Burundi Source: Kenya National Bureau of Statistics and World Economic Outlook (IMF). Annual growth (percent) Annual growth rate in selected middle income economies, Kenya is still eligible for International Development Association (IDA) support, because its per capita GNI in 2013 (US$1,160) was below the IDA eligibility cut-off level of US$1,215. The World Bank s upper threshold for middle-income countries is US$12,746. December 2014 Edition No. 11 v

14 Executive Summary Growth in 2014 was broad based. On the supply side, agricultural production saw robust growth, driven by increased use of high-quality inputs; increased livestock output, as a result of better pasture; and expanded credit to the sector. A favorable macroeconomic environment low inflation, a stable exchange rate, expanded private credit as well as more reliable supply and lower prices of electricity boosted manufacturing output. On the demand side, aggregate demand was the main driver of growth, as private consumption rose, as a result of increased credit, and government consumption increased at both the national and subnational level. Public investment, mainly in massive road and energy projects, also spurred growth. Kenya s growth compares favorably with other countries. It no longer lags its regional peers or other lower-middle-income countries. Average growth between 2010 and 2013 was 6.2 percent significantly higher than the 5.3 percent average for Sub-Saharan Africa (Figure 2, panel a). Kenya s 2013 growth rate of 5.7 percent was above the 5.0 percent average growth rate for lower-middleincome countries (Figure 2, panel b). Kenya s macroeconomic policies remained generally accommodative. The government continued to finance larger fiscal deficits without creating excessive pressure on domestic financial markets and keeping public debt within the 50 percent threshold. The additional spending went to infrastructure projects and to finance activities at subnational levels of government. The Central Bank maintained its accommodative monetary policy stance, in order to support economic activities without triggering inflation or putting pressure on the exchange rate. Credit growth to the private sector grew, as a result of declining inflation and accommodative monetary policies. Thanks to proceeds of the Eurobonds, the Central Bank was able to build enough reserves to finance the current account deficit and support the exchange rate. The external sector remained weak and vulnerable, as import growth outpaced export growth and short-term flows financed the current account deficit. Sluggish external demand for exports, especially from the Euro area and emerging economies, contributed to the widening of the current account deficit. The level of the deficit points to underlying structural weaknesses in Kenya s economy that need to be addressed. Merchandise exports have weakened significantly since 2012, and high oil prices (until 2014) drove import growth. Import needs and financing inflows for large infrastructural investment projects added pressure on the balance of payments. Exports of services and remittances inflows remain strong. The vulnerability of the external account emanates from the fact that the current account is financed mainly from shortterm flows, which can easily reverse should the global economic environment change. Average growth between 2010 and 2013 was 6.2 percent significantly higher than the 5.3 percent average for Sub-Saharan Africa The outlook for the near and medium term is strong For the first time in years, Kenya begins a new year in a sound economic position. The economy is expected to grow 6 percent in 2015; external and internal balances are expected to improve significantly, thanks to falling oil prices; and public investment, mainly in infrastructure (energy and the standard gauge railway), is expected to firm up growth in the medium term. The perennial downside risk factors of drought and higher food prices and their consequences for overall inflation and electricity prices are no longer significant in the forecast horizons. Falling global oil prices are a boon to Kenya s economy, boosting real income and reducing inflationary pressure. The rise in real income is expected to trigger significant increases in private consumption, the engine of Kenya s economy. Higher aggregate demand is also likely to incentivize private investment, particularly in the manufacturing sector. World Bank simulations suggest that a 30 percent vi December 2014 Edition No. 11

15 Executive Summary decline in the price of oil from the baseline price of US$65/barrel could increase GDP growth by up to 1.2 percentage points in The World Bank projects that Kenya s GDP will grow 6.0 percent in 2015, 6.6 percent in 2016, and 7.0 percent in Rapid growth mainly reflects increased aggregate demand emanating from the fall in oil prices and ongoing infrastructural projects. Higher public investment spending on infrastructure, especially the standard gauge railway, will also enhance Kenya s competitiveness, particularly beginning in 2016, and help boost output in the medium term. The positive externalities of the massive infrastructural projects (roads, railway, and energy) and devolved county spending will also stimulate the economy. but challenges remain Although the fall in oil prices reduces the size of the current account deficit, easing pressure on the shilling, the external account problem will remain, because export growth is slow. However, an improved outlook for the shilling will decrease the likelihood that the Central Bank will tighten monetary policy, allowing consumer and business confidence to increase. Kenya s expansionary fiscal position remains worrisome, as public debt continues to build up. Even with the recent GDP rebasing, the size and trend of fiscal indicators remain big concerns. The government s commitment to fiscal discipline is proving to be a challenge. Tax revenues have been rising, but increased spending has made narrowing both the overall fiscal deficit and the primary balance difficult. Large increases in government spending relative to revenue were fueled mainly by expenditures associated with devolution, constitutional offices, and the infrastructure necessary for high sustainable growth. Past fiscal Kenya s economy has benefited immensely from the stimulus by the U.S. Federal Reserve, in terms of both short- and long-term capital flows spending led to growth spurts but it also increased the fiscal deficit and public debt. These episodes raise the question of whether the growth Kenya has experienced is organic (and therefore sustainable) or fiscally propelled (and therefore unsustainable). It is important for Kenya to allocate fiscal space to public investment, in order to generate a virtuous cycle between economic growth and debt sustainability. Kenyan s entry into the sovereign bond market integrated it with global markets, but it increased its vulnerability to external shocks. To protect against such vulnerabilities and be in a position to handle adverse shocks, the government needs to preserve and rebuild fiscal policy buffers. As the Ghanaian experience has shown, foreign investors tend to discriminate more clearly between countries with strong fundamentals and those in which imbalances have been allowed to build up when they turn risk averse. The security situation continues to pose a threat to growth. Fear of terrorism has hurt the tourism sector, forcing several coastal hotels to close. 2 Further deterioration of the security situation could affect private investment decisions and force the government to divert resources away from productive purposes toward security. Policy changes in the United States and lack of growth in Europe may slow growth in Kenya. Kenya s economy has benefited immensely from the stimulus by the U.S. Federal Reserve, in terms of both short- and long-term capital flows. With the ending of the Fed s monetary stimulus, the flow of cheap capital that has been funding the current account could dry up, as risk-averse foreign investors exit the region, creating volatility in the foreign exchange market and putting pressure on the Central Bank to raise interest rates, which could choke growth. The strong dollar in the fourth quarter of 2014 and early 2 Tourists may also have stayed away from Kenya in 2014 as a result of the Ebola scare. Some tourism market analyst argues that high-end tourism has not been affected while conference tourism actually picked up. December 2014 Edition No. 11 vii

16 Executive Summary 2015 has already weakened the shilling, offsetting some of the benefits of low international oil prices. In addition, a depressed Euro area will dampen the growth pick-up, as Europe is one of the main destinations of Kenya s merchandise exports, a main source of tourists, and the source of most equity funds. The drop in global oil prices does not obviate the need to undertake reforms to reduce the structural imbalance in the external account. Kenya s current account is projected to fall from 8.3 percent of GDP in 2013 to 4.7 percent in 2017 as a result of falling oil prices. Lower oil prices are expected to reduce the urgency of the structural reform agenda to enhance competitiveness and boost exports. The structural imbalance problems have not gone away, however. Kenya s export sector has been lagging since the mid-1990s (the last tea and coffee boom). As a result, Kenya relies too heavily on short-term capital flows to service its current account. In order to service and reduce external indebtedness, Kenya needs to increase the production of traded goods. Correcting the structural imbalance requires reforms that the government has already started implementing. The infrastructure investment underway not only boosts domestic demand in the short term, it also increases potential output down the road, by supporting export growth. Structural reforms to raise growth and its inclusiveness should focus on creating the conditions for higher productivity and capital spending, including by addressing shortcomings in infrastructure provision and the business environment. Without such reforms, the growth Kenya is currently enjoying will not be sustainable. Structural reforms will help raise medium-term growth, create jobs, and improve living standards and equity. Business climate and governance reforms and greater trade are critical to reducing firms operating costs and increasing employment. Improving manufacturing performance and the business environment is critical Kenya needs to create a competitive manufacturing sector if it is to meet its ambitious goal of becoming a globally competitive and prosperous upper-middle-income country with a high quality of life by 2030 (Vision 2030). The manufacturing sector is particularly important given the demographic structure in Kenya, which is adding more than half a million people to the labor force every year. Absorbing such a large number of new entrants into the formal sector requires massive employment creation, ideally in higherproductivity jobs. The formal manufacturing sector is small, and trends are not promising. It contributed just 11 percent of GDP in 2013 and employed a mere 280,000 people (12 percent of the 2.3 million people in Kenya s labor force). It accounted for 26 percent of Kenya s merchandise exports, 40 percent of which were exported to the East African Community (EAC). Its largest subsectors are food, beverages and tobacco, and chemicals. Although the contribution of the manufacturing sector to GDP is in line with comparator countries, sector growth trails that of the Kenyan economy as a whole and of comparator countries. There are also worrisome indications that the sector is losing competiveness. Manufacturing exports are losing ground in the EAC to exports from Kenya s economy has benefited immensely from the stimulus by the U.S. Federal Reserve, in terms of both short- and long-term capital flows India and China. Moreover, the mortality rate among exporters is high, and there is little dynamism in export relationships. These negative trends reflect structural issues, as suggested by firm-level analysis based on data from the Census of Industrial Production and the World Bank s Enterprise Survey. The value added per worker in Kenyan manufacturing firms has declined steadily since the 1970s (Figure 3). Moreover, productivity differences across firms are very high viii December 2014 Edition No. 11

17 Executive Summary in some subsectors. In a competitive market, these differences should be small, as very low-productivity firms are driven out of business; the fact that they are large suggests lack of competition. Inefficiencies in the capacity of the economy to allocate resources from low- to high-productivity firms (known as allocative efficiency ) is also manifested by the poor correlation between the number of employees in a firm and productivity. In an efficient economy, one would expect that more productive firms grow more (in terms of employment); in Kenya firms with fewer employees appear to be more productive than firms with more employees. In addition, high-productivity firms in Kenya are not growing and employing as many people as they could, constraining the ability of the sector to create employment. In the United States, for example, older firms (more than 35 years old) employ six times more people than younger firms (less than 5 years old). In Kenya older firms employ just two to three times as many people as younger firms. Value added per worker (KSh) Figure 3: Value added per worker in Kenya s manufacturing sector is a fraction of what it was 30 years ago Total economy Manufacturing Source: Based on data from de Vries, Timmer, and de Vries Despite some variance among sectors, large differences in productivity are prevalent across subsectors. This underlines the importance of prioritizing cross-sectoral approaches that remove market distortions and emphasize industry-wide productivity policies, and calls for caution on the over-use of narrow, sector-specific approaches. The weak business environment is a key constraint for the manufacturing sector. Manufacturing firms are particularly dependent on the business environment for the success of their operations. They need access to capital for their investments, infrastructure to import inputs and export and distribute finished products, affordable and reliable electricity to produce, skilled labor to man their operations, and fair and streamlined regulations that allow them to compete. In 2013 firms in Kenya reported that the obstacles that most constrained them were costly and unreliable electricity; inadequate access to finance; difficulties in trading across borders; competition from the informal sector; and crime, theft, and disorder (Enterprise Survey 2013). The Government has already made substantial improvements to alleviate business environment constraints. It has simplified business registration, land registry, and property transactions; established the Huduma one-stop shops; and streamlined customs procedures at the Mombasa Port. For electricity, the recent drop in oil prices, combined with the government s infrastructure projects, will reduce prices, increase generation, and improve distribution. Much more remains to be done, however. The manufacturing sector is stuck, with large productivity differences and a difficult business environment constraining sector growth and employment. Addressing inefficiencies in the capacity of the economy to allocate resources from low to high productivity firms, removing market distortions, and improving the business environment should be top priorities. Some actions the government could take include the following: December 2014 Edition No. 11 x

18 Executive Summary help raise firm productivity growth by facilitating the stock and flow of skills, technology, and information among firms (through management and technology extension services, or incentives to improve firms knowledge base and equipment); level the playing field between formal and informal firms, by reducing and streamlining regulation, and ensuring their even and fair application; decrease the cost of doing business by: further reducing the price and increasing the reliability of electricity; increasing access to finance, particularly through lower interest rates; improving the speed and accuracy of cargo clearance by customs and other border agencies; and reducing the prevalence of nontariff barriers; and ensure that devolution and the new revenueraising business levies imposed by counties do not hamper business growth and employment. x December 2014 Edition No. 11

19 The State of Kenya s Economy

20 The State of Kenya s Economy 1. Economic performance in 2014 Kenya is where it wants to be on a higher growth path. Massive investments in infrastructural investments, a favorable external borrowing environment, and a strong economy have helped boost aggregate domestic demand and growth. The rebased national accounts data depict a more diversified economy than previously thought, with a larger role played by the traditional sectors of agriculture and manufacturing and the emerging sectors of financial intermediation, real estate, and business services. Expansionary fiscal policy has been key in boosting aggregate demand, while accommodative monetary policy has helped support growth by increasing private sector credit and keeping inflation low. As a result, the economy is estimated to have grown 5.4 percent in 2014 and is forecasted to grow 6.0 percent in Macroeconomic indicators are solid, with inflation expected to remain within the Central Bank target of 5 percent; public debt remaining below 50 percent of GDP; and the current account deficit, which has perennially remained high as a percent of GDP, expected to declined significantly to 4.7 percent in Risks remain, however. On the domestic front, the weak security environment and fiscal position pose significant risks to growth prospects. On the external front, the winding down of monetary easing by the U.S. Federal Reserve and the subsequent tightening of global financial conditions could trigger new volatility, which may reduce growth in Kenya, as risk-averse foreign investors change their minds about Kenya, leading to capital outflows. In addition, a deflated Euro area will dampen the export growth pick-up the economy expects to see in the near to long term. 1.1 Rebasing reveals that Kenya s economy is larger than previously estimated Kenya s economy is larger and growing more rapidly than previously estimated. In 2014 the national accounts were rebased (to a base year of 2009) (Box 1.1). As a result, estimated GDP for 2013 was 25 percent larger than previously estimated (Figure 1.1). Average annual growth for GDP (billions of KSh) Figure 1.1: Kenya s economy is larger than previously estimated 5,000 4,000 3,000 2,000 1, GDP (old) Source: Kenya National Bureau of Statistics. GDP (new) was 5.0 percent in the new GDP series, up from 4.3 percent in the old series (Figure 1.2). Rebased GDP growth was stronger than earlier estimates had indicated in four out of seven years. 1 Based on the new series, Kenya is a lower-middle-income country, with GDP per capita of US$1,246 and GNI per capita of US$1,160 in Annual growth (percent) Figure 1.2: Rebasing GDP revealed that Kenya grew more rapidly than previously estimated GDP growth, 2001 = 100 GDP growth, 2009 = 100 Source: Kenya National Bureau of Statistics The earlier series excluded certain activities the new series includes. In 2009, 2010, 2011, and 2013, these activities grew faster than the average rate. In years in which the old series revealed higher growth, growth of the excluded activities was slower than the average growth rate. 2 December 2014 Edition No. 11

21 The State of Kenya s Economy Table 1.1: Selected indicators before and after GDP rebasing Indicator GDP (old) KSh billion 1,623 1,834 2,108 2,376 2,570 3,047 3,404 3,798 GDP (new) KSh billion 1,862 2,151 2,483 2,864 3,169 3,726 4,255 4,758 Percent change Exchange rate (average) GDP (old) US$ billion GDP (new) US$ billion GDP per capita (old) US$ GDP per capita (new) US$ Source: Kenya National Bureau of Statistics. With a GDP of US$55.2 billion, Kenya is currently the ninth-largest economy in Africa and the fifthlargest in Sub-Saharan Africa. Within Sub-Saharan Africa, only Nigeria, South Africa, Angola, and Sudan are larger than Kenya, which is now larger than Ethiopia and Ghana (Figure 1.3). Kenya s GDP per capita ranking also improved, elevating it from 12 th place to ninth place in Sub-Saharan Africa. Real estate, financial services, agriculture, and manufacturing accounted for most of the change in Kenya s gross output as a result of rebasing. The share of agriculture in gross output increased from 22.6 percent to 24.0 percent, as a result of new data from the cost of agriculture survey, livestock census data from the population census, and research (Figure 1.4). Manufacturing s share of GDP increased from 9.7 percent to 11.9 percent, as a result of analysis of new data from the census of industrial production, which revealed that manufacturing of food, beverages, and tobacco and other manufacturing had been underestimated. Real estate s share rose from 5.3 percent in the old series to 8.3 percent in the new series, as a result of a significant increase in the stock of high-quality dwellings, data from the 2009 census, and more accurate estimates of Box 1.1: Why rebase GDP? The Kenya National Bureau of Statistics (KNBS) uses System of National Accounts (SNA) guidelines in compiling the national accounts statistics. It rebased Kenya s GDP in 2014 following the recommendations of the 2008 SNA. This revision was the sixth, similar exercises having been conducted in 1957, 1967, 1976, 1986, and GDP rebasing involves replacing old base-year volume and price measures with a more recent base year or process structure. It yields a more accurate snapshot of the economy by updating the production structure; structural changes in relative prices of various products; and consumption patterns, utilization, and acquisition of capital goods. It also incorporates product changes caused by developments and innovations. In Kenya, for example, the mobile revolution has greatly affected the nature and structure of the economy something the old national accounts did not capture well. The rebasing of 2014 involved changing the base year from 2001 to 2009; updating the production structure; updating structural changes in the relative prices of various products and incorporating product changes made because of new developments and innovations; updating the consumption patterns, utilization, and acquisition of capital goods; and adopting the current classification of economic activities. The KNBS invited a team of statisticians and economists from the World Bank Group and other international experts to peer review the rebasing exercise. Their findings confirmed that Kenya conducted the rebasing exercise with professionalism, with integrity, and in accordance with the latest international technical standards. The new numbers are credible and constitute an important improvement in Kenya s economic and statistical knowledge base. Source: World Bank. December 2014 Edition No. 11 3

22 The State of Kenya s Economy Figure 1.3: Kenya s now has the ninth-largest economy in Africa ,000 Total GDP (US dollar current, 2013) Sao Tome and Principe Comoros Gambia, The Guinea-Bissau Seychelles Djibouti Central African Rep. Cabo Verde Liberia Lesotho Burundi Eritrea Malawi Swaziland Sierra Leone Mauritania Togo Guinea Niger Rwanda Benin Madagascar Mali Burkina Faso South Sudan Mauritius Namibia Zimbabwe Chad Congo, Rep. Botswana Senegal Equatorial Guinea Mozambique Gabon Uganda Zambia Cameroon Cote d'ivoire Congo, Dem. Rep. Tanzania Kenya Old Tunisia Ethiopia Ghana Kenya New Sudan Libya Morocco Angola Algeria Egypt, Arab Rep. South Africa Nigeria Source: World Development Indicators. Kenya before GDP rebasing US$ 44.1 billion Kenya after GDP rebasing US$ 55.2 billion GDP per capita (US dollar current, 2013) 20,000 15,000 10,000 5,000 0 Malawi Burundi Central African Rep. Niger Liberia Madagascar Congo, Dem. Rep. Gambia, The Ethiopia Guinea Eritrea Kenya before GDP rebasing US$ 994 Kenya after GDP rebasing US$ 1,246 Bissau Guinea Uganda Mozambique Togo Rwanda Sierra Leone Burkina Faso Tanzania Mali Benin Comoros Zimbabwe Kenya Old South Sudan Senegal Chad Mauritania Lesotho Kenya New Cameroon Cote d'ivoire Sao Tome and Principe Djibouti Sudan Zambia Ghana Nigeria Swaziland Morocco Congo, Rep. Egypt, Arab Rep. Cabo Verde Tunisia Algeria Namibia Angola South Africa Botswana Mauritius Gabon Libya Seychelles Equatorial Guinea Figure 1.4: GDP rebasing increased the contribution of some sectors and decreased the contribution of others Real estate, renting, business services Manufacturing Agriculture, forestry and fishing Financial intermediation Public administration Construction Hotels and restaurants Education Mining and quarrying Electricty and water Other services Transport and storage Financial intermediation services indirectly measured -1.3 Information and communication -2.2 Taxes on products -3.1 Wholesale and retail trade -3.4 Source: Kenya National Bureau of Statistics Percentage change in shares by economic activities relative to new GDP numbers, average average rentals. Financial services rose from 4.0 percent to 5.5 percent. Wholesale and retail trade saw significant declines, based on data from a survey of trade margins. The rebasing of Kenya s GDP affected a number of macroeconomic indicators, with implications for policy makers. Because most critical indicators are shares of GDP, a larger economy reduces the ratios, with serious macroeconomic consequences. Gross public debt as a share of GDP fell from 58.9 percent of GDP to 47.2 percent (from 42.0 percent to 43.1 percent in net terms) in 2013/14. This decline might seem to take debt pressure off policy makers and encourage them to borrow more. However, Kenya s ability to pay (revenue generation) fell from 23.4 percent of GDP to 19.4 percent, and its exports to GDP ratio fell significantly (Table 1.2). Rebasing makes Kenya s debt metrics look favorable, but the new figures may not justify additional borrowing. After rebasing, government spending in 2013/14 as a share of GDP declined from 31.2 percent to 25.9 percent, the fiscal deficit fell from 7.4 to 6.2 percent, and public debt dropped from 52.0 to 43.1 percent in net terms. These changes could be interpreted as indicating that additional development spending could be financed through public borrowing. But the rebasing also affected revenues, which fell from 23.4 percent of GDP to just 19.4 percent. Kenya s ability to cover its external debt (measured as total debt service as a share of exports) was eroded, as exports share of GDP also declined. The appropriate metric for determining whether Kenya should take on more debt to finance viable projects is the ability to pay, as measured by the ratio of revenue to GDP and total debt service, but only the scope to borrow. Efforts to find new ways to fund the government such as reintroducing the capital gains tax in the 2014/15 budget and adopting tax administration measures aimed at increasing taxation from rental income increase this ratio and are therefore welcome. 4 December 2014 Edition No. 11

23 The State of Kenya s Economy Macroeconomic indicator Table 1.2: Policy implications of GDP rebasing for macroeconomic indicators (percent of GDP) Old series New series Comment Government revenue Old series overestimated revenue effort, given the size of economy. More needs to be done to improve resource mobilization. Government expenditure Size of government is not as alarming as previously thought. Wages and salaries (central government) Wages and salaries are no longer a hot-button issue at the national level. The combined wage and salaries at National and County level is 7.1 percent of GDP, which can be considered high. Fiscal deficit The fiscal deficit remains an issue that needs to be addressed. Gross public debt The fiscal space has expanded: public debt is now below the target Net public debt of 50 percent. However, the decision to borrow more should be based on the ability to pay (government revenue to GDP or Kenya s exports earning). Current account deficit Imports (merchandise) Exports (merchandise) Source: World Bank calculations The external position has improved, but exports still lag far behind imports. 1.2 Kenya s economy is strong Growth remains robust Kenya s economy is estimated to have grown 5.4 percent in 2014, driven by good performance in agriculture, manufacturing, and other industry (Figure 1.5). 3 The performance of the services sector, which anchored Kenya s growth in the past, was lower than in previous years, as a result of security concerns. Although economic performance in the first three quarters of 2014 was robust, growth was significantly lower than the 6.6 percent growth in the same period in A sluggish services sector, which grew at 3.9 percent (down from 5.7 percent growth in 2013), was the main cause of lower growth. Growth in 2014 was highest in the second quarter, when the economy grew 5.7; growth was 5.5 percent in the third quarter and 4.5 percent in the first quarter. Fourth quarter growth is estimated at 5.9 percent. Figure 1.5: Growth was robust Quarterly GDP growth, Annual GDP growth Sources: Kenya National Bureau of Statistics and World Bank estimate The International Monetary Fund (IMF) projected growth of 5.3 percent in 2014,and the government forecast was percent December 2014 Edition No. 11 5

24 The State of Kenya s Economy Agriculture grew at a healthy rate. Agriculture grew 5.4 percent in the first three quarters of 2014, down from 5.6 growth in This performance is remarkable given the mild drought in the fourth quarter of 2013, the delayed rains in early 2014, and the decline in tea prices. The volume of tea production rose 2.2 percent (from 432,135 metric tonnes to 441,754 metric tonnes), but prices fell 13.8 percent (from KSh 224 to KSh 193 per kilo) (Figure 1.6). Good performance is attributable to continued subsidized seeds and fertilizer; increased livestock output, as a result of good pasture; increases in both coffee production, which rose 8 percent in 2014, and coffee prices, which rose 21.8 percent; improved statistics; and increased credit to the sector. A favorable macroeconomic environment boosted manufacturing output, which rose 6.9 percent during the first three quarters of the year. Modest inflation, a stable exchange rate, lower electricity prices, and improved access to private credit drove up manufacturing output. Greater demand for manufactured goods by Uganda and Rwanda also helped the sector. Other industry (construction, mining and quarrying, and electricity and water supply) showed strong performance in 2014, growing 8.9 percent in the first three quarters of the year, up sharply from 6.0 percent in the same period in 2013 (Figure 1.7). This extraordinary growth is explained by the 12.9 percent growth in construction, which reflects the booming market for residential buildings, other buildings, and civil works and construction of traditional dwellings, which propelled demand for cement, bitumen, and construction. Mining and quarrying picked up as well, growing 4.5 percent in the first three quarters of 2014, after declining 6.6 percent in Growth in the electricity and water supply subsector declined, from 6.5 percent in 2013 to 2.7 percent in the first three quarters of 2014, but generation increased 8.2 percent, from 8,208 million to 8,881 million KWH. Hydropower generation declined 22 percent, from 4,387 to 3,411 million KWH; geothermal increased 64 percent, from 1,781 to 2,917 million KWH; and thermal increased 25 percent, from 2,040 to 2,556 million KWH. First three quarters growth (percent) Figure 1.7: Other industry saw the fastest growth (0.9) Agriculture Manufacturing Other industry Services Source: Kenya National Bureau of Statistics. Figure 1.6: Tea production remained constant and prices declined significantly Tea production in metric tonnes, thousands Tea production, Price in KSh per kilo Tea auction prices, Source: Kenya National Bureau of Statistics December 2014 Edition No. 11

25 The State of Kenya s Economy Figure 1.8: Generation of electricity rose, and geothermal generation became the largest source of energy Million KWh Total domestic electricity generation Source: Kenya National Bureau of Statistics. Geothermal generation is now the main source of power in Kenya. The most significant development in the subsector was geothermal generation, which became the largest source of energy, overtaking hydroelectric power generation (Figure 1.8). This development is significant, because it will delink or reduce the negative impact of drought on electricity prices. The security environment in 2014 dragged down performance of the services sector. Services output grew 3.9 percent in the first three quarters of 2014, much lower than the 5.7 percent growth in 2013 (Figure 1.9). Leading subsectors in terms of growth were finance and insurance (9.1 percent), wholesale and retail trade (8.5 percent), and information and communication technology (ICT) (8.2 percent). All of these subsectors grew less rapidly than in 2013, Figure 1.9: Growth in the services sector slowed Financial and insurance Wholesale and retail trade Information and communication Health Education Real estate Other services Transport and storage Professional, administration and support Public administration Accomodation and restaurant First three quarters growth, percent Source: Kenya National Bureau of Statistics. Local electricity generation, million of KWh January Domestic electricity generation by source, March May July September November January March however. Finance and insurance grew 10.3 percent, wholesale trade 10.9 percent, and ICT 14.6 percent. In addition, education, which grew 7.8 percent in 2013, rose just 4.8 percent. The hotel and restaurant sector has shrunk almost 30 percent since 2012, as a result of security incidents and threats. The sector shrank 14.2 percent in the first three quarters of 2014, after contracting by 5.2 percent in Some tourist hotels in coastal areas have closed, eliminating many thousands jobs. The good news in the services sector is the continuing ICT revolution. The number of mobile money transfer customers in 2014 stood at 26 million, and the number of transactions increased 24 percent, to 86 million (Figure 1.10). The value of transactions of mobile payments increased 24 percent, to KSh 226 billion, and the number of mobile agents rose 9 percent to 123,703. Inflation remained within target levels and declining oil prices reduced upside risks Lower energy and food prices and prudent monetary policy kept inflation low. Average overall inflation stood at 6.9 percent in 2014, within the government target of 5.0 percent plus or minus 2.5 percentage points (Figure 1.11). The 2014 average inflation was higher than the 2013 average (5.7 percent), as a result of higher prices of food (up 8.7 percent, from 7.3 percent in 2013) and transport (up 9.1 percent, from 4.8 percent in 2013). May July September November January March May July Hydro Geo-thermal Thermal September November December 2014 Edition No. 11 7

26 The State of Kenya s Economy Figure 1.10: Mobile money payments continued to soar 250 Mobile money payment Jan Feb Mar Ap May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Ap May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Ap May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Ap May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Ap May Jun Jul Aug Sep Oct Nov Dec Source: Central Bank of Kenya. Number of customers (millions) Transactions (millions) Value of transactions (billions of KSh) Agents (thousands) Energy inflation is easing, thanks to lower international oil prices, which have been pushing electricity, gas, and transport prices down. The average cost of a barrel of crude oil fell 39.3 percent between June and December 2014, from US$108.4 to US$ Kenya s energy inflation, which averaged 9.1 percent in June and July, dropped throughout the rest of year, standing at 6.0 percent in December. Food inflation remains the main driver of inflation in Kenya. In December 2014, it accounted for 45.8 percent of total inflation. Energy accounted for 26.6 percent,and items that constitute core inflation accounted for 27.7 percent. Figure 1.11 Inflation was low albeit higher than in 2013 Declining international oil prices should lower prices and boost aggregate demand. Kenya is oil dependent, with about a quarter of its import bill attributed to oil. Most production use factors that use oil as an input, and the pass-through of changes in oil prices to domestic inflation is very high. Declining oil prices will boost the domestic economy through both first- and second-round effects. Firstround effects affect goods and activities that use oil directly (for example, transport and electricity). Second-round effects occur through goods that use oil as inputs (for example, shipping costs, fertilizer prices). There is a threat that most of these benefits may not be passed on to consumers. Between Inflation rate (percent) Contribution of food, energy and core inflation to overall inflation rate, May December Food inflation Core inflation Source: Kenya National Bureau of Statistics. Transport inflation Overall inflation Food Energy Core 3 GEM commodities, Commodity price data (Pink sheet), World Bank. 8 December 2014 Edition No. 11

27 The State of Kenya s Economy September 2014 and February 2015, crude oil prices fell 48 percent but the price of unleaded gasoline fell just 18 percent and the price of diesel just 19 percent (Figure 1.12). Taking the lag effects of price transmission to the domestic economy into account, prices should have fallen by 39 percent. US$ per litre Figure 1.12: Gasoline prices fell but by much less than international crude oil prices Unleaded Murban ADNOC, crude oil Diesel Lagged crude oil Source: Kenya National Bureau of Statistics (Leading Economic Indicators, various issues). In the recent path, Kenya s economic growth has been driven by higher public spending. Since 2008, growth has been jumpstarted by various fiscal expansion measures that have led to growth spurts: the economic stimulus program of enhanced growth as did the devolution and increase in spending on public infrastructure in 2012/13 and 2013/14; recent public investment in the standard gauge railway project, roads, energy and the LAPSSET projects 4 will enhance growth and strengthen economy s ability to repay external debt. The procylical nature of Kenya s fiscal policy raises questions about the sustainability of its growth path and whether growth in Kenya is organic (and therefore sustainable) or fiscally propelled (and therefore unsustainable). We discuss Kenya s fiscal policy and outturns in the next section. 1.3 Fiscal policy was expansionary, increasing the deficit and the debt burden Kenya s expansionary fiscal position needs to be under watch, as public debt continues to build up. Even with the recent GDP rebasing, the size and trend of fiscal indicators remain concerns. The government s commitment to fiscal discipline is proving to be a challenge (Figure 1.13). Tax revenues rose in 2013/14, but increased spending made narrowing both the overall fiscal deficit and the primary balance a challenge. Large increases in government spending relative to revenue were fueled mainly by expenditures associated with devolution, constitutional offices, and the infrastructure necessary for sustained growth. Total government expenditure reached 25.9 percent of GDP in 2013/14, up from 24.8 percent in 2012/13. Revenue rose from 18.8 percent to 19.4 percent of GDP during the same period. The fiscal deficit stood at 6.2 percent of GDP in 2013/14, up from 5.1 percent in 2012/13. The primary balance (cash basis) fell 1.1 percentage points, from 2.4 percent to 3.5 percent of GDP. Percent of GDP Figure 1.13: Kenya s fiscal deficit has increased since 2006/ (0.9) (2.5) (2.4) (3.5) (3.0) (4.5) (5.1) (6.2) / / / / /14 Government revenue Government expenditure Fiscal balance, after grants, cash basis Primary deficit, after grants, cash basis Sources: National Treasury (Quarterly Economic and Budgetary Review, November 2014) and Kenya National Bureau of Statistics. The government tapped international markets to finance its budget. For the first time, the government issued a sovereign bond, worth US$2.75 billion, the proceeds of which were used to repay a US$600 million syndicated loan and finance energy and infrastructural projects. The issue was one of the most successful Eurobonds in Africa in 2014, in terms of both the volume of the subscription and the priced offered. External borrowing during 2013/14 increased by 2.9 percent of GDP, a significant increase over 2012/13. Domestic borrowing increased by 4 LAPSSET is the Lamu Port Southern Sudan-Ethiopia Transport a transport and infrastructure project. December 2014 Edition No. 11 9

28 The State of Kenya s Economy 2.3 percent of GDP. Domestic borrowing remained dominated by Treasury bonds (82.1 percent of total domestic borrowing) and Treasury bills (16.6 percent). The large share of longer maturities muted the effect on the debt service burden. Spending pressures are growing The combined budgets of the central and local governments expanded, although central government spending declined slightly. Recurrent expenditure reached 17.6 percent of GDP, and development spending stood at 7.1 percent of GDP (Figure 1.14). The decline in both recurrent and development central government spending reflected the devolution of functions and funding to county governments. Recurrent expenditure by the central government contracted 2.6 percentage points in 2013/14, from 17.5 percent to 14.9 percent of GDP, and development spending fell from 6.6 percent to 6.4 percent of GDP. National transfers to county governments amounted to KSh billion. Total county-level expenditure reached KSh billion (KSh billion in recurrent spending and KSh 36.6 billion in development spending). The overall wage and salaries bill rose, and spending on operations and maintenance fell. Wages and salaries at the national level declined, falling from 6.1 percent of GDP in 2012/13 to 5.6 percent of GDP in 2013/14, as up to 60,000 former civil servants Percent of GDP Figure 1.14: Total government spending rose, but spending by the central government fell / /09 Recurrent (national) Development (national) 2009/ / / / /14 Recurrent (central government) Development (central government) Sources: National Treasury (Quarterly Economic and Budgetary Review, November 2014) and Kenya National Bureau of Statistics. moved off the national government rolls and on to county budgets. 5 However, the overall government wage bill rose to 7.1 percent of GDP, up from 6.1 percent in 2012/13. Total government expenditure on operations and maintenance fell to 6.1 percent of GDP in 2013/14, down from 8.1 percent (Table 1.3). Development spending was marked by the commencement of several major projects in 2013/14. These included expansion of the Olkaria geothermal plants and the start of construction of the Standard Gauge Railway from Mombasa to Nairobi. The public debt load rose, as a result of increased borrowing to finance planned and ongoing infrastructure projects. In 2013/14 Kenya s (net) public debt experienced the largest expansion since 2000/01, increasing 24.9 percent (Figure 1.15). Public debt stood at 43.1 percent of GDP at the end of 2013/14, following an uptick in both external and domestic debt. The increase in external debt was driven by the US$2 billion Eurobond issued in June 2014, an additional US$750 million in December 2014 from the same issue. In addition, during the fourth quarter of 2013/14, the government borrowed US$3.6 billion from China to finance the 500-kilometer Standard Gauge Railway from Mombasa to Nairobi. Consequently, external debt rose from 18.7 percent of GDP at the end of 2012/13 to 21.6 percent of GDP at the end of 2013/14. Percent of GDP Figure 1.15: Public debt has been rising but remains sustainable External debt Domestic debt Total debt, net Sources: National Treasury (Quarterly Economic and Budgetary Review, November 2014) and Kenya National Bureau of Statistics. 5 Over 60,000 Civil Servants Transferred to the Counties, Daily Nation, January 28, December 2014 Edition No. 11

29 The State of Kenya s Economy Table 1.3: Both recurrent and development spending rose in 2013/14 (percent of GDP) 2010/ / / /14 Recurrent spending Central government Counties n.a n.a n.a 2.6 Wages and Salaries Central government Counties n.a n.a n.a 1.5 Interest payments Pensions Operations and maintainance Transfers to counties Development spending Central government Counties n.a n.a n.a 0.7 Judicial service Parliamentary services Total expenditure and net lending Fiscal balance, cash basis after grants (3.4) (4.5) (5.1) (5.1) Central government (3.4) (4.5) (5.1) (6.2) Counties n.a n.a n.a 1.1 Sources: National Treasury (Quarterly Economic and Budgetary Review, November 2014); Kenya National Bureau of Statistics; and Office of the Controller of Budget. Note: Not available. n.a. Not applicable. Domestic debt reached 25.6 percent of GDP, up from 23.3 percent the previous fiscal year. Public debt levels remain sustainable in the medium term. The joint World Bank IMF Debt Sustainability Analysis results released in October 2014 indicated low risk of distress for Kenya s domestic and external debt, with all debt indicators below debt burden thresholds. In addition, a large share of Kenya s external debt is on concessional rather than commercial terms, which lightens the debt service burden. The economy continues to rely on macroeconomic stability and resilient growth to keep public debt within the government s threshold of 45 percent of GDP. Kenya s level of public debt is below the average of its middle-income peer countries (Figure 1.16). Middle-income Africa Middle-income Africa (without South Africa) Kenya Tanzania Zambia Uganda Sub-Saharan Africa Figure 1.16: Kenya s debt position is below the average of its middle-income peers Mauritius South Africa Ethiopia Public debt as percent of GDP, 2013 Sources: National Treasury (Quarterly Economic and Budgetary Review, November 2014); Kenya National Bureau of Statistics; and World Economic Outlook (International Monetary Fund). December 2014 Edition No

30 The State of Kenya s Economy Revenues rose Revenue collection rose significantly (Figure 1.17). Total tax revenue represented 19.4 percent of GDP at the end of 2013/14, a 15.3 percent increase over the previous year. The increase followed tax reforms and other measures implemented in 2013/14, including the VAT Act of September 2013 and increased collection from rental income. Valueadded tax (VAT) on imports, import duty, excise duty, and corporate tax were all above budgeted targets. Percent of GDP Figure 1.17: All types of tax revenues rose 2006/ / / / /14 Income tax VAT Import Duty Excise Duty Sources: National Treasury (Quarterly Economic and Budgetary Review, November 2014) and Kenya National Bureau of Statistics. Income tax remained the main source of tax revenue. Income tax revenues represented 9.0 percent of GDP, up from 8.3 percent of GDP in 2012/13. The increase reflected good performance of pay-as-you earn and corporation tax achieved after including county payrolls in the base. Income tax accounted for 46.1 percent of total revenue, followed by VAT (23.9 percent), excise duty (10.5 percent), and import duty (6.9 percent). Income tax is a tax on sources of production (labor and capital), which can act as a distortion to economic activities if overutilized. All sources of revenue exceeded targets. VAT revenues rose 13.1 percent, to stand at 4.6 percent of GDP. Strong performance reflected reforms that increased the VAT base by taxing some previously zero-rated/exempt products and increasing the number of VAT taxpayers in key business outlets. VAT revenues reached KSh billion, exceeding the target of KSh billion. Import duty collection exceeded the target of KSh 67.3 billion to stand at KSh 67.6 billion (1.3 percent of GDP). Excise duty stood at KSh billion (2.0 percent of GDP), against a target of KSh billion. The government continues to embark on initiatives to increase tax revenue and narrow fiscal deficits. Tax Procedure Bill 2014 would simplify the tax system by introducing uniform tax procedures for major tax laws and enable automation. Customs and Excise Duty Bill 2014 would impose a 25 percent duty on steel (there is currently no duty). 6 Both bills are expected to be presented to Parliament in 2014/15. In addition, the government will consider introducing an extractive industry tax and making changes to the income tax to reflect best international practices. These endeavors would facilitate investment by reducing the cost of doing business. Budget execution remains weak Low budget absorption remains a challenge, despite slight improvement in ministerial implementation. 7 The overall execution rate of ministerial expenditure stood at 86 percent, the highest in five years. The average execution rate of the recurrent budget since 2008/09 was 92 percent. The development budget recorded low execution rates, as a result of several challenges, including inadequate use of the Integrated Financial Management Information System (IFMIS) for cash management, slow procurement, and insufficient local technical expertise and financial ability to implement projects. 8 According to the Quarterly 6 National Treasury Medium Term Budget Policy Statement. February Edition; and Highlight of the 2014/15 Budget by the Cabinet Secretary, National Treasury Henry Rotich. 7 There are large disparities between Quarterly Budget and Economic Review (QBER) and Office of the Controller of Budget (COB) data, for both gross estimates and actual spending. For example, the QBER indicates that 77 percent of the development budget was executed, whereas the COB gives a figure of 52 percent. 8 Office of the Controller of Budget National Government Annual Budget Implementation Review report for 2013/ December 2014 Edition No. 11

31 The State of Kenya s Economy Budget and Economic Review, 77 percent of the 2013/14 development budget was executed, above the 65 percent average between 2008/09 and 2012/13. Although more public finance data have been made available in recent years, there is scope for better consistency across budget documents. Better funds flow is needed from the National Treasury, and procurement procedures need to be improved if the economy is to reap greater benefits from public spending. Execution rates varied widely across sectors. The Ministry of Health recorded the lowest execution rates, in both recurrent (73 percent) and development (56 percent) spending (Figure 1.18). Energy infrastructure and ICT ministries, which accounted for 20 percent of the ministerial budget, implemented 78 percent of their budgets. The largest share of the budget (26 percent) went to human resource development through education. This sector, which includes the Ministry of Education and the Teachers Service Commission, implemented 91 percent of its budget. The medium-term outlook shows fiscal consolidation but not without risks Fiscal expansion will continue in 2014/15, but the National Treasury projects fiscal consolidation in 2015/16 and 2016/17. Government expenditure in 2014/15 is estimated at KSh 1.7 trillion (30 percent of GDP); it is projected to stand at KSh 1.8 trillion (28.6 percent of GDP) in 2015/16 and reach KSh 2.0 trillion (26.9 percent of GDP) in 2016/17. Because of major infrastructural projects highlighted in the Second Medium Term Plan (MTPII), the development budget for the central government is estimated at 10.1 percent of GDP in 2014/15, 10.4 percent of GDP in 2015/16, and 9.3 percent of GDP in 2016/17. 9 Although the government continues to strike a balance between consolidating its fiscal position, supporting county governments, developing infrastructure, and creating employment, risks could undermine this effort. These risks include growing expenditure pressures emanating from high recurrent expenditure on debt service and wages, as well as the implementation risk of devolution. In addition, low economic growth would result in wide deficits and high public debt. Counties ran surpluses but delayed implementation of the development agenda Counties poor budget execution led to overall fiscal surplus in the first year of devolution. Unlike the central government, they registered budget surpluses in their first year of operations. These surpluses were achieved, however, at the expense of executing the development budget. During their first fiscal year, county governments budgeted KSh billion, to be financed mainly by national transfers (KSh 210 billion), own revenue Figure 1.18: Budget execution of ministerial expenditure varied widely across sectors Ministerial expenditure for FY 2013/14 Overall ministerial budget implementation for FY 2013/14 Education National Security Energy, Infrastructure and ICT Education Public Administration and International Relations General, Economic and Commercial Affairs Governance, Justice, Law and Order Governance, Justice, Law and Order National Security Public Administration and International Agriculture, Rural and Relations Urban Development Social Protection, Culture and Recreation Environmental Protection, Water Environmental Protection, Water and Natural Resources and Natural Resources Health Energy, Infrastructure and ICT Social Protection, Culture and Recreation Agriculture, Rural and Urban Development General, Economic and Commercial Affairs Health Billion, Ksh Target Actual Percent Source: National Treasury (Quarterly Economic and Budgetary Review, November 2014). 9 The National Treasury Medium Term Budget Policy Statement. February Edition. December 2014 Edition No

32 The State of Kenya s Economy (KSh 67 billion), and the equalization fund (KSh 3.4 billion). They managed to spend only KSh billion, 59 percent of the budget estimate (Figure 1.19). County governments total revenue consisted of national transfers (KSh billion), own revenue generation (KSh 26.3 billion), and KSh 4.3 billion rolled over from 2012/13, yielding a KSh 54.7 billion fiscal surplus (Table 1.4). Ksh billion Figure 1.19: County budget execution in 2013/14 was weak County budget implementation Estimates Actual Recurrent Development Source: Office of the Controller of Budget. Poor expenditure performance was attributed to transitional challenges, including inadequate capacity at the beginning of 2013/14, which affected budget preparation, management, and execution. Because there was no link between the budget cycle and planning (as counties were operating in their first fiscal year), frequent budget revisions were needed. Most county governments have not yet fully implemented the IFMIS, which affects funds flow management. These constraints appeared to be transitional, however; both expenditure and revenue implementation rates improved from quarter to quarter, with much improvement in the second half of the year. County budget execution remains a challenge, particularly for development spending. Budget estimates were in line with 2012 Public Finance Management Act thresholds, with counties allocating 43 percent of their overall budget to development expenditure. However, only a handful Table 1.4: County governments registered a surplus in 2013/14 (millions of KSh) Item 2012/ / /15 (actual) Estimates (budgeted) Actual (budgeted) Revenues Total revenues 20, , , ,200 Transfers 13, , , ,300 Equitable share 9, , , ,700 Conditional grants (donors) 20,000 2,600 Equalization fund 3,400 3,400 Local Authority Transfer Fund 3,763 Roll over from previous fiscal year 4,331 27,420 Own revenues 6,756 67,388 26,296 63,080 Expenditures Total expenditure 16, , , ,050 Recurrent 14, , , ,490 Wages and salaries 6,530 74,740 77,376 Operations and maintenance 6,687 51,712 Other recurrent Debt payments 1,695 3,711 Development 1, ,404 36, ,560 Balance 3,951 (7,837) 54,694 12,150 Source: Office of the Controller of Budget and National Treasury (Medium Term Budget Policy Statement). 14 December 2014 Edition No. 11

33 The State of Kenya s Economy of counties achieved the minimum 30 percent of total spending on development stipulated in the act. Actual development expenditure stood at KSh 36.6 billion, just 22 percent of total expenditure (Figure 1.20). Personnel emoluments, which absorbed 46 percent of total expenditure (KSh 77.4 billion), dominated county government spending, crowding out spending on development. Counties executed 80 percent of the recurrent budget but less than 30 percent of development expenditure. This large disparity is explained by the fact that unlike recurrent expenditure, development expenditure requires project preparation that must follow procurement procedures. Funding of the development agenda was also affected by delays in transfers by the national government, particularly in the first quarter. Figure 1.20: The lion s share of county spending went to recurrent expenditures, not development Development expenditure Ksh % Debt repayment and pending bills KSh % If not addressed, weak budget execution will result in uneven development across counties. Top performers in recurrent budget included Meru (115 percent), Nyeri (108 percent), Murang a (102 percent), and Vihiga (100 percent). Bottom performers included Turkana (36 percent), Garissa (51 percent), and Lamu (53 percent). Outstanding development spending was observed in Bomet (92 percent), Wajir (78 percent), and Trans Nzoia (74 percent). The lowest absorption rates were in Mombasa (2.4 percent), Tana River (2.7 percent), and Kisumu (4.0 percent). Few counties achieved their local revenue collection targets. County governments generated only KSh 26.3 billion, 39 percent of the annual target of KSh 67 billion. Weak revenue collection partly reflected unrealistic projections made at the beginning of the fiscal year, which had to be revised in every quarter. Remarkably, four counties overachieved their revenue targets: West Pokot (155 percent), Kericho (110 percent), Marsabit (105 percent) and Tharaka Nithi (102 percent) (Figure 1.21). Operations and maintainance Ksh 51.7 (30.5%) Source: Office of the Controller of Budget. Personnel emoluments Ksh 77.4 billion (45.7%) Low own revenue not only delays fiscal autonomy, it also affects project implementation. Cross-county comparisons showed a positive correlation between budget absorption rate and own revenue collection (Figure 1.22). Figure 1.21: Revenue collection varied widely across counties Ratio of actual to target local revenue percent target Ratio of actual to target local revenue Taita Taveta Elgeyo M. Tharaka N. Source: Office of the Controller of Budget. December 2014 Edition No

34 The State of Kenya s Economy Expenditure (actual percent of estimates) Figure 1.22: In cross-county comparisons, low budget execution is associated with poor revenue collection Source: Office of the Controller of Budget. Local revenue (actual percent of target) National transfers to counties are estimated at KSh billion in 2014/15, an 18.6 percent increase over 2013/ Transfers are expected to increase to KSh billion in 2015/16 and KSh billion in 2016/17. However, delivering the devolution promise at the county level will require both prioritization of the development agenda and continuous capacity building for better budget formulation and implementation. 1.4 The Central Bank s monetary policy stance supported growth The Central Bank s policy of keeping the central bank rate constant paid off, as most market rates declined. The Monetary Policy Committee kept the rate constant (at 8.5 percent) for 21 consecutive months ending in December 2014 (the last policy rate change was in April 2013). Although the transmission mechanism has been slow, shortand long-term rates declined while private credit growth increased in response to lower interest rates (Figure 1.23). Short-term rates declined in line with the monetary policy stance. The government s demand for shortterm liquidity from commercial banks declined in 2014, easing pressure on short-term rates. The reduction in demand was as a result of liquidity injection by the Central Bank after monetizing proceeds of the Eurobond. The weighted interbank rate fell 220 basis points, from 9.1 percent in December 2013 to 6.9 percent in December The 91-day Treasury bill rate fell 90 basis points, from 9.5 percent in December 2013 to 8.6 percent (average) in December Long-term rates also fell, although transmission of monetary policy to long-term rates remains weak. To enhance the transmission of policy rates on long-term rates, in July 2014 the National Treasury introduced the Kenya Banks Reference Rate (KBRR), an average of the central bank rate and the Treasurybill rate. Between December 2013 and December 2014, weighted lending rates declined 1 percent, falling from 17 percent to 16 percent. Deposit rate Figure 1.23: Both short- and long-term rates declined 30 Short-term interest rates, August December Long-term interest rates, June December 2014 Interest rate (percent) Aug-10 Dec-10 Apr-11 Aug-11 Dec-11 Apr-12 Aug-12 Dec-12 Apr-13 Aug-13 Dec-13 Apr-14 Aug-14 Dec-14 Interbank 91-Day Tbill Central bank rate Source: Central Bank of Kenya. 10 The National Treasury Medium Term Budget Policy Statement. February Edition. Long-term interest rate (percent) Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jan-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Deposit Lending Interest rate spread Jun-13 Jun-14 Dec December 2014 Edition No. 11

35 The State of Kenya s Economy 40 Figure 1.24: The growth of monetary aggregates boosted private sector credit 40 Change in money supply (percent) Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar Reserve money M0 M1 Source: Central Bank of Kenya. Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Dec-14 rose from 6.6 percent to 6.8 percent, and savings rate increased from 1.6 percent to 1.8 percent. As a result, the interest rate spread (the difference between lending and deposit rates) narrowed by 110 basis points, from 10.3 percent in December 2013 to 9.2 percent in December The Central Bank operationalized its policy stance by allowing monetary aggregates to grow more rapidly in Reserve money rose 11.2 percent in September 2014, up from 9.2 percent in December 2013; M2 rose 18.8, up from 11.1 percent; and M3 grew 20.9 percent, up from 13.3 percent (Figure 1.24). This monetary expansion allowed credit to the private sector to increase. Private sector credit growth by sector, December December 2014 Finance and insurance Transport & communication Private households Real estate Manufacturing Agriculture Business services Trade Consumer durables Building & construction Mining & quarrying Other activities Annual growth (percent) Jun-11 Aug-11 Oct-11 Figure 1.25: Credit to the private sector was brisk Dec-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12 Feb-13 Apr-13 Jun-13 Aug-13 Oct-13 Dec-13 Feb-14 Apr-14 M0 M1 Private sector credit growth Jun-14 Aug-14 Oct-14 Dec-14 Credit to the private sector soared in 2014, increasing 22.2 percent, up from a 20.2 percent in The growth of credit increased in all sectors except private households, consumer durables, building, and construction and mining. Growth in credit to most sectors was in the double digits. Credit to finance and insurance increased 68.4 percent in 2014, after having contracted 8.5 percent in 2013 (Figure 1.25). Credit to transport and communication rose 45.6 percent, up from 18.1 percent a year earlier. Credit to real estate grew 32.4 percent, up from 22.5 percent. Credit to private households rose 39.1 percent, up from 29.8 percent in A few sectors saw slower increases Contribution to credit growth, December 2013-December 2014 Private households Real estate Manufacturing Trade Transport & communication Business services Finance and insurance Consumer durables Agriculture Building & construction Mining & quarrying Other activities Change in volume of credit to private sector (percent) Contribution to credit growth (percentage points) Source: Central Bank of Kenya. Note: Unweighted growth is annual percentage growth. Weighted growth is annual growth times each sectors share of credit. December 2014 Edition No

36 The State of Kenya s Economy in credit in 2014, though credit growth remained robust. Credit to business services grew 25.0 percent in 2014, down from 52.6 percent in 2013; credit to mining and quarrying decelerated by 15.8 percent, down from 11.0 percent in In terms of contribution to credit growth (weighted growth), the top sectors were private households (5.8 percentage points), real estate (4.2 percentage points), manufacturing (3.6 percentage points), trade (3.5 percentage points), transport and communication (2.6 percentage points), and business services (2.2 percentage points). Stock market performance was tepid, because of uncertainty about the capital gains tax Performance of the Kenyan stock market was weak relative to global markets. The Nairobi Securities Exchange (NSE) stock index rose 3.8 percent, to 5,113, in 2014 (Figure 1.26). Over the same period, the Dow Jones rose 7.5 percent. Security concerns and the imposition of a capital gains tax of 5 percent on sold stocks dampened performance. 1.5 Kenya s external balance deteriorated in 2014 but is set to improve in 2015, thanks to falling oil prices Kenya s external balance deteriorated in 2014, but the position is poised to improve in The current account deficit averaged 8.1 percent of GDP during It reached 9.0 percent in 2014, higher than the 8.7 percent level of 2013, confirming fears that threats to Kenya s external NSE index (1966 = 100) Figure 1.26: Kenya s stock market underperformed the Dow NSE 20-share index Source: Central Bank of Kenya. Dow Jones Industrial average 19,000 18,000 17,000 16,000 15,000 14,000 13,000 12,000 11,000 10,000 vulnerability remain (Figure 1.27). The level of the deficit points to underlying structural weaknesses in Kenya s economy that need to be dealt with in order to increase exports as a share of GDP, reduce nonessential imports, or both. However, falling global oil prices may relegate the urgency of any reform to a later date, as the current account deficit is forecast to decline to 4.7 percent by Higher non-oil imports and weak merchandise exports are driving the current account deficit. Non-oil imports accounted for 23.5 percent of GDP, while merchandise exports accounted for just 10 percent. Merchandise imports grew 7.6 percent in 2014, up from 2.0 percent in Most of the growth was driven by non-oil merchandise imports, which grew 8.5 percent in 2014, up from 4.5 percent in At the same time, merchandise exports Dow Jones Industrial average Figure 1.27: Kenya s external sector remains out of balance, with exports failing to keep up with imports Percent of GDP Percent of GDP (Nov) (Nov) Current account Short-term flows (including net errors and ommissions) Other flows Overall balance Source: Central Bank of Kenya. Exports (fob) Nonfactor services Imports (non-oil) Oil imports Balance of trade Balance of trade (non-oil) 18 December 2014 Edition No. 11

37 The State of Kenya s Economy continued to be lower, growing at 1.3 percent, after having contracted 5.8 percent in The tepid performance of exports suggests that current policy stances needs to be reviewed over the medium term. The vulnerability of the external account emanates from the fact that the current account is financed mainly from short-terms flows, which can easily reverse should the global economic environment change. In 2014 the current account deficit was US$5.5 billion (9.0 percent of GDP). Long-term flows totaled US$2.2 billion (3.7 percent of GDP), up from US$481 million (0.9 percent of GDP) in The difference was financed by short-terms flows, US$4.7 billion (US$2.8 billion of which was errors and omissions), equivalent to 7.8 percent of GDP (errors and omissions represented 4.5 percent of GDP). Kenya is still not attracting enough foreign direct investment to finance its development. Capital account inflows are very small, accounting for just 2.6 percent of capital and financial account in 2014, from 1.8 percent in The significant inflows are in the financial account. However, long-term flows accounted for only 15.0 percent of US$924 million in 2014, up from 6.2 percent (US$334 million) in 2013 (Figure 1.28). 11 Billions of dollars Figure 1.28: Short-term flows dominated the capital and financial account (Nov) Capital account Financial account Official, medium and long-term Private, medium and long-term Short term (including portfolio flows) Net errors and omissions (NEO) Source: Central Bank of Kenya. Kenya s major export crops underperformed in Merchandise exports grew marginally, at 3.9 percent in the 12 months ending November 2014 an improvement over 2013, when they declined 5.8 percent. Poor export performance was driven by declines in major export goods, including tea (exports of which fell 12.4 percent), manufactured goods (down 15.6 percent), and chemicals (down 4.0 percent). On the positive side, exports of other goods including nonfactor services (up 13.3 percent), coffee exports (up 20.1 percent), and horticulture exports (up 10.9 percent) rose. Exports are critical to reinvigorating Kenya s growth prospects, but policy makers have not taken direct actions to promote production for export. Increasing exports, particularly in manufacturing, is crucial for creating the thousands of low-skilled jobs needed to reduce high unemployment, particularly among young people, whose unemployment poses a threat to social stability. After a significant slowdown in 2013, imports recovered in Imports of merchandise grew 7.6 percent, driven by machinery and transport (up 30.3 percent), chemicals (up 5.7 percent), and oil (up 4.0 percent). The growth in imports reflects some positive sentiment about Kenya s growth prospects but mainly the import of equipment for geothermal projects, the standard gauge railway, and, to a lesser extent, oil and gas equipment. The exports coverage ratio often seen as a crude indicator of an economy s ability to pay for its imports continued to fall. Kenya s ability to finance its imports from exports has been declining since 2006 (Figure 1.29). Merchandise exports were able to finance 48 percent of merchandise imports in 2006, 34.1 percent in 2013, and 33.1 percent in Adjusting for nonfactor services, the coverage ratio deteriorated from 70 percent in 2006 to 56 percent in The credibility of balance of payment numbers, especially the classifications and recording of inflows, has been called into question. The debate is fueled by the high level of errors and omission in the balance of payments (which is not unusual) and by the sources of funding of some capital imports, which may not be recorded. 12 Nonfactor services include travel, transportation, and other services, including receipts and payments in dollars in the central bank foreign exchange statistics corresponding to embassies, UN agencies, development agencies, and receipts and payments relating to insurance, royalties, and license fees. December 2014 Edition No

38 The State of Kenya s Economy Percent Figure 1.29: The export coverage ratio has declined since (Nov) Ratio of exports plus nonfactor services to imports Ratio of exports to imports Source: Central Bank of Kenya. The nominal exchange rate demonstrated mixed performance in The shilling fell 4.2 percent against the U.S. dollar, remained stable against the British pound (depreciating 0.5 percent), and rose against the Euro (appreciating 5.0 percent) (Figure 1.30). Weighted exchange rates indicate the need for further adjustment. In the past 10 years, the shilling appreciated 33 percent in real terms and depreciated 7 percent in nominal terms (Figure 1.31). Because Kenya s competitiveness has been eroded, its exports have performed poorly in global markets. As a result, the share of exports ingdp has declined. These undesirable changes require policy consideration. K sh per unit of foreign currency Figure 1.30: The shilling demonstrated mixed performance Exchange rate versus the dollar, pound, and euro, January December 2014 Jan Feb Mar April May June July Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar April May June July Aug Sep Oct Nov Dec Jan Feb Mar April May June July Aug Sep Oct Nov Dec Jan U.S. dollar British pound Euro Index December 2010 = Exchange rate versus the dollar, pound and Euro, December 2010 = Dec Jan Feb Mar April May June July Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar April May June July Aug Sep Oct Nov Dec Jan Feb Mar April May June July Aug Sep Oct Nov Dec Jan Source: Central Bank of Kenya December 2014 Edition No. 11

39 The State of Kenya s Economy Index (January 2003 = 100) Figure 1.31: The real exchange rate shows the shilling has appreciated significantly since 2000 Remittances remained robust in Remittances increased 11 percent in U.S. dollar terms in 2014, from KSh 1.3 billion (2.3 percent of GDP) to KSh 1.4 billion (2.4 percent of GDP) (Figure 1.32). The boom reflects both improved data collection by the Central Bank and improved economic activity in North America (the source of 50 percent of remittances) and Europe (the source of 27 percent). These funds are an importance source of financing for the current account deficit. Sep-00 Feb-01 Jul-01 Dec-01 May-02 Oct-02 Mar-03 Aug-03 Jan-04 Jun-04 Nov-04 Apr-05 Sep-05 Feb-06 Jul-06 Dec-06 May-07 Oct-07 Mar-08 Aug-08 Jan-09 Jun-09 Nov-09 Apr-10 Sep-10 Feb-11 Jul-11 Dec-11 May-12 Oct-12 Mar-13 Aug-13 Jan-14 Jun-14 Nov-14 Nominal effective exchange rate Source: Central Bank of Kenya. Real effective exchange rate Figure 1.32: Remittances reached an all-time high Sources: Central Bank of Kenya and Kenya National Bureau of Statistics. December 2014 Edition No

40 The State of Kenya s Economy 2. Outlook for The World Bank projects that Kenya will grow at 6.0 percent in 2015, 6.5 percent in 2016, and 7.0 percent in The new projections reflect the stimulus effect of the massive infrastructure investments currently being undertaken by the government and the effects of falling oil prices. These high growth figures are predicated on a sustained demand boost from infrastructure projects as they start coming on line; expansion of productive capacities, especially in electricity production and construction; increased manufacturing output, as a result of cheaper electricity and a weaker shilling; and lower crude oil prices. 2.1 Kenya s growth prospects are favorable in the near to medium term The World Bank projects that economic growth in Kenya will rise to 6.0 percent in 2015, after estimated growth of 5.4 percent in These estimates are higher than earlier projections, as a result of the ongoing infrastructural projects, lower oil prices, and the 2014 rebasing of GDP, which improved estimation of national accounts and reflected the new growth sectors, which had been omitted. Average growth is projected to rise to 6.5 percent in , supported by strong domestic demand and tailwinds from lower oil prices (Figure 2.1). Growth will exceed the average for Sub-Saharan Africa, making Kenya one of the fastest-growing economies in the region over the next three years. Percent Figure 2.1: The outlook for economic growth in Kenya is strong Growth outlook, estimate forecast forecast Baseline High case scenario Low case scenario Source: World Bank estimates. Note: Figures for 2014 are estimates. Figures for 2015 and 2016 are forecasts. In the baseline scenario, GDP is projected to grow 6.0 percent in 2015 and 6.6 percent in 2016, thanks mainly to increased aggregate demand as a result of the ongoing infrastructural projects and the fall in oil prices. The boost in real income will allow a robust increase in private consumption, the engine of Kenya s economy. Higher public investment spending on infrastructure, especially on the standard gauge railway, will also stimulate the economy and enhance Kenya s competitiveness, particularly beginning in Private investment in the manufacturing sector will rise, supporting a rapid increase in industrial production. A gradual pick-up in tourism and continued recovery in agriculture will further support growth. In contrast, the contribution of net exports is expected to be marginal. Although the fall in oil prices will reduce the current account deficit, it will remain relatively large, because of slow export growth. In the high-growth scenario, GDP will grow 6.5 percent in 2015 and 7.0 percent in Lower inflation as a result of falling oil prices and the standard gauge railway will provide the main boost to the economy. 13 The decline in the price of oil will also reduce the current account deficit, easing pressure on the shilling. 14 Simulations suggest that a 30 percent decline in the price of oil from the baseline that is, a price of US$45 a barrel could increase GDP growth by up to 1.2 percentage points in The positive externalities of the massive infrastructural projects (roads, railway, and energy) 13 The simulation results refer to 2015 not In the baseline forecast, GDP growth rises to 6 percent in 2015, from 5.4 percent in In the high-case scenario, GDP growth rises to 6.5 percent in 2015, a full 1 percentage point increase over A case could be made that growth could reach 7 percent in In the baseline, the price of oil is relatively high (albeit lower than the oil baseline); security concerns continue to hurt tourism;and the current account deficit, though improving, remains relatively large, keeping Kenya vulnerable to a slowdown in capital inflows. Given the relatively large current account deficit, the shilling is likely to remain under pressure. As a result, inflation will be higher than it would otherwise have been, possibly prompting the Central Bank to raise interest rates. All of these risks are reduced in the high-case scenario. 22 December 2014 Edition No. 11

41 The State of Kenya s Economy and devolved county spending will also stimulate the economy. Lower inflation, and an improved outlook for the shilling, will decrease the likelihood that the central bank will tighten monetary policy, allowing consumer and business confidence to increase. Even in the low-growth scenario, growth will be higher in 2015 and beyond. Under this scenario, GDP is projected to grow 5.6 percent in 2015 and 2016 and 5.7 percent in The low-growth scenario assumes that security concerns continue to hurt tourism. Another large-scale security incident could significantly weaken the tourism industry, with adverse spillovers to the rest of the economy. This scenario also assumes that investment remains constrained or delayed by the government s focus on current expenditure and security sector. In addition the current account deficit remains high, despite the fall in the price of oil, as a result of weaker recovery of exports, keeping Kenya vulnerable to a slowdown in capital inflows. Pressures on the shilling could lead to interest rate hikes. The drop in global oil prices is a boon for Kenya, but it does not obviate the need to undertake reforms to reduce the structural imbalance in the external account. Kenya s current account is projected to drop from 8.3 percent of GDP in 2013 to 4.7 percent in 2017 as a result of falling oil prices (Figure 2.2). Lower oil prices will reduce the urgency of the structural reform agenda. The structural imbalance Percent Figure 2.2: The current account balance is projected to improve significantly as a result of lower oil prices -8.5 Current account outlook, estimate forecast forecast Baseline High case scenario Low case scenario Source: World Bank estimates problems have not gone away, however. Kenya s export sector has been lagging since the mid-1990s (the last tea and coffee boom). As a result, Kenya relies too heavily on short-term capital flows to service its current account. In order to service and reduce external indebtedness, policy makers need to focus on increasing the production of traded goods in order to enhance capacity to generate foreign exchange. Kenya will need to shift resources toward the export sector. 2.2 Risks have diminished, although they remain significant The risks to Kenya s outlook are similar to those highlighted in the June 2014 Update. On the domestic front, the weak security environment and fiscal position pose significant risks to growth prospects. On the external front, the winding down of monetary easing by the U.S. Federal Reserve and the subsequent increase in interest rates in the United States may reduce growth in Kenya. A deflated Euro area will dampen the growth pick-up the economy expects to see in the near to long term. The security situation threatens growth. The Al Shabaab terrorists, who escalated their attacks in 2014, continue to be a threat to national security. Terrorist activities have scared away tourists and potential investors. Tourist arrivals and hotel occupancy rates have plummeted, and several coastal hotels have closed. Tourism s contribution to GDP declined by one third in The current expansionary fiscal path is not sustainable and presents a risk to growth. Devolution added pressure to the fiscal position, but it is the lack of rationalization of spending after devolution, the duplication of functions at the national and county level, and the strong appetite for spending at both levels of government that have worsened Kenya s fiscal position. Although heavy infrastructural spending is a boon for Kenya s production space and future growth, the short- to medium-term macro-fiscal framework is shaky should there be a macroeconomic shock. December 2014 Edition No

42 The State of Kenya s Economy Kenya remains vulnerable to the winding down of the U.S. monetary stimulus. Kenya s economy has benefited immensely from the Fed stimulus, in terms of both short- and long-term capital flows. Yields on shilling-denominated assets have been high, outstripping the depreciation risks and large interest rate differentials, making Kenya a more attractive destination for world capital than many other emerging economies or Africa as a whole. With the ending of the Fed s monetary stimulus, the flow of cheap capital that has been funding the current account could dry up, creating volatility in the foreign exchange market and prompting the Central Bank to raise interest rates, which could choke growth. The strong dollar in the fourth quarter of 2014 and early 2015 has already offset part of the benefits of low international oil prices. Deflation in the Euro area poses a risk to exports. Weak exports will continue to drag down growth. Europe is one of the main destinations of Kenya s merchandise exports. It is also a main source of tourists to Kenya, as well as the source of most equity funds. A continued or deeper slowdown in Europe would hurt Kenya s growth prospects. Structural reforms are needed to increase Kenya s attractiveness as a destination for long-term capital. Long-term capital inflows to Kenya represent less than 2 percent of GDP. Foreign direct investment (FDI) as a share of GDP is the lowest in the region (Figure 2.3). Several reforms could help attract longterm capital. First, Kenya could improve the business climate, as discussed in Part 3 of this Update. Second, it could improve the macroeconomic environment, to make export activities more profitable, so that exports do not continue to lag imports. Third, it could initiate reforms that could lead to the real depreciation of the exchange rate. Since 2003 the real exchange rate has appreciated at an average annual rate of 3 percent. The interest rates on Treasury bills and other Kenyan securities continue to attract capital inflows, as the yields on shillingdenominated assets are high given the interest rate differentials with other markets. As a result, the shilling has been kept artificially strong, discouraging exports and encouraging imports (most consumer goods in Kenya are imported, as a walk down the aisle of any supermarket will attest). Fourth, Kenya could create a more favorable tax regime. Recent tax reforms will discourage FDI. Figure 2.3: Foreign direct investment in Kenya is much lower than in peer countries US dollar, million FDI inward flow FDI inward flow, percent of GDP Sources: UNCTAD and Kenya National Bureau of Statistics Percent Ghana Tanzania Uganda Middle income Sub-Saharan Africa (developing only) South Africa Lower middle income Rwanda Nigeria Kenya Burundi Foreign direct investment percent of GDP, December 2014 Edition No. 11

43 Special Focus: Manufacturing and the Business Environment in Kenya