Growth Recovery in Kenya: What Caused it and How Can

it be Sustained

Praveen Kumar

AFTP1

September 29th, 2008

2

Presentation Outline

I. Kenya’s Growth experience

II. Analysis of drivers of recent trends

III. Constraints to accelerating and sustaining growth

IV. Outline of a growth strategy

3

Overall message

Macro framework reasonably sound, fiscal well-managed

Micro-reforms are working. Key growth challenges are:

Keeping political risk low Using fiscal space wisely to scale-up

infrastructure services Reducing micro-risks such as corruption, security

4

Growth bypassed Kenya even as it accelerated in neighboring countries…

Trends in annual GDP growth (Real LCU)

Mozambique

Kenya

Mauritius

TanzaniaUganda

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1991 1993 1995 1997 1999 2001 2003 2005

5

…but recovered strongly after 2003

012345678

2002 2003 2004 2005 2006 2007 2008(est)

Year

%

6

Recovery was broad-based

0

5

10

15

20

Agr

icul

ture

and

For

estr

y

Man

ufac

turin

g

Con

stru

ctio

n

Who

lesa

le a

ndT

rade

Hot

els

and

rest

aura

nt

Tra

nspo

rt a

ndC

omm

unic

atio

n

Fin

anci

alIn

term

edia

tion

GD

P g

row

th (

perc

ent)

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

Con

trib

utio

n (p

erce

nt)

% Change(annualized)

Contribution toChange in totalGDP (annualized)

7

Investment grew in an impressive manner…

Annual Percentage Change in Expenditure on GDP (constant 2001 prices)2003 2004 2005 2006 2007*

Government Consumption 6.0 0.6 -0.6 1.5 7.2

Private Consumption 2.2 2.4 6.4 7.6 7.3

Gross fixed Capital Formation -8.0 7.3 27.8 18.5 13.3

Exports of Goods and Services 7.2 12.8 9.7 3.4 6.0

Imports of Goods and Services -0.1 12.3 15.0 18.2 12.7

Source : Economic Survey 2008, KNBS.

(*) Provisional

8

for example, Imports of Machinery and Transport Equipment Increased (% of Gross Domestic Expenditure)

0.0

4.0

8.0

12.0

16.0

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

year

% o

f g

ross

do

mes

tic

exp

end

itu

re machinery and industrial transport machinery

industrial transport equipment

9

TFP also improved

Physical capital Human Capital TFP

1960-1980 3.0 0.4 0.8 1.8

1981-1990 0.7 -2.0 0.1 2.6

1991-2000 -1.2 -1.1 1.0 -1.1

2001-2007 1.6 0.9 0.1 0.5

2003-2007 2.4 1.0 0.1 1.3

1960-2007 1.4 -0.4 0.6 1.2Source : Staff calculations. GDP, investment, and Labor Force data are from World Development Indicators database, World Bank. Capital stock data are from Nehru and Dhareswar (1995). Factor shares in GDP are based on Economic Surveys. KNBS.

Average Annual Change in GDP per unit of labor (%)

Contribution to GDP per unit of labor change (%)Period

10

Three drivers of positive trends after 2003:

Lagged benefits of liberalization of price, trade, exchange rate & interest rate forced by reduced aid after the Goldenberg scandal uncovered in 1992;

Solid foundation for solvency based on significant revenue collection as a payoff to the reform of tax policy & administration which started in the mid-1990s; & critically;

Declining political risk after the successful 2002 elections fueling an improvement in sovereign creditworthiness & the private investment climate;

11

Driver 1: Economic liberalization in the mid 1990s

Era of price controls ended; Import licenses abolished, tariff structure simplified –

average tariff reduced; Unified, market-based exchange rate adopted and

exchange controls lifted; KRA established, tax reforms introduced; Agricultural marketing liberalized;

Major spur for reform was: the need to establish macro credibility in the wake of the Goldenberg scandal, and the reduction of aid.

12

Driver 2: Sustainable trajectory of public debt

0

10

20

30

40

50

60

70

80

1995/96 1996/97 1997/98 1998/99 1999/00 2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07

Domestic debt

External debt

Debt to GDP ratio

13

What lowered the debt ratio?Debt decomposition

1996/97 - 2002/3 2003/04 - 2006/7 1996/97 - 2006/7

Change in public sector debt -1.8 -5.8 -3.2

Contribution from

1. Primary Deficit (- surplus) -1.7 -0.1 -1.1

2. Real GDP growth -1.4 -2.8 -1.9

3. Real interest rate 2.1 0.3 1.5

4. Real exchange rate (- appreciation) 0.6 -2.5 -0.5

5. Other Factors -1.4 -0.7 -1.1

Factors Explaining Falling Indebtedness 1996/97-2006/07(% points of GDP, annual average)

14

Solid foundation for solvency – Revenue mobilization Significant reforms in tax policy Improved tax administration

0.5

5.5

10.5

15.5

20.5

25.5

30.5

19

95

/96

19

96

/97

19

97

/98

19

98

/99

19

99

/00

20

00

/01

20

01

/02

20

02

/03

20

03

/04

20

04

/05

20

05

/06

20

06

/07

Revenue, excluding grants Income Tax VAT Import Duty Excise Duty

15

Driver 3: Decline in country risk

Cost of domestic borrowing declined Sovereign risk ratings improved Reduced perception of risk by firms

16

Driver 3: Decline in country risk:Cost of domestic borrowing

1999 2000 2001 2002 2003 2004 2005 2006 2007

91-day Treasury Bill 13.3 12.1 12.7 8.9 3.7 3.0 8.4 6.8 6.8

U.S. Treasury Bill 4.7 5.8 3.5 1.6 1.0 1.4 3.2 4.7 4.4

Difference 8.6 6.2 9.3 7.3 2.7 1.6 5.3 2.1 2.4

Actual KSh./US$ depreciation 17.8 7.0 0.7 -1.9 -1.2 1.6 -6.4 -4.1 -9.7

EMBI Africa (In Basis Points) .. .. .. 529 232 177 145 74 166

-Nigeria 1,338 2,037 1,426 2,276 732 667 523 481 ..

-South Africa .. .. .. 238 141 95 85 85 164

EMBI + Spread (In basis points) 824 756 731 765 418 356 245 169 239

Source : Central Bank of Kenya; International Financial Statistics; JP Morgan; and, Staff Estimates

Interest Rate Decomposition(In percent)

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Decline in country riskSovereign risk ratings

40

60

80

Jan

-95

Jan

-96

Jan

-97

Jan

-98

Jan

-99

Jan

-00

Jan

-01

Jan

-02

Jan

-03

Jan

-04

Jan

-05

Jan

-06

Jan

-07

Jan

-08

Month-year

ICR

G R

ati

ng

10

15

20

25

30

35

month-yearII

ratin

g Kenya Mozambique Tanzania

Uganda Zambia

ICRG* Institutional Investor**

*Scale 0 to 100, with 100 as lowest risk.

**Scale of zero to 100, with 100 representing the least chance of default

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Reduced perception of risk by firms

Issue 2003 2007

Crime, Theft and Disorder 69 59

Tax Rates 69 56

Electricity 47 55Corruption 73 54

Transportation 36 53

Practices of Competitors in Informal Sector 64 50Tax Administration 52 50

Customs and Trade Regulations 40 42

Telecommunications 45 28Business licensing and Permits 13 28

Macroeconomic Instability 50 28

Access to Finance 71 26

Political Instability 47 18

Access to Land 23 16

Labor Regulations 22 16Inadequately Educated Labor Force 31 11Source : Kenya ICA, 2003 and 2007.

Percent of Manufacturing Firms Perceiving Issue as Being a Major or Severe Constraint to Business

19

What can be done to accelerate and sustain growth: Multi-pronged analysis

Growth diagnostics Cross – country benchmarking A stylized (real) macro-model (MAMS) Use of ICA Sectoral analysis: Tourism, ICT, agriculture

20

Key results from Growth Diagnostics

Cost of finance is not a binding constraint in Kenya currently

Scarcity of human capital is not a binding constraint currently

High cost of infrastructure services - energy, ports etc hurting returns

Macro risk receded, but micro-risks (corruption, security situation) deterring investment

21

Evidence of high business costs from ICA 2007

Cost as % of sales Kenya (2007)

China (2002)

India (2006)

S. Africa (2003)

Senegal (2003)

Tanzania (2006)

Uganda (2006)

Production lost due to crime

3.9 0.3 0.2 0.6 1 1.1 1

Payment for security

2.9 0.8 1.3 0.9 1.5 2.3 1.4

Bribes 3.6 1.9 2.1 0.3 0.4 3.4 3.7

Production lost in transit

2.6 1.2 0.8 0.8 n.a. 1.6 1.2

Production lost due to power outages

7.1 2 7.8 0.9 5.1 10.7 10.2

Total costs 20.1 6.2 12.2 3.5 n.a. 19.1 17.5

Source : ICA, 2007

Cost of crime, security, bribes, and lost production are several times higher in kenya than in other countries

22

Cross-country benchmarking on deeper determinants of growth

Indicators used by Johnson, Ostry and Subramanian (2007) Institutions – broad political and economic Extent of integration into global economy

Two sets of countries Fast-growing SSA countries that are not

resource-rich, not post-conflict 12 Sustained Growth economies

23

Benchmarking Institutions:Kenya does OK on indicators of broad political and economic institutions

Indicator (range) A higher value indicates…

Fast -growing

SSA countries –

average (year)

Sustained growth

countries–average (year)

Kenya (year)

Constraint on the executive (1–7)a More constraint 3.9 (2004) 2.2 (T)e 6 (2004)

Economic risk (1–50)b Lower risk 31 (2002) 31.7 (1984) 33 (2002)

Investment risk (1–12) Lower risk 8.1 (2006) 7.1 (1996) 9.5 (2006)

Control of corruption (1–6)c Higher control 2.4 (2005) 3.4 (1996) 1 (2005)

Income inequality–Ginid Higher inequality 49 39.5 (T) 43

Source: Johnson, Ostry, and Subramanian (2007).a. Polity IV database.b. ICRG database.c Normalized Kaufmann-Kraay index.d. WDI database.

24

Benchmarking Institutions:Kenya has high social fractionalization

Indicator Fast-growing SSA countries average

Sustained growth countries average

Kenya

Ethnica0.72 0.3 0.83

Ethnicb0.75 0.33 0.85

Religionb 0.53 0.3 0.7

Ethnicc 0.68 0.32 0.86Linguisticc

0.76 0.29 0.89

Religionc0.54 0.42 0.78

Source : Johnson, Ostry, and Subramanian (2007).

Note : A higher value represents higher fractionalization.

a. Easterly and Levine (1997).

b. Fearon (2003).c. Alesina and others (2003).

Indicators of Social Fractionalization, Fast-Growing SSA Countries, Sustained Growth Countries, and Kenya

25

Benchmarking macro and trade policy and outcomes: Kenya looks not bad

Measure Fast-growing SSA countries average

Sustained growth countries– average

Kenya

Total exports to GDP 25.1 19.1c24.7

Manufacturing exports to GDP 4.8 2.2 3.2

Apparel, footwear, textiles exports to GDP 3.9 1.1 0.5

Fuel and ore exports to GDP 3.1 4.2 3.1

Agriculture and food exports to GDP 7.3 7.8 7.7

Trade restrictiveness (0– 1)b0.9 0.4 1

Balassa-Samuelson average currency overvaluation 10.8 -17.7 9.4

Largest consecutive spell of overvaluation in years since 1970 15.4 6.4 21

Average overvaluation during largest spell 43.8 11.4 16.9

Inflation 7.3 14.6 10.3

Aid to GDP 13.3 4.7 (T -4 to T +5) 4

Source : Johnson, Ostry, and Subramanian (2007).

a. Average for years after 2000 unless otherwise indicated.

b. Sachs-Warner measure updated by Wacziarg and Welch (2003). It is a dummy variable, with 1 indicating fully open trade.

c. All export outcomes for sustained growth countries are averages for T to T+4.

Macroeconomic and Trade - Policies and Outcomes, Fast-Growing SSA Countries, Sustained Growth

Countries, and Kenyaa

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Benchmarking extent of integration into global economy: Kenya’s low integration

Trends in Shares of Exports in Total GDP, Sustained Growth Countries and Kenya, 1960-2005

Ireland

Kenya

Korea

Mauritius

Thailand

Taiwan

Vietnam

China

Chile

0

10

20

30

40

50

60

70

80

90

1001

96

0

19

63

19

66

19

69

19

72

19

75

19

78

19

81

19

84

19

87

19

90

19

93

19

96

19

99

20

02

20

05

% o

f c

ou

ntr

y's

re

al G

DP

27

Benchmarking extent of integration into global economy: Kenya’s declining competitiveness

Shares in World Exports of Goods and Services, High Performing Economies (HPEs) and Kenya, 1975–2005

Kenya goods (left axis)

Kenya services (left axis)

HPE goods (right axis)

HPE services (right axis)

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

0.16

0.18

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

year

per

cen

t o

f W

orl

d e

xpo

rts

0

2

4

6

8

10

12

14

16

18

20

per

cen

t o

f W

orl

d e

xpo

rts

Source: Staff calculations, based on COMTRADE data. Averaged using SITC2 3-digit classification.

28

Benchmarking sophistication of exports: Low sophistication

EXPY (Proxy for Degree Sophistication), Sustained Growth Economies and Kenya, 1992-2003

Korea, Rep.

China

Chile

Kenya

Ireland

Mauritius

Singapore

Botswana

Thailand

Japan

2000

4000

6000

8000

10000

12000

14000

16000

180001

99

2

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

year

$ p

er c

apit

a

29

A stylized (real) macro-model (MAMS)

Real Macro Indicators by Simulation (% annual growth from 2006-2030)

base base+gns

base+fdi

base+aid

v30-gradual

v30-fast

Absorption 5.0 6.5 5.4 5.7 8.8 9.2

Consumption-private 4.8 6.0 5.0 5.5 8.1 8.5

Consumption-private per capita 2.5 3.6 2.6 3.1 5.6 6.0

Consumption-government 5.4 6.4 5.9 5.8 7.6 7.8

Fixed investment-private 4.6 8.3 5.9 5.9 11.8 12.3

Fixed investment-government 6.5 8.0 7.2 7.2 10.5 10.8

Exports 5.0 7.5 6.5 5.5 10.6 11.1

Imports 5.0 7.0 5.6 5.8 9.7 10.2

GDP at market prices 5.0 6.6 5.6 5.6 9.0 9.4

GDP at factor cost 5.0 6.6 5.6 5.6 8.9 9.4

Total factor employment 3.9 5.3 4.5 4.4 6.4 6.6

Total factor productivity (TFP) 1.1 1.3 1.2 1.1 2.6 2.7

ICORa 3.8 4.0 3.8 3.8 3.3 3.3

Real exchange rate -0.1 0.0 0.2 -0.2 -0.4 -0.4

30

Outline of growth strategy

Keep political risk low – address issues of social and political cohesion

Sustain macro-stability Preserve favorable government debt dynamics and use

available fiscal space to finance only high-return projects Strengthen institutional framework for project selection and

subject capital projects to systematic economic analysis Reduce high costs of backbone services:

Logistics costs, particularly of trading across borders Transportation costs Telecommunications and energy costs

31

Outline of growth strategy

Improve global integration of Kenyan economy. Towards that: Deepen regional integration, BUT Focus on global competitiveness beyond the region:

Use membership of trade groups – EAC and COMESA – to further improve openness

Liberalize unilaterally where possible Use multilateral route for securing access to protected

Asian markets Maintain a competitive real exchange rate

Proactively provide solutions to government/market failures in key export sectors Example ICT Example Tourism