Conditions for economic growth have improved in Kenya, but challenges remain

After the costly drought and political uncertainty of 2017, in 2018 the Kenyan economy appears to have stabilised on an upward trajectory, with most forecasts seeing a more robust expansion of economic activity. However, a structural fiscal deficit and ballooning public debt continue to pose significant challenges. Consequently, an increased sense of urgency surrounds the process of economic reform by which Kenya hopes to establish itself as a globally competitive, prosperous nation by 2030.

The Big Picture

Since its independence in 1963 Kenya’s economy has undergone fundamental change. The industrial and trade polices inherited from the colonial period were largely based on import substitution, with the state playing a large role in economic activity. Effective rates of protection were high, and those large multinationals that were pursued by the government to produce for the domestic and regional market often enjoyed virtual monopolies.

This restrictive economic environment began to change after the 1980 signing of a structural adjustment loan with the World Bank, conditional on the government adopting a more outward-orientated industrial policy, as well as liberal trade and interest rate regimes. The following decades saw the gradual lifting of import restrictions; the loosening of foreign exchange limits; trade-promotion activities, such as the 1990 introduction of export processing zones; and the wholesale liberalisation of the financial sector.

This process of reform, despite occasional setbacks, has established Kenya as East Africa’s economic powerhouse and the region’s principal business centre. Some of the world’s biggest multinationals, attracted by the nation’s well-regarded legislative framework and favourable economic policies, have located their East African or sub-Saharan operations in Nairobi, including IBM, Toyota, ASUS, Coca-Cola, Nestlé and BASF. The nation’s economic growth has been particularly strong since the turn of the century: GDP more than doubled between 2000 and 2017, from KSh2.1trn ($11.6bn) to KSh4.3trn ($25.3bn), according to the IMF, largely thanks to a rapidly expanding services sector.

More recently, the country has faced some economic headwinds. Kenya entered 2018 on the back of a challenging year, during which an extended election process and a severe drought threatened to impede investment and economic growth. Nevertheless, despite a modest slowdown in GDP growth from 5.8% in 2016 to 4.8% in 2017, Kenya’s economy has shown a welcome robustness. According to the IMF, inflation has declined to below the mid-point of the authorities’ target range, the banking system and the exchange rate have remained stable, and foreign-exchange reserves had risen to $7.1bn as of end-January 2018. With the election process concluded, the government can turn its attention to tackling longer-term challenges to economic development, the most pressing of which is a run of fiscal deficits over recent years which have raised concern over public debt vulnerability.

Fiscal Matters

Political events have impinged on Kenya’s fiscal performance over the past year. After a court ruling annulled the August 2017 presidential election, Kenya held a second vote in October of that year which was boycotted by the main opposition coalition. While President Uhuru Kenyatta’s Jubilee Party was victorious in the second ballot, an appeal to the Supreme Court resulted in further political uncertainty. These events had a negative effect on investment sentiment which, combined with budget amendments to accommodate unplanned election expenses, resulted in the National Treasury revising its 2017/18 budget deficit from 6.8% of GDP to 8.5%. When official data for FY 2017/18 – which ends in June – was collated, the deficit was estimated at 7.2%. The structural deficit and the resulting need to borrow to meet spending obligations have led to an increase in public debt. Moody’s, the international credit ratings agency, has forecast that government debt will climb to 60% of GDP in FY 2018/19, up from 56% in 2016/17 and 41% in 2011/12. This trend prompted the agency to downgrade Kenya’s issuer rating in February 2018 from “B1” to “B2”; both grades are in the non-prime segment of the Moody’s scale.

As well as prompting action from international credit ratings agencies, Kenya’s rising public debt is exerting pressure on state finances: in 2018 the National Treasury reported that it expected 45% of tax revenue to be directed to paying off loans. The government has responded to these developments by undertaking efforts to reduce the fiscal deficit to 5.7% of GDP in 2018/19, down from 7.2% as of June 2018 and 8.8% in FY 2016/17.

Cutting Costs

Reducing government spending in order to narrow the fiscal deficit is a challenging proposition. The government’s first cost-cutting gesture has been to delay the implementation of lower-priority investment projects. However, a reduction in development spending reduces the capital stock of the economy. This has negative implications for long-term growth because it reduces the government’s ability to foster industrialisation, create jobs and maintain the competitiveness of the Kenyan economy.

A better target, from a purely economic perspective, is recurrent spending, which in FY 2016/17 accounted for more than 90% of the revenue gathered from taxes and levies. Tackling the recurrent spending bill, however, is problematic, as many of the major items, such as interest payments on government debt, are essentially fixed. The public sector wage bill, which accounts for around 49% of tax revenue, according to Kenya’s Salaries and Remuneration Commission, is the area of recurrent spending which represents the single biggest trimming opportunity for the state. But reducing the salaries and benefits of the nation’s civil servants is no easy task. The difficulty faced in surveying the country’s balance sheet for items on which to reduce spending, and the lack of progress in cutting annual expenditure led the World Bank to declare in a report published in December 2017 that “fiscal consolidation is yet to commence”.

Boosting Revenue

Increasing government revenue is the other side of the equation when it comes to bridging the deficit. Kenya’s tax returns have consistently come in under target over recent years, and the government has responded by committing itself to a range of revenue-boosting measures. Improving tax administration is one of them, and the authorities have therefore begun to work with Kenya’s 47 counties to improve collection rates. Under the devolved system, counties have the ability to apply tax to a range of services but to date have largely depended on central government funds to meet their spending obligations. Since 2017 the government has been signing memoranda of understanding with individual counties, starting with Laikipia and Kiambu, with view to ending this reliance on state coffers.

Removing the large number of exemptions which are applied to both the corporate income tax and value-added tax (VAT) schedules is another means by which the government can boost revenue. These two taxes account for around half of all government tax revenue, according to a recent World Bank report, but could contribute as much as KSh33.3bn ($187.3m) more to the state’s finances each year if applied to a greater slice of economic activity.

In 2018 the government announced that it would extend the 16% VAT rate to petroleum products as of September, a move which would see the price of petrol rise to KSh122.75 ($0.69) per litre and diesel increase to KSh111.07 ($0.62) per litre. Earlier in the year an attempt by the Kenya Revenue Authority (KRA) to impose an excise duty on bottled drinks was rebuffed by the High Court, which declared that the KRA should consult more extensively with the counties before enacting such a change. The decision leaves the door open to future reform of the excise duty schedule, but the real gains for the government rest in broadening of the tax base through the removal of income tax and VAT exemptions (see analysis).

Bridging the Gap

While the fiscal gap remains, the government is able to meet its spending obligations thanks to a combination of international support, bank loans and a history of sovereign debt issuance. Kenya has, for example, received support from the IMF since 2015, when it secured a 12-month stand-by agreement (SBA) and stand-by credit facility (SCF) worth a combined $688m. These drawing rights were precautionary, and the Kenyan authorities made clear at the time that they would only call upon them if exogenous shocks led to a significant deterioration in the nation’s balance of payments.

The SBA and SCF agreements were refreshed in March 2016, this time with 24-month drawing rights of $990m and $495m, respectively. The SBA received a six-month extension in March 2018, giving the IMF and the government more time to complete reviews which were delayed in 2017 due to the election process and the IMF’s requirement that Kenya undertake stronger fiscal measures to counter its structural deficit. To support its extension request, the government committed to pursue policies aimed at reducing the deficit, and to substantially modify interest rate controls on banks’ lending and deposits.

While it has yet to call upon its precautionary IMF facilities, its ability to do so is an important stabilising factor that has enabled Kenya to secure large loans from other development finance organisations and banks. The National Treasury reports that between 2015 and 2017 Kenya secured syndicated loans from bank consortia (which comprise Standard Chartered Bank, Citibank and Standard Bank of South Africa) worth $2.5bn, while a further $1.6bn was obtained from development finance institutions including China Development Bank, Africa Export-Import Bank, and the Trade and Development Bank.

Support from the IMF has also helped Kenya sell its bonds on global markets at favourable rates. In February 2018 Kenya raised $2bn of long-dated bonds in a bid to inject liquidity into the economy and repay some of its outstanding bank facilities. The 10- and 30-year, dollar-denominated instruments were priced at 7.25% and 8.25%, respectively – slightly below initial guidance from the arranging banks.

While Kenya’s ability to borrow from banks and the market has proved useful, by June 2017 its debt burden had reached 56.4% of GDP – a development which has elicited concern from ratings agencies. In early 2018 both Moody’s and Fitch said that they expected Kenya’s debt to rise to 60% of GDP by mid-2018. If the upward trend is sustained as projected, the government is likely to face higher debt-servicing costs, while the private sector will be confronted with increasingly expensive financing options.

Private Sector Challenge

Despite the nation’s positive economic trajectory, a 2016 World Bank survey of Kenya’s long-term economic performance showed that the stagnation of manufacturing and agriculture, the mainstays of the domestic economy, has meant job creation has not kept pace with the growing working-age population. Unemployment remains a key challenge, running at around 11% of the workforce, and twice that for those between the ages of 15 and 24. Moreover, most new job opportunities are largely being created in the informal economy, and concentrated in low-productivity sectors such as trade, hospitality and jua kali – entrepreneurs who can be hired on an ad hoc basis to carry out almost any task. According to the World Bank, the population of 44m is growing at a rate of 2.5% per year, and 9m more jobseekers will enter the market by 2025.

Given the government’s desire to curtail its spending, the task of providing employment opportunities to meet the expanding workforce falls to the private sector. Recent government policy, however, has threatened to impair the ability of the private sector to perform this function. In August 2016 the president signed the Banking (Amendment) Act Bill, which establishes a ceiling on lending rates of no more than four percentage points above the central bank’s base rate, as well as a floor on interest-earning deposits of at least 70% of the same rate. While the intention was to spur economic activity by lowering the cost of borrowing, the effect was the opposite: unable to price correctly for risk, banks decreased the amount of funds they made available for the private sector, and in the year to July 2017 private sector credit growth fell from 7.5% to 1.2%. In June 2018, the government proposed lifting the cap, but in August legislators voted to retain the ceiling, repealing only the minimum deposit rate (see Banking chapter).

Monetary Policy

The interest rate cap also adversely affected the ability of the Central Bank of Kenya (CBK) to influence the economy through its monetary policy. According to the CBK, the rate regime has meant that whereas a low central bank rate which would normally act as a spur to lending and business activity, the restriction has instead resulted in a curtailment of private sector growth. In effect, the cap has made the effects of a change in the central bank rate unpredictable, and therefore weakened it as a policy tool. The bank had thus been hoping to see the cap repealed, as had the IMF, which made it a condition to access further support.

Inflation

Looking to the longer term, the CBK has a good record of pursuing its monetary policy goal of price stability. Since the annual rate of inflation spiked to double digits in 2012, the yearly average has remained broadly in line with National Treasury targets. In September 2017 the Treasury reaffirmed its target range of between 2.5% and 7.5% (a 5% target rate with a 2.5% margin on either side). The annual rate of inflation in September 2017 stood at 8.4%, a slightly higher figure than in previous years, which was largely attributable to a temporary spike in food prices caused by an extended period of drought. Recently, the CBK has sought to boost economic expansion by loosening its monetary policy: after holding the base lending rate steady at 10% from September 2016, in March 2018 the bank reduced it by 50 basis points to 9.5%. In explaining its decision the CBK stated that despite the risk of “perverse outcomes” caused by the government’s legislation on interest rate caps for banks, inflation was dropping, and there was a need to ease monetary policy to encourage economic growth.

Trade

Kenya’s trading patterns represent another economic challenge for the government. The nation’s trade deficit reached the KSh1.1trn ($6.2bn) mark by the close of 2017, a 33% rise on the previous year. The trajectory continued to climb in the first half of 2018, with the trade deficit standing at KSh601.9bn ($3.4bn) as of end-June. Imports grew by 20.5% in 2017, according to the Kenya National Bureau of Statistics (KNBS), mainly driven by rising inflows of petroleum products, industrial machinery, motor vehicles, and iron and steel. Just over 64% of imports were derived from Asia, with China, India, Saudi Arabia and the UAE accounting for a combined 73.5% of Asian imports. Kenyan exports, meanwhile, expanded by just 2.8% in 2017, with tea and horticulture products accounting for nearly half of domestic export earnings.

The government’s response to the stubborn trade deficit is encapsulated in a new National Trade Policy. Launched in 2017, the strategy aims to address both tariff and non-tariff barriers to trade, and boost exports by improving trade-related infrastructure, deepening finance options for local companies and increasing the value-added component of domestic manufacturing (see analysis).

In this effort, Kenya is aided by the depth of its global, regional and bilateral relationships. The country has been a member of the World Trade Organisation since 1995, and in 2015 the body held its 10th Ministerial Conference in Nairobi. At the regional level, Kenya is a member of COMESA, which establishes a preferential tariff system for member countries, and since 2010 has maintained a fully fledged Customs union among its 19 members.

Strategy

The government’s attempts to tackle its economic challenges are guided by its long-term blueprint for economic development, Kenya Vision 2030. Launched in 2008, the strategy aims to establish Kenya as a globally competitive, prosperous nation with a high quality of life. Its economic component contains a number of ambitious goals, including increasing annual GDP growth rates to a sustainable 10%; establishing Kenya as one of the top-10 long-haul destinations in the world; raising incomes in agriculture, livestock and fisheries by enhancing the level of processing, and thereby adding value to products before they reach the market; expanding the size and efficiency of the formal wholesale and retail sector; and transforming Kenya into one of the top-three business process offshoring destinations in Africa. The Kenya Vision 2030 strategy is being implemented in successive five-year, medium-term plans, the first of which covered the 2008-12 period.

The Big Four

In early 2018 the government was finalising its third medium-term plan, covering the 2018-23 period. According to the Ministry of Planning and National Development, it will focus on the Big Four strategic initiatives established by the Economic Transformation Agenda, which is guiding the process of Kenya’s industrialisation according to the vision laid out in the 2030 plan. By 2022 this agenda aims to raise the manufacturing sector’s contribution to GDP to 15%; guarantee food security to all Kenyans; establish universal health coverage; and provide sufficient housing for the expanding population by constructing at least 500,000 affordable homes.

Major Sectors

A successful implementation of this long-term strategy would result in significant shifts in economic activity. For now, however, the agriculture sector remains the single biggest contributor to GDP, accounting for 31.5% of the total in 2017, according to the KNBS. Agriculture showed a mixed performance in 2017, with drought contributing to a decline in production and a slowdown in sector growth to 1.6%, compared to the previous year’s expansion of 5.1%. However, the volume of fresh horticultural exports increased over the year, from 261,000 tonnes in 2016 to 304,000 tonnes in 2017 (see Agriculture chapter).

The manufacturing sector accounted for 8.4% of GDP in 2017, making it the second-biggest contributor. The sector showed modest growth of 0.2%, compared to 2.7% the previous year, a decline which was attributable to political uncertainty, the high cost of inputs and competition from cheap imports. Manufacturing’s GDP contribution has been falling since 2013, when it stood at 10.7% – a trend which the government hopes to reverse as it works to meet its economic objectives (see Industry & Retail chapter).

Transport and storage, which accounted for 7.7% of GDP, is a bright spot in the economy, expanding by 7.3% in 2017 thanks to increases in port throughput and the volume of products transported through pipelines. However, a 22.5% decrease in the number of newly registered lorries, trucks and pick-ups suggests that the decline in land freight seen over the year may grow more acute in the near term (see Transport chapter). Meanwhile, the wholesale and retail trade is a mainstay of the economy and a reliable provider of employment. In 2017 it increased its contribution to GDP by 0.3 percentage points to 7.6% of the total.

The financial services industry is the fifth-biggest contributor to GDP, accounting for 7.5% of the total, and plays a vital role in providing funding for both the private sector and the government. The interest rate cap was instrumental in the sector’s growth rate declining to 3.1% in 2017. However, the insurance sector’s strong performance over the year, which saw it expand by 6.5%, helped to mitigate the contraction in overall financial services activity.

Outlook

Kenya’s diverse economy forms a solid platform from which the government can generate economic growth over the coming years. The resolution of the electoral process, improving business confidence and strong private consumption are likely to support GDP expansion over 2018 and into 2019. In April 2018 the IMF estimated the economy would expand by 5.5% in 2018 and 6% in 2019, compared to 4.8% in 2017. The Ministry of Finance, meanwhile, anticipates a 5.8% expansion – although it cautions that pressure to reduce debt may result in the slower rollout of large infrastructure developments. It is worth noting, however, that despite the rising concern surrounding Kenya’s public debt, the secondary markets have been relatively bullish over the past year. Yields on 10-year government bonds reached an all-time high of 17.35% in October 2011 and have since declined to around 13% as of mid-2018 – indicating a more positive outlook for the economy. According to the KNBS, inflation is expected to ease throughout 2018, thanks to lower food prices due to improved agricultural output. A pick-up in global trading activity, meanwhile, is expected to support Kenya’s export activity, adding momentum to GDP growth.

Downside risks include a sharp rise in oil prices and a continuation of the declining trend in private sector credit growth. On the latter point, the government can exert considerable influence by pressing ahead with its efforts to enhance the business environment. Some progress has already been made in this regard: Kenya’s ranking in the World Bank’s “Doing Business” report has risen 49 places since President Kenyatta assumed office in 2013, to stand at 80th out of 190 countries in 2018, up 12 spots from 92nd in 2017.