Tuesday, March 29, 2011

How Kenya can navigate through the economic storm and come out on top

By W. Fengler & R.Gudmundsson

Kenya is going through turbulent economic times. Rising inflation, a weakening shilling, and a declining stock market index have led to concerns about the country’s economic outlook.

Is Kenya facing another episode of turbulence similar to 2008-09? This need not be so for two main reasons.

First, since 2010, a new growth momentum has been building aided by structural reforms, the new Constitution, and a dynamic private sector.

Second, Kenya has a strong track record of economic policymaking that has helped it to navigate previous shocks. This is a time to prepare, not panic.

Over the past decade, Kenya has developed a reputation for resilience and strong macroeconomic management. Public debt levels declined from about 60 per cent in 2000 to about 35 per cent in 2007, a trend supported by prudent fiscal policies and strong growth.

Inflation declined from about 16 per cent at end-2008 per cent to below 4 per cent by end-2010, enabling Kenya to issue domestic debt at lower rates. That the country can issue bond tenors of 30 years signals private sector confidence in future prospects.

Banking reforms have helped to deepen access to finance among the population, while significantly reducing the share of non-performing loans.

These indicators are impressive and help explain the recent increase in Diaspora remittances and the renewed interest shown by foreign investors in financing Kenya’s pressing development needs.

The country entered the global financial crisis buoyed by a strong macroeconomic performance that allowed for some fiscal stimulus, equal to 1 per cent of GDP in 2009/10. This helped the economy to stage a strong and unexpected recovery in 2010, growing at above 5 per cent.

All key sectors experienced strong growth, especially agriculture and manufacturing, both of which recovered from two years of negative growth.

Five structural factors could enhance prospects for a more sustained growth path this decade: the new Constitution; investments in infrastructure; strong macroeconomic policies; regional integration, and accelerated adoption of ICT technologies.

Even though global growth is projected to be moderately strong in 2011, economic policymaking will be fraught with significant challenges, and Kenya will need to traverse a number of shocks.

Turbulence in the Middle East, rising global food prices, uncertainty concerning the debt crisis in Europe, and recent developments in Japan have all added to global economic volatility.

The higher oil price alone has resulted in a widening of the current account deficit by 2 per cent of GDP. Combined with political tensions that triggered some capital outflows, this has started to put pressure on the shilling.

Downside risks to growth in advanced economies could also affect horticulture and tourism, two of Kenya’s main foreign exchange earners.

The lower shilling, coupled with higher oil and food prices, increased inflation from 3.2 per cent in October 2010 to 6.5 per cent in February 2011.

The Nairobi Stock Exchange has also been affected by the turbulence: after remarkable growth in 2010, the NSE index has lost ground in 2011, declining by more than 10 per cent since the start of the year.

Kenya can build on its track record of strong macroeconomic management.

Moreover, the country has recently embarked on a three-year economic reform programme supported by the IMF, the objective of which is to ensure the sustainability of growth-enhancing policies while providing a reserve cushion to deal with the anticipated deterioration of the terms of trade in the next two years.

If economic turbulence continues or intensifies, four measures could help Kenya to navigate the storm:

First, stand ready to tighten monetary policy further if inflationary pressures persist. Last week’s upward revision of the Central Bank’s policy rate was not only a good decision, but also a strong signal that the authorities intend to preserve the hard-won gains of low inflation and price stability. That decision also led to a stabilisation of the shilling while preserving the benefits of a flexible exchange rate.

Second, keep the fiscal deficit within current targets. Though still low by international standards, Kenya’s public debt-to-GDP ratio increased from 35 per cent in 2007 to almost 50 per cent today. This is reason enough not to increase the fiscal deficit further.

The 2011 fiscal deficit is projected to reach 6.5 per cent, and to come down to 4 per cent by 2014. This gradual fiscal consolidation will provide the right balance between public investments, especially in infrastructure, while bringing the debt-to-GDP ratio below the government’s official target of 45 per cent.

Third, Kenya needs to enhance its export competitiveness. The economy is still running on one engine — domestic consumption — which accounts for 90 per cent of GDP. The other engine, exports, is weak and has declined over time.

Kenya has demonstrated that it can compete internationally, as its leadership in sectors as diverse as horticulture, tea, tourism, Business Process Outsourcing and a number of consumer products demonstrate.

However, the country needs to better leverage its good location and as a hub of the larger East African region in upgrading its infrastructure, creating a better business environment, and continuing with regional integration. The best way is to modernise the port of Mombasa.

Fourth, cash is usually better than food in responding to food shortages. One cannot emphasise enough the danger of price controls that end up hurting the consumers they are intended to protect.

Kenya can learn many lessons from the 2009 food crisis, including attempts to manage food markets that resulted in subsidies going to the rich, while creating opportunities for corruption.

Instead of trying to deliver food aid directly to the poor — which can be expensive and inefficient — it could provide the poor with cash transfers, enabling them to purchase sufficient food in the market.

Mr Gudmundsson is the Resident Representative of the IMF in Kenya while Mr Fengler is the Lead Economist of the World Bank in Kenya.

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