1. My Kenyan authorities thank management and staff for the constructive policy dialogue and the Board for candid policy advice. The authorities have been implementing prudent macroeconomic policies in line with their medium-term development strategy. However, the balance of payments position has been adversely impacted by a succession of exogenous shocks—the high fertilizer and fuel prices of 2008, the current global economic slowdown, and the severe drought of 2008. The authorities request disbursement under the rapid-access component of the Exogenous Shock Facility (ESF) to mitigate the adverse impact of these shocks. They believe that the shocks are sudden and temporary and are confident that their commitment to effectively implement their medium-term development strategy will aid recovery from the impact of the shocks.
2. The IMF Executive Board concluded the 2008 Article IV Consultation on September 10, 2008 during which the Directors commended the authorities for maintaining economic stability, despite the post-election turmoil, and pursuing sound macroeconomic policies while implementing economic reforms. The authorities remain committed to implement sound macroeconomic policies and the structural reform agenda, and to consolidate the government of national unity.
Recent economic developments
3. Economic performance was robust and broad-based in 2007, with real GDP growth recorded at 7 percent, anchored on a package of bold economic and structural reforms within the framework of the Economic Recovery Strategy. Hardly had the country recovered from the post-election unrest than it was hit by three external shocks, in rapid succession—high fuel and fertilizer prices, drought and the global economic contraction. The global contraction and weaker commodity prices led to a sharp slowdown in the growth of real GDP to 3.5 percent in 2007/08 and 3.0 percent in 2008/09 from 6.7 percent in 2007. Growth is projected to remain at around 3 percent for 2009/10. The slowdown in economic growth threatens to erode the significant gains made in reducing poverty in the recent past.
4. Inflationary pressures remained elevated on account of post-election shortages in the first quarter of 2008 and, thereafter, high global food and fuel prices, shortage of maize as a consequence of the drought, and depreciation of the shilling. Inflation eased slightly to 27.7 percent in December 2008 from a peak of 31.5 percent in May 2008 (noting that the CPI inflation is overstated by a factor of about 2 because of methodological problems). Annual growth in broad money supply stood at 14.9 percent in December 2008, mainly attributed to an expansion in net domestic assets of 22.9 percent on account of increased domestic credit to the private sector.
5. We wish to differ with the staff perception that “the impact of the Central Bank of Kenya’s (CBK) countercyclical policy has been relatively ambiguous”. The CBK monetary program has been unambiguous in helping the economy recover from the downturn associated with the political unrest earlier in 2008 and, later, the impact of the global contraction. These developments should also be understood in the context of other underlying dynamics in the financial sector. In particular, the outcome of the Safaricom IPO skewed liquidity in the banking system—a few banks had too much liquidity while the majority of banks experienced liquidity shortages. The CBK advised the Safaricom receiving banks to open lines of credit with other banks, while keeping a cap on interbank rates. The authorities further provided reverse repo to banks facing liquidity shortages. These measures ensured adequate liquidity and helped keep the short-end interest rates low. Moreover, the perceived economic risks associated with the global financial crisis made economic agents risk averse, who adopted “the wait and see” attitude in case the fallout from the crisis would be more severe and persistent. As a result, demand for real balances fell. Thus, in view of increased global uncertainty, the approach by the authorities was countercyclical, with a focus on dampening interest rates and providing the necessary liquidity to the banking system in order to stimulate economic activity. Given the sudden drop in economic activity, the adjustment process is still taking place, explaining why money demand is still adjusting from a low base.
6. The fiscal stance was loosened somewhat with the overall budget deficit expanding from 3.6 percent of GDP in 2007/08 to a projected 5.2 percent in 2008/09, reflecting both revenue shortfalls and expenditure adjustments in response to the economic challenges. The net domestic borrowing is expected to be much larger than anticipated mainly because of the postponed issuance of the foreign currency denominated bond on account of unfavorable external conditions, and inability to proceed with privatization in the significantly worsened economic/business environment. Although total expenditure is projected to decline, it is higher relative to revenue on account of an initial high fuel import bill which combined with subsidized importation of maize. The main fiscal challenges are to resettle people who were displaced during the elections unrest, ensure adequate supply of fertilizer and seed, and continue importing maize, even though the latter adversely affected the international reserves position.
7. The external current account deficit is estimated to widen to 6.0 percent of GDP in 2008/09 from 4.6 percent in 2007/08 due to a deterioration in the trade balance. The capital and financial account deteriorated on account of a sharp drop in foreign direct investment and intensified outflows of portfolio investment. These developments have resulted in a significant overall balance of payments deficit and depletion of foreign exchange reserves from $3,443 million (3.6 months of imports cover) in 2007/08 to an estimated $2,796 million in 2008/09 (equivalent to 3.1 months of imports). International reserves are projected to recover only slightly to about $3,000 million (2.9 months of imports) in 2009/10 compared to a statutory requirement of 4 months import cover. The financial support being requested is to alleviate this external account pressure.
8. Risks continue to be on the down side on account of high food prices, weakening global demand and commodity prices, as well as worsening drought situation with many parts of Eastern and North Eastern Kenya in dire need of humanitarian assistance—an estimated 10 million people have become food insecure and many more at risk of starvation.
Macroeconomic policy framework
9. My authorities would like to assure the Board that they remain committed to pursuing prudent macroeconomic policies and structural reforms. In line with the objective of restoring a sustainable high growth trajectory for the economy, consistent with the Medium Term Plan and the Budget Strategy Paper, both of which are derived from the National Vision 2030. They are cognizant that economic policymaking will be challenging in the near term, given the global contraction, terms of trade shocks and weak domestic growth. These challenges notwithstanding, they remain committed to their development agenda.
10. In order to address the above challenges and ensure that the budget remains on course, the authorities have anchored fiscal policy on net domestic financing. In this regard, the measures being implemented focus on:
i. rationalizing expenditures, while safeguarding key infrastructure projects and spending on vulnerable groups;
ii. mobilizing additional revenue through strengthening tax administration, especially for excise taxes and VAT to recoup revenue loses; and
iii. seeking external financing to accommodate the additional food relief expenses and containing domestic borrowing to ensure medium-term debt sustainability.
11. Accordingly, recruitment in the public sector has been frozen for this financial year. Capital spending will also be frozen where projects have not yet commenced. With regard to supporting vulnerable groups, the authorities have withdrawn the generalized maize subsidy in preference for a new well-targeted food subsidy program in late 2009, which avoids price distortions while minimizing opportunities for abuse. The authorities are also seeking TA to improve tax administration. The authorities recognize downside risks of a larger-than-projected revenue shortfall. Any further shortfalls in revenue will be met by corresponding cuts in spending. Moreover, the authorities have no intention of further loosening the fiscal stance beyond the target for net domestic borrowing as a way of continuing to stimulate the economy while containing domestic liquidity pressure. The above fiscal approach will avert the risk of raising interest rates and jeopardizing recovery of the private sector, as well as pursue the authorities’ commitment to reduce the debt-to-GDP ratio in the medium-term.
Monetary and exchange rate policies
12. The immediate monetary policy aims at easing liquidity. The policy rate (the central bank rate) has been lowered to 8 percent and bank reserve requirements reduced to 5 percent. This will ensure adequate liquidity to support economic activity while containing domestic inflation. Monetary policy is anchored on the desire by the CBK to build up international reserves to the statutory requirements of 4 months import cover at an appropriate time, with partial sterilization of liquidity to ensure consistence with the inflation target in the medium-term.
13. The market determined exchange rate policy has served the country well, and the exchange rate remains broadly in line with fundamentals. In this regard, the authorities are determined to maintain this policy framework, with intervention limited to smoothing short-term volatile fluctuations.
14. The key element of Kenya’s structural reform agenda is to improve competitiveness. In this regard, significant progress has been made in removing impediments to the business environment and creating an efficient and effective public sector. This includes the on-going implementation of the Governance Action Plan (GAP)—continued strengthening of the legal platform to fight corruption, operationalization of the public complaints standing committee, and development of implementation plan for GAP. Furthermore, the government has adopted risk-based auditing and rolled out the IFMIS. Finally, several reforms are being made in terms of business licenses.
15. Progress has also been recorded in the implementation of financial sector reforms in microfinance, insurance, banking and capital markets. A specific example is the Microfinance Act which is now operational. To avoid increased risk to the financial sector, more still needs to be done to strengthen and improve the competitiveness of the sector. While exposure to the global financial crisis has been limited, there has been some exposure to the regional market. The banks and authorities are closely monitoring the situation, committed and prepared to respond appropriately to avert any financial crisis. To this end, a number of measures will be introduced to make adequate provisioning and enhance the proactive approach to surveillance and enforcement through the enactment of the Banking Bill. Other measures include increasing the minimum capital requirements for banks in the next two years; enacting the Savings and Credit Cooperatives (SACCOs) and national payments bills; and selling more shares of the National Bank of Kenya to the private sector.
16. My authorities consider Fund support as crucial to help meet their developmental challenges in the context of the global financial crisis and economic contraction. The authorities are requesting financing under the rapid access component of the Exogenous Shock Facility in order to help increase international reserves and market confidence. They believe that the policies put in place are appropriate to address the shocks and remain ready to take additional measures should circumstances warrant.