Chapter

Chapter 3 Kenya’s Recent Exchange-Rate Policy and Manufactured Export Performance

Author(s):
International Monetary Fund
Published Date:
August 2001
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Trade liberalisation has formed a major component of the several structural adjustment programmes that Kenya has implemented since the mid-1970s. It has involved a reduction in tariffs and their variance as well as the tariffication of quantitative restrictions. Efforts to implement compatible macroeconomic and institutional reforms have accompanied it, along with direct export-promotion policies that, as explained below, have not had much success. This chapter analyses how, within this context, the real exchange rate (RER) has influenced the performance of Kenyan manufactured exports during the 1980s and 1990s.

The exchange rate plays an important incentive role in promoting manufactured exports. Nearly all countries that have become successful exporters of manufactures have had a stable and well-aligned real exchange rate. A good exchange-rate policy, however, cannot be sustained without both compatible fiscal and monetary policies and supportive non-price policies. If macroeconomic and trade policies are mismanaged, an appreciation in the real exchange rate and an increase in its volatility are likely, along with adverse effects on export performance caused by reduced profitability and the increased uncertainty of producing for export.

Diversifying a country’s export basket has several advantages. First, it reduces vulnerability to changes in the external economy and the commercial risks arising from reliance on a few exports. Second, it should contribute to increasing export earnings and reducing their instability, thereby enhancing economic growth. Third, the potential for learning-induced productivity improvements may also increase with the number and variety of export products. According to Mayer (1996), the primary objective of an export-diversification policy should be to upgrade a country’s production and export patterns by helping it to move successfully up the technological and skill ladder, consistent with its human and physical resource endowments, while tapping the dynamic demand potential of world markets. Indeed, recent studies indicate that the impact of exports on growth increases markedly with the share of manufactures in exports, and that the effect of non-fuel primary exports is very nominal (Fosu, 1990, 1996).

Export-Promotion Policies and Incentive Measures

This section puts the export-promotion efforts into a perspective that includes the nexus of trade liberalisation and institutional reform. Most direct export-promotion schemes, largely unsuccessful, became increasingly irrelevant as trade liberalisation and market reforms proceeded.

Direct Export-Promotion Policies

The Export Compensation Scheme. The Local Manufactures (Export Compensation) Act of 1974 provided for cash compensation to offset import duties paid on inputs used to produce certain qualifying manufactured exports. It tried to encourage production of non-traditional exports, specifically manufactured ones.

Was it an effective tool to offset the anti-export bias? By the early 1980s, general agreement emerged that the export subsidy had quite limited impact. The rate, at 10 per cent of the f.o.b. value of goods manufactured in Kenya with a local value added of at least 30 per cent, was fairly low. Payments encountered much delay. In the 1980s, one-third to two-thirds of the total subsidy payments accrued to four firms, while the payments covered only about 5 per cent of manufactured exports. Hence, the subsidy had minimal incentive value (World Bank, 1990), and its impact on Kenyan manufactured-export performance was at best marginal. In effect, the few firms that received the subsidy treated it as a windfall rather than as an incentive to increase exporting. The programme had several inadequacies, such as definitional ambiguities regarding eligible export goods, a lack of sufficient incentive value, restrictive eligibility requirements, and excessive paperwork and procedural requirements. These inadequacies—especially the poor definitions—created large loopholes and led to fraud.

A Duty and Value-Added Tax (VAT) Drawback scheme for intermediate inputs replaced it definitively in 1993. Drawback had been established in 1990 to provide incentives to manufacturers whose exports were not eligible for export compensation and whose imports attracted duty and VAT. Under the scheme, the Export Promotion Programmes Office at the Treasury provides full refunds on duties and valued-added taxes paid on raw materials by exporting firms. The scheme covers more than 300 firms selling a wide range of goods and services. Yet it too has problems, such as limited public knowledge of the scheme’s existence and its procedures, too much documentation, unclear eligibility criteria and a non-transparent bureaucracy. It takes too long to obtain refunds, which involve cumbersome audit procedures and expensive bonds that block capital in an environment where credit is very expensive.

The Manufacturing-Under-Bond Scheme, started in 1988, is implemented jointly by the Investment Promotion Centre and the Customs Department. Designed for firms producing entirely for export, it offers incentives such as waivers on import duties and taxes on imports used to produce export goods. A firm wishing to be licensed under it must show evidence of a market for its products, access to adequate technology and know-how, and sufficient financial backing. Its problems also include expensive security bonds. It requires a bewildering array of multiple bonds—for warehouse imports, removal of goods for manufacture and export, duty and import cover for imports cleared at the Inland Container Terminal in Nairobi and import cover for goods cleared through the airport in Nairobi and another at Mombasa. These bonds tend to block funds needed for company operations because production is wholly for export. Serious administrative problems in the Customs Department entail additional costs to firms. At its peak in 1989, the scheme included almost 40 firms. The number fell to 21 in 1994, 11 in 1996, operating at 50 per cent of capacity, and only eight in 1998, mainly subcontractors of large firms. Judged a failure, the scheme’s impact on export promotion has been marginal.

Export-Processing Zones (EPZs) facilitate the processing, manufacture and assembly of goods and services destined primarily for export markets. Transactions in EPZs are not subject to import restrictions and tariffs, and thus they escape the delays and administrative costs often associated with other “partial-export” regimes. Established in 1991, the EPZ scheme provides a package of benefits to export-oriented firms within designated zones. By 1995, Kenya had 12 EPZs at various stages of development. They had an accumulated total investment of Ksh. 3.9 million. In 1998, 22 companies operated in EPZs.

The EPZ firms receive various benefits, such as exemption from corporate tax for the first ten years of operation, from duty and VAT on all their inputs and from stamp duty, rent and tenancy controls, industrial and statistics registration requirements and the Factories Act. They are granted work permits for expatriate staff and get on-site customs inspection and high-quality infrastructure. These incentives are intended to lower production costs compared with those of firms operating outside the EPZs. Yet the EPZs’ contribution to total exports in the economy has not reached 1 per cent on average, and they touched only 1.1 per cent of total exports in 19971.

Products from EPZs do not get preferential treatment in regional trade, where rules of origin seem to apply effectively. In the Common Market for Eastern and Southern Africa, exports from EPZ companies are treated as foreign products. Because of the incentives granted to them, these companies do not operate on an equal footing with firms from other member countries. This defeats the whole intent of EPZs, namely to promote export expansion in regional trade, and it may explain why EPZs have stagnated and the number of firms has not increased. It has been a major drawback to investing in EPZs.

Since liberalisation, the environment for EPZs has changed. Some of the incentives provided to EPZ firms would better encompass the whole economy, instead of an enclave of foreign firms assembling for export and adding no significant value to the domestic economy. In a liberalised economy, EPZs are not particularly necessary. The same incentive structure (or variants of it) should extend to all exporters.

Trade Liberalisation and Institutional Reform Policies

Policies, notably trade liberalisation, to enhance competitiveness in both domestic and external markets made up the first category of reforms. Institutional reform policies, the second category, touch on domestic markets, including the labour market.

External Trade Liberalisation. Liberalisation of external trade received great attention in Kenya’s reform programme. A number of measures implemented under the Fourth Development Plan (1979-84) had the overall objective of making the industrial sector more efficient and outward-oriented. They included removing quantitative restrictions, reducing tariff levels, introducing additional direct export-promotion measures and allowing a flexible exchange-rate regime. The first two were adopted between 1980 and 1984.

Import liberalisation has made considerable progress since the early 1980s. Between 1980 and 1985, the share of items that could be imported without restrictions rose from 24 per cent to 48 per cent of the total value of imports. The average tariff rate fell by about 8 per cent (Swamy, 1994). An improved import-licensing system established at that time, with restricted and unrestricted schedules, underwent significant improvement in 1988. The new system created five schedules to increase strictness in licensing requirements. Unrestricted licensing gradually extended to certain schedules, and several items moved from one schedule to another over the years; by July 1991 the only imports still under licensing were those restricted largely on health, security, and environmental grounds. Further changes occurred between 1991 and 1993, when the Foreign Exchange Allocation Committee, the Import Management Committee, and the requirement for a foreign-exchange allocation licence were abolished.

By November 1993, all administrative controls on international trade—including import licensing and foreign-exchange allocation, together with their institutional infrastructures—had been abolished. Tariff reform also progressed, with tariff rates gradually lowered and tariff bands reduced. Between 1989/90 and 1991/92, for instance, overall production-weighted tariffs declined from 62 per cent to 48.5 per cent (Swamy, 1994). The maximum tariff rate dropped from 135 per cent in the 1980s to 45 per cent by 1994. The number of non-zero bands narrowed from 25 to six during the same period, and since 1987/88 this has reduced tariff dispersion (Table 3.1).

Table 3.1.Distribution of Goods by Tariff Band(percentages)
Tariff1987/881988/891989/901990/911991/921992/931993/941994/951995/96
06.975.86.13.72.93.13.23.3
1-100.36.91.61.644.65.24.91.8
11-3030.729.637.637.447.647.656.567.871.8
31-5045.443.723.821.617.620.835.324.123.1
51-603.95.66.06.33.024.0
61-703.84.124.0
7199.225.227.1
Total100.0100.0100.0100.0100.0100.0100.0100.0100.0
Source: Kenyan Ministry of Finance.
Source: Kenyan Ministry of Finance.

Tariff harmonisation has also gone forward. Average tariff rates declined significantly by the 1990s, but two factors disturbed the general downward trend. First, average tariffs reached their highest level in 1989/90 as equivalent tariffs replaced quotas. Second, temporarily raised tariffs covered a government revenue shortfall in 1993/94. Table 3.1 shows a clustering of goods around the tariff level of 11-30 per cent and a slightly smaller one at 31-50 per cent. Average tariffs rates fell drastically, however (Table 3.2). The only trade protection remaining in Kenya by the end of 1995 was the provision to impose countervailing duties, aimed at curbing unfair competition from exports subsidised by other countries.

Table 3.2.Average Tariff Rates(percentages)
Tariff Rate1987/881988/891989/901990/911991/921992/931993/941994/95
Average42.544.3849.1747.1739.3936.5640.4827.27
WeightedNANANA31.7827.1727.2530.9022.21
Source: Kenyan Ministry of Finance.NA = not available.
Source: Kenyan Ministry of Finance.NA = not available.

Domestic Trade Liberalisation. Price controls extended to most Kenyan manufactured and agricultural products at the end of the 1970s. Their origin traced back to the Price Control Ordinance of 1956. Price controls on staple commodities tried to protect low-income wage earners, whereas those on manufactured products sought to prevent monopolistic pricing practices (Swamy, 1994).

From 1986 to 1995, price controls for nearly all commodities were dismantled. Between 1983 and 1991, the number of commodities with prices subject to control under the general order dropped from 56 to six, while those controlled under specific order fell from 87 to 29 (Swamy, 1994). By September 1993, only the prices of petroleum products and some pharmaceuticals remained controlled under the general order, while only three items remained under specific order. By July 1995, even the maize market (hitherto the most resistant to reform and the central focus of donors) and the petroleum/oil sector had been completely liberalised.

Marketing Support. The Kenyan authorities have also attempted to strengthen the government departments responsible for promoting exports and supporting regional and multilateral trade arrangements. The establishment of the Export Promotion Council (EPC) in 1993 improved the environment in which private exporters operate by helping them to overcome bottlenecks. Its main objectives include formulating market strategies and identifying export opportunities; promoting an “export culture” to enhance export-led growth; and co-ordinating and harmonising export-promotion activities.

Reducing Barriers to Foreign Ownership and Investment. A free exchange regime has facilitated the repatriation of dividends by foreign investors. Together with the removal of barriers to foreign commercial private borrowing, it has provided a more enabling environment for foreign investors. Furthermore, the establishment of EPZs has allowed unrestricted foreign ownership and employment of expatriates as well as control over foreign exchange earnings, in addition to extensive tax advantages.

Financial-sector reforms—particularly the amendment of the Capital Markets Authority (CMA) Act—have further eased restraints on foreign ownership. The CM A, established in 1990, has attempted to liberalise Kenya’s financial and capital markets. As one result, trading on the Nairobi Stock Exchange (NSE) was opened to foreign investors on a limited scale in January 1995. In June 1995, the limit on portfolio investment in Kenyan companies quoted on the NSE by foreigners was raised from 20 per cent to 40 per cent for corporate investors and from 2.5 per cent to 5.0 per cent for individual portfolio holders.

Labour Market Reforms. The labour market has undergone considerable liberalisation since 1993. In July 1994, the Industrial Court allowed trade unions to seek full compensation for price increases without hindrance from wage guidelines. Various laws have been amended to allow firms to discharge redundant workers more easily when necessary. The removal of wage guidelines made it possible for firms to negotiate and change the level of wages on the basis of productivity and performance rather than, as hitherto, on the basis of cost-of-living indices. All these reform measures have a direct bearing on the performance of the export sector.

Performance of Manufactured and Other Exports in the 1980s and 1990s

The performance of Kenya’s export sector in the 1980s was lacklustre; exports grew less than GDP (Table 3.3), with their value falling at an average of 2.6 per cent per year. Recovery occurred in the 1990s, however, and they increased by 15 per cent per year on average, to reach 26.1 per cent of GDP by 1996. Exports can be categorised as traditional and non-traditional, with the latter further subdivided into primary and manufactured products. Defining traditional exports broadly to include the Standard International Trade Classification (SITC) three-digit categories accounting for more than 3 per cent of total exports in a base year (1980), they include for Kenya coffee (SITC 071), tea and mate (SITC 074), petroleum products (SITC 334) and crude vegetable materials (SITC 292). Table 3.3 shows how the share of these traditional exports in GDP declined between 1980 and 1989, then rose through 1996. Their share of total exports followed a similar pattern, but in both cases the 1996 levels remained well below the highs of 1980. The export basket has indeed become more diversified. Table 3.4 shows a significant decline in the ratio of the top three exports as a group to total exports between 1980-84 and 1995-96.

Coffee, tea, and petroleum are by far the dominant traditional exports, although petroleum products make only a small contribution to foreign-exchange earnings because Kenya mainly re-exports them after processing. While export volumes of coffee and tea expanded [coffee from 86 994 metric tons (mt) a year in 1979-83 on average to 94 976 mt in 1994-96, and tea from 84 905 mt to 218 336 mt], their prices either remained stagnant or generally declined. The price of coffee, for example, averaged $2.95 in 1979-83 and $2.90 in 1994-95, while that of tea dropped from $1.81 to $1.64. Petroleum export prices also declined (from $0.23 to $0.19 per litre), as did the volume exported (from an average of 814 mt per year in 1979-83 to 444 mt in 1994-96). Tea and crude vegetable products increased their shares relative to those of coffee and petroleum products.

Table 3.3.Total Export Performance
Total ExportsTraditional Exports
Year$ Million% of GDP$ Million% of GDP% of Exports
19801 318.021.8930.7515.470.6
19811 388.819.8936.3313.367.4
1982992.218.5703.8113.170.9
1983994.819.1650.913.168.9
19841 041.219.6766.1714.473.6
1985957.417.9694.6913.072.5
19861 182.618.8858.4813.772.6
1987913.213.3591.688.664.8
1988986.814.2626.169.063.5
1989925.813.4364.655.339.4
19901 022.814.7634.099.152.4
19911 091.616.1671.149.961.5
1992943.615.0564.199.059.8
19931 063.225.6499.4012.047.0
19941 162.024.7886.0511.746.9
19951 674.824.2794.4611.647.7
19962 071.226.1971.8412.246.9
Source: Government of Kenya, Economic Survey and Annual Trade Report, various issues.
Source: Government of Kenya, Economic Survey and Annual Trade Report, various issues.
Table 3.4.Composition of Exports
SITC Article1980-841985-891990-941995-96
Percentage Composition of Traditional Exports
71Coffee34.743.227.532.2
74Tea and Mate23.432.345.642.4
292Crude Vegetable Materials4.05.29.312.5
334Refined Petroleum Products37.819.317.613.0
Total100.0100.0100.0100.0
Top Three Exports as Percentage of Total Exports
71Coffee24.829.714.515.2
74Tea and Mate16.822.024.019.9
334Refined Petroleum Products26.813.29.66.1
Total68.464.948.041.2
Source: Government of Kenya, Annual Trade Report, various issues.
Source: Government of Kenya, Annual Trade Report, various issues.

Exports of manufactures are relatively unimportant. The import-substitution industrialisation strategy pursued until the early 1980s did not successfully increase them. Their value generally declined in the 1980s but increased in the 1990s. Manufactured exports made up about 11.7 per cent of total exports and about 36.9 per cent of non-traditional exports in the 1980s (Table 3.5), and, except for beverages and tobacco, the proportion of output exported by Kenyan industries declined (Table 3.6). Industrial goods then rose in the 1990s to about 27 per cent of total exports and 60 per cent of non-traditional exports; hence, some diversification towards manufactures has occurred.

Table 3.5.Shares of Manufactures in Total and Non-Traditional Exports(percentages)
SITCType of Export1980-841985-891990-941995-96
TotalN-T*TotalN-T*TotalN-T*TotalN-T*
5Chemicals and Related3.118.73.27.54.210.96.515.2
Products
6Manufactured Goods,6.722.16.210.111.425.715.030.0
classified by material
7Machinery and Transport0.53.00.71.40.61.61.32.9
Equipment
8Miscellaneous Manufactured1.27.31.73.810.424.95.212.0
Articles
Total11.551.011.922.826.563.127.960.0
Note: * N-T = non-traditional.Source: Government of Kenya, Annual Trade Report, various issues.
Note: * N-T = non-traditional.Source: Government of Kenya, Annual Trade Report, various issues.
Table 3.6.Shares of Manufacturing Output Exported in the 1980s(Annual averages, in percentages)
1979-831984-88
Food Products5.72.7
Beverages and Tobacco (excluding coffee and tea)2.02.4
Chemicals (including petroleum products)7.34.6
Machinery and Transport Equipment1.51.3
Other Manufactures7.55.7
Total, Manufacturing Sector5.93.8
Source: World Bank (1990).
Source: World Bank (1990).

The United Nations Development Programme (UNDP) and the World Bank (UNDP/World Bank, 1993) attribute Kenya’s poor performance in both traditional and non-traditional exports in the 1980s to domestic policies rather than external constraints, with incentives biased against exports, especially manufactured ones. Landell-Mills and Katz (1991) postulate that restrictive trade policies during the first half of the 1980s were responsible. Quantitative import restrictions imposed in 1980 and 1982 raised effective rates of protection, which shielded inefficient activities and tended to discriminate against products for which Kenya had a comparative advantage, such as food-based manufacturing. This discretionary and non-transparent system made costs, competition in domestic markets, and access to inputs difficult to predict2. Other factors often cited include a decrease in exports to neighbouring countries, especially Tanzania, where the volume of imports from Kenya has still not recovered from the break-up of the East African Community in 1977; growth in domestic demand for such products as paper; and supply constraints, especially intermittent shortages of foreign exchange to purchase intermediate inputs (Sharpley and Lewis, 1988).

The Kenyan authorities attribute the good performance in the 1990s to trade reforms and the depreciation of the Kenyan shilling. In addition, rescue activities arising from turmoil in neighbouring countries, particularly Somalia and Rwanda, boosted production and exports of manufactures to the region. In general, the performance of manufactured exports has reflected that of the manufacturing sector, where growth slowed to 4–5 per cent per annum in the 1980s after advances in the 1960s and 1970s. Manufacturing investment and its productivity declined. Until the reforms of the early 1990s, this arose from increased political instability, cumbersome bureaucracy, price controls, constraints on repatriation of dividends, and shortages of foreign exchange, which made acquisition of imported inputs uncertain or irregular (Friedrich-Naumann-Stiftung, 1992). Reduced opportunities for easy import substitution in consumer goods also played a role.

To recapitulate, exports have not only increased significantly in the 1990s after a very poor performance in the 1980s, but also have diversified somewhat from traditional to non-traditional products and, within non-traditional exports, from primary to manufactured goods. The Gini-Hirschman concentration index, for example, declined steadily from 0.43 in 1980 to 0.28 in 19963.

Yet an anti-export bias persists. Table 3.7 measures it, in a formulation based on effective import-tariff and export-tax rates. Any form of import barrier also is an implicit tax on exports. For example, exchange controls forced exporters to surrender their export proceeds at grossly overvalued exchange rates, thus reducing profit margins measured in local currency4. Export taxes reduce the profitability of exports and bias the production structure towards non-tradable goods. The index of anti-export bias in Table 3.7 approached the level of one (no bias) only in 1991–92. It was highest in 1987, at 23 per cent, and lowest in 1992, at 8 per cent. The index captures only observable tax policies. Other administrative biases are difficult to observe and quantify. Dismantling marketing monopolies and liberalising exchange-rate regimes are important avenues for raising the profitability of export activities and encouraging outward-oriented production. With further liberalisation and reduction of tariffs and taxes, the anti-export bias should be eliminated. As a complementary measure, the administrative machinery for imports and exports should be fine-tuned.

Table 3.7.Indicators of the Anti-Export Bias
Year1 + tm1 - txAnti-Export Bias*
19801.130.9851.14
19811.160.9941.17
19821.180.9901.19
19831.170.9881.18
19841.170.9871.19
19851.140.9661.18
19861.170.9591.22
19871.180.9591.23
19881.160.9831.18
19891.140.9731.17
19901.120.9991.13
19911.111.001.11
19921.081.001.08
19931.131.001.13
19941.161.001.16
Note: * The bias is calculated from the effective import-tariff rate, tm = (total value of tariff revenue/total value of imports)* 100, and the computed effective export-tax rate, tx = (total value of export taxes/total value of exports)*100. The index emerges as (1+tm/)/(1-tr). It measures bias in terms of deviations from a value of one.
Note: * The bias is calculated from the effective import-tariff rate, tm = (total value of tariff revenue/total value of imports)* 100, and the computed effective export-tax rate, tx = (total value of export taxes/total value of exports)*100. The index emerges as (1+tm/)/(1-tr). It measures bias in terms of deviations from a value of one.

Foreign Exchange Reforms, the Real Exchange Rate and Misalignment

The implementation of competitiveness-enhancing reforms benefited from the liberalisation of foreign-exchange operations, which included the removal of controls and freeing of the exchange rate that led to a large devaluation of the shilling, especially in 1992–93. Other moves introduced Foreign Exchange Bearer Certificates (Forex Cs) in October 1991, started export-earnings retention schemes for exporters in 1992, merged the official rate of exchange with the inter-bank rate in 1993, removed exchange controls from current-account transactions and nearly all capital-account transactions, and scrapped the 90-day Forex surrender limit. These reforms made the foreign-exchange market much less restrictive. In the 1994 Budget Speech, all regulations pertaining to the Exchange Control Act were suspended, and in December 1995 Parliament finally repealed it. A move to allow legalisation of foreign exchange bureaux also came in 1995.

These reforms considerably eased the constraints on Kenya’s productive sectors—especially manufacturing and agriculture—from acute shortages of imported inputs, which had occurred whenever foreign exchange was not available when required. They had resulted not only in frequent interruptions of many firms’ production schedules but also in chronic under-use of installed capacity. As long as foreign-exchange controls persisted, the availability of imported inputs depended on available foreign-exchange allocations. Once they were removed, the determination of import demand reverted to its fundamentals, with foreign-exchange availability no longer a significant determinant. Reform may also have helped to improve hitherto prohibitive transaction costs.

One objective of these reforms has been to reduce RER misalignment, defined as sustained deviations of the actual real exchange rate from its long-run “equilibrium” rate (ERER)5. RER is formally defined as the price of tradables in terms of non-tradables (P/Pnt). It is difficult to find an exact empirical measure for this definition, and various proxies for RER have been adopted in the literature. It usually is approximated by the product of an index of the nominal exchange rate (NER) and an index of wholesale foreign prices (WPI) divided by an index of domestic consumer prices (CPI). Figure 3.1 shows the evolution of a bilateral RER measured against the US dollar and a multilateral RER, which are fairly successful in reproducing the salient episodes in the macroeconomic history of Kenya in the 1980s and 1990s6.

Figure 3.1.Changes in RER, 1980–96

(1987=100)

Between October 1975 and December 1982, the Kenyan shilling was pegged to the SDR, which, calculated from a basket of currencies, was considered to be relatively more stable than a single-currency peg, especially following the floating of the US dollar in 1973. During the SDR peg, the shilling underwent a number of discretionary devaluations.

Kenya implemented a crawling peg in 1983–91, adjusting the exchange rate daily against a composite basket of currencies of the country’s main trading partners to reflect inflation differentials. It considered the abandoned SDR peg inadequate to maintain the competitiveness of the Kenyan shilling because the weights used did not reflect Kenya’s trade pattern (which was more diversified, with the currencies included in the SDR accounting for only 40 per cent of the country’s combined exports and imports). In this period, the RER held relatively stable.

Since 1991, the authorities have used a more market-based regime; the shilling has been made convertible by fully liberalising the current and capital accounts, with a stable and “realistic” rate to be maintained through prudent fiscal and monetary policies. In June 1994 the government said it would abide by the requirements of Article III of the IMF’s Articles of Agreement to promote the full convertibility of the Kenyan shilling, at least for current-account transactions. A massive depreciation of the RER in 1993 followed the introduction of the inter-bank market in August 1992. The RER subsequently appreciated in 1994-96. Because ERER is not observable, RER misalignment is proxied in various ways. One method, suggested by Ghura and Grennes (1993), estimates the time path of ERER from a co-integration equation and normalises it, so that it starts from a common base with the actual RER during a period when the economy was to a large extent in internal and external balance7. Taking 1970 as a year when Kenya had both internal and external balances (Elbadawi and Soto, 1995), Figure 3.2 shows the evolution of RER misalignment. The country registered average misalignment of 6.8 per cent in the 1980s and 11 per cent in 1990-96, supporting the contention that Kenya has on average maintained a fairly good exchange-rate policy (Takahasi, 1997).

Figure 3.2.The Evolution of RER Misalignment, 1980–96

(1987=100)

Impact of the RER and Its Misalignment on Manufactured Exports

A wide range of policies and factors can influence manufactured exports. Kenya’s 1997-2001 Development Plan calls for more outward-oriented policies to increase the volume of exports and thus improve the balance of payments. Liberalisation of the trade regime through a reduction of tariffs and their variance as well as the tariffication of quantitative restrictions is usually expected to lead to export diversification, with new markets discovered and new products becoming exportable. Dynamic effects during the liberalisation process, caused by resource flows into new exporting firms, may increase creativity and innovation, which in turn result in further diversification. The impact of trade liberalisation, however, will likely depend as well on accompanying factors, particularly a high and stable real exchange rate, compatible fiscal and monetary policies, and low distortions in factor markets (Nogues and Gulati, 1994).

One can employ a standard analysis to investigate the extent to which manufactured exports have responded to the real exchange rate and its misalignment, using annual panel data for 1980-95 with the derivation of data on RER and RERMIS as reported above. It postulates the supply of exports to be a function of domestic capacity to produce (usually measured by real GDP) and the price of exports relative to domestic prices (usually proxied by the real exchange rate). It assumes that Kenya is a small economy, so that exporters take external demand conditions as given. In this case, a simple dynamic panel model was estimated for the 170 three-digit manufactured-export categories (SITCs 5-8) in Kenya’s annual trade reports:

where RXt is nominal manufactured exports deflated by their one-digit SITC export price indices, RGDP is aggregate real manufacturing GDP, RER is the bilateral RER, and RERMIS is RER misalignment.

The first equation in Table 3.8 shows the random-effects results from estimating the model for manufactured exports. The table also shows the results from estimating the model using the generalised method of moments (GMM), as significant feedback effects from manufactured exports to manufacturing GDP are likely when the lagged dependent variable is correlated with the residuals. These variables were therefore replaced by instrumental variables using the GMM estimator proposed by White (1982)—lagged values of the endogenous variables, with RER and RERMIS taken to be exogenous. This follows the proposal by Holtz-Eakin, Newey, and Rosen (1988) and Allerano and Bond (1991) that one can use the orthogonal restrictions implied in the data dynamics to achieve efficiency if the error terms are serially uncorrelated8.

Table 3.8.Panel Regression Model Estimates for Aggregate Manufactured Exports
Random EffectsGMM-IVGMM-IV
VariableCoeff.t-stat.Coeff.t-stat.Coeff.t-stat.
Constant-0.296-0.0971.1880.306-16.178-3.335
LnRGDP0.8545.0700.6763.4210.9784.732
LnRER-0.816-1.482-0.966-1.499
Trend in RER2.3162.774
Transitory in RER-0.465-0.711
RERMIS-0.011-2.560-0.012-2.596-0.003-0.710
LogflXt-10.85778.1650.90246.8730.91046.652
Sample2.2071.9921.992
Adjusted R20.7100.7000.700
Standard Error1.4801.4721.462

The results show the following. First, manufactured exports increase consistently with capacity to produce, with the GDP coefficient positive and significant in both equations. A1 per cent increase in real manufacturing GDP increases real manufactured exports by 0.68-0.97 percentage points. Second, the first two equations show RER to have a non-significant coefficient, which suggests that it has not played an important role in the promotion of manufactured exports in Kenya. RER misalignment, conversely, has a negative and significant impact on manufactured exports, which suggests that what has mattered is not the level of the RER but the extent to which it deviates from the equilibrium real exchange rate. As Table 3.9 reveals, however, RER and RERMIS are highly correlated (-0.78), making it difficult to separate their individual effects with confidence.

Table 3.9.Correlation Coefficients
(1)(2)(3)(4)(5)(6)
l. Ln/ff1.000
2. LnRGDP0.1691.000
3. LnRER-0.100-0.0301.000
4. Trend in RER-0.0050.2780.4701.000
5. Transitory in RER-0.087-0.3080.466-0.5611.000
6. RERMIS0.0590.011-0.777-0.320-0.4071.000

The third equation in Table 3.8 decomposes RER into trend and transitory RERs9. In these GMM-IV results, which control for feedback effects from manufactured exports to real manufacturing GDP as well as the lagged dependent variable, the trend RER has a positive and significant coefficient, while both the transitory RER and RERMIS have negative but non-significant coefficients10. This suggests that depreciating the trend RER has a positive impact on manufactured exports. Yet Table 3.10 shows that this result is not very robust and is reproduced only for machinery and transport equipment (SITC 7), with trend RER non-significant for the other manufactured export categories (although it has a consistently positive coefficient). Last, lagged real manufactured exports have the most significant coefficient, suggesting the presence of strong persistence effects in export behaviour.

Table 3.10.GMM-IV Estimates for Manufactured Exports by the Various SITC Categories
SITC 5SITC 6SITC 7SITC 8
VariableCoeff.t-stat.Coeff.t-stat.Coeff.t-stat.Coeff.t-stat.
Constant-5.126-0.609-10.054-1.251-31.475-2.600-16.040-1.653
Log RGDP0.5901.6450.6932.0571.1942.3461.6363.835
Trend Log RER0.4570.3111.3801.0075.2902.5151.4530.886
Transitory Log RER-0.409-0.330-0.048-0.044-2.018-1.296-0.616-0.490
RERMIS0.0030.363-0.002-0.268-0.013-1.108-0.002-0.180
Log RXt0.91526.2090.92022.0030.90514.9620.88324.753
Sample377697513405
Adjusted R20.7600.6700.4600.790
Standard Error1.2131.4891.6651.285

Several factors constrain the responsiveness of manufactured exports to exchange-rate policies. The effectiveness of the real exchange rate in influencing their growth depends crucially on accompanying policies. Trade policies in Kenya have not been very supportive. Reversals and lack of credibility characterised trade-liberalisation efforts in the 1980s (Reinikka, 1994). Although some such efforts were implemented in the early and mid-1980s, mainly as part of the policy conditionality of the World Bank, they faced problems of macroeconomic incompatibility and probably timing because a new government had just taken over in 1978. Those in 1988–89 were perceived as macroeconomically incompatible, as aid flows contracted with compensating devaluation delayed. Loopholes in the tariff law, import-duty avoidance and illegal imports undermined tariffication of quantitative restrictions and tariff reduction.

Unlike Southeast Asia, where foreign direct investment (FDI) played a crucial role as an “engine” of growth by strengthening export capabilities, it has been relatively unimportant in Kenya. FDI and net long-term capital inflows have both declined as a proportion of GDP. The ratio of FDI to GDP fell from 1.37 per cent in 1980 to 0.03 per cent in 1993.

Long-term net capital inflows declined from 8 per cent of GDP in 1980 to negative average net flows in the 1990s, obviously unable to cover the current-account deficit. The rate of investment also declined, from 29.3 per cent in 1980 to 16.9 per cent in 1992, before partially recovering to 21.1 per cent in 1996.

Collier (1996) argues that economic reforms implemented in African countries are a necessary but not sufficient condition for achieving rapid export-growth rates. Investors view Africa as a high-risk area. The perceived high probability of policy reversals acts as a major deterrent to investment. It partly reflects the long history of economic controls in the region, compounded by poor dissemination of information to potential investors on the conditions in individual African countries and the region in general. In addition, dismantling of controls has progressed along lines dictated by pressure groups, which gain by extracting illegal rents in the process.

A reforming government should accordingly place a high priority on accelerating the reduction of the perceived risks. It can establish and use policy lock-in mechanisms or “agents of restraint”, both domestic and external. The domestic options include export lobby groups, an independent central bank, use of a cash budget, and balanced-budget constitutional amendments. The external ones might involve the World Trade Organisation, reciprocal trade arrangements, the Multilateral Insurance and Guarantee Agency and associated insurance agents, and currency convertibility. Governments need to signal their determination to implement reforms by extending and deepening them even when foreign aid is not forthcoming, in order to establish the reputation and credibility of their policies.

The ability of exporters to respond to exchange-rate policy will also depend on non-price variables. Jebuni et al. (1992) identify several of these. The first is the availability of finance, which respondents in field surveys usually identify as one of the most important constraints on exporting. Producing for export requires access to finance for working capital and pre-shipment activities, as well as to capitalise production to enhance export capabilities. Export-credit insurance helps exporters gain confidence in tapping new markets. Kenya does not provide either export-credit or insurance guarantees. Despite several recommendations, the argument has held that as long as the government will cover political risks, a consortium of private firms or their trade organisations would combine efforts to cover commercial ones. The government has lacked a firm commitment.

In Kenya’s RPED survey, 80 per cent of the respondent firms mentioned lack of financing for their operation and expansion, or the cost of financing, as a moderate to major obstacle. They ranked lack of credit ahead of slow demand, poor infrastructure, and inadequate business-support services as a key constraint on expansion. An analysis of this survey concludes that collateral borrowing does not work well, and access to debt is restricted for nearly all groups of firms, particularly the very small ones (Gothenburg University and University of Nairobi, 1994). One analyst recommends stronger, expanded property rights, to allow owners to transfer real property without the consent of the Land Control Boards. These boards can veto the transfer of land to banks after borrowers fail to repay loans, creating uncertainty in the loan-recovery process.

A second barrier lies in infrastructural inadequacies—in transport, water supply, electric power, waste disposal, security and telephones, as well as the availability of secure, reasonably priced storage and warehousing facilities at ports. In the RPED survey, only 31 per cent of the firms felt unaffected by infrastructural problems. In the face of poor delivery of these services, many firms must themselves provide some of them, which reduces their competitiveness.

Third, poor access to external markets arises from ignorance, lack of agents abroad, the high cost of operating in foreign markets, insufficient interest and experience in selling abroad given a fairly protected domestic market, and poor product quality. Fourth, and notwithstanding its rapid reform throughout the 1990s, an adverse regulatory environment still affects ownership of firms, tax structures, investment, labour regulations, licensing and registration procedures, obstacles to exit and price controls (Gothenburg University and University of Nairobi, 1994).

Conclusions

This chapter has analysed the role that the real exchange rate (RER) and its misalignment have played in influencing Kenyan manufactured export performance in the 1980s and 1990s. It has looked at the performance of manufactured exports in the context of the country’s overall export performance, discussed the evolution of the RER and its misalignment, and assessed their impact on manufactured exports.

Kenya’s export sector performed poorly in the 1980s and exports grew less than GDP. The value of exports declined by 2.6 per cent per year in the 1980s but recovered somewhat in the 1990s, with an average growth rate of 15 per cent in 1990-96. Traditional, non-traditional, and manufactured exports all evolved similarly, with some diversification from traditional to non-traditional exports and, within the non-traditional category, from primary to manufactured exports.

Between October 1975 and December 1982, the Kenyan shilling was pegged to the SDR. The country adopted a crawling peg exchange-rate regime in 1983-91. In this period, the RERs were relatively stable and on average depreciated. A more market-based exchange-rate regime has developed since 1991. A massive depreciation of the RER in 1993 followed the introduction of the interbank market in August 1992. The RERs subsequently appreciated in 1994-96. Kenya registered average misalignment of 6.8 per cent in the 1980s and 11 per cent in 1990-96, supporting the contention it has on average maintained a fairly good foreign exchange-rate policy.

The empirical results suggest the following conclusions. First, manufactured exports increase with productive capacity, proxied by GDP in manufacturing. A 1 per cent increase in real manufacturing GDP increases real manufactured exports by 0.68 to 0.97 percentage points. Second, depreciating the trend RER has a positive impact on manufactured exports, although this not very robust result appears only for machinery and transport equipment (SITC 7), in a more detailed sub-sector analysis based on GMM-IV estimates. Third, lagged real exports have the most significant coefficient, suggesting the presence of strong persistence effects in export behaviour.

Besides the exchange rate, non-price factors are likely to be important for manufactured export performance. These include the availability of finance, infrastructure, access to external markets, and a conducive regulatory environment.

Notes

EPZ export earnings between 1993 and 1997 show the following (with the shilling values in nominal terms): 1993, KSh. 900 million, or 0.7 per cent of total exports; 1994, KSh. 1.2 billion, or 0.8 per cent of total exports; 1995, KSh. 1.5 billion, or 0.9 per cent of total exports; 1996, KSh. 1.6 billion, or 0.9 per cent of total exports; and 1997, KSh. 2.0 billion, or 1.1 per cent of total exports.

The same authors also note a massive increase in the volume of horticultural exports in 1986-88.

The Gini-Hirschman concentration for exports moved as follows from 1980 to 1996:

19801981198219831984198519861987198819891990199119921993199419951996
0.430.410.420.400.430.420.470.380.370.380.360.340.350.330.290.280.28

This explains why the parallel-market exchange-rate premium could measure the extent of export taxation by way of income transfers to the government.

The equilibrium RER is defined as the rate at which the economy would be at internal and external balance for given sustainable levels of the other variables such as taxes, international prices and technology (Edwards, 1989). The equilibrium RER therefore varies continuously in response to changes in actual and expected economic fundamentals.

The multilateral RER was estimated as: RERt=NER/(ΣWjt*CPI/WPIjt), with NER measured by NERt=ΣWjt*Rt*Ejt, where Wjt is the export shares of Kenya’s six major partner countries at time t; WPIjt is the wholesale price index; Rt is the value of one US dollar in terms of Kenyan shillings; and Ejt is the value of one unit of currency of trading partner j in terms of the US dollar.

The following co-integration RER equations, estimated by Mwega and Ndung’u (1996), were used (t-values in parentheses):

CONSTlog TOTOPENGEXPEGROWTHKFLOWR
log RER1.025-0.452-0.322-1.782-4.9311.6460.69
(1.39)(1.951)(0.38)(1.76)(1.44)(0.54)
log RER0.537-0.306-1.025-2.8900.58
(2.81)(2.54)(2.45)(1.94)

where TOT is the terms of trade, OPEN is the trade ratio (exports plus imports divided by GDP), GEXPE is the share of government expenditures in GDP, GROWTH is real economic growth, and KFLOW is the proportion of net capital inflows to GDP.

GMM exploits the idea that disturbances in the equations are uncorrelated with the instruments and minimises the correlation between the instruments and disturbances according to a criterion given by a weighting matrix. According to this approach, suppose the theoretical model gives the condition that E[f(Z,β)] = 0, where f is a known function, Z is a vector of endogenous and instrumental variables, and β is a vector of parameters. GMM minimises the following criteria function:

f^T(ZT,β^),A^T(ZT,β^)f^T(ZT,β^)

where:f^T(ZT,β^)

is a vector of realisations of the function, andA^T(ZT,β^)

is an estimate of the inverse of their covariance matrix.

The methods used to take account of the correlations among the disturbance terms define the weighting matrix and compute the covariance matrix of the resulting estimators. To exploit the cross-section variability of data, White’s (1980) covariance matrix estimator is used to derive both the weighting matrix and the covariance matrix of the estimators.

The trend log RER was derived by smoothing the log RER series using the Holt-Winters method. The method computes recursive estimates of the constant and the trend components that minimise the sum of the squared forecasting errors.

10

Bigsten et al., (1998) find the RER to have an insignificant effect on industrial exports using firm-level data from the 1991–93 RPED survey. They attribute this to the short period covered, while movements in the RER may not adequately capture changes in the relative price incentives facing Kenyan exporters. They argue that sunk costs are important in determining firms’ responses to export incentives, implying that even if the exchange rate were to increase profitability, the response may be limited unless profitability crosses the threshold at which firms are willing to invest in exporting.

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