Chapter

3. The East African Community: Taking Off?

Author(s):
International Monetary Fund. African Dept.
Published Date:
May 2011
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Introduction and Summary

The members of the East African Community (EAC) have been among the fastest growing in sub-Saharan Africa (SSA)—and more broadly in the developing world—in recent years. Three countries in the EAC (Rwanda, Tanzania, Uganda) were among the fastest growing economies in the world during 2005-09 (Table 3.1). Part of the recent high growth is “catching up” after years of very poor growth—in the last part of the 20th century the region suffered periods of severe civil strife and bouts of economic instability. Since then, the region has demonstrated commitment to strong policies. Despite the recent advances, however, per capita incomes remain low.

Table 3.1.Top 20 Fastest-Growing Economies in 2005–09
RankingCountryReal GDP Growth
(percent change)
1Angola14.7
2Afghanistan, I.R. of12.9
3Ethiopia11.4
4China, People’s Republic of11.4
5Myanmar9.4
6Uganda8.3
7Uzbekistan8.2
8India8.2
9Rwanda7.9
10Sudan7.8
11Cambodia7.8
12Belarus7.7
13Dominican Republic7.4
14Vietnam7.4
15Mozambique7.1
16Tanzania6.9
17Peru6.8
18Argentina6.8
19Kazakhstan6.7
20Malawi6.5
EAC6.4
SSA5.6
Source: IMF, World Economic Outlook.Note: Excluding countries with population less than 9 million.

Medium-term prospects are favorable for translating recent gains into sustained high growth for the region. The recent growth path, however, will not be enough to achieve middle-income status and substantial poverty reduction by the end of the decade—the ambition of most countries in the region. Higher growth is needed to achieve these objectives.

This chapter looks at opportunities for the EAC to achieve sustained higher growth and to move to middle-income status over the next 10 to 15 years. It compares the EAC’s recent growth record to that of countries that successfully achieved growth take-offs during the past decades—referred to as sustained growth countries (SGs) in this chapter—and considers the possible implications of ongoing changes in the global economy for the EAC’s future growth path. The main conclusions are as follows:

  • Extensive macroeconomic stabilization and policy reforms ushered in an uninterrupted period of financial stability, market development, and institution strengthening, setting the stage for the recent growth surge. The benefits of reforms have increased over time, and a continuation of prudent, market-based economic management should help sustain growth in the years to come.

  • Compared with countries that have achieved successful growth take-offs, the EAC lags in terms of export growth and savings mobilization. The causes are largely of a structural nature (limited physical and financial infrastructure, high financing and regulatory costs) as exchange rates have been broadly in line with fundamentals. There is scope for active policies to unlock potential in these areas. Deeper regional integration, particularly in trade and investment (both public and private), could help raise productivity and reduce costs, facilitating higher exports.

  • The EAC is well positioned to take advantage of new trade and financing opportunities offered by a changing global economy. Macroeconomic tools may need to be fine-tuned to mitigate any adverse impact of increased financial volatility and risks. Fiscal revenue and spending will need to be carefully managed to avoid the “resource curse” that could come from higher commodity exports and the “debt trap” that could follow excessive non-concessional borrowing.

The EAC Growth Experience

The East African Community (Burundi, Kenya, Rwanda, Tanzania, Uganda) has achieved strong growth during the last two decades (Box 3.1).1 Two noticeable growth breaks emerge in the period. The pace of growth increased from the early 1990s, in line with the trend in SSA (Figure 3.1). More recently, since 2005, the EAC has grown noticeably faster than the rest of SSA, and almost doubled the rates achieved in the previous 15 years. With annual per capita growth averaging close to 4 percent over the past 6 years, the EAC comes close to qualifying for a “growth acceleration” episode as defined in the economic literature.2

Figure 3.1.Real GDP Growth1

Source: IMF, World Economic Outlook.

1Weighted by purchasing power parity GDP.

Growth rates are now trending upward in all EAC members, even though significant heterogeneity remains across them. Uganda stands out with the longest period of high growth (an average of 6.9 percent per year during 1990–2009) (Figure 3.2).

Figure 3.2.Cumulative Growth in Real per Capita GDP

Source: IMF, World Economic Outlook.

Rwanda and Tanzania have expanded rapidly since the early 2000s (7.7 percent per year in Rwanda and 6.8 percent in Tanzania). Since 2005, these countries have been among the fastest growing economies in the world, with annual average GDP growth rates of close to 8 percent—similar to other sub-Saharan

Box 3.1.East African Community—An Overview

The East African Community (EAC) was established in 2000 by Kenya, Tanzania, and Uganda; Burundi and Rwanda joined in 2007. Its objectives are to deepen cooperation among member states in political, economic, and social fields with the aim of establishing a monetary union and ultimately a political federation of East African states. While progress had initially been slow, the project has gained significant political momentum recently; efforts at policy and legal harmonization have accelerated, culminating with the establishment of a common market in July 2010.

While the current EAC has existed for just over a decade, there is a long history of cooperation under successive regional integration arrangements in the region dating back to 1917, starting with a customs union (Kenya, Tanzania, Uganda); the East African High Commission (1948—1961); the East African Common Services Organization (1961—1967); the East African Community (1967—1977), and the East African Co-operation (1993—2000).

EAC members nonetheless remain diverse in terms of incomes, industrial structures, and social indicators. The EAC has a population of about 127 million, a land area of 1.8 million square kilometers, and nominal GDP of $73.8 billion (2009). Kenya has the largest economy, with a nominal GDP of US$30.1 billion (41 percent of the region’s total). Measured in GDP per capita, Burundi is the poorest member, with an average nominal per capita GDP of US$164, less than one-third of the EAC average (US$560). Large shares of the population live in rural areas across the region. Three of the countries are landlocked (Burundi, Rwanda, Uganda). Compared with the rest of Africa, commodities do not account for a large share of output or exports—although Tanzania is an important gold exporter, and large oil and gas reserves have been found in Rwanda and Uganda.

EAC Countries: Selected Indicators, 2009
BurundiKenyaRwandaTanzaniaUganda
GDP and inflation
Nominal GDP (billions of U.S. dollars)1.330.15.221.315.8
Nominal GDP per capita (U.S. dollars)164762533517525
Real GDP per capita (U.S. dollars)1115487345460366
Real GDP growth (percent, annual average 1995–2009)11.03.37.65.87.5
Consumer price inflation (percent, annual average 1995–2009)13.68.010.69.76.0
Social indicators2
Population (millions)8.135.99.840.530.1
Population growth (percent, annual average 1995–2009)32.22.13.72.33.3
Rural population (percent of total population)89.378.181.474.086.9
Mortality rate of infants (per 1,000 live births)101.354.870.468.479.4
Literacy rate (percent of people ages 15 and above)65.986.570.372.674.6
Geographical factors
Landlocked
Natural resources4
Sources: IMF, World Economic Outlook; World Development Indicators; Barro and Lee (2010); and United Nations data.
This box was prepared by Catherine McAuliffe and Masafumi Yabara.

African high performers like Mozambique and high performers in other regions like Vietnam and Cambodia. After a period of stagnation, growth is picking up in Kenya, averaging 4.6 percent per year since 2005, providing momentum for the region as a whole to outpace the rest of Africa. Output declined in Burundi during most of the period since 1990—reflecting periods of political conflict—but is showing signs of recovery in recent years.

With strong output growth, per capita incomes in the region are catching up. Average real per capita GDP in the EAC reached US$412 in 2009—close to the average of US$420 for sub-Saharan Africa (excluding South Africa and Nigeria)—although wide variations remain within the region, from US$487 in Kenya to US$115 in Burundi.3

The region’s high population growth (close to 3 percent per year over the last two decades, compared with the sub-Saharan Africa’s average of 2.6 percent) has constrained poverty reduction. Income poverty fell by about 4 percentage points between 1990 and 2006 (latest available data from national poverty surveys) but remains unacceptably high, varying from about 20 percent of the population in Kenya to 68 percent in Burundi. At the same time, there have been advances in key social delivery indicators. In particular, most EAC countries are close to achieving universal primary education, and child mortality rates have come down.

To reach middle-income status by 2020—the ambition of most EAC countries—the region would have to grow at an average rate of about 8.5 percent per year for the rest of the decade, some two percentage points faster than in the last five years.4

Rwanda, Tanzania, and Uganda, with per capita income somewhat below the regional average, would have to grow by about 10—11 percent a year to meet that goal. Kenya is already close to middle-income levels, and should achieve this earlier if current growth rates are maintained. Burundi—the poorest of the EAC members—will take much longer to reach that goal. The question this chapter investigates is whether the EAC is well positioned to reach that target and what policies would facilitate its achievement.

How Does the East African Community Compare with Other Fast Growers? Benchmarking East African Community Growth

The ample growth literature has identified a long list of potential economic, political, and social drivers of growth. However, it has not been able to reach categorical conclusions about their respective contribution across countries or time. As a recent study puts it, there are “no recipes, just ingredients.”5 In the absence of firm theoretical foundations, “benchmarking” against high-growth comparators (comparing levels and trends in certain indicators to those observed in countries that actually achieved a high and sustained rate of growth) is often used to judge the growth potential of a country or region. Benchmarking can help identify potentially promising areas as well as possible constraints to growth, although by definition its capacity to serve as a basis for unconditional policy advice is limited.

The benchmark against which to compare the EAC’s growth record is that of a group of high performers from different regions that graduated from low-income status at different times (“sustained growth,” or SG countries).6 The exercise shows that growth determinants in the EAC have been similar in many respects to those observed in SGs but also differed in some important areas.7

Context Variables: Macroeconomic Stability, Open Markets, and Reliable Institutions

Financial stability, the existence of market-based price setting mechanisms, openness to international trade, and reliable economic institutions have been repeatedly identified as key ingredients for a sustained growth take-off.8 The operation of market forces in a context of low inflation and respect for property rights allows for the discovery of profitable investment opportunities, boosts confidence, and facilitates a structural transformation of the economy from agriculture into higher-productivity activities. These features were present in all SG cases. Similarly for the EAC, the extensive reforms introduced in the 1990s and 2000s ushered in a period of uninterrupted macroeconomic stability—as shown, for example, by sharp declines in inflation in both SGs and EAC countries (Figure 3.3)—as well as of market development and institutional strengthening. These reforms set the stage for the growth surge.

Figure 3.3.Inflation since Growth Turnaround

Source: IMF, World Economic Outlook.

Before the reforms, the economic record of the countries that were to form the EAC was rather poor. Fiscal spending was largely unchecked, monetary management accommodative, external tariffs high, and state intervention pervaded all key sectors, including banks. The results were large and rising budget deficits, growing debt burdens, high inflation, negative real interest rates, and unstable real exchange rates. Extensive price distortions created incentives for misallocation of resources that stunted growth and investment, while high inflation hit hardest the poor and vulnerable. The bleak economic outcomes often fueled political conflicts, with violent strife and even civil wars breaking out in many EAC members. Overall, real per capita GDP stagnated between the mid-1970s and the mid-1990s, during two “lost decades” (Figure 3.4).

Figure 3.4.Real GDP per Capita

(at 2000 exchange rates)1

Sources: IMF, World Economic Outlook; and IMF, African Department database.

1Weighted by population.

Since the late 1980s, all EAC countries—at different moments—introduced extensive reforms aimed at restoring macroeconomic balance and allowing the free functioning of markets. They eliminated the most onerous taxes and restrictions to economic activity and liberalized financial and exchange rate markets; introduced stricter budget controls (most often through binding cash budgeting procedures) while granting central banks more autonomy to curb runaway inflation. Trade reforms led to substantial reductions in the level and dispersion of tariffs and nontariff barriers. In Uganda, one of the first sub-Saharan African countries to embrace the process of liberalization and pro-market reforms in the late 1980s, virtually all sectors of the economy have been liberalized. Tanzania, Kenya, and Rwanda have focused on restructuring and privatizing state-owned banks, opening the system to foreign banks, and creating new prudential frameworks, while interest rates and exchange rates were liberalized and most restrictions on capital account transactions removed. Burundi has made significant progress as a post-conflict economy and is also embracing these reforms, albeit at a slower pace.

The reforms brought a radical turnaround in macroeconomic outcomes (Figure 3.5). With tighter monetary and fiscal policies, inflation was brought down to single digits—7.4 percent annual average across the region in the last decade, down from 27 percent in the 1980s. External debt has declined to less than 10 percent of GDP across the region, thanks to debt relief and fiscal consolidation—fiscal deficits have dropped and stabilized at an average of less than 3 percent of GDP in the last decade compared with more than 5 percent during the 1980s. With fiscal restraint, substantial international reserves were accumulated which, combined with flexible exchange rate regimes, avoided lasting overvaluation of the currencies. Trade liberalization spurred faster export and import growth. Increases in pro-poor public spending—with the financial support of the international community—contributed to gradual improvements in health and education indicators.9 Last but not least, macroeconomic stability has been buttressed by the strengthening of key economic institutions (including the central banks, tax revenue administration, and regulatory agencies) with well-defined mandates, stable legal frameworks, and high professional expertise.10 There have also been efforts to improve public financial management and public administration, but progress in these areas has been uneven.

Figure 3.5.East African Community: Macroeconomic Stabilization1,2

Sources: IMF, World Economic Outlook; and IMF, African Department database.

1 Weighted by purchasing power parity GDP.

2 Top panels exclude initial periods of hyperinflation and large fiscal imbalances in Uganda.

The EAC’s experience suggests a strong link exists between macroeconomic stabilization and policy reform, on the one hand, and acceleration in growth, on the other. Uganda, the earliest reformer, starting in the late 1980s, experienced the earliest and longest boost in growth. Tanzania and Rwanda followed in the mid-1990s; Kenya in the late 1990s; and Burundi in the early to mid 2000s. In all cases, after extensive market-oriented policy reforms, higher output growth rates ensued. The impact of policy reform may have been stronger in the EAC because these economies suffered at the start from higher instability and price distortions than most other high-growth cases.

Maintenance of a stable and open macroeconomic environment has yielded higher benefits over time and facilitated adjustment to shocks, helping sustain growth through the years. Key macroeconomic determinants of growth—domestic savings and investment, and export growth—have continued to improve in recent years. The EAC has weathered global shocks, including the 2008—09 surge in international fuel and food prices—when deft and credible monetary management allowed for a rapid decline in domestic prices once international prices abated. Likewise, improved fiscal and monetary policies allowed for the use of countercyclical policies to mitigate the impact of the recent global economic slowdown, and have underpinned a faster rebound to precrisis growth levels.

Sources of Growth: Labor, Capital, and Productivity

Complementing the supporting role of macroeconomic and institutional factors, sustained productivity growth is often seen as a prerequisite for rising income. As in the rest of SSA, the increase in GDP growth since the mid-1990s has been accompanied by a turnaround in total factor productivity growth (TFP) in the EAC, reflecting efficiency gains achieved since the onset of liberalization and structural reforms in the region (Figure 3.6).11 Consistent with its higher GDP growth, TFP growth in the EAC has outpaced that in SSA since 2005. The rate of TFP growth in the EAC, particularly in Uganda and Tanzania, also compares favorably to the record in other SG countries. By contrast, capital stock accumulation in the EAC is low relative to SG countries. Based on the observed TFP gains, higher investment could boost growth further if sufficient resources are mobilized while maintaining macroeconomic stability.

Figure 3.6.Total Factor Productivity

Numerous studies have tried to unbundle total factor productivity and identify more precisely the elements behind this “catch all” concept. Obvious candidates include increases in human capital, access to new technologies, and market deregulation. Although precise data is lacking, indications are that the EAC would generally score high on these counts. Steady improvements in access to health and education services, for example, likely contributed to the shift to higher growth.12 Similarly, trade liberalization facilitated access to modern technology and structural reforms supported a more productive use of resources. However, the EAC falls short on two other important drivers of productivity growth: (i) international trade, and the fast expansion of high-value exports—EAC exports are relatively small and little diversified—and (ii) domestic financial depth, generally associated with high domestic savings and declining current account deficits—EAC economies are highly dependent on foreign savings.

Level and Composition of Exports

Export growth in the EAC has been much more modest than in other SGs (Figure 3.7). While the latter quickly increased the share of exports in their GDP to 30—40 percent soon after their take-offs, the increase has been more protracted and subdued in the EAC, and the share of exports in GDP remains much lower in the EAC.

Figure 3.7.Exports since Growth Turnaround

Sources: IMF, World Economic Outlook; and IMF staff estimates.

Within this overall trend of relatively modest export growth, there are encouraging signs of budding diversification. This is largely associated with increasing regional trade integration—in particular the gradual elimination of tariffs with the establishment of a common market (Box 3.2). Unlike the EAC’s exports outside the region, which are mainly commodities, the bulk of intra-EAC exports are manufactured goods (food products, beverages, tobacco, cement). Kenya, Tanzania, and Uganda (the earliest members of the EAC) are the main sources of such intraregional exports. Partly as a result, Uganda and Kenya have relatively well diversified export structures (Figure 3.8). In contrast, Rwanda’s exports to the region remain concentrated in agricultural commodities; and its export concentration is high.

Figure 3.8.Export Concentration

Sources: UNCTAD (2010), UNCOMMTRADE; and IMF staff estimates. The measure of concentration is the normalized Herfindahl-Hirschmann index.

1 Harmonized System 1988/92, 6-digit classification.

Regional integration is still in its early stages and it remains modest in scope. Intraregional trade more than doubled from about US$0.9 billion in 2004 to US$1.8 billion in 2008 but still accounts for less than 30 percent of total trade.13 Although a common market is in place, nontariff barriers are still high in the region and common standards and harmonized regulations are yet to be agreed upon. Removing these remaining obstacles could facilitate faster growth and greater diversification of the region’s exports.

Box 3.2.The East African Community Common Market: Achievements and Remaining Challenges

Trade integration has been a central objective of the EAC since its establishment. The customs union was established in 2005, followed by a common market in 2010. Internal tariffs on goods from other EAC countries have been eliminated over a 5-year period. A common external tariff (CET) was established for imports from third countries: a zero rate for raw materials, a 10 percent rate for intermediate products, and a 25 percent rate for finished goods. The new tariff structure lowered the maximum tariff rate in each EAC country. EAC members also agreed to eliminate gradually restrictions on trade in services, the free movement of workers, and the right of establishment.

In practice, however, significant obstacles remain to the operation of the EAC common market. While agreement was reached to remove nontariff barriers gradually and mechanisms are in place in each country to monitor implementation, actual progress has been limited. Customs procedures have not been fully harmonized, delays exist in issuance of certificates of origin, standards are not applied uniformly, and procurement procedures still need to be liberalized. Weak administrative capacity hinders the application of existing rules, while modalities for collecting and accounting for customs revenues at the regional level are not in place. Structural weaknesses, notably inadequate transport infrastructure, also hamper intraregional trade.

This box was prepared by Iacovos Ioannou.

There have also been some examples of successful export “hits” to markets outside the region. Rwandan companies have gained market share for their coffee by capturing gains along the value chain of particular market niches (improving the quality of coffee by fully washing it in Rwanda and securing market access overseas). Kenyan, Tanzanian, and Ugandan companies are exporting fresh fish and cut flowers to Europe by air, also through a close articulation of all phases of the export process, from seeds to final distribution—and in the case of Uganda, overcoming its geographical disadvantage as a landlocked country. These exports, however, have not taken sufficient hold to make a significant difference at the national or regional level.

Export growth has been too low to drive changes in the structure of output in the EAC. The transition from agriculture—whose share of GDP declined steadily from more than 50 percent in the 1980s to about 30 percent at present—has been largely toward services (mainly telecommunications, financial services, and tourism). The weight of these sectors has risen to about 50 percent of GDP, while that of manufacturing has remained relatively unchanged at 20 percent over the last three decades—well below that in SG countries. The modern services sector (e.g., data processing for the financial industry) can contribute to productivity gains and export diversification. However, its share in EAC exports remains relatively small and mostly limited to tourism and transfer trade. Similarly, the still high share of the labor force in agriculture (70 percent to 80 percent) suggests that there is a large, still untapped potential for increasing productivity in that sector.

High transportation and energy costs are acknowledged constraints to expanding high-value exports in the region. There is no consistent information allowing a comparison with SG countries at the beginning of the growth spell. But transportation unit costs are estimated to be six times higher in the EAC than in China and India;14 close to 60 percent of EAC businesses identified inadequate or poor electricity supply as a major constraint to business operations. Better provision of transportation and energy services is now high on the agenda of all EAC members, and a number of projects have been initiated in these areas, including at the regional level. Technical as well as financing difficulties have, however, limited progress in delivery so far.

High regulatory costs further hamper export price competitiveness. While EAC members have embraced market-supportive policies at the broader level and often put in place legal frameworks amicable to investors, business surveys show that enforcement is problematic (Figure 3.9). Despite the elimination of internal tariffs, customs procedures remain uncoordinated and burdensome at the regional level and nontariff barriers are pervasive. Duty drawback and tax refund schemes are complex and poorly administered, resulting in substantial delays. Investment incentives are uncoordinated and often enterprise-specific. Such obstacles not only constrain investment and export levels; they also hamper private investment in infrastructure, further increasing costs; and they deter innovation, and thus output and export diversification. Although most EAC country authorities have plans to improve the investment climate, progress to date has been uneven across the region, with only Rwanda implementing ambitious and comprehensive reforms in this area. In addition, reform efforts have not been closely coordinated at the regional level, reducing to some extent their impact.

Figure 3.9.East African Community: Business Environment

Sources: World Bank, Doing Business 2011, World Economic Forum, The Global Competiveness Report 2010–11; and IMF staff estimates.

1A high ranking (i.e., a low number) indicates a favorable competitive environment.

Low Domestic Savings and High Aid Dependence

EAC countries have relied on external resources—mainly donor aid—to finance the bulk of investment. Investment has increased steadily in the EAC to about 24 percent of GDP in 2009 but remains well below that observed in SG countries (Figures 3.10 and 3.11). In addition, while the gap between savings and investment closed in SG countries relatively rapidly after their take-off—thanks to sharp and continued increases in savings—the growth in savings has been weaker in the EAC, even when normalized to per capita income levels. Since 2005, the gap between savings and investment has grown markedly, reflected in the widening of already high external current account deficits across the region—a major source of vulnerability to sustaining growth and stability.

Figure 3.10.East African Community: Investment and Savings1

Source: IMF, World Economic Outlook.

1Weighted by purchasing power parity GDP.

Figure 3.11.SGs: Investment and Savings1

Source: IMF, World Economic Outlook.

1Weighted by purchasing power parity GDP.

Aid provided the main source of financing for the initial investment push in the EAC (Figure 3.12). It remains large, with grants averaging more than 3 percent of GDP over the past decade (excluding debt relief), above the average for sub-Saharan Africa (1 percent of GDP). More recently, there has been a noticeable increase in foreign direct investment (FDI) (Figure 3.13). FDI flows to the EAC region increased threefold, from about US$590 million in 2000 to about US$1.7 billion in 2009. Nevertheless, on average, FDI flows to the EAC (2.5 percent of GDP in 2009) remain below average flows of about 4.3 percent to SSA as a whole.

Figure 3.12.Grants1

Source: IMF, World Economic Outlook.

1Weighted by purchasing power parity GDP.

Figure 3.13.Inward Foreign Direct Investment1

Sources: IMF, World Economic Outlook; and UNCTAD.

1Weighted by purchasing power parity GDP.

There is a large but so far inconclusive debate on the impact of aid on macroeconomic outcomes. Aid can stunt export growth if it leads to currency overvaluation, or stimulate export growth if it raises the provision of public services in the productive or social sectors. In the EAC, there is no evidence that real exchange rates deviated in a marked and sustained manner from macroeconomic fundamentals (Figure 3.14).15 The authorities have generally managed aid inflows wisely, smoothing their impact on both fiscal accounts and foreign exchange markets.

Figure 3.14.Misalignment from Equilibrium Exchange Rate

(3-year moving averages)

Source: Opoku-Afari and Dixit (2011).

Large aid inflows also facilitated substantial improvements in access to health and education in the EAC. Over the medium term, however, the dependence on aid inflows to finance current spending could lead to an unsustainable structural worsening of the external current account and weaken the foundation for higher sustained growth.

Shallow financial sectors have gone hand-in-hand with low domestic savings in the EAC (Figure 3.15). Notwithstanding extensive liberalization, the region’s financial markets remain small, segmented, and illiquid. A recent study by FINSCOPE shows that less than one-third of the population in Rwanda, Tanzania, and Uganda have access to formal financial services, compared with nearly two-thirds of the population in South Africa. Efforts to promote microfinance institutions have had limited success. Nonbank financial institutions, such as pension funds or insurance companies, are in most cases only embryonic. Credit to the private sector and the level of monetization in the EAC is well below that observed in SG countries at the time of their take-off. More recently, however, mobile banking—including the innovative M-PESA mobile banking platform in Kenya—has emerged as a promising vehicle to broaden access to financial services and savings instruments without endangering macroeconomic stability (Box 3.3).16

Figure 3.15.Financial Deepening

Sources: IMF, World Economic Outlook, International Financial Statistics, and IMF African Department database.

Small market size and pervasive structural weaknesses limit competition in the financial system and keep domestic financing costs relatively high (Box 3.4). Uncertain property rights (in part related to weaknesses in land titling) hamper the assessment and enforcement of collateral, credit information on borrowers is patchy, and the legal and regulatory framework is insufficient to facilitate the swift resolution of commercial disputes. All these factors continue to pose risks to credit delivery and increase financial costs. Although private sector credit growth has increased, it has largely focused on consumer financing (particularly mortgages). Access to finance by budding small and medium-sized enterprises (SMEs) has been limited to the (largely unregulated) informal financial sector. With the exception of Kenya, domestic capital markets are shallow, and stock exchanges are well below the size required to support the economies’ financing needs. Continued efforts are needed to tackle these deeply rooted obstacles to financial deepening. Here again, regionally coordinated approaches have the potential to bring larger and faster benefits. Recently, Kenya’s infrastructure bonds and a number of private IPOs in Kenya, Uganda, and Rwanda have attracted significant regional participation, suggesting a substantial pool of regional savings could be mobilized to support public and private investment.

New Challenges and New Opportunities

Although benchmarking can provide useful policy insights, its relevance is reduced if the global environment changes markedly. The world economy is currently undergoing wide-ranging changes, particularly in trade and finance. These changes raise new challenges—as well as new opportunities—that could have a meaningful impact on the EAC’s growth prospects. Even if their final effect is uncertain, trying to understand their implications can provide useful insights for policy design.

Changes in the Direction and Composition of Global Trade

During the past decade, global trade has shifted markedly in its direction and composition. China and other fast-growing emerging market economies have doubled their share of global demand, from about 6 percent in 2000 to 12 percent in 2009. Because imports from these economies are more commodity-intensive than those of advanced economies, the global demand for raw materials has increased sharply—with the share of raw materials in global trade rising 5 percentage points since 2000 and commodity prices, particularly those for oil and metals, more than doubling over that period. This trend is expected to continue during the medium term, and metal and oil prices are projected to remain high by historical standards.17

Global demand for food—especially from emerging markets—is also on the rise, as reflected in the recent reversal in the historical trend decline in real food prices. With rising incomes in emerging economies, the need to feed large concentrations of population migrating from rural to mega-urban centers, competing uses for agricultural land (mainly ethanol), and changes in weather patterns because of climate change, food demand is forecast to rise by 70 percent over the next four decades.18 While most of the food demand is now concentrated in unprocessed agricultural products, demand for semiprocessed and processed food is also expected to swell in the future.

Box 3.3.Kenya: Mobile Money and Financial Sector Deepening

The mobile-banking revolution has accelerated financial deepening in Kenya.

Launched in 2007, M-PESA (Pesa is Swahili for money) enables customers to transfer money quickly and cheaply within Kenya via mobile phone without a bank account. Money can be uploaded and withdrawn from a network of agents and used for transfers, bill payments, and airtime purchase. In 2009, M-PESA had 13.1 million users (30 percent of Kenya’s population) and over 17,000 agents conducting financial transactions on behalf of banks. Similar schemes have emerged in other EAC countries, including Uganda and Tanzania.

M-PESA has facilitated a rapid increase in financial intermediation. Banks have been able to penetrate untapped markets as mobile-based transfers surged. With growing access to financial services, deposits by low-income segments of the population contributed to a sizable increase in broad money: Kenya’s broad money growth doubled in 2006—10 relative to 2001–05. Banks were able to increase their deposit base on the heels of a 70 percent expansion in their branch network (140 percent growth in rural branches). The resulting impact on monetization contributed to an acceleration of credit growth (to an annual rate of 20 percent at end-2010).

The increase in broad money brought about by mobile banking has helped keep inflation at around the central bank target level of 5 percent. Because broad money growth exceeded GDP growth, the income velocity of money declined; because more financial transactions have been made possible by mobile banking for a given level of reserve money, the money multiplier increased.

The launch of M-kesho (mobile phone-based deposit accounts; kesho is Swahili for tomorrow), and agency banking (expanding the scope of authorized operations by agents in underserved locations) has further strengthened the link between mobile banking and financial intermediation. In addition to broadening access, these developments help reduce the cost of financial transactions and facilitate trade. M-kesho has the potential to become a convenient savings instrument for low-income households.

Financial stability has been preserved throughout the expansion of M-PESA operations thanks to adequate regulatory and supervisory safeguards, a conducive environment for business (avoiding the dominance of early entrants and maintaining competition in the provision of telecommunication services), and involvement of the private sector in policy formulation and enforcement.

Kenya: M-PESA Customers and Agents (2007–2010)

Kenya vs. EAC Countries: M2 (y-o-y percent changes)

(Size of bubbles represent percent change between 2001–05 and 2006–10)

Source: IMF, World Economic Outlook.

Kenya: M2 Growth and Velocity

Sources: IMF, African Department database; and IMF staff estimates.

This box was prepared by Sarah Sanya and Rogelio Morales.

Box 3.4.Competition in East African Community Banking Systems: Evidence from a Price-Setting Behavioral Model

Competition in banking is extremely important because banks play a pivotal role in the provision of credit, the transmission of monetary policy, and the maintenance of systemic stability. Empirical studies on EAC banking systems are notoriously scarce. A recent study attempts to estimate measures of bank competitiveness in the EAC and identify their determinants.1

The study finds that although no regulatory barriers to entry exist in EAC financial systems, structural impediments reduce competition and enable some banks to enjoy a degree of monopoly power. Reflecting higher financial depth, Kenya has a somewhat more competitive banking system than other EAC members.

Panel data regressions identify five important determinants of banking competition.

  • Higher economic and institutional development increase banking competitiveness.

  • Greater market concentration reduces competition.

  • Larger markets (proxied by population) spur competitive behavior between banks, possibly because banks are willing to take smaller profit margins if spread over a higher volume of transactions.

  • Stronger market contestability—reducing market segmentation by lowering government ownership of financial institutions and leveling the playing field for new entrants—matters for competition.

  • Increased lending to the private sector fosters competition whereas higher bank profitability (from nonlending-related activities) has the opposite effect.

Eliminating structural barriers that weaken the credibility of the threat of entry is a key requirement in spurring banking competition. Contestable markets reduce noncompetitive behavior because the threat of entry with price-cutting by potential competitors will force incumbent banks to reduce their prices to try to protect their market power. Enhancing macroeconomic performance and the quality of institutions that provide information and protect property rights is the first line of action to ensure that markets are contestable. Other options include: selling government-owned banks to private domestic investors to reduce the market segmentation owing to large state and foreign bank presence; promote policies of financial inclusion; and strengthen supervisory and regulatory capacity to reduce systemic vulnerabilities that may arise from a more competitive banking sector.

1Gaertner, Sanya, and Yabara (2011).This box was prepared by Matthew Gaertner, Sarah Sanya, and Masafumi Yabara.

The EAC has not been immune to these trends. Emerging markets have become increasingly important trade partners, and now account for almost 20 percent of the region’s exports (compared with 12 percent in 2000).19 In contrast to the rest of sub-Saharan Africa, where China has been the main driver behind the shift, the fastest-growing markets for the EAC have been in the Middle East and North Africa (Box 3.5). EAC exports to that region—mainly coffee, tea, fish, and some semiprocessed gold—have risen from 9 to 11 percent of total EAC exports between 2000 and 2009, while exports to this region from non-oil sub-Saharan Africa countries, and LICs more generally, remained constant during the same period. The Middle East and North Africa is a particularly promising market for food exports, because of natural constraints to expanding domestic production in that region together with continued strong import financing capacity from oil and gas revenue.

Foreign investment in mining and oil has also increased sharply in the EAC in recent years, and exports are set to expand significantly as these investments begin to come on-stream. In Tanzania, gold exports already account for more than a third of total exports of goods and services, while in Uganda oil production is expected to account for close to 10 percent of GDP and up to one-third of government revenues. There has been considerable exploration in nickel, uranium, and oil and natural gas across the region, all of which are believed to have significant potential.

Dynamic new markets provide an opportunity to both increase growth and accelerate poverty reduction, but policy actions may be needed to reap their full benefits. Investment in the mining and oil sectors can quickly lift output and government revenues, but harnessing such activities into longer-term growth raises considerable policy challenges. A large body of literature suggests that most commodity exporters have fallen into a “natural resource trap” detrimental to long-term growth because of the adverse impact of commodity exports on productivity, the real exchange rate, institutional development, and governance.20 For East Africa, a region that has remained relatively less commodity-dependent than its African neighbors, the impact of increasing commodity exports could be a double-edged sword: while they could increase output growth and income in the near term, they could also stunt the development of higher value-added exports needed to reach faster, sustained growth over the medium term. Early, determined policy action is needed to preserve competitiveness and ensure that the revenue from commodity exports is successfully intermediated into productive spending and investment in other sectors of the economy.

The New International Financial Landscape

Similar to trends elsewhere in emerging and developing economies, private capital inflows—transfers (including remittances) as well as financial flows (FDI and short term capital)—have risen sharply in the EAC in recent years (Figure 3.16). Since 2005, they have replaced official flows (grants and loans) as the largest source of external financing. Most private flows have been concentrated in Kenya and Uganda, given their open capital markets, but indications are that part of the flows was then invested in other EAC members, including Rwanda and Tanzania.

Figure 3.16.Private and Official Flows to the East African Community

Source: IMF, World Economic Outlook.

New sources of bilateral loans are also opening up. China and India, in particular, are becoming an important source of bilateral loans, mainly for infrastructure and agricultural projects. The share of these loans in total borrowing is still relatively small in the EAC, particularly when compared with other parts of sub-Saharan Africa. However, this share is expected to grow substantially in the coming years, as a number of projects now in the planning stages roll out. Demand for bilateral loans is also expected to increase as traditional donor assistance is pressured by donor budget constraints.

These new sources of financing—private inflows and new bilateral loans—can support faster investment growth but managing them poses new challenges. Bilateral loans are generally more flexible and faster-disbursing than official assistance, but they are also less concessional. Their shorter maturities and higher and often front-loaded servicing costs can have a significant fiscal impact that should be carefully considered. To ensure that such borrowing does not generate excessive servicing burden for the public accounts, it is advisable to develop or strengthen processes for project selection and implementation, as well as build capacity for sound debt management.

Private capital flows, on the other hand, are much more volatile than official flows. Unlike aid, they move closely in cycle with global liquidity conditions. As in the rest of sub-Saharan African “frontier markets,” private financial flows to the EAC grew markedly before the global crisis, declined sharply during the crisis; they recently began to rebound. Reflecting the growing share of private financing flows, nominal exchange rates in the EAC have become more volatile (Figure 3.17).

Figure 3.17.Exchange Rate Volatility

(U.S. dollars/National Currency)

Sources: Thomson Reuters; and IMF staff estimates.

Beyond increasing volatility, growing private flows raise challenges for money targeting—the predominant framework for monetary management in the EAC. They erode the position of central banks as main providers of foreign currency to the markets, and thus the effectiveness of foreign exchange sales as an instrument to manage money supply. More broadly, deeper financial integration tends to make money demand less stable and the achievement of money targets more uncertain.

Because the region’s financial markets are not yet deep enough to allow a smooth shift to interest rate or inflation targets, central banks in the EAC have generally responded by expanding their toolkit at the short end of the markets, intervening more frequently on spot foreign exchange markets and developing new instruments to better control short-term domestic liquidity.

Box 3.5.Shifting Trends in EAC Trade

EAC trade is shifting away from its traditional partners (mainly the euro area) toward emerging markets—mainly China and India, and more importantly the Middle East, North Africa, and the rest of SSA. Intra-EAC trade also accounts for an important share of total EAC trade. EAC exports to Brazil, Russia, India, and China (BRICs) rose to about 7 percent of total EAC exports in 2009, slightly lower than the share of BRICs in exports of non-oil SSA countries in general, and below the share for all non-oil LIC exports (Figures 13). Compared with non-oil SSA countries, however, EAC trade with the Middle East and North Africa is much larger. EAC exports to the Middle East and North Africa have risen from 9–11 percent of total EAC exports between 2000 and 2009.

Figure 1.EAC Exports

Figure 2.SSA Exports, excl. FuelExporters

Figure 3.LIC Exports, excl. FuelExporters

Source: IMF, Direction of Trade Statistics.

EAC exports to India and China come mainly from Tanzania and account for about 80 percent of total EAC exports to BRICs. Tanzania’s exports to China increased from less than US$1 million to US$135 million during the last decade, with gold accounting for more than half in 2009. Its exports to India (a mix of cashews, cotton, and peas) increased from US$100 million to US$153 million during the same period. Imports from India and China go primarily to Kenya and Tanzania, and to a lesser extent, Uganda.

Traditionally, Kenya has been the predominant EAC exporter to the Middle East and North Africa, accounting for more than 90 percent of total EAC exports to that region in 2000, with black tea accounting for approximately one-third of exports. However, Kenya’s share has gradually halved over the last decade, while Uganda’s exports to the Middle East and North Africa rose from US$11 million to US$355 million (almost 44 percent of EAC exports to the region in 2009). In addition to coffee, Uganda exports semimanufactured gold and fish products to the Middle East and North Africa.

This box was prepared by Laure Redifer.

Policy Priorities for Higher, Sustained Growth

The economic policy framework now prevailing in the EAC, based on sound macroeconomic management, open markets, and relatively strong institutions, has delivered fast growth over the past decade. In future, however, changing dynamics in the global economy could challenge policy making in the region. Enhancing policy instruments to respond to external volatility, combined with a continued focus on competitiveness and regional integration, will be important to facilitating even faster growth and accelerating the move to middle-income status for the region. This closing section tries to identify areas where policies could be sharpened to better unlock the region’s growth potential. These are only general guidelines; the detail and relative priority will vary across EAC members, depending on their specific circumstances.

Bolstering the Macroeconomic Response Capacity

Sound monetary and fiscal policies have helped the EAC achieve high growth rates, and they should certainly be preserved. However, the new global context, with rising private inflows and a declining share of aid, is already increasing financial volatility in the region and, if not adequately managed, could increase the region’s vulnerabilities to external shocks. This raises the urgency to further develop the capacity and tools to respond to abrupt shifts in the global environment.

Rebuilding fiscal policy buffers is a particularly urgent goal. Countries in the region were able to judiciously use the fiscal space gained from over a decade of consolidation to weather the storms of the recent global economic crises. Because they are now growing again, the time has come to resume the drive to enhance domestic revenue mobilization and reduce the share of aid in public budgets. As exposure to less concessional financing increases, there is a need to strengthen debt management processes to safeguard hard-won debt and fiscal sustainability. Countries could also foster private participation, including through public-private partnerships (PPPs), as a viable means to address large infrastructure gaps while maintaining fiscal policy buffers.

Enhancing the flexibility of monetary policy is another important objective. It will require a broadening of options for short-term liquidity management, with measures to support further development of domestic interbank markets and risk-hedging instruments. A gradual shift away from monetary targets now dominant in the region to some form of inflation targeting could also allow more flexible monetary management and anchor expectations and confidence.

Deepening Regional Integration

Deeper regional integration can help the EAC achieve economies of scale and allow the region to compete more efficiently in the global economy. Many studies have shown that small markets like those of individual EAC countries—and most of sub-Saharan Africa—tend to be less competitive and reduce the scope for productivity gains. Small markets also tend to make the business environment more risky because they frequently enable monopoly power and opportunistic behavior.

EAC integration is already advancing. Regional institutions are being put in place, a customs union and common market have been established, and initial steps are being taken toward a future monetary union. At the entrepreneurial level, however, critical obstacles remain, and removing them should be a priority. A time-bound process to eliminate nontariff barriers would let businesses reap the benefits of the regional common market and prepare them for competition in broader markets. Development of common standards and harmonized regulations would greatly enhance the business environment and facilitate legal enforcement. Regional coordination of investment promotion and tax reform would limit intraregional incentive competition and help attract financing for larger projects.

In the financial area, more active regional initiatives—building, for example, on the recent regional bond issues—could help to develop and increase the depth of domestic markets in the region by pooling savings across the region, expanding market size beyond each country, and reducing the fixed costs of developing market infrastructure. The harmonization of national regulatory frameworks, now under way, could be accelerated to facilitate the emergence of regional financial instruments. Deeper government debt markets could enhance the efficiency of monetary policy and serve as a benchmark yield curve for the private sector, facilitating the pricing of financial products. The local currency debt market of the West African Economic and Monetary Union (WAEMU) provides a useful example of a regional approach to bond market development (Box 3.6).

Unlocking the Potential for High-Value Exports

Higher productivity is the first requirement to raise the EAC’s export potential. In particular, a better educated and skilled labor force is needed to take advantage of new investment opportunities within and outside the EAC. Continued upgrades in regional infrastructure (including transportation, energy and information technologies) will reduce production costs and facilitate higher-value inter- and intraregional trade. Stepped-up efforts to increase agricultural productivity could raise EAC exports and increase incomes in areas where the poorest segments of the population are concentrated.

Increased FDI and exports in the commodity sectors raise well-known challenges for competitiveness and export diversification. Preserving competitiveness in noncommodity sectors will require forceful improvements in the business environment to reduce operation and transaction costs. Tax collection and public investment systems may also have to be strengthened to ensure that commodity export proceeds are successfully intermediated into other sectors of the economy.

Higher export penetration may also demand, at least in the initial years, targeted “catalytic” interventions in natural niche sectors where EAC economies could build up or strengthen their comparative advantage, overcome latecomer and scale handicaps and establish a market presence. Interventions should be coordinated over complementary areas (skills, transportation, technology, FDI, market access). They should be carefully targeted, both sectorally and geographically. Resources are insufficient to enhance skills, roads, and power in the entire region at the same time, and an equal distribution of these limited resources will not give any area sufficient traction to become competitive. Regional coordination—with a common focus, for example, on a few “trade corridors”—could help mobilize financing and increase returns. To prevent “state capture,” implementation of the export push policy should be time bound with a clear exit strategy. More broadly, its fiscal cost should be strictly constrained, given the many demands faced by the government, particularly social needs.

The private sector should be closely involved in the design of such interventions, helping identify concrete needs and efficient delivery modes. Targeted areas should be selected transparently, with a focus on their impact on sustainability of both exports and productivity. Given its potential for expanding exports and reducing poverty, agriculture would likely offer the greatest payoff from targeted support.

Box 3.6.Regional Bond Market Development in West Africa

Background: The local currency debt market of the West African Economic and Monetary Union (WAEMU)1 has rapidly grown since the establishment of a regional securities market, the Bourse Régionale des Valeurs Mobilièress (BRVM), in 1998. The size of government debt outstanding and issues of debt securities in the market have more than doubled in the last 5 years, extending the maturities of treasury bonds up to 10 years at the longest. The success of WAEMU’s debt market is attributed in part to: (i) the existence of strong common institutions, such as a regional central bank and supervisory bodies; (ii) uniformity of issuance and distribution procedures; and (iii) greater macroeconomic stability in member countries, as well as the elimination of central bank financing of governments (Sy, 2007; and Bank of France, 2006). Furthermore, multilateral financial institutions have contributed to increasing the volume of bonds in the market. Bonds issued by the West African Development Bank, a development bank serving the WAEMU countries, account for about 11 percent of total securities outstanding in the market at end-2009. The International Finance Corporation floated its first local currency bond issue (equivalent to US$44.6 million) in sub-Saharan Africa in the BRVM, at end-2006.

Policy Lessons for the EAC: Debt markets in the EAC countries are largely underdeveloped, especially in Burundi and Rwanda. EAC members have made cooperative efforts to develop the markets through harmonization of market infrastructures. While there are fundamental differences between the EAC and the WAEMU, some general policy recommendations for the EAC can be drawn from the case of the WAEMU:

  • Strengthen the capacity of regional institutions. Strong regional institutions play a pivotal role in facilitating the development of regional bond markets, through coordinating and monitoring country efforts, as well as providing research inputs. To that end, the capacity needs of EAC regional institutions, both in terms of budget and staff, should be addressed.

  • Investigate necessary actions to promote local currency bond issues by multilateral financial institutions in the EAC market. Multilateral financial institutions have ample experience in issuing local currency bonds in local markets to facilitate their development. Debt issues by these institutions in the EAC market, if accomplished, would facilitate the development of the regional market, by providing know-how and benchmark transactions for long-term financing and mobilizing domestic and international savings.

1 The WAEMU is a customs and monetary union, established in 1994, that consists of Benin, Burkina Faso, Côte d’Ivoire, Guinea-Bissau, Mali, Niger, Senegal, and Togo. The member countries share a common currency, the CFA franc.This box was prepared by Masafumi Yabara.

This chapter was prepared by Martine Guerguil, Catherine McAuliffe, Hamid R. Davoodi, Maxwell Opoku-Afari, and Shiv Dixit, with editorial assistance from Jenny DiBiase and administrative assistance from Natasha Minges.

Regional aggregates are computed using unweighted averages, unless otherwise indicated.

Hausmann, Hwang, and Rodrik (2007) define a growth acceleration episode as an increase in per capita output growth of at least 2 percentage points during at least 8 years with annual growth reaching at least 3.5 percent at the end of the period.

Real per capita GDP at 2000 prices and exchange rates. In nominal terms, the gap with respect to the regional average increased in the 2000s, largely reflecting the appreciation of several African currencies with respect to the U.S. dollar during this period.

For illustrative purposes, the calculation assumes a middle-income threshold of US$1,000 GDP per capita in 2009 (close to the US$995 threshold of middle-income status defined by the World Bank). We assume this threshold grows in nominal terms at about 3 percent a year—the observed growth of the middle-income threshold over the last decade—for the next decade to reach an estimated US$1,353 in 2020.

The sustained growth countries (SGs) used as benchmarks in this chapter are those identified in Johnson, Ostry, and Subramanian (2007). They include Chile, China, the Dominican Republic, Egypt, Indonesia, Korea, Malaysia, Singapore, Taiwan Province of China, Thailand, Tunisia, and Vietnam.

The comparisons mostly refer to Rwanda, Tanzania, and Uganda because these three countries have experienced the longest growth spells, allowing a discussion of trends over a longer period than would be available for Burundi or Kenya.

IMF-supported stabilization programs accommodated increases in social spending in the 1980s and 1990s (Gupta and others, 2000).

With the exception of Burundi, EAC countries have consistently ranked higher than the SSA average in the World Bank’s Country Policy and Institutional Assessment (CPIA) ratings.

Since the mid-1990s, SSA as a whole has registered a rebound from low or negative TFP growth and a corresponding decline in the contribution of factors of production to growth (IMF, 2008b; Radelet, 2010).

A number of studies have found that inadequate schooling and health indicators and high income inequality could reduce returns on investment and magnify the adverse impact of negative shocks on activity, thereby undermining the potential for sustained growth (Berg, Ostry, and Zettlemeyer, 2008).

Excluding informal (unrecorded) cross-border trade. Although it is difficult to pinpoint the extent of these transactions, surveys suggest they make up a significant portion of trade in the EAC. In Uganda, for example, it is estimated that during 2008/09 informal export earnings stood at US$810 million compared with US$480 million recorded in 2007/08. Meanwhile, informal imports also increased significantly from US$57.2 million in 2007 to US$78.1 million in 2008.

The 2011 World Bank Enterprise Survey estimates that exporting a container costs about US$3,300 in Rwanda, US$3,200 in Uganda, but far less in China (US$500) and India (US$945).

Opoku-Afari and Dixit (2011).

Excluding exports to emerging markets in SSA.

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