Abstract

A financial program is a set of coordinated policy measures—mainly in the monetary, fiscal, and balance of payments fields—intended to achieve certain economic targets in a relatively short period of time. The task of setting economic targets, choosing policy instruments, and quantifying the appropriate magnitudes of the instruments required to reach the targets is described as financial programming.

A financial program is a set of coordinated policy measures—mainly in the monetary, fiscal, and balance of payments fields—intended to achieve certain economic targets in a relatively short period of time. The task of setting economic targets, choosing policy instruments, and quantifying the appropriate magnitudes of the instruments required to reach the targets is described as financial programming.

NATURE OF FINANCIAL PROGRAMMING

Financial programming is based on the assumption that there is a relatively stable relationship between financial variables (such as money and domestic credit), on the one hand, and nonfinancial variables (such as real national income and prices), on the other hand, and that the monetary authorities can control some of the financial variables so as to affect the real side of the economy. Although financial variables are emphasized, nonfinancial policy measures are also often included in financial programs.

A financial program such as the one described below for Kenya is prepared with the purpose of achieving or maintaining a desirable balance between real income and real absorption.1 Consideration is also given to changes in prices, international reserves, and the exchange rate. The desirable balance between real income and real absorption and the desirable level of prices, international reserves, and the exchange rate are policy objectives that must be set by the authorities of a country. If the program assumes a substantial inflow of capital from abroad, then the policies must be attuned to this objective as well.

Financial programs that cover a short period of time, such as 12 months, and that are designed to reduce the imbalance between real income and real absorption with reasonable price stability and a given target of international reserves, usually focus on eliminating the most serious distortions that have held back output and on restraining the rate of increase of absorption. Even in such short-run programs, however, attention is given to stimulating the rate of growth through a better allocation of financial and physical resources. In a financial program covering an extended period, such as three years, the authorities consider longer-run policies to bring about a balance between real income and real absorption in order to keep inflation within acceptable limits and to promote a sustainable rate of growth. These could include policies to eliminate structural imbalances, measures to stimulate investment, adjustment of exchange rate and pricing policies to bring about a more desirable resource allocation, measures to promote financial markets, and a reform of the fiscal system.

Financial programming is used in a number of countries, even when the economic situation is satisfactory, in order to ensure further economic progress. However, it is essential to undertake financial programming when, for example, the domestic use of resources or real absorption tends to exceed real income by more than the desired amount and there are excessive price increases or large payments imbalances.

Techniques for Formulating a Financial Program

Various techniques, in principle, may be used to formulate a financial program. If adequate data are available, as well as computing facilities and time, a large-scale econometric model could be built; and if the model is sufficiently reliable (that is, the statistical tests were satisfactory and simulation showed that the model “tracked” quite well over the sample period), it could be used to prepare a financial program. The procedure would be to fix the targets to be achieved in a specified period of time and, after inserting the forecast values for the exogenous variables, the required values of the policy instruments could then be calculated either by solving or by simulating the model.

The computed values of the policy instruments would be subject to various errors associated with this type of analysis—namely, errors in the statistical data used, in the specification of the model, in the estimation procedure, and in forecasting exogenous variables. Furthermore, the stability of the behavioral relationships that are the linkages between variables in the model cannot be taken for granted outside the sample period; this is especially true for a developing economy undergoing rapid structural change. Hence, in the ultimate analysis, judgmental considerations would influence the final decision on the precise values of the policy instruments. Some of the problems associated with prediction on the basis of an econometric model are discussed in the Introduction to Workshops (Chapter 1).

The desirability of having a comprehensive econometric model arises, in part, because a simple model may not accurately portray the structure of the economy and, in part, because the authorities of a country may be concerned with more objectives than the simple model can handle. Even in financial programs where the major objective is a reduction in the balance of payments deficit, the measures aimed at achieving it (such as credit restriction, reduction of the budget deficit, and a change in the exchange rate) usually involve costs in terms of disposable real income that may severely affect certain groups or sectors. The authorities may, therefore, use other policy instruments to minimize these costs—that is, they may utilize multiple policy instruments to achieve multiple targets simultaneously. A comprehensive econometric model will permit the investigation of the effects on all relevant variables of the policy measures that may be used.

When the construction of a comprehensive econometric model is not feasible, it may be necessary to adopt a more pragmatic approach. Nevertheless, the approach must be one that permits judgment of the likely effects of proposed policy actions. On the basis of this pragmatic approach, the authorities should be able to decide on a mix of politically acceptable policy actions that permit the attainment of the primary objectives. One of the various possible methods, which is presented only as an illustration, is described below.

Steps in the Financial Programming Exercise

As a starting point, the values of the exogenous variables needed for the preparation of a financial program may be estimated for the program period—say, the next 12 months. These variables are those over which the current economic policy of the country has relatively little influence during that period, such as the foreign demand for its exports. The next step is to fix tentatively the values of the target variables and to “envisage” the policy actions that may be necessary to achieve such targets, given the values of the exogenous variables. At the outset, a decision must be made whether an adjustment in the exchange rate (a key ingredient in the envisaged policy “mix”) is required in the light of recent, as well as expected, changes in either domestic prices and costs or external factors. If a policy mix is found to be inadequate to achieve the desired targets without an exchange rate adjustment, such an adjustment may have to be envisaged; in this event, a new set of policies consistent with the new exchange rate would be formulated. After this preliminary work, it is necessary to check whether the envisaged policy actions are appropriate to achieve the results expected of the financial program.

A convenient procedure is to estimate the values, for the next 12 months, of the various items appearing in a monetary or financial survey (see Workshop 1), as has been done in Workshop 6: Projection of Monetary Aggregates. These estimates should be made on the basis of the assumed values for the target variables and the exogenous variables. Thus, starting with the monetary survey, “net foreign assets” may be taken as a target variable on the basis of a given exchange rate. This is likely to be the procedure followed in financial programs for countries that have a deficit in the balance of payments and have a low level of international reserves. Accordingly, a value that is desirable in view of the circumstances is assigned to this item.

The next step is to estimate “money.” This is done on the basis of a demand for money function. It is frequently necessary to estimate several different specifications of the demand for money function, including different coverage of the variables in the relationship, in order to find the one that is reasonably satisfactory, i.e., where the relationship is plausible and relatively stable and where the probable magnitude of prediction errors is relatively small. However, in practice, many estimates of the demand for money function contain prediction errors that are uncomfortably large. This leaves room for judgmental considerations to be used in the projection.

If the demand for money is a function of nominal income alone, estimates of the real income and the level of prices over the next 12 months are needed in order to obtain the estimate for money.

The rate of growth of real national income is a policy objective that must be realistic and also be consistent with the other policy objectives. Hence, there is no simple and easy way to estimate the rate of growth of real national income over the next 12 months. It depends on numerous and complex relationships that underlie aggregate supply and demand. On the supply side, perhaps one of the crudest but simplest ways is to investigate the growth of real output over the last few years and then to consider any new factors that are likely to affect real output over the 12-month period. These would include factors affecting agricultural output, particularly in primary producing countries; new plants and equipment coming on stream; measures to increase the rate of capacity utilization, such as changes in import restrictions, particularly on raw materials and semifinished products, and in credit allocation; and changes in the labor force.

On the demand side, it is necessary to consider fiscal, monetary, exchange rate, and incomes policies, as well as economic conditions in the rest of the world that affect the prices and volumes of exports and imports. A simultaneity problem occurs in the estimation of real income. The estimated real income, which is used to estimate the demand for money, is in part determined by the monetary and fiscal policy stances. However, the domestic credit derived from the estimated demand for money (see below), given the amount of net foreign assets, may not be consistent with the monetary and fiscal policy stances envisaged initially. This implies that real income, the demand for money, and the monetary and fiscal policies must be determined simultaneously. Operationally, this difficulty may be circumvented by making general assumptions about the effects of these policies and by checking later to see whether these are borne out by the calculations. Thus, the estimated level of the real national income has to take into account the exogenous factors, as well as the effects of the initially envisaged monetary, fiscal, exchange rate, and incomes policies.

The level of prices over the next 12 months is a target variable. However, as in the case of real national income, the value of this target cannot be set arbitrarily. The prices of imports and exports in foreign currency may be largely outside the sphere of influence of the authorities of the country. The prices of domestic products for the home market may change not only because of events that have already occurred (such as an increase in the wage rate, already granted) or because of likely events over which the authorities have no control, but also because of monetary, fiscal, exchange rate, and incomes policies. The complication of simultaneity again arises—namely, that the level of prices is used to estimate the demand for money, which in turn, together with the supply of money, influences the level of prices. This implies that the demand for money, the supply of money, and the level of prices must be determined simultaneously. A procedure similar to the one described in connection with the estimation of real national income may be used here.

If the demand for money is a function of other variables besides nominal income, such as the expected rate of inflation or the expected rates of return on competing financial assets, these have to be estimated before the amount of money demanded can be calculated. The expected rate of inflation may be inferred from the already estimated level of prices over the next 12 months. Established techniques for generating expectation, such as adaptive expectation or rational expectation, can be utilized. Similarly, the expected rate of interest may be estimated on the basis of the stance of monetary policy and certain behavioral assumptions concerning expectation.

The next step involves the estimation of “quasi-money.” Generally, quasi-money is explained by the same variables as those operating in the demand for money function, or by closely related variables. However, the interest rates on savings and time deposits tend to influence the demand for money and the demand for quasi-money in opposite directions.

For “other items (net)” in the monetary survey, it is useful to check whether this component changes very much from year to year. If it does, the cause of its variations should be investigated so as to derive some basis for estimating the numerical value of this item 12 months hence.

Once money, quasi-money, and other items (net) have been estimated and the target value for net foreign assets has been fixed, the amount of domestic credit of the banking system 12 months hence can be calculated; that is:

DCt=MOt+QMOt+NOItNFAt(1)

where DC stands for domestic credit, MO for money, QMO for quasi-money, NOI for other items (net), NFA for net foreign assets, and the subscript t stands for the value of the variable at the end of the 12-month program period.

Thus, in order to reach the specified target for net foreign assets, the authorities would have to ensure that domestic credit created by the banking system during the next 12 months (ΔDCt) does not exceed the amount

ΔDCt=DCtDCt1(2)

where DCt is given by equation (1) and the subscript t−1 stands for the value of the variable at the beginning of the 12-month program period.

If it is believed that the credit expansion can be limited to the amount calculated in equation (2) without upsetting the estimates of the macroeconomic variables, such as real income and prices, used in estimating the items in equation (1), then the calculated overall credit expansion is considered to be consistent with the policies initially envisaged. However, it is only rarely that the amount of credit expansion calculated in equation (2) turns out to be consistent with the policies initially envisaged, as well as with the estimated values of other variables in the economy. Furthermore, the amount of credit expansion yielded by equation (2) does not indicate how the new credit is to be allocated, for example, between the government and private sectors. Therefore, it is useful to continue the work and to project (on the basis of the estimated exogenous variables and the policy actions) government sector revenue and expenditure, private sector income and expenditure, and the major components of the balance of payments, in order to ensure the internal consistency of the financial program.

On the basis of the forecasts of national income and its major components (e.g., consumption, imports, etc.), it may be possible to estimate the bulk of government revenue. Typically, in fact, the major part of government revenue depends on income, consumption, exports, and imports (as illustrated in Workshop 7: Revenue Forecasting), as well as on the tax structure and the envisaged changes in tax laws and in collection procedure. Implicit or explicit assumptions must already have been made about government expenditure in estimating the national income. Any change in the exchange rate would also affect estimates of government revenue as well as expenditure. The resulting budgetary deficit, if any, may or may not be such that it can be financed through government borrowing abroad, which is reflected in net foreign assets in equation (1) or by the expansion of domestic credit calculated on the basis of equation (2). If such financing of the government is feasible, then the exercise can proceed. Account should be taken of the fact that the private sector and the rest of the public sector (see Workshop 2: Government Finance Statistics) also need bank credit to finance their economic and financial activities. Therefore, the entire amount of the calculated credit expansion is not available to finance the government deficit. If the deficit cannot be financed by borrowing from the banking system or abroad, various possibilities are open—such as borrowing from domestic non-bank sources, increase in taxation, or reduction in government expenditure below the level initially envisaged. But if some of these policy actions change the values of the endogenous variables already used to calculate credit expansion (such as net foreign assets, real national income, and prices), the calculated expansion of credit would also change. If this is the case, the initially envisaged policies are obviously not compatible with the objectives and therefore the exercise must be repeated with different policies or objectives. It may require several iterations before a consistent set of values for the relevant variables is obtained.

On the basis of the forecasts of the state of the world economy and of domestic supply and demand, exports and imports may be estimated. For the values of exports and imports in domestic currency, assumptions about exchange rate policies have to be made. In estimating private capital movements in a country where the exchange system is free of restrictions on capital transactions, it is necessary to take into account domestic interest rates in relation to the interest rates in international money and capital markets. For other items of the balance of payments, it is necessary to use the information available and to investigate the relationships in each specific case (see Workshop 8: Balance of Payments Forecasting). If these estimates yield a value for the outturn of the balance of payments that is compatible with the target for net foreign assets fixed in calculating the credit expansion, the exercise can proceed further.

If the outturn in the balance of payments is not the desired one, different policies (including possibly a different exchange rate) will be required and these will inevitably affect the endogenous variables used elsewhere in the calculations. Thus, it would be necessary to start all over again with fresh assumptions about the policies to be undertaken and perhaps new values for the target variables. This process would continue until policy measures are found that are compatible with the values of the target variables, given the estimated exogenous variables.

The next step would be to calculate the expansion of central bank credit that is compatible with the expansion of banking system credit. This step would be necessary in order to give the authorities an instrument that is essential for both the execution and control of a financial program. Some countries, for a variety of reasons, have strong objections to imposing credit ceilings on individual commercial banks and prefer to impose a single ceiling on central bank domestic credit. If the relationships involved in the estimation of the credit multiplier (i.e., the ratio between total bank domestic credit and central bank monetary liabilities) are stable, the imposition of a ceiling on the central bank domestic credit would effectively constrain bank credit, given the assumptions about net foreign assets. This would avoid involvement in the sensitive and difficult task of allocating credit among banks. Besides, the ceiling on the central bank domestic credit can be readily controlled.

The task is therefore to estimate the relationships between the monetary liabilities of the central bank and the principal components of the consolidated balance sheet of the commercial banks, taking into account the interest rates on both bank deposits and loans (if such interest rates play a role in the case investigated). This exercise may also give an indication of how a government deficit or surplus can be financed, that is, whether it can be financed through direct advances from the central bank, or from commercial banks, or both. It may be found that, for institutional or other reasons, the domestic credit of the central bank has to be higher than that derived from the credit multiplier. If this is so, a policy to reduce the size of the multiplier, such as the imposition of higher reserve requirements on banks or other similar policy actions, may be necessary.

The technical task of preparing a financial program is accomplished when the set of policy measures required to produce the desired targets has been determined.

The technique of financial programming described above has been presented in rather general terms. It should be noted that several iterations may be necessary in order to ensure the overall consistency of the financial program. In actual application of the program to specific cases, suitable modifications may have to be made in the light of the relevant economic circumstances and the availability of data. Furthermore, the order of steps in the financial programming exercise is not sacrosanct; in fact, in the formulation of a hypothetical financial program for Kenya as presented under Exercise and Issues for Discussion, the order of steps differs from that outlined above.

This workshop, which contains an illustration and application of one possible technique of financial programming, provides the elements for preparing a hypothetical financial program for Kenya for the calendar year 1978. The first section discusses the medium-term policy objectives, the annual targets, and the performance criteria incorporated in the International Monetary Fund’s extended facility arrangement for Kenya in fiscal years 1976–78. The second section reviews the actual performance of the Kenyan economy and discusses the implementation of government policies during 1975 and 1976. The third section describes and analyzes Kenya’s economic situation in 1977. In conclusion, the section on Exercise and Issues for Discussion contains a possible methodology to be utilized for the formulation of a hypothetical financial program for Kenya in 1978. It is assumed that the program is being formulated in early January 1978. The forecasting techniques and other elements of information from previous workshops may be used as ingredients in the preparation of this financial program.

OBJECTIVES AND POLICY CRITERIA FOR KENYA’S EXTENDED FACILITY PROGRAM

Kenya has experienced payments imbalances in recent years because of an adverse trend in the external terms of trade and policies that have resulted in increases in both the capital intensiveness and import intensiveness of production. Gross official international reserves declined from SDR 220 million (equivalent to six months’ imports) at the end of 1970 to SDR 162 million (equivalent to two months’ imports) at the end of 1974. The authorities considered that a lower rate of growth than the 6.5 per cent achieved during the 1965–74 period was more realistic, in view of these developments. In addition, to prevent further deterioration in the balance of payments, prices needed to be stabilized.

Accordingly, in July 1975, the Government of Kenya undertook a three-year program, supported by the use of the International Monetary Fund’s resources under an extended facility arrangement, seeking the attainment of (1) an annual rate of growth in real gross domestic product (GDP) of 5 per cent, (2) a rate of increase in domestic prices substantially lower than that of import prices, and (3) the elimination of the need for balance of payments assistance by 1980. To achieve these objectives, the program stressed both medium-term policies, designed to change Kenya’s structure of production and pattern of factor use, and short-term demand management policies. The medium-term policies attempted to shift public and private investment toward agriculture, mainly through increased development outlays on agriculture, provision for remunerative producer prices, and more adequate credit facilities; to reform the tariff structure, which had favored imports of capital goods and raw materials; and to hold down the labor-capital cost ratio through wage guidelines.

Within the medium-term framework, Kenya’s financial program for fiscal year 1976 was formulated to promote specific objectives. The growth target for real GDP was set at 5.4 per cent in 1975 and 5.1 per cent in 1976 (Table 1). In spite of the intended policy shifts, the overall balance of payments deficits were forecast at KSh 732 million (SDR 84 million) in 1975 and KSh 400 million (SDR 41 million) in 1976. These targets implied a limitation of the increase in total domestic credit to 19 per cent in fiscal year 1976, with the increase in credit to the private sector being contained to 17 per cent. To control the expansion in total credit, ceilings were put on the level of net domestic assets of the Central Bank of Kenya.2 Government capital expenditure and lending minus repayments were to rise by about 20 per cent over fiscal-year 1975 actuals and were to be reoriented toward agriculture. The overall budget deficit was estimated at KSh 1.4 billion. A limit, consistent with the overall limitation on increase in bank credit, was placed on borrowing by the Government from the banking system for this fiscal year.

TABLE 1.

Kenya: Total Availability and Use of Resources, 1974–78

(In billions of Kenya shillings)

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Source: Rattan J. Bhatia and Saul L. Rothman, “Introducing the Extended Fund Facility: The Kenyan Case,” Finance and Development, Vol. 12, No. 4 (December 1975), pp. 39–41, table on p. 41.

At constant 1974 prices.

In the financial program formulated in June 1976 for fiscal year 1977, the second year of the extended facility arrangement, the targets for growth of real GDP were 4.9 per cent in calendar year 1976 and 5.2 per cent in 1977. The balance of payments targets were overall deficits of KSh 400 million (SDR 41.4 million) in 1976 and KSh 460 million (SDR 47.6 million) in 1977. The program envisaged an increase in money plus quasi-money of 10 per cent during the program period. It implied an overall increase in domestic credit of 21 per cent. Credit to the nongovernment sector was expected to increase by 18 per cent. These rates of credit expansion were calculated to contain imports to levels consistent with the GDP and balance of payments targets. The financial program for fiscal year 1977 also included one performance clause limiting the increase in net domestic assets of the Central Bank of Kenya and another limiting government borrowing from the banking system. The budgetary targets were to reduce the magnitude of the overall deficit and to maintain the real level of capital expenditure, thus implying a significant reduction in the rate of increase in real current expenditure.

The observance of the limits on the net domestic assets of the Central Bank, as well as of those on net credit to the Government, would be a condition for Kenya’s access to Fund resources under the proposed arrangement.3 In addition, the conditionally included the Government’s intention not to introduce any multiple currency practices or any new restrictions, nor to intensify existing ones on payments and transfers for current international transactions, nor to introduce restrictions or intensify existing ones on imports.

POLICY IMPLEMENTATION AND ECONOMIC PERFORMANCE IN KENYA IN 1975–76

The Kenyan authorities implemented several measures that were envisaged in the program. Following the 30 per cent rise in producer prices for domestically consumed agricultural commodities in January 1975, producer prices for maize, wheat, and milk were raised by an average of 28 per cent in September 1976. In mid-1975, the Government announced new wage guidelines limiting the average rate of increase in wages and salaries to 75 per cent of the increase in the consumer price index. These guidelines were revised further in February 1976 to limit average wage and salary increases to two thirds of the increase in the consumer price index. In July 1975, the Central Bank of Kenya issued a directive requiring commercial banks to increase the share of their deposits lent to the agricultural sector by 7 percentage points, to 17 per cent by the end of June 1976. Government capital expenditure and lending minus repayments were also shifted in favor of the agricultural sector. In October 1975, Kenya depreciated the shilling by about 12 per cent and changed its peg from the U.S. dollar to the special drawing right (SDR). A wide-ranging import tariff reform was initiated to discourage excessive use of imports and to encourage the use of domestic raw materials and factors of production.

The economic picture that emerged for 1975 was mixed. For the second successive year, there was a decline in the rate of economic growth. Real GDP increased by only 1.2 per cent, mainly because of unusually bad weather conditions. Nevertheless, there was a substantial improvement in the balance of payments, as well as some moderation of inflation. The balance of payments in 1975 showed a deficit of KSh 338 million (SDR 47 million), which was considerably smaller than the extended facility program’s target of a deficit of KSh 732 million (SDR 84 million). The annual rate of increase in the cost of living for the lower-income group in 1975 as a whole was 19.2 per cent, which was slightly higher than in 1974. However, the increase in the second half of 1975 was much lower than in the first half. The budget outturn indicated a shortfall in revenue as well as greater current expenditure than initially budgeted. Development projects were cut back, but cost overruns kept the nominal level of capital expenditure only slightly short of the budgeted level. Net credit to the Government from the banking system amounted to KSh 400 million for fiscal year 1976 and KSh 837 million for the calendar year 1975. The domestic counterpart of Kenya’s SDR allocation (KSh 134 million) was transferred in September 1975 to treasury deposits with the Central Bank. Money and quasi-money increased by 17 per cent in 1975. Domestic credit went up by 29 per cent, while net foreign assets (net of Fund credit) actually declined.

In 1976 economic conditions were much more favorable. Real GDP increased by 6.1 per cent, wage employment rose by 4.7 per cent, the inflation rate (in terms of the cost of living for the lower-income group) was reduced to 11.4 per cent, and the balance of payments recorded a large surplus of KSh 776 million. The rise in world prices for coffee, Kenya’s major export, and the improvement in weather conditions were the most important factors underlying this turnaround, but the economy also might have responded to the policy shifts introduced in 1975 and 1976. The budgetary situation did not register the expected improvement, mainly because of a substantial increase in defense expenditure for fiscal year 1977. Nevertheless, there was a small reduction in the overall budget deficit. Net credit to the Government from the banking system amounted to minus KSh 5 million for fiscal year 1977 and KSh 131 million for calendar year 1976. The rate of growth in money and quasi-money accelerated to 24 per cent in 1976. Domestic credit expanded by 17 per cent, while net foreign assets increased by two and a half times to KSh 1,459 million.

ECONOMIC DEVELOPMENTS IN KENYA IN 1977

In 1977, the rate of Kenya’s economic growth accelerated and the balance of payments registered a record surplus, mainly because of favorable weather conditions and a continued upsurge in coffee prices. However, inflation worsened, and the budgetary situation remained under pressure, as the Kenyan authorities were obliged to incur a substantial increase in expenditures on defense and development.

Production, Expenditure, and Prices

The rate of increase in real GDP accelerated from 6.1 per cent in 1976 to an estimated 7.3 per cent in 1977 (Tables 2 and 3). Agricultural production is estimated to have increased by about 12 per cent, attributable mainly to favorable weather conditions and the continued increase in export prices. Production of coffee, tea, and sugarcane increased by 21 per cent, 39 per cent, and 14 per cent, respectively, while other crops and livestock products showed little change. Manufacturing output is estimated to have risen by 15 per cent. The effects on this industry of the expansion of rural output and incomes more than compensated for the disruptive effects of the breakup of the East African Community (EAC) in 1977. The output of building and construction is estimated to have increased by 6 per cent, compared with a decline of 5 per cent in 1976, reflecting a turnaround in private residential building activity and the start of several major government projects (e.g., the Upper Tana Reservoir, Mombasa Water Supply Development Program, and Bura Irrigation Project). Tourism was adversely affected by the closing of the Tanzanian border. Nevertheless, the decline in the number of visitors was offset by an increase in the average length of stay, resulting in a 7 per cent increase in the number of bed-nights for tourists. Output of transport and communications is estimated to have declined by 6 per cent, reflecting mainly the strains experienced by the EAC corporations and the closure of the Tanzanian border. Wholesale and retail trade, distribution, and other sectors of the economy all recorded reasonable rates of increase.

TABLE 2.

Kenya: Selected National Accounts Data, 1975–77

(In millions of Kenya shillings)

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Source: Kenya, Economic Survey, 1978.

Provisional figures.

TABLE 3.

Kenya: Sectoral Origin of Gross Domestic Product, 1974–77

(In millions of Kenya shillings)

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Source: Kenya, Economic Survey, 1978.

Provisional figures.

Aggregate domestic demand (as measured by the sum of consumption and investment expenditures) rose by an estimated 24 per cent in nominal terms, compared with 19 per cent in 1976. Gross fixed capital formation as a proportion of GDP rose from 20 per cent in 1976 to 21 per cent in 1977. The ratio of consumption to GDP declined from 79 per cent in 1976 to 75 per cent in 1977. Private sector investment in real terms increased most significantly in agriculture (44 per cent); transport, storage, and communications (30 per cent); and manufacturing (15 per cent). By type of asset, investment in 1977 mainly took the form of machinery and equipment. The decrease in the consumption ratio reflected, in part, the reinvestment of the gross farm revenue and business profits and, in part, the impact of the wage guidelines.

Wage employment rose by 5.3 per cent in 1977, with the most significant expansion occurring in finance, insurance, real estate, and business services (16 per cent); transport and communications (9 per cent); and manufacturing (8 per cent). Wage employment in agriculture also expanded by 4 per cent, compared with a decline of 1 per cent in 1975 and an increase of 1 per cent in 1976. Employment in the public sector went up by 5.6 per cent in 1977, compared with an increase of 4.1 per cent in 1976. While in 1976 growth of public sector employment was largely concentrated in central government employees, in 1977 the rise in public sector employment occurred mainly in the parastatal bodies and other enterprises partly owned by the public sector.

Average wage earnings rose by 8 per cent in 1977, compared with 16 per cent in 1976. The rate of increase of average earnings in the public sector decelerated more than that in the private sector. The 9 per cent increase in average earnings in the private sector was in accordance with the wage guidelines, which allowed an average increase in wage earnings equivalent to two thirds of the increase in the cost of living. The highest increase in average earnings in 1977 occurred in manufacturing (13 per cent); transport and communications (11 per cent); and trade, restaurants, and hotels (9 per cent). Average earnings in agriculture declined by about 1 per cent, compared with an increase of 17 per cent in 1976.

In spite of the increase in domestic supply, inflation emerged as the foremost problem in 1977. The sharp increase in domestic liquidity, together with an upward adjustment of retail prices of foods to correspond with higher producer prices, exerted considerable pressure on consumer prices. Between December 1976 and December 1977 consumer prices for the lower-income group in Nairobi rose by 21.0 per cent. The food index went up by 17.2 per cent while the rent index rose by 31.9 per cent for the lower-income group. In terms of the implicit GDP deflator, inflation was estimated at about 20 per cent in 1977.

Balance of Payments

Kenya’s balance of payments recorded an overall surplus of more than KSh 2 billion in 1977 (Table 4). The value of merchandise exports rose by 51 per cent (4 per cent in volume), and that of merchandise imports rose by 31 per cent (21 per cent in volume). The terms of trade improved by about 32 per cent following an improvement of 17 per cent in 1976. The trade deficit declined sharply, while the combined surplus in invisibles and capital accounts remained broadly unchanged. At the end of December 1977, Kenya’s gross international reserves were SDR 438 million, or the equivalent of about five months’ imports.

TABLE 4.

Kenya: Balance of Payments Summary, 1976–77

(In millions of Kenya shillings)

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Sources: For current account and capital account (except commercial banks), the data are taken from Kenya, Economic Survey, 1978. The data for commercial banks and financing are taken from International Monetary Fund, International Financial Statistics, July 1978, in order to ensure consistency with the monetary accounts for purposes of financial programming. The adjustment for the resulting discrepancy is contained in the residual item, errors and omissions.Note: n.e.s. = not elsewhere specified.

Includes foreign banks’ deposits with the Central Bank of Kenya and International Monetary Fund deposits.

The principal factor underlying the overall improvement in 1977 was the continued rise in the prices of coffee and tea, Kenya’s major exports. While these prices peaked in late spring 1977, their weighted averages for the year were higher than in 1976 by 80 per cent and 91 per cent, respectively. Export volumes of coffee and tea also rose by 22 per cent and 19 per cent, respectively. Kenya’s “other” exports, which include some manufactured products, rose slightly (5 per cent) in value despite the virtual loss of the Tanzanian market.

The increase in imports was due, in part, to higher incomes and greater availability of domestic credit and, in part, to greater government imports, including those of new capital equipment required for replacing some EAC corporations by Kenyan corporations and defense-related imports. The average propensity to import was 32 per cent, which was about the same as in 1976 but lower than in 1974 and 1975 when high oil prices raised the import propensity to an average of 39 per cent.

As a result partly of the dissolution of the East African Community, and even more as a result of the closure of the Tanzanian border, Kenya’s tourist and other service receipts grew more slowly in 1977, while payments of investment income rose faster, reflecting higher profits of foreign firms, particularly those engaged in production and marketing of Kenya’s major exports. Larger inflows of private capital, mostly direct investment, were partly offset by a decline in government capital inflows.

Public Finance

Kenya’s budgetary position improved considerably in fiscal year 1977, as the overall deficit declined by 22 per cent to KSh 1.3 billion (Table 5). Current revenue increased by 20 per cent as a result of a general economic recovery, while total expenditure increased by 17 per cent. External financing fell short of the budgeted level, but the Government succeeded in mobilizing funds from the domestic non-bank sector. Thus, the recourse to the banking system decreased.

TABLE 5.

Kenya: Summary of Central Government Budgetary Operations, Fiscal Years 1976–78

(In millions of Kenya shillings; year ending June 30)

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Sources: International Monetary Fund, Government Finance Statistics Yearbook, Vol. 2 (1978) and International Financial Statistics, various issues; Central Bank of Kenya, Annual Report for the Financial Year Ended 30th June, 1977; Kenya, Estimates of Revenue, 1977/78, Estimates of Recurrent Expenditure, 1977/78, and Development Estimates, 1977/78.

Budget estimates.

Includes operating revenue of departmental enterprises.

Includes operating expenditure of departmental enterprises.

The budget for fiscal year 1978 was formulated against the background of the forecast of a record high balance of payments surplus. Although realizing the danger of renewed acceleration of inflation, the Government felt that there was a need to step up development effort. Budget estimates aimed at increasing the current account surplus by restraining the growth of current expenditure to below that of current revenue. New tax measures, including an export tax on coffee and tea, were estimated to generate KSh 500 million of revenue. Capital expenditure and lending minus repayments were projected to rise sharply, and the overall budget deficit was estimated at KSh 2.4 billion. About half of the deficit was expected to be financed by borrowing from the banking system, including financing by the Cereals and Sugar Finance Corporation.

Since the inception of the budget for fiscal year 1978, two developments have assumed increasing importance. First, the dissolution of the East African Community has necessitated additional expenditure to set up Kenyan replacements for various EAC corporations. Second, defense expenditure increased more than anticipated. The budgetary outturn during the first half of fiscal year 1978 showed an overall budget deficit of KSh 1.3 billion. Current revenue was increasing significantly faster than current expenditure. Capital expenditure was running below the budgeted rate, primarily because deliveries of equipment were later than expected. During this period, the budget deficit was financed almost equally by nonbank domestic borrowing (KSh 565 million) and by bank borrowing (KSh 537 million). The latter included KSh 232 million of financing from the Cereals and Sugar Finance Corporation.

Money and Credit

The growth in money and quasi-money accelerated sharply in Kenya from 25 per cent in 1976 to 47 per cent in 1977 (Table 6). Both the increase in net foreign assets and the increase in domestic credit contributed to the monetary expansion. Domestic credit increased by 24 per cent in 1977, as the 34 per cent increase in credit to the private sector was only partially offset by a decline of KSh 98 million in net credit to the Government. The expansion in private sector credit occurred in response to rising economic activity and to higher prices, as well as to a relaxation of the limits on domestic borrowing by foreign companies. Beginning in April 1977, foreign-controlled companies engaged in direct agricultural production and manufacturing and tourism industries were allowed to borrow locally up to 100 per cent of their investment while previously such borrowing had been limited to between 20 and 60 per cent.

TABLE 6.

Kenya: Monetary Survey, 1973–77

(In millions of Kenya shillings)

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Sources: Central Bank of Kenya, Annual Report for the Financial Year Ended 30th June, 1977; International Monetary Fund, International Financial Statistics. Jury 1978.

Foreign liabilities include use of Fund credit.

Foreign exchange holdings.

Includes Cereals and Sugar Finance Corporation and Agricultural Finance Corporation.

Adjusted for “uncleared effects.”

The domestic counterpart of Kenya’s SDR allocation was transferred in September 1975 to treasury deposits with the Central Bank of Kenya.

In terms of the sectoral distribution, credit to all sectors, except building and construction, expanded sharply. Credit to the priority sectors of agriculture, manufacturing, and African small-scale enterprises rose by 34 per cent, 33 per cent, and 39 per cent, respectively. Because of the large expansion of deposits, credit to the agricultural sector in 1977 averaged only about 12 per cent of commercial bank deposits, considerably below the 17 per cent requirement set by the Central Bank.

The decline in net credit to the Government reflected a considerable improvement in the budgetary position, particularly during the first half of 1977. With a view to reducing the creation of primary liquidity, the Government shifted its bank borrowing from the Central Bank to commercial banks. Thus, the Government’s position with the Central Bank changed from a net debtor position of KSh 778 million at the end of 1976 to a net creditor position of KSh 35 million by the end of 1977. At the same time, net credit from commercial banks to the Government rose by KSh 715 million.

Commercial banks were highly liquid throughout the year. Their liquidity ratios averaged 32 per cent, compared with the legal requirement of 18 per cent. In mid-1977, the Central Bank announced that, effective January 1, 1978, the liquidity ratio requirement would be raised to 20 per cent. In September 1977 the Central Bank announced a redefinition of liquid assets to net out interbank borrowing, which became effective January 1, 1978.

The composition of money and quasi-money stayed about the same as in 1976. Reflecting the increase in domestic liquidity, the average tender rate for treasury bills declined from over 4 per cent at the beginning of 1977 to about 1 per cent at the end of the year.

EXERCISE AND ISSUES FOR DISCUSSION: A Hypothetical Financial Program for Kenya in 1978

A discussion of the following issues may help in formulation of a financial program for Kenya for calendar year 1978.

Issues for Discussion

1. Given the Kenyan authorities’ objectives, what do you consider to be the principal problem areas in recent economic developments of the Kenyan economy? Would you suggest any change in the medium-term strategy? Are there corrective actions needed in 1978, particularly in the areas of bank liquidity, import restrictions, tax efforts, wage guidelines, and price controls?

2. Comment on the appropriateness and the effects of the 1975 and 1976 wage guidelines and the exchange rate depreciation of 1975.

3. What scenario would you anticipate in 1978 for government expenditure and coffee prices? How does this scenario affect the desire of the Kenyan authorities to curb inflation?

4. In general, how does the choice of the targets for growth, inflation, and international reserves influence the formulation of a financial program? Are these objectives conflicting?

5. Discuss the rationale for setting a ceiling on the expansion of domestic credit of either the Central Bank or the banking system, and the appropriateness of allocating total domestic credit among different sectors of the economy by administrative decision. What is the impact on the economy of a ceiling on government borrowing?

Exercise: A Suggested Procedure

It is assumed that the financial program for Kenya for the calendar year 1978 is being formulated in early January 1978. A suggested, though by no means exclusive, procedure for drawing up the financial program is outlined below.

1. Indicate the principal objectives that are to be attained for the calendar year 1978. Among the objectives that should be considered are the growth rate in real GDP,* the rate of price increase, and the desirable balance of payments outturn (a minimum surplus or a maximum deficit). In fixing the GDP target for 1978, it should be determined whether the medium-term growth objective is realistic.

2.Given the preliminary selected objectives, forecast the components of the balance of payments and the overall balance of payments deficit or surplus for 1978. Is the forecast balance of payments outturn compatible with the assumed objectives? If not, there are several choices available. First, you can change the assumed objectives to make them more consistent with your forecast. Alternatively, you can change policies if you insist on the attainment of the objectives. In this case, you may consider varying capital flows either through renegotiation of foreign debts or through drawing on official loans, or you may consider putting more restrictive controls on the foreign borrowing of the commercial banks. You may also consider a change in the exchange rate or a change in monetary and fiscal policy. Note that these changes will also affect domestic prices and production.

3. Having determined the target for the level of net foreign assets of the banking system and the policies involved, you can now proceed to construct the “desired” balance sheet for either the banking system or the monetary authorities of Kenya. For the balance sheet of the banking system as a whole, this procedure may be followed:

(a) Estimate the demand for money and quasi-money on the basis of the target rate of growth of output and prices established in (2) above. The observed ratio of money to quasi-money over several periods may be useful for this projection.

(b) Calculate the desired domestic credit for the banking system according to the monetary survey identity. Table 6 may be used for the calculations.

For the balance sheet of the monetary authorities of Kenya, a possible procedure is the following:

(a) Fix the desired net international reserves of the monetary authorities.

(b) Estimate the demand for money.

(c) Project the monetary liabilities of the monetary authorities. The observed ratios of these liabilities to total money stock over several periods may be useful for this projection.

(d) Project the net domestic assets of the monetary authorities that are equal to reserve money less the desired net international reserves of the monetary authorities, compatible with the estimated demand for money and the level of international reserves. Table 7 may be used for this purpose.

TABLE 7.

Kenya: Summary Accounts of the Monetary Authorities, 1973–77

(In millions of Kenya shillings)

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Sources: Central Bank of Kenya, Annual Report for the Financial Year Ended 30th June, 1977; International Monetary Fund, International Financial Statistics, July 1978.

Includes balances with banks abroad and foreign securities.

Includes use of Fund credit.

Includes revaluation account, uncleared effects, and other unclassified assets and liabilities.

The domestic counterpart of Kenya’s SDR allocation was transferred in September 1975 to treasury deposits with the Central Bank of Kenya.

4. The credit projections so derived are in accordance with the target rate of growth in GDP and the target level of net international reserves. However, the projection for either domestic credit of the banking system or net domestic assets of the monetary authorities of Kenya may not be compatible with both the Kenyan Government’s budgetary position and the private sector investment plan.** Make a forecast for the principal items in the Government’s budget (revenue as well as expenditure). The forecast of tax revenue has to be consistent with the target rate of growth in nominal income, flows of international trade that affect government receipts, and the proposed changes in tax laws, administration, or structure. Calculate the required borrowing (net) of the Government from the banking system for the program period. Seek to reconcile the projections for the balance of payments and the monetary aggregates with the projections for government revenue and expenditure and for investment of the private sector.

5. Re-examine the entire program to see whether it is internally consistent and whether it is realistic and feasible. For this purpose, it may be useful to construct a summary of flow-of-funds accounts for the program period similar to that which appears in Workshop 4: Flow of Funds. Does the program imply substantial deviation from the past performance of the economy? If so, are the required changes in the available policy instruments feasible? If new instruments are proposed, to what extent can they be effectively used during the program period? Insofar as possible, state how your program can be implemented.

6. Determine the performance criteria for the program. Among possible criteria, the following are often utilized: (a) a limit on the domestic credit of the banking system, (b) a limit on the net domestic assets of the monetary authorities, (c) a limit on the net credit to the Government from the banking system, (d) a limit on new short-term and medium-term foreign borrowing by the public sector and the banking system, and (e) a limit for the decline in net foreign assets of the banking system. Are there other performance criteria that might produce the desired effect in the context of Kenya?

APPENDIX

Kenya: Selected Statistical Data, 1966—77

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Fiscal year figures. For example, the figure for 1966 is for fiscal year July 1, 1965 to June 30, 1966.

1

Absorption is defined as consumption plus investment, both private and public.

2

Defined as the sum of currency issued plus nonbank private deposits minus net foreign assets.

3

Conditionality of this nature is required for extended facility programs that involve drawings from the International Monetary Fund above the first credit tranche.

*

Projections for sectoral growth and the demand components in the economy (Tables 2 and 3) are often useful in order to arrive at a reasonable target for the rate of growth in GDP.

**

Sometimes the credit expansion so calculated must be adjusted several times. The reason is that the change in the rate of credit expansion would have an impact on the macroeconomic aggregates, including both GDP and net international reserves, which have been taken as given (targets) in the initial calculations of the credit projection.