Kenya
Recent Economic Developments

This paper reviews economic developments in Kenya during 1990–95. Real GDP growth decelerated from 4.3 percent in 1990 to close to zero in 1992/93. Inflation accelerated from 12 percent in the 12-month period ended December 1989 to 34 percent in March 1993. The central government’s budget deficit increased from 6.7 percent in 1989/90 to 11.4 percent of GDP in 1992/93. Broad money growth (M2) accelerated from 21 percent in the 12-month period ended December 1991 to 36 percent in March 1993.

Abstract

This paper reviews economic developments in Kenya during 1990–95. Real GDP growth decelerated from 4.3 percent in 1990 to close to zero in 1992/93. Inflation accelerated from 12 percent in the 12-month period ended December 1989 to 34 percent in March 1993. The central government’s budget deficit increased from 6.7 percent in 1989/90 to 11.4 percent of GDP in 1992/93. Broad money growth (M2) accelerated from 21 percent in the 12-month period ended December 1991 to 36 percent in March 1993.

I. Introduction

The Kenyan economy performed relatively well in the first two decades after independence in 1963. Real GDP grew at an annual average rate of 7 percent, and substantial improvements in living standards were achieved. Kenya’s economic performance began to weaken in the mid-1980s--resulting in a slowdown in real GDP growth to an average of 5 percent in 1986-90 and a deterioration in social indicators of welfare--and worsened further in the early 1990s, culminating in an economic crisis in early 1993. Real GDP growth decelerated from 4.3 percent in 1990 to close to zero in 1992/93. Inflation accelerated from 12 percent in the 12-month period ended December 1989 to 34 percent in March 1993. The Central Government’s budget deficit (commitment basis and excluding grants) increased from 6.7 percent in 1989/90 to 11.4 percent of GDP in 1992/93. Broad money growth (M2) accelerated from 21 percent in the 12-month period ended December 1991 to 36 percent in March 1993. Although the current account deficit (excluding official transfers) was reduced from 10.3 percent of GDP in 1989 to 4.1 percent in 1992 through quantitative restrictions on imports, gross international reserves fell to the equivalent of about one month of imports in early 1993. External payments arrears developed in 1991-92 for the first time in Kenya’s history.

The main factors that contributed to this crisis were the following:

♦ Political uncertainties associated with the transition to a multiparty democracy; opposition parties were legalized in December 1991 and multiparty elections were held in December 1992 for the first time since independence; the political changes also contributed to increased ethnic tensions, which led to the loss of lives, destruction of property, and displacement of an estimated 250,000 people;

♦ Massive credits extended by the Central Bank of Kenya;

♦ Adverse exogenous shocks, including irregular rainfalls, a large influx of refugees from neighboring countries, and substantial declines in prices of Kenya’s export products;

♦ Suspension of balance of payments assistance from bilateral donors in late 1991, which reflected the donors’ concern over political and economic reforms;

♦ Economic policy reversals, in particular in the liberalization of the external sector and the maize market; and

♦ Continued difficulties in government budgetary management and inefficiencies in the public enterprise sector.

Faced with the economic crisis, the Government adopted in April 1993 a macroeconomic framework for the remainder of 1993, designed to begin stabilizing the economy and to resume economic reforms. On the basis of good progress under this framework, an economic program was adopted for he period October 1993-September 1994, with support from the Fund. In the context of this program, Kenya made major strides in economic reform. In response, inflation decelerated to less than 7 percent in the 12-month period ended December 1994, the current account deficit (excluding official transfers) was reduced to 0.4 percent of GDP in 1994, and gross international reserves increased to the equivalent of 3.7 months of imports at end-1994. Exports responded favorably to external liberalization and this, together with the return of normal weather conditions, led to a recovery in economic activity. Real GDP grew by 3 percent in 1994.

The major achievements in Kenya’s economic reform since April 1993 include:

♦ a tightening of monetary policy, through sales of treasury bills, increases in the reserve requirements, tightened access to central bank credit, and collection of outstanding central bank credits;

♦ re-establishment of stability in the financial system, which was achieved, inter alia, through the closure of a number of weak financial institutions;

♦ the re-establishment of fiscal restraint, through revenue measures and improved expenditure management such that the overall budget deficit (excluding grants) was reduced from 11.4 percent of GDP in 1992/93 to 8.0 percent of GDP in 1993/94 and 2.5 percent of GDP in 1994/95;

♦ the liberalization of the external sector, with the removal of trade and exchange restrictions and reduction in import tariffs, as well as a simplification of the overall tariff structure;

♦ a substantial deregulation of domestic activities, including the removal of price controls, the liberalization of the maize and petroleum markets, and some easing of the labor market guidelines; 1/ and

♦ the reduction of the size of the civil service.

The key area where progress fell short of expectations was public enterprise reform. Although the financial performance of some key enterprises improved, the public enterprise sector continued to represent a heavy burden on the central government budget. Moreover, while the privatization program was ahead of schedule in terms of the number of public enterprises privatized, the, process of privatization gave rise to concerns. In particular, the enterprises privatized were on the whole small and relatively insignificant, and the privatization process was not fully transparent.

This report reviews economic developments and reform in Kenya since April 1993. It is organized as follows: Chapter II reviews the domestic economy; Chapter III discusses central government operations, including civil service reform; Chapter IV provides an overview of the public enterprise reform program; Chapter V discusses monetary policy developments and financial sector reform; and Chapter VI reviews balance of payments developments and external sector reform. Appendix I provides a summary of the tax system as of August 1, 1995, Appendix II summarizes the exchange and trade system, and Appendix III includes the statistical tables.

II. Domestic Economy

1. Production

a. Overall trend

Real GDP growth declined steadily from 4.3 percent in 1990 to 0.5 percent in 1992 and 0.2 percent in 1993 (Chart 1, Table 1). This development reflected a prolonged drought, compression of imports, political turmoil related to the transition to a multi-party democracy, and a decline in investment. In 1994, real GDP grew by 3 percent, in response to the economic reforms pursued since early 1993 and the return of normal weather conditions.

CHART 1
CHART 1

KENYA: Real GDP Growth, 1989–94

(In percent)

Citation: IMF Staff Country Reports 1995, 133; 10.5089/9781451821031.002.A001

Sources: Data provided by the Kenyan authorities; and staff estimates.1/ Includes agriculture, forestry, and mining.2/ Includes manufacturing, construction, and utilities.3/ Includes all services.

The Kenyan economy is relatively diversified. During 1989-94, the share of the primary sector in GDP (essentially the agricultural sector) was reduced from 31 percent to 28 percent. The secondary sector (manufacturing, construction, utilities) remained stable at about 20 percent of GDP; a slight increase in the share of the manufacturing sector, to nearly 14 percent of GDP, was offset by a decline in the construction sector to about 4 percent of GDP. Finally, the share of the tertiary sector increased from 50 percent to 53 percent of GDP; the financial sector and other services (including government services) contributed to the increase in the tertiary sector share.

b. Agriculture

In 1993, the agricultural sector as a whole performed poorly for the third year in a row, and real value added in the sector declined by 3.5 percent. This poor performance was caused by unfavorable weather and rising costs of production due to inflation and the depreciation of the Kenya shilling. The performance was particularly poor for food crops such as maize, wheat, and paddy rice (Table 7). In 1994, the agricultural sector registered a major turnaround and grew by 5 percent, helped primarily by the return of favorable weather conditions. Large increases in world coffee prices helped sustain coffee export earnings, while the appreciation of the currency weakened other agricultural exports. The performance of agriculture over the period was enhanced by the liberalization of marketing and pricing of a number of crops, favorable external market conditions for tea, coffee, and horticultural products, improved price incentives (including retention of foreign exchange earnings), and reductions in import duties on some agricultural inputs.

Tea production recovered strongly in 1993 and remained stable in 1994 with 209,000 tons sold to the Tea Marketing Board. It is the largest agricultural production in Kenya and accounts for 35 percent of the value of total agricultural production (Table 8). Tea is also second behind tourism in foreign exchange earnings (US$301 million in 1994), and accounted for 20 percent of exports of goods in 1994. Kenya is the world’s third largest producer of black tea, and accounts for 15 percent of the world market. A number of factors contributed to the favorable performance of the tea sector in 1993: the “short rains” prior to the drought had been sufficient to maintain production in the early part of 1993; rural access roads were improved; and the tea sector was liberalized, with the introduction of dollar-based tea auctions. Smallholders account for slightly more than 55 percent of total production. The yield in tea production by smallholders has been stable since 1990, at about 75 percent of the yields realized by large estates (2,817 kg per hectare). The areas cultivated for tea production have increased by 9 percent since 1990, to 106,000 hectares in 1994.

After a period of sustained decline from the 1980s to 1993, the coffee sector turned around in 1994, with nearly 82,000 tons of coffee delivered to the Coffee Board of Kenya, compared to 77,800 tons in 1993. Coffee is Kenya’s second largest agricultural production with 22 percent of total agricultural value in 1994 and the third largest foreign exchange earner (US$233 million) behind tourism and tea. It accounted for 16 percent of exports of goods in 1994. The gradual recovery of coffee prices since 1991 and coffee trading incentives have helped revive the coffee industry. 1/ Auctions of the Coffee Board of Kenya have been denominated in foreign exchange since October 1992. A new payment system was implemented in March 1993, providing direct payments to cooperatives according to the lots purchased at the auction. 2/ As a result, coffee farmers have benefited from higher revenues, and the lag between the deliveries of cherries and payment has been considerably shortened. Milling was also liberalized in December 1994, breaking the monopoly of Kenya Planters Cooperative Union (KPCU). Cooperatives continued to dominate coffee production in 1993/94, accounting for 52 percent of the marketed crop, while large-scale commercial farms accounted for the remainder. The productivity of cooperatives, however, declined by about 40 percent between 1990 and 1993, to 347 kg per hectare, whereas the large-scale farms were able to maintain much higher yields at about 935 kg per hectare. Cultivated coffee areas have been fairly stable since 1989/90 and covered 158 thousand hectares in 1994.

The livestock sector accounted for 18 percent of the total value of agricultural production in 1994, the third largest sector. Marketed milk production increased by 13 and 4 percent in 1993 and 1994, respectively, to reach a level of 258 million liters in 1994. This increase in milk production reflected in part the liberalization of the milk industry in May 1992. Sales and purchases of milk were liberalized; consumer and producer prices were decontrolled; and competition in the processing of milk was allowed. As a result, the Kenya Co-operative Creameries (KCC) has lost its monopoly on the marketing of milk and milk products. Deliveries to KCC have declined, while firms registered by the Kenya Dairy Board (KDB) have increased their share to 15 percent of total deliveries.

The sugarcane production increased by 8 percent in 1993, but declined by 16 percent in 1994, to 3.3 million tons. The reduced production in 1994 was precipitated by large imports of sugar in response to the liberalization of the economy. This resulted in Kenyan sugar factories taking a long time to clear their sugar stocks and reducing their purchases of sugarcane.

Maize and wheat productions dropped by 25 percent and 42 percent in 1993, respectively. These dramatic declines were caused by unfavorable rainfalls, high fertilizer prices, and low quality of the marketed seeds. The prolonged drought had also discouraged planting, reducing the hectarage under cultivation of maize. In 1994, production of both maize and wheat recovered as a result of good weather conditions, lower input prices, and the complete liberalization of grain marketing (see Section II.4). Production of wheat increased by 44 percent to 105 thousand tons in 1994, though this level was only equivalent to 53 percent of the 1991 production. The production of maize for the crop season 1994/95 was 34 million bags, the highest since 1991/92 and nearly twice the 1993/94 production.

The production of fresh horticultural products for export stagnated in 1993 and increased by 5 percent in 1993/94, to 65,200 tons. A series of measures to boost the sector were taken in the 1994 budget, including the removal of import duties on fertilizers and greenhouse sheeting, and tax exemptions on tools and inputs of the industry. In addition, the monopoly of Kenya Airfreight Handling Limited (KAHL) on cool storage was removed through the licensing of private cool stores at the Nairobi international airport in October 1993; the handling services of KAHL were reorganized in March 1994 and its handling fees were reduced at the same time. Exports of horticultural products earned US$115 million in 1994, and followed tourism, tea, and coffee in terms of foreign exchange earnings. Although the export potential is high, the development of this sector remains constrained by inadequate air cargo and storage capacity, as well as high freight costs.

c. Manufacturing

Kenya’s manufacturing sector is relatively developed and diversified by African standards. The manufacturing sector saw a number of fundamental changes in its operating environment in 1993-94. Full liberalization of imports in May 1994 exposed manufacturing industries to increased competition. At the same time, the virtually complete liberalization of the exchange and trade system, removal of export taxes and licensing, and rationalization of the import tariff structure, all contributed to improved incentives for export production.

Following a broad-based growth of 4-5 percent in 1990 and 1991, the output of the manufacturing sector grew by about 1.8 percent in each of 1993 and 1994 (Table 10). In 1993, the lower output growth was concentrated in agro-based sectors (such as food processing) and in sectors dependent on imported inputs (such as electrical machinery and transport equipment). The performance of the agro-based sectors reflected the drought and the import-dependent sectors were adversely affected by the scarcity of foreign exchange and the depreciation of the Kenya shilling. For 1994, economic liberalization, coupled with the appreciation of the Kenya shilling, resulted in massive importation of finished products and reduced demand for the domestically produced goods.

Within the manufacturing sector, food processing remained stagnant in 1993 and 1994, as a result of the continuing unfavorable weather conditions and increased foreign competition in 1994. Similarly, the beverages sector was stagnant in 1993, when breweries were operating below capacity as a result of poor weather and the scarcity of foreign exchange. This stagnation in beverage production was offset to some extent by a favorable performance in the tobacco sector due to improved production incentives to farmers. In 1994, the tobacco sector registered a slight growth as a result of increased exports to the Preferential Trade Area, while the beverages sector declined by 7 percent as a result of foreign competition in the domestic market.

The textile industry resumed its expansion in 1993, reflecting considerable investment in the sector in the preceding years. The appreciation of the currency in 1994 resulted in increased foreign competition and a contraction of the industry by 25 percent. The clothing sector also was hurt by a surge in imports of low cost garments following the import liberalization, and its output declined by nearly 45 percent over the period 1993-94.

Production in the petroleum and other chemical sector declined by 2.6 percent and 3.3 percent in 1993 and 1994, respectively, reflecting in part technical problems at Kenya Petroleum Refinery Ltd. (KPRL) and the foreign exchange crunch in 1993. The paper industry output also declined by nearly 14 percent in 1994.

All other manufacturing sub-sectors have experienced some output growth in 1993-94. The plastic industry continued to benefit from technological advances and grew by 12 percent in 1993-94 as a result of a shift in demand toward this sector (such as PVC pipes, plastic shoes, and plastic floor tiles). The glass product sector also recorded substantial growth during the period and the production of cement was boosted by increased exports to Uganda and Tanzania, while domestic consumption of cement declined.

d. Construction

Following some expansion in the early 1990s, the construction industry stagnated during 1993-94, owing to rising costs of construction materials, a slack in private sector construction activity, and cuts in government construction projects. The overall cost index for building and construction rose by 52 percent in 1993. In particular, the price of cement increased by 80 percent. The overall cost index for building and construction increased by only 6 percent in 1994.

The private sector plays a vital role in the provision of housing and other building facilities, accounting for about 95 percent of the value of all completed buildings in Kenya. The value of completed buildings in 1994 was equivalent to 15 percent of the new building plans approved during the period, a slight decline compared to 1993. New building plans approved in 1994 increased by 25 percent in value (Table 11). The Central Government’s expenditure on housing represented less than 2 percent of the approved budget on development expenditure, channeled mainly through grants and loans to the National Housing Corporation (NHC).

e. Energy

Seventy percent of the energy consumed in Kenya is in the form of imported petroleum. The balance is provided by local energy power from hydro and geothermal energy sources and some imports of electricity from Uganda. In 1993-95, the per capita consumption of energy recovered to its 1990 level and reached the equivalent of 110 kg of oil, resulting in a national energy demand equivalent to 2.9 million tons of oil.

There was a slight decline in domestic demand for petroleum products in 1993 (Table 12). This decline was mainly attributable to lower economic activity, and was reflected in lower demand for kerosene, diesel, and fuel oils. In contrast, as a result of reduced prices and relief flight missions to Somalia, the demand for aviation spirit and jet/turbo fuel went up in 1993. In 1994, total petroleum consumption went up by about 10 percent, driven by an increase in the demand for jet fuel by nearly 40 percent. Excluding jet fuel, the consumption of petroleum products increased by 3 percent. With the liberalization of the petroleum sector in October 1994 (see Section 4), private oil companies and the National Oil Company of Kenya (NOCK) can import freely, either in refined form or in crude form for refining at the Kenya Petroleum Refinery Ltd (KPRL).

Electricity is second to petroleum fuels as a source of energy. It is produced by the Kenya Power Company (KPC) and the Tana River Development Authority (TARDA), under the management of Kenya Power and Lighting Company (KPLC). The power-generating companies sell electricity to KPLC, which is responsible for the transmission and distribution. The generation of electricity comes from hydroelectric sources (87 percent), thermal-based diesel power (6 percent), and geothermal plants (7 percent). There has been no private sector participation in the electricity area, although the Government has decided to allow private sector power generation in the near future.

Demand for electricity mainly derives from the commercial and household sectors, with large industrial and commercial users accounting for slightly more than 50 percent of the total demand. Local demand for electricity increased by 6.2 percent in 1993, while net electricity generation increased by 5.6 percent in 1993 as a result of improved water levels in some large dams. This implied a continuation of the recent trends, with demand for electricity outstripping generation and resulting in frequent blackouts, notwithstanding imports from Uganda. In 1994, electricity production increased by 4 percent, reflecting the return of normal rains and an increase in thermal-base diesel power generation by 60 percent as a result of the completion of rehabilitation of the Kipevu thermal station.

f. Tourism

Tourism performed well in 1993. The number of arrivals went up by 6 percent, to 826,000 visitors, and recorded an increase for the first time since 1990. This recovery resulted from an increase in visitors for holidays by 12 percent, reflecting the improved competitiveness of Kenya as a tourist destination in 1993. Holiday visits accounted for 82 percent of arrivals, while business visitors and transits accounted for the remainder.

The tourism sector continued to grow by about 5 percent in 1994, to 863,000 arrivals, but the number of visitors for holidays stagnated at its 1993 level. Moreover, there was a reduction in the number of visiting days and hotel occupancy declined by 17 percent. This rather unsuccessful tourist season reflected new emerging tourism markets in the African region, adverse publicity on the local security situation, and the appreciation of the Kenya shilling.

g. Other sectors

The transport sector recorded some expansion in 1993 and 1994. Air transportation grew and the completion of the extension of the oil pipeline to the Western Region in early 1994 resulted in increased activity of the Kenya Pipeline Company (KPC). Throughput at the port of Mombasa also increased in 1994 as a result of the need for the provision of emergency food supplies to neighboring countries, including Rwanda. This increase in activity was achieved in spite of considerable delays in cargo handling at the port associated with inefficient management, coordination problems with Kenya Railways, and start-up problems with new import clearance procedures.

The financial sector was the only sector to show significant buoyancy in 1993-94. Benefiting from higher interest rates, real value added in the financial sector increased by 8 percent and 7 percent in 1993 and 1994, respectively.

2. Use of resources

Domestic absorption fell by 4.6 percent of GDP to 95.9 percent in 1993 (Table 4). This contraction in overall domestic expenditure was caused by a decline in consumption, while total investment increased slightly. The decline in consumption was matched by a reduction in imports of goods and nonfactor services. The external balance of goods and nonfactor services turned around from a deficit of 0.5 percent of GDP in 1992 to a surplus of 4.1 percent in 1993. The overall external current account balance also improved, reflecting a stronger increase in national savings than in investment. Gross national savings rose by 4.1 percent of GDP in 1993, led by private savings (Chart 2).

CHART 2
CHART 2

KENYA: Savings and Investment, 1990–94

Citation: IMF Staff Country Reports 1995, 133; 10.5089/9781451821031.002.A001

Sources: Data provided by the Kenyan authorities; and staff estimates.

In 1994, domestic absorption recovered to reach the equivalent of 97 percent of GDP. While investment increased by 2.5 percent of GDP, consumption slightly declined, and the surplus in the balance of goods and nonfactor services deteriorated to 2.9 percent of GDP. The increase in investment was financed by an increase in gross national savings by about 1.5 percent of GDP, as well as a deterioration in the external current account. The increase in gross national savings reflected the improvement in Central Government savings (by 5.1 percent of GDP), while private savings declined by 3.6 percent of GDP. The private sector’s savings and investment decisions are likely to have reflected expectations of exchange rate movements as well as the response to the transitory increase in income stemming from the terms of trade improvement.

a. Consumption

Total consumption declined by 4 percent in real terms in 1993. This decline resulted from a contraction in private consumption by 7 percent, partially compensated for by an increase in public sector consumption (Table 3). The increase in public consumption reflected an increase in primary recurrent expenditures of the General Government as well as burgeoning expenditures in a number of public enterprises. Private consumption weakened as a result of the stagnant economy and in particular of the loss of incomes in the agricultural sector (which provides the livelihood for 80 percent of Kenya’s population).

In 1994, private consumption increased by 12 percent in real terms, reflecting the restoration of macroeconomic stability, the increase in real GDP, and the appreciation of the Kenya shilling. As public consumption continued to grow at about the same pace, total consumption increased by 11 percent.

b. Investment

Total investment was virtually stagnant in real terms in 1993, with an increase in stocks matched by a decline in gross fixed capital formation (by 4 percent). Recovery in stocks partly reflected speculative stock-building of imported raw materials and intermediate goods. The stock building was most pronounced in the chemicals and non-electrical machinery sectors. Fixed capital formation declined for the third year in a row and reflected a compression of both public and private investment. Private capital formation was affected by the scarcity of imported capital goods, the depreciation of the Kenya shilling, the tightening of domestic credit, high interest rates, and depressed demand for domestic goods. Public investment declined as central government development expenditures were cut. Within the overall decline in investment in 1993, there were significant sectoral differences (Table 6). Significant real increases were recorded in transport (38 percent), electricity and water (46 percent), manufacturing (7 percent), and other services (10 percent), while investment in the construction and government sectors fell by more than 40 percent.

In 1994, fixed capital formation expanded by 21 percent. This increase occurred primarily in the transport and government sectors but also in most sectors of the economy, particularly in manufacturing. The completion of the extension of the oil pipeline to Western Kenya was the main contributor to the increase in investment in the transport sector.

3. Prices, wages, and employment

a. Prices

The rate of inflation, as measured by the composite Consumer Price Index (CPI) for Nairobi, remained high through most of 1993, exceeding 50 percent in the 12-month period ended September 1993 (Table 14). Exchange rate adjustments, most notably the two large devaluations in March and April, appear to have been the most significant factor driving inflation in this period, with monetary aggregates expanding broadly in line with inflation (Chart 3). Beginning in October 1993, inflation appeared to decelerate, reflecting the stability in the exchange rate as well as a favorable supply response in production. 1/ Monthly inflation registered an average 1.3 percent per month in the last quarter of the year, as compared to an average 4.6 percent in the first nine months.

CHART 3
CHART 3

KENYA: Price Developments, December 1992 - June 1995

Citation: IMF Staff Country Reports 1995, 133; 10.5089/9781451821031.002.A001

Source: Data provided by the Kenyan authorities.1/ The exchange rate Index corresponds to the Ksh per US dollar rate.

Pressures reemerged in January 1994, with monthly inflation rising from 1.6 percent in December to 5.1 percent in January, in this case reflecting the sudden surge in the monetary aggregates as well as sharp increases in food prices, the latter driven by the adverse impact of drought as well as the ongoing price liberalization in the maize market. As a result, inflation reached a 12-month peak of 61 percent in January. Thereafter, monthly inflation began to decelerate sharply, bringing the 12-month inflation down to 28.7 percent in June 1994 from 41 percent a month earlier. Inflation continued to decelerate to below 7 percent in the 12-month period ended December 1994, and 0.3 percent in June 1995. Several factors accounted for this declining trend, including the relatively tight monetary policy against an apparent increase in money demand, nominal appreciation of the Kenya shilling owing to a relatively comfortable foreign exchange position as well as high interest rates, a reduction in excise duties and import tariffs, and the positive supply response, most notably in the manufacturing sector. Food prices also benefited from the bumper grain crop that followed the good long rains in 1994.

In general, the pattern in the composite index throughout was broadly matched by its food and nonfood subcomponents (Chart 3). Consumer price indices for the other three major urban centers (i.e., Mombasa, Kisumu, and Nakuru) also indicated similar trends with the CPI for Nairobi (Table 15).

b. Wages

Average monthly earnings in the formal sector of the economy increased by 14 percent in 1993 and declined substantially in real terms. Average earnings in the private sector increased at a faster pace than those in the public sector at 17 percent and 11 percent, respectively.

In the private sector, the highest wage increase was observed in agriculture (22 percent), followed by building and construction (19 percent). The transport and communications sector had the lowest increase in wages, with an increase of only 10 percent. The highest private sector salaries were earned in business services, finance, and transport and communications. The agricultural sector had the lowest salaries, reflecting the large share of casual labor in this sector working at the minimum wage.

In the public sector, average earnings for teachers rose by 11 percent in 1993, reflecting the implementation of the final phase of a graduated schedule for wage increases (by the Mbithi Salary Review Commission). For civil servants in Central Government, the wage increase was 8 percent. Generally, wage levels are higher in public enterprises than in other areas of the public sector.

In 1994, average earnings in the private sector increased by 17.9 percent, reflecting revisions of collective agreements and general adjustments in wages to compensate for the inflation that prevailed in 1993. The highest wage increase occurred in the banking sector (46 percent). Public sector average earnings increased by 18.4 percent in 1994. Central Government’s wages increased by 15.9 percent, while earnings for employees of the Teachers Service Commission increased by 20 percent, reflecting upward revisions of wages and other employee benefits effected during the year.

c. Employment

The labor force of Kenya was estimated at 11 million in 1993. The rural labor force accounts for about 80 percent, with small-scale agriculture and pastoralist activities providing most of the rural employment. Outside these activities, total employment was estimated at 3 million in 1993, equally divided between the formal and informal sectors. The informal sector is mainly urban and covers all semi-organized and unregulated activities largely undertaken by self-employed persons as well as small employers in open markets or street activities. The informal sector has been an important source of employment growth throughout, with an average annual increase of 16 percent during 1990-94.

Employment in the formal sector increased by about 1 percent in 1993. This was driven by growth in private sector employment (nearly 3 percent) while public employment declined slightly. Private sector employment accounted for 54 percent of the formal sector employment, with the largest share employed in agriculture (26 percent). This was followed by community, social and personal services (22 percent), manufacturing (19 percent), and trade, restaurant, and hotels (14 percent). Public sector employment has been declining since 1991, reflecting Government’s efforts to reduce the civil service.

There was a significant increase of nearly 4 percent in formal private sector employment in 1994. Public sector employment was broadly unchanged, with an increase in the number of teachers (5 percent) offset by reductions in Central Government and parastatals employment.

4. Domestic deregulation

The liberalization of the domestic economy was virtually completed over the last two years. In addition to maize and petroleum prices, as discussed below, the Government freed the remaining price controls on wheat, sugar, fertilizer, and pharmaceuticals in 1993-94. Furthermore, the marketing of maize and petroleum products was liberalized and some deregulation of the labor market was effected.

Maize market liberalization proceeded in several stages. The objectives of the reform were to allow private sector participation in the marketing of maize, reduce government intervention, and strengthen market forces, while preserving national food security. First, in October 1993, the Government allowed free importation of maize, and free domestic transportation of up to 80 (90 kilograms) bags at a time. Second, in December 1993, all forms of movement controls and restrictions on maize, whether imported or locally produced, were removed; the marketing of maize and maize-meal was fully liberalized; finally, private traders were free to import maize and charge competitive prices. 1/

However, despite an increase of about 40 percent in the wholesale price of maize in the six-month period preceding the liberalization and the severe shortfall in domestic production, private sector imports were slow to emerge. Thus, there was a further increase of about 20 percent in wholesale maize prices by June. Between May and August there was a large volume of maize imports both by the private sector and foreign donors. There was a rapid shift from a situation of maize shortfall to surpluses, and much of the price increase of the previous year was reversed.

The 1994/95 budget presented in June introduced a variable import duty on maize and wheat to prevent dumping of subsidized foodgrains, but this was not forcefully administered. As maize prices continued to fall, there was increased concern about the adverse impact on farmers’ incomes and disincentives for planting in the next crop season. In an effort to avoid cheap maize imports, putting further downward pressure on domestic prices, the Government introduced an import ban on maize and wheat on August 12, 1994 for a period of six months. By the time the ban was introduced, it had little impact because domestic prices had already fallen sufficiently that importing maize was no longer profitable. At the same time, the reintroduction of the import ban led to a reduction in confidence concerning the Government’s commitment to liberalization of this sector and in general.

This was soon recognized by the Government, and on September 7, the import ban was removed and a variable import duty became operative again. However, as a bumper crop started coming on the market starting in September, and combined with the high stocks from what proved to have been excessive imports, domestic prices continued to fall. Concerned about the impact on farmers, the Government instructed NCPB to start buying at above market prices of K Sh 950 per bag for maize and K Sh 1,100 per bag for wheat. Before it stopped purchases in March 1995, NCPB purchased almost 6.0 million bags of maize, and despite recovering K Sh 2.6 billion from the Government, it still owed farmers K Sh 2.4 billion.

In April 1995, the Government reintroduced the import ban on maize, wheat, milk and related products for a period of six months to protect the local production. Although the ban was lifted in mid-June 1995, these policy reversals delayed further progress in the restructuring of the maize sector. So far during 1995/96, the price of maize has continued to decline to below K Sh 700 per bag and NCPB has made virtually no domestic sales or purchases of maize, although it has contracted to export K Sh 3 million bags to drought-affected southern African countries.

On October 28, 1994, the imports, marketing, and pricing of petroleum products were completely liberalized. This step entailed the removal of all price controls, and the regulations pertaining to the private oil companies’ obligation to trade with National Oil Company of Kenya and to refine part of their requirements at Kenya Petroleum Refinery were rescinded. This liberalization of the petroleum sector was implemented smoothly and the markets for petroleum products have behaved in an orderly manner.

In order to give the Kenya Petroleum Refinery LTD (KPRL) time to adopt to the new deregulated environment, the refinery throughput tax was abolished and a temporary (two-year) duty was imposed on imported refined products except jet kerosene, illuminating kerosene, cooking gas, and automotive diesel. For the first year, the rate was set at K Sh 0.5 per liter. Slightly earlier on October 21, the controlled consumer prices of petroleum products were reduced and the import and excise duties on diesel were lowered by a total of K Sh 2.0 per liter and on LPG by K Sh 1.75 per kg. These reductions were taken to reflect the appreciation of the Kenya shilling in the preceding months and to facilitate a favorable public reaction to the forthcoming liberalization by lowering the prices of the most politically sensitive products.

As for the restrictions on the supply of petroleum products, the 30 percent crude oil market share previously reserved for the National Oil Corporation of Kenya (NOCK) was abolished and all marketing companies were expected to compete for sale of petroleum fuels in the domestic market. The Government also directed the oil companies to build up stocks to a minimum of 30 days of consumption and encouraged them to avoid single sourcing and to rely on competitive tenders. Higher petroleum product standards were introduced. Finally, the tariffs of the Kenya Pipeline Company were also liberalized to introduce competition between the pipeline and the other two transport modes, namely rail and road.

A series of measures was also introduced in the 1994/95 budget to initiate the liberalization of the labor market. Wage guidelines were extensively liberalized and reduced from 10 to 5 to allow greater freedom in wage negotiations between employers and employees. Previous guidelines covered various aspects of the labor markets, such as periodicity of negotiations (not more frequent than annually), compensation for inflation (up to 70 percent for lower income earners), basic standards of living, disparity with non-unionized workers, and benefits from productivity. Under the new guidelines, costs of living are only related to the minimum wage, revisions of up to 100 percent of inflation are allowed with decreased compensation for higher income groups, relative returns to labor are not automatic, and negotiations are permitted as frequently as necessary. The Employment Act and the Trade Dispute Act were also amended to permit the discharge of redundant workers without ministerial approval. The statutory amount that had to be paid to workers declared redundant was increased by 50 percent.

III. Central Government Operations

1. Introduction

The overall fiscal deficit (commitment basis, excluding grants) fell from 11.4 percent of GDP in 1992/93 to 2.5 percent of GDP in 1994/95 (Table 16). This adjustment came about primarily as a result of a strong rise in revenue (by 7.4 percentage points of GDP), while budgetary expenditure and net lending was reduced by 1.6 percentage points of GDP (Chart 4).

CHART 4
CHART 4

KENYA: Fiscal Developments, 1987/88-94/95

Citation: IMF Staff Country Reports 1995, 133; 10.5089/9781451821031.002.A001

Sources: Data provided by the Kenyan authorities; and staff estimates.1/ Commitment basis.2/ Excluding grants.

The revenue increase was supported by improvements in tax administration and broadening of the tax base. At the same time, improvements were initiated in the tax structure aimed at easing the tax burden for the economy and making it more equitable. The maximum import duty rate, the maximum VAT rate, the top marginal income tax rate, and excise tax rates on soft drinks and beer were all reduced, along with the lifting of export duties and the elimination of kerosene taxes. The VAT retail base was expanded, while petroleum taxation was shifted from VAT to excise taxes. The problem of tax arrears incurred by several large parastatals was, however, not satisfactorily resolved. Expenditure and net lending was reduced reflecting the Government’s efforts to achieve budgetary restraint. The reduction was helped by lower domestic interest payments in 1994/95. Considerable work was done to improve the expenditure control mechanism. The quality of overall expenditure began improving, with larger shares of social areas and productive outlays in total. Overall budget financing (on a cash basis and after accounting for grants) was significantly reduced. However, domestic financing remained high owing to net foreign financing turning negative in 1994/95.

2. Revenue developments

a. Revenue policy

Since 1992/93, the authorities embarked on a major effort to reform the whole system of taxation in order to broaden the tax base, lower the tax rates, improve the efficiency of tax administration and ease the burden of taxation for the economy, while offsetting the resulting temporary revenue losses by new revenue measures. Along with this general trend, however, the Government had to resort several times to ad hoc measures to raise resources needed in extraordinary circumstances, or to safeguard the deficit targets under considerable expenditure pressures.

The tax reform efforts in the period of 1993/94 and 1994/95 resulted in the following changes:

Income taxes. The top marginal income tax rate was reduced from 40 to 35 percent (not including the drought levy), along with broadening of income tax brackets by 30 percent, and expanding reliefs for single and married taxpayers by 50 percent. These measures served to offset some of the erosion of real income due to the high levels of inflation experienced in previous years and to reduce the tax burden on the low income earners. A withholding tax was introduced on the original issue discount on financial instruments. Significant improvements were achieved in the income tax administration, including implementation of the installment and self-assessment tax system and making the full value of employee benefits subject to tax, as well as expanded use of personal identification numbers (PINs)--among other things, in such new areas as vehicle registration and in relation to self-employed people not trading under a business name. A temporary drought levy was in force in 1994/95, composed of an additional 2.5 percent charged on corporate income and on income of individuals in the highest tax bracket.

Foreign trade taxes. The maximum import duty rate was reduced from 50 to 45 percent (and further lowered to 40 percent under the 1995/96 Budget law), with a significant reduction in the number of items in the top band and rationalization of investment incentives. Export duties were eliminated. The preshipment inspection (PSI) was strengthened in May 1994 to secure proper classification and valuation of goods for customs purposes to guard against undervaluation of imports. The PSI proved its effectiveness in 1994/95--according to the authorities’ estimates, it helped to raise customs revenues on non-oil imports by more than 20 percent.

Value-added tax. The maximum VAT rate was reduced from 40 to 30 percent together with a reduction in the number of VAT rates and expansion of VAT coverage to construction, automobile parts, and equipment repair and rental. The number of goods subject to VAT at the retail level was increased from about 390 to some 1,400. At the same time, taxation of major petroleum products (premium and regular gasoline, aviation gasoline and automotive diesel) was shifted from the VAT to excise taxes to reduce the VAT offset.

Other taxes. Changes in other taxes included introduction of a road maintenance levy, i.e., an earmarked levy on automotive fuel for funding road maintenance; abolition of the refinery throughput tax; elimination of taxation of kerosene; and lower excise taxes on soft drinks and beer by 5 percent.

The new Kenya Revenue Authority (KRA) became operational in July 1995, as a central body for the assessment and collection of income taxes, VAT, customs and excise duties and a number of other levies and charges. It is expected that KRA will serve as a vehicle for improving tax administration, in particular regarding more effective collection of taxes, and provision of better services to taxpayers to make compliance of the tax laws simpler and cheaper. Increased remuneration and funding, and easy dismissal are expected to improve professionalism and motivation of the staff, as well as the transparency of the tax collection.

b. Revenue trends

The composition of budgetary revenue shifted significantly during 1993/94 and 1994/95 (Table 17). The share of tax revenue increased from 83 to 87 percent of total revenue, with a corresponding decrease in the share of nontax revenue. The share of excise duties increased by 4 percentage points to 15 percent of total revenue as a result of the above-mentioned shift of several important petroleum products from the VAT to excises. The same amount of receipts was lost for VAT, which additionally suffered from rate decreases and a large accumulation of arrears by the Kenya Posts and Telecommunications Corporation (KPTC). As a result, the share of VAT in total revenue declined from 32 to 20 percent (in terms of GDP, the decline was not so striking--from 7.7 to 6.2 percent). Import duty collections were on the rise from 10 to 15 percent of total revenue, and taxes on income and profits from 29 to 35 percent of total revenue.

During the whole period, the authorities encountered difficulties in collecting taxes from several largest taxpaying enterprises on time. The accumulated stock of tax arrears was reduced from K Sh 9.9 billion (2.8 percent of GDP) at the end of 1993/94 to K Sh 9.3 billion (2.3 percent of GDP) at the end of 1994/95. The composition of outstanding tax arrears changed. In 1993/94, 48 percent of the total stock (or K Sh 4.8 billion) were VAT and telecommunications tax arrears, largely incurred by KPTC, and the rest were corporate tax arrears by Agricultural Finance Corporation, Kenya Power and Lighting Company (KPLC), Kenya Pipeline and several other parastatals. At the end of 1994/95, the share of VAT in the total stock of arrears increased to 77 percent (K Sh 7.2 billion), while the VAT arrears of KPTC more than doubled. Corporate tax arrears that had been incurred in 1993/94 were mostly repaid in 1994/95, but new arrears were incurred by KPTC (which became the largest debtor also in this type of taxation), Kenya Ports Authority, as well as by one large private corporation and eight other companies in smaller amounts.

3. Expenditure developments

a. Expenditure trends

Total expenditure and net lending decreased from 35.6 percent of GDP in 1992/93 to 34.0 percent of GDP in 1994/95. The overall expenditure reduction was achieved against heavy pressures stemming from unexpected and unbudgeted outlays. In 1993/94, it was necessary to provide drought relief (primarily in the form of maize) to about 4 million people following the disappointing rains of December-January. The authorities also found it essential to intensify security operations along the Kenya-Somalia border to prevent the inflow of firearms into the country. Extraordinary outlays were also made by the Government to cover losses incurred by the Central Bank of Kenya (CBK) in 1992/93 as a result of irregular transactions. In 1994/95, large drought-related outlays, as well as increased security expenditures for patrolling the Kenya/Somali border continued. The Government granted unbudgeted salary increases for teachers and medical doctors, and had to increase the provisions for the civil service reform to accelerate the retrenchment program. Furthermore, the expenditures were boosted by higher-than-expected transfers to the National Cereals and Produce Board (NCPB) to finance purchases of maize; allocation of K Sh 1.2 billion as development expenditures for the construction of an airport at Eldoret; and an additional provision for improving local authorities’ water facilities.

These outlays were partly offset by the impact of lower domestic interest rates in 1994/95 (5.7 percent of GDP in 1994/95 as compared to 10.6 percent of GDP in 1993/94 and 8.7 percent of GDP in 1992/93). In 1994/95, payments on behalf of parastatals for guaranteed loans were also radically lowered; stricter controls by the Treasury resulted in parastatals meeting more of their debt service themselves. Such savings, however, were not sufficient to achieve the fiscal policy targets. Some budgeted outlays had to be cut, including non-interest, nonwage recurrent expenditures which support operations and maintenance, and in certain development expenditures.

b. Composition of expenditure

The composition of expenditure and net lending was characterized by a gradual shift of resources toward the development budget, with the share of recurrent expenditure in total expenditure decreasing from 82 percent in 1992/93 to 77 percent in 1994/95 (Table 18)--the development part of the budget, however, contained outlays to support NCPB purchases of maize, in the order of 0.8 percent of GDP in 1994/95.

The share of interest payments in total expenditure and net lending reached as much as 36 percent in 1993/94, driven by high payments on domestic debt. In 1994/95, the problem was ameliorated by falling interest rates, but the stock of domestic debt remained large (at 24 percent of GDP at the end of 1994/95).

Wages and allowances fell from 26 percent of total expenditure and net lending in 1992/93 to 24 percent in 1993/94, but rose to 32 percent in 1994/95 when a cash medical allowance for civil servants was granted, followed by salary increases for teachers and medical doctors, partly made retroactive for the previous year (the retroactive payments made in November 1994 amounted to K Sh 1.2 billion or 1 percent of total expenditure). In addition to a safety net provision for civil service retrenchment, the 1993/94 and 1994/95 budgets included allocations for free distribution of food to individuals affected by drought, bursaries for poor students, greater availability of medical supplies in rural areas, and improvements in housing for the urban poor.

As to the functional breakdown of expenditure, the budgetary outlays for social services increased from 9.2 percent of GDP in 1993/94 to 11.1 percent of GDP in 1994/95 (Table 19). Within this category, education gained most of all (from 6.4 to 7.7 percent of GDP), but the share of health expenditures also increased (from 2.0 to 2.4 percent of GDP). The outlays on economic services increased from 7.5 to 8.1 percent of GDP, with the gains distributed between mining, manufacturing, construction, electricity, water and gas supply, road construction and transportation, while the GDP ratio of agricultural expenditures shrank from 3.4 to 2.5 percent of GDP. The authorities’ efforts to contain general administrative outlays resulted in this type of expenditure going down from 5.2 to 4.5 percent of GDP. The outlays on defence increased, though slightly, from 1.5 to 1.9 percent of GDP, due to the above-mentioned unforseen outlays to enhance security on the border with Somalia.

c. Expenditure monitoring

The control of expenditure commitments in Kenya is based on the vote book system designed to keep expenditures within the amounts voted by the Parliament. Accounting officers are required to maintain lists of provisions voted for each item in the budget against which all commitments made during the year are entered. Actual payments for supplies and services received are carried out within the limits of “exchequer issues”, i.e., periodic (monthly or more frequent) transfers of money by the Treasury to ministerial accounts, on the basis of which checks to suppliers are written. The size of exchequer issues depends on the overall cash position of the Government, which is determined by the availability of revenue. If revenue falls short of projections, so are the issues; shortages (“underissues”) are distributed among ministries on a pro rata basis.

This system has intrinsic weaknesses. Accounting officers normally assume that they are entitled to enter into commitments up to the budget provisions for the whole year. After the commitments are made, goods and services are received in due course and the relevant claims scrutinized and passed for payment. At this payment stage, it often turns out that funds available from the latest exchequer issue are not enough to settle all the claims on hand--either because of fiscal tightening for macroeconomic reasons, or just due to a shortfall in government receipts. In this case, an accounting officer has two options: leave the bill pending, or pay without having a positive balance on a ministerial account, i.e., increasing the central bank overdraft. The first way of handling the situation gives rise to pending bills, while the second to expenditure not covered by issues (spending in excess of authorizations).

At the end of 1993/94, the outstanding stock of pending bills amounted to K Sh 4.2 billion, of which K Sh 2.6 billion was in the recurrent part of the budget and K Sh 1.6 billion in the development part. During 1994/95, there was little overall change in recurrent pending bills (although K Sh 1.3 billion was repaid at the beginning of the fiscal year, practically the same amount was then accumulated again). There also was a further accumulation of pending bills for the development expenditure; as a result, the total outstanding stock increased by K Sh 0.7 billion. As to expenditures not covered by issues, the ministries reduced their central bank overdraft by K Sh 1.4 billion for recurrent expenditures, but increased it by K Sh 2.2 billion for development expenditure; consequently, total spending in excess of authorizations increased by K Sh 0.8 billion.

The authorities introduced the following stringent expenditure control system, starting with the 1994/95 budget:

(1) Ceilings to expenditure commitments. The Treasury began communicating periodic expenditure ceilings to all ministries and departments at least two weeks before the beginning of each period. These ceilings are monthly for the recurrent budget and quarterly for the development budget, and cumulative within each financial year so that ministries can spend in subsequent periods what they have saved in the current one.

(2) Returns on pending bills. The Treasury began obtaining monthly returns on pending bills from ministries by the 10th of each month.

(3) Computer linkage of the Paymaster General (PMG) and the CBK. Daily reconciliation of the ministries’ account balances at the CBK and the PMG was established through a link between their respective computer systems.

(4) Measures relating to excess spending. Decisions were taken that any accounting officer responsible for more than two overdrawn checks should be subject to serious disciplinary actions, and the Central Bank should refer to the Treasury checks drawn from a ministry account lacking sufficient funds.

(5) Strengthening the Treasury’s capacities. A unit was created at the Treasury which is monitoring the budget on a monthly and quarterly basis, and reviewing general economic matters.

The efforts to implement these measures in the course of 1994/95 resulted in improved availability and timeliness of information about pending bills and expenditures not covered by issues. However, some of the more practical actions, such as sanctioning of officials responsible for overspending, were not appropriately enforced. The expenditure control mechanism remained not fully satisfactory.

4. Budget financing

The total cash financing requirement of the budget, after accounting for grants, fell gradually from 8.2 percent of GDP in 1992/93 to 0.9 percent of GDP in 1994/95. Net foreign financing turned around from a net inflow of 2.2 percent of GDP to an outflow of 1.2 percent in 1994/95. As a result, domestic financing requirement could only decline from 6 percent of GDP in 1992/93 to 2.2 percent in 1994/95.

The stock of central government’s domestic debt, which had reached 32 percent of GDP at end-June 1993, has been a central issue in Kenya’s fiscal policy during 1993/94-1994/95. Along with the overall objective of deficit reduction, the Government undertook several debt-restructuring measures in 1993/94, including conversion of treasury bills held by the CBK into long-term bonds. At end-June 1994, the total stock of government domestic debt stood at K Sh 103 billion (Table 21), all backed by issues of government paper, with no Central Bank overdraft. In 1994/95, net redemption of K Sh 16 billion in treasury bills and other securities (4 percent of GDP) was effected. At the same time, however, Government’s borrowing from the CBK reached K Sh 25 billion (6.2 percent of GDP). As a result, the total outstanding stock of government debt (including CBK overdraft) increased to K Sh 111 billion.

5. Civil service reform

a. Background

In the years following independence in 1963, Kenya’s civil service registered strong growth. At the time of independence in 1963, the civil service numbered about 60,300; by the early 1990s, the number of civil servants had increased to about 270,000. While this growth to some extent reflected a growing population, the share of civil servants in the total population rose from 0.8 percent to 1.1 percent. Also, the wage bill expanded, reaching some 25 percent of total government expenditures on average in 1990/91-1992/93.

Several factors contributed to this expansion of the civil service. First, the strong population growth, of 3.3 percent on average per year in 1980-1993 led to increased demand for public services, in particular health and education. Second, in the post-independence period, the Government sought to improve both the quality and availability of social services for the wider population. Third, when employment growth in the private sector was lagging, the Government stepped in as an employer of last resort; this was reflected in a particularly sharp expansion in the number of government employees at the lower grades. And fourth, there was a widespread lack of central control over hiring practices in individual government ministries, which sometimes led to hiring beyond the number of established posts.

b. Key problems

The expansion of the Government caused a number of difficulties, which hampered efficient service delivery and made the operation of the Government unnecessarily expensive:

♦ the civil service organization became increasingly complex and coordination became more difficult. The number of ministries increased, as did the number of government committees; in comparison with some other African countries, Kenya has a relatively large number of government ministries. Moreover, the expansion was not always harmonized, with the result that different ministries dealt with identical or closely related issues. For instance, several ministries, as well as the Office of the President, have been involved in sectors such as development planning, public enterprises, land use policy, and education;

♦ the wages and benefits were eroded in an effort to tighten fiscal policy, as attempts were made to contain the Government’s personnel costs. Similarly, the health benefits and housing allowances of civil servants -- an important component of the overall remuneration package--became increasingly restricted. These developments were detrimental to the efficiency of the civil service and the recruitment of qualified staff;

♦ as the number of civil servants increased rapidly, by more than 6 percent per annum in 1965-1990, 1/ problems emerged with regard to over-staffing at lower levels (where the establishment control has been weakest), and inadequate resources for operations and maintenance (to keep the workers productive) and for hiring staff at higher grade levels; and

♦ the resources devoted to personnel management and training have been insufficient, with a resultant misallocation of resources and mismatch between the composition of the actual staff and the staffing needs of individual ministries.

c. Objectives and design of the civil service reform program

In 1993, the Government approved a Civil Service Reform Program (CSRP). This program was spelled out in a Government Paper, prepared with the support of the World Bank. The CSRP is to be implemented over seven years, in several phases. The first phase focuses on the containment of the wage bill through a reduction in the civil service, the development of staffing norms for ministries, improved establishment control, and the rationalization of selected ministries. Subsequent phases will shift the focus toward fundamental reforms in a larger number of ministries and the reform of wages in the public service.

The staff reduction exercise is closely associated with the restructuring of individual ministries, as it will affect the ministries’ ability to carry out their designated functions. From the outset, the program was intended to cover individuals paid directly from the central government budget; in effect, it excluded employees of public enterprises and local governments, as well as teachers. Subsequently, in mid-1994, the Government decided to broaden the program to include teachers, nonacademic staff of public universities, and local government employees. Public enterprise employees were deliberately excluded, as the streamlining of staff structures at these enterprises was being dealt with in the context of the reform of the individual enterprises (see Chapter IV).

The key objectives of the CSRP, as outlined in the Government Paper, were the following:

♦ to help fiscal adjustment by containing the growth in wage bill;

♦ to reverse the decline in efficiency and productivity; and

♦ to strengthen the civil service’s capacity to deliver government services.

To these ends, the strategy contained in the Cabinet Paper sought to: (i) achieve a leaner ministerial structure, with fewer and better organized ministries, and to reorient the Government’s activities toward “core functions”; 1/ (ii) decentralize service delivery, including by contracting out certain functions to the private sector; (iii) reduce the number of civil servants progressively over time, and strengthen personnel management; (iv) support the downsizing of the civil service by a social safety net; and (v) improve the ethics and public-service orientation of the civil service (inter alia, through the introduction of a Code of Regulations, i.e., an ethics code).

d. Achievements under the civil service reform program

Following the government approval of the CSRP, a National Steering Committee was established to guide the overall direction of the program, and a Civil Service Reform Secretariat (CSRS) was established, under the Directorate of Personnel Management (DPM) of the Office of the President, to handle the CSRP on a day-to-day basis. Good progress has been made in reducing the number of civil service positions and the number of civil servants. However, while the number of ministries was reduced from 33 to 22 prior to the launching of the CSRP, less headway has been made since toward the more fundamental restructuring and streamlining of existing government ministries.

The rationalization of the civil service structure aims to reduce both the number of civil servants and the number of civil service positions by about 16,000 per year over the 1994-96 period. Prior to the inception of the CSRP, the Government had put in place a hiring freeze for positions in the lower grades with a view to start reducing the number of civil servants at these grades while the CSRP was being designed. The underlying notion was that such positions in general were less essential for the running of ministries, but provisions were put in place to ensure that essential positions would remain staffed.

Once the CSRS was established and allocations made in the 1993/94 budget for a social safety net for early retirees, a Voluntary Early Retirement Scheme (VERS) was introduced. The VERS is seen as the central element of the strategy for downsizing of the civil service, and is targeted at the lower-grade groups (i.e., Grades A-G, which constitute about 85 percent of the total civil service). In 1993/94, the budgeted provision for the social safety net associated with the VERS was set at K Sh 1.5 billion; this amount was intended to cover early retirement of 10,000 civil servants. The social safety net, which is administered by the CSRS, has three components: (i) a payment of 3 months’ salary in-lieu-of-notice; 1/ (ii) a “golden handshake” of K Sh 60,000 (equivalent to about US$1,300 at the January 1995 exchange rate); and (iii) for nonpensionable civil servants, severance pay of 3 months’ salary for every year worked (this payment is intended to ensure equitable treatment with pensionable employees, who would in any event receive a lump-sum payment plus monthly payments).

Between January 1993 and June 1995, nearly 20,400 civil servants have taken early retirement through the VERS program and another 15,800 have departed through natural attrition. During the same period, about 6,700 new civil servants have been recruited, including roughly 4,000 security agents. Thus, over this period, the number of civil servants declined by 11 percent, from 269,300 on January 1, 1993 to nearly 239,800 on June 30, 1995.

Moreover, to ensure a lasting reduction in the civil service establishment, the DPM has sought to reduce the number of civil service positions in tandem with the reduction in actual staff. While this exercise proved relatively simple in the early stages, when the DPM eliminated positions across the board in line with the reduction in staff, it quickly encountered more difficulties, as ministries became concerned about their ability to carry out their designated functions. It was realized that more careful reviews of staffing norms would be necessary to proceed with the program; and ministerial committees, with external technical assistance, were set up for this purpose. As a result, the reduction in the number of positions has been limited to positions left vacant under the Voluntary Retirement Scheme, and more than 20,000 positions were eliminated from April 1994 to June 1995.

Restructuring of government ministries proceeded slowly. While some work toward establishing restructuring plans for certain key ministries had already started at the time the Government approved the CSRP, little actual progress has been made in implementing these plans. Six ministries have now been earmarked for rationalization in 1995-97, in the first phase of the CSRP. These ministries are the Ministry of Health; the Ministry of Finance; the Ministry of Lands and Settlement; the Ministry of Public Works and Housing; the Ministry of Land Reclamation, Regional and Water Development; and the Ministry of Agriculture, Livestock Development and Marketing. Plans are already developed for the Ministry of Health and the Ministry of Agriculture; the implementation of the restructuring plans for these ministries is planned for late 1995/early 1996. Ministerial reform Committees have been established to develop plans for the other ministries.

IV. Public Enterprises

1. Introduction

During the 1980s, the public enterprise (PE) sector took on an increasing importance in the economy, as the “Kenyanization” and the drive to industrialize led to increasing government ownership in commercially oriented enterprises, as well as in “strategic” enterprises engaged in providing utilities, transport, communications, and agricultural marketing services. In spite of much stronger investment expansion in the PE sector than in the rest of the economy, growth in the PE sector lagged behind. As a result, the expanding PE sector represented a drag on overall economic growth and on the central government budget.

The Government of Kenya has made a number of attempts at reforming the PE sector. These included initiatives in the context of the Working Party on Government Expenditure (1982), achieving a compression of direct subsidies, and the Task Force on Divestiture (1983). However, the overall progress was slow, to a large extent because of the firm-by-firm approach taken in these reform efforts.

The current reform program, which started in 1992, involves a comprehensive and coordinated approach to PE reform. PEs classified as “strategic” would remain in government hands but would be restructured in order to improve their efficiency and financial performance, while all PEs classified as “non-strategic” would be privatized. Although progress has been made in improving the financial performance of some strategic PEs, the overall implementation of the program has been constrained by the complexity of the issues involved, the lack of staff and technical skills in the implementing agencies, as well as other difficulties.

2. Overview of the public enterprise sector 1/

For the purpose of the current reform program, the public enterprise sector has been defined to include all commercially-oriented enterprises in which the Government holds a direct or an indirect ownership. The Government held majority ownership in about half of the 243 enterprises covered under this definition in 1992. While the types of activities were quite diverse, the largest number of PEs were found in the manufacturing sector (60 percent); other important sectors were distribution (18 percent) and finance (15 percent). As a whole, the PE sector was quite large in relation to the total economy.

Concerning their role in production, the PEs accounted for some 11 percent of GDP in 1986-90. However, the sector’s direct contribution to economic growth was modest in the second half of the 1980s; while real GDP in other sectors increased by on average by 8.2 percent per year in 1986-90, real GDP of PEs increased by 5.9 percent per year. The various PE sectors’ growth performance differed greatly; manufacturing value added declined between 1986 and 1990, while average annual growth rates of 6-8 percent were registered in other PE sectors. This pattern is significant, in that manufacturing is the sector in which the Government has the largest ownership interest. In addition, the PE sector had an increasingly negative indirect impact on economic growth: public-sector monopolies in transportation (railways and the ports), electricity generation, and telecommunications all failed to keep up with the demands of the economy, causing bottlenecks that acted as deterrents to private investment and growth.

The PE sector accounted for some 7 percent of total formal sector employment in 1986-90, most of this in manufacturing, transport and communications. The wages and salaries in the PE sector were almost twice the national average, primarily reflecting high wages in the financial and the transport and communications sectors. The PE sector counted for 16 percent of gross fixed capital formation in 1986-90. The bulk of this investment took place in the transport and communications sector but substantial investment was also undertaken in manufacturing companies. The type of investment showed a pattern similar to that of the overall economy and was concentrated in particular on machinery. The growth in investment in the PE sector far outpaced that of the rest of the economy; while real fixed investment in non-PE sectors grew on average by 0.5 percent annually in 1986-90, in the PE sector the average annual growth in fixed investment in that period was 30 percent.

The PE sector had a direct negative impact on the external accounts. While majority government-owned PEs’ direct imports on average accounted for 13 percent of total merchandise imports in 1987-90, their direct share in total merchandise exports was only 4 percent. The PE sector thus made a significant direct contribution to the trade deficit over this period. Also, this contribution increased over time, as the share of total imports increased from 6 percent in 1986 to 18 percent in 1990, while the share of total exports increased more slowly, from about 4 to 5 percent.

The PEs’ external debt at end-1991 amounted to US$1,021 million, or 18 percent of total external public and publicly-guaranteed external debt. The bulk of this debt was guaranteed by the Central Government. Most of the external debt of PEs has been contracted by a group of about ten companies, mainly companies in-transportation, banking, and electricity generation. In recent years, a number of PEs have encountered cash flow difficulties and failed to meet their debt service obligations, which then had to be met by the Government, with adverse consequences for the achievement of budgetary targets.

The PEs had a direct impact on the central government budget through budgetary outlays as well as receipts. Total direct outflows to PEs include loans (accounting for about 60 percent of total outlays to PEs in 1986/87-1990/91), transfers (21 percent), and equity purchases (20 percent). The main direct inflows have been in the form of dividends and profits. The World Bank has estimated that, on average over the 1987/88-1991/92 period, the PEs contributed directly to the central government budget deficit by 0.3 percent of GDP (the average annual deficit in the period was estimated at 5.3 percent). Net government payments to PEs, which amounted to about 1 percent of GDP in 1991/92, were reduced to 0.5 percent of GDP in 1993/94 and 0.2 percent in 1994/95 (excluding transfers of 0.8 percent of GDP to NCPB for its purchases of maize). This reduction reflects some improvement in parastatal performance and increased controls of the financial situation of parastatals having difficulties to service their debt.

The PEs have also affected the budget adversely in indirect ways. For instance, some enterprises have collected taxes on behalf of the Government, but have failed to pass the proceeds on to the Treasury. Also, a number of PEs received indirect subsidies such as subsidized interest rates on loans, below-market rents on government land, and exemptions from tax (corporate tax, customs duties, and VAT). A study, carried out in 1993, concluded that the indirect subsidies received by a subset of 11 PEs amounted to about K Sh 7 billion, or some 2.5 percent of GDP, in 1992/93. The Government has addressed this issue and the Budget speech of June 1993 included a commitment to reduce the burden of subsidies and improve the efficiency of parastatals. A study of subsidies was completed and its action plan approved in September 1993. Government on-lending is now at market interest rates, and a 2 percent charge is imposed on government guarantees. Offsets of mutual indebtedness through the budget process has been agreed. In addition, a study of cross-debt elimination was initiated in October 1994 and finalized in August 1995 with the recommendations of procedures for dispute resolution and clearing of cross-debts.

The importance of the PE sector was also evident in the financial system. Their combined deposits accounted for 10 percent of all deposits with commercial banks in 1986-90, and a full 16 percent of the deposits of nonbank financial institutions (NBFIs).

3. General objectives and design of the reform program

The overall objectives and strategy of the current public enterprise reform program were spelled out in a government Policy Paper on Public Enterprise Reform and Privatization (Government of Kenya, July 1, 1992). The key objective of PE reform is to improve overall efficiency in resource allocation. From this central goal follows the specific objectives of the program, as spelled out in the government paper;

  • ♦ enhancing the role of the private sector in the economy;

  • ♦ reducing the claims of the PE sector on the central government budget;

  • ♦ rationalizing the PEs’ operations in a nonreversible manner;

  • ♦ improving the regulatory environment for PEs;

  • ♦ broadening the base of ownership; and

  • ♦ enhancing capital market development.

A two-pronged approach was adopted to achieving these objectives. First, for PEs defined as “strategic” the Government would retain its ownership, and reforms aimed at rationalizing their operations would be implemented. These enterprises would be given increased autonomy in their business decisions, within a framework aimed to simulate “private-sector conditions”. The enterprises defined as “strategic” comprise those that provide essential services and are considered to play a key role either for national security, health, or protection of the environment; a total of 32 enterprises were classified in this category. Second, enterprises categorized as “non-strategic”--which encompass all other enterprises--would be privatized; a total of 211 enterprises fell into this category. To manage the reform program, two implementing agencies were established: the Department of Government Investments and Public Enterprises (DGIPE), which primarily would be responsible for the part of the reform program relating to strategic enterprises, and the Executive Secretariat and Technical Unit (ESTU), which would be responsible for the privatization of nonstrategic enterprises.

4. Reform and financial performance of “strategic” public enterprises

a. Principles of the reform program

The main principles for reform of strategic PEs were as follows:

♦ the operations of PEs will only include viable commercial activities, except for certain cases where the Government would direct a PE to undertake activities for non-commercial reasons. These non-commercial activities would be retained on a separate operational and accounting basis, accompanied by contractual arrangements giving the PE full compensation for the activities through transparent budgetary provisions. Regulatory functions would be removed from commercial PEs;

♦ the PEs would operate on a self-sustaining basis, and all subsidies (except those intended to cover costs associated with specific activities, referred to above) would be phased out; in particular, all indirect subsidies should be eliminated;

♦ profitability of PEs would be sought through improved efficiency in a competitive environment; to this end, barriers to entry and other protection would be gradually removed to ensure a “level playing field” for private companies and PEs, and the PEs given autonomy in their pricing, staffing, and other business decisions. A governance code--establishing an arm’s-length relationship with the Government--would be adopted; and

♦ PEs that would remain in a monopoly position would be regulated by specialized government bodies, through government review and approval of tariffs, investment plans, and cost containment measures.

b. Institutional arrangements

In support of this strategy, the institutional arrangements for management of the PE sector were changed. The Department of Government Investments and Public Enterprises (DGIPE) was established within the Ministry of Finance; the DGIPE was meant as a caretaker of the Government’s ownership in all PEs, and would exercise oversight of all majority-owned PEs. To give DGIPE clout in its dealings with the PEs, its head (the Investment Secretary) was given the rank of permanent secretary, reporting directly to the permanent secretary of finance. The DGIPE’s tasks fall within three major categories: (i) to design and oversee the implementation of the PE reform process; (ii) to monitor the performance of majority-owned PEs and all other government investments, and to ensure effective PE debt management and PE accountability for all budgetary allocations to PEs; and (iii) coordinating the social safety net schemes associated with staff rationalizations. Performance contracts would be established between the strategic enterprises and Government. Within this framework, the role of PE Boards and management would be to define the corporate strategy and implement personnel and salary policies, pricing, and procurement independently, in line with the general objectives of the respective performance contracts.

c. Achievements under the program

The Government’s general approach to PE reform was defined in the July 1992 policy paper, but specific objectives and policies for individual enterprises remained to be formulated. In the context of the policy framework paper (PFP) for 1994-1996, drawn up in consultation with the World Bank and the Fund, specific objectives and policies consistent with the general approach were articulated. For selected PEs--i.e., those that were the recipients of the largest direct and indirect subsidies from Central Government and those that provide infrastructure services--targets were set for the combined operating profit, as well as for the overall cash flow. 1/ These targets were set to facilitate the contribution of these PEs to overall macroeconomic adjustment, and were underpinned by actions relating to financial management, including measures to cut costs, raise revenue, and limit external and domestic borrowing. Importantly, the planned cost-cutting measures in all selected enterprises included major staff rationalization. These were planned for implementation in the context of broader restructuring of these enterprises; while the restructuring plans were being put in place, the enterprises would seek to reduce their staff through hiring freezes and natural attrition. Moreover, the PFP provided for the establishment of performance contracts for all “strategic” PEs by June 1995; these contracts were intended to provide a basis for allowing PE management to pursue a commercially-oriented strategy, with autonomy from Government, provided that specified objectives for service delivery and financial performance were achieved.

Concerning the financial performance of the selected PEs, considerable improvement has been achieved in the operating profit since the Government’s reform program was launched. From 1992/93 to 1994/95, the combined operating profit of the five key PEs monitored under the ESAF-supported program increased from K Sh 4.2 billion, or 1.5 percent of GDP, to K Sh 10.8 billion, or 2.7 percent of GDP; most of this improvement occurred in 1993/94 (Table 22). The main turnaround in profits occurred in the Kenya Power and Lighting Company, the Kenya Posts and Telecommunications Corporation, and the Kenya Ports Authorities. The improved profit position to a large extent reflected major tariff increases, appreciation of the Kenya shilling, and other special factors, while substantial improvements in operational efficiency were slow in being effected. Moreover, the PE sector as a whole continued to experience debt-servicing difficulties, and was unable to generate sufficient cash to finance its operations and carry out capital expansion. These problems were caused to a large extent by excessive indebtedness as reflected in very high debt-to-equity ratios and past accumulation of arrears.

The Kenya Power and Lighting Company (KPLC) returned to profitability in 1993/94. It further strengthened its financial performance in 1994/95, when its operating profit more than doubled to reach K Sh 5.0 billion, or 1.2 percent of GDP. This improvement reflected the full year impact of an increase in tariffs by 60 percent in March 1994 and a near doubling of its revenue. KPLC’s staff was reduced by 17 percent between July 1993 and June 1995, to a level of about 8,700 employees. 1/ The substantial reduction in the staff resulted from a hiring freeze, natural attrition, and the implementation of a Voluntary Retirement Program in April 1994. This program benefited 1,240 employees by end-June 1995. A redundancy plan was also implemented in April 1995 with a view to achieving further improvements in the customer/staff ratio. In addition, in May 1995, a report on the implementation of a reorganization of the power sector was completed, performance contracts for all power sector parastatals were prepared, and the balance sheets of various companies of the power sector were revaluated.

Kenya Railways’ (KR) operating profit increased from K Sh 0.1 billion in 1992/93 to K Sh 0.5 billion in 1993/94. This improvement derived to a large extent from increases in domestic tariffs (15 percent on January 1, 1994, and 10 percent on July 1, 1994), as well as in international tariffs (which were linked to the exchange rate of the Kenya shilling). In spite of this improvement, Kenya Railways continued to have liquidity problems and accumulate arrears on its servicing of government-guaranteed external debt. The implementation of actions to strengthen the performance--such as staff cuts and divestiture of peripheral activities--was also delayed. In 1994/95, KR’s operating profit virtually disappeared. Revenue from freight traffic, which accounts for nearly 85 percent of KR’s revenue, declined by 9 percent. This drop reflected tariff reductions granted by KR to regain customers that it had lost in the process of transporting large amounts of relief food at the request of the Government in 1993/94. The implementation of structural reforms improved substantially in 1994/95. Staff reductions, funded through the sales of land, started in September 1994 and 600 departures were recorded as of June 1995, resulting in a staff of less than 17,300 employees. A policy paper with proposals for financial restructuring and performance contracts was prepared in September 1994 and submitted to the Government for approval. The separation of passenger and freight services accounts was effected in July 1995 and a study on the physical separation of the two activities is expected to be completed by end-1995. KR is also in the process of contracting out all of its locomotive maintenance activities.

The operating profit of the Kenya Posts and Telecommunications Corporation (KPTC) increased from K Sh 4.5 billion in 1992/93 to K Sh 5.9 billion in 1994/95. The cash flow generated by these operating profits was not, however, sufficient to cover the amortization of KPTC’s debt, the payment of its tax and debt service arrears, and its investment program. As a result, the balance sheet of the corporation did not improve over the period and its cash position remained precarious. The increase in profitability reflected an increase in domestic telecommunications tariff by 50 percent in March 1994 and benefited from the appreciation of the exchange rate in 1994 which reduced the costs of international connections, as well as the Kenya shilling value of the external debt servicing. KPTC, however, kept delaying transfers to the Treasury of the VAT that it collected on behalf of the Government. A salary increase by about 35-40 percent was granted in December 1994, which was partially offset by a retrenchment of 7,800 staff during July-December 1994. The privatization of equipment maintenance, block wiring, mobile telephone, directory and terminal equipment supply was substantially implemented, and negotiations on a performance contract started in May 1995. In addition, the separation of KPTC’s postal and telecommunications functions has not been completed as a result of the delay in preparing the necessary legislation.

The National Cereals and Produce Board (NCPB) was the only key enterprise to register a weakening in its performance from 1992/93 to 1993/94. Overall, the operating deficit of NCPB increased from K Sh 1.8 billion in 1992/93 to K Sh 2.5 billion in 1993/94. NCPB purchased substantial amounts of maize at above-market prices in 1994/95 and its operating loss reached K Sh 2.2 billion. As a result of continued operation at a high level of activity, NCPB’s targets for reductions in permanent staff on grain depots operated were not observed.

The operating profit of the Kenya Ports Authorities (KPA) doubled in 1993/94, to K Sh 3.3 billion. This performance resulted from larger volumes of imports passing through the port of Mombasa because of the crises in Somalia and Rwanda, and the drought. KPA also benefited from the favorable effect of the appreciating Kenya shilling on the local currency cost of external debt service. In 1994/95, the operating profit was reduced to K Sh 2.2 billion: revenue declined slightly and expenditure increased by more than 25 percent, reflecting substantial increases in staff and material costs. The structure of the balance sheet also worsened in 1994/95, and severe cash constraints emerged as a result of large increases in fixed assets and stocks as well as a deterioration in the operations of KPA. The productivity of the container terminal was less than 30 percent of international levels, and had fallen from 220 moves per ship per day in 1994 to 170 movers per ship per day at end-June 1995. Handling charges were higher than international levels by 50 percent and containers staying three times longer than in most international ports. Structural reforms implemented included the contracting out of equipment maintenance for three categories of equipments in September 1994 and the completion of a study to evaluate options for the management of the container terminal in May 1995.

Overall, a number of factors contributed to the delays in implementing the reforms of strategic PEs. These factors included: (i) weak management in certain enterprises; (ii) weak capacity and inadequate staffing at DGIPE; (iii) resistance to the reforms within some of the PEs; and (iv) delay in meeting the conditions for securing funding for technical assistance for the program. Also, delays in completing performance contracts precluded a timely transition to a market-based mode of operations.

5. The privatization program

a. General approach

Privatization, as defined for “non-strategic” PEs under the Kenyan program, involves the sale of government shares in a company, to achieve either a full divestiture of the government share or a minority government share. In addition, as the reform program for “strategic” PEs progressed, it became apparent that the distinction between “strategic” and “non-strategic” enterprises was not always relevant, as the Government decided to privatize (either through contracting out or divesting) a number of functions of “strategic” PEs. In particular, these functions included electricity generation (which has been carried out by PEs under the KPLC umbrella), several telecommunications functions (KPTC), the maintenance of railways equipment (KR), grain marketing (NCPB), and the maintenance of port equipment and handling of goods (KPA).

At the outset of the privatization program, the Government set up institutional arrangements for the privatization process. A Parastatal Reform Program Committee (PRPC), under the chairmanship of the Minister for Finance, was established to supervise the privatization program and approve the timing of sale of each enterprise. The management, coordination, and implementation of the privatization program was vested with the Executive Secretariat and Technical Unit (ESTU), which acts as a secretariat of the PRPC. The principles guiding the privatization include provisions that PEs be divested into competitive markets and that bidding be open to all. To facilitate the privatization process, priority would be given to PEs that require minimal restructuring and that generate a profit. Strict guidelines were established to ensure transparency of the privatization process, as well as the management of privatization proceeds.

b. Progress under the program

Progress under the privatization program has been mixed. On the one hand, the number of enterprises privatized has exceeded the objectives. As of January 1995, 52 enterprises had been divested out of the 211 non-strategic enterprises. 1/ In addition, the Government divested its holding in the 43 tea factories by April 1995 and completed 18 more divestitures by end-June 1995. Moreover, government shares in National Bank of Kenya, a large commercial bank, were sold in the Nairobi Stock Exchange in October 1994; in effect, the Government’s shareholding in NBK was reduced to less than 50 percent. Finally, a sales memorandum was prepared regarding the privatization of Kenya Airways in March 1995 and expression of interest to buy the airline was received in May 1995.

On the other hand, there have been concerns that the Government may not have received a realistic market price for the enterprises sold, and that the process may have lacked the desired transparency; the majority of PEs privatized (23 out of the 52 divested in January 1995) were sold through pre-emption rights. Moreover, the enterprises sold were all relatively small, and some had not been in active operation prior to the sale; privatization of more prominent enterprises (notably, Kenya Airways) was delayed. To address these concerns, public announcements of the particulars of privatizations, and audits of the proceeds, have commenced. The proceeds have so far been kept in a special account, earmarked for restructuring of PEs to be privatized; the Government is reviewing the procedures, to determine whether the proceeds could be directed toward financing of the budget.

V. Monetary Developments and Financial Sector Reforms

Over the recent past, Kenya has undertaken significant reforms in the financial sector, which have led to fundamental changes in the conduct of monetary and exchange rate policies. Key among these reforms were the liberalization of interest rates, and the attendant steps to ensure rapid transition to an indirect monetary policy framework. 1/ At the same time, however, monetary control proved difficult, and this has been reflected in large swings in key prices--exchange rate and interest rate--as well as sudden surges in monetary aggregates. While such volatility appears to be typical during transition from direct to indirect monetary policy instruments, 2/ Kenya’s own circumstances, coupled with various external and policy-induced developments, contributed to the outcome. These included, inter alia, episodes of widespread financial mismanagement (during 1992 through mid-1993) and erratic foreign exchange flows (from late 1993 through present), as well as conflicting policy objectives centered around the management of a growing domestic debt stock of the central government.

1. Developments in the monetary policy framework

The institutional setting of monetary policy implementation began to change dramatically at the end of the 1980s, when Kenya embarked on a comprehensive program of financial sector reforms. 3/ By mid-1991, the authorities had moved completely away from reliance on quantitative credit ceilings and interest rate controls, toward an indirect monetary policy environment, with cash (reserve) ratio, rediscount window, and open market operations as the main policy instruments.

In the period prior to 1991, the Central Bank of Kenya (CBK) set ceilings on total domestic credit and (net) banking system credit to the Government. Commercial bank credit to non-government borrowers, i.e., parastatals and the private sector, was controlled through monthly credit ceilings on individual banks. All interest rates were administered. Although the CBK held rediscount and advance facilities for commercial banks on the basis of eligible paper, the effectiveness of this instrument for monetary policy purposes was limited; interest rates charged on such lending were derived from the below-market treasury bill rates, and thus were not sufficiently penal. 1/ Beginning in 1986, commercial banks were subject to a cash ratio equivalent to 6 percent of total deposit liabilities. 2/ Effectively, the only monetary policy instrument at the disposal of the Central Bank was the (residual) ceiling on credit to nongovernment sectors, given that the responsibility of the observance of credit ceilings to the Government rested with the Treasury, and that Kenya operated a fixed exchange rate regime. Direct controls on credit ceilings, however, were often evaded, and, in general, could not be used as an instrument for short-term liquidity management.

A central component of reforms was the strengthening of the treasury bill market which, following the liberalization of interest rates in July 1991, was considered as the key vehicle to achieve a fully market-determined rate. An active treasury bill market was also recognized as the critical element in moving toward an indirect monetary control framework, allowing the authorities to affect reserve money through open market operations. 3/ In early 1993, treasury bill auction techniques as well as tender procedures were revised. The Central Bank was given the responsibility to determine the volumes in the primary auctions, which were to be conducted on a weekly basis. Total sales by the CBK would be guided by budgetary financing needs as well as monetary policy considerations. As to the latter, the CBK began to conduct open market operations through sales of treasury bills “on tap” to banks and nonbank financial institutions (NBFIs) during the week. 4/ Except for a brief period in the early stages, the CBK has not been carrying treasury bills in its portfolio, and has been functioning purely as a sales agent to the Government.

While open market operations were to become the principal instrument for managing the liquidity position of the banking system, the cash ratio has also been actively used since April 1993, initially as an instrument to absorb liquidity resulting from widespread financial mismanagement and later, in response to sudden surges in foreign exchange inflows. The compliance with the ratio was ensured through frequent increases in penalties on deficient reserve positions (see below). 1/ The cost of this strategy, however, was reflected in the large interest rate spreads of the commercial banks, that followed the adjustments in cash ratio closely. The strength of this association was mainly attributable to the lack of competition in Kenya’s financial sector, despite the existence of numerous banks. In addition, except for a short period during November 1993 through March 1994, required reserves were not remunerated by the CBK. Furthermore, banks and NBFIs have been required to meet a liquidity ratio, set at 5 percent above the cash ratio for banks, and 10 percent for NBFIs. 2/

The CBK continued to implement its rediscount and advance facilities. With interest rates determined on the basis of treasury bill auctions. In effect, activity through the discount window has been fairly limited since mid-1993. Punitive rates apply to borrowing at the window, which has often been raised, particularly during 1993, to signal the tightening in CBK’s monetary policy stance (see below).

Parallel measures to establish an appropriate legal and regulatory framework for the financial system were introduced to support the move to an indirect monetary policy framework. Amendments to the banking laws, which had begun in the mid-1980s, resulted in the introduction of the revised Banking Act of 1989. New banking legislation considerably enhanced the CBK’s regulatory and supervisory functions, introduced prudential requirements, including capital adequacy, risk exposure, and the cash and liquidity ratios, and established guidelines on portfolio provisions. A further amendment to the Banking Act has been tabled in the Parliament in late 1994. As to the banking supervision, the CBK has a relatively strong Supervision Department, and the past problems in the financial sector is viewed primarily to be the outcome of deficient enforcement of a broadly adequate capacity.

A well-developed secondary market in treasury bills does not exist in Kenya, and this considerably limits available monetary policy options for the authorities. Several factors account for this outcome, including: (i) a lack of trust among banks; (ii) the existence of a relatively high liquidity ratio, which locks in a large volume of treasury bills with banks and NBFIs; (iii) excessive involvement by the CBK in the open market through during-the-week sales, thus obliterating the need for banks to adjust their liquidity through the interbank market; and (iv) poor treasury management techniques at the banks.

2. Structure of the financial sector

As of June 1995, Kenya’s financial sector comprised the Central Bank of Kenya, 37 (domestic and foreign) commercial banks, 43 nonbank financial institutions (NBFI), the Post-Office Savings Bank, 1/ as well as numerous specialized institutions (mortgage banks, insurance companies, etc.). The Nairobi Stock Exchange (NSE), an old establishment dating back to early 1950s, is overseen by the recently established (1991) Capital Markets Authority--the supervisory body in charge of capital market developments in Kenya. As of June 1995, 56 firms, with a market capitalization of US$3.3 billion, were listed in the NSE. Foreign firms accounted for about 75 percent of total market capitalization. The NSE has been open to foreign investors since the beginning of 1995, but the inflow of funds has been limited.

Although relatively diversified, Kenya’s financial structure is in need of strengthening, in terms of both enhancing competition and restructuring of financial portfolios. Despite the existence of numerous banks and NBFIs, the sector is dominated by a few large banks. For instance, as of June 1995, about 65 percent of deposits were being held with two foreign and two state-owned banks. Furthermore, many of these institutions are reportedly poorly capitalized, and large disparities exist among banks in management and technical expertise, the latter, particularly, in relation to operations in Kenya’s fast-developing money and foreign exchange markets. The banks also exploit a dual deposit structure, whereby a relatively flexible wholesale depositor base, sensitive to relative returns, co-exists with a large and mostly stagnant retail component. 2/

The large number of banks in Kenya is more a legacy of past weaknesses in the management of the sector, than indicative of a competitive market structure, and is mainly attributed to laxity in licensing new entrants during the 1980s. Through early 1993, despite a broadly adequate regulatory framework, enforcement of the prevailing banking regulations and prudential requirements was particularly weak; a growing number of commercial banks and NBFIs were not complying with prudential requirements. Discretionary exemptions to Banking Act provisions were frequently granted, while other unsound banking practices, including inside lending or directed lending to parastatals, had left banks with large portfolios of non-performing loans, and in illiquid or insolvent conditions. By early 1993, about a one-third of The banks--accounting for 63 percent of total banking system assets--had been identified as distressed.

A number of important steps were taken to restructure the sector. These include, inter alia, regulations pertaining to NBFIs and a program of overall rehabilitation and divestment of mostly state-owned banks. During the 1995/96 budget speech in June 1995, it was announced that the NBFIs will be brought fully under the cash ratio requirement by end-1995, thereby providing the incentives to merge with the parent banks. Subsequently, the CBK issued a circular in mid-June, laying out the pace at which NBFIs are expected to meet the cash ratio. The program is proceeding as scheduled, and the NBFIs have been complying with the cash ratio. 1/ During 1993/94 financial year, 7 NBFIs became banks, 12 received the authority to convert, 2 converted to mortgage companies, and 4 received the approval to merge with their parent banks. The authorities also embarked on a program to rehabilitate and privatize government-owned banks. Most notably, Government’s share in the National Bank of Kenya--one of the largest state-owned commercial banks--had been reduced to below 50 percent by June 1995.

3. Monetary developments. July 1993-June 1995

Monetary developments in the period from July 1993 through June 1995, can be broadly viewed in two phases: (i) implementation of measures to restore monetary stability through September 1993; and (ii) experience with erratic foreign exchange flows thereafter. During 1992 and early 1993, the expansionary liquidity conditions contributed substantially to the sharp macroeconomic deterioration in Kenya. 2/ In the context of the Government’s macroeconomic program (for the period from April 1993 through December 1993), the CBK took several measures to tighten access to its lending facilities and strengthen prudential supervision of the banking system, including strict enforcement of all regulations and recovery of irregular credit extended earlier.

First, in a circular issued in March 1993: (a) the margin on central bank discounts and advances was raised to 5 percentage points above the prevailing treasury bill rate for the first K Sh 50 million and an additional one percentage point on every additional K Sh 50 million; (b) only those securities with a period of 45 days or less to maturity were allowed for discount at the CBK; (c) overdraft facility for commercial banks at the CBK was closed; and (d) banks were instructed not to enter new commitments under the preshipment facility. Second, in April, the cash ratio was raised to 8 percent (from 6 percent), and the penalties associated with non-compliance with the cash ratio were increased. 1/ Third, effective July 28, the cash ratio was raised further to 10 percent. Fourth, in August, new clearing arrangements were effected in the Nairobi Clearing House, with a view to eliminating automatic provisions of CBK credit to banks; the CBK participation in the Clearing House was limited to receiving items cleared to it by commercial banks. Finally, also in August, securities eligible as collateral for overnight loans were restricted, more specifically, to treasury bills and bonds, and paper eligible for rediscounting was restricted by lowering of maturities: treasury bills (half way to maturity) and bonds (45 days or less). In addition to these direct measures, the CBK began to sell treasury bills to eliminate the liquidity overhang; in the quarter ended June 1993, the CBK sold treasury bills amounting to K Sh 30 billion, by substantially raising interest rates. On 90-day bills, interest rates reached an average 70 percent during June-July, substantially positive in real terms. 2/

Following these actions, monetary expansion slowed down dramatically in the period from December 1992 through September 1993 (Charts 5a and 5b). While reserve money increased from K Sh 25.7 billion at end-1992 to K Sh 30.8 billion in September, this reflected the impact of the higher cash ratio, with currency in circulation declining by 7 percent from K Sh 20 billion to about K Sh 18.6 billion during the same period. Broad money (M2) grew by only 6 percent, from K Sh 99 billion in December 1992 to about K Sh 111 billion in September 1993. 3/ Given the increase in the price level during the period, the contraction in monetary aggregates was much more pronounced in real terms, with reserve money and broad money declining by 20 percent and 25 percent, respectively.

CHART 5a
CHART 5a

KENYA: Monetary Indicators, December 1992 – June 1995

Citation: IMF Staff Country Reports 1995, 133; 10.5089/9781451821031.002.A001

Source: Data provided by the Kenyan authorities.
CHART 5b
CHART 5b

KENYA: Monetary Indicators, December 1992 – June 1995

(Real monetary indices, December 1992=100)

Citation: IMF Staff Country Reports 1995, 133; 10.5089/9781451821031.002.A001

Source: Data provided by the Kenyan authorities.

In late 1993, with the earlier sources of liquidity injection closed, Kenya entered a new phase of policy challenges: coping with erratic foreign exchange flows. A period of strong inflows, which began broadly at around October 1993, 1/ was later followed by two episodes of foreign exchange market turmoil, in November 1994 and Hay 1995, translating into sudden losses in CBK’s foreign exchange reserves. An important characteristic of the entire period was the emergence of a strong link between the money and foreign exchange markets, with developments in the treasury bill holdings having an immediate impact in the foreign exchange market, and often times, on CBK’s foreign exchange position (Chart 5c).

CHART 5c
CHART 5c

KENYA: Monetary Indicators, December 1992 – June 1995

Citation: IMF Staff Country Reports 1995, 133; 10.5089/9781451821031.002.A001

Sources: Data provided by the Kenyan authorities; and staff estimates.

Kenya began to experience strong foreign exchange inflows in October 1993. The inflows lasted for about a year, complicating macroeconomic management, as reflected, most notably, in inflationary pressures which did not fully abate until mid-1994 (see Chapter II.3.a). While several elements contributed to large foreign exchange inflows to Kenya, very high domestic interest rates, resulting from a combination of tight monetary policy, budgetary financing needs, as well as sterilization efforts, appeared to be the principal factor. 2/ The tight stance of monetary policy through September 1993, associated with a policy of high interest rates on treasury bills, produced an extremely high interest rate differential in favor of the domestic currency. The differential, as measured by an uncovered interest rate parity relationship, had risen to 8-10 percent (on a three-month basis) around mid-1993 (Chart 5c). 3/ In the face of large capital inflows, and strong pressures for exchange rate appreciation, the CBK’s initial policy response was to intervene in the foreign exchange market to limit the appreciation, while sterilizing the domestic liquidity impact of the foreign exchange purchases. In the circumstances, the CBK used massive sales of treasury bills to sterilize the foreign exchange inflows, with net treasury bill sales amounting to K Sh 34 billion between October 1993 and March 1994 (85 percent of average reserve money stock for this period). While the nominal interest rate began to decline in the period, it remained substantially positive in real terms. The cash ratio was raised four times--each time by 2 percentage points in October 1993, December 1993, February 1994, and March 1994--to control the liquidity expansion. 1/

The treasury bill sales as well as adjustments in the cash ratio, however, were not sufficient to fully sterilize the liquidity injection from heavy foreign exchange purchases. Fiscal expansion, largely driven by interest payments and financed by increased borrowing from the CBK, also contributed to the domestic liquidity expansion. As a result, monetary conditions were broadly expansionary during October 1993-March 1994, contributing to the renewal of inflationary pressures in early 1994. At end-March 1994, reserve money stood at K Sh 45.5 billion, 48 percent higher than its level in September 1993. This corresponded to a sharp expansion in broad money, which reached about K Sh 162 billion at end-March, growing by some 45 percent from September 1993; currency in circulation expanded by 30 percent during the same period.

In response to the loosening in monetary conditions, a major policy shift took place in the second quarter of 1994. Fiscal policy was substantially tightened, and the CBK refrained from large-scale intervention in the foreign exchange market. The fiscal tightening allowed large Government repayments to the CBK, which, in turn, led to a contraction in reserve money. Net government credit declined by about K Sh 5 billion in this quarter with treasury bill sales increasing by about K Sh 3 billion. 2/ At end-June, reserve money contracted by about 3 percent from its level at end-1993, while broad money expanded slightly. However, in the 12-month period through June 1994, reserve money expansion remained substantial at 52 percent (Table 23). Growth in broad money at 21 percent, although less pronounced, was also strong during the period (Tables 24 and 25).

In early November 1994, the circumstances in the financial markets suddenly shifted, leading to massive reserve losses to both CBK--about US$200 million in a matter of weeks--and the banking system as a whole. While the surge in imports by petroleum companies--in the wake of petroleum market liberalization--partly accounted for the increased foreign exchange demand, it also reflected a shift in exchange rate expectations. Sharp adjustments in interest rates appeared costly, however, given the high treasury bill stock at the time. 1/ In November, a large expansion in net domestic assets (NDA) of the CBK was accepted owing to redemptions in treasury bills (K Sh 13 billion), leading to a dramatic shift in the Government’s position from treasury bills to CBK overdraft despite a broadly balanced fiscal position. Although a sharp decline in the foreign exchange reserves of the banking system followed, this was more than offset by the expansion in the net domestic assets. As a result, reserve money reached K Sh 55 billion in December 1994, 35 percent higher than its level in June 1994. This was mainly driven by the increase in the government overdraft position, with net redemptions in the treasury bill market amounting to 17 billion during November-December. Growth in broad money was also substantial, at 28.8 percent, in the period from June 1994 through end-1994.

After a short period of stability, largely owing to seasonally strong balance of payments and a sharp reduction in inflation, strong downward pressures in the foreign exchange market re-emerged in April 1995, as reflected in a sharp drop in the foreign exchange reserves of the CBK. In April, foreign exchange reserves declined by US$80 million--at constant exchange rates--and the exchange rate depreciated by 5 percent to K Sh 46 to the U.S. dollar, from K Sh 43.6. Pressures continued through May, with CBK’s reserves declining by another US$60 million, and the exchange rate depreciating by 17.6 percent to K Sh 54 to the U.S. dollar. The authorities sought to contain further depreciation and loss in international reserves by some fiscal tightening and various monetary policy measures, most notably by bringing forward the adoption of cash reserve requirement to NBFIs and discouraging access to discount window through punitive interest rates. As to the latter, in July, CBK raised the overnight lending rate to 4 percentage points above the highest prevailing treasury bill rate for the first K Sh 50 million, and 2 percentage points above for each additional K Sh 50 million. 2/ Despite these measures, however, treasury bills amounting to K Sh 9 billion were redeemed during April-June. As a result, with a view to avoiding increases in relatively longer term treasury bill races and the adverse effect on expectations, the CBK issued short term treasury bills--at 9, 16, and 23 day maturities--in mid-July, seeking to arrest the excess demand for the shilling. 1/ Because of low demand and continued redemptions in treasury bills, CBK was forced to raise interest rates on short term bills further. Although the policy appeared to have worked in terms of stabilizing the foreign exchange market, the composition of domestic debt began to shift toward shorter maturity; subsequently, the CBK revised the structure of interest rates, tilting the slope of the yield curve in favor of longer term treasury bills.

Notably, reserve money was stable at around K Sh 55 billion in the period from end-1994 through July 1995, with the decline in net foreign assets fully matching the expansion in credit to the Government; the latter reflected the expansion in the Government’s overdraft position owing to net redemptions of treasury bills. Growth in broad money (M2) was modest at about 6 percent during the same period.

VI. External Sector Developments and Policies. 1993-95

1. Introduction

Beginning in late 1991, Kenya experienced a period of severe balance of payments problems (Table 32). Kenya also started to accumulate external payments arrears in 1991, which rose to US$585 million at end-December 1993. Moreover, in late 1991, out of concern over economic and political reform, bilateral donors suspended balance of payments support to Kenya. 2/ These developments culminated in a crisis in early 1993 when the value of the Kenya shilling was devalued three times by a total of about 42 percent in nominal effective terms.

In the period May 1993-June 1994, Kenya’s external position strengthened considerably with improvements on both the current and the capital account, and there was an increase in the confidence in the Kenya shilling. In the year to June 1995, however, there was a significant weakening in the current account and substantial volatility on the capital account. The strong improvement in 1993/94 followed a significant improvement in the Government’s fiscal position, a rapid and extensive liberalization of the exchange system, and a reduction and simplification of the trade regime. Much of the volatility in capital flows noted for the year to end-June 1995 reflect uncertainty created by Kenya’s worsening relations with the international donor community, and domestic macroeconomic economic policies. The following sections describe the reform and developments that have taken place in the external sector in Kenya since March 1993.

2. Reforms of the external sector. April 1993-June 1995

A rapid liberalization of the exchange and trade regime was implemented in the context of a macroeconomic policy framework that the Government adopted in April 1993. Exchange restrictions on almost all current transactions were effectively removed in May 1993, with upward adjustment of the indicative limits (payments requests under these specified limits do not require prior approval by the Central Bank of Kenya) and with the introduction of the “bona fide” clause (payments request exceeding the indicative limits are approved without undue delay provided they are bona fide requests). Moreover, in May 1993, import and foreign exchange licenses were abolished, except for items on a short list based on health, security, and environmental considerations. Also, import procedures were made easier and more transparent with simplified import documents. Furthermore, a foreign exchange retention scheme was reintroduced that allowed all exporters of goods and services to keep 50 percent of exports earnings in foreign currency accounts in local banks. The export proceeds sold to the CBK were purchased at the market exchange rate. Finally, the Kenya shilling was devalued by 25 percent in March 1993, and further by 31 percent in April 1993. The exchange rate was unified on October 17, 1993, and, the rate was left to be determined by market forces.

In 1994, Kenya completed the process of liberalizing its exchange system. The export license requirement was removed in March 1994, except for a short negative list based on health, security, and environmental considerations, and all export taxes were eliminated in the context of the 1994/95 budget. With the relaxation of the Exchange Control Act on May 25, 1994, exporters are allowed to retain 100 percent of foreign exchange proceeds in foreign currency accounts. Since mid-1994, the Kenyan exchange system is free from restrictions on all current account transactions, including earlier restrictions set out with respect to the maximum amount of foreign exchange that was remittable per year for payment of invisibles. Customs tariffs are applied as the sole form of protection of domestic industry. In 1994, the number of tariff bands was reduced from eight to seven (0, 5, 10, 15, 20, 30, and 45 percent), with the highest rate down from 62 percent. On June 30, 1994, Kenya formally accepted the obligations under the Fund’s Article VIII, Sections 2, 3, and 4.

Moreover, in 1994 all of the Government’s exchange rate guarantee schemes were eliminated, and the Central Bank of Kenya ended the practice of selling forward cover to oil companies effective January 1994. One multiple currency practice remains in place, namely the Exchange Risk Assumption Fund (ERAF), which has ceased, however, to take on new commitments effective June 1994. The inventory of existing commitments under the ERAF has been completed, and the outstanding obligations are to be settled by end-1996. With respect to capital transactions, the blocked funds provision was revoked on May 25, 1994. Also, residents are now allowed to borrow offshore without limit. Furthermore, restrictions on outward investments were relaxed. Kenya residents may now freely invest outside Kenya up to a maximum of US$500,000 and all “bona fide” transactions for investments requiring amounts beyond this limit are approved by the CBK without delay.

In January 1995, the remaining restrictions on capital transactions, pertaining to inward portfolio investments, were removed, and foreign investors may now freely invest in listed shares as well as in government securities. Initially, the Capital Markets Authority Regulations of 1995 allowed up to 20 percent of the issued share capital of a company to be owned by foreign investors, with the limit for individual foreign ownership in a company set to 2.5 percent of the issued share capital. These limits were later raised to 40 percent and 5 percent, respectively. Furthermore, foreign exchange bureaus have been authorized, effective January 5, 1995 to deal in cash and foreign traveler’s checks. Also, in June 1995, the Government reduced further the number of customs tariff bonds to six (0, 5, 10, 15, 25, and 40 percent).

3. External sector developments in 1993

In 1993, the current account position strengthened to a small surplus (excluding official transfers) of US$4 million in 1993, or about 0.1 percent of GDP, compared with a deficit of US$325 million, or about 4.1 percent of GDP in 1992 (Chart 6). The liberalization of the exchange system, together with the sharp depreciation of the exchange rate in the first half of the year, contributed significantly to the strengthening of the balance of payments.

CHART 6
CHART 6

KENYA: External Indicators, 1990-95

Citation: IMF Staff Country Reports 1995, 133; 10.5089/9781451821031.002.A001

Sources: Data provided by the Kenyan authorities; and staff estimates.1/ For 1995, estimate for end-Juno.2/ Market growth = growth of world non-oil Import volume weighted by Kenya’s composition of exports.

Exports increased by about 11.5 percent in volume terms as, in particular, nontraditional exports (e.g. horticulture) responded to the liberalization of the exchange system and the depreciation of the exchange rate. Exports of coffee, increased by about 13 percent in volume terms, after having been on a decline since 1990. 1/ Tea exports increased by about 13 percent in volume terms despite the drought, and this increase in production and exports was stimulated by the complete liberalization of the tea industry and the introduction of a dollar auction system. The export performance of other agricultural products was mixed. In all, exports increased by more than the world demand for Kenya’s exports, indicating an increase in market share after declines in 1991 and 1992.

Imports declined by about 12 percent in volume terms in 1993, and real imports as a share of real GDP declined to 86 percent of the level recorded in 1990. This import compression largely reflected adjustments in inventories of imported goods. With the removal of cumbersome administrative import procedures and the improved access to foreign exchange, importers sharply reduced the level of their inventories of imported materials and spare parts. Before the reforms, many manufacturers kept as much as six months of their import requirement in stocks. Consumer goods accounted for about 11 percent of total imports, and capital goods for 21 percent. The remainder consisted of fuels and lubricants (24 percent), processed industrial inputs (38 percent) and primary industrial inputs (5 percent).

The tourism sector benefited markedly from the liberalized foreign exchange system and depreciation of the shilling. The foreign exchange earnings from tourism is sensitive to changes in the nominal exchange rate, and the sector’s very good performance in the fourth quarter of 1993 can to a large extent be attributed to the depreciation earlier in the year. Despite increasing competition from South Africa, the number of tourists arriving in Kenya rose by 12 percent in 1993 to 679,800 after having declined in 1991 and 1992, and hotel bed-nights occupancy increased by 52 percent. The average number of days stayed for all visitors increased by about 3.7 percent. Western Europe, especially Germany and the United Kingdom, continued to be the most important market for Kenya’s tourist sector. However, for the year as a whole, the foreign exchange earnings in this sector declined by about 12 percent.

Perhaps the most spectacular improvement in the balance of payments in 1993 took place on the capital account. Official capital inflows increased in 1993 to US$425 million from US$276 million in 1992 in response to the resumption of balance of payments support and an increased disbursement of project loans of bilateral donors. Moreover, the inflow of short-term capital (net) is estimated at about US$300 million, compared with an outflow of US$60 million in 1992. While the lack of firsthand data on short-term capital flows in Kenya prevents a detailed investigation of the factors that determine these flows, the private capital flows are likely to have been attracted by the liberalized environment, the high interest rates caused by the fiscal deficit and the tight monetary policy stance, and expectations of an appreciation of the shilling. A significant part of the private capital inflow reflects a likely portfolio adjustment in the private sector from holdings of dollars to shillings.

The large capital inflows contributed to an overall balance of payments surplus of US$282 million, as against deficits of roughly the same magnitudes in 1991-92. Gross international reserves of the Central Bank of Kenya rose by US$300 million, adjusted for valuation changes, to the equivalent of 3.5 months of import cover at the end of the year, up from 1.2 months of imports in 1992.

4. External sector developments in 1994

The current account balance is estimated to have registered a small deficit of 0.4 percent of GDP in 1994, with the deterioration in the trade balance following the sharp pickup in imports. During 1994, the inflow of short-term capital continued in the first half of the year; thereafter, it slowed down and reversed in the last quarter of the year. Gross official reserves rose markedly in the first half of 1994 to about 5 months of import coverage at end-June 1994 and declined to 3.7 months of imports at end-December, 1994.

Exports continued to grow strongly in 1994, by about 7 percent in volume terms. The strongest growth continued to be recorded for nontraditional exports, such as fresh and processed fruits and vegetables, and soap. However, exports of nonprocessed horticultural products slowed down somewhat in the second half of the year, mainly on account of the exchange rate appreciation. Earnings from coffee exports increased by US$57 million, or about 32 percent. This increase was entirely due to the higher world coffee prices. While the U.S. dollar price of exported Kenyan coffee was about 45 percent higher in 1994 than in 1993, in volume terms, coffee exports recorded a decline of about 10 percent, to about 80,000 tons. Tea exports were significantly affected by the drought early in the year. For the year as a whole tea exports declined by about 7 percent in volume terms, to about 178,000 tons from about 191,000 tons in 1993. The effect of this volume drop was offset by the increase in tea prices. Tea has become an increasingly important export product for Kenya, and Kenya’s share in the world market has risen markedly in recent years to about 9 percent in 1994.

Imports grew by around 31 percent in volume terms in 1994. Excluding the exceptional large imports of maize that took place in the first half of 1994, the volume growth is estimated at around 16 percent. Import demand was particularly strong in the second half of 1994 for manufactured goods, machinery and equipment, commercial vehicles, and chemical products. This strong growth was in response to the 48 percent appreciation of the real effective exchange rate in 1994 and the firm pickup in economic activity. As most companies have completed adjustment of stock holdings in the first half of 1994, the pickup in domestic demand translated quickly into an increase in imports.

For tourism, the first half of 1994 was good as the sector continued to benefit from the depreciation of the exchange rate in 1993. However, for the year as a whole total number of tourists stagnated at around 679,200. The stagnation was caused by the economic slowdown in Europe, new competing destinations in Africa, and the sharp rise in costs in U.S. dollar terms in Kenya. Although gross earnings rose significantly, profitability in the sector was severely squeezed as a consequence of this increase in costs in 1993-94 and the decline in earnings in shilling terms following the appreciation.

On the capital account, 1994 was characterized by a decline in official capital inflows and by large fluctuations in short-term capital flows. Official capital inflows in 1994 amounted to US$252 million. To a large extent the decline in official capital inflow reflected slow project realization in Kenya. Private capital flows, mainly short-term, continued to be strong in the first half of 1994. These flows slowed down, reversed, and eventually stabilized in the second half of 1994 in response to the marked appreciation of the exchange rate, the decline in interest rates on treasury bills, and the differential vis-à-vis international interest rates. For the year as a whole, short-term private capital net inflows are estimated at about US$321 million.

5. External sector developments in January-June 1995

The first six months of 1995 saw a marked weakening of the balance of payments. This weakening was caused by exceptionally strong import demand and a shortfall in official capital inflows. This led to strong pressure on the exchange rate, and the shilling depreciated from K Sh 44.47 = US$1 at end-January 1995 to K Sh 54.62 = US$1 at end-June. The gross official reserves of the Central Bank declined by about US$130 million, adjusted for the valuation change. At end-June 1995, the import cover was estimated at about 2.7 months compared with 5.0 months one year before.

Customs data for the first six months of 1995 are not yet available. However, data from the Coffee Board of Kenya, African Tea Brokers, the Horticultural Development Authority, commercial banks’ foreign exchange statistics, and the preshipment inspection agencies give the following picture.

With regard to exports, favorable weather conditions during the winter and the spring have led to strong growth in production of, in particular, tea, coffee, and horticultural products. Tea production in the period January-June 1995 was up by 41 percent compared with the same period in 1994, and the volume sold at the auction in Mombasa was up by 49 percent. However, the price per ton averaged US$1,370 as against US$1,688 in the same period 1994. Coffee production was also significantly higher in the first half of 1995 compared with the same period 1994, but the volume sold at the auction in Nairobi was actually lower by about 13 percent. The average price per ton at the auction, although on a declining trend as international production has picked up, was US$3,587 in the first half of the year compared with US$2,482 the same period in 1994. For horticultural products, strong export growth continued for cut flowers, in particular, while some vegetable products recorded a decline. For horticultural exports as a whole, growth is estimated at around 5 percent compared with the same period in 1995.

Data from preshipment inspection agencies through June show a very strong increase in imports, which averaged US$235 million per month compared with US$170 million for calendar year 1994. Particularly strong growth was recorded for imports of machinery and transport equipment, and manufactured goods, consistent with the pickup in investment activity. The strong growth in import demand is likely to reflect lagged effects of the real appreciation of 1994.

The capital account saw a large shortfall in the inflow of project loans. In particular, disbursements from the World Bank were delayed because of delays in the audit of accounts and a general slowdown in project execution.

6. External payments arrears

In 1991-93, Kenya accumulated US$585 million of external debt service payments arrears. On January 19, 1994, all arrears on debt to official bilateral creditors outstanding as of end-1993 (US$501 million) were rescheduled under the aegis of the Paris Club. Moreover, in 1994, all arrears to multilaterals and non-Paris Club bilateral creditors were paid. Also, in December 1994, a preliminary understanding was reached with London Club commercial banks on rescheduling of the outstanding debt service arrears as of end-1993. The rescheduling, which would cover both principal and interest arrears, amounts to about US$70 million, and includes accrued penalty interest and refinancing costs. The agreement is expected to be signed later in 1995, on terms comparable to those agreed with official creditors in January 1994, and covers all outstanding commercial debt arrears.

APPENDIX I

Kenya: Summary of Tax System as of end-August 1995

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Source: Data provided by the Kenyan authorities.

APPENDIX II Exchange Arrangement and Exchange Restrictions

(Position as of June 30, 1995)

Exchange Arrangement

The currency of Kenya is the Kenya Shilling. On October 18, 1993, the market and the official exchange rates were unified. The market rate is determined on the basis of underlying supply and demand conditions in the interbank market. The principal intervention currency is the U.S. dollar. On June 30, 1995, the exchange rate was K Sh 54.63 per US$1.

Under the foreign currency accounts scheme, exporters are allowed to retain 100 percent of foreign exchange proceeds in foreign currency accounts and may use the retained proceeds to finance business-related current expenses and debt-service payments or sell them to local banks at a market-determined exchange rate. Banks, in turn, are permitted to sell foreign exchange to any client at market-determined exchange rates for the same purposes, to purchase foreign exchange for their own accounts, to offer forward exchange contracts to exporters and importers at market-determined rates without restriction on the amount of period covered, and to sell foreign exchange to another bank.

Commercial banks are authorized to enter into forward exchange contracts with their customers at market-determined exchange rates in currencies of their choice; there are no limits on the amount or period of cover. There are no official schemes for currency swaps or exchange rate guarantee schemes for external debt servicing, except for the Exchange Risk Assumption Fund (ERAF) which covers the foreign exchange losses associated with exchange rate fluctuations occurring after July 1, 1989 for three development finance institutions. ERAF has ceased to take on new commitments effective June 1994.

Kenya formally accepted the obligations of Article VIII, Sections 2, 3 and 4 of the Fund Agreement, as from June 30, 1994.

Administration Control

The Minister for Finance has delegated the administration of exchange control to the Central Bank. Authority is delegated to the authorized banks to approve certain payments for imports, all payments for current invisibles, and some capital payments.

There are no import controls. Import and foreign exchange allocation licenses were abolished in May 1993, except for a short negative list of goods prohibited for health, security, or environmental reasons. The responsibility for issuing import licenses, when required, rests with the Director of Internal Trade in the Ministry of Commerce. The Director also issues special licenses for the exportation of restricted goods, including certain agricultural products and goods whose exportation is restricted based on security and environmental reasons.

Prescription of Currency

Payments to residents of other countries may be made in Kenya shillings to the credit of an external account in Kenya or in any foreign currency. Receipts may be obtained in Kenya shillings from an external account in Kenya or in any marketable foreign currency.

Resident and Nonresident Accounts

Kenyan residents who have foreign exchange earnings (including earnings from services) are allowed to open foreign currency accounts with local banks. There is no limit on the amounts of the use of these accounts. Foreigners with work permits in Kenya may open foreign currency accounts with Kenyan banks and may credit their local earnings to these accounts; use of funds in these accounts is not restricted. Accounts in foreign currency held by residents of other countries with authorized banks in Kenya are designated foreign currency accounts. They may be freely credited with authorized payments by residents of Kenya, with transfers from other foreign currency accounts, with the proceeds from sales of any currency and gold by nonresidents to authorized dealers, and with retained foreign exchange earnings. Foreign currency accounts may be freely debited for payments to residents and nonresidents. Payment of interim dividends to nonresident shareholders may be remitted without limit, provided that the application is supported by adequate documentation. Commercial banks may, without reference to the Central Bank, remit pension contributions to nonresidents.

Enterprises operating in export processing zones (EPZs) are permitted to hold foreign currency accounts abroad or with authorized banks in Kenya and may use the balances on these amounts to pay business-related expenses (including imports, debt service, and dividends). They are not required to surrender foreign exchange earnings to the Central Bank.

Imports and Import Payments

Import and foreign exchange allocation licenses are not required except for a few items that, for health, security, and environmental reasons, are included on a negative list.

Customs tariffs are applied as the sole form of protection of domestic industry. There are six customs tariff nomenclatures, with rates varying from zero to 40 percent. Exporters of horticultural goods and agro-based products are exempt from import duties and value-added tax on imported inputs.

Authorized banks are permitted to provide foreign exchange against the following documents: a copy of the import declaration, a final invoice, an original clean report of findings from a nominated inspection agency, and a copy of the customs entry.

Advance payments for imports may be made through commercial banks without prior approval from the Central Bank.

All imports with a f.o.b. value of more than US$500,000 are subject to preshipment inspection for quality, quantity, and price and require a clean report of findings. Authorized banks in Kenya may not issue shipping guarantees for the clearance of imports until they receive the report. All goods purchased by importers in Kenya must be insured with companies licensed to conduct insurance business in Kenya.

Payments for Invisibles

All restrictions on current account transactions including restrictions with regard to maximum amount of foreign exchange remit table per annum under payment of invisible were removed May 25, 1994. Payments to nonresidents for current account transactions may be remitted without limit, provided that the application is supported by adequate documentation. Commercial banks may, without reference to the Central Bank of Kenya, remit pension contributions to non-residents. Foreign workers may transfer abroad any amount of their earnings upon verification of income and payment of taxes. The exportation of domestic bank notes exceeding K Sh 100,000 requires approval from the Central Bank and must be declared to customs.

Exports and Export Proceeds

Most goods may be exported without special licenses. Exports of certain foodstuffs and agricultural products require special licenses and may be restricted to ensure adequate supplies in the domestic market. Exports of tea, coffee, minerals, precious stones, and other essential strategic materials are also subject to special licensing. Coffee, tea, and horticultural produce may be exported only if a sales contract is registered with the Coffee Board, Tea Board, and Horticultural Crops Development Authority, respectively.

Proceeds from Invisibles

All receipts from invisibles may be kept in foreign currency accounts. Travelers may freely bring in and take out foreign currency notes, except those of countries with restrictions on the exportation of currencies; however, foreign currency notes in excess of the equivalent of $5,000 must be declared at the point of entry or departure. The importation of domestic bank notes is limited to K Sh 100,000; exceeding amounts require prior approval from the Central Bank.

Capital

All restrictions on capital account transactions have been removed.

The investments of foreign funds in Kenya is generally not restricted, but to ensure eventual repatriation it is necessary to obtain from the treasury a “certificate of approved enterprise” for the investment. Foreign and domestic investment in specified types of production require approval. Foreign investors may repatriate the value of the original equity investment denominated in the currency in which it was initially made and the value of any profits that were reinvested and denominated in the currency of the original investment. Borrowing by foreign-controlled companies, on the domestic market is not restricted.

Outward investments: Residents may invest freely up to $500,000 without referring to the CBK. Investments above $500,000 should be referred to CBK who will approve all bona fide transactions without undue delay.

Inward investments: Restrictions on investment by foreigners in shares and Government securities were removed on January 4, 1995. The Capital Market Authority Act has been amended to allow foreign equity participation of up to 40 percent of share capital.

Offshore borrowing by residents is allowed without limit.

Gold

Residents may hold and acquire gold bullion (ingots, bars or sheets) without restrictions.

APPENDIX III

Table 1.

Kenya: Gross Domestic Product by Origin at Constant Prices, 1989–94

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Sources: Government of Kenya, Economic Survey, 1995; data provided by the Kenyan authorities; and staff estimates.

Includes General Government.

Table 2.

Kenya: Gross Domestic Product by Origin at Current Prices, 1989–94

(In millions of Kenya shillings)

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Sources: Government of Kenya, Economic Survey, 1995; and staff estimates.

Includes General Government.

Table 3.

Kenya: Expenditure on Gross Domestic Product at Constant Prices, 1989–94

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Sources: Government of Kenya, Economic Survey, 1995; and staff estimates.

GNFS: goods and nonfactor services.

Table 4.

Kenya: Expenditure on Gross Domestic Product at Current Prices, 1989–94

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Sources: Government of Kenya, Economic Survey, 1995; and staff estimates.

GNFS: goods and nonfactor services.

Table 5.

Kenya: Gross Domestic Product GDP Deflator, Population, and Real per Capita Income, 1987–94

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Sources: Government of Kenya, Economic Survey, 1992 and 1995; data provided by the Kenyan authorities; the World Bank, Stars Data Bank; and staff estimates.
Table 6.

Kenya: Gross Fixed Capital Formation at Current Prices, 1989–94

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Source: Government of Kenya, Economic Survey, 1995; data provided by the Kenyan authorities; and staff estimates.
Table 7.

Kenya: Sales of Agricultural Production to the Marketing Boards, 1989–94

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Source: Statistical Abstract, 1990; Economic Survey, 1995; and data provided by the Kenyan authorities.

Except pyrethrum, which is expressed in metric tons.

Table 8.

Kenya: Value of Agricultural Production Sold to the Marketing Boards, 1989–94

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Source: Economic Survey, 1995; data provided by the Kenyan authorities; and staff estimates.
Table 9.

Kenya: Average Prices to Producers For Selected Commodities, 1989–94 1/

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Source: Economic Survey, various issues; data provided by the Kenyan authorities; and staff estimates.

These prices are for calender–year deliveries and reflect actual payouts, although average prices for two seasons that overlap during a calendar year may have differed. For tea and coffee, the prices are for made tea processed coffee respectively.