Kenya: Request for a Three-Year Arrangement under the Poverty Reduction and Growth Facility

Kenya showed poor implementation of policies and weak economic performance under the Poverty Reduction and Growth Facility (PRGF) arrangement. The government formulated a new Economic Recovery Strategy for Wealth and Employment Creation (ERSWEC) aimed to address major macroeconomic vulnerabilities. Executive Directors emphasized the need for domestic debt reduction, the restructuring of spending, and a sustained implementation of the reform agenda. They suggested that bold reforms will be essential to encourage private investment and to mobilize adequate donor support for the reforms.

Abstract

Kenya showed poor implementation of policies and weak economic performance under the Poverty Reduction and Growth Facility (PRGF) arrangement. The government formulated a new Economic Recovery Strategy for Wealth and Employment Creation (ERSWEC) aimed to address major macroeconomic vulnerabilities. Executive Directors emphasized the need for domestic debt reduction, the restructuring of spending, and a sustained implementation of the reform agenda. They suggested that bold reforms will be essential to encourage private investment and to mobilize adequate donor support for the reforms.

I. Introduction

1. In the attached letter, the Kenyan authorities request a three-year arrangement under the Poverty Reduction and Growth Facility (PRGF) in an amount equivalent to SDR 175 million (64.5 percent of quota). Seven disbursements are contemplated during the three-year period, with one disbursement following the approval of the arrangement in November 2003 and six disbursements in May and October of succeeding years, following satisfactory conclusion of the semiannual reviews under the program (Table 1).

Table 1:

Kenya. Disbursement Schedule Under the Three-Year PRGF Arrangement

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Source: IMF staff projections.

2. The authorities’ case for a new PRGF arrangement is predicated on the need for Kenya to implement, in a systematic manner, a coherent package of economic and structural reforms aimed at decisively addressing Kenya’s tepid growth, weak budgetary position, large domestic debt, and fragility in the banking sector. Implementation of this package will facilitate the realization of its poverty reduction objectives. The authorities’ development strategy, which is outlined in the ERSWEC, is expected to require a marked increase in donor assistance. Present indications are that adequate donor assistance will be forthcoming if Kenya pursues a comprehensive poverty reduction program and strong policy reforms, supported by the Fund, and addresses the major weaknesses in governance. Medium-term projections indicate that the external current account gaps would be covered by the expected disbursements of concessional donor assistance, provided that the envisaged measures are fully implemented. The proposed access level takes into account the need to support an ambitious agenda of reforms, particularly in the governance and trade areas, a buildup of foreign reserves from 2.7 months of import cover at end-June 2003 to 4.0 months of import cover by end-June 2006, and an appropriate exit strategy for Kenya from use of Fund resources under the PRGF. Moreover, at the end of the three-year program period, total outstanding Fund credit to Kenya would remain relatively low, amounting to 74.4 percent of quota or about 10.6 percent of gross reserves (Table 2), reflecting the limited drawings under earlier arrangements.

Table 2.

Kenya: Projected Payments to the Fund, 2003-12

(In millions of SDRs, unless otherwise indicated)

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Sources: Kenyan authorities; and Fund staff estimates and projections as of August 30, 2003.

Projections are based on current PRGF and SDR interest rates. SDR net charges past 2012 are not included in the analysis.

II. Review of Performance Under the Last PRGF-Supported Program

A. Macroeconomic Outcomes

3. With the exception of inflation and the external current account position, macroeconomic outcomes in the three-year period 2000/01-2002/03 (July-June) covered by the last PRGF arrangement were well below expectations (Table 3). The key developments were as follows:

Table 3.

Kenya: Comparison of Projected and Actual Outcomes for Selected Economic Indicators Under the 2000-03 Program, 1999-2003

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12-month period ending December, except 2000 ending May.

Data are on a fiscal-year basis; e.g., 1999 refers to 1999/2000.

  • real GDP growth averaged less than 1.0 percent in the three-year period;

  • average consumer price inflation (excluding food and energy) slowed down from 5.9 percent in 1999/2000 to 2.7 percent in 2002/03 (Figure 1);

  • the overall fiscal deficit before grants was substantially larger than initially projected and net domestic financing expanded from 0.3 percent of GDP in 2000/01 to 5.0 percent in 2002/03, partly on account of a drop in revenue;

  • domestic debt increased from 19.6 percent of GDP at end-June 2001 to 25.0 percent of GDP at end June 2003;

  • three-month treasury bill rates declined from 18.9 percent in January 2000 to about 1 percent in September 2003 (Figure 2), despite the large domestic funding requirements of the government (Figure 3);

  • The external current account deficit (before grants) narrowed markedly, reflecting in part a contraction in investment; and

  • gross international reserves declined from a cover of 3.3 months of import in 2000/01 to 2.7 months of import in 2002/03.

Figure 1.
Figure 1.

Kenya: Consumer Price Inflation Rates, January 2000 - August 2003

(Percentage changes from the same period of the previous year)

Citation: IMF Staff Country Reports 2003, 399; 10.5089/9781451821109.002.A001

Sources; Kenyan authorities; and staff calculations.
Figure 2.
Figure 2.

Kenya: Real1/ and Nominal 91-Day Treasury Bill Rates, January 1998 - August 2003

(in percent)

Citation: IMF Staff Country Reports 2003, 399; 10.5089/9781451821109.002.A001

Source: Kenyan authorities and staff estimates.1/ Based on the annual changes in the overall CPI excluding food and energy.
Figure 3.
Figure 3.

Kenya: Key Monetary Aggregates, December 1997 - July 2003

(In millions of Kenya shillings)

Citation: IMF Staff Country Reports 2003, 399; 10.5089/9781451821109.002.A001

Source: Kenyan authorities.1/ There is a break in the series between November and December 1999 and between April and May 2000.

4. The weak economic performance was mainly the result of persistent governance failures and the slow pace of reforms. In addition, the external environment, as reflected by the declines in the terms of trade and in donor inflows since 2001, was more difficult than envisaged (Table 3). The strong inflation performance was the result of weak aggregate demand but also benefited from improvements in monetary policy implementation procedures, as well as from increased stability in the nominal exchange rate of the shilling (Figure 4). The decline in the treasury bill rates during 1999/2000-2001/02 reflected the success in lowering the inflation rate and the perceived country risk premium. The sharp decline in the rates since January 2003, however, has been due primarily to the persistence of liquid market conditions on account of a reduction in CBK repurchase operations and the lowering, with effect from July 2003, of banks’ required reserves from 8 percent to 6 percent of deposits. Banks have responded to the increase in liquidity by raising the proportion of free reserves held at the CBK.1

Figure 4.
Figure 4.

Kenya: Exchange Rate Developments The Nominal and Real Effective Exchange Rates, and Kenya Shillings per U.S. Dollar and Euro Rates for End January, 1999 - End September, 2003

Citation: IMF Staff Country Reports 2003, 399; 10.5089/9781451821109.002.A001

Sources: IMF African Department; and IMF Information Notice System.1/ An increase in the index denotes a depreciation.

B. Structural Measures

5. In late 2000, Kenya’s PRGF-supported program suffered major setbacks. First, parliament rejected the Public Service (Code of Ethics) Bill on the grounds that it contravened the principle of the separation of powers among the executive, judiciary, and legislative branches of government. Second, the Constitutional Court ruled that the Kenya Anti-Corruption Authority (KACA) was unconstitutional. Third, parliament passed the so-called Donde Bill, which sets limits on banks’ interest rates. Finally, the cabinet put on hold the privatization of the telecommunications company (Kenya Telkom) and the Kenya Commercial Bank (KCB), although both decisions were subsequently reversed. Details of the status of the structural performance criteria and benchmarks under the previous PRGF arrangement are provided in Table 4.

Table 4.

Kenya: Structural Performance Criteria and Benchmarks Under the Previous PRGF Arrangement

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Source: Kenya authorities.

6. To bring the program back on track, understandings were reached with the government on an alternative governance plan, which was intended to (i) build upon and strengthen the operations of the Anti-Corruption Police Unit (ACPU); (ii) strengthen the Office of the Attorney General (AG); (iii) enact appropriate versions of the Anti-Corruption and Economic Crimes Bill and the Public Officer Ethics Bill; (iv) establish special courts for corruption cases; and (v) demonstrate progress in tackling corruption.2 In December 2001, key elements of the new strategy were converted into prior actions for bringing the PRGF-supported program back on track. Most of these prior actions had not been implemented by December 2002, when the previous administration lost the parliamentary and presidential elections.

III. The Medium-Term Program

7. At the time of the last Article IV consultations, the authorities and the staff largely agreed on the diagnosis of Kenya’s principal economic problems—poor governance and widespread corruption; major structural distortions in the financial, parastatal, and utilities sectors; low savings and investment; and an inward-looking trade system—which have given rise to low economic growth, poverty, and mass unemployment.3 As a result, most poverty indictors have worsened in recent years (Table 5). The ERSWEC outlines a broad economic agenda to address these economic problems over the medium term. The three-year program, as well as the economic reform agenda presented in the MEFP, is fully consistent with the government’s economic recovery strategy, which has been evolving since the government took office and since the June 12 budget speech as more information has become available on the underlying weaknesses of the economy.4

Table 5.

Key Social Indicators

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Source: World Bank

8. The main objective of the economic recovery strategy is to reduce poverty by promoting strong economic and employment growth. The program for 2003/04-2005/06 aims at creating opportunities for productive employment through the rebuilding of sound governance structures, addressing the country’s major macroeconomic vulnerabilities, particularly the weak budgetary position, large domestic debt, and distressed financial system;5 and reforming the parastatal sector, labor markets and the trade system to foster a more competitive private sector. This is part of a broader reform agenda, which is supported by many donors and development agencies, including the World Bank. To achieve these goals, the program contains a package of policy measures (Box 1). The actions covered by structural conditionality under the program are presented in Box 2. The sequencing of the measures is driven by several considerations, including implementation capacity, political feasibility, and the need to rebuild, at an early stage, credible governance institutions.

Kenya: Main Actions Under the Program, 2003/04-2005/06

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A. Macroeconomic Framework, Outlook, and Risks

9. Under the program, the recovery in economic growth is expected to gain momentum over the medium term. Based on the sustained implementation of fiscal consolidation and restructuring, as well as the governance and other economic reforms described in the MEFP, inflows of donor budgetary assistance are expected to resume. The latter would support the assumed pickup in government investment from 3.6 percent of GDP in 2002/03 to 7.6 percent of GDP in 2005/06, as well as the required increase in public outlays on social and economic infrastructure (Table 6). Private investment is also projected to increase, reflecting improvements in public infrastructure and a rebound in business and consumer confidence in response to reduced political uncertainty. Real GDP growth is forecast to pick up from 1.2 percent in 2002/03 to 3.9 percent in 2005/06, reflecting a forecast improvement in the terms of trade, and the implementation of policies under the program. Initially, the economic recovery is expected to be driven by a resurgence of activity in the manufacturing, construction, transport, telecommunications, and financial sectors, with the construction and transport sectors benefiting from increased public and private investment outlays. The telecommunications and financial sectors would be aided by the ongoing reforms. Over the medium term, the pickup in growth would be more broadly based and would reflect both higher productivity and capital accumulation from reforms in the parastatal, financial, and labor market sectors, as well as from improved terms of trade and infrastructure.

Table 6.

Kenya: Macroeconomic Scenario, 2000/01-07/08 1/

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Sources: Kenyan authorities; and staff estimates and projections.

Fiscal year ending June 30.

The projecte decline in reseve money for 2003/04 is due to a reduction in cash reserve ratio from July 2003 onwards.

For the period 2003/04-2007/08. includes unidentified program support (financing gap).

10. Notwithstanding forecasts of a strong export performance, medium-term projections for the program period (2003/04-2005/06) indicate that Kenya is likely to face external financing needs averaging about US$1.3 billion a year, as a result of growing deficits in the external current account (excluding grants).6 The needs would stem in large part from the envisaged expansion in investment-related imports, although part of the investment would be financed by an expected pickup in foreign direct investment. Moreover, external resources would be required to achieve the targeted buildup of foreign reserves to about 4.0 months of projected imports by end-2005/06 from 2.7 months of imports at end-2002/03.

11. There are, however, risks to this outlook:

  • In addition to possible terms of trade shocks, the increased reliance on donor assistance would raise the vulnerability of budget outcomes from shortfalls in such inflows.

  • An increase in tensions within the ruling coalition could delay the implementation of critical reforms, particularly in areas where the government has just begun to build a broad consensus behind the reforms, such as the rationalization of public services, changes in the wage-setting mechanisms of public employees, privatization, and financial sector reforms. Moreover, close coordination between the executive and legislative branches of government will be required to maintain the reform momentum.

  • A resurgence of terrorist attacks could also undermine program implementation. However, the authorities, with the assistance of the main donors, have been taking strong and comprehensive steps to address this problem.

Kenya: Structural Conditionality

Coverage of structural conditionality under the proposed PRGF arrangement

The structural conditions in the first year of the proposed new arrangement cover policy measures to promote economic growth and poverty reduction. The key areas include the following;

  • strengthening expenditure management—by developing an action plan for introducing a Commitment Control System (CCS) to minimize deviations of expenditure outcomes from targets and a buildup of arrears, completing a report on the new mechanism for determining the salaries of public officials to facilitate a reduction of the wage bill in total expenditure, and reaching understandings on the fiscal implications of restructuring the National Social Security Fund (NSSF), as well as strengthening the financial position of NSSF;

  • improving the coverage and timeliness of data on fiscal operations—by presenting the 2002/03 final budgetary accounts to the Auditor General by March 2004;

  • reducing conflicts of interest and deepening anticorruption measures—by creating a clear timetable for completing initial asset declarations by all senior public officials, establishing the Kenyan Anti-Corruption Commission, transferring financial sector regulatory functions from the Ministry of Finance to the Central Bank of Kenya, and devising a plan to clear the stock of pending bills and resolve the stalled projects problem; and

  • accelerating the privatization process—by presenting a bill for the transparent privatization and sale of public assets, and reaching agreement on a time-bound plan for either liquidating or restructuring the National Bank of Kenya (NBK).

  • additional trade reforms to be agreed in the context of the first review under the arrangement.

Status of structural conditionality from earlier programs

The status of structural performance criteria and benchmarks for the previous program are presented in Table 4. The first and subsequent reviews under the program were not completed.

Structural areas covered by World Bank lending and conditionality

The following areas are covered:

  • public sector financial management and audit system;

  • expenditure management;

  • judicial system reform;

  • procurement systems;

  • civil service restructuring and pay reform;

  • capacity building in the delivery of public services; and

  • reforms in the parastatal sector.

B. Fiscal Policy

12. The authorities’ fiscal program aims at restoring debt sustainability, while providing increased resources for priority poverty reduction spending and the realization of the medium-term development objectives. The repayment of domestic debt and expected inflows of grants and concessional external finance would facilitate the achievement of both the overall development and debt objectives. Accordingly, the program envisages an expansion of the overall deficit, before grants, from 4.8 percent of GDP in 2002/03 to 6.2 percent of GDP in 2005/06 (Table 7). The primary deficit would also widen modestly. The projected significant expansion in donor assistance would facilitate a reduction in domestic debt in percent of GDP from 25.0 percent in 2002/03 to 20.9 percent in 2005/06 and in the net present value (NPV) of total central government debt from 52.6 percent of GDP in 2002/03 to 45.9 percent of GDP in 2005/06.7 The resulting reduction in interest payments from 14 percent of total expenditure in 2002/03 to 9 percent in 2005/06 would free up budgetary resources for priority poverty spending. Box 3 outlines the key actions under the program to contain the growth of debt and to restore fiscal sustainability.

Table 7.

Kenya Central Government Financial Operations, Program Scenario, 1999/2000-2007/08 1/

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Table 7.

Kenya Central Government Financial Operations, Program Scenario, 1999/2000-2007/08 1/ (concluded)

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Sources: Kenyan authorities; and Fund staff estimates and projections.

Final year ending June 30.

Differ from authorities numbers because of difference accounting treatment of finance defense leases.

The fiscal accounts are on a cash basis (with the exception of foreign interest due). To adjust to a commitment basis, the accumulation of peding bills is added and the cash payment of these bills deducted.