The Process

The Government of Kenya subscribed to the Poverty Reduction and Growth Facility (PRGF) in 2000 and embarked on the preparation of the Poverty Reduction Strategy Paper (PRSP) at the same time. This preparation was undertaken through wide-ranging consultations and dialogue in order to build consensus on priority actions and activities necessary for economic growth and poverty reduction. The PRSP was preceded by the Interim Poverty Reduction Strategy Paper (IPRSP) released in 2001. The IPRSP only involved limited consultations at the national level. The PRSP consultations followed a three-tier approach: national, provincial and district levels. The stakeholders in the consultations included the Private Sector, Civil Society, the Development Partners and local communities. A national steering committee that included all the stakeholders was formed to spearhead the process and ensure inclusion at all levels.

The consultations also covered thematic areas to take care of important issues that are cross cutting and which tend to be left out in mainstream sector working groups. The consultations went as far down to the divisions, locations and villages in some of the districts. Participatory Poverty Assessments (PPA) were carried out in ten (10) sampled districts. The District PRSP reports and PPA reports together with inputs from the Sector Working Groups were synthesized into the PRSP (2001-2004). The PRSP formed the basis for the 2002/03 budget.

In December 2002, a new government under the National Rainbow Coalition (NARC) took office and immediately embarked on the process of preparing an economic recovery strategy, focusing on reviving the economy and creating employment. The ERS presents a road map for economic recovery during the next five years. The ERS takes into account existing Government policy documents, particularly the PRSP and NARC’s Manifesto and Post-Election Action Plan.

The development of ERS was also a result of wide-ranging consultations with stakeholders. The stakeholders included, parliamentarians; trade unions; professionals; financial institutions; industrialists; ASALs; Development Partners; Civil society and government. The strategy therefore embodies the views and aspirations of all Kenyans.

Based on the ERS, an Interim Investment Programme was developed. The Interim Investment Programme provides a framework for implementing the ERS. The Interim Investment Programme was discussed at a National Investment Conference in November 2003, organized jointly by the government and the private sector. At this conference the private sector committed itself to continued partnership with the government for the success of the programme. It was also the Investment Programme that formed the basis of discussions at the Donor Consultative Group meeting held in November 2003. A prioritization workshop was also held in January 2004 where all the activities in the logical framework of the programme were prioritized in line with the sector objectives. During the same workshop, the Rapid Result Initiative (RRI) was launched in one of the sectors. Comments by the development partners, other stakeholders and inputs from the National Investment Conference, the Donor Consultative Group meeting and the prioritization workshops has be used to generate this final version of the Investment Programme.

Mechanisms of Linking the Ministerial Public Expenditure Reviews to the MTEF Budget Process

A key priority of the MTEF process is to improve the planning and resource allocation process to achieve a more effective use of resources and to redirect available resources towards implementation of policy priorities. The MTEF is an outcome based planning and budgeting process that seeks to establish an explicit link between policy, planning and budgeting. More importantly, the MTEF objective is to strengthen the linkage between the annual budget and national development policies and provide means of aligning expenditures to national priorities, outputs and outcomes set in the Economic Recovery Strategy. This way the National Budget will be guided by national objectives and the desired outcomes.

A review of the existing policies, analysis of the ministerial expenditure trends and the impacts of programmes and activities financed through the MTEF process is what is widely referred to as Public Expenditure Reviews (PER), and generally used to review and analyse trends and impacts of these expenditures.

The PER process in Kenya is implemented through an established institutional framework led by the National Steering Committee of Permanent Secretaries, Technical Officers in all the line Ministries and representatives of Development Partners. The Steering Committee is responsible for policy on PER and is chaired by the Permanent Secretary, Ministry of Planning and National Development and co-chaired by the Country Director World Bank Kenya office. The Steering Committee is supported by a Technical Working Group (TWG) drawn from all the ministries and representatives of key Development Partners under the leadership of the Ministry of Planning and National Development and is responsible for all the analytical work on PER and the back stopping roles form ministerial public expenditure reviews. The TWG is supported by a Secretariat, which has been modeled along the sector wide approach used in the MTEF process.

The outputs of PER are used in preparing reports of the Sector Working Groups (SWG) which are responsible for the coordination of MTEF sector policies, priorities and activities. Future institutional reforms for PER will entail the introduction of Public Expenditure Tracking Surveys (PETS) which have been piloted in the Ministries of Health and Education Science and Technology.

The government, having recognized that public expenditure reviews are an integral part of the MTEF process issued one circular that is going to guide the MTEF process for the period 2004/05 – 2006/07 and the Ministerial Public Expenditure Reviews (MPERs). The MPERs will review the past trends of expenditures including those expenditures that are related to core poverty programmes or social spending. The MPER reports will also include costed programmes and activities. The costed programmes and activities must be in line with those identified in the Investment Programme. Having costed the programmes, they will draw a three year financial/financing plan for the Ministry.

While the work of the sectors and Ministries is going on, the macro working group will draw up a fiscal strategy which will state the resources available and based on the ERS and the Investment Programme indicate which sectors are going to support faster recovery needed for poverty reduction.

The sector resource envelopes will be developed after having reviewed sector needs as given in the SWG reports and after having matched those needs with the Fiscal Strategy Paper (FSP) and other policies. Once sector envelopes are approved by cabinet, ministries will participate in the sharing of the resources through a criteria which must be seen to support the overall National goals/strategies as will be outlined in the fiscal strategy. Thereafter the Ministries will prepare their itemized budget according to resources they will get from the sectors.

A review of the MTEF process is in its final stages of completion. The main thrust of the review is to determine the main strengths and weaknesses of the current MTEF budget process and make recommendations for better public expenditure management. Together with the MTEF Review Report will be detailed implementation action plan with definite time lines that will pave the way for a revised MTEF for Kenya.

Coordination Arrangements for the Implementation of the Economic Recovery Strategy

The Economy

Since the 1980s, the economy has performed below its potential, with low economic and employment growth and a decline in productivity. Consequently, per capita income in constant 1982 prices declined from US$271 in 1990 to US$239 in 2002. The number of people openly unemployed currently stands at over 2 million or 14.6 per cent of the labour force, with the youth accounting for 45 percent of the total. The majority of the unemployed, though educated, do not have necessary skills. In addition, the number of the working poor is staggering comprising primarily subsistence farmers, female-headed households and slum dwellers. Disguised unemployment is also a serious problem, especially in the public sector. Moreover, the incidence of HIV/AIDS has increased, thereby imposing an increasing social and economic burden. The factors underlying the weak economic performance and high incidence of poverty include the persistence of pervasive governance failures, the slow pace of economic reforms, low savings and investment, intermittent shortages and high costs of power, and poor physical and telecommunications infrastructure.

The weak economic growth has been accompanied by deterioration in the fiscal position and a growing domestic debt. As a result of reduction in the tax rates, Government revenue fell from 29 percent of GDP in 1999/2001 to 22 percent in 2002/03. This reduction in tax rates was in line with Government policy of creating an enabling environment for business. However, a weakening tax administration resulting largely from widespread corruption contributed to fiscal pressure as the revenue declined. As the tax revenue declined, public expenditure did not respond concomitantly and continued to come under expansionary pressure on account of increased spending on wages, salaries and interest, as well as the burden of supporting a large parastatal sector. With donor budgetary support falling concurrently, the resulting fiscal pressures was accommodated by a squeeze in spending on operations and maintenance and public investment, an increase in arrears, including pending bills and stalled projects, and growing domestic borrowing.

Despite improvements in governance, several external developments have kept economic growth subdued. Recent data indicate that overall economic performance remained weak due to recent terrorism alert, which has taken a heavy toll on the tourism industry. Partly due to this reason, real GDP growth in 2003 is projected to remain below 2 percent. Excluding food and energy, inflation has risen to 3.7 percent in June 2003 from 1.6 percent in October 2002, reflecting in part a loosening of monetary conditions during 2002 that was accompanied by a depreciation in the nominal and real effective exchange rates of the shilling. While the exchange rate does not appear to have been a major impediment to export performance in recent years, the government has been monitoring exchange rate developments closely, as a continuation of the recent appreciation trend could have adverse effects on export and output growth.

Poverty Diagnostics in Kenya

Poverty rose in Kenya during the 1990s. Three national surveys conducted in the 1990’s provide valuable information about welfare levels, poverty and other household and individual characteristics. Several poverty profiles have been constructed spanning 1991/92, 1994 and 1997. The surveys are, however out of date and not fully comparable. Nevertheless, it is estimated that the proportion of the population living in poverty has risen from about 48.8 percent in 1990 to 55.4 percent in 2001. The proportion is estimated to have risen to more than 56 percent in 2003. Poverty increased sharply during the early 1990s, declined during the mid-1990s, and rose steadily since 1997. Thus, an additional 2.7 million people were living below the poverty line in 2001 than were in 1997 (from 14.4 million in 1997 to 17.1 million in 2001). Regionally, there are pockets of very high poverty that exceed the national average, calling for deliberate intervention in such regions.

Non-income dimensions of poverty worsened. In step with poor economic performance, key social indicators during the 1990s. Illiteracy rates increased as enrolment rates in primary school declined during the 1990s. Life expectancy declined from 57 years to 47 years between 1986 and 2000, while the situation in infant and child mortality and HIV/AIDS worsened. Preliminary results of the Kenya Demographic and Health Survey conducted in 2003 indicate that Infant mortality increased from 62 per thousand in 1993 to 78 per thousand in 2003, while under five mortality rose slightly from 96 per thousand births to 114 per thousand in the same period. Trends in nutritional status of children under age three show that the percent of stunted children (short for their age) increased from 29 percent in 1993 to 31 per cent in 2003. Similarly, the percent of children aged 12-23 months who were fully vaccinated dropped from 79 percent in 1993 to a dismal 52 percent in 2003. These national averages conceal substantial regional variations. For example, the proportion of children fully vaccinated in Nyanza, Western and North Eastern provinces falls below 50 percent as of 2003.

Estimates on unemployment also indicate an increasing trend over the last two decades. In 1978 the urban unemployment rate was approximately 7 percent. By 1986 it had increased to 16 percent and continued to rise to 25 percent by 1999. The unemployment rate in the rural areas for the same period was less acute at 9.4 percent, while for Kenya as a whole it was estimated at 14.6 percent. However, underemployment is significant, which has contributed to the existence of a class of Kenyans who are the working poor.

Currently, Geographical variations in the distribution of poverty are large. The WMS indicate that three quarters of the poor live in rural areas while the majority of the urban poor live in slum and peri-urban settlements. The 1994 WMS revealed that North Eastern Province had the highest proportion of people living in absolute poverty (58 percent), the highest in Kenya, followed by Eastern Province (57 percent) and Coast Province (55 percent). In 1997, Nyanza had the greatest proportion of its population living in poverty (63 percent) followed by Coast (62 percent). Moreover, more than 50 percent of the population in all other provinces except for Central (31 percent) were living in poverty. In urban areas, Kisumu town recorded the highest prevalence of poverty (63 percent), followed by Nairobi with 50 percent. Results of poverty mapping in Kenya indicate similar patterns in levels of poverty at the provincial levels, but depict large differentials at the sub-district level. For instance, rural poverty rates within Central province (least poor province in Kenya -31 percent) ranges from 10 per cent to 56 percent across its 171 locations. In Coast, about 61 per cent of the rural people are poor, and poverty ranges from 13 per cent to 90 per cent across the 140 rural locations. As in the rural areas, the urban areas similarly exhibit considerable heterogeneity with sub location measures showing high variability in the incidence poverty. In Nairobi, for instance, overall poverty rate is 50 percent, but at the sub-location level (110 sub-locations) poverty ranges between 6 and 78 percent. The poor in urban areas are concentrated in small areas (slums) where living conditions are pathetic. In all provinces except North Eastern, poverty levels show significant variations between locations in the same division and similarly for divisions within the same district. The Poverty mapping estimates also show that people in relatively less poor districts, divisions and locations depict much smaller poverty gaps (consumption shortfalls). Poverty gaps in such areas are typically around 5 percent of the poverty line, whereas in the poorest areas, poverty gaps are in the range of 30 to 50 percent.

Households that are large, headed by females, headed by adults with low educational attainment, or deriving most income from agriculture are more likely to be poor than others. In Kenya, as in other countries, poverty increases with household size.¹ Thus, households with a larger number of infants and children have a lower level of consumption, and thereby a higher probability of being poor. Female-headed households in urban areas are poorer than otherwise similar households. Not surprisingly, the educations of both the household head and of the spouse appear to be important determinants of poverty. For example, an urban household whose head has at least some primary education has a level of consumption 20 percent higher than a comparable household whose head has no education at all. In rural areas, the gap is only 13 percent. As the level of education attained by the head and spouse increases, the effect on consumption also increase. Working in the non-farm sector in rural areas is associated with a higher level of consumption. Wage workers, whether in the public or private sector, are better off than informal workers such as unpaid family workers. Land ownership, it is associated with higher levels of consumption in rural areas. Land owners can expect a 7 percent increase in consumption versus otherwise similar households, and each hectare of land brings an additional gain.

Determinants of Poverty: The key determinants of poverty in Kenya include location (rural/urban); household size; level of education of head of household, gender (male versus female headed households); agricultural output (cash crop farmers or subsistence farmers); access to land; and ownership of livestock and of selected durable farm tools. Factors highlighted in participatory poverty studies as affecting household consumption include having low agricultural productivity and poor access to markets; being unemployed or earning low wages; living in areas with poor infrastructure (especially roads), and with limited availability of affordable basic services; living with HIV/AIDS or with a disability; being a member of a minority or other group that is discriminated against; and living in an area with a poor and degrading environment. The poor also attribute their poverty to natural calamities, and traditions and cultural beliefs that deny women access to productive assets. The government recognizes that much is still to be done to understand the causes of poverty and to identify interventions that can effectively and rapidly reduce poverty.

Gender Dimensions of Poverty: Social factors and cultural norms emphasize the unequal power status of men and women. Some traditions favour male dominance, resulting in low social status of women. Special efforts are needed to empower women to make them less vulnerable. Efforts are ongoing to mainstream gender in the Economic Recovery Strategy. Constraints, however, include lack of gender-disaggregated analysis, except for the fields of basic education and some areas of healthcare. In addition, gender specific targets for defining improvements in the economic, social and legal situation are still lacking. The macroeconomic framework that forms the core of the Economic Recovery Strategy is still analyzed in gender-neutral terms.

Actions to deepen the understanding of the incidence, depth, trends, distribution, and determinants of poverty: An improved process for poverty diagnostics has been undertaken recently by the government in collaboration with the World Bank, through the establishment of a Poverty Analysis and Research Unit in CBS which is spearheading poverty analysis including poverty mapping exercise aimed at revising the poverty profiles for all the districts. The first volume of the poverty mapping exercise was released in October 2003 and further analysis to produce a volume two on socio economic dimensions is underway. To further improve on prior weaknesses of the WMS type of surveys, the CBS is planning to undertake an Integrated Household Budget Survey in 2004/05, which will provide critical data for estimating poverty headcount, distribution, causes, and trends. These data will provide the basis for a comprehensive poverty assessment to be undertaken during 2005/06. While the comprehensive survey data are very important for assessing poverty trends, the government recognizes a need for frequent information on poverty trends. It therefore plans to implement a program to generate such data through the use of quick monitoring survey instruments such as the Core Welfare Indicators Questionnaire (CWIQ) preferably every 2-3 years.

Such information will be used not only for designing targeted poverty interventions but also for monitoring and evaluating the ERS and MDGs. The information will also be used to develop a scorecard to indicate the number of households/individuals lifted out of poverty every year.

Macroeconomic Framework

The overall objective of macroeconomic policy is to restore economic growth within a sustainable framework of low inflation, declining fiscal imbalances, declining net domestic borrowing and healthy balance of payments. Specific objectives include increasing domestic savings and investment, improving accountability in the use of public resources, and restructuring and refocusing public spending toward priority activities.

Economic Forecasts

Table 3.1 below gives the economic forecasts for the period 2003 to 2007 for key economic variables. This forecast is consistent with the expected external environment especially trading partner growth and price levels, prices of key commodity exports and imports and expected growth in external support which will be used to boost Government investment and reduce domestic financing needs. The main elements of the forecast are as follows:

• Economic growth is expected to rise from 1.1percent in 2002 to 1.3 percent in 2003 and continue to reach 4.9 percent in 2007;

• Investment growth is expected to be the primary driver for economic growth. Investment levels are expected to rise from 13.6 percent of GDP to 24.3 percent. Domestic savings are expected to rise from 13.8 percent to 18.5 percent over the period, implying that there will be need for substantial external inflows for the investment levels to be achieved.

• Exports and imports are expected to be a major factor in the growth outcome. Exports to begin with are seen to be constrained by the low prices of Kenya’s major commodities. However, a quick response by the exporters to the policy regime currently being put in place to make them more competitive is expected to provide almost immediate gains by 2005. As for the imports, the volume growth will be driven mainly by the movements of the other components of the GDP, primarily investments and exports.

• Private consumption is expected to remain low as the Government focuses on investments and as lower proportion of incremental profits is disbursed from the private sector to households.

• Inflation: continuation of the conservative monetary policy will allow Kenya’s underlying inflation to remain below 3.5 percent, comparable with the forecasts for trading partner inflation. This will allow for the maintenance of a stable nominal exchange rate policy without risking real appreciation of the Kenyan shilling. Low inflation as well as externalization of the deficit is expected to allow the rate of interest on Government debt to remain below 6 percent in the medium term.

Table 3.1:

Forecasts for key economic parameters

Table 3.1:

Forecasts for key economic parameters

	2002	2003	2004	2005	2006	2007
GDP Growth (percent real)	1.1	1.3	2.5	3.7	4.1	4.9
Investments (percent of GDP)	13.6	16.5	20.4	23.3	24.4	24.8
Investment volume growth (percent)	-1.8	23.2	26.2	18.5	9.3	6.3
Savings (percent of GDP)	13.6	14.9	15.7	17.6	18.5	19.7
Export growth (volume, percent annual)	5.0	15.8	2.0	4.8	9.9	12.3
Import volume growth (percent annual)	-16.7	13.0	18.2	10.5	9.3	8.8
Inflation (percent)	2.0	9.8	3.5	3.5	3.5	3.5

View Table

Table 3.1:

Forecasts for key economic parameters

	2002	2003	2004	2005	2006	2007
GDP Growth (percent real)	1.1	1.3	2.5	3.7	4.1	4.9
Investments (percent of GDP)	13.6	16.5	20.4	23.3	24.4	24.8
Investment volume growth (percent)	-1.8	23.2	26.2	18.5	9.3	6.3
Savings (percent of GDP)	13.6	14.9	15.7	17.6	18.5	19.7
Export growth (volume, percent annual)	5.0	15.8	2.0	4.8	9.9	12.3
Import volume growth (percent annual)	-16.7	13.0	18.2	10.5	9.3	8.8
Inflation (percent)	2.0	9.8	3.5	3.5	3.5	3.5

Fiscal Strategy for Economic Recovery

The Government in June 2003 published an Economic Recovery Strategy that will guide major reforms to be undertaken over the period 2003 – 2007. The Budget mechanism presents one of the most fundamental instruments of implementing the economic reforms and other policy options outlined in the ERS in order for the objectives and the outcomes of the strategy to be realised. Core to the Budget is the ability to have a stable and sustainable Macroeconomic Framework. The overall objective of macroeconomic policy in the ERS is to restore economic growth within a sustainable framework of low inflation, declining fiscal imbalances, declining net domestic borrowing and healthy balance of payments. Specific objectives include increasing domestic savings and investment, improving accountability in the use of public resources, and restructuring and refocusing public spending toward priority activities. Fiscal policy together with other instruments such as monetary policy provides the Government with useful handles that can be used to ensure the realisation of the goals of the ERS. In the following section, the fiscal strategy that will guide the Government’s fiscal framework in the next three fiscal years is outlined.

Factors underlying the Fiscal Strategy

Several critical factors underlie Kenya’s fiscal strategy. The strategy is hinged on the projected performance of the economy. The key factors determining the projected economic performance will be:

• a) Recovery and sustained good performance in Kenya’s trading partners’ growth: Recent economic data shows that the European Union, East African Community, rest of Africa, and East Asia are Kenya’s major trading partners accounting for 31 percent, 11.4 percent, 15.7 percent and 14.4 percent respectively of Kenya’s major exports. It is forecast that Kenya’s trading partners will have an annual average growth rate of 4.2 percent over 2003 to 2007.

• b) Forecasts for trading partner inflation: It is also projected that Kenya’s trading partners will have a weighted average inflation of between 3.2 to 3.6 percent. Hence, a low inflation regime will be imperative for Kenya’s international competitiveness:

• c) Growth in export and import prices is expected to be subdued: Kenya’s merchandize export basket is heavily oriented towards agricultural products and commodities (coffee and tea account for over 31 percent while manufactured products account for less than 40 percent) while its import basket is heavily biased in favour of petroleum fuels (16.3 percent) chemicals (13.9 percent) machinery and transport equipment (32.4 percent) and manufactured goods (16.3 percent). Given the low price forecasts for both export and import commodities, overall external trade prices are expected to be low.

• d) Interest rates: Kenya has recently moved to a low domestic interest rate regime as a result of low underlying inflation and stable exchange rate regime. With restoration of donor support, the Government is expected to rely less on domestic borrowing allowing for interest rates to remain low and stable.

The expected trends of these key economic variables between 2003-2007 are shown in table 3.2 below.

Table 3.2:

Forecasts for key economic variables affecting Kenya

Table 3.2:

Forecasts for key economic variables affecting Kenya

	2002	2003	2004	2005	2006	2007
Trading Partner Growth	3.70	3.37	4.17	4.44	4.45	4.45
Trading Partner CPI	3.24	3.52	3.58	3.25	3.25	3.25
Growth in Export Prices (Kshs.)	6.7	-9.34	1.55	3.94	0.78	0.78
Growth in Import Prices	6.4	-5.45	-4.14	0.15	0.78	0.78
Domestic Treasury Bill Rate	7.9	4.0	3.00	5.00	5.00	5.00

View Table

Table 3.2:

Forecasts for key economic variables affecting Kenya

	2002	2003	2004	2005	2006	2007
Trading Partner Growth	3.70	3.37	4.17	4.44	4.45	4.45
Trading Partner CPI	3.24	3.52	3.58	3.25	3.25	3.25
Growth in Export Prices (Kshs.)	6.7	-9.34	1.55	3.94	0.78	0.78
Growth in Import Prices	6.4	-5.45	-4.14	0.15	0.78	0.78
Domestic Treasury Bill Rate	7.9	4.0	3.00	5.00	5.00	5.00

(ii) Donor relations and implications

Like most other low income countries, Kenya relies on its development partners to assist it in accelerating economic development. Table 3.3 shows the trends of inflows during 1999/2000 to 2002/03 fiscal years. Over 1999/2000 to 2002/2003 the Government received disbursements amounting to Kshs 52,436 million of grants (including Kshs 12,444 million of drought related grants in 2000/01 fiscal year) and Kshs 48,480 million of loans (including Kshs 4,382 of drought related loans and Kshs 4,045 of programme loans). Hence, donor inflows into the budget totaled Kshs 100,916 million. However, over the same period the country repaid external principal to the tune of Kshs 90,059, implying that net inflows over the period totaled Kshs 10,857 million, and excluding drought related inflows were negative². The low level of donor support were primarily driven by Kenya being “off track” with key development partners and especially the Bretton Woods institutions.

Table 3.3:

External Loans and Grants, 1999/00-2002/03 (Values in Kshs. mn)

Table 3.3:

External Loans and Grants, 1999/00-2002/03 (Values in Kshs. mn)

	1999/2000	2000/01	2001/02	2002/03
Programme grants	4,247	5,955	1,473	458
Project grants (cash)	938	1,521	1,090	3,804
Project grants (AiA)	3,309	4,160	4,260	10,777
Drought related grants	0	12,444	0	0
Project loans (AiA)	6,020	5,323	7,133	5,276
Programme loans	0	4,045	0	4,045
Project cash loans	2,830	4,337	2,898	2,191
Drought related loans	0	4,382	0	0
Total Grants	8,494	24,080	6,823	15,039
Total loans	8,850	18,087	10,031	11,512
Total external support	17,344	42,167	16,854	26,551

View Table

Table 3.3:

External Loans and Grants, 1999/00-2002/03 (Values in Kshs. mn)

	1999/2000	2000/01	2001/02	2002/03
Programme grants	4,247	5,955	1,473	458
Project grants (cash)	938	1,521	1,090	3,804
Project grants (AiA)	3,309	4,160	4,260	10,777
Drought related grants	0	12,444	0	0
Project loans (AiA)	6,020	5,323	7,133	5,276
Programme loans	0	4,045	0	4,045
Project cash loans	2,830	4,337	2,898	2,191
Drought related loans	0	4,382	0	0
Total Grants	8,494	24,080	6,823	15,039
Total loans	8,850	18,087	10,031	11,512
Total external support	17,344	42,167	16,854	26,551

This situation has however changed following Kenya’s accessing the IMF’s Poverty Reduction and Growth Facility (PRGF) and the holding of a successful Consultative Group (CG) meeting in November 2003 where US$4.1 billion in support was pledged over 2004-2006. The restoration of working relations with development partners therefore enables the Kenya Government to accept a more ambitious stance with respect to donor assistance to the budget.

Domestic factors

The following are the key domestic factors that will underlie the economic recovery efforts and thus the fiscal strategy:

• Response of private investors to the incentives and measures put in place by the Government,

• The capacity of the Government to absorb the external inflows and the restructuring capacity given the need to shift resources from one expenditure category to another,

• The Monetary policy stance adopted by the Central Bank of Kenya,

Private Investment

Private investments in Kenya have continued to perform below expectation and to a large extent the poor performance explains partly the slow economic growth that the economy has transited to. An in-depth analysis of private investment behaviour in Kenya indicates that private investment is driven by: growth in national income; profitability; interest costs; crowding-in factor of public investments; and availability of credit to the private sector. The link with the interest costs is weak implying that fiscal policy lends itself as a more effective instrument that the Government can use as part of its economic recovery strategy to stimulate investments.

The measures currently in-built in the ERS in line with the key determinants of private investments in the country is the restructuring of public expenditures towards public investments outlined in this strategy. Immediate dividends through the crowding-in factor of such public investments are expected will create a positive response for the private investments. In addition, the public investments will are expected will reduce the costs, particularly infrastructural facing private firms, and this will lead to increased profitability. Private investors in the country on average have been shown to re-invest one-third of their profits net of interest costs in a given year. The increased profits through lower costs occasioned by public investments are also likely to be positively augmented by a continuation during the ERS implementation period of strong fiscal policy that addresses the profitability of private businesses through the use of current tax policy that allows faster depreciation of machinery and equipment. This has a direct effect of raising retained earnings in businesses and subsequently private investments.

The principal objective of fiscal policy under the ERS is fiscal consolidation to reduce domestic debt, and fiscal restructuring to reallocate resources to high priority programs. The budget envisages substantial reduction in domestic borrowing requirements which will maintain the ongoing efforts to remove competition between the public and private sector for domestic credit. With the realisation of increased credit availability for the private sector, it is anticipated that the impetus for private investments will be supported.

Government Capacity

The public sector has been undergoing continual reform since the early 1990’s with a view to reducing the share of Government recurrent expenditure (especially wages) and increasing the development budget. The country has however failed to register any major successes in this areas as indicated by the continually rising wage bill, under provision for operations and maintenance and declining development vote. Given the ambitious targets of the recovery strategy, achieving success in restructuring the public sector and enhancing its capacity will be paramount. Success in this area will depend on the following:

• Internalising the MTEF process to ensure all budgets are MTEF budgets;

• The Public Expenditure Review (PER) process which seeks to institutionalise an annual Ministerial PER (MPER) process and use this annual process as the basis for guiding resource allocation; and

• The Public Expenditure Management (PEM) reform process which seeks to improve the efficiency and effectiveness of Kenya’s public expenditure and ensure the tax payer gets value for money.

Revenues

Table 3.4 below shows the recent revenue performance as well as projections for 2003/04-2006/07 consistent with the fiscal strategy. Kenya’s recent revenue experience has seen the revenue to GDP ratio decline from 23.3 percent in 1999/2000 to 20.8 percent in 2002/03. In 2003/04 the ratio is expected to remain below 21 percent of GDP. Decline in revenue performance has been occasioned by a reduction in tax rates partly as a result of liberalization measures and partly as a means of lowering consumption costs, to non adjustment of specific tax rates for inflation and to administrative and capacity constraints. Government policy will focus on arresting the decline in the revenue to GDP ratio to ensure the ratio is maintained above 21 percent. The overall tax and administrative reform agenda will focus on achieving the above revenue target as well as ensuring that revenue enhancement measures are not based on additional taxation.

Table 3.4:

Revenue and Grants, 1999/00-2006/07

Table 3.4:

Revenue and Grants, 1999/00-2006/07

	1999/2000	2000/01	2001/02	2002/03	2003/04	2004/05	2005/06	2006/07
Total revenue	178,443	192,312	194,507	210,759	228,819	255,907	285,109	310,689
Direct taxes*	54,402	54,497	60,555	70,452	73,113	70,865	79,485	83,737
Indirect taxes	98,042	10,7342	104,294	112,455	119,124	137,555	152,196	163,573
Non-tax revenue**	25,999	30,473	29,658	27,852	36,582	38,386	41,174	47,460
Revenue enhancement measures***	0	0	0	0	0	9,100	12,254	15,919
Revenue/GDP	23.34	22.91	21.00	20.78	20.83	21.66	22.34	22.42
Grants****	8,494	24,080	6,823	15,039	24,108	27,028	22,518	23,357
Total revenue and grants	186,937	216,392	201,330	225,798	252,927	282,934	307,627	334,046
Revenue and grants/GDP	24.4	25.8	21.7	22.3	23.0	23.9	24.1	24.1

View Table

Table 3.4:

Revenue and Grants, 1999/00-2006/07

	1999/2000	2000/01	2001/02	2002/03	2003/04	2004/05	2005/06	2006/07
Total revenue	178,443	192,312	194,507	210,759	228,819	255,907	285,109	310,689
Direct taxes*	54,402	54,497	60,555	70,452	73,113	70,865	79,485	83,737
Indirect taxes	98,042	10,7342	104,294	112,455	119,124	137,555	152,196	163,573
Non-tax revenue**	25,999	30,473	29,658	27,852	36,582	38,386	41,174	47,460
Revenue enhancement measures***	0	0	0	0	0	9,100	12,254	15,919
Revenue/GDP	23.34	22.91	21.00	20.78	20.83	21.66	22.34	22.42
Grants****	8,494	24,080	6,823	15,039	24,108	27,028	22,518	23,357
Total revenue and grants	186,937	216,392	201,330	225,798	252,927	282,934	307,627	334,046
Revenue and grants/GDP	24.4	25.8	21.7	22.3	23.0	23.9	24.1	24.1

Tax reform

The objectives of tax reform are to improve transparency and efficiency of taxation, strengthen tax collection to maintain a revenue/GDP ratio at or above 21 percent, and harmonize tax systems within the East African Community (EAC). To improve the structure of taxation, the government will undertake an assessment of tax policy and its impact on the economy and make the tax system more pro-growth and sensitive to the poor. This will be achieved by undertaking a comprehensive review of past policy regime, evaluate its effects on growth and poverty and use the lessons learnt to draw a pro-growth tax policy regime. In particular, the Government will establish an optimal tax rate framework for those tax heads considered high currently, institute tax regime that encourages new investments, economic growth and employment creation and use tax instruments to make social interventions for alleviating poverty.

In view of the prevailing low tax efforts for a number of tax heads, the Government will make expansion of the tax base a priority. This is in recognition of the relationship between tax policy and tax administration capacity. Towards this end, the Government is well aware that without effective tax administration infrastructure, little economic growth can be achieved through tax policy instruments. Making tax administrative effective will achieved by instituting effective enforcement in revenue administration. To strengthen tax collection, the reform will implement a modernization of tax administration, including computerization of the tax administration infrastructure through the development of integrated information architecture. In addition, as already initiated, Kenya Revenue Authority will implement a functional based tax administration to enhance efficiency and effectiveness of the tax administration system in Kenya. Further system support enhancements to Income Tax, Value Added Tax and Customs functions and strategic capacity building and development will be will a priority.

Harmonization and rationalization of tax regimes and integration of trade arrangement within the EAC and COMESA includes, among others, the lowering of tariffs and other barriers to imports of goods from the rest of the world. The loss in revenue arising from trade arrangements and subsequent tariff reductions will be compensated for by enhanced customs administration capacity, especially through implementation of regional transit cargo control strategy, deployment of scanners at the ports of entry to assist with valuation and verification, computerization of customs operations and effective management of warehouse.

During the 2003/04 - 2005/06, Kenya Revenue Authority’s operational reform agenda will be guided by the 2003-2006 Corporate plan. Among the key goals envisaged are the reorganization of the tax administration, restructuring the port handling facilities and procedures of revenue administration, implementing effective strategy for the management of excisable products, enforcing the withholding requirement by public sector and collection-agents to enhance compliance with tax laws and revamped and streamline the bond and transit cargo management. Other reform measures include strict enforcement of the traffic Act and development of new number plates and second generation driving licenses to improve compliance.

Expenditure

Despite the declining performance on the revenue side, the bulk of Kenya’s fiscal strategy will need to focus on expenditure reduction, expenditure restructuring and expenditure reform. Whereas Kenya’s revenue performance at over 21percent of GDP has been above par for low income countries, Kenya’s expenditure levels at over 26percent of GDP have been significantly above that for low income countries, yet the public investments level at below 2.5percent of GDP is below the recent sub Saharan African performance. The country also has a poor public expenditure management record with only 3 out of 16 indicators of public expenditure management being considered acceptable³.

Table 3.5 below shows the major categories of expenditure over 1999/2000-2002/03 and the forecast of the fiscal strategy over 2003/04-2006/07.

Table 3.5:

Expenditure, 1999/00-2006/07

Table 3.5:

Expenditure, 1999/00-2006/07

		1999/2000	2000/01	2001/02	2002/03	2003/04	2004/05	2005/06	2006/07
Consolidated fund services		116,333	89,634	107,661	107,478	131,540	118,676	118,699	121,341
Of which: Principal repayment		79,921	52,530	59,998	54,453	80,034	74,661	71,686	71,142
	Payment of arrears	4,104	3,295	0	0	0	0	0	0
	Foreign interest due	8,635	7,803	6,357	8,459	6,419	5,991	5,752	6,194
	Foreign interest paid	8,635	3,479	7,858	8,459	6,419	5,991	5,752	6194
	Domestic interest (inc. CBK Comm.)	20,752	23,232	23,744	26,767	27,323	21,090	21,724	21,816
	Wages and salaries	132	146	153	353	360	367	374	382
	Constitutional Review	300	1,100	701	800	0	0	0	0
	Goods and services	296	281	215	215	215	215	215	215
	Current transfers (pensions)	4,717	5,709	8,627	11,653	13,493	15,517	17,844	20,521
	Capital transfers (guaranteed loans)*	1,880	3,957	1,862	1,582	2,897	835	1,103	1,072
Discretionary Expenditures		140,464	198,008	175,669	212,984	245,813	280,837	289,244	318,456
Total Expenditures		256,797	287,642	283,330	320,461	377,354	399,513	407,943	439,797
Total Expend. Excluding principal		176,876	235,112	223,332	266,008	297,320	324,852	336,257	368,655
Total Exp. Exc. Principal/GDP percent		23.1	28.0	24.1	26.2	27.1	27.5	26.4	26.6

View Table

Table 3.5:

Expenditure, 1999/00-2006/07

		1999/2000	2000/01	2001/02	2002/03	2003/04	2004/05	2005/06	2006/07
Consolidated fund services		116,333	89,634	107,661	107,478	131,540	118,676	118,699	121,341
Of which: Principal repayment		79,921	52,530	59,998	54,453	80,034	74,661	71,686	71,142
	Payment of arrears	4,104	3,295	0	0	0	0	0	0
	Foreign interest due	8,635	7,803	6,357	8,459	6,419	5,991	5,752	6,194
	Foreign interest paid	8,635	3,479	7,858	8,459	6,419	5,991	5,752	6194
	Domestic interest (inc. CBK Comm.)	20,752	23,232	23,744	26,767	27,323	21,090	21,724	21,816
	Wages and salaries	132	146	153	353	360	367	374	382
	Constitutional Review	300	1,100	701	800	0	0	0	0
	Goods and services	296	281	215	215	215	215	215	215
	Current transfers (pensions)	4,717	5,709	8,627	11,653	13,493	15,517	17,844	20,521
	Capital transfers (guaranteed loans)*	1,880	3,957	1,862	1,582	2,897	835	1,103	1,072
Discretionary Expenditures		140,464	198,008	175,669	212,984	245,813	280,837	289,244	318,456
Total Expenditures		256,797	287,642	283,330	320,461	377,354	399,513	407,943	439,797
Total Expend. Excluding principal		176,876	235,112	223,332	266,008	297,320	324,852	336,257	368,655
Total Exp. Exc. Principal/GDP percent		23.1	28.0	24.1	26.2	27.1	27.5	26.4	26.6

As shown in the table above, total expenditure excluding interest grew from Kshs. 176,876 million in 1999/2000 to Kshs. 266,008 million in 2002/03, an annual average growth of 14.6 percent. There was a consistent trend of rising expenditure to GDP, from 23.1 percent in 1999/2000 to 26.2 in 2002/03⁴. The fastest growing component of expenditures was the pensions expenditures which grew at an annual average of 41percent over this period. Given that the rise in expenditure coincided with declining revenue performance, it will clearly be imperative to rein in expenditure growth as a key plank of the fiscal strategy.

In achieving the expenditure objective of restructuring to focus on poverty alleviation, promotion of economic growth and increasing access of the poor to social services, the following will be the main areas to be covered by the expenditure strategy:

• Reducing overall expenditure to GDP ratio as the primary means by which the budget deficit will be brought down to sustainable levels;

• Raising the level of development expenditure from 4.3 percent of GDP in 2002/03 to [6.7 percent] by 2006/07,

• Ensuring that core poverty expenditures are maintained at or above 4percent of GDP;

• Ensuring that the wage bill to GDP ratio declines to 8.5 percent by 2005/06 and to 7.2percent by 2007/08;

• Reducing the overall level of transfers to subvented bodies (universities and parastatals);

• Increasing expenditures on health in a manner consistent with achieving 12percent of total expenditures by 2010 while maintaining the level of primary education expenditures;

• Improved public expenditure management by tackling PEM shortcomings and internalizing the annual MPER process,

• Reduction in Government contingent liabilities through termination or completion of stalled projects and elimination of pending bills.

Table 3.6 below shows the forecast expenditure outcomes by economic categories. The major forecasts are:

• Overall expenditure is expected to rise from Kshs 266,008 million to Kshs 370,623 million over 2002/03-2006/07 representing a rise from 26.2 percent of GDP to 26.5 percent of GDP; and

• Expenditure composition is expected to change in favour of development (from 16.3 percent in 2002/03 to 25percent in 2006/07) and core poverty (from 7.3percent to 8.3 percent over the same period) while wages (from 32 percent to 31 percent) and interest payments (from 13.2 percent to 7.6 percent) and transfers to paratstatals and universities (from 5.4 percent to 5.0 percent) decline.

Table 3.6:

Economic Analysis of Expenditure, 1999/00-2006/07

Table 3.6:

Economic Analysis of Expenditure, 1999/00-2006/07

		1999/2000	2000/01*	2001/02	2002/03	2003/04	2004/05	2005/06	2006/07
Total Expend. excl. principal		176876	235112	223332	266008	297320	324852	336257	368655
Wages and salaries		65861	68119	78125	85087	96716	101583	108514	115585
Retrenchment costs		443	6095	1665	957	0	5335	0	0
Goods and services		56256	84215	74454	83071	92267	96697	97941	103843
	Of which: core poverty programmes	6696.14	9232	10150	14536	18347	20100	21708	23577
Transfers and subsidies		8224	11280	14008	17636	27246	30103	25637	28503
Interest		29387	31035	30101	35226	33742	27081	27476	28010
Other (Constitutional review)			300	1100	701	800
Development		16705	34068	23879	43330	46549	64054	76688	92715
	Of which: core poverty programmes	9704.58	8751	12599	19487	24790	27158	29332	31856
Wages/Exp. (percent)		37.24	28.97	34.98	31.99	32.53	31.27	32.27	31.35
Retrenchment/Exp (percent)		0.25	2.59	0.75	0.36	0.00	1.64	0.00	0.00
G&S/Exp. (percent)		31.81	35.82	33.34	31.23	31.03	29.77	29.13	28.17
Transfers/Exp. (percent)		4.65	4.80	6.27	6.63	9.16	9.27	7.62	7.73
Interest/Exp. (percent)		16.61	13.20	13.48	13.24	11.35	8.34	8.17	7.60
Dev./Exp. (percent)		9.44	14.49	10.69	16.29	15.66	19.72	22.81	25.15
Core poverty programmes/Exp/(percent)		5.49	3.72	5.64	7.33	8.34	8.36	8.72	8.64
Transfers to parastatals & universities/Exp.(percent)			5.99	7.54	5.42	5.49	5.14	5.24	5.03
Wages/Revenue (percent)		36.91	34.93	35.95	40.37	37.93	38.55	36.34	35.63
Transfers to parastatals & universities/GDP (percent)			1.68	1.82	1.42	1.48	1.41	1.38	1.34
Core poverty programmes (percent of GDP)		2.14	2.14	2.46	3.35	3.93	4.00	4.00	4.00
Development expenditures/GDP (percent)		2.18	4.06	2.58	4.27	4.24	5.42	6.01	6.69

View Table

Table 3.6:

Economic Analysis of Expenditure, 1999/00-2006/07

		1999/2000	2000/01*	2001/02	2002/03	2003/04	2004/05	2005/06	2006/07
Total Expend. excl. principal		176876	235112	223332	266008	297320	324852	336257	368655
Wages and salaries		65861	68119	78125	85087	96716	101583	108514	115585
Retrenchment costs		443	6095	1665	957	0	5335	0	0
Goods and services		56256	84215	74454	83071	92267	96697	97941	103843
	Of which: core poverty programmes	6696.14	9232	10150	14536	18347	20100	21708	23577
Transfers and subsidies		8224	11280	14008	17636	27246	30103	25637	28503
Interest		29387	31035	30101	35226	33742	27081	27476	28010
Other (Constitutional review)			300	1100	701	800
Development		16705	34068	23879	43330	46549	64054	76688	92715
	Of which: core poverty programmes	9704.58	8751	12599	19487	24790	27158	29332	31856
Wages/Exp. (percent)		37.24	28.97	34.98	31.99	32.53	31.27	32.27	31.35
Retrenchment/Exp (percent)		0.25	2.59	0.75	0.36	0.00	1.64	0.00	0.00
G&S/Exp. (percent)		31.81	35.82	33.34	31.23	31.03	29.77	29.13	28.17
Transfers/Exp. (percent)		4.65	4.80	6.27	6.63	9.16	9.27	7.62	7.73
Interest/Exp. (percent)		16.61	13.20	13.48	13.24	11.35	8.34	8.17	7.60
Dev./Exp. (percent)		9.44	14.49	10.69	16.29	15.66	19.72	22.81	25.15
Core poverty programmes/Exp/(percent)		5.49	3.72	5.64	7.33	8.34	8.36	8.72	8.64
Transfers to parastatals & universities/Exp.(percent)			5.99	7.54	5.42	5.49	5.14	5.24	5.03
Wages/Revenue (percent)		36.91	34.93	35.95	40.37	37.93	38.55	36.34	35.63
Transfers to parastatals & universities/GDP (percent)			1.68	1.82	1.42	1.48	1.41	1.38	1.34
Core poverty programmes (percent of GDP)		2.14	2.14	2.46	3.35	3.93	4.00	4.00	4.00
Development expenditures/GDP (percent)		2.18	4.06	2.58	4.27	4.24	5.42	6.01	6.69

The above forecasts are based on the following underlying assumptions and measures:

• Wages and salaries: Wages are expected to decline from 8.7 percent of GDP in 2003/04 to 8.5 percent by 2005/06. The Government, in 2003/04, awarded substantial increases to the disciplined forces (police and prisons) as well as begun implementation of the teachers salary award. No awards have as yet been given to civil servants. Achieving the 8.5percent target by 2005/06 will require that any awards to be provided to the civil servants or any additional awards (other than the remaining phases of the teachers’ awards) will be matched by a proportionate downsizing of the civil service. To this end, 21,500 civil servants are forecast to leave the service through a Voluntary Early Retirement (VER) scheme to enable civil service wages to be raised as part of an overall pay and benefits strategy.

• Interest payments: the fiscal strategy is based on the premise that the Government will be able to raise substantial additional external resources and thus allow for a reduction in both domestic borrowing levels and interest rates. The Central Bank will also continue with its policy of lengthening the term structure of domestic debt,

• Ministerial recurrent expenditures: non-wage ministerial expenditures (excluding transfers to subvented bodies) depend on exchequer releases and Appropriations in Aid (AiA) expenditures. The strategy assumes that these expenditures will be maintained constant in real terms, other than education, health and core poverty expenditures.

• Transfers to parastatals and universities: are expected to be maintained at their 2003/04 levels in real terms, with any increases in personnel emoluments being catered for through downsizing,

• Pensions: Kenya currently operates a non-contributory pension scheme. Pension payments have however been rising at an unsustainable rate and there will be a need to reduce these expenditures. The Government is scheduled to introduce a contributory pension scheme in the 2004/05 fiscal year. The fiscal strategy assumes that pension payments will continue to rise at 15percent per year, but an early introduction of the contributory scheme could lower this growth.

• Core poverty expenditures: The main objective of re-prioritizing and selecting the core poverty programmes was to allocate and ring-fence resources to those programmes that have a direct impact in reducing poverty levels in the medium term. The objective of the core poverty expenditures is to ring fence and deliver a set of programmes that improve access of the poor to infrastructural and social services especially rural infrastructural services, education and health, enhance the capacity of the poor to participate in productive service activities, and improve the governance and security environment.

  The Government has recently reexamined its list of ring fenced core poverty expenditures and updated the list. In 2002/03 core poverty expenditures were expected to account for Kshs.34,043 million or 3.35 percent of GDP. In 2003/04 the Government expects to spend Kshs. 43,137 million or 3.93percent of GDP over 2004/05-2006/07 the policy objective is to maintain core poverty expenditures at 4percent of GDP. Consequently, Kshs. 153,729 million is expected to be spent on core poverty expenditures over this period.

• Guaranteed loans and capital transfers: the major components of this category have tended to be Government repayments of parastatal debt. However, the Government has adopted an ambitious strategy to restructure the National Bank of Kenya (NBK). It is proposed that over 2003/04 and 2005/06 Kshs. 12,000 million be used in this endeavour.

• Health expenditures: the Government is committed to raising the level of health expenditures to at least 12percent of total expenditures as part of its strategy for providing adequate health services. Since overall recurrent health expenditures were 6.7percent of total recurrent expenditures, achieving the 12percent target by 2010 will require that recurrent health expenditures grow by at least 7.5percent faster than overall expenditures. The fiscal strategy assumes that these health expenditures will be focused on non wage non transfer expenditures and will thus enable the rapid increase in basic health services.

• Development expenditures: Over the recent past development expenditures in Kenya have declined as a percentage of total expenditures and as a percentage of GDP. Implementing the ERS will require a massive increase in development expenditures. Over 2002/03-2006/07 development expenditures are expected to rise from Kshs. 43,330 million to Kshs. 92,715 million, an annual average of 23.6percent. Over 2003/04-2006/07 a total of KShs. 280,006 million will be available for implementing development projects in the ERS.

• Stalled projects: Over the 1990s Kenya built up a substantial inventory of stalled projects as lax fiscal control led to the initiation of more projects than could be sustained by the development budget. As a result, by 1997 the completion rate for projects was as low as 3percent. Stalled projects, those projects that were initiated, not completed and which are currently not receiving funding, mushroomed. By 1999, the Government had a total of 164 stalled projects with an estimated original contract cost of Kshs. 31,357 million, accrued expenditures of Kshs. 13,319 million and an estimated completion cost of Kshs. 13,227 million for those than could be completed and Kshs. 2,448 million for those that required termination. By 2003 the stalled projects were estimated to have increased to 207. The Government will review all stalled projects with a view to terminating as many as possible and only completing those that fall in the ERS core priority areas or which have potential for meeting ERS core objectives. It is estimated that reviewing the stalled projects will cost Kshs. 90 million.

Public Expenditure reform

The 1997 Public Expenditure Review concluded that expenditure management trends were not consistent with the objectives of achieving sustained growth and poverty reduction. Following this review, the Government introduced a number of reforms to strengthen expenditure management. These include: The adoption of Medium Term Expenditure Framework (MTEF) approach to budget formulation in 2000/01; establishment of the Budget Monitoring Department in 2000; introduction of the Integrated Financial Management Information System (IFMIS); and ministerial rationalization. The 2003 PER noted that expenditure management weaknesses identified in the 1997 PER still persist.

The Government recognizes that economic recovery efforts will require efficient use of public resources and sound management of public expenditure geared towards enhanced service delivery and value for taxpayer’s money. In this regard, the government has institutionalized PER as part of the wider efforts to improve budget planning, execution and monitoring. In June 2003, a comprehensive public expenditure management reform program was initiated. This program includes legislative changes to improve the legal framework for public expenditure management as well as institutional and system changes. It incorporates the recommendations emanating from the Country Financial Accountability Assessment (CFAA) and a Public Expenditure Management Assessment and Action Plan (PEMAAP) exercises, both carried out by the Government in collaboration with key development partners.

As part of the PER institutionalization process, the Government issued the Treasury Circular No 26/2003 dated 3^rd December to initiate the 2004 PER process at the ministry level. Unlike the 2003 PER which involved only eight key ministries, the process has been rolled out to cover all the other ministries and integrated with the MTEF budget process. The PER will support the budget process by analysing expenditure allocations and budget institutions to identify weaknesses and recommend measures to enhance the impact of public expenditure. The MTEF budget process is being reviewed and the exercise will also involve development of an action plan to strengthen the budget process.

The IFMIS has been procured and IFMIS team and supervisors trained. Piloting of the system in the Ministries of Finance and Planning and National Development started in January 2004 and roll out to all other ministries is expected by mid 2004.

The government is improving the legislative framework for Public Expenditure Management (PEM). This includes: the enactment of the Anti-Corruption and Economic Crimes Bill (facilitated the establishment of an anti-corruption commission) and the Public Officer Ethics Bill (requiring the declaration of wealth by public officers) in 2003. Additional three pieces of legislation have been published and are awaiting enactment. These are: The Government Financial Management Bill (2003), which aims at enhancing accountability in public financial management practices; the Public Audit Bill (2003)- which aims at strengthening the independence and operational capacity of the Controller and Auditor General; and the Public Procurement and Disposal of Assets Bill (2003) which aims at enhancing the oversight role of the Directorate of Public Procurement.

The government is creating the institutional framework in which these reforms can be effectively designed and implemented; establishing a robust program of analysis and evaluation that can be the basis for building the expenditure management reform program; and defining a timetable for reforms. Priorities include: i) the creation of strong coordination and management arrangements between the departments in the Ministry of Finance and the Ministry of Planning and National Development that have lead responsibility for designing and implementing the expenditure management reform program; ii) phased reform of the MTEF; iii) implementation of short term reforms set out in the government’s Action Plan for Enhanced Financial Management in the Public Sector; vi) adherence to the timetable for the budget process for 2004/05; vii) early conclusion of the PER work program to provide information on the costing of ERS priority programs, and savings from low priority programs, and track expenditures of core poverty programs; and viii) design of MTEF budget for 2004/05 based on early decisions on the macro-economic framework and sector ceilings, on the objectives of the ERS, and on the analysis of the PER.

Development partners are supporting the public expenditure management reform through a technical coordination group that includes each of the main donors’ active in this area. In addition to supporting the PER process, the development partners are members of the PER steering committee and technical working group. These arrangements already provide a means for coordinated dialogue. Further, the government is exploring the use of a formal common memorandum of understanding to capture donor assistance to the PER. Development partners will consider the provision of basket funding within this framework for the PER and other aspects of the public expenditure management reform program.

Public Expenditure Management Reform

Public expenditure management has been a major weakness in Kenya in recent years. In particular, Kenya has had declining performance with respect to forecasting expenditures and/or disbursing the same. As table 3.7 below shows, the poor performance has been especially visible with respect to the development budget. Over 2000/01-2002/03 less than 40percent of projected ministerial development expenditure were actually realized. Given the rapid increase in development expenditures required to ensure the recovery targets are met, the Government will be focusing its efforts on improving public expenditure management.

Table 3.7:

Projcted and Actual Ministerial Expenditure (values in Kshs. mn)

Table 3.7:

Projcted and Actual Ministerial Expenditure (values in Kshs. mn)

Year	Actual			Target			Actual/Target (percent)
	Recur.	Develop.	Total	Recur.	Develop.	Total	Recur.	Develop.	Total
1999/2000	108809	7095	115904	109169	7339	116508	99.67	96.68	99.48
2000/2001	144019	22998	167017	149216	20012	169228	96.52	114.92	98.69
2001/2002	154403	14668	169071	163975	43577	207552	94.16	33.66	81.46
2002/2003	165724	19111	184835	182247	49735	231982	90.93	38.43	79.68
99/00-02/03	572955	63872	636827	604607	120663	725270	94.76	52.93	87.81

View Table

Table 3.7:

Projcted and Actual Ministerial Expenditure (values in Kshs. mn)

Year	Actual			Target			Actual/Target (percent)
	Recur.	Develop.	Total	Recur.	Develop.	Total	Recur.	Develop.	Total
1999/2000	108809	7095	115904	109169	7339	116508	99.67	96.68	99.48
2000/2001	144019	22998	167017	149216	20012	169228	96.52	114.92	98.69
2001/2002	154403	14668	169071	163975	43577	207552	94.16	33.66	81.46
2002/2003	165724	19111	184835	182247	49735	231982	90.93	38.43	79.68
99/00-02/03	572955	63872	636827	604607	120663	725270	94.76	52.93	87.81

Following recommendations from a Country Financial Accountability Assessment (CFAA) study done in 2001 and the Public Expenditure Management Assessment and Action Plan (PEMAAP) exercise done in 2003, an Enhanced Financial Management Action Plan was prepared. Since the recommendations covered a broad scope, it was decided that concentration be focused first on the public sector before moving to the private sector actions.

The main objectives of the Enhanced Financial Management Action Plan include:-

• Enabling the Government to focus resources within realistic fiscal constraints, on core priorities including economic recovery and poverty eradication. These will be achieved through improving and strengthening the tools used in the budget preparation and in particular, the MTEF process;

• Dealing comprehensively with the issue of pending bills and preventing future recurrence by improving the quality of budget preparation, broadening commitment control, and strengthening financial discipline through timely reconciliation and reporting;

• Improving the quality and timeliness of information available for financial management decision making, through the establishment of improved and relevant reporting systems. Facilitation in the medium term will be by the implementation of the government-wide integrated financial management information system.

To achieve the above objectives, the Enhanced Financial Management Action Plan addresses the following key areas:

• Budget Formulation – focus is on government policies, resource allocation, comprehensiveness, classification and projections

• Budget Execution – this covers issues on financial management procedures which include commitment control, payment management, project management, procurement and debt management

• Monitoring and Evaluation – the effort is to improve internal audit systems; monitoring of expenditures especially on those projects/programmes aimed at reducing poverty; achieving timely and accurate information; and, better information sharing.

• Institutional and Human Resources - actions will include undertaking a review of available and required financial management skills and other associated resources; and, articulating roles and responsibilities of central and line ministries in the management of financial resources.

• State Corporations – the main actions will include, reviewing of the overall government policy on investments, rationalization and restructuring of the parastatals, review of the parastatal financing policy, and review of procedures for accounting and monitoring of the remaining state corporations.

Public Expenditure Tracking (PETS)

The Kenya Government recognizes the importance of Public Expenditure Tracking (PETS) as a tool for diagnosing problems of service delivery and as a cost effective way for overcoming systemic problems in service delivery. To this end, it has already initiated a pilot PETS, which was carried out by the Kenya Institute for Public Policy Reasearch and Analysis (KIPPRA).

KIPPRA conducted a Public Expenditure Tracking Survey (PETS) in 2003. The PETS covered education, health, and the agriculture sectors. The KIPPRA survey had the following shortcomings:

• It does not track expenditures through the release system in terms of identifying the amounts allocated to particular votes, and tracking them down to the end user.

• It does not clearly define the kind of leakages that exist.

Recognizing the weaknesses of the KIPPRA study, the Government has initiated the process of undertaking another PETS. Programmes aimed at directly having a positive impact in poverty reduction have been identified and the second PETS will focus on tracking expenditures for specific core poverty programmes. Two programmes, (i) School Equipment Scheme and (ii) Bursary Programme for primary schools have been identified as pilot programmes for the exercise. Preliminary preparations started in early March 2004.

Deficit and Financing Strategy

The objectives to be pursued by the deficit and financing strategy are to first reduce the overall deficit including grants to a sustainable level and secondly to externalize deficit financing to reduce pressure on domestic financial markets and increase private sector access to credit. Over the medium term the deficit is expected to decline to below 3 percent of GDP, while net domestic borrowing is forecast for rapid reduction and ultimate elimination.

The provisional overall deficit for 2002/03 was Kshs. 40,210 million or 3.96 percent of GDP. Current forecasts for revenue and expenditure for 2003/04 indicate a widening of this deficit to Kshs. 49,700 or 4.52 percent of GDP, mainly driven by increased expenditures on the free education programme and health. Initial actions on restructuring the NBK as well as wage awards to the teachers and disciplined forces. As this fiscal strategy is implemented, this deficit is expected to decline to 3,67 percent in 2004/05, 2.38 percent in 2005/06 and 2.64 percent in 2007/08.

There will therefore be need for deficit financing over the fiscal strategy period. The Public Sector Borrowing Requirement (PSBR) is expected to total Kshs. 460,640 million over 2003/04 and Kshs. 330,906 million over 2004/05—06/07. Of the Kshs. 460,640 million, Kshs. 159,917 million will be required for financing the cumulative deficits, Kshs. 76,559 million will be required for external redemption, Kshs. 220,964 for domestic redemptions and Kshs. 3,000 million projected for paying of pending bills.

Financing the deficit will focus on maximizing external concessional borrowing consistent with maintaining the external debt to GDP ratio of below 36 percent. Given the nominal GDP forecasts and projected exchange rate movements, external borrowing over 2003/04-2006/07 is expected to total Kshs. 198,306 million, of which Kshs. 26,647 million will be rescheduling, and over 2004/05-2006/07 Kshs. 143,385 million of which Kshs. 20,718 million will be rescheduling. Net external borrowing over 2003/04-2006/07 will then total Kshs. 121,747 million, compared to a net repayment of Kshs 25,225 million over 1999/2000-02/03.

With external debt accounting for Kshs. 198,306 million, there will be need for domestic financing totalling Kshs. 262,334 million over 2003/04 and Kshs. 187,521 million over 2004/05-06/07. Of the 262,334 million, Kshs. 220,964 million will be accessed by rolling over domestic debt, while the remainder, Kshs. 41,370 million will be accessed through additional domestic borrowing. Of the Kshs. 187,521 million over 2004/05-06/07, Kshs. 165,723 will be accessed by rolling over domestic debt while Kshs. 21,798 will be accessed from additional domestic borrowing.

The outcome of the deficit and financing strategy is expected to be an external debt to GDP ratio that remains below the 36 percent level achieved in 2002/03 and a domestic debt to GDP level that declines from 24.3 percent in 2002/03 to 20.8 percent in 2006/07. Such declines will lead to a significant reduction in the Present Value (NPV) of debt to GDP ratio.

Privatization proceeds: The Government has published a privatisation bill which will lay the legal framework for its privatisation programme. Once the bill is enacted into law, the privatization process is expected to begin in earnest. This fiscal strategy has not factored in privatisation proceeds. However, should they arise, they will be used to reduce the net domestic borrowing requirement.

Table 3.8:

Deficit and Financing Strategy, 2003/04-2006/07

Table 3.8:

Deficit and Financing Strategy, 2003/04-2006/07

	1999/2000	2000/01	2001/02	2002/03	2003/04	2004/05	2005/06	2006/07
Deficit before grants (commitment basis)	1567	-42800	-28825	-55249	-68501	-68945	-51148	-57966
Deficit before grants/GDP(percent)	0.20	-5.10	-3.11	-5.45	-6.24	-5.84	-4.01	-4.18
Overall Deficit (Revenue+Grants-Exp.)	10061	-18720	-22002	-40210	-44393	-41918	-28630	-34609
Overall Deficit/GDP percent	1.32	-2.23	-2.38	-3.96	-4.04	-3.55	-2.24	-2.50
Overall Deficit: cash basis	4026	-15608	-30286	-38005	-44393	-42918	-29630	-35609
Repayment of domestic principal	-48903	-45374	-38458	-36897	-55241	-55241	-55241	-55241
Repayment of external principal (current FY)	-31018	-7156	-21540	-17556	-24793	-19420	-16445	-15901
Repayment of external principal (arrears)	0	-5390	-4104	-3295	0	0	0	0
Public sector borrowing requirement	-75895	-73528	-94388	-95753	-124427	-117579	-101316	-106751
External financing (borrowing)	15546	18087	10031	11512	48992	38207	37063	47397
External financing (rescheduling)	0	21793	0	0	5929	8930	8064	3724
External Financing (change in arrears)	0	5886	2738	1114	0	0	0	0
Privatisation proceeds	5660	0	955	0	0	0	0	0
Sale of housing				0	0	0	0	0
Domestic financing needs	54689	27762	80664	83128	69505	70442	56189	55630
Change in pending bills	-2285	5163	-765	6686	0	0	0	0
Securitised pending bills	3472	3538	2788	4481	0	1000	1000	1000
IMF PRGF	0	1968	0	0	0	0	0	0
Net foreign borrowing	-15472	5541	-12875	-8226	30128	27717	28682	35220
As percent of GDP	-2.02	0.66	-1.39	-0.81	2.74	2.35	2.25	2.54
Net domestic borrowing	17536	616	47334	44025	14264	15201	948	389
As percent of GDP	2.29	0.07	5.11	4.34	1.30	1.29	0.07	0.03
Total domestic debt	206127	213773	227655	296378	310643	325844	326792	327180
On lending		5701	5701
Govt. deposits and Treasury advances	42722	38357	24880	49578	49578	49578	49578	49578
Net domestic debt	163405	164205	202775	246800	261065	276266	277214	277602
Net domestic debt/GDP percent	21.37	19.56	21.90	24.33	23.77	23.38	21.73	20.03
Total external debt	409419	390971	376859	364582	387351	416602	449941	488672
total External Debt to GDP (percent)	54	47	41	36	35	35	35	35
Expenditure - Interest	147489	204077	193231	230782	263578	297771	308781	340645
Primary surplus	39448	12315	8099	-4984	-10651	-14837	-1154	-6599
Primary surplus/GDP percent	5.16	1.47	0.87	-0.49	-0.97	-1.26	-0.09	-0.48
Expenditure - Capital	158291	197087	197591	221096	247874	259963	258466	274868
Current surplus	20152	-4775	-3084	-10337	-19055	-4056	26643	35821
Current surplus/GDP percent	2.64	-0.57	-0.33	-1.02	-1.73	-0.34	2.09	2.58
GDP at market prices	764624	839534	926039	1014441	1098497	1181449	1275992	1385831

View Table

Table 3.8:

Deficit and Financing Strategy, 2003/04-2006/07

	1999/2000	2000/01	2001/02	2002/03	2003/04	2004/05	2005/06	2006/07
Deficit before grants (commitment basis)	1567	-42800	-28825	-55249	-68501	-68945	-51148	-57966
Deficit before grants/GDP(percent)	0.20	-5.10	-3.11	-5.45	-6.24	-5.84	-4.01	-4.18
Overall Deficit (Revenue+Grants-Exp.)	10061	-18720	-22002	-40210	-44393	-41918	-28630	-34609
Overall Deficit/GDP percent	1.32	-2.23	-2.38	-3.96	-4.04	-3.55	-2.24	-2.50
Overall Deficit: cash basis	4026	-15608	-30286	-38005	-44393	-42918	-29630	-35609
Repayment of domestic principal	-48903	-45374	-38458	-36897	-55241	-55241	-55241	-55241
Repayment of external principal (current FY)	-31018	-7156	-21540	-17556	-24793	-19420	-16445	-15901
Repayment of external principal (arrears)	0	-5390	-4104	-3295	0	0	0	0
Public sector borrowing requirement	-75895	-73528	-94388	-95753	-124427	-117579	-101316	-106751
External financing (borrowing)	15546	18087	10031	11512	48992	38207	37063	47397
External financing (rescheduling)	0	21793	0	0	5929	8930	8064	3724
External Financing (change in arrears)	0	5886	2738	1114	0	0	0	0
Privatisation proceeds	5660	0	955	0	0	0	0	0
Sale of housing				0	0	0	0	0
Domestic financing needs	54689	27762	80664	83128	69505	70442	56189	55630
Change in pending bills	-2285	5163	-765	6686	0	0	0	0
Securitised pending bills	3472	3538	2788	4481	0	1000	1000	1000
IMF PRGF	0	1968	0	0	0	0	0	0
Net foreign borrowing	-15472	5541	-12875	-8226	30128	27717	28682	35220
As percent of GDP	-2.02	0.66	-1.39	-0.81	2.74	2.35	2.25	2.54
Net domestic borrowing	17536	616	47334	44025	14264	15201	948	389
As percent of GDP	2.29	0.07	5.11	4.34	1.30	1.29	0.07	0.03
Total domestic debt	206127	213773	227655	296378	310643	325844	326792	327180
On lending		5701	5701
Govt. deposits and Treasury advances	42722	38357	24880	49578	49578	49578	49578	49578
Net domestic debt	163405	164205	202775	246800	261065	276266	277214	277602
Net domestic debt/GDP percent	21.37	19.56	21.90	24.33	23.77	23.38	21.73	20.03
Total external debt	409419	390971	376859	364582	387351	416602	449941	488672
total External Debt to GDP (percent)	54	47	41	36	35	35	35	35
Expenditure - Interest	147489	204077	193231	230782	263578	297771	308781	340645
Primary surplus	39448	12315	8099	-4984	-10651	-14837	-1154	-6599
Primary surplus/GDP percent	5.16	1.47	0.87	-0.49	-0.97	-1.26	-0.09	-0.48
Expenditure - Capital	158291	197087	197591	221096	247874	259963	258466	274868
Current surplus	20152	-4775	-3084	-10337	-19055	-4056	26643	35821
Current surplus/GDP percent	2.64	-0.57	-0.33	-1.02	-1.73	-0.34	2.09	2.58
GDP at market prices	764624	839534	926039	1014441	1098497	1181449	1275992	1385831

External Aid and Debt Policy Framework

Kenya’s external debt and Foreign Aid policy framework is built around the following Principles:

• Maintaining Kenya’s external debt sustainability to ensure Kenya does not become a Highly Indebted Poor Country (HIPC) or Severely Indebted Low income Country (SILIC);

• Ensuring only concessional borrowing is contracted to minimize servicing costs and maximize the grant element of borrowing;

• Implementing a Foreign Aid policy that harmonizes donor practices along the lines proposed in the Rome Declaration of February 2003 and minimizing the transaction costs related to external aid; and

• Ensuring that foreign aid is aligned to the national budget, the national development priorities and implementation should be based on best practice principles.

External debt

During January 2004, the Paris Club of Creditors agreed to reschedule US$ 350 million of arrears and maturities for interest and principle falling due between January 2004 and 31^st December 2006. The rescheduling was done on Houston terms It is anticipated that on completion of this rescheduling, the county will graduate from future Paris Club rescheduling.

Kenya’s external debt policy is guided by the accepted principle that the country shall obtain and service her debt on a timely basis as per the signed loan agreements. It is also premised on the recognition that there is an optimal debt level above which the economy may not be able to sustain. Any variations to this premise have to be authorized by Parliament for which an adequate explanation based on macro-economic parameters has to be considered.

To ensure that the country is able to finance its deficits in a sustainable manner, the country’s debt strategy will be built around the following

• Focusing on external concessional debt as a means of reducing the NPV of debt, lengthening the term structure of debt and reducing servicing costs,

• Mitigating exchange rate risk through currency diversification and improving forecasting of repayments to ensure repayments do not undermine the foreign exchange reserves position,

• Refinancing to replace expensive debt with less expensive debt, and

• Where necessary, rescheduling on Houston terms to mitigate cash flow problems.

Foreign Aid policy

The government has initiated measures for the development and eventual publishing of an External Aid Policy to guide in the optimal utilisation of external resources received from development partners. The policy will aim to harmonize and simplify donor practices in the country, as required under the Rome Declaration of February 2003 to which Kenya is a signatory. The policy will provide a framework for effective multilateral and bilateral negotiations and assess capacity building needs to manage external resources. The objective is to increase external inflows, and improve disbursement rates. It is envisaged that an External Aid Policy will be in place before December 2004.

External Resource Requirements

In considering the overall external resource requirements for the ERS, the following were taken into account:

1. Total demand for foreign exchange for all purposes, including for imports, debt service and buildup of official reserves, taking into account the macro projections and requirements;

2. Projections of resource availability taking into account macro level projections of exports, private and public transfers, foreign direct investment, other projected private inflows and the public inflows for which there are existing commitments;

3. Estimation of the financing gap taking into account existing; and

4. Taking account of resources pledged during the Consultative Group (CG) meeting held in November 2003 and implications for disbursement levels if the ERS is to be adequately funded.

Overall Financing Needs

The overall external financing framework including the financing gap is shown in table 3.10 below. Total financing needs are estimated at US$ 23,513 million over 2003-06 and US$ 25,398 million over 2004-2007. These requirements include the following:

• a) Overall import demand of US$ 20,191 million over 2003-2006 and US$ 22,097 million for 2004-07 of which US$ 4,909 million will be required for 2004 alone;

• b) Total debt service of US$ 1,377 million over 2003-2006 and US$ 1,249 million over 2004-07 of which US$ 380 million will be required in 2004;

• c) IMF repayments estimated at US$ 56 million over 2003-06 and US$ 49 million over 2004-07 of which US$14 million are required in 2004;

• d) US$ 1,418 million needed for buildup of official reserves over 2003-06 and US$ 1,567 million over 2004-2007; and

• e) Estimated private interest payments of US$ 365 million and US$ 387 million over the two periods respectively.

Domestically available Resources

Domestically available resources are estimated to total US$ 20,083 million over 2003-06 and US$ 21,728 million over 2004-07 and include the following:

• f) Merchandise exports estimated to total US$ 11,221 million over 2003-2006, and US$ 12,348 million over 2004-07 of which 2004 merchandise exports are expected to total US$ 2,788 million;

• g) Service exports estimated to total US$ 4,878 million over 2003-2007 and US$ 5,042 over 2004-07 with a 2004 estimate of US$ 1,077 million;

• h) Net foreign direct investment (FDI) of US$ 234 million over 2003-2006 and 257 million over 2004-07 with a 2004 estimate of US$ 55.4 million;

• i) Private transfers of US$ 1,466 million over 2003-06 and US$ 1,378 million over 2004-07 with US$ 376 million estimated for 2004,

• j) Other capital movements (private) estimated at US$ 1,975 million over 2003-2006 and US$ 2,301 million over 2004-07 with 2004 estimated to total US$ 535 million⁵.

Given the required external resources, this leaves a financing gap of US$ 3,430 million over 2003-2006 and 3,670 million over 2004-2007.

Existing External Commitments to the Public Sector

In closing the financing shortfall the Government, based on existing commitments, expects to have access to US$ 2,439 million over 2003-04 and US$ 2,645 over 2004-07. These commitments comprise the following⁶:

1. Project grant support of US$ 984 million over 2003-2006 and US$ 1,156 million over 2004-2007;

2. Project loans of US$ 778 million over 2003-2006 and US$ 1,016 million over 2004-2007;

3. Other public loans of US$251 million over 2003-06 and US$ 209 million over 2004-07;

4. Projected IMF disbursements of US$ 261million over 2003-06 and US$ 265 million over 2004-07;

5. Paris Club rescheduling of pre-cutoff debt⁷: following agreement with the Paris Club the country can expect to benefit from US$ 341 million of rescheduling over 2003-06 and US$ 295 million over 2004-07;and

6. Programme support already received in 2003 and 2004 totaling US$ 165 million.

These resource estimates leave a residual financing gap of US$ 649 million over 2003-06 and US$ 730 million over 2004-07. This implies total external support of US$ 3,430 million over 2003-06 and US$ 3,670 million over 2004-07. This compares to US$ 4,100 million pledged during the 2003 Consultative Group meeting. The implication is that virtually all the pledges made during the consultative meeting will need to be turned into commitments if the external financing gap is to be closed. Virtually all the additional resources will need to be programme support to the budget to reduce the domestic borrowing requirements to sustainable levels.

Table 3.9:

External Financing Requirements

Table 3.9:

External Financing Requirements

(Values in $mn)	2002	2003	2004	2005	2006	2007	2003-06	2004-07
Domestic Resources Available
Merchandise exports	2165	2424	2788	2880	3129	3551	11221	12348
Service exports	1112	1258	1077	1211	1332	1422	4878	5042
Private transfers	576.8	421.11	376	335	334	333	1466	1378
Foreign Direct investment (net)	50	50.4	55.4	61	67.1	73.8	234	257
Earnings from reserves	35.4	46.6	56.5	89.7	116.2	139.6	309	402
Other capital (net)	-5	306	535	502	632	632	1975	2301
TOTAL	3934	4506	4888	5079	5610	6151	20083	21728
Financing Needs
Imports	3740	4277	4909	5279	5726	6183	20191	22097
Net factor payments	32	6	13	12	12	12	43	50
Debt service: principal	253	277	291	235	210	210	1013	945
Debt service: interest	86	106	89	84	84	47	364	304
IMF repayments	19	19	14	9	14	12	56	49
Reduction in arrears	107	64	0	0	0	0	64	0
Private interest payments	76	80	90	95	100	102	365	387
Buildup of official reserves	3	192	168	462	596	341	1418	1567
TOTAL	4315	5021	5574	6175	6742	6907	23513	25398
FINANCING GAP	381	515	687	1097	1131	755	3430	3670
External Public Financing (estimated)							0	0
Project grants (cash)	32	44	141	101	103	103	389	477
Project grantrs (AiA)	97	81	132	188	194	194	595	709
Programme grants	12	106					106	0
Project loans (AiA)	48	29	98	154	193	193	474	639
Project loans (Cash)	33	26	87	93	98	98	304	377
Drought related loans	0	0	0	0	0	0	0	0
Programme loans	26	58					58	0
Defense loans	30	33	32	21	21	21	107	95
IMF diusbursements	0	36	75	75	75	40	261	265
Parastatal borrowing	39	56	36	26	26	26	144	114
TOTAL	317	469	601	659	710	675	2439	2645
Others							0	0
Rescheduling of principal	0	26	79	79	57	0	240	214
Rescheduling of interest	0	13	32	30	19	0	94	81
Change in arrears	64	7	0	0	0	0	7	0
Sub-Total	64	46	110	108	76	0	341	295
FINANCING GAP	0	0	-25	330	345	80	649	730

View Table

Table 3.9:

External Financing Requirements

(Values in $mn)	2002	2003	2004	2005	2006	2007	2003-06	2004-07
Domestic Resources Available
Merchandise exports	2165	2424	2788	2880	3129	3551	11221	12348
Service exports	1112	1258	1077	1211	1332	1422	4878	5042
Private transfers	576.8	421.11	376	335	334	333	1466	1378
Foreign Direct investment (net)	50	50.4	55.4	61	67.1	73.8	234	257
Earnings from reserves	35.4	46.6	56.5	89.7	116.2	139.6	309	402
Other capital (net)	-5	306	535	502	632	632	1975	2301
TOTAL	3934	4506	4888	5079	5610	6151	20083	21728
Financing Needs
Imports	3740	4277	4909	5279	5726	6183	20191	22097
Net factor payments	32	6	13	12	12	12	43	50
Debt service: principal	253	277	291	235	210	210	1013	945
Debt service: interest	86	106	89	84	84	47	364	304
IMF repayments	19	19	14	9	14	12	56	49
Reduction in arrears	107	64	0	0	0	0	64	0
Private interest payments	76	80	90	95	100	102	365	387
Buildup of official reserves	3	192	168	462	596	341	1418	1567
TOTAL	4315	5021	5574	6175	6742	6907	23513	25398
FINANCING GAP	381	515	687	1097	1131	755	3430	3670
External Public Financing (estimated)							0	0
Project grants (cash)	32	44	141	101	103	103	389	477
Project grantrs (AiA)	97	81	132	188	194	194	595	709
Programme grants	12	106					106	0
Project loans (AiA)	48	29	98	154	193	193	474	639
Project loans (Cash)	33	26	87	93	98	98	304	377
Drought related loans	0	0	0	0	0	0	0	0
Programme loans	26	58					58	0
Defense loans	30	33	32	21	21	21	107	95
IMF diusbursements	0	36	75	75	75	40	261	265
Parastatal borrowing	39	56	36	26	26	26	144	114
TOTAL	317	469	601	659	710	675	2439	2645
Others							0	0
Rescheduling of principal	0	26	79	79	57	0	240	214
Rescheduling of interest	0	13	32	30	19	0	94	81
Change in arrears	64	7	0	0	0	0	7	0
Sub-Total	64	46	110	108	76	0	341	295
FINANCING GAP	0	0	-25	330	345	80	649	730

Higher case scenario

The high case scenario is predicated on a faster response of the economy to the bold economic reforms envisaged in the ERS resulting on a growth increase from 1.4 percent in 2002/2003 to 2.4 percent in 2003/2004 and 5.5 percent growth in 2006/07 to deliver an average yearly growth of 3.9 percent during 2003-2007.

In this scenario recovery is driven by a better performing export sector and investment. Exports would grow at 6 percent in 2003/04 from 5.8 percent growth in 2002/2003, and peak at 7.6 percent growth in 2006/2007. Gross investment would increase from 11.4 percent of GDP in 2002/2003 to 16.7 percent in 2006/07. Higher consumer confidence would support the pace of economic recovery with a private consumption growth rising from -6.7 percent in 2002/03 to 1.0 percent in 2003/04 and 3.3 percent in 2006/07. The faster growth in household consumption is in line with the desired policy of its growth being at least higher than the population growth rate. Gross domestic savings would improve gradually from 9.0 percent of GDP in 2002/03 to 9.6 percent in 2003/2004 and 14.6 percent in 2006/2007.

Imports would be expected to rise in response to the recovery in investments and private consumption. Export growth is expected to continue as the potential existing under COMESA and EAC continue to be exploited with the improved competitiveness of the Kenyan exports. AGOA related exports are also expected to continue expanding and these will sustain the expected higher export growth. The current account is therefore expected to be around 2 percent of GDP and the import cover to improve from 3.3 months of imports in 2002/03 to 7.7 months in 2005/06.

The objective of fiscal policy is to maintain revenues at above 21 percent of GDP and achieving a sustainable overall deficit (including grants) of below 3.2 percent of GDP over the 2003/2004-2006/07 period. The restructuring of public expenditure would entail public consumption to rise slightly from 14.8 to 15.5 percent of GDP during 2002/03-2003/04 due to increased social spending commitments, and thereafter fall to 14.3 percent of GDP in 2005/06. Salaries and wages of the civil service, teachers’ service and the disciplined forces which are part of public consumption would remain at below 8.5 percent of GDP over the period 2003/04-2006/07. Transfers to parastatals and universities will be maintained at current levels i.e. below 1.8 percent of GDP which is equivalent to 6.9 percent of total expenditures over the period 2003/04-2006/07. Total capital expenditure would rise from 4.1 percent of GDP in 2002/03 to 4.7 percent of GDP in 2003/04 and 5.9 percent of GDP in 2005/06 and eventually rise to 6.3 percent in 2006/07. This reflects an increasing proportion of capital expenditure in the budget from 16.2 percent of total expenditures in 2002/03 to 23.4 percent in 2006/07.

Low case scenario

Te basic purpose of the low case scenario is to investigate what would be the impact on the base case scenario were the economy to be affected by various shocks which would undermine some of the key assumptions underpinning the base case scenario. To construct the low case scenario, the following assumptions were made:

• The country’s return to good relations with the donors does not lead to high inflows and anyway, absorptive capacity constraints undermine the potential to absorb all available funding. Hence actual disbursements remain in line with 1999/2000-2002/03 levels,

• The rescheduling agreed with the Paris Club of creditors is not reversed,

• The Central Bank of Kenya continues with its monetary policy targeting 3.5 percent underlying inflation rate,

• Terms of trade do not deteriorate further due to the low prices for commodities already existing and the lack for a basis to assume higher oil prices,

• Private sector response to the changed policy and institutional environment is muted, meaning that investment does not recover as fast as expected.

Table 3.10 below provides the outcomes for the major economic variables under this scenario.

Table 3.10:

Economic Outturn for Low Case Scenario

(Annual percentage changes, unless otherwise specified)

Table 3.10:

Economic Outturn for Low Case Scenario

(Annual percentage changes, unless otherwise specified)

	2002	2003	2004	2005	2006	2007
GDP (factor cost and constant prices)	1.1	1.3	0.9	1.2	1.5	1.7
Consumer Price Index	2.0	9.8	3.7	3.2	3.6	3.6
Exports Volume growth	5.0	6.6	9.7	4.5	4.4	5.3
Imports Volume growth	-18.7	3.6	3.9	3.3	2.5	3.3
Gross National Savings (percent of GDP)	13.40	13.17	13.81	14.32	14.51	15.12
Govt. External Debt (US$ mn)	4690	4696	4563	4575	4545	4522
Govt. External Debt Service Ratio (percent)	10.49	10.00	9.09	7.10	6.17	5.68
Govt. Foreign Interest Payments Ratio	2.88	2.60	1.99	1.75	1.66	1.60
Interest Rates	7.9	4.0	8.00	8.0	8.00	8.00

View Table

Table 3.10:

Economic Outturn for Low Case Scenario

(Annual percentage changes, unless otherwise specified)

	2002	2003	2004	2005	2006	2007
GDP (factor cost and constant prices)	1.1	1.3	0.9	1.2	1.5	1.7
Consumer Price Index	2.0	9.8	3.7	3.2	3.6	3.6
Exports Volume growth	5.0	6.6	9.7	4.5	4.4	5.3
Imports Volume growth	-18.7	3.6	3.9	3.3	2.5	3.3
Gross National Savings (percent of GDP)	13.40	13.17	13.81	14.32	14.51	15.12
Govt. External Debt (US$ mn)	4690	4696	4563	4575	4545	4522
Govt. External Debt Service Ratio (percent)	10.49	10.00	9.09	7.10	6.17	5.68
Govt. Foreign Interest Payments Ratio	2.88	2.60	1.99	1.75	1.66	1.60
Interest Rates	7.9	4.0	8.00	8.0	8.00	8.00

As a result of the expected shocks, the economy experiences lower growth, lower levels of external debt, slower growth in import volumes and higher domestic interest rates due to the need for increased domestic borrowing to meet budgetary requirements.

This poor performance would be in line with the low growth phase that the economy transited between 1997 and 2002.

To appreciate the major areas of change, table 3.11 below indicates the magnitudes of change of major variables from the base case scenario.

Table 3.11:

Magnitudes of Changes in Key Economic Aggregates

Table 3.11:

Magnitudes of Changes in Key Economic Aggregates

	2003	2004	2005	2006	2007	‘03-06	‘04-07
GDP growth (Real, percentage points decline)	0	-2	-2	-3	-3	-2	-2
Exports (US$ milion reduction)	82	140	189	83	-65	494	348
Imports (US$ million)	76	-453	-623	-842	-1,022	-1,842	-2,940
Savings/GDP percent points change	-2	-2	-3	-4	-5	-3	-3
Investment/GDP ratio: percent points change	-2	-7	-10	-11	-11	-7	-9
Estimated change in formal employment(000”s)	0	-18	-31	-36	-49	-85	-134
Estimated change in poverty rates(percent points)		1	2	2	4
Inflation rate (percent points decline)	0	0	0	0	0	0	0
Treasury bill interest rates (percent points change)	-4	5	3	3	3	2	4
Revenues (Kshs billion, Fiscal Year)	0	-10,420	-24,517	-34,376	0	-69,312	-69,312
External Grants (Kshs. Billion, Fiscal year)	-11,320	-17,603	-11,736	-13,792	0	-54,451	-43,131
Net external borrowing (Kshs million, Fiscal yr)	-35,573	-29,356	-28,605	-38,610	0	-132,144	-96,571
Net resources shortfall (incl. External borrowing)	-46,892	-57,379	-64,858	-86,778	0	-255,907	-209,015

View Table

Table 3.11:

Magnitudes of Changes in Key Economic Aggregates

	2003	2004	2005	2006	2007	‘03-06	‘04-07
GDP growth (Real, percentage points decline)	0	-2	-2	-3	-3	-2	-2
Exports (US$ milion reduction)	82	140	189	83	-65	494	348
Imports (US$ million)	76	-453	-623	-842	-1,022	-1,842	-2,940
Savings/GDP percent points change	-2	-2	-3	-4	-5	-3	-3
Investment/GDP ratio: percent points change	-2	-7	-10	-11	-11	-7	-9
Estimated change in formal employment(000”s)	0	-18	-31	-36	-49	-85	-134
Estimated change in poverty rates(percent points)		1	2	2	4
Inflation rate (percent points decline)	0	0	0	0	0	0	0
Treasury bill interest rates (percent points change)	-4	5	3	3	3	2	4
Revenues (Kshs billion, Fiscal Year)	0	-10,420	-24,517	-34,376	0	-69,312	-69,312
External Grants (Kshs. Billion, Fiscal year)	-11,320	-17,603	-11,736	-13,792	0	-54,451	-43,131
Net external borrowing (Kshs million, Fiscal yr)	-35,573	-29,356	-28,605	-38,610	0	-132,144	-96,571
Net resources shortfall (incl. External borrowing)	-46,892	-57,379	-64,858	-86,778	0	-255,907	-209,015

From the table above the following are the major impacts;

1. GDP growth declines by an average of 2percent points over 2003-2007. Given that economic growth is the major driver for poverty reduction, poverty rates are estimated to increase by 3 percentage points compared to the base case;

2. With the assumption of employment growth being tied to economic activity a net total of 80,000 jobs are lost over 2003-2006 and 134,000 over 2004-2007,

3. The tight monetary framework leads to inflation remaining as per the base case. However, the need for domestic borrowing increases the domestic (t-bill and bond) interest rates by 3 percentage points over the period,

4. Investment rates are substantially lower as a result of Government not being able to access investible resources and the lower than expected response by the private sector. Since the base case assumed a much higher dependence on foreign savings for investment, there is a lower savings gap and thus improved balance of payments,

5. Imports decline drastically improving the trade balance. The main drivers are reduced importation of investment goods and those commodities (oil products, chemicals and manufacturing inputs) that tend to grow in line with GDP,

6. The greatest impact is however felt on the budget. Over the 2004/05-2006/07 fiscal period, revenues decline by a cumulative total of Kshs. 69,312 million, while net external borrowing declines by Kshs. 132,144 million and external grants by Kshs. 54,461 million, for a cumulative resource shortfall (compared to the base case) of Kshs. 255,907 million. It is this resource shortfall that the Government expenditures will have to adjust to.

Government adjustment to a resource constrained scenario will be based on 2 core principles:

• To the largest extent possible fiscal sustainability must be maintained. This will be interpreted to mean that whereas it may be impossible to maintain a declining domestic debt position, the overall debt to GDP ratio should be maintained in present value terms. Thus, given that the NPV of external debt is below its face value, the net increase in domestic borrowing shall only compensate for the shortfall in NPV of external borrowing,⁸

• To the largest extent possible expenditures in education and health and core poverty expenditures will be shielded from expenditure cuts.

Table 3.12 below shows the expected adjustments that would occur under this scenario.

Table 3.12:

Adjustments to Reduced Revenues and External Resource Inflows in Low Case Scenario

^*Excluding education and health

Table 3.12:

Adjustments to Reduced Revenues and External Resource Inflows in Low Case Scenario

(values in Kshs million)		2003/04	2004/05	2005/06	2006/07	‘03/04-06/07
Change in net domestic borrowing		46446	24652	30670	40111	141879
Change in total expenditures		-446	-32,726	-34,188	-46,668	-114028
	Of which interest payments	0	14,870	12,477	15,692	43039
	Of which wages and salaries	0	1967	2007	2047	6021
	Of which ministerial expenditures*	0	-842	-1,427	-1,879	-4148
	Of which transfers to subvented bodies	0	0	-110	-147	-256
	Of which free education and health**	0	-27	-51	-79	-157
	Of which development expenditures	-12446	-34220	-45258	-60554	-152478
	Other changes in total expenditures	12,000	-14,475	-1,825	-1,748	-6048
Change in core poverty expenditures		0	-648	-1,695	-3,060	-5403

^*Excluding education and health

View Table

Table 3.12:

Adjustments to Reduced Revenues and External Resource Inflows in Low Case Scenario

(values in Kshs million)		2003/04	2004/05	2005/06	2006/07	‘03/04-06/07
Change in net domestic borrowing		46446	24652	30670	40111	141879
Change in total expenditures		-446	-32,726	-34,188	-46,668	-114028
	Of which interest payments	0	14,870	12,477	15,692	43039
	Of which wages and salaries	0	1967	2007	2047	6021
	Of which ministerial expenditures*	0	-842	-1,427	-1,879	-4148
	Of which transfers to subvented bodies	0	0	-110	-147	-256
	Of which free education and health**	0	-27	-51	-79	-157
	Of which development expenditures	-12446	-34220	-45258	-60554	-152478
	Other changes in total expenditures	12,000	-14,475	-1,825	-1,748	-6048
Change in core poverty expenditures		0	-648	-1,695	-3,060	-5403

^*Excluding education and health