Introduction

1. The Kenyan authorities thank the mission team for the extensive consultation and constructive dialogue during recent Fund Missions and for the comprehensive assessment and valuable suggestions on Kenya’s economic development, and the implementation of the reform program. The authorities welcome the well written and balanced staff report on the 2006 Article IV Consultation and Second Review Under the Three-Year Arrangement of the Poverty Reduction and Growth Facility (PRGF); and request the Extension and Rephasing of the Arrangement (to November 20, 2007), a Reduction in Access, and a Waiver of Performance Criteria.

2. The Kenya Vision 2030 program launched recently, calls for a sustained increase in GDP growth to an average 10 percent per annum, with a view to making Kenya a middle-income country by the year 2030. As a step in this direction, a medium-term strategy that builds on the Economic Recovery Strategy is being developed for the period 2008-12 aimed at accelerating growth, maintaining macroeconomic stability, reducing poverty, improving equity and strengthening institutions of governance.

Performance under the PRGF Arrangement

3. The authorities are committed to the implementation of the vision and the strategy. However, the fact that the current PRGF program was burdened by the introduction of numerous new prior actions in the middle of the program, causing significant delays, has been of concern. Nevertheless, the authorities did not allow the delayed PRGF program to reduce their resolve and determination to improve competitiveness, accelerate growth and reduce poverty. They have instead pursued their reform program vigorously and steadfastly, with impressive results. Despite the difficulties posed by additional conditions and exacerbated by exogenous shocks, notable progress has been made in the main components of the authorities’ reform agenda. This includes improvements in tackling governance weaknesses, strengthened fiscal policy for stability and growth, enhanced public financial management, actions to strengthen the financial sector, as well as progress in productive sector reform, public enterprise reform, and the privatization program. My authorities have therefore demonstrated their commitment to reducing poverty and establishing a macroeconomic and institutional framework that is conducive to accelerating growth.

4. Program implementation, supported by the PRGF arrangement remained broadly on track in 2005/06 although five out of the thirteen performance criteria for 2004/05 were not met. The end-March 2005 quantitative performance criterion on the reserve money of the Central Bank of Kenya was also missed, as was the continuous criterion on non accumulation of external payments arrears. The structural performance criteria on non-imposition of controls on banks’ fees and charges (Section 44 of the Banking Act) and the issuance of new guidelines for wage arbitration by the Industrial Court, were also missed as was the structural performance criterion requiring that the declaration of assets by ministers, permanent secretaries, and heads of state bodies be completed.

5. My authorities have, however, taken decisive remedial actions to address these slippages. Among other things, they have developed modalities for implementing Section 44 of the Banking Act that are broadly consistent with the original program objectives. They have cleared a small amount of bilateral external arrears, and taken steps to improve debt management practices. Furthermore, they have begun an audit of external commercial contracts on which payments were suspended due to governance concerns. In addition to this, the Industrial Court issued new guidelines for wage arbitration in November 2005, and the verification of asset declarations of ministers and senior officials is continuing.

6. Given the good performance record achieved under difficult circumstances, and the continued commitment to successful program implementation, the authorities request the completion of the Second Review of the PRGF-supported program and the approval of the associated waivers for the nonobservance of the five performance criteria detailed above. They also seek an extension of the PRGF arrangement to November 20, 2007, which would allow them time to complete the third review under the arrangement after reaching understandings with Fund staff on the 2007/08 budget. In view of the substantial improvements in Kenya’s balance of payments since the approval of the PRGF arrangement, the authorities also request a reduction in access of SDR75 million, with the remaining access of SDR75 million to be disbursed in two equal installments for the second and third reviews.

7. On the issue of a noncompliant disbursement for Kenya and accumulated external payments arrears, the authorities agree that in addition to the two non-concessional external loans reported at the time of the second disbursement under the PRGF arrangement, a third loan was contracted on January 20, 2004 which was not concessional. This should have been reported as non-concessional borrowing at the time if information had been available. This information became available following the recent audit by the Auditor and Controller General and the publication of his report. This clearly shows that the governance measures on transparency and accountability introduced by the government are working. The accumulation of external payments arrears during the period monitored for the first PRGF review was greater than the amount reported to the Executive Board in December 2004. The authorities regret the inaccuracy of the information that was provided at the time of the first review, which was attributable to weak institutional arrangements, a debt database shortcoming, changes in key personnel in the Ministry of Finance and inadequate staff in the debt management department at that time. The authorities have since undertaken a number of actions to address these challenges including implementing external debt management reforms with support from the World Bank/DFID under the Financial and Legal Sector Technical Assistance Program to ensure that additional non-concessional loans are not contracted or guaranteed and that outstanding legitimate external arrears are settled. The authorities request for a waiver for nonobservance of the performance criteria underlying the noncomplying disbursement.

Recent Economic Developments and Outlook

8. The authorities have taken significant steps to secure macroeconomic stability and put in place a strong foundation for growth. The results of this stewardship have been impressive: GDP growth has increased ten-fold from a low of 0.6 percent in 2002 to an estimated 6 percent in 2006; the highest level in two decades. Meanwhile, inflation fell sharply to 6.8 percent in the 12-months to February as food price inflation eased. Non-food inflation continued to hover around 6 percent. Economic growth has also been broad based.

9. This positive outcome can be attributed to prudent macroeconomic policies, a generally favorable external environment, rising world prices for tea and coffee, and continued strong demand for horticultural exports. Manufacturing has also benefited from strong regional demand and the formation of the East African Community Customs Union. There has also been robust growth in the service sector.

10. Last year, Kenya received its first international credit rating. Standard and Poor’s Rating Service assigned Kenya a B+ for foreign currency and BB-for local currency. Within Sub-Saharan Africa, only mineral-rich countries have a higher rating. The favorable long-term sovereign credit rating gave the country a positive outlook, emphasizing the authorities’ strong political commitment to prudent financial policies and market-oriented structural reforms. The authorities have directed their efforts at reducing inflationary pressures through tighter fiscal and monetary policy, and have taken measures to contain domestic debt and so achieve program targets and maintain debt sustainability.

11. With respect to governance, Kenya also received a moderate rating along side other countries in the recent release of the Global Integrity Index, which assesses the existence and effectiveness of anti-corruption mechanisms that promote public integrity. It is also noteworthy that Kenya is one of the few countries in Sub-Saharan Africa, which has voluntarily subjected itself to the NEPAD’s Africa Peer Review Mechanism.

12. The authorities believe that they have made important progress, delivering on objectives outlined in the Economic Recovery Strategy and the Kenya Vision 2030. They recognize, however, that a lot of work remains to be done. They acknowledge that the economy still remains vulnerable to external exogenous shocks and that the government continues to face challenges in a number of areas, including in improving the effectiveness of key institutions, increasing the breadth and quality of infrastructure and pursuing a reform agenda which continues to buttress strong growth and poverty reduction and improve external competitiveness.

Fiscal Policy and Debt Management

13. On the fiscal front, the authorities continue to pursue a fiscal policy that is supportive of a higher growth path for the economy, while ensuring macroeconomic stability and fiscal sustainability. They are refocusing and increasing expenditure to areas that will enhance infrastructure development and reduce widespread poverty. Despite receiving less external development assistance than expected, they took action to protect priority areas by, among other things, cutting non-priority expenditure. This in turn helped to contain domestic borrowing at 1.8 percent of GDP, while accommodating drought-related spending of 0.8 percent of GDP.

14. The authorities realize that the reallocation of public expenditure is only a beginning and more needs to be done. They will continue taking significant steps, including strengthening revenue performance and tax administration, customs reforms, implementing public expenditure management reforms, and increasing poverty reduction spending by reorienting public expenditure in favor of essential social and economic outlays. Recognizing the importance of infrastructure for continued competitiveness and enhanced growth, the authorities doubled the allocation for development expenditure in the Ministry of Roads and Public Works in the 2006/7 budget. With limited external financing available however, scaling-up expenditure on core anti-poverty programs and expenditure will require a determined effort to rein in non-priority spending and ensure strong domestic revenue collection.

15. Kenya has also managed its debt relatively well and has regularly met its obligations to most of its creditors. The authorities’ limited external borrowing has left them with more manageable debt ratios than most low-income country peers. The joint IMF-World Bank debt sustainability analysis (DSA) found Kenya’s debt to be low and sustainable.

Monetary and Exchange Rate Policy

16. Under its current monetary policy framework, the Central Bank of Kenya will continue to target reserve money growth. Consistent with inflation objectives, the authorities will control the growth in reserve money in order to achieve the broad money objective. They are committed to further enhancing the transparency of monetary policy and improving the signaling of policy intentions to the market. With respect to exchange rate policy, Kenya maintains an exchange system that is free of restrictions on payments and transfers for international current account transactions. The current floating exchange rate regime is seen as supportive of macroeconomic stability and external competitiveness.

External Sector

17. Despite large inflows of remittances, the current account deficit widened on account of higher world oil prices and the strong import demand in line with stronger growth. Sizeable financial inflows resulted in a significant buildup in foreign exchange reserves and an appreciation of the Kenyan shilling, largely reflecting increased confidence in Kenya’s economy. This has not however affected Kenya’s external competitiveness. Nevertheless there are risks ahead. Going forward the authorities are committed to continuing streamlining Kenya’s business licensing system, pursuing efficiency-enhancing structural reforms and increasing infrastructure spending while reducing outlays on parastatals and containing the wage bill.

Financial Sector Policy

18. The financial sector in Kenya remains stable. Key financial soundness indicators point to a sector that is well capitalized, profitable and liquid. This soundness is the result of strengthened financial regulation and improved compliance with prudential regulations over the last four years. While the value of non-performing loans remains high, the number has been substantially reduced.

19. The authorities will submit a new Banking Bill to Parliament that establishes a legal and regulatory framework for mandatory supervisory intervention and prompt corrective actions against inadequately capitalized and failing banks. My authorities acknowledge the contribution that a strong financial sector can make in the delivery of their objectives and remain committed to implementing measures designed to ensure the stability of the financial system and to develop it further.

20. The Kenyan Government is also committed to accelerating public enterprise reforms, including privatizing troubled financial institutions, and developing a financial sector reform strategy that is based on market principles. The cabinet has approved the restructuring of the National Bank of Kenya and the authorities are now preparing for cabinet consideration of a strategy to divest from the National Bank of Kenya. Pending this divestiture, the bank will remain under the close supervision of the Central Bank of Kenya. The Charterhouse Bank (CHB) was put under management of the Central Bank of Kenya in June 2006. On 9 March 2007, the Court of Appeal rejected the application by CHB to remove the statutory manager, while the license, which expired in December 2006, was not renewed by the government. The authorities will also undertake a diagnostic audit of the National Social Security Fund (NSSF) that will provide a basis to address its financial and governance problems. Meanwhile, the Crime and Anti-Money Laundering Bill that will enable Kenya to comply with international best practice, has been republished and will be submitted to Parliament.

Tackling Governance Weaknesses

21. The authorities have achieved real progress in strengthening governance institutions, but recognize that challenges still remain. Kenya’s Governance Action Plan (GAP) has set out very clearly the authorities’ priorities. It has been well received and welcomed by citizens, the private sector and donors. The governance policy initiatives will focus on four broad areas namely: i) prevention, ii) investigation, iii) restitution, and iv) improving governance in priority sectors. Top priority is being given to administrative and preventive actions, which are expected to result in measurable improvements in governance and anti-corruption efforts in the short run.

22. A key objective of the 2006/07 program is to improve governance. The centerpiece of this agenda is the implementation of the Governance Action Plan, focusing initially on measures that can be undertaken without legislative action, yet with significant payoffs in the short-run. The authorities have already taken decisive actions on corruption cases and strengthened institutions to further enhance transparency and accountability. In this connection, they have already begun the implementation of the Governance Action Plan, in some cases, earlier than envisaged.

23. The Government is also conducting audits of the Anglo leasing contracts, which could provide additional evidence for subsequent prosecution. They intend to resubmit to Parliament the Miscellaneous Amendment Bill, which contains key measures to support implementation of the Governance Action Plan, including hiring 20 more judges and making asset declarations by senior public officials available to the general public. Resubmission of the bill to parliament will be a performance criterion for the third review.

24. The authorities acknowledge the importance of prosecuting prominent corruption cases and completing the legislative agenda for the Governance Action Plan. They have made important progress in investigating corruption cases and bringing them to trial; however, the pace at which cases are brought to conclusion has been slow. By March 6, 2007, the Kenya Anti-Corruption Commission had forwarded 254 files to the Attorney General and recommended prosecution in 185 files. Of all these, the Attorney General was unable to deal with only three files. There are currently a number of high-profile corruption cases in court including cases involving three former permanent secretaries linked to Anglo-Leasing contracts, two former central bank governors and one former Minister. The remaining Anglo leasing contracts are being investigated by the Kenya Anti-Corruption Commission in tandem with an external audit of the contracts to assess their fair values. The Kenya Anti-Corruption Commission has indicated that it intends to complete its investigations of all Anglo leasing contracts before making its recommendations to the Attorney General’s office.

Structural measures

25. The authorities have focused on further strengthening and improving public financial management. A number of steps have been taken to enhance the efficiency of public resource management and to improve governance. Important progress has been made in fiscal reporting, improving transparency in granting exemptions, subjecting all procurement to transparent and competitive procedures, timely presentation of the Controller and Auditor General’s report to Parliament, and completing a survey of the contingent liabilities of 24 parastatals.

26. On public enterprise reform and private sector development, the authorities have made considerable progress in parastatal reform. This includes the concessioning of Kenya Railways, the partial privatization of KenGen and Mumias Sugar Company, the introduction of a management contract for Kenya Power and Lighting Company, and performance contracts for all public commercial enterprises. The authorities have also made significant progress in streamlining Kenya’s business licensing system. The result is a more favorable business environment which will help to sustain growth driven by a vibrant private sector. The reform program further envisages establishment of a Privatization Commission under the Privatization Act.

27. On trade reforms and regional integration, the authorities will continue to pursue trade liberalization to enhance efficiency and strengthen growth prospects. Within the region, the authorities will implement their East African Community (EAC) commitments, continue to pursue greater regional economic and social integration, and advocate for further steps to open up the EAC with a view to enhancing competition and efficiency.

Conclusion

28. My authorities are committed to delivering on the objectives set out in the Economic Recovery Strategy, Vision 2030 and the Governance Action Plan. They have taken important steps in this regard. They are also committed to taking further additional steps that may be necessary. They believe that the Fund can play a positive and catalytic role in supporting them in the delivery of their objectives. The authorities intend to remain engaged with the Fund, through an appropriate program, after the completion of the third review.