Kenya: Selected Issues and Statistical Appendix

Like most Sub-Saharan African countries, Kenya’s economic growth appears to have been primarily driven by factor accumulation. The Selected Issues paper and Statistical Appendix for Kenya examines economic developments and policies. During the last two decades, Kenya has been plagued by pervasive problems of internal conflicts, constitutional crises, and corruption scandals. The governance agenda focuses on several reforms, including upgrading the public budget and financial management systems, strengthening the anticorruption institutions, and improving the judicial framework.

Abstract

Like most Sub-Saharan African countries, Kenya’s economic growth appears to have been primarily driven by factor accumulation. The Selected Issues paper and Statistical Appendix for Kenya examines economic developments and policies. During the last two decades, Kenya has been plagued by pervasive problems of internal conflicts, constitutional crises, and corruption scandals. The governance agenda focuses on several reforms, including upgrading the public budget and financial management systems, strengthening the anticorruption institutions, and improving the judicial framework.

III. Estimation of the Equilibrium Real Exchange Rate for Kenya1

A. Introduction

1. One important indicator of a country’s external competitiveness is the real exchange rate.2 Given the strong evidence of a positive link between export performance and economic growth, notably in East Asia, fostering a competitive real exchange rate is integral to Kenya’s development objectives.

2. Since the early 1990s, Kenya has made considerable progress in liberalizing its trade and exchange rate regime. In the early 1990s, Kenya removed capital controls and moved from a fixed exchange rate regime to a managed floating system, with the U.S. dollar as the principal intervention currency. During the same period, Kenya also embarked on trade liberalization, which involved a reduction in the number of tariff bands from 15 in 1990 to 4 in 1999 and a lowering of the top tariff rate from 100 percent to 25 percent. However, its current trade regime, which is rated 6 on the IMF’s 10-point trade restrictiveness index (with 10 being the most restrictive), is the most restrictive regime among the three members of the East African Community. 3

3. Developments in nominal and real exchange rates since 1980 are presented in Figure III.1. Generally speaking, the nominal effective exchange rate (NEER) has shown a depreciating trend during the past two decades, while Kenya’s domestic prices have outpaced those of its trading partners and swamped the nominal depreciation of its currency, resulting in an appreciated real exchange rate. The figure demonstrates that the real effective exchange rate (REER) volatility has diminished since the shift to a managed float.

Figure III.1b.
Figure III.1b.

Kenya: Exchange Rates and Relative CPI, 1980-2004

Citation: IMF Staff Country Reports 2009, 192; 10.5089/9781451821253.002.A003

Source: Information Notice System.Note: An increase in an exchange rate index means an appreciation. An increase in the trade-weighted relative CPI means Kenya’s CPI increases faster than its trading partners.

4. This chapter examines Kenya’s CPI-based equilibrium REER. 4 It identifies a long-run cointegrating relationship between the real exchange rate and a number of explanatory economic variables during 1980–2004. 5 Using the estimated cointegrating equation, an equilibrium real exchange rate path is calculated and compared to the actual data. The econometric results suggest that the current REER level is above the equilibrium level implied by economic fundamentals.

5. The chapter is organized as follows: section B presents a theoretical and econometric framework used in estimating the equilibrium REER. The results are presented in section C, and the chapter concludes with policy implications in section D.

B. Model

Theoretical Background

6. A single reduced-form approach is used to estimate the equilibrium REER. 6Specifically, the equilibrium REER is assumed to be a function of several “fundamentals,” which include:7

  • Relative productivity of the tradable sector—This classic Balassa-Samuelson effect assumes that while prices of tradable goods are equalized across countries, increased productivity growth in a country’s tradable sector relative to its trading partners will bid up wages in the domestic economy. Assuming that productivity growth in the nontradable sector is slower than the tradable sector, prices of nontradable goods will have to increase to compensate for the higher wages, thereby resulting in a rise in the overall CPI and hence a real appreciation of the local currency.

  • Export prices of tea and coffee—Given the prominence of tea and coffee in Kenya’s exports, an increase in the price of these commodities will tend to improve Kenya’s terms of trade and appreciate the real exchange rate. 8

  • Openness to trade—A more restricted trade regime is likely to appreciate the real exchange rate as trade barriers, such as tariffs, tend to raise prices in the tradable sector, thereby increasing overall prices, and hence the real exchange rate.

  • Net foreign assets (NFAs)—Higher NFAs are likely to be associated with a more appreciated real exchange rate. As discussed in Lane and Milesi-Ferretti (2000), a decline in the NFA position implies a rise in the home country’s net indebtedness to the rest of the world. Therefore, over the medium term, the home country needs a more depreciated real exchange rate to achieve a larger trade surplus required to service the higher debts. Conversely, a strong NFA position implies that the country can sustain a higher trade deficit that is associated with an appreciated real exchange rate. In addition, the NFA position can also be used as a proxy for net capital inflows, which tend to appreciate the real exchange rate.

Data

7. The following data were used to estimate the equilibrium REER:

  • Agricultural productivity relative to the rest of the world—since Kenya’s main exports are agricultural products, changes in agricultural productivity vis-à-vis comparator countries were used to examine the Balassa-Samuelson effect. For this purpose, Colombia, Sri Lanka, Tanzania, and Uganda were selected as comparator countries because of the prominence of tea or coffee in their exports. 9

  • International commodity prices of tea and coffee—calculated as the average of the commodity indices of tea and coffee.

  • Openness to trade—measured by the ratio of the sum of exports and imports to GDP;10 and

  • The net foreign assets of the banking system—measured by the ratio of NFA of the banking system to GDP.

8. The following observations can be drawn from the data on the explanatory variables used to estimate the equilibrium exchange rates: (Figure III.2)

  • Kenya’s productivity in the agricultural sector has declined relative to comparator countries, suggesting a more depreciated real exchange rate;

    Figure III.2.
    Figure III.2.

    Kenya: Economic Fundamentals Underpinning the Equilibrium REER, 1980-2004

    Citation: IMF Staff Country Reports 2009, 192; 10.5089/9781451821253.002.A003

    Source: Kenyan Authorities, World Development Indicators, and Staff Estimates.Note: The trend is obtained from the Hodrick-Prescott filter.

  • The average export prices of tea and coffee have trended downward, suggesting a more depreciated real exchange rate;

  • The economy has become less open, suggesting a more appreciated real exchange rate; and

  • The NFA position has increased, suggesting a more appreciated real exchange rate.

Methodology

9. The Dynamic Ordinary Least Squares (DOLS) estimator developed by Stock and Watson (1993) is used to identify the cointegrating (equilibrium) relationship between the REER and the explanatory variables. Specifically, the DOLS estimates the cointegrating relation by an ordinary least squares regression augmented by the first difference of the explanatory variables, together with their lags and leads. 11

10. The equilibrium real exchange rate path is calculated based on the estimated cointegrating relation. Given that the explanatory variables have exhibited a high degree of volatility, to derive a proxy for the equilibrium values for these explanatory variables, following MacDonald and Ricci (2003), the Hodrick-Prescott filter is used to smooth out the short-term noise in the explanatory variables. The equilibrium path is then derived by substituting these smoothed variables in the regression equation.

C. Results

11. The econometric findings presented in Table III.1 are as follows:

  • A one percent increase in agricultural productivity vis-à-vis comparator countries is associated with a 0.8 percent appreciation of the REER;

  • A one percent increase in the average export prices of coffee and tea is associated with a 0.3 percent appreciation of the REER;

  • A one percent increase in openness is associated with a 0.5 percent depreciation of the REER;

  • A one percentage point increase in the ratio of NFA of the banking system to GDP is associated with a 3 percent appreciation of the REER.

Table III.1.

Kenya: Equilibrium (Cointegrating) Relation between the REER and the Economic Fundamentals, 1980-2004

article image
Source: Staff estimates.Note: In regression equation (1), the Dynamic Ordinary Least Squares of Stock and Watson (1993) is used to estimate the equilibrium (cointegrating) relation between Kenya’s real effective exchange rate (REER) and the economic fundamentals (explanatory variables) using quarterly data during 1980-2004. Equation (2) is a modified version of equation (1), with insignificant lags and leads omitted. The dependent variable is the logarithm of REER. The explanatory variables include: NFA (the net foreign assets of the banking system in Kenya as a percentage of the GDP); AGRICULTURAL PRODUCTIVITY (the logarithm of the relative agricultural productivity index of Kenya relative to Sri Lanka, Colombia, Tanzania, and Uganda); TEA AND COFFEE (the logarithm of the average of the international commodity price indices of tea and coffee); and OPENNESS (the logarithm of the sum of exports and imports as a percentage of GDP). The numbers in the parenthesis underneath the explanatory variables are the corresponding absolute t-statistics, based on standard errors calculated using Newey-West heteroscedasticity and autocorrelation consistent covariances.

12. Figure III.3 shows the actual REER and the estimated equilibrium path. The econometric results suggest that Kenya’s actual REER appears to be more appreciated than suggested by economic fundamentals.

D. Policy Implications

13. Fostering a competitive REER is key to Kenya’s objective of promoting strong growth and poverty reduction. Policies should therefore be directed to:

  • Enhancing labor productivity—Macroeconomic and structural reforms including policies aimed at increasing labor market flexibility are key to improving productivity and ensuring that wage adjustments are guided by productivity changes and cost of living, and not by other criteria. Recently, the authorities have established a wage-setting mechanism for public sector employees and will issue guidelines for the private sector to help align wage increases to productivity gains.

  • Liberalizing trade—Greater openness is essential to promoting competitive economic conditions and to reducing supply costs. Given that Kenya’s trade regime is the most restrictive among EAC members, further trade liberalization is warranted.

  • Allowing a more flexible nominal exchange rate—The authorities should allow the nominal exchange rate to adjust freely to fully reflect economic fundamentals. In this regard, foreign exchange intervention should be restricted to smoothing short-run fluctuations.

  • Maintaining price stability—Given that the rise in Kenya’s domestic prices relative to its trading partners has played an important role in the real appreciation of the REER during the past decade, lowering Kenya’s domestic cost structure by maintaining disinflation would help to enhance Kenya’s external competitiveness. In this regard, monetary policy should be guided by the overriding objective of price stability.

Figure III.3.
Figure III.3.

Kenya: Actual And Equilibrium REER, 1980-2004

Citation: IMF Staff Country Reports 2009, 192; 10.5089/9781451821253.002.A003

Source: Staff Estimates
1

This chapter was prepared by Kevin C. Cheng (AFR).

2

External competitiveness has many other aspects that are not directly captured by the real exchange rate. For instance, unit labor costs, labor quality, physical infrastructure, judiciary soundness, political stability, and governance affect a country’s competitiveness.

3

For details on Kenya’s current trade regime, see Chapter V.

4

The concept and measurement of an equilibrium exchange rate are a contentious issue in the economics literature. In addition, there are always drawbacks to the various approaches that have been employed by different analysts. Therefore, the results of the econometric analysis presented in this chapter should be interpreted with this caveat in mind.

5

The sample is truncated at 1980 because REER data were only compiled beginning in 1980.

6

This approach is one of the most standard approaches used to identify the equilibrium REER for a variety of countries today. For a detailed survey on various estimation method for equilibrium REER, see MacDonald (1995), Montiel (1999), and Rogoff (1996).

7

These are the variables that are typically used to estimate the equilibrium exchange rate for developing countries. Some papers have also used fiscal and external indicators, which were also initially incorporated in the analysis, but were later dropped owing to either statistical insignificance or non-robustness.

8

Commodity prices instead of the terms of trade are used because most empirical studies in this area have found that commodity prices are strongly cointegrated with the real exchange rate while finding little link between the real exchange rate and the terms of trade. See, for example, Chen and Rogoff (2002), McDonald (2002).

9

Productivity refers to labor productivity, calculated as the agricultural output per worker in the agricultural sector. Data were obtained from the World Bank’s World Development Indicators.

10

While the IMF’s trade restrictiveness index may be a better indicator for openness, the data are only available after the mid-1990s.

11

Formally, suppose Xt and Yt are two non-stationary and cointegrated stochastic processes, then there exists a θ such that Yt - θXt is stationary. The DOLS of Stock and Watson (1993) estimates θ by running the following regression using the ordinary least squares: Yt=β0+θXt+Σj=-ppδjΔXt-j+ut

Kenya: Selected Issues and Statistical Appendix
Author: International Monetary Fund