Kenya
2004 Article IV Consultation, First Review Under the Poverty Reduction and Growth Facility, and Requests for Augmentation of Access, Rephasing of the Arrangement, and Waiver of Performance Criteria: Staff Report; Staff Statement; Public Information Notice and Press Release on the Executive Board Discussion; and Statement by the Executive Director for Kenya

This 2004 Article IV Consultation highlights that monetary policy of Kenya has been expansionary since 2003/04 to promote economic growth. This has, however, contributed to the recent rise in inflation. Executive Directors have observed the progress that has been made under the Poverty Reduction and Growth Facility (PRGF)-supported program, which has contributed to a rebound in economic growth and arrested the rise in domestic debt. However, Directors have noted that Kenya faces serious challenges. In particular, growth remains too slow for making inroads into poverty, and governance remains a critical concern.

Abstract

This 2004 Article IV Consultation highlights that monetary policy of Kenya has been expansionary since 2003/04 to promote economic growth. This has, however, contributed to the recent rise in inflation. Executive Directors have observed the progress that has been made under the Poverty Reduction and Growth Facility (PRGF)-supported program, which has contributed to a rebound in economic growth and arrested the rise in domestic debt. However, Directors have noted that Kenya faces serious challenges. In particular, growth remains too slow for making inroads into poverty, and governance remains a critical concern.

Kenya: Past Fund Policy Recommendations and Implementation

Before 2003, pervasive governance problems and weak political commitment to economic reforms did not provide a favorable environment for the implementation of Fund policy advice. Despite the challenges detailed in this report, implementation of Kenya’s economic policies has improved substantially since 2003, when the coalition government led by President Kibaki took office. This box considers recent experience with the implementation of Fund policy in four areas: governance, fiscal sustainability, financial sector, and poverty reduction.

Governance: The Fund has emphasized governance as key to improving Kenya’s economic performance; failure to implement reforms in this area led to the interruption of several previous Fund programs. Since December 2002, Kenya has implemented an ambitious and multifaceted program of reforms, including passing key anticorruption and public ethics legislation, strengthening the judiciary, and reforming the policy, as well as the public audit system. Additional steps to strengthen governance are discussed in this report.

Fiscal sustainability: The Fund has urged Kenya to address fiscal sustainability by, among other steps, strengthening revenue performance, lowering the wage bill as a proportion of revenue, and decisively tackling contingent fiscal liabilities. Noting the concern about fiscal sustainability, the government has already taken various measures to this end, including strengthening tax administration, initiating public expenditure management (PEM) reforms, continuing civil service rationalization, and establishing a new wage-setting mechanism for public employees. The government has also stressed the need to increase poverty reduction spending. For this reason, the reorientation of public expenditure in favor of essential social and economic outlays is a key priority of the government

Financial sector: Over the recent past, Kenya has taken important steps to strengthen financial sector supervision in response to Fund advice. It has been less successful in responding to the recommendations of the Fund and the Bank to reduce public sector ownership of banks. The government has indicated that the slow progress in this area reflects primarily fears that privatization may adversely affect financial intermediation in rural areas.

Poverty Reduction: Kenya has produced an ambitious poverty reduction strategy paper. Fund policy advice has emphasized the links from improved PEM, fiscal sustainability, and financial sector stability to enhanced poverty reduction strategies and pro-poor spending. The government has made strides in these areas by addressing budget rigidity through the new wage-setting mechanism for public employees, but it has also indicated that its intentions to restructure expenditure toward poverty reduction have been hampered by uncertain donor support.

I. Recent Economic Developments

1. A narrowly based rebound in economic activity has begun. Although real GDP growth at an estimated 2.1 percent in 2003/04 was above the program assumption of 1.9 percent, growth has depended primarily on a recovery of the tertiary sectors (Figure 1). Primary sector output has been adversely affected by a drought, and gross investment (in percent of GDP) has remained at prereform levels (Table 1). Kenya’s growth has been driven primarily by factor accumulation, with efficiency gains, as measured by total factor productivity, declining (Box 2).

Figure 1.
Figure 1.

Kenya: Real and External Developments

Citation: IMF Staff Country Reports 2009, 225; 10.5089/9781451821260.002.A001

Source: Staff estimates.
Table 1.

Kenya: Medium-Term Macroeconomic Framework, Base Case Scenario, 2002/03-07/08

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Sources: Kenyan authorities; and staff estimates and projections.

12-month period ended June 2003.

2. The loosening of monetary policy has led to an increase in inflation and a depreciation of the shilling. In response to the lowering of banks’ required reserves from 10 percent to 6 percent in July 2003, the money multiplier rose precipitously, resulting in a 13 percent expansion of broad money in 2003/04 and negative real interest rates (Table 2). Headline inflation rose to 19 percent in September 2004 from 8 percent a year earlier (Figure 1). Kenya’s inflation has also been driven by increases in energy prices, and a weakening of the Kenyan shilling (Box 3).

Table 2.

Kenya: Monetary Survey, Base Case Scenario, 2003-2007

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Source: Central Bank of Kenya and staff projections

Note:

Constant Kenya shilling per U.S. dollar exchange rate prevailing on September 30, 2001

Calculated as 6% of total deposit

3. Recent economic developments may have worsened poverty indicators. With real GDP growth broadly in line with the increase in population and the economy suffering from the effects of major negative shocks—the drought and the oil price increase—the poverty rate may have increased in the recent past. Moreover, progress on poverty alleviation has been hampered by delays in initiating major poverty reduction programs in the social and economic sectors. AIDS remains a major challenge (Box 4).

Kenya: Sources of Economic Growth

Kenya’s economic performance since 1990 has been lackluster, with growth averaging 1.6 percent a year. A simple growth accounting exercise has shown that, like most sub-Saharan African countries, much of the economic growth in Kenya has been driven by factor accumulation, notably physical capital formation and employment growth. Total factor productivity (TFP) broadly declined during the past two decades. However, TFP growth is projected to be positive in 2004. A simple econometric study shows that TFP growth is strongly and positively associated with governance and significantly and negatively associated with inflation.1

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1 For details, see Chapter I of the Selected Issues Paper.

Kenya: Inflation Dynamics and Its Determinants

Kenya’s inflation has recently risen sharply. Annual overall inflation was 19 percent in September 2004, with underlying inflation (overall inflation excluding food, fuel, and energy) reaching 7 percent. These rates have exceeded the Central Bank of Kenya (CBK)’s target of 5 percent for underlying inflation.

Potential factors that may have contributed to Kenya’s recent high inflation include an expansionary monetary policy and, on the supply side, a poor harvest and high energy prices. A simple econometric study shows that the recent high overall inflation has been driven primarily by a high growth rate of broad money, a weakening of Kenya’s nominal exchange rate, high energy prices, and low agricultural output.1

Source: Fund staff.1 For a detailed discussion of the econometric model, see Chapter II in the Selected Issues paper.

Kenya: Economic and Social Impact of HIV/AIDS

HIV/AIDS is a serious problem in Kenya, with the infection rate estimated at 14 percent of the adult population. The number of AIDS-related deaths is estimated at 150,000 in 2002.

Economic consequences

  • The high death rates among the working-age population imply that AIDS deaths may directly reduce potential annual economic growth by 1.0-1.2 percentage points a year.

  • Poor health of workers weakens labor productivity.

  • High medical costs take resources away from other, more economically productive areas.

AIDS and poverty

  • Family income falls when adults fall victim to AIDS or when they reduce work hours to care for sick family members.

  • High medical costs push the infected and their families into poverty.

4. Overall fiscal performance strengthened during the fiscal year 2003/04. Central government fiscal imbalances were much lower than expected under the program, leading to a marked drop in the ratio of domestic debt to GDP from 24.3 percent at end-June 2003 to 22.2 percent at end-June 2004 (Table 3 and Figure 3). While this performance reflected the positive effects of strong revenue collection and the steps taken to tighten the management of recurrent expenditure, fears that the planned large domestic borrowing might crowd out private activity also induced the authorities to curtail some spending programs. In addition, there were delays in implementing some programs, such as the recapitalization of the National Bank of Kenya.

Figure 2.
Figure 2.

Kenya: Monetary and Financial Developments

Citation: IMF Staff Country Reports 2009, 225; 10.5089/9781451821260.002.A001

Source: Kenyan authorities.
Figure 3.
Figure 3.

Kenya: Fiscal Developments

Citation: IMF Staff Country Reports 2009, 225; 10.5089/9781451821260.002.A001

Source: Kenyan Authorities.
Table 3a.

Kenya: Central Government Financial Operations, 2001/02-2007/08

Base Case Scenario

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

Revenue measures is a policy variable that reflects resources needed to achieve policy targets.

Includes allocation of KSh 4 bln to meet costs of additional emergency food supply.

Financing gap includes uncommitted external project and program grants and loans.

Table 3b.

Kenya: Central Government Financial Operations, 2001/02-2007/08

Base Case Scenario

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

Revenue measures is a policy variable that reflects resources needed to achieve policy targets.

Includes allocation of KSh 4 bln to meet costs of additional emergency food supply.

Financing gap includes uncommitted external project and program grants and loans.