My authorities continue to demonstrate strong commitment to sound macroeconomic policies and program implementation. Economic growth has remained strong and fiscal imbalances have narrowed on account of revenue buoyancy and spending restraint despite considerable budgetary pressures. However, balance of payments challenges remain. The balance of payments needs have intensified stemming from the impact of severe drought conditions in the Horn of Africa and high food and fuel prices. These shocks have exerted pressure on macroeconomic stability and are threatening to slow Kenya’s strong economic growth unless urgently addressed. It is in this regard that my authorities request augmentation of access under the existing Extended Credit Facility (ECF) program to help reverse the deteriorating balance of payments and stabilise the exchange rate. On account of their strong commitment to the implementation of the program, my authorities request Directors’ support in concluding the second review under the ECF, augmentation of access and modification of performance criteria.

Program performance

My authorities met all quantitative performance criteria and indicative targets for end-June 2011. The fiscal position was significantly strong, despite heightened spending pressures to cushion vulnerable households from the impact of the drought and persistently higher food and fuel prices. Fiscal structural reforms moved forward with the new VAT bill set to be submitted to parliament before the end of this fiscal year, while the new PFM bill is ready for submission to the Constitution Implementation Commission (CIC).

Recent economic developments and medium term outlook

Kenya’s economic growth is vulnerable to prevailing external shocks including the severe drought in the Horn of Africa, persistently higher food and fuel prices, rapidly deteriorating global conditions, and the security threats from the immediate neighborhood. Although the economy recorded strong growth of 4.5 percent in the first half of 2011, spurred by recovery in tourism and agricultural production, the expected growth for the FY 2011/12 has been revised downwards to 5.3 percent from 5.7 percent due largely to the impact of these external shocks. My authorities consider faster, stable and inclusive growth as a key objective of economic policy. In this regard, they remain committed to the implementation of the policies under the ECF program to maintain macroeconomic stability, foster sustainable and inclusive growth which is crucial for employment generation and poverty reduction.

Since the beginning of the second quarter of 2011, inflationary pressures have intensified with inflation rising from 12 percent in April to 19.7 percent in November, 2011. In recognition of the current macroeconomic challenges and rising inflationary pressures, the Minister for Finance has set an inflation target of 9 percent for the fiscal year 2011/12 and 5 percent in the medium term. Further, my authorities are committed to free market prices and have indicated that they will refrain from using the powers provided under the recently enacted Price Controls (Essential Goods) Act 2011 to regulate prices of essential commodities. Instead, they will rely on targeted subsidies and cash transfers to protect the poor and studiously implement the recently enacted Competition Act.

The current account deficit has widened to almost 9 percent of GDP in 2010/11 from 5.5 percent in 2009/10, due mainly to higher drought-related energy and food imports and slow recovery in export growth. The exchange rate depreciated to a historic high of KES 107 to the US dollar in October but has since appreciated by about 15 percent due to recent monetary policy tightening and review of foreign exchange guidelines. However, international reserves have remained low especially since June 2011 when the CBK suspended purchases of foreign exchange reserves from the market while capital flows have moderated.

The fiscal position remains strong with the primary deficit contracting by more than 2 percentage points to 1.5 percent of GDP in 2010/11 from its 2009/10 level, reflecting good revenue performance. My authorities target a fiscal primary deficit of 2.2 percent in 2011/12 a downward revision from the 2.7 percent envisaged at the beginning of the program.

Monetary policy developments

My authorities consider price stability as the key objective of monetary policy. As such the current monetary policy calibration is aimed at stabilising inflation and the exchange rate. During the global financial crisis the Central Bank of Kenya (CBK) rightly adopted an accommodative monetary policy which saw the Monetary Policy Committee (MPC) drop the policy rate from 9 percent in December 2008 to just under 6 percent in January 2011. However, as conditions have begun to change, the stance of monetary policy has tightened: since the beginning of second quarter 2011 the policy rate has begun to rise, reaching 18 percent in November 2011. This has led to an increase in short term interest rates while commercial banks have revised upwards their base lending rates. In addition, the MPC has raised the cash reserve requirement by 0.5 percent effective December 15, 2011.

The authorities have also adopted a new framework for monetary policy giving more prominence to the policy rate. In addition, various administrative measures were implemented, in particular the review of the foreign exchange guidelines, to streamline foreign exchange trading including a reduction in foreign exchange exposure from 20 to 10 percent. My authorities are committed to a floating exchange rate regime and accumulation of foreign reserves as a measure to better manage exchange rate volatility.