Country Report Kenya at a Glance: 2003-04

Country Report

Kenya

Kenya at a glance: 2003-04

OVERVIEW Despite the landslide victory won by the new president, Mwai Kibaki, and the National Rainbow Coalition (Narc), his new regime confronts formidable challenges. Apart from reviving the moribund economy and fulfilling election pledges to tackle corruption, provide free primary education and finalise the constitutional review, Mr Kibaki has the difficult task of holding his broad- based coalition together. The Narc contains many highly ambitious politicians and, although Mr Kibaki is expected to co-ordinate the talent at his disposal skilfully, he is old and in poor health. The main challenge may come from Raila Odinga who, though loyal to date, would like to become prime minister. The post does not currently exist but is a key element of the proposed new constitution, which also calls for a weaker president. The issue may generate a considerable dispute within the party. More rapid progress is expected on tackling corruption, a key demand of the IMF. We expect external financial support to resume by mid-year, which will help stimulate more rapid economic growth over the forecast period.

Key changes from last month Political outlook • The government has launched a special commission to re-investigate the so- called Goldenberg scandal. The collapse of the Nairobi-based Euro Bank has led to the replacement of the governor of the Central Bank of Kenya, Nahashon Nyagah, by Andrew Mullei. Mr Nyagah was forced to resign after the loss of KSh1.4bn (US$18m) of public funds deposited in the bank by various government institutions. Economic policy outlook • Tight fiscal and monetary policies will continue to shape economic policy.. Economic forecast • The country’s economic prospects are unchanged from last month: real GDP is forecast to edge up in 2003-04, supported by external funds and investor confidence.

March 2003

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Outlook for 2003-04

Political outlook

Domestic politics Kenya’s political environment has been transformed by the landslide victories won by Mwai Kibaki and his National Rainbow Coalition (Narc) in the presidential and legislative elections held on December 27th 2002. The Kenya African National Union (KANU) was pushed into opposition for the first time since independence in 1963 and Daniel Arap Moi’s 24-year reign was brought to a close. The challenges confronting Mr Kibaki and his Narc government are, nevertheless, daunting. The new regime has inherited a run-down infrastructure, weak and corrupt institutions, a country riven with ethnic divisions, and one of Africa’s worst-performing economies. Furthermore, apart from fulfilling specific electoral pledges to tackle corruption, introduce universal, free primary education, and complete the constitutional review process, Mr Kibaki faces the task of holding his broad-based coalition together. Narc membership is exceedingly diverse and cuts across traditional boundaries of ethnicity and ideology. It also includes many opportunists, including defectors from KANU, who are seeking to prolong their own political careers. The main inspiration for party unity was the defeat of the old regime, but with this objective achieved, the forces acting on the Narc will tend to promote fragmentation. As part of the government’s war on corruption, it launched at the beginning of March a special commission to re-investigate the biggest corruption case in Kenya’s history, the so-called Goldenberg scandal of 1991. The scandal involved the pay-out of KSh68bn (US$1bn) for fictitious exports of gold and diamonds. At the centre of the affair is a local businessman, Kamlesh Pattni, who is accused of defrauding the government of Ksh22bn. There can be no doubt that a satisfactory conclusion of the Goldenberg scandal, which also involves some members of Mr Kibaki’s government, will be a demonstration of the new government’s commitment to tackling corruption at the highest level. The collapse of the Nairobi-based Euro Bank has led to the replacement of the governor of the Central Bank of Kenya, Nahashon Nyagah, by Andrew Mullei. Mr Nyagah resigned after the loss of KSh1.4bn (US$18m) of public funds deposited in Euro Bank by a number of government institutions (Kenyatta National Hospital, the Postal Corporation, Kenya Sugar Authority and the National Social Security Fund among others), which were subsequently lent to politically connected individuals. The Euro Bank scandal is likely to prompt resignations (and prosecutions) of other members of the Kibaki cabinet that served in the Moi government.

International relations The international community welcomed the smooth transition of power and Mr Kibaki’s promise of fundamental economic reforms and efforts to combat corruption. The new government’s efforts to date on both reforms and corruption is viewed positively by the World Bank and IMF, and the government has good prospects of normalising relations with them, especially the IMF. External assistance is likely to resume by mid-2003, provided the

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government does not weaken in its commitment to fight corruption and restructure parastatal enterprises. On a less encouraging note, both the US and the UK have again warned that Kenya is a soft target for possible further terrorist attacks. This will undoubtedly delay the recovery of the country’s tourism sector, following a very poor winter season.

Economic policy outlook

Policy trends The state of Kenya’s economy will challenge the abilities of the new finance minister, David Mwiraria, as he attempts to produce a coherent set of policies and honour electoral promises. In the short-term, the government’s strategy relies on the restoration of donor support. High-level talks were held with visiting IMF and World Bank delegations to Nairobi in mid-January. There are three main preconditions for IMF support: the passage of anti-corruption legislation, the prosecution of high-profile offenders and a renewed commitment to privatisation. The government appears dedicated to meeting these demands, and the Economist Intelligence Unit expects negotiations on a new IMF programme to start in April or May, followed by the resumption of funding in mid-year. The government is currently redrafting the poverty reduction strategy paper prepared in 2000, and is expected to focus it on job creation and sustainable development. IMF approval would release non-project support from the World Bank and allow access to Paris Club debt rescheduling. Progress with the sale of key state assets including Telkom Kenya, the Kenya Railways Corporation, the Kenya Ports Authority and Kenya Commercial Bank may prove slower. The government wishes to restore them to profitability (in order to get a better price) and will initially concentrate on commercialisation rather than privatisation. The more favourable policy environment is expected to raise foreign direct investment from its current low level, especially if progress is made in tackling corruption and repairing dilapidated infrastructure.

Fiscal policy Although external assistance, including budgetary support, may resume in mid- 2003, it may take longer to come through. Faced with severe resource constraints, Mr Mwiraria will be obliged to follow fairly tight fiscal policy in the next fiscal year (July 2003-June 2004). The deficit has mounted steadily in fiscal year 2002/03 and continues to do so—the result of both pre-election spending by the outgoing regime and the need for the incoming administration to fulfil its promises, especially on education. The targeted deficit of around KSh34bn (US$435m; 4% of GDP) is overoptimistic, and Mr Mwiraria recently forecast a full-year deficit of KSh57bn (7% of GDP). Data for the first five months of 2002/03 (July-November) showed a deficit (on a commitments basis) of KSh17.9bn (US$230m), compared with a target of KSh13.2bn. Although spending was KSh12.3bn less than expected, at KSh98.7bn, revenue was KSh17bn less than the target of KSh80.8bn. The fiscal deficit will grow in the next few months. Although revenue will remain weak because of sluggish economic growth and lack of external funds, the introduction of free primary education is expected to add KSh5bn to the budget. Mr Mwiraria will seek savings in other areas and has frozen spending

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on major public projects until they have been properly audited. The situation is forecast to improve in 2003/04, as revenue recovers in line with economic growth and the expected return of external support, though the final deficit may be close to 6% of GDP. The government will continue to rely on domestic sources to fund the deficit, at least for the remainder of 2002/03, which will put pressure on interest rates and limit the availability of credit to the private sector.

Monetary policy Monetary policy will be geared towards keeping inflation below the official 5% target and maintaining exchange-rate stability. The government’s reliance on domestic borrowing to finance the budget deficit was responsible for an upward trend in the key 91-day Treasury-bill rate in the second half of 2002— from 7.3% in June to 8.4% in December. As inflation was subdued over the period, real interest rates also moved upwards: a boon to savers but a deterrent to investors, especially in the private sector. After taking office, the new finance minister warned of even higher interest rates due to the government’s need to finance the mounting fiscal deficit but, to date at least, his fears have proved unfounded and the T-bill rate edged down to 7.9% in early February. This reflects both the decline in global interest rates and increased confidence in future economic performance, which has reduced the premium on future money. The growing importance of medium-term Treasury bonds, in place of bills, will facilitate the development of capital markets. The ratio of bonds to bills rose to a new high of 60:40 in December: renewed confidence in economic prospects may enable the government to achieve its targeted 70:30 ratio in the year ahead.

Economic forecast

International assumptions International assumptions summary (% unless otherwise indicated) 2001 2002 2003 2004 Real GDP growth World 2.1 2.8 3.1 3.8 OECD 0.8 1.6 1.8 2.5 EU 1.4 0.9 1.3 2.1 Exchange rates ¥:US$ 121.5 125.3 120.3 121.5 US$:€ 0.896 0.946 1.115 1.105 SDR:US$ 0.785 0.772 0.719 0.724 Financial indicators € 3-month interbank rate 4.26 3.33 2.44 2.94 US$ 3-month Libor 3.78 1.80 1.36 3.17 Commodity prices Oil (Brent; US$/b) 24.5 25.0 26.6 19.6 Gold (US$/troy oz) 271.1 309.8 316.3 290.0 Tea (US$/kg) 1.6 1.5 1.5 1.4 Coffee (arabica; US cents/lb) 62.3 61.9 63.5 62.4 Note. Regional GDP growth rates weighted using purchasing power parity exchange rates. The short-term outlook for the world economy remains gloomy: weak growth is forecast for the first half of 2003. However, by the latter half of 2003 and

into 2004, the world economy is expected to pick up. Global GDP—weighted using purchasing power parity exchange rates—is forecast to grow by 3.1% in 2003 and 3.8% in 2004, following growth of just 2.8% in 2002. The pace of recovery in the euro area, which is vital for Kenya’s trade, has weakened, and its GDP is now estimated to have expanded by just 0.7% in 2002. Real GDP in the euro area is forecast to grow modestly, by 1.2% in 2003 and 2% in 2004. Prospects for the prices of Kenya’s main commodity exports during the outlook period are poor: the average price of arabica coffee is forecast to decline from 63.5 US cents/lb in 2003 to 62.4 US cents/lb in 2004. Tea prices will fall from US$1.5/kg in 2002 to US$1.4/kg in 2004. World prices for crude oil are likely to spike in the first half of 2003 owing to the political crisis in Venezuela, which has halted oil exports from that country, and the US-led attack on Iraq, but will fall back quickly after that. We forecast that the price of Brent crude will average US$26.6/barrel in 2003, before falling to US$19.6/b in 2004. Upward pressure on interest rates is now expected in the second half of 2003, leading to a more significant rise in 2004.

Economic growth We estimate that in 2002 real GDP grew by only 0.8%, because of erratic mid- year rains, low investor confidence, lack of donor support and uncertainties associated with the elections. Assuming that donor support resumes in the second half of 2003 and the agricultural sector continues to perform strongly, we forecast economic growth of 2.5% in 2003 and 3.3% in 2004, short of the official target of 4% per year. The agricultural sector (some 20% of GDP) is forecast to expand by 2% in 2003 and 2.5% in 2004, depending on rainfall. Projected new investment in telecommunications, higher textile production and the improved power supply should boost industrial growth to 3% in 2003 and 3.8% in 2004, a stronger recovery being hampered by the shortage of credit to the private sector (domestic credit to the private sector stagnated in the year to September 2002, whereas credit to the government grew by 38%) and low investor confidence, at least during the first half of 2003. Activity in the services sector will also pick up over the forecast period as tourism recovers from the mini-slump of 2002 and financial services benefit from the privatisation of a number of state assets and the slow but steady decline of bad debts. However, the tourism sector has yet to feel the full impact of the terrorist attack on a Mombasa hotel at the end of November 2002. Domestic demand will remain subdued until foreign assistance returns in the second half of 2003. Exports of goods and services are forecast to grow more strongly in 2003 and should maintain this momentum into 2004, in line with an upturn in global demand. Import demand will track domestic consumption and investment trends and start to recover in the second half of 2003, rebounding more strongly in 2004 as the overall economy gradually improves.

Inflation Headline year-on-year inflation fell from a temporary peak of 2.8% in June 2002 to 1.7% in October 2002, as seasonal factors reduced the price of food (which accounts for 50.5% of the index). Inflation subsequently surged to 4.1% in December and 6.5% in January 2003, however, which exceeded the government’s 5% target level for the first time for two years. The rise is due to several factors including higher food prices (because of stronger demand over

the festive season and low rainfall in November) and increased housing and fuel costs. In addition, Kenya’s main oil supplier increased the price of crude oil to the local market by 9% in December, which has had a knock-on effect throughout the wider economy by raising the cost of transport for all commodities. Although any further rise in oil prices associated with conflict in the Middle East will add to inflationary pressure, this is expected to be a temporary phenomenon. Furthermore, weak domestic demand and the appreciation of the shilling against the US dollar (in which oil prices are denominated) will help to keep inflation in check. As a result, average annual inflation is forecast to rise from 1.9% in 2002 to no more than 3% in 2003, before subsiding to 2.5% in 2004.

Exchange rates The Kenya shilling remained fairly stable against the US dollar during 2002 and averaged KSh78.7:US$1 over the year, compared with KSh78.6:US$1 in 2001. At the same time, the real effective rate fell by 2.6%, which helped maintain export competitiveness. The shilling, however, fell by 15.3% against the euro in 2002. The nominal value of the local currency is compatible with economic fundamentals, while the steady accumulation of foreign reserves has limited speculative trading. Although uncertainties associated with the election pushed the shilling below the psychologically important KSh80:US$1 for a short time in late November, it settled back again in December. The smooth transfer of power to the new government has been accompanied by an erratic, but significant, appreciation, and the shilling was trading at just under KSh77.6:US$1 on February 14th. The prospective return of external assistance from mid-2003 and the improved outlook for GDP growth have more than compensated for the jump in inflation. We expect the shilling:dollar exchange rate to remain fairly stable during the forecast period, with an average exchange rate of KSh79.5:US$1 in 2003 and KSh79.8:US$1 in 2004.

External sector Fears that Kenya’s current-account deficit/GDP ratio would deteriorate in 2002 have not been realised, according to recent data. The deficit in 2002 was US$261m (2.3% of GDP), compared with US$318m (2.8% of GDP) in 2001. Despite the sharp downturn in the invisible trade surplus, due mainly to the collapse of private transfers in the nervous pre election period, combined with weaker tourism inflows, this was more than offset by the decline in the merchandise trade deficit. Imports fell by 6.7%, as a result of subdued demand, while exports climbed by some 11%. Although revenue from tea and coffee exports stagnated, horticultural sales grew strongly and manufactured exports benefited from higher demand for steel and cement in East Africa and from a steep rise in textile shipments to the US under the Africa Growth and Opportunity Act. We expect the current-account deficit to rise again to 2.8% of GDP in 2003 (US$332m) before it eases to 2.5% of GDP in 2004 (US$304m). Imports are forecast to climb in 2003 because of higher oil prices and renewed demand for manufactured goods and capital equipment due to the resumption of external financial assistance and the associated revival of domestic activity. At the same time, export growth in 2003 will be inhibited by the continuing weakness of commodity markets, poor growth in the key EU market and domestic

infrastructure constraints. Tourism will also remain subdued, although current transfers will pick up strongly. The overall picture for 2004 is slightly brighter. Although imports are likely to continue rising, despite the fall in oil prices, exports will benefit from improved commodity prices, closer regional integration and increased textile sales to the US. In addition, a recovery in tourism, combined with Kenya’s growing importance as a regional centre for financial services, should boost invisible earnings.

Forecast summary (% unless otherwise indicated) 2001a 2002b 2003c 2004c Real GDP growth 1.2 0.8 2.5 3.3 Industrial production growth 1.0b 0.9 3.0 3.8 Gross agricultural production growth 1.2 1.2 2.0 2.5 Consumer price inflation (av) 5.7 1.9 3.0 2.5 Consumer price inflation (year-end) 0.6 2.5 2.5 2.0 Short-term interbank rate 19.7 18.5 19.5 19.0 Government balance (% of GDP) -4.3 -7.0 -6.0 -4.5 Exports of goods fob (US$ bn) 1.9 2.1 2.3 2.4 Imports of goods fob (US$ bn) 3.2 3.0 3.4 3.6 Current-account balance (US$ bn) -0.3 -0.3 -0.3 -0.3 Current-account balance (% of GDP) -2.8 -2.3 -2.8 -2.5 External debt (year-end; US$ bn) 5.9b 5.7 6.1 6.4 Exchange rate KSh:US$ (av) 78.56 78.75a 79.53 79.79 Exchange rate KSh:¥100 (av) 64.65 62.82a 66.14 65.67 Exchange rate KSh:€ (year-end) 69.27 80.88a 89.48 87.21 Exchange rate KSh:SDR (year-end) 98.8 104.8a 110.8 109.9 a Actual. b Economist Intelligence Unit estimates. c Economist Intelligence Unit forecasts.

Editors: Pratibha Thaker (editor); David Cowan (consulting editor) Editorial closing date: March 13th 2003 All queries: Tel: (44.20) 7830 1007 E-mail: [email protected] Next report: Full schedule on www.eiu.com/schedule