Country Report

Kenya Kenya at a glance: 2006-07

OVERVIEW The president, Mwai Kibaki, will continue to push ahead with key social and economic reforms, but deep divisions within the ruling National Rainbow Coalition (NARC) will generate tension and uncertainty. Even if Mr Kibaki wins the referendum on the new constitution, he will need to take firm action against corruption to win the trust of the electorate and donors again in 2007. Economic policy will be guided by the country’s poverty reduction and growth facility (PRGF) with the IMF and the donor community. Real GDP growth of an estimated 5.2% in 2005 is forecast at the similar level of 5.3% in 2006, rising to 5.5% in 2007 as donor-backed investment projects make it cheaper and easier to conduct business.

Key changes from last month Political outlook • Mr Kibaki and his allies are urging Kenyans to vote “yes” to the proposed new constitution in the referendum that is due to take place on November 21st, using the banana as the symbol for a “yes” vote. However, the opposition Kenya African National Union and rebel NARC ministers have united under the “orange” banner to call for a “no” vote on the grounds that the new draft does nothing to curb the president’s extensive powers. An opinion poll in October gave the “no” camp a slight advantage, but there are still a large number of undecided voters. The prospect of a close result has added intensity to campaigning, leading to violent three-way clashes involving rival supporters and the police. A “no” vote would weaken the president and increase pressure for early elections, but a “yes” vote would cement his authority and give him a good chance of winning the next general election, scheduled for 2007. Economic policy outlook • Kenya has complied with most loan conditions during the second year of the PRGF, according an IMF mission that visited the country in October 2005. The mission will recommend that the IMF executive board authorise the release of the third and fourth tranches of the loan, worth US$72m, when it meets in December 2005. The funds are likely to be disbursed in January 2006. Economic forecast • Economic prospects remain essentially unchanged. November 2005

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Kenya 1

Contents

Kenya

3 Summary

4 Political structure

5 Economic structure 5 Annual indicators 6 Quarterly indicators

7 Outlook for 2006-07 7 Political outlook 9 Economic policy outlook 11 Economic forecast

14 The political scene

18 Economic policy

23 The domestic economy 23 Economic trends 25 Agriculture and horticulture 26 Energy 28 Transport and communications 29 To u r i s m 29 Financial services

30 Foreign trade and payments

List of tables 11 International assumptions summary 13 Forecast summary 20 Corruption Perceptions Index 2005: selected countries in Sub-Saharan Africa 23 East African Community: selected business indicators 26 Cash crop production 29 Tourist arrivals by air and sea (January-August) 31 Current account (year to July) 32 Foreign direct investment into Sub-Saharan Africa

List of figures

13 Gross domestic product 13 Consumer price inflation

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Kenya November 2005 Summary

Outlook for 2006-07 The president, Mwai Kibaki, will continue to push ahead with key social and economic reforms, but deep political divisions over the proposed new consti- tution and the future of the ruling NARC will generate tension and uncertainty. Corruption will remain a key battleground, particularly in respect of maintain- ing the support of donors and the public. Real GDP growth is forecast at 5.3% in 2006 and 5.5% in 2007 as rising donor-backed investment projects make it cheaper and easier to conduct business. The current-account deficit is expected to widen to 6.5% of GDP in 2005, before narrowing to 5.5% of GDP in 2006 and 4.1% of GDP in 2007 as visible and invisible export earnings grow strongly.

The political scene Kenya’s politicians and the public are deeply divided over the proposed new constitution and have split into two opposing camps in the run-up to the country’s first ever referendum, scheduled for November 21st. The “banana” team, backed by Mr Kibaki, is urging a “yes” vote for the new draft, while the “orange” team, an alliance between NARC rebels and the opposition KANU, is calling for a “no” vote. An opinion poll suggests that the result will be close, adding intensity to the campaigns and fuelling widespread violence.

Economic policy An IMF mission in October endorsed Kenya’s performance under the second year of the poverty reduction and growth facility, and will recommend to the board that it release the next two tranches of the loan, worth a total of US$72m, when it meets in December. The mission warned, however, that more needs to be done to tackle corruption. According to the latest annual rankings from TI, Kenya’s score was unchanged in 2005, illustrating how the fight against graft has stalled. Parliament finally passed the long-awaited privatisation bill in August, although it does not give a firm timetable or the list of assets for sale.

The domestic economy Real GDP growth has remained robust, supported by strong performance across a number of sectors, particularly tourism. Agriculture has also recovered after last year’s drought, and a bumper maize harvest is forecast. Inflation has been heading steadily downwards owing to a fall in food prices.

Foreign trade and payments Kenya’s current-account deficit surged to 5.9% of GDP in the year to June 2005, as imports grew much faster than exports, but capital inflows helped to keep the overall balance of payments in surplus. FDI inflows to Kenya remained low, however, at only US$46m in 2004—much lower than its East African partners— according to recent data from UNCTAD. Editors: Pratibha Thaker (editor); David Cowan (consulting editor) Editorial closing date: November 11th 2005 All queries: Tel: (44.20) 7830 1007 E-mail: [email protected] Next report: Full schedule on www.eiu.com/schedule

Country Report November 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 4 Kenya

Political structure

Official name Republic of Kenya

Form of state Unitary republic

Legal system Based on English common law and the 1963 constitution; the draft of a new constitution was published in September 2002

National legislature Unicameral National Assembly of 210 elected members plus 12 nominated members, the attorney-general and the speaker; a multiparty system was introduced in December 1991

National elections Next presidential and legislative elections are to be held in December 2007

Head of state President, directly elected by simple majority and at least 25% of the vote in five of Kenya’s eight provinces

National government The president and his cabinet, composed entirely of members of the National Rainbow Coalition (NARC)

Political parties in parliament National Rainbow Coalition (NARC, 132 seats); Kenya African National Union (KANU, 68 seats); Forum for the Restoration of Democracy-People (Ford-People, 15 seats); Safina (2 seats); Ford-Asili (2 seats); Sisi Kwa Sisi (2 seats); Shirikisho (1 seat)

President & commander-in-chief Emilio Mwai Kibaki Vice-president Moody Awori

Key ministers Agriculture Kipruto Arap Kirwa East African & regional co-operation John Koech Education George Saitoti Energy Simeon Nyachae Environment & natural resources Kalonzo Musyoka Finance David Mwiraria Foreign affairs Chirau Ali Mwakwere Gender, sport & culture Ochillo Ayacko Health Charity Ngilu Information & communication Raphael Tuju Justice & constitutional affairs Kiraitu Murungi Labour & manpower development Dr Newton Kulundu Lands & housing Amos Kimunya Local government Musikari Kombo National security John Njoroge Michuki Planning & national development Anyang Nyong’o Regional development Abdi Mohamud Roads & public works Raila Odinga Tourism & wildlife Morris Dzoro Trade & industry Mukhisa Kituyi Transport Chris Murungaru

Head of the civil service Francis Muthaura

Central Bank governor Andrew Mullei

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Economic structure

Annual indicators 2001 a 2002 a 2003 a 2004 a 2005 b GDP at market prices (KSh bn) 1,025.9 1,038.8 1,141.8 1,277.1 1,339.7 GDP (US$ bn) 13.1 13.2 15.0 16.1 17.8 Real GDP growth (%) 4.4 0.4 2.8 4.3 5.2 Consumer price inflation (av; %) 5.7 2.0 9.8 11.7 10.5 Population (m) 31.4 32.0 32.7 33.5 34.3 Exports of goods fob (US$ m) 1,891.4 2,162.5 2,412.2 2,722.7 3,257.2 Imports of goods fob (US$ m) 3,238.2 3,159.0 3,554.8 4,320.2 5,760.8 Current-account balance (US$ m) -341.2 -136.9 67.8 -378.4 -1,158.3 Foreign-exchange reserves excl gold (US$ m) 1,064.9 1,068.0 1,481.9 1,519.3 1,988.0 Total external debt (US$ bn) 5.6 6.1 6.8 7.0 b 7.4 Debt-service ratio, paid (%) 16.0 16.6 15.8 12.1 b 9.1 Exchange rate (av) KSh:US$ 78.56 78.75 75.94 79.17 75.38 a Actual. b Economist Intelligence Unit estimates.

Origins of gross domestic product 2004a % of total Components of gross domestic product 2004a % of total Agriculture, forestry & fishing 27.5 Private consumption 74.7 Manufacturing 13.3 Government consumption 17.0 Trade, restaurants & hotels 11.2 Gross domestic investment 16.3 Transport, storage & communications 10.5 Stockbuilding 1.1 Government services 14.8 Exports of goods & services 28.0 Others (net) 22.7 Imports of goods & services 37.1

Principal exports 2004a US$ m Principal imports cif 2004a US$ m Horticultural products 499.4 Industrial supplies 1,379.5 Tea 455.6 Consumer goods 330.6 Coffee 87.7 Machinery & other capital equipment 651.2 Fish products 52.8 Food & beverages 182.2

Main destinations of exports 2004a % of total Main origins of imports 2004a % of total Uganda 13.1 United Arab Emirates 12.7 UK 11.3 Saudi Arabia 9.8 US 10.4 South Africa 6.5 Netherlands 8.0 US 4.4 a Actual.

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Quarterly indicators 2003 2004 2005 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr Central government finance (KSh m) Revenue & grants 59,047 62,839 60,366 88,653 64,031 80,524 74,581 81,385 Expenditure & net lending 60,335 64,288 64,653 86,459 69,823 72,850 72,895 83,632 Balance -1,288 -1,449 -4,287 2,194 -5,792 7,674 1,686 -2,247 Prices Consumer prices, Nairobi (2000=100) 118.3 118.9 124.5 129.7 135.3 139.1 142.4 148.1 Consumer prices, Nairobi (% change, year on year) 9.0 8.8 9.0 6.1 14.4 17.0 14.4 14.2 Financial indicators Exchange rate KSh:US$ (av) 76.20 76.83 76.65 78.81 80.51 80.73 76.58 76.41 Exchange rate KSh:US$ (end-period) 78.42 76.14 77.76 79.51 81.11 77.34 75.02 76.21 Deposit rate (av; %) 4.01 3.51 2.58 2.13 2.19 2.84 4.38 5.02 Lending rate (av; %) 14.95 14.11 13.20 12.46 12.26 12.20 12.43 13.10 Treasury bill rate (av; %) 1.07 1.29 1.59 2.31 2.43 6.35 8.52 8.59 M1 (end-period; KSh bn) 179.50 193.13 189.88 193.68 200.49 209.37 206.51 217.12 M1(% change, year on year) 35.3 29.5 29.6 27.0 11.7 8.4 8.8 12.1 M2 (end-period; KSh bn) 410.73 437.46 445.14 455.67 475.58 497.38 506.10 506.99 M2 (% change, year on year) 10.8 11.9 13.8 14.3 15.8 13.7 13.7 11.3 Stockmarket NSE 20 (1996=100) 2,380 2,738 2,771 2,640 2,671 2,946 3,126 3,972 Stockmarket NSE 20 (% change, year on year) 128.1 100.9 72.3 36.4 12.2 7.6 12.8 50.5 Sectoral trends (annual totals; ‘000 tonnes)a Tea production ( 290 ) ( 290 ) n/a n/a Coffee production: unroasted ( 64.5 ) ( 64.5 ) n/a n/a Foreign trade (KSh m) Exports fob 43,225 45,553 48,586 53,816 53,176 57,025 63,499 n/a Imports cif -69,654 -72,579 -80,881 -86,397 -93,616 -99,918 -103,265 n/a Trade balance -26,429 -27,026 -32,295 -32,581 -40,440 -42,893 -39,766 n/a Foreign reserves (US$ m) Reserves excl gold (end-period) 1,326.1 1,481.9 1,401.9 1,399.5 1,309.6 1,519.3 1,435.9 1,587.3 a Estimates. Sources: Food & Agriculture Organisation; IMF, International Financial Statistics; Central Bank of Kenya, Monthly Economic Review.

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Outlook for 2006-07

Political outlook

Domestic politics The president, Mwai Kibaki, will remain committed to a reformist agenda over the forecast period in an attempt to quicken the pace of economic growth and reduce poverty. However, he will continue to confront two main challenges during the remaining period of his presidency: political in-fighting within the ruling National Rainbow Coalition (NARC) and the need to take decisive action against persistent high-level corruption. Mr Kibaki has promised to accelerate the anti-corruption effort, but will have to match the rhetoric with concrete action if he is to fulfil his election promises before his term expires in December 2007. Meanwhile, the president will continue to confront serious divisions between the constituent parties in NARC. The partnership between the National Alliance of Kenya (NAK) and the Liberal Democratic Party (LDP) broke down soon after the last election, with several LDP members moving to the opposition benches as Mr Kibaki allegedly reneged on a secret pre-election Memorandum of Understanding to share power equally and create the post of prime minister with executive powers. Mr Kibaki brought opposition members into government in mid-2004 to rebuild his parliamentary majority, which has enabled him to push through key legislation, including the new, amended draft constitution. However, the parliamentary arithmetic will remain fluid and uncertain as different factions within and outside NARC fight for advantage in the run-up to the next elections. As a result, the government’s majority will remain vulnerable to the shifting alliances that characterise Kenyan politics. The NAK and the LDP agreed a truce in mid-2005, leading to the return of LDP rebels to the government fold, but the rapprochement was short-lived, as the two factions split into separate camps over the new draft constitution, which retains the powers of the presidency. Mr Kibaki and his supporters in the “banana” camp (the banana is the symbol for a “yes” vote and the orange for a “no” vote) are urging people to vote “yes” in the referendum planned for November 21st, but the LDP has joined the Kenya African National Union (KANU) in the “orange” camp and is calling for a “no” verdict; the two parties have united under the banned of the Orange Democratic Movement (ODM). Whatever the outcome, it will be very difficult for “orange” ministers to return to the cabinet alongside their banana counterparts because of the exceptional bitterness of the referendum campaign. Even those in the moderate wing of the Kibaki camp—such as the special programmes minister, Njenga Karume—who favoured keeping the rebels on board, now appear to have lost patience, and the rebels may be sacked after the referendum, when Mr Kibaki is expected to carry out a reshuffle. Meanwhile, NARC also faces a split as to whether it should become a party of individuals (as favoured by the president) or remain a party of parties (as favoured by the LDP). Kibaki loyalists are pushing for NARC to be opened to individual members and for the holding of grassroots elections, but the LDP, together with two other NARC components, the Forum for the Restoration of Democracy-Kenya, and the National Party of Kenya, is opposed to this.

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Election watch The next presidential and parliamentary elections are not scheduled to take place until December 2007, but with voters expected to use the constitutional referendum to give their verdict on the wider Kibaki presidency, the outcome will indicate who is likely to win in 2007, and may also influence the timing of the ballot. If Mr Kibaki and the “banana” camp emerge victorious in the referendum, it will put them in a strong position to win in 2007. Mr Kibaki is thought to want a second term, health permitting. The ODM would become redundant and the LDP may split apart as its “banana” component formally defects to the government side. However, if the “orange” camp wins, Mr Kibaki’s presidency will be seriously damaged and his authority undermined, leaving him little chance of winning in 2007. A “no” vote would also encourage calls for an early election—on the grounds that Kenya was being ruled by a lame-duck president—and although the Kibaki camp has dismissed the idea of going to the country early, it may find it hard to resist the pressure. In the case of a “no” vote, the ODM may decide to stick together, and would have a good chance of triumphing in 2007 if it could agree on a single presidential candidate. However, this would require the LDP’s de facto leader, Raila Odinga, to keep his ambitions in check once again, as it is very unlikely that the KANU leader, Uhuru Kenyatta, would step back to accommodate him. The latest opinion poll, in October, shows Mr Kibaki to be ahead in the presidential stakes, with a 33% share (slightly up since July), followed by the LDP’s Kalonzo Musyoka, with 20%, and Uhuru Kenyatta on 17%. Mr Kibaki continues to enjoy support from many rural areas, where policies such as free primary education have had the greatest impact, but he has lost the backing of many urban dwellers. Even if the “banana” camp wins the referendum, the Kibaki government will still have to work very hard in the next 24 months to develop and execute economic policy, and to maintain political stability, if it is to win the support of the electorate again in 2007.

International relations Kenya will continue to strive for better ties with its major bilateral and multilateral partners during the forecast period. The outlook for relations with key donors has improved following the re-engagement of the IMF in December 2004 and the Consultative Group meeting in mid-April 2005, which helped to restore confidence. However, relations will deteriorate again if the government fails to stick to its latest commitment to crack down on high-level corruption. Kenya will also nurture regional relations within bodies such as the Common Market for Eastern and Southern Africa and the East African Community. The East African Customs Union came into force in January 2005, and full political federation between Kenya, Uganda and Tanzania is proposed by 2013. The ongoing threat of terrorist attacks by Islamists in the Horn of Africa will ensure that the country’s close ties with the US remain high on the agenda. Kenya continues to play a key mediatory role in the conflicts in neighbouring Somalia and Sudan, the resolution of which would do much to enhance regional stability and prosperity.

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Economic policy outlook

Policy trends Economic policy during 2006 will continue to be guided by the country’s poverty reduction and growth facility (PRGF) with the IMF. Kenya complied with most of the loan conditions during the second year of the PRGF, according an IMF mission that visited the country in October 2005. The mission will recommend that the IMF executive board authorise the release of the third and fourth tranches of the loan, worth US$72m, when it meets in December 2005. The Economist Intelligence Unit believes that the funds will be disbursed in January, although the IMF’s country representative, Jurgen Reitmaier, has warned that more needs to be done to stamp out graft. The battle against corruption will continue to be the main concern of donors during the forecast period, and unless firm action is taken the government’s credibility will be tarnished and external funding will be threatened. In a positive move, Kenya unveiled a new, two-year anti-graft plan at the latest Consultative Group meeting in mid-April—based on amended anti-corruption legislation, tighter enforcement of the law and a campaign to stigmatise corruption—but nothing substantial has been achieved since then. The recent IMF mission welcomed the strengthening of the Kenya Anti-Corruption Commission (KACC) and improvements in the investigative process, but warned of “serious capacity constraints” in the judiciary, particularly in carrying out prosecutions. The IMF mission also called for the urgent passage of amendments to the Public Officers Ethics Act that aim to strengthen the system of asset declarations—mainly by removing the rights to secrecy that the current act confers. Kenya has yet to decide whether or not to try to negotiate a new PRGF when the current one expires in November 2006. The finance minister has indicated that Kenya may instead seek a policy support instrument (PSI), a new vehicle that will serve as an IMF seal of approval for a country’s policies but without involving actual IMF funding. The PSI is designed mainly to give other donors the confidence to remain engaged. However, owing to the fact that Kenya does not yet have a solid record of economic reform with the Fund, we do not expect the country to secure a PSI. Kenya’s parliament finally passed the long-awaited privatisation bill in August 2005, which provides the legal and institutional framework for the divestiture of state assets. However, it does not give a list of enterprises that will be sold or a precise timetable for doing so. Apart from presaging a speedier retreat by the state from the productive sectors of the economy, the bill’s passage meets a key condition under the PRGF and will expedite donor funding for Kenya. Parliament’s earlier opposition to privatisation stems partly from a belief that foreigners will purchase “strategic” assets cheaply, and that this will be detrimental to Kenya. This view is probably mistaken, as privatisations involving foreign partnerships (such as the Kenya Airways link-up with KLM in the 1990s) have often proved more successful than solely local efforts (because of better management and technology transfer, for example). However, to get the bill passed the government stressed that, wherever possible or feasible, privatisation would be effected via flotation on the Nairobi bourse, which is dominated by domestic entities, and that specified fractions of divested companies could be reserved for Kenyans. It is too early to judge whether the

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government is truly serious about privatisation or is just trying to appease donors. The only confirmed developments at present are the proposed sale of 30% of the power generator, KenGen, via flotation on the bourse in early 2006 and the recent naming of a concessionaire to run Kenya Railways. The government is still undecided about how and when to privatise Telkom Kenya.

Fiscal policy The 2005/06 budget (July-June) forecasts a deficit equivalent to 3.4% of GDP. The budget will rely heavily on the ability of the Kenya Revenue Authority (KRA) to raise KSh296bn (US$3.96bn), about 10% more than the final outcome in 2004/05. This assumes a second year of strong tax growth, based on a further pick-up in economic activity and rising corporate profits. Early signs are promising, with revenue collection 16% higher year-on-year in the first four months of 2005/06 and 11% higher than budget forecasts—partly due to soaring corporate profits—which means that the projected figure for domestic borrowing is not likely to be exceeded. On the spending front, the government proposes to lift outlays on the key poverty-linked sectors of education, health, agriculture and infrastructure (although this includes wages, typically the largest component of ministerial budgets). The 2005/06 budget also promises to cut spending on parastatals, but this may not be realised. Despite the good intentions, the latest public-expenditure review for 2005 identifies many weaknesses, which are evidenced by the large number of stalled projects and pending bills. The most politically challenging aspect of fiscal policy is the need to reduce the government’s wage bill (about 9.6% of GDP in 2003/04, including parastatals) while also meeting demands for wage rises among key workers. Retrenchment is not an explicit donor condition but the government will find it almost impossible to reduce the wage bill over the next two years. The government will move cautiously, fearing widespread strike action (particularly in the run- up to the 2007 election), and hopes instead that voluntary redundancy packages will be effective, although these may prove to be prohibitively expensive. Despite the difficulty in cutting the wage bill, we expect the budget deficit in 2005/06 to be much lower than the government forecast (as was the case in 2004/05), at 0.8% of GDP, because of better than expected revenue collection and the continued inability of some ministries to spend all the money allocated to them (for capital projects in particular) due to bottlenecks in the system. We forecast that the budget deficit will widen to 1.9% of GDP in 2006/07 as the government increases spending in the run-up to the scheduled general election in late 2007. The shortfall is to be financed by committed donor funding for projects, bank restructurings, privatisation proceeds and domestic borrowing. In a break with past policy the government is no longer factoring in pledged donor funding for the budget, but only committed monies, in a bid to end damaging uncertainty about when and if funds will be released and under what conditions.

Monetary policy Monetary policy over the forecast period will remain geared towards keeping underlying inflation (which excludes food and energy) below the official 5% target and maintaining exchange-rate stability. The government is targeting money supply (M3) growth of 8% and private credit growth of 12% in order to

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achieve this, although these rates are currently being exceeded. To assist policy implementation, the Central Bank of Kenya (CBK, the Central Bank) proposes a new benchmark interest rate—the Central Bank rate—and the establishment of a monetary policy advisory committee—although this is unlikely to take place until 2006. The switch would also de-link interest rates from the public-sector borrowing requirement and tie them to real macroeconomic variables. The new rate would be similar to the repurchase rate currently used in South Africa, and would be lower and less volatile than the 91-day Treasury-bill rate. The 91-day T-bill rate fell to under 8% at the end of October, after hovering at around 8.6% for several months, reflecting rising demand for government paper (because of continued high liquidity) and the downturn in inflation. We expect further gradual easing in the next six months, to about 7%.

Economic forecast

International assumptions International assumptions summary (% unless otherwise indicated) 2004 2005 2006 2007 Real GDP growth World 5.0 4.3 4.0 4.0 OECD 3.3 2.4 2.3 2.4 EU25 2.4 1.5 1.9 2.3 Exchange rates ¥:US$ 108.1 108.6 103.8 96.3 US$:€ 1.244 1.255 1.290 1.343 SDR:US$ 0.675 0.673 0.662 0.643 Financial indicators € 3-month interbank rate 2.13 2.08 2.00 2.88 US$ 3-month Libor 1.62 3.64 5.27 5.02 Commodity prices Oil (Brent; US$/b) 38.5 56.7 56.3 46.8 Gold (US$/troy oz) 409.5 430.1 410.0 370.0 Tea (US$/kg) 1.7 1.6 1.6 1.6 Coffee (Arabica; US cents/lb) 80.5 112.7 89.5 76.8 Note. Regional GDP growth rates weighted using purchasing power parity exchange rates.

Having slowed to an estimated 4.3% in 2005, world GDP growth, measured at purchasing power parity, is expected to continue decelerating, to 4% in 2006 and 2007. Economic growth in the EU25, Kenya’s most important market, is expected to tumble to 1.5% in 2005, held back by weak domestic demand and high oil prices, although we expect a slight rebound in 2006 and 2007, to 1.9% and 2.3% respectively. The prices of Kenya’s main commodity exports are expected to either stagnate during 2006-07 (in the case of tea) or to fall (in the case of coffee), as both are suffering from excess global supply. Oil prices will decline from an average of US$56.7/barrel in 2005 to an average of US$56.3/b in 2006 as the global economy slows, falling more sharply in 2007, to US$46.8/b, as crude output and refinery capacity expand.

Economic growth Real GDP is estimated to rise by 5.2% in 2005, driven by trade, tourism and hotels, and transport and communications. Visitor arrivals were up by 30% year on year in the first eight months of 2005, and the positive trend is expected to

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continue. Transport and communications were boosted by the expansion in other sectors and the rapid rollout of mobile phones: subscriber numbers reached 5m in September. The key agriculture sector is estimated to rise by 2.7% in 2005—much better than in 2004—as good mid-year rains are likely to produce a bumper harvest. Real GDP growth is forecast at 5.3% in 2006 and 5.5% in 2007 as ongoing investment in the transport infrastructure, electricity and telecom- munications boosts all economic sectors by making it easier and cheaper to conduct business. Visitor arrivals are expected to grow strongly in 2006 and 2007, making tourism the fastest-growing sector in the economy, provided that there are no high-profile incidences of terrorism. High world oil prices will have a dampening effect on growth in 2006, although prices are projected to fall sharply in 2007. The biggest downside risk to growth during the forecast period is the unpredictable climate, as severe drought would depress the vital farming sector. Political uncertainty in the run-up to the 2007 election could also be damaging.

Inflation Average annual inflation fell from a recent peak of 15.2% in July to 11.9% in October, and is forecast to continue declining in the coming months because of weaker food prices (which account for about 50% of the index) following good mid-year rains and a bumper harvest. High oil prices are continuing to feed through the price system, but we have trimmed our estimate for average inflation in 2005 as a whole to 10.5%. Average annual underlying inflation (excluding food and energy costs) breached the government’s 5% target ceiling in June and rose to 5.4% in October, largely because of the rapid expansion in private credit, although we expect the rate to move back below 5% in 2006. We forecast that headline inflation will fall from 10.5% in 2005 to 7% in 2006, provided that next year’s rains are satisfactory, although the persistent strength of world oil prices will continue to apply upward pressure. For 2007 we project that inflation will decline to 5.5%, provided that there are no major food or oil price shocks.

Exchange rates The Kenya shilling strengthened to approximately KSh73.7:US$1 in October, an appreciation of 9.2% from a year earlier. The relative strength of the shilling in 2005 reflects several factors, including improved confidence following the re- engagement of the IMF, the strength of export and tourism earnings, higher domestic interest rates and the weakness of the US dollar. The CBK acknowledges that export competitiveness is suffering but welcomes the respite for importers (particularly with imports booming and oil prices high) and will not intervene in the market unless it believes that currency move-ments are being influenced by speculation, which does not appear to have been the case in 2005. We expect a gradual weakening of the shilling during the forecast period as interest rates ease and demand for foreign currency rises (particularly as investment picks up), which will help to boost export competitiveness. We forecast that the exchange rate will weaken from KSh75.4:US$1 in 2005 to KSh77.1:US$1 in 2006 and KSh81.9:US$1 in 2007.

External sector In line with trends for the first seven month of 2005, we expect the current- account deficit to widen to 6.5% of GDP for the year as imports outpace exports. Export receipts are forecast to continue rising during 2006-07, driven by

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manufactures, re-exports, raw materials, horticulture and tea. However, import growth is projected to be similarly robust in 2006-07, owing to the pick-up in domestic demand, increased purchases of equipment and materials for donor- funded projects, and higher oil costs (although world oil prices are expected to subside in 2007). The surplus on invisible trade is expected to rise strongly in 2006-07, driven mainly by growth in tourism. The outlook for current transfers, both public and private, is more uncertain. The contribution of the diaspora, in the form of private transfers, remains very important but is nevertheless expected to continue declining, particularly as political uncertainty rises in the run-up to the next election, which is scheduled for 2007. As a result of these trends the current account will remain in deficit, but we expect the gap to narrow to 5.5% of GDP in 2006 and 4.1% of GDP in 2007 as visible and invisible earnings post solid gains.

Forecast summary (% unless otherwise indicated) 2004 a 2005 b 2006 c 2007 c Real GDP growth 4.3 5.2 5.3 5.5 Industrial production growth 3.6 4.6 4.7 5.0 Gross agricultural production growth 1.4 2.7 3.0 3.0 Consumer price inflation (av) 11.7 10.5 7.0 5.5 Consumer price inflation (year-end) 13.8 6.0 5.5 5.0 Lending rate (av) 12.5 12.0 11.0 10.0 Government balance (% of GDP) -0.4 0.3 -0.8 -1.9 Exports of goods fob (US$ bn) 2.7 3.3 3.6 4.1 Imports of goods fob (US$ bn) 4.3 5.8 6.1 6.4 Current-account balance (US$ bn) -0.4 -1.2 -1.0 -0.7 Current-account balance (% of GDP) -2.3 -6.5 -5.5 -4.1 External debt (year-end; US$ bn) 7.0 b 7.4 7.9 8.1 Exchange rate KSh:US$ (av) 79.17 75.38 77.11 81.90 Exchange rate KSh:¥100 (av) 73.22 69.43 74.32 85.09 Exchange rate KSh:€ (year-end) 104.71 90.03 108.88 109.35 Exchange rate KSh:SDR (year-end) 120.10 106.90 125.70 128.10 a Actual. b Economist Intelligence Unit estimates. c Economist Intelligence Unit forecasts.

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The political scene

Kenya is deeply divided over Kenya’s politicians and people are deeply divided over the proposed new the proposed new constitution constitution, and have split into two opposing camps in the run-up to the country’s first ever referendum, scheduled for November 21st. The team representing the faction of the president, Mwai Kibaki, within the ruling National Rainbow Coalition (NARC), is urging Kenyans to vote “yes” (using the banana as the symbol for a “yes” vote) for the so-called “Wako” draft (named after the attorney-general, Amos Wako, who produced the document in August, based on the draft passed by parliament a month earlier). Pitted against them is an alliance between elements of the Liberal Democratic Party (LDP; the president’s erstwhile colleagues in NARC) and the official opposition, the Kenya African National Union (KANU), which is calling for a “no” vote, using the orange as the symbol for “no”. They have established the Orange Democratic Movement (ODM), although this will be short-lived it if is unsuccessful. The split goes to the heart of the cabinet and has intensified existing divisions. Seven ministers are leading lights in the “orange” team—including Raila Odinga (roads), Kalonzo Musyoka (environment), Najib Balala (heritage), Anyang Nyong’o (planning), and Ochillo Ayacko (sports)—and all are members of the LDP. However, other LDP ministers are firmly in the “banana” camp. The “banana” team gained a boost in late October when the maverick health minister, Charity Ngilu, came out in favour of a “yes” vote (after extracting some concessions for her constituency). Meanwhile, cabinet meetings have been on hold for several weeks to allow for referendum campaigning.

The referendum outcome is If the referendum results in a “yes” vote, the Wako draft will be proclaimed as

likely to be close the new constitution on December 12th (although much legislation will need to be passed to bring all its clauses into effect); if “no”, the existing 1963 consti- tution (as subsequently amended) will be retained and the five-year search for its replacement will have failed. An opinion poll conducted by the Steadman Group (part of Gallup International) in mid-October gave the “orange” (no) camp a 10-percentage-point lead over the “banana” (yes) camp, at 42% to 32%, but the margin is closer in rural areas and a large number of Kenya’s 11.7m eligible voters remain undecided, leaving the outcome far from certain.

Violence, tension and disorder The choice of simple fruit motifs was intended to make the referendum simpler

are on the increase for illiterate voters, but they have become highly charged political symbols (as well as the butt of many jokes, compounded by the probable closeness of the result). The referendum campaign has become a bitter partisan affair, with a large number of “banana” and “orange” rallies having been accompanied by violence—as activists from the opposing side try to disrupt proceedings—and the police have waded in on several occasions. There have been fist-fights between legislators, arrests of journalists and politicians, accusations of bribery—and of treason—and a stream of other inflammatory rhetoric. Also as a matter of concern, both sides have been playing tribal politics, which is always a dangerous tactic in Kenya. Incidents of disorder have become more frequent,

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while appeals for calm—including from church groups and foreign diplomats— have gone unheeded.

Four are killed as violence The worst violence to date took place in Kisumu, in late October, when police flares in Kisumu used live ammunition on crowds trying to disrupt a “banana” rally in what is an “orange” stronghold. Four people were killed (including two children) and many more injured. The police tried to justify their action by saying that a mob attacked a police station, but whether or not this is true, their response was typically heavy handed. The “banana” rally in Kisumu was staged by the information minister, Raphael Tuju, who defected from the LDP in September to form a new party, the People’s Progressive Party (PPP), under the NARC banner. He hopes to drum up support for the “yes” votes in Nyanza province but faces stiff competition from Mr Odinga of the “orange” camp, the local hero and leader of the LDP.

Donors repeat their call for One consequence of the Kisumu killings was the issuing of another joint

calm in Kenya statement by donor representatives urging restraint and condemning the use of live ammunition. In addition, the envoys requested a schedule of “banana” campaign rallies, no doubt to monitor them more closely. The “orange” and “banana” campaign teams were also summoned to a meeting to discuss the recent clashes by the Election Commission of Kenya, which is responsible for conducting the referendum. However, with both camps consistently blaming each other for every incident (and seeking to capitalise on every opportunity to push their agenda forward), further incidents of violence are expected as the referendum approaches. The last major “orange” rally, planned for Nairobi on November 18th, could be a major flashpoint. Moreover, the tension will not necessarily fade immediately after the poll if either side feels unduly aggrieved or cheated. Foreign observers have been invited, but so far only France has agreed to send monitors.

The president will retain most The most controversial aspect of the Wako draft is the retention of a very strong

of his powers presidency. This mirrors the existing constitution but represents a major shift from the proposals in the “Bomas” draft document that emerged from the national constitutional conference in March 2004 (May 2004, The political scene). Although Mr Kibaki and his allies supported such a new dispensation when in opposition (mainly to curb the excesses of the former president, Daniel arap Moi), they have been keen to preserve a strong presidential system since entering State House in December 2002. This is partly for selfish reasons, but also reflects the more fundamental problem of whether or not the resulting twin centres of power would be productive or destructive. The Wako draft creates the post of prime minister for the first time in Kenya, but the holder will not have executive powers and will be appointed by the president. The prime minister will serve mainly as the leader of government business (a role currently carried out by the vice-president). The Wako draft is probably an improvement on the current constitution, as it defines the president’s powers more clearly: some powers have been increased (the president can declare a state of emergency for 14 days without parliamentary approval), while others have been trimmed (the president can now be

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impeached in certain circumstances). Other positive aspects are the increase in the parliamentary quorum, from 30 to 67 (which should boost attendance in the chamber); the establishment of the office of Leader of Opposition as a constitutional post; and a commitment to increase the representation of women in parliament to 30% (although how this will be achieved is not stated). However, these changes are of no concern to supporters of the Bomas draft, who, under the “orange” banner, are urging a “no” vote.

Devolution and religious The Wako draft also waters down controversial proposals in the Bomas draft for

courts also prove divisive a major devolution of powers under a new four-tier administration including an upper house of parliament. The Wako draft proposes a two-tier system, at national and district levels (with no upper house) and, furthermore, districts would enjoy little real autonomy; they would, in effect, serve as a branch of central government. Additional legislation would be required to fine-tune the details. Whether or not Kenya would benefit from greater autonomy is a difficult question and one without a clear, objective answer. Another contentious aspect of the new constitution is the provision for religious courts. Muslims (about 20-25% of the total population) have long called for constitutional recognition of their kadhi courts—to go with the de facto recognition that they have enjoyed since independence—but this has sparked demands by the dominant Christian churches for equal treatment. The Wako draft fudges this difficult area, promising a system of religious tribunals, separate from the main judiciary, for all major local religions (Christian, Muslim and Hindu) but, once again, this would require subsidiary legislation to demarcate legal boundaries precisely. It also leaves the precise fate of kadhi courts in the hands of parliament, to the anger of many Muslims.

The new constitution will be A major potential problem with the new constitution is that it would be very

difficult to amend hard to amend once implemented, which could deter those tempted to vote “yes” in the hope that controversial aspects might be amended later. Amending the constitution would require a 75% majority in parliament (much higher than the current two-thirds majority) or a petition of 1m registered voters (which would trigger a referendum). Another unsettled issue lurking in the background is the contention by some experts that the current constitution cannot be legally replaced unless Article 47 is amended. This would require a two-thirds majority in parliament, but the government has consistently avoided this, as it does not have the necessary votes. In the case of a “yes” vote, Kenya could therefore have two constitutions—a bizarre situation—although the courts are likely to give further guidance before then. The constitution drives other business from parliament

The national preoccupation with the constitution is proving to be detrimental to the conduct of vital government business. Neither the cabinet nor most parliamentary committees have met for several weeks, while parliament in October shelved about 20 pending bills as it prepared to recess prior to the referendum, and may not convene again until March 2006. Bills put on the back-burner include those concerning witness protection, international crimes, pensions, sugar, the cereals board, HIV/AIDS, sexual offences and maritime authority. An important “miscellaneous” bill to amend investment legislation also appears to be on hold. In

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the case of a “yes” vote in the referendum parliamentarians can expect an exceptionally busy schedule in 2006, as they will be required to pass a whole raft of new legislation to bring different aspects of the new constitution into effect, as well as catching up on this year’s backlog.

Moves to halt the referendum Given the worsening unrest associated with the referendum, there is

are likely to fail considerable support among “neutrals” (such as church groups) for postponing the ballot, to create space for the negotiation of a draft acceptable to all sides. A motion to this effect has been put forward to the speaker of the National Assembly by a group of members of parliament (MPs) calling themselves the Middle Ground Group. They claim the backing of 80 MPs but, as their motion is a private members bill without official endorsement, it is highly unlikely that it will be heard until well into 2006 (given the huge parliamentary backlog), in which case it will be irrelevant. The case for postponement received another boost at the end of October when a Nobel Peace Prize winner, Wangari Maathai, endorsed it (she is also the assistant environment minister in the NARC government). However, there has been plenty of time to reach consensus, without success, and an additional few months is unlikely to help. There is a separate pending court challenge over the legality of the Consensus Bill that brought the Wako draft into being, but the lead lawyer has withdrawn and the case may fail.

The referendum is being The referendum will give voters the opportunity to do much more than give

turned into a mini-election their verdict on the Wako draft; it also allows them to give their verdict on the wider Kibaki presidency. The outcome will be a useful guide as to what is likely to happen at the next election and may also influence the timing of the ballot. Although purists may wish that there were nothing more at stake than the constitution, the referendum campaign has become a wider political battle- ground as personalities and factions seek influence and power in the run-up to the scheduled legislative and presidential elections in 2007. However, if it comes down to a personality contest between the president and his detractors, Mr Kibaki may hold the upper hand. He was the most popular presidential candidate in October, according to the aforementioned Steadman poll, with a 33% share (up from 29% in July)—compared with 20% for Mr Musyoka, 17% for Uhuru Kenyatta (both down since July) and 6% for Mr Odinga. If the president takes a more public stance in favour of the constitution, this could help to sway undecided voters to the “banana” camp.

An early election is possible If the president’s camp emerges victorious, this will put his faction in a strong position to win the next election. The ODM would become redundant, as may the LDP itself, as its “banana” component formally defects to the government side. However, if the “orange” camp wins, the presidency of Mr Kibaki will be damaged and his authority undermined, leaving him little chance of winning in 2007. A “no” vote would encourage calls for an early election—to prevent Kenya from being ruled by a lame-duck president—and although the Kibaki camp has dismissed such an outcome, it may struggle to resist the pressure.

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Whatever the referendum outcome may be, it will have a significant impact on Kenya’s political scene. At the very least it will be difficult for the “orange” ministers to return to the cabinet alongside their “banana” counterparts because of the exceptional bitterness of the referendum campaign. For some time the main opposition in Kenya has been provided not by the official opposition but by rebels in the cabinet, and although both coalition factions formerly appear to be resigned to continue co-existing within their shaky marriage, the referendum is likely to change this and the rebels may be sacked. Even those on the moderate wing of the Kibaki camp—such as the special programmes minister, Njenga Karume—who favoured keeping the rebels on board, now appear to have lost patience. The UK refuses entry to Kenya’s transport minister

Relations between Kenya and the UK have been strained since the former High Commissioner, Edward Clay, launched his first highly public tirades against corruption in July 2004—which he repeated in February 2005—and although Adam Wood has now taken over, after Sir Edward retired on July 1st, corruption remains a major concern for the UK and other donors. In a concrete expression of this, the transport minister, Chris Murungaru, has been banned from visiting the UK. Mr Murungaru had already been demoted from the higher-profile security docket in February 2005—partly to try to appease donors about corruption in security contracts—but this did not relieve the pressure. The UK ban has caused a furore in Kenya, not least because there has been no official explanation from the UK as to why it was imposed. Mr Murungaru has launched legal action in the UK to rescind the ban—he has been a regular traveller to London for medical treatment—but the UK position was bolstered in October when the US imposed its own similar ban, which specifically cited corruption concerns; other donor countries are expected to follow suit. Mr Murungaru has been a loyal ally of the president, Mwai Kibaki, but Mr Kibaki is under pressure to remove him. His immediate fate may be decided during the expected post-referendum cabinet reshuffle. Economic policy

The IMF remains concerned Kenya has complied with most of the IMF’s loan conditions during the second about corruption year of the US$326m (SDR225m) poverty reduction and growth facility (PRGF), according to an IMF mission that spent 12 days in the country during October. It is likely that the IMF executive board will approve the release of the next two loan tranches (the fourth and fifth), worth a total of US$73m, when it meets in December. The funds are likely to become available in January 2006 and, as with this year’s similar disbursement, will help to underpin the Kenya shilling. The IMF’s latest endorsement represents a vote of confidence in the govern- ment’s reform programme, and will help to bolster Kenya’s relationship with the wider donor community, but the IMF’s resident representative, Jurgen Reitmaier, says that more needs to be done, especially in tackling corruption. In particular, the Fund welcomed the strengthening of anti-corruption institutions (mainly the Kenya Anti-Corruption Commission, KACC), and improvements in the investigative process. It warns of “serious capacity constraints” in the judiciary, particularly in carrying out prosecutions. The IMF mission also called for the urgent passage of amendments to the Public Officers Ethics Act, which

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aims to strengthen the system of asset declarations—mainly by removing the rights to secrecy that the current act confers—but the bill has not yet been approved by parliament. If it is not passed by the time the Executive Board meets in December, disbursement of the next PRGF tranches could be delayed. Kenya may seek a PSI with the IMF

Kenya will make a final decision on whether or not to try to negotiate a new poverty reduction and growth facility when the current one expires in November 2006, but the finance minister, David Mwiraria, has indicated that Kenya may instead seek a non-financial policy support instrument (PSI). This would serve as an IMF seal of approval for Kenya’s policies without involving actual IMF funding, and would be designed mainly to give other donors the confidence to remain engaged. However, owing to the fact that Kenya does not yet have a solid record of economic reform with the Fund, the Economist Intelligence Unit does not expect the country to secure a PSI.

EU funding for the budget The EU’s committed budgetary support, worth US$150m for the fiscal years of

remains on hold 2004/05-2006/07 (July-June), is still being withheld, mainly because of the failure so far of the president, Mwai Kibaki, to give his assent to the new public procurement bill. This was passed by parliament in August, and aims to tighten the gaping loopholes in the procurement process that have encouraged rampant corruption (with firms linked to officialdom winning overpriced contracts and giving kickbacks), but has not yet entered into law. Although the president is unlikely to withhold his assent, this must be done by the end of 2005 or the whole EU funding package will not longer be accessible (as the EU’s spending authorisation will expire). In October the new EU representative to Kenya, Erick van der Linden, sparked a diplomatic furore by reiterating this time limit in such a way that it appeared that he had issued an ultimatum to the president. He apologised for any misunderstanding but confirmed that all sides were aware of the time restrictions and said that he was merely restating what was already known. The affair shows that the government has become even more sensitive than usual to real or implied donor criticism during the build-up to the referendum on the constitution. However, it is likely that presidential assent will be given to the procurement bill before the deadline, thus leading to the release of the first US$50m tranche in early 2006 (a year and a half later than originally envisaged). The EU is expected to impose additional conditions for the release of the second and third tranches, which are most likely to be linked to public- spending management, privatisation and the war on corruption. It should be noted that EU project funding is not affected by the row over the budget support package.

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Corruption Perceptions Index 2005: selected countries in Sub-Saharan Africa Country 2005 rankinga 2005 score b 2004 scoreb Changec Botswana 32 5.9 6.0 deterioration South Africa 46 4.5 4.6 deterioration Ghana 65 3.5 3.6 deterioration Senegal 82 3.2 3.0 improvement Tanzania 88 2.9 2.8 improvement Ethiopia 137 2.2 2.3 deterioration Zimbabwe 107 2.6 2.3 improvement Uganda 117 2.5 2.6 deterioration Kenya 144 2.1 2.1 no change Nigeria 152 1.9 1.6 improvement a Out of 159 countries. b Zero indicates totally corrupt; 10 indicates totally clean. c Between 2004 and 2005. Source: Transparency International, Corruption Perceptions Index.

Corruption shows little sign of Corruption in Kenya was no better in 2005 than it was in 2004, according to the

diminishing latest Corruption Perceptions Index (CPI) from a Berlin-based non-governmental organisation, Transparency International. Kenya once again scored 2.1 out of 10)—implying that it continues to suffer from “rampant” corruption (that is, a score of less than 3.0), although not from “acute and pervasive” corruption (a score of less than 2.0). Just as the improvement in Kenya’s CPI from 1.9 in 2003 to 2.1 in 2004 reflected the National Rainbow Coalition (NARC) government’s encouraging start in the anti-graft war, the subsequent stagnation in Kenya’s CPI usefully illustrates how the campaign has stalled. Kenya is now ranked 144th in the world—jointly with Somalia, Sudan, the Democratic Republic of Congo, Tajikistan, Paraguay and Pakistan—out of the 159 countries assessed in the latest 2005 index. It is also joint 31st in Sub-Saharan Africa out of the 39 countries assessed in the region—only five are worse: Angola, Côte d’Ivoire, Equatorial Guinea, Nigeria and Chad. This high level of perceived corruption is a major deterrent to foreign investment. Transparency International in Kenya names a new head

Transparency International (TI) Kenya appointed Mwalimu Mati as executive director of the local chapter in August, in an attempt to restore the organisation’s credibility following the controversial resignation of the former head, Gladwell Otieno, earlier in 2005 (May 2005, Economic policy). Mrs Otieno stood down in April after being censured by her board for being too critical of government officials, raising concerns that TI Kenya was no longer operating impartially. The founder and chairman of TI, Peter Eigen, admitted as much in October, noting that the local chapter had become close to supporters of the president, Mwai Kibaki, prior to the 2002 election (in their joint fight against the former president, Daniel arap Moi), and had failed to create enough distance between themselves and the new government after Mr Kibaki was elected, making it harder for TI Kenya to speak up. Mr Mati, a long-term servant of the organisation and former deputy leader, is a respected choice, but TI Kenya will remain under head-office scrutiny for the time being.

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High hopes are placed in Donors and the government have vested considerable hope in the ability of the

the KACC KACC, under ex-justice Aaron Ringera, to really move forward with the fight against corruption, which became fully operational only in mid-2005. Despite having pushed ahead strongly with a series of investigations—including into the infamous Anglo-Leasing affair (August 2004, Economic policy)—no significant prosecutions have been undertaken to date by the attorney-general’s office, as suspected persons typically use every legal method at their disposal to stall the process. Some attribute this failure to bottlenecks at the attorney- general’s office—leading to the view that the KACC should have the power to prosecute—but Amos Wako, the long-serving attorney-general, denies this and instead accuses the KACC of not co-operating with him closely enough. The fact that different agencies are blaming each other for the lack of progress is of concern, as it suggests that the government is not committed to the anti- corruption battle. This partly reflects the current preoccupation with November’s constitutional referendum, but once this is out of the way the government will have to take concrete steps before the end of the year—in particular by passing amendments to the Public Officer Ethics Act and enacting the new procurement law—if it is to maintain IMF and EU support for the anti-poverty programme. Unless the government makes further discernable progress in 2006 it will appear toothless and will lose credibility among both donors and the Kenyan public. Next year is the key year, as it will be harder to take action against corrupt individuals in 2007, an election year, because of the risk of alienating important groups of voters. Despite the currently rather gloomy prognosis, there have been some positive developments. • The government remains engaged with the ongoing donor-backed Governance, Justice, Law and Order Sector (GJLOS) reform programme, which includes training programmes to alter the perceptions of public officers and the adoption of tighter procurement rules. • A final report on the investigation by Kroll Associates into the supposed US$1bn that has been hoarded in foreign banks by corrupt Kenyans was delivered to the government in August. A plan of action to retrieve the money is currently being devised. • The government has commissioned a firm of auditors, Deloitte South Africa, to inspect several donor-funded projects following the earlier detection of fraud in the World Bank-funded Kenya Urban Transport Improvement Project (November 2004, Economic policy). Some projects have already been reviewed— such as the US$36m decentralised reproductive health and HIV/AIDS project— but the findings have not yet been made public and it is not clear when the audits will be completed. • The final report from the long-running Goldenberg inquiry into the looting of the Central Bank of Kenya in the 1990s will be released soon, according to a government official, and all of its recommendations implemented, including the prosecution of those involved. Some fear that the findings will be used in a politically motivated witch-hunt against those in the “orange” camp opposed to the new constitution, but if the report is truly impartial it will probably

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incriminate personalities on both constitutional sides. What the findings are and how the government deals with them will give a clearer pointer as to how effective the anti-graft campaign is likely to be.

Kenya adopts a new In mid-August Kenya’s parliament finally passed the long-awaited privatisation

privatisation law bill, which provides the legal and institutional framework for the divestiture of state assets. However, it does not give a list of enterprises that will be sold or a precise timetable for selling them. Presidential assent for the bill is also needed, but this is likely to be a formality. Apart from presaging a speedier retreat by the state from productive sectors of the economy, the bill’s passage meets a key condition under the IMF’s current PRGF programme for Kenya and will expedite donor funding for the country. The parliament’s earlier opposition to privatisation partly stems from a belief that foreigners will purchase “strategic” assets cheaply, and that this will be detrimental to Kenya. This view is probably mistaken, as privatisations involving foreign partnerships (such as the Kenya Airways link-up with KLM in the 1990s) have often proved to be more successful than solely local efforts (because of better management and technology transfer, for example). To ensure that the bill was passed, however, the government stressed that wherever possible or feasible privatisation would be effected via flotation on the Nairobi bourse, which is dominated by domestic entities, and that specified fractions of divested companies could be reserved for Kenyans. It is too early to judge whether the government is truly serious about privatisation or is just trying to appease donors. How quickly the government sets up the promised new privatisation commission, and how independent this proves to be, will play a key part in determining the outcome of the programme. On a positive note, the government promises that asset valuation will be carried out by an independent agency. The lack of proper valuation has scuppered several sales in the past, such as that of Telkom Kenya in 2000. The only confirmed privatisations at the present time are the proposed sale of 30% of the power generator, KenGen, via flotation on the bourse in early 2006 (see The domestic economy: Energy) and the recent naming of a concessionaire to run Kenya Railways (see The domestic economy: Transport and communications). Telkom Kenya was supposed to have been part-privatised in 2005 but the government is moving slowly with this project, partly because of the company’s financial problems.

Kenya ranks favourably in the The now annual World Bank report, Doing Business In, published in September,

business climate stakes ranked Kenya 68th out of a total of 155 surveyed countries, and 7th in Africa for overall ease of doing business. Moreover, Kenya is the best place in East Africa (ahead of Uganda at 72nd and Tanzania at 140th) in which to conduct business, which is somewhat surprising given Kenya’s low inflows of foreign direct investment (see Foreign trade and payments). However, the World Bank index focuses exclusively on the regulatory environment and does not include vital aspects such as corruption, political stability, macroeconomic stability and proximity to markets. In Kenya’s case the high level of corruption is undoubtedly a major deterrent.

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East African Community: selected business indicators Trading across Rigidity of borders Protecting Overall ease of Starting a labour laws Average time Enforcing Investors Registering Paying taxes business (rank business Index for exports contracts Index property % of out of 155) Time (days) (0-100) a (days) Time (days) (0-10) a Time (days) gross profit Kenya 68 54 28 45 360 5.3 73 68 Uganda 72 36 13 58 209 5.3 48 43 Tanzania 140 35 69 30 242 2.0 61 51 EAC average - 42 37 44 270 4.2 61 54 World average - 47 41 31 393 5.1 85 46 a The higher the figure, the better the business environment. Source: World Bank, Doing Business in 2006. According to the World Bank’s indices, Kenya ranked best on “getting credit”— 13th in the world—scoring eight out of ten on the legal rights index and five out of six on the credit information index, far better than its East African Community (EAC) partners. Kenya also scored well on dealing with licences (15th in the world) in terms of the cost and the time taken—although anecdotal evidence suggests otherwise. Kenya performed moderately well in the categories of hiring and firing (42nd in the world) and protecting investors (60th). Kenya scored 5.3 out of 10.0 on the investment protection index, compared with a world average of 5.1, mainly because it scored full marks (ten out of ten) on the shareholder index, indicating strong shareholder powers. Kenya ranked worse than its overall 68th position on all the other parameters, such as enforcing contracts (82nd in the world), starting a business (93rd), paying taxes (100th), closing a business (111th), registering property (113th) and trading across borders (126th). Notably, taxes consume 68% of gross profits in Kenya, far higher than other EAC states’ and the world average. Trade also takes a comparatively long time—45 days for exports and 62 days for imports, compared with respective world averages of 31 and 39—and is comparatively complex in terms of the paperwork and authorisations needed.

The domestic economy

Economic trends

Real GDP remains on course Recent official data indicate that real GDP growth of at least 5% will be reached

for faster growth in 2005 in 2005, the best performance for more than a decade, as last year’s fastest- growing sectors—trade, transport and communications, and tourism—continue to perform strongly, corporate earnings are buoyant and the dominant agricultural sector has recovered after drought in 2004. However, this is seen as a conservative figure by some local private forecasters, such as African Alliance and Old Mutual, which are projecting growth of between 5.3% and 5.5%. The Economist Intelligence Unit has upped its estimate to 5.2% in the light of the very good harvest. Kenya’s performance in 2005 has been impressive to date, although growth would probably have been faster still were it not for the enduring strength of world oil prices—we project that they will rise by 47%, to US$56.7/barrel in 2005—which is probably inhibiting consumption. Moreover,

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economic growth in 2005 owes little to foreign direct investment, which remains muted because of corruption and political uncertainty (see Foreign trade and payments). Nevertheless, business confidence is robust, with a mid- year survey showing that 75% of chief executive officers expected profits growth in the second half of 2005, due mainly to rising demand.

Almost all key sectors are According to leading indicators, the transport and communications sector

performing well (11% of GDP) also continues to register strong growth. The number of mobile- phone subscribers more than doubled, from 2.2m in June 2004 to 4.6m in June 2005, and hit a new high of 5m in September 2005 (3m to the market leader, Safaricom, and 2m to Celtel Kenya). In other subsectors, cargo handled at Mombasa port climbed by 8% year on year, to 7.8m tonnes, in the first eight months of 2005, while air passenger numbers rose sharply owing to the rise in tourism, although freight traffic on the railways continues its long decline, falling by 11.8%. The manufacturing sector (10% of GDP) showed mixed results in January to August 2005. Production rose in the case of cigarettes (by 24%), cement (by 23%), processed milk (by 16%), beer (by 12%) and soda ash (by 3%), but fell in the case of processed sugar (by 6%). The buoyancy of the manufacturing sector is reflected in the 5.8% rise in power consumption in the first eight months of 2005 and the strength of imports, although the sector continues to suffer from a dilapidated infrastructure, slow port clearance and costly power. A further concern is the decline in garment exports to the US in 2005 under the African Growth and Opportunity Act (AGOA) after three consecutive years of rapid growth, because of increased competition in the US market following the end of the Multi-Fibre Arrangement in January 2005. Kenya’s garment sales to the US slipped by 5%, to US$178m, in the first eight months of 2005 compared with the same period in 2004. The key agriculture sector is performing better than in drought-affected 2004, although the improvement is evident mainly in the case of food crops, not cash crops. The US Department of Agriculture predicts that Kenya’s maize harvest will reach 2.8m tonnes in 2005/06 (compared with 2m tonnes in 2004/05 and a five-year average of 2.4m tonnes), mainly because of good rainfall, which has pushed up yields. However, cash crops showed little improvement in the first eight months of 2005, with tea up by 1% (reflecting early-season drought), sugarcane up by 1.9% and coffee up by 0.8%. Horticulture production for export grew by 7.8%, although this represents a considerable slowdown compared with last year (see Agriculture and horticulture).

Inflation retreats from Inflation is on a downward trend in Kenya because of the fall in food prices,

recent peaks which account for 50% of the consumer price index, following better rains in 2005. Average annual inflation peaked at 15.2% in July, before easing to 11.9% in October, while year-on-year inflation declined for the sixth month in succession, to just 3.7% in October, the lowest level since 2002. Although high world oil prices continue to feed through the price system—pushing up transport and communications prices (5.7% of the CPI) and fuel and power prices (4.2% of the CPI)—the harvest is proving better than expected and the strong Kenya shilling is helping to subdue imported inflation. Annual average

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underlying inflation (excluding food and fuel) has continued to rise in 2005, spurred by rapid growth in money supply and credit allocation to the private sector. It climbed to 5.4% in October 2005 and has been above the govern- ment’s 5% ceiling since June. However, credit growth has slowed in 2005 under the impact of higher interest rates—declining from 25% in the year to March 2005 to 17% in the year to September—and the year-on-year underlying rate has moved downwards, from 6.4% in May to 4.8% in October. Overall, we have trimmed our estimate of average inflation for 2005 as whole to 10.5%. Interest rates start to drift downwards

After remaining stable at between 8.5% and 8.7% between February and September, the interest rate on the benchmark 91-day Treasury bill has drifted steadily downwards in recent weeks—averaging 8.1% in October and reaching 7.9% at the end of the month. The decline is in line with the expectations of the Central Bank of Kenya and reflects the high demand for government paper (as financial institutions are cash-rich and lack sufficient alternative investment opportunities), the easing of inflationary pressures and expectations that the government will not exceed the ceiling for domestic borrowing set out in the 2005/06 budget because of strong tax inflows. The Kenya Revenue Authority collected KSh99bn in taxes between July 1st and October 28th, 16.3% higher than in 2004/05 and 11.5% higher than budget expect- ations. The rise reflects soaring corporate profits and more efficient tax collection.

The Kenya shilling continues The Kenya shilling has continued to appreciate against the US dollar in recent to strengthen months, averaging KSh73.7:US$1 in October 2005, 9.2% stronger than a year earlier. Against the euro the shilling traded at KSh88.6:€1 in October, an appreciation of 15.9% year on year. The recent strength of the shilling stems from robust foreign-exchange inflows (from exports and tourism), relatively muted demand for dollars in the corporate sector (due to sluggish investment) and the higher interest-rate regime prevailing in 2005, which has attracted short- term capital inflows. Predictably, exporters are complaining about the loss of competitiveness, but the Central Bank of Kenya (CBK, the Central Bank) has reiterated its intention not to intervene in the market unless it perceives the shilling to be moving in response to speculation, which is not thought to have been the case in 2005. Moreover, the stronger shilling has kept import costs down, at the very time when imports are booming, and is helping to dampen overall inflationary pressures associated with higher world oil prices. However, the shilling is unlikely to strengthen much further in the near term, and is expected to return to a path of gradual depreciation, facilitated by the easing of interest rates. We estimate that the shilling will average KSh75.4:US$1 in 2005, 4.8% stronger than in 2004.

Agriculture and horticulture

Horticulture growth slows as The rapid expansion in export-based horticulture that has taken place in recent

profits fall years has slowed significantly in 2005, with the volume of exported output rising by a relatively modest 7.8% in the first eight months of 2005—compared with 24.7% in 2004—according to the Horticulture Crops Development Association. Flowers, the most valuable subsector, grew by 7.2% and vegetables by 12.2%, but fruit exports fell by 1%. The difficulties in the sector are partly the

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result of rising competition from other African states, especially North African countries such as Morocco and Egypt that benefit from proximity to Europe, and subregional competitors like Ethiopia, where the government is offering a range of incentives to floriculture investors. By contrast, export-based horti- culture in Kenya has grown without state assistance and has been one of the few sectors of the economy to have attracted inflows of foreign direct investment (FDI). Apart from rising competition, Kenyan producers are suffering from massive cost pressures due to the surge in world oil prices (and hence freight charges, which account for about 40% of total outlays) coupled with a stronger shilling—against both the dollar and the euro—which has eaten into profits, with some flower producers citing a 20% decline in 2005. This has led some growers—such as a leading exporter, Homegrown—to lay off workers, while a smaller number have relocated to Ethiopia, according to the Kenya Flower Council.

Cash crop production (‘000 tonnes unless otherwise indicated) Jan-Aug Jan-Aug % change 2003 2004 2004 2005 2005/04 Sugarcane 4,184.5 4,654.0 2,908.1 2,963.5 1.9 Tea 293.7 324.6 207.4 209.4 1.0 Horticulture 133.2 166.1 105.8 114.0 7.8 Coffee 61.2 49.9 38.7 39.0 0.8

Sources: Central Bureau of Statistics; Kenya Sugar Authority; Horticulture Crops Development Association.

Kenya is the largest supplier of Kenya remains the largest supplier of cut flowers to the European market, and

cut flowers to the EU markets the outlook is not entirely gloomy. Kenya is proving particularly successful at meeting the EU’s ever-tighter standards and regulations, and in July became the first non-EU state to win a standards certificate for good agricultural practices in floriculture, under the Eurepgap scheme being driven by EU retailers. Kenya is also pressing for its standards agency—the Kenya Plant Health Inspectorate Service (Kephis)—to be granted international recognition as a plant import certifying agency, which would prevent the need for phytosanitary inspections to be duplicated in Europe. The downside to the drive for better standards is that small farmers are being squeezed out—or at best are becoming outgrowers for larger firms. Most growth in the industry has been driven by large firms, and the share of exports attributable to small farmers has fallen from over 50% a decade ago to less than 10% currently.

Energy

Kenya’s main power generator The government is moving ahead with plans to float 30% of the state-owned is to be privatised power generator, KenGen, on the Nairobi stock exchange, in the form of an initial public offering (IPO), most probably in the first quarter of 2006. The government intends to retain the remaining 70%. It will be one of the largest sell-offs in Kenya to date and is expected to raise about KSh8-10bn (US$107m-134m) for the government. A key hurdle was overcome in mid- October, when KenGen passed a “due diligence” test, according to the lead transaction adviser, PricewaterhouseCoopers (PWC): a notable feature of the

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float is that a large number of advisers have been appointed to manage different aspects of it. The next main step will be to set a price for the shares before the final stage of seeking approval for the IPO from the stock exchange and the Capital Markets Authority. The IPO is likely to prove popular, particularly given the high levels of liquidity in the financial system and the dearth of new “listings” in recent years. However, pricing the issue could prove crucial, particularly in attracting institutional investors. PWC warned in September that some institutional investors may be deterred by the lack of a long-term power purchase agreement between KenGen and the state-owned distributor, Kenya Power and Lighting Company (KPLC), currently its only customer; this will make it harder to predict future revenue streams. Of particular concern for investors is that the last tariff movement, in April 2005, was downwards, from KSh2.36/kwh (3.16 US cents/ kwh) to Ksh1.76/kwh, as the government moved to relieve KPLC’s financial difficulties at KenGen’s expense. PWC recommended that a long-term power contract between KenGen and KPLC be agreed before the flotation (even if it only comes into effect at a specified date in the future), but the government has dismissed PWC’s concerns, saying that the revenue environment is sufficiently predictable to satisfy investors.

Kenya plans to expand power The part-sale of KenGen and a planned restructuring of KPLC are just two

generation elements in the government’s wider energy strategy, a key part of which is the installation of new generating capacity. Kenya’s current effective capacity of 1,032 mw—of which KenGen accounts for about 85%—is more than adequate to meet current peak demand of about 900 mw, but the surplus will soon be eroded (with power consumption growing at about 6% per annum), meaning that new stations will be needed urgently. The government recently proposed the addition of 392 mw of extra capacity between August 2006 and April 2008, including 60 mw from the Sondu Miru hydroelectric dam and 35 mw from the expansion of the Olkaria II geothermal station: these projects are the most advanced. Additional capacity is envisaged from new projects in the geothermal, hydro- electric, gas, wind and possibly even coal sectors—the government has commissioned a study into the viability of deposits in the east—as well as imports of gas-fired power from Tanzania. Tanzania and Kenya currently plan to install a 330 kilovolt transmission line between Arusha and Nairobi by 2009 (provided that donor funding for the US$110m project can be sourced), with initial sales estimated at 30 mw. However, geothermal power has been identified by the government and donors as the least-cost option, with untapped reserves estimated at 2,000 mw. The state plans to create a new firm, the Geothermal Development Company, in a joint venture between KenGen and local companies, to assess and develop geothermal resources. Geothermal power accounted for nearly 20% of power generation in the first eight months of 2005, compared with 19% for thermal stations, although hydroelectricity was still dominant, with a 61% share; it is, however, susceptible to drought.

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Transport and communications

The railway system is awarded In a major development for the transport infrastructure (and the privatisation

to a private concessionaire process), Kenya and Uganda in mid-October finally chose a concessionaire to run their joint 2,350-km railway (the bulk of which lies in Kenya). A 25-year contract was awarded to Rift Valley Railways (RVR) consortium, led by South Africa’s Sheltam Corporation (with a 61% stake), in partnership with a local firm, Primefuels (15%), South Africa’s Comazar (10%), Tanzania’s Mirambo (10%) and South Africa’s CDIO Institute for Africa (4%). Sheltam and Comazar have extensive experience of operating railways in Africa. Only two of the initial bidders reached the final stages, with the defeated bidder being a venture between Rail India Technical and Economical Services (RITES) of India (70%) and UK-owned Magadi Soda (30%). Notably, the process was led by the International Finance Corporation (IFC), the World Bank’s private-sector arm, and is judged to have been largely transparent. A final contract is due to be signed in November, with RVR formally due to take over operations in March 2006. Under the proposed ownership structure, RVR will form a holding company in which 20% of shares will be reserved for Kenyan and Ugandan investors. RVR (and the losing venture) both offered the same entry payments, of US$3m for Kenya (and US$2m for Uganda)—but RVR offered far better terms, of 11.1% of annual freight revenue (worth upwards of US$8.5m a year), more than double the government’s specified 5% minimum. RVR will also pay US$1 a year to run passenger services for five years (whereas the losing bidder wanted a subsidy) after which the passenger contract will be re-evaluated. This will allow RVR to withdraw from what is potentially a lossmaking service, although efforts will be made to improve profitability. RVR will also operate ferry services on Lake Victoria.

RVR and the government hope that new investment will reverse the railway’s long decline. Freight traffic has fallen steadily over the past 20 years or so, from 4.3m tonnes in 1983 to 1.9m tonnes in 2004/05, while volumes declined by a further 11.8% year on year in the first eight months of 2005. Average speed on the line is just 25 km per hour—compared with a standard minimum global level of 35 km per hour. At the same time, the debts of the state-owned Kenya Railways have mounted, reaching about KSh20.5bn in mid-2005, although these have been taken on by the government, otherwise a concessionaire would not have been interested. RVR plans to invest US$322m—US$280m on rehabilitating existing assets and US$42m on new rolling stock and operating equipment. In addition, RVR is committed to raising cargo volumes by 175% within five years, and will take out a performance bond to help to guarantee compliance. RVR will be free to set freight rates within the parameters of the Monopolies and Price Control Act. The deal gives RVR a free hand over Kenya Railways’ currently bloated workforce. Almost all of the 6,200-strong permanent staff will be laid off, although some 3,500 will be re-employed by RVR, with the rest being offered redundancy terms and retraining. The retrenchment, costing an estimated US$42m, will be part-financed by the World Bank. The railways concession is a concrete example of regional co-operation and shows that

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the private sector is willing to invest in infrastructure if the process is well organised.

Tourism

Tourism sector continues to The performance of Kenya’s tourism sector has been particularly impressive in

show strong growth 2005, with the number of overseas visitors rising by 30% year on year, to 540,155 for the period January-August. This reflects successful marketing campaigns, additional airline capacity, a perception of heightened security, burgeoning conference tourism and the switch of tourists away from countries affected by the Indian Ocean tsunami in December 2004 (which left Kenya almost unscathed). Arrivals increased from all locations, but especially from Asia and the Americas, although Europe retained its dominant position with a 55% market share. Tourism is expected to continue to increase for the remainder of the year, posting particularly strong growth in the final quarter. However, tourism is potentially threatened by two main factors: rising violence associated with the constitutional referendum and fears over a global influenza epidemic.

Tourist arrivals by air and sea (January-August) 2004 2005 % change Europe 233,721 299,395 28.1 Africa 88,121 105,627 19.9 Americas 46,028 64,957 41.1 Asia 40,890 58,424 42.9 Total (incl others) 415,660 540,154 30.0

Source: Kenya Tourist Board.

Financial services

The World Bank defers a Financial sector reform remains a key component of the government’s donor-

decision on a loan backed anti-poverty strategy, but although key initial steps have been taken progress has slowed recently. The government intends to reduce its stake in state-dominated banks, including two major banks—Kenya Commercial Bank (KCB) and National Bank of Kenya (NBK)—and to improve the overall lending environment, backed by a new, US$65m financial sector reform credit (FINSRC) from the World Bank (to be supplemented by US$70m from other donors, including the EU and the African Development Bank). However, the World Bank executive board deferred a decision on the loan in late October, deciding that some issues needed clarification, according to the Bank’s local country director, Colin Bruce. In particular, the World Bank requires that state banks make greater efforts to track down bad debts incurred under the previous government, but this is proving to be difficult politically, particularly in the charged environment surrounding the constitutional referendum.

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Although bad debts have fallen significantly as a proportion of total loans, from 23.2% in August 2004 to 19.3% in August 2005, the absolute level of bad debts remains stubbornly high, at KSh70.6bn in August 2005, owing mainly to the difficulty in recovering old loans. Of total bad debts, about half are held by state banks, particularly KCB and NBK, whereas they hold just 28% of sector assets. Apart from the dispute over non-performing loans, the World Bank credit also comes with several conditions attached. The first, US$25m, tranche will be released only after the government has produced a strategy paper (with input from international specialists), while the second, US$40m, tranche is con- ditional on the preparation of a final plan and its presentation to the cabinet and parliament. The main risks to financial sector reform, according to the World Bank, are political resistance to bank privatisation and political pressure for the government to take a more interventionist stance.

Privatisation of banks rises up The government has prepared a detailed plan for the restructuring and

the government’s agenda privatisation of state-led banks, according to the World Bank, and has established the Bank Restructuring and Privatisation Project in the finance ministry to serve as the implementing institution. However, progress to date has been limited: the government diluted its share in KCB from 35% to 26% in mid-2004, when it opted not to take up its share of a new rights issue (August 2004, The domestic economy: Financial services), and the assets of the Industrial Development Bank (IDB) were sold by tender to a private bank, Equity Bank, in March 2005 after the authorities accepted that the IDB could be privatised and maintain its role as a development finance institution. The government now intends to appoint a financial adviser to oversee the sale of 80% of its remaining stake in KCB to large investors (either strategic or institutional).

NBK is to be restructured The restructuring and privatisation of NBK is a key plank of both the World and sold Bank’s financial sector project and the IMF’s poverty reduction and growth facility (PRGF). NBK is majority owned by the National Social Security Fund (48%): the government holds 22% and private investors on the Nairobi Stock Exchange the remaining 30%. To support the process, the Central Bank has signed a supervisory agreement with the NBK, implementing stringent liquidity, credit and cost controls, and the government promised in mid-2005 to repay NBK the KSh13.9bn in non-performing loans that are guaranteed by the state. Provided that privatisation plans are implemented, there is likely to be considerable interest in the institution, as NBK is now showing a profit, following a number of years of heavy losses. Standard Chartered, Kenya’s second largest bank, is interested in the state’s 22% share (and will possibly take on the 100% state-owned Consolidated Bank as well), while South Africa’s Standard Bank is looking at the National Social Security Fund’s 48% stake.

Foreign trade and payments

The current-account shortfall Kenya’s current-account deficit surged to US$1.1bn in the year to July 2005

grows wider (about 5.9% of GDP), a sevenfold rise compared with the previous 12-month period, according to the Central Bank of Kenya (CBK, the Central Bank), as

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imports grew faster than exports. Exports grew by a rapid 20%, to US$3.1bn, with manufactures posting the fastest rise (26%), followed by re-exports (20%), raw materials (11%), tea (8%) and horticulture (8%). However, garment sales to the US (mostly under the African Growth and Opportunity Act, AGOA) slipped by 5% year on year, to US$178m, in the first eight months of 2005, after four years of consecutive growth, following the end of the Multi-Fibre Arrangement in January. Imports grew faster than exports, leaping by 41%, to US$5.4bn, leading to a sharp rise in the trade deficit. All major import categories recorded steep increases, including equipment (up by 62%), oil (up by 25%) manufactures (up by 23%) and chemicals (up by 16%). The growth in imports also reflects the acquisition of new Boeing aircraft in the second quarter of 2005, the rise in world oil prices and the pick-up in overall economic growth. As a result, the trade balance widened by 85%, to US$2.4bn. Meanwhile, the invisible trade surplus edged up by 8%, to US$1.2bn, driven by a 23% rise in tourism earnings to US$509m, although private transfers (representing remittances from the diaspora) slid by 5%, to US$600m; this no doubt partly reflects a loss of confidence because of the political instability generated by the divide over the proposed new constitution. Despite the steep rise in the current-account deficit, the overall balance of payments posted a larger surplus in the first seven months of 2005 because of the stronger inflows on the capital account—although these were mainly due to stronger short-term flows, including errors and omissions. This satisfactory overall performance is reflected in the rise in foreign-exchange reserves, to a new record of US$1.73bn at the end of August 2005. For 2005 as a whole, we estimate that the current- account deficit will widen to 6.5% of GDP as imports continue to outpace exports. However, the overall balance of payments is likely to remain in surplus because of capital inflows.

Current account (year to July) (US$ m unless otherwise indicated) 2004 2005 % change Merchandise exports (fob) 2,555 3,055 19.6 Tea 441 478 8.4 Horticulture 396 427 7.8 Raw materials 370 409 10.5 Manufactures 259 326 25.9 Re-exports 647 776 19.9 Merchandise imports (cif) -3,846 -5,442 -41.5 Trade balance -1,291 -2,387 -84.9 Invisible trade (net) 1,150 1,244 8.2 Non-factor services (net) 559 748 33.8 Tourism 413 509 23.2 Income (net) -104 -105 0.1 Current transfers (net) 695 600 -13.7 Private transfers 630 600 -4.8 Current-account balance -141 -1,144 -711.3 Balance of payments 153 290 89.5

Source: Central Bank of Kenya, Monthly Economic Review.

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Kenya fails to attract much While Kenya’s capital and financial account shows a strong surplus, foreign

foreign direct investment direct investment (FDI) inflows have played a minor role and are comparatively small, even by African standards, despite the relatively advanced state of the economy. FDI inflows to Kenya fell from US$81m in 2003 to US$46m in 2004, according to the latest World Investment Report from the UN Conference on Trade and Development (UNCTAD), and compare very unfavourably with the country’s East African Community (EAC) partners, Uganda and Tanzania. Moreover, Kenya experienced FDI outflows of US$49m in 2004 (due to both disinvestment and outward investment by Kenyan firms), implying that net FDI flows were very slightly negative. Nevertheless, FDI has been important in specific sectors in recent years, particularly horticulture, mobile phones and aviation. Kenya’s poor overall performance in the FDI stakes reflects several factors, but especially the high level of corruption (the worst in the EAC), political instability under the ruling National Rainbow Coalition (NARC) government because of persistent in-fighting, high utility charges, physical insecurity and the dilapidated infrastructure.

Foreign direct investment into Sub-Saharan Africa (US$ m) 2000 2001 2002 2003 2004 FDI into Sub-Saharan Africa 5,810 14,126 9,122 12,743 12,821 Tanzania 282 467 430 527 470 Uganda 275 229 203 211 237 Kenya 111 5 52 81 46

Source: UN Conference on Trade and Development, World Investment Report 2005.

Kenya’s new investment law Kenya’s parliament adopted a new Investment Promotion Act (IPA) in 2004, is flawed with the aim of boosting foreign interest, but this has had the opposite effect, as several of the Act’s provisions are flawed, according to UNCTAD. Although the government says that it will amend the most contentious aspects of the Bill, there is considerable confusion about exactly which regulations currently apply and what the precise legal implications are, which is making investors very cautious. Two key problems with the IPA are the minimum capital requirement of US$500,000 and the need for all investors to submit to screening in order to procure an investment certificate. The motives may have been well intentioned—they aim to protect small local firms and to make sure that foreign investors are both sufficiently serious and able to make a positive contribution to the economy—but screening creates delays and an extra level of bureaucracy. Moreover, the minimum capital requirement is far too high, according to UNCTAD, which notes that three-quarters of foreign investments into Kenya during 2002-04—including in key areas such as horticulture—fell below the ceiling and would not have been allowed to proceed under the new regime, to the detriment of the economy. The high ceiling also precludes low-cash, knowledge-rich ventures in the service sector, a field in which Kenya’s relatively skilled and motivated workforce could enjoy a competitive advantage. In a positive development, the government has taken the concerns of UNCTAD and others seriously, and in October announced that the IPA would be amended to reduce the minimum capital requirement to US$100,000 and to give all investments the benefit of fast-track procedures—and work permit

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incentives—instead of making them dependent on the type of investment and the amount involved. It also appeared as if investment certificates would be scrapped or made optional. Although these changes are welcome, the amendment bill has not yet been passed. At the same time, the original bill has come into force without the necessary institutional arrangements in place to ensure that its provisions are carried out. It is currently not clear, for example, whether investment certificates apply to new investors only or to existing investors as well, or whether they will be retained at all. Investments undertaken without a certificate may be deemed illegal, and a private law firm, Kaplan and Stratton Associates, warned investors in October that they risked losing funds and/or assets unless they complied strictly with the rules in force. The confusion and delay is no doubt related to the current preoccupation with the referendum on the constitution.

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