Country Report Kenya at a Glance: 2003-04

Country Report

Kenya

Kenya at a glance: 2003-04

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

Key changes from last month Political outlook • Kenya’s new government has reaffirmed its commitment to concluding the long-running constitutional review process, although this complex task may take longer than expected. The original pledge to deliver a new constitution within 100 days of taking office has now been rescheduled to end-2003. Economic policy outlook • The passage of anti-corruption legislation, mainly the Constitution of Kenya (Amendment) Bill, is expected to become law before June. Economic forecast • Economic prospects remain unchanged from last month: assuming that donor support resumes in the second half of 2003 and the agricultural sector continues to perform strongly, economic growth is forecast to pick up to 2.5% in 2003 and 3.3% in 2004.

April 2003

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Outlook for 2003-04

Political outlook

Domestic politics Kenya’s new president, Mwai Kibaki, and his National Rainbow Coalition (NARC), following their victories in the December elections, are facing a challenging period as they struggle to meet their electoral promises, including political and economic reforms, over the forecast period. The new regime has inherited a run-down infrastructure, weak and corrupt institutions, a country riven with ethnic divisions, and one of Africa’s worst-performing economies. Furthermore, apart from fulfilling specific electoral pledges to tackle corruption, introduce free primary education and complete the constitutional review process, Mr Kibaki faces the task of holding his broad-based coalition together. Membership of NARC is diverse and cuts across traditional boundaries of ethnicity and ideology. It also includes many opportunists, including defectors from the former ruling party, the Kenya African National Union (KANU), who are seeking to prolong their own political careers. The main inspiration for party unity was the defeat of the old regime but, with this objective achieved, the forces acting on NARC will tend to promote fragmentation. The two most prominent and ambitious personalities are the minister of public works, Raila Odinga—who has switched party allegiance several times in the past decade—and the minister of education, George Saitoti—a defector from KANU. Mr Odinga took a leading role in the election campaign, and Mr Saitoti became de facto leader for a period in January when both the president and vice-president were incapacitated. However, it is doubtful whether either man has wide enough support to hold the party together. Although Mr Odinga has so far displayed no signs of disloyalty, he is thought to view the Ministry of Public Works—despite its large budget—as no more than a stepping-stone towards higher office. In particular, Mr Odinga is likely to seek to become prime minister. Although this post does not currently exist, the draft document prepared by the Constitution of Kenya Review Commission in 2002 calls for the creation of the post of prime minister with considerable executive powers.

War on corruption At the beginning of March, as part of the its war on corruption, the government set up a special commission to reinvestigate the biggest corruption case in Kenya’s history, the so-called Goldenberg scandal of 1991. The scandal involved the pay-out of KSh68bn (US$1bn) for fictitious exports of gold and diamonds. At the centre of the affair was a local businessman, Kamlesh Pattni, who is accused of defrauding the government of KSh22bn. There can be no doubt that a satisfactory conclusion of the Goldenberg scandal, which also involves some members of Mr Kibaki’s government, will be a demonstration of the new government’s commitment to tackling corruption at the highest level. The collapse of the Nairobi-based Euro Bank and the investigations into it are expected to put pressure on several senior government officials, including ministers implicated in the scandal. The collapse led to the replacement of the governor of the Central Bank of Kenya, Nahashon Nyagah, by Andrew Mullei. Mr Nyagah resigned after the loss of KSh1.4bn (US$18m) of public funds

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deposited in Euro Bank by a number of government institutions (Kenyatta National Hospital, the Postal Corporation, the Kenya Sugar Authority and the National Social Security Fund among others), which were subsequently lent to politically connected individuals. The Euro Bank scandal is expected to lead to the resignation (and prosecution) of members of the Kibaki cabinet that served in the Moi government.

Constitutional review The government has reaffirmed its commitment to concluding the long-running constitutional review process, although this complex task may take longer than expected. The original pledge to produce a new constitution within 100 days of taking office has now been rescheduled to end-2003. The draft document published by the Constitution of Kenya Review Commission (CKRC) in September 2002 embodies many valuable principles but is flawed and incomplete. Furthermore, proposals for a new executive prime minister and a complementary reduction in the power of the presidency find little more favour with the new NARC leadership than they did with KANU. Mr Kibaki is popular and will be reluctant to weaken his authority so soon after assuming power. In addition, the process of selecting a prime minister would probably create tension and possible disunity within NARC ranks. At the same time, Kenya needs a new constitution and the government appears sincerely committed to devising one, although tactical considerations will inevitably slow the process. Even the legal status of the CKRC is in dispute. The minister of justice and constitutional affairs, Kiraitu Murungi, appears to take the view that its mandate expired at the turn of the year, although last October’s pronouncement by the attorney-general suggested that the commission could not be dissolved until a new constitution was adopted. Whatever the interpretation, parliament is expected to point the way forward in the coming months. A reduced commission is likely to emerge, with just 10 members compared with 27 currently. Although many of the principles that guided the draft—such as decentralisation, power sharing and greater accounta- bility—will be kept, the new draft could differ significantly from the earlier one.

International relations The international community welcomed the smooth transition of power and Mr Kibaki’s promise of fundamental economic reforms and efforts to combat corruption. The new government’s efforts to date on both reforms and corruption is viewed with approval by the World Bank and the IMF, and the government has good prospects of normalising relations with them, especially the IMF. External assistance is likely to resume by mid-2003, provided the government does not weaken in its commitment to fight corruption and restructure parastatal enterprises. Kenya has also been identified as a key strategic regional partner in President Bush’s National Security Strategy. The US also recently renewed airbase, port access, and overflight agreements with the Kenyan government. This was followed by a visit by the US secretary of defence, Donald Rumsfeld, to the region in early December to develop security co-operation. Of the US$20m authorised by the US Congress for counter- terrorist security in Africa, Kenya is expected to receive US$15m, confirming the country’s regional importance and also its vulnerability to terrorist activities.

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The new regime will also continue to promote regional economic integration through the East African Community and seek an end to political instability in the Horn of Africa, which is causing bandit activity and an influx of refugees in north-eastern Kenya. As chairman of the peace forum of the Inter- Governmental Authority on Development—a regional agency grouping the countries around the Horn of Africa—Kenya will continue to promote a regional solution to the long-running civil war in Sudan.

Economic policy outlook

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

Fiscal policy Although external assistance, including budgetary support, may resume in mid- 2003, it may take longer to come through. Faced with severe resource constraints, Mr Mwiraria will be obliged to follow fairly tight fiscal policy in the next fiscal year (July 2003-June 2004). The deficit has mounted steadily in 2002/03 and continues to do so—the result of both pre-election spending by the outgoing regime and the need for the incoming administration to fulfil its promises, especially on education. The original targeted deficit of around KSh34bn (US$435m; 4% of GDP) was overoptimistic: Mr Mwiraria recently forecast a full-year deficit of KSh57bn (7% of GDP). Data for the first seven months of 2002/03 showed a deficit (on a commitments basis) of KSh20.6bn (US$26m), or 2.1% of GDP. Although spending was KSh14.9bn less than expected, at KSh139.6bn, revenue (including grants) was KSh10.4bn less than the target of KSh129.4bn.

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Spending is expected to continue to rise for the remainder of the fiscal year, partly owing to the recent increase in MPs’ salaries, including allowances, from about US$5,000 to over US$6,000 per month, and the introduction of free primary education, which is expected to add KSh5bn to the budget. Although Mr Mwiraria will seek savings in other areas and has frozen spending on major public projects until they have been properly audited, revenue will remain weak because of sluggish economic growth and the lack of external funds. The fiscal situation is forecast to improve in 2003/04, as revenue recovers in line with economic growth and external support returns, though the final deficit will only fall to 5% of GDP. The government will continue to rely on domestic sources to fund the deficit, at least for the remainder of 2002/03, which will put pressure on interest rates and limit the availability of credit to the private sector. Recent official data indicate that total domestic credit had increased to KSh39.3bn by the end of January. Of the total, credit to government accounted for 62.2%, reflecting the government’s reliance on domestic bank resources to finance the budget deficit.

Monetary policy Monetary policy will be geared towards keeping inflation below the official 5% target and maintaining exchange-rate stability. The government’s reliance on domestic borrowing to cover the budget deficit was responsible for an upward trend in the key 91-day Treasury-bill rate in the second half of 2002—from 7.3% in June to 8.4% in December. As inflation was subdued over the period, real interest rates also moved upwards: a boon to savers but a deterrent to investors, especially in the private sector. After taking office, the finance minister warned of even higher interest rates due to the government’s need to finance the mounting fiscal deficit but, to date at least, his fears have proved unfounded and the T-bill rate edged down from 8.4% in January to 7.8% in February. This was due both to the decline in global interest rates and to increased confidence in Kenya’s economic prospects, which has reduced the premium on future money. The growing importance of medium-term Treasury bonds, in place of bills, will facilitate the development of capital markets. The ratio of government bonds (long-term securities) to bills (short-term securities) rose to a new high of 60:40 in December; renewed confidence in the economy may enable the government to achieve its targeted 70:30 ratio in 2003.

Economic forecast

International assumptions International assumptions summary (% unless otherwise indicated) 2001 2002 2003 2004 Real GDP growth World 2.1 2.9 3.1 3.9 OECD 0.8 1.8 1.7 2.5 EU 1.5 0.9 1.1 2.1 Exchange rates ¥:US$ 121.5 125.3 118.2 117.0 US$:€ 0.896 0.946 1.113 1.105 SDR:US$ 0.785 0.772 0.720 0.722

Financial indicators € 3-month interbank rate 4.26 3.33 2.42 2.94 US$ 3-month Libor 3.78 1.80 1.35 2.53 Commodity prices Oil (Brent; US$/b) 24.5 25.0 24.5 18.2 Gold (US$/troy oz) 271.1 309.8 325.5 290.0 Tea (US$/kg) 1.6 1.5 1.5 1.4 Coffee (Arabica; US cents/lb) 62.3 61.5 66.5 63.1 Note. Regional GDP growth rates weighted using purchasing power parity exchange rates. Our near-term outlook for the global economy remains gloomy, and we expect to see little evidence of a recovery until late in 2003. We forecast that this will lift world growth to just 3.1% in 2003 and 3.9% in 2004 (at purchasing power parity exchange rates), from 2.9% in 2002. The pace of recovery in the euro area, which is vital for Kenya’s trade, has weakened, and its GDP is now estimated to have expanded by just 0.7% in 2002. Real GDP in the euro area is forecast to grow modestly, by 1.1% in 2003 and 2% in 2004. However, Kenya will benefit from rising prices for its key commodity exports, such coffee and tea. Despite the poor near-term outlook for global growth—and by extension, demand for oil—we have revised our forecast for oil prices upwards since January: the benchmark oil price, for dated Brent Blend, is now expected to average US$25.3/barrel in 2003 (compared with our previous forecast of US$26.4/b). We expect oil prices to fall relatively quickly in the second half of 2003. The downward trend will persist into 2004, driving Brent Blend down to an average of US$19.5/b. International interest rates are expected to start to rise in the second half of 2003, and into 2004, which will push up the cost of servicing variable-rate external debt. Economic growth The Kenyan economy grew by an estimated 0.9% in 2002, owing to erratic mid- year rains, low investor confidence, a lack of donor support and uncertainties associated with the elections. Assuming that donor support resumes in the second half of 2003 and the agricultural sector continues to perform strongly, economic growth is forecast to pick up to 2.5% in 2003 and 3.3% in 2004, but will fall short of the official target of 4% per year. The agricultural sector (some 20% of GDP) is forecast to expand by 1.5% in 2003 and 2.5% in 2004, depending on rainfall. Projected new investment in telecommunications, higher textile production and the improved power supply should boost industrial growth to 2.5% in 2003 and 3.8% in 2004. A stronger recovery will be hampered by the shortage of credit to the private sector (domestic credit to the private sector stagnated in the year to September 2002, whereas credit to the government grew by 38%) and low investor confidence, at least during the first half of 2003. Although growth in the services sector is expected to pick up, it will be constrained by the negative impact on tourism of the Mombasa bombing in November 2002 and lower levels of travel generally because of the war against Iraq. Tourism is expected to recover in 2004, which, in tandem with higher levels of trade-related services, should enable the services sector to return to stable growth. Domestic demand will remain subdued until foreign assistance returns in the second half of 2003. Exports of goods and services are forecast to grow more strongly in the second half of 2003 and should maintain this momentum into 2004, in line with the upturn in global demand. Import

demand will track domestic consumption and investment trends and start to recover in the second half of 2003, rebounding more strongly in 2004 as the overall economy gradually improves.

Inflation Annual inflation rose to 3% in February from 2.4% in January, owing to shortfalls in the supply of basic food items following a spell of unusually dry weather. The rapid increase in the cost of petroleum, reflecting the tensions in the Middle East, also contributed to overall inflationary pressure. Although any further rise in oil prices associated with conflict in the Middle East would add to inflationary pressure, this is expected to be a temporary phenomenon as oil prices are likely to trend downwards for the rest of 2003. Import-price inflation will be low, owing to the relatively stability of the Kenyan shilling and subdued domestic demand. Furthermore, lower food prices (food accounts for 50.5% of the index) will help to keep inflation in check. As a result, average annual inflation is forecast to rise from 1.9% in 2002 to no more than 3% in 2003, before subsiding to 2.5% in 2004.

Exchange rates The Kenya shilling has proved fairly resilient in recent months to adverse news. Although the shilling slipped below the psychological important KSh80:US$1 barrier at the end of November, as the election approached, this proved to be temporary. The currency averaged KSh79.5:US$1 in December, owing to subdued corporate demand for foreign exchange and inflows of revenue from tea exports. Confidence picked up strongly following the smooth transition of power to the new government, and the shilling strengthened to KSh77.3:US$1 on 30th December. The stability that has characterised the Kenyan currency over the past two years has continued in 2003. The impact of rising oil prices and inflation has been offset by renewed economic optimism due to the prospective return to normality in relations with the international financial community. The shilling stood at KSh76.25:US$1 on April 12th, and will be supported for the remainder of the year by the expected weakness of the US dollar, high international oil prices and the promise of loans from the IMF and other multilateral and bilateral donors. In 2004 the currency will be supported by higher economic growth, inflows of external funds, the recovery of tourism and net foreign direct investment, to average KSh80.1:US$1.

External sector Fears that Kenya’s current-account deficit/GDP ratio would deteriorate in 2002 have not been realised, according to recent data. The deficit in 2002 was US$216m (1.9% of GDP), compared with US$318m (2.8% of GDP) in 2001. The sharp downturn in the invisibles surplus, due mainly to the collapse of private transfers in the nervous pre-election period, combined with weaker tourism inflows, was more than offset by a decline in the merchandise trade deficit. Imports fell by 6.3%, as a result of subdued demand, and exports increased by almost 12%. Although revenue from tea and coffee exports stagnated, horticultural sales grew strongly and manufactured exports benefited from higher demand for steel and cement in East Africa and from a steep rise in textile shipments to the US under the Africa Growth and Opportunity Act. We expect the current-account deficit to rise again to 2.2% of GDP (US$256m) in 2003 before it eases to 1.6% of GDP (US$189m) in 2004. Imports are forecast to

climb in 2003 because of high oil prices and renewed demand for manufactured goods and capital equipment due to the resumption of external financial assistance and the associated revival of domestic activity. At the same time, export growth in 2003 will be inhibited by the continuing weakness of commodity markets, poor growth in the key EU market and domestic infrastructure constraints. Tourism will also remain subdued, although current transfers will pick up strongly. The overall picture for 2004 is slightly brighter. Although imports are likely to continue rising, despite the fall in oil prices, exports will benefit strongly from improved commodity prices, closer regional integration and increased textile sales to the US. In addition, a recovery in tourism, combined with Kenya’s growing importance as a regional centre for financial services, should boost invisible earnings.

Forecast summary (% unless otherwise indicated) 2001a 2002b 2003c 2004c Real GDP growth 1.2 0.9 2.5 3.3 Industrial production growth 1.0b 0.9 2.5 3.8 Gross agricultural production growth 1.2 1.0 1.5 2.5 Consumer price inflation (av) 5.7 1.9 3.0 2.5 Consumer price inflation (year-end) 0.6 2.5 2.5 2.0 Short-term interbank rate 19.7 18.4a 17.0 16.0 Government balance (% of GDP) -4.3 -3.7 -6.5 -5.0 Exports of goods fob (US$ bn) 1.9 2.1 2.2 2.3 Imports of goods fob (US$ bn) 3.2 3.0 3.1 3.3 Current-account balance (US$ bn) -0.3 -0.2 -0.3 -0.2 Current-account balance (% of GDP) -2.8 -1.9 -2.2 -1.6 External debt (year-end; US$ bn) 5.9b 5.7 6.0 6.3 Exchange rate KSh:US$ (av) 78.56 78.75a 78.79 80.05 Exchange rate KSh:¥100 (av) 64.65 62.82a 66.65 68.42 Exchange rate KSh:€ (year-end) 69.27 80.88a 90.40 87.30 Exchange rate KSh:SDR (year-end) 98.8 104.8a 111.9 110.2 a Actual. b Economist Intelligence Unit estimates. c Economist Intelligence Unit forecasts.

Editors: Pat Thaker (editor); David Cowan (consulting editor) Editorial closing date: April 11th 2003 All queries: Tel: (44.20) 7830 1007 E-mail: [email protected] Next report: Full schedule on www.eiu.com/schedule