Report No. 25840-KE

KENYA: A POLICY AGENDA TO RESTORE GROWTH

August 18,2003

Poverty Reduction and Economic Management 2 Country Department AFCOS Africa Region

Document ofthe World Bank GOVERNMENT FISCAL YEAR

July l-June 30

CURRENCY EQUIVALENTS

(Exchange Rate Effective August 15,2003)

Currency Unit Kenyan shillings (Ksh) US$1.OO = 76 Kenyan shillings Kenyan shillings 1.00 = US0.01366

ABBREVIATIONS AND ACRONYMS

AGOA African Growth and Opportunity Act ofthe United States CBS Central Bureau of Statistics COMESA Common Market for Eastern and Southern Africa CPI Consumer price index EAC East African Community EPZ Export Processing Zone FDI Foreign direct investment ICT Information and Communication Technology IFC International Finance Corporation IMF International Monetary Fund IS0 Industrial Standards Organization IT Information technology KANU Kenyan African National Unity KBES Kenya Bureau of Standards KCC Kenya Cooperatives Creameries KIPPRA Kenya Institute for Public Policy Research and Analysis URD1 Kenya Industrial Research and Development Institute KPLC Kenya Power and Lighting Company KTDA Kenya Tea Development Agency MTEF Medium-term expenditure framework NGO Nongovernmental organization REER Real effective exchange rate RPED Regional Program on Enterprise Development RSA Republic of South Africa SITC Standard International Trade Classification WTO World Trade Organization

Country Director: Makhtar Diop Sector Director: Paula Donovan Sector Manager: Robert Blake CONTENTS

SUMMARY AND RECOMMENDATIONS ...... i Introduction ...... i The 1990s: A Decade of Decline and Lost Opportunities...... i A Strategy for The Recovery Of Growth ...... iii Conclusion...... x

1. RECENT ECONOMIC DEVELOPMENTS...... 1 A . Recent Macroeconomic Performance ...... 1 B. Trade Integration ...... 8 C . Financial Integration...... 11 D. Export Performance ...... 12 E. Future Prospects ...... 16 F. Summary and Recommendations ...... -17 2 . GROWTH AND POVERTY REDUCTION IN KENYA ...... 19 A Poverty In Tke 1990s 19 . / ...... B. Growth Prospects ...... 28 C . The Future Potential for Poverty Reduction...... 32 D. Summary and Recommendations ...... 35

3 . AGRICULTURE ...... 37 A . Overview. Structure and Performance ofthe Agriculture Sector ...... 37 B . Sectoral Perspectives ...... 41 C . Summary and Recommendations ...... 53 4 . MANUFACTURING ...... 57 A . Manufacturing Performance ...... 57 B. Evidence from Surveys ofEnterprises ...... 60 C . Why Did the Manufacturing Sector Perform Poorly? ...... 62 D. A Success Story: The Garment Sector and the Africa Growth and Opportunity Act...... 65 E. Summary and Recommendations ...... 68

5. SERVICES...... 71 A . Background...... 71 B . Information and Communication Services ...... 72 C . Tourism...... 78 D. Summary and Recommendations ...... 83 6 . THE INVESTMENT CLIMATE ...... 85 A . The Regulatory Framework ...... 85 B. Governance ...... 92 C . Infrastructure and Financial Services for Investment and Growth...... 100 D. Conclusions ...... 114 BIBLIOGRAPHY...... 181 ANNEXES Annex I: Revisiting Kenya’s Poverty Lines. Welfare Measures And The Poverty Profile 115 Annex 11: Kenyan Growth Prospects From An International Perspective...... 129 Annex 111: Statistical Appendix ...... 137

BOXES Box 1.1: Major Policy Reforms and External Events 1990-2003 ...... 3 Box 2.1 : AIDS. Mortality and Growth in Kenya ...... 30 Box 2.2: Basic Assumptions Underpinning the Growth Poverty Scenarios ...... 32 Box 5.1: Telecommunications Framework...... 73 Box 5.2: Extending Universal Access In Chile ...... 77 Box 6.1 : Reform of Public Procurement...... 96. Box 6.2: How One Large Rail User Created its Own Solution ...... 105 Box 6.3: The Financial Sector in Kenya ...... 113

FIGURES Figure 1.1: External Debt Indicators ...... 7 Figure 1.2: ODA and Private Transfers ...... 10 Figure 1.3: Kenya FDI Inflows, Outflows and Real GDP ...... 11 Figure 1.4: Share of World Exports: Kenya, Vietnam and Malaysia ...... 13 Figure 1.5: Manufactures as a Share of Total Merchandise Exports Selected Countries ...... 13 Figure 1.6: Commodity Exports ...... 14 Figure 1.7: Market Destination for Kenya’s Exports ...... 14 Figure 1.8: Export Performance and REER ...... 15 Figure 1.9: Kenya-Prices Ratios ...... 15 Figure 1.10: Unit Labor Costs by Sector ...... 16 Figure 2.1: Poverty in Kenya During the 1990s ...... 22 Figure 2.2: Predicted and Actual Long Run Annual Per Capita GDP Growth...... 28 Figure 2.3: Poverty Reduction and Growth in Kenya ...... 35 Figure 3.1: Agriculture Domestic Terms of Trade ...... 39 Figure 3.2: Agriculture Share of Government Expenditure ...... 41 Figure 3.3: Coffee and Tea Exports ...... 42 Figure 3.4: International Coffee and Tea Prices ...... 43 Figure 3.5: Coffee Factory Operating Costs (Real) Murang’s District ...... 43 Figure 3.6: Horticultural Exports ...... 45 Figure 3.7: Maize Prices in Capital City ...... 47 Figure 3.8: Sugar Prices in 2001 ...... 48 Figure 3.9: Live Animals and Meat Exports ...... 50 Figure 3.10: Livestock Gross Marketing ...... 50 Figure 3.11: Milk Prices ...... 52 Figure 5.1 : Annual Bed Nights by Location...... 79 Figure 5.2: Growth in Arrivals, 1990-99 ...... 79 Figure 6.1 : Kenya’s Governance Indicators Compared with the Sub-Saharan Africa Average, 2000/01...... 93 MAPS Map 2.1 : Headcount Poverty Rates: Census-Based Location Level Estimates (Nairobi- Kibera Area) ...... 25 Map 2.2: Example from the Coast: Poverty Incidence in the Watamu Area ...... 26 Map 2.2a. Division-Level in Malindi District ...... 26 Map 2.2b. Location-Level in Malindi Division...... 26 Map 2.2~. Sublocation Level in Watamu Location...... 26

TABLES Table 1-1: GDP Growth and Sectoral Contribution to Growth. (Constant 1982 Prices) ...... 2 Table 1-2: Macroeconomic Indicators. 1990-2003 ...... 4 Table 1-3: Composition of Expenditure ...... 5 Table 1-4: Trade Policy Regimes in the East African Community ...... 9 Table 1-5: The Inward FDI Performance and Potential Indexes: Selected Countries ...... 12 Table 1-6: Kenya’s Export Performance ...... 12 Table 1-7: The External Environment for Kenya ...... 17 Table 2-1 : Sensitivity ofthe Poverty Line and Poverty Measure ...... 21 Table 2-2: Social Indicators...... 23 Table 2-3: Province-Level Rural Overall Poverty Incidence Estimates ...... 24 Table 2-4: Factors explaining Kenya’s Predicted Growth Shortfall Relative to High-Performing Asian Economies (percentage points) ...... 29 Table 2-5: Economic Growth Scenarios and Their Effect on Poverty and Inequality in 201 5 ... 34 Table 3-1: Kenya Compared to Other Countries ...... 39 Table 3-2: Horticultural Exports, 2001 ...... 45 Table 4- 1: Benchmarking Kenya’s Industrial Performance ...... 59 Table 4-2: Technological Structure of Manufactured Exports by Kenya and Comparators ...... 59 Table 4-3 : Tertiary Technical Enrollments, 1985 and 1997 ...... 64 Table 5-1 : Services Sector: Real Growth and Share of GDP ...... 71 Table 5-2: Exports of Nonfactor Services: Average annual rates of growth (in percent) and..... 72 Table 5-3: The Cost ofTelkom Kenya Services ...... 74 Table 6-1 : Institutional Quality Scores for Kenya, 1985-2001 ...... 93 Table 6-2: World Business Environment Survey Results ...... 95 Table 6-3: Crime in Nairobi ...... 97 Table 6-4: The Port of Mombasa: Performance Indicators ...... 107 Table 6-5: Sources of Finance for Firms ...... 112

This report was prepared by a team led by Miria Pigato (AFTP2) and comprising Lionel Demery (AFTPM). Johan Mistiaen (DECRG). Luc Christiaensen. Lucas Ojiambo. Sibel Kulaksiz. Eric Hawthom. and Wendy S . Ayres (AFTP2). Donald Mitchell (DECPG). Charles Kenny (CITST) and Andrew Singer and Sanjaya La11 (Consultants). and Samuel Gitonga contributed to Annex I11. The team visited Kenya in January 2003 . Mr . Joseline Ogai . Ms . Monica Aoko and Mr Nelson Muturi from the Ministry of Finance. Govemment of Kenya. provided comments to the Concept Paper and advised the team . The report benefited from comments by its peer reviewers Quentin T . Wodon (AFTPM) and Edgardo Favaro (PREMEP) and from Mathew Wyatt (Department for Intemational Deve’lopment. U.K.). The report was desk topped by Tanisha McGill with the contribution of Saba Solomon Tekle. Makhtar Diop (Country Director) and Fred Kilby (Sector Manager) provided guidance. Financial assistance from Department for Intemational Development (U.K.) is gratefully acknowledged.

SUMMARY AND RECOMMENDATIONS

INTRODUCTION

1. Kenya is experiencing a unique historical moment. On December 27, 2002 Kenyan voters elected their first new president in 24 years, thereby ending the political domination ofthe party that has ruled Kenya since independence. The new Government has already made a clear break from the past by its policy actions. Among these are adopting key legislation to improve governance, the reintroducing universal fiee primary education, and accelerating the constitutional reform process.

2. The government is developing a consultative economic recovery strategy aimed at translating its manifesto commitments into practical actions that will stimulate growth. This country economic memorandum (CEM)-the first since 19954s a contribution to the government’s economic recovery strategy and to its poverty reduction strategy paper (PRSP), which is also being finalized. It examines Kenya’s economic performance during the past decade, and identifies the structural weaknesses that have contributed to the decline in productivity and the competitiveness of the economy during this period. It also recommends policy and institutional reforms to revitalize economic growth and to reduce poverty.

3. The message from the CEM is a sober one. Increased poverty is the legacy from almost two decades ofslow growth. The burden ofdisease, particularly malaria and HIV/AIDS, is heavy and will constrain growth in the years to come. However, given the improved economic policy environment, the potential for growth of the economy is significantly better than the poor performance in the 1990s would indicate. But even in our high-case scenario Kenya is unlikely to reach the Millennium Development Goal of cutting in half by 2015 the proportion ofKenyans living in poverty in 1990. Reducing poverty will remain a tremendous challenge.

4. The CEM is organized into six chapters. Chapter 1 reviews recent economic developments and Kenya’s integration with the world economy. Chapter 2 discusses trends in poverty and focuses on the long term economic factors that affect productivity and institutional effectiveness. Chapters 3-5 provide detailed analyses of the agricultural, manufacturing, and services sectors, identifying specific cross-sectoral issues and recommending policy and institutional reforms to promote broad-based economic growth. Finally, chapter 6 discusses the investment climate and its relationship to private sector investment.

THE 1990s: A DECADEOF DECLINEAND LOSTOPPORTUNITIES

5. For the first two decades after independence, Kenya pursued economic growth on the basis of an import substitution industrialization strategy, with the state playing an increasingly important role in the economy. The economy performed well, and per capita income grew by 2.3 percent a year. Agricultural growth came mainly from the smallholder farmers, who benefited from the redistribution of the land of former colonial estates; from subsidized credit, agricultural inputs, and marketing services; and from protection from imports. Industrial growth was stimulated by policies protecting industries from imports, while exports were increasingly taxed, directly and indirectly, to finance growing public sector expenditures. In summary, growth during that period was explained by the availability of land for expansion of agriculture, a buoyant world economy, the benefits of early stages of industrialization, and low population pressure. During the 1970s the economy was hit by a number of shocks. These included a fivefold increase in the price of oil, the boom and bust-cycle in coffee and tea prices, and the breakup of the East African regional agreement in 1977. But more importantly, the underlying stimulants of growth had run their course. In the absence of sustained investment and with limited scope for expanding into new lands, agricultural growth started declining in the 1980s. Productivity in the economy fell, and so did the growth in exports. By the end of the 1970s the rising share of the public sector in the economy and the low productivity of the state enterprises had become a drag on economic performance.

6. The limitations of import substitution policies and the lack of sustained economic reforms during the 1980s and 1990s led to a decline in economic performance. The government embarked on a series of structural adjustment programs starting in the early 1980s, and continuing into the late 1990s. However, efforts at sustaining fiscal stabilization and at reducing the role of government in the economy proved difficult. Adjustment programs were implemented at an uneven pace, and reversals occurred periodically. Overall, the programs did little to address in depth the underlying structure of relative prices and incentives in the economy, and consequently did little to stimulate growth. While exogenous factors (droughts and floods) contributed to volatile agricultural output, policy related factors-the poor sequencing of reforms, the absence of a coherent land policy, and misallocation of resources for agriculture-played a larger role. The manufacturing sector responded poorly to the trade and investment reforms of the early 1990s, revealing its lack of competitiveness. Investment stagnated and productivity declined. While reduced, the antiexport bias of policies continued. As a result, Kenya’s share in world exports is now half of what it was in the 1980s.

7. A key policy failure during the 1980s and 1990s was the poor management of the economy. This is especially true of the public sector, which gave rise to an inequitable use of public resources. Kenya was relatively successful in reducing the fiscal deficit in the 1990s, but the burden of adjustment fell on capital investment which shrunk to 11 percent of government expenditures by the end of the 1990s compared to 20 percent at the beginning, while the wage bill increased from 29 percent to 38 percent of government spending. The mirror image of this was that, while revenues remained relatively high (representing 22-25 percent of GDP during the 19909, the quality of services delivered by the public sector deteriorated, thus contributing to the fall in the productivity and the competitiveness of the economy as a whole. The public sector continues to dominate the delivery of energy, telecommunications, transportation, and water services. The lack of investment in the utilities and infrastructure combined with their poor management has significantly constrained the growth of the economy and contributed to the increases in poverty. Weak public financial management and procurement systems, ineffective systems of accountability (including through the courts), weak law enforcement, and relatively poor public service pay have fueled corruption and resulted in rising crime rates and deteriorating security. These problems have not only lowered the quality of life for the Kenyan citizens, but have also increased the cost of doing business in the country. Importantly, they have harmed the image of Kenya as a good place to do business in the international investment community.

8. Poverty increased during the 1990s. Reflecting these developments, the proportion of the population living in poverty increased from 48.4 percent in 1990 to 5 1.4 percent in 1997 and to 55.4 percent in 2001. The number of poor increased from 11.3 million in 1990 to 14.4 million in 1997 and 17.1 million in 2001. Inequality has remained high. The nonincome dimensions of poverty also deteriorated in Kenya during the 1990s, although Kenya’s indicators of health and

11 education are better than those of many other Sub-Saharan African countries. Primary school enrollment rates have declined since the early 1990s, although Kenya spends over 6 percent ofits GDP on education, more than twice the low-income country average of about 3 percent of GDP. Partly because of the HIV/AIDS pandemic (the infection rate reached 13.5 percent of the adult population in 2000), life expectancy declined from 58 years in 1986 to 47 years in 2000, just above its level in 1960. The infection has a gender dimension in that girls and young women are more likely to be infected than men. Infant and child mortality have worsened. Gender disparities have persisted with women having on average, lower educational attainment, less access to health services, and a heavier workload than men.

9. The 1990s has also been a period of transformations that indicate the way forward. First, strong monetary management has produced low inflation and a stable exchange rate. Second, agriculture has responded with dynamism in the subsectors that have little direct government involvement, notably smallholder tea, smallholder dairy, and horticulture. This growth has occurred despite declining world prices in some markets (tea, for example) and a very competitive environment in others (horticulture). Third, Kenya has become a leader in the race to benefit from the U.S. African Growth and Opportunity Act (AGOA), and the garment industry is enjoying a spectacular recovery. Factors such as efficiently run export processing zones, good air and sea transport links to Asia and the United States, and a skilled workforce have facilitated the success of the garment industry. These attributes could become important in attracting other businesses as the investment climate improves. Finally, while the privatization program was stalled by a lack of political commitment, a number of initiatives to restructure public enterprises and to retrench personnel have been launched. These measures should enable the enterprises to become more efficient and more competitive. The preparatory work needed to reform competition policies and regulatory frameworks to allow private sector participation has progressed well.

A STRATEGY FOR THE RECOVERY OF GROWTH

Kenya’s GDP growth potential

10. Given its current structure, the Kenyan economy can be expected to grow by about 4.5 percent per year. On the basis offindings from several cross-country studies, and ofcurrent economic and social conditions, we estimate that Kenya’s long-run growth potential is low, around 2.0 percent per capita per year, translating into GDP growth of4.5 percent per year. This is our base case. We also present a high-case scenario with a 3.3 percent per capita GDP growth per year, which could result from a strong supply response from the industrial and tourism sectors to rapid improvement in the investment climate. However, even in this high-case scenario growth is lower than that achieved in the recent past by the high-performing Asian economies.

11. Factors influencing the growth prospects. A number of factors explain this relatively low growth potential. First, the continued high fertility rate and the burden ofdisease are slowing growth by keeping the dependency ratio-the proportion ofpeople either too old or too young to be employed-high. The recent increase in mortality reduces per capita economic growth by almost a percentage point. This is the approximate economic cost of malaria and of the HIV/AIDS pandemic. Second, with respect to gender, Kenyan women are completing fewer years of school and are far less likely to complete secondary school than are men. This results in lower labor female force participation in the nonwage economy and higher fertility. Third, the high level of corruption and the deterioration in institutions have harmed Kenya’s growth

iii prospects. Finally, past fiscal policy has constrained growth prospects, although recent corrections are encouraging.

12. Broad-based growth of agriculture is critical to substantially reduce poverty. Will the expected growth be sufficient to reduce poverty? Our analysis suggests that it is unlikely that Kenya can cut in half by 2015 the proportion of people living in poverty in 1990, even in the high-case growth scenario. Yet, more importantly, the poverty reducing potential of economic growth will critically depend on the nature ofthe growth path followed. While the industrial and service sectors may grow rapidly in the short-term with the improvement in governance and the investment climate, broad-based agricultural growth is critical for reducing poverty. Without success in fostering agricultural growth, poverty will remain unacceptably high during the coming decades, with the number of people living below the poverty line in 2015 roughly equal to that in 1997.

13, Reducing poverty will require reallocating public spending towards pro-poor programs, and eliminating obstacles to the full participation of women and other groups in the economy. Including the poor in the growth process will require reallocating spending to key public services, particularly health and education, and ensuring that the services actually reach the neediest. The government has already made primary education free for all. Refocusing on health services in view of the recent increases in mortality rates due to the HIV/AIDS pandemic, and encouraging girls to attend and stay in school, especially secondary school, are important. While time constraints have prevented a full integration of gender issues in the proposed development strategy, this CEM does suggest that removing gender-related obstacles to growth could make a significant contribution in raising Kenya’s long-term growth potential. More generally, it recognizes that inclusive policies will accelerate the pace of economic and social progress. This CEM has focused on analyzing existing information on living standards, which is the first step in monitoring the impact ofprograms intended to reduce poverty. The last nationally representative household survey was conducted six years ago. The Central Bureau of Statistics should initiate a new one as soon as it can develop an improved survey instrument. At the same time it should review and improve its methodologies for estimating household well-being and for deriving the poverty line.

14. This CEM recommends a number of policy and institutional reforms to promote growth and to ensure that the poor participate in and benefit from the growth. First, maintain a stable macroeconomic environment while improving the allocation ofpublic spending and further opening up the economy. Second, improve food security, by increasing the productivity of smallholders and facilitating the move of smallholders away from production for subsistence towards more commercialized agriculture. A third set of recommendations, and key to the recovery of the manufacturing and tourism sectors, relates to improving the investment climate, by strengthening the competitive environment and building firms’ capabilities, improving governance, and improving the delivery of energy, telecommunications, transportation, and water services.

Achieving a sound macroeconomic environment and better allocating public resources

15. The continuation and deepening of sound macroeconomic policies are prerequisites for economic recovery and require building on the achievements of the previous administration in maintaining a stable macroeconomic environment with low and predictable inflation rates. This report has identified the following priorities:

iv e First, reorient expenditures away from wages towards capital expenditures and delivery of services for poverty reduction. This is possibly the most important action that the government can take to revitalize growth. This will require resisting demands for wage increases, accelerating reform of the civil service, and adopting strong measures for expenditure monitoring and control.

e Second, reduce the debt burden. Measures include accelerating the privatization program and using the proceeds to retire part of the domestic debt, and securing external financing for budgetary expenditures, particularly in the form of grants and concessional loans.

e Third, allocate public spending according to the priorities identified through the PRSP consultations and in the ongoing public expenditure review. Finalizing the PRSP provides the opportunity to revisit the core poverty program-both the design of the program and arrangements to implement and protect it-making sure that it is consistent with pro-poor spending. e Fourth, pursue measures to increase private sector participation in provision of key infrastructural services. Little investment has made in the key parastatals such as telecommunications and energy during the past decade. They now require substantial new investment if they are to deliver services efficiently and reliably-which is essential to bring down costs to business and improve the competitiveness Kenya’s economy. Given the government’s budget constraints, private sector finance will be needed for investment. This will require measures, including privatization, to encourage private sector participation in the delivery of services.

e Fifth, lower tariffs and increase the international integration of the Kenyan economy. Kenya is working with the other members of the EAC and of COMESA to remove internal obstacles to trade and to establish a common external tariff, thereby moving towards regional integration. Kenya should also accelerate the process of becoming more integrated in the world economy by lowering tariffs and other barriers to imports of goods from the rest of the world. This is crucial to encourage the medium and large manufacturing firms to become more efficient and competitive.

Increasing agriculture productivity

16. While growth will come from all sectors of the economy, agricultural growth is particularly important to reduce poverty. More rapid agricultural growth than occurred during the 1990s is possible with prudent policy reforms and investments to lift long-term productivity and reduce the costs of inputs. Broad-based growth in the rural sector requires a holistic approach to agriculture and rural development. However, due to time constraints, this CEM has not covered several issues that are important for broad-based agricultural growth. Credit, research and extension, and input supply are not covered in detail and are priorities for future work. Policies to deal with the highly variable natural environment are not covered, but are taken up in other World Bank work. Land and water management, and issues related to environmental sustainability are obviously priorities in any agricultural strategy, as is fully integrating gender issues, which is discussed in the upcoming gender strategy. However, this CEM has identified a number of priorities for agricultural growth, and for ensuring that this growth includes smallholders and subsistence farmers:

V 0 First, reconsider food security policies. A full liberalization of the maize market, with unrestricted imports from neighboring countries, would improve food security, as the poor are net buyers of these staples. At the same time, efforts to improve the productivity of smallholder maize producers should be pursued, particularly with respect to the supply of seeds and fertilizer. As to the sugar subsector, the Sugar Act should be amended to limit the Kenya Sugar Board to a regulatory role, curtailing its responsibility for industry operations. The development levy should be reduced and put under the supervision of elected representatives of growers and millers. The sector should be liberalized and factories privatized.

0 Second, reform the coffee sector. Smallholders are already benefiting from reforms in the tea and dairy sectors. It is now urgent to reform smallholder coffee marketing and processing so that farmers receive a larger share of final sales. First, an agency should be established for coffee along the lines of the Kenya Tea Development Agency to operate processing facilities, handle marketing, and provide inputs to farmers on credit. Second, the Coffee Act should be amended to allow the agency to operate as the agent for smallholders and to allow growers to sell coffee outside the auction if they wish. Third, update the register of producers and implement procedures to prevent side-selling by farmers who are attempting to avoid repaying input loans. Finally, make coffee research more demand driven and effective.

0 Third, support the livestock subsector. This sector is key to the livelihood of subsistence farmers and pastoralists and has large growth potential. Disease control is key to promoting growth of the livestock subsector. The government should monitor disease outbreaks and develop systems to facilitate a coordinated response to prevent diseases from spreading. The government also has a responsibility to ensure that private sector veterinarians and service providers are certified and perform in accordance with professional standards. The government should also work to help harmonize import standards among countries in the region, eliminate the numerous tolls on animal movements, and introduce a single permit for cattle movement. Enforcing laws against animal theft and generally improving security would also help promote livestock production. Lack of reliable water supplies in the arid and semiarid regions is a key constraint to the development of the livestock sector, and improving the sustainable management of water resources in these areas needs to be made a central priority.

0 Fourth, rationalize public expenditure. Preliminary findings from the ongoing public expenditure review also point to severe problems of misallocation of resources within the Ministry of Agriculture. About three-quarters of public spending in agriculture is in fact absorbed by parastatals to perform functions that in many cases have been designated as noncore. Only around 50 percent of the requirements for extension services that were believed to be essential in the PRSP are provided. Thus, it appears that a restructuring of spending in agriculture and a revival of reforms of parastatals is necessary-particularly in the context of the PRSP priorities.

17. Over the medium and long terms, commercialization of agriculture will lead to higher growth. Nonfarm employment is the path out of poverty for many of the rural poor, whether employed on large farms, or in nonfarm activities. The key to the development of a robust nonfarm sector is increased agricultural production. Incomes generated by agriculture are

vi spent on agricultural inputs, processing of agricultural outputs, and consumer goods. The government’s role in fostering a more commercialized agricultural sector should focus on improving the enabling environment, by improving rural roads, which will reduce transport costs; taking action to bring down the costs of electricity, which will reduce irrigation and factory operating costs; reducing fuel taxes which will reduce transport costs; and improving communication systems, which will facilitate trade and closer monitoring ofmarkets. In addition, research that is responsive to producer demands is needed to develop new higher yielding, disease resistant crop varieties. Livestock research to deal with diseases endemic to the area is also required. Extension services need to be rationalized and access to credit, particularly for the smallholders, enhanced. The fraudulent practices of some input suppliers and marketing agents must also be eliminated.

Strengthening the competitive environment and building firms’ capabilities

18. Manufacturing. Increasing competitiveness in the manufacturing sector, requires more closely linking increases in wage to increases in productivity, and enhancing the flexibility of labor markets by, for example, introducing an appeal facility for employers. These are essential if firms are to again become profitable enough to increase investment and to create jobs. Measures to increase labor productivity include raising the quality and range of formal education, particularly at the technical level, stimulating greater employee training by enterprises, and improving the functioning ofthe training levy/grant system.

19. To increase the productivity of capital, firms must enhance their capacity to acquire and absorb technology. Three actions are recommended. First, strengthen the capabilities and technology support institutes by upgrading equipment, staff training, and ICT facilities; and encourage the institutes to develop stronger linkages with enterprises. Second, strengthen protection intellectual property rights by launching a campaign to raise public awareness of intellectual property rights issues, by intensifying control of counterfeiting, by introducing more rapid legal action and severe penalties, and by bringing counterfeiting penalties in line with those for patent infringement. Third, increase acquisition of technology through subcontracting arrangements and by attracting FDI. To attract foreign investors, it is important to finalize the new investment code (after removing the requirement for an investment license), to strengthen and centralize promotion activities, and to improve data collection.

20. The legal framework for competition and for intellectual property protection appears to be adequate. But the entities that implement and enforce the laws need to be strengthened by recruiting new staff and upgrading the skills of existing staff, and by improving the information base. Strengthening institutions is also important in areas such as commercial justice and financial sector supervision. Access to financial services can be increased by improving the legal protection ofcreditors, strengthening the judicial system (commercial courts), limiting recourse to court injunctions by borrowers, improving the protection of property rights (by facilitating registration of property liens and access to credit information), and facilitating claims on collateral.

21. Micro and small firms. The constraints on the growth ofmicro and small firms include lack of property rights which limits their ability to access external finance, inadequate infrastructure, and undeveloped business support services. While this CEM has not dealt in detail with the issues ofmicro and small firms and with the informal sector, it recognizes that they have a key role in the economic recovery. A key challenge will be to foster the growth ofthese firms so that they graduate from the informal to the formal sector. Further work needs to be done to

vii explore ways of increasing their access to training, technology, and financial services, including credit. In this context, the government should aim to foster the development of private financial services in the country, rather than providing credit itself.

22. Tourism. For the tourism sector, the key issue is to improve security. Measures to address the high crime rates in Kenya need to start with broadly reforming the police force, through measures such as providing better pay, equipment, and support. Besides security, several specific sectoral actions may help in revitalizing tourism and broadening its benefits. Diversifying into community-based tourism and ecotourism, and attracting more tourists to little visited parks (for example, through differential pricing) could make tourism more effective in reducing poverty. Helping communities diversify into tourism would require technical assistance to set up small and medium size enterprises, access finance, train guides, and develop information materials. A strategy to promote tourism must include actions to protect the environment. Considerable scope exists for improved land management carried out in partnership with the private sector and communities. Improved coastal zone management is important to ensure that beach and coastal resources are protected. Government-private-communitypartnerships could play an important role in extending reserve areas around national parks for the benefit of all.

Improving governance

23. The government has demonstrated its commitment to eliminating corruption and restoring the rule of law. Parliament passed in May 2003 two key pieces of legislation aimed at improving governance. The first of these defines corruption and economic crimes, and creates an independent Kenya Anti-Corruption Commission to investigate them. The second, the Public Officer Ethics Act, requires that all public officers adhere to codes of conduct, including declaring their assets. Three additional pieces of governance legislation were approved by cabinet in May 2003 and will be presented to parliament for enactment at the first opportunity. The public procurement and disposal of assets bill, addresses a set of problems that have contributed to corruption in the public procurement of goods. The government financial management bill addresses accountability in the management of public finances. The public audit bill creates a national audit office and adopts measures that will improve the quality and timeliness of audit reports and help parliament effectively oversee the management of public finances. The ongoing constitutional review will establish an improved framework for accountable government in Kenya, including stronger parliamentary institutions and a more independent judiciary. In the immediate future, dealing quickly with the suspicion and distrust surrounding many current judicial appointments-building on the appointment of the new chief justice and high court judges-is essential. Looking forward, a number of initiatives that will benefit the private sector-such as those intended to enhance debt recovery and land administration, to improve court recording and records management, and to strengthen alternative mechanisms of dispute resolution-should be given priority.

24. Government’s actions so far have already had an important effect on investors’ perceptions of the investment climate in Kenya by signaling a strong intention to reform. Recent issues of the InternationalCountry Risk Guide indicate that investors already perceive that Kenya is a better place to do business than it was under the previous government. They have in particular named institutional quality, including corruption and law and order, as having improved. Investors’ perceptions will improve further once it is clear that reforms are having an impact in reducing uncertainty and lowering the costs of doing business. Effectively

... Vlll implementing the new anticorruption legislation will help in further improving perceptions and promoting investment.

25. The government has undertaken impressive measures to curb corruption. To obtain the full effect of these anticorruption measures and unleash Kenya’s growth potential and significantly reduce poverty, fiscal austerity will also be necessary. Reducing corruption and ending the misallocation and misuse ofpublic resources will free resources for public investment and provision of services. However, nearly half of government spending is on wages and interest payments, and these are not likely to be significantly reduced by improved oversight and budget management. In the short run, the government will need to adopt austerity measures and therefore make difficult choices to keep the budget deficit from expanding to levels that will require increased domestic borrowing, crowding out private borrowing.

Improving the quality and efficiency of transportation, energy, water, and telecommunications services

26. Productivity growth in Kenya necessarily involves better quality and lower cost infrastructural services. This will require increased public spending as well as increased private provision. This CEM argues that the government should increase private sector participation, mostly through privatization. The parastatals after a long period of neglect now require significant new investments that the government cannot afford without cutting key programs intended to reduce poverty. Thus, difficult choices are necessary. The key recommended reforms include:

0 First, improve airport management, safety and security. Otherwise Nairobi will not be able to maintain its status as the major air transport hub in East Africa. Introducing private sector management of the airports (or concessions) is a model other countries have used successfully to improve the management of airports. Reviewing airport fees with the aim ofbringing down costs to users is also important. Improving security is key to reaching Federal Aviation class status 1, allowing flights from and to the U.S.

0 Second, continue the significant institutional reforms initiated to reverse the deterioration in road quality. The government should set an accelerated timetable for road concessioning, starting with the northern corridor. The road levy fund has succeeded in slowing the pace of road deterioration. Its operations could be improved by reducing the audit backlog and improving public information on the use of the levy. Charges for heavy vehicles could possibly be increased and vehicle license collections improved.

0 Third, complete the privatization of the Kenya Railways by means of a long-term concession.

0 Fourth, convert the Kenya Ports Authority into a landlord port authority. Private provision and competition should be introduced into all services. Clearance processes and customs procedures should be radically simplified to reduce the scope for discretion and rent seeking and to reduce costs to port users.

ix 0 Fifth, accelerate power sector reforms. After discussion of ongoing studies, the government should decide on and move towards implementation of the chosen option for private sector participation in the power sector. The government should also review the existing tariff regime and the current supply contracts with independent power producers, with a view towards lowering tariffs for users.

0 Sixth, approve an action plan and timetable for the full implementation of the detailed provisions of the Water Act 2002. Implementationof the Water Act 2002 has started with the establishment through a notice in the Kenya Gazette in March 2003 of the notice of the water services boards, the water services regulatory board, and the water services trust fund. This is a good start. Technical assistance may be sought to help implement the provisions ofthe act.

0 Finally, remove the remaining barriers to competition in the telecommunications sector. Telkom Kenya should then be privatized, but expectations about the proceeds need to be scaled back, given the difficult international telecommunications environment. Increasing access to rural areas is an important objective. Community broadcasting and mobile telephony are technologically appropriate and sustainable tools that will help in achieving this. Offering a reverse-auction subsidy to private mobile operators to roll out mobile footprint coverage could be considered.

CONCLUSION

27. This report analyzed Kenya’s growth experience in the 1990s and discussed future prospects for growth and poverty reduction. The 1990s has been a decade of decline and transformation. Poverty has increased and many social indicators have worsened. And yet, at the beginning of the new century, Kenya is still one of the most advanced countries in Africa. It has a geographically strategic position, a favorable climate, and a skilled and relatively well educated labor force. It has maintained macroeconomic stability, despite a lack of donor aid. It is a key player in the EAC and in the COMESA. It has a confident private sector and a free press. Most of all, it has a new democratically elected government that is committed to reform. But the challenges are great. The recent improvements in governance need to be grounded by legal and institutional changes. The reforms must be wide ranging, extending beyond the macroeconomic arena, and include redefining the role of the state in all sectors to keep pace with the advances in other countries. Most of all, the reforms must ensure that growth is broad based, allowing the poor to both contribute to and benefit from economic growth.

X 1. RECENT ECONOMIC DEVELOPMENTS

1.1 Kenya gained independence from Great Britain in 1963, and Jomo Kenyatta, its first president, ruled the country until his death in 1978. Daniel Arap Moi, who remained in office for 24 years, succeeded him. During the past two decades Kenya, once the most prosperous and politically stable country in East Africa has experienced economic decline, a fall in living standards, and a deterioration in the quality of its institutions. On December 27, 2002 Kenyan voters elected a new president and ended the political domination ofthe country by the party that had ruled it since independence. The new government is now facing the formidable challenge of reversing years of economic mismanagement, increasing growth, and including all the people- and particularly the poor-in the development ofthe country.

1.2 This chapter provides a review of macroeconomic trends, (section A), the current status of trade and financial integration (sections B and C), the performance of exports (section D), future prospects (section E) and conclusions and recommendations (section F).

A. RECENTMACROECONOMIC PERFORMANCE

1.3 Per capita income in Kenya is now below its level of 1990. During 1990-2001, Kenya’s real GDP grew at an annual average rate of2.2 percent (table 1.1). This was well below the average GDP growth rate of neighbors such as Uganda (6.8 percent) and Tanzania (3.1 percent). This was also lower than the Sub-Saharan Africa regional average (2.6 percent), and the average for low-income countries in general (3.4 percent) (World Bank, 2003). Kenya’s weak economic performance coupled with population growth rates averaging 2.7 percent during the 1990s, led to a contraction in per capita income by an average of0.5 percent per year.

Three distinct phases in the growth performance can be discerned during the 1990s:

0 Economic mismanagement during 1990-93 negatively affected growth through high inflation rates and high interest rates. Per capita income contracted by 1.5 percent during the period. Concerns with a broad range of governance issues led both bilateral and multilateral donors to freeze aid and, in some cases, cancel their programs. Investor confidence also sank, linked to government’s slow pace in implementing reforms (box 1.1).

0 Rapid recovery during 1994-97 was due to sustained implementation of reforms and buoyant world demand. GDP grew at an average annual rate of 3.3 percent during this period due to reforms that included the elimination ofprice and exchange controls and the removal of most trade restrictions. Agricultural marketing was liberalized, and by the end of 1995 the government divested its holdings in about 170 small nonstrategic public enterprises. Some 36,000 civil servants left the government’s payroll, most through voluntary early retirement. Over the same period, the central bank took steps to reduce the use of overdrafts by commercial banks and to strengthen its autonomy and bank supervision.

0 Performance worsened during 1998-2001, due to wavering government commitment to reforms and several weather-related shocks. These included the severe droughts of 1997 and 2000 that reduced agriculture output and disrupted electricity generation, and the El Nifio floods in 1998. A drop in tourist arrivals and the withdrawal of capital due to political violence related to the 1997 elections negatively affected growth. In addition, a large number of teachers were recruited and salaries of civil servants were significantly increased. Commitment to privatization also faltered. In 1997, given the slow pace of implementation of the reforms, the International Monetary Fund (IMF) cancelled its Enhanced Structural Adjustment Facility. The World Bank followed, canceling in June 1998 its Structural Adjustment Credit. After a new attempt at governance reforms in early 2000, supported by the two institutions, a three-year PRGF and a World Bank’s budget support credit went off track in November 2000. The programs were still off track at the time of the election at the end of 2002. 1.4 As discussed in chapters 3, 4, and 5, much of growth during the past two decades can be attributed to the expansion of services. The services sector grew by 3.0 percent during 1990- 2001, while agriculture grew by just 1.0 percent, and industry grew by 1.7 percent. Tourism is the largest contributor to the services sector. Finance and business services grew fastest in the mid-l990s, benefiting from the liberalization of the trade and foreign exchange regimes in the early 1990s. The industrial sector’s performance was poor, reflecting a deterioration in the investment climate.

Table 1-1: GDP Growth and Sectoral Contribution to Growth, (Constant 1982 Prices) Real GDP Growth Share in GDP Contribution to Growth 80-89 90-93 94-97 98-01 90-01 80-89 90-93 94-97 98-01 90-01 80-89 90-93 94-97 98-01 90-01

GDP 4.3 1.3 3.3 1.0 2.2 100.0 100.0 100.0 100.0 100.0 4.3 1.3 3.3 1.0 2.2

Agriculture 3.5 -1.0 3.4 0.5 1.0 31.8 28.9 27.3 26.7 27.6 1.1 -0.3 0.9 0.1 0.3

Industry 4.0 1.8 2.7 0.5 1.7 19.9 20.1 19.5 19.0 19.5 0.8 0.4 0.5 0.1 0.3

Manufactures 4.8 3.0 2.9 0.5 2.1 12.7 13.5 13.5 13.2 13.4 0.6 0.4 0.4 0.1 0.3

Services 5.0 3.3 4.3 1.5 3.0 48.3 51.0 53.2 54.3 52.8 2.4 1.2 1.8 0.8 1.6

Government services 4.9 3.1 1.5 0.7 1.8 14.9 15.7 15.3 14.6 15.2 0.7 0.5 0.2 0.1 0.3 GDP per capita 0.7 -1.5 1.6 1.0 -0.5

Source: Central Bureau of Statistics

2 3 1.5 Investment and savings are low and falling. Weak economic growth has been accompanied by a decline in both savings and investment rates and by a strong increase in consumption. Gross domestic investment fell from 20 percent in the early 1990s to about 13 percent in 200 1, with most ofthe decline occurring in public sector investment (table 1.2). From about 10 percent ofGDP in the early part ofthe decade, public sector gross capital formation fell to just 5 percent of GDP in 2001, and is now substantially below the Sub-Saharan average of 7 percent. Private sector gross capital formation also fell from an average of 11 percent achieved in the early part ofthe decade to about 9 percent ofGDP in 2001, This is well below the average for Sub-Saharan Africa of about 13 percent. In line with the declines in gross capital formation, gross national savings fell from an average of 14 percent of GDP in the first half ofthe decade to about 4 percent in 2001. By contrast, over the decade private consumption rose from 60 to 86 of GDP, increasingly financed, at the margin, by net current transfer and net factor income.

1.6 Revenues have declined since the mid-1990s. Revenues (excluding grants) declined from nearly 30 percent of GDP in 1996 to 22 percent in 2002, due partly to the slowdown in economic activity and an increase in tax evasion and partly to the decline in tax rates. The revenue decline coupled with and a collapse in donor financing complicated budget management.

Table 1-2: Macroeconomic Indicators, 1990-2002 1990-93 1994-97 1998 1999 2000 2001 2002 (annual percentage change) Real GDP at market prices 1.8 3.7 1.6 1.3 -0.2 1.1 1.2 Inflation rate (national CPI, annual average) 28.2 12.8 6.7 5.8 10.0 5.8 2.0 (in percent of GDP) Gross domestic investment 19.9 20.0 17.4 16.2 15.4 14.5 13.5 Private investment 10.1 11.6 10.4 9.7 9.1 8.8 ... Gross domestic savings 18.2 16.9 12.5 14.0 11.8 10.2 9.3 Private savings n.a. 15.1 9.0 10.5 11.0 11.0 10.5

Total expenditure and net lending 1/ 32.2 31.6 29.5 27.6 23.0 27.4 25.0 Interest payments 8.3 8.4 5.8 5.6 4.0 3.2 3.0 Wage expenditures 9.3 9.0 9.5 8.8 8.6 8.1 8.5 0 Capital expenditure 6.0 5.9 5.0 5.0 2.5 3.9 2.7 Total revenue 1/ 17.0 25.9 27.2 26.8 23.1 22.6 21.6

Overall balance (with grants) 1/ -13.4 -4.6 -1.5 0.0 0.7 -2.0 -2.2 Overall balance (without grants) 1/ -10.4 -5.7 -2.3 -0.7 0.2 -4.8 -3.4

Current account balance (with grants) -3.7 -3.1 -4.9 -2.2 -2.7 -3.5 -4.2 Current account balance (without grants) -1.5 -3.1 -4.9 -2.2 -3.6 -4.3 -4.2

Domestic debt, net (end of period) ...... 20.6 20.5 21.2 19.6 21.9 Source: World Bank database, IMF International Financial Statistics. Notes: n.a. means not available 1/ July-June fiscal year.

1.7 Domestic debt increased substantially to finance the growing public sector deficit. The revenue decline, coupled with poor expenditure and enforcement controls led to increased recourse to domestic financing and the accumulation of domestic arrears (or pending bills). The stock ofgross domestic debt (in nominal terms) tripled, peaking at 44 percent ofGDP in 1994. It declined to less than 20 percent of GDP in fiscal 2001 in association with a reduction of the deficit. However, worryingly it increased to 30 percent of GDP by the end of fiscal 2003.

4 Moreover, despite recent progress in lengthening maturities, half of the debt is still in the form of 91-day treasury bills. This high burden of debt will pose challenges for macroeconomic management during the short and medium terms.

1.8 The government mobilizes adequate revenues, which should allow it to finance critical social and capital expenditures, while maintaining a balanced budget. The government of Kenya mobilizes a higher share of GDP in revenues than the Sub-Saharan Africa average. The revenues if allocated appropriately would be adequate to finance critical social services and investment in infrastructure. During the 1990s, however, public sector wages and interest payments on domestic debt have absorbed a large and growing share of government expenditures. During 1990-99, spending on public sector wages rose from 29 percent to 38 percent of total government expenditures. The wage bill currently represents about 9 percent of GDP, which is significantly above the level in neighboring countries of around 5 percent (table 1.3 and table 111.5.4 in annex 111). Over the same period, spending on interest payments increased from around 12-13 percent of expenditures in the 1980s to 27 percent of expenditures in the late 1990s. Although spending on interest payments has fallen since 2000 due to a drop in rates, spending on public sector wages and on interest payments combined still accounts for about 50 percent of government expenditures, leaving few resources for capital expenditures and delivery of essential services for poverty reduction. Thus, central government capital expenditures have fallen from about 20 percent of government expenditures in 1990 to 11 percent in 2001. Moreover, they have declined from about 6 percent of GDP in 1990 to less than 3 percent of GDP in 2001.

Table 1-3: Composition of Expenditure (in percent of GDP) 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 KENYA Total expenditure and net lending 28.8 34.3 35.7 31.5 30.0 29.1 29.5 27.6 23.0 27.4 25.0 27.7 of which: Wages 8.8 9.0 8.6 9.9 9.2 8.4 9.5 8.8 8.6 8.1 8.5 9.2 Capital expenditure 5.5 6.1 6.7 6.7 5.6 4.6 5.0 5.0 2.5 3.9 2.7 3.4 TANZANIA Total expenditureand net lending 14.2 17.7 15.6 16.2 15.8 13.6 13.7 14.1 16.1 15.5 17.2 21.2 of which: Wages 2.7 3.4 3.4 3.7 4.1 4.2 3.9 3.4 3.9 3.8 3.8 4.1 Capital expenditure 2.4 3.7 3.2 2.8 3.2 2.3 3.5 3.9 5.0 3.5 3.2 5.9 UGANDA Total expenditure and net lending 21.2 18.6 18.6 16.7 16.2 16.8 16.4 18.0 26.8 20.7 25.9 25.4 of which: Wages 1.7 1.6 1.9 2.5 2.7 3.4 3.4 4.2 4.2 4.6 5.5 5.7 Capital expenditure 9.4 10.2 9.7 7.5 7.1 6.8 6.7 7.3 14.2 7.5 10.4 10.1 SENEGAL Total expenditure and net lending 21.5 20.8 21.0 19.6 21.0 19.0 20.1 20.9 20.0 21.7 20.2 22.8 of which: Wages 8.7 8.6 7.4 7.1 6.8 6.1 5.8 5.7 5.6 5.2 5.6 5.3 Capital expenditure 5.2 4.2 5.0 5.0 7.5 6.2 8.5 8.5 6.4 6.3 7.8 8.4 Note: Capital expenditure includes development and net lending. Source: World Bank database, IMF-International Financial Statistics.

5 1.9 Due to spending a high proportion of the resources on wages and interest payments to service domestic debt, delivery of services has been poor. Despite collecting a higher share of revenues in relation to GDP than many other Sub-Saharan African countries, delivery of services in Kenya in many areas is worse than in the other countries. For example, although Kenya spends more than 5 percent of GDP on education, its gross primary school enrolment rates stand at only about 93 percent compared with an average of 112 percent in countries with similar levels of spending, and its gross secondary school enrolment rates stand at 28 percent compared with an average of 50 percent (Ministry of Education, Science, and Technology, 2003). Similarly, although Kenya spends a higher level of GDP on health services than do other Sub- Saharan African countries, its health outcomes are relatively poor. For example, infant mortality stands at 78 per 1,000 infants, compared with 58 in Ghana and 60 in Senegal (World Bank, 2003e). Moreover, infant mortality has risen from 62 in 1985 (Ministry ofHealth, 2003).

1.10 Budget management in the future will require difficult tradeoffs. Overall, the deficit (including grants) turned from a peak of 9.6 percent of GDP in fiscal year 1993, to a surplus in 2000 and back to a deficit again in 2001-02. The budget deficit is expected to grew substantially in fiscal 2003 and is projected to increase further in fiscal 2004 because, in particular, of increased spending for education (which is essential to reduce poverty), and increases in salaries for teachers and civil servants. In the short-run to avoid further increases in domestic borrowing that will choke off growth the government will need to adopt tough austerity measures and reduce government consumption. Difficult choices will have to be made to reorient expenditures towards the core functions of government and away from programs that are popular in the short- run, but which damage the country’s long-term growth prospects. The government will have to reduce the size of the civil service to bring public consumption at a sustainable level. In addition, the government will not be able to finance essential investment in key parastatals, such as telecommunications and energy. Instead, privatization will be required to provide the resources necessary to improve delivery of essential infrastructural services.

1.11 In 2000, the government adopted a medium term expenditure framework, but has not used it effectively to shift spending towards priority programs for growth and poverty reduction. The medium term expenditure framework (MTEF) is a three-year program that provides the basis for making spending more effective and more oriented to expenditure categories with the highest potential to affect growth and to improve the quality of life for the majority of Kenyans. It is intended to strengthen the linkage between policy, planning and budgeting, and to improve monitoring of expenditures and public accountability. However, the MTEF has not been used effectively to shift spending towards priority programs. For example, the share of government expenditures devoted to health services fell from 8.4 percent in fiscal 2000 to 7.3 percent in fiscal 2001, before rising slightly to 7.6 percent in fiscal 2002 (Ministry of Health, 2003). The MTEF has not been supported in Kenya as in other countries through an annual public expenditure review process that evaluates budget strategy and performance, costs priority programs, suggests reallocations of expenditures, and recommends measures to strengthen pubic expenditure management systems. An initial public expenditure review was produced during the first few months of 2003, but not in time to influence the fiscal 2004 MTEF budget. The countries that have succeeded in aligning expenditure with priorities for poverty reduction have embedded the use of the MTEF and public expenditure reviews in their budget formulation processes.

6 1.12 The external debt is relatively Figure 1.1: External Debt Indicators low. Total external debt stood at US$7.1 1 billion in 1990 (87 percent of gross 140 120 domestic product, GDP) and at US$5.6 100 billion in 2001 (50 percent of GDP) (figure 80 60 1. l).’During the decade the government 40 continued to service its debt, bringing 20 down the debt service payments from 34 0 percent of export of goods and services in 1990 to 14 percent in 2001 (figure 1.1). Extemal debt/GDP H Debt service/exborts I This task was also facilitated by several World Development Indicators database. debt reschedulings.2 Kenya’s external debt Source: appears to be low by international standards and sustainable according to the criteria of the HIPC initiative. According to the new debt-sustainability analysis, in 2002 the net present value of debt to exports ratio was 111 percent and the debt service to export ratio was 11 percent (see IMF, 2003).

1.13 The government has pursued a tight monetary policy, which has succeeded in lowering the inflation rate. During the early 1990s, the money supply expanded rapidly to finance the electoral campaign triggering strong inflationary pressures. Improved economic management contributed to a decline of the inflation rate from a peak of 46 percent in 1993 to 2 percent in 2002. Since the mid-l990s, however, inflation has been volatile, reflecting increases in food prices associated with the droughts in 1997 and 2000, fluctuating petroleum prices, and movements in the exchange rate. The promulgation of the Central Bank of Kenya Act in 1996 limited the government’s access to central bank credit to a maximum of 5 percent of the government’s gross recurrent revenue. Subsequently, the share of credit to the private sector increased from 52 percent in 1990 to 73 percent in 2001, while the share going to the central government and to other public institutions declined from 37 percent to 28 percent.

1.14 Nominal interest rates have fallen in line with the drop in inflation (the 3-month treasury bill rate decreased from 33 percent in 1993 to 8.3 percent in December 2002). However, the gap between lending interest rates and deposit rates remains high. The gap reflects the high level of nonperforming loans in the state-owned banks and in small banks. The share of nonperforming loans in banks’ portfolios peaked at 38 percent in 2000, before declining to 30 percent of gross loans at the end of July 2002, with state owned banks accounting for over 59 percent of nonperforming loans. The high proportion of nonperforming loans is due to the recent poor economic performance making it difficult for borrowers to repay, interference with licensing and other lending decisions, and difficulty with recovering loans through the judicial process.

1 Data are for calendar years.

2 In 1994, Kenya rescheduled on concessional terms debts of US$500 million it owed the Paris Club. In 1998 it also rescheduled part of its commercial debt with the London Club. The agreement provided for a cancellation of US$21 million of arrears and a rescheduling ofUS$49 million. In November 2000 the Paris Club agreed to reschedule about US$300 million of Kenya’s arrears and maturities falling due during July 2000 to June 2001. The country completed a similar agreement with the London Club in early 2003, rescheduling US$ 45 million of debt. The debt reschedulings allowed the country to reduce its extemal debt outstanding and disbursed in the 1990s.

7 B. TRADEINTEGRATION

1.15 Protection has been reduced but is still relatively high. A result of the extensive trade and exchange reform of the early 1990s is that there are virtually no price and foreign exchange restrictions (with the exception of some import controls based on health, environmental and security concern^).^ The number of tariff bands has been reduced from 24 in 1988 (with a top rate of 170 percent) to 8 in 2002 (with rates ranging from 0 to a maximum of 35 percent, except sugar and wheat which are taxed at 100 percent and 60 percent respectively, see Chapter 3 ). All suspended duties, except on petroleum products, have been eliminated.5 The average import duty rate decreased from 21.4 percent in 1999/2000 to 16.9 percent in 2001/02 (IMF, 2002). However, in addition to tariffs, an import declaration fee of 2.75 percent is collected on all imports. 6 Protection is highest on consumer goods produced domestically, and lowest (0-5 percent) for capital goods and intermediate goods. The government has formulated a comprehensive reform of the trade system, to improve external competitiveness and to facilitate the introduction of a common external tariff for countries of the Common Market for Eastern and Southern Africa (COMESA) and the East African Community (EAC). The reform aims at reducing the number of nonzero tariff bands to four, capping by 2004 the top tariff rates to 25 percent, and further reducing the duty on raw materials and capital goods.

1.16 Kenya’s trade openness is relatively high, but has not improved during the past twenty years. Countries that are integrated with the world economy tend to exhibit low tariffs (indicating less divergence between domestic and international prices) and a high trade to GDP ratio, or openness ratio. On the basis of these measures, Kenya’s trade openness is relatively high, about 64 percent during 1995-2000, compared with 62 percent for Sub-Saharan Africa and 47 percent for low-income countries. However, this ratio has declined since the early 1990s and is roughly the same as it was some twenty years ago. This is in contrast with more dynamic countries in Africa and Asia, which have become significantly more open to trade over time (see table 111.3 in annex 111).

1.17 Kenya has deepened the process of regional integration. Kenya is a member of the World Trade Organization (WTO) and is participating in various subregional and regional

3 The govemment has abolished export duties, introduced export earnings retention schemes, improved the provision of short-term export finance and established the National Export Credit Guarantee Corporation. Licenses for the export of agricultural products are no longer required, though a number of special licenses are still needed for the export of minerals and precious stones and state trading in strategic agricultural goods. Since the liberalization of the foreign exchange in 1994, exporters are allowed to retain all foreign exchange proceeds in foreign currency accounts at commercial banks and to use them for business related expenses. Both Kenyans and residents can operate foreign currency accounts and borrow from the market. There are no restrictions on remittances of foreign investment income. 4 However, imports are subject to preshipment inspection for quality, quantity and prices and require a clean report of findings by a govemment appointed inspection agency. 5 In the fiscal 2000 budget Kenya introduced suspended duties-ad valorem duties levied temporarily on specific products at the discretion of the authorities. Imports which faced the highest suspended duties were maize (50 percent), rice (50 percent), sugar (70 percent), milk and cream (50 percent). The average effective import duty protection increased from 19.0 percent in 1998 to 21.4 percent in 1999. Suspended duties were eliminated in the fiscal 2001 budget. 6 The import declaration fee of 2.75 percent includes the fee for preshipment inspection (all import with an f.0.b. value of over US$5,000 are subject to preshipment inspection for quality, quantity, and price). Failure to obtain the preshipment inspection results in a penalty duty of 15 percent for nonvehicle imports and of 25 percent for vehicle imports.

8 initiatives, including the COMESA, the EAC, the Inter-governmental Authority on Development, and the African Union. These initiatives have different approaches to the integration process and a number of efforts are being put in place to minimize duplications and rationalize initiative^.^

1.18 Table 1.3 details the trade policy regimes within the newest block, the EAC. Liberalization of the trade regime has proceeded in a synchronized way in the three members of the EAC-Kenya, Uganda and Tanzania. An ongoing project is aimed at harmonizing customs procedures. A single bill of entry was recently adopted by member states and the number of documents for customs clearance was reduced from seven to one. A customs union is to be established by 2004. Last year Kenya and eight other countries within COMESA also launched a free trade initiative to establish a common external tariff by 2004 that would coincide with the introduction of a common external tariff by the EAC.8 This will also require the harmonization of customs exemptions and export support regimes.

Table 1-4: Trade Policy Regimes in the East African Community Policy change Status

Kenya Uganda Tanzania

Quantitative restrictions, price and Eliminated Eliminated Eliminated exchange controls Export duties Apply only to fish and timber. 20 Apply to coffee exports Abolished during 1986-94, but a 2 percent duty in raw hides, skins, and percent export tax reintroduced in scrap metal introduced in 2002/03 1996 on traditional exports. budget.

Export promotion schemes The main schemes were Main incentive schemes are the Investment incentives under the manufacturing under bond 1988; manufacturing under bond and Mining Act of 1998. Other Export Promotion Zones (EPZ) 1990; the fixed duty draw back incentives include EPZ; export and dutyNAT exemption scheme scheme. credit guarantee scheme 1990; and 1990. duty drawback scheme 1988.

Export restrictions (licensing) Eliminated Eliminated except for charcoal, Eliminated, except for exports of whole fiesh fish and timber. natural resources. No surrender requirements for exports except coffee. Maximum ad valorem rate 35 percent 15 percent. 25 percent Unweighted average tariff 16.6 percent 9 percent 14.3 percent VAT 16 percent 17 percent 20 percent Alternative minimum specific duties Specific duties applied to oil products. None None, except on sugar and minimum values Altemative minimum duties are applied to maize, wheat, sugar, rice, milk, alcohol, tobacco, textile, clothing, footwear. Other charges on imports Import declaration fee of 2.75 percent None Import license on sugar Suspended duties None Imported sugar for final 12 categories of imports (but not consumption for EAC members); rate varies between 10 percent and 50 percent. Anti-dumping, countervailing and Regulations introduced in 1999 in line Legislation in line with WTO Not applied yet. safeguard measures with WTO rules. arrangements. Rules of origin An EAC rules of origin being negotiated. Currently the countries rely on COMESA rules of origin, which requires that a certificate of origin must be produced as evidence that imports originate 60m the member states. However, goods produced within the EPZ are treated as foreign goods. Source: Ng’eno, 2002; IMF, 2002.

7 For example, COMESA is focusing on liberalizing trade among its member states, the EAC is attempting to create a customs union that will allow the free movement of goods across member countries, and the Inter- governmental Authority on Development is concentrating on managing drought and controlling desertification, enhancing food security, and managing conflict. See Ministry ofTrade and Industry (2002). 8 Other members include Djibouti, Egypt, Madagascar, Malawi, Mauritius, Sudan, Zambia, and Zimbabwe.

9 1.19 But important issues still to be addressed for effective regional cooperation. Despite recent progress, the process of regional integration is moving slowly:

0 First, the reduction of protection for some agricultural commodities and manufacturers and the consequent rise in imports, has led to trade disputes and claims of dumping. Some local industries and the people and communities that depend on them are resisting the move towards greater openness.

0 Second, the process of harmonizing investment incentives, the judicial and legal frameworks, and the tax systems is complex and is proceeding slower than anticipated.

0 Finally, the loss of revenue that derive from tariff reforms, which has important fiscal implications, may be contributing to government’s reluctance to move quickly towards regional integration. Import duties still represent an important component of government revenues-around 17 percent of total tax revenue or about 7.5 percent of GDP. Given existing trade flows, the revenue loss deriving from eliminating internal EAC trade tariffs and from the adoption of a common external tariff would be insignificant, 0.03 percent of total tax revenue collection, according to a recent report (Ng’eno and others, 2002). However, establishing a common external tariff would have important fiscal consequences, which of course would be higher the lower the level of the common external tariff. The authors recommend that the EAC adopt a maximum common external tariff close to the current average of 20 percent for final goods, 5-10 percent for intermediate goods, and zero percent for primary goods. This would lead to a loss of about 10-20 percent of total annual tax revenues. The determination of the common external tariff would require a careful balance between revenue considerations and potential dynamic gains arising from improved trade.

1.20 The balance of payments improved. The current account deficit improved during 1998-0 1, reflecting improvements in the trade balance as well as the large Figure 1.2: ODA and Private Transfers (USDS million) inflows of private transfers 1400~ I_ __ - __ __ - 1 (remittances and funds from private NGOs), which doubled from US$409 million in 1995 to an estimated US$785 million in 2001 (figure 1.2). The deficit deteriorated in 2002 however due to a reduction in 6KCZOP$ %zg2%%= private transfers associated with a 222LEZE2Z252EX -0fSiaal development sssuitnnce - - - -Privatetransfar drop in drought assistance. Export volume growth also slowed to 8.3 Source: OECD and World Bank data. percent ii 2002 from 11.6 percent in 2001. Official transfers which had peaked in 1990, fell throughout the decade as donors channeled resources for development through NGOs rather than through the g~vernment.~Lack of support from donors has resulted in a net outflow of long-term and medium-term official capital averaging almost 2 percent of GDP a year during 1995-2001.

9 Official development assistance and net official aid record the actual international transfer by the donor of financial resources or of goods and services valued at the cost to the donor, less any repayments of loan principal during the same period. Grants by official agencies of the members of the Development Assistance Committee are included, as are loans with a grant element of at least 25 percent, and technical cooperation and assistance.

10 By contrast, the high interest rates in the late 1990s have attracted increasing flows of short term capital.

C. FINANCIAL INTEGRATION

Figure 1.3: FDI Inflows, Outflows and real GDP complete reversal with US%millions and oercent outflows during 1993-99 140 25 amounting to US$728 million. I20 20

Within this context, Kenya 100 managed to attract small flows 15 80 of FDI. The ratio of FDI to IO GDP was only 0.4 percent 60 os during the 1990s compared 40 00 with the 1.9 percent Sub- 20

Saharan Africa average. A 0 05 number of countries in Africa (for example, Tanzania, I Uganda, Mozambique, South 1 ’ Africa) have attracted Source: World Development Indicators and Global Development Finance databases. significant in Y amounts of FDI recent years, because of improvements in the investment climate and acceleration in the process of privatization (see table 111.3.22 in annex 111). Figure 1.3 shows the increasing trend in FDI outflows. Inflows remained relatively constant, with the exception of 2000, when one-time investment of US$111 million was made in mobile telephone infrastructure and license fees. FDI dropped to US$50 million in 2001.

1.22 In most respects, Kenya is missing out on the opportunities arising from global trends in capital flows. Kenya’s low performance in attracting FDI reflects, to a certain extent, the slowdown in the world economy, which was exacerbated by the September 11, 2001 events, and a decline in new international investment, particularly the cross-border mergers and acquisitions. However, the worsening of security conditions and the deterioration in the investment climate have significantly contributed to the lack of interest by foreign investors. Kenya’s ability in attracting FDI, as measured by its rankings on United Nations Conference on Trade and Development’s inward performance index-the ratio between a country’s global share in FDI and that of GDP-has declined significantly compared with other countries during the 1990~~with its rank falling from 90 to 117 of 140 countries between 1990 and 1998-2000.’0 The

IO The inward FDI performance index is the ratio of a country’s share in global FDI flows to its share in global GDP. Countries with an index value of one receive FDI exactly in line with their relative economic size. Countries with an index value greater than one attract more FDI than may be expected on the basis of relative GDP. Countries with index values below one may suffer from instability, poor policy design and implementation, or competitive weaknesses in their economies.

11 Performance Index Potential Index Score Rank (lower is better) Score 0-1 Rank (lower is better) 1988-90 1998-00 1988-90 1998-00 1988-90 1998-00 1988-90 1998-00 Kenya 0.5 0.2 90 117 0.127 0.168 120 124 Uganda 0.0 1.o 130 59 0.115 0.228 123 94 Ethiopia 0.1 0.5 118 97 0.085 0.171 135 122 Mozambique 0.3 1.8 109 23 0.068 0.178 137 118 Cote d’Ivoire 0.4 0.9 101 64 0.15 0.195 107 107 Ghana 0.2 0.2 113 107 0.14 0.179 110 117 Vietnam 1.o 2.0 53 20 0.134 0.277 115 71 Honduras 1.2 1.o 49 53 0.155 0.232 101 93

1.23 Credit ratings, as measured by the institutional investor index, have been historically low in Kenya and worsened from 1997.12 Kenya ranked 103 among 151 countries by September 2002. By contrast, credit ratings of Tanzania and Uganda have shown a cyclical but rising trend.

D. EXPORTPERFORMANCE

1.24 Table 1.5 reports various indicators of export performance during the last two decades. Overall, the share of exports has remained roughly at around 25 percent of GDP, with merchandise and services exports representing two-thirds and one-third of total exports respectively. Real exports growth rates turned negative during 1997-99, in association with a deterioration in the terms of trade.

Table 1-6: Kenya’s Export Performance 1980-89 1990-93 1994-97 1998 1999 2000 2001 2002 Share in world exports 0.049 0.032 0.030 0.027 0.025 0.020 0.023 Share in world exports of top ten products 2.9 1.7 1.6 1.6 1.5 1.4 1.3 (in percent of GDP) Total exports (goods and nonfactor services) 25.3 31.3 32.6 24.9 25.3 24.8 28.4 24.6 Merchandise exports 15.1 14.9 21.0 17.6 16.6 16.1 18.0 15.6 Exports of nonfactor services 10.2 16.4 11.6 7.3 8.8 8.8 10.4 9.0 (real growth rate) Total exports (goods and nonfactor services) 3.0 4.3 7.7 -4.5 -5.5 2.1 8.2 -0.9 Merchandise exports 0.3 5.0 17.8 -2.3 -12.8 1.1 6.1 -0.8 Exports of nonfactor services 7.0 3.9 -5.1 -9.3 12.2 4.0 12.1 -1.0

11 The inward FDI performance index is an unweighted average of eight variables: GDP growth rate; GDP per capita; telephone lines per 1,000 inhabitants; commercial energy use per capita; share of research and development expenditures in gross national income; share of tertiary students in the population; and country risk. 12 Credit ratings is measured by the institutional investor index. The information for constructing the index is provided by 75-100 leading international banks which grade each country on a scale 0-100, with 100 representing the least chance of default. Individual responses are weighted using a formula that gives more importance to responses from banks with greater worldwide exposure.

12 Manufactured exports in percent of GDP 1.9 2.5 3.1 1.9 2.2 2.3 2.6 2.4 REER (annual percentage change) -2.7 -4.5 9.6 4.8 -8.1 6.7 5.2 -2.3 Terms of trade (annual percentage change) 1.1 0.7 3.3 -5.0 -1.3 -0.7 -2.6 -5.2 Source: UN COMTRADE Statistics; World Bank database.

1.25 Kenya’s share in world markets is small, around 0.02 percent, and has been cut in half during the past twenty years,

and the world market share of its top Figum 1.4: Share ofWodd &porta -Kenya, Vietnam and Malaysia ten exports has declined even more (Index 1990-100) (figurel.4). The sharp fall in coffee _. exports has greatly contributed and there are signs of a long-term loss in competitiveness in many other sectors. Countries such as Vietnam, which in 1990 had a similar share of world exports, managed to perform much better than Kenya (and gained increasing- shares of the coffee market). Source: UN COMTRADE Statistics

1.26 Manufactured exports stagnated. In fast-growing developing countries the share of manufactures in merchandise exports ranges between 70-90 percent (figure Agure 15: Manufacturea as a Share 0fTot.l Merchandie Rpom Selected Countries 1.5). In Kenya, manufactures have 90 -. represented around 10-1 2 percent of -~_~ merchandise exports during the past twenty years, reflecting the low international competitiveness of the manufacturing sector. However, in 2001 the ratio of manufactured exports to total merchandise exports increased to 16.3 percent, the result of a 44 percent growth in garments export^.'^

changed significantly in the late 1990s (figure 1.6). Tea increased its share of merchandise exports from 25 percent in 1980-85 to 29 percent in 1996-2001. More remarkable is the increase in the share of cut flowers (from 1.8 percent to 10 percent), in vegetables (from 2.3 percent to 7.4 percent), and outer garments (from 0.6 percent to 2.4 percent). The latter increased greatly in 2002, due to the response to the U.S. African Growth and Opportunity Act (see chapter 4). By contrast, between the 1980s and the late 1990s, the share of coffee in merchandise exports declined by 50 percent (from 33 percent to 16 percent), due both to lack of domestic reforms and a sharp decline in world prices (see chapter 3).

13 Particularly women’s and men’s outer garments oftextile fabrics and men’s cotton shirts.

13 Figure 1.6: Commodity Exports (Percent of Merchandise) 34 32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 Tea Cut flowers Vegetables Coffee Outer garments Fruits Bovine & equine Fish hides

Source: UN COMTRADE Statistics

1.28 The products that increased their share in merchandise exports were also the best performers in world markets. During 1996-2001 a number of commodities-tea, cut flowers and vegetables-outperformed the growth of world exports and increased their share in world markets. Thus, Kenya has maintained the top leadership as a tea exporter (24 percent of world market in 2001, up from 13 percent in 1980). The share of cut flowers and vegetables in world exports of these commodities jumped from 1.2 percent and 0.9 percent in 1980 to 4.2 percent and 1.6 percent in 2001. By contrast, the plunge in coffee exports was more severe than for other countries and Kenya’s share of world coffee exports declined from 2.7 percent in 1980 to 1.3 percent in 200 1.

1.29 Africa is now the dominant market for Kenya’s total exports. During the 1990s an increasingly large share of ~ Kenya’s exports have gone to Figure 1.7: Market Destination for Kenya‘s Exports (in percent of total) markets in Africa (figure 1.7). I 30 43 While the main export markets 40 35 for primary commodities remain 30 the industrialized countries, 25 20 manufactured goods are IS increasingly destined for African 10 5 countries. This reflects a deeper 0 regional integration but also a loss of international competitiveness outside of Source: Central Bureau of Statistics Africa.

Export Competitiveness

1.30 Export competitiveness has many aspects, not easily captured in a single indicator. This section discusses some of the most used indicators of external competitiveness. Other aspects, such as the cost of doing business, governance issues, and infrastructure problems are discussed in chapter 6 of the report.

14 exchange rate (REER). The pattern followed by the REER Figure 1.8: Export Performance and REER shows that Kenya became more competitive during the early 1990s, then became less so during 1996-98, then again became more competitive following a O-"~~wCwhO-N depreciation of the currency in h"mhhhhhh000 1999, but again lost 2ZZ%Z2%2%2ZZZ competitiveness thereafter (figure -REER (Index 1990=100) - - - - Value ofexports (US$ millions) 1.8).14 Overall, between 1990 and 2001 the REER appreciated by 35

1.32 Two other indicators of competitiveness are the ratio Rgure 1.9: Kenya - Price Ratios (Index 1990=100) between the prices of tradables 1 140 7 130 - .---.-.---- and nontradables and that of 120 - / export prices to the price of \. nontradables (see figure 1.9). Both indicators worsened during 90 - 80 - the 1990s, particularly after 1995, suggesting that the relative attractiveness of producing for the domestic market, and in -Ratio of export prices to nontradable -Ratio of tradable to nontradable prices goods and services that are not - - tradable, increased significantly Source: Central Bank of Kenya and Central Bureau of Statistics. during the past decade.

14 A number of caveats should be kept in mind regarding the behavior of the REER. First, the choice of the base year is important. Second, the REER approach assumes that the equilibrium exchange rate remains unchanged over the period considered. Under this assumption, an increase in the value of the REER index means that competitiveness is worsening. 1s However, it is difficult to conclude with certainty that Kenya has lost competitiveness. The losses in competitiveness in the late 1990s appear to compensate for earlier gains. Thus, in 2001 the value of the 1990 REER index was 135, which roughly coincides with the value of the index during the early 1980s.

15 1.33 Unit labor costs show a strong increase. A further measure of competitiveness is given by the behavior of unit labor costs, defined as wage costs per unit of output. While wage dynamics and the functioning of the labor market will be discussed in chapter 6, Figure 1-10 provides 0- 1JO - I an overall picture during 1990- I I 2001 of the behavior of unit labor 100 - costs indices by sector. Unit labor 1, I $01 . . I costs increased by 20 percent for the manufacturing sector, 150 percent for the agriculture sector, Source: Central Bureau ofStatistics. and 45 percent for the transport and communications sector. Indications are that real wages increased faster in the private sector than in public sector.

E. FUTUREPROSPECTS

1.34 Prospects for the immediate future remain uncertain. Table 1.6 reports estimates of world trade and demand, and projections for the international demand for Kenya’s products, given by the projected growth in imports among Kenya’s trade partners.16 Recent Bank forecasts suggest that world demand for Kenya’s products (trade partners’ growth) will rise by 5.5 percent during the next two years, despite political and economic uncertainties (World Bank, 2003). Interest rates, exemplified by the London interbank offered rate, are expected to decline in 2003- 04. Most commodity prices, including coffee, are expected to increase (the overall change in the export price index would average 4.5 percent a year). The combination of a recovery in export prices, a return to more normal weather conditions, an increase in external demand and an improvement in the investment climate, would contribute to a better external environment and augur well for an increase in export growth, which could average 6.5 percent during the next couple of years in Kenya.

16 For a specific country, world demand is measured as a weighted average of the real imports of all trade partners, weighted by their share in total exports of that country.

16 Table 1-7: The External Environment for Kenya (average annual percentage changes, unless otherwise indicated) 1991-96 1997-2002 2003-04 Real GDP growth World 2.3 2.5 2.8 OECD countries 1.9 2.3 2.4 Developing countries 3.1 3.3 4.3 Sub-Saharan Africa 1.9 2.8 3.5 Kenya 2.5 1.3 2.0 Export market indicators World trade growth 1/ 5.3 6.0 1.2 World exports 1/ 6.1 5.8 6.9 OECD import demand 4.8 6.4 6.1 Developing countly import demand 3.8 6.2 10.1 Market growth for Kenya 2/ 11.0 4.1 5.5 Kenya’s exports (GNFS) 5.7 0.6 6.5 Terms of trade Developing countries -0.5 -0.4 -1.8 Sub-Saharan Africa 0.1 0.7 -2.2 Kenya 3.1 -2.1 2.4 Prices (1990=100) Export price indices 3.3 -2.1 4.5 Coffee 9.1 -3.5 9.2 Tea -0.3 0.9 5.6 Ho rt i c uI tu r e 5.5 10.1 8.5 Manufactures 2.7 -3.5 2.2 Import price indices -0.4 2.5 3.0 Food 4.8 -1.3 3.2 Memo: Manufacturedunit value index (value of index; 1990=100) 109 8 104.3 107.1 London interbank offer rate (US%,6 months) 5.0 4.8 2.3 Source: World Bank database.

F. SUMMARY AND RECOMMENDATIONS

1.35 Kenya has admirably maintained macroeconomic stability in recent years, despite a lack of donor aid and other sources of official extemal finance. This has not led to economic growth, primarily because the burden of adjustment has fallen on capital and social expenditures, while the wage bill and expenditures on interest payments to service domestic debt have expanded. The high domestic debt burden has also contributed to high real interest rates, which has further discouraged private investment. Kenya’s participation in the world economy has worsened in the last two decades or so. Trade openness, as measured by the ratio of trade to GDP, has stagnated. Real exports per capita have remained constant in the last decade, while they have more than doubled in East Asia and South Asia. The share of Kenya’s exports in world exports is now half of what it was in the 1980s. The overall protection of the economy has declined but it is still high, particularly on goods that compete with domestically produced products. International competitiveness has declined because of the appreciation of the REER during the second part of the 1990s, a decline in the incentives to produce tradables, and a strong increase in unit labor costs. As for financial integration, Kenya has been completely marginalized. The ratio of FDI to GDP is one of the lowest in Africa. Credit ratings have been historically low in Kenya and have worsened since the mid-1990s.

1.36 On the positive side, exports of a number of commodities, such as tea and horticulture products, have grown strongly and gained market share. But others, notably coffee, have performed worse than in other countries. Notwithstanding its poor performance in international integration, Kenya is deepening the process of regional integration. Africa has substituted for

17 Europe as the main destination for Kenya’s manufactured exports. Kenya is a dominant player in regional trade flows within both the EAC and COMESA. These two regional groups are working towards adopting a common external tariff and establishing customs unions by 2004.

1.37 Sound macroeconomic policies will continue to be essential for the recovery of growth. Recommendations include: Reorient expenditures away from wages towards capital expenditures and delivery of services for poverty reduction. This is possibly the most important action that the government can take to help the growth recovery. This will require resisting demands for wage increases, accelerating reform of the civil service, and adopting strong measures for expenditure monitoring and control. Reduce the debt burden. Measures include accelerating the privatization program and using the proceeds to retire part of the domestic debt, and securing external financing for budgetary expenditures, particularly in the form of grants and concessional loans. Allocate public spending according to the priorities agreed in the PRSP and identified in the ongoing public expenditure review. Finalizing the PRSP provides the opportunity to revisit the core poverty program-both the design of the program and arrangements to implement and protect it-making sure that it is consistent with pro-poor spending. Spending for poverty-reducing priorities should not be based on incremental adjustments, as it has been the case in previous budgets, but should be sufficient to reach over time the desired improvements in welfare. The focus on using public expenditures to implement the PRSP priorities needs to be reinforced with appropriate policy and institutional reforms in the various sectors (for example, by privatizing the agriculture parastatals). Pursue measures to increase private sector participation in provision of key infrastructural services. Little investment has made in the key parastatals such as telecommunications and energy during the past decade. They now require substantial new investment if they are to deliver services efficiently and reliably-which is essential to bring down costs to business and improve the competitiveness Kenya’s economy. Given the government’s budget constraints, private sector finance will be needed for investment. This will require measures, including privatization, to encourage private sector participation in the delivery of services. Lower tariffs and increase the international integration of the Kenyan economy. At the macro level, the authorities will need to monitor the competitiveness of the exchange rate, particularly in view of the pressures that may come from increased donor assistance. Exchange rate movements (relatively to partner countries) should be monitored with a view to accelerating structural reforms to enhance competitiveness. Kenya should work with the other members of the EAC and of COMESA to remove internal obstacles to trade and to establish a common external tariff, thereby speeding regional integration. Kenya should also speed up the process of becoming more integrated in the world economy by lowering tariffs and other barriers to imports of goods from the rest of the world. 2. GROWTH AND POVERTY REDUCTION IN KENYA

2.1 This chapter reviews the prospects for growth and poverty reduction over the coming decade in Kenya. Section A revises recent consumption poverty estimates and provides a poverty profile for Kenya, using recently developed poverty mapping techniques. These show that poverty in Kenya is widespread and worsening. Even in the modern capital city of Nairobi, just under half the population is living below the poverty line. Section B assesses the longer run growth prospects for the Kenyan economy, drawing upon international cross-country evidence. The analysis suggests that long-run growth of per capita GDP is around 2 percent per year, although more rapid growth is likely as the economy recovers from stagnation. Finally, section C assesses the future prospects for reducing poverty in Kenya. Substantial economic growth will be necessary to reduce poverty in Kenya, and it is unlikely that by 2015 Kenya can cut by half the proportion of its population living in poverty from 1990s levels and achieve this key Millennium Development Goal.

A. POVERTY IN THE 1990s

2.2 Establishing profiles and trends of poverty and inequality in Kenya present two challenges. First, household data are very outdated. The most recent data were collected six years ago in the 1997 welfare monitoring survey. Second, while the incidence of poverty most likely increased in the 1990s, sound statistical evidence for this trend is lacking because of survey noncomparability and welfare measurement pr0b1ems.l~This section assesses the extent of these problems, proposes a revised set of estimates and discusses some preliminary findings on poverty profiles and trends.

Revisiting Kenya's poverty lines and welfare measure

2.3 Estimating poverty involves two steps: first, establishing a measure of economic well- being, and second, identifying a benchmark (or poverty line) to be applied to that measure, and below which individuals are considered to be poor. The criteria and methods used for setting poverty lines and the poverty measure can have substantial implications for policy.''

2.4 Revising the poverty line. Official food and overall poverty lines are obtained from the 1997 welfare monitoring survey. The food poverty line is based on the monetary value of food baskets that allow basic minimum human nutrient requirements (set at 2,250 calories) to be met. The overall poverty line is obtained by adding the monetary value of two bundles of basic nonfood requirements to the food poverty line. The practical implementation of this approach has suffered from two main problems:

17 Earlier welfare monitoring survey data were collected in 1992 and 1994 but the respective poverty measures derived from them are neither very robust nor comparable (because of survey design changes and seasonality effects). 18 Poverty lines, although frequently treated as given, are in fact endogenously set and are crucial in any poverty assessment. For descriptions of different methodological approaches, discussion of best practices, and sensitivity assessments, see Atkinson (1993), Bidani and Ravallion (1994), Lanjouw (1996), Hentschel and Lanjouw (1996), Ravallion (1998), and Lanjouw and Lanjouw (2001).

19 0 First, the food poverty lines uses a food basket obtained from the 1982 rural household budget ~urvey.'~To the extent that food consumption patterns have changed since then, the 1997 poverty estimates reported in Ministry of Finance and Planning (June 2000) could be inadequate (see annex I).

0 Second, the calculation of the overall poverty line is based on the average total expenditures ofthe 10 percent of households above the food poverty line and the 20 percent ofhouseholds below. This is too wide a band for poverty line estimation. A preferred method is to take incremental percentage point expansions either side ofthe food poverty line and utilize the average set of mean total expenditures that are obtained. We have applied this approach and have obtained a lower overall poverty line for urban areas, although the rural poverty line remains broadly the same.

2.5 Revising the poverty measure. The poverty measure also presents some problems. In particular, it includes housing expenditure only for those urban households that reported paying rent but not for the other urban households and not for rural households.20 Thus, the poverty measure is not consistent or comparable across households. We have taken care ofthis problem by omitting housing expenditure altogether. As a result, the overall urban poverty line is adjusted downward by a sizable 10 percent (see table 2.1, technical details in annex I).The overall urban poverty headcount increases only marginally to 43 percent (from the 42 percent estimate that was obtained using the revised poverty line), suggesting that the relative incidence ofrenting in urban areas is fairly distribution neutral. Together, the revisions to both the poverty line and the welfare measure (given in the World Bank line oftable 2.1) suggest that the incidence of urban poverty is somewhat less than government estimates (43 percent instead of 50 percent), although it is still a serious policy challenge.21 By contrast, the poverty incidence in rural areas is broadly unchanged.

19 There is reason to suspect changes in the consumption basket could have occurred. For example, the prices for the three main starch sources in the Kenyan diet have evolved quite differently since 1982. Average prices in 1997 increased by factors of 8.86 for bread, by 12.51 for maize, and by 14.17 for cereals (Ministry of Finance and Planning, June 2000). If these consumers view these food items as close substitutes, then these relative price changes are likely to have induced demand responses, and changes in the relative quantities consumed. 20 Two possible issues arise from this treatment. First, in urban areas this overestimates nonfood consumption of households who rent vis-&-vis those that own their dwelling. Second, this has the potential to distort rural versus urban comparisons of living standards, because expenditures of rural households will be understated.

" Additional adjustments that could be made include the omission of durable goods and transfers, but these have only a marginal effect on the poverty lines and measures.

20 Table 2-1: Sensitivity of the Poverty Line and Poverty Measure Rural Urban Poverty line Poverty incidence Poverty line Poverty incidence (Ksh) (in percent) (Ksh) (in percent) Food poverty Ministry of Finance and Planning (June 2000) 927.09 50.58 1,253.90 38.37 Overall poverty Ministry of Finance and Planning (June 2000) 1,238.86 53.06 2,648.04 50.11 Revisions to overall poverty World Bank' 1,244.53 52.81 2,130.99 43.14

Who are more likely to be poor?

2.6 Households that are large, headed by females, headed by adults with low educational attainment, or deriving most income from agriculture are more likely to be poor than others. In Kenya, as in other countries, poverty increases with household size (see annex Ifor details).22 Thus, households with a larger number ofinfants and children have a lower level of consumption, and thereby a higher probability of being poor. Female-headed households in urban areas are poorer than otherwise similar households. Not surprisingly, the education of both the household head and of the spouse appear to be important determinants of poverty. For example, an urban household whose head has at least some primary education has a level of consumption 20 percent higher than a comparable household whose head has no education at all. In rural areas, the gap is only 13 percent. As the level of education attained by the head and spouse increases, the effect on consumption also increase. Working in the nonfarm sector in rural areas is associated with a higher level of consumption. Wage workers, whether in the public or private sector, are better off than informal workers such as unpaid family workers. Land ownership, it is associated with higher levels of consumption in rural areas. Land owners can expect a 7 percent increase in consumption versus otherwise similar households, and each hectare of land brings an additional gain.

Inequality

2.7 Kenya has a rather unequal distribution of income as shown by its Gini coefficient in 1997 of about 0.42.23 As with the poverty measures, estimates of inequality in Kenya must be interpreted with caution. Inequality measures are computed from household expenditure data that are outdated and were collected using a survey instrument that needs impr~vement.~~Higher quality data are also needed to improve the understanding ofwhat determines inequality in Kenya

22 This analysis is based on the 1997 household survey. 23 The Gini coefficient measures the degree to which the cumulative distribution of expenditure (or income) diverges from a situation where each individual is equally well off (perfect equality). A value of zero in the Gini coefficient implies perfect equality and the closer the measure is to one, the more unequal the distribution. 24 An additional concem is the incidence of survey nonresponse in Kenya; it is plausible that richer households more often rehse to participate in a survey which would result in an underestimation of inequality (Mistiaen and Ravallion, 2003).

21 and the nature of the relationship between economic growth and inequality. Annex Ishows the preliminary results of an exercise undertaken to understand the impact on inequality of reducing the price (or tax) of certain goods. It appears that reducing the price (or tax) of a number of goods-notably maize and sugar-would significantly reduce inequality. This is important given the presence of price distortions for these products (see chapter 3). While these results are preliminary and should be regarded with caution, they underscore the importance for policy purposes of updating the information on poverty and inequality in Kenya using improved survey instruments.

Poverty and welfare trends during the 1990s

2.8 Poverty rose in Kenya during the 1990s. Tracking past poverty trends in Kenya is made difficult by the absence of comparable household survey data during the1990s. Nevertheless, we estimate that the proportion of the population living in poverty has risen from about 48.8 percent in 1990 to 55.4 percent in 2001. Poverty increased sharply during the early 1990s, declined during the mid- 1990s, and rose steadily since 1997 Figure 2.1: Poverty in Kenya During the 1990s (figure 2.1).25 Thus, an additional 2.7 million people were living below the poverty line in 2001 than were in 1997 (from 14.4 million in 1997 to 17.1 million in 2001). In the absence of an observed poverty ,451 , , , , , , , , , , , , rate in 1990,48.8 percent is used in 40 the remainder of this report as the ,99” ,99’ 99% 99’ *qb 495 ++ 99‘ 99% 999 +QQ+Q’ benchmark by which to assess progress towards attaining the Source: Bank-staff estimates.

2.9 The nonincome dimensions of poverty also deteriorated in Kenya during the 199Os, although Kenya’s indicators of health and education are better than those of many other Sub-Saharan African countries. Kenya’s achievements in education have been impressive- adult illiteracy is among the lowest of any country in Sub-Saharan Africa. However, primary school enrollment rates have declined since the early 1990s, although Kenya spends over 6 percent of its GDP on education, more than twice the low-income country average of about 3 percent of GDP (table 2.2). Life expectancy has declined from 57 years in 1986 to 47 years in 2000, just above what it was in 1960. Infant and child mortality have worsened. HIV/AIDS prevalence peaked in 2000 at 13.4 percent. Gender disparities have persisted. On average,

25 As an alternative, we explore the evolution of poverty by taking the revised poverty estimate of the 1997 welfare monitoring survey, and the national account estimates of sectoral GDP growth rates during the 1990s. We apply the observed sectoral GDP and population growth rates to the 1997 distribution of household income to backcast the evolution of poverty to 1990 and to forecast it to 200 1. The population is divided across the different sectors based on the sectoral employment of the household head in 1997. The basic assumptions underpinning these simulations are described in detail in box 2.3, section C, where we will use similar methods to simulate how future economic growth after 2001 will affect in poverty reduction.

22 women have fewer years of schooling, lower health status and a heavier work load than men (in rural areas women work 13 hours compared with eight hours for men).

Table 2-2: Social Indicators Sub-Saharan Low Income Kenya Africa Countries 1990 2001' 1998-2001 1998-2001 Real GDP per capita (constant 1995 US$) 358.0 324.9 57 1.9 477.5 GDP per capita, PPP (current international $) 976.7 1,032.0 1,689.5 2,084.5 Aid per capita (current $) 50.8 17.0 20.4 9.3 Life expectancy at birth (years) 57.1 47.0 46.5 58.9 Fertility rate, total (births per woman) 5.6 4.4 5.2 3.6 Infant mortality (per 1,000 live births) 62 78 91 76 AIDS prevalence rate (percentage ofadults) ... 13.0 9.0 2.0 Prevalence rate, for girls 15-24 ... 18.7 11.4 2.0 AIDS cases by year of reporting 7,672 2,565 Illiteracy (percentage of population over age 15) 29.2 16.7 37.4 36.8 Female 39.2 22.7 45.4 46.0 Male 19.0 10.5 29.3 27.7 Gross primary school enrollment rate 95.0 90.7 79.3 95.0 Girls 93.3 90.0 73 .O 88.5 Boys 96.6 91.4 85.5 101.3 Access to improved water source (% of population) 40.0 49.0 55.4 75.6 Expenditure on education Percentage of GDP 6.7 6.2 3.4 3.4 Percentage of total govemment expenditures 17.2 18.4 Health expenditure, total Percentage of GDP 1.4 2.0 5.6 4.2 Percentage of total govemment expenditures 3.9 5.8 Source: Most data are from the World Bank World Development Indicators database or the IMF, 2002. Figures in italics are from the Government of Kenya Economic Survey 2002.

A census-based subdistrict level poverty profile

2.10 The Central Bureau of Statistics is undertaking a study that applies a new technique combining information from the 1997 welfare monitoring survey with the geographical coverage provided by the 1999 population and housing census.26 The principal advantages of this technique is that it provides relatively accurate poverty estimates even at the provincial and

26 The basic idea behind the methodology is straightforward. First, using the 1997 welfare monitoring survey, regressions are estimated relating household expenditures with a number of socioeconomic variables that are contained in the census, such as household size, education levels, housing characteristics, and access to basic services. Household expenditures for all households covered in the census can be inferred by applying the 1997 welfare monitoring survey- based estimated relationships to the 1999 population and housing census socioeconomic (right-hand-side) variables. This in tum allows for estimation of poverty statistics in small geographical areas. For further details on the methodology and practical implementation of the approach, see Elbers, Lanjouw and Lanjouw (2002), Demombynes and others (2002), and Mistiaen and others (2002).

23 district levels and that it permits new estimates for 452 divisions and 2,208 locations.27 Table 2.3 compares estimates of poverty derived from the 1997 welfare monitoring survey and with those census-predicted. They are very close, and the associated standard errors (in parenthesis) are small, suggesting that census-based predictions are broadly accurate. 28

Table 2-3: Province-Level Rural Overall Poverty

(0.020) Coast 0.622 0.620 (0.024) Eastem 0.586 0.579 (0.010) Nyanza 0.630 0.635 (0.020) Rift Valley 0.501 0.537 (0.040) Westem 0.588 0.595 (0.020) Note: Estimates in per adult equivalent terms. Standard errors in parentheses. Poverty line set at 1,238.86 Kshs. Source: Central Bureau of Statistics

2.1 1 There is considerable geographical variation in the distribution of poverty within each province and district. This is true in both rural and urban areas, including Nairobi. Previously only a single poverty estimate, about 50 percent, was available for Nairobi’s 2.2 million people. The census-based estimates suggest that the incidence of poverty within Nairobi range from lows of around 8 percent of people living in poverty in one location, to close to 65 percent of the population in another. Moreover, spatial visualization of these estimates indicate that poverty hotspots are frequently located directly adjacent to very affluent locations. For instance, map 2.1 reveals that both slums and very affluent neighborhoods exist in an area of about 64 square kilometers within Nairobi. While many in Kenya are familiar with this observation, much less is known (even anecdotally) about the existence of such hotspots in the rural areas of the country.

21 This does not include the three districts, 46 divisions and 219 locations in the Northeastem province that were not covered by the 1997 welfare monitoring survey. Further research is underway to extrapolate estimates for this province based on previous household surveys. It is strongly recommended that the next survey also covers the Northeastem province. 28 A similar comparison at the district level is hindered somewhat because new districts were created in the two- year span bridging the fielding of the 1997 welfare monitoring survey and population and housing census. Nonetheless, comparisons of unaffected districts confirm the results obtained at the provincial level.

24 Map 2.1: Headcount Poverty Rates: Census-Based Location Level Estimates (Nairobi-Kibera Area)

25 Map 2.2: Example from the Coast: Poverty Incidence in the Watamu Area

MaD 2.2a. Division-Level in Malindi District Map 2.2b. Location-Level in Malindi Division

A Poverty Incidence' - 30% - 35% 35% -40% I40% - 60% I60% - 65% - 70% - 75% 7Preiiminsry Estimare)

rMatamu Location

Map 2.2~.Sublocation Level in Watamu Location I

1u I-oca tio n

Poverty Incidence' 0 20% - 30% 30% - 35% 35% -40% 40% - 60% m 60% - 65% m 65% - 70% m 70% - 75% '(Preliminary Estimate) WATAMU (sub-loc)

2.12 A second example is given by the Malindi district in the Coast province. It consists of three divisions, with Malindi division having the lowest proportion of people living in poverty, at 40-60 percent (map 2.2a). However, at the location level, poverty incidence is very heterogeneous ranging between 30 percent and 75 percent (map 2.2b). Watamu location along the coastline appears to be the least poor. But even in this area variation in poverty incidence is substantial at the sublocation level with the proportion of the population living in poverty

26 reaching 65 percent in Mbaraka, while this proportion falls to 20-30 percent in Watamu, where tourist hotels are located (map 2.2~).

2.13 These estimates of poverty incidence at previously unavailable levels ofgeographic detail provide an opportunity to understand what determines poverty outcomes. The Central Bureau of Statistics in collaboration with the World Bank is currently drawing up a research agenda to explore this question. A potentially useful practical application is to compare estimates of economic living standards with spatial patterns of other indicators of well-being, opportunity, and access, such as use ofprimary health care centers or rates of school enrollment. Such information will be important to policymakers who are implementing the poverty reduction strategy, by, for example, guiding decisions about where to situate new schools or health care facilities.

Sociogeographic disaggregation of the poverty profile

2.14 The combination of data from the welfare monitoring survey and the census can provide information on many aspects ofpoverty. We have calculated measures for various socioeconomic subgroups of the population within an administrative area (following methodologies by Elbers, Lanjouw and Lanjouw, 2002). In particular, three socioeconomic dimensions of the geographic poverty profile of the coastal province are examined: gender, employment in agriculture, and level of education. The results, which confirm the findings from regression analysis on the determinants of poverty discussed in annex I,suggest the following:

0 Female-headed households are more likely to be poor than male-headed households. At the provincial level, 32 percent of families are headed by females. About 65 percent of these households are poor, compared with about 60 percent of male-headed household^.^^ While female-headed families are poorer on average, the differential in poverty incidence between female and male-headed households varies geographically. In some locations, headcount differentials are up to 10 and even 15 percent percentage points higher.

0 Households that derive most of their income farming are more likely to be poor than households that earn most income from nonfarm sources. Poverty rates of agricultural households are about 10 percentage points higher than of other households. Again, the geographical variation in this differential is considerable. Some very preliminary analysis suggests that poverty rates among agricultural households might be relatively higher in coastal locations where nonfarm employment opportunities are available, such as jobs in tourist establishments. By contrast, in the more remote rural locations poverty rates between the two groups are very similar.

0 Households with better educated members are less likely to be poor than others. About 70 percent of households whose head never attended school are living below the poverty line, but only 58 percent of those whose head completed primary school and 38 percent of those whose head completed secondary school are The

29 A family was defined as a household with at least two members. 30 About 52 percent of the population of the Coast province belong to households whose head has never attended school, 37 percent whose head only attained primary schooling, and 11 percent whose head has secondary education or higher.

27 incidence of poverty among households headed by a person who has attained at least secondary education is consistently lower than that of other households, but across geographic locations the differential ranges from 5 to 40 percentage points.

2.15 This newly generated database of geographically disaggregated poverty estimates can be integrated with many other socioeconomic indicators and yield a richer and more detailed profile of poverty than was hitherto available. Moreover, this database provides a basis for further analysis into the determinants of well-being in Kenya, the geographic variation of poverty, and the potential impact of policies and programs intended to reduce poverty.

B. GROWTHPROSPECTS

2.16 With over 50 percent of the rural population and 40 percent of the urban population living below the poverty line, reducing poverty sustainably will be possible only by expanding GDP and per capita incomes. The rise of poverty in Kenya is mainly due to low economic growth per capita. This section assesses the growth potential of the Kenyan economy.

What growth can be expected over the coming decade?

translating into GDP growth of 4.5 Figure 2.2: Predicted and Actual Long Run Annual Per percent per year.32 Two of the four Capita GDP Growth studies (Sachs and Warner, and Dollar 31 and Kraay) predict Kenya’s GDP per capita growth to be 1.9 percent per year (figure 2.2). The most recent (1990- 1997) data from O’Connell and Ndulu indicate that Kenya’s potential per capita growth is 2.0 percent per year.33 Taking a different approach which utilizes Kenyan GDP time series data, Njuguna O’Connell- Sachs-Warner Dollar-Kraay Klassen Mean of Ndulu (1965-90) (1960-1997) (1960-92) long-run and others (2003) find that Kenya’s (1960-97) predictions

31 One approach, and the one adopted here, is to use the determinants of growth across a range of countries. The approach involves estimating a cross-country regression, with country growth rates the dependent variable, and a set of explanatory variables covering initial conditions and key socioeconomic determinants-what may be termed the “deep” determinants of growth. Kenya’s growth potential is derived by simply applying Kenyan values of the explanatory variables to the estimated regression. The details of how this is done are presented in annex 11.

32 The studies are Sachs and Warner, 1997; O’Connell and Ndulu, 2001; Dollar and Kraay, 2001; and Klasen, 2002. The studies by Sachs and Warner and O’Connell and Ndulu focus on African growth, which makes them particularly relevant to our present concem. The findings of Dollar and Kraay and Klasen are included because unlike the others they highlight the role played by inequality in constraining growth. 33 The word “predict” has a specific technical meaning as used here. It does not refer to predicting the future, but to regression-based estimates ofvariables.

28 years. While their results vary depending on the specification of the model, they conclude that the potential early 2000s annual output growth to be between 1.9 and 2.3 percent-well below the rate emerging from the cross-country data. Their findings cannot be fully reconciled with the cross-country predictions, because their focus is on the short run growth potential rather than the long run potential. But they point to the same important policy conclusion: that structural changes are needed to raise Kenya’s growth performance in the long term.

2.18 Kenya’s growth potential appears to be below that of the high-performing Asian countries because of demographic factors and relatively poor economic policies. All the studies predict Kenya’s long-run per capita growth potential to be between 3 and 4 percentage points below those ofthe high-performing Asian economies. This is somewhat surprising. In fact, Kenya’s low initial year GDP relative to that of the Asian economies should give it a growth advantage. This so-called convergence effect is quite marked.34 It means that other things being equal Kenya should grow between 1.2 and 1.6 percentage pointsfaster than the Asian economies (table 2.4). But other things are not equal, and all the other determinants of economic growth specified in these studies reduce Kenya’s growth prospects relative to those of the Asian economies. Two broad factors seem to explain most of Kenya’s low growth potential: demographic factors and economic policy.

Table 2-4: Factors explaining Kenya’s Predicted Growth Shortfall Relative to High-Performing Asian Economies (percentage points) Political Initial Demo- stability/ Macro- Predicted Period year gaphic institution Open- economic growth GDP factors Geography Shocks quality ness policy difference

O’Connell and Ndulu 1965-89 1.60 -2.88 0.00 -0.84 0.03 da -1.03 -3.12

Sachs and Wamer 1965-90 1.20 -1.61 -0.3 1 da -0.36 -2.35 -0.53 -3.97

Sources: staff calculations based on Sachs and Wamer (1997) and O’Connell and Ndulu (2001).

Factors influencing the growth prospects

2.19 Kenya’s high population growth rate and heavy burden of disease are slowing growth. The high-performing Asian economies experienced a demographic transition in the 1960s, resulting in lower mortality and fertility, reduced age dependency ratios, and higher labor force participation of women.35 These factors helped to accelerate growth in the Asian economies. Kenya was one of the first African countries to begin a demographic transition. Population growth fell rapidly from independence up to the 198Os, but then it tapered off. The total fertility rate is now at 4.4, below the average for Sub-Saharan Africa but higher than in low income countries. But the recent increase in mortality is somehow unwinding the demographic transition-it is not clear yet what the effect of the HIV/AIDS-induced increase in mortality on fertility will be (see box 2.1). Besides the high dependency ratio, the disease burden that Kenyans have to bear is also a serious problem-both in itself and for the country’s economic

34 Generally, the lower the initial GDP, the higher is the expected economic growth in following years. Other things constant, this would lead to a convergence in incomes across countries, with poorer countries growing faster than richer ones. 35 A demographic transition is a permanent decline in the death rate and a lagged decline in fertility.

29 prospects. Kenya’s high level of mortality (and low life expectancy) compared with the high- performing Asian economies is shown by these studies to have a negative influence on its long- run growth (see annex 11). According to the O’Connell-Ndulu results, the demographic factors explain almost 3 percentage points of Kenya’s predicted growth shortfall relative to the high- performing Asian economies (table 2.4).36

2.20 The low level of female educational attainment contributes to the problem. The importance of population and health factors for economic growth points to a more general set of social conditions which constrain Kenyan growth, Klasen (2002) shows that girls’ education,

r 36 These are life expectancy as birth, the age-dependency ratio, and the growth of the labor force.

30 particularly secondary school education, is associated with more favorable growth outcomes. The fact that Kenyan women during 1960-92 did not complete as many years of schooling on average as did men accounts for almost a percentage point difference between the growth potential of Kenya and that of the high-performing Asian economies-amounting to one third of the total predicted differen~e.~’This finding stresses the economic as well as the social advantages to be gained in schooling girls, and encouraging such schooling at the secondary level.

2.21 Kenya’s poor economic policies also hinders growth. Poor economic policies are also significantly slowing growth. The Sachs-Warner data suggest that 75 percent of Kenya’s growth shortfall is explained by its low openness (reflecting mainly the trade policy stance of the government). The O’Connell-Ndulu findings suggest that Kenya’s high level of government consumption penalizes Kenya’s growth potential. High - government consumption financed through domestic borrowing may be crowding out private sector investment by increasing real interest rates. Given that the government can do little in the short-run to change the age structure of the population, it is all the more important that it adopt economic policies that encourage growth.

Updating the growth predictions

2.22 The burden of disease just about cancels out the favorable impact on growth of improved economic policies, leaving the pace of economic advance largely unchanged. Most cross-country studies are ill-equipped to deal with the medium term because of their very long- run perspectives. The O’Connell-Ndulu (2000) assessment is relevant, given its half-decade empirical orientation and we have used this model to speculate about Kenya’s growth path in the future. We update the explanatory variables of the model, using three main assumptions: first, economic policy variables improve substantially (details are provided in annex II).38Second, life expectancy declines and the health status of the population worsens.39 Third, there are no changes in political stability and no shocks.40 With these assumptions, the model predicts a

37 Girls schooling is important because it contributes to reducing the fertility rate as women with more education (especially secondary school education) give birth at a later age, have healthier children, and bear fewer children 38 Revised data on the economic policy variables are applied: the black market exchange rate premium declines (from 19 percent to just 11 percent), inflation falls dramatically (from 20 percent to 4 percent), and government consumption falls from 17 percent ofGDP to 13 percent. 39 The demographic determinants are updated to reflect the current situation: life expectancy has fallen from 57.1 years (at the close ofthe 1980s) to 49.3 years, the U”s estimate for the 2000-05; age dependency improves (from 1.O to 0.9); and the growth potential ofthe labor force (relative to overall population growth) declines.

40 The assumption that there are no improvements in political stability for this experiment needs some explanation. As reported in table 6.1 in chapter 6, the overall mean of the quality of institutions, as measured for Kenya by the International Country Risk Guide, has remained remarkably stable over the past couple of decades. But the components ofthis index have moved quite differently-government stability has sharply improved, the investment profile has improved marginally, and other dimensions (bureaucratic quality, corruption and law and order) have declined sharply. How this is interpreted in an assessment of growth prospects depends on what weight is assigned to each component. Ifthey are given roughly equal weight, our assumption of no change in institution quality is justified. But if the corruption and law-and-order indicators are considered more telling in describing the investment and business climate, our growth assessment for the coming years will be optimistic. For simplicity, we have also assumed that no shocks occur. While this is unrealistic, it should be emphasized that we are not providing forecasts of growth, but conditional statements about Kenya’s growth potential given the conditions that currently prevail. If the global economic environment changes (either favorably or not), clearly the growth path will be profoundly affected.

31 medium-run acceleration in growth of just 0.3 of a percentage point. Thus, Kenya’s predicted growth increases from 2 percent per annum during 1990-97, to 2.3 percent in the early 2000s. This is not a big improvement, particularly considering the changes that the government is introducing to improve governance and economic policy. The sober message of this exercise is that an improvement in economic policies will have a positive impact on growth - but economic development will remain constrained by the deteriorating health of Kenyans.

c. THE FUTUREPOTENTIAL FOR POVERTY REDUCTION

2.23 We now turn to the most fundamental challenge of this report-shedding light on the potential of the Kenyan economy to reduce the proportion of its population living in poverty, and, more specifically, to achieve the Millennium Development Goal of cutting to 24.4 percent the proportion ofthe population living in poverty by 2015 from its level in 1990 of48.8 percent.

2.24 We examine different growth scenarios and how they translates into poverty reduction. In particular, we explore the poverty reducing potential of three scenarios, the sectoral composition of their growth (agriculture, industry, and services), and the assumed mobility of the population across the different sectors over time. The basic assumptions underpinning the analysis are discussed in box 2.2. In each scenario, actual observed sectoral and population growth rates have been applied from 1997 to 2001.

2.25 We start by examining the evolution of the poverty incidence if the economy were to continue from 2001 onwards at the average growth rate observed during the 1990-2001, 1.e. 2.15 percent a year (scenario 1, table 2.5). Abstracting from any change in the sectoral employment shares, poverty incidence in 2015 is projected to be similar to the 2001 level, although the number of poor people would have increased by about 5.2 million to 22.3 million.

32 2.26 Next, we consider two scenarios: (1) the Kenyan economy grows at its long-term potential of 4.2 percent during 2001-15; and (2) the economy grows at its long-term potential, although with initial catch up growth (5.6 per cent) during the first five years after 2001.41 In addition, we explore how overall growth patterns change assuming (1) strong agricultural growth, (2) strong industrial growth, and (3) growth following the same sectoral growth pattern as observed during its best three-year period of the 1990s (1994-1996). Finally, we consider the expected poverty reduction if all sectors were to grow at twice their average rate during the 1990s (table 2.5).

2.27 Results are described in Table 2.4. Note that the difference in poverty reduction between the high and low agricultural growth scenarios is substantial. In the former scenario, poverty incidence would fall to 37.4 percent of the population (and to 34.1 per cent if there were also catch up growth) compared with 43.7 percent (and 40.8 percent with catch up growth) in the latter case. Inequality, as reflected in the Gini coefficient, would basically remain constant if agriculture grew strongly, while it would increase if agriculture grew at about the same pace as the overall population. Clearly, a growth scenario driven by strong agricultural growth generates faster poverty reduction and is more equitable. Given that the models assume that within sector inequality remains constant over time, it must be emphasized that to achieve higher poverty reduction, growth in agriculture must be broad based.

2.28 In a third set of scenarios, the Kenyan economy is also expected to grow at its long-term potential, but with labor moving across the different sectors in line with the urbanization rate projected by the UN Population Division.42 In particular, we assume that people adopt the existing sectoral employment shares in the urban areas (they shift from agriculture to industry and services) as they move from the countryside to the cities. The sectoral labor composition in rural and urban areas is assumed constant over time and the urbanization process is considered exogenous.43 As in the second set of scenarios, high broad-based agricultural growth scenarios are more poverty reducing than low agricultural growth scenarios. When the high agricultural growth scenario is combined with initial catch up growth, poverty declines to 31.3 per cent in 2015, the lowest level among all the different scenarios considered. In absolute numbers, this still leaves 12.5 million people in poverty or only about 2 million less than in 1997.

41 This scenario corresponds closely to the base case scenario considered by the IMF (2003) assuming that the economy continues to grow at 4.6 percent after 2008. 42 Following these projections, 47 per cent of the Kenyan population would live in urban areas by 2015 compared with 30 percent in 1997. 43 Important factors which could further accelerate the transformation of the occupational structure out of agriculture into non-agriculture even in rural areas are education and the proximity to market centers.

33 Scenarios Growth rates Projected Poverty Head Projected Gini fnercen t) Count (percent) coefficient Agri- Industry Services GDP 2005 2010 2015 2015 culture

Average sectoral growth 1990-01 1.11 1.73 2.71 2.12 56.4 56.4 55.6 0.44

(2a) best 3-year growth period during 4.1 1 2.95 4.64 4.19 51.1 44.5 37.4 0.43 1990s (average 1994-96) corresponding to long term growth potential of2 percent per capita' (2b) doubling 1990-2001 sectoral 2.20 3.50 5.40 4.22 52.5 48.0 43.7 0.47 growth patterns corresponding to long term growth potential of 2 percent per capita' (2c) as 2a but with 3.3 percentlcap 5.49 3.94 6.20 5.60 47.9 40.6 34.1 0.43 growth during first 5 years after 4.11 2.95 4.64 4.19 2001(reflecting catch up growth) (2d) as 2b but with 3.3 percentlcap 2.91 4.63 7.15 5.60 49.9 45.4 40.8 0.47 growth during first 5 years after 2001 2.20 3.50 5.40 4.22 (reflecting catch up growth) Scenario 3: Frontier growth with labor mobility (3a) as (2a) but with sectoral 4.11 2.95 4.64 4.19 50.1 42.6 34.8 0.41 employment shifts following urbanization while keeping locational sectoral employment shares constant3 (3b) as (2b) but with sectoral 2.20 3.50 5.40 4.22 51.3 45.3 38.6 0.43 employment shifts following urbanization while keeping locational sectoral employment shares constant (3c) as (2c) with sectoral employment 5.49 3.94 6.20 5.60 46.9 38.4 31.3 0.41 shifts following urbanization while 4.11 2.95 4.64 4.19 keeping locational sectoral employment shares constant (3d) as (2d) with sectoral employment 2.91 4.63 7.15 5.60 48.7 42.0 35.2 0.43 shifts following urbanization while 2.20 3.50 5.40 4.22 keeping locational sectoral employment shares constant 1/ All scenarios use the 1997 income distribution derived from the welfare monitoring survey as baseline; they use actual sectoral and population growth rates (World Bank data) until 2001 and the different growth scenarios thereafter. Quinquennial national population growth projections as well as projected urbanization rates are obtained from the UN Population Division. Population growth between 200045 is projected at 2.3 percent, between 2006-2010 at 1.83 percent and between 2011-2015 at 1.6 percent. 2/ The sectoral GDP decomposition in the (a) and (c) scenarios are based on the 1994-96 average (agriculture: 31.29 percent, industry: 16.59 percent, services: 52.11 percent) while the (b) and (d) scenarios use the 1997 sectoral GDP composition (agriculture: 27.35 percent, industry: 15.47 percent, services: 57.18 percent). 3/ Following projected urbanization rates and keeping sectoral employment shares in rural and urban areas constant, employment in the agricultural, industrial and service sector is projected to grow at 0.95 percent, 3.54 percent and 3.48 percent respectively between 2000 and 2005, at 0.45 percent, 2.93 percent, and 2.88 percent between 2006 and 2010 and at 0.27 percent, 2.55 percent, and 2.51 percent between 201 1 and 2015. Source; World Bank staff calculations.

34 2.29 The Millennium Development Goal of cutting in half the proportion of the population living in poverty by 2015 is not likely to be attained. Clearly, even in the best-case scenario (3c), the goal of cutting the proportion of Kenyans living in poverty to 24.4 percent of the population will not be attained. Even then-with the Kenyan economy sustaining its high agricultural, catch up growth path of 3.3 per cent per capita with labor mobility up to 2015- headcount poverty will remain significantly above the target (31 percent versus 24 percent-a shortfall of 7 percentage points, figure 2.4).

2.30 Broad-based growth of agriculture is critical to substantially reduce poverty. The poverty reducing potential of economic growth will critically depend on the nature of the growth path followed. Figure 2.3: Poverty Reduction and Growth in Kenya: Future Scenarios Without concerted GDP Growth Scenarios and Poverty Reduction efforts to Poverty projection based on growth frontier: 60 no sectoral labor mobility and low and high agricultural growth patterns foster \\ agricultural 55 growth,

poverty levels 50 will remain h T unacceptably > 45 high during u the coming p 40 decades with 2 the number of g 35 b poor people in a 2015 roughly 30 the same as in 25 1997. In 2015 poverty target = 24.4 %

considering 20 the nature of 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 growth, it must also be Source: World Bank staff estimates. emphasized that to filly capture the poverty reducing effect of strong agricultural growth, this growth must be broad based and must include the vast majority of smallholders and subsistence farmers.

D. SUMMARY AND RECOMMENDATIONS

2.31 This chapter has reviewed the 1997 poverty estimates, discussed poverty trends in the 1990s and presented some preliminary findings on the determinants of poverty and on inequality. But obtaining a more accurate and robust poverty benchmark will require developing a new household survey, as well deeper analyses of the collected living standards data. The following are recommended:

0 Review methodologies used to derive the poverty line. The Central Bureau of Statistics needs to review its own methodologies in estimating household well-being and in deriving the poverty line.

0 Identify an appropriate poverty line through wide consultation with Kenyan stakeholders. A wider debate on the meaning and measurement of poverty in the

35 context of the social and economic conditions of Kenya is needed. The analysis and identification of appropriate poverty lines should be broadened to include researchers, policymakers, and the civil society at large. Such consultations should go beyond purely technical issues, but deal with how poverty is viewed in Kenya’s social context. Future surveys should be tailored to enable researchers to test how closely subjective poverty lines (based on consumption adequacy as perceived by respondents) accord with objective poverty lines, such as those derived above (see Pradham and Ravallion, 2000). Undertake a new household survey using an improved survey instrument as soon as possible. The Central Bureau of Statistics needs to review its choice of household survey instrument, and then to undertake a new households survey as soon as possible using an improved design. The last survey was undertaken in 1997, six years ago. New information is needed for the poverty baseline against which the success of future programs will be measured. 2.32 The chapter has also estimated different growth scenarios. Given current conditions, the growth potential in Kenya is significantly better than the performance during the 1990s. Cross- country evidence suggest that Kenyan per capita GDP should grow over the long-run at around 2 per cent per year. The key recommendations of this assessment ofKenya’s growth prospects are:

Address Kenya’s burden of disease and high mortality. The burden of disease and mortality are major impediments to accelerating growth. The recent increase in Kenyan mortality reduces economic growth by 0.7 of a percentage point, and this can be considered as an approximate measure of the cost of the HIV/AIDS epidemic and the persistent burden of malaria. Dealing with disease, and especially HIV/AIDS, is not only a priority in its own right, but is also important to stimulate pro-poor growth and to reduce poverty. Intensify efforts to encourage girls to attend and stay in school, especially at the secondary level. Gender inequality in schooling is adversely affecting economic growth. Getting and keeping girls in school is not only an end in itself, but raises the growth potential of the economy. And it is an essential element of the demographic transition, encouraging higher labor force participation of women, lower fertility, and lower age dependency. Continue efforts to improve economic policies and governance. Past fiscal policy stances have constrained growth. Growth will be enhanced if public sector reforms reduce the size of the wage bill (thus lowering government consumption), and redirect public spending towards capital investments and essential public services that reduce poverty. Key institutions (affecting for example law and order) have deteriorated in recent years, which has reduced Kenya’s growth, and unless reversed will continue to slow growth below the estimate of 2 percent per capita per year.

36 3. AGRICULTURE

3.1 After two decades of sustained growth, the agriculture sector in Kenya performed poorly during the 1990s. This chapter discusses the reasons for the poor performance and suggests reforms to promote broad-based agricultural growth. It is divided into three parts. Section A describes the main features, trends, and policies characterizing the agriculture sector. Section B reviews the performance and policies in the important crop and livestock subsectors and provides specific recommendations. Section C provides conclusions and recommendations. The chapter is selective in its coverage of issues because this is an initial review, which will need to be followed by a more intensive assessment of the agricultural sector and the rural economy. Thus, issues related to credit, research and extension, and input supply are discussed only briefly. Forestry and fisheries, land and water management, and issues related to environmental sustainability are not covered in this report and will be the subjects of future work. The selective focus of this chapter does not intend to suggest that the topics that have been given limited coverage are not important.

A. OVERVIEW, STRUCTURE AND PERFORMANCE OF THE AGRICULTURE SECTOR

3.2 Kenya is still a rural society with an estimated 67 percent of the population living in rural areas.44 However, rural livelihoods are changing and more than half of the incomes of people living in rural areas now comes from nonfarm activities. Thus, many small farmers have transitioned to part-time farming with multiple sources of incomes. Agriculture accounts for about 25 percent of total GDP, 60 percent of total employment, and 75 percent of merchandise exports. Approximately 40 percent of agricultural GDP derives from livestock, 30 percent from food crops, and 30 percent from export crops. More than 80 percent of the poor live in rural areas, and the poorest are subsistence farmers and pastoralists. Female-headed households are almost twice as likely to be subsistence farmers as male-headed households and are more likely to be poor (Geda de Jong, Mwabu, Kimenyi, 2001).

3.3 Smallholder farmers account for 70 percent of marketed agricultural production, with the share in specific subsectors and crops varying greatly (smallholders produce 60 percent of tea, 15 percent of marketed maize, and 50 percent of coffee).45 Smallholders produce most dairy products, with subsistence farmers producing about 15 percent of the Large farms account for 30 percent of marketed agricultural production and typically have higher input use, better management, and higher crop yields than small farms. Yields of smallholder tea farmers, for example, are about two-thirds of estate yields, and yields of smallholder coffee farmers during 1990-98 averaged about one-half those of estates (Nyangito, 2001). The average land holdings for small and large farms are 1.2 and 700 hectares respectively. About 25 percent of all farms are between 20 and 50 hectares (Central Bureau of Statistics, 2001).

44 World Bank, World development indicators database. 45 Smallholders are defined as having between 0.2 and 12 hectares of land by the Central Bureau of Statistics (2001). Large farms average around 700 hectares. 46 Based on discussions with staff of livestock department, Ministry ofAgriculture.

37 3.4 Smallholder farmers are predominantly women who face even more severe constraints than male farmers. Because men are increasingly migrating from rural areas in search of work, women are assuming many of the responsibilities previously handled by men in tending livestock and crops. Women provide 75 percent of the labor for small-scale agriculture. Despite their roles in agriculture, they have limited access to credit from formal channels. The gender imbalance in agricultural land ownership can be directly attributed to Kenya’s law of succession, which indicates that, when there is no will (the most common case), agricultural land is to be distributed according to the customary or religious laws of the deceased land owner. The traditional customary law, which provides for land to be passed on through the male lineage, implies that women do not have the right to inherit land.47

3.5 Kenya’s growth of agricultural value added of 1.3 percent per year during 1990-2000 was well below the growth of more than 4 percent per year achieved during the 1980s. It was also below the agricultural growth rates of neighboring Tanzania and Uganda and of selected Asian comparators (table 3.1). Kenya’s export growth was better at 4.0 percent per year in current U.S. dollars, but it was still below the average of nearby neighbors and Asian comparators. Rapid population growth has cut the amount of arable land per capita by almost half during the past 20 years. Nonetheless, Kenya has similar levels of arable land per person as do many other countries. The decline in available land per person has been partially offset by increased intensification of production, with both the number of tractors and fertilizer use per hectare more than doubling during the past 20 years. Fertilizer use (a very broad indicator of productivity) is less than one-third that in India, one-quarter that in Indonesia, and roughly one- tenth that in China or Vietnam. Value added per agricultural worker was about on par with neighboring countries but well below that of most Asian comparators. On balance, Kenya’s agricultural endowments and input usage are equal to or better than those of Tanzania or Uganda, but well below those of Asian countries considered-especially with respect to the share of irrigated land, fertilizer usage, and tractors per hectare. Kenya is also more dependent on rainfed agriculture than most of the comparator countries, and this contributed to reduced output during the 1990s when weather was highly variable.

47 See the forthcoming World Bank, “Kenya Strategic Country Gender Assessment.”

38 Table 3-1: Performance of Agriculture: Kenya Compared to Other Countries Kenya Tanzania Uganda China India Indonesia Vietnam Growth of agricultural value added, average 1.3 3.2 3.7 4.1 3 .O 2.1 4.8 annual percent, 1990-2000 Agriculture productivity, value added per worker 225 189 353 321 397 736 240 1998-2000 in 1995 US$ Growth ofagricultural exports, average percent 4.0 6.2 3.1 1.6 5.7 5.0 12.8 1989-91 to 1999-2001 Per capita gross national income 2000 US$ 350 270 300 840 450 570 390 Rural share of population, percent 2000 67 72 86 68 72 59 76 Arable land as percent of land area, 1999 7.0 4.2 25.7 13.3 54.4 9.9 17.7 Arable land per capita, hectares 1997-99 .14 .12 .24 .10 .17 .09 .07 Irrigated land as percent ofcropland 1997-99 1.5 3.3 0.1 39.0 33.6 15.5 41.3 Fertilizer use, hundred grams per hectare of 346 81 6 2,911 1,058 1,415 3,179 arable land 1997-99 Tractors per 100 square kilometers of arable 36 20 9 60 92 39 218 land, 1997-99

Source: World Bank, 2003a

990s and then weakened‘Om 996 to 998, Figure 3.1: Agriculture Domestic Terms of Trade but ended the decade higher than in 1990. Profitability in the agriculture sector declined significantly because the domestic terms of lZo I trade deteriorated as input prices rose (figure 110 - 3.1).48 Seed and fertilizer prices rose 80 100 -\ percent from 1997 to 2001, fuel prices rose 50 percent, and animal feed prices rose 40 1 V 3c 80 - percent (Central Bureau of Statistics, 2002). - \ 70 - The causes of the increases are not clearly understood in light of low inflation and stable 60 _I 1980 1985 1990 1995 2000 exchange rates. International fertilizer prices source Centra, Bureauof Stat,~,cs fell during this period, with U.S. dollar

3.7 Productivity declined due to a combination of exogenous and policy factors. The productivity of both land and labor in agriculture increased until about 1990 and has declined ever since (Gerdin, 2002). As already discussed in chapter 1, total factor productivity growth for the overall economy was negative during the 1990s and consistent with trends in agricultural productivity (Ndulu and O’Connell, 2000). Several reasons explain the poor performance of agriculture and the decline of land and labor productivity:

48 Calculated as the agricultural output index divided by the weighted average index ofprices paid.

39 Exogenous factors: Poor weather and declining world commodity Figure 3.2: Rainfall Variability, Ag GDP and GDP prices. Droughts and floods were particularly important negative factors during the 1990s, since 60 rainfall variabili 10 much of Kenya’s agriculture is 40 6 20 rainfed (figure 3.2). Other 6 0 negative factors included the 4 decline in global commodity -28 2 prices, particularly of coffee. -40 -60 0 Declining fertility of land and poor -80 -2 management of water resources. -4 High and rising population density Source Government ofKenva. has contributed to rapid soil nutrient depletion and declining yields, which is leading to environmental degradation. In addition, poor management of water resources has affected irrigation development. While the legal framework is adequate, monitoring and protection of water catchments areas has been negle~ted.~’ Reduced use of hybrid maize. The private maize seed industry in Kenya has been slow to develop, despite liberalization, because the government still has a strong role in the industry and has almost exclusive rights to breeder seeds through the Kenya Seed Company. The favored treatment of the Kenya Seed Company has discouraged the private sector from actively participating in seed production, which has contributed to lower seed quality and use. Other problems such as fraudulent labeling further undermine the use of hybrid seeds. Poor access to credit. In the past, the government provided subsidized credit to farmers through the Agricultural Finance Corporation and the Co-operative Bank. By 1995 the Agricultural Finance Corporation had collapsed due to poor loan repayments. The Co- operative Bank provided credit mainly to farmers producing cash crops, particularly coffee. A number of microfinance institutions are operating and new initiatives are underway, but they reach only a small proportion of smallholder farmers. Credit is not generally available to smallholder farmers through commercial channels, and when available, real interest rates are high. Declining health status of the population. This has been made worse, in recent years, by the HIV/AIDS pandemic, which has contributed to the decline in labor productivity. Poor in>astructure, particularly the rural road network. The resulting high transport costs reduce the competitiveness of bulky products and increase the cost of access to inputs and markets. Electricity in rural areas is expensive and often not available, which has reduced investments in cold storage facilities, irrigation, and processing. Lack of a coherent land policy, covering land use and administration, land tenure, and land delivery systems.

49 See the Environmental Management and Coordination Act (1999) and the 1999 sessional paper number 1 on national policy on water resource management and development.

40 Reduced effectiveness of extension services. The effectiveness of extension services declined throughout the 1990s due both to the ineffectiveness of the travel and visit extension model pursued and to reductions in the operational budgets of the Ministry of Agriculture (World Bank, 2000).

Public expenditure and policy framework

and provided strong extension support. But, such high support was not Figure 3.3: Agriculture Share of Government sustainable, and the share of Expenditure government budget expenditures

allocated to agriculture declined from 12 about 11 percent in the mid-1980s to 10

less than 4 percent in the late 1990s 8 (figure 3.3). Services such as livestock vaccination, disease control, and E6 4 artificial inseminations, which had been 2 provided to farmers for low or no fees, 0 were curtailed. The private sector has 1886187 1989iSJ 18W95 1995486 19WSS begun to provide services, but the Source: Ministry of Agriculture and Rural Development.

3.9 Although the government took substantial steps to liberalize agriculture and the economy during the 1990s, poor sequencing of and partial reforms often hampered efforts. Policy reforms since 1986 include liberalization of marketing and removal of price controls, deregulation of markets, and reduction in public pend ding.^' A number of subsectors such as cereals, seeds, fertilizers, and animal feed were commercialized or privatized. However, some of these reforms were ill-sequenced and poorly implemented. The curtailment of certain government services, such as livestock disease prevention and control, led to the resurgence of problems that had previously been contained. As discussed in the following section, prices of maize and sugar (basic food staples that account for a combined 47 percent oftotal calories in the average Kenyan diet) have been kept above world market levels through border measures and the reentry of the National Cereals and Produce Board as a purchaser of maize. Of the spending allocated to extension services, a large share went to central level administration, while funds for extension field offices were insufficient to meet their most basic operational needs. Research has not focused on smallholder production. Certain subsectors, such as coffee, continue to be plagued by inefficient and sometimes corrupt management of cooperatives, delayed payments to producers, and excessive marketing costs.

B. SECTORAL PERSPECTIVES

3.10 This section examines the most important crops and livestock in each of the main subsectors (see table 111.7.2 in annex 111). Some crops and livestock, such as rice, wheat, and poultry were not covered because oftime constraints. They will be priorities in follow up work.

50 See the sessional paper number 1 of 1986 on economic management for renewed growth.

41 Among export crops, tea, coffee, and horticulture are examined. Tea production and export earnings continued to rise during the 1990~~while coffee production and export receipts declined dramatically. The poor performance of coffee was due partly to declines in world market prices, but more to the institutional arrangements governing the marketing of coffee, including poor management of the cooperatives. Horticultural exports did well and owe their success to a dynamic private sector that has innovated to stay competitive in the international market. Among important food crops, the analysis focuses on maize and sugar because they are importance in the diets (and household expenditures) of poor Kenyans and in production and marketing, and because they present important policy issues. The government remains more heavily involved in food crops than in most other agricultural subsectors, with maize and sugar producers protected from cheaper imports. Livestock production is the largest subsector of agriculture, with both cattle and dairy being important. Dairy farmers have successfully adjusted to the liberalization reforms, while beef cattle producers have problems with disease control, marketing, and exporting. Poultry production is growing, but it is still relatively small. Specific recommendations are included with the analysis of each crop or livestock, and this is followed with a conclusion and overall recommendations in section C.

Export crops

3.11 Coffee and tea are Kenya’s largest export earners, accounting for an average of US$580 million per year during 1990-2001 and 47 percent of total merchandise export^.'^ Coffee plantations also employ about 60,000 workers and tea plantations employ about 80,000 workers (Central Bureau of Statistics, 200 1). In addition, about 250,000 smallholder coffee growers and 360,000 smallholder tea growers earn cash incomes from the crops, in addition to a number of estate growers of both coffee and tea. continuing on a rising trend, while coffee export earnings have declined Figure 3.4: Coffee and Tea Exports sharply (figure 3.4). Coffee 600 __ __- -- ____ - - - - __ - production declined from a peak of - I

128,700 tons in fiscal 1988 to 51,700 500 - tons in fiscal 2002, while tea 400 production reached 294,000 tons in 5 300 1- ----\ fiscal 2002-nearly double the level 3 */- \ 200 3\ of fiscal 1988. Production of \./’ -. x. 100 - smallholders fell more rapidly than I that of estates, and it now accounts for 07 I 1990 19% 2000 less than half of total production, 1- Coffee -Tes I compared to 60 percent a few years Source: UN Comtrade ago. Output of smallholder tea

51 UN Comtrade data.

42 3.13 The difference in performance was partly due to international price movements. j or exporter, increased exports by Figure 3.5: International Coffee and Tea Prices Brazil following its currency

(figure 3.5). However, this price L decline was preceded by a sharp -

which provided large returns to I990 1995 20w coffee growers. By contrast, tea 1-Coffee (Arabica) - Tea (Avg 3 Auction) 1 prices remained relatively stable. Souwe WMd Bank

3.14 The coffee sector underwent reforms in 1993, which liberalized foreign exchange regulations, processing, milling, and brokering. Growers were then free to appoint their own pulping stations, millers, and marketing agents, but they were not permitted to sell cherry or parchment coffee except through a central auction and authorized marketing agent. A cooperative society was considered an agent in charge of issuing credit to growers, making advance and final payments for cherries and parchment, and providing management, inputs, and other services. The reforms led to new problems that now require attention. A new Coffee Act was approved in 2002, but the changes were not sufficient to correct important organization and incentive problems in the sector. Prior to reforms, the Coffee Board of Kenya had control over all the organizations involved in the delivery of services, including production inputs, extension, coffee pulping, storage, transportation, milling, marketing, and payments to farmers. After reforms the Coffee Board of Kenya continued to be responsible for regulatory and marketing functions, but not for delivering services, which became the responsibility of primary societies and cooperatives. Smallholder farmers are licensed to grow coffee under their cooperative societies. The farmers grow and deliver the ripened fresh coffee cherry or dried coffee berries (mbuni) to the coffee factory owned by the cooperative societies ofwhich they are members. The coffee is processed into parchment, stored, and then transported to the cooperative societies for delivery for milling and sale at the auction. The proceeds from coffee sales are used to pay cooperative staff operating the coffee factories, and for services such as bookkeeping, credit, and supervision provided by the parent society. The cooperatives pay the farmers for their coffee after deducting costs for processing and marketing from the sales proceeds.

3.15 Operating costs of coffee factories increased uncontrollably after reforms (figure 3.6). Smallholder coffee farmer’s share of Figure 3.6: Coffee Factory Operating sales proceeds fell to 30 percent from about Costs (Real) Murang’s District 70 percent that they had been receiving before the reforms (and compared with 70 percent of sales proceeds received by 30,0001 1 Coffee Melket Liberalized In smallholder tea growers). A survey of 12 25,CCU factories in the main coffee growing area 20,000 near Mount Kenya showed that real !j 15000 E operating costs increased by an average of 1 low0 2 68 percent per year from fiscal 1991 to fiscal 5 000

1997 (Nyangito, 2000) (figure 3.6). This 0 was attributed primarily to mismanagement 1990/91 1991/92 1992193 1993194 1994/95 1995/96 1996/97 Source: KIPPRA,

43 and deducting ofexpenses unrelated to coffee processing and marketing.

3.16 The success of the tea industry has been attributed to the supportive role of two institutions. The first, is the Tea Board of Kenya, which has followed a noninterference policy for estates, and the second is the Kenya Tea Development Agency (KTDA) (Nyangito, 2001). The smallholder tea subsector is under the supervision ofthe KTDA, which was converted from a government parastatal to a farmer-owned corporation in June 2000. The KTDA manages the 5 1 smallholder tea factories and the input supply and green leaf collection from smallholder growers cultivating an average of less than 1.0 hectares each. The KTDA receives 3 percent of the total proceeds from smallholder tea sales as a management contract. Producers may sell their tea either through the auction at Mombasa or directly to buyers. The KTDA provide inputs such as fertilizer to the smallholders, and deducts their value from the monthly green leaf payments. Variable costs are about 30 percent of the value of gross outputs, and fertilizer costs comprise almost half of variable costs. Smallholder farmers are given payment for a proportion of the estimated value oftheir green leaf each month that they deliver tea to the factory, and the balance in two payments after the factory has sold the tea and deducted its costs. A small amount of smallholder green leaf is sold to traders who then sell to estate factories. This most often occurs when the KTDA is unable to collect green leaf because of factory or transportation problems. A survey oftea farmers and factories in five districts in 1998 found that farmers received nearly 70 percent of gross sales. Factory expenses were about 23 percent, selling and distribution costs were 4 percent, and agricultural services and taxes were 2 percent (Nyangito and Kimura, 1999).

3.17 The solution to the coffee crisis is to gain control of processing and marketing costs and to increase the producer’s share of sale proceeds. This will require professional management of processing and marketing of smallholder coffee, as is done with smallholder tea. Coffee estate operating costs processing and marketing costs are nearly the same 30 percent share of coffee sale proceeds as is the case for tea. Thus, smallholder coffee producers should be able to receive about 70 percent ofcoffee sale proceeds, if processing and marketing costs are properly managed. This would more than double incentives to farmers. The current system of coffee processing and marketing through more than 460 coffee societies and unions has led to mismanagement and abuse of responsibility. A more rigid contractual arrangement is needed, which engages the societies and unions in coffee processing but does not grant them financial management of coffee proceeds. The poverty implications of reforms to coffee processing and marketing are substantial because ofthe large number of smallholders and wage employees who depend on coffee production.

3.18 Other changes are also needed if coffee is to reach its potential. The Coffee Act approved in 2002 did not provide the same marketing flexibility to coffee producers as did the Tea Act to tea producers. Coffee producers are required to sell all coffee through the auction, while tea producers are free to sell either through the auction or privately. Allowing coffee producers the same freedom would permit some to develop marketing arrangements that would increase their overall earnings and reduce year-to-year variability in prices by permitting them to enter into long-term contracts with buyers. It would also permit the financing of inputs by international buyers who are currently discouraged from such financing because they are not assured that they will acquire the coffee at auction after having contributed to its production costs. Additional measures are likely to be needed to finance inputs for smallholders who are unable to get credit from commercial sources. A professionally managed and audited corporation could provide this service for smallholder coffee similar to that provided by the KTDA. The cost of professional management would probably be similar to the 3 percent of tea sales that is paid to the KTDA.

44 Recommendations

Create a management company along the lines of the KTDA to manage smallholder coffee processing, marketing, input supply, and extension. Require an annual independent audit by an accredited accounting firm. Recruit an internationally recognized expert to manage the corporation and negotiate the necessary agreements with societies, unions, and input suppliers, as well as oversee the prompt payment of growers for their coffee. Update the register of producers and implement necessary procedures to prevent side-selling by farmers who are attempting to avoid repaying input loans. Amend the Coffee Act to allow the management company to operate as the agent for smallholders, and to allow producers to sell coffee outside the auction if they wish. Allowing sellers to market their output through alternative channels will also enable them to link directly with buyers of specialty coffees, who pay premium prices. Make research more demand driven and effective. The most recent release of a new coffee variety, Ruiru 11, was in 1986.

Horticulture

Africa (figure 3.7). Starting with basic Figure 3.7: Horticultural Exports advantages-a favorable climate and a relatively skilled labor force-the industry managed to attract substantial Y 25 r foreign investment, foreign technology w 20 - / and expertise and to integrate them well - $15- A with local skills. The industry is entirely 6 10- dominated by the private sector, with the I government playing only a facilitating P .- - role. Over the years, Kenyan growers and 5 exporters have managed to keep pace 0. 1990 1992 1994 1996 1998 2000 with market trends and changing Souroe Economr Surv.ry technologies. Some segments of the

3.20 In 2001, horticultural exports reached 23.6 billion Ksh (US$300 million), with cut flowers accounting for over half of the total, fresh Table 3-2: Horticultural Exports, 2001 vegetables accounting for 35 percent, and fruits Billion Ksh Share (YO) accounting for almost 11 percent (table 3.2). Real Cut flowers 12.7 53.8 exports increased 63 percent in 2001 due to value Vegetables 8.4 35.6 additions from improved packaging of vegetables Fruits 2.5 10.6 Total 23.6 100 into ready-to-eat portions, coupled with higher Source: Central Bureau of Statistics, 2002. values for cut flowers from direct marketing rather

45 than auction sales. The horticultural sector faces stiff competition from other African exporters, especially from COMESA countries. Continued success depends on producers being sensitive to market demand and being able to adjust quickly to changing trends.

Recommendations

0 The government should continue to play a facilitating role, focusing on improving laws and regulations for foreign direct investment, lowering operating costs (such as power), and improving infrastructure for the sector. However, private initiative must continue driving the industry to ensure continuous growth.

Food crops

3.21 Maize is the basic food staple in the diet of Kenyans, accounting for 36 percent of total calories. For people living at the poverty line, maize accounts for 58 percent of calories and 28 percent of food expenditures. 52 53 Almost all rural households grow maize for consumption, and more than half are also net buyers of maize. Among the lowest income quintile of rural households, more than 80 percent are net maize buyers. Among urban households, virtually all are net buyers of maize according to a 1995 survey of Nairobi consumers. Maize is politically sensitive because of its importance to the poor, and because it is an important cash crop for large farm holders. More than 83 percent of marketed maize is sold by the largest 10 percent of farms (Jayne and others, 2000). Thus, the government, faced with a policy dilemma of keeping maize prices low to benefit the poor or supporting prices to benefit large maize farmers, has often chosen the latter course.

3.22 Maize production has been stagnant since the mid-1980s and imports have been increasing. An estimated 3.5 million smallholders produce about 75 percent of Kenya’s maize, and about 1,000 large farms who produce the remaining 25 percent. Large and small maize farmers are about equally productive and adopt hybrid maize and fertilizer in equal proportions (Karanja, Jayne, and Strasberg, 1998). Increasing maize productivity would reduce maize prices, improve household food security, and free resources to produce other more profitable crops for the rapidly growing urban population. Higher productivity will require more intensive production, development and adoption of improved hybrid seeds, higher fertilizer use, and expanded irrigation in favorable areas. Other factors which contribute to maize productivity in Kenya include proximity to roads, education, extension, and the presence of a male in the household. Karanja, Jayne, and Strasberg (1998) found that high interzonal productivity differences exist, which suggests the potential for overall productivity growth is considerable.

3.23 Maize marketing was liberalized beginning in 1988 and by December 1993 it was fully liberalized. That policy change was intended to allow maize to be imported freely, subject to tariffs, and to permit the free movement of maize within Kenya (Ministry of Agriculture and Rural Development, 2000). The National Cereals and Produce Board, which had been the monopoly buyer of maize, was fully commercialized, its staff downsized, and its activities

52 Wheat is the second food staple after maize. Wheat is particularly consumed in urban areas. The annual production meets some 50 percent of local demand. Rice is also consumed, and is produced in six main irrigated areas, mostly under the control ofthe National Irrigation Board. 53 Ministry of Finance and Planning, 2000.

46 undertaken only on a commercial basis. Between 1994 and 1999, the marketing and pricing of maize was increasingly done by the private sector as they were allowed to have a greater role in maize transport, storage, and processing. Real maize prices declined by 25 percent in the 1995- 99 period compared with the 1985-93 period, and maize became more readily available in retail markets (Jayne and others, 2000). However, the reform process was controversial and doubts about the effects on farmers and consumers probably contributed to the government's decision in 1999 to bring back the state-run National Cereals and Produce Board to manage the government's strategic reserve of maize on a commercial basis.54 Import tariffs, border restrictions on maize shipments, and occasional import bans have been used to support prices at higher than world market levels despite the negative impact on the poor (Jayne and others, 2000; and Institute of Economic Affairs, 2001).

3.24 Maize prices in Kenya remain higher than in neighboring countries. Wholesale maize prices in Nairobi averaged 33 percent higher than in neighboring capital cities during January 1996 to July 2000 (figure 3.8). Producer prices in the major maize growing areas were also well above those in neighboring Figure 3.8: Maize Prices in Capital City countries-44 percent higher than Ethiopia, 47 percent higher than in Zambia, and 48 percent higher than in South Africa. Imports from 250 7 COMESA countries face a 3 percent duty while imports from non-COMESA countries face a 30 percent duty. However, trucked imports are sometimes prevented from neighboring Uganda and Tanzania. The margin between international maize prices and Kenyan prices Kenya Elhiopia Zmbm Zimbabwe Sovlh Africa Mozambique widened during the 1990s and remains large despite minimal import duties from COMESA countries. The poverty impact of high maize ~ prices is substantial because of the large share Source: Jayne and others, 2000. of maize in the food expenditures of the poor. More than half of the population in Kenya Is living below the poverty line. Yet, they pay roughly 33 percent more for their basic staple than people in neighboring countries.

3.25 Kenya, like many other countries in Africa, has struggled with providing food security for its population. Food security basically entails ensuring that adequate supplies of food are available in the market at reasonable prices, and that people have adequate means to acquire the food. Governments can create entitlements for the poor and for those who have suffered temporary income shocks due to adverse weather or other calamities. In Kenya, government policy to achieve household food security has been to encourage farmers to produce maize. Instead, farmers should be encouraged to produce whatever commodity is most profitable, and use their earnings to buy a variety of food products. However, because of the large number of smallholders who produce maize and its importance in the diet, it is also important to improve maize productivity and reduce average per unit production costs.

54 The government maintains a strategic maize reserve stock of up to 3 million 90 kilogram bags and a strategic fund of US$6 million.

47 Recommendations

0 Fully liberalize the maize market, allowing unrestricted imports from neighboring countries. This will reduce the cost of the basic food staple for all consumers, disproportionatelybenefiting the poor.

0 Liberalize the hybrid maize seed industry. This will encourage the development of private sector competition, which should lead to production and distribution of higher quality seeds. Proper labeling of hybrid maize seeds needs to be enforced.

0 Take action to raise maize productivity. Factors that determine maize productivity, such as hybrid seed quality and price, fertilizer quality and prices, and extension services should be examined to determine whether policy changes can be made to improve the quality or lower the prices of these factors of production.

Sugar

3.26 The sugar industry in Kenya is heavily protected by 100 percent duties on imports from non-COMESA countries, and by quotas on imports from COMESA countries. Some Figure 3.9: Sugar Prices in 2001 producers, millers, and traders make large profits from this protection, while consumers bear the burden by paying higher prices than necessary 50 (figure 3.9). The additional cost of sugar to y" 40 consumers in 2001 was approximately US$172 k 30 million-a little less than US$6 per person.55Sugar 3 20 is a basic staple in the diet, accounting for 11 10 percent of total calories. If the sector were fully 0 CIF Mombaaa Ex Factory Wholesale Retail liberalized, sugar prices would decline sharply, Source Kenya Sugar Board food expenditures on sugar would decline, and food poverty headcounts would diminish.

3.27 The sugar sector was developed with government assistance, and five of the seven sugar factories are government parastatals. Of the remaining two, the largest is the Mumias Sugar Company which is a share company, with nearly one-third owned by the government. It accounts for 60 percent of total Kenyan sugar production and has production costs that could make it competitive with imports. The sugar subsector has been partially liberalized since 1995, but the government still controls the industry through the Kenya Sugar Board, which is under the control of the Ministry of Agriculture. Approximately 29,000 individuals are employed by the sugar industry, and an additional 40,000 smallholders grow sugar cane on an outgrower basis.

3.28 A new Sugar Act became effective in April 2002, which created the Kenya Sugar Board to replace the previous Kenya Sugar Authority. The act continued the broad authority of the Sugar Board and the Minister of Agriculture to control all aspects of the sugar industry (production, manufacturing, marketing, imports, and exports of sugar, and its by-products). One provision, which likely assures compliance with the dictates of the Sugar Board, provides for

55 Computed as annual consumption of 600,000 tons multiplied by the price difference between sugar imports (cif Mombasa) and the ex-factory price (22.48 Ksh per kilogram). Assumes that transport costs from Mombasa to the main consuming areas are equal to the same as from the western producing areas.

48 annual renewal of licenses for all sugar and jaggery mills. Another provision that may discourage investors, stipulates that any privatized sugar mill must have at least 5 1 percent grower ownership and representation on the board of directors. The act authorizes the board to impose a sugar development levy on all domestically produced and imported sugar. The development levy, currently 7 percent, generates annual revenues of about US$19 million; it is under the control of the Sugar Board, and can be used to support research, develop the industry, rehabilitate factories, and other activities that the board specifies.

3.29 About one-third of the 600,000 tons of sugar consumed per year are imported, with sugar imports from countries of COMESA subject to a VAT of 18 percent and a development levy of 7 percent, and a duty of 100 percent on sugar imports above a quota of 200,000 metric tons per year. Imports from countries outside of COMESA face a 100 percent duty plus the 18 VAT and 7 percent development levy (Kenya Sugar Board, 2001). In 2001, imports from COMESA countries rose sharply and accounted for 40 percent of total imports. Subsequently, a temporary quota was negotiated with COMESA countries to limit imports. Letting imports grow would lead to a decline of domestic sugar prices to the level of import prices plus VAT and development levy. This would be politically difficult, as it would undermine high producer prices, which are set by negotiations between producers and management of sugar factories.56

3.30 Kenya lost its preferential Africa, Caribbean and Pacific sugar quota to the EU a number of years ago because it did not file the required documents to invoke the force majeure clause when it failed to meet its quota. The quota, which was granted under the Lomd Convention of 1975, allows certain African, Caribbean and Pacific countries to export sugar to the EU at the internal EU price, which is more than double the world market price. Kenya has been attempting to regain its quota for the past several years, and the EU has granted Kenya a temporary quota of 11,000 tons under its special preference program. The quota must be met by domestic production, but Kenya is free to import sugar to meet domestic demand. The approximate value of the quota is given by the EU quota price of US$0.25 per pound of sugar compared to the world market price of US$O.OS per pound (approximately US$4 million). The proceeds from the sales to the EU under the agreement are added to the sugar development funds under the direction of the Sugar Board.

3.3 1 The sugar subsector is rife with conflicts of interest that make reforms difficult. The government owns one-third of the largest sugar company and it profits from the high protection afforded the industry through high import duties. Five other sugar factories are government parastatals, which are under consideration for privatization, but they are unlikely to find buyers because of their poor condition and high operating costs. Producers receive high prices for their cane through negotiated agreements with sugar factories that are in most cases also parastatals. Without the protection of high prices, some factories would be unprofitable and either have to close or incur large losses. The Sugar Board (under the authority of the Ministry of Agriculture) currently controls the proceeds of the sugar development levy. While reforming the sugar sector would be politically difficult, not doing so means that consumers pay twice as much for their sugar as they would under a fully liberalized system.

56 The Council of Ministers of the COMESA has just granted a one-year extension to continue levying 100 per cent duty on sugar imports above the quota of 200,000 metric tons per year and 60 per cent duty on imported wheat flour. These measures are meant to protect the sugar and wheat growers and processors, whose performance in recent times has been affected by illegal imports.

49 Recommendations

0 Amend the Sugar Act to limit the Kenya Sugar Board to a regulatory role, rather than giving it overall responsibility for all aspects of industry operation, as is currently the case.

0 Reduce the development levy to levels comparable to the levies imposed on other crops for research and development (the development levy on coffee is currently 1 percent).

0 Liberalize the sector and privatize the factories. Part ofthe industry would still be able to compete in a liberalized environment after some restructuring. However, some sugar factories unable to compete would close and some sugar growers would need to produce other crops. This would entail some loss ofjobs to sugar factory workers and lower incomes to cane growers, but the costs would be much less than the current high costs of sugar to consumers.

Livestock

(figure 3.10). Disease control, dipping Figure 3.10: Live Animals and Meat Exports stations, and vaccination programs became community based, sometimes with the assistance of NGOs, however 20 - their sustainability and coverage remains a 16 . h concern. Increased diseases and a lack of 1 confidence in the government's inspection $12 - and certification procedures reduced 8- livestock exports to the lucrative Middle f A East markets, thus depressing livestock 4- V prices in the local market. Gross 0, marketing of livestock and products has 1980 1985 19% 1995 2024 begun to recover, but remains below the - swmeFAos'AT

3.33 Beef cattle are trailed or trucked Figure 3.11: Livestock Gross Marketing to the main markets in Nairobi and other urban areas and slaughtered. The long inn ~ distances and poor grazing conditions encountered along the trail mean that trailed animals arrive in poor conditions and receive low prices. Regulations against livestock movement to prevent movement of stolen animals combined 40 with the numerous tolls make the d 20 movement ofcattle expensive. Inadequate 1980 1985 1990 1995 2000 slaughtering facilities is another factor source cant6 BYISPY of StmbstIm

50 keeping supplies of meat in the major markets low and prices high, while cattle prices in producing areas remain low.

3.34 The cattle rearing areas in the arid and semiarid regions of Kenya have high rates of poverty and have been among the hardest hit by the withdrawal of government services. The collapse ofthe parastatal Kenya Meat Corporation meant the loss of processed meat exports and this contributed to a surplus ofcattle being sold in the domestic market. Financial arrears and declining demand for processed meat make it unlikely that the meat processing facility will reopen. However, live animal are preferred by importers, and a consortium of livestock exporters and foreign importers are working to improve disease control and certification, and are planning quarantine areas, with the intention ofresuming regular livestock exports.

3.35 The sharp reduction in government services to the livestock sector following liberalization of marketing in the early 1990s caused an initial increase in livestock disease and reduction in output and quality. However, the private sector and NGOs are now providing many of these services, and the government no longer needs to provide routine disease control and veterinary services. Also, it has not done an adequate job of inspection and certification of disease-free animals for export, but the private sector is beginning to develop its own system.

Recommendations

Monitor disease outbreaks and develop systems to facilitate a coordinated response to prevent diseases from spreading. The government also has a responsibility to ensure that private sector veterinarians and service providers are certified and provide services in accordance with professional standards. Improve infrastructure to reduce the cost of livestock movement, marketing, and processing. The government can also assist by providing land to quarantine cattle prior to disease inspection and certification. Improve port facilities at Lamu in northern Kenya to lower costs of live animal exports and reduce the cost of feed imports for animals awaiting certification for export. Work to harmonize import standards among countries in the region. This would assist exports. Eliminate the numerous tolls on animal movements and permit the use of a single permit for cattle movement. This would substantially reduce marketing costs. Enforce laws against animal theft and, generally, improve security. This would reduce the risk oflivestock raising.

51 Dairy

capacity. The decline was due to Figure 3.12: Milk Prices competition from small-scale raw milk sellers, increased competition from private milk processors, and the poor record of payment by KCC, which often did not pay farmers for their milk for up to six months after delivery. KCC continues to operate in some milk deficit areas and converts surplus L 4~ 104 milk during peak production periods into kn I powder for later reconstitution. Real milk I z 5- prices rose immediately after marketing liberalization, but have since declined (figure 3.12). Now 80-85 percent of milk is sold in unprocessed form directly to consumers.

3.37 Smallholder dairy is an important driver of rural incomes and employment. Total milk production is estimated to be about 3 million tons per year from about 3 million dairy cows. Dairy accounts for about 15 percent of agricultural GDP. According to official government statistics, smallholders own 83 percent of all dairy cattle, with households holding an average of about 2.5 cattle. A recent survey of 8,000 rural households by the Smallholder Dairy Project-a joint research project of the Ministry of Agriculture and Livestock Development, Kenya Agricultural Research Institute, and the Intemational Livestock Research Institute-suggests that the number of dairy cattle and total milk production may be double the official estimate^.^' Smallholder dairy farmers earn twice as much income from milk production as from other agricultural activities or from rural labor, according to these surveys. Holding dairy cattle also provides additional benefits. Dairy cows provide insurance against emergencies, an inflation- proof store of savings, and they produce the manure that allows sustained multiple cropping on smallholdings, thereby contributing to food security on farms with cattle. The research shows that The research of the Smallholder Dairy Project also shows that 50 percent of dairy farmers in many areas hire full-time dairy workers, and that 60 percent hire some workers.

3.38 Consumers have benefited from lower prices and higher quality milk products since liberalization. Most consumers report preferring raw milk because it contains the butter-fat that is skimmed off during processing. Moreover, the price of raw milk is 25-50 percent lower than that of processed milk. Most raw milk is sold directly by the farmer to consumers and to restaurants. Small traders, some of whom are licensed and some of whom are not, handle 25-30 percent of milk sales. Most operate from fixed premises (milk bars), but some operate as small- scale mobile traders (including hawkers). The selling of milk is estimated to create two full time

57 The Smallholder Dairy Project conducts research and development work to support development of smallholder dairy production. Core finding for the project comes from the Department for Intemational Development of the United Kingdom.

52 jobs per 100 liters handled daily, at a monthly income of Ksh 5,000. This is higher than the minimum wage and about equal to monthly wages for low-skilled laborers. According to the surveys of the Smallholder Dairy Project, both licensed and unlicensed traders sell milk ofsimilar quality and bacteria counts. Since all urban and most rural households boil milk before consuming it, the public health risk from raw milk appears to be small. Since the selling of raw milk in urban areas is illegal, small traders often use cheap containers for transporting milk to reduce the loss should such containers be confiscated by the authorities. This often leads to the use of containers, such as fuel cans, which may contain substances that can contaminate milk.

3.39 Services to the dairy industry declined following the liberalization of marketing, as the government largely withdrew from provision of veterinary and artificial insemination services. The government provided free or heavily subsidized services from 1966 until the mid- 1980s, when budgetary constraints caused the government to reconsider its policies. Individuals and farmers’ groups are gradually starting to provide such services, but farmers have been slow to use them due to their high cost (Odhiambo and others, 2003). Local communities, which were supposed to operate communal dips after the government stopped providing the services, have been only partially successful in maintaining and operating the dips; more than half are no longer operating. East coast fever limits dairy production in some areas, as the government provides vaccination services only in the coast provinces where the disease is most common.

3.40 The main constraints to growth of the dairy sub-sector include poor roads, lack of adequate feed, lack of veterinary services, and outdated regulations that encourage unsafe handling practices by small traders. Contrary to reports in the press, imports of dairy products amount to less than 1 percent of dairy products sold in the country and do not currently pose a threat to producers. Rather, poor roads that limit the range over which milk can be profitability transported and which limit access to and raise the costs of veterinary and artificial insemination services, lack of adequate feed, and outdated regulations that encourage unsafe handling practices by small traders constrain the growth of the industry. Demand for milk is expected to grow rapidly due to rapid population growth and a high income elasticity of demand for milk (estimated to be 0.8 percent). Demand may grow more rapidly than supply unless the constraints on production and marketing are eased.

Recommendations

0 Support the smallholder dairy sector by legalizing the sale of raw milk in urban areas. This would reduce the incentives for milk sellers to use cheap unsanitary containers in order to avoid loss due to confiscation.

0 Improve rural infrastructure, especially rural roads in order to reduce transport and other costs.

c. SUMMARY AND RECOMMENDATIONS

3.41 The performance of agriculture during the 1990s suggests that market-driven and private sector-led growth can be the key to the recovery of agricultural growth. The commodities that grew the most rapidly in output and exports during the 1990s were those led by the private sector-smallholder tea, smallholder dairy, and horticulture. This growth occurred despite a very competitive international market (horticulture) and declining world market prices (tea), Many other crops-coffee, maize, sugar-had strong government or cooperative union

53 involvement and slow output growth. The coffee subsector was severely constrained by the rapidly increasing marketing and processing costs of cooperative unions and delayed payments to farmers. Maize and sugar producers were protected from international competition, but managed only modest output growth during the 1990s. Maize production stagnated because of reduced hybrid seed and fertilizer use. Sugar production expanded into marginal areas because of high cane prices supported by government, while global and regional price signals were indicating that the industry should contract to areas where the costs of producing are low. Lack of confidence in the government’s animal health certification procedures contributed to the decline in livestock exports.

3.42 Public spending in agriculture needs to be restructured. Large public expenditures on subsidized inputs and services during the 1980s have not provided a strong foundation for continued agricultural growth. The large share of the government’s budget expenditures directed to agriculture during the 1980s was not sustainable and did not raise the long-term output growth of the sector. Spending in agriculture was severely cut during the 1990s, and this certainly contributed to the decline of the sector. However, preliminary findings from the ongoing public expenditure review also point to severe problems of misallocation of resources within the Ministry of Agriculture. About three-quarters of public spending in agriculture is in fact absorbed by parastatals to perform functions that in many cases have been designated as noncore. Only around 50 percent of the requirements for extension services that were believed to be essential in the PRSP are provided. Thus, it appears that any request for increasing government expenditure-particularly in the context of PRSP priorities-must be associated with a restructuring of spending in agriculture and a revival of parastatal reforms.

3.43 Creating a favorable environment for the private sector and making specific subsector policy changes can increase broad-based agricultural growth. Smallholders are already benefiting from the reforms in the tea and dairy subsectors. Currently, the highest priority is reforming smallholder coffee marketing and processing so that farmers receive a larger share of final sales. Smallholder coffee farmers receive about 30 percent of export earnings while smallholder tea producers receive 70 percent, despite similar marketing and processing cost structures. A professionally managed authority should be established for coffee patterned after the KTDA to operate processing facilities, handle marketing, and provide inputs to farmers on credit. Coffee production and exports would likely double. Further growth could be expected as farmers improved husbandry, replaced aging trees, and increased use of fertilizers and chemicals.

3.44 Food security policies need to be reconsidered. The government maintains a maize buffer stock to be used in case of domestic crop failure and a financial reserve to purchase food from international or neighboring suppliers. However, the government’s policy of supporting maize and sugar prices-basic staples which account for 47 percent of total calories in the Kenyan diet-above those of neighboring countries reduces household food security by increasing the prices of basic staples. Maize prices were nearly one-third higher in Nairobi than in neighboring capital cities during 1996-2000 and sugar prices are double world market levels. Imports should be allowed to reduce food prices to benefit the poor. Farmers should be encouraged to produce the most profitable crop rather than being encouraged to produce maize for food self-sufficiency. Maize productivity should be increased through improved hybrid seeds, improved infrastructure (especially rural roads) and reduced costs of important purchased inputs such as fertilizer.

3.45 The livestock sector remains important for subsistence farmers and pastoralists. The subsector has the potential to grow and the government has a key role to play to make it

54 happen. Improving infrastructure to reduce the cost of livestock movement, marketing, and processing is important. Providing land to quarantine cattle prior to disease inspection and certification would also help. The government needs to monitor disease outbreaks and be able to coordinate a response to prevent diseases from spreading. It also has a responsibility to ensure that private sector veterinarians and service providers are certified and perform in accordance with professional practice. Improved port facilities at Lamu in northern Kenya would lower costs of live animal exports and reduce the cost of feed imports for animals awaiting certification for export. Efforts to help harmonize import standards among countries in the region, elimination of numerous tolls on animal movements, and the introduction ofa single permit for cattle movement would help promote marketing and help to raise prices to producers. Finally, enforcement of laws against animal theft would reduce the risk oflivestock raising.

3.46 In the long term, nonfarm employment is the path out of poverty for many of the rural poor. Arable land per capita has declined by nearly half over the past 20 years because of rapid population growth and subdivision of farms acquired through inheritance. Future growth will need to come from more intensive agricultural production, which depends on increased input use, improved crop varieties, and higher yields. More intensive agricultural production will need to come primarily from increased commercialization of agriculture among the medium and large- scale farmers who have the resources to expand production where incentives provide the justification. Smallholder and subsistence farmers will best be able to diversify and raise their incomes through off-farm employment. Substantial evidence shows that the relationship between increased employment in rural nonfarm activities and reduced rural poverty is strong (Lanjouw, 1998; Reardon and others, 1998, Collier and others, 1986). Increased off-farm earnings can also increase farm output by providing capital for purchased inputs. Research in Ghana and Uganda has shown that nonfarm activities are linked to falling poverty rates for both male and female- headed households, but the rate of decline is faster for female-headed households (World Bank, 2002~). The key to the developing a robust nonfarm sector is to increase agricultural production to generate incomes which are spent on consumer goods, inputs supplied to the agricultural sector, and processing of agricultural output. Because agriculture is the engine of growth in the rural nonfarm economy, the policies that promote agricultural growth also promote the rural nonfarm economy.

3.47 A more intensive and commercially oriented agricultural sector requires increased profitability, which will need to come from reduced input costs and higher yields. The profitability of agriculture deteriorated sharply in the late 1990s due to sharply higher input costs that appear unrelated to domestic inflation rates, exchange rate movements, or international commodity prices. Fertilizer prices, for example, rose 80 percent from 1997-2001 while international dollar fertilizer prices fell by roughly 20 percent. The reasons for these increases need to be fully understood, and if they are related to a lack of competition among input suppliers, as some suggest, then efforts need to be made to increase competition. Other input costs also need to be reduced to increase the profitability of the sector. This can be done by improving rural roads, which will reduce transport costs; taking action to bring down the costs of electricity, which will reduce irrigation and factory operating costs; reducing fuel taxes which will reduce transport costs; and improving communication systems, which will facilitate trade and closer monitoring of markets. While this report has not discussed in detail agriculture services and inputs (extension, research, credit) they are important. Improved research that is more responsive to producer demands is needed to develop new crop varieties that are higher yielding and more disease resistant. Livestock research to deal with diseases endemic to the area is also required. A stable macroeconomic environment and a fairly valued exchange rate are also essential to a more market oriented and intensive agriculture. The agricultural sector may not

55 return to the high growth rates of the 1970s and 1980s because most land in the high-potential areas is already under production. However, more rapid growth than occurred during the 1990s is possible with prudent policy reforms and investments to lift the long-term productivity of the sector and reduce input costs.

56 4. MANUFACTURING

4.1 While Kenya remains the most industrialized country in East Africa, the performance of its manufacturing sector in the 1990s has been characterized by stagnation in output and investment and by low capacity utilization. The recent spectacular recovery of the garment sector is an exception, and it is due to the significant quota and tariff advantages granted by the African Growth Opportunity Act (AGOA) of the United States. This chapter reviews the performance of the manufacturing sector in Kenya in light of international comparisons and findings from surveys of enterprises (section A, B, and C). Section D discusses the revival of the garment sector and the sustainability of its revival. Section E provides a summary ofthe issues.

A. MANUFACTURINGPERFORMANCE

Output and productivity have stagnated

4.2 As discussed in chapter 1, the share of manufacturing output remained roughly stable at around 13 percent of GDP during the past two decades. However, the growth rate of manufacturing value added fell from 4.8 percent per year during the 1980s to 2.1 percent per year during the 1990s. Gross capital formation in manufacturing peaked at 5 percent of GDP during 1995-96, declining then to around 3 percent of GDP by the end of the 1990s, the same level as a decade earlier (see table 111.2.5 in annex 111). Manufacturedexports represented on average 2-2.5 percent of GDP during the past 20 years. Overall the sector is characterized by low value added, low capacity to create employment, and high wages. It is heavily dependent on imports of intermediate and capital goods and it has weak backward linkages with local suppliers. Manufacturin growth in Kenya has been driven by increases in factor inputs, not rising productivity.” Food processing industries represent the most important subsector (with almost 40 percent of manufacturing output), followed by textiles and clothing, metal and machinery, wood and furniture, printing and paper products, and smaller subsectors such as leather products, clay and glass, chemical and petroleum.”

The informal sector has absorbed the excess supply of labor

4.3 Overall, the manufacturing sector employs half a million people, of which 220,000 are in the formal sector (representing some 14 percent of total wage employment). The rest of the

58 See International Monetary Fund (1999). Total factor productivity in the manufacturing sector grew at an annual rate of 0.8 percent during 1973-98, accounting for 14 percent of the sector growth. However, performance was uneven during different periods. Thus, total factor productivity remained constant during 1973-80, when the 10 percent expansion in the manufacturing sector was supported by increases in factor inputs. Growth of total factor productivity was 2.5 percent a year during 1981-90, and this contributed more than one-half of the sector’s growth in value added. The situation reversed in 1991-98, and total factor productivity fell by 0.5 percent a year with capital accumulation becoming the main contributor of the growth of value added. Gerdin (1997) found that productivity growth was almost nonexistent (-0.12 percent) during 1964-94.

59 Food processing includes meat and dairy products, canned vegetables, fish, oils and fats, grain mill products, bakery products, sugar, miscellaneous foods, beverage and tobacco. Textile and garments includes clothing. Wood and furniture includes wood and cork products, furniture and fixture. Metal and machinery includes metal products, nonelectrical machinery, electrical machinery.

57 employed are in the informal sector, which includes all semiorganized and unregulated small activities.60 Informal firms fabricate consumer goods for low-income households, farming instruments, and motor vehicle parts. While few reliable statistics about the informal sector exist, it appears that it is expanding rapidly, and it now accounts for a significant proportion of domestic manufacturing. Employment growth in the formal manufacturing sector was slow during the 1990s, at about 2 percent a year and real value added per employee was virtually stagnant over the decade. By contrast, employment in the informal sector grew rapidly; by the end of the 1990s twice as many people worked in the informal sector as in the formal manufacturing sector.

4.4 The government has long recognized the importance of small-scale enterprises in creating employment. Policies to promote this sector were stipulated in various sessional papers issued in 1986, 1992 and 1997. A number of initiatives followed, aimed at improving the enabling environment, expanding access to credit, and improving access to technical training and of business services. The newly-formed National Association for Technology Transfer and Entrepreneurial Training and the Department of Micro and Small Enterprise Development are focusing on increasing training and business development services for micro and small enterprises. A new sessional paper is under preparation to provide a new strategic framework. However, the development of the informal sector must be synchronized with that of the formal sector, and both must be aimed at meeting the critical challenge of creating jobs for the expanding labor force.

Kenya is a better industrial performer than its neighbor, but it is losing rank

4.5 Table 4.1, which shows indicators and rankings of industrial performance, suggests that Kenya is still a better industrial performer than are its immediate neighbors. Most of the indicators also improved during 1985-98. However, Kenya's performance has been worse than other countries, including countries of Sub-Saharan Africa, and it has been dropping in rank. As discussed in chapter 1, Kenya has barely reduced its reliance on primary exports during the past two decades. By contrast, the share of manufactures has grown rapidly and to very high levels in East Asian and in Latin America countries.

60 About 4.6 million people were employed in 2001 in the informal sector (including 1.6 million in cities and 3 million people in rural areas). This is about 70 percent of all workers. Employment in the informal sector has been rising by about 12 percent a year during the past 5 years, while employment in the formal sector has hardly grown at all. Kenya has a strong microfinance industry, involving a specialized commercial bank, savings and credit cooperatives, and a number of NGOs and informal groups. However, these serve primarily urban microenterprises, and do not reach the rural small enterprises. A microfinance law that would allow microfinance institutions to mobilize savings has been stalled at the central bank.

58 Table 4-1: Benchmarking Kenya’s Industrial Performance (values and ranks out a 1 countries-in 1985 a 8) Manufacturing value added danufactured exports per Mediumhigh tech per capita capita products inmanu. products in exports (constant US$ and rank) (current US$ and rank) value added (percent and rank) (percent and rank) 1985 1998 1985 1998 1985 1998 1985 1998 Kenya 32 (74) 37 (77) 17 (65) 28 (74) 28 (50) 24 (65) 3.2 (54) 7.6 (55) Tanzania 31 (75) 16 (85) 2.6 (78) 3 (83) 24 (58) 25 (63) 2.3 (58) 1.5 (76) Uganda 10 (79) 24 (81) 0.2 (SO) 0.9 (87) 11 (77j 15 (76j 0.2 (76) 0.8 (83) South Africa (RSA) 366 (38) 557 (45) 158 (35) 322 (48) 44 (30) 44 (33) 16.6 (31) 26 (34) Nigeria 84 (66) 62 (74) 2.6 (79) 1.5 (85) 34 (38) 38 (40) 0.1 (78) 1.5 (77) Mauritius 182 (51) 739 (38) 400.(29) 1,434 (29) 12 (73) 12 (81) 3.4 (52) 1.4 (78) Malaysia 36 8. (3 7) 936 (32) 550 (24) 2,973(20) 47 (24) 60 (11) 21 (26) 65.(6) Thailand 167 (55) 584 (44) 71 (45) 731 (34) 18 (66) 39 (38) 14 (33) 45 (25) India 44 (72) 65 (72) 8.1 (70) 26 (75) 56(9) 59(12) 9.8 (37) 16 (40) China 101 (63) 287 (55) 5.8 (74) 135 (52) 49 (19) 51 (22) 4 (48) 36 (29)

region Sub-Saharan Africa 83 92 25 45 38.6 37.6 24.8 30.8 (including RSA) Sub-Saharan Africa 49 40 8 14 26.5 24.2 13.0 12.7 (excluding RSA) MENA 202 392 96 220 30.7 36.8 15.6 22.5 South Asia 42 65 9 32 49.8 52.7 12.0 15.8 LAC 462 77 1 116 404 42.5 39.7 31.8 56.9 East Asia 145 387 84 409 44.3 54.4 39.1 59.7 Developing world 147 300 60.2 242.2 42.5 48.7 33.5 53.8 All countries 619 1094 292.5 821.0 56.8 58.7 57.7 63.8

4.6 The technological structure of Kenyan manufactured exports improved between 1985 and 2000, with resource based manufactures losing ground, mainly to low technology products (table 4.2). However, little progress has been made in moving towards production of medium or high technology goods. Several high technology exports (electronic circuits and telecom apparatus) are reexports; local productive capacity in these activities is nonexistent. Thus, their growing share does not mean sophisticated industrial capabilities are growing. Exports of complex engineering and electronics products, which indicate that firms are participating in the global value chains of leading multinationals, are absent in Kenya. Such participation has, however, driven rapid export and employment growth in many developing countries in all regions (United Nations Conference on Trade and Development, 2002).

1985 2000 Resource High Medium Lowtech based High Medium Low tech Resourcebased tech tech tech tech Kenya 2.0 6.8 12.1 79.0 5.5 9.5 27.6 57.5 Ghana 0.8 2.0 0.8 96.4 1.o 5.5 12.7 80.8 South Africa 9.0 21.2 16.5 53.4 6.1 33.8 16.6 43.4 Nigeria 2.6 3.0 8.6 85.8 0.5 60.3 24.4 14.8 Egypt 1.1 1.7 35.2 62.0 2.4 10.9 31.9 54.8 Morocco 0.7 15.4 28.7 55.2 11.7 14.8 43.3 30.2 World 11.6 28.5 14.2 19.4 22.9 29.6 15.6 15.6 Source: Calculated from the UN Comtrade database, based on export values for each country

59 B. EVIDENCE FROM SURVEYS OF ENTERPRISES

4.7 The World Bank’s Regional Program on Enterprise Development (RPED) surveyed firms in 1993, 1994, 1995, and 2003 in Kenya to investigate whether the private sector is growing and whether government policies are having a positive impact on firm productivity.62 The surveys included a total of 274 firms (75 percent in the formal and 25 percent in the informal sector) in four key areas: food processing, textiles and garments, wood working, and metal working. Together these sectors cover about 73 percent of manufacturing employment. A Kenya Manufacturing Enterprise Survey, consistent with the 1995 RPED survey, was undertaken in 2000, covering 223 firms and focusing on the same four subsectors (Soberdom, 2001). The survey results reveal a number of important findings.

4.8 First, the structure of manufacturing changed little during the 1990s, reflecting specific historical characteristics. Thus, small and micro firms continue to operate with family labor, face strong competition, and generate most employment opportunities. Females run a relatively high percentage of such firms (22 percent in 2000). By contrast, medium and large enterprises are mostly male owned, and they operate in a relatively protected environment.

4.9 Second, pressures to improve productivity have remained weak and the opening up of the economy has had little effect on the competitive position of medium and large firms. Their acquisition and use of technology licenses has been almost nonexistent. Productivity of labor is now lower than during the mid-1990s. Compared with the early 1990~~large firms in 2000 continue to be more capital intensive, more export-oriented, and twice as productive as smaller firms. The 2000 survey confirmed that labor productivity differentials across subsectors and firm sizes is ~ubstantial.~~Thus, labor productivity in food processing was found to be 62 percent higher than in wood working and furniture making and about 125 percent higher than in textile and garment manufacturing. Labor productivity increases with firm size, and this is associated with capital intensity.64

4.10 Third, investment was low throughout the 1990s. Investment growth is an important indicator of how firms are reacting to structural reforms and other policy changes. Investment was low both in the early 1990s and in 2000. Half of the firms covered in the 2000 survey were not investing at all and the rest were investing very little. Moreover, the investment rate of firms

62 The mandate of the RPED is to carry out investment climate assessments for the Africa Region. Surveys are carried out every 3-5 years. The Kenya survey was undertaken jointly by the Economics Department of Goteborg University and Nairobi University and the Kenya Associations of Manufacturers. Results are collected in Bigsten, Arne, and Peter Kimuyu (eds.) (2002). A new survey was taken by the WED group and KIPPRA in early 2003 and a summary report is being finalized. 63 The authors also look at total factor productivity across sectors. They find that the food processing industry has the highest total factor productivity, followed by bakery, and wood working. The textile subsector has the lowest total factor productivity; the average total factor productivity in the textile sector is about 40 percent lower than in the benchmark category, which is the metal and machinery industry. The gap between food and textiles is such that the total factor productivity of the latter is 57 percent lower than that of the former. Foreign ownership and firm age appear to have no significant effect on total factor productivity. By contrast, education has an effect: a one-year increase in the average education of the workforce increases value added by about 14 percent, everything else being equal. 64 This relationship is true for firms up to 50 employees-for these firms, a 1 percent increase in the labor force is associated with a 0.8 percent increase in the capital labor ratio; the relationship is weaker for larger firms.

60 that did invest was very low at 0.12 percent, just sufficient to offset depre~iation.~~The smallest firms were the least likely to invest. Only a very small percentage of firms were investing to expand. Food processing businesses had the highest investment rate, and the textile industry had the lowest. Moreover, very few firms were specializing in exports. Food processing firms were the most export-oriented of firms, exporting around 20 percent oftheir output. None of the micro firms exported their goods, while 70 percent of the large firms did, primarily to regional markets.

4.1 1 Finally, wages increase with firm size, irrespective of other conditions. In Kenya, statutory minimum wages are set by the government, but they do not appear to be binding in the formal sector, or in small enterprises.66 For example, the 1999 micro and small enterprise survey found that the firms paid their workers an average of 2.7 times the minimum wage (4.5 times in urban areas and 0.8 time in rural areas). However, further work needs to be undertaken to assess the impact of wage determination mechanisms on employment. In recent years both minimum wages and average wages have increased faster than the growth of labor productivity, and this has likely been a factor in the dramatic rise in informal sector employment versus that in the formal sector. What appears from the surveys of enterprises is that wages increase with firm size, though women earn less than men in firms of all sizes. Large firms employ higher-skilled workers, and the returns to workers with longer experience and better education are higher in these firms than in small ones. Higher wages are strongly associated with higher productivity in larger firms. Tenure also increases with firm size, suggesting that large firms pay higher wages in part to reduce turnover and training costs. The surveys found a strong positive firm size-wage effect that persists even after controlling for labor skills, working conditions, and the presence of trade unions. It is likely that firms share rents with the workers to increase potential profits through increased productivity, or to maintain the loyalty, cooperation Figure 4.1: Earnings by Firm Size and Skills 1999 and morale of their employees.

4.12 Figure 4.1 provides a snapshot of mean earnings by size of the firm and level of skills found in the 2000 ~urvey.~’The data show that employees with similar skills earn more the larger the firm for Micro Small Medium Largemacro Finn Size which they work. Unskilled workers earn twice the average if they work for large firms, rather than micro firms.68 Skilled workers Source: Soberdom, 2001.

65 The investment rate is defined as the investment expenditure divided by the replacement value of the capital stock. 66 At the end of 2002, at current exchange rates, minimum monthly wages ranged from US$21 for unskilled workers to US$SO for a machine attendant, to US$84 for a salesman. The wages actually negotiated by companies in recent collective agreements tend to be considerably higher than the minimum levels, For example, at the end of 2002, wages in the knitwear sector ranged from US$39 to US$89 per month. Wages in food processing ranged between US$45 and US$SS. Multinational companies producing consumer goods paid the best salaries ranging from US$lSO to US$386.

67 Earnings is the sum of monthly wages and non-wage payments such as housing allowance, food and other allowances as applicable. 68 Unskilled laborers include unskilled office workers, cleaners and guards, and unskilled production workers. Skilled laborers are managers, professionals, sales personnel, supervisors, and skilled industry-specific employees.

61 in large firms earn almost four times as much as those in micro firms. The mean earnings of skilled workers are less than 30 percent higher than those of unskilled workers in micro firms; but about 130 percent higher than the earnings of unskilled workers in large firms.

4.13 The most important problems for firms are insufficient demand, lack of access to credit, power shortages, and corruption. Respondents to the 2000 survey ranked their firm’s three biggest problems. The most frequently cited problem was insufficient demand, followed by lack of access to credit, followed by power shortages and corruption. Micro and small firms stated that insufficient demand and access to credit were their most serious problems. Capacity utilization remained low throughout the 1990s for most firms (because of lack of demand). Small and micro firms obtained loans from relatives and friends, and as trade credit and advance payments from large firms. Large firms by contrast did not name lack of access to credit to be among their most critical constraints. They relied to a large extent on trade credit for financing. Large firms specified power shortages to be among their most serious constraints, a particular problem during 1999-2000, when the drought reduced the generation of hydropower. Large firms were also more likely than micro and small firms to identify corruption as a major problem. Corruption was especially problematic in obtaining public service connections (5 5 percent of firms reported always or frequently making unofficial payments), in customs (47 percent), licenses, in permit processing (44 percent), and in tax collection (38 percent). Preliminary results from the 2003 survey indicate that firms are most concerned widespread corruption, high interest rates, poor infrastructure, and crime.

c. WHY DID THE MANUFACTURINGSECTOR PERFORM POORLY?

4.14 Trade liberalization negatively affected most manufacturing firms, revealing their inability to compete. Both aggregate statistics and firm-level data point indicate that manufacturing firms responded poorly to the trade liberalization and investment reforms of the early 1990s. Protection was reduced, though only partially-and in fact it is still high. But many firms closed down, partly because of unfair competition from imports due to massive duty evasion, Some smaller firms found it profitable to move into trading activities. The depreciation of the exchange rate in 1993-94, while improving incentives for exports, raised the cost of imported inputs and reduced firms’ profitability. It also encouraged entry into the import- competing sector by micro and small enterprises, which could provide cheaper and lesser quality consumer products. But many informal firms were not viable and soon went out of business, or, to avoid taxes, decided not to expand.

4.15 Trade liberalization did not stimulate private sector investment. International experience shows that liberalization tends to stimulate short-run output growth and exports. This is what happened in Kenya during 1994-96. However, the main channel through which trade liberalization affects long-term growth is by stimulating investment, rather than by increasing the efficiency of production factors. In Kenya, private sector investment as a share of GDP stagnated throughout the 1990s. Part of the reason for the poor investment response may be that manufacturers were able to employ underutilized capacity in production. However, investment were also constrained by the high cost of imported inputs, rising interest rates and, particularly for the smaller firms, lack of access to credit.

4.16 Rising unit labor costs have reduced the competitiveness of manufacturing firms. During 1990-94 real wages declined by some 40 percent of their initial value, suggesting that workers bore most of the adjustment costs. However, this decline was followed by a 30 percent

62 increase during 1995-2001. Figure 4.2 shows that the index for private sector real wages (with base 1990=100) increased from 61 in 1994 to 151 in 2001. Unit labor costs declined by about 8 percent during 1990-94. Prices of manufactured goods moved in the opposite direction. The manufacturing price index increased by 20 percent during 1990-95. But during the next six years it declined by 16 percent. Thus, it appears that the profitability of manufacturing firms declined in the late 1990s.

Figure 4.2: Real Wages in the Figure 4.3: Unit Labor Costs and Prices in the Manufacturing Sector (Index 1990=100) Manufacturing Sector (Index 1990=100)

145 T I -L;." __-e- - 130 . 115 - 100 85 .

-Pnvats sector -Public sector I ------.Unit labor costs -Manufacturing price index Source: Central Bureau of Statistics. I Source: Central Bureau of Statistics.

4.17 Kenya has a literate workforce relative to other countries of Sub-Saharan Africa, but school enrollments and the quality of training have been declining. As described in Chapter 2, illiteracy rates have fallen over time and are under half the rate for Sub-Saharan Africa as a whole. However, the imposition of fees in 1985 led to a fall in primary school enrollment (introduction of free primary education by the new government has already led to a substantial increase in enrollment). Moreover, more than half the children who enroll in school do not complete primary school (Institute of Economic Affairs, 200 1). Gross secondary enrollment grew from 2 percent in 1960 to a peak of 28 percent of the age group in 1991. Since then enrollment has dropped substantially, likely due to the rising costs of education and a fall in employment opportunities. Transition rates from primary to secondary schools (defined as the percentage of primary school graduates who enroll in secondary schools) also declined during the 1990s.

4.18 Tertiary level enrollments in Kenya have stagnated and are at the low end for Sub- Saharan Africa, itself much lower than in other parts of the developing world. Another disturbing trend is the low and declining level of tertiary level enrollment in technical subjects (science, mathematics, computing and engineering) (table 4.3). This provides the base for high- level skills needed for industrial development and for the use of new technologies, and the erosion seen in Kenya may be very damaging in the long term.

63 1985 1997

’000 share, in percent ’000 share, in percent 1985-97)’ in percent Kenya 5.5 0.1 4.6 0.1 -2.2 Ghana 1.9 0.0 2.1 0.0 1.3 Senegal 3.3 0.1 4.4 0.1 3.7 Nigeria 23.5 0.5 63.3 0.9 13.2 South Africa 68.9 1.4 68.1 1.o -0.1 Zimbabwe 0.9 0.0 9.5 0.1 34.3 Algeria 29.8 0.6 115.1 1.7 18.4 Egypt 75 1.6 69.6 1.o -0.9 Morocco 56.8 1.2 66.7 1.o

4.19 The quality of industrial training is inadequate. Industrial training is su ported through a levy-grant system, run by the official National Industrial Training Council! The council reimburses a proportion ofthe costs of approved training undertaken in specified facilities by employers, but the levels of reimbursement are much lower than the actual costs to employers, so the program provides little incentive to employers to release their staff for training. The government does not offer finance or incentives to private enterprises to invest in in-house training, and private firms invest relatively little in this form of training. Quality of training is affected by the low salaries of trainers, which lead to high turnover, while obsolete equipment affects the quality and relevance of the training given.

Government industrialization policy

4.20 The government’s long-term strategy is to promote sustainable growth with a strong industrial base. The 1997 sessional paper, “Industrial Transformation to the year 2020” lays out the foundations for this strategy, which is based on promoting small and medium size firms in areas where Kenya has a comparative advantage and on encouraging the development of capital and technology intensive enterprises with high value-added potential. The strategy is basically sound as it recognizes that the private sector is to play the leading role, while the government’s role is to facilitate the industrialization process. However, a number of criticisms ofthe strategy have been made. For example, the industrialization policy gives insufficient attention to the importance of costs and product quality for competitiveness. Nor does it address the fiscal implications of the policy. A number of its specific proposals are also questionable (for example, credit subsidies to small scale enterprises and direct lending by the central bank to priority industrial projects). More fundamentally, the strategy has few suggestions on how to improve the investment climate, especially on how to reduce corruption and rent seeking behavior among government officials. These criticism helped to inform the industrial policy presented in the 2000 interim PRSP. This document, in addition to measures to improve the business environment (for example, introducing a single business permit and reviewing licensing provisions), gives prominence to good governance and improved financial management, audit controls, and procurement rules as key to promote industrial growth.

69 The levy rates vary by industry. In banking and general engineering the levy is Ksh 250 per employee per half year. In chemicals and general processing the rate is Ksh 300. In food processing and plantations the rate is Ksh 150. In motor engineering and textiles the levy is Ksh 200. In building construction and civil engineering the rate is 0.25 percent of contract values for contracts of over Ksh 1 million.

64 D. A SUCCESS STORY: THE GARMENTSECTOR AND THE AFRICA GROWTHAND OPPORTUNITYACT

4.21 Despite the poor performance of the manufacturing sector overall, the garment subsector has grown spectacularly during the past two years. The textile and garment industry was seriously affected by the liberalization policies of the early 1990s, which reduced tariffs on imports and allowed used clothes to be imported. The cotton ginning industry collapsed and many textile firms closed. Output of the garment industry-which is concentrated in the export processing zones (EPZs)-contracted by 11 percent per year during 1990-98, and by the end of the 1990s the industry employed only about 6,000 workers. The situation changed completely in 2000, when Kenya became eligible to export garments to the United States under the Africa Growth and Opportunity Act (AGOA). Foreign investment in the EPZs, which had declined by 16 percent during 1998-2000, rose in 2001 by 42 percent to reach US$114 million. Entrepreneurs already experienced in exporting to the U.S. market were responsible for virtually all the FDI flowing into Kenya’s textile and garment industry. Many of these entrepreneurs relocated production from countries of the Middle East and from Sri Lanka. During 2002, employment in the industry reached 25,000 workers, and another 15,000 jobs are expected to be created in 2003. Exports increased from US$10 million in 1999 to US$127 in 2002 and are expected to reach US$200 million in 2003. Given the failure of Kenya to attract significant FDI in other sectors, the success of the garment industry is noteworthy.

4.22 The reason for this exceptional success lies in the act itself. As described in box 4.2, AGOA provides exceptionally attractive market access concessions for garments assembled in Sub-Saharan Africa, particularly the 28 least developed countries in Africa. The concession allows the least developed countries to source the cloth they use from anywhere in the world. This concession is intended as a short-term measure to allow these countries to catch up and is due to expire in September 2004. AGOA offers a huge potential competitive advantage to a factory assembling in Kenya, compared to its main competitors, assembling in Asia. The duty and quota benefit is valued at approximately US$1-2 per typical garment. Considering that the typical market price for sewing such a garment is often around US$1, it is clear that the advantage is very substantial. This is why AGOA has resulted in such dramatic growth in garment exports from Africa to the United States.”

4.23 Several factors allowed Kenya to quickly become a leader in the race to take advantage ofthe benefits of AGOA:

Kenya moved fast to establish its visa system. Before countries can be certified to export under AGOA they must establish a visa system through which a government agency verifies that each shipment has indeed been assembled locally (to prevent garments assembled in Asia being labeled as assembled in Africa). Customs is responsible for issuing the visa but the industry through the Kenya Association of Manufacturers operates the monitoring system. Kenya was the second country to be certified to export garments under AGOA, only six days after Mauritius, and was the first African least developed country to achieve this status.

70 The European Union has also taken a measure recently to open its markets to manufactured exports from poorer African countries. In February 2001, it implemented its Everything but Arms concession, again giving these countries duty-free and quota-free access to European markets. However, this concession applies only to the world‘s poorest 48 nations, and Kenya is not among them. Hence AGOA is much more important to Kenya right now.

65 0 A working EPZ system was already in place. This gives garment investors tax-free status and access to fast-track clearances. Moreover, both ready-to-use standard factories and serviced plots are available in various EPZs in Kenya, including in the Mombasa area close to the port; in Nairobi, where labor is abundant and where expatriate managers can be attracted; and at the Athi River, around 40 kilometers from Nairobi, an EPZ with space and good facilities.

0 Transport links both to Asia and the United States are adequate. Mombasa port is well served by regular shipping services. Cloth can be brought reasonably quickly from Asia. Garments can be sent rapidly to the U.S. Nairobi is a major airline hub. Customers, suppliers, factory managers, and others can fly at short notice to and from Asia and the United States to address urgent issues.

0 Kenyan workers are relatively well educated and speak English. Since all garment factories rely on expatriate supervisors and technicians, being able to communicate in English is a great advantage. Factory managers report that Kenyan workers learn quickly. Although Kenya does not have the lowest labor costs in Africa, productivity in the garment sector is comparable to that of Madagascar or South Africa, and is not far from that of India, though it is still only 70 percent of that achieved in China. Labor costs represent only around 8 percent of the total free on board cost of a typical garment, such as a casual shirt. 4.24 The big issue facing the industry now is uncertainty as to how long the AGOA concession for least developed countries will last. There are two sources of uncertainty. The more immediate concern is the expiration in September 2004 of the least developed country concession on source of cloth. The other concern is the ending in 2005 of the Multifiber Agreement.

4.25 If the least developed country concession is indeed ended next year, then countries such as Kenya could be in serious trouble. Cloth from the United States is generally too expensive to serve as an alternative to Asian cloth. Currently, the only African countries that produce cloth of suitable quality to use in garments for export are Mauritius and South Africa.

66 Both are expected to use their limited capacities for their own fast-growing export garment industry. The existing mills in Kenya producing for the domestic market cannot be economically converted to produce cloth of the quality required for the U.S. market. Starting in late 2004, Kenya and other least developed countries may face serious shortages of cloth or may have to pay substantial price premiums, or both. Although a factory assembling a garment for export under AGOA can expect recoup the investment costs in around 2-3 years, production of cloth is much more capital-intensive, and at least 6-10 years are needed to recover the investment costs. With the Multifiber Agreement ending in 2005, investors are understandably wary of investing in facilities to produce cloth in Africa, given the seemingly short period during which they will enjoy the advantages ofAGOA.

4.26 The second concern is the ending of the Multifiber Agreement in 2005. The AGOA concessions as a whole were intended to end in 2008. President Bush has recently announced that he will ask Congress to extend AGOA until 2015. However, some producers are now more worried about the end of the Multifiber Agreement in 2005 than about the potential expiration of AGOA in 2008. Once the Multifiber Agreement ends all quantitative quotas will be lifted. The worry is that countries such as China and other large Asian countries will be able to dominate the market by aggressively pricing their products. Even the 16 percent duty advantage given by AGOA may not be sufficient to keep the production of garments in Africa.

4.27 Reasons for optimism. India took about 12 to 15 years to raise its levels of productivity sufficiently to be able to compete with China. The productivity levels of Kenya’s industry are not far behind those in India. But the industry right now faces considerable uncertainty. To gain time to catch up, Kenya and other African least developed countries intend to submit a formal request for special and differential treatment to the WTO ministerial meeting to be held in September 2003 in Cancun, Mexico.71

Internal constraints will need to be addressed in the medium term to allow the growth to continue

4.28 The main concern will probably be skill development. The basic skill required in the garment assembly industry is sewing-machine operation. Most factories hire applicants with no previous experience and train them onsite to operate the sewing machines, a process that typically requires six weeks. In the absence of pre-employment training in operating the sewing-machines, this system works reasonably well. However, along with other Kenyan firms, factories have to pay a training levy into a central fund. The problem with this system, they claim, is that the established rules and procedures make it difficult to be reimbursed from the fund for expenses related to onsite training. The other specialized skills required within the factories are provided by expatriate, mainly Asian, employees on term contracts (for example, supervisors, machine repair technicians, laundry operatives, quality control specialists, and the like). This arrangement is expensive. Therefore, if Kenya’s garment industry is to compete in the long term, it will need to replace expatriate experts with Kenyans trained in these skills.

4.29 Non cloth inputs will need to be produced locally. Most factories source virtually everything they use from Asia. A few have attempted to develop local sources of services and

71 This covers a complex set of 145 specific provisions, aimed at giving special treatment to developing countries within the general WTO rules.

67 supplies, for instance laundry services, embroidery, sewing threads, buttons and polythene bags. To compete in the long term and to maximize employment benefits in this sector, more backward and forward linkages need to be developed.

4.30 Like others, this industry is negatively affected by the generally high costs of doing business in Kenya. The garment assembly industry uses substantial electricity, which is both expensive and unreliable in Kenya, so most factories have standby generators. Washing of jeans in particular demands a lot of water, which is also expensive in Kenya. Port and transport costs are high, certainly in comparison with Asian competitors. With the concessions granted under AGOA, the costs of these inputs are not significant enough to discourage production. Over time, however, they may lessen the attractiveness of Kenya to garment producers.

E. SUMMARY AND RECOMMENDATIONS

4.3 1 This chapter has evaluated the performance of the Kenyan manufacturing sector during the 1990s. The period was characterized by stagnation in both investment and productivity. The formal sector in particular scarcely grew, while the informal sector expanded rapidly. Kenya remains a better industrial performer than its neighbors in East Africa, but has not kept pace with other countries in Sub-Saharan Africa and in other regions. And while the technological structure has improved, exports remain concentrated in the low technology categories.

4.32 Survey data confirm that the manufacturing sector remains polarized. On one side are the many young micro and small firms that face strong competition but are unable to increase their productivity. On the other side are the medium and large-size enterprises that have considerable market power and export to regional markets, but despite a lowering of tariffs are still relatively protected from external competition. Unit labor costs have increased significantly since the mid- 1990s, which has contributed to the low profitability of the manufacturing sector. Findings from the surveys of enterprises suggest that the large firms pay higher wages to attract qualified and experienced workers, and to reduce turnover and therefore training costs. The firm size-wage differentials are large and significant after controlling for other variables (labor quality, working conditions, and the like). Firms appear to share rents with their workers in order to maintain loyalty and cooperation and to increase potential profits through increased productivity.

4.33 AGOA has since 2000 led to a dramatic increase in investment in an industry that had been in steep decline. The benefits of quota-free access to U.S. markets provided through AGOA will, however, vanish in 2005 when the Multi-fiber Agreement comes to an end. Moreover, the AGOA requirement that garments be assembled after 2004 using cloth produced in Africa is likely to constrain the growth of Kenyan apparel exports. The longer-term issue is whether Kenyan apparel producers will be able to compete effectively with Asian manufacturers starting in 2008 when AGOA is scheduled to end. The long-term sustainability of apparel exports-as well as of other manufactures-depends on the Kenyan industry raising its productivity to that of the countries with which it competes. This will require efforts to upgrade skills and technology as quickly as possible, since raising productivity will require time. Efforts will also have to be taken to eliminate logistics bottlenecks along the supply chain to better link input suppliers to production centers and outputs to markets. Overall, raising the quality and quantity of formal education, reducing dropout rates, and introducing flexible curricula related to the needs of industry are important. In addition, efforts will be needed to encourage students at the tertiary level to enroll in technical and management subjects and to persuade qualified Kenyans living overseas to return.

68 4.34 A summary of the recommendations to improve productivity in the manufacturing sector is as follows.

0 Improve the enabling environment for micro and small firms, to facilitate the graduation of these firms from the informal to the formal sector. In this context, Increasing access to credit appears to be a priority. The government should aim at increasing financial deepening, rather than providing credit itself. Provision of business support services is also important.

0 Increase the competitiveness and productivity of the medium and large firms, by lowering entry barriers, further liberalizing trade, improving infrastructure, facilitating the acquisition and use of technology licenses, and improving access to quality training opportunities are priorities.

0 Review the mechanisms of wage determination and assess their impact on employment creation. The government should engage with the private sector (representatives of both the workers and firms) on issues such as the minimum wage, its impact on employment creation and the link between wages and productivity increases.

0 Improve the quantity and quality of training by: (a) encouraging enterprises to offer training to employees, perhaps by providing tax or other incentives; (b) involving enterprises more closely in managing industrial training institutions; (c) improving the functioning of the training levy/grant system and restructuring the National Industrial Training Council to make it more autonomous; and (d) upgrading the skills and qualifications of staff of the council and allow it to use international trainers until the shortage of qualified Kenyan trainers can be overcome.

69

5. SERVICES

5.1 The services sector has been a significant source of growth and of employment creation in recent years. An acceleration of this growth, particularly of the private services sector, is crucial for the recovery of the entire economy, given the strong linkages that services have with other sectors. This chapter reviews the recent performance of two of the most promising subsectors, information and telecommunication (ICTs) services and tourism. It then examines recent government proposals for reform and recommends a number ofrevisions.

A. BACKGROUND

5.2 Services as a whole represent half of real GDP. In relation to countries at a similar level of income, Kenya has a large nongovernment services sector representing more than two- thirds oftotal services. The most important subsectors are trade, restaurants and hotels, transport and communications, and financial services. Kenya also has a growing business services sector, based in part on its role as a regional hub for transport and consulting services. While services have increased their importance in terms ofGDP, in recent years productivity has declined, due in large part to mismanagement of state owned enterprises, which dominate infrastructure and communications.

5.3 Services are also a significant source of employment. Nongovernment services alone account for 40 percent of nonagricultural employment, and are well represented in better-paid employment opportunities. It should be noted that the picture is not as positive when looking at the gender breakdown of employment in the services sector. While women are over-represented in the low paid personal services, and account for about half of employment in government services, fewer than 10 percent of paid employees in the transport and communications sectors are women.

Rates of growth Share to GDP 1991-96 1997-01 1990-01 1991-96 1997-01 1990-01 Services (at constant 1982 prices) 3.8 1.8 3.0 52.3 54.1 52.8 of which: Government services 2.2 0.8 1.8 15.6 14.6 15.2 Trade, restaurants, and hotels 4.3 2.1 3.2 11.4 12.5 11.8 Transport, storage, and communications 2.9 1.9 2.6 6.1 6.1 6.1 Financial institutions 6.7 2.4 4.9 9.3 10.5 9.7 Other services 3.6 1.5 3.0 3.4 3.4 3.4 Domestic services 10.0 4.2 7.8 2.2 2.8 2.4

71 5.4 Services also contribute significantly to exports. Exports of nonfactor services represented during the 1990s about 29 percent ofGDP and 32 percent oftotal export^.'^ Exports of government services account for less than one third of export services. Commercial services-about 60 percent of which are travel, and transport, insurance, royalties, and business related service-account for the rest. These also include telecom, financial and computer services, which are often associated with the process ofglobalization.

Rates of growth Share to total exports Share to GDP 91-96 97-01 91-01 91-96 97-01 91-01 91-96 97-01 91-01 Total exports (GNFS) 5.7 -0.3 3.0 100.0 100.0 100.0 32.5 26.2 29.6 Exports of nonfactor services -3.8 3.0 -0.7 44.3 33.3 39.3 14.3 8.7 11.8 Transportation n.a. 8.4 4.0 n.a. 12.7 7.5 n.a. 3.3 2.1 Travel 0.0 -6.1 -2.8 18.2 10.9 14.9 5.9 2.8 4.5 Government services -10.8 13.5 0.3 10.4 8.3 9.4 3.4 2.2 2.8 Private services 1.9 5.6 3.6 2.7 1.5 2.1 0.9 0.4 0.7

5.5 This chapter focuses on travel and communications, while infrastructure and financial services are discussed in chapter 6.75 In the Kenyan context, travel is dominated by the tourism sector, and is a major source of income and employment. Although less significant in terms of a direct contribution to GDP, the communications subsector offers significant development potential through the exploitation of advances in information and communications technologies. It would therefore benefit from sector policy reform.

B. INFORMATION AND COMMUNICATION SERVICES

5.6 Kenya’s performance in the fixed telecommunication sector is poor, mostly due to the weak management and financial performance of the government-owned monopoly telecom company, Telkom Kenya Limited. Approximately 2 percent ofhomes in Kenya have fixed lines, and these are overwhelmingly located in a limited number ofurban areas (about 60 percent of all telephones are in Nairobi). In addition, the cost ofthese services is high and the quality is low. International calls are expensive and outgoing call volumes are low. Service provision is inefficient and waiting time for new fixed services is above eight years. By contrast, the mobile network has expanded quickly, since the Telecommunications Act of 1998 opened the way for investment by the private sector. At the end of 2002 1.3 million people subscribed to mobile services, dwarfing the approximately 300,000 customers ofTelkom Kenya.

5.7 Telecommunication services in Kenya are provided by Telkom Kenya, a state corporation that is commercially operated. In 2000 in an attempt to introduce some competition three companies were awarded regional fixed line licenses in competition with Telkom Kenya.

14 Kenya’s specific commitments under the General Agreement on Trade in Services covers services in communication, finance, tourism, travel, and transport. Horizontal commitments set limitations on market access as they require foreign service providers to incorporate or establish the business locally (see WTO, 2000). 75 Government services and domestic services are only briefly discussed in this report, as they are discussed in other Bank reports.

72 However, none of these companies began operations, claiming that they could not operate and meet license payments in the poor environment that then characterized the global telecommunications sector. Telkom Kenya thus keeps its monopoly over fixed voice as well as international services.

5.8 International experience suggests that the monopoly on international data and voice traffic keeps the average cost of all services higher than would be the case with competition and that it reduces the efficiency and quality of service provision. Telkom Kenya has 65 employees per 1,000 lines compared to a standard benchmark of4 employees per 1,000 lines. The regulator, Communications Commission of Kenya, has fined Telkom Kenya for missing targets named in the license for rollout of lines and public payphones (it installed only 66 out of the 5,000 it promised). The regulator has also allowed other operators to provide public payphone services and inter-corporate data exchange in response to service failures on the part of the monopoly. Telkom Kenya also cross subsidizes the costs of local calls and rentals of 300,000 fixed line users with revenues from the far larger number of mobile phone users and the 220,000 Internet users who pay inflated data transmission prices (through charges on Internet service providers).

5.9 Despite the low level of telecommunications development in Sub-Saharan Africa, telecommunications have grown rapidly in a number of countries following privatization of the parastatal, including in Guinea, Cote D'Ivoire, Ghana and Senegal. In Senegal, for example, the number of main lines in use doubled from 84,000 to 166,000 in the three years following privatization, while connection charges were cut. In May 2003, Sonatel, Senegal's telecommunications operator, announced reductions in rates for international calls and for connecting to the Internet. A one-minute call to other African countries dropped by 15 percent, from US$0.44 cents to US$0.37 cents per minute at the regular day rate. Similarly, a one-minute

76 Responsibility for broadcasting is split between the Ministry of Information and Tourism and the Ministry of Transport and Communications.

73 call to destinations outside of Africa dropped from US$0.47 to US$0.40 cents. Such a call costs US$1.46 from Kenya, US$O. 19 from South Africa, and US$0.42 from Ghana. In Senegal, rates for Internet connection for 30 hours have just been lowered from US$36 to US$24 per month. The fixed charge per month for Internet access in Kenya is US$lOO, and US$50 in Ghana. Table 5.3 shows the pricing structure of Telkom Kenya’s services in 2002 compared with that of OECD countries.

Table 5-3: Cost of Telkom Kenya Services Compared to Costs in OECD countries, 2002 Telkom Kenya OECD country range Residential monthly subscription US$5.59 US$9-18 Local call (US$ per minute) US$0.086 US$0.023-0.053 National long distance call (US$ per minute) US$O.24-0.30 US$O.lO Call to the U.S. (US$ per minute) US$1.46 US0.33 Source: Data for Telkom Kenya from Telkom Kenya, data for OECD countries from International TelecomunicationsUnion.

5.10 Telkom Kenya’s current license suggests that the monopoly will be maintained up to 2004. However, the government has indicated that it may move quickly to introduce competition in the international segment, which will force Telkom Kenya to lower rates for international calls far more rapidly than the expected deadline, reducing revenues from this source.77 Given the problems of politically-dictated underinvestment in the network and overstaffing, a global telecommunications slump, and new competition, the outlook for Telkom Kenya is poor.

5.11 Performance of other ICT subsectors is mixed. Kenya’s postal service is suffering from slow economic growth, underinvestment, and increased competition from 46 courier firms. The liberalized broadcasting sector has recently grown vigorously. Already, 23 radio and 12 television stations have been licensed. Kenya Broadcasting Corporation, the public broadcast corporation, reaches homes in 90 percent of the country, and a number of regional stations broadcast programs in local languages. The computer (hardware and software) market is also growing. It expanded from US$5.9 million in 1993 to US$40.6 million in 1998 (Government of Kenya, 2002a). A recent survey has found that about 87 percent of organizations in Nairobi have an email address (although outside of Nairobi only 60 percent have one), that the country has about 1,000 cyber cafes, and that 15 percent of the workforce in Nairobi use computers (Ministry of Finance and Planning, 2002).

Isadoption of ICTs likely to expand?

5.12 The ICT skills base is poor but expanding. Approximately 310 people per year in Kenya earn Bachelor of Science degrees in computer science, information science, and electrical and electronic engineering. A further 70 receive post graduate diplomas or degrees (Institute of Economic Affairs, 2002). Kenya has 17 institutes of technology, and over 1,000 commercial institutes and technical training institutes (Ministry of Finance and Planning, 2002). About 56 percent of surveyed institutions in Nairobi have also developed in-house training for ICT applications. However, the feasibility for more broad-based training through Kenya’s school system is currently limited. Most primary schools in Kenya lack access to a telephone and only

77 Telkom Kenya is already suffering from competitive pressures from mobile service providers. Telkom Kenya has built up significant arrears with the mobile companies.

74 about 2 percent of Kenya’s secondary schools have Internet access (ICT Plan Working Group, 2001). The high cost of ex anding this access suggests that mass training in Internet use is not 7P achievable in the short run.

5.13 Other factors are likely to slow the adoption of advanced information technology applications. Cost is clearly one such factor, followed by weak transport and financial networks and institutional barriers, which reduce the utility of such applications. For example, only about 60,000 people in Kenya (0.2 percent of the population) hold credit cards. To use a credit card to undertake an e-transaction, requires photocopying passport pages and the credit card itself and faxing these pages along with an authorization for payment to the website owner for verification at its bank. The government has some way to go to move from a lagging to a catalytic role in the use of ICTs in the country. For example, while the Kenya Revenue Authority will now accept electronic records, only 32 percent of government departments in Nairobi had registered domain names, and just 4.3 percent of government departments outside Nairobi do (Ministry of Finance and Planning, 2002).

Government ICT policy

5.14 The government’s draft policy statement on ICT, discussions with staff ofthe Ministry of Communications in January 2003, and a review of the government’s draft Strategy for Economic Recovery suggest that the government plans to pursue the following key actions to foster development ofthe ICT sector:

0 Remove most ofthe remaining monopoly rights ofKenya Telkom

0 Commit to privatize Kenya Telkom

0 Introduce a third in mobile operator

0 Develop a plan for increasing access to computers in schools and for rolling out telephone services to unserved areas

0 Support with an international partner the installation of a submarine fiber optic cable on the east coast of Kenya linking to cables to the south and the north ofthe region

0 Support the creation of software parks

0 Draft bills dealing with e-commerce, consumer protection, and cybercrime

0 Create a framework for e-government that will support the electronic submission and dissemination of government documents. 5.15 The government’s stance in favor of immediately and fully opening the sector is extremely important for modernizing the entire economy. Section 5(5) of the Kenya Communications Act of 1998 allows for the introduction of competition across the sector by ministerial gazette notice, even in subsectors now dominated by a monopoly. Kenya now has an opportunity to implement a state of the art regulatory model by opening up competition in all

78 It costs between US$78-104 per student to equip a classroom with one computer per 20 students. By comparison, the government spends US$2 per year for each student in the primary system, and only 34 cents per student on development expenditure. The government spends about US$11.70 per year for each student in the secondary system, but only 5 cents of that goes to development expenditure.

75 aspects of information infrastructure, placing limits only where there is a natural scarcity of supply-primarily in the allocation of radio spectrum. Communications Commission of Kenya already has significant capacity, which could, with technical assistance, successfully support the introduction of a fully competitive model. Naturally, competition will increase the complexity of the regulatory framework and there is a need for a number of detailed regulatory improvements, including with regard to interconnection. Greater transparency and consistency in regulatory decision making are also needed.79Communications Commission of Kenya itself has identified a number of these areas where it requires capacity building to implement a new strategic plan. By contrast, issuance of a specific second national operator license, or the revival of existing subnational fixed licenses, are not priorities. Full introduction of competition should allow for the development of local fixed and mobile services where they are in highest demand.

5.16 Plans to privatize Telkom Kenya itself, important both at a political level and to encourage sector growth, will have to be designed with care. Emphasis should be placed on developing a design that is will encourage future sector growth, rather than on maximizing sale proceeds. Even so, given the current global telecommunications environment and a local environment of significantly increased competition, privatization of an inefficient fixed line provider will be complex. In particular, the significant overstaffing of Telkom Kenya is likely to require some painful short-term reductions in staff. To gain the acceptance ofthe employees, the government may wish to consider options for allowing employees to benefit directly from the privatization, such as reserving a percentage ofshares for employees at a preferential price.

5.17 The government’s plan to expand telephone services to the rural areas is important. However, plans to expand access in rural areas should be based on a realistic assessment of the needs of citizens and the ability of the economy to bear the costs. For example, while (near) universal telephone access might be a realistic and valuable goal for even the poorest areas in the country, the same might not be true for Internet access. The Internet is more difficult and expensive than telephony to provide on a nationwide basis, as it requires electricity, computers, modems, and access to skilled technical support for users. International experience also suggests that a phased approach to rural access should be put into place after full competition has been introduced, starting with basic communications services where the costs are lowest and where the benefit-cost ratios are highest. Given that mobile operators in Kenya already reach 50 percent of the population, a first step may be to increase coverage to a greater percentage of the population. An active secondary market for scratch-cards already exists in Kenya, and it is likely that considerably improved public access to telephony through resale of time on mobile telephones in rural areas would quickly follow. A reverse-subsidy mechanism used by Chile to extend access would be one model to achieve these rollout goals (box 5.2).

5.18 International telecommunications issues. While a submarine cable on the east coast of Kenya linking to cables to the south and the north of the region would significantly reduce data transport costs in the long term, the long-distance data traffic segment has been one of the hardest hit sectors of the global telecommunications industry, and many of the companies once involved are no longer operating. The government may wish to coordinate with neighboring governments to ensure that a critical mass in the regional Internet industry is achieved by removing any barriers to linking Kenya’s existing Internet exchange point with ones to be constructed in Uganda and Tanzania. This will create a large local market that will attract regional companies to

79 For example, cellular operators are currently asked to implement some universal services, such as the providing global service for mobiles public phones without a subsidy scheme being in place.

76 host their sites locally, thus lowering international data connectivity costs and speeding response times.

5.19 The government’s decision to withdraw idle broadcast frequencies and reallocate them is welcome, if they are offered to applicants under a transparent, equitable regime. Licenses should be issued to private firms through a transparent, competitive evaluation of factors such as service coverage, public service commitments, and price offered for the license. Community licenses should be issued on the basis of such factors as the level of community involvement and interest, sustainability of business plans, and willingness to provide public services and access. Licenses can be issued to private broadcasters on the basis of their programming or their commitments to produce and broadcast educational and information programs and programs with local content.

5.20 The government’s decision to withdraw idle broadcast frequencies and reallocate them is welcome, if they are offered to applicants under a transparent, equitable regime. Licenses should be issued to private firms through a transparent, competitive evaluation of factors such as service coverage, public service commitments, and price offered for the license. Community licenses should be issued on the basis of such factors as the level of community involvement and interest, sustainability of business plans, and willingness to provide public services and access. Licenses can be issued to private broadcasters on the basis of their programming or their commitments to produce and broadcast educational and information programs and programs with local content.

5.21 The government information technology services department needs to upgrade its capacity. Sector experts and specialists in the reform of management systems also have an important role to play in the short term in each department where IT is to be introduced to ensure that the procedural changes related to the introduction of IT are carried out effectively. They should have prior experience in introducing IT into their sector or in other government departments. The focus of government efforts in using ICT, as suggested above, should be to improve government back-office functions, to foster interactions with large businesses which are likely to have the capacity to use advanced ICT, and to post key information to improve transparency. This alone is a significant agenda, which, if carried out, would act as a catalyst to increase private sector use of ICT while also improving governance and efficiency.

5.22 Plans to actively support the establishment of ICT-based industrial parks through tax breaks and other incentives needs to be approached with caution. The record of such parks is mixed, with the costs of government support frequently outweighing the benefits of

77 increased investment (Dedrick and Kraemer, 2000). At this point, efforts to improve the broader environment to encourage development and use ofICT should be the priority. At the same time, however, punitive taxation of ICT sector inputs should be reduced. Components for personal computers attract a higher duty than completed units, one reason why only 4 percent of the total hardware employed is locally assembled (Ministry of Finance and Planning, 2002). Further, although the duty on computers has been lowered to 3 percent, other computer equipment such as data processing equipment and related ICT hardware such as routers and switches (both of which are powered by microprocessors) carry duties ranging from 15 to 35 percent. To reduce the possibility that the same equipment attracts duties at different rates and to encourage sector growth, import duties should be harmonized at a common rate, and temporary export of ICT equipment for repair (even if it is returned with a different serial number) should not carry duties.

5.23 Finally, there is also a role for government support for the development of ICT skills. It is not currently economically feasible for the government to roll out Internet access to primary and secondary schools for use as a major pedagogical tool. However, the government should support the rollout of the Internet in tertiary institutions. And, since people with ICT skills in general earn higher than wages than those without such skills, there is a role for private institutions to offer courses and diplomas in ICT-related subjects.

C. TOURISM

5.24 Tourism is central to Kenya's economy but its recent performance has been disappointing. The Kenya Tourism Federation estimates that, directly and indirectly, tourism accounts for about 9 percent of GDP and 18 percent of foreign exchange earnings in Kenya. It also estimates that it may account for some 11 percent of government revenue and 500,000 jobs in the formal and informal sectors (180,000 directly and a further 320,000 indirectly employed).'' However, recent performance has been disappointing, with stagnation in the early 1990s followed by a slump in the late 1990s. Table 5.2 shows that within exports of nonfactor services, travel- which is essentially tourism-declined from 5.9 percent of GDP in 1991-96 to 2.8 percent of GDP in 1997-01.''9 During this period, the number of days that visitors stayed fell by about 24 percent and Kenya dropped far behind other countries of the region (figures 5.1 and 5.2).

5.25 Long-term factors, exacerbated by recent security problems, account for the decline, These long-term factors include deteriorating infrastructure, growing crime and corruption, declining public health, degrading environmental conditions, and weak marketing. More immediate factors include the civil unrest during the 1997 elections, the August 1998 terrorist attack on the U.S. embassy in Nairobi, violence associated with the inflow of refugees from neighboring countries experiencing civil conflicts, and the introduction of visa requirements (Ikiara and others, 2001).

5.26 Because they are responsible for client welfare and because planning holidays requires a lead time of 12-15 months, package holiday operators are highly risk averse and price sensitive.

80 The tourism industry is also a significant source of FDI. Approximately 78 percent of coastal hotels and 66 percent of those in Nairobi and the national parks have some foreign investment (although under 20 percent are fully foreign-owned). 'I9 In 1998, the Kenyan Tourism Board launched a campaign to improve Kenya's image abroad. The campaign was partially successful in reversing some of the fall in tourism revenues.

78 A 1 percent rise in relative prices in a destination leads to a 3-5 percent loss in bookings to alternative destinations. Political or civil instability or changes in policy such as unexpectedly introducing new taxes or tariffs and requirements for visas can therefore create significant problems for the industry. The dramatic drop in tourist arrivals from the European Union since 1997 (primarily beach-bound vacationers) is strong evidence that potential security risks are important to tour operators, who have been made legally responsible for tourist safety through EU legislation.

Figure 5.1: Annual Bed Nights by Location Figure 5.2: Growth in Arrivals, 1990-99

1991 1997 2001 Kenya I Other Nairobi 0 Coastal 0 100 200 3W 400 500 600

I I I Source: Central Bureau of Statistics and World Tourism Organization data.

5.27 Despite the overall stagnation oftourism, the number of visits to parks and game reserves has grown, although visits are concentrated in a few parks. The number of visits increased by 21 percent during 1997-2001, with the top six parks accounting for 54 percent of total visitsin 2001. By contrast, only one half of Kenya’s public parks had any visitors services at all (Weaver, 1999). Use is also concentrated within parks.

5.28 The high concentration of visits to a small number of parks threatens the sustainability of all parks. For example, ofthe 57 parks overseen or managed by the Kenya Wildlife Service, only six collect more in entrance and leasing fees than they cost to maintain. Of particular concern is the sustainability of significant areas outside of the national park system that cover approximately 6 percent of the country. The large animals that are most important in attracting tourists naturally range over larger areas than those covered by the parks. For example, the Maasai Mara, which is reported to generate as much as 15 percent of tourist revenue, has been threatened by declining migration of animals in part because wetlands outside the park used for dry-season grazing have been converted into farmland. Some estimates suggest that, since 1980, animal populations in the Maasai Mara ecosystem have declined by over 50 percent, with wildebeest populations declining from 119,000 to 22,000 during 1977-97. This ecosystem is particularly vulnerable because this land can be productively used for crop production. While wildlife resources are the source of much of the country’s comparative advantage, competition for land is perhaps the most important long-term issue facing Kenya’s tourism industry. For example, 71 percent of tourists departing Kenya in a recent survey stated that nature and wildlife were among principal attractions for their visit; just 33 percent cited beaches (Weaver, 1999). Thus, the opportunity to spend some time at a game park is the primary reason tourists come to Kenya in the first place.

5.29 Studies also suggest that tourism in Kenya has relatively weak poverty reducing linkages. While the tourist industry is a significant employer and provides a market for

79 agricultural products, many local people benefit little from neighboring tourist destinations. For example, expenditures made outside hotels amount to only 50 percent of hotel expenditures in coastal areas, and poverty maps of Mombasa indicate that many people living close to holiday resorts survive in dire poverty.

Government policy for the tourism sector

5.30 The government is committed to the tourism sector as a major source of income and employment. The government’s plan for tourism, as laid out in recent press announcements, in the draft Strategy for Economic Recovery, and in discussions with tourism and information ministry staff in January 2003 is based on:

Attracting tourists from a broader range of countries by marketing Kenya in new countries. Encouraging tourists to visit a wider range of sites within Kenya, including in the west of the country. Maximizing the net benefits oftourism by attracting high-spendingtourists. Encouraging pro-poor tourism, by providing grant support to enable villages to encourage tourists to visit and through outreach programs explaining to communities the benefits of tourism. Protecting the environment. Improving training and standards. Refurbishing hotels with support from the Ministry of Finance through duty remission to hotels. 5.3 1 This ambitious agenda addresses key areas needed to increase the benefits of tourism for economic growth and poverty reduction. However, some of the most important hindrances to tourism currently-security concerns and general economic conditions-fall outside the remit of the tourism ministry.

Reversing the slump

5.32 Kenya has the natural attractions, the experience, and the institutions to quickly attract many more tourists. With rehabilitation of infrastructure and hotels and an improvement in the perceived and actual levels of security, Kenya could rapidly rebound as a tourist destination, enabling tourism to again contribute a substantial proportion of GDP.

5.33 Security is the first concern. The Kenya Tourism Foundation argues that the tourism police force (currently a small separate unit of the police force) should be expanded to cover known danger spots and to respond to every incident of crime reported by tourists.81 While this policy might have a short-term role, the presence of a large tourism police force has a number of

81 The Kenya Tourism Foundation also argues that security of tourists is better in national parks, which are serviced by the Kenya Wildlife Services in than it is in the national reserves, and it recommends extending the security mandate of the Kenya Wildlife Services to the reserves.

80 drawbacks. First, tourists do not like to perceive themselves as a group in need of special protection. Second, enclaves, as discussed above, reduce the potential poverty and local economic impact of tourism. The longer-term answer is clearly to address the broader crime situation in the country, an agenda that is likely to involve significant reform of the police services.

5.34 Within the sector, there may be a case for reducing sector-specific taxes. The tourism sector appears to be heavily taxed. The combination ofvisa fees, airport passenger fees, VAT on hotel stays, catering levy, VAT on visitor purchases, corporate and income taxes, is estimated to amount to 22 percent oftourist spending in Kenya (Thuo, 2003). Because the price elasticity of demand for tourist travel is high (a 1 percent increase in the total price of a package holiday leads to a 3.5 percent decline in travel to that destination), a reduction in taxation on tourism would significantly expand the number of tourist visits and increase sector revenues. However, studies have also suggested that tourists are quite willing to pay fees and taxes as long as those fees support preservation of tourism assets (Christie and Crompton, 2001). Moreover, reducing the price by lowering taxes will not be effective in attracting tourists who are staying away because of concerns about security. Improving security and infrastructure would have a far more immediate effect than lowering taxes in attracting tourists.** Similarly, improving the overall macroeconomic climate will reduce interest rates and encourage investment in a manner that is far more sustainable than providing subsidized credit. Perhaps the most beneficial tax relief would be to abandon visa requirements, as this is not only an issue ofmoney but also one of inconvenience.

5.35 Increasing sustainability and long-term growth will require improved marketing, both to improve Kenya’s image as a safe destination, to attract visitors from new countries, and to encourage tourists to visit more destinations within Kenya. The Kenya Tourist Board is in charge of government-backed marketing efforts and already runs effective marketing campaigns. However, according to officials of the Kenya Tourist Board, Kenya’s marketing budget for tourism is considerably smaller than that of direct competitors (South Africa’s is 12 times larger; Thailand’s is 32 times larger). This suggests that increasing funds available for marketing could be another high-return use ofrevenues generated through tourism.

5.36 Within the country, the strategy should be to foster community-based tourism, ecotourism, and visits to new areas. Successful efforts to redirect tourism to the northern and western areas will help spread the benefits of tourism spending. Backpackers and nationals are two groups that can help bring tourism into these new areas, which lack fully developed tourism infrastructure. Further, because backpacker and domestic tourists are likely to consume locally- produced goods and services, the benefits to local communities can be significant (Hampton, 1998).

5.37 Additional support and incentives may be justified to foster the development of new tourism areas. Communities who want to diversify into tourism may require technical assistance to help set up small and medium enterprises, access finance, train guides, and develop

82 In addition to improving roads, encouraging airlines that have abandoned operations to return and new airlines to start services is important. Airport services can be sustained through revenues from airport shops, rather than airport charges. Opening up domestic routes to international airlines may encourage tourists to spend more time in the interior. This would allow carriers other than Kenya Airways to offioad and pick up passengers in Nairobi prior to flying on to Mombasa.

81 information materials and technical know-how. The Tourism Development Corporation, which formerly built hotels for the government, is now largely moribund, but it could be redirected to help small enterprises in new areas.

5.38 Differential pricing would support a policy that encouraged tourism to new parks. At present, the minister sets tariff rates in parks, and it is difficult to change the tariffs to reflect supply and demand. Reducing entrance fees for less-visited parks would encourage tourists to visit the less well-known parkseS3

5.39 Considerable scope exists for improved land management carried out in partnership with the private sector and communities. Improved coastal zone management is clearly important to ensure that beach and coastal resources are protected. An integrated coastal zone management structure to oversee development in Mombasa and Milindi could form an important element of the recovery process for the coastal hotel industry. Regarding wildlife tourism, the private sector should be encouraged to work with local communities within parks and reserves to increase the benefits of tourism to local people and to improve environmental managements4 Government-private-community partnerships could play an important role in extending reserve areas around national parks for the benefit of all. The Kenya Wildlife Services has found it necessary to erect fences around its parks because of encroachment by farmers and settlements onto the lands, much of which is ill-suited for crop cultivation in any case. To integrate wildlife tourism with national land use policy, the National Environment Management Act should be used to involve local communities in designing and implementing plans for sustainable land use management that can benefit all. This is especially important for the north of the country, where crop production on semiarid land will have a far lower economic rate of return than game viewing by tourists.

5.40 The 15,000 acre Selenkay Conservation Area bordering the Amboseli national park may be one model for encouraging sustainable land use through tourism development that has a real impact on the local economy. The local community set aside the area as a reserve and in return receives income from tourism activities to fund community projects. Tourism generates employment for rangers, trackers, camp staff, and road construction and maintenance crews. Over 100 conservancies have been created to date, but many require further investment to operate.

5.41 The private sector can also play a significant role in improving environmental management. The Ecotourism Society of Kenya, for example, has put in place a certification scheme for ecofriendly resorts based on a number of indicators such as percentage oflocal people employed and use of ecofriendly waste disposal methods. Hotels pay to be certified under the scheme.

83 A study to estimate the optimum pricing of (nontransferable) leases in parks was carried out in the early 199Os, and needs to be updated. Further, the Kenya Wildlife Services Strategic Plan dates back to 1989-90 and needs to be revisited. A new plan should focus on the sustainability of the Kenya Wildlife Services, and should cover issues including diversifying activities, and outsourcing of bandas, shops at park entrance, and even elements of park management.

84 It may also be that Maasai Mara should be placed under the regulatory and security control of Kenya Wildlife Services.

82 5.42 More broadly, there may be an increased role for the private sector in support of policy development in the sector. The two major acts that underpin the sector-the Tourism Industry Licensing Act and the Hotels and Restaurants Act-were both first drafted in the 1960s. A stakeholder forum to update these acts should be held, and perhaps a move towards implementing a model of industry self-regulati~n.~~This process is underway. At the same time, the various government-funded authorities and services concerning the tourism industry (the Tourist Board, Wildlife Services, the Tourism Development Corporation, and the hotel and restaurant authority) should include representatives from the Kenya Tourism Foundation, its member groups, and other stakeholders.

D. SUMMARY AND RECOMMENDATIONS

5.43 This chapter has discussed a number of issues related to information and communication services and tourism. A summary of the recommendations to improve ICT follows:

0 Remove barriers to competition as quickly as possible. The government plan to remove the remaining barriers to competition in the telecommunications sector should be pursued immediately, and the Communications Commission of Kenya should be given technical support to help promote competition.

0 Proceed with plans to privatize Telkom Kenya. Competition will further decrease the market value of Telkom Kenya in a difficult international telecommunications environment. Full (1 00 percent) privatization should move forward, but expectations about the proceeds from the sale need to be scaled back.

0 Involve the private sector in formulation of policy and strengthen capacity to evaluate policy options and regulate the industry. The government should consult with the private ICT sector regarding new laws covering Internet transactions. It should also strengthen its own capacity in information technology. The costs and benefits of ICT parks should be rigorously evaluated before they are rolled out.

0 Improving access to ICT in rural areas is a priority. Community broadcasting and mobile telephony are technologically appropriate and sustainable tools with which to do this. Offering a reverse-auction subsidy to private mobile operators to roll out mobile footprint coverage should be a priority.

0 Postal reform might include private sector participation. The private sector could be involved through management contracts, and through provision of support for investment in modern equipment, to retrench staff, and to retrain remaining staff. 5.44 The government is committed to encouraging tourism and to increasing the benefits of tourism expenditures for poor communities. A number of recommendations might support implementation of the strategy:

0 Take actions to improve security and infrastructure in the country. Sector- specific policies will have little impact unless security and infrastructure improve.

85 At the same time, the Kenya Wildlife Services mandate also needs to be clarified because currently one law covers both protected and unprotected areas, and the Kenya Wildlife Services combines regulatory and management functions.

83 Improve security by reforming the police force, rather than by providing a tourist police force. The tourism police force may be a useful stopgap measure, but a broad reform ofthe police has a more important role to play. Undertake comprehensive land use planning to improve management of natural resources. Land use planning, involving differential pricing ofscarce resources, will increase sustainability ofKenya’s natural resources. e Support community initiatives to diversify into tourism. Encouraging communities to diversify into tourism requires technical assistance. Support for private-sector initiatives to create community-managed private parks on the borders of national parks will increase sustainability of wildlife tourism and enable communities to benefit more from tourism, thereby helping to reduce poverty. e Include various stakeholders in the government-funded tourism organizations. Representatives of the Kenya Tourism Foundation, its member groups, and other stakeholders should be included in the decision-making bodies of the government- funded tourism organizations (Tourist Board, Wildlife Service, the Tourism Development Corporation and the Hotel And Restaurant Authority) to ensure that decisions of the government-funded groups reflect a consensus of the key stakeholders.

84 6. THE INVESTMENT CLIMATE

6.1 The quantity and quality of investment that takes place in a country, as well as its effectiveness in generating growth, is influenced by the overall policy and institutional environment, both present and expected. This environment, often referred to as the investment climate, includes several interrelated dimensions. First, political and macroeconomic stability as well as an open investment and trade regime are critical. Kenya, as already discussed in previous chapters, has done relatively well in these areas. Second, an effective and transparent regulatory environment-easy entry and exit of fms, adequate competition policies, and functioning factor markets-is required. Third, the issue of corruption and, more generally, of governance is important. Finally, the quality and quantity of physical infrastructure, such as power, transport, telecom, water, and financial services are important elements of the investment climate. This chapter focuses on most aspects ofthe investment climate in Kenya. The regulatory framework is discussed in section A. Sections B and C review governance and infrastructure issues respectively (with the exception of telecommunications, discussed in chapter 5). There are two justifications for this focus. First, virtually all observers name the deterioration in the investment climate as being the main cause for the stagnation in investment and the decline in productivity growth during the past decade. Second, most of the variables that make up the investment climate are amenable to public choices. This chapter suggests a number of policy actions that will help spur investment and increase productivity.

A. THE REGULATORYFRAMEWORK

6.2 The regulatory framework for investments includes competition policy, taxes and incentives, the labor market, and technology, infrastructure, and institutions.86 An efficient regulatory framework is one where regulations do not encourage adverse selection and moral hazard, and are implemented without harassment or corruption. Smooth entry and exit processes are key to fostering competition and for creating pressure for firms to innovate-less efficient producers being forced to improve their productivity or exit the market.

Competition policy

6.3 The entry of new businesses in Kenya has been streamlined in recent years and startup of an enterprise is not seriously constrained by legal requirements. The Investment Promotion Center provides a one-stop shop for local and foreign investors that choose to use its services. The center issues the certificate of authority within 30 days of application and often in just a few days. Since last year, local authorities are required to issue a single business permit automatically, allowing enterprises to start operating without waiting for all permits (except where public health and environmental issues are involved). This has improved entry in many areas but in many small cities local authorities are slow and obstructive. The cost of the single business permit, around US$l,OOO, is considered high by small and micro enterprises.

86 Also important for the well functioning of the regulatory framework is the adequacy of the commercial legislation (company law, bankruptcy law, protection of shareholders, and creditors rights). These issues should be assessed in further work.

85 6.4 The framework for competition is adequate but specialized skills for safeguarding competition are lacking. Competition policy in Kenya originated with the price control ordinance of 1956. A comprehensive act covering restrictive trade practices, monopolies and price control was passed in 1988 and revised in 1990, and is currently under review (Institute of Economic Affairs, 2002). The control of prices is less relevant today since prices have been, liberalized. The Monopolies and Prices Commission (MPC) is in charge of safeguarding competition, and the commissioner is empowered to conduct enquiries and make recommendations to the Minister of Finance.

6.5 On restrictive trade practices, the act covers such restraints as discriminatory pricing, tied purchasing, resale price controls, predatory pricing, and collusive tendering. Tied purchases are widespread, and shops can insist that customers buy additional items along with goods in short supply. Experts have argued that several restrictive trade practices cannot be banned by legal proceedings (Vyas, 2001). For instance, collusive pricing by manufacturers are deemed void but are not illegal. This ambiguity has caused confusion in the enforcement agencies. Moreover, the MPC lacks the necessary legal and economic skills to mount the investigations that are necessary to prove the actual impact of restrictive trade practices on competition. Finally, fines are very low. The maximum for undertaking restrictive business practices, for example, is around US$1,250 (Institute of Economic Affairs, 2002).

6.6 On control of monopolies, the act covers market dominance and mergers and acquisitions. It defines monopolies and concentration of economic power fairly broadly and the MPC is empowered to investigate any instance of unwarranted con~entration.~’ In this, the Kenyan law follows the practice of the United Kingdom of case-by-case analysis in the public interest, rather than viewing activities against predetermined criteria on market dominance. However, controlling monopoly power on a case-by-case basis requires significant skills, information, and time. The MPC has few resources for training staff in the specialized skills required and therefore has weak capacity to fulfill its antimonopoly functions. The last industrial census in Kenya was undertaken in 1982 and was never published. No reliable data on market concentrations in industry exist, making the task of the MPC more challenging. In addition, the MPC is required to assess the impact of all proposed mergers and acquisitions on productivity, export competitiveness, and employment creation. As with controlling monopoly power, this is an activity requiring specialized skills and information, and the capacity of the MPC to effectively perform this task is limited. The number of mergers and acquisitions in Kenya has been rising in response to liberalization (from around 9 per year during the seven years 1989-96 to 23 in 1998 and to 24 in 1999). Mergers and acquisitions comprised 70 percent of the MPC caseload during 1996-2000, up from 56 percent during 1989-96.

Taxes and incentives

6.7 Kenya’s tax regime is comparable to other countries in the region, but the extent and effectiveness of investment and export incentives should be reviewed and possibly

87 The definition is where one or a few firms control an economic activity to the extent that they are in a position to dictate terms and conditions on which goods/services provided by them are bought or sold. The factors that require particular attention in identifying concentration of economic power include control of distribution with sales exceeding 33 percent of the relevant market, control of over 66 percent of the supply of a manufactured product in the domestic market, shareholding exceeding 20 percent in a manufacturing enterprise, and a beneficial interest in the distribution of the relevant product.

86 rationalized." The tax base is narrow and many firms and individuals have escaped paying taxes because mechanisms of enforcement are weak. Historically, Kenya has offered significant 89 90 incentives to investors and exporters but they have not spurred high rates of investment. , Kenya enacted EPZ legislation in 1990, well ahead of most African countries. It now has 23 zones operating, some of which are run by the government, but most or which are privately operated.

The labor market

6.8 Kenya has a fairly well developed system of industrial relations. Labor laws are being revised to make them consistent with the conventions and recommendations of the International Labor Organization. Firms experiencing competitive pressures and economic difficulties, can lay off workers fairly easily if they pay due compen~ation.~'The main problem appears to be the industrial court. Employers claim that the court is biased in favor of employees, and that its decisions are not open to appeal by employers. In recent years, wage increases approved by the court have tended to exceed productivity rises by a significant margin.

The proposed investment code

6.9 A draft investment code has been in discussion since 1998, and has yet to be finalized. Under the proposed code (the Kenya investment bill, 2002), the Investment Promotion Center will be transformed into the Kenya Investment Center, which will become responsible for licensing new businesses, promoting Kenya as a place to invest, and advising on the investment climate. The incentives offered under the code will be available to all businesses with paid up capital of Ksh 10 million or more that obtain a license from Kenya Investment Center. Besides the existing incentives, investors will have the right to deduct expenditures on basic infrastructure

88 The corporate tax rate is 32.5 percent for locally incorporated companies and 40 percent for branches of foreign companies operating in Kenya. The withholding tax is 15 percent on interest, 10 percent on dividends, and 20 percent on management fees and royalties. The rates of VAT are 18 percent on most goods, 16 percent on restaurants, 0 percent on inputs for healthcare and education, and 0 percent on exports of goods and services. Excise duties are levied on beer, tobacco, matches, spirits, wines, mineral water and confectionaries. The personal tax on income is 0- 32.5 percent (IMF, 2003). 89 Investment incentives include investment allowances at 100 percent on plant, machinery, equipment and buildings. Liberal depreciation allowances are: 2.5 percent on industrial buildings; 4 percent on hotels; 12.5 percent on plant and machinery; 25-37.5 percent on motor vehicles, trucks and tractors; and 30 percent on computers and office equipment. Businesses that suffer losses can carry forward such losses to be offset against future taxable profits. Imported materials used for exports are eligible for duty remission under the Export Promotion Programs Office. The 'Manufacturing under bond' (MUV) scheme grants 100 percent investment allowance. 90 Incentives to industries operating within EPZs include ten-year tax holidays and a flat 25 percent tax for ten years afterwards, exemptions from all withholding taxes on dividends and other payments during the first ten years and exemption from import duties on machinery, raw materials and intermediate inputs. Other export incentive schemes include: the dutyNAT remission, available to all industries importing raw materials for use in export production; the MUV, which allows participating industries duty and VAT exemption on imported plant, machinery equipment, raw materials and intermediate inputs; and all enterprises producing for export or for duty free sale in domestic markets are exempt from duty and or VAT on imports for production of such goods.

91 The procedures for processing redundancy is contained in section 16 A (1) of the Employment Act and section 4, subsections 4, 5, and 6 of the Trade Disputes Act. Employers are entitled to effect the redundancies without any prior approval of the Minister of Labor. The compensation for layoffs as severance pay is no less than 15 days pay for each completed year of service.

87 from corporate taxes. Spending on research and development will be entitled to exemptions and privileges. Export activity, under bond or in EPZs, will receive the usual privileges according to the EPZ Act. Investments in priority areas are entitled to rebates on corporate taxes. The code provides for a board for the Kenya Investment Center and proposes that a national investment council be established, chaired by the president of Kenya, with 12 public officials and 12 private sector members. The council is to identify and consult on impediments to investment, and monitor and promote industrial development and public-private cooperation. The act envisages that an investment appeals tribunal will hear appeals from enterprises or license holders on the decisions of the center or of the minister. The act provides for guarantees against expropriation except for security and related reasons.

6.10 The proposed investment code introduces the investment license, which is unnecessary. The current draft reflects many of the comments given by the Foreign Investment Advisory Services (FIAS) of the World Bank in 2000 on an earlier draft of the code. An important exception, however, relates to the licensing of new investments, which is not best practice. Applicants for a license will have to provide information on the qualifications, number and nationality of management staff, as well as on technology transfers and management agreements. The Kenya Investment Center will be required to appraise app