Tuesday, December 13, 2011

Kenya Economic Update.Navigating the Storm, Delivering the Promise

Kenya is entering a decisive year. Three main developments will make 2012 extraordinary. First, Kenya will hold national elections for the first time since the traumatic post-election violence of 2007-08, which ended Kenya’s high growth momentum abruptly. Second, Kenya’s economy will need to navigate through a severe economic storm, which could well become a hurricane, especially if Europe enters into a recession. Third, the country will implement its most ambitious governance reforms ever, namely the devolution of responsibility to forty-seven new counties. Kenya’s policy makers will need to display tremendous skill and steadfast leadership in order to balance the need for fiscal prudence, with ensuring that resource flows to new local governments are sufficient to meet their needs. High expectations of the promise of devolution need to be met by equally high quality planning and execution of its delivery.

Flying on one engine through the economic storm

Kenya will enter 2012 from a weaker-thanexpected economic position. Kenya’s economy is navigating rough economic waters, where existing structural weaknesses have been compounded by short-term shocks. The most visible sign of Kenya’s economic challenge is the depreciating Shilling, which reached an all time low against the US Dollar in October 2011. The elements behind this situation are high international food and fuel prices, the drought compounded by conflict in the Horn of Africa, the Euro crisis, widening fiscal and current account deficits, and major inefficiencies in Kenya’s agriculture sector. The recent developments are also undermining one of Kenya’s main strengths over the last decade: the credibility and predictability of its macroeconomic policies.

Kenya has been caught in a vicious inflationary cycle. Higher import prices–initially for food and fuel–have sparked inflation, which in turn weakened the Shilling and put further pressure on prices. Because of the sharp depreciation of the Shilling, import prices continued to rise even after global food and fuel prices had started to retreat. Like in many other African countries, inflation increased substantially as global food and fuel prices rose sharply in the first half of 2011. But in Kenya, food prices have been well above high global prices due to the National Cereal and Produce Board’s policy of maintaining high maize producer prices, and its inefficient marketing systems. As a result, overall inflation is expected to reach an estimated average of 13 percent for the whole year–with Kenya’s poor bearing the brunt of the cost. The Central Bank’s recent move to increase the benchmark policy rate from 7 to 16.5 percent has calmed the markets, improved prospects for 2012, and proven that decisive action could shape expectations.

Despite challenges, Kenya is still projected to grow at 4.3 percent in 2011. This is lower than in 2010 (5.6 percent) but substantially higher than during the recent crisis of 2008-09, and also above Kenya’s long-term average performance (3.7 percent). The services sector remains buoyant and tourism is also expected to have a record year, in spite of the recent security concerns. Agriculture was also performing better than expected in the first half of 2011, after a good year in 2010. The short rains are promising a strong harvest for end 2011 and early 2012.

In the absence of further shocks, inflation will slow down in the first half of 2012. Global food and fuel prices have already been declining, and there is a possibility that global commodity prices will fall further, if Europe’s economic situation deteriorates further. Kenya’s good harvest prospects should lower the demand for food imports. Finally, the Central Bank’s tighter monetary policies will slow credit supply and start to reduce core inflation.
But exchange rate and inflation woes are just the tip of the iceberg: underneath the surface is a deep structural problem. Kenya’s economy is increasingly imbalanced, with a growing gap between exports and imports.

This makes the economy particularly vulnerable to external shocks. In 2011, imports soared (mainly due to higher oil and food costs), while exports remained stagnant. The gap between imports and exports of goods and services, known as the current account deficit, now stands at above 10 percent of GDP, which is even higher than in Greece. Today, Kenya’s four main exports do not even earn enough to pay for its oil imports, not to mention other imports beyond oil (see figure 1)! For too long Kenya’s economy has been like an airplane flying on one engine: its strong domestic demand and a vibrant service sector keep it up in the air, but to get to its destination, the second engine (exports) will have to pick up.

Kenya’s economic imbalance is driven by a combination of weak exports and high dependence on oil imports. Its export performance is poor due to a number of factors, including inefficiencies at the port of Mombasa, and an inadequate and expensive supply of energy. This makes Kenya too expensive for international investors, especially in manufacturing, despite low labor costs than in emerging Asia. Kenya is globally competitive in a number of sectors–especially tea, tourism and horticulture–but it has not ventured sufficiently into new products, especially light manufacturing, where opportunities could materialize as Asia’s emerging economies start to graduate from these sectors. At the same time, oil currently accounts for over a third of the import bill, which reinforces the need for accelerating non-fossil based domestic energy generation. The scaling-up of Kenya’s geothermal energy production provides an unmatched opportunity to create reliable clean energy and at the same time reduce the import bill.

If macroeconomic stability is restored, Kenya can reach 5 percent growth in 2012. This is a slight downgrade from the World Bank’s last projection of 5.3 percent, reflecting domestic economic challenges and a weaker global environment. Kenya’s economic vitality will depend crucially on the restoration of macroeconomic stability, prospects for stabilization in Somalia, and a smooth run up to the next elections, followed by a peaceful transition of power from one administration to the next. Services will continue to drive growth in this election year as the country gets into campaign mode. Investment growth will be moderate, as players will hold off on major decisions until a new government is in place.

However, there are substantial risks going forward, especially if the economic crisis in the Euro zone deepens and if the national elections usher a period of economic uncertainty. If one or both risks fully materialize, growth could be as low as 3.1 percent. The ongoing crisis in Europe will have a negative impact on some of Kenya’s main exports which are still dependent on European markets (horticulture and tourism). On the domestic scene, election years in the past have been problematic for Kenya’s growth as investors have held back, waiting to see the outcome and whether there would be a peaceful transition. Over the last 30 years, election years have been associated with a one percentage point lower growth rate than the long-term average. If government does not take pro-active steps to set the stage for a peaceful run-up to voting and a smooth transition thereafter, this unfortunate pattern could be repeated in 2012.

Delivering the promise of devolution

Economic turbulence has hit Kenya at the very moment when it is preparing for the most far-reaching institutional reforms in its history. In the long run, successful implementation of the Constitution is likely to be the single most critical factor in determining Kenya’s development prospects. The establishment of a new leadership team in the justice sectors has created great hopes for lasting change. The next wave of reform, of even greater scale and importance, is the transfer of functions and finance to forty-seven entirely new county governments.

Kenya’s devolution program is one of the most ambitious in the world, because it is transferring a substantial amount of power and resources to an entirely new level of government. In one go, Kenya’s eight provinces and over 280 districts will be replaced by forty-seven brand new counties. In many countries, devolution is a process of giving political autonomy to administrative units that are already in place. By contrast, in Kenya, devolution will entail creating new political and administrative units at once of a more equitable model of development. The prevailing feeling is that investments and services have been spread unequally across the country, often following political and tribal affiliations, thus fuelling resentment. To a large extent, this is in fact correct: not only is economic activity concentrated spatially (which is not inherently problematic), but access to services (which determines future opportunities), also remains highly unequal. The hope is that devolution will address these historical and spatial inequities, by shifting significant resources and responsibilities to semi-autonomous and locally accountable county governments. But there are important challenges to be managed along the way, if the theoretical promise of devolution is to be made a reality.

In a tight fiscal environment, matching resources to needs will be extremely challenging. In order to avoid major resource allocation mismatches, which could leave either the county or the national governments strapped for cash, a detailed process of function assignment will have to be worked-out. In turn, this process should guide the division of revenues between the two levels of government.

Moreover, equitably sharing the county share of national revenue across the forty-seven new counties will be immensely challenging as the fiscal space is simply not there to expand public spending. Any attempt to drastically rebalance expenditures spatially, would undermine existing service delivery and compromise future growth. The Constitution mandates that a minimum of 15 percent of national revenue is to be transferred unconditionally to counties, but this would not be enough to finance the full set of devolved functions. Therefore, determining how many of these functions will effectively be devolved and when, and designing the transfer architecture around this, will constitute the main challenge and potentially determine whether additional fiscal stress is created or whether service delivery is likely to decline in the short run. Preliminary estimates suggest that current spending on functions that could be devolved is well in excess of the minimum 15 percent. (See figure 3) A central paradox of Kenya’s devolution is that counties which stand to gain the most in theory could well be the biggest losers in practice.

The capacity of the new county governments to manage funds efficiently and transparently, and to retain skilled staff to deliver devolved services will vary tremendously. Regions of the country which have been historically left out are precisely the ones for which capacity constraints are likely to be most binding, with the potential for weak financial management, major disruptions in service delivery, and unmet expectations. Therefore, the success of devolution will depend critically on capacity building and preparation at the local level. The national government will also have a crucial supporting role to play, in setting and monitoring minimum standards of financial management and service delivery.

Establishing strong systems and institutions for accountability of county governments will determine whether devolution is successful. Devolution requires renewed emphasis on enhancing accountability of local government to citizens. In many countries, accountability failures have undermined devolution, leading to more corruption and weaker public services. With Kenya’s pioneering “Open Data” initiative and a worldclass ICT sector, the tools are there to be used to ensure that there is accountability between county governments and citizens.

Kenya Economic Update.Navigating the Storm, Delivering the Promisef