Kenya: Kenya Economy Profile

Overview

Kenya’s economy continues to grow strongly (5% in 2014) on the back of increased consumption and investments. However, public finances are still weak and the depreciating currency poses short term risks for inflation and deficit service. In the medium term, elections in 2018 could give rise to increased ethnic tensions and result in civil unrest.

Strengths (+) and weaknesses (-)

(+) Regionally significant and relatively well diversified economy

The economy is relatively well diversified. Furthermore, Kenya’s central role in regional transport, telecommunications and financial services should keep is supportive of economic activity.

(-) Ethnically heterogeneous society prone to violent outbreaks

The high degree of ethnic diversity and the rivalry amongst the various tribes on issues such as land division and political preferences, create an environment prone to violent conflicts.

(-) High reliance on external flows as a result of structural twin deficits

Large and structural current account and fiscal deficits render Kenya highly reliant on external financing.

(-) Economy vulnerable to weather conditions

Droughts have a significant negative impact on the Kenyan economy as they affect output in agriculture, agro-processing industries and cause reduced energy supply from hydroelectric plants. This as well impacts inflation, through higher prices for food and fuel.

Key developments

1. Kenya’s increase story is still attractive

Kenya’s economic increase was strong in 2014 (5%), mainly driven by consumption and investment increase (Figure 1). Consumption increase has been helped by lower commodity prices (as Kenya is a net commodity importer), an increasing people and financial inclusion (reflected by, amongst others, an increase in mobile financial services). Moreover, Kenya’s economic outlook remains favourable, which is for example reflected in increasing business confidence.

Namely, the new CFC Stanbic Purchasing Managers Index (PMI) is rising and the CBK Market Perceptions survey as well indicates increasing a positive outlook (in the sectors agriculture and tourism). We expect GDP increase to remain a little over 5% in the near next. Risks to this outlook stem from currency depreciation, which may lead to a spike in inflation and/or an increase of the key interest rate of Kenya’s Central Bank. The Central Bank of Kenya faces the difficult decision to raise rates again in order to fight inflation, but as a consequence hurt economic increase.

Moreover, even if the central bank raises rates, this may not be very effective because fiscal policy is expansionary. Namely, the government has ambitious infrastructure investment plans. These plans bode well for economic increase but as well put upward pressure on inflation, making tighter monetary policy less effective.

2. The government is struggling to clean up public finances

Kenya’s government is planning major infrastructure projects to tackle its infrastructure deficit and to diversify its power mix towards renewable energy as part of its “Vision 30” development plan. In the long term, this bodes well for economic increase. But in the short term, the government’s inability to reduce its spending is likely to weaken the by presently weak public finances (Figure 2). Revenue collection is weak and tensions between President Kenyatta and his deputy William Ruto will delay fiscal consolidation.

As a result, Kenya’s fiscal deficit in 2016 is expected to widen to 8% of GDP and its public deficit is expected to increase to 56% of GDP, which is high for a developing country. Moreover, since governance of public finances is weak, issuing deficit is relatively difficult. As an example, a recent statement by Auditor General Edward Ouko on Kenya’s public accounts highlighted that the government cannot adequately account for a large part of its spending.

3. The depreciating currency remains the major risk

The major short to medium term risks for Kenya is a sharp depreciation of the Kenyan Shilling (KES). The KES has by presently depreciated significantly (18%) against USD since January 2014. Moreover, this depreciation is likely to continue presently that the luck of a US Fed interest rate hike in December 2015 has increased. Because Kenya has large twin deficits and relies on foreign capital to finance these deficits, the country is perceived as relatively risky part investors. Furthermore, capital flows (for example deficit and FDI) can react strongly to external factors because Kenya has a relatively well developed financial market. Thus, an increase in the US interest rates (which makes Kenyan government bonds less attractive) causes capital to flow out of Kenya relatively quickly, which puts downward pressure on the KES. Imported goods become additional expensive as a result and since Kenya imports a lot food and fuel (the request of which tends to be relatively price inelastic), inflation rises. Inflation not only reduces purchasing power but as well increases the luck that the Central Bank may raise its key interest rate (which has happened twice in 2015, to fight inflation inclunding defend the KES). Both outcomes hurt economic increase. A weaker currency carries an extra risk: the depreciation of the KES to the USD makes servicing foreign currency deficit additional expensive in local currency. As 43% of Kenya’s public deficit is denominated in foreign currency, the impact may be significant.

4. In the medium term, the 2018 elections pose a risk of instability

Although terrorist attacks (such as the one on Garissa University in April 2015) still pose a threat to Kenya’s tourism sector, the better risk to instability in the medium term is presidential election in 2018. Namely, voting in Kenya tends to be based on ethnicity and politicians tend to politicize these tensions. Interethnic tensions have cause political upheaval around elections in the completed. In 2007, for example, outgoing Prime Minister Raila Odinga protested against the outcome and called for his supporters to take to the streets. This caused violence and bloodshed. Moreover, Kenya has only had presidents of the Kikuyu or Kalenjin ethnic groups, which could cause the other communities to feel being left out of political power. We do not believe the luck of upheaval is large since the 2013 elections were peaceful. In the 2013 elections, Odinga as well protested, but this time in court rather than on the streets. This signals and increase in the perceived credibility of the legal system. In addition, a new constitution has (by creating 47 new counties) given some power back to lower levels of government. These factors indicate that risks due to ethnic tensions may have reduced. But interethnic tensions do not die over one election cycle and Kenya remains susceptible to instability around elections, given its completed, high unemployment levels and poverty.

Background information

Kenya has a relatively well diversified and sophisticated economy that plays an significant role in the East African Community, a customs union as well comprising Burundi, Rwanda, Tanzania and Uganda. The agricultural sector is an significant foreign currency earner and source of employment, but the services sector is the major sector. It comprises, for example, vibrant financial and telecommunications industries. Telebanking is widespread part mobile phone users. Furthermore, Nairobi is regarded the financial centre of East Africa. Tourism and transportation are as well significant for the economy, as Kenya is an significant vacation destination and a regional hub for logistics. Africa and Europe are Kenya’s major export markets. The dynamic private sector in Kenya is in stark contrast to the country’s high level of corruption and the difficult business environment, as indicated by indices in the factsheet. Decompositions hereof reveal that Kenya’s tax regime scores particularly poorly. Poverty as well remains persistent in Kenya and social development is low.

The Kenyan political landscape is highly divided along ethnical lines and the changing nature of coalitions makes it very volatile. Kenya gained independence in 1963 and became a one-party national under the Kenya African National Union (KANU). In 1991 it switched to a multi-party system. The fragile democratic credentials built up by the initial (peaceful) shift of power in 2002 was damaged by the post-electoral violence in 2007. In response, a new constitution was adopted in 2010 to strengthen the democratic institutions and Kenya presently has a presidential system characterized by a clear division of powers between the executive, the legislative and the judiciary.