RaboResearch - Economic Research

Kenya: climbing economy, sliding currency

Country Report


Kenya flag
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 debt service. In the medium term, elections in 2018 could give rise to increased ethnic tensions and result in civil unrest.

Strengths (+) and weaknesses (-)

(+) Regionally important 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 also impacts inflation, through higher prices for food and fuel.

Key developments

1. Kenya’s growth story is still attractive

Kenya’s economic growth was strong in 2014 (5%), mainly driven by consumption and investment growth (Figure 1). Consumption growth has been helped by lower commodity prices (as Kenya is a net commodity importer), an increasing population 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 latest CFC Stanbic Purchasing Managers Index (PMI) is rising and the CBK Market Perceptions survey also indicates increasing a positive outlook (in the sectors agriculture and tourism). We expect GDP growth to remain a little over 5% in the near future. 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 growth. Moreover, even if the central bank raises rates, this might not be very effective because fiscal policy is expansionary. Namely, the government has ambitious infrastructure investment plans. These plans bode well for economic growth but also 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 growth. But in the short term, the government’s inability to reduce its expenditure is likely to weaken the already weak public finances (Figure 2). Revenue collection is weak and tensions between President Kenyatta and his deputy William Ruto will delay fiscal consolidation. Consequently, Kenya’s fiscal deficit in 2016 is expected to widen to 8% of GDP and its public debt is expected to increase to 56% of GDP, which is high for a developing country. Moreover, since governance of public finances is weak, issuing debt is relatively difficult. As an example, a recent report by Auditor General Edward Ouko on Kenya’s public accounts highlighted that the government cannot adequately account for a large part of its expenditure.

Figure 1: Economic growth is still strong
Figure 1: Economic growth is still strongSource: Macrobond
Figure 2: Public finances are weakening
Figure 2: Public finances are weakeningSource: Macrobond

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 already depreciated significantly (18%) against USD since January 2014. Moreover, this depreciation is likely to continue now that the chance 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 among investors. Furthermore, capital flows (for example debt 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 more expensive as a result and since Kenya imports a lot food and fuel (the demand of which tends to be relatively price inelastic), inflation rises. Inflation not only reduces purchasing power but also increases the chance that the Central Bank might raise its key interest rate (which has happened twice in 2015, to fight inflation as well as defend the KES). Both outcomes hurt economic growth. A weaker currency carries another risk: the depreciation of the KES to the USD makes servicing foreign currency debt more expensive in local currency. As 43% of Kenya’s public debt 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 greater 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 past. 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 chance of upheaval is large since the 2013 elections were peaceful. In the 2013 elections, Odinga also 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 might have reduced. But interethnic tensions do not die over one election cycle and Kenya remains susceptible to instability around elections, given its past, high unemployment levels and poverty.

Factsheet Kenya
Factsheet KenyaSource: EIU, CIA World Factbook, UN, World Economic Forum, Transparency International, Reporters Without Borders, World Bank.

Background information

Kenya has a relatively well diversified and sophisticated economy that plays an important role in the East African Community, a customs union also comprising Burundi, Rwanda, Tanzania and Uganda. The agricultural sector is an important foreign currency earner and source of employment, but the services sector is the largest sector. It comprises, for example, vibrant financial and telecommunications industries. Telebanking is widespread among mobile phone users. Furthermore, Nairobi is regarded the financial centre of East Africa. Tourism and transportation are also important for the economy, as Kenya is an important vacation destination and a regional hub for logistics. Africa and Europe are Kenya’s largest 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 also 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 state under the Kenya African National Union (KANU). In 1991 it switched to a multi-party system. The fragile democratic credentials built up by the first (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 now has a presidential system characterized by a clear division of powers between the executive, the legislative and the judiciary.

Economic indicators of Kenya
Economic indicators of KenyaSource: EIU
Raphie Hayat
RaboResearch Global Economics & Markets Rabobank KEO

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