Buoyant growth, low inflation and stable currency
Kenya's economic growth has strengthened thanks to receding political tensions after the prolonged 2017 election cycle. Moreover, the new Kenyatta government has outlined four major priority areas for development over the next five years[1] in order to increase growth potential and create a middle-income economy.
According to the National Bureau of Statistics estimates, during the third quarter of 2018, real GDP growth reached 6.0%, compared with the low point of 4.7% in Q3 2017. The recovery in 2018 was driven by the strong performance in the agricultural sector (+6% y-o-y in the first nine months of 2018) due to improved weather conditions, resilient growth in the services sector (+7% y-o-y) and the rebound in activity in the manufacturing sector (+2% y-o-y) coming from stronger electricity and water supply.
The easing of political uncertainty has restored confidence in the economy, as evidenced by the greater stability of the shilling. The stability of the Kenyan shilling (KES) firstly is due to the narrowing of the current account deficit, itself the result of improved receipts from services, strong inflows from tea and horticulture exports and resilient diaspora remittances, which have compensated the increased dollar demand for manufacturing and energy imports. Moreover, it reflects the strong direct investment inflows which reached USD 925 million in 2018 (1.3% of GDP, +38% y-o-y).
Hikes in tariffs on power in mid-2018 and tax rises imposed in September of that year put upward pressure on energy costs at end-2018, although declines in oil prices provided some relief. The inflation rate rose slightly to 4.3% in March 2019 (from the low point of 4.0% in August 2018), but favourable rains and broadly stable food prices have maintained inflation rate within the central bank’s target range of 2.5%–7.5%.
Moderate inflation and the stable shilling allowed the central bank to ease the monetary policy in 2018, which allowed a slight decline in interest rates compared with the same period in 2017[2].
Low fiscal credibility and high borrowing needs
Kenya’s public accounts suffer from low fiscal policy credibility up to 2017 and rising government debt. Budget deficits averaged 8% of GDP in the past five years because of expansionary fiscal policy driven by several factors (implementation of the 2010 Constitution, elections, drought relief and the large social program planned for the implementation of the “Big Four” program throughout the president’s new mandate).
In 2018 a significant fiscal adjustment was achieved with the fiscal deficit declining to 6.8% of GDP from 8.5% of GDP in 2017. This was achieved primarily by reducing development expenditure (by 2.7 percent points of GDP) in a context of a significant decline in revenues (15.5% of GDP against 16.3% the previous fiscal year). In an attempt to compensate for the decline in revenue, the authorities adopted some measures in September 2018[3]. However, in January 2019 the Treasury published a draft budget with higher deficit targets (6.3% of GDP in 2019 and 5% in 2020 compared with previous projections of 5.8% and 4.7% respectively).
The revised deficit targets will translate into higher public debt (expected to reach 59% of GDP in 2019). Interest payment has reduced the fiscal room as they represent 21% of fiscal revenues in 2018 vs. 13% two years earlier. Albeit manageable, this implies more borrowing from both external and domestic sources. Domestically, the government announced the issuance of KES 50 bn (1% of GDP) in 10 to 20-year Treasury bonds in April to finance the 2018/2019 budget.
The government is also preparing to launch a third sovereign bond for about USD 2bn in 2019 (after the first USD 2.75 bn bond issue in 2014 whose five-year portion of USD 750 million will be repaid in June this year and a second bond USD 2 bn issue in February 2018). But the precise timing will depend on market conditions since risk appetite for Kenyan sovereign risk has deteriorated so far with current sovereign spreads rate at 490 compared with 280 at beginning 2018. Treasury is looking to roll over maturing debt and issue USD 1 bn syndicated loan for new cash. The increasing recourse to private borrowing increase both exchange rate and refinancing risks.
In order to contain external borrowing costs, the government recently restarted discussions with the IMF to try to obtain a new loan agreement in 2019 after the expiration of the previous IMF stand-by arrangement in September 2018[4].
Banking sector: improvements in the offing
One of the policy changes that the IMF has been pushing to reach a new agreement has been the removal of the controversial law capping lending rates on bank loans[5]. The cap has negatively affected lending to small and medium-sized enterprises, although private-sector credit was already experiencing decelerating growth due to structural constraints (such as inadequate provisioning and reporting and corporate governance deficiencies) and economic headwinds.
De facto, the lending rate cap has reduced the access to credit for small businesses as banks prefer to lend to the government and large companies leading to a distortion in the credit allocation so far.
While the legal provision on deposits was removed last year, the Nairobi High Court suspended the implementation of the lending cap in March 2019 citing unconstitutional sections that disrupt the relationships between banks and customers. The law has been suspended for 12 months, but loans should continue to be priced at the current capped rate to give parliament time to reconsider the unconstitutional sections.
During 2018, banks’ gross loans increased by 5.4%, with about 16% for government loans. With average interest currently at 13% against 10% rate for government T-bills, growth in credit to the private sector remains subdued (+3% y-o-y in January 2019), and the banking system’s non-performing loan ratio remains high (12.5% in January 2019). Overall liquidity in the system improved thanks to a notable rise in gross deposits (+12.6% y-o-y in January 2019).
The lifting of the loan-rate cap will certainly increase interest rates on lending in the medium term. According to the World Bank, this measure may boost private-sector credit through reestablishing of lending support (consumer and mortgage loans) to households with a positive impact on the private consumption. In the meantime, the move could favor and speed up the signature of a credit agreement with the IMF.