Project Report On Macro Economics

Kenya Economy

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TABLE OF CONTENTS

...............................................................................................................................................1 TABLE OF CONTENTS............................................................................................................2 Introduction: Kenya Economy (Sub-Saharan Africa)...............................................................3 Objective of the study...........................................................................................................5 Macro Economic Indicator Table ...........................................................................................6 GDP Trend............................................................................................................................7 Trade and Industrial Policy..................................................................................................10 Exchange rate policy...........................................................................................................19 Monetary policy & Fiscal Policy...........................................................................................23 References:........................................................................................................................29

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Introduction: Kenya Economy (Sub-Saharan Africa)

Kenya is considered by many today to be the heartland of East Africa. It has a total area of approximately 580,000 km2, making it slightly smaller than the state of Texas. The country's southeastern border is defined by the Indian Ocean, and its southwestern border includes a small portion of Lake Victoria. Kenya's climate changes from tropical along the coast to arid in the interior. Although Kenya is located on the equator, temperatures of many of its cities are moderate because they were built at high altitudes. The terrain consists of low plains, central highlands, which are separated by the Great Rift Valley, and a fertile plateau. However, as little as 3% of the total land area of the country is arable (able to support a crop). It is the 47th largest country in the world in terms of land area; Major agricultural products in the country are tea, coffee, wheat, sugar cane, dairy products and eggs. Important industries of the country are cement, tourisms, oil refining, and consumer goods. Kenya's economy relies heavily on agriculture and tourism Currency: Kenya shilling. National accounts base year: 2001. SNA price Kenyas economy suffers from a high population growth rate and rampant corruption. Kenya stands at the 147th position, Kenya's economic performance weakened over the last decade because of the failure to sustain prudent macroeconomic policies, the slow pace of structural reform, and the persistence of governance problems. The often Tax fiscal policy led to a rapid build up of short-term government debt which, in combination with declines in the saving rate, translated into lending rates in excess of twenty percent in real terms. This, together with other high costs of doing business in Kenya because of corruption, a deteriorating infrastructure, and an inefficient parastatal sector (e.g., utilities, and transportation services) - depressed investment and its effectiveness, and as a consequence economic growth. The Political Setting: The first three decades after independence, Kenya remained largely a oneparty state except for brief periods between 1963 and 1964 and 1966 and 1969 when the Kenya African Democratic Union (KADU) and the Kenya Peoples Union (KPU), respectively, served as opposition political parties.

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Objective of the study

1.

Review fiscal , monetary , industrial , trade and exchange rate policy of last three decades Analyze How and why they have changed Analyze Impact of policy change on the economy

2. 3.

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Macro Economic Indicator Table

Subject Descriptor
Gross domestic product, constant prices Gross domestic product, constant prices Inflation, average consumer prices Inflation, average consumer prices Population General government revenue General government revenue

Units
National currency Percent change Index Percent change Persons National currency Percent of GDP

Scale Billion s

1980 530.2 45 5.572 7.931 13.86 6 16.63 2 n/a n/a

1985 622.9 15 4.073 14.61 11.39 8 19.87 1 24.36 2 16.95 1 -0.101 -1.152

1990 814. 48 4.13 4 22.8 37 11.2 23.5 52 52.3 53 18.7 98 0.47 9 3.93 1

1995 872.1 99 4.287 66.14 1.554 26.92 142.0 11 23.11 9 -0.509 -4.265

2000 967.8 38 0.599 100 9.955 30.1 195.0 25 20.15 1 -0.284 -2.309

2009 1,366. 31 2.406 204.03 9 9.251 35.884 538.39 4 23.679 -2.032 -6.742

Million s Billion s

Current account balance

U.S. dollars Percent of GDP

Billion s

Current account balance

-1.083 10.72 4

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GDP Trend
Between 1974-1990 implementation of import substitution, rising oil prices made Kenya's manufacturing sector uncompetitive. Lack of export incentives, tight import controls, and foreign exchange controls made the domestic environment for investment even less attractive. All these reasons are responsible for low GDP growth GDP growth slow from 1985-90 but positive as Implement structural policy reforms to achieve food security main objective is self sufficiency in major food item, improved food security at national level first phase of the agricultural reform (because country second largest contributor is agriculture sector) was implemented during 1986-88 , main goal was to increase agricultural production by increasing the supply of fertilizer , setting producer price for food crops in an effort to provide adequate economic incentive & stable earning ,relaxing market regulation From 1991 1993 Kenya had its worst economic performance since independence. Growth in GDP stagnated, and agricultural production shrank at an annual rate of 3.9and the government's budget deficit was over 10% of GDP. As a result of these combined problems, bilateral and multilateral donors suspended program aid to Kenya in 1991. Poor harvests slowed growth. Disagreements over the direction of future investments led to a suspension of foreign aid in 1992 resulting in low growth and high inflation. In 1993, the Government of Kenya began a major program of economic reform and liberalization a new minister of finance and a new governor of the central bank undertook a series of economic measures with the assistance of the World Bank and the International Monetary Fund (IMF). As part of this program, the government eliminated price controls and import licensing, removed foreign exchange controls, privatized a range of publicly owned companies, reduced the number of civil servants, and introduced conservative fiscal and monetary policies. From 1994-1996 Kenya's real GDP growth rate averaged just over 4% a year. Stable macroeconomic conditions, liberalized markets, and more efficient operations of the strategic public enterprise share expected to enhance the level and the efficiency of private investment, and result in increased income and job creation. To achieve these objectives, Kenya will require an increase in gross fixed capital formation from 21.7 percent of GDP in1995 to 23.2 percent

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in 1998. The investment recovery will be financed out of national saving, which is projected to increase from about 20 percent of GDP in 1995 to 24.5 percent in 1998. In 1997 the economy entered a period of slowing or stagnant growth. A drought caused continuing power interruptions slowed business and manufacturing and cast doubts on the country's ability to sustain growth Reasons 1. Due in part to adverse weather conditions and reduced economic activity prior to general elections in December 1997 2. In July 1997, the Government of Kenya refused to meet commitments made earlier to the IMF on governance reforms. As a result, the IMF suspended lending for three years, and the World Bank also put a $90 million structural adjustment credit on hold In1999 Government mismanage the funds during the period, most development agencies (including the IMF and World Bank) refused to extend loans and gave up on structural reform programs. The Government of Kenya took positive steps on reform for taking loan from IMF & World Bank, establishment of the Kenyan Anti-Corruption Authority, and measures to improve the transparency of government procurements and reduce the government payroll. The fiscal deficit (on a commitment basis before grants) has been gradually reduced and is estimated to have been 0.6 percent of GDP in 1999/2000 From 2005-2008 Corruption is the biggest impediment to Kenya's economic growth. Following the foreign aid frauds, international agencies delayed fund advancements. Corruption is the biggest impediment to Kenya's economic growth. The post-election violence in 2008 worsened the economic conditions. Thus, without the establishment of political stability, Kenya's economic growth will remain volatile. 2008, Kenya placed into power a Coalition Government following the signing of a Peace Accord, which led to stability and opened a renewed opportunity for growth. The services sector, which is the main driver of the economy, accounted for as much as 59.5% of the GDP in 2008. That same year, tea exports totaled $850 million, while fresh horticulture exports fell to $838 million (from a record high of $1.12 billion in 2007). Tourism earned Kenya $762 million in 2008, a decline of 19% from 2007. In 2005 horticulture accounted for 23 percent and tea for 22 percent of total export earnings. The

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reduction from the 2007 growth was brought about by disruptions in the free flow of goods, labor and services that occurred in the first two months of 2008. Tourism was highly affected, with manufacturing and agriculture also declining. In 2009 The Economic Survey, 2009 showed impressive gdp growth of 7.1% , was severely affected in 2008 by number of factor included the 2008 post election crisis, the global financial crisis, the high fuel and food prices among others. Political instability and budget deficits In2010 Kenya has seen the return of higher growth projected at 4.9 percent and growth was 4.1 closely, and may now be at a tipping point for robust growth. Five factors are creating a positive momentum: the new constitution, EAC integration, ICT innovations, strong macroeconomic management, and recent investments in infrastructure. ICT has been the main driver of Kenya's economic growth over the last decade, growing on average by 20 percent annually. Transport and communications sector into the economies second largest after agriculture.

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Trade and Industrial Policy

The manufacturing sectors share of GDP has increased only marginally in the last three decades. Kenya's economic performance declined during 80s. Import ratio high than Export, Import dependency varied in accordance with production fluctuation so Kenya's inward-looking policy of import substitution Table-1 show the sectors growth rates and contribution between 197395. It is evident that the contribution of the sector has only risen marginally from 11.8 percent in the 197379 periods to only 13.6 in the 199095 periods. The sectors growth slowed down from 10 percent in 197379 periods to only 3 percent in the 1990s. A combination of factors including the import substitution strategy, poor weather conditions, import liberalization and deteriorating infrastructure could explain the slack. All these reasons are responsible for low GDP growth

Table-1: Percentage Growth and Contribution to GDP, 198095 Growth of output Contribution to GDP 1973-79 1980-89 1990-95 1995-99 10 4.8 3 11.8 12.8 13.6 2 13.1

Source: Republic of Kenya, Development Plan, 19972001

The manufacturing sector in general suffers from low value added and depends heavily on imported raw materials, capital goods and spare parts. Consequently, local linkages between and among industries are weak to generate requisite growth and employment synergy. The only exceptions are industries based on natural resources and agriculture. Manufacture sector Export performance has also in many ways been disappointing. Annual Growth Rates of Kenya Exports
Period 1976-84 1984-90 1990-97 Total export -2.13 4.01 2.3 Manufactures 2.83 4.28 2.1 Food and beverages 0.66 1.85 1.62 Other product (primary) -3.38 -3.55 1.1

Source: Republic of Kenya, Statistical Abstracts and Economic Surveys

Post-independence at 1963 the Government recognized the important role that industrialization could play in the national development process and

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consequently accorded high priority to industrial development to achieve the objectives of industrialization which include employment generation, diversification of the economy and conservation of foreign exchange, the government pursued a number of policies and strategies. The Moi Regime -1978 to 2002 Mois regime also witnessed the emergence of multilateral and bilateral donor institutions as crucial actors in the countrys economic policy formulation especially in the 1980s and 1990s. These changes started in 1980 when the country joined a group of other African countries implementing the World Bank-IMF SAPs. By the close of the 1990s, the role of the donor community had become perhaps the most important force in Kenyas policy formulation process. The participation of donors was particularly enhanced by the economic crisis which gripped the country in the second half of the 1990s making the country heavily dependent on external donor resources. The 1980s saw increased cases of deliberate harassment of leading indigenous businessmen who were perceived to be opposed to the political regime. Some of the publicized cases of locally owned manufacturing firms that became bankrupt due to officially instigated measurers include Madhupaper and J.K. Industries. There was a widespread perception within a large section of the Moi political elite that the entrepreneurial class that emerged during Kenyattas era was largely drawn from a narrow ethnic base and did not have adequate loyalty to the regime. Liquidity pressures from government-owned banks, denial of import licensing, credit facilities and other licensing measures were used to drive some of these local firms into bankruptcy, resulting in considerable slowdown in the indigenization of key sectors especially manufacturing, banking and distribution. Mois regime has been generally characterized by poor performance of the economy in the 1980s and the 1990s. While a number of external factors like commodity and oil shocks and the unfavorable international environment are partly responsible for the performance, a number of domestic factors such as mismanagement, corruption, poor infrastructure and insecurity have been more important.

Evolution of Trade and Industrial Policies

Kenyas industrialization efforts in the post-colonial period have been undertaken through three main phases of industrial policy:

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1. 2. 3.

Import substitution Export promotion and Structural adjustment phases.

The Import Substitution Phase After independence, Kenya pursued an import substitution strategy as a means of promoting industrialization. The strategy was influenced by the conventional wisdom prevailing during this period in most developing countries. The objectives of the strategy were rapid growth of industry, easing balance of payments pressure, increased domestic control of the economy and generation of employment. To achieve these objectives, the government relied on a variety of policy instruments including an overvalued exchange rate, high tariff barriers, import licensing, foreign exchange controls and quantitative restrictions to protect local producers against foreign competition Foreign exchange measures were extensively used during this phase to protect local manufacturers. The Foreign Exchange Allocation Committees were established to administer foreign exchange quotas for imports for which a limited quota had been established to protect domestic producers. Foreign exchange controls were used to discriminate against certain imports, promote foreign exchange earning industries and to conserve foreign exchange which was a major constraint in the economy. Kenya tariff structure reflected the overall import substitution strategy. Tariffs were generally high on imports of final products relative to capital and intermediate goods. For example, throughout the import substitution period, the average unweighted scheduled tariff rates for textiles and clothing were about twice the rates for capital and intermediate goods such as machinery and building materials. Until the collapse of the East African Community (EAC) in 1977, Kenya could not unilaterally change external tariffs. However, due to a weak administrative capacity, quantitative restrictions proved to be more effective in controlling imports compared to tariffs. Import license requirement was the main instrument for quantitative regulation, with inputs and certain products receiving preferential or priority treatment in the issuance of import licenses. Impact of the Import Substitution Industrialization Policies: The import substitution phase and the policies that sustained it had mixed results.
On the positive side:

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Country enjoyed a considerably high rate of industrial growth during the first decade of independence with the manufacturing sector growing at an average rate of 8.0 percent compared with rates below 5 percent in the 1980s and 1990s. Industries that recorded rapid development during this period were processing of plastics, pharmaceuticals, steel rolling and galvanizing, electrical cables, paper, vehicle assembly, industrial gases, rubber ceramics, and batteries manufacture. Some industries expanded from a few establishments into industries with a wide range of products and a large number of employees. They include paper, textiles and garment manufacturing, food processing, leather tanning and footwear

Growth Rates of Selected Economic Indicators, 19801994

Growth rates (%) Industrial Manufacturing GDP 1980-85 12.9 3.7 10.4 1985-90 7.3 5 11.3 1990-94 9.6 2.5 12.1 1994-98 17.4 0.7 12.4

Source: Republic of Kenya, Economic Survey and Statistical Abstracts

Investment was encouraged through high protection, a liberal attitude toward foreign investors, an active role played by the government in promoting industrialization through provision of credit facilities and other incentives and a relatively stable political and economic environment that was attractive to both domestic and foreign investors. The high growth rate was also facilitated by the economic dynamism normally associated with the import substitution strategy in the initial stages. On the negative side: There was a general deterioration in the countrys overall economic performance due to a number of factors. Industrial production for export markets slowed down substantially because the incentive structure favored production for domestic markets creating an inward-looking industrial sector whose potential was severely limited by the size of the domestic market. Import-substituting industries created too few jobs while many industries used inappropriate capital-intensive technologies that created a manufacturing sector heavily dependent on imported equipment and raw materials. Moreover, the sector failed to develop strong linkages with the rest of the economy partly because of undue emphasis of production of consumer goods

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at the expense of capital and intermediate goods. Under the strategy, the indigenous population failed to control a significant portion of the manufacturing sector. Manufactured exports thus formed only a small proportion of the countrys exports while industrial development was concentrated in Nairobi and a few major towns (Ikiara, 1988; Nyongo, 1988; Ogonda, 1990). There was thus growing disenchantment with this strategy by early 1980s due to these and other shortcomings. Impact of policy change on the economy:
1.

Failures of the import substitution strategy were caused by external factors beyond the control of Kenyas policy-makers. First, the 1973 oil crisis resulted in an escalation of costs of production and exerted pressure on the balance of payments with adverse effects on availability of imported raw materials and equipment. The collapse of the regional market in the late 1970s forced manufacturers to depend on a much narrower market, making many of them operate with excess capacity and carrying high overheads which undermined their competitiveness even with various protective measures.

2.

The Export Promotion Phase As a result of increasing recognition of the economic realities facing the country, the government made some attempt to change the industrial strategy from import substitution to export-led industrialization. These intentions were evident from development plans and policy documents published during late 1970s and early 1980s. The Fourth Development Plan (19791984), for instance, advocated a more open strategy for the industrial sector. Policies designed to create an enabling environment for industry through increased reliance on marketbased incentives and less regulatory structures. This was to be done through a series of reforms in trade and industrial regimes
1.

The quantitative restrictions were to be gradually replaced with equivalent tariffs. The tariff rates were to be rationalized and reduced over time.

2.

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Other recommended measures included a more liberal exchange rate policy and strengthening export promotion schemes During the period 198590 A number of institutional and market oriented initiatives were taken to reorient the economy away from the import substitution strategy to export promotion. These included the export compensation scheme, manufacturing under Bond (MUB), and import duty and VAT remission schemes that were intended to improve export producers access to imported inputs at world prices. The export compensation scheme was to compensate exporters for government taxes on inputs, while the manufacturing under bond programme was meant to encourage manufacturing for world market. Under the programme, which was open to local and foreign investors, inputs were imported duty-free. Establishment of the export processing zones in Nairobi, Mombasa, Athi River and Nakuru. Another scheme was initiated in 1991 to promote exports through duty and VAT exemption. The scheme also introduced regulatory changes designed to make investment in bonded factories and export processing zones more attractive. Impact of export promotion policies: The structure of Kenyas total exports by broad economic category between 1984 and 1994. While traditional commodity products such as food and beverage continued to dominate over the period accounting for over 50 percent of the total exports there were signs of increasing diversification. The share of the food and beverage products in total exports had declined from 68 percent in 1986 to 52 percent by 1994 meanwhile the shares of industrial supplies and consumer goods categories had, respectively, risen from 15.0 percent to over 26 percent and 3.8 percent to 13.6 percent between 1984 and 1994. Nonetheless, Kenyas industrial sector remained predominantly inward looking throughout the 1980s and 1990s. A number of factors have constrained the countrys export growth. Implementing liberalization but also did little to put in place effective export promotion policies insufficient exchange rate adjustments in the 1980s frustrated import liberalization while inefficient fiscal adjustments worked against investment. The end result was a persistent bias against exports despite the announced shift away from import-substitution to an outward-

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looking export strategy. High tariff rates and burdensome administrative procedures contributed in discouraging Kenyan exporters from vigorously pursuing export expansion programs as manufacturers found it more profitable to produce for the protected domestic market. Both the public and private sectors exhibited adverse attitudinal stances that worked against a successful push to increase export of manufactures. Despite government policy announcements in favor of exports, exporters were often not given adequate support by the government. Exporters frequently experienced difficulties in obtaining foreign exchange to facilitate trade promotion trips and other activities while their export compensation claims were delayed. The private sector, for its part, was often unwilling to take the steps necessary to raise their competitiveness in international markets. The Structural Adjustment Phase The beginning of 1990s marked the beginning of sweeping economic and political reforms that included privatization of parastatal, liberalization of the financial and energy sectors, price decontrols, and phasing out of import controls. The main thrust of the adjustment programs was to affect a shift from a highly protected domestic market to a more competitive environment that would facilitate increased use of local resources, outward oriented production policies that would promote employment creation and exports expansion. In the early 1980s, The government did not seriously implement the reforms. In November 1991, the donors froze their quick disbursing aid to Kenya as a result of the slow pace in economic and political reforms. This aggravated the countrys economic crisis and balance of payments deficits. This was to serve as a critical catalyst for radical economic and political reforms soon after, and by end of 1991, the government had introduced Foreign Exchange Certificates (Forex-Cs), which became an important source of foreign exchange to the private sector. This marked an important first step in the liberalization of Kenyas foreign exchange market The government continued with the reforms and in the 1993/94 budget introduced a number of changes relevant to the manufacturing sector, including further reduction of import duties, restructuring of Value Added Tax (VAT), introduction of an Essential Goods Production Support Programme and increased incentives for the Export Processing Zone (EPZ) enterprises. As part

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of the policy to reduce government participation, there was need for privatization and restriction of government investment to certain aspects of infrastructure and social services. This period of economic adjustments also witnessed increased pressure for reforms in the political system from a single party regime to a more open, accountable and transparent system for efficient management of public affairs. In early 1990s Coincided with a particularly difficult period for the countrys economy. The period witnessed a sharp decline in major macro-economic performance indicators. The GDP growth rate recorded a negative rate of -0.4 percent between 1991 and 1992, the lowest rate in the post independence period. The real annual growth rate of the manufacturing sector fell from 3.8 percent in 1991 to 1.8 percent. Inflation more than doubled to 46.8 percent from 19.62 percent between 1991 and 1993. The liberalization policies that started in 1980 had a number of weaknesses. First, for a long time the country was unable to attain the necessary speed and the intensity of reform was wanting. The reforms were carried out rather gradually and without full ownership or commitment. The overall protection of the manufacturing sector continued to be high. During the first two phases of liberalization, implementation moved slowly and intermittently, mainly due to little commitment on the part of policy makers and rampant rent seeking which was rapidly becoming one of the most serious bottlenecks in the countrys economic and socio-political development. Weaknesses in the Policy Formulation Process Interviews with retired and currently serving senior policy makers in the country as well as private sector professional and business executives reveal the following weaknesses in Kenyas policy formulation process.
1.

The process has not been adequately consultative even with some of the key stakeholders. Government officials and donor representatives have dominated the initiation of trade and industrial policies, with the private sector playing no or only a minimal role. The low involvement of the private sector and civil society in policy formulation was due to the long period of single-party rule in the country that created a culture of fear and passiveness in national policy issues.

2.

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Kenyas trade and industrial policies have also been greatly influenced by external factors, often seriously diluting the local contribution.
3.

The import substitution industrialization strategy which dominated the first two decades of Kenyas post-independence period, for instance, was largely formulated by the government although this was then the conventional industrialization strategy in most of the developing countries. Poor implementation of policies has been one of the main weaknesses in the countrys economic policy process. This is due to a number of factors including too much concentration of decision-making at the Office of the President, corruption and mismanagement of national resources, inadequate supervision of the public sector workers, inadequate checks and balances and weak reward and punishment mechanisms in the public service.

4.

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Exchange rate policy

Exchange rate and monetary policies are key tools in economic management and in the stabilization and adjustment process in developing countries, where low inflation and international competitiveness have become major policy targets. The real exchange rate is a measure of international competitiveness, while inflation mostly emanates from monetary expansion, currency devaluation and other structural factors. Kenya's exchange rate policy has undergone various regime shifts over the years, largely driven by economic events, especially balance of payments crises. A fixed exchange rate was maintained in the 1960s and 1970s, with the currency becoming over-valued, though not extremely so. Exchange controls were maintained from the early 1970s until a market-determined regime was adopted in the 1990s. Background of Kenya regime Up to 1974, the exchange rate for the Kenya shilling was pegged to the US dollar, but after discrete devaluations the peg was changed to the special drawing rate (SDR). Between 1974 and 1981: The movement of the nominal exchange rate relative to the dollar was erratic. In general the rate depreciated by about 14% and this depreciation accelerated in 1981-82 with further devaluations. The exchange rate regime was changed to a crawling peg in real terms at the end of 1982. This regime was in place until 1990; a dual exchange rate system was then adopted that lasted until October 1993, when, after further devaluations, the official exchange rate was abolished. That is, the official exchange rate was merged with the market rate and the shilling was allowed to float. Exchange controls were maintained until the 1990s, initially in response to the balance of payments crisis in 1971-72. In order to conserve foreign exchange and control pressures on the balance of payments, the government chose controls instead of liberalization. The controls were an easy response to contain balance of payments and inflationary pressures, but they created major distortions in the economy that were not evident until the early 1980s. The major instruments of monetary policy in Kenya have been:
1. 2. 3.

Open market operations, Cash and liquidity ratios, Credit ceilings, and reserve requirements.

In the 1990s, the authorities have relied more on the indirect instruments, the most active being open market operations. The recurring policy objectives have been to maintain an exchange rate that

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would ensure international competitiveness while at the same time keeping the domestic rate of inflation at low levels, conducting a strict monetary stance and maintaining positive real interest rates. This has been difficult in practice. The floating exchange rate system The floating exchange rate system adopted in the 1990s was expected to have several advantages for Kenya. 1. It would allow a more continuous adjustment of the exchange rate to shifts in the demand for and supply of foreign exchange. 2. It would equilibrate the demand for and supply of foreign exchange by changing the nominal exchange rate rather than the levels of reserves. 3. It would give Kenya the freedom to pursue its monetary policy without having to be concerned about balance of payments effects. Thus the country would have an independent monetary policy, but one that was consistent with the exchange rate movements.

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Under the floating system external imbalances would be reflected in exchange rate movements rather than reserve movements. However, the exchange rate was allowed to float in an environment of excess liquidity, and massive depreciation and high and accelerating inflation ensued (in a specified way). The mopping up process pushed the treasury bill rate up and, because this is the benchmark for other interest rates, all other interest rates shot up to historic high levels. The exchange rate was devalued three times in 1993. After 1993, the exchange rate appreciated under the influence of short -term capital flows taking advantage of the high interest rate on the treasury bills. Those who were importing on trade credit during this time were uncertain as to what prices they would have to pay for foreign exchange when their letters of credit were called and hence wrote the expected foreign exchange redemption into their price structure. This increased the spiral of inflation. Monetary and real exchange rate Monetary shocks drive real exchange rate movements, and real exchange rate movements have an impact on monetary shocks. That is, they drive each other. This implies that when money supply or domestic credit growth is excessively out of line with the growth in economic activity, it feeds into the real exchange rate movements with feedback effects with excess money supply growth. Domestic credit has no feedback effects with the real exchange rate, but excess money supply has, through the channel of net foreign assets.

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Effects between monetary shocks and the cyclical movements of the real exchange rate, and that this cyclical component appreciates the nominal exchange rate. In addition, money supply growth depreciates the nominal exchange rate, exchange rate interventions have been important in explaining nominal exchange rate movements, and real income and inflation are negatively associated with the nominal exchange rate movements. Central Bank of Kenya (CBK) will seek to ensure that money supply expands at rates consistent with the growth of economic activities. The Bank will continue to rely mainly on open Market Operations (OMO) to manage the supply of money and credit to the economy. Interest rates in such operations will be allowed to vary, as necessary, to achieve this goal. Credit to the financial institutions from the CBK will be kept low. Foreign exchange intervention by the CBK will be limited to smoothing out short-term fluctuations in the exchange rate. CBK will seek to improve its capabilities to forecast accurately and on a timely basis the movements in reserve money. The Bank will also strive to improve its intervention techniques in the money and foreign exchange markets. Steps will be taken by the CBK to develop secondary markets in Treasury bills to increase the effectiveness of financial markets. Preparatory work on the legal and technical infrastructure for the introduction of Repurchase Agreement instruments (REPOs) will be undertaken in 1996. The Capital Markets Authority will also encourage the private sector to establish a central depository for Treasury bills, which would ensure an efficient delivery and payment system for the bills. An expanded role for the Nairobi Stock Exchange is envisaged, particularly through a widening of the range of financial instruments traded on the exchange and assistance in the privatization of public enterprises.

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Monetary policy & Fiscal Policy

The monetary policy framework has essentially remained the same after independence; the CBK has been continuously refining its monetary policy operations and procedures in order to enhance efficiency and effectiveness in delivering its objectives in a changing financial and economic environment. Thus, following the persistent failure of monetary policy to deliver on its inflation objective in the late 1980s and the early 1990s, the CBK effected significant changes to monetary policy implementation procedures, including the introduction of new instruments. The radical changes effected included the shift towards using indirect instruments of monetary control by introducing open market operations (OMO) and by liberalizing interest rates and the shilling exchange rate. Thus, the monetary policy framework has become more specific with respect to the inflation objective being pursued and the instruments used to achieve it. Before then, monetary policy in Kenya was sparingly used as a tool of economic management because of the pervasive controls covering almost all economic activities, including the banking sector. Monetary policy, under the regime of direct controls, was more preoccupied with reacting rather driving monetary developments. This was of course not unique to Kenya; control was then the fashionable approach to economic policy management in most developing countries. Monetary policy classified into two distinct periods: 1. The period between 1966 and 1992 when Kenya was pursuing a fixed exchange rate and 2. The period after 1993 to date when the country adopted a floating exchange rate From the late 1960s to mid 1980s monetary policy in Kenya was generally passive and focused mainly on the protection of the countrys foreign exchange reserves and supporting the import substitution policy. From the mid 1980s to date to June 2008, Kenya has been implementing monetary policy within an IMF supported programs through the use of facilities such as Structural Adjustment Facility (SAF) in 1986, Enhanced Structural Adjustment Facility (ESAF) and Poverty Reduction and Growth Facility In 1980-81 Liberalize imports, devalue the shilling exchange rate and raise interest rates, these improvements were short-lived. In 1982, the balance of payments worsened to large deficits and inflation accelerates to double digits with growth in real domestic product averaging 3.2 % per annum. This followed the

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second oil shock and a highly expansionary stance in fiscal policy, owing mainly to sharp increase in government expenditures. Throughout the fiscal years 1979 1982, the budget deficit averaged 8 per cent of GDP per annum and was principally financed by borrowing from the banking system. These large budget deficits and the inevitable large borrowing from the banking system marked the beginning of a rough course for the Banks management of monetary policy. While the use of monetary policy before 1979 had yielded reasonable results, it thereafter proved less effective largely because of the non-supportive fiscal policy To redress the rising domestic and external imbalances and restore stability, the government tightened fiscal policy in the fiscal years 1983 and 1984, significantly reducing the borrowing from the banking system. The increase in credit to the private sector also slowed down to around 8 %. Consequently, total domestic credit and money supply also increased less rapidly rising on average at 10.5 and 8 per cent per annum, respectively, over this period. Partly as a result of these developments, the overall balance of payments turned into surpluses. In 1983-84 and inflation declined to 14.6 and 9.1 % In 1983 and 1984, respectively, from 22.1 per cent in 1982. The improvement in the economy during 1983/84 was short-lived. In 1985, the balance of payments reverted to a deficit and inflationary pressures intensified, partly due to the rapid expansion in credit, especially to the government, following a weakened budgetary position. Thanks to another coffee boom, the situation improved in 1986 when the overall balance of payments turned into another large surplus. But because the budget was not tightened in the fiscal year 1986, government borrowing continued to increase. As a result, total domestic credit and money supply rose rapidly by 35.1 and 32.5 %, respectively. Inflation, however, declined to about 6 per cent in the year. By 1985 it had become clear to the Kenya government that the economic difficulties the country faced were more structural in nature and, as such, in addition to the stabilization measures, it called for far-reaching structural reforms in the economy. As part of a comprehensive economic and financial programme, a number of reform measures intended to enhance the effectiveness of monetary policy were put in place from 1986.New government debt instruments, that is, Treasury bonds of one-, two-, and fiveyear maturities, intended mainly for monetary policy purposes, were introduced in 1986 and the cash ratio for commercial banks was reintroduced at 6 per cent in December 1986. A more flexible management of the exchange rate was adopted and significant liberalization of other areas of exchange and trade systems was undertaken. Perhaps a more significant reform was the

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liberalization and complete decontrol of interest rates in July 1991 and the introduction of open market operations in the same month. Despite the increase in the number of monetary policy instruments available to the CBK, the fluctuations in the growth of domestic credit and the money supply persisted. Domestic credit and money supply expanded much faster than expected in most years between 1987 and 1991. This partly reflected the effect of the expansionary fiscal policy, which made it necessary for the government to resort to more borrowing from the banking system to finance its burgeoning budget deficits. This made the Banks task of managing monetary policy even more difficult. The CBK manages monetary conditions in the economy using the following instruments: 1. Open Market Operations (OMO). 2. The cash ratio requirement 3. Rediscount facilities. Kenyan government revenue versus spending is shown in figure. The Kenyan government has been in budget deficit most years since 1975. Since 2000, government spending has been on a rapid rise without commensurate increases in tax revenue. This rise in spending is due largely to government initiatives to improve infrastructure and support the countrys free education system for an increasing population. In efforts to rein in spending, the Kenyan government made policy changes in 2000 and 2001, including efforts to improve fiscal discipline and transparency by strengthening the governments Office of the Controller and Auditor General. In order to increase tax revenue, the Kenyan government has also expanded its consumption tax policy to apply to more goods. These policy changes have been successful at managing the recent budget shortfall, but budget deficits continue to be a problem for Kenya.

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The major goal of Kenyan monetary policy has been to maintain price stability within the country specifically to keep inflation below 5 percent. Kenyas price inflation over time is shown in figure I. Inflation in the country has been quite high at times and was highest in the early 1990s. This spike in inflation was due to monetary expansions coupled with relaxation of rules governing the exchange of the Kenyan shilling with other currencies; the result was a flood of Kenyan shillings into the domestic market and a drastic increase in inflation. With IMF and World Bank assistances and with further relaxation of exchange rules, the Kenyan government was able to bring inflation back down by the mid 1990s. Since 1995, inflation has been held below 10 percent.

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Kenyan exchange rates are now a managed floating system, a condition of past IMF loans. This designation allows the monetary authority to intervene to control the exchange rate, but no specific level is set as a target rate (unlike crawling peg and fixed systems). Figure shows the exchange rate between the Kenyan shilling and US dollar over the last 35 years. The exchange rate, now that it fluctuates on the world market, is more difficult to predict than in past years. For example, the 2002 rate was depreciated from the year prior, while 2003 rates appreciated.12 falling exchange rates would help theoretically help increase exports, but the world pricing system for commodities may complicate this conclusion. As with the commodity prices, Kenya is limited in its ability to change its exchange rate and affect its exports.

Problem: Low and erratic savings rate

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A major contributor to Kenyas sluggish economic growth is the fact that capital investments are stagnating due to recent decreases in average domestic savings from 1993 to 2001.Without the necessary investment to grow Kenyan capital stock, yearly population increases will very likely continue to intermittently outpace GDP increases and the result will be a per capita GDP that rises in some years and falls in others. Without sporadic losses in per capita GDP, the standard of living in Kenya will not trend ever higher as it should in a nation that successfully transitions from developing to developed status.

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References:
https://www.cia.gov/library/publications/the-world-factbook/geos/ke.html http://www.africaneconomicoutlook.org http://en.wikipedia.org/wiki/Economy_of_Kenya http://www.republicofkenya.org/economy/domestic-economy/ http://www.imf.org/external/ns/cs.aspx?id=28 http://www.imf.org/external/country/KEN/index.htm https://editorialexpress.com/cgi-bin/.../download.cgi?db_name. http://www.idrc.ca/en/ev-71256-201-1-DO_TOPIC.html www.centralbank.go.ke/FAQs/MonetaryPolicyFAQs.aspx

http://unpan1.un.org/intradoc/groups/public/documents/IDEP/UNPAN003896.pdf

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