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How to kick-start Kenya’s second growth engine

Wolfgang Fengler's picture

Last year, Kenya’s economy was behaving like a plane flying through a storm on one engine. After a lot of turbulence, especially when the shilling reached a record low against the dollar, the Central Bank intervened forcefully, and brought the plane back to stability.

But Kenya’s exchange rate woes are just the tip of the iceberg (see figure). Kenya’s big challenge is to reduce the gap between the import bill and exports revenues, what economists call the “current account deficit” (which remains large, even when services—such as tourism—are included). Last year, the deficit reached more than ten percent of GDP, approximately Ksh 400 billion (US$ 4.5 billion). This is larger than Greece’s.

Figure: Kenya’s exchange rate – The tip of the iceberg (click on it to see it larger)
Source: World Bank estimate, adapted from Kenya Economic Update, December 2011

In order to balance its current account, Kenya would have to more than double the volume of its three top exports—tea, tourism and horticulture. In addition, Kenya is vulnerable to shocks, like increasing oil prices.  Oil is one of Kenya’s top imports, and the oil import bill alone rose from $2.7 billion in 2010 to $4.1 billion in 2011, further weakening Kenya’s fragile current account.  A large current account deficit does not automatically translate into a falling currency, so long as capital inflows fill the gap. But in Kenya, capital inflows have increasingly been short-term (by contrast to Foreign Direct Investment which finances factories and offices). Short-term capital can leave a country as fast as it comes, and this uncertainty is an additional source of fragility for the national currency.

When the Central Bank increased interest rates sharply at the end of last year, it brought the airplane into safety, cooling the engine that was overheating. The price was some economic slowdown, as loans (which businesses rely on to invest), became more expensive. Now that the plane has emerged from turbulence, every attempt should be made to make it fly faster and higher. Kenya’s first engine—domestic consumption—which is fuelling vibrant service and construction sectors, has always been strong. But the second engine—exports—needs to perform better. If not, Kenya will continue to operate below potential, for years to come.

But how do you do that? What products could Kenya realistically export? Picking winners is typically not a good idea. The government needs to provide the conditions—such as infrastructure, the rule of law, and basic social services—for businesses to thrive, but not run them. At the same time, it is clear that Kenya needs to move into new products, because it cannot grow rich on tea and flowers alone. The natural starting point is manufacturing. Kenya has a good location and a skilled labor force, which is rapidly urbanizing. The global manufacturing market is also changing. Today, Asia is the world’s workshop, producing almost everything from clothes, shoes, toys and increasingly cars. But Asia’s economic success translates into higher wages, and many manufacturing jobs will soon leave its emerging economies. The World Bank projects that 85 million manufacturing jobs will leave China over the next decade. Where will these jobs go? Can Kenya get a share?

A new way to understand a country’s competitiveness is to look at the existing composition of exports or “product space”. Ricardo Hausmann from Harvard University has been spearheading the global analysis of countries’ product spaces, and the World Bank recently hosted him in Kenya. According to him, some countries are richer than others because they have more productive knowledge, which they can use to make more and more complex products. In short, rich countries make a lot of products, including several which only few countries produce. Poor countries only make a few products, and the margins they earn are low because many other nations are also producing them. Realistically, a country will only be able to diversify gradually, moving first to products where a country can apply existing capabilities. Kenya is strong in tea and flowers, but it will have a hard time producing airplanes overnight.

What types of products are within Kenya’s reach, and which activities are most likely to create the conditions for industry to invest and expand? There is some light at the end of the tunnel. Kenya has started to diversify its export products and markets. Three sub-sectors stand out: textiles (exported mainly to the US), chemicals and machines (to Africa and Asia). In the 1990s, these exports accounted, on average, for about US$ 120 million in earnings. In the following decade, the figure was four times larger at US$ 480 million. On an international scale, these are still extremely small numbers, but they are starting to add up.

Still, Kenya is currently punching below its weight. According to simulations by the Harvard team, Kenya should grow at 7 percent a year. If it did, it would reach Middle Income status by 2018, and remain East Africa’s uncontested economic heavyweight. We know that Kenya can grow at such levels. It happened in 2007, but the big question is how to sustain the momentum? Can Kenya really grow at 7 percent year after year, including through election turbulence? Can the second engine start pulling its weight? Once it does, sit back, enjoy the flight, and definitely buckle up!
 

Comments

Submitted by Maina Edward on
Soaring to new heights in the economy is a possibility, however, inadequacy in dealing with factors such as inflation and taking a reative stand rather than a proactive one by cbk will retard future growth.

Submitted by Leosis on
Hello Edward, we have Inflation and Inflation then we also have hyper inflation. Which of the 3 are you talking about? See below from Ha-Joon Chang on Inflation (select comment but very valid) "During South Korea’s period of supergrowth, inflation was between 17% and 20%. This is higher than many of the Latin American countries. Even the most liberal intellectuals like Bill Easterly, ex-economist for the World Bank, stated that if inflation stays below 20%, it won’t make much of a difference. There are no studies that categorically defend inflation indexes below 10%." http://www.cartamaior.com.br/templates/materiaMostrar.cfm?materia_id=10417

Submitted by Reginald Kadzutu on
Research by FAO shows that a 10% growth in the agricultural sector leads to 3% growth in a countries GDP. The sector employs close to 75% of the Country, income growth for workers and farmers will have an exponential impact on the little to non- existent Kenyan domestic demand. Increase in domestic demand will have ripple effects on other sectors on the economy to increase supply to meet demand. However the sad thing is that investment into this sector is not congruent with its importance. the sector is always at the mercy of the forces of nature, and the economic effects of a drought in Kenya are well known. Land under irrigation is small, more investments need to be made there, Is this the golden goose to propel the country into double digit growths, and we are missing it right under our nose?

Submitted by Wolfgang on
Dear Reginald, Agriculture has an important place in Kenya's economy representing about 25% of total output. At the same time, once a country increases its income the share of agriculture in the economy tends to decline. But this is happening while agriculture is becoming more productive and more connected to markets. As a result there will be fewer, more productive, people working in agriculture. In addition, it is important to note that key economic activities complement each other. Some of Kenya’s key industries are in agriculture processing and these agriculture based industries will also need services such as education, health, and ICT. Wolfgang

Submitted by edgar on
The funny thing with economic development is that it comes down to a copy paste affair and theoritizing about it just makes matters complex. Which country or where does Kenya want to be like? The thing to do then is for the country to cultivate ideas which will propel it to the desired status,right! In doing so the country must be alive to the its strengths and be very resilient with contagion effects because of interconnectivity. An opportunity exists in LAPPSET which will litrally open up and provide the much needed impetus to development not only economically but socially. Sound debt management policies at the highest offices should also be enacted to curtail Greece like scenarios but all in all infrastructural investments (ports,roads and communication),tweaking the financial industry and modernizing agriculture are key for this nation.

Submitted by Anonymous on
To kick-start you may also have to kick-out part of the the flying team. Also, you mention "definitely buckle up!" Do you expect turbulence? Cause I prefer the freedom to move around the aisle anytime during the flight especially to use the bathroom. i.e. will growth be shared equally? Or will the income inequality and preferential treatment increase the chances of another 20007.

Submitted by Wolfgang on
Thank you very much for developing the plane analogy further. You correctly highlight Kenya’s inequities. Free movement of people, be it in a plane or between locations of one country will remain critical. In terms of “creating a level playing field” and Kenya’s momentous devolution you may want to have a look at this week’s supplement in the East African and check out one of my previous blogs: http://blogs.worldbank.org/africacan/creating-a-level-playing-field

Submitted by fadzleen on
Should Kenya opt for food manufacturing industry for a kick start. May i know the current status of Kenya basic income level in USD (minimum wage)

Submitted by Wolfgang on
Dear Fadzleen, You are right. Kenya has already a number of food processing industries (e.g. cooking oil) and could build on this. However, as mentioned earlier, the key is to provide the right environment for other export industries to take of (good roads, reliable energy, an efficient port), instead of “picking winners”. Kenya’s annual per-capita now stands at US$ 780 per capita which translates into slightly above US$ 2 per day. Kenya’s poverty line is similar to the international poverty line (US$ 1.25). Wolfgang

Submitted by Kenyan on
Agriculture, tourism, manufacturing including new capital intensive industries that target local, regional and international markets, services, why not try all these approaches and yes, the government should help pick winners since you can create the conditions but it may take a long time before private investors acknowledge the newly created environment, or are convinced that there is a new and conducive environment? Kenya does have the potential, we only need good leadership and good governance.

Submitted by Wolfgang on
I agree that good governance will decide on the issues you highlight. Also, my next blog is on tourism, clearly a sector with huge untapped potential. But why should the government pick winners? Which ones would you choose?

Submitted by Sam on

I like the plane analogy. There is also the issue of recurrent expenditure by govt, I,e salaried , wages etc. the economy must grow faster that the increasing wage bill. Over 50% of Kenya's budget is going to recurrent expenditure. This is a a dangerous precedence as development project are starved of funds. The new Uhuruto administration must find ways to tame the growing wage bill. To refer to aviation, to fly further and longer, the plane must mantain high altitude I.e FL 350 or 400 where air is thinner hence lower jet fuel consumption.

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