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The Budget to Boost Economic Growth

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The macroeconomic environment in Kenya has remained relatively stable in the first half of 2018, supported by (i) continued investment in infrastructure, (ii) a stable interest rate environment, (iii) a relatively stable currency, having gained by 2.1% in H1’2018, and (iv) improved business confidence and strong private consumption as evidenced by an average Stanbic PMI of 55.0 in the first 5 months of 2018 up from 50.2 in the first 5-months of 2017. The outlook on economic growth for 2018, is positive following improved weather conditions set to boost agricultural productivity, water supply and electricity that will in turn favor the manufacturing sector and (ii) recovery in the business environment following easing of political risk caused by the prolonged political impasse over the 2017 presidential elections. Low private sector credit growth, which stood at 2.8% as at April as compared to the 5-year average of 14.0%, remains one of the key concerns for economic growth.

Kenya’s Finance Minister Henry Rotich presented the largest budget on record for the 2018/2019 fiscal year to parliament on 14 June, with the income tax bill tabled alongside it. Both came into effect on 1st July 2018. The government aims to strike a tough balance between realizing an accelerated pace of economic expansion through increased infrastructure investment while also striving for an improved fiscal picture. However, it remains to be seen if the government will be able to meet its ambitious fiscal target, as the budget was devoid of bold tax reforms and the country has suffered from low revenue collection in recent years.

The new budget is 25% bigger than the previous one and amounts to around KES 3 trillion (USD 29 billion). It targets a deficit of 5.7% of GDP for the new financial year, below the estimated 7.2% of GDP for FY 2017/2018. If achieved, this would mark the lowest deficit since 2013. Spending will be tailored to meet the goals set under President Uhuru Kenyatta’s “Big Four” agenda, which will prioritize investment in manufacturing, food security, universal healthcare and affordable housing over a five-year span. In addition, a large chunk of expenditure will go towards servicing the country’s burgeoning debt. On the revenue front, a number of small tax measures were introduced, including a Robin Hood tax of 0.05% that will be instituted on any amount exceeding KES 500,000 transferred through banks or financial institutions. However, the budget was devoid of a large tax reform. While a higher tax bracket of 35% for Kenyans earning above KES 250,000 per month was proposed in the early stages of the draft, this measure was withdrawn from the final bill and awaits further guidance from the cabinet.

Meanwhile, the highlight of the income tax bill was the repeal of the interest rate cap on commercial bank lending rates that has long stymied the availability of credit to the private sector, especially to small- and medium-sized enterprises, and has been a persistent impediment to achieving higher economic growth. The overturn was eagerly awaited by Kenyan banks that have long voiced opposition to the ceiling on the cost of loans, which has hindered their ability to price risk. However, the bill has yet to be approved by parliament, which is likely to see pushback against the law in favor of maintaining access to cheap credit.

Kenya’s economy was derailed last year by a severe drought that crippled agricultural output and a prolonged election cycle, in addition to growth being limited by the interest rate cap. With the political scene returning to stability and weather conditions improving, economic activity has picked up since the start of the year, expanding at a solid pace for six consecutive months. While the measures proposed by the budget should aid the economy onto a higher growth trajectory, the government will be tasked with a tough challenge in meeting the ambitious fiscal consolidation aims given its track record of missed revenue targets.

The latest national accounts data released by Kenya’s National Bureau of Statistics on 29 June published GDP figures for both the final quarter of last year and the first quarter of the current year. The economy expanded 5.7% annually in Q1 2018 and 5.3% in Q4, up from a revised 4.7% in Q3 (previously reported: +4.4% year-on-year). Improved weather conditions and more upbeat business and consumer confidence, thanks to a return to political stability following last year’s prolonged election cycle, powered the upturn in both quarters. Growth in quarter-on-quarter seasonally-adjusted terms shot up to 1.7% in Q4 from a revised 1.1% rise in Q3 (previously reported: +0.9% quarter-on-quarter), before edging up to 1.9% in Q1.

Looking at a breakdown by production, most sectors improved. The agricultural sector made a marked recovery in Q1 on the back of favorable weather conditions, including the onrush of heavy rains in early March, with output expanding 5.2% after losing considerable pace in Q4 when it slowed to a 1.4% expansion (Q3: +3.8% yoy). Manufacturing output rebounded in Q1, growing 2.3% after contracting 0.4% in Q4, which followed a flat reading in Q3. Higher economic growth was also supported by a surge in the real estate sector, which expanded 6.8% in Q1 (Q4: +6.3% yoy; Q3: +6.1% yoy) and a steady pace of expansion in wholesale and retail trade (Q1: +6.3% yoy: Q4: 6.2% yoy).

On the other hand, both the mining and quarrying, and electricity and water supply sectors recorded a slower pace of expansion in Q1. Mining and quarrying output lost momentum for the second consecutive quarter, expanding 4.5% in Q1 (Q4: +5.0% yoy; Q3: +6.4% yoy). Although the electricity and water supply sector grew a robust 5.1% in Q1, largely owing to geothermal power generation, the sector slowed slightly from a 5.8% upturn in Q4 (Q3: +4.5% yoy).

This year, it is expected that the government’s record-high budget for the 2018/2019 financial year would support an accelerated pace of expansion through increased infrastructure spending, but the drive to achieve greater fiscal consolidation at the same time will be tough given the administration’s poor track record in meeting revenue collection targets in recent years. And while the proposal to repeal the cap on commercial bank lending rates—a policy that has long thwarted the availability of credit for high-risk borrowers, has been tabled through the income tax bill—the Treasury will face a tough battle in doing so, owing to stiff opposition from parliament.

Offering their take on the budget, EFG Hermes’ research team stated:

“As in 2017/18, we think potential revenue shortfalls will require the government to submit supplementary budgets through the fiscal year, which could lead to the deficit coming in higher than the 5.7% estimated by the finance minister, which in turn could worsen the country’s growing debt burden. Banks currently own more than 50% of total domestic outstanding debt, given that the government intends to raise almost half of the net additional borrowing from domestic sources, any offshoot in the budget estimate is likely to further crowd out the private sector, especially since banks’ exposure to government securities is already at a seven-year high (due to the introduction of rate caps in 2016).”

Nonetheless, the economy is expected to accelerate this year, thanks to the fading impact of the drought, increased investment and a continued expansion in the agricultural sector. Private consumption should be supported by more favorable credit conditions stemming from the removal of the interest rate cap. Moreover, completion of phase one of the standard gauge railway between Mombasa and Nairobi should help curb import demand and narrow Kenya’s current account deficit. While the return to political stability will lift confidence, substantial fiscal tightening could limit the pace at which the economy will expand. Analysts project GDP growth of 5.5% in 2018.

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Kenya

Kenya’s Economy to Experience Moderate Slowdown In 2019

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Kenya’s economy entered the year on a less promising note, with weaker domestic demand causing a notable slowdown in private sector activity. That said, a buoyant tourism sector and solid remittance inflows, which have helped narrow the current account deficit, likely cushioned the impact of the decline. Unfortunately, the country aimed to raise up to KES 50 billion (USD 500 million) through auctioning a tax-free 25-year amortized infrastructure bond on 20 March, with proceeds expected to fund the “Big Four Agenda” development projects and the bond was to some extent undersubscribed and resulted to a total of KES 16.3billion bonds accepted by the Central Bank of Kenya (CBK) as against the KES 50billion bonds anticipated.

The government’s appetite for spending, however, is at loggerheads with the need for fiscal consolidation. Reining in the country’s escalating public debt burden is a necessary condition to securing a new IMF standby credit facility; discussions with the IMF are currently underway.

 

Highlights of Kenya’s Economic Performance

  • It is expected that headwinds to growth in private consumption, investment and exports will see Kenya’s economy expand at a slower pace in 2019.
  • The ongoing cap on bank lending rates – which will continue to dampen credit growth – and rising inflation will constrain growth in private investment and household consumption.
  • Public investment directed under the ‘Big Four’ agenda will support GDP growth, but is likely to fall short of government expectations.
  • Moreover, export growth is likely to decelerate in 2019 due to reduced production of tea, the country’s main export.
  • It is forecasted real GDP growth of 5.2% will be experienced in 2019 and 5.5% in 2020 respectively, down from an estimated 5.8% in 2018.

 

 

Subdued Credit Growth to Hurt Trade Sector and Households In 2019

It is expected that the harmful banking sector regulations and rising inflation will temper the pace of growth in private investment and private consumption in 2019. Credit growth will continue to be constrained by an interest rate cap introduced in 2016, which limits bank lending rates to 400 basis points above the central bank policy rate. It is forecasted credit growth will remain in single digits in 2019, growing by 7.5% by year-end, compared to a 2010-2015 year-end average of 20.4% (prior to the cap).

This will continue to affect business investment in the wholesale and retail trade sector (the largest recipient of private credit) as well as private consumption, given that household credit represents the second largest share of total private credit. Moreover, these effects will be compounded by an acceleration of inflation to a forecast of 6.0% in 2019 from 4.7% in 2018, given normalizing weather conditions which are likely to boost food prices. It is expected rising inflation will further weigh on private investment and consumption growth in 2019 by increasing firms’ input costs and weakening households’ purchasing power.

 

Meanwhile, public investment as a driver of growth will fall short of the government’s ambitions. It is noted that overall, fixed investment in 2019 will benefit from a healthy infrastructure project pipeline, which includes the Standard Gauge Railway (Phase 2A) and the Lamu Port, scheduled to reach completion in 2019 and 2020 respectively. A forecast on the construction sector is expected to grow at a robust 8.6% in 2019, from 7.5% in 2018, to then tail off from 2020 given project completions.

Public investment will also be directed under President Uhuru Kenyatta’s ‘Big Four’ agenda, which aims to boost healthcare coverage, affordable housing, food security and the manufacturing sector. That said, we believe that implementation of the agenda’s objectives will face structural constraints stemming from administrative inefficiencies and funding shortfalls.

Moreover, several tax measures introduced in the 2018/19 fiscal budget to fund the various programs encountered resistance from lawmakers, including a value-added tax on fuel that was imposed at half the initially proposed rate (8.0% instead of 16.0%). Therefore, it is believed that public spending under the Big Four agenda will have a lesser impact on growth than the authorities expect.

Lower Tea Output to Weigh On Total Export Growth In 2019

Furthermore, weaker tea production is likely to weigh on export revenue growth. In February 2019, the Tea Directorate of the Agricultural and Food Authority estimated a 12.0% y-o-y reduction in tea exports for the full year, owing to lower output in the tea-growing regions of the west. Kenya is one of the world’s main producers of tea, which accounted for 25.6% of total exports in 2018 – the largest share of the country’s export revenue.

Therefore, it is believed that this will drag on total export growth, further contributing to a slowdown in headline growth. Moreover, it is highlighted the possibility that normalizing weather conditions after favorable agricultural yields in 2018 could also weigh on production growth of horticultural goods, the second largest export component (accounting for 19.5% of Kenya’s exports), posing further downside risks.

 

It is believed that risks are tilted firmly to the downside. Kenyatta’s inability to push many economic policies through parliament have in the past hampered implementation of key initiatives, including proposals to remove or modify the interest rate cap on commercial banks. It is believed that, should Kenyatta’s position weaken further, this could slow policy-making and progress on the Big Four agenda. Moreover, weaker-than-expected global economic activity could see the return of risk-off sentiment to financial markets and renewed pressure on emerging market currencies later in the year (although it is stressed that this is not a core view).

Since more than half of Kenya’s government debt (which stands at 61.3% of GDP) is denominated in foreign currency, pressure on the Kenyan shilling would significantly increase debt servicing costs, posing further headwinds to public investment and clouding the country’s short-term growth outlook.

While risks are weighted to the downside, it is to be noted that the removal of the interest rate cap on commercial banks in 2019 would pose an upside risk to our view. Indeed, on March 14 2019 a Kenyan court ruled that the cap is unconstitutional, though judges suspended the implementation of the ruling for 12 months to allow legislators to review the law.

 

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