Jul 16, 2017

Introduction

There has been a couple of reports and statics that have been released which provide investors and business decision makers with insights on economic stability, growth and progression. This week, we seek to review the performance of economic environment in Kenya and take a view as to the likely direction of the country’s economic performance. The upcoming general elections have been at the centre stage of influencing trends in economic activity in recent past. Political stability has complimented the economic stability of the country and infrastructural spending has supported growth of the economy with developments such as the Standard Gauge Railway being launched in June this year. Below, we discuss some of the key themes that have shaped the economic environment in Kenya.

GDP Growth

The country’s GDP growth for Q1’2017 came in at 4.7%, lower than 5.9% in the same period in 2016. The decline in economic growth was attributed to a 1.1% contraction in the agricultural sector, which was due to the drought that was experienced during the last quarter of 2016, and slower growth in the financial services sector, which grew by 5.3% in Q1’2017, from 8.2% during Q1’2016. Combined, these two sectors contribution to GDP stands at 31.1% and any effect on their growth will reflect on the performance of Kenya’s GDP. The slowdown in GDP growth has come at a time when the World Bank, International Monetary Fund (IMF) and Kenya National Bureau of Statistics (KNBS) have revised downwards their projections on Kenya’s economic growth for 2017 to 5.5%, 5.3% and 5.7%, respectively, from 6.0% for the World Bank and IMF, and 5.9% for the KNBS at the start of the year. All these institutions cited a contraction in the agricultural sector and a slowdown in private sector credit growth being the core reasons for the downward revision of the GDP growth expectations. Economic growth for 2017 is set to be supported by increased spending on infrastructural developments by the government, with the National Treasury having presented a Kshs 2.3 tn budget for the fiscal year 2017/2018, with development expenditure allocation increasing to 33.0% from 28.0% in the previous fiscal year.

We expect GDP growth in 2017 to average between 4.7% - 5.2%, which is stable and quite competitive in the Sub-Saharan Africa region, which is projected to grow by 2.7% in 2017 according to the IMF. However, a lot more needs to be done to diversify the economy to reduce the over reliance on a few sectors to support economic growth.

Private Sector Performance

Private sector in the country has gone through a challenging period as the environment turned sour propelling a decline in the sector’s growth. Some of the key challenges facing the sector is access to credit especially those players that rely on bank funding to support their activities. Private sector credit growth slumped to 3.3% as at March 2017, the lowest in 8-years, from a high of 17.0% in 2016, as a result of reduced loan disbursement by commercial banks following the enactment of Banking Act (Amendment) 2015. The challenging operating environment has seen firms restructure their operations mainly through layoffs and downsizing. Commercial banks have been at the forefront of this, having retrenched 1,470 of their employees and shutting down 32 branches. In our view, crowding out of the private sector remains one of the key challenges that policy decision makers will continue grappling with especially in this era of interest rate caps. For Kenya to be an environment where credit is accessible and affordable there is need to diversify funding sources and reduce over reliance on bank loans as the source of funding.

In our view, in order to spur private sector growth it is crucial to develop capital markets and alternative sources of funding to bring down the 95% funding dominance by banks, as highlighted in our Cytonn Weekly #25/2017.

Public Sector Wage Bill

The public sector has witnessed an expanding recurrent expenditure with salaries and wages to civil servants currently amounting to 52.0% of the GDP above the sustainable level of 35.0% provided for by the Public Finance Management Act. In the recent past, we have experienced strikes by teachers, lecturers, doctors, and nurses, all affecting important sectors of the economy. The downing of tools by these civils servants have pushed the cost of living up as citizens have to access services at a higher cost. The collective bargaining agreements in these sectors are set to push the recurrent expenditure further from the target of 35.0% of the GDP as significant amounts have to be channelled to meet these pay demands, and this is likely to put the country into further debt or cut on development expenditure. However, there could be relief as recently the Salaries and Remuneration Commission (SRC) has recommended a pay structure that will cut salaries of state officers in the National Assembly, Senate, and the Executive arm of the National government by 12.5% to cut the unsustainable public sector wage bill. The hiring freeze by government institutions is also a step in the right direction in addressing the growing public sector wage bill.

In our view, we believe the SRC’s expected wage cut is a good move that will lead to allocation of more resources towards development expenditure in infrastructure that will in turn provide conducive environment for private sector to operate and hence propelling economic growth.

Food Security

According to the Ministry of Agriculture, maize production is expected to decline by 24.3% to 28 mn bags in 2017 from 37 mn bags in 2016, against the country’s strategic food reserve requirement of 40 mn bags. This expected decline is attributable to (i) an army worm invasion in the key maize-producing regions in the country that is expected to cut production by approximately 5.0%, and (ii) rainfall shortages in the main maize producing regions of Uasin Gishu and Trans-Nzoia Counties, expected to cut production by a further 20.0%. The country has undergone a wave of inflationary pressures in the first half of the year, with inflation hitting a high of 11.7% in May up from 6.4% in December 2016. The inflation rate for the first half of the year averaged 9.8%, compared to 6.2% in a similar period in 2016. The rise in inflation was primarily driven by an increase in food prices, which rose by 15.8% during the first half of the year, on account of the prevailing drought in the country. Given that a maize shortage is expected in the coming seasons, we are of the view that if the government does not put in place precautionary measures to address food security in the country, this could lead to a higher inflationary environment in 2018, escalated by the importation of food, which will further increase Kenya’s import bill.

We expect the government to step up initiatives to cure for the deteriorating food situation in the country, with a positive step being the Kshs 2.0 bn per year allocation in the budget for the National Drought Emergency Fund. Inflation rate is expected to stabilize in the second half of 2017 due to subdued food prices following the rainfall witnessed in the second quarter of 2017. For a comprehensive analysis on food security, see our report on cost of living here.

International Trade and Exchange Rate

Kenya has experienced a widening current account deficit, which expanded by 36.1% in March 2017 to USD 4.6 bn from USD 3.4 bn the same period last year. This was due to rising levels of imports, which increased by 23.6% driven by importation of fuels, maize and machinery, while exports increased marginally by 2.4% over the same period driven by tea exports. This has led to a trade deficit expansion of 43.1% in the first four months of the year to USD 3.4 bn from USD 2.4 bn in a similar period last year.

The Kenya Shilling has remained relatively stable during the year having depreciated against the US Dollar by 1.3% on a year to date basis. In our view, the shilling should remain relatively stable in the short term, supported by; (i) the high forex reserve level currently at USD 7.9 bn (equivalent to 4.6 months of import cover), (ii) the IMF precautionary credit facility of USD 1.5 bn (equivalent to 1 more month of import cover) that Kenya can utilize to stabilize the shilling in case of adverse movement in the forex market, (iii) low global oil prices, despite the decision by OPEC to extend oil production cut timelines, which is expected to provide a buffer to the current account balance as Kenya is a net importer of oil, and (iv) improved diaspora remittances, which increased by 2.2% in the first four months of the year compared to a similar period last year.

In the long term, the government needs to address structural issues that affect the stability of the shilling so that the country can benefit from a relatively stable exchange rate environment. These include; (i) promoting exports in order to address the expanding balance of trade deficit, (ii) promoting tourism so as to attract more foreign exchange income, and (iii) putting in place initiatives aimed at increasing diaspora remittances.

Foreign Direct Investments

Frontier and emerging markets have maintained positive investor sentiment in comparison to the developed economies since the beginning of the year, thus attracting foreign investors especially Sub-Saharan Africa. According to a report released by Ernst & Young (EY) Africa dubbed the EY Africa Attractiveness Program 2017, there was a 31.9% increase in capital investments into Africa to USD 94.1 bn in 2016 from USD 71.3 bn in 2015. Most of the FDI inflows were concentrated in the largest economies per region with South Africa in southern Africa, Egypt and Morocco in northern Africa, Nigeria in western Africa and Kenya in eastern Africa. We have witnessed foreign investors bidding for African Eurobonds at high rates, the most recent being Senegal, which recorded a subscription rate of 8.5x on its 16-year international bond, at a yield of 6.3%. Fitch ratings agency has affirmed Kenya’s Long-Term Foreign and Local Currency Issuer Default Ratings (IDRS) at ‘B+‘, with a negative outlook. The ‘B+’ rating is pinned on the country’s solid growth record, strong medium-term growth potential, and a favourable business environment, while the negative outlook is as a result of increased current account deficit, slowing credit growth and uncertainty around the August General elections.

The equities market has witnessed net outflows of USD 11.1 mn since the start of the year, but we expect long term investors to enter the market seeking to take advantage of the current attractive valuations. The upcoming general election creates an uncertain environment and investors are expected to take a wait-and-see approach. We however expect security to be maintained at high levels towards and after the election period as the parliament has previously approved a supplementary budget with an allocation towards security.

Though the uncertainty is likely to affect foreign participation leading to significant foreign outflow from the market, owing to the expected stability during and after the general elections, we expect long term investors to enter the market seeking to take advantage of the current attractive valuations. Kenya’s improvement in the Ease of Doing Business ranking is also set to attract more international investors as witnessed by the entry of leading multinational corporations such as Wrigleys, Johnson & Johnson and Volkswagon.

Conclusion:

For the stable economic environment to persist, the monetary and fiscal policies put in place should be geared towards price stability and revamping the private sector, which is a key driver for economic growth in any developing economy. The government should come up with policy framework aimed at providing a conducive environment for private sector to operate, thereby creating more jobs, improving the standards of living and hence spurring economic growth.