Poised to bounce back?

This is a critical time for Kenya, as the incoming administrations at national and devolved levels face the high expectations of ordinary Kenyans to deliver on ambitious economic development agendas and hasten the attainment of Vision 2030.

It is against this backdrop that the sixteenth edition of the World Bank’s Kenya Economic Update has been produced – a report which seeks to contribute to the policy discourse on pertinent economic issues. The report has three key messages.

The Kenyan economy faced multiple headwinds in 2017. A drought in the earlier half of the year, the ongoing slowdown in private sector credit growth, and a prolonged election cycle weakened private sector demand, notwithstanding an expansionary fiscal stance. Nonetheless, reflecting the relatively diverse economic structure, these headwinds were partially mitigated by the recovery in tourism, better rains in the second half of the year, still low global oil prices, and a relatively stable macroeconomic environment. Consequently, GDP growth is projected to dip to 4.9 percent in 2017 – its lowest in the past five years, but still higher than the Sub-Saharan African average.

With headwinds subsiding, economic growth is projected to rebound over the medium term, reaching about 5.8 percent in 2019. However, this rebound is predicated on policy reforms needed to address downside risks that have the potential to derail medium term prospects.

Two macroeconomic risks are pertinent. First, there is a need to consolidate the fiscal stance in order not to jeopardize Kenya’s hard-earned macroeconomic stability – a critical ingredient to Kenya’s recent robust growth performance. Second, is the need to jumpstart the recovery of credit growth to the private sector; particularly to micro, small and medium size businesses and households. Further, efforts to mitigate weather-related risks by climate proofing agriculture could be supportive of a robust and inclusive medium term growth agenda.

A rich menu of policy options is tabled in this edition of the Kenya Economic Update, identifying opportunities for the consolidation of the fiscal stance, both from an expenditure and revenue mobilization perspective. This is complimented with specific suggestions of macroeconomic and microeconomic reform measures that could help address the slowdown in credit growth and the broader issue of access to credit. Finally, policy options to climate proof the agriculture sector, to mitigate the worse effects of adverse weather conditions are discussed.

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Executive summary

Buffeted by multiple headwinds, economic activity decelerated in 2017. After posting a solid 5.8 percent growth in 2016, GDP growth slumped to 4.8 percent in the first half of 2017, with the third quarter showing signs of continued weakness. The slowdown in Kenya’s growth momentum has been triggered by three main headwinds. First, poor rains led to a contraction in agricultural output and curtailed hydropower generation in the first half of the year. Relatedly, this led to the build-up of inflationary pressures and dampened household consumption. Second, private sector credit growth continued its trend decline, thereby further dampening aggregate demand. Third, private sector activity weakened over the first three quarters of 2017 on account of the election induced wait-and-see attitude. However, tail winds from the rebound in tourism, strong public investment, and still low oil prices partially mitigated the headwinds.

Near term growth is projected to weaken, however with the easing of headwinds, economic activity is projected to rebound in the medium term. Given ongoing headwinds, GDP growth in 2017 is expected to decelerate to 4.9 percent – its weakest growth in five years. However, predicated on the easing of headwinds and policy reforms, growth is expected to recover to 5.5 and 5.9 percent in 2018 and 2019 respectively.

Nonetheless there remain significant downside risks that could scuttle the projected rebound in economic activity. First, delays to fiscal consolidation risks jeopardizing Kenya’s hard earned macroeconomic stability with adverse implications on medium term growth and the inclusivity of that growth. Second, the weakness in credit growth risks curtailing a robust recovery. Third, lingering political uncertainty can further undermine business confidence, and stunt a robust recovery.

Implementing key macroeconomic and sectoral reforms can avert downside risks and contribute to a robust medium term outlook. First, safeguarding macroeconomic stability – a foundation for robust growth – will require fiscal consolidation. Fiscal consolidation can be supported through enhancing domestic revenue mobilization and reining in of recurrent expenditures, crowding in the private sector to carry out development projects thereby reducing the burden on the public purse, and improving the efficiency of public investment spending. Second, private sector credit growth can be crowded in through fiscal consolidation as well as through the establishment of an electronic collateral registry and improvements to the credit scoring system. Third, a durable and robust growth can be supported by climate proofing agriculture through increased adoption of drought tolerant seeds, investing in water management systems and improving agronomical practices.

The second part of the Kenya Economic Update focuses on two topical issues. These are the slowdown in credit growth to the private sector and domestic revenue mobilization.

Slowdown in Private Sector Credit Growth

Credit growth has slowed significantly in Kenya since 2015 reflecting a series of shocks. Private sector credit growth fell from its peak of about 25 percent in mid- 2014 to 1.6 percent in August 2017 – its lowest level in over a decade. The slowdown in credit is not attributable to one single event. It reflects the impact of the liquidity shock in 2015/16, the impact of the resolution of three non-systemic banks on confidence within the banking system, and the liquidity implication of a segmented interbank market. With the advent of a less supportive demand environment in 2017, regional slowdown in credit growth and supply constraints – most importantly, the rise in non-performing loans – the outlook for strong credit growth remains dim.

The enactment of the interest rate caps in September 2016 made an already tough lending environment more difficult. Although the interest rate cap was meant to reduce the cost of credit, thereby making credit accessible to a wider range of borrowers, after a year of implementation the decline in credit growth to the private sector has continued with several unintended negative consequences. First, banks have shifted lending to corporate clients and government at the expense of small and medium sized enterprises and personal household loans. Second, the proportion of new borrowers has fallen by more than half, likely impacting entrepreneurship and new job creation. Third, the operating environment for banks has become more challenging for them to perform their financial intermediation role. Fourth, the interest rate cap has undermined monetary policy implementation with adverse implications for Central Bank’s independence and ability to steer the economy.

The removal of the interest rate cap is critical to preserving medium term growth prospects. Removing the interest rate cap can help jump start domestic credit to the private sector, support the flow of funds to longer term private investments, and allow the Central Bank to effectively implement monetary policy, a key role in fostering growth.

Though important, the reversal of the interest rate cap, will not be sufficient to improve access to credit. As discussed, the weakness in credit growth started well before the enactment of the rate caps. In this regard, there is a need to carry out a deeper set of macro and microeconomic reforms to improve credit access and financial inclusion. On the macroeconomic side, a reduction in fiscal deficit and better management of public debt is key to lowering benchmark interest rates and ultimately bank lending rates. On the microeconomic front, the universal adoption of credit scoring and sharing would help counteract perennially high interest rates for borrowers and improve bank lending policies. Furthermore, accelerating the implementation of the movable collateral registry can help fast track the resolution of non-performing loans. In addition, reforms that strengthen consumer protection and increase financial literacy is essential to address predatory lending.

Domestic Revenue Mobilization

Improvements to domestic revenue mobilization can be supportive of the medium term fiscal consolidation plans. Despite the robustness of GDP growth in recent years, revenues have underperformed targets by an annual average of about 3.7 percentage points of GDP since FY11/12. While a rapid rise in the expenditures has significantly contributed to the deficit, the underperformance of revenues has also played a role in the widening deficit. The Special focus section on Domestic Revenue Mobilization reviews two taxes – Corporate Income tax (CIT) and Value Added Tax (VAT), and gives policy options that could enhance revenue collection for the two taxes. Three key messages emerge from the analysis.

First, there remains substantive scope to boost tax revenues by rationalizing exemptions. The analysis finds that exemptions represent a significant source of forgone tax revenues. While tax exemptions may have been set for specific reasons, over time the initial objective might have lapsed. Forgone revenues from corporate income tax alone account for 1.8 percentage points of GDP with the bulk of tax exemptions concentrated in a few subsectors. Similarly, on VAT, the indiscriminate application of exemptions account for revenue leakages of up to 3.1 percent of GDP arising from various exemptions (over 70 percent of actual revenue).

Second, there is need to enhance revenue collections in the sectors where the losses in revenue are the greatest. The financial, manufacturing, health and social work activities, account for 88 percent of total exemptions. Any rationalization of the CIT exemptions regime therefore, should have a focus on these sectors, to the extent that the specific tax exemptions being enjoyed in these sub sectors are no longer a priority within the national development agenda. On the VAT front, taking into account international best practice, the report finds that Kenya applies a relatively liberal VAT exemptions regime on domestic supplies. This suggests that there is scope to improve VAT collection by streamlining exemptions on domestic supplies. Other areas for streamlining VAT exemptions with the potential to augment revenues include zero-rated supplies and VAT on exempt imports.

Third, the tax base could be widened and compliance improved. Measures such as cleaning up of the tax register to ensure it includes an accurate number of taxpayers as well as accurate master data could be adopted. The KRA’s adoption of an electronic system is a step in the right direction and should contribute to ensuring a wider tax base coverage.