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Kenya: Request for a Three-Year Arrangement under the Poverty Reduction and Growth Facility

Author(s):
International Monetary Fund
Published Date:
January 2004
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I. Introduction

1. In the attached letter, the Kenyan authorities request a three-year arrangement under the Poverty Reduction and Growth Facility (PRGF) in an amount equivalent to SDR 175 million (64.5 percent of quota). Seven disbursements are contemplated during the three-year period, with one disbursement following the approval of the arrangement in November 2003 and six disbursements in May and October of succeeding years, following satisfactory conclusion of the semiannual reviews under the program (Table 1).

Table 1:Kenya. Disbursement Schedule Under the Three-Year PRGF Arrangement
DisbursementAmount

(In millions of SDRs)
DateContingent on
1st25November-03Board Approval November 2003
2nd25May-04End-December 2003 PC
3rd25October-04End-June 2004 PC
4th25May-05End-December 2004 PC
5th25October-05End-June 2005 PC
6th25May-06End-December 2005 PC
7th25October-06End-June 2006 PC
Total175
Source: IMF staff projections.
Source: IMF staff projections.

2. The authorities’ case for a new PRGF arrangement is predicated on the need for Kenya to implement, in a systematic manner, a coherent package of economic and structural reforms aimed at decisively addressing Kenya’s tepid growth, weak budgetary position, large domestic debt, and fragility in the banking sector. Implementation of this package will facilitate the realization of its poverty reduction objectives. The authorities’ development strategy, which is outlined in the ERSWEC, is expected to require a marked increase in donor assistance. Present indications are that adequate donor assistance will be forthcoming if Kenya pursues a comprehensive poverty reduction program and strong policy reforms, supported by the Fund, and addresses the major weaknesses in governance. Medium-term projections indicate that the external current account gaps would be covered by the expected disbursements of concessional donor assistance, provided that the envisaged measures are fully implemented. The proposed access level takes into account the need to support an ambitious agenda of reforms, particularly in the governance and trade areas, a buildup of foreign reserves from 2.7 months of import cover at end-June 2003 to 4.0 months of import cover by end-June 2006, and an appropriate exit strategy for Kenya from use of Fund resources under the PRGF. Moreover, at the end of the three-year program period, total outstanding Fund credit to Kenya would remain relatively low, amounting to 74.4 percent of quota or about 10.6 percent of gross reserves (Table 2), reflecting the limited drawings under earlier arrangements.

Table 2.Kenya: Projected Payments to the Fund, 2003-12(In millions of SDRs, unless otherwise indicated)
2003200420052006200720082009201020112012BeyondTotal
Obligations on outstanding disbursements
Principal
General Resources Account (GRA) repurchases
Poverty Reduction and Growth Facility (PRGF) repayments7.09.55.09.26.76.76.76.70.00.00.057.6
Charges and interest 1/
PRGF interest0.10.20.20.20.10.10.00.00.00.00.01.0
SDR net charges0.30.60.60.60.60.60.60.60.60.6
Total outstanding obligations7.410.35.79.97.47.47.37.30.60.60.063.9
As a percent of quota2.73.82.13.72.72.72.72.70.20.20.023.5
Obligations from prospective disbursements
Principal (PRGF repayments)0.00.00.00.00.00.07.517.527.535.087.5175.0
Interest and charges (PRGF interest)0.00.20.50.70.90.90.90.80.70.50.66.7
Total prospective obligations0.00.20.50.70.90.98.418.328.235.588.1181.7
As a percent of quota0.00.10.20.30.30.33.16.710.413.132.567.0
Total obligations (outstanding and prospective)
Total principal (PRGF repayments)7.09.55.09.26.76.714.224.227.535.087.5232.6
Total charges and interest (PRGF int. and SDR chg.)0.41.01.21.41.51.51.51.41.21.10.67.7
Total outstanding and prospective obligations7.510.56.210.78.38.215.725.628.736.188.1240.3
As a percent of quota2.73.92.33.93.03.05.89.410.613.332.588.5
Outstanding Fund credit75.6116.1161.1201.9195.2188.4174.2150.0122.587.5
As a percent of:
Exports of goods and services2.94.25.46.35.44.74.03.32.51.7
External public debt2.02.93.54.23.83.53.12.62.01.4
Gross official reserves8.310.311.010.69.17.86.25.03.82.6
GDP0.71.01.41.61.41.11.00.80.60.4
Quota27.842.859.474.471.969.464.255.345.132.2
Sources: Kenyan authorities; and Fund staff estimates and projections as of August 30, 2003.

Projections are based on current PRGF and SDR interest rates. SDR net charges past 2012 are not included in the analysis.

Sources: Kenyan authorities; and Fund staff estimates and projections as of August 30, 2003.

Projections are based on current PRGF and SDR interest rates. SDR net charges past 2012 are not included in the analysis.

II. Review of Performance Under the Last PRGF-Supported Program

A. Macroeconomic Outcomes

3. With the exception of inflation and the external current account position, macroeconomic outcomes in the three-year period 2000/01-2002/03 (July-June) covered by the last PRGF arrangement were well below expectations (Table 3). The key developments were as follows:

Table 3.Kenya: Comparison of Projected and Actual Outcomes for Selected Economic Indicators Under the 2000-03 Program, 1999-2003
19992000200120022003
Est.Act.Proj.ActProj.ActProj.Act.Proj.Est.
(Annual percentage change)
National accounts and prices
GDP volume (factor cost)1.41.41.5-0.23.11.24.41.15.51.3
Consumer price index (end of period) 1/8.010.54.28.64.51.64.04.24.06.5
External sector
Export volume, goods and services-5.213.14.63.85.75.05.65.05.55.7
Import volume, goods and services-6.3-5.26.217.715.65.8-3.2-16.79.48.8
Terms of trade, goods (- deterioration; based on c.i.f. imports)-1.4-1.3-3.3-0.60.9-2.6-0.1-4.5-0.8-1.5
(In percent of GDP)
Investment and saving
Investment15.916.216.015.419.914.719.413.623.415.4
Gross national saving13.413.912.712.713.811.115.414.117.512.8
Central government budget 2/
Total revenue23.923.124.822.825.021.225.120.725.122.2
Total expenditure and net lending24.523.026.327.626.024.925.625.625.527.8
Overall balance (commitment basis), excluding grants-0.60.2-1.5-4.9-1.0-3.7-0.5-4.8-0.5-5.6
Total grants0.70.61.72.91.51.21.01.20.92.0
Overall balance (commitment basis), including grants0.10.70.2-2.00.5-2.40.5-3.60.4-3.6
Stock of domestic debt, net (end of period)21.421.219.219.617.321.915.025.312.627.6
Balance of payments
Current external balance, including official transfers-2.6-2.2-3.3-2.7-6.1-3.5-3.90.5-5.8-2.6
Current external balance, excluding official transfers-3.2-2.2-4.5-3.6-7.7-4.3-5.00.5-6.7-2.6

12-month period ending December, except 2000 ending May.

Data are on a fiscal-year basis; e.g., 1999 refers to 1999/2000.

12-month period ending December, except 2000 ending May.

Data are on a fiscal-year basis; e.g., 1999 refers to 1999/2000.

  • real GDP growth averaged less than 1.0 percent in the three-year period;
  • average consumer price inflation (excluding food and energy) slowed down from 5.9 percent in 1999/2000 to 2.7 percent in 2002/03 (Figure 1);
  • the overall fiscal deficit before grants was substantially larger than initially projected and net domestic financing expanded from 0.3 percent of GDP in 2000/01 to 5.0 percent in 2002/03, partly on account of a drop in revenue;
  • domestic debt increased from 19.6 percent of GDP at end-June 2001 to 25.0 percent of GDP at end June 2003;
  • three-month treasury bill rates declined from 18.9 percent in January 2000 to about 1 percent in September 2003 (Figure 2), despite the large domestic funding requirements of the government (Figure 3);
  • The external current account deficit (before grants) narrowed markedly, reflecting in part a contraction in investment; and
  • gross international reserves declined from a cover of 3.3 months of import in 2000/01 to 2.7 months of import in 2002/03.

Figure 1.Kenya: Consumer Price Inflation Rates, January 2000 - August 2003

(Percentage changes from the same period of the previous year)

Sources; Kenyan authorities; and staff calculations.

Figure 2.Kenya: Real1/ and Nominal 91-Day Treasury Bill Rates, January 1998 - August 2003

(in percent)

Source: Kenyan authorities and staff estimates.

1/ Based on the annual changes in the overall CPI excluding food and energy.

Figure 3.Kenya: Key Monetary Aggregates, December 1997 - July 2003

(In millions of Kenya shillings)

Source: Kenyan authorities.

1/ There is a break in the series between November and December 1999 and between April and May 2000.

4. The weak economic performance was mainly the result of persistent governance failures and the slow pace of reforms. In addition, the external environment, as reflected by the declines in the terms of trade and in donor inflows since 2001, was more difficult than envisaged (Table 3). The strong inflation performance was the result of weak aggregate demand but also benefited from improvements in monetary policy implementation procedures, as well as from increased stability in the nominal exchange rate of the shilling (Figure 4). The decline in the treasury bill rates during 1999/2000-2001/02 reflected the success in lowering the inflation rate and the perceived country risk premium. The sharp decline in the rates since January 2003, however, has been due primarily to the persistence of liquid market conditions on account of a reduction in CBK repurchase operations and the lowering, with effect from July 2003, of banks’ required reserves from 8 percent to 6 percent of deposits. Banks have responded to the increase in liquidity by raising the proportion of free reserves held at the CBK.1

Figure 4.Kenya: Exchange Rate Developments The Nominal and Real Effective Exchange Rates, and Kenya Shillings per U.S. Dollar and Euro Rates for End January, 1999 - End September, 2003

Sources: IMF African Department; and IMF Information Notice System.

1/ An increase in the index denotes a depreciation.

B. Structural Measures

5. In late 2000, Kenya’s PRGF-supported program suffered major setbacks. First, parliament rejected the Public Service (Code of Ethics) Bill on the grounds that it contravened the principle of the separation of powers among the executive, judiciary, and legislative branches of government. Second, the Constitutional Court ruled that the Kenya Anti-Corruption Authority (KACA) was unconstitutional. Third, parliament passed the so-called Donde Bill, which sets limits on banks’ interest rates. Finally, the cabinet put on hold the privatization of the telecommunications company (Kenya Telkom) and the Kenya Commercial Bank (KCB), although both decisions were subsequently reversed. Details of the status of the structural performance criteria and benchmarks under the previous PRGF arrangement are provided in Table 4.

Table 4.Kenya: Structural Performance Criteria and Benchmarks Under the Previous PRGF Arrangement
Status
Performance criteria
1. Issue a treasury circular to shift by December 31, 2000 the responsibility for the supervision of district treasury officers from the Office of the President to the Ministry of Finance.Done.
2. Issue a treasury circular to bring by December 31, 2000 all financial management units in line ministries under the control and supervision of the finance officer and provide all finance officers with sufficient independence by requiring that their annual performance review be finalized by the Ministry of Finance.Partially implemented.
3. Develop by December 31, 2000 terms of service that would allow competitive remuneration of the Controller and Auditor General’s staff, on terms comparable to those applicable to the pay structure of the KRA and KACA.Partially addressed.
4. Complete the development or a tariff reform program by March 31, 2001, with a view to implementing it under the 2O01/02 (July-June) budget.Done. (with a delay).
Structural benchmarks
1. Amend by October 2000 the draft bill containing the code of ethics for public officials, inter alia, to strengthen the independence of the Public Service Committee examining alleged infractions of the code, to extend the requirement to declare assets and liabilities to include immediate families of the officials, and to broaden the definition of the types of assets and liabilities to be declared.Bill to be discussed in this session of parliament.
2. Publish in the official gazette an Anti-Corruption and Economic Crimes bill that is essentally similar to the one annexed to the report of the Select Committee of Parliament on Anti-Corruption not later than 30 days after the determination by parliament on the report.Bill to be discussed in this session of parliament.
3. Offer for sale to a strategic investor (to be identified through a bidding process) by September 30, 2000 at least 26 percent of the Kenya Commercial Bank (KCB) with an announcement that the remaining shares of the KCB will be offered for sale to the market by March 31, 2001.Not done.
4. Submit by September 30, 2000 an amendment to the Banking Act to clearly define “reckless lending” and related activities, as well as any other necessary amendment to relevant legislation, applicable to, inter alia, financial fraud, with a view to enabling the courts to deal more effectively with fraud and realisation of security.Done.
5. The CBK will by September 30, 2000 issue prudential regulations and policies, including on the amount of risk that banks may incur in lending operations, with a view to clarifying and expanding on prohibited activities.Done.
6. Set up by December 31, 2000 a system by which the CBK will share debtor information with licensed banking institutions, as provided in the amendment to legislation.Done.
7. Complete by December 31, 2000 a review of operating procedures and methods of the Deposit Protection Fund (DPF) and produce recommendations, with a view to ensuring efficiency and maximizing asset recoveries. Implement these recommendations by June 30, 2001.Done

Implementing recommendations

of March 2001 IMF mission.
8. Submit by March 31, 2001 amendments to the Building Society Act and the Banking Act that will explicitly specify that the CBK is authorized and responsible for supervising and regulating all institutions involved in “banking activities”; require apppropriate and specific responses in case a bank is insolvent and formally prohibit directors of restructured problem banks from borrowing from the reopened institution.Done.
9. Revise by December 31, 2000 the format of the “vote book” and expenditure returns to incorporate information on expenditure commitments and pending bills.Done.
10. Develop by December 31, 2000, with technical assistance from the Fund, a system to strengthen expenditure control in the districts.Done.
11. Complete and submit to parliament by June 30, 2001 audited public accounts for fiscal years 1998/99 and 1999/2000.1998/99 done; 1999/2000 expected shortly.
12. Issue treasury instructions requiring by July 1, 2000 the Debt-Management Division, the External Resources Department, and the Accountant General’s Office to prepare quarterly reconciliations of their external debt data.Done.
13. Issue a treasury circular requiring that all noncentral government public institutions develop by December 31, 2000 and subsequently implement a strategy to prevent any further accumulation of pending bills, and to eliminate the outstanding pending bills after appropriate verification.Not done.
14. Prepare by March 31, 2001 a plan for the elimination of major import exemptions awarded to the public sector, with a view to implementing the plan under the 2001/02 budget.Done.
15. Develop a plan to reform the internal audit system by December 2000. Implement the reform plan of the internal audit system by March 31, 2001.Done.
Source: Kenya authorities.
Source: Kenya authorities.

6. To bring the program back on track, understandings were reached with the government on an alternative governance plan, which was intended to (i) build upon and strengthen the operations of the Anti-Corruption Police Unit (ACPU); (ii) strengthen the Office of the Attorney General (AG); (iii) enact appropriate versions of the Anti-Corruption and Economic Crimes Bill and the Public Officer Ethics Bill; (iv) establish special courts for corruption cases; and (v) demonstrate progress in tackling corruption.2 In December 2001, key elements of the new strategy were converted into prior actions for bringing the PRGF-supported program back on track. Most of these prior actions had not been implemented by December 2002, when the previous administration lost the parliamentary and presidential elections.

III. The Medium-Term Program

7. At the time of the last Article IV consultations, the authorities and the staff largely agreed on the diagnosis of Kenya’s principal economic problems—poor governance and widespread corruption; major structural distortions in the financial, parastatal, and utilities sectors; low savings and investment; and an inward-looking trade system—which have given rise to low economic growth, poverty, and mass unemployment.3 As a result, most poverty indictors have worsened in recent years (Table 5). The ERSWEC outlines a broad economic agenda to address these economic problems over the medium term. The three-year program, as well as the economic reform agenda presented in the MEFP, is fully consistent with the government’s economic recovery strategy, which has been evolving since the government took office and since the June 12 budget speech as more information has become available on the underlying weaknesses of the economy.4

Table 5.Key Social Indicators
KenyaSub-Saharan
19902001Africa
Real GDP per capita
(Constant 1995 US$)358.0324.9571.9
Aid per capita (current $)50.817.020.4
Life expectancy at birth57.147.046.5
Fertility rate (births per woman)5.64.45.2
AIDS prevalence rate13.09.0
For girls (15-24 years)18.711.4
Gross primary school enrolment95.090.779.3
Girls93.390.073.0
Boys96.691.485.5
Access to improved water40.049.055.4
Source: World Bank
Source: World Bank

8. The main objective of the economic recovery strategy is to reduce poverty by promoting strong economic and employment growth. The program for 2003/04-2005/06 aims at creating opportunities for productive employment through the rebuilding of sound governance structures, addressing the country’s major macroeconomic vulnerabilities, particularly the weak budgetary position, large domestic debt, and distressed financial system;5 and reforming the parastatal sector, labor markets and the trade system to foster a more competitive private sector. This is part of a broader reform agenda, which is supported by many donors and development agencies, including the World Bank. To achieve these goals, the program contains a package of policy measures (Box 1). The actions covered by structural conditionality under the program are presented in Box 2. The sequencing of the measures is driven by several considerations, including implementation capacity, political feasibility, and the need to rebuild, at an early stage, credible governance institutions.

Box 1.Kenya: Main Actions Under the Program, 2003/04-2005/06

Implementation Period
during 2003/04-2005/06
High domestic debt burden
  • Elimination of the domestic borrowing requirement by 2004/05, with a significant reduction in 2003/04.
  • Clearance of outstanding pending bills over the three-year program period.
  • Cancellation of stalled projects as announced in the 2003/04 budget, with a provision for paying termination costs.
  • Continued enhancement of governance legal and enforcement framework.
2003/04-2005/06





2003/04-2005/06



2003/04-2005/06



2003/04
Weak financial system
  • Transfer of Ministry of Finance’s power of bank regulation and supervision to the CBK.
  • Restructuring of the National Bank of Kenya (NBK).
  • Divestment of government shares in the KCB.
  • Divestment of public sector ownership and control of other public banks.
  • Strengthening of prudential rules governing foreign currency-denominated lending by banks.
  • Restructuring of nonbank financial institutions in distress.
  • Improved judicial and legal framework for enforcement of creditors’ claims.
  • Strengthen safety net arrangements for Deposit Protection Fund.
2003/04



2003/04



2003/04



2003/04-2005/06



2003/04-2005/06



2003/04-2005/06



2003/04-2005/06



2003/2004
Reforms in the parastatal sector (under the World Bank)
Fiscal
  • Fiscal consolidation to sharply reduce dependence of the budget on domestic borrowing.
  • Tax reform to streamline the tax system, widen the tax base, and remove disincentives to economic activity.
  • Restructuring of public expenditure in favor of social and economic outlays.
  • Civil service restructuring (under the World Bank).
  • Implementation of new mechanisms for setting wages in the public sector that pay close attention to resource constraints and productivity considerations.
  • Liquidation of nonessential publicly funded parastatals.
  • Improved expenditure monitoring and control, including a move to a Commitment Control System (CCS).
  • Upgrading of the system for tracking poverty reduction expenditures.
2003/04-2005/06



2004/05-2005/06



2003/04-2005/06



2003/04-2005/06



2004/05



2003/04-2005/06



2003/04-2004/05



2003/04-2005/06
Labor market rigidities
  • Increase in labor market flexibility, including through a review of the labor market regulations, the wage-setting mechanisms, and the role of the minimum wage.
2003/04-2005/06
Governance
  • Enactment of corruption control bill.
  • Enactment of Public Officer Code of Ethics Bill.
  • Strengthening of the judiciary.
  • Constitutional reforms.
  • Application and enforcement of corruption laws and regulations.
May 2003



May 2003



2003/04-2005/06



2003/04-2005/06



2003/04-2005/06
Trade regime
  • Reduction of top external tariff rate from 35 percent to 25 percent
  • Implementation of a customs improvement program designed to speed up the verification and clearance of goods.
  • Formulation of new trade policy.
  • Implementation of comprehensive trade reforms.
2003/04



2003/04



2003/04



2004/05-2005/06
Regulatory and investment environment
  • Reform of the regulatory framework in the telecommunications industry.
  • Rationalization of the investment code.
2003/04



2004/05-2005/06

A. Macroeconomic Framework, Outlook, and Risks

9. Under the program, the recovery in economic growth is expected to gain momentum over the medium term. Based on the sustained implementation of fiscal consolidation and restructuring, as well as the governance and other economic reforms described in the MEFP, inflows of donor budgetary assistance are expected to resume. The latter would support the assumed pickup in government investment from 3.6 percent of GDP in 2002/03 to 7.6 percent of GDP in 2005/06, as well as the required increase in public outlays on social and economic infrastructure (Table 6). Private investment is also projected to increase, reflecting improvements in public infrastructure and a rebound in business and consumer confidence in response to reduced political uncertainty. Real GDP growth is forecast to pick up from 1.2 percent in 2002/03 to 3.9 percent in 2005/06, reflecting a forecast improvement in the terms of trade, and the implementation of policies under the program. Initially, the economic recovery is expected to be driven by a resurgence of activity in the manufacturing, construction, transport, telecommunications, and financial sectors, with the construction and transport sectors benefiting from increased public and private investment outlays. The telecommunications and financial sectors would be aided by the ongoing reforms. Over the medium term, the pickup in growth would be more broadly based and would reflect both higher productivity and capital accumulation from reforms in the parastatal, financial, and labor market sectors, as well as from improved terms of trade and infrastructure.

Table 6.Kenya: Macroeconomic Scenario, 2000/01-07/08 1/
2000/012001/022002/032003/042004/052005/062006/072007/08
Actual
(Annual percentage change, unless otherwise indicated)
National accounts and prices
Nominal GDP (market prices, in billions of Kenya shillings)8409261,0111,0761,1411,2291,3311,450
GDP volume (factor cost)0.51.21.21.93.13.94.54.7
GDP volume (factor cost) per capita-1.7-0.9-0.70.21.42.33.03.2
Consumer price index (annual average)10.02.36.64.12.83.53.53.5
Consumer price index (end of period)4.62.813.7-4.03.53.53.53.5
Consumer price index, excl. food, energy (annual average)5.94.12.73.03.53.53.53.5
Consumer price index, excl. food, energy (end of period)5.13.33.72.73.53.53.53.5
Export volume, goods and services4.45.05.46.06.57.79.810.7
Import volume, goods and services11.3-5.7-5.115.118.611.87.16.6
Terms of trade, goods
(- deterioration; based on c.i.f. imports)-1.6-3.6-3.00.12.02.01.10.6
Kenya shilling per US dollar exchange rate (end of period)78.978.773.976.076.677.277.878.5
Nominal effective exchange rate (- depreciation; end of period)8.3-5.9-2.4
Real effective exchange rate (- depreciation; end of period)10.6-4.47.5
Money and credit
Net domestic assets (end of period)-6.26.712.45.03.6-1.33.66.3
Net credit to the government (end of period)-17.538.030.73.9-1.4-15.6-11.8-16.7
Credit to the rest of the economy (end of period)1.2-1.34.94.86.16.39.212.5
M3X (M3 plus foreign currency deposits; end of period)2.16.710.97.17.97.98.18.1
Reserve money (end of period)-8.510.911.2-5.4 2/6.86.87.07.0
Interest rate (90-day treasury bill; end of period)12.47.51.8
(In percent of GDP, unless otherwise indicated)
Investment and saving
investment15.014.114.517.922.725.926.928.4
Central government3.62.53.64.86.47.68.48.4
Other11.411.611.013.116.318.318.519.9
Gross national saving11.912.713.613.113.514.716.317.5
Central government1.2-0.9-1.2-0.10.01.32.02.2
Other10.613.614.813.213.513.414.315.3
Central government budget
Total revenue22.821.220.722.222.823.223.423.3
Total expenditure and net lending27.624.925.627.829.229.629.829.5
Overall balance (commitment basis), excluding grants-4.9-3.7-4.8-5.6-6.5-6.4-6.5-6.2
Overall balance (commitment basis), including grants-2.0-2.4-3.6-3.3-4.3-3.9-3.6-3.2
Net domestic borrowing0.34.25.03.3-0.5-2.1-2.7-2.0
Financing gap0.10.1-0.22.74.45.35.44.5
Total donor support (grants and loans) 3/5.02.51.97.08.910.010.39.3
Balance of payments
Current external balance, including official transfers-3.2-1.4-0.9-4.8-9.3-11.1-10.6-10.9
Current external balance, excluding official transfers-4.0-1.8-1.1-5.0-9.3-11.1-10.6-10.9
Gross international reserve coverage
in months of next year’s imports (end of period)3.43.12.72.83.24.04.24.3
Net present value of central government debt (end of period)55.555.456.555.654.351.848.044.7
Domestic debt, net (end of period)19.621.925.026.824.821.016.713.3
Net present value of external debt (end of period)36.033.531.428.829.430.931.331.3
Sources: Kenyan authorities; and staff estimates and projections.

Fiscal year ending June 30.

The projecte decline in reseve money for 2003/04 is due to a reduction in cash reserve ratio from July 2003 onwards.

For the period 2003/04-2007/08. includes unidentified program support (financing gap).

Sources: Kenyan authorities; and staff estimates and projections.

Fiscal year ending June 30.

The projecte decline in reseve money for 2003/04 is due to a reduction in cash reserve ratio from July 2003 onwards.

For the period 2003/04-2007/08. includes unidentified program support (financing gap).

10. Notwithstanding forecasts of a strong export performance, medium-term projections for the program period (2003/04-2005/06) indicate that Kenya is likely to face external financing needs averaging about US$1.3 billion a year, as a result of growing deficits in the external current account (excluding grants).6 The needs would stem in large part from the envisaged expansion in investment-related imports, although part of the investment would be financed by an expected pickup in foreign direct investment. Moreover, external resources would be required to achieve the targeted buildup of foreign reserves to about 4.0 months of projected imports by end-2005/06 from 2.7 months of imports at end-2002/03.

11. There are, however, risks to this outlook:

  • In addition to possible terms of trade shocks, the increased reliance on donor assistance would raise the vulnerability of budget outcomes from shortfalls in such inflows.
  • An increase in tensions within the ruling coalition could delay the implementation of critical reforms, particularly in areas where the government has just begun to build a broad consensus behind the reforms, such as the rationalization of public services, changes in the wage-setting mechanisms of public employees, privatization, and financial sector reforms. Moreover, close coordination between the executive and legislative branches of government will be required to maintain the reform momentum.
  • A resurgence of terrorist attacks could also undermine program implementation. However, the authorities, with the assistance of the main donors, have been taking strong and comprehensive steps to address this problem.

Box 2.Kenya: Structural Conditionality

Coverage of structural conditionality under the proposed PRGF arrangement

The structural conditions in the first year of the proposed new arrangement cover policy measures to promote economic growth and poverty reduction. The key areas include the following;

  • strengthening expenditure management—by developing an action plan for introducing a Commitment Control System (CCS) to minimize deviations of expenditure outcomes from targets and a buildup of arrears, completing a report on the new mechanism for determining the salaries of public officials to facilitate a reduction of the wage bill in total expenditure, and reaching understandings on the fiscal implications of restructuring the National Social Security Fund (NSSF), as well as strengthening the financial position of NSSF;
  • improving the coverage and timeliness of data on fiscal operations—by presenting the 2002/03 final budgetary accounts to the Auditor General by March 2004;
  • reducing conflicts of interest and deepening anticorruption measures—by creating a clear timetable for completing initial asset declarations by all senior public officials, establishing the Kenyan Anti-Corruption Commission, transferring financial sector regulatory functions from the Ministry of Finance to the Central Bank of Kenya, and devising a plan to clear the stock of pending bills and resolve the stalled projects problem; and
  • accelerating the privatization process—by presenting a bill for the transparent privatization and sale of public assets, and reaching agreement on a time-bound plan for either liquidating or restructuring the National Bank of Kenya (NBK).
  • additional trade reforms to be agreed in the context of the first review under the arrangement.

Status of structural conditionality from earlier programs

The status of structural performance criteria and benchmarks for the previous program are presented in Table 4. The first and subsequent reviews under the program were not completed.

Structural areas covered by World Bank lending and conditionality

The following areas are covered:

  • public sector financial management and audit system;
  • expenditure management;
  • judicial system reform;
  • procurement systems;
  • civil service restructuring and pay reform;
  • capacity building in the delivery of public services; and
  • reforms in the parastatal sector.

B. Fiscal Policy

12. The authorities’ fiscal program aims at restoring debt sustainability, while providing increased resources for priority poverty reduction spending and the realization of the medium-term development objectives. The repayment of domestic debt and expected inflows of grants and concessional external finance would facilitate the achievement of both the overall development and debt objectives. Accordingly, the program envisages an expansion of the overall deficit, before grants, from 4.8 percent of GDP in 2002/03 to 6.2 percent of GDP in 2005/06 (Table 7). The primary deficit would also widen modestly. The projected significant expansion in donor assistance would facilitate a reduction in domestic debt in percent of GDP from 25.0 percent in 2002/03 to 20.9 percent in 2005/06 and in the net present value (NPV) of total central government debt from 52.6 percent of GDP in 2002/03 to 45.9 percent of GDP in 2005/06.7 The resulting reduction in interest payments from 14 percent of total expenditure in 2002/03 to 9 percent in 2005/06 would free up budgetary resources for priority poverty spending. Box 3 outlines the key actions under the program to contain the growth of debt and to restore fiscal sustainability.

Table 7.Kenya Central Government Financial Operations, Program Scenario, 1999/2000-2007/08 1/
1999/002000/012001/022002/032003/042004/052005/062006/072007/08
ActualActualActualBudgetRevisedActualProj.Proj.Proj.Proj.Proj
BudgetQ1Q2Q3Q4
Cumulative
(In millions of Kenya shillings)
Revenue178,024191,160196,613218,929215,272209,66254,088111,152169,439239,177259,660285,205310,797337,895
Income tax54,40255,82855,86267,52966,37970,45215,58032,00145,90171,56574,37779,48583,73788,160
Import duty (net)28,60528,72621,58419,89519,89518,4775,55810,88316,10021,68426,90030,79333,38437,268
Excise duty28,49328,31832,07742,67135,81235,6439,09418,28228,62039,49943,46547,74650,67954,882
Value-added tax40,94550,29850,87157,18456,35556,13513,09027,54241,15057,12467,20973,67779,53087,155
Investment income3052,4787672,1231,7621,2432868261,4811,8681,9802,1332,3092,516
Other25,27425,51235,45229,52635,06927,7128,75118,16030,00040,52236,60139,08045,19149,070
New revenue measures000001,7293,4585,1866,9159,12812,29115,96718,844
Expenditure and net lending176,732232,117230,439266,562277,151258,63465,001138,700218,623299,321333,563363,497396,707427,543
Recurrent expenditure157,851199,289205,486218,511229,495221,33957,805117,068177,992244,685259,736269,978284,238304,114
Interest payments30,70326,82427,13938,34135,22636,0268,49416,53625,34133,74234,93635,35734,73832,092
Domestic interest22,06819,02119,54329,88226,76727,5676,68713,15120,60027,32327,59626,75924,99023,274
Foreign interest due8,6357,8037,5978,4598,4598,4591,7973,3854,7406,4197,3408,5989,7488,818
Wages and benefits (civil service)65,86168,11977,67482,02885,74485,08721,76244,32666,66293,380-92,62493,637100,033107,526
Civil service reform4436,0951,6651,6001,30001252503755008,2838,0906,0234,709
Pensions, etc.5,1456,1368,99512,92112,9209,4503,5177,42610,48514,06715,48815,45416,22619,119
Other44,77773,23469,17966,32873,01267,54818,34936,39556,92778,72683,52092,538103,192115,667
Of which; operations and maintenance30,63739,17249,25744,90640,62612,18424,14238,04853,54959,05066,95076,35387,366
Defense and NSIS 2/12,56416,91919,06417,29321,29323,0966,06712,13518,20224,27024,88423,90324,02525,001
Of which IMF adjustment for defense leases002,0641,8036291,2571,8862,5152,259373-446-450
Pending bills 3/-1,6421,9721,7700013200000000
Development and net lending18,88132,82824,95348,05147,75637,2957,19621,63240,63154,63673,82694,519112,469123,429
Domestically financed4,25311,4915,90816,103.011,3989,6402,8865,8429,77515,88524,99136,41646,44852,947
Foreign financed13,09715,34120,34526,666.030,37621,9923,59514,34228,68335,85448,00057,00064,94969,393
Net lending1,5312,8051,8625,2825,9821,2807241,4492,1732,8978351,1031,0721,090
Pending bills 3/03,191-3,162004,38300000000
Balance (commitment basis, excluding grants)1,292-40,957-33,826-47,634-61,97948,972-10,913-27,548-49,184-60,144-73,902-78,291-85,910-89,649
Grants4,24724,08011,26515,86616,92412,5593,09910,41519,84425,05125,00030,00038,67343,333
Food relief grants012,444000000000000
Project grants4,2475,68110,31515,86616,44112,5592,1108,44116,88221,10225,00030,00038,67343,333
program grants05,955950048309871,9752,9623,9490000
Balance (commitment basis, including grants)5,539-16,877-22,561-31,768-45,055-36,413-7,815-17,132-29,340-35,093-48,902-48,291-47,237-46,316
000000000000
Adjustments to cash basis-3,7891,512-8,4040-1,2433,599-375-750-1,125-1,5000000
Balance (cash basis, including grants)1,750-15,365-30,965-31,768-46,298-32,814-8,190-17,882-30,465-36,593-48,902-48,291-47,237-46,316
Financing-53414,81729,87131,76846,26234,3959373,3768,7067,580-1,817-17,225-24,974-18,939
Net foreign financing-18,97412,601-10,855-4,331-6,790-11,460-5,900-8,850-10,324-12,2347,24911,89610,44210,402
Project loans8,85014,04210,03116,39413,9356,4861,4755,90111,80214,75223,00027,00026,27626,060
Program loans04,0451220009311,8632,7943,7260000
Financial defense least loan adjustment002,0641,8030002,5152,259373-446-450
Repayments due-31,018-27,887-27,672-17,556-20,725-20,724-4,857-9,715-14,572-19,429-15,397-15,475-15,388-15,208
Change in arrears3,194496-193-3,1690975-3,449-6,899-10,348-13,798-2,613000
Rescheduling021,9054,79500000000000
Privatization proceeds5,66009553,5000000000000
Bank restructuring costs0000000-12,000-12,000-12,0000000
Expenditure arrears securitization00-4,481-4,4810-1,222-2,445-3,667-3,667-3,66700
Net domestic borrowing12,7802,21639,76932,59957,53350,3366,83725,44833,47435,481-5,400-25,457-35,416-29,341
Of which: excluding bank restructuring costs12,7802,21639,76932,59957,53350,3366,83713,44821,47423,481-5,400-25,457-35,416-29,341
and excluding expenditure arrears securitization32,59953,05245,8556,83712,22619,03019,814-9,066-29,123-35,416-29,341
Financing gap (flat, discrepancy for outturns)-1,2165481,0940-36-1,5817,25314,50621,76029,01350,72065,51672,21165,254
Memorandum items:
Core poverty spending23,50234,02400043,13947,45356,94362,63868,901
Free primary education spending02,8002,8002,4254,8507,2759,70010,70210,70511,70911,715
Total project support13,09732,16720,34632,26030,37619,0453,58514,34228,68335,95448,00057,00064,94969,393
Total identified and unidentified gross external support13,09742,16721,41832,26030,85919,04512,75732,68656,19972,54298,720122,516137,160134,647
Nominal GDP769,911839,534926,039984,176984,1761,010,7610001,076,1741,140,9561,229,1341,330,5581,449,506
Primary budget balance32,45311,459-3,8266,573-11,0713,212294-1,347-5,124-2,851-13,966-12,935-12,499-14,224
Stock of domestic debt net (end of period)163,405164,203202,775235,374260,308253,111259,948278,559286,585288,592283,192257,736222,320192,979
Table 7.Kenya Central Government Financial Operations, Program Scenario, 1999/2000-2007/08 1/ (concluded)
1999/002000/012001/022002/032003/042004/052005/062006/072007/08
ActualActualActualBudgetRevised

Budget
ActualProj.Proj.Proj.Proj.Proj
(In percent GDP)
Revenue23.122.821.222.221.920.722.222.823.223.423.3
Income tax7.16.66.06.96.77.06.66.56.56.36.1
Import duty (net)3.73.42.32.02.01.82.02.42.52.51.6
Excise duty3.73.43.54.33.63.53.73.83.93.83.8
Value-added tax5.36.03.55.85.75.65.35.96.06.06.0
Investment income0.00.30.10.20.20.10.20.20.20.20.2
Other3.33.03.83.03.62.73.83.23.23.43.4
New revenue measure0.00.00.00.00.00.00.60.81.01.21.3
Expenditure and net lending23.027.624.927.128.225.627.829.229.629.829.5
Recurrent expenditure20.523.722.222.223.321.922.722.821.921.421.0
Interest payments4.03.22.93.93.63.63.13.12.92.62.2
Domestic interest2.92.32.13.02.72.72.52.42.21.91.6
Foreign interest due1.10.90.80.90.90.80.60.60.70.70.6
Wages and benefits (civil service)8.68.18.48.38.78.48.78.17.67.37.4
Civil service reform0.10.70.20.20.10.00.00.70.70.30.3
Pensions, etc.0.70.71.01.31.30.91.31.41.31.21.3
Other5.88.77.56.77.46.77.37.37.57.88.0
Of which operations and maintenance4.04.75.34.64.05.05.23.45.76.0
Defense and NSIS 2/1.62.02.11.82.22.32.32.21.91.81.7
Of which IMF adjusment for defense leases0.00.00.20.20.20.20.00.00.0
Pending bills 3/-0.20.20.20.00.00.00.00.00.00.00.0
Development and ret lending2.53.92.74.94.93.75.16.57.78.58.5
Domestically financed0.61.40.61.61.21.01.52.23.53.53.7
Foreign financed1.71.82.22.73.12.23.34.24.64.94.8
Net lending0.20.30.20.50.60.10.30.10.10.10.1
Pending bills 3/0.00.4-0.30.00.00.40.00.00.00.00.0
Balance (commitment basis, excluding grants)0.2-4.9-3.7-4.8-6.3-4.8-5.6-6.5-6.4-6.5-6.2
Grants0.62.91.21.61.71.22.32.22.42.93.0
Food relief grant0.01.50.00.00.00.00.00.00.00.00.0
Project grants0.60.71.11.61.71.22.02.22.42.93.0
Program grants0.00.70.10.00.00.00.40.00.00.00.0
Balance (commitment basis, including grants)0.7-2.0-2.4-3.2-4.6-3.6-3.3-4.1-3.9-3.6-3.2
Adjustments to cash basis-0.50.2-0.90.0-0.10.4-0.10.00.00.00.0
Balance (Cash basis, including grants)0.2-1.8-3.3-3.2-4.7-3.2-3.4-4.3-3.9-3.6-3.2
Financing-0.11.83.23.24.73.40.70.2-1.4-1.9-1.3
Net foreign financing-2.51.5-1.2-0.4-0.7-1.1-1.10.61.00.80.7
Project loans1.11.71.11.71.40.61.42.02.22.01.8
Program loans0.00.50.00.00.00.00.30.00.00.00.0
Financial defense 1ease loan adjustment0.0000.20.20.20.20.00.00.0
Repayments due-4.0-3.3-3.0-1.8-2.1-2.1-1.8-1.3-1.3-1.2-1.0
Change in arrears0.40.10.0-0.30.00.1-1.3-0.20.00.00.0
Rescheduling0.02.60.50.00.00.00.00.00.00.00.0
Privatization proceeds0.70.00.10.40.00.00.00.00.00.00.0
Bank restructuring costs0.00.00.00.00.00.0-1.10.00.00.00.0
Expenditure arrears securitization0.0-0.5-0.4-0.3-0.3-0.30.00.0
Net domestic borrowing1.70.34.33.35.85.03.3-0.5-2.1-2.7-2.0
Of which excluding bank restructuring, costs1.70.34.33.33.85.02.2-0.5-2.1-2.7-2.0
and excluding expenditure across securitization3.35.44.51.8-0.8-2.4-2.7-2.0
Financing gap (stat. discrepancy for outturns)-0.20.10.10.00.0-0.22.74.45.35.44.5
Memorandum item
Core poverty spending2.53.44.04.24.64.74.8
Free primary education spending0.00.30.30.90.90.90.90.8
Total project support1.73.82.23.33.11.93.34.24.64.94.8
Total identified and unidentified gross external support1.75.02.33.33.11.96.78.710.010.39.3
Nominal GDP769,911839,534926,039984,176984,1761,010,7611,076,1741,140,9561,229,1341,330,3581,449,306
Primary budget balance4.21.4-0.40.7-1.10.3-0.3-1.2-1.1-0.94.0
Stock; of domestic debt, net (end of period)21.219.621.923.926.425.026.824.821.016.713.3
Sources: Kenyan authorities; and Fund staff estimates and projections.

Final year ending June 30.

Differ from authorities numbers because of difference accounting treatment of finance defense leases.

The fiscal accounts are on a cash basis (with the exception of foreign interest due). To adjust to a commitment basis, the accumulation of peding bills is added and the cash payment of these bills deducted.

Sources: Kenyan authorities; and Fund staff estimates and projections.

Final year ending June 30.

Differ from authorities numbers because of difference accounting treatment of finance defense leases.

The fiscal accounts are on a cash basis (with the exception of foreign interest due). To adjust to a commitment basis, the accumulation of peding bills is added and the cash payment of these bills deducted.

13. The program also includes explicit budget provision for dealing with most known contingent liabilities and for addressing the main sources of contingent risks, which have hitherto arisen primarily from bank loans, parastatal operations, pending bills, and stalled projects.8

14. A reorientation of public expenditure as well as improvements in public expenditure management is required to put the economy on a sustainable, rapid, and poverty-reducing growth path. The program includes the following actions aimed at fiscal restructuring and strengthening expenditure management:

Box 3.Kenya: Central Government Debt Situation and Prospects

Debt dynamics

Kenya’s past weak economic growth performance, coupled with decreasing tax revenues (as a share of GDP) and a significant expansion in public sector outlays, has resulted in a fragile fiscal position and large domestic debt. The net present value (NPV) of total debt-to-GDP ratio is estimated to have exceeded 50 percent, with domestic debt accounting for over 48 percent of total debt at end-2002/03 (Table 6).

Under the staff report scenario, which assumes full implementation of the structural and macroeconomic reforms under the program, the ratio of the NPV of total central government debt to GDP is projected to decline to below 37 percent in 2007/08 (Table 6). However, as suggested by the debt sustainability analysis presented in a supplement (to be issues shortly), Kenya’s central government debt dynamics are sensitive to the macroeconomic environment. While NPV of total debt remain broadly on a declining path over the medium term under most of the adverse shocks considered, debt-to-GDP ratios could be significantly higher over the medium term than that in the baseline scenario.1 In particular, negative shocks to the real exchange rate could undermine fiscal sustainability, with the debt-to-GDP ratio in 2010 significantly higher than the level in 2002.

While this analysis is informative, it should be interpreted with caution for several reasons. First, the assumed shocks are relatively short-lived and occur in 2003 and 2004 only, while the analysis ignores the effects of adverse shocks in other years. More persistent adverse shocks would, therefore, pose more substantial risks to debt sustainability. Second, the analysis does not take into consideration the endogenous relationships between economic variables. For example, a slowdown in economic growth would likely reduce fiscal revenues, thereby worsen the primary deficit. Similarly, high interest rates not only raise the debt burden, but also depress investment demand, thus hampering economic growth. These considerations suggest that the potential risks to debt sustainability could possibly be larger than described here. All of these point to the importance of steadfast structural reforms to promote economic growth, and prudent fiscal adjustments to improve budget performance, thereby reducing the vulnerability of Kenya’s debt dynamics to exogenous shocks.

Measures to address the debt problem comprise the following:

  • elimination of domestic borrowing by the end of the program period;
  • substitution of concessional external borrowing and grants for domestic loans;
  • improved debt-management practices, including in the management of defense contracts;
  • up-front resolution of known contingent liabilities in the financial and parastatal sectors and an acceleration of the public enterprise divestiture program;
  • up-front payments of all London Club debts that have hitherto given rise to large default costs;
  • improvements in the modalities for external debt payments that have in the past resulted in arrears and the imposition by creditors of high penalty fees;
  • cancellation of all stalled projects, as well as planned elimination of all pending bills; and
  • completion of a thorough inventory of all external obligations, with a view to ensuring that all prospective payments arc budgeted for.
1 The baseline scenario in the supplement (to be issued shortly) differs from the staff report scenario in Table 6 in that in the baseline scenario the financing gap is closed by additional external borrowing.
  • reductions in the wage bill through revised modalities for setting public wages and other entitlements, as well as the minimum wage and the ongoing civil service reform;
  • increased spending on priority social and economic outlays;9
  • ongoing reform of the procurement systems, including defense procurement, that aims at reducing corruption and getting value for money;
  • strengthened connection between the annual budgets and the medium-term expenditure framework through better forecasting of resources, costing of programs, and a reorientation of the budget management institutions;
  • enhanced modalities for monitoring, tracking, and reporting of budget operations, particularly the tracking of poverty spending (Box 4); and
  • development of a Commitment Control System (Box 5).

15. Comprehensive tax reforms are under way to improve the neutrality, simplicity, and revenue-yielding capacity of the system. Reforms initially focus on a combination of actions to improve tax administration and to broaden the tax base. The government is introducing several measures designed to rebuild the credibility and capacity of the Kenya Revenue Authority (KRA). These include a reform of the customs administration; the institution of new modalities for managing the taxation of the petroleum sector, and the full application of the law in enforcing compliance with respect to public entities that are tax collection agencies. Over the medium term, the strategy for reform will be based on: (a) merging the income tax and value-added tax (VAT) administrations to create one domestic tax administration organized along functional lines; (b) strengthening the large taxpayers department as a first step towards full integration; and (c) developing an integrated information technology system. Proposed measures to broaden the tax base include the removal of most exemptions, the lowering of some tax rates to align them with rates in neighboring countries, and taxation of a larger proportion of informal transactions.

Box 4.Kenya: Core Poverty Programs and the Tracking of Expenditures

Following on the work already done during the last few years, the government decided in early 2003 to expand its current system of tracking poverty-related expenditures. Up to end-2002/03, the Ministry of Finance had been monitoring, on a quarterly basis, a set of “core poverty programs.” These were mainly social expenditures, which could be considered as a basic social safety net for the poor. However, this list of expenditures was very limited, and the government, as part of the medium-term expenditure framework, consulted with development partners and spending ministries to expand this list.

The ultimate aim of this exercise is to ensure that core poverty expenditures are fully embedded in the ERSWEC and are derived from specific development targets (like improving access to primary education, providing safety nets such as training to long-term urban unemployed youth, etc.). This is important because (i) when Kenya completes a full PRSP, the PRSP process will allow continuous monitoring of these expenditures; and (ii) any future changes to the list of expenditures would result from stakeholder consultations.

The government has recently completed a draft listing of pro-poor expenditures for both recurrent and development expenditures, which contains priority programs per sector, linked to their budget codes to enable tracking of these key programs. As the PRSP process moves forward, this listing could be further refined, if needed, to fully reflect government expenditure priorities.

Some of the main poverty-reduction measures under the program include:

  • actions designed to maintain low inflation and promote strong economic growth;
  • a reorientation of the budget toward pro-poor expenditure through increased allocations for education, health, roads, water, and sanitation;
  • the move to universal free education from January 2003 onward;
  • steps to revamp the vocational education and training system;
  • an improvement of governance and reduction of corruption, with a view to lowering the costs of service delivery, particularly in rural areas as informal fees and charges are curtailed;
  • a strengthening of the civil service and the public service delivery system;
  • a restructuring of the trade system, which is expected to reduce the prices of key imported food items (maize and sugar) that feature prominently in the consumption basket of the poor;
  • actions to tackle the high prevalence of AIDS/HIV in rural areas, which are expected to positively affect agricultural productivity and rural incomes; and
  • a rehabilitation of rural health facilities.

Box 5.Kenya: Public Expenditure Management

Background

Weak public expenditure management (PEM) has been a long-standing issue in Kenya. A recent joint assessment mission by the World Bank, the IMF, the European Commission, the U. K. Department for International Development (DFID), and the Kenyan authorities found Kenya’s PEM systems to be satisfactory in only 3 out of 15 areas. Shortcomings in PEM arise in all steps of the budget process, including budget formulation, budget execution, and budget reporting.

Weaknesses in budget preparation, together with poor budget execution and expenditure control, including poor financial compliance and accountability as well as flawed contract design and insufficient costing of policies, have led to the persistent accumulation of expenditure arrears. By December 2002, pending bills amounted to nearly 8 percent of projected 2002/03 recurrent expenditure (excluding wages and interest).

Measures

Measures to improve PEM are important elements of the program. Several structural and quantitative performance criteria and benchmarks target improvements in key areas of PEM, Structural performance clauses in the areas of budget formulation and execution include the development of a Commitment Control System (CCS) to minimize deviations of expenditure outcomes from the approved budget and avoidance of a buildup of new arrears. In the area of budget reporting, presentation of the Auditor General’s Report on the 2002/03 public accounts to parliament is another benchmark. Corresponding to these structural measures, quantitative performance criteria include the nonaccumulation of domestic budgetary and external payments arrears.

These measures are consistent with the findings and recommendations of two FAD technical assistance missions in 2000 and 2001 and a PEM assessment mission in 2003. The government is preparing a comprehensive program of public finance reforms that will include the recommendations made by the 2003 PEM mission.

C. Poverty Reduction under the ERSWEC

16. The ERSWEC aims at tackling poverty by expanding the opportunities available to the poor for productive employment and at improving the quality of life of the poor. It also outlines special programs aimed at addressing entrenched poverty in specific geographical areas, particularly the arid and semiarid lands. As most of the poor live in rural areas, the focus will be on reforming the agricultural sector and encouraging the growth of medium- and small-scale enterprises. A key element of the strategy is the budgeted expansion of spending on rural infrastructure, particularly feeder roads, which are essential to the broadening of market opportunities. Moreover, a review of the agricultural extension and research systems is planned to help in the development of crop and input mixes most suitable for different agronomic regions. Plans are under way to upgrade microfinance institutions. Increasing access of the poor to better education and health services would also play a central role in the revitalization of rural areas. Box 4 provides a list of some of the main poverty reducing measures under the program.

D. Governance Strategy

17. The government has placed its anticorruption strategy at the top of its reform agenda and has embarked on a major strengthening of Kenya’s governance and anticorruption institutions, as corruption has been largely responsible for Kenya’s poor economic performance (Box 6). The governance reform agenda that is spelled out in the MEFP includes the following actions:

  • Enforcement of the Anti-Corruption and Economic Crimes Bill and the Public Officers Ethics Bill enacted in May 2003.
  • Institution of mechanisms for implementing the Public Officer Ethics Act under which all public officials, including members of the judiciary, executive, and legislature, are expected to complete declarations of their assets and those of their families by December 2003. Completion of these declarations by December 2003 is a benchmark under the program.10
  • Establishment of an independent Anti-Corruption Commission, which will be responsible for investigating alleged corruption cases. However, the Constitution Review Commission has proposed that the Anti-Corruption Commission should not have independent powers of prosecution, which will continue to be vested in the Attorney General. Full establishment of the Anti-Corruption Commission, including the filling of the key management positions of the body, is a benchmark under the program.
  • Initiation of judicial reform, which has also involved the removal of corrupt judges.
  • The cancellation of all stalled projects with effect from June 2003 was one of the 2003/04 budget measures. A provision for covering the resulting penalty fees has been included in the budget. The program also includes clearance of all pending bills during the thee-year period. The gestation of stalled projects and pending bills, and the amount and timing of payments on these activities have been driven primarily by corruption.
  • Reform of the public sector procurement system, with World Bank assistance. In addition, public officials have been forbidden from supplying goods to the government and from participating in public auctions.

Box 6.Recent Governance Measures Taken or Announced by the Government

  • The government has publicly placed the fight against corruption and the completion of the constitutional review process at the top of its agenda.
  • The government has established a Ministry of Justice and Constitutional Affairs, which is spearheading efforts in the governance area. The Ministry has completed a five-year strategic plan, in collaboration with both civil society and development partners, and launched a five-year national anti-corruption campaign in July 2003.
  • The government has established a Department of Governance and Ethics in the Office of the President to advise the President on governance matters and, among more specific duties, to oversee the implementation of the Public Officer Ethics Act and provide guidance to public servants on possible conflict of interest and ethical matters in the execution of their duties. The department is headed by a well-respected former head of Transparency international, Kenya.
  • The Ministry of Justice and Constitutional Affairs and the Office of the President (Governance and Ethics) launched the Public Complaints Office in April 2003 to receive, process, and act on complaints of maladministration, abuse of office and corruption, and to act as the government’s “clearing house” for such complaints. It is a precursor to the anticipated Ombudsman Office that is expected to be established via the constitutional review process.
  • In May 2003, Parliament enacted the Anti-Corruption and Economic Crimes Act (2003) and the Public Officer Ethics Act (2003). The Kenya Anti-Corruption Commission (KACC)—with five regional offices—is to be established shortly, following the endorsement by Parliament of the KACC Advisory Board. The administrative procedures for assets disclosures have been published and various codes of conduct and ethics are being finalized.
  • All sales of public assets, including housing, have been suspended because of concerns about corruption. The government plans to establish a policy framework for privatization - to be approved by parliament - that will provide a transparent process for determining public assets to be sold and how privatization would be undertaken, A draft bill is before parliament.
  • A Commission of Inquiry into the Goldenberg scam has been established with a mandate that covers the seizures of assets acquired with illegally obtained money under the Goldenberg scheme.
  • All payments of pending bills have been suspended, pending a thorough audit of the outstanding stock, because of concerns about corruption. The government is reviewing all contracts relating to jobs undertaken for the government and for which payments are pending.
  • With the assistance of the World Bank and other donor agencies, the government has initiated an action program to strengthen the judiciary. This reform program is led by the Ministry of Justice and Constitutional Affairs. As part of the reform of the judiciary, a new Chief Justice has been appointed and a High Court Judge, who while under investigation by the Anti-Corruption Police Unit was presiding over the Goldenberg case, has resigned and been charged in court for involvement in corrupt activities. In addition, 42 judicial officers have either resigned or been dismissed on corruption-related suspicion. A committee on “reform and development” of the judiciary that was appointed in March 2003, has issued a report confirming that corruption has been endemic in the judiciary. A nonpublic second part of the report reportedly identifies by name, and with documentation, five out of Kenya’s nine Appeal Court judges and 18 of 36 High Court judges as corrupt, and these reportedly have been asked by the Chief Justice to resign or face trial.
  • The police force has been reshuffled under a new Police Commissioner.
  • All senior public officials under serious investigation for corruption have been suspended. All procurement officers in the public sector have also been suspended, with a view to breaking corruption networks that had emerged in the procurement system.
  • Seminars and workshops on corruption prevention for civil servants at all levels are conducted under the auspices of the Public Service Integrity Program (PSIP) and the Anti-Corruption Police Unit (being replaced by the KACC). In July 2003, a national anti-corruption workshop was held with President Kibaki, the World Bank President and the Transparency International President in attendance, with participants from civil society and the private and public sectors.

E. Financial System Issues

18. Over the medium term, the reforms aim at addressing the major weaknesses in the financial system that are discussed in Box 7, with an initial focus on banks in distress and a strengthening of the regulatory system. Effective implementation of the complex reform agenda that is outlined in Box 8 will be essential to reduce financial sector vulnerabilities and address some of the main problems that have given rise to the large nonperforming loans (NPLs). This will require close consultations between banks and the monetary authorities, the building of a broad consensus behind the reforms, and a comprehensive revision of key banking legislation. In this regard, some of the provisions of the Banking Act provide for the control by the Minister of Finance of the interest rates and charges set by banks. The authorities intend to bring before parliament by June 2005 major revisions to the Banking and CBK Acts, which would, among other things, bring them in line with the market orientation of their economic policies. Pending the revision of the Acts, the authorities will not apply the restrictive provisions of the Acts—a continuous performance criterion under the program. The work of the ongoing Financial Sector Assessment Program (FSAP) will be of considerable assistance in helping the authorities to develop the strategies for addressing the issues mentioned above.

F. Trade Reform and Competitiveness Issues

19. The authorities recognize that greater attention will need to be devoted to trade policy to realize the growth and poverty reduction objectives of the ERSWEC. To this end, trade reforms will, over the medium term, focus on:

  • an immediate lowering of the maximum external tariff to 25 percent from 35 percent and a reduction in the number of tariff-bands from 5 to 3, consistent with the agreement of the East African Community (EAC) customs union (Box 9);
  • a further reduction of the maximum external tariff rate during the program period from 25 percent to 15 percent to be discussed in the context of the first review; and
  • reduction of current export incentive schemes.

The authorities are also implementing a variety of measures designed to improve the efficiency of customs administration, particularly the clearing system to facilitate trade.

These include the following:

Box 7.Kenya: Main Weaknesses in the Financial Sector

The financial sector suffers from the following main weaknesses:

  • High level of nonperforming loans (NPLs). NPLs were reported at about 30 percent of total loans at end-June 2003, a level arising from political lending at public sector banks, insider or connected lending, especially at smaller private banks, and pervasive legal problems in enforcing creditor rights.
  • Large intermediation margins. A high level of NPLs, together with high costs related to the need for relatively large spending on security and poor financial infrastructure, results in substantial intermediation margins, with spreads between lending and deposit rates of about 13 percentage points.
  • Undercapitalized banking system. The banking system is undercapitalized and is therefore vulnerable to negative shocks. An adjustment for loan misclassification and underprovisioning lowers the aggregate capital adequacy ratio from the reported figure of 17 percent to a figure well below the 12 percent minimum requirement. The large banks with government ownership have negative capital after the adjustment.
  • Unhealthy public sector banks. Public sector banks suffer from low or negative profitability, high costs, and substantial NPLs. The National Bank of Kenya is bankrupt.
  • Weak banking supervision. The legal frameworks for the supervision of banks and other financial institutions are inadequate and need improvement.
  • Fragile National Social Security Fund (NSSF). The NSSF has large losses arising from governance problems and unsound investment decisions.
  • Weak insurance companies. There is a proliferation of insurance companies in Kenya relative to the volume of premiums, and many companies appear to have insufficient reserves to meet their liabilities.
  • Underdeveloped capital market. There is a shortage of new issues on the Nairobi Stock Exchange. Bond markets, housing finance, insurance, and microfinance appear to be underdeveloped relative to Kenya’s potential.
  • Fragmented legal framework for insolvency and creditor rights. Insolvency laws are outdated.

Box 8.Kenya: Financial Sector Reforms

The program for 2003/04 includes the following measures designed to improve the performance of the financial system:

  • amendments of the Banking and Central Bank Acts to facilitate the transfer from the Ministry of Finance (MOF) to the Central Bank of Kenya full powers of licensing, delicensing, regulation, and supervision of banks;
  • a tightening of prudential regulations on provisioning, with a view to ensuring conformity with international best practice and ensuring compliance with all prudential norms by all banks;
  • commence work on a comprehensive revision of the Banking and CBK Acts, which would also involve the removal of the restrictive provisions of the Acts;
  • a budget provision of Ksh 12 billion for the restructuring of the NBK, which should enable the bank to comply with the prudential regulatory requirements by December 2003;
  • a restructuring of the National Bank of Kenya, with the assistance of the World Bank, by June 2004 and subsequent privatization;
  • placement on the market of government shares in the KCB by December 2003;
  • increase the transparency of the banking industry through the regular publication of base fees, commissions, and service charges; and
  • initiation of new anti-money-laundering legislation, taking into account relevant findings from the anti-money-laundering/combating the financing of terrorism (AML/CFT) assessment included in the Bank-Fund Financial Sector Assessment Program for Kenya.

Additional medium-term measures to further improve the financial system include the following:

  • enactment of revised Banking and CBK Acts;
  • divestiture of the government’s ownership in the remaining public banks;
  • strengthening the judicial system, which should result in better enforcement of creditor rights, and an expansion of the role of commercial courts (the ongoing work of the Law Review Commission will lead to the updating of the Insolvency and Companies Acts);
  • expand the outreach and improve the operations of microfinance institutions;
  • recapitalize and strengthen the management and oversight of the NSSF; and
  • strengthen supervisory frameworks for nonbank financial intermediation.

Box 9.Trade Reform and Competitiveness Issues

Background

Protection has been reduced, but is still relatively high. Following the extensive trade and exchange reforms of the early 1990s, no price and foreign exchange restrictions remain. There are, however, some import controls based on health, environmental, and security concerns, and imports are subject to a preshipment inspection for quality, quantity, and prices. The trade regime is rated as moderately restrictive,1 but complex with 5 tariff bands and rates ranging from 0-35 percent; highest for domestically produced consumer goods, and lowest for raw materials, capital, and intermediate goods.2 In addition, an import declaration fee of 2.75 percent is levied on all imports.

Kenya has developed a wide range of export incentives including a manufacturing-under-bond scheme, the export promotion zones (EPZs),3 and a VAT exemption scheme. Exporters contend that except for the EPZs, the schemes do not function effectively. Cumbersome and inefficient customs procedures, moreover, are frequently cited in business surveys as a major impediment to efficiency and the expansion of exports, as well as a source of corruption.

Reforms

The key trade policy actions are the following:

  • the immediate lowering of the maximum tariff rate from 35 percent to 25 percent consistent with the agreement on EAC Customs Union;
  • the reduction from November 2003 of tariff bands from five (0, 5, 10, 25,35) to three (0, 10, 25);
  • introduction of the electronic and verification systems as part of the ongoing reform and modernization of the customs administration system; and
  • addressing the weaknesses in the system of export incentives.

Impact of Reform Agenda

A key concern is the revenue losses associated with trade liberalization. Kenya receives about 43% of its customs revenue from items that attract a tariff rate of 30-35%:

  • Tariff bracket
0-55-1010-1515-2020-2525-3030-3560-100
  • Share of revenues
8%2%22%3%11%4%43%7%

Current estimates suggest that a lowering of the upper band from 35 percent to 25 percent may result in a near-term reduction of customs revenues by as much as 2.3 billion Kenyan shillings (13 percent of customs revenues). In addition, as regards customs revenues, the authorities highlight the following:

  • The major shortfalls in revenues compared to the budget projections for the last three years have been in the customs area, and this has been attributed to weaknesses in customs administration and corruption.
  • Improved tax administration, particularly at the port of Mombassa, as well as a reduction in smuggling could result in a substantial increase in revenue. This would facilitate a more ambitious tariff reduction effort.
1 Kenya’s trade regime is rated 6 on the IMF’s 10-point trade restrictiveness index, with 10 being the most restrictive.2 With an exception for sugar and wheat that are taxed at 100 percent and 60 percent respectively.3 Kenya enacted EPZ legislation in 1990, well ahead of most African countries. It now has 23 zones. Some are run by the government but most are privately operated.
  • Introduction of electronic clearance and verification systems; and
  • Institution of work shifts by staff to speed up the turnaround time at Kenyan ports and cope with the requirements of the African Growth and Opportunity Act, This will also help to reduce the clearance time for goods destined to neighboring countries to a maximum of two days.

20. The first review of the PRGF-supported program will focus on further reforms of the trade regime.

21. To complement the trade reforms and ensure that producers face an appropriate structure of economic incentives, the authorities intend to maintain the flexible exchange rate system. Other actions under the program are expected to influence the evolution of factors determining Kenya’s international competitiveness. These include the following:

  • the reform of the utility and telecommunications sectors;
  • the ongoing improvement of port services and customs procedures;11
  • upgrading of the road network;12 and
  • labor market reforms, particularly the wage determination mechanism, to enhance labor market flexibility.

IV. The Program for 2003/04

22. The macroeconomic framework for 2003/04 is based on the following: (i) a modest real GDP growth of 1.9 percent (Table 6), reflecting in part the negative effects of the terrorism-related travel ban, which is expected to lower GDP by slightly over 1 percent in 2003;13 (ii) a significant dissipation of price pressure, with CPI falling by 4 percent by end-2003/04 (Table 6), reflecting a projected return of food and fuel prices to trend levels; underlying inflation is projected to remain below 5 percent; and (iii) a modest buildup in gross international reserves to about 2.8 months of import cover. Achievement of these objectives will require concerted implementation of the fiscal and structural measures outlined in the MEFP. Structural conditionality under the program covers key areas such as governance, fiscal policy, and privatization (see Box 2 and Table 1 of Annex I to the Attachment).

A. Fiscal Policy

23. Consistent with the objective of debt sustainability, the approved budget for 2003/0414 targets a substantial reduction in the domestic borrowing requirement from 5.0 percent of GDP in 2002/03 to 3.3 percent of GDP, with about 1.7 percent of GDP of the latter arising from transitory payments, including the recapitalization of banks, a spike in external debt repayments, and the programmed reduction of pending bills. The 2003/04 budget envisages an increase in total revenue collection of 1.5 percent of GDP,15 with the focus of revenue policy on the enhancement of capacity and integrity of tax administration (Table 7).

24. Expenditure is projected to rise by 2.2 percent of GDP in 2003/04, driven primarily by increases in public outlays on education, operations and maintenance, and capital spending. The increased allocations represent the first important step toward implementing the ERSWEC. The budget includes expenditure rationalization measures, which are outlined in the MEFP (paras. 16-18). Details of the expenditure management measures under the program are provided in Box 5 and in the MEFP (para. 19), and the main elements of the system to track expenditure on poverty reduction programs are provided in Box 4.

25. An important element of the authorities’ development strategy is to raise the proportion of local authorities’ spending to at least 20 percent of total expenditure by 2008.16 To achieve this objective without undermining fiscal prudence, the focus of the program will be on actions to strengthen the local authorities’ revenue base, budget management, and program implementation capacity. This will lay the basis for an expanded role for local governments in the implementation of the poverty reduction program.

26. Public enterprise reform is an important plank in the government’s reform agenda and is critical to enhancing the role of the private sector in the economy. Kenya’s large parastatal sector has been a significant source of contingent liabilities and has generally operated inefficiently. The planned reforms include the privatization of most of the enterprises, the concessioning of natural monopolies, and the strengthening of the operations of the remaining few state bodies, such as universities (MEFP, para. 27). To ensure transparency in the privatization process, the government intends to introduce a Privatization Bill in parliament by the end of 2003, which is also a benchmark under the program. An important part of the bill is the establishment of a Privatization Commission to manage the process. The government has decided to accelerate the privatization of key public enterprises and will announce by December 2003 a timetable and list of enterprises to be placed on the market. Already, the government has announced its intention to place on the market its 35 percent shareholding in the KCB.

B. Monetary and Exchange Rate Policies

27. In line with the emphasis of the authorities on the maintenance of low inflation, the monetary program aims at containing underlying inflation below 5 percent in 2003/04 (Table 8). The inflation objective will be achieved through reserve money targeting, with broad money (M3X) as the intermediate target, and open market (repurchase and reverse repurchase) operations as the main instruments. In this regard, broad money growth will be targeted at 7 percent in 2003/04, consistent with the anticipated gradual increase in economic activity (Table 8). By promoting financial stability and low inflation, the monetary program would be consistent with a continued lowering of the country’s risk premium and sustained low interest rates during 2003/04. Together with the planned financial sector reforms, this program would help encourage a gradual 5 percent expansion of bank credit to the private sector. As money demand is expected to display some variability in response to changes in economic conditions, the CBK will continue to use a broad set of indicators to monitor future inflationary pressures and to gauge the appropriateness of the monetary policy stance. Monetary targets will be reassessed at the time of program reviews.

Table 8.Kenya: Monetary Survey, 2001-08 1/
Mar-01Jun-01Sep-01Dec-01Mar-02Jun-02Sep-02Dec-02Mar-03Jun-03Sep-03Dec-03Mar-04Jun-04Jun-05Jun-06Jun-07Jun-08
Cental Bank of Kenya (CBK)
Net foreign assets63,14566,80673,15675,87878,03277,91476,01170,10578,97780,67081,46083,10189,41795,644119,875163,349194,435219,067
Net domestic assets6,9032,504-3,3653,247-2,253-1,0332,57818,3485,1364,824-2,790473-8,720-14,791-33,554-71,199-95,817-113,505
Net domestic credit479-2,934-7,0021,671-5,015-3,2052,33519,7745,8635,984-1,5631,773-7,340-13,322-31,633-68,616-92,265-108,534
Government (net)18,81710,8072,98914,55410,74020,04017,56118,01122,36314,39514,79315,18815,58415,9808,724-14,648-39,875-66,328
Commercial banks (net)-18,338-13,741-9,991-12,883-15,755-23,245-15,3261,763-16,500-8,411-18,053-15,143-24,674-31,096-42,213-55,890-54,378-44,264
Other items (net)6,4345,4383,6371,5762,7622,172343-1,426-727-1,160-1,227-1,300-1,380-1,469-1,921-2,583-3,552-4,972
Reserve money (RM)70,04869,31069,79179,12575,77976,88178,58988,45384,11385,49478,67083,57480,69780,85386,32192,15098,618105,562
Currency outside banks41,73342,37441,70645,28946,02246,92046,33853,87849,39049,68851,19855,82453,04553,61058,34263,37068,90574,829
Bank reserves28,31526,93628,08533,83629,75729,96132,35134,57534,72335,80627,47227,75027,65127,24427,97928,78029,71330,733
Net foreign assets26,42224,39019,52818,37517,77719,20820,82631,87625,40022,87022,64222,41522,19121,96921,10320,27219,47318,706
Reserves38,31526,93628,08533,83629,75729,96132,25134,57534,72335,80627,47227,75027,65127,24427,97928,78029,71330,733
Credit to CBK18,33813,7419,99112,88315,75523,24515,326-1,76316,5008,41118,05315,14324,67431,09642,21355,89054,37844,264
Net domestic assets243,703247,186258,085257,955256,688258,892272,577287,427232,748302,592305,157308,077310,663315,000334,213353,055390,699439,887
Domestic credit306,367306,951325,735317,953317,231320,364335,102345,251345,962367,021370,875374,453377,702382,709404,672426,374466,996519,282
Government (net)57,1.1657,85673,72774,52477,91074,69484,06390,59692,496109,432109,680110,671111,661112,652110,579107,657104,504100,095
Other public sector8,5429,8778,9598,0276,9386,6309,6718,0167,5136,32010,0098,2977,7766,5416,7707,0077,2527,506
Private sector240,690239,218243,049235,402232,383239,040241,369246,639245,953251,269251,186255,485258,265263,516287,323311,710355,240411,681
Other items (net)-62,664-59,765-67,651-59,999-60,543-61,472-62,524-57,824-63,214-64,429-65,718-66,375-67,039-67,709-70,458-73,319-76,296-79,394
Total deposits316,778312,253315,688323,049319,976331,306340,981352,114359,371369,679373,324373,386385,180395,308425,508457,997494,263533,590
Monetary survey
Net foreign assets89,56791,19692,68494,25395,80997,12296,838101,980104,378103,540104,101105,516111,608117,613140,978183,621213,908237,773
Net domestic assets269,004263,487264,760274,141270,242281,154290,527304,029304,439315,879320,915326,440326,921331,686343,706339,115351,257373,370
Domestic credit326,559319,141330,233334,004329,467341,951354,304364,932370,016383,149387,365391,369395,036400,483415,251413,648429,109455,012
Government (net)75,95368,66376,71689,07889,65094,734101,624108,607114,859123,827124,471125,858127,245128,632119,30293,01064,62933,767
Rest of the economy250,606250,478253,518244,926240,817247,217252,680256,325255,157259,321262,893265,510267,791271,850295,949320,638364,480421,245
Other public sector8,5439,8778,9598,0276,9386,6309,6718,0167,5136,32010,0098,2977,7766,5416,7707,0077,2527,506
Private242,065240,601244,558236,898233,879240,587243,010248,309247,644253,001252,884257,214260,014265,309289,179313,631357,228413,739
Other items (net)-57,555-55,654-65,473-59,862-59,225-60,797-63,776-60,903-65,577-67,270-66,450-64,929-68,115-68,797-71,546-74,533-77,852-81,643
Money and quasi money (M3)308,791305,529310,649322,325320,948331,633335,873350,733352,748362,596368,761376,263383,393394,714432,250472,368516,782564,667
M3 and foreign currency deposits (M3X)358,571354,683357,444368,394366,051378,276387,365406,009408,817419,419425,016431,956438,529449,299484,684522,736565,165611,143
Currency outside banks41,73342,37441,70645,28946,02246,92046,33853,87849,39049,68851,19855,82453,04553,61058,34263,37068,90574,829
Deposits316,831312,309315,738323,106320,028331,356341,027352,131359,426369,731373,818376,132385,483395,690426,342459,366496,260536,314
M3X and nonbank holdings of government debt (M4X)441,147446,588451,356462,127466,430483,886499,352521,198527,417542,794552,700563,206573,345587,682622,030657,161696,437738,006
Memorandum items:
M3-0.1-1.30.82.53.98.58.18.89.99.39.87.38.78.99.59.39.49.3
M3X3.72.11.83.32.16.78.410.211.710.99.76.47.37.17.97.98.18.1
M4X4.85.36.56.15.78.410.612.813.112.210.78.18.78.35.85.66.06.0
Money base2.8-8.50.21.88.210.912.611.811.011.20.1-5.5-4.1-5.46.86.87.07.0
Currency outside banks8.910.09.24.310.310.711.119.07.35.910.53.67.47.98.88.68.78.6
Domestic credit-9.0-3.50.20.80.97.17.39.312.312.09.37.26.84.53.7-0.43.76.0
Government (net)-9.0-17.5-5.916.516.738.032.521.929.630.722.515.910.83.9-7.3-22.0-30.5-47.8
Rest of the economy-9.01.21.2-3.9-3.91.3-0.34.76.04.94.03.65.04.88.98.313.715.6
Nonbank holdings of government debt (millions of Kenya shillings)82,57691,90593,91293,733100,380105,610111,987115,189118,600123,374127,684131,250134,817138,383137,346134,423131,272126,863
Stock of domestic dept (millions of Kenya shillings)158,529160,568170,627182,811189,039200,344213,611223,796233,459247,202252,155257,108263,062267,015256,649227,435195,900160,630
Multiplier (M3X/RM)5.15.15.14.74.84.94.94.64.94.95.45.25.45.65.65.75.75.8
Reserve cover (in months of next year’s imports)3.23.33.53.63.23.13.12.92.72.72.82.92.6-2.83.34.04.24.3
Source: Central Bank of Kenya and staff projections

Constant Kenya shilling per U.S. doller exchange rate prevailing on September 30, 2001

Source: Central Bank of Kenya and staff projections

Constant Kenya shilling per U.S. doller exchange rate prevailing on September 30, 2001

28. During the first two months of 2003/04, reserve money was well above the target under the program. However, the authorities have agreed to sterilize the excess reserves by end-December 2003. In discussions with the authorities, the staff has pointed out that the combination of excess liquidity and low interest rates on government securities could induce undue pressure on the balance of payments. In this regard, the timing of the reduction of required cash reserves—before addressing major weaknesses in the judiciary and the banking system that have increased the credit risks, contributed to the high interest rate margins, and caused the banks to be cautious toward new lending—was premature and would likely not result in the envisaged reduction in bank lending rates and increased credit to the private sector. In addition, the staff has pointed out that, in setting monetary policy, consideration should be given to the state of the banking system. In this regard, the environment of low treasury bill interest rates, when set against the large NPL problem and other weaknesses in the banking system, carries major risks; it could lead to widespread bank failures, because government securities comprise a substantial proportion of banks’ assets. The staff has also requested that the authorities expand their coverage of financial statistics to include the regular collection and publication of data on the assets and liabilities of nonbank financial institutions, which would improve the authorities’ ability to monitor and manage the financial system. Meanwhile, the monetary authorities have continued to study the monetary transmission mechanism and the scope for introducing inflation targeting in Kenya.

29. Kenya has a floating exchange rate regime, which has, thus far, served the economy well. The authorities have expressed their intention to retain this regime. They intend to limit exchange rate interventions to smoothing short-term volatility, offsetting the variability in donor flows, effecting government external debt payments, and meeting the net foreign reserves targets. They are committed to making full use of exchange rate flexibility in response to both medium- and long-term exogenous shocks.

30. The appreciation of the exchange rate through May 2003 has raised concerns about its likely impact on the competitiveness of the export sector, particularly at a time of falling export prices for Kenya’s traditional export crops: tea and coffee. Export volumes of these commodities have been sluggish in the recent past. However, the strong performance of horticultural and manufacturing exports, which grew at annual average rates of 23 percent and 36 percent, respectively, in the three years to 2002, suggests that some major export operations have remained competitive. In view of this mixed record, exchange rate developments will need to be monitored closely.

C. Safeguards Assessment

31. The recently completed on-site safeguards assessment of the CBK found that the bank had made notable progress in strengthening its safeguards since the December 2000 assessment. The principal achievements of the CBK include the following: (i) adoption of an external audit rotation policy and appointment of a new external audit firm to replace a firm that had audited the CBK since 1966, (ii) resolving accounting issues around government transactions, including reaching agreement with the government on regularizing the frozen government loan accounts, (iii) improvements in the internal audit function, and (iv) adoption by the CBK Board of an internal control policy paper. Despite these actions, some vulnerabilities remain, mainly in the areas of financial reporting and in monetary data reporting. The authorities accepted the actions proposed by the staff for addressing these weaknesses, which will be incorporated in the program at the time of the first review.

D. Statistical Issues

32. While Kenya produces adequate macroeconomic statistics to monitor performance under the program, those statistics have deteriorated over the past decade, and weaknesses in key statistics hamper economic analysis and surveillance (Appendix V). The staff expressed concerns about (i) the problems involved with monitoring budgetary data, in particular domestic arrears and pending bills; (ii) the timeliness of foreign trade data; and (iii) the accuracy of national accounts data. The authorities indicated that they were taking actions, with donor assistance, to improve the quality and timeliness of these data.

V. External Financing and Capacity to Repay the Fund

33. The external current account deficit is expected to widen by about 4 percent of GDP to 4.9 percent of GDP in 2003/04, and to rise further over the medium term, to about 11 percent of GDP in 2005/06 as both private and public investments are projected to register marked increases in response to a pickup in economic rehabilitation activities, causing a strong rebound in imports (Table 9). On the other hand, export volume growth would take place with a lag, and would be modest in 2004 and 2005 before strengthening in later years. Reflecting these projected trends and the programmed buildup in gross international reserves, Kenya would face substantial financing gaps (Table 10). The latter are expected to be largely filled by donor inflows, which are projected to increase markedly, partly in response to the resumption of a Fund-supported program. Also, reflecting a reduction in political uncertainty and the increased integration of the Kenyan economy into global markets, both private transfers and foreign direct investment would rise. Nevertheless, a rescheduling of Kenya’s external debt obligations with the Paris Club would be required to fill the financing gaps. Total projected financing needs17 are expected to average about US$1.3 billion per year over 2003/04 to 2005/06 (Table 10). For 2003/04, the unidentified gap reflects a possible Paris Club rescheduling, while for 2004/05 and 2005/06, the unidentified gap is expected to be filled by both a Paris Club rescheduling and an expected but unidentified program support.

Table 9.Kenya: Balance of Payments, 2001-2008(in millions of U.S. dollars, unless otherwise indicated)
2001

Est
2002200320042005200620072008
Current account-398-57-316-1,051-1,721-1,837-1,814-2,217
Excluding official transfers-486-57-369-1,051-1,721-1,837-1,814-2,217
Exports, f.o.b.1,8812,1692,5142,6402,8073,0933,4943,917
Coffee948495104113127143156
Tea435437477517551599650695
Oil products17754615552515254
Other1,1761,5941,8801,9642,0902,3162,6493,012
Imports, fob,-3,176-3,181-3,712-4,527-5,349-5,774-6,208-7,113
Public-91-94-212-114-119-125-133-141
Private-3,085-2,964-3,500-4,413-5,230-5,649-6,075-6,972
Oil-721-741-847-981-931-950-980-1,069
Other-2,364-2,346-2,654-3,432-4,299-4,700-5,095-5,903
Balance on goods-1,295-1,012-1,199-1,887-2,542-2,681-2,715-3,196
Services (net)261500456444436461508530
Credit1,0871,1121,1601,2251,2841,3681,4791,597
Foreign travel308286257288305323346370
Other7798269039379791,0451,1331,226
Debit-825-612-704-781-849-908-971-1,066
Balance on goods and services-1,033-512-743-1,443-2,107-2,221-2,207-2,666
income (net)-148-122-179-148-153-161-156-105
Credit433547577293112126
Debit-190-157-225-205-225-253-268-231
Of which: official interest payments-111-89-131-98-114-129-141-102
Current transfers (net)783577605540539544549554
Private (net)694577552540539544549554
Official (net)8805300000
Capital and financial account418744978841,3051,3691,4311,661
Capital account7189232328331448550559
Of which: capital transfers7189232328331448550559
Financial account347-152655569749218821,102
Investment assets and liabilities (net)-273-6312149511333412511
Official, medium and long term-31523-6677177157158156
Inflows136211248306409387385376
Program loans305000000
Project loans101141109237362340338329
Defense bans030333221212121
Government guaranteed/parastatal3240563626262626
Outflows-452-188-314-229-232-229-227-220
Commercial banks (net)96-69000000
Private (net)-54-177872334175254355
Short-term (net) and net errors and omissions 1/62049252407463588470591
Overall balance2018180-167-416-469-382-556
Financing items-21-18-180167416469382556
Reserve assets (gross)-167-3-197-299-462-596-341-382
Use of Fund credit and loans to the Fund (net)-24-1816586559-9-14
Change in arrears484-200-810000
Rescheduling1220000000
Rescheduling of arrears 3/00000000
Cancellation of arrears00000000
Rescheduling of current maturities1220000000
Cancellation of current maturities00000000
Remaining gap002004888141,006733952
Tentatively identified program support0036359472659355385
Unidentified support00164129342347378567
Memorandum items:
Gross official reserves (end of period)1,0641,0671,2641,5632,0252,6212,9623,344
(in months of next year’s imports) 2/3.52.92.93.03.64.44.34.6
(In months of this year’s imports) 2/3.23.43.43.53.94.75.04.9
(percent of short-term debt by remaining maturity)129116142177227295333378
Stock of arrears276.4280.480.80.00.00.00.00.0
Current account balance
(percent of GDP, excluding official transfers)-4.3-0.5-2.6-7.2-11.2-11.1-10.2-11.5
(percent of GDP, excluding special imports) 3/-2.40.3-1.0-6.0-9.3-10.9-10.0-11.3
Debt-service ratio after rescheduling 4/5/19.89.08.25.45.76.25.34.0
Import volume growth, goods (percent)7.3-6.99.223.319.08.26.914.6
Import volume growth, goods (percent; excluding special im8.4-3.64.728.317.313.16.914.7
Export volume growth, goods (percent)11.616.75.84.54.88.611.712.1
Sources: Kenyan authorities; and staff estimates and projections.

Includes undenecorded tourism earnings

In months of projected imports of goods and nonfactor services

Special imports include defense-related imports, imports of maize, sugar, and airplanes, and imports related to rehabilitation of the energy sector.

After November 2000 Paris Club rescheduling and assumed rescheduling, under comparable terms, by commercial and non-Paris Club bilateral creditors.

In percent of exports of goods and services.

Sources: Kenyan authorities; and staff estimates and projections.

Includes undenecorded tourism earnings

In months of projected imports of goods and nonfactor services

Special imports include defense-related imports, imports of maize, sugar, and airplanes, and imports related to rehabilitation of the energy sector.

After November 2000 Paris Club rescheduling and assumed rescheduling, under comparable terms, by commercial and non-Paris Club bilateral creditors.

In percent of exports of goods and services.

Table 10.Kenya: External Financing Requirements and Resources, 2001/02 - 2007/08 1/(In millions of U.S. dollars)
2001/022002/032003/042004/052005/062006/072007/08
Est.Projections
External financing requirements-755.2-735.8-1385.8-2047.3-2548.4-2533.1-2612.1
Current account (excl. official transfers)-271.4-213.1-710.4-1386.1-1779.1-1825.6-2015.4
Scheduled amortization (official)-319.7-250.6-271.0-230.2-230.5-228.1-223.4
IMF payment, gross-20.9-18.8-16.3-10.1-9.8-11.0-11.8
Reduction in arrears-58.1-153.3-140.2-40.40.00.00.0
Buildup of gross official reserves-85.1-100.1-247.9-380.5-529.0-468.5-361.5
Resources755.0684.01209.31811.82204.22170.72139.4
Program support (committed and tentatively identified)13.687.6302.8487.0637.1542.7369.7
IMF0.017.953.671.471.435.70.0
Program loans1.635.0129.4232.8327.9216.155.5
African Development Bank (ADB)0.010.031.844.947.851.355.5
IDA1.625.097.6188.0280.1164.80.0
Program grants12.134.7119.8182.8237.7290.8314.3
U.K. Department for International Development0.00.033.387.2111.5119.7129.4
European Union12.134.779.765.778.4119.7129.4
Other0.00.06.829.947.851.355.5
Project Support200.8285.0453.0629.2740.1837.7887.9
Project loans120.7124.6172.9299.7350.9338.9333.4
IDA7.87.98.18.213.919.620.0
ADB/African Development Fund0.50.50.50.50.50.50.5
Other (including bilateral)112.4116.2164.4290.9336.6318.8313.0
Project grants80.1160.4280.1329.5389.2498.8554.4
Government-guaranteed and defence loans51.379.678.757.546.746.746.7
Private financing-22.0-4.174.9203.0254.9214.8304.7
of which, foreign direct investment50.255.060.181.2148.3233.2322.4
Short-term (net) and net errors and omissions 2/366.4180.5299.9435.0525.3528.9530.4
Accumulation of arrears83.955.50.00.00.00.00.0
Rescheduling of debt61.00.00.00.00.00.00.0
Unidentified gap 3/0.051.8176.5235.5344.2362.4472.7
Sources: Kenyan authorities; and staff estimates and projections

Fiscal years ending June.

Short-term (net) and errors and omissions in Kenya are traditionally large and volatile. They are believed to include unreported tourism inflows.

The unidentified gap is defined as program support that is expected but unidentified plus possible rescheduling.

Sources: Kenyan authorities; and staff estimates and projections

Fiscal years ending June.

Short-term (net) and errors and omissions in Kenya are traditionally large and volatile. They are believed to include unreported tourism inflows.

The unidentified gap is defined as program support that is expected but unidentified plus possible rescheduling.

34. Overall total donor support is projected to increase from 6.5 percent of GDP in 2003/04 to 9.9 percent of GDP in 2005/06 (Table 6). While Kenya has received primarily project support in recent years, the share of program support in total donor financing would rise over the program period, so that program and project support would come to comprise roughly equal shares of total donor support.18 It is also expected that the share of grants in total donor support would rise from about 43 percent in 2000/01 to around 50 percent during the program.19 The World Bank is expected to provide an average of US$ 300 million per annum (program and project support) over the period 2003/04 to 2005/06.

35. Kenya’s projected external financing requirements are high but appear achievable, based on the experience of other low-income countries that have implemented, on a sustained basis, strong policy reforms. Since donor grants (as opposed to concessional loans) would comprise a large share of total external resources over the period during 2003/04–2005/06, and as FDI flows increase in the medium term, Kenya’s external debt (in percent of GDP) would be on a declining trend (Tables 10 and 11), despite the large external inflows. Based on the baseline medium-term framework, which foresees increased growth and low inflation, Kenya’s external debt is projected to be below the thresholds under the enhanced HIPC Initiative.20 Total Fund credit outstanding to Kenya is projected to rise from 8.3 percent of gross international reserves at end-2003 to 11.0 percent at end-2005 (Table 2) before declining to 5.0 percent by end-2010. Over this period, debt service to the Fund, as a share of exports of goods and services, would rise from 2.3 percent in 2002 to a peak of 6.3 percent in 2006, before declining to 3.3 percent by 2010. Even if the high level of external financing envisioned under the program was delayed or failed to materialize in full, it is expected that Kenya would still be able to meet its repayments to the Fund, as these obligations would not exceed 14 percent of international reserves (even if reserves were to remain at their end-2002 level). Given Kenya’s good repayment record to the Fund, the projected increase in its gross international reserves, and the authorities’ commitment to economic reforms, Kenya is expected to meet its financial obligations to the Fund in a timely manner.

Table 11.Kenya: External Debt Indicators, 2000-08 1/(In millions of U.S. dollars, unless otherwise indicated)
200020012002200320042005200620072008
Debt-stock indicators
Stock of external debt by creditor 2/3/5,4964,7135,1875,1065,3286,0656,8697,3247,962
Multilateral creditors3,0012,9193,0443,0573,2043,7524,3804,6625,108
IMF128998810996169197188179
World Bank2,3562,2912,4742,4242,5132,8013,2093,2913,462
African Development Bank/African Development Fund355302305314348458580710907
Other162228177210247324394473560
Bilateral creditors1,8891,6001,5911,7571,8772,1082,3172,5242,744
Paris Club1,8451,5521,5271,6651,7541,9292,0862,2412,407
Non-Paris Gub44486492123179231283337
Other creditors 4/606194273293247205171138110
Stock of external debt by debtor 2/3/5,7234,7135,1875,1065,3286,0656,8697,3247,962
Central government4,8574,3124,4914,6074,8315,4906,2586,7197,361
Government guaranteed511303328390401406413418422
Central bank128998810996169197188179
Net present value (NPV) of debt 3/5/
In million of U.S. dollars4,0993,4304,1894,0794,1554,6775,1815,5716,052
In percent of exports of goods and services 6/149123140123115121125124121
In percent of government revenue 7/171139157135132141
In percent of GDP393034292930313131
Stock of arrears 8/22827628081..........
Debt-service indicators
Principal payments by creditor 3/425373256332240229232227224
Multilateral creditors1561289112210799111103103
IMF422419191371399
World Bank706352666462677173
AfDB/AfDF191911121111111211
Other2523825202020129
Bilateral creditors1221511411048787889193
Paris Club116149135978485858890
Non-Paris Club617733333
Other creditors 4/14795231064642343328
Interest payments by creditor 3/9992899398114114141156
Multilateral creditors384929323340475157
IMF11212222
World Bank263419191921242526
AfDB/AfDF8126555678
Other4246811141822
Bilateral creditors372848485363678292
Paris Club362843413936313230
Non-Paris Club10071527365062
Other creditors 4/241516131111086
Debt-service ratio (in percent of current year exports)1916111298877
Debt-service to fiscal revenue ratio 7/22191314111010109
Sources: Kenyan authorities; and staff estimates and projections.

Based on a preliminary debt sustainability analysis

Does not include arrears.

After Paris Club rescheduling in November 2000; assumes comparable treatment by non-Paris Club and commercial creditors but also reflects recent agreement with some commercial creditors.

Includes commercial banks’ and suppliers’ credit, includes slock and repayment of arrears according to the terms agreed with commercial banks. Data on debt service to other creditors beginning in 2003 reflect preliminary information on recent creditor agreements and may be revised.

Refers to the present value of debt service calculated by using the currency-specific commercial interest reference rate (CERR) as the discount rate.

Three-year backward-looking average.

Central government revenue, excluding grants.

The stocks of arrears at end-2000 and end-2001 are largely composed of arrears to commercial creditors that are assumed to be cleared when Kenya reaches a rescheduling agreement with these creditors.

Sources: Kenyan authorities; and staff estimates and projections.

Based on a preliminary debt sustainability analysis

Does not include arrears.

After Paris Club rescheduling in November 2000; assumes comparable treatment by non-Paris Club and commercial creditors but also reflects recent agreement with some commercial creditors.

Includes commercial banks’ and suppliers’ credit, includes slock and repayment of arrears according to the terms agreed with commercial banks. Data on debt service to other creditors beginning in 2003 reflect preliminary information on recent creditor agreements and may be revised.

Refers to the present value of debt service calculated by using the currency-specific commercial interest reference rate (CERR) as the discount rate.

Three-year backward-looking average.

Central government revenue, excluding grants.

The stocks of arrears at end-2000 and end-2001 are largely composed of arrears to commercial creditors that are assumed to be cleared when Kenya reaches a rescheduling agreement with these creditors.

36. The authorities have indicated their intention to seek a rescheduling from the Paris Club.21 In previous reschedulings, Kenya requested Houston (nonconcessional) terms because of concerns about the potential negative impact of concessional terms on export credit flows and aid flows. However, as an IDA only country, Kenya is potentially eligible for more concessional terms (such as Naples terms), although given its debt levels, it would not qualify for assistance under the enhanced HIPC Initiative. The Kenyan authorities are currently discussing with their key creditors/donors possible Paris Club rescheduling terms. A revised debt sustainability analysis (DSA) has been prepared based on updated debt data, including possible assistance to support the poverty-reduction and other Millennium Development goals. The new DSA confirms that the NPV of Kenya’s external debt to exports remains below the HIPC threshold. The results also indicate that following the prospective Paris Club rescheduling, Kenya would not require future reschedulings of its external debt, as debt sustainability indicators do not deteriorate significantly under a variety of plausible shock scenarios.

VI. Staff Appraisal

37. Notwithstanding the poor implementation of policies and the weak economic performance under the last PRGF-supported program, a new PRGF arrangement is proposed for several reasons. First, the authorities have implemented all the governance measures that had not been undertaken under the previous arrangement. Second, the government has formulated and begun to implement a development strategy—the ERSWEC—which outlines a broad-based agenda for tackling Kenya’s deep-seated economic problems. Third, the authorities have developed a credible plan for completing a full poverty reduction strategy paper (the Economic Recovery Strategy; ERS), as outlined in the accompanying ERS preparation status report. Finally, balance of payments forecasts indicate that moving the economy to a sustainable long-run growth path will result in large financing gaps over the medium term that will require significant concessional assistance.

38. Key priorities for the new three-year arrangement include the promotion of strong economic growth through the implementation of governance and anticorruption measures, public enterprise restructuring, trade liberalization, and financial sector reform; restoration of fiscal sustainability; and the reorientation of public finances, particularly public expenditure, in line with the poverty reduction and growth objectives.

39. The authorities’ decision to place governance at the center of its development strategy is the right approach in view of the pervasive role that corruption has played in recent years in undermining overall economic performance and the environment for foreign direct investment, and in weakening the fiscal position and Kenya’s relations with the donor community. The wide-ranging nature of the reforms and the authorities’ determination to implement them fully should help to revitalize the economy, garner broad public support for the reforms, and promote strong donor support. Continued focus on strong enforcement of the anticorruption laws and on reforms of the judiciary and procurement systems is essential and should yield early dividends. Rigorous and sustained implementation of the anticorruption agenda will be necessary to establish credibility for the governance efforts.

40. The program’s focus on fiscal consolidation is essential if the large domestic debt is to be reduced, real interest rates kept low, and the exchange rate maintained at competitive levels. The staff supports the strategy of strengthening revenue performance by improving tax administration and broadening the tax base, as well as the planned reorientation of expenditure in favor of priority social and economic spending. To sustain such a shift in expenditure, it will be important to address the forces that have in recent years led to the marked rise in the wage bill. The staff, therefore, welcomes the decision to set up a committee to advise on new mechanisms for determining the wages of civil servants; the committee is expected to complete its work before the conclusion of the first review under the program. Looking ahead, the staff would like to encourage the authorities, with World Bank assistance, to complete the civil service reform expeditiously, as this will also help to ease pressure on the wage bill.

41. Successful implementation of the poverty reduction program will depend to a large extent on improving public expenditure management, including a better tracking of poverty spending. The staff commends the authorities on the steps that they have recently taken to enhance their poverty-tracking system, as effective monitoring of expenditure on a regular basis is essential to achieve budget intentions. Success in this area will also depend on establishing an appropriately well-staffed unit in the Ministry of Finance.

42. Addressing the distortions in the public enterprise sector is essential for growth and fiscal consolidation. The staff, therefore, commends the authorities’ decision to accelerate the privatization process and to set up a Privatization Commission to manage the divestiture program. However, care needs to be taken if this undertaking is to succeed and public support is to be maintained. In the past, the program experienced difficulties in completing divestiture, owing to low offer prices, in part because of deficiencies in managing the sales process and corruption. The staff urges the authorities to engage professionals as a way of generating strong investor interest and to maximize realized values. The staff believes that the measures that have been taken to increase the transparency of the divestiture process will help to make the program successful.

43. Financial sector policies need to emphasize the strengthening of performance in the sector to promote financial intermediation. The banking system is in a fragile state and could deteriorate further, with large fiscal costs, if early remedial actions are not taken. The staff, therefore, welcomes the reform strategy elaborated in the MEFP, which, if fully carried out, will help to reduce NPLs and the role of the government in the financial sector and strengthen CBK oversight over the sector. For this to be achieved, a speedy restructuring and subsequent privatization of NBK are crucial The staff would also urge the authorities to move promptly with the reforms of the pension fund (NSSF) and to strengthen the supervision of nonbank financial enterprises. Effective implementation of these reforms will require close cooperation between the monetary authorities and banks, an early revision of key banking legislation, and the building of a broad consensus behind the reforms.

44. Monetary policy should remain focused on combating inflation. The authorities’ decision to mop up the outstanding excess liquidity by the end of this year is, therefore, welcome as allowing banks to draw down their large excess reserve position could undermine the effectiveness of monetary policy and generate balance of payments pressures. The CBK should remain vigilant, however, as monetary aggregates are expected to show some variability in response to the changing economic environment and reforms under the program. This will be a major focus of the next program review.

45. The staff welcomes the increased attention that the authorities are devoting to trade policy and structural reforms to ensure international competitiveness. This should help to foster a more competitive domestic environment and to expand exports, which are key ingredients to achieving the authorities’ poverty reduction and growth objectives. In this regard, further trade reforms will be discussed in the context of the first program review. In addition, it is vital that the authorities take steps to fully implement their regional trade commitments.

46. The staff welcomes the decision of the authorities to maintain a flexible exchange rate system. While the exchange rate does not appear to have been a major hindrance to export performance, the appreciation of the currency in the first half of 2003 is potentially a source of concern, and there remains a need to monitor closely exchange rate developments.

47. The program faces risks largely centering on possible terms of trade shocks and likely transitory shortfalls in donor inflows, as well as on regional and political developments that need close monitoring. In particular, domestic political developments could necessitate consultations that are wider ranging than normal and that may have a bearing on the pace and intensity of policy implementation.

48. In view of the strength of the authorities’ program, including the prior actions that have been taken to date, the staff recommends Executive Board approval of the request for a new three-year PRGF arrangement in an amount equivalent to SDR 175 million.

APPENDIX I Kenya: Relations with the Fund

(As of July 31, 2003)

I. Membership Status: Joined February 3, 1964; Article VIII.

II. General Resources Account:

SDR millionPercent of quota
Quota271.40100.00
Fund holdings of currency258.7795.35
Reserve position in Fund12.634.65

III. SDR Department:

SDR millionPercent of allocation
Net cumulative allocation36.99100.00
Holdings0.310.83

IV. Outstanding Purchases and Loans:

SDR millionPercent of quota
Poverty Reduction and Growth Facility (PRGF) arrangements57.6021.22

V. Financial Arrangements:

ApprovalExpirationAmount ApprovedAmount Drawn
TypeDateDate(SDR million)(SDR million)
PRGF8/4/008/3/03190.0033.60
ESAF4/26/964/25/99149.5524.93
ESAF2/22/9312/21/9445.2345.23
ESAF5/15/893/31/93261.40216.17

VI. Projected Obligations to Fund

(SDR million; based on existing use of resources and present holdings of SDRs):

Forthcoming
20032004200520062007
Principal7.029.514.999.216.72
Charges/interest0.420.790.750.710.68
Total7.4310.305.749.937.39

VII. Safeguards Assessments

Under the Fund’s safeguards assessment policy, the Central Bank of Kenya is subject to a new safeguards assessment with respect to the anticipated PRGF arrangement. An on-site assessment to follow up on the pending recommendations of the previous safeguards report and to review the CBK’s framework of safeguards for any possible new vulnerabilities was conducted in September 2003.

VIII. Exchange Arrangements

The currency of Kenya is the Kenya shilling. Kenya has adopted a unitary exchange rate structure in which the exchange rate is determined in the interbank market. The official exchange rate, which is set at the previous day’s average market rate, applies only to government and government-guaranteed external debt-service payments and to government imports for which there is a specific budget allocation. The exchange rate regime is a managed float, in which the U.S. dollar is the principal intervention currency. Kenya maintains an exchange arrangement that is free of exchange restrictions and multiple currency practices. On August 28, 2003, the exchange rate was K Sh 76.8=US$1.

IX. Article IV Consultations

Kenya is on the 12-month cycle for Article IV consultations. The 2003 Article IV consultation was concluded on May 2, 2003 (IMF Country Report No. 03/199).

X. FSAP Participation

The first of two joint IMF-World Bank Financial Sector Assessment Program (FSAP) missions visited Nairobi during July 15-24, 2003. The second mission will be held in October.

XI. Technical Assistance

DepartmentPurposeTime of Delivery
MAEMission on banking supervisionNovember 1999
MAEMission on banking supervision and bank restructuringFebruary 1999
STAResident expert on balance of payments statisticsMay-August 1999
MAEMission on banking supervisionJuly 1999
STAMission on government finance statisticsNovember-December 1999
FADMission on improving expenditure management and controlFebruary 2000
MAEMission on banking supervisionMay 2000
STAMission on balance of payments statisticsMay-July 2000
FADMission on internal auditNovember 2000
FADMission on tax and customs administrationJanuary 2001
MAEMission on bank restructuring and review of deposit insurance systemJune 2001
MAEMission on review of banking conditions and systemic vulnerabilityJanuary 2002
STATwo-year ongoing project on national AccountsMay 2002-May 2004
MAEMission on elements of a plan to deal with the nonperforming loan problemJuly 2002
FADAFRITAC East work plan missionDecember 2002
FADAFRITAC East/Bank mission on assessment of tracking of public expenditure management systemMarch 2003

XII. Resident Representative

The Fund has had a resident representative in Kenya since December 1993. Mr. Samuel Itam is the current Senior Resident Representative.

APPENDIX II Kenya: IMF-World Bank Relations

(As of August 31, 2003)

A. Partnership in Kenya’s Development Strategy

1. Kenya’s development strategy is set forth in the Economic Recovery Strategy (ERS) being finalized by the new government that assumed office in December 2002. The ERS draws upon the draft poverty reduction strategy paper (PRSP), prepared by the previous government following large-scale consultations with stakeholders. It is expected to be presented to the Bank and Fund for a joint assessment as Kenya’s PRSP later this year. Key themes of the strategy are the following:

  • accelerating economic growth in an environment of macroeconomic stability;
  • strengthening institutions for governance, including implementation of the recently enacted Anti-Corruption and Economic Crimes Act and the Public Officer Ethics Act; strengthening security and law and order;
  • rehabilitating and expanding physical infrastructure, specifically the road network, including rural access roads and the energy sector;
  • improving access to, and quality of, education and health services; and
  • improving the investment climate particularly for micro- and small enterprises, and reforming the financial sector.

2. Both the Bank and Fund have been involved in commenting on the ERS during its preparation, and this strategy is expected to provide the framework for Bank-Fund support to Kenya’s development efforts in the medium term. The government intends to use the ERS to coordinate donor support in general, and it is planning to hold an investment conference and a Consultative Group meeting in November of this year involving donors and other lenders.

3. In supporting Kenya’s development strategy, the IMF leads the dialogue on macroeconomic policies and coordinates with the Bank on structural reforms in the areas of public expenditure management, governance, financial sector, and the public wage bill. The Fund is negotiating a three-year arrangement under the poverty reduction and growth facility (PRGF) to help Kenya maintain macroeconomic stability. Prior to this, the Fund had been conducting Article IV consultations with the government, the last one of which was concluded in May 2003. In addition to macroeconomic targets, the PRGF arrangement is expected to include structural performance criteria related to expenditure control, the public wage bill, anticorruption efforts, and the financial sector. The Fund’s work complements the Bank’s, which takes the lead on sectoral reforms in the context of projects and analytic work in the areas of infrastructure development, social sectors, private sector development, and public enterprise and civil service reforms.

B. Bank Group Strategy

4. A Country Assistance Strategy (CAS) was approved in 1998 that put the Bank’s lending program for Kenya in the “low case,” with a projected lending program of up to US$150 million over the following three years. Subsequently, the government undertook a series of governance and public sector reforms, paving the way for the resumption of a base-case lending program in August 2000.

5. A new CAS for fiscal year (FY) 04-07 is expected to be completed by January 2004. It will be aligned closely with the development priorities set forth in the ERS. A key challenge will be to build on the ERS as the basis for much greater harmonization of donor programs, while shifting assistance away from projects and toward increasing levels of budget-based support. The latter will require the following:

  • improvements in the public accountability framework, specifically in the areas of procurement and financial management;
  • development of a strong participatory monitoring and evaluation system for the ERS objectives;
  • improvements in public expenditure management supported by an annual public expenditure review (PER);
  • development of a positive reform track record through the implementation of Bank-and IMF-supported reform programs; and
  • undertaking of necessary analytical work, such as the cross-cutting assessment of Kenya’s social, structural, and key sectoral development policies.

6. As described in the following sections, the Bank’s current portfolio of projects and nonlending activities is consistent with the development strategy in ERS and is expected to expand in size and content as the relationship with the new government matures. The CAS will discuss various instruments for delivering aid, including budget support through Poverty Reduction Support Credits.

7. Economic and public sector management. The ERS gives high priority to budgetary and public expenditure reforms. The Economic and Public Sector Reform Credit (EPSRC) for US$150 million, approved in 2000, supports reforms in the areas of economic governance, civil service, expenditure management, and public enterprises. The Bank is also working with the government to institutionalize a process of PERs with a view to strengthening budget management and strategic resource allocation and engendering greater openness and participation in budget matters. A Public Sector Management Technical Assistance Program (PSMTAP) for US$15 million approved in July 2001 is providing support for reform and capacity building in the areas of civil service restructuring, pay reform, auditing, medium-term expenditure framework (MTEF), the Integrated Financial Management and Information System (IFMIS), and procurement. The project also supports the legal sector reform secretariat and reforms in some key judicial systems.

8. In order to enhance the capacity of the Central Bureau of Statistics and other similar agencies, the bank is preparing a Statistical Capacity-Building Project (STATCAP), to be delivered in FY 04. A Country Economic Memorandum (CEM) has recently been completed that focuses on the issue of growth, in particular on the structural weaknesses that have contributed to the decline in productivity and competitiveness of the economy, and identifies policy and institutional reforms to address these weaknesses.

9. Financial sector development. The ERS (a) identifies the urgent need to reform the financial sector in Kenya, which is beset with a high level of nonperforming loans, and wide interest rate spreads, and faces a weak legal and judicial system. The government is considering divestiture of the state’s stake in two of the biggest banks and has also announced a number of policy initiatives recently. The Bank, too, places considerable emphasis on financial sector development as a means to improve the functioning of the sector itself and thereby contribute to economic growth and contain mounting contingent fiscal liabilities. To support the government’s reform agenda, the Bank is designing a Financial Sector Adjustment Credit (FSAC)—a budget support operation—for a possible delivery in FY 04. As noted in paragraph 23, the Bank is working with the Fund on a Financial Sector Assessment Program (FSAP). The Bank team is also working on a Technical Assistance Credit that will provide support for reforms identified in both the FSAC and the FSAP.

10. Privatization and private sector participation. Bank activity in this area has aimed at providing technical advice toward developing and implementing strategies for private sector participation in major public utilities. The Bank completed a report that took stock of progress on parastatal reform and highlighted priorities to be adopted by the government. The report also stressed the need to change the privatization law and made specific recommendations to this end. The Bank is also administering the Public-Private Infrastructure Advisory (PPIAF) grants for setting up an appropriate regulatory and legal framework for private sector participation in roads and railways. The Bank is also providing on-demand technical advice on liberalization of the telecommunications sector.

11. Private sector development. In April 2001, the Bank approved a Regional Trade Facilitation Project (US$25 million) aimed at improving access to financing for productive transactions and cross-border trade between participating countries. The Bank is carrying out an Investment Climate Assessment that will identify key bottlenecks and main constraints on the investment climate in Kenya, including governance, customs administration, regulatory framework, etc. The assessment will feed into a major piece of the economic and sector work (ESW) in FY 04 focusing on constraints on private sector development in the country.

12. Infrastructure development. The ERS recognizes the lack of adequate physical infrastructure as a major impediment to private sector development in Kenya. The Bank has three ongoing infrastructure projects: an Urban Transport Project, which finances new and expanded road links, intersections, and public transport facilities in urban areas; the Nairobi-Mombasa Road Rehabilitation Project, which supports rehabilitation of Kenya’s chief transport corridor; and the Energy Sector Reform and Power Development Project, which is expected to increase generation capacity, reform energy pricing, and encourage private sector participation in the sector. Preparation is under way for a transport project, which is currently planned for Board delivery in FY 04. A proposed Power Sector Recovery Credit is also planned for FY 04.

13. Agriculture. The Bank’s activities in the agriculture sector support the government’s development strategy, which aims at realigning the policy framework and the incentive structure, redefining the role and core functions of the government in the sector, and encouraging a more competitive marketing system, with increased participation by the private sector. The government’s development strategy also envisages support for the core programs of research and extension. The Bank currently has three ongoing projects in the agriculture and environmental areas, including a second phase of the Arid Lands Resource Management Project for US$60 million approved in June 2003.

14. Education and health. In education, the Bank’s emphasis is on (i) supporting the most immediate challenges created by the new policy environment, and particularly the government’s commitment to free primary education; (ii) restructuring key institutions and policies to improve the quality and sustainability of primary and secondary education through curriculum reform, better teacher training and redeployment, textbook policy reforms, management strengthening and decentralization; and (iii) carrying out associated analytical work, especially on the restructuring of public expenditure to improve the efficiency of service delivery and enhance access to quality basic education, particularly in remote and slum areas. In health, the emphasis is on (i) the development of prevention programs for sexually transmitted diseases, including AIDS; (ii) a shift in resources from curative to efficient primary care, including reproductive services; and (iii) a clarification of the respective roles of the private and public sectors.

15. The Bank has four ongoing human resource development operations: (i) an early Child Development Project, which aims at reinforcing existing institutions and improving the quality of services offered to children of preschool age; (ii) an HIV/AIDS Disaster Response Project to reduce the spread of HIV/AIDS, to mitigate the socioeconomic impact of the disease, and to increase the access to care and support for people infected or affected by the HIV/AIDS epidemic in Kenya; (iii) a Decentralized Reproductive Health and HIV/AIDS Project aimed at improving mother-and-child health by promoting delivery of comprehensive reproductive health services; and (iv) a quick-disbursing operation for supporting the new government’s policy of free primary education. The last project will focus primarily on providing textbooks along with a small capacity-building component. This will be followed up by a larger program of assistance in FY 04, with a broader focus on secondary as well as primary education.

16. Other nonlending activities. The Bank has recently completed economic studies on Community-Driven Development, Local Service Delivery and Local Governments, Transport Sector, and Gender Assessment. Sector work on education, energy, health, urban poverty, the linkages between agriculture, poverty, and rural growth, and watershed management is planned for FY 04. The Bank is also supporting the government in developing and executing an Integrated Household-Based Survey to improve the information base for poverty analysis and monitoring.

Summary of Bank’s Lending Portfolio(As on 31 August, 2003)
ProjectSectorClosing

Date
Loan/Credit

Amount (in

millions of

US dollars)
Undisbursed

on 8/31/03
Nairobi-Mombasa Road RehabilitationTransport3/0450.006.00
National Agricultural Research Project IIAgriculture12/0339.701.50
Early Childhood DevelopmentEducation6/0427.8010.20
Energy Sector Reform and power developmentPower6/04125.0038.10
Urban Transport InfrastructureTransport6/04115.0024.10
HIV/AIDS Disaster ResponseHealth6/0550.0032.50
Decentralized AIDS and Reproductive Health ProjectHealth6/0550.0038.90
Regional Trade Facilitation ProjectPrivate Sector6/1125.0020.10
Public Sector Management TA ProgramPublic Sector12/0415.0010.30
Arid Lands IIAgriculture6/0960.0060.90
Free Primary EducationEducation12/0650.0022.40
Lake Victoria Environment (GEF)Environment12/0411.506.10
Economic & Public Sector Reform CreditPublic Sector4/04155.37107.90
Total Active = 13774.4379.0

C. IMF-World Bank Collaboration in Specific Areas

17. The IMF and World Bank staffs maintain a close collaborative relationship in supporting structural reforms in Kenya through lending, country analytic work, and technical assistance.

18. Joint assessment of government’s poverty reduction strategy. Kenya’s interim PRSP, produced by the previous government, was jointly assessed by the Bank and Fund in July 2000. The previous government had also completed a PRSP, which has been incorporated by the present government into its ERS after reconciling it with its own priorities. The government is presently finalizing the ERS, incorporating comments received from the Fund and the Bank, and a final version is expected to be delivered for a joint assessment by Bank and fund staff by end-December. The Bank and Fund have collaborated on a joint assessment of the PRSP preparation status report.

19. Macroeconomic framework The Fund leads the analysis and dialogue on monetary policy, which serves as input into the Bank program. The monetary policy dialogue focuses on issues related to quantitative monetary targets, such as money supply and inflation, exchange rate changes, and central bank operations. The Bank collaborates with the Fund on fiscal policy dialogue, which broadly covers issues related to fiscal sustainability and size of the public sector. Currently, the dialogue focuses on the size of overall fiscal deficit, fiscal risks, public service wage bill, revenue performance, including tax administration and adjustment to tax policy, and domestic debt financing of the deficit. The Bank takes the lead on the analysis of issues related to economic growth and poverty. The recently concluded CEMs by the Bank, on which the Fund also provided peer review comments, included analysis of sources of growth and determinants of poverty, and the impact of alternative policies and programs on economic growth and poverty reduction. The CEM is expected to serve as an input into policy formulation and advice for both the Bank and Fund.

20. Budgetary and public expenditure reforms. The Bank and Fund work closely to support government efforts in budgetary and public expenditure reforms. The Fund contributes largely on financial management and control issues, while the Bank leads the dialogue on planning, MTEF, strategic resource allocation (particularly expenditure on core programs benefiting poor), expenditure restructuring, and issues related to efficiency of public spending, such as expenditure tracking. The Bank conducted a Country Financial Accountability Assessment (CFAA) in November 2001, which was recently updated by the government. Separately, a joint Bank-Fund HIPC Expenditure-Tracking Assessment and Action Plan focusing on financial management issues was completed in June 2003. The government has prepared a broad Public Expenditure Management Reform Program, focusing on institutional and policy reforms in budget management and based on the recommendations of these two analytic works. A technical working group that includes Bank and Fund representatives, along with other donors and stakeholders, monitors the PER process and implementation of the reform program. The Bank’s ongoing adjustment credit has conditions related to improving the effectiveness of the Auditor General, public expenditure reporting, and monitoring of programs benefiting the poor. The Bank and Fund also collaborate on issues related to internal audit reform and IFMIS in the context of (PSMTAP).

21. Debt management and debt sustainability analysis. As part of the HIPC eligibility exercise, the Bank and Fund jointly carried out a debt sustainability analysis in 1999-2000. The Fund is now updating the external debt sustainability analysis, in which the Bank is helping with reconciliation of debt data. In the context of the Financial Sector Assessment Program (FSAP), a joint World Bank/IMF initiative is being undertaken to support capacity-building in the area of sovereign debt management and domestic debt market development.

22. Governance reforms. High levels of public corruption and a poor security situation were largely seen as the cause of Kenya’s poor economic performance in the last decade, and governance reforms are a key element of the government’s strategy to promote economic growth and reduce poverty. The Bank’s adjustment credit—EPSRC—included conditionality related to strengthening accountability for the use of public resources, making procurement reforms, and establishing a code of conduct for judicial officers. Prior actions for PRGF negotiations with the IMF also included enactment of anticorruption legislation. The PRGF arrangement itself is expected to support a deepening of anticorruption measures. The Bank is supporting the strengthening of legal and judicial institutions in the context of the PSMTAP and is working on an IDF grant to support the Anti-Corruption Commission. A project on legal and judicial reforms is also under preparation.

23. Financial sector reforms. The Fund and Bank are collaborating on financial sector reforms in several ways. They are conducting a joint in-depth assessment of the financial sector (banking, insurance, and capital markets) through the FSAP being led by the Fund. The FSAP will produce technical notes on selected topics, detailed assessments of standards and codes, the Fund’s Financial System Stability Assessment, and the Bank’s Financial Sector Assessment The FSAP will provide analytical input to the FSAC. There is expected to be close coordination between the Bank and the Fund on the prior actions and conditionality for the FSAC.

24. Privatization and private sector development. The dialogue on privatization and regulatory reforms is led by the Bank, and the Fund is a partner in this policy dialogue, particularly from the point of view of fiscal burden issues. The PRGF is expected to have conditionality regarding the legal framework for privatization.

25. With the onset of the Doha development agenda, trade issues have assumed prominence within the government of Kenya’s policymaking priorities. Kenya is negotiating a customs union with Uganda and Tanzania as a member of the East African Community (EAC) and is actively involved in Common Market for Eastern and Southern Africa (COMESA) negotiations and activities. While the Fund is focusing on reform of the tariff regime, the Bank is providing technical advice on regional integration issues. The Bank has planned a diagnostic trade study on integration issues, to be completed in FY 04, The Bank is also producing two policy notes on implications of an EAC customs union for revenue and effective protection in member states. The Fund was involved in the Concept Review of these two policy notes. The Bank is undertaking an assessment of nonfiscal investment incentives, which will feed into a report proposing measures to harmonize such incentives in the three EAC member states for the planned customs union. This work is complemented by an IMF assessment of fiscal investment incentives, which will likewise feed into suggestions for harmonization.

Prepared by World Bank staff. Questions may be addressed to Makhtar Diop, Country Director, Kenya, at 5368+3441, or Praveen Kumar, Country Economist, at X-36347.

APPENDIX III Kenya: Statistical Issues

1. Weaknesses in key macroeconomic statistics hamper economic analysis and surveillance. Kenya’s macroeconomic statistics have deteriorated significantly over the past decade, reflecting primarily managerial and organizational weaknesses, and inadequate resources at the Central Bureau of Statistics (CBS). During the 2002 Article IV consultation discussions, the staff emphasized the need to improve the timeliness and quality of these statistics, and encouraged the authorities to promptly implement the recommendations of past technical assistance missions from the STA.

2. The authorities are taking actions, with donor assistance, to improve the quality and timeliness of the data. Kenya is participating in the General Data Dissemination System project for Anglophone Africa that is funded by the Department for International Development (DFID) of the UK, and metadata and detailed plans for improving the data over the short and medium term have been posted on the Fund’s Data Standards Bulletin Board. Kenya received Fund technical assistance in the context of this project, and further assessment of the need for capacity building has been undertaken by the AFRITAC East Statistical Advisor. The authorities, moreover, are preparing a statistical master plan and a new statistical act that would improve the independence of the CBS.

3. A multisector STA mission to Kenya in 1998 undertook a comprehensive review of the major statistical areas and prepared a work program providing a broad time frame for implementing the principal recommendations, which address most of the statistical problems discussed below. A peripatetic STA advisor assisted the authorities in improving the balance of payments statistics in the course of 1999 and 2000, and a peripatetic STA advisor is currently assisting the authorities in improving their national accounts statistics. A revised set of national accounts data is expected to be released in mid-2003.

4. Monetary, exchange rate, and some external data are published on a monthly and biannual basis by the Central Bank of Kenya (CBK) in its Monthly Economic Review. Core financial data are also made available to the Fund on a regular basis. A detailed account of various sectoral activities and the corresponding statistical data are published annually by the CBS in its Economic Survey.

National accounts

5. Data quality, which was previously reported as good, has deteriorated significantly because of budgetary and staff constraints at the CBS. GDP is believed to be significantly underestimated, as important and increasing parts of the economy, such as the informal sector, nonagriculture subsistence, horticulture, and self-employed professionals are not properly covered. Moreover, the constant-price base year is seriously outdated (1982). The authorities urgently need to revise their annual national accounts statistics and strengthen their institutional capacity to improve the quality of data. The latest available official national accounts data are for 2001.

Prices and production

6. The CBS commenced publication in early 2002 of a new national CPI (covering 12 urban areas), with 1997=100 and weights based on the 1992-93 HBS. The index is compiled and published on a timely basis. There is no producer price index, or any short-term export and import price indices produced.

Government finance statistics

7. The 1998 multisector statistics mission found several statistical problems with the cumulative year-to-date monthly and quarterly fiscal data that the Ministry of Finance (MoF) compile and report to the AFR for budget-monitoring purposes. These data, which do not conform to the Fund’s government finance statistics (GFS) methodology, do not adequately facilitate economic analysis, mainly because of inappropriate classification of expenditure data. The MoF has not developed a system to adequately monitor expenditure commitments, or domestic arrears, and relies mainly on monitoring cash movements in government accounts at the CBK. The recording of external financing and expenditure directly financed from abroad also remains an area for improvement. The 1998 mission made several recommendations for improving the data, most of which have not been implemented.

8. The CBS compiles and reports to the STA aggregate annual GFS revenue and expenditure data for budgetary central government based on detailed data in the reports of the Controller and Auditor General, using a methodology established by a 1999 STA GFS mission. Lack of proper computerization prevents the CBS from compiling more detailed GFS data. Considerable differences exist between these data and the data compiled by the MoF and reported to the AFR for monitoring purposes.

Monetary statistics

9. Monetary statistics are compiled from a bank reporting system and are broadly adequate for policy, analytical, and supervisory purposes. A STA technical assistance mission in January 2000 observed that the authorities had implemented virtually all recommendations of the previous STA missions, which had led to a number of improvements in Kenya’s monetary statistics. However, the mission identified and made recommendations to address further problems in monetary data, in particular (a) asymmetrical interbank positions, (b) the statistical implications on the data of numerous bank closures, and (c) the coverage of international reserves. Since then, the authorities have initiated revisions to monetary statistics in line with the recommendations of the mission.

Balance of payments statistics

10. The CBS compiles and reports balance of payments data in Kenya shillings annually on a regular basis to the STA, although with a considerable lag. The CBK, in addition, compiles a complete set of annual balance of payments statistics in U.S. dollars, which are reported to the AFR and used for programming and surveillance purposes. The two sets of balance of payments data are not entirely consistent, and the staff has been strongly encouraging the authorities to reconciling the two sets. Recently, the CBK also started to compile and publish discrete quarterly balance of payments estimates.

11. The quality of the data has deteriorated. Although the overall quality of trade data may be reasonably good, data for other current account and many financial account transactions are rather weak. Following the liberalization of the exchange system in 1993-94, gaps have emerged in the coverage of balance of payments source statistics. The compilation system (other than that used for compiling customs statistics), used since 1994, relies on reports from domestic banks and may result in a substantial underrecording of current earnings, including tourism receipts, as well as a failure to capture transactions that are settled via accounts held abroad. Present estimates of direct and portfolio investment are believed to be substantially understated. The large positive errors and omissions that have emerged in the balance of payments since 1994 raise concerns as to the potential size of external obligations.

12. The MoF compiles data covering Kenya’s public and publicly guaranteed external obligations to official and commercial creditors. This database does not take account of nonresident purchases of the government’s domestic currency-denominated debt securities. The 2001 STA BOP mission noted that, should the results of the benchmark foreign investment survey become available, the CBS can start compiling and disseminating more comprehensive annual external debt data for Kenya.

Kenya: Debt Statistics

13. While, as part of the 2002 DSA, steps were taken by the authorities to address the main data problems identified in discussions with the staff, significant data weaknesses remain. The loan-by-loan data submitted to the World Bank’s DRS database differs from the ones more recently provided to the Fund for an update of the DSA based on end-2002 debt stock numbers. Moreover, the debt service projections for 2003 onwards based on the new DSA differ from the authorities projections.

Kenya: Survey of Reporting of Main Statistical Indicators(as of September 24, 2003)
Exchange

Rates
Central

Bank

Balance Sheet
International

Reserves
Reserve/

Base Money
Broad

Money
Interest

Rates
Consumer

Price

Index
Central

Government

Balance
Exports/

Imports
Current

Account

Balance
External

Debt
GDP/

GNP
Date of latest observation7/31/037/31/037/31/037/31/037/31/037/31/037/31/0307/200312/200206/200312/31/0112/20002002
Date received9/17/039/17/039/17/039/17/039/17/039/17/0309/20031/21/200309/20038/21/023/200109/2003
Frequency of data1DDDDMWMMMAAA
Frequency of reporting1D/WD/WD/WD/WMW/MMMMAAA
Frequency of publication1DMMMMDMQMMAA
Source of data2DRDRDRDRDRDRDRDRDRDRDROP
Mode of reporting3FFFFFFFFF/PP/SVP/SVP/SV
Confidentiality4ERRREEEREEEE

D = daily; W - weekly; M = Monthly, Q = quarterly; A = annually.

DR = direct reporting from the Central Bank of Kenya or Ministry of Finance; OP = official publication.

F = facsimile; P = mail; SV = staff visit.

R = restricted use; E = embargoed for a specified period and then unrestricted use.

D = daily; W - weekly; M = Monthly, Q = quarterly; A = annually.

DR = direct reporting from the Central Bank of Kenya or Ministry of Finance; OP = official publication.

F = facsimile; P = mail; SV = staff visit.

R = restricted use; E = embargoed for a specified period and then unrestricted use.

ATTACHMENT

September 22, 2003

Mr. Horst Köhler

Managing Director

International Monetary Fund

Washington, D.C. 20431

U.S.A.

Dear Mr. Köhler:

1. On behalf of the government of Kenya, I am transmitting the annexed memorandum of economic and financial policies (MEFP) that outlines the objectives and policies that the government intends to pursue in 2003/04-2005/06. The main goal of our policies and reforms is to reduce poverty and increase economic growth and employment through the pursuit of sound macroeconomic policies and key structural reforms, including the continued fight against corruption, fiscal restructuring, financial sector reform, trade liberalization, and the privatization of public enterprises. These measures will contribute to current real GDP growth of about 1 percent, rising to about 4 percent in 2005/06; underlying inflation of less than 5 percent; and a marked improvement in domestic and overall debt dynamics.

2. The program outlined in the attached MEFP is embedded in the Economic Recovery Strategy for Wealth and Employment Creation (ERSWEC), which outlines our medium-term development policies. Our approach to economic management has continued to evolve since the government took office and since the June 12, 2003 budget speech as more information has become available on the underlying weaknesses of the economy. Moreover, the budget that was passed by parliament in August 2003 is consistent with the attached memorandum. In the coming months, we intend to expand the ERSWEC into a full poverty reduction strategy paper (PRSP) that will include a medium-term expenditure framework, as well as a macroeconomic framework that would be aligned with the Poverty Reduction and Growth Facility (PRGF)-supported program and the 2003/04 budget. A PRSP preparation status report has been prepared that describes the actions we are taking to produce a full PRSP.

3. The prior actions, performance criteria, and benchmarks under the program are set out in Tables 1 and 2 of the MEFP. The first review under the PRGF arrangement is expected to be completed by May 2004, which will also focus on trade liberalization. The second review would be completed by October 2004.

4. In support of the objectives and policies set out in the MEFP, we hereby request a three-year arrangement under the PRGF in an amount equivalent to SDR 175 million (64.5 percent of quota), including one disbursement following Board approval of the arrangement in November 2003 and six equal disbursements in May and October of the succeeding years, following satisfactory conclusion of the semiannual reviews under the program.

5. We believe the measures outlined in the MEFP to be adequate for the achievement of the growth and poverty objectives, but stand ready to take additional measures to these ends if deemed necessary. During the arrangement period, and subsequently while the government has outstanding financial obligations to the Fund arising from loans under the arrangement, we will consult with the Managing Director on Kenya’s economic and financial policies at the initiative of the government or whenever the Managing Director requests such a consultation. We authorize the publication and distribution of this letter and all reports prepared by Fund staff regarding the program under the new PRGF arrangement, including reports regarding the program prepared jointly with the World Bank staff.

Very truly yours,

/s/

David Mwiraria

Minister of Finance

Attachments

ATTACHMENT ANNEX I KENYA Memorandum of Economic and Financial Policies for 2003/04 Under the Three-Year Program of the PRGF Arrangement

I. Introduction and Background

1. Kenya stands at a critical juncture in its post-independence history. After two-and-a-half decades of one-party rule and deteriorating economic opportunities, the recent change in government has raised expectations in the country that an improvement in living standards, in the context of a liberal democratic political order, may be achievable. However, in addition to the democratic political dispensation that the government has begun to entrench, a significant improvement in economic conditions will require the sustained implementation of bold economic reforms to address the major structural dislocations in the economy. To this end, the government has launched a comprehensive economic reform and poverty reduction strategy, the Economic Recovery Strategy for Wealth and Employment Creation (ERSWEC), with the aim of creating an environment conducive to private sector-led growth and the expansion of employment opportunities. Since taking office in December 2002, and notwithstanding severe resource constraints, the government has begun to implement a wide range of reforms, particularly in the areas of governance and education services.

2. Since the 1980s, the economy has performed well below potential, with low economic and employment growth and a decline in productivity. As a result, real per capita GDP was lower in 2002 than it was a decade earlier, and the number of people living below the poverty line is estimated to have risen from 11.3 million in 1990 to 17.1 million in 2001. Moreover, the incidence of HIV/AIDS has increased, thereby imposing an increasing social and economic burden. The factors underlying the weak economic performance and high incidence of poverty include the persistence of pervasive governance failures, the slow pace of economic reforms, low saving and investment, a weak banking system, intermittent shortages and high costs of electric power, and the poor physical and telecommunications infrastructure, together with an inward-looking trade regime that has enabled protected industries to absorb high increases in real wage rates.

3. Weak economic growth has been accompanied by a deterioration in the fiscal position and a growing domestic debt Government revenue fell from 22.8 percent of GDP in 2000/01 to 20.7 percent in 2002/03, owing mainly to a reduction in tax rates. However, a weakening in tax administration resulting largely from widespread corruption has also contributed to the decline in revenue. Public expenditure came under expansionary pressure on account of increased spending on wages, salaries, and interest, as well as the burden of supporting a large parastatal sector. With donor budgetary support falling concurrently, the resulting fiscal pressures were accommodated by a squeeze in spending on operations and maintenance and public investment, an increase in arrears, including pending bills and stalled projects, and growing domestic borrowing.

II. Recent Economic Developments

4. Recent data indicate that overall economic conditions remain subdued, against the background of the recent terrorism alert, which has taken a heavy toll on the tourism industry. Partly for this reason, real GDP growth in 2003 is projected to remain at the 2002 rate of about 1 percent. Headline consumer price inflation rose sharply to about 14 percent in June 2003 from 1.8 percent in September 2002, driven by a sharp increase in food and oil prices, Excluding food and energy, inflation rose to 3.7 percent in June 2003 from 1.6 percent in October 2002, reflecting in part a loosening of monetary conditions during 2002 that was accompanied by a depreciation in the nominal and real effective exchange rates of the Kenyan shilling. During the first five months of 2003, however, the shilling has appreciated by 5.1 percent against the U.S. dollar. While the exchange rate does not appear to have been a major impediment to export performance in recent years, the government has been monitoring exchange rate developments closely, as a continuation of the recent appreciation trend could have adverse effects on export and output growth. Broad money expanded by 10.9 percent in the 12-month period to June 2003. Three-month treasury bill rates have declined substantially from 25 percent in June 2002 to 3.0 percent in June 2003, despite the large increase in the domestic funding requirements of the government, reflecting primarily the persistence of liquid market conditions and a shift in domestic borrowing toward high-maturity bonds.

5. The provisional fiscal outturn for 2002/03 (July-June) indicates that the overall deficit, before grants, widened by 1.1 percent of GDP relative to 2001/02 on account of both lower revenues and higher expenditures. In addition, domestic borrowing remained high, contributing to a marked buildup in domestic debt to 25 percent of GDP at end-June 2003. Revenue performance was weaker than in 2001/02 and below the budgeted amount, mainly because the expected improvements in excise tax collections and the broadening of the value added tax (VAT) base did not materialize. In addition, considerable problems were experienced in the management of oil reexports as a large volume of these untaxed products reportedly found their way back into the domestic market. Moreover, challenges emerged in the administration of excise taxes on tobacco. Expenditure exceeded the budget and the 2001/02 outcome, primarily on account of an increase in housing allowances for teachers and additional spending associated with the move to universal free primary education in January 2003.

III. Medium-Term Framework and Policies

A. The Economic Recovery Strategy for Wealth and Employment Creation

6. To address Kenya’s weak economic fundamentals and thus lay the groundwork for strong economic and employment growth and poverty reduction, the government has developed a broad reform agenda, as outlined in the ERSWEC. During the coming months, the government intends to expand the ERSWEC into a full poverty reduction strategy paper (PRSP) by incorporating a more detailed discussion of the reform agenda and of the consultative process that was followed in its formulation, and by deepening the poverty diagnosis to include a comprehensive review of the determinants of poverty and their evolution over time, as well as a clarification of the economic, social, and institutional constraints on poverty reduction. A medium-term expenditure framework will also be added that would indicate how public expenditure would be restructured over the medium term to achieve the growth and poverty goals. Moreover, there will be a common macroeconomic framework underpinning the PRSP, the Poverty Reduction and Growth Facility (PRGF)-supported program, and the 2003/04 budget.

7. The ERSWEC elaborates a broad development agenda, encompassing reforms aimed at accomplishing the following: (a) revitalizing the agricultural sector and encouraging the growth of medium- and small-scale enterprises; (b) enhancing the competitiveness of the economy through measures designed to increase labor market flexibility; (c) privatizing and restructuring parastatals; (d) rebuilding the public sector, social institutions, and the social and economic infrastructure; (e) improving the delivery of government services, in part through the establishment of cost benchmarks and services delivery targets for all public bodies; and (f) addressing the special problems of the arid and semiarid lands.

8. The three-year program to be supported by the Fund under the PRGF will focus on the following issues:

  • fiscal consolidation to reduce the high domestic debt to a sustainable level;
  • fiscal restructuring to achieve the growth and poverty reduction objectives;
  • an improvement in governance and transparency, in part through the effective enforcement of the new anticorruption legislation and strict adherence to the public sector budget management and accounting system;
  • a strengthening of the financial system by an early resolution of the problems of financial institutions in distress, enhancement of the regulatory and prudential supervisory framework, and the privatization of state banks;
  • an acceleration of the privatization process; and
  • an elaboration of an ambitious trade liberation strategy, which would include a simplification of the tariff structure, a phased reduction of the tariff rates, and the elimination of any remaining quantitative restrictions.

B. The Macroeconomic Framework

9. While aiming for sustained growth of 7 percent over the medium term, our macroeconomic framework is based on a steady pickup of real GDP growth to about 4 percent by 2005/06, with gross investment expanding from 14.5 percent of GDP in 2002/03 to 25.9 percent of GDP in 2005/06; gross national savings would initially fall moderately and then rise to 14.9 percent of GDP by 2005/06, with both public and private savings increasing in response to improving economic conditions under the program. In the absence of major adverse exogenous shocks, a prudent monetary policy would help to contain underlying inflation at below 5 percent. With the increase in investment-related imports, the current account deficit would rise to 4.9 percent of GDP in 2003/04 and then to an average of 8.8 percent of GDP in 2004/05 and 2005/06. Given the projected current account deficits and committed net capital inflows, substantial financing needs are foreseen during 2003/04-2005/06 (averaging US$1.3 billion a year). The projected inflows of donor support would be expected to cover these gaps, as well as a buildup in foreign reserves from 2.7 months of imports in mid-2003 to 4.0 months of imports in mid-2006.

10. Over the three-year program period, the overall fiscal deficit (excluding grants) is expected to increase from 4.8 percent of GDP in 2002/03 to about 6.2 percent of GDP in 2005/06, reflecting the initial emphasis of the program on expending development outlays for the rehabilitation of key social and economic infrastructure. The latter would be largely funded with concessional donor inflows, For this reason, as well as the sizable external debt repayments and outlays for bank restructuring and arrears reduction, the government’s overall financing needs are likely to be quite substantial (9.8 percent of GDP) in 2003/04, falling to an average of 8.0 percent of GDP over the following two years. Since the combined inflows of grants and net foreign financing, based on existing commitments, are estimated to only increase from 1.7 percent of GDP in 2003/04 to 3.3 percent of GDP in 2005/06, substantial additional foreign assistance (including debt relief) will be needed to implement the ERSWEC and maintain financial stability. Such assistance will need to be provided on grant and very concessional terms to maintain debt sustainability.

C. The Governance Strategy

11. A key element of the government strategy to promote strong economic growth and poverty reduction is the prompt and major strengthening, now under way, of the country’s governance structures. Over the medium term, these measures are expected to contribute significantly to an improvement of the revenue effort, a reduction in rent-seeking activities, and an increase in the productivity of public investment. The governance and anticorruption reform program has several important elements:

  • The ongoing entrenchment of democratic political governance, with its emphasis on (a) the separation of powers among the various branches of government; (b) rule of law; (c) decentralization of the delivery of public services; and (d) promotion of a free press and a robust civil society. These measures are essential to advancing transparency and accountability in the conduct of public operations at all levels of government.
  • Building institutions and practices that support market-oriented reforms. The actions under way include the ongoing strengthening of the regulatory framework and the prudential supervision of financial institutions, the planned establishment of a Privatization Secretariat to facilitate the privatization of parastatals in a transparent manner, and judicial reform, which has also involved the institution of a strict code of ethics for the judiciary and the removal of corrupt judges.
  • Contracting the size of the public sector, in part through an acceleration of the parastatal privatization process.
  • Strengthening the anticorruption legal structures and the enforcement mechanisms, including the enactment in May 2003 of the Anti-Corruption and Economic Crimes and the Public Officer Code of Ethics Bills. In addition, the Law Reform Commission has begun to update several important acts, including the Company and Investment Laws. To help implement the anticorruption legislation, the government intends to make the Anti-Corruption Commission fully operational by the end of the year. In addition, all public employees are required to declare their assets and those of their families by end-2003.
  • Reducing opportunities for corruption and eliminating conflicts of interest. Several measures under the program address these issues, including the transfer of the responsibility for the regulation of the financial sector from the Ministry of Finance to the Central Bank of Kenya; the cancellation of all stalled projects; the elimination of all pending bills; and the reform of the public sector procurement system. Civil servants have already been forbidden from supplying goods to the public sector.
  • Improving the coverage and timeliness of data on fiscal operations, including the timely presentation of final accounts on government operations to the Auditor General.

IV. Macroeconomic Objectives and Policies for 2003/04

A. Macroeconomic Framework

12. Real GDP growth is expected to pick up to 1.9 percent in 2003/04 from an estimated 1.1 percent in 2002/03, underpinned by strong performance of both the construction and the transport and communications sectors. End-period headline inflation is expected to decline to 4.0 percent in 2003/04 from about 13.7 percent in 2002/03, reflecting primarily a significant easing of price pressures in response to the fall in oil and fuel prices. Underlying inflation is projected to moderate to 2.7 percent by the end of 2003/04 from 3.7 percent at end-2002/03. The current account deficit would widen by 3.8 percent of GDP to 4.9 percent of GDP in 2003/04 as the rehabilitation of plant and equipment gains momentum. Gross international reserves are targeted to rise moderately to 2.8 months of import cover.

13. The principal objective of fiscal policy is to begin to stabilize and eventually reduce the domestic debt in order to stem the increase in interest payments and to ease pressures on real interest rates. Lower domestic debt will also facilitate the absorption of a much larger volume of concessional external credits in a sustainable manner. Accordingly, the budget for 2003/04 targets a substantial reduction in the domestic borrowing requirement from 5.0 percent of GDP in 2002/03 to 3.3 percent of GDP in 2003/04; of the latter, about 1.4 percent of GDP is associated with the need to accommodate some transitory payments, including the recapitalization of banks, the spike in external debt repayments, and the programmed reduction in the amount of pending bills. The realization of the domestic deficit target will be a daunting task for a number of reasons. First, the government has embarked upon a major upgrading of social and economic infrastructure, with a view to achieving the Millennium Development Goals as soon as possible. Second, the new administration has inherited large contingent liabilities that will need to be addressed at the outset of the program. Finally, the resumption of donor assistance is expected to be gradual.

14. Achieving the domestic deficit target while protecting priority spending on essential economic and social services will require some improvement in revenue performance. The budget for 2003/04 envisages total revenue collection of 22.2 percent of GDP, which would imply a 1.5 percent of GDP increase over the expected outcome for 2002/03, To help achieve the 2003/04 revenue target and to lay the groundwork for a more ambitious medium-term program for rationalizing the tax system, the immediate focus of revenue policy will be on the rehabilitation of capacity and integrity in tax administration. Capacity has been severely eroded by widespread corruption and cronyism in the hiring and promotion of staff, and these developments have resulted in low compliance rates across all tax brackets and the erosion of the tax base, particularly in the petroleum sector, where cheap untaxed products account for a sizable portion of the market. Weak tax administration capacity has greatly circumscribed the scope for new tax policy measures at this stage.

15. The government believes that a major reform of the Kenya Revenue Authority (KRA) could significantly improve revenue collection over and above budget expectations, which mainly reflect the doubling of the VAT on mobile telephone use and the 0.5 percent of GDP of revenue collections that were previously not channeled through the budget—a dividend of the anticorruption effort. The tax administration measures underpinning the program include the following:

  • an overhaul of the top management of KRA, particularly heads of key collection centers, such as the port of Mombassa and main airports;
  • a restructuring of the port-handling facilities and revenue administration systems at Mombassa;
  • the institution of new modalities for managing the taxation of the petroleum sector;
  • the full application of the law in enforcing compliance by public entities that are tax collection agencies; and
  • a revamping of the bond and warehousing facilities and the management of transit goods.

16. In light of the pressures on the budget, the program includes expenditure reduction measures of around 0.8 percent of GDP. These include continued wage restraint for the civil service, excluding teachers (0.5 percent of GDP); a continuation of the partial freeze on the filling of vacancies that arise from natural attrition (half of the 10,000 vacancies falling due will not be filled); and a cut in noncore outlays on goods and services equivalent to 0.2 percent of GDP. The expenditure measures will not compromise spending on social and economic priorities.

17. The government has initiated a number of actions to facilitate a restructuring of public expenditure in favor of priority spending on social and economic services:

  • As part of the measures aimed at reducing the size of the wage bill in total expenditure, a Commission of Enquiry has been established to propose new mechanisms for determining changes in public sector wages. Public sector wage rises for different categories have hitherto been set on an ad hoc basis, with no regard for the overall fiscal position and productivity improvements, resulting in considerable negative effects on pay relativities and the overall wage bill. Understandings on new wage setting mechanisms for public employees designed to reduce the share of the wage bill in total expenditure will be a benchmark for completion of the first review.
  • Spending on defense and security will be rolled back to below 2.0 percent of GDP, beginning in 2005/06, from about 2.3 percent of GDP at present.
  • Transfers to parastatals will be cut through the liquidation of nonessential public bodies and the privatization of commercial public entities.
  • Other actions being implemented in the context of World Bank programs, including the ongoing restructuring of public services and the introduction of new procurement procedures, are also expected to be cost saving.

18. Total poverty-related expenditure (including wages and salaries), as defined in the Core Poverty Spending Program, is budgeted at 4.0 percent of GDP in 2003/04, compared with an estimated 3.4 percent of GDP in 2002/03.

B. Expenditure Management Issues

19. The government places considerable importance on the effective control and close monitoring of public expenditure as a means of reducing corruption, minimizing deviations of budget outcomes from intentions, promoting budget discipline, and preventing the accumulation of new arrears. Accordingly, the following additional actions will be taken to improve expenditure management:

  • The present expenditure Commitment Control System (CCS) will be strengthened, beginning in the second half of 2003/04. In the meantime, during the first half of the year, short-term Fund technical assistance will be sought to assist the government in the identification of the major weaknesses of the system and to develop an action plan for strengthening it. With regard to arrears, the verification of all outstanding arrears, including utility bills, will be completed by end-December 2003. Moreover, new mechanisms for preventing a buildup of new utility arrears are being explored, including prepaying for telephone and electricity use.
  • Improvements will be made in the near- and medium-term forecasting of macroeconomic variables, as well as of expected donor assistance, with a view to providing a sound basis for expenditure management and the medium-term expenditure framework.
  • The poverty reduction expenditure-tracking system is being improved to ensure that it provides comprehensive data on a timely basis.

C. Exchange Rate and Monetary Policy

20. The monetary program will be based on a floating exchange rate regime, which has, thus far, served the economy well. In this regard, exchange rate interventions will continue to be limited to smoothing short-term volatility and the variability in donor flows, effecting external debt payments, and meeting the net international reserve (NIR) target under the program. The government is committed to making full use of exchange rate flexibility in response to both medium- and long-term exogenous shocks.

21. Monetary policy will continue to be aimed at containing inflation at below 5 percent. The inflation target would be sought largely through reserve money targeting, with broad money (M3X) as the intermediate target, and open market (repurchase and reverse) operations as the main instrument. In line with the anticipated increase in economic activity, broad money growth will be targeted at 7.1 percent in 2003/04. By promoting financial stability and low inflation, the monetary program would be consistent with a continued lowering of the country’s risk premium and maintenance of low interest rates during 2003/04. This would, together with the planned financial sector reforms, help to promote an expansion of bank credit to the private sector of about 4.8 percent.

22. However, since money demand is expected to display considerable instability in response to changes in economic conditions and the economic reforms under the program, the CBK will continue to use a broad set of indicators of future inflationary pressures to gauge the need for any tightening of monetary policy and, consistent with the objectives of the program, to adjust the stance of policies as appropriate.

D. Financial Sector

23. The reform agenda in the financial sector will focus on the following:

  • The transfer of virtually all the licensing, regulatory, and disciplinary authority of the Ministry of Finance over the banking system to the CBK. A bill to this end has already been drafted and will be presented to parliament by March 2004.
  • A tightening of provisioning regulations to conform to international best practice. The CBK has already initiated decisive actions aimed at ensuring full enforcement and compliance by banks with prudential requirements by December 2004.
  • An audit of the financial position of National Social Security Fund (NSSF).
  • The removal of Section 44 of the Banking Act, which seeks to regulate banks’ charges and commissions. Pending its removal, the act will be used solely to improve the transparency of the banks’ practices in this area. The program is based on the maintenance of a liberal financial system, under which deposit and lending rates, as well as bank charges and commissions, will be market determined.
  • A restructuring of the National Bank of Kenya with World Bank assistance by June 2004 and privatization of the bank thereafter.
  • Further development of a program for the divestiture of the remaining public banks.
  • The initiation of new anti-money-laundering legislation that would also take account of the findings from the anti-money-laundering/combating the financing of terrorism (AML/CFT) assessment that is planned as part of the Fund-Bank Financial Sector Assessment Program (FSAP) for Kenya.
  • The promotion of increased bank lending to the private sector, mainly by taking measures to reduce the spread between lending and deposit rates. This will require actions to ease cost pressures in the sector, support secured transactions, lower credit risk, and improve borrower accountability, as well as strong efforts to reduce nonperforming loans (NPLs) and to enhance competition in the industry.

E. External Sector Policies

24. Kenya’s medium-term external prospects are mixed. The terms of trade are expected to improve, albeit only moderately, and tourism receipts should rebound in 2003/04 in response to recent actions to improve security and tourism facilities. In addition, a significant resumption of donor assistance is foreseen, which would be growth enhancing, as the resources would be used primarily to build the economy’s social and economic infrastructure. However, in the near term, the external sector position is expected to be difficult for a number of reasons. First, imports are expected to rise markedly in response to the recovery in investment. Second, a marked initial slowdown in export growth is envisaged, mainly due to the recent decline in the terms of trade and in response to the tapering off of the export expansion that followed the liberalization of the Common Market for Eastern and Southern Africa (COMESA) regional market. Finally, foreign debt repayments are projected to rise markedly in 2003/04 before coming down sharply over the medium term.

25. The anticipated improvement in the capital and financial account positions would not be adequate to cover the projected increase in the current account deficit. Partly for this reason, and because of the need to build an adequate buffer of reserves against external shocks that could result from the increasing openness of the economy and from the volatility in donor inflows, the government intends to seek a rescheduling of its external debt obligations under the Paris Club.

26. In the context of Kenya’s membership in the East African Community (EAC), which the government regards as an inner grouping of COMESA that would move on a “fast track” to achieve the COMESA customs union objective, Kenya’s top external tariff will be reduced to 25 percent from 35 percent, following the signing of the EAC customs union protocol on November 30. While this is a step in the right direction, achievement of the strong economic growth objectives under the ERSWEC will require that Kenyan enterprises be competitive in the broader global markets. To this end, the government plans to review the adequacy of the trade regimes under the EAC and COMESA to foster competitive economic conditions, and it will, therefore, seek World Bank technical assistance to conduct a detailed analysis of the reforms to the trade and investment regime that are needed to promote efficiency and international competitiveness and that will, in turn, maximize the gains from globalization.

F. Privatization

27. The government remains committed to the liquidation of defunct public enterprises, privatization of commercial activities, and strengthening of the operations of the remaining public enterprises. Privatization is intended to help in the mobilization of private sector financial, technical, and managerial resources and to improve the efficient utilization of these resources. To set the privatization process on a sound and transparent basis, the government intends to enact a Privatization Bill, which will be placed before parliament by end-2003. The bill will also provide for the establishment of a Privatization Commission, which will manage the privatization process. To assist in meeting the ERSWEC growth objectives, the government has decided to accelerate the privatization process. To this end, the government will announce, before the end of the year, a list of enterprises to be privatized on an expedited basis. The timing of the sale of individual enterprises will be the responsibility of the Privatization Commission and will depend on market conditions. Meanwhile, the government has announced its intention to place on the market its 35 percent stake in the Kenya Commercial Bank. With regard to the telecommunications sector, the government intends to liberalize further the sector and to privatize Kenya Telecom as soon as possible.

V. Safeguards and Statistics Issues

28. The government remains committed to protecting the financial soundness of the CBK, and to adhering to the principles of good governance and best practices, including those encapsulated in the IMF’s safeguards policy. A safeguards assessment of the CBK was conducted in September 2003, which found that the Bank had made notable progress in strengthening its safeguards since the December 2000 on-site assessment. The bank is committed to implementing measures to address the remaining vulnerabilities, further strengthen the CBK’s operations, and reduce the possibility of misreporting and misuse of Fund resources.

29. On statistical issues, the government plans to release a revised set of national accounts data shortly, and is preparing a statistical master plan and a new Statistics Act that is aimed at enhancing the independence of the Central Bureau of Statistics (CBS). The government is also taking steps to improve the monitoring of fiscal data, in particular, the preparation, on a regular basis, of summary statistics on domestic arrears and pending bills. Moreover, the government intends to develop a framework for systematically monitoring productivity changes in the economy, and to produce, on a regular basis, trade data. Kenya participates in the General Data Dissemination System project for anglophone Africa.

VI. Program Monitoring for 2003/04

30. Technical memorandum of understanding (TMU). The program will be monitored using the definitions, data sources, and frequency of monitoring set out in the accompanying TMU. The government will make available to Fund staff all data appropriately reconciled and on a timely basis, as specified in the TMU.

31. Prior actions. The government will undertake a number of prior actions before the issuance of the staff report on the request for a three-year arrangement under the PRGF. The prior actions are described in this memorandum (Table 1).

32. Performance criteria. Table 2 shows the quantitative performance criteria and benchmarks to be used in monitoring performance in 2003/04. Structural performance criteria and benchmarks, with corresponding dates, are identified in Table 1.

33. Program review. The first review under the PRGF arrangement will be completed by May 31, 2004. This review will focus on the development of actions to restructure expenditure in favor of social and economic spending; the privatization process; progress in rationalizing the financial system; and the fiscal implications of restructuring the National Social Security Fund. The second review under the PRGF arrangement is expected to be completed by October, 2004.

Table 1.Kenya: Structural Performance Criteria and Benchmarks Under the PRGF Arrangement for 2003/04
Policy ActionImplementation DateStatus
Prior Actions
Presentation to parliament of a budget for 2003/04 consistent with program understandings.End June 2003Done
Government to decide on transfer of financial sector regulatory functions from the Ministry of Finance to the Central Bank of Kenya (CBK).End June 2003Done
Reaching an understanding with staff on a time bound plan for restructuring the National Bank of Kenya (NBK).End June 2003Done
Structural Performance Criteria
Finalize an audit on the stock of pending bills and adopt measures that provide for the clearing the stock of pending bills over a three-year period.End December 2003
Completion of a report of the Committee of Officials on the new mechanism for determining the salaries of public officials to ensure the reduction of the wage bill in total expenditure.End December 2003
Completion of an audit on the financial position of National Social Security Fund (NSSF).End December 2003
Submission to Parliament of an Banking Act Admendment Bill providing for transfer of all financial sector regulatory functions from the Ministry of Finance to the CBK.End March 2004
No imposition of controls by the government or the CBK on the determination by commercial bank of bank fees, charges, or interest rates.Continuous
Structural Benchmarks
Presentation of 2002/03 final budgetary accounts to the Auditor General.End March 2004
Reaching an understanding with staff on new wage setting mechanisms for public employees designed to reduce the share of the wage bill in total expenditure.End March 2004
Presentation to parliament of a bill to establish a framework for the transparent privatization and sale of public assets.September/December 2003
Development of an action plan and timetable for introducing a Commitment Control System (CCS) to minimize deviations of expenditure outcomes from targets and the buildup of arrears.End December 2003
Establishment of a clear timetable for completion of initial asset declarations by all senior public officials.End December 2003
Establishment of the Kenya Anticorruption Commission, with a credible management.End December 2003
Reaching of understandings on the fiscal implications of restructuring the NSSF.End March 2004
Table 2.Kenya: Quantitative Performance Criteria and Benchmarks Under the Program for 2003/04 1/2/(In millions of Kenya shillings)
20032004
End June

Est.
End-September

Benchmark
End-December

Performance

Criterion
End-March

Benchmark
End-June

Performance

Criterion
Cumulative change in net foreign assets of the Central Bank of Kenya (CBK) 3/7902,4318,74714,974
Cumulative change in net domestic assets of the CBK 4/-7,614-4,351-13,544-19,615
Cumulative change in net domestic financing of the central government, excluding government debt issues for any bank restructuring, and the new securitization of expenditure arrears 4/6,83612,22319,02719,814
Central government wages and salaries 4/21,26244,32666,66293,380
New contracted or guaranteed nonconcessional external medium- and long-term debt by the central government or the CBK 4/5/0Continues zero ceiling throughout the arrangement
New contracted or guaranteed external short-term nonconcessional debt by the central government or the CBK 4/00000
Accumulation of new domestic budgetary arrears 4/5/0Continues zero ceiling throughout the arrangement
Accumulation of new external payments arrears 4/5/0Continues zero ceiling throughout the arrangement
Memorandum items:
Programmed external budgetary support 6/19,04510,64928,46949,87464,109
Of which: nonproject support 6/07,06414,12721,19128,255
Privatization receipts 6/00000
Program exchange rate (Kenya shillings per U.S. dollar)78.9578.9578.9578.9578.95

The fiscal year begins on July 1, 2003.

The performance criteria and benchmark under the program, and their adjusters, are defined in the technical memorandum of understanding (TMU). AH test dates for the performance criteria and benchmarks are on an end-of-period basis.

Floor.

Ceiling.

Continuous performance criterion.

Cumulative.

The fiscal year begins on July 1, 2003.

The performance criteria and benchmark under the program, and their adjusters, are defined in the technical memorandum of understanding (TMU). AH test dates for the performance criteria and benchmarks are on an end-of-period basis.

Floor.

Ceiling.

Continuous performance criterion.

Cumulative.

ATTACHMENT ANNEXE II KENYA Technical Memorandum of Understanding

VII. Introduction

1. This memorandum sets out the understandings between the Kenyan authorities and the International Monetary Fund (IMF) regarding the definitions of the quantitative and structural performance criteria and benchmarks for the 2003/04 program (July-June) supported by the Poverty Reduction and Growth Facility (PRGF) arrangement, as well as the related reporting requirements.

VIII. Quantitative Performance Criteria and Benchmarks

A. Net Foreign Assets (NFA) of the Central Bank of Kenya

2. Definition. NFA are defined as the difference between the Central Bank of Kenya (CBK) holdings of gross official reserves (excluding pledged, swapped, or any encumbered reserves assets, including but not limited to reserve assets used as collateral or guarantees for third-party external liabilities) and its foreign liabilities (including IMF loans and other short-and long-term liabilities). Exchange rates prevailing on September 30, 2001 will be used to convert the NFA into Kenya shillings at the end of each test period. Table 2 of the letter of intent shows the floors on NFA, specified in Kenya shillings, for June 30, September 30, and December 31, 2003, and for March 31 and June 30, 2004.

3. Adjustment clauses. The NFA floors will be adjusted upward (or downward) by the sum of (i) excess (or shortfall) in external budgetary support relative to projected amounts (excluding grants and loans for the development budget); (ii) excess (shortfall) in non-project-related external budgetary support relative to the programmed amount; and (iii) excess (shortfall) in privatization proceeds. Excess proceeds are defined as the difference between actual and programmed proceeds. The downward adjustment is capped at the equivalent of U.S. dollar 280 million. All targets are cumulative from July 1, 2003 onward.

4. Reporting requirements. Data on gross international reserves, encumbered reserves, and foreign liabilities of the CBK will be transmitted to the Fund on a weekly basis within five working days of the end of each week. Detailed data on external budgetary support (by donor/creditor and by currency of denomination) will be transmitted on a weekly basis within five working days of the end of each week.

B. Net Domestic Assets (NDA) of the Central Bank of Kenya

5. Definition. NDA are defined as the average over the calendar month of the test dates of reserve money, defined as total currency in circulation and reserves of the banking system with the CBK, minus the average over the calendar month of net foreign assets (NFA) plus encumbered foreign assets. Table 2 of the letter of intent shows the ceilings on NDA for June 30, September 30, and December 31, 2003 and for March 31 and June 30, 2004. The authorities will consult with the Managing Director of the Fund on any changes in the ratio of reserve requirements.

6. Adjustment clauses. The ceilings on the NDA will be adjusted downward (upward) by the sum of (i) excess (shortfall) in external budgetary support; (ii) excess (shortfall) in non-project-related external budgetary support; (iii) excess (shortfall) in privatization proceeds; and (iv) excess (shortfall) in the holdings of government debt instruments by the nonbank public relative to programmed amounts. Excess privatization proceeds are defined as the difference between actual and programmed proceeds. The upward adjustment is capped at the equivalent of U.S. dollar 280 million, converted to Kenya shillings at the program exchange rate prevailing on September 20, 2001. All targets are cumulative from July 1, 2003 onward.

7. Reporting requirement. The daily balance sheets of the CBK will be transmitted on a weekly basis within five working days of the end of each week.

C. Net Domestic Financing (NDF) of the Central Government

8. Definition. NDF includes financing by the banking system (the CBK and commercial banks) and the nonbank public of the budget of the central government of Kenya; where the central government is defined as in the Appropriation Accounts and in the parliament approved budget estimates for 2003/04.22 NDF consists of treasury bills, government stocks and bonds, promissory notes and other domestic debt instruments issued by the government, and loans and advances net of government deposits with the CBK and the banks. For the purposes of the program, NDF excludes privatization proceeds, government debt issued for any bank restructuring, and the new securitization of expenditure arrears. NDF is calculated as the cumulative change from July 1, 2003 onward in the sum of (i) loans and advances to the government by the CBK minus all government deposits with the CBK, from the balance sheet of the CBK; (ii) loans and advances to the government by the commercial banks minus all government deposits held with the banks, from the balance sheet of the commercial banks; and (iii) the outstanding stock of domestic debt, excluding principal arrears but including interest arrears; minus (iv) government debt instruments issued for bank restructuring; and minus (v) any new securitization of expenditure arrears. Table 2 of the letter of intent shows the ceilings on NDF for June 30, September 30, and December 31, 2003, and for March 31 and June 30, 2004.

9. Adjustment clauses. The ceiling on NDF will be adjusted upward (downward) by the sum of (i) the excess in the cumulative net reduction in domestic budgetary arrears by the central government relative to the programmed amount; and (ii) the cumulative shortfall (excess) in external budgetary support relative to programmed amounts. The value of the cumulative excess or shortfall in external budgetary support will be converted into Kenya shillings at the program exchange rate prevailing on September 30, 2001. The upward adjustment is capped at the equivalent of U.S. dollar 280 million, converted to Kenya shillings at the program exchange rate prevailing on September 20, 2001.

10. Reporting requirements. Data on NDF of the central government will be submitted to Fund staff on a monthly basis within six weeks of the end of each month.

D. Central Government Wages and Salaries

11. Definition. Central government wages and salaries consist of all compensation of central government employees (excluding social contributions paid by employer). Table 2 of the Letter of intent shows the ceilings on central government wages and salary payments for September 30 and December 31, 2003, and for March 31 and June 30, 2004. For the purpose of this definition, the central government of Kenya is defined as in the Appropriation Accounts and in the parliament approved budget estimates for 2003/04.

12. Reporting requirement. Data on central government wages and salaries will be provided on a monthly basis within three weeks of the end of each month.

E. Contracting or Guaranteeing of New Nonconcessional External Medium- and Long-Term Borrowing Public External Debt

13. Definition. This performance criterion not only applies to debt as defined in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt (see Decision No. 12274-00/85, August 24, 2000) but also to commitments contracted or guaranteed for which value has not been received. It applies to debt contracted or guaranteed with original maturities of more than one year by the CBK or the general government of Kenya (as defined by the 2001 IMF Government Finance Statistics Manual). It excludes financial obligations to the Fund, domestically issued Kenya Shilling denominated treasury bonds with maturity greater than a year held by non-residents, and debt subject to debt rescheduling and debt reorganization. The ceiling for new nonconcessional external debt will be zero on a continuous basis throughout 2003/04.

14. For program purposes, a debt is concessional if it includes a grant element of at least 35 percent, calculated using currency-specific commercial interest reference rates (CIRRs) published by the OECD. For debt with maturity of at least 15 years, the ten-year average CIRR will be used, and for debt with maturity of less than 15 years, the six-month average CIRR will be used.

15. Reporting requirement. Data on all new debt and guarantees by the CBK and the general government (including terms of loans and creditors) will be provided on a monthly basis within three weeks of the end of each month.

F. New External Nonconcessional Short-Term Debt Contracted or Guaranteed by the General Government or the Central Bank of Kenya

16. Definition. This performance criterion not only applies to debt as defined in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign debt (see Decision No. 12274-00/85, August 24, 2000) but also to commitments contracted or guaranteed for which value has not been received. It applies to nonconcessional (see paragraph 14 above) debt with original maturities of up to and including one year contracted or guaranteed by the CBK or the general government (as defined by the 2001 IMF Government Finance Statistics Manual) of Kenya. It excludes financial obligations to the Fund, normal trade-related credits, and domestically issued Kenya Shilling denominated treasury bills with maturity of less than a year held by non-residents. Table 2 of the letter of intent shows the ceilings on new external short-term debt for June 30, September 30, and December 31, 2003, and for March 31 and June 30, 2004.

17. Reporting requirement. Data on all new debt and guarantees by the CBK and the general government (including terms of loans and creditors) will be provided on a monthly basis within three weeks of the end of each month.

G. Domestic Budgetary Arrears

18. Definition. Domestic budgetary arrears are defined as the sum of all due and unpaid obligations of the central government of Kenya, where the central government is defined as in the Appropriation Accounts and in the Parliament approved budget estimates for 2003/04, including, but not limited to, payment obligations from procurement contracts for goods and services and other contracts providing for payment in domestic currency, as well as statutory obligations for payment (e.g., civil service wages and other entitlements). Changes in domestic budgetary arrears are defined as the stock of outstanding domestic arrears on the test date minus the stock of outstanding domestic arrears as of June 30, 2003. Under the program, the nonaccumulation of new domestic budgetary arrears is a continuous performance criteria.

19. Reporting requirement. Detailed data on repayment and new accumulation of domestic budgetary arrears and the remaining previous-year stock of domestic budgetary arrears will be transmitted on a monthly basis within four weeks of the end of each month.

H. External Payments Arrears (On Nonreschedulable Debt)

20. Definition. External payments arrears are defined as the non-payment of external obligations of the CBK or the general government of Kenya (general government as defined by the 2001 IMF Government Finance Statistics Manual) both with regard to principal and interest that are valid and due, but shall exclude arrears on obligations that are subject to debt-rescheduling. Under the program, the nonaccumulation of new external payments arrears is a continuous performance criteria.

21. Reporting requirement Detailed data on repayment and new accumulation of external payments arrears by the CBK and the general government and the remaining previous-year stock of external arrears will be transmitted on a monthly basis within four weeks of the end of each month.

IX. Other Reporting Requirements for Program Monitoring

A. Public Finance

22. Monthly data on domestic financing (bank and nonbank) of the budget (including treasury bills and government bonds held by the nonbank public) will be transmitted on a monthly basis within three weeks of the end of each month.

23. Data on the implementation of the development budget, with detailed information on the sources of financing, will be transmitted on a quarterly basis within four weeks of the end of each quarter.

24. Public sector external and domestic scheduled debt service and payments will be transmitted on a monthly basis within three weeks of the end of each month.

B. Monetary Sector

25. The following data will be transmitted on a daily/weekly basis within one/five working day of the end each day/week:

  • treasury-bill rates (weekly); and
  • interbank interest rate (daily).

26. The following data will be transmitted on a monthly basis or as specified below within four weeks of the end of the month:

  • the consolidated balance sheets of deposit money banks and the individual bank balance sheet, as needed;
  • the monetary survey;
  • lending and deposit rates;
  • standard bank supervision indicators for banks and nonbank financial institutions, respectively, and for individual institutions as needed; and
  • net foreign assets of commercial banks and nonbank financial institutions, broken down by instruments.

C. External Sector

27. The following daily buying, selling, and average exchange rates will be transmitted on a weekly basis within five working days of the end of each week: (i) exchange rates used in interbank transactions among the commercial banks; (ii) the average of (i) (official exchange rate, quoted daily based on the transactions of the previous day); and (iii) foreign exchange purchases and sales by the CBK on interbank market and other inflows and outflows of foreign exchange to/from the CBK, separately.

28. Export and import data, including volumes and prices, will be transmitted on a quarterly basis within eight weeks of the end of each quarter.

29. Other balance of payments data, including the data on services, private transfers, official transfers, and capital account transactions, will be transmitted on a quarterly basis within four weeks of the end of each quarter.

D. Real Sector

30. Monthly disaggregated consumer price indices for Nairobi (Central Bureau of Statistics) will be transmitted on a monthly basis within four weeks of the end of each month.

31. Any revisions to the national accounts data will be transmitted within three weeks of the date of revision.

32. Data on real sector leading indicators will be transmitted within three weeks of the end of each month.

33. Data on employment (formal and informal) and wages (including minimum wages and collective wage agreements) will be transmitted within four weeks of the end of each month.

E. Governance and Other Structural Reforms

34. Documentation of all measures undertaken by the government will be transmitted to the IMF’s African Department within five working days after the day of implementation.

1Some of these free reserves are held for transaction purposes necessitated by changes in clearing procedures introduced in July 2003.
2See Box 3, IMF Country Report No. 02/85, for details.
3See IMF Country Report No. 03/199.
4The authorities’ policies that are outlined in the attached memorandum are in line with the budget that was approved in August 2003.
5The program will also focus on strengthening macroeconomic management, including policy instruments and institutions.
6Section V provides more details.
7A sensitivity analysis of the fiscal debt dynamics under the program is provided in Box 3.
8Provision has been made for an amount of Ksh 12 billion for the restructuring of the NBK in 2003/04 and Ksh 11 billion over the program period for the securitization of all verified pending bills.
9Capital expenditure is projected to rise from 3.6 percent of GDP in 2002/03 to 7.6 percent of GDP in 2005/06 (Table 7). Maintenance and operations outlays would increase from 4.6 percent of GDP in 2002/03 to 5.4 percent of GDP in 2005/06. Spending on essential social and economic services is budgeted to rise from 3.4 percent of GDP in 2002/03 to 4.6 percent of GDP in 2005/06. Meanwhile, spending on defense and interest payments is slated to fall.
10Significant progress has already been made in these areas.
11Surveys indicate that many investors believe that inefficient port operations are Kenya’s single most important infrastructural constraint.
12Kenya’s road system is a serious impediment to export performance, especially since many products need to be transported from remote agricultural areas to main shipping areas (Nairobi and Mombassa).
13Growth was also weakened by the early onset of rains, which hurt agricultural production.
14The budget for 2003/04 that was passed by parliament in August 2003 is consistent with the macroeconomic framework of the program.
15As indicated in the MEFP, most of the increase in revenue is accounted for by the rechanneling to the budget of revenues that were previously used to support extrabudgetary outlays. These identified new revenue sources are expected to more than offset losses in revenue arising from the reduction in VAT from 18 percent to 16 percent and excise duty on soft drinks from 15 percent to 10 percent.
16Transfers from the central government under the Local Authorities Transfer Fund (LATF) account for about 25 percent of the resources of local governments. LATF resources are used to fund poverty-reduction outlays.
17Total financing needs are the sum of program support, project support, and the unidentified gap in Table 10; the latter is defined as expected, but unidentified support, and includes possible debt rescheduling.
18Budgetary support was withheld on concerns about Kenya’s of governance system.
19This assumes that the bulk of the expected but not yet identified program support would be in the form of grants.
20A new DSA, based on revised data has just been completed (Table 11). The main results of the new DSA are presented in a supplement that will be issued shortly.
21For program financing purposes, a comprehensive rescheduling of pre-cut-off debt maturities (principal and interest) falling due through end-June 2004 is assumed along with comparable treatment from other creditors.
22The 2003/04 Estimates of Revenues, 2003/04 Estimates of Recurrent Expenditures, and 2003/04 Estimates of Development Expenditures.

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