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Chapter 2. Sustaining Growth in the East African Community

Author(s):
Paulo Drummond, S. Wajid, and Oral Williams
Published Date:
January 2015
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Information about Sub-Saharan Africa África subsahariana
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Author(s)
Catherine Mcauliffe, Sweta C. Saxena and Masafumi Yabara 

The Growth Record

In the midst of sub-Saharan Africa’s best decade of economic growth since at least the 1970s, the East African Community (EAC) is among the fastest-growing regions. Growth rates have picked up strongly since 2000, outpacing the rest of sub-Saharan Africa (Figure 2.1). During 2005–11, per capita income growth reached 3.6 percent a year in the EAC, compared with 3.0 percent for sub-Saharan Africa as a whole, quadrupling the rate achieved in the previous 15 years. Part of the recent high growth is “catching up” after years of very poor growth—in the last part of the 20th century, the region suffered periods of severe civil strife and bouts of economic instability. Since then, governments in EAC countries have been committed to strong policies.

Figure 2.1Real GDP Growth per Capita

Source: IMF, World Economic Outlook database.

Note: Weighted by population. EAC = East African Community; SSA = sub-Saharan Africa.

However, growth has been uneven. Rwanda, Tanzania, and Uganda have had the longest periods of high growth. Uganda’s growth started speeding up earlier than the others and has lasted more than 20 years, with per capita income growth averaging 3.4 percent a year during 1990–2011 (Figure 2.2). Growth in Rwanda and Tanzania has been strong since the early 2000s. After a period of stagnation, growth is picking up in Kenya—the largest of the EAC’s five economies—averaging 1.9 percent per year since 2005 compared with −0.2 percent in 1990–2004. Output declined in Burundi in most of the period since 1990—reflecting periods of political conflict—but has shown signs of recovery in recent years.

Figure 2.2Cumulative Growth in Real GDP per Capita

Source: IMF, World Economic Outlook database.

Addressing Social Challenges

Some progress has been made toward the Millennium Development Goals. Most EAC countries are close to achieving universal primary education and child mortality rates have come down. Tanzania, Uganda, and Rwanda sharply have reduced poverty, driven by strong income growth (Figure 2.3). However, Kenya, despite having the lowest poverty ratio, and Burundi have not made much progress in the last decade. Poverty remains unacceptably high, especially in Burundi, Rwanda, and Tanzania. The region’s high population growth (close to 3 percent per year over the last two decades) could constrain efforts to improve social indicators.

Figure 2.3Poverty Headcount Ratio at $1.25 a Day (Purchasing Power Parity)

Source: World Bank, World Development Indicators database.

Achieving Middle-Income Status

The recent growth path will not be enough to achieve middle-income status and substantial poverty reduction by the end of the decade—the ambition of most countries in the region. To achieve these objectives, the region would need to grow at an average rate of about 5.5 percent in real per capita GDP per year for the rest of the decade, about 2 percentage points faster than in the last five years.1 Rwanda, Tanzania, and Uganda, with per capita income somewhat below the regional average, would have to grow 7–8 percent per capita a year to meet that goal. Kenya is already close to middle-income levels and should achieve this earlier if it maintains current growth rates. Burundi—the poorest country in the EAC—will take much longer to reach that goal.

What Drives Growth?

There is no consensus on what it takes to initiate and sustain growth.2 As a recent study puts it, there are “no recipes, just ingredients” (Commission on Growth and Development, 2008). The many factors vary from country to country, including macroeconomic policies, investment and trade, political and economic institutions, infrastructure and financial development, human capital, and income distribution. It is also widely recognized that the factors behind growth upturns are not necessarily the same as those that sustain growth, and that while starting growth is relatively easy, sustaining it is more difficult (Berg, Ostry, and Zettelmeyer, 2012; Hausmann, Pritchett, and Rodrik, 2004).

We look at the factors that have contributed to growth in the EAC and assess the prospects for translating the recent upturn into sustained high growth. To do this, we compare growth in the EAC countries with other countries that have achieved sustained growth by comparing levels and trends in certain indicators.3 For example, are the EAC countries undergoing important shifts in growth patterns—similar to other sustained growth countries—that could underpin longer-term high growth? We also compare the record of sustained growth countries with countries that started to grow but failed to sustain it. And we look at the key factors that distinguish sustained and nonsustained growth and consider whether there are lessons for the EAC. Although this type of benchmarking cannot be used to make unconditional policy advice, it has been used with greater frequency in the growth literature to help judge the growth potential of a country or region by identifying the types of strategies and policy interventions that have been successful, as well as identifying constraints to growth.

In the rest of this chapter, we explain the methodology used to identify growth accelerations and sustained growth episodes, and highlight factors contributing to sustained growth. We then provide a comparison of EAC growth with other growth episodes; the final section makes policy recommendations.

Explaining Growth: The Empirical Framework

Identifying Growth Episodes

We identify countries where growth accelerated and was sustained, building on the methodology established in Hausmann, Pritchett, and Rodrik (2004); Johnson, Ostry, and Subramanian (2007); and Xu (2011). Our methodology modifies these earlier studies in two important areas. First, we extend the time series to 2009 (or 2006 depending on the explanatory variables), which covers the high growth period in sub-Saharan Africa, particularly in the EAC.4 Second, our sample consists of commodity-exporting, low-income countries; that is, countries with similar economic characteristics to EAC countries.

According to the methodology, growth acceleration episodes must satisfy three criteria: (1) a period of rapid growth in per capita GDP of at least 3.5 percent a year for seven years, (2) an improvement in growth in per capita GDP of at least 2 percentage points (which captures the idea of acceleration), and (3) a higher postacceleration income level than the preacceleration peak (this requirement rules out cases in which accelerations are simply a rebound from a prior period of bad performance, owing to conflict or other shocks). On the basis of these criteria, and using the latest available data through 2009, we can identify growth acceleration episodes starting as late as 2002.5

Not all countries can sustain high growth. Therefore, to identify sustained high-growth episodes—that is, countries that not only exhibited accelerated growth but also sustained it—we add a fourth criterion: (4) that growth rates must stay above 3 percent for at least five years after the first seven years, similar to methodologies used in the literature. Given the end-year of 2009 in our data set, we can identify sustained growth episodes that started on or before 1997.6 Some growth acceleration episodes did not meet the fourth criterion, although they started before 1997. We refer to these episodes as nonsustained growth episodes and use them to investigate factors distinguishing sustained and nonsustained growth.

We identify 34 episodes of sustained growth in 28 countries (SGs), as well as 35 nonsustained growth episodes in 28 countries (non-SGs). Table 2.1 shows all of the growth episodes and the years of acceleration (time t). The list of SGs includes most of the well-known growth episodes that followed significant policy changes or policy reforms. None of the EAC countries make this list. Uganda, Tanzania, and Rwanda have achieved growth accelerations (satisfying criteria 1–3, with acceleration in 1992 for Uganda, 1999 for Tanzania, and 2002 for Rwanda). However, they are not SGs and none meet criteria 4 (the growth episodes for Rwanda and Tanzania are too short, whereas Uganda fell just short of the threshold). In contrast, Burundi and Kenya, two countries with the lowest and highest per capita income in the EAC, respectively, have not yet registered a growth acceleration, failing to meet criteria 1–3.

Table 2.1Growth Episodes of Commodity Exporters
Sustained Growth (Meet all the criteria 1–4)Nonsustained Growth (Meet only criteria 1–3)
Brazil1966Afghanistan1977
Cambodia1994Argentina1989
Cameroon1971Benin1976
Chile1974* 1983Chad1997
China (Mainland)1967 1976 1989Haiti1970
Colombia1967 1991*Honduras1972
Congo, Republic of1968 1976*Jordan1972
Dominican Republic1965 1999Lao P.D.R1978 1988
Ecuador1966Lebanon1978
Egypt1958* 1972 1988*Mali1972 1983
Ghana1964* 1997Nicaragua1958
Guatemala1963Papua New Guinea1970 1989
Indonesia1967 1985Peru1958
Iran1964Philippines1969
Malawi1961Sri Lanka1976 1991
Malaysia1966 1986Tunisia1969
Mexico1962Uganda1992
Morocco1957 1970*Uruguay1972 1987
Mozambique1994Zambia1962
Nigeria1957* 1966* 1996
Oman1982
Pakistan1959
Panama1957 1974*
Paraguay1968
Syria1969 1989*
Thailand1957 1983
Turkey1964
Vietnam1988
Sources: Penn World Tables Version 7.0; and authors’ calculations.Note: * denotes a nonsustained growth episode.
Sources: Penn World Tables Version 7.0; and authors’ calculations.Note: * denotes a nonsustained growth episode.

Differentiating Sustained and Nonsustained Growth

A simple review of the economic characteristics of countries with different growth experiences can be informative. The events that give rise to a growth acceleration may well be different from those that sustain an upturn, and contributory factors may be self-reinforcing or offsetting. In short, growth outcomes possibly reflect multifaceted processes that may be difficult to identify through econometric analysis alone. This section looks at possible lessons using a more low-tech approach to examine the evidence.

On average, growth tends to start stronger and last twice as long in SGs. For the sample of countries in Table 2.1, average real per capita growth in the first six years of growth acceleration was 4 percent for SGs, compared with just 1.8 percent for non-SGs (Figure 2.4). The growth upturn was also more durable. For SGs, growth remained at initial rates for a 10-year period, whereas for non-SGs, growth peaked after the first 5 years and subsequently slowed rapidly. This suggests that at least two different sets of growth-contributing factors may be at work. The first can be seen as contributing to the faster pace of growth in SGs during the initial expansionary period, whereas a second set may contribute to the collapse of growth rates in non-SGs around the five-year mark. Possible candidates for these roles are considered in the following.

Figure 2.4SGs versus Non-SGs: Real Gross Domestic Product per Capita (growth rate)

Sources: IMF, World Economic Outlook database; and authors’ calculations.

Note: Five-year moving average. Non-SG = country with nonsustained growth; SG = country with sustained growth.

Growth accounting analysis suggests important roles for both foreign direct investment (FDI) and productivity in explaining differences in growth performance. There is little evidence that domestic investment contributes to the faster initial growth of SGs because average investment rates during the first five-year period are very similar to non-SGs (Figure 2.5). Domestic investment declines beyond the five-year mark for non-SGs, but it is not clear whether this is a contributory factor to slow growth: most likely it is caused by the growth slowdown in these countries. The story is different for FDI, which rises much more sharply in SGs, paralleling the higher growth rates for this group. Similarly, total factor productivity rises faster for SGs and continues to grow beyond the five-year mark, in contrast to a slump in productivity for non-SGs.7 These findings are consistent with other studies that find FDI is an important source for transferring technologies and enhancing productivity at firm levels, and is important for growth (Javorcik, 2004). The causalities are unclear, but it may be that sustained strong growth is closely linked to a successful and sustained upturn in productivity growth. And this may make SGs more attractive investment locations, reflected in higher FDI flows. We now turn to the factors thought to contribute to the favorable productivity trends associated with SGs.

Figure 2.5SGs versus Non-SGs: Investment and Productivity

Sources: IMF, World Economic Outlook database and Regional Economic Outlook: Sub-Saharan Africa; Johnson, Ostry, and Subramanian (2007); Bosworth and Collins (2010); Barro and Lee (2010); and authors’ calculations.

Note: Five-year moving average. Non-SG = country with nonsustained growth; SG = country with sustained growth.

Public Sector Finances and Institutions

On public sector finances, there are strong indications that large deficits are not helpful to growth. There is a striking and sustained difference between the size of fiscal deficits in SGs and those for non-SGs (Figure 2.6). This suggests that the macroeconomic instability that can arise from large deficits is a more important negative influence on growth than the possible benefits that larger deficits could offer in financing, say, higher public investments. There is little evidence in this sample that higher levels of official development assistance support productivity and growth. Overall, fiscal deficits appear to be a major risk factor for sustaining growth.

Figure 2.6SGs versus Non-SGs: Public Sector Finance

Sources: IMF, World Economic Outlook database; Organization for Economic Cooperation and Development, OECD.Stat; and authors’ calculations.

Note: Five-year moving average. Non-SG = country with nonsustained growth; SG = country with sustained growth; ODA = official development assistance.

The quality of public institutions does not seem to help sustain growth upturns. Survey results on government stability are slightly higher in the first five years of the growth upswing for SGs, but the difference is not large. Moreover, government stability continues to improve in non-SGs through year 10, even as growth weakens (Figure 2.7). And survey data on political risk is very similar across both types of countries. Overall, there is little here to suggest that the quality of public institutions makes a large difference in whether countries can sustain their growth accelerations.

Figure 2.7SGs versus Non-SGs: Quality of Institutions

Sources: International Country Risk Guide; and authors’ calculations.

Note: Non-SG = country with nonsustained growth; SG = country with sustained growth.

Inflation Discipline

Inflation appears to be inversely related to growth performance. For the SGs, inflation averages about 11 percent in the decade after growth acceleration, compared with 18 percent for non-SGs (Figure 2.8). This may be linked to the higher fiscal deficits for non-SGs. Inflation, then, is another possible risk factor.

Figure 2.8SGs versus Non-SGs: Consumer Price Index Inflation

Sources: IMF, World Economic Outlook database; and authors’ calculations.

Note: Five-year moving average. Non-SG = country with nonsustained growth; SG = country with sustained growth.

Health and Education

There is little evidence that superior health and education outcomes sustain growth upturns. Health and education indicators change only slowly over time, and there is little evidence that they either trigger growth upturns or make a difference on how long they last. Based on the country sample in this study, childhood mortality is lower and school attendance higher for SGs (Figure 2.9). Both samples show steady improvements largely unrelated to short-term growth performance, and the difference between SGs and non-SGs is broadly stable. Although investments in better health and education are important, especially in the long term, they appear to be unrelated to the chances of sustaining faster growth in the 5- to 10-year range.

Figure 2.9SGs versus Non-SGs: Human Capital

Sources: World Bank, World Development Indicators database; Barro and Lee (2010); and authors’ calculations.

Note: non-SG = country with nonsustained growth; SG = country with sustained growth. Observations are linearly interpolated because source data are available only in increments of every five years. For average years of schooling, only observations whose t are after 1980 are included.

Infrastructure

This chapter has only limited data on the quality of public infrastructure. Evidence of the density of telephone landlines suggests that infrastructure is, on average, worse for SGs, albeit improving (Figure 2.10). Although evidence for this assessment, it is difficult to make a case that the quality of infrastructure does not play a role in triggering and sustaining strong growth.

Figure 2.10SGs versus Non-SGs: Infrastructure—Telephone Lines (per 100 people)

Sources: World Bank, World Development Indicators database; Barro and Lee (2010); and authors’ calculations.

Note: non-SG = country with nonsustained growth; SG = country with sustained growth. Observations are linearly interpolated because source data are available only in increments of every five years.

Financial Sector Depth

There is some evidence that the financial sector can make a difference to sustained growth. Domestic savings tend to be much higher, as a share of GDP, in SGs, though this may not entirely reflect financial sector performance (Figure 2.11). Smaller fiscal deficits also tend to increase domestic savings. Private sector credit tends to be higher in SGs, with credit picking up strongly in outer years in those countries that sustained high growth. SGs also typically made an earlier start in financial liberalization, although after five years, the head start in reforms relative to non-SGs is significantly narrowed. In sum, deep and efficient financial systems, providing access to finance, may play a role in triggering and supporting sustained strong growth.

Figure 2.11SGs versus Non-SGs: Financial Development

Sources: IMF, World Economic Outlook database; World Bank, World Development Indicators database; Abiad, Detragiache, and Tressel (2008); International Country Risk Guide; and authors’ calculations.

Note: non-SG = country with nonsustained growth; SG = country with sustained growth. All the series besides financial liberalization are represented by five-year moving average.

External Competitiveness

External competitiveness appears to be critical to sustained strong growth. One of the largest differences between SGs and non-SGs is in terms of the more favorable real exchange rates of the former during growth upswings.8 In the first five years, the real exchange rate depreciated by about 30 percent in SGs, compared with a slight appreciation for the non-SGs (Figure 2.12). For SGs, real exchange rates continued to depreciate during most of the period of sustained growth. More competitive currencies are associated with smaller current account deficits in SGs, and with higher export-to-GDP ratios. While competitiveness appears important, it likely reflects other contributory factors, rather than being a direct policy instrument for growth promotion. For instance, large fiscal deficits, higher inflation, and low domestic savings tend to appreciate real exchange rates and foster larger current account deficits.

Figure 2.12SGs versus Non-SGs: External Competitiveness

Sources: IMF, World Economic Outlook database; and authors’ calculations.

Note: Five-year moving average. Non-SG = country with nonsustained growth; SG = country with sustained growth.

Based on the previous review, a number of factors appear to be associated with differences in growth outcomes. The next section examines these in the context of EAC countries. In particular, we look at how these countries compare to sustained growth “benchmarks” for each variable, and whether this benchmarking exercise reveals important risk factors for sustaining strong growth in Rwanda, Tanzania, and Uganda. We also examine what the exercise shows for the prospects for initiating sustained strong growth in Kenya and, importantly, Burundi.

Benchmarking East African Community Growth Against High-Growth Countries

The growth performance of Rwanda, Tanzania, and Uganda in the initial phase of growth take-off is comparable to those experienced by SGs, whereas Burundi and Kenya are largely falling behind (Figure 2.13).9 Rwanda, Tanzania, and Uganda achieved strong growth during the first five years of the take-off. Burundi and Kenya have been trending upward since 2000, but have not yet reached the growth experienced by SGs and Rwanda, Tanzania, and Uganda in their early take-off periods.10 Despite a strong performance in the three countries, sustaining growth has been more difficult for them. Only Tanzania has sustained high growth beyond the critical five-year mark, when growth rates started to trend down in non-SGs. Growth rates in Uganda were sharply lower in the second five-year period, before rising in later years. In Rwanda, growth rates have been more erratic, but are recently trending downward, partly driven by the global financial crisis.

Figure 2.13Real GDP per Capita (Growth rate, five-year moving average)

Sources: IMF, World Economic Outlook database; and authors’ calculations.

Note: Non-SG = country with nonsustained growth; SG = country with sustained growth.

To identify areas that can help policymakers in Rwanda, Tanzania, and Uganda turn their growth take-offs into sustained growth—and help accelerate growth in Kenya and especially Burundi—the following section looks at factors that have contributed to the EAC’s experience so far and benchmarks them against the group of SGs.

Investment and Productivity

Similar to the SGs, productivity gains have played an important role in explaining the recent growth performance in the EAC. For Rwanda, Tanzania, and Uganda, improvements in productivity have been rapid since the start of their growth episodes (Figure 2.14).11 Productivity gains in Tanzania and Uganda outpaced SGs during the take-off period, and Rwanda’s productivity has closely tracked the SG’s experience. In contrast, productivity has declined in Burundi and Kenya—where growth has stagnated—although there has been a turnaround in Kenya in recent years.

Figure 2.14Total Factor Productivity (t = 100, five-year moving average)

Sources: Barro and Lee (2010); Bosworth and Collins (2010); IMF, Regional Economic Outlook: Sub-Saharan Africa; Johnson, Ostry, and Subramanian (2007); and authors’ calculations.

Note: SG = sustained growth, Non-SG = non-sustained growth.

FDI also surged in Rwanda, Tanzania, and Uganda during their growth take-off, similar to SGs. FDI rose strongly in Uganda for about 15 years after the start of its growth take-off, in contrast to SGs where FDI declined over time because they eventually relied more on domestic investment to sustain growth rates (Figure 2.15). Tanzania had sizeable FDI at the start of its growth episode—significantly higher than SGs and Rwanda, Tanzania, and Uganda at the start of their growth episodes. But Tanzania’s has since been trending down, approaching levels in SGs. FDI increased sharply in Rwanda during the growth take-off and is trending toward SGs. After stagnating, FDI has recently picked up in Kenya, while FDI has remained low in Burundi.

Figure 2.15Ratio of Foreign Direct Investment to GDP (Five-year moving average)

Sources: IMF, World Economic Outlook database; and authors’ calculations.

Note: Non-SG = country with nonsustained growth; SG = country with sustained growth.

Improved Macroeconomic Stability

Similar to SGs, sound macroeconomic management, especially in public finances, has coincided with stronger growth. For Rwanda, Tanzania, and Uganda, the period since their growth upturns has generally coincided with declining fiscal deficits (Figure 2.16). These declined in Uganda and Rwanda during the growth take-off, with Rwanda outperforming SGs and Uganda trending toward SGs. On the other hand, Tanzania has seen a steady deterioration in its budget deficit since its growth upturn, in sharp contrast to SGs. Budget deficits have also been growing in Kenya, while Burundi significantly improved its budget balance, thanks to substantial donor support. Inflation has generally been lower in the EAC compared with SGs during the initial growth take-off years. For Rwanda, Tanzania, and Uganda, in particular, tighter fiscal and monetary policies led to significantly lower inflation—9.5 percent year-over-year on average during the seven years since the growth turnaround, down from 45 percent before the turnaround (Figure 2.17).

Figure 2.16Ratio of Fiscal Balance to GDP (t = 100, five-year moving average)

Sources: IMF, World Economic Outlook database; and authors’ calculations.

Note: Non-SG = country with nonsustained growth; SG = country with sustained growth.

Figure 2.17Consumer Price Index Inflation (Five-year moving average)

Sources: IMF, World Economic Outlook database; and authors’ calculations.

Note: Non-SG = country with nonsustained growth; SG = country with sustained growth.

Quality of Institutions and Infrastructure

Contrary to the findings for SGs and non-SGs, the quality of public institutions matters for growth performance in the EAC. Since the mid to late 1990s, all EAC countries—albeit at different times—have introduced extensive liberalization and structural reforms. Rwanda, Tanzania, and Uganda, in particular, appear to have benefited from improved government stability (Figure 2.18). In contrast, in Kenya, less stable government conditions—at least during this period—may have contributed to lower productivity and lower growth, given the extent of the country’s structural reforms and high capacity of labor and institutions.

Figure 2.18Quality of Institutions

Sources: International Country Risk Guide; and authors’ calculations.

Note: Non-SG = country with nonsustained growth; SG = country with sustained growth; UGA/TZA = average of Uganda and Tanzania. For Kenya, t is set to be 2000. Rwanda and Burundi are not covered by the source data.

Inadequate infrastructure is a constraint to accelerating and sustaining growth in the EAC, as in the rest of sub-Saharan Africa. Using the proxy of telephone lines for infrastructure, all EAC countries are at very low levels (Figure 2.19). Other anecdotal evidence also points to infrastructure constraints in the EAC. Electricity supply in the EAC lags far behind other sub-Saharan African countries (Ranganathan and Foster, 2011), and close to 60 percent of EAC businesses identified inadequate or poor electricity supply as one of the top problems for doing business in the EAC (World Economic Forum, 2010). Better provision of transportation and energy services is now high on the agenda of all EAC countries, and a number of projects have been initiated in these areas, including at the regional level. However, technical and financing difficulties have limited progress.

Figure 2.19Telephone Lines (per 100 people)

Sources: World Bank, World Development Indicators database; and authors’ calculations.

Note: Observations are linearly interpolated because source data are available only in increments of every five years. Non-SG = country with nonsustained growth; SG = country with sustained growth.

EAC countries have made continuous progress in improving human capital, but remain well below SGs, with the exception of Kenya. Health conditions in Rwanda, Tanzania, and Uganda have improved rapidly—catching up with SGs—and the pace at which school years are lengthening is similar to those of the comparators (Figures 2.20 and 2.21).12 Kenya has consistently outperformed SGs, both for health conditions and education, giving the country a comparative advantage in human capital. On the other hand, Burundi lags behind the other EAC countries in health and education, which has likely contributed to the country’s steady decline in productivity and lower growth.13

Figure 2.20Under-Five Mortality Rate (per 1,000)

Sources: World Bank, World Development Indicators database; and authors’ calculations.

Note: Observations are linearly interpolated because source data are available only in increments of every five years. Non-SG = country with nonsustained growth; SG = country with sustained growth.

Figure 2.21Average Years of Schooling

Sources: Barro and Lee (2010); and authors’ calculations.

Note: Observations are linearly interpolated because source data are available only in increments of every five years. For SG and Non-SG, only observations whose t are after 1980 are included. Non-SG = country with nonsustained growth; SG = country with sustained growth.

The EAC falls short of SGs in two important areas for sustained growth: domestic financial depth generally associated with high domestic savings and external competitiveness.

Limited Financial Depth and Low Domestic Savings

For the EAC, financial deepening is occurring very slowly and remains well below SGs. Credit to the private sector as a percent of GDP is one-fourth the levels in SGs. Kenya—which has the most developed financial markets in the region—had a higher level of credit to the private sector around the year 2000 compared with SGs at the start of their growth episode. But the level has since declined (Figure 2.22). This development coincides with the deterioration of the fiscal balance, indicating the possibility of crowding out by the public sector. Burundi, where commercial banks play a dominant role in the economy, experienced rapid credit growth since the end of the civil war in 2005, although it has slowed in recent years.

Figure 2.22Ratio of Credit to Private Sector to GDP (Five-year moving average)

Sources: World Bank, World Development Indicators database; and authors’ calculations.

Note: Non-SG = country with nonsustained growth; SG = country with sustained growth.

Unlike SGs, EAC growth has been financed in part by external savings. While domestic savings picked up rapidly in SGs after their take-off, quickly narrowing the gap between savings and investment, the growth in savings has been weaker in the EAC (Figure 2.23). EAC countries have relied on external resources—mainly donor aid—to finance the bulk of investment. Official development assistance (excluding debt relief) has averaged more than 15 percent of GDP since the growth take-off in Rwanda, Tanzania, and Uganda, well above the average for SGs (Figure 2.24). The data from SGs and non-SGs, however, provide little evidence that donor aid supports higher productivity and growth.14

Figure 2.23Ratio of Domestic Savings to GDP (Five-year moving average)

Sources: IMF, World Economic Outlook database; and authors’ calculations.

Note: Non-SG = country with nonsustained growth; SG = country with sustained growth.

Figure 2.24Ratio of Official Development Assistance, Excluding Debt Relief, to GDP (Five-year moving average)

Sources: IMF, World Economic Outlook database; Organization for Economic Cooperation and Development, OECD.Stat; and authors’ calculations.

Note: Non-SG = country with nonsustained growth; SG = country with sustained growth.

Financial sector liberalization has been quicker in the EAC compared with SGs (Figure 2.25). Structural reforms since the mid-1990s rendered the banking sector more market based, with more competition and privatization. Capital account restrictions have also been reduced. However, since financial sector liberalization alone did not distinguish SGs from non-SGs, a greater focus on maintaining macroeconomic stability—especially avoiding large fiscal deficits that tend to crowd out resources available for private sector credit—may be more important to enhancing financial deepening in the EAC.

Figure 2.25Financial Liberalization: 0 (fully repressed)–1 (fully liberalized)

Sources: Abiad, Detragiache, and Tressel (2008); and authors’ calculations.

Note: Non-SG = country with nonsustained growth; SG = country with sustained growth.

Notwithstanding the extensive liberalization, the region’s financial markets remain small, segmented, and illiquid. A recent study by FinScope (2009) shows that less than a third of the population in Rwanda, Tanzania, and Uganda has access to formal financial services, compared with nearly two-thirds in other developed financial markets, such as South Africa. Nonbank financial institutions, such as pension funds or insurance companies, are in most cases only embryonic. Recently, however, greater efforts are being made to increase financial inclusion by opening more bank branches, promoting microfinance institutions and saving and credit cooperatives, and locating these institutions where the poor and the disadvantaged live and work. To sustain these efforts, financial literacy campaigns are being stepped up in a number of EAC countries. These efforts are further complemented with building a sound regulatory framework for nonbank financial institutions and increasing supervisory capacity. Other innovations, such as mobile banking—including the innovative M-Pesa mobile banking platform in Kenya—have emerged as a promising vehicle to broaden access to financial services and savings instruments (Kimenyi and Ndungu, 2009; Jack and Suri, 2010).

Domestic financing costs also hamper financial market deepening in the EAC. Uncertain property rights (in part related to weaknesses in land titling) hamper the assessment and enforcement of collateral, credit information on borrowers is patchy, and the legal and regulatory framework insufficient to facilitate the swift resolution of commercial disputes. All these factors continue to pose risks to credit delivery and increase financial costs. Although private sector credit growth has increased, it has largely focused on consumer financing, particularly mortgages. Access to finance for budding small- and medium-size enterprises has been limited to the largely unregulated informal financial sector. With the exception of Kenya, domestic capital markets are shallow and stock exchanges are well below the size required to support the economies’ financing needs. Continued efforts are needed to tackle these deeply rooted obstacles to financial deepening. Here again, regionally coordinated approaches can bring larger and faster benefits. Recent examples of regional approaches to financing that attracted regional and international investors are encouraging developments. These include Kenyan authorities’ partial financing of their infrastructure investment through a series of local currency infrastructure bonds with long maturities, and several initial public offerings and cross-listings in the region.

External Competitiveness

Unlike SGs, real exchange rate behavior in the EAC has not necessarily translated into external competitiveness. When real exchange rates depreciated in Burundi and Tanzania, similar to SGs, there was a corresponding deterioration in current account deficits (Figures 2.26 and 2.27). In Rwanda and Kenya, current account deficits also deteriorated in the face of real exchange rate appreciation. Only Uganda, where the real exchange rate remained broadly unchanged, has seen a slight improvement in its current account. Structural factors including diversification and regulatory costs of doing business better explain the external competitiveness of EAC countries, as discussed below.

Figure 2.26Real Effective Exchange Rate (t = 100, five-year moving average)

Sources: IMF, World Economic Outlook database; and authors’ calculations.

Note: Non-SG = country with nonsustained growth; SG = country with sustained growth.

Figure 2.27Ratio of Current Account Balance to GDP (Five-year moving average)

Sources: IMF, World Economic Outlook database; and authors’ calculations.

Note: Non-SG = country with nonsustained growth; SG = country with sustained growth.

Unlike the export-led growth of SGs, exports have played a relatively small—albeit growing—role in the growth take-off of EAC countries. While the SGs rapidly increased the share of exports in their GDP to 30–40 percent soon after their take-offs, the increase has been more protracted and subdued in the EAC (Figure 2.28). The share of exports in GDP remains at less than 15 percent of GDP in Burundi, Rwanda, and Uganda some seven to eight years into their growth episodes. Kenya and Tanzania have export shares of about 25 percent of GDP, inching up to SGs.

Figure 2.28Ratio of Exports to GDP (Five-year moving average)

Sources: IMF, World Economic Outlook database; and authors’ calculations.

Note: Non-SG = country with nonsustained growth; SG = country with sustained growth.

Underlying more subdued export growth in the EAC, regulatory bottlenecks hamper the region’s competitiveness. Although a common market is in place, nontariff barriers are still high in the region and common standards and harmonized regulations have yet to be agreed upon. While EAC members have embraced market-supportive policies at the broader level and often put in place legal frameworks amicable to investors, business surveys show that enforcement is problematic (World Economic Forum, 2010). Investment incentives are uncoordinated and often enterprise-specific. Such obstacles not only constrain investment and export levels, but also hamper private investment in infrastructure, further increasing costs. In addition, they deter innovation and, thus, output and export diversification. Although most EAC country authorities have plans to improve the investment climate, progress to date has been uneven across the region, with only Rwanda implementing ambitious and comprehensive reforms. In addition, reform efforts have not been closely coordinated at the regional level, thereby reducing their impact. Removing these remaining obstacles could facilitate faster export growth for the region.

Opportunities exist to expand exports, particularly in mining and oil, but these sectors need to be cautiously developed for these gains to be translated into sustained growth. In Tanzania, gold exports already account for more than a third of total exports of goods and services, while in Uganda oil production is expected to account for close to 10 percent of GDP and up to one-third of government revenues. Considerable exploration findings in nickel, uranium, and oil and natural gas across the region are believed to have significant potential. Export expansion in this area can quickly lift output and government revenues, but harnessing such activities into longer-term growth raises the significant policy challenge of avoiding the “natural resource trap.”15 Early, determined policy action is needed to preserve competitiveness and ensure that revenue from commodity exports is successfully intermediated into productive spending and investment in other sectors of the economy.

Conclusions and Policy Priorities for Sustained Growth

Prudent macroeconomic policies, productivity gains, financial sector depth, and a competitive external sector are important to sustaining growth. Comparing the growth performance of countries that have achieved sustained growth against those that accelerated but failed to achieve this, we find that SGs tend to maintain (1) low inflationary environments and low fiscal deficits; (2) steady improvements in productivity encouraging higher investment, especially FDI; (3) high domestic savings and private sector credit underpinned by liberalized financial markets; and (4) competitive external sectors fostering export growth with better current account balances. These findings concur with various growth determinants found in recent literature.

Within the EAC, Rwanda, Tanzania, and Uganda have grown at rates comparable to SGs and share many of the key characteristics of sustaining growth. Similar to SGs, the growth upturn in Rwanda, Tanzania, and Uganda has coincided with a period of low inflation and low budget deficits, while improved business environments and government stability have contributed to strong productivity gains and increasing FDI, in some cases exceeding SGs.

A number of challenges remain for Rwanda, Tanzania, and Uganda to stay on the path of SGs. Unlike SGs, external savings, mainly donor grants, has primarily financed growth in these countries. Domestic savings and financial deepening in Rwanda, Tanzania, and Uganda are much lower compared with the SGs. Similarly, the contribution of exports to growth has been fairly limited in the three countries, with widening current account deficits, compared with the SGs. This is attributable to weak competiveness, including the high costs of doing business in the region. Physical and human capital are also lagging in EAC countries, which could impede further productivity gains, especially over the longer term.

Elsewhere in the EAC, Burundi and Kenya have only recently started to grow after many years of stagnant growth or contractions. Burundi has suffered from unstable macroeconomic performance and poor quality of institutions and physical and human capital. Although levels of investment, savings, and exports are all lower in Burundi compared with Rwanda, Tanzania, and Uganda, the benchmarking exercise suggests that the more fundamental constraint for Burundi is poor quality of institutions, infrastructure, and human capital. Doing business in Burundi is seen to be the most difficult in the region, its child mortality rate remains stubbornly high, and the level of education is by far the lowest in the EAC.

Macroeconomic and government instability may be dampening growth in Kenya. Real GDP growth rates have been trending upward since 2000 in Kenya, but not high enough to be considered accelerated. Kenya, unlike the other EAC countries, has a deep financial sector and a large export sector, even compared with SGs. Kenya’s health conditions and education perform better than SGs. Nevertheless, productivity of Kenya has been declining until recently. This may reflect rising fiscal deficits and inflation since 2000 and a less stable government at least in recent years.

The EAC is at a critical juncture at which policy decisions will determine whether they follow the path of SGs—thereby accelerating the move to middle-income status—or non-SGs. With the growth rates of Rwanda, Tanzania, and Uganda generally closely tracking those in SGs, it is now critical for them to ensure that accelerated growth is translated into sustained growth—and for Burundi and Kenya to boost their current growth momentum into full-fledged growth acceleration. For this, the following policy recommendations will be important, albeit with different priorities for each EAC country:

  • Maintain macroeconomic stability, namely low inflation and low budget deficits.
  • Deepen financial sectors to mobilize domestic savings.
  • Develop stable institutions and a conducive business climate.
  • Improve competiveness and diversify exports.
  • Overcome the bottlenecks of infrastructure and human capital.

Maintaining macroeconomic stability—low inflation and fiscal deficits—is important for all EAC countries. Fiscal deficits in the EAC have risen in recent years in line with planned fiscal stimulus policies amid the global recession. Recent increases in fiscal deficits may have been important to sustain growth over the short term, but they could be an impediment for sustaining growth over the longer term if they are not appropriately unwound. Also, inflation rose sharply in 2011, reflecting rising global food and fuel prices as well as drought-induced food shortages in the region. This will have to be carefully managed to avoid second-round effects that could have more lasting effects on longer-term inflation. Maintaining macroeconomic stability also requires that natural resource export proceeds are managed carefully to avoid real exchange rate appreciation.

Intensified efforts are needed to deepen regional integration and help the EAC to cooperatively achieve its key policy priorities. The mechanism of regional surveillance backed up by appropriate convergence criteria could be used to mutually ensure prudent macroeconomic management by the members. Financial integration would allow the pooling and mobilization of scarce domestic savings and efficient allocation of such savings. Well-designed regional infrastructure projects could help overcome bottlenecks of physical infrastructure and encourage efficient use of invested resources. Free movement of goods, services, and capital would enhance competition across the region, thereby boosting productivity and output growth.

In the external sector, raising the EAC’s export potential requires continued focus on improving productivity across the region. In particular, a better educated and skilled labor force as well as a better business environment and improved infrastructure—including regional transportation, energy, and information technologies—will reduce production costs and facilitate higher-value exports. Stepped-up efforts to increase agricultural productivity, for example, could both raise the EAC’s export potential and lift incomes in areas where the poorest segments of populations are concentrated. In the near term, the region could broaden its export markets to neighboring Democratic Republic of Congo and South Sudan, especially food crops and light manufactured goods, while efforts are put in place to penetrate broader international markets over the longer term. This would require investments in upgrading rural road networks and simplification of customs and border procedures.

Expanding exports may also demand, at least in the initial years, targeted catalytic interventions in natural niche sectors in which EAC countries could build up or strengthen their comparative advantage, overcome latecomer handicaps, and establish a market presence. Coordinated interventions should cover complementary areas (skills, transportation, technology, market access). These interventions should be carefully targeted, both sectorally and geographically. Resources are insufficient to enhance skills, roads, and power in the entire region at the same time. An equal distribution of these limited resources will not give any area sufficient traction to become competitive. Regional coordination—with a common focus, for example, on a few trade corridors—could help mobilize financing and increase returns. To prevent “state capture,” export push policies should be time bound with clear exit strategies. More broadly, the fiscal cost of regional coordination should be strictly constrained, given the many other demands faced by governments, particularly in the social area.

The private sector should be closely involved in the design of such interventions, helping identify concrete needs and efficient delivery modes. Targeted areas should be selected transparently, with a focus on their impact on the sustainability of both exports and productivity. Given its potential for expanding exports and reducing poverty, agriculture would likely offer the greatest payoff from targeted support.

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1To illustrate, the calculation assumes a middle-income threshold of $1,000 GDP per capita in 2010 (close to the $1,006 threshold of middle-income status defined by the World Bank). We assume this threshold grows in nominal terms at about 3 percent a year—the observed growth of the middle-income threshold over the last decade—for the next decade to reach an estimated $1,331 in 2020.
2See Barro (2003) and Barro and Sala-i-Martin (2004) for comprehensive analysis.
3To support the benchmarking exercise, we also run regressions on drivers of growth, using models developed in the literature extended for additional variables relevant for the EAC, such as a peace dividend. We find that maintaining peace and liberalizing financial sectors improve the chances of both growth accelerations and sustained growth after some five to seven years. Persistence pays off. See McAuliffe, Saxena, and Yabara (2012) for more details.
4We use Penn World Tables 7.0 (May 2011) which covers 1950–2009 for 189 countries for identifying growth episodes. The International Monetary Fund’s World Economic Outlook database and the World Bank’s World Development Indicators database are used in benchmarking the EAC growth experience against identified growth episodes. They cover data starting in 1960.
5Since growth episodes must last for at least seven years to qualify as a growth acceleration (criterion 2), the latest year for the start of an acceleration is 2002 using Penn World Tables 7.0, which includes data through 2009.
6Countries that achieved growth acceleration in 1998 or after cannot meet the criterion for sustained growth simply because their episodes are too short and data are unavailable.
7Total factor productivity for countries is estimated using a growth accounting methodology developed by Bosworth and Collins (2010) as follows:Δln(Y/L) = 0.35[Δln(K/L)]) + (1 − 0.35)ΔlnH + ΔlnA, Kt = K t–l (1 − d) + It, and H = (1 + r)s, where Y denotes real GDP, L work force, K capital stock, A total factor productivity, I gross fixed investment, and H educational attainment or human capital. The d is a depreciation rate of capital, which is assumed to be 5 percent, whereas r, a return to each schooling year s, is assumed to be 7 percent.
8Although the link between real exchange rates and growth is tenuous, Rodrik (1999) finds that undervalued real exchange rates stimulate economic growth.
9In the rest of the chapter Rwanda, Tanzania, and Uganda are frequently referred to as a group.
10In the following benchmarking exercise, for illustration, we assume that time t is 2000 for Burundi and Kenya.
11Since the mid-1990s, sub-Saharan Africa has rebounded from low or negative total factor productivity growth and a corresponding decline in the contribution of factors of production to growth (IMF, 2008; Radelet, 2010).
12It should be noted that the data do not adjust for the quality of education.
13Isaksson (2007) and others have tried to identify channels to enhance total factor productivity, including education, health, openness, competitiveness, institutions, infrastructure, and financial development.
14A recent study on the impact of scaling up aid to meet the Gleneagles commitments, however, suggests that aid can have a substantial positive influence on growth as long as projects financed by aid are well designed and implemented.
15Collier (2007) and others. Commodity exporters have fallen into a detrimental long-term growth because of the adverse impact of commodity exports on productivity, the real exchange rate, and institutional development and governance.

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