Public Information Notice No. 02/43

Public Information Notice: IMF Concludes 2001 Article IV Consultation with Kenya

April 19, 2002

On March 15, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Kenya.¹

Background

Kenya's economic performance during the past decade has been well below its potential. This reflects the failure to sustain prudent macroeconomic policies, the slow pace of structural reform. Consequently, Kenya's real per capita GDP is now lower than it was in 1990 and poverty is much more prevalent. In recent years, the HIV/AIDS pandemic has been incapacitating and killing an increasing number of the population and imposing a rising social and economic burden.

Executive Board Assessment

Directors noted that Kenya's economic performance during the past decade has been well below its potential, reforms have been slow, and there have been pervasive governance problems. Moreover, the country has suffered from the impact of a drought in 2000 and the HIV/AIDS pandemic. As a result, Kenya's real per capita GDP is now lower than it was in 1990, and poverty is much more prevalent.

Directors commended the authorities for achieving a measure of macroeconomic stability during recent years, in difficult circumstances. Nonetheless, they were concerned that Kenya's macroeconomic and financial situation remains fragile, and that investor confidence is very low. Risks in the period ahead are considerable, and include the continuation of mixed performance, which would further undermine investor confidence; the high level of non-performing loans in the banking system, especially in the public sector banks, which represent a serious risk to financial stability; and uncertainties associated with the presidential and parliamentary elections scheduled for late 2002. An inability to maintain financial discipline in the period ahead-which will be difficult without a resumption of external financing-could also jeopardize Kenya's budgetary and external positions well into the future.

To help obtain tangible results, Directors stressed the importance of departing from the "stop-go" policies of the 1990s. The authorities should implement a comprehensive medium-term economic and structural reform program, and demonstrate commitment to reform by undertaking measures to address the governance problems that have stalled progress to date. Directors observed that the Poverty Reduction and Growth Facility (PRGF)-supported program had sought to break with this negative record through an ambitious program of governance actions, the reinforcement of macroeconomic stabilization, and meaningful and sustained structural reforms. They were concerned, however, that the program had suffered major setbacks, particularly in the governance area, and that efforts to bring the program back on track have not yet been successful. Directors stressed that it is important that Kenya implement the needed prior actions to allow resumption of the PRGF program, which would help to restore investor confidence.

Directors suggested that medium-term financial policies should aim at adjusting the policy mix by tightening fiscal policy to reduce government domestic borrowing, while maintaining a prudent monetary policy. They considered that the budget needs to allow for a decrease in domestic debt relative to GDP. On the revenue side, Directors welcomed the good performance of the Kenya Revenue Authority and suggested that the authorities should continue to keep the revenue-to-GDP ratio at the level of recent years.

Directors welcomed the comprehensive consultation process which has been carried out in Kenya in the context of the preparation of the full Poverty Reduction Strategy Paper (PRSP), and hoped that the government's action plan for implementing the PRSP will be finalized soon. They noted, however, that to maintain the credibility of the PRSP process and reduce poverty in Kenya, budget execution should reflect the priorities identified in the PRSP, including the need to reduce the government wage bill as a share of GDP. Directors considered that, with further retrenchment, there should be room for civil service wage rates to rise in the medium term. They also stressed the urgency of dealing with the problem of stalled projects and pending bills.

Directors considered that monetary policy should continue to aim at keeping inflation low, while providing a stable environment for financial markets. They stressed the need to preserve the Central Bank of Kenya's independence in conducting monetary policy and to allow bank interest rates to be market determined. Directors welcomed the High Court's decision to declare the Central Bank of Kenya (Amendment) Act-the "Donde Act"-null and void, as this has removed the potential for serious distortions and allowed commercial banks to resume normal banking operations.

Directors expressed concern about the very high risks associated with the level of non-performing loans in the Kenyan banking system, and stressed the need to establish a clear plan to address them urgently, including, in particular, plans to deal with publicly owned banks. They recommended that the government move decisively to sell the remaining shares of the Kenya Commercial Bank to a strategic investor. Irredeemably weak financial institutions should be allowed to close, and concrete steps should be taken for the full privatization of the government's interests in the remaining banks. Directors urged the authorities to undertake a Financial Stability Assessment Program as a matter of priority.

Directors considered that Kenya's flexible exchange rate regime continues to be appropriate. They noted that recent exchange rate stability may have helped to reduce currency risk premia and interest rates over the period. Directors considered that Kenya's lack of external competitiveness reflects the relatively high costs of doing business and prevalent structural bottlenecks, rather than the level of the exchange rate. They therefore encouraged the authorities to take actions to reduce the cost of doing business in Kenya and to remove those bottlenecks; in this context, steady progress in the structural and institutional reforms supported by the World Bank will be important.

Directors welcomed the recently formulated tariff reform that aims to simplify the tariff structure, with a view to ultimately adopting the common external tariff of COMESA and the EAC. It will be important to continue to liberalize the trade regime, pursue the tariff reform strategy, and increase policy coordination with other members of COMESA and the EAC.

Directors considered that implementing a vigorous anti-corruption strategy, as part of a wider program of governance reforms, is necessary to generate the conditions for stronger per capita income growth in Kenya. They welcomed the authorities' publication of their National Governance Programmes and Initiatives, and the government's intention to strengthen the office of the Attorney General and the investigatory capabilities of other branches of law enforcement. Directors stressed the importance of passing key governance legislation during the current session of parliament, which will establish a code of ethics for civil servants, legislators, and the judiciary, as well as strengthening and better protecting the legal status of the Anti-Corruption Police Unit. They underscored the importance of demonstrating clear results from this strategy.

Directors suggested that these actions would have to be reinforced through a multifaceted approach involving the strengthening of all other institutions whose operations have a bearing on combating corruption, such as the Controller and the Auditor General's office. They emphasized the importance of fully implementing recently agreed reforms of procurement regulations, and noted that the judiciary needs a major strengthening.

Directors saw the strengthening of the management at the Central Bureau of Statistics as a positive step toward improving Kenya's data collection. They underscored that this should be supplemented with more resources to improve poverty analysis and to help monitor the poverty reduction programs. At the same time, increased efforts are needed to improve the core macroeconomic statistics, both in terms of quality and of timeliness.

It is expected that the next Article IV consultation with Kenya will be held on the standard 12-month cycle.