GDP Growth Outlook under Pressure

Kenya is among the brighter spots in Africa at present although we have become a little bit more concerned about the medium term outlook as a result of fiscal slippage, a lack of co-ordination between policy makers and increasingly tight liquidity conditions.

h3. GDP Growth

GDP growth recovered slightly in 2Q15 to 5.5% y/y, up from a one-year low
of 4.9% y/y in 1Q15, on the back of higher electricity production and elevated
growth in construction. The former can be attributed to an increase in
hydroelectricity output and the commissioning of a new geothermal power
plant in 2014 while the latter is due to substantial public sector infrastructure
investment. Better rain fall has also boosted the agricultural sector where
output could improve further over the coming quarters. Meanwhile, activity in
the hospitality industry has continued to decline, albeit at a slower rate. This
sector has been buffeted by negative sentiment amid concerns over terrorist
activity in Kenya with the level of tourist arrivals being very low by historical

Looking ahead, sharply higher policy interest rates will likely place downward
pressure on credit growth and household spending. Also, we are concerned
that rising public debt and elevated borrowing costs will increasingly weigh
on the economy. Additional downside risks to growth include the possibility of
further fiscal slippage, heightened terrorist activity and more pronounced
currency weakness. Despite these pressures, Kenya’s longer term growth
prospects remain relatively robust. Unlike most Africa countries, Kenya
doesn’t rely on mining exports, while its main trading partners are in Europe
and North America – regions with decent medium term growth prospects.
Furthermore, there are benefits to be had from recent oil discoveries and the
government’s aggressive infrastructure investment programme.
Nevertheless, the short to medium-term fiscal outlook has weakened
in recent months.

h3. Budget Deficit

The deterioration was initially driven by a larger than
expected budget deficit (10.1% of GDP) announced in the national budget in
June. We have also raised our forecasts for deficits over the medium term
due to higher debt service costs because of a spike in domestic borrowing
costs and a weaker currency causing higher foreign debt service costs.
Forex debt is now about half of total government debt; as such the exchange
rate is an increasingly important determinant of the interest bill. As we have
seen in other African countries, uncertainty around fiscal management and
resulting higher interest costs can act as a destabilising force in the
economy. At present, the net public debt ratio is approximately 45% of GDP,
but this is likely to rise to slightly above 50% by next

h3. Credit Rating

Concerns over Kenya’s fiscal position saw S&P
reduce the outlook on its sovereign credit rating to
negative from stable, while maintaining its foreign
currency rating at B+. Kenya will need to grow its
way out of its high public debt problem. In this
regard, we are encouraged that growth should
remain relatively strong and that government
spending should slow once the country’s major
infrastructure projects are completed over the next 2
– 3 years.

h3. Fiscal Outlook

Risks to the fiscal outlook are, however, skewed
towards larger than expected deficits due to the
possibility of spending overruns (as we have seen
happen before). These overruns could occur as a
result of excessive spending ahead of the 2017
elections or fiscal ill-discipline among the still newly
devolved and immature counties. Two other
concerns on the fiscal front are teachers’ salaries
and the bailout of Kenya Airways. The government is
expected to be forced by a court ruling to pay a
previously agreed 50% – 60% increase in teachers’
salaries. The government is currently weighing
options between cutting their 2015/16 budget or
borrowing externally to implement this US$170m
increase. Additionally, the government has vowed to
assist Kenya Airways financially after it was declared
insolvent in July 2015. This will likely take place
through the means of commercial loans.
Despite these fiscal risks, the large budget deficit is
less concerning than those seen in many other
African countries due to the substantial share of
development spending in total spending
(approximately one third).

h3. Currency Outlook

The Kenyan shilling has recently recovered some
ground against the US Dollar. This is thanks
largely to a decision to delay interest rate hikes in the
US. However, slowing inflation and tight monetary
policy in Kenya have also contributed to the rebound.
Despite a modest recovery, the shilling is still 13%
weaker against the US Dollar since the start of 2015.
With tourism revenues still under pressure and US
interest rate hikes in the pipeline, we expect to see a
further gradual depreciation over the coming year.
Inflation increased marginally to 6% y/y in
September, from a six-month low of 5.8% in August.
Inflation peaked in April this year at 7.1%, which is
close to the top end of the CBK target range (2.5% –
7.5%). Inflation in the month continued to be driven
by the single largest component of the basket i.e.
food and beverages, with price growth of 9.8% y/y.
Despite being elevated, the September rate was at a
seven-month low, which confirms our view that
improved rains and base effects are gradually
slowing food inflation. The upward pressure on
inflation emanated from clothing, furniture, transport
and hotels and restaurants. While these items have
inflation rates that are all below the top end of the
Central Bank’s target band, we are seeing an upward
trend emerge due to currency weakness. Transport
inflation is also likely to increase significantly in 4Q15
as the petrol price cuts from last year move into the
base. Near term risks to the inflation outlook appear
to be evenly balanced. Recent currency weakness,
high levels of credit growth and unfavourable
transportation base effects pose upside risks, while
improving food inflation prospects and a tightening
monetary policy stance pose downside risks.
The central bank policy rate currently stands at
11.5%. This reflects 300bps of cumulative increases
since the start of the year. As inflation is now
comfortably within target, we do not anticipate any
further hikes this year or in 2016. The tight monetary
policy stance, along with high levels of government
borrowing have contributed to an increase in short
term borrowing rates. At the latest auction on October
12, the 91 day government treasury bill reached an
average yield of 21.35%. This is up substantially on
the average rate of 8.12% that was secured at the
May auction.

h3. Central Bank Supervision

We have noted that the CBK put Imperial Bank under
curatorship in October due to allegations of
malpractices and money laundering. In September
Dubai Bank was also put under liquidation. We do not
think that either of these banks poses systemic risks
to the financial sector. Rather, recent events in the
banking space can be seen as an indication that the
CBK is stepping up banking supervision and is
cracking down on banks that have been contravening

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