Kenya's economic dominance in East Africa depends on diversificationBy WOLFGANG FENGLER | Saturday, March 3  2012 at  18:00

Last year, Kenya’s economy was behaving like a plane flying on one engine through a storm.

After a lot of turbulence, especially when the shilling reached a record low against the dollar, the Central Bank intervened forcefully, and brought the plane back to stability.

But Kenya’s exchange rate woes are just the tip of the iceberg — the symptom of a bigger underlying problem.

Kenya’s big challenge is to fix what economists call the “current account deficit” or the gap between the import bill and exports revenues (which remains large, even when services — such as tourism — are included).

Last year, Kenya’s current account deficit reached more than 10 percent of GDP, approximately Sh400 billion ($4.5 billion). This is larger than Greece’s.

In order to balance its current account, Kenya would have to more than double the volume of its three top exports — tea, tourism and horticulture.

In addition, Kenya’s is vulnerable to shocks, like increasing oil prices.

The oil import bill rose from $2.7 billion in 2010 to $4.1 billion in 2011, further weakening Kenya’s fragile current account.

A large current account deficit does not automatically translate into a falling currency, so long as capital inflows fill the gap.

But in Kenya, capital inflows have increasingly been short-term (by contrast to foreign direct investment which finances factories and offices).

Short-term capital can leave a country as fast as it comes. When Central Bank increased interest rates sharply at the end of last year, it brought Kenya’s economic plane into safety, cooling the engine that was overheating.

The price was some economic slowdown as loans became more expensive. Now that the plane is again out of the turbulence, every attempt should be made to make it fly faster and higher.

Kenya’s first engine — domestic consumption — which is fuelling vibrant service and construction sectors, has always been strong.

But the second engine — exports — needs to perform better. If not, Kenya will continue to operate below potential, for years to come.

But how do you do that? What products could Kenya realistically manufacture, export and be competitive in? Picking winners is typically not a good idea.

The government needs to provide the conditions — such as infrastructure, the rule of law, and basic social services — for businesses to thrive, but not running them.

At the same time, it is clear that Kenya needs to move into new products, because it cannot grow rich on tea and flowers alone.

The natural starting point is manufacturing. Kenya has a good location and a skilled labour force, which is rapidly urbanising.

The global manufacturing market is also changing. Today, Asia is the world’s workshop, producing almost everything from clothes, shoes, toys and increasingly cars.

But Asia’s economic success translates into higher wages, and many manufacturing jobs will soon leave its emerging economies.

The World Bank projects that 75 million manufacturing jobs will leave China over the next decade. Where will these jobs go? Can Kenya get a share?

A new way to understand a country’s competitiveness is to look at the existing composition of exports or “product space”.

Ricardo Hausmann, from Harvard University, has been spearheading the global analysis of countries’ product spaces, and the World Bank recently hosted him in Kenya.

According to him, some countries are richer than others because they have more productive knowledge, which they can use to make more and complex products.

In short, rich countries make a lot of products, including several, which only few countries produce.

Poor countries only make a few products and the margins they earn are low because many other nations are also producing them.

Realistically, a country will only be able to diversify gradually. Kenya is strong in tea and flowers, but it will have a hard time producing airplanes, overnight.

What type of products are within Kenya’s reach, and which activities are most likely to create the conditions for industry to invest and expand?

There is some light at the end of the tunnel. Kenya has started to diversify its export products and markets.

Three sub-sectors stand out: textiles, chemicals and machines. In the 1990s, these exports accounted, on average, for about $120 million in earnings.

In the following decade, the figure was four times larger at $480 million. These are still extremely small numbers, but they are starting to add up.

Still, Kenya has unfulfilled potential. According to simulations by the Harvard team, Kenya should grow at seven per cent each year.

If it did, it would reach Middle Income status by 2018, and remain East Africa’s uncontested economic heavyweight.

We know that Kenya can grow at such levels. It happened in 2007, but the big question is how to sustain the momentum.

Wolfgang Fengler is the Lead Economist for the World Bank in Kenya.