Monday, March 19, 2012

Decentralizing Kenya: Four Paradoxes

These lessons are important for Kenya as it embarks on a massive decentralization program—

Devolution will reshape the country’s institutional architecture, not just because of the transfer of functions and finance, but also because it involves the creation of a forty-seven brand-new counties which will bring together deconcentrated offices of many national ministries, local authorities, and district administrations.

Kenyans have sky-high expectations of what devolution will bring, but decentralization is not in-and-of itself a panacea for development. Almost everywhere, at different times in history, decentralization has been driven by political imperatives, not by economic arguments.

The challenge for Kenya’s policy makers in the next year and beyond will be to manage expectations carefully because the risk of disappointment will be huge. To do this they will need to be mindful of four paradoxes that will characterize the decentralization process in this early phase of transition:

Paradox 1. What is politically desirable is economically impossible.

 Ideally, wealth and incomes should be distributed evenly across Kenya’s 47 counties. This is economically impossible because firms and individuals tend to locate where there are already clusters of economic activity—which is mostly in the cities—so they can benefit from “economies of scale.” Investments by companies also tend to be lumpy—think of establishing a factory—and thus geographically concentrated. This is why in Kenya most economic activity is concentrated along the Northern corridor—from Mombasa to Nairobi and onward to Kisumu and Kakamega—where the majority of Kenyans live

Paradox 2. To make decentralization work, you need strong central systems.

Some Kenyans want the central government to stay out of devolution and leave it to the counties to manage their own affairs. In fact, devolution requires sustained central coordination to be effective. Central systems serve two main purposes: to make sure weaker counties’ needs are being addressed through capacity building and that the spending and performance of county governments can be compared on a common basis thanks to accountability systems.

Paradox 3. If not managed well, decentralization may lead to greater inequality. Some counties will start at a relative disadvantage and it will take time to build up their capacity. They will be the least equipped in practice to make efficient and transparent use of their resources and retain the skilled staff that is essential to making services work.

Paradox 4.Despite decentralization, county governments won’t have a lot of additional resources to spend. Counties will receive transfers from the center but also inherit responsibility for delivering a wide array of existing services. The size of the transfers for each county will also be small. If the government would devolve 15 percent to sub-national governments, each of the 47 counties will only receive 0.3% of national revenues. Counties will have the latitude to shift funding to new uses but they will need to make cuts in other services that are currently provided.

In many countries, decentralization is associated with great hopes and disappointments. The disappointments resulted from a misunderstanding of what decentralization can realistically achieve in the short run.

One thing is clear. To address spatial imbalances in lagging regions while maintaining services where Kenya’s growth is generated, Kenya has to grow the cake while splitting it. This would make sure that each slice of the cake is bigger.

Friday, March 9, 2012

How to kick-start Kenya’s second growth engine

Last year, Kenya’s economy was behaving like a plane flying through a storm on one engine. 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. Kenya’s big challenge is to reduce the gap between the import bill and exports revenues, what economists call the “current account deficit” (which remains large, even when services—such as tourism—are included). Last year, the deficit reached more than ten percent of GDP, approximately Ksh 400 billion (US$ 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 is vulnerable to shocks, like increasing oil prices. Oil is one of Kenya’s top imports, and the oil import bill alone 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, and this uncertainty is an additional source of fragility for the national currency.

When the Central Bank increased interest rates sharply at the end of last year, it brought the airplane into safety, cooling the engine that was overheating. The price was some economic slowdown, as loans (which businesses rely on to invest), became more expensive. Now that the plane has emerged from 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 export? 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 run 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 labor force, which is rapidly urbanizing. 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 85 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 more 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, moving first to products where a country can apply existing capabilities. Kenya is strong in tea and flowers, but it will have a hard time producing airplanes overnight.

What types 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 (exported mainly to the US), chemicals and machines (to Africa and Asia). In the 1990s, these exports accounted, on average, for about US$ 120 million in earnings. In the following decade, the figure was four times larger at US$ 480 million. On an international scale, these are still extremely small numbers, but they are starting to add up.

Still, Kenya is currently punching below its weight. According to simulations by the Harvard team, Kenya should grow at 7 percent a 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? Can Kenya really grow at 7 percent year after year, including through election turbulence? Can the second engine start pulling its weight? Once it does, sit back, enjoy the flight, and definitely buckle up!