metadata: authors: 0: author: Bruce, Colin A.
1: author: Ndii, David
count: Kenya
docna: 0: docna: Framework for macroeconomic analysis applied
            to Kenya
docty: Policy Research Working Paper
subtopic: Fiscal & Monetary Policy,Public Sector Administrative & Civil
            Service Reform,Banks & Banking Reform,Inflation,Macroeconomic Management,Democratic Government,Public Sector Administrative and Civil
            Service Reform,De Facto Governments
teratopic: Finance and Financial Sector Development
abstracts: cdata!: The authors develop a macroeconomic
            model for Kenya that projects detailed national, fiscal,
            monetary, and private sector accounts, and the balance of
            payments. With no changes in its logical structure, the
            model also calculates the magnitude of policy adjustments
            that would eliminate external and internal imbalances. Their
            approach emphasizes transparency and user-friendliness,
            which they achieve in two ways. First, historical data - the
            basis for projections, and second, key behavioral
            assumptions and targets are entered in a clearly designated
            worksheet. This worksheet also accommodates coefficients for
            the import and export price and income elasticities by major
            commodity groups; the interest and income elasticities of
            private investment; and the impact of inflation, income
            growth, and changes in interest rates on the demand for
            currency, demand deposits, and time deposits. The targets
            include domestic inflation and sectoral growth rates.
geo_reg_key: 517191
repnme: repnme: Framework for macroeconomic analysis
            applied to Kenya
display_title: Framework for macroeconomic analysis
            applied to Kenya
listing_relative_url: /research/1991/09/699875/framework-macroeconomic-analysis-applied-kenya
topicv3: Commercial Banking m1326069 1236,Interest Rate Policy m1326222 1125,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Balance of Payments m1326965 441,Public Administration m1327723 723
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: World Bank Office: Nairobi (AFMKE)
no_of_pages: 110
model_extractions: **Policy, Research, and External Affairs**

# **Country Operations**

# WPS 767

This papera product of the Country Opcrations Division, Eastern Africa Department, Africa Regional Office - is part of a larger PRE effort, led by the Macroeconomic Adjustment and Growtlh Division, Country Economics Department, to develop a macroeconomic projection model that will improve and extend the Bank's RMSM model. Copies are available free from the World Bank, 1818 H Street NW, Washingtor DC 20433. Please contact Margaret Lynch, room 110-271, extension 34046 (10(4 pages, including figures and tables).

Bruce anl Ndii develop a macroeconomic model for Kenya that projects detailed national, fiscal, monetary, and private sector accounts, and the balance of payments. With no changes in its logical structure, the model also calculates the magnitude of policy adjustments that would eliminate external and internal imbalances.

Their approach emphasizes transparcticy and user-friendliness, which they achieve in two ways. First, historical data - the basis for projections - are entered in worksheets that are similar (in format, coverage, and units of account) to standard tables produced by the data generating agencies. Second, key behavioral assumptions and targets are entered in a clearly designated worksheet. This worksheet contains details such as commodity price projections and the LIBOR rate that would nornally be provided by the Bank's International Trade Division. This worksheet also accommodates coefficients for the import and export price and income elasticities by major commodity groups; the interest and income elasticities of private investment; and the impact of inflation, income growth, and changes in interest rates on the demand for currency, demand deposits, and time deposits. The targets include domestic inflation and sectoral growth rates.

Initially, they use the f'ramework to project detailed national and sectoral accounts, including the financeable fiscal deficit. But they arc especially interested in the external financing gap and the residual public sector borrowing requirement (PSBR) that emerge in these base projections. For ease of exposition, these gaps are assumed to be independent.

Next, Bruce and Ndii illustrate the model's usefulness in calculating the policy adjustments - exchange rate, interest rate, and monetization - that would eliminate intemal and extemal macroeconomic imbalances. The policy adjustments are applied independently and jointly. Predictably, the exchange rate depreciates to eliminate the external financing gap. Similarly, the real domestic loan interest rate rises, crowds out private investment, and releases financing for the residual PSBR. The model also calculates the level to which domestic inflation would have to rise to finance the residual PSBR throughi an inflation tax.

When activated jointly with exchange rate depreciation, a smaller increase in the interest rate eliminates the residual PSBR. This is because the exchange rate adjustment improves the net foreign assets position and increases the scope for creating domestic credit. Understandably, therefore, the increase in interest rate is even smaller whCIl action in the exchange rate is combined with partial monetization of the fiscal deficit.

As an important by-product. these simulations also illustrate the impact of exchange rate and interest rate adjustments on the fiscal deficit.

Subsequent versions of the model will endogeniize growth andi extend coverage to the consolidated public sector.

The PRE Working Paper Serics disseminates **thc** findings of work under way in the Bank's l'olicy, Research, and Extemal AffairsCornplcx. An objectiveofthcseries is to get these finidingsout quickly. even if presentations are less than fully polished The findings, interpretations, and conclusions in these papers do not necessarily represent offic ial Bank policy.

ProdUced hy the PRE Dissemination Center
TABLE OF CONTENIS

**I1**

## **I. INTRODUCTION** ...............

## **U.** FRAMEWORK FOR MACROECONOMIC POLICY **ANALYSIS.**

2

|Overview|**2**.....<br>:|
|---|---|
|Behavioral Relationships, Accounting Rules md Flow-of-Funds Consistency|3<br>|
|The Monetary Sector: the demand for fimancial assets.|3<br>|
|Government revenue...............<br>...............|5..<br>S|
|Government expenditure ...............|_6_|
|The balance of payments ...............|6|
|National accounts ...............|7|
|Miscellaneous.........................................<br>|..... 8|
|Flow of Funds Consistency ................................|8|

# III. POLICY SOLUTIONS .10

|Introduction .10||
|---|---|
|The Economics of the Exchange Rate Solu.on .10<br>||
|The Econouics of the Interest Rate Solution .13||
|The Economics of Monetizing the Fiscal Defcit .15||
|The Economics of Joint Policy Action.|.16|
|Summary .18<br>IV. POLICYSIMLATIONS .18||
|The Base Projections ... .<br>........................................|18|
|Exchange Rate Solution .........................................|22|
|TheInterestRate Solution .....................................|26|
|Monetization<br>.......|29|
|lointExchange Rate and Interest Rate PolicyAction.ii*v***@******|*****30|
|Joint Exchange Rate and Interest Rate Policy Action and Monetzati.on<br>.34||
|Summary of Simulation Results**.**.............<br>.......<br>..|.<br>34|

# V. LIMITATIONS AND FUTURE EXTENSIONS ..........

37

## ANNEXES

|Annex I: Descripdon of Model .<br>.............................|40|
|---|---|
|<br>Annex 11: Fiscal Deficits and Macroeconomic<br>Consistency ....................|49|
|<br>Annex III: Import Elasdcities in Kenya: 1968 and Beyond|56|
|<br>Annex IV: Key Assumptions and Targets Input Worksheets and Output Tables|66|
|<br>Annex V: Time Bound Formulae .....................<br>I|100|

# REEEESNCS .103
# TEff TABLES

|TableI:|Key Indicators: Base Projections..........................|20<br>|
|---|---|---|
|Table 11:|Key Indicators: ExchageRate Policy ........<br>...............<br>|23<br>|
|Tablem:|Key Indicators: Interest RatePolicy........................<br>|<sup>27</sup><br>|
|Table TV:|Monetzaton of the Residual Pt'blic Sector<sup>Borrowing Requirement ....</sup><br>|28<br>|
|Table V:|Key Indicators: Joint Exchange/Inters Rate Policy<sup>.....</sup><br>.........|31<br>|
|**Table**VI:|Exchange, Interest Rate Policy and Monedizatio<sup>................</sup>|35|

||FIGURES IN**TEXT**||
|---|---|---|
|Figure One:|External Gap and Residual Public Sector Borrowing<br>Requirement ..........<br>.........................|25|
|Figure Two:|<br>Exchange Ra Simulations, Real<sup>Loan nterest Rate</sup><br>Simuaion, flation Rate Simulaions ........................|33|

We gtezly wknowledge the ugemeand helpful suggestio of John Holem, Pew Miovic and coleague i AF2CO. Katheen<sup>B. Jordan provided valuable editonal</sup> ausitanc whil plyabha Kongsamut wiligly shared<sup>her experence with JAVELIN.</sup>
# Introduction

1.1 This paper presents a transparent, user-friendly framework for analyzing macroeconomic policy issues in Kenya. It adheres to flow-of-funds consistency, covers the fiscal, monetry, national and private sector accounts, and balance of payments, and is an analytical tool for grappling with the economic relationships and institutional realities which ultimately dictate the design, implementation and effectiveness of macroeconomic policies. The model is programmed in JAVELIN.

1.2 A recent report concluded that Kenya's "... recovery ... is somewhat fagile as it has relied on foreign savings, leaving the economy vulnerable to external shocks, and the remaining domestic macroeconomic imbalances, unless corrected, threaten to undermine recent economic and stabilization gains." (World Bank, 1990). The model presented in this paper is usefil to the policy analyst who may wish to project the broad magnitude of these imbalances under different fiure growth assumptions. With these results in hand, the policy analyst may choose to revise growth targets in an ad hoc, piecemeal manner until acceptable" imbalances are obtained and then focus on mobilizing inflows to fill the resource gaps. Alternatively, the policy analyst may wish to determine what levels of imbalances are sustainable, financeable and consistent with other development goals. Here judgment about institutional/political feasibility is indispensable. But so too is a map of inviolable accounting macro-relationships, their evolution under different behavioral assumptions, and the technical limitations they impose on policy selection and effectiveness. The model developed in ftis paper is such a map which could also demonstrate
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the usefulness of instruments such as the interest rate, exchange rate and monetary policy in managing macroeconomic imbalances and steering the economy doser to its development goals.

1.3 The paper is organized as follows. Chapter Two sketches the analytical firamework and discusses the econemics of its structure. Chapter Three contains the policy solutions (the technical details are presented in Annex I). Chapter Three illustrates three policy optionsexchange rate adjusunent, interest rate adjustment and monetization-and highlights their implications when used individually and jointly. Chapter Five identifies the model's limitations and scope for expansion.

# II. Framework for Macroeconomic Policy Analysis

## Ovrview

2.1 The model comprises .ix data input worksheets, debt modules for existing and new external debt, and output tables (Diag:am One). There is also one central worksheet which contains key behavioral assumptions and macroeconomic targets. The model covers the national accounts as well as the accounts of the central bank, the monetary authority, the commercial banks, the central government, the external sector (trade, balance of payments and external debt) and the non-financial private sector. _11_ The projection period is 1990-96.

2.2 The data inpit worksheets contain annual historical data for 1987-89. In general the format, units of account and coverage of these worksheets are similar to standard tables produced by the data-generating agencies of the GovernAent of Kenya. The exceptions are the worksheets .L1/. TM accounts of monewy auhority consolidate the accounts of the central bank with the accounts arising from moncay funiions undertaken by other insitutions or tho cntral govemment.
3 for central government finances and exteumal debt which eome from the IM and the World Bank respectively. Ihese historical data must be consistent within and across sectors, and conform to standard macroeconomic accounting rules. Both of these requirements obtain in the flow of finds famework. Accordingly, the model reconciles historical data for flow of fumds consistency and then uses them as the basis for projections.

# Behavioral Relationships, Accoundng Rules and Flow-of-Funds Consistency

2.3 Macroeconomic accounting rules and flow of funds consistency set limits within which economic behavior takes place in the model. The accounting rules and flow of funds consistency requirements are the same as those set out in Holsen (1989), Khadr et al. (1989) and Easterly et al. (1990). The behavioral relationships are the projection rules for variables. Some originate in econometric analysis that has yielded coefficients linking the variable of interest to its determinants. Others are constant ratios of other vaiables with which they had, or are exp -- ted to have, a stable long run relationship. Yet others are projected on the basis of their relationship to variables whiclt are exogenous to the model.

2.4 To simplify the exposition of the model, this section only specifies and discusses the main behavioral relationships in the monetary sector, the central government accounts, the external sector and the national accounts. A more comprehensive notational presentation of the behavioral relationships, with their flow-of-fimds accounting identities, is provided in Annex I.

# **The** Monetar Sector: the demand for financial assets

2.5 The model identifies demand functions for three financial assets-currency, demand deposits and time deposits (quasi-money). The demand for currency is a positive fniction of real income growth and a negative function of the real deposit interest rate and the rate of inflation.
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The demand for demand deposits and time deposits is a positive fnction of real income growth, a negative function of the rate of inflation, and a positive function of the real interest rate on deposits. In essence, the demand for currency, demand deposits and time deposits increases with national income but is eroded by inflation. Demand and time deposits, unlike currency, earn interest and therefore move in the same direction as interest rates. The coefficients entering the framework are based on econometric estimates discussed in Annex H. The model ensures consistency between financial stocks and flows by expressing flows as changes in the respective stocks over the specified period. Where appropriate, stocks are derived by aggregating flows.

# Government revenue

2.6 In the model, government revenue falls into two main categories, recurrent revenue and capital revenue. Recurrent revenue is subdivided into direct taxes, indirect taxes and other recurrent items. Direct taxes throughou **t** he projection period are assumed to maintain the ratio of direct taxes to GDP (at factor cost) estimated for the base period, 1987-89. Other recurrent items obey a similar projection rule. Indirec **t** axes are disaggregated into sales taxes on domestic manufactures and imports, duties on imports, and other taxes and licenses. 21 In turn, each of these revenue categories is projected with respect to the activities which generate them. Sales taxes on imports (in local currency) are assumed to maintain the ratio of sales taxes to total imports (in local currency) esimated for the base period, 1987-89. The same relationship is assumed for sales taxes on exports with respect to exports and for duties on imports with respect to imports. Other indirect taxes are projected in a similar way but are linked instead to the pool of tax revenues (net of indirect taxes).

Z/ Duties on exports have been discontinued by the Government of Kenya.
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# **Governm** t **penditure**

2.7 Govenment consumpdon expenditr has two main cowponents. The first is wages and salaries which are determined by an exogenous nominal growth target. The second component is expenditure on goods and services. Its relationship to government consumpdon expenditue is assumed to be the same in the future as in 19874B9. Subsidies, trnsfers and other current expenditures are projected in a similar mner but with respect to GDP. Interest on foreign debt is calculated by the debt module on the basis of the debt stock. Interest on domestic debt is calculated in a similar manner.

2.8 External inflows are an important source of _funding_ for and determinant of government capital expenditure. Often these inflows finance imported investment goods. Accordingly, the model projects government capital expenditure as a fixod ratio of government imports, based on the ratio in 1987-89. In turn, govermment imports are linked to long-term capital inflows (as at 198749) which are computed in the debt module.

# **The** balance of payments

2.9 Exports are disaggregated into commodity groups-coffee, tea, horticulture, petroleum, maize, manufacatring, re-exports, other goods and non-factor services. The import groups idendfied are food, petroleum, other consumption goods, primary intermediate goods, manufacturing intermediate goods, capital goods, leases, government imports, and non-factor services. With the exception of leases of aircrafts and government imports, these traded goods are projected solely on the basis of their estimated elasticities with respect to GDP and to their prices in local currency (Annex o).
2.10 Thrughout the projecon peiod net crret fer, nct direct rbr?ign investment, offici gram and short-term captal are deemined by their respective ratios<sup>**to**</sup> GDP<sup>estiated</sup> for 1987-89. Long-term public and publicly guamteed inflows, Don-guaranteed private medium and long-tem inflows together with their amorzation and interest obligadons are<sup>calculated in</sup> the debt module. Short-term public and private debt are assumed to be a fixed ratio of total<sup>long-</sup> term inflvuw. Interest on short-term extenal debt and on reserves is determined<sup>by applying</sup> the exogenous foreign interest rate to their stocks. Reserve accumlation is derived<sup>from the</sup> overall balance of payments or stated as an explicit target.

# National accounts

2.11 Several items for the national accounts are determined in the sectoral accounts described in paras. 2.6 to 2.10. They include indirect taxes, subsidies, the net current<sup>transfers in the</sup> balance of payments, Government consumption and investment. Domestic<sup>savings is simply the</sup> difference between total investment and the external resource gap. LikbwiLe, national<sup>savings</sup> is the difference between total investment and the current account balance. Private savings<sup>is the</sup> residual after public savings-defined as the current balances in the fiscal accounts-is subtracted from national savings.

2.12 GDP at ftctor cost is broken down into value added in agriculture,<sup>mining,</sup> imanufacturing, other industry and services. Growth in each<sup>of these sectors is projected</sup> exogenously. GDP at market prices is then determined in conjunction<sup>with net direct taxes which</sup> are calculated in the fiscal account.

2.13 Public investment and consumption are projected in the public sector<sup>accounts. Private</sup> Iinestment is a negative function of the change in the real domestic loan<sup>interest rate and a</sup>
-8-

positive function of GDP growth. Private consumption is the residual item for balancing GDP at market prices with gross domestic expenditure

## Miscellaneous

2.14 Tle projected population growth rate, dollar prices of Imports and exports including the manufactuing uiit index, and LIBCOR are external to the model and are obtained from sources within the World Bank. The commodity prices from these sources serve as inputs into the exl,ort, import, investment, consumption and GDP deflators. All deflators are weighted by the shares of commodities whose prices enter their calculation.

# Flow of Funds Consistency

2.15 Economic flows generated in one sector may be used within that sector or other sectors of the economy. This is the fundamental organizing principle of the flow of _funds_ consistency framework as presented in Holsen (19S9), Khadr et al. (1989) and Easterly et al. (1990). It classifies each variable as a source of funds or a use of funds. The sources and uses may be current or capital. Consistency prevails when current sources of funds equal current u;es of funds within eack. sector and in the overall economy. The same condition holds for capita sources and uses of finds.

2.16 The flow of funds identities for the nonetary sector, central government finances, the balance of payments and the national accounts are presented in Annex I. They include the stocks and flows of the central bank, monetary authority and commercial banks, as well as the nonfinancial private sector. The projectigns derived from the behavioral relationship **s** atisfy these identities at the sectoral and aggregate level. Historical data, however, required several adjustments to achieve consistency. An adjustment was made for consistency among the capital
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fiows and stocks implied by the debt data, the<sup>balance of payments, the fiscal accoun and the</sup> monetary accounts. Similar calculations were<sup>done after balance of payments data in the national</sup> accounts were compared with the figures in<sup>the balance of paymen. The rule of thvmb was to</sup> identify those adjustments which made the data<sup>in each input worksheet internally consistent,</sup> reconciled stocks with flows and achieved<sup>intersectoral consistency in relation to the national</sup> accounts.

2.17 Historical net foreign assets of the central bank<sup>and monetary authority were also adjusted</sup> for consistency with their capital sourcm. This<sup>adjuement became the balancing item in the</sup> capital sources of the balance of payments.<sup>An adjustment was also needed to make the capital</sup> uses of government revenue equal to the capital<sup>sources. This adjustment balanced the private</sup> sector's sources and uses of funds. Finally,<sup>the total historical sources of the capital funds of</sup> the central government were changed by an amount<sup>which became the balancing item for the</sup> historical uses of capital funds by the private<sup>sector.</sup> After reconciliation for flow-of-funds consistency, the historical data are used by<sup>the model as the basis for projections and policy</sup> simulations.
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# **HI. POLICY** SOLUTIONS

## **Introduction**

3.1 This chapter discusses the economics of using exchange rate policy, interest rate policy and monetization of the fiscal deficit, independently and jointly, to redress macroeconomic imbalances. These policy instruments have been selected because of their increasing role in managing the Kenyan economy. Prior to 1982, Kenya had a fixed exchange rate regime. Increasingly since 1985, the exchange rate adjustments have been used to ensure Kenya's external competitiveness, support the import liberalization program, and strengthen the overall macroeconomic policy environment. The regulation of interest rates in Kenya dates back to 1974 but movement toward market-determined interest rates is expected to be completed by June 1991. Other instruments for managing monetary aggregates are also being strengthened.

## The Economics of the Exchange Rate Solution

3.2 The exchange rate policy simulation computes the exchange rate at which the specified external financing gap would be closed at a given GDP level. _ai_ The solution depends largely on the negative relationship between import demand and import prices, and the positive relationship between export supply and export prices. A devaluation of the exchange rate would, other things being equal, raise the domestic currency prices of traded goods, increase the supply of exports, decrease the demand for imports and narrow the resource gap. Because the exports and imports are each subdivided into major commodity groups-each with its own price and income elasticity-the model can account in a realistic way for differences in response lags. For / 'MTho ternal fancing gap is the additional capital inflows-over and above those already accounted *br-which are required to finance the current account deficit in the balance of payments and to meet the reserve accumulaton target.
- I1 -

example, in the absence of large stocks, the supply response of coffee exports to coffee price increases is likely to be slower than manufactured items. Imported food, with its many local substitutes, is likely to be more sensitive to price changes than imported crude oil which has no close local substitutes. Similarly, to the extent that government imports are financed by donors, their demand is expected to be fairly inelastic with respect to prices.

3.3 All other variables in the model which are linked to exports, imports and the exchange rate are affected by this solution. When the exchange rate is devalued, governnent revenue from imports falls if there is a reduction in the local currency value of imports. An exchange rate devaluation would also increase the domestic currency expenditure on foreign debt service and externally financed activities. In addition, it would increase the domestic currency receipts from external transfers, loans and grants. The impact of the exchange rate depreciation on the fiscal deficit therefore would be ambiguous.

3.4 To maintain macroeconomic consistency, domestic investment and/or savings must adjust when an exchange rate devaluation results in the importation of fewer goods and the export of more goods. Consider the simple macroeconomic identity: (1) where GDP(fc) is gross domestic product at factor cost, Ti (net) is net indirect taxes, Cp and Cg are private and public consumption respectively, Ip and Ig are private and public investment respectively, X is exports and M is imports-all in domestic currency units. Equation (1) equates the total current sources of fimds with the total current uses of funds in the national accounts. The
12 signs above the variables indicaze their possible response ('+' is positive,'-' is negative) to an exchange rate devaluation. Equation (1) shows that variables on left and right hand sides of equation (1) may have to adjust to maintain equality.

3.5 GDP at factor cost (measured in domestic prices) is exogenous and therefore does not change with exchange rate movements in the model. In contrast, indirctames could rise or fall. Public consumption comprises government consumption and wage targets, and therefore is not affected in the model by exchange rate changes (paras. 2.7, 2.12). Private investment is deternined by the real domestic loan interest rate and GDP at factor cost. Neither is affected by exchange rate movements in the model. By definition, the increase in the resource balance (X-M) would be greater than any increase in net indirec **t** axes Ti) (for a given tax rate). Accordingly, Cp and/or Ig must fall to maintain equality in equaion (1). Ig could only fall on economic grounds if government imports, including inputs into investment, fall in response to the exchange rate devaluation. Ultimately, if government investment does not contract sufficiently, the residual variable-private consumption-must fall. In essence, private domestic savings must rise to finance the unchanged level of private investment and a largely unchanged or slightly reduced level of government investment, becuse of the reduction in foreign savings (X-M).

3.6 The exchange rate solution affects monetary aggregates via its impact on the net foreign exchange assets and the demand for financial assets. Equation (2): M g+ **+** * . +4. M1 (rd,wr,gdpfc) **+** QM (rd,Tr,gdpfc) **+** Nol = NFA **+** Lcg **+** Ldg + Lmip (2)
- 13 -

represents equilibrium in the monetary sector, where MI is currency (negative function of the real interest rate) and demand deposits (positive function of the real interest rate), QM is time deposits (quasi-money), **rd** is the real domestic loan interest rate, X is the rate of domestic inflation, NOL is the flow of net other liabilities of the monetary system, NFA is the net foreign assets, Lcg is the flow of net credit from the central bank to the government, Ldg is the flow of net lending from the commercial banks to the government and Lmp is the flow of net credit to the private sector. Equation (2) equates the total capital sources of funds with the total'capital uses of funds in the monetary survey; that is, equality of the liabilities and assets of the banking system as a whole. While it is obvious that NFA could be affected by an exchange rate devaluation, it is also conceivable that only variables on the left hand side of the equation would change. MI and QM are negatively affected by inflation which could be induced by the exchange rate policy but they are driven in different directions by real interest rates. The important point is that equation (2) has economically meaningful behavioral flexibility to achieve overaU balance after an exchange rate adjustment.

# The Economics **of** the Interest Rate Solution

3.7 The interest rate simulation computes the interest rate at which the residual public sector borrowing requirement would be met by borrowing from domestic commercial banks, given the level of GDP and the private sector's demand for credit from these banks. _4/ Because of data limitations, the 'public sector" is limited to the central government in the model.

3.8 The recent Country Economic Memorandum ascribes three main objectives to interest rate policy in Kenya. The first is to maintain positive real interest rates in order to encourage

> _41_ The residual public sector borrowing requirement is defined in the model u the additional domestic financing-net of the anticipated current and capital revenues, and domestic and foreign financing-which would cover total government expenditure.
- 14 -

savings and thereby contribute to the mobilization of financial resources. The second objectve is to move gradually to market determined interest rates which in turn would encourage a more efficient allocation of credit across and within sectors. The third goal is to encourage competition between commercial banks and near-bank financial institutions by reducing the artificial differentials between their lending rates (World Bank, 1990). Towards this end, restrictions on commercial bank fees and charges were lifted as of April 1, 1990, providing these institutions with greater flexibility in determining the cost of borrowing and lending. The Government plans to adopt a fully liberalized interest rate structure by June 1991.

3.9 In recognition of this policy direction, the model uses the real interest rate to reallocate domestic credit between the private sector and the public sector, given the pool of credit in the economy. This means that net credit to the private sector must fall when net credit to the public sector increases, other things being equal (equation (2)). Accordingly, the private sector's demand for credit is negatively related to real interest rates, reflecting the negative relationship between the real interest rate and private investment.

3.10 Research in several countries suggests that the transition from negative to positive interest rates, rather than the levels themselves, has a more significant impact on the level of domestic savings. Once the rate becomes positive, further increases appear not to affect savings. The reasons may be two-fold. First, target savers-persons wishing to reach a certain level of savings-would not need to increase their savings because of rising interest income from a given level of savings. This income effect may actually lower savings at higher interest rates. Second, and in contrast to the first, higher real interest rates raise the opportuniy cost of consumptionsavings and its interest income. Savers may therefore switch from consumption to savings when real interest rates rise. Because of this indeterminate impact of interest rates and savings in
- 15 -

theory, and indeed in practice, no direct link is forged In the model between domestic savings and interest rates. Increases in the government's demand for credit would raise the real domestic loan interest rate and cause private investment (and d.rivatively, private sector credit demand) to contract. However, aggregate consumpdo **n** eed not fall or savings rise if the additional credit to the govermment is spent on consumption.

3.11 Increases in the real domestic interest rates in the model affect tke demand for currency negatively, but affect the demand for demand deposits and quasi-money positively (para. 2.5). In equation (2) therefore, both right and left hand side variables may change. Accordingly, the policy solution for the residual public sector borrowing requirement of the government which is fimanced by domestic borrowing would be higher real domestic interest rates, subject to the indirect changes induced in the assets (currency, deposits, etc) of the monetary system. The interest rate solution provided by the model also covers any incremental financing which may be required if higher real, and derivatively nominal, interest rates increase the residual public sector borrowing requirement. Such increases in the residual public sector requirement are possible because the debt service obligations of the government would rise as interest rates rise.

# The Economics of Monetizing the Fiscal Defcit

3.12 Instead of borrowing domestically to finance the public sector borrowing requirement, the Government could print money. However, 'excessive' monetary expansion creates inflation. Loosely speaking, monetary expansion is excessive if it exceeds what individuals would ordinarily hold at given levels of real income. Annex m shows how the willingness of individuals to hold mon'v helps to determine the *financeable" fiscal deficit. One of its conclusions is that the Government mighg be able to monetize a larger fiscal deficit if it is also willing to tolerate a higher level of domestic inflation.
- 16 *

3.13 Ihe model computes the rate of inflation, measured as the change in the GDP deflator, which would be required to maintain macroeconomic consistency when given fiscal defichs (or portions thereof) are monetized at the given level of GDP. Higher inflation raises nominal values of the domestic interest rates, the exchange rate and GDP growth (at factor cost) but leaves their real values unchanged. In consequence, real private investment remains unchanged. In contrast, the demand for currency, demand deposits and quasi-deposits all fail as inflation rises. To maintain macroeconomic consistency at the fixed level of GDP, the reduction in the demand for the financial assets-currency, demand deposits and quasi-deposits-must be offset by an increase in the demand for government debt; that is, the residual public sector borrowing requirement. In practice, the portfolio reallocation to government debt would be induced by monetary expansion which raises inflation, reduces real money balances, and yields the government an inflation tax which eliminates the public sector borrowing requirement.

The Economics of Joint Policy Action 3.14 This solution calculates the exchange rate, interest rate and level of inflation which, if applied together, would eliminate the residual public sector borrowing requirement and close the external financing gap. Put differendy, it shows how the same outcome may be obtained by various combinations of policies. The underlying economies is the same as in the application of individual policy instruments. But the magnitude of the required adjustment may differ because of the indirect effects of each policy instrument on the policy target to which it is not directly assigned. For example, exchange rate depreciation reduces the external financing gap but may simultaneously worsen govenament revenue (from indirect taxes). It may also worsen the residual public sector borrowing requirement if the reduction in recurrent revenue is less than the reduction in govermnent investment expenditure. At the same time however, higher real interest
- 17-

<!-- Start of picture text --> Policy<br>Target External Residual Primary<br>Financing Public Sectr Adjusting<br>Policy Gap Borrowing Variables<br>Solution Requirement<br>Exchange Rate Exports &<br>X Imports<br>Interest Rate X Private<br>Investment<br>Deficit Money<br>Monedzation Private Sector<br>x ~~~~Credit<br>X Net Foreign<br>Assets<br>Joint Policy<br>Action: Exports<br>Exchange Rate Imports<br>& Interest X X Private<br>Rate Investment<br>Joint Policy<br>Action:<br>Exchange Rate, All of the<br>Interest Rate X X Above<br>and<br>Monetization<br><!-- End of picture text --> Poligy Matrix rates squeeze private investment and thereby reduce the private sector demand<sup>for credit while</sup> the improvement in the extemal account increases the scope for domestic credit creation.
- 18 -

## Summary

3.1S Ita policy solutions discussed in paras. 3.2 to 3.14 are distlled in the policy matrix above for easy reference. In brief, the exchange rate solution depends on export expansion and Import contraction to meet the economy's surplus demand for foreign exchange. The interest rate solution crowds out private Investment and releases domestic credit to finance the residual public sector borrowing requirement. Finally, the fiscal deficit could be financed through monetary expansion which raises inflation and the resulting inflation tax. Our next task is to illustrate these solutions and thereby demonstrate how the analytical framework presented in this paper could be helpful in designing macroeconomic policy packages for Kenya.

# **IV.** POLICY SIMULATIONS

**4.1** This chapter is illustrative, not predictive or prescriptive. The first and only order of business is to demonstrate that the tool-the analytical framework sketched in Chapter E-can calculate policy adjustments which would be required to achieve particular policy targets, given selected behavioral assumptions and inviolable macroeconomic accounting rules. S/ However, the leap from illustration to prescription would merely involve agreement on base year data and behavioral coefficients, most of which are conveniently assembled in one worksheet (Annex IV).

# Base Projections

4.2 Table 1 shows key indicators of the Kenyan economy as they would evolve under the projection rules and assumptions discussed in Chapter 2 and base year data in the input worksheets in Annex IV. In these base projections, domestic interest rates are based on I/ . To better demonstmte how the interest rate solution of the modd works, an adjustment factor was used to _Inflate_ the residual public sector borrowing requirement (albeit without violating flow of funds consistency).
v 19 exogenous fbrecasts for LIBOR, while the exchange rate<sup>is adjusted to reflect the differential</sup> between the future inflation rates which are assumed<sup>for Kenya and the rest of the world.</sup> Accordingly, the exchange rate (K£1US$) moves from 1.202<sup>in 1991 to 1.581 in 1993 and 1.856</sup> in 1996. The real domestic loan interest rate is 11.2 percent in 1991,<sup>10.5 percent in 1993 and</sup> 10.3 percent in 1996. The corresponding domestic inflation<sup>target is 9.5 percent, 6.0 percent and</sup> S.0 percent. The complete set of input and output tables<sup>of the model fori e base projections,</sup> including the flow of funds consistency check, is at<sup>Annex IV.</sup> 4.3 In this base scenario, the current account deficit falls from<sup>8.4 percent of GDP</sup> (excluding grants) in 1991 to 8.3 percent of GDP (excluding<sup>grants) in 1996. Exports (goods</sup> and nonfactor services) and imports (goods and nonfactor<sup>services) are 21.1 percent of GDP and</sup> 28.9 percent of GDP respectively in 1991 compared with<sup>23.7 percent of GDP and 31.4 percent</sup> of GDP in 1996. 6/ In dollar terms, the external financing<sup>gap moves from US$19.8 million</sup> in 1991 to US$159.5 million by the end of the period (Table<sup>I). Meanwhile, government revenue</sup> and expenditure reach 26.2 percent of GDP (excluding<sup>grants) and 31.4 percent of GDP</sup> respectively in 1996, from 19.8 percent (excluding grants)<sup>and 32.2 percent of GDP in 1991.</sup> The residual public sector borrowing requirement is 27.8<sup>million Kenya pounds in 1991, 97.8</sup> million Kenya pounds in 1993 and 450.7 million Kenya<sup>pounds in 1996.</sup> f lThroughout, exports and imports refer to goods and nonflactor services.
-20 -

TABLE I: Key Indfcators ..... ......... - -

**lase** Projectlos

0,,,

|.<br>.<br>.<br>.<br>.<br>.<br>..|.Nut............|.............||P|rojected. .|...............|.........||
|---|---|---|---|---|---|---|---|---|
||1989|1990|1991|_199Z_|1993|1994|195|1996|
|Gor**(fc)**Growth Rate|4.9X|3.4X|4.7X|4.82|5.32|5.92|5.92|_5.9°_|
|tnvest. Growth Rate|6.5X|1.52|5.4X|4.2X|8.22|4.52|8.3X|7.7X|
|Private 1/|5.92|1.22|4.02|I?.|7.02|7.9X|7.82|8.02|
|Pubtlic<br>investmnt|8.72|2.6|10.42|5.7X|12.52|-7.2X|10.42|6.6o|
|GOPper capita Growth Rate|0.32<br>|<br>1.6"|1.1X|1.32|2.02|2.22|2.72|2.72|
|**Consumption**<br>per capita growthrate|-2.2X|5.7X|4.5X|1.32|3.7X|2.2X|3.22|<br>2.82|
|GrossInvestment/GOP|25.52|<br>29.72|30.52|<br>32.3X|33.7S|33.52|35.92|37.42|
|hostic<br>Savings/GOP|19.72|24.82|22.72|26.52|26.52|30.12|29.12|29.82|
|National Savings/GOP|20.0X|23.6S|22.2Z2|<br>25.32|25.3X|29.02|28.42|29.1X|
|Private Investment/GOP**1/**|19.82|23.02|23.32|25.42|26.2X|28.52|28.72|30.02|
|Consumwtion/GDP**1/**|65.42|61.4X|61.12|56.22|57.3X|S4.61|<br>55.8X|53.12|
|Private<br>Savings/GOP<br>**1/**|22.2X|<br>22.02|27.42|24.32|<br>22.32|27.42|26.42|26.92|
|Private<br>Resource<br>Balance/GDP<br>**1/**|2.42|<br>-1.02|4.02|-1.12|-3.9X|-1.12|-2.3X|-3.12|
|**Public**Investment/GOP<br>**1/**|5.7X|6.72|<br>7.22|<br>6.92|7.52|7.02|7.22|7.42|
|Public Savings/GOP<br>**1/**|-2.22|1.4X|-5.22|<br>1.12|<br>3.02|1.62|2.02|2.22|
|Governmeent<br>Revenue/GDP<br>1/2/|24.22|<br>24.42|19.8S|26.72|27.1X|24.32|24.12|26.21|
|Government<br>Expenditure<br>**1/**2/|30.12|29.52|32.2X|32.S|31.52|29.72|29.3X|31.42|
|Public Expenditures/GDP<br>3/ 8/|32.12|29.52|32.22|32.52|<br>31.52|29.72|29.3X|31.42|
|PubLicDeficit/GDP 3/ 8/|7.8%|5.1%|12.42|5.82|<br>4.42|<br>S.42|5.2Z|5.2X|
|Public Deficit/GDP<br>**(Inct Grants)**<br>3/ 8/|4.52|3.02|11.02|_3.61_|1.52|5.0X|3.72|4.7X|
|Total Financing|4.2|3.0X|11.02|3.62|1.52|5.02|3.72|4.7X|
|**NLT External**<br>Financing|6.62|4.3X|5.6"|3.72|4.42|3.52|3.22|3.6%|
|ST**External**<br>Financing|0.72|<br>0.42|<br>0.7X|<br>0.42|0.52|0.42|0.32|O.S5|
|Domestic financing-financifL<br>system|-0.7X|0.82|5.62|<br>1.9X|3.9X|1.82|2.9X|3.0%|
|monetary Authority|-0.92|-0.52|4.6X|1.52|2.9%|1.62|2.22|2.32|
|CommerciaL<br>Banks|0.2X|1.3X|1.02|<br>0.4X|1.02|<br>0.2%|0.7X|0.72|
|Domesticfinancing-private<br>sector|1.6X|3.1X|3.1X|3.1X|3.12|3.12|3.12|3.1%|
|Residual|3.80|-3.1X|2.22|2.22|4.2X|3.7X|5.0X|5.72|
|Adjustment<br>tofinancing|-7.72|-2.52|-6.32|-7.72|-14.5|-.7.4|-10.82|-11.12|
|Real exchange rateIndexC1987s1001|95.80|94.03|90.91|82.39|80.12|72.68|73.48|**7o.73**|
|Real Exchange<br>Rate Depreciation|-4.22|-1.82|-3.3X|-9.42|-2.82|-9.3%|1.12|-3.8X|
|**Nominal**<br>exchange<br>rate CKL/USS)|1.028|1.1%6|1.202|1.428|1.581|1.790|1.782|1.856|
|Domestic Inftation|10.62|10.02|<br>9.52|7.02|6.02|5.02|<br>5.02|5.02|
|omfinal<br>(Deposit)<br>Interest<br>Rate|15.0X|14.72|14.72|11.82|10.62|9.42|9.42|9.42|
|<br>**Real**Deposit Interest<br>Rate|4.02|4.22|4.8X|4.52|4.3X|4.22|<br>4.22|4.22|
|Loan Rate|22.02|21.62|21.72|18.52|<br>17.12|15.8|15.8|15.82|
|Real Loan Rcte|10.3Z|10.62|11.2X|10.7X|10.5X|10.3%|10.32|10.3X|
|StockofWi/COP|14.92|17.92|17.7X|17.62|<br>17.32|17.0%|<br>16.52|15.9°|
|Stock of auasi-money/GOP|12.32|11.9X|11.42|11.22|10.82|10.5%|10.12|<br>9.7X|
|Stock of credit to private sectr/GOP|20.8X|20.9X|21.02|21.9X|22.7X|23.9X|24.92|<br>26.1X|
- 21 -

||1989|1990|1991|1992|1993|194|1995|<br>1996|
|---|---|---|---|---|---|---|---|---|
|ExportGrowthRate4/|5.0X|<br>16.01|-3.6X|3.11|<br>2.1X|<br>1.4X|7.2X|5.4X|
|Experts/GDP 5/|23.46|22.5X|21.1X|22.0X|22.4X|23.41|23.31|23.7X|
|ImportGrowthRate 4/|-9.31|-10.4.|**_T.11_**|-8.6"|9.5X|-6.3X|12.31|6.60|
|1 arts/GOP 5/|29.31|27.41|28.91|27.81|29.61|28.81|30.11|31.41|
|Curr. Ace. Def. 6/(ineL. grants)|337.2|339.3|655.8|418.1|489.5|542.2|600.5|<br>833.0|
|Curr. Ace.De..7/(exct. grants)|454.3|517.6|788.8|621.1|754.S|581.2|730.5|883.0|
|Curr. Acc.Oef./GDPCexcI.grants)|7.41|<br>6.11|8.41|<br>7.01|<br>8.31|6.51|<br>7.51|<br>8.31|
|Curr. Ace.Oet./GOP(lncl.grants)|4.1X|4.02|6.91|4.71|5.41|6.1X|6.01|7.81|
|Net I'tl<br>Reserves Stk CUSS.)|-87.9|-218.1|*526.8|-501.2|-540.7|-433.7|-296.6|*111.8|
|Clnmonths inports)|-0.46|-1.12|-2.31|-2.43|-2.43|-2.03|-1.19|-0.40|
|_Change_in Ilt% Resrves Stk|49.2|-130.2|-308.6|25.6|-39.5|107.0|137.1|184.8|
|TotaLExternaL Debt**Ratio**|60.91|**62.21**|**63.21**|**70.31**|**73.51**|78.0x|**72.6**|**72.o0**|
|Pubtic Debt Ratio|**73.91**|78.01|**85.01**|**94.41**|102.31|108.91|106.71|108.51|
|**Memo:**<br>Residual PSIR|-532.4|109.4|27.8|65.9|**97.8**|122.2|149.0|**4SO.?**|
|External<br>Financing<br>Gap (USSm)|CS49.4)|80.0|819.8|s57.9|S67.9|S119.8|S136.9|S159.5|

- 1/ Includes aLl lnvestmn ts other than central government's. 2/ Historical fiscal data are from the IMF but GOP Cin denomfnator) Is from GOK. Itf IMFs GDP figure is used, Rev/GDP would be 23.31 in 1989, while Exp/GOP equals 30.41 The deffcit/GDP would then be 7.2 percent excludin **g** rants.

- 3/ Includes adjustments for flow-of-funds consistency. 4/ Goods and nonfactor services in historical accounts. 5/ Growth rates In 1989 are 10.11 and s.1 percent if the historical implicit trade deflators C1982u1D0) from the national accounts are used. The model calculates deftlators which are linked explfcitly to exchange rate movements and comeodity price movements (198a7100).

- 5/ Growth rates In 1989 are 10.11 and s.1 percent if the historical

- 6/ Ratio for 1989 exeludes adjustments for consistency with national accounts.

- 7/ Ratio for 1989 fncLudes an adjustment for consistency with national accounts.

- 8/ Publie expenditure contains an adjustment factor whfch Inftlates the residual pubife sector borrowing requirement (albeit without violating flow of funds consistency). The reason Is heuristic: the policy solutions can be more elearly illustrated.
-22 -

# Exchange Rate Solution

4.4 Table II shows that the external financing gap would be eiim;nated It the nominal exchange rate (K£/USS) depreciated from 1.215 in 1991 to 1.639 in 1993 and 1.976'in 1996. The depreciation would raise exports from 21.2 percent of GDP in 1991 (21.1 percent 3f GDP in the base projections) to 24.4 percent of GDP in 1996 (23.7 percent of GDP in the base projections). Imports adjust from 28.8 percent of GDP (28.9 percent of GDP in the base projections) in 1991 to 30.7 percent of GDP (31.4 percent in the base projections) in 1996.

**_4.5_** Although the exchange rate policy action targets the external financing gap, it affects other important variables. The residual public sector borrowing requirement averages -84.7 million Kenya pounds per year during 1991-96 compared with 152.2 million Kenya pounds before the exchange rate policy action (Figure One). This occurs even though the exchange rate action causes the fiscal deficit to deteriorate to **_S.5_** percent of GDP (excluding grants) in 1996 (5.2 percent of GDP, excluding grants, in the base projections) as the local currency cost of foreign debt service rises. The reduction in the residual public sector borrowing requirement occurs because the exchange rate action improves the net foreign assets position to - US$1.1 billion by 1996 (- US$0.1 billion in the base projections). Since Ml is not affected by this solution, the pool of domestic credit increases as the net foreign assets position improves. Since the private sector's demand for credit is not altered significantly by the exchange rate solution, the additional domestic credit created goes to the government and reduces the residual public sector borrowing requirement.
-23-

# TABU tt: Key _tditcartos_

# xchawge Rate Pot icy

....................

|,,<br>,,,,,,,,,,.,,,,,,,,,,|.............|P|rolected....|.................|.||
|---|---|---|---|---|---|---|
||1991|1992|199|1994|1995|1996|
|UDP(tp) Growth Rate|4.8J|5.03|5.X|6.02|6.3X|6.2|
|Invest. Growth Rate|5.4X|3.9X|8.2X|4.2X|8.32|7.82|
|Private<br>|4.02<br>|<br>7.23<br> <br>|7.ox<br>|7.92<br> <br>|78X<br>|8.0X<br>|
|Pubticinvestmet|_10.2X_|<br>6.7X|12.62|<br>-8.72|10.41|6.72|
|GOPper capitaGrowth<br>Rate|1.1|1.3X|_2.0X_|2.2X|2.73|2.72|
|<br>Conswptifn per capita grcoshrat|4.X|1.33|3.62|2.1X|3.1X|2.7X|
|GrossInvestment/UP|30.73|33.0%|34.42|37.02|37.32|38.92|
|Doamestfc Savings/GOP|23.1X|27.8x|27.92|32.9X|31.82|32.62|
|NaltialtSavings/GP|**_2.5X_**|<br>_26.4X_|26.52|31.42|30.7Z|31.62|
|Privatetnvestment/GOP|23.53|26.02|26.82|29.9X|30.02|31.4b|
|Consmptifa/GDP|60.72|55.02|55.92|51.82|<br>53.2%|<br>50.3%|
|<br>Prfvate Savfngs/DP|z2.7x|25.52|23.62|30.02|28.82|_29.5s_|
|<br>Private Resource Bata<br>COP|4.2X|_*0.5X_|-3.32X|<br>_O.X_|-1.2|-1,2X|
|Pubtfc<br>Investment/COP|7.2x|7.0x|7.6X|7.1X|7.3x<br>|7.62<br>|
|Pubic Savings/GOP|-5.ZX|0.9X|2.92|1.42|1.92|2.12|
|Government Revenue/U0P|19.80|26.72|27.12|24.33|24.1X|26.2%|
|Government Expenditure|32.33|32.7X|31.72|30.02|29.62|31.6X|
|Fiscalt Defict/UP|12.52X|<br>_6.0_|4.6X|5.72|5.52|5.35|
|Ffscal Deficit/GP<br>CInol Grants)|11.0X|3.7X|1.62|5.32|3.9z|5.02|
|Totat financing|l1.OX|3.72|1.62|5.3X|3.9X|5.0X|
|NLT Externml Financing|5.72|3.9X|4.62|3.72|3.42|3.8%|
|STExternal<br>Financfng|0.82|0.42X|<br>O.5|0.42|0.33|0.5X|
|<br>Domestec financing-ffnancitl<br>**_syats_**|5.92|2.72|4.82|3.42|4.42|4.7Z|
|<br> <br>Monetary Authority|4.92|2.32|3.82|3.2X|3.82|4.02|
|<br>Commrciat Banks|1.OX|0.4X|1.02|0.2|0.7X|0.7%|
|Ocm tic fInncing-prfvate<br>setor|3.1X|3.12|3.12|3.12|3.12|3.12|
|Residual|2.3X|2.42|4.42|4.12|5.3X|6.12|
|Adjustment to financing|-6.72|-8.7|15.7X|-9.42|-12.7%|-13.2X|
|Restexchange<br>rate index C198741003|89.93|79.61|77.32|68.01|69.10|66.44|
|<br>Rest Exchange Rate Deprecatfon|-4.42|-11.32|-2.92|-12.02|1.68|-3.82|
|_Nominat_exchangerate CKL/U35)|1.215|1.478|1.639|1.913|1.B9|1.976|
|Domestic Inflatfon|9.53|7.02|6.02|5.0X|<br>5.0X|5.0J|
|Nominal<br>(Oeposit)<br>InterestRats|14.72|11.82|10.6X|9.4X|9.42|9.4%|
|**Rest**DepositInterest**Rate**|4.82|4.52|4.3X|4.2Z|4.22|4.2X|
|<br>LoanRate|21.72|18.5X|17.1X|19.82|15.82|15.82|
|<br>**Reat**<br>Loan Rate|11.2X|10.7X|10.52|10.32|10.3X|10.32|
|Stock ofMI/GOP|17.72|17.62|17.32|17.0X|<br>16.52|15.9%|
|Stock of<br>uai-mney/GDP|11.42|11.22|108|10.52|10.12|9.72|
|stock of credit to private setor/UP|21.12|22.0X|22.92|24.32|25.42|26.62|
|Export Growth Rate|.4.32|-4.53|2.02|-0.22|7.62|5.52|
-24-

||1991|1992|1993|1994|1995|1996|
|---|---|---|---|---|---|---|
|Exports/GOP|21.2X|<br>22.2X|22.7X|24.12|23.9X|<br>24.42|
|InportGrowth Rate|S.6|-11.52|9.32|-10.12|13.0X|<br>6.52|
|Imports/GOP|28.82|2.42|29.2|ZaLIX|29.4x|30.7X|
|Curr. Acc. Oef. CUSS,inct.<br>grants)|636.6|362.3|424.4|428.6|470.3|681.S|
|Curr. Ace. Oef. (USS., exel. grants)|769.6|565.3|689.4|467.6|620.3|731.5|
|Curr. Ace. Oaf .GOP (axeL. grants)|8.22|6.62|7.92|5.62|6.62|7.32|
|Curr. Ace. D*f./GDP Cnet. giants)|6.8X|4.22|4.92|5.22|5.02|6.82|
|NetI'tl<br>Reserves Stk USSW)|-554.1|.613.5|-765.6|-880.9|-994.6|-1113.2|
|(Cn months Imports)|-2.47|-3.11|-3.61|-4.52|-4.33|-4.34|
|Change fn Pllt Reserves Stk|-336.0|-59.3|-152.2|-115.2|-113.7|-118.6|
|TotaL Extemal Debt Ratio|63.9X|72.72|76.22|83.32|77.22|76.72|
|Public Debt Ratio|85.92|97.72|106.72|117.22|115.62|<br>118.72|
|Memo:|||||||
|Residual PS5R CKLm)|-19.2|-64.1|.71.3|-192.7|-188.8|27.9|
|ExternaL Financig<br>Gap CUSSm)|SO.0|CSO.1)|<br>90.0|CS0.2)|S0.0|80.0|
# KENYA: FRAMEWORK FOR MACROECONOMIC ANALYSIS External Gap and Residual PSBR

Value <!-- Start of picture text --> 600<br>375-<br>150<br>-75-<br>-300 1991 1992 1993 1994 1995 1996<br><!-- End of picture text --> Years Base projections: ext. gap (US$m) gRR Base projections: residual PSBR (KLm) Residual PSBR after exchange rate action (KLm) Ext. gap after interest rate action (US$m) Figure One
26 -

# The Interest Rate Solution

4.6 The results of the interest rate policy action are<sup>presented in Table m.The real</sup> domestic loan interest rate which would eliminate<sup>the residual public sector borrowing</sup> requirement is 11.2 percent in 1991, 10.9 percent in 1993<sup>and 13.0 percent in 1996. The figures</sup> for the base projections are 11.2 percent, 10.5<sup>percent and 10.3 percent respectively. The kty</sup> adjusting variable is private investment which is<sup>23.3 percent of GDP in 1991, 25.9 percent of</sup> GDP in 1993 and 27.7 percent of GDP in 1996 (Table<sup>Im). In comparison, it is 23.3 percent of</sup> GDP in 1991, 26.2 percent of GDP in 1993<sup>and 30.0 percent of GDP in 1996 in the base</sup> projections (Table 1). Similarly, the stock of credit<sup>to the private sector in 1996 is 25.5 percent</sup> of GDP after interest rate policy action but<sup>is 26.1 percent of GDP in the base projections.</sup> 4.7 The interest rate policy action causes government expenditure<sup>to reach 31.6 percent of</sup> GDP in 1996 (31.4 percent in the base projections),<sup>reflecting higher interest payments and larger</sup> domestic debt. Since loan and deposits interest<sup>rates move in the same direction under this</sup> scenario, the policy action also affects the demand<sup>for currency, demand deposits and time</sup> deposits. Table m shows a marginal increase<sup>in the stock of MI and quasi-money in 1996 to</sup> 26.6 percent of GDP relative to 25.6 percent<sup>of GDP in the base projections. Since the policy</sup> action leaves domestic credit unchanged, the net<sup>foreign assets position worsens slightly from - -</sup> - US$111.8 million in 1996 in the base projections<sup>to - US$104.2 million after the interest rate</sup> policy action. In turn, the external financing gap rises<sup>marginally to US$161.8 million compared</sup> with US$159.5 million in the base projections (Figure<sup>One).</sup>
-27 -

TA3LB ItSS Key Indicators .......... ................. ,0

# Interest Rate Policy

....................

|--...<br>.-..<br>.-...||..<br>P|rojected....|................|||
|---|---|---|---|---|---|---|
||199|1992|199|1994|1995|199|
|GOP(mp) Growth**Rate**|4.IIX|5OX|5.83|6.0b|6&.3X|<br>6.23|
|tnvest.<br>GrowthRate|5.4X|3.93|7.53|**3.6X**|**6.6X**|4.61|
|Private|3.93|6.8|6.1X|6.7|5.73|4.1X|
|PublIc<br>invesmnt|10.4IX|<br>*9.7|12.53<br>|7.21|10.4X|6.6X<br>|
|GOP per capita Growth Rate|1.1X|1.3X|2LU|2.ZX|2.73|2.73|
|<br>Conswpton<br>per capita<br>growth rate|4.5X|1.4X|4.03|2.61|3.8X|3.81|
|Gross Investenwt/GOP|30.5X|32.2X|33.3X|34.8X|34.73|35.13|
|Damestfi Savings/GOP|Z.7X|26.4X|26.2|29.4$|27.93|27.43|
|9tfiol<br>Sav+in/GDP|22.1Z|25.2|Z5.0X|28.5X|27.21|26.93|
|Private<br>Investment/GOP|23.3X|25.3X|25.93|27.83|27.5|27.73|
|Coneusttion/GOP|_61.13_|56.3X|57.63|55.31|57.13|59.41|
|Private<br>Savings/COP|27.41|24.2X|22.03|o<br>26.X|25.33|24.91|
|Private<br>Resource Balance/GOP|4.13|-1.13|-3.9X|-1.01|-2.13|-2.7X|
|Public<br>Investment/GOP|r.2|6.93|7.52|7.03|7.23|7.43|
|Pubifc_Savings/GDP_|-5.2X|1.03|3.DX|1.5X|1.93|2.01|
|GovernmentReveCD/GOP|19.86|26.7X|<br>27.11|<br>24.3X|24.13|26.22|
|Goverrent<br>Expenditure|32.2X|32.53|31.6|29.8X|29.51|31.6X|
|Fiscat<br>efficit/GOP|12.4S|5.sx|4.53|5.5X|5.41|5.43|
|Fiscal Deffcit/GOP<br>(tmc Grants)|11.03|3.61|1.53|5.11|3.8X|5.0S|
|Total Financing|11.0X|3.6Z|1.53|5.11|3.8x|5.03|
|NLTExternal<br>Finncing|5.6X|3.77|4.4X|3.5X|3.23|3.6X|
|<br>ST External<br>financing|0.73|0.41|0.53|0.43|0.31|0.53|
|<br>Domestc financing-financial<br>syetem|5.61|1.86|3.Z|1.61|2.53|2.33|
|<br> <br>ne14tary<br>Authority|4.61|1.51|2.86|1.43|1.83|1.61|
|Conarcial<br>Banks|1.01|0.43|1.03|0.2X|0.73|0.73|
|Domestic financing-private<br>seator|3.13|3.11|3.13|3.13|3.13|3.13|
|<br>Residual|Z.2X|2.1X|3.9x|3.21|4.21|4.33|
|Adjustment to financing|-6.35|-7.5X|-14.11|-6.61|-9.43|-8.8%|
|Resl_exchange_rate<br>index_C1981o0o]_|90.91|82.39|80.12|72.68|7148|70.73|
|<br> <br>RealExchaneRate Depreciation|-3.3S|-9.41|-2.86|-9.33|1.13|-3.81|
|Nominal**exchangerate**CU L/USS)|1.202|1.428|1.581|1.790|1.7a2|1.856|
|<br>oamstic inflatfon|9.21|7.o0|6.03|5.03|5.0X|<br>5.03|
|mina l COepasit) Interest<br>Rate|14.6X|12.03|11.01|10.23|10.83|12.03|
|<br>Real Deposit Interest<br>Rate|**4.81**|4.73|4.7X|4.9X|S.X|6.73|
|<br>Loan**Rate**|218X|1863|1753|16.63|17.43|18a.7|
|<br>**Real**Loan Rate|.<br>11<br>.ZX|.<br>l.93|.<br>lo.9x|<br>11.11|<br>11.63|<br>13.03|
|Stock of M1/GOP|17.73|17.73|<br>17.41|<br>17.2X|<br>16.93|<br>16.73|
|<br>Stock of Guasf-money/GOP|11.43|<br>11.21|10.63|<br>10.53|10.23|<br>9.93|
|Stock of credit to private sector/GOP|21.03|21.93|22.73|23.8X|24.63|25.5S|
|Export Growth Rage|.3.61|-3.13|2.13|1.41|7.2x|5.46|
# - 28 -

|Exprtas/OP|1991<br>21.1t|1992<br>22.02|1993<br>22.4X|199<br>23.X|1995<br>23.3X|196<br>23.7X|
|---|---|---|---|---|---|---|
|taort<br>Grath<br>Rate|7.1X|-8.6|9.52|-6.3X|12.3X|<br>6.62|
|Imorts/GOP|28.9X|27.8|29.6X|28.8X|30.12|31.42|
|Curr.Acc. Def. CMs,<br>Mld.grants).|655.7|417.?|488.3|539.5|595.1|821.6|
|Curr.Ace.Otf.<br>(USM,6exel.grants)|78.7|620.7|73.3|578.5|745.1|871.6|
|Curr. Ace.D*f./GDPCexal. gornts)|8.4X|7.0|8.32|6.52|7.5s|8.22|
|Curr.Ace.Def./GOP (Inst.<br>grants)|6.9X|4.72|5.4|6.12|6.0X|7.72|
|**Net**I'tt<br>Rserves<br>StkCIUSM)|-S26.7|-501.1|-540.3|-432.3|-293.2|-104.2|
|(inmonths<br>aports)|-2.31|-2.43|-2.43|-2.03|-1.17|-0.37|
|Change in Iltt<br>Reseves<br>Stk|-308.6|25.7|-39.2|108.0|139.1|189.0|
|Total Extermt<br>Debt Ratfo|63.22|70.3|n73.52|78.02|_72.6_|72.02|
|Publle Debt Ratfo|84.92|94.42|102.12|108.52|106.02|107.12|
|Ne:|||||||
|Residuat<br>PSI<br>CKL.)|0.0|0.A|0.0|0.0|0.0|0.0|
|External<br>Ffnrclng<br>Cap (UP.)|119.8|158.0|S68.1|1120.3|1138.0|1161.8|
- 29 -

# Monetization

4.8 If the Government were to attempt to monetize the residual public sector borrowing requirement, given the level of private investment, domestic inflation would be 8.2 percent in 1996 after reaching levels of **8.1** percent in 1992 and 10.1 percent in 199 1(Table **IV)-** In the base projections, domestic inflation is 5.0 percent in 1994 and 1996, and 9.5 percent in 1991.

|..<br>.<br>**,:**<br>NTBe.:.t<br>.,:.:::.:.tiati<br>of..**t,es**<br>i<br>.<br>**ph**<br>**_.t_**<br>**sector**<br>'<br>..<br>Mem<br>-'.f-.:'**.**-.f<br>..` .<br>..**.**.- . ...<br>..|
|---|
|1991<br>1992<br>**t993**<br>**194**<br>**.199**<br>**1:996**|
|Simutation<br>ResuLts.<br>...<br>-|
|**PoQty**Target.-|
|**ResidL PSSR (KEin)**<br>**0.'**<br>**O.GXD.0**<br>**0**Ov<br>**4.**<br>05.......**2,& **<br>:.<br>.. .du:<br>:<br>-_O iR- .K M.:_<br>.<br>.<br>a|
|-Pot fcyrnsteument..<br>:<br>,|
|**cm: est1.C**<br>**tInfation(X):**<br>-<br>**.:11**<br>.-. t**.6.9**<br>**-5<**<br>**-5***<br>:S.a<br>iz|
|.<br>:;mry Adui<br>tJ4 V<br>taestX<br>.<br>.<br>**.Oe**.. i<br>**Stack**<br>**17:<**'F<br>**.6**<br>**1.4**<br>**:~.**<br>1:.'4.**16 0t7 IS{**fi$ 8v.5<br>~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~..'t<br>o<br>,<br>.". :<br>dX***.**<br>' C< ......<br>**0uasi-morey S3tockt.**<br>**A106**<br>**0Z**<br>**9&**<br>**91**<br>.::stock".<br>**oCre zt:**<br>Prfvate<br>or<br>**2**<br>**2.**<br>9<br>:<br>**.**<br>**23.5**<br>**2**<br>**25A**|

In the model higher inflation increases nominal values of the domestic interest rates, the exchange rate and GDP growth (at factor costs) but leaves their real values unchanged. In contrast, the demand for currency, demand deposits and quasi-deposits all fall as inflation rises, given a fixed real deposit interest rate and the fixed real growth of GDP at factor cost. Since higher inflation causes the stock of high powered money to fall as a share of GDP but leaves the net foreign assets position and government's demand for credit unchanged, the credit to the private sector must contract to maintain macroeconomic consistency. Indeed, Table IV shows the stock of credit to the private sector at 25.1 percent of GDP in 1996 compared with 26.1 percent of GDP in the base projections.
-30 -

# Joint Exchange Rate and **Interest** Rate **PoUcy Action**

4.9 Table V presents the key economic indicators when joint exchange rate and interest rate policy action is taken to eliminate a public sector borrowing requirement which is additional to an external financing gap. Exchange rate action retuces the residual public sector borrowing requirement compared to a situation in which no such action is taken (para. 4.5). In principle, the interest rate policy action also reduces the overall demand for credit in the economy relative to the base projections. From this perspective therefore, the required exchange rate adjustment would be expected to approximat that of the independent exchange rate policy solution while the required interest rate adjustment would be less than in the independent interest rate policy solution (Figure Two). These expectations are confirmed by the simulation results presented in Table V.

4.10 The required real domestic loan inerest rate is 11.1 perce' a 1991, 10.1 percent in 1993 and 8.3 percent in 1996. In comparison, it is 11.2 percent in 1991, 10.9 percent in 1993 and 13.0 percent in 1996 when only interest rate policy action is taken. The equilibrating interest rate is lower because the net foreign assets increase to - US$1119.4 million in i996 aoint exchange rate and interest rate action) compared with - US$104.2 million (mterest rate action only). Because the pool of domesdc credit increases when joint exchange rate and interest rate action are taken, more private investment can be accommodated for a given level of residual public sector borrowing. Thus, private investment is only 27.7 percent of GDP in 1996 when interest rate policy action is used (33.1 percent with joint policy action).
-31 -

TAILS VS Key tndieators ........ .............. .,.., Ixoange _wad Interest_ Rate PolICy .................................

|,, ,,,,,,....-<br>|,,,.,,,,,........<br>||P r<br>ed ...<br>|.................<br>|d..<br>......<br>|......<br>-<br>"Prol<br>|
|---|---|---|---|---|---|---|
||191|1992|193|19K|199S|1996|
|GOP(ap) Growth Rate<br>|4.82<br>|5.0X<br>|5.8X<br>|6.02<br>|6 3X<br>|6.2%<br>|
|Invest. Growth Rate<br>|5.52<br>|4.22<br>|8.72<br>|5.32<br>|9.92<br>|9.12<br>|
|Private<br>|4.12<br>|7.62<br>|7r.7<br>|9.22<br>|9.82<br>|9.62<br>|
|Public investment<br> <br>|10.22<br>|-6.72<br>|12.62<br>|_-8.6X_<br>|10.41<br>|6.71<br>|
|GOP per capita<br>rowth Rate<br>|1.1X<br>|1.32<br>|2.02<br>|2.2X<br>|2.72<br>|2.?X<br>|
|Conaurptifn per capita.growth r ate|4.4X|1.2X|3.12|1.82|2.62|2.2X|
|Gross Investment/GUP<br>|30.7X<br>|33.12<br>|34.?X<br>|37.7X<br>|38.52<br>|40.72<br>|
|Domestic Savings/GUP<br> <br>|23.12<br>|27.92<br>|28.2%<br>|33.6X<br>|33.02<br>|34.42<br>|
|lational<br>SavIngs/GP|22.5|26.51|26.82|52.02|31.82|33.32|
|Private tnvestment/UP<br>|23.52<br>|26.12<br>|27.12<br>|30.62<br>|31.22<br>|33.12<br>|
|Consuiption/GDP<br>|60.7X<br>|54.82<br>|55.62<br>|51.12<br>|51.92<br>|48.5X<br>|
|Privste Savings/UOP<br>|27.72<br>|25.52<br>|23.82<br>|30.52<br>|29.82<br>|31.02<br>|
|Private Resource Balanne/CP|4.22|-0.62|-3.32|0.02|-1.42|-2.12|
|PubtlcInvestmnUt/GOP<br>|_7.Z4_<br>|7.0o<br>|7.61<br>|7.12<br>|7.3x<br>|7.62<br>|
|PubLic Savings/GUP|-5.22|1.02|3.02|1.52|2.02|2.32|
|Government Revenue/UP<br>|19.82<br>|26.72<br>|27.12<br>|24.3X<br>|24.12<br>|26.22<br>|
|Govenrant Expendfture|32.32|32.62|31.7%|29.92|29.42|31.5X|
|Fifscal Deficit/GP<br>|12.52<br>|6.0X<br>|4.6X<br>|5.62<br>|5.32<br>|5.32<br>|
|FIscatDefifit/GDP(Inct Grants)|11.0X|3.62|1.52|1.2%|3.71|4.8%|
|Total Ffnancfng<br>|11.02<br>|3.6X<br>|1.52<br>|5.22<br>|3.71<br>|4.82<br>|
|NLTExternal Financfng|1.72|3.92|4.62|3.7X|3.t%|3.82|
|ST External Penancing|0.82|0.42|0.5%|0.41|0.32|O.5|
|Danmestic ffnancing-ff<br>fnaalsstom<br>|5.92<br>|2.72<br>|4.92<br>|3.7X<br>|4.82<br>|5.22<br>|
|Monetary Authority<br>.|4.92|2.32|3.92|3.42|4.1S|4.5%|
|Conmercfel Banks<br>|1.02<br>|0.42<br>|1.02<br>|0.21<br>|0.71<br>|0.7X<br>|
|Doamstfc ffnaning-prfvate owstor|3.1X|3.1%|3. W|3.1X|3.12|3.11|
|Residual<br>|2.32<br>|2.52<br> <br>|9.6X<br> <br>|4.52<br> <br>|6.22<br> <br>|7.22<br>|
|Adjustmn t to financing|-6.72|-8.92<br>|.16.1X<br>|-10.22<br>|-14.02<br>|-15.02|
|Real exchange rate Index t1987*1003|89.93<br>|79.62<br>|77.32<br> <br>|68.02<br> <br>|69.10<br><br>|66.44<br>|
|Real Exchange Rate Depreciatfon|-4.4Z<br>|-11.51|_-2.9%_<br>|-12.02<br>|1.6X<br> <br>|-3.82<br>|
|_Nominal_oxchwne rate CKL/USS)|1.215<br>|1.478<br>|1.639<br>|1.913<br>|1.896<br>|1.976|
|Domestic Inflatfin|9.5X|7.ox|6.02|5.0X|5.0X|5.02|
|ominafl (Deposit) Internet Rate|14.7X|11.72|10.2%|1.72|8.12|7.62|
|Real Dwosit Interest Rste|6.82|4.42|4.02|3.52|2.9X|2.32|
|Loan Rate|21.72|18.32|16.72|14.92|14.32|13.71|
|Rtes Loan Rate|11.11|10.6X|10.12|9.52|8.82|8.32|
|Stockz of Mi/UP|17.72|17.62|17.2%|16.82|16.12|15.32|
|Stock of Quas-monay/GDP<br>|11.42<br>|11.2X<br>|10.82<br>|10.42<br>|10.0<br>|9.52<br>|
|Stock of credft to private sector/UDP|21.12|22.02|22.9%|24.42|25.71|27.12|
|exportGrowth Rate|-4.32|.4.5X|2.02|-0.22|7.62|5.52|
_-32_ -

|**Exports/GOP**|1W1<br>21.2X|1992<br>22.2X|1993<br>22.7X|1994<br>24.1X|Sws<br>23.9X|1996<br> <br>24.4X|
|---|---|---|---|---|---|---|
|**lIport**Growth Rate|5.6X|-11.52|9.32|-10.12|13.02|6.52|
|Imports/GOP|28.82|27.42|29.2X|**5.1M**|29.42|30.72|
|**Curr.**Ace.Daf. CUSS.,rct.<br>grants)|769.6|565.8|690.4|470.6|625.8|740.2|
|Curr. Ace. Def. (USSm,**exet.**grants)|636.6|362.8|425.4|431.6|475.8|690.2|
|COrr.Ace.**Oe**<br>**_/ClDP_(anct.**<br>**grants)**|8.2X|6.62|7.9X|5.72|6.72|7.4X|
|Curr. Ace. Def./GDP texel. grants)|6.82|4.21|4.9X|5.2X|5.1X|6.92|
|**NetI'tL**ReservesStk (USSW)|-554.1|-613.3|-765.8|-881.5|-997.4|-1119.4|
|(In**onths**faports)|-2.47|-3.11|-3.61|-4.52|-4.34|-4.36|
|Change fn [lOt ReservesStk|-336.0|-59.2|-152.5|-115.7|-115.8.|122.1|
|Totat ExternalDebtRatio|63.92|72.7X|76.2X|83.32|77.22|76.i%|
|**Pubtic**Debt**Ratio**|8S.92|97.82|106.82|117.oX|116.32|119.82|
|1e:|||||||
|Residual PS8R**tKLM)**|0.0|0.0|0.0|0.0|0.0|0.0|
|EAternat<br>**Financing G**<br>Up<br>**tU)**|S0.0|0.0|(30.2)|(30.5)|(31.1)|tS1.8)|
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-34 -

# Joint Exchange Rate and Intereat Rate Policy Actiop and Monetization

4.11 The simulation results in Table VI are from joint exchange rate and interest<sup>rate policy</sup> action and monedzation of the residual public sector borrowing requirement.<sup>Viewed</sup> appropriately, this scenario is one of exchange rate and interest rate policy action<sup>when the</sup> domestic inflation target is not of primary concern. In &ict, under this scenario infladon<sup>is</sup> allowed to reach 8.5 percent in 1992 and _6.5_ percent in 1993 compared with 7.0 pecent<sup>and 6.0</sup> percent respectively in the base projections. Real domestic interest rates also behave differently: 11.1 percent in 1991, 9.7 percent In 1993 and 5.3 percent in 1996 when the exchange<sup>rate,</sup> interest rate and monetization are used; 11.2 percent in 1991, 1O.S percent in 1993<sup>and 10.3</sup> percent in the base projections; 11.2 percent in 1991, 10.9 percent in 1993 and 13.0 percent<sup>in</sup> 1996 when the interest rate is used alone; and 11.1 percent in 1991, 10.1 percent<sup>in 1993 and</sup> 8.3 percent in 1996 when joint exchange rate and interest rate policy action is taken (Figure Two). Clearly, the interest rates are lowest when all three policy options<sup>are activated</sup> simultaneously. Then private investment reaches 36.0 percent of GDP in 1996<sup>compared with</sup> 27.7 percent of GDP in 1996 when the interest rate policy is used aloae,<sup>and 33.1 percent when</sup> interest rate policy is supported by exchange rate policy action. In sum, the<sup>economy reaches</sup> a higher equilibrium path but experiences slightly higher inflation than all scenarios<sup>except when</sup> the fiscal deficit is monetized.

# Summary of Simulation Results

4.12 Para. 1.2 identified domestic macroeconomic imbalances as threats to recent<sup>economic</sup> and stabilization gains In Kenya. The prevailing threats arise,<sup>in part, from high fiscal deficits,</sup> monetary expansion and external shocks. The gains originated, in part,<sup>in adjustment programs</sup> which reduced the fiscal deficit and lowered its domestic financing, maintained positive<sup>real</sup> borrowing prudently. Other reforms in key sectors such as agriculture,<sup>industry and interest</sup>
- -35

# tASLE Vl: Key Indtceton

....... ............ , -.. ExchOnge **wa** Interest **Pace** Potliy

||.................|..........................<br>eNd M<br>................|oneStzat|an|||
|---|---|---|---|---|---|---|
|...............................|.**.....**...<br>|.......<br>P<br>|...<br>rojected...<br>|...............<br>|........<br>||
||1991|1992|1993|1994|1995|**1996**|
|GOP(wp)<br>Growth Rate|4.81|4.91|5.82|6.01|6.3S|6.ZX|
|Invest.<br>Growth<br>Rats|**5.31**|4.2X|9.41|5.43|<br>12.01|12.61|
|Private|4.1X|7.81|8.62|10.61|12.41|13.91|
|Pubtic Investment|10.21|<br>-7.31|<br>12.31|<br>-9.1X|<br>10.2S|<br>6.91|
|GOPper capita<br>Growth<br>Rate|1.1X|1.2X|2.11|2.21|2.7X|2.71|
|Consumpcian<br>per coplu growth<br>rate|4.4X|1.0X|3.31|1.3X|1.81|0.8X|
|Grosa Investment/COP|30.71|33.0X|34.9X|**38.82**|39.8S|43.4a|
|Oomestic<br>savings/COP|23.1X|27.81|28.41|34.11|34.31|37.01|
|National S5vings/cOP|22.51|26.31|27.0S|32.31|33.11|35.81|
|Private Investm nt/GOP|23.51|26.11|27.4X|31.21|32.61|36.01|
|Consumption/GDP|60.71|55.11|55.71|51.01|51.11|46.31|
|<br>Prfvate Savings/GOP|27.7X|25.63|23.81|30.61|30.4X|<br>32.81|
|Private<br>Reource<br>Baltae*/GOP|4.21|-0.61|-3.61|-0.61|-2.2%|-3.21|
|Pubtictnvestment/GOP|7.21|6.91|7.51|7.01|7.21|7.41|
|Pubtle Savings/GOP|-5.21|<br>_0.91_|3.2t|1.81|2.61|3.0X|
|Gcvernment Revenue/COP|19.8X|26.53|27.01|24.2X|24.11|26.11|
|Govenernt<br>Expenditure|32.31|32.51|31.31|29.41|28.71|30.61|
|Fiscat OeffcVt/GDP|12.5|6.0X|4.31|5.2Z|4.6o|4.46|
|Fiscal Deicit/GOP trtnt Grants)|11.01|<br>3.71|1.31|4.71|3.01|3.91|
|TotaL Ffinacing|11.01|<br>3.71|1.31|4.7T|3.01|3.91|
|MLT Extemnal Financing|5.72|<br>3.9'|4.61|3.71|3.31|3.81|
|<br>ST ExternaL Financing|0.81|<br>0.4X|0.S|0.41|0.31|0.51|
|Domestic tfnancing-financiat<br>ysctm|5.91|<br>2.8t|5.11|3.91|5.31|<br>6.1X|
|Monetary Authority|4.91|<br>2.4X|4.11|3.71|4.61|5.41|
|Cemerciat<br>Banks|1.01|0.41|1.01|0.21|0.72|0.71|
|Oemstfic*inacing-prvatce<br>sector|3.11|3.11|3.11|3.1X|3.11|3.11|
|<br>Residual|2.31|2.61|4.9X|5.21|7.82|9.3%|
|Adjustmen'. to financfng|-6.71|_-9.11_|-16.8S|-11.51|-16.31|-18.91|
|Restexchange**rate**fndex n1987r1002|89.93|79.97|77.41|68..1|69.40|66.80|
|<br>Real Exchange Rate Depreciation|-4.41|-I1.11|<br>-3.2X|-11.61|1.bX|<br>-3.7?|
|Nominel<br>exchange<br>rate CtL/U5 )|1.215|1.492|1.668|1.956|1.941|2.021|
|<br> <br>Domestic<br>_Inftacion_|9.51|8.51|6.31|6.01|5.01|5.01|
|Noaminat<br>(Deposft) Interest**Rate**|14.71|<br>13.11|10.41|8.91|6.51|<br>4.7X|
|<br>Reat Oeposit<br>Interest<br>Rate|4.81|<br>4.3X|<br>3.61|<br>2.71|<br>1.41|<br>-0.31|
|<br>Loan Rate|21.71|<br>19.91|16.81|15.2X|12.51|10.51|
|Resl Loan Rate|11.11|10.5X|9.71|8.61|7.11|5.32|
|SCock_.a*_<br>MI/GOP|17.7X|17.3X|16.81|16.1X|15.21|14.0X|
|Stock of auwsl-morteyC/OP|11.4X|11.01|10.61|10.11|<br>9.51|<br>8.81|
|<br>Stock of credft to prfvate<br>sectoe/GDP|<br>21.11|21.81|22.71|24.11|25.61|<br>27.41|
-36-

||1991|1992|1993|1994|1995|1996|
|---|---|---|---|---|---|---|
|Export GrowthRate|-4.31|-4.1X|2.0Z|0.4%|<br>7.6X|<br>5.61|
|Exparras/P|.<br>21.21|22.3X|22.81|24.21|<br>24.01|<br>24.5X|
|lRport Growth Rate|5.61|-11.2X|9.2|-9.6X|12.9X|<br>6.81|
|eportas/GDP|2Z.8X|<br>27.5X|29.31|23.31|29.6X|<br>30.91|
|Curr. Ace. Ocf. CUSS.<br>lncl. grants)|636.6|364.1|423.s|438.0|486.8|714.8|
|Curr.Ace._Oot. Cln_USS,cxcl. grants)|769.6|567.1|693.|47r.o|436.8|764.8|
|Curr. Ace. Dcf./GDP (out.<br>grants)|8.21|6.61|7.91|5.71|6.81|7.61|
|Curr. Ace. D*t./GDP (tntl.<br>grans)|6.81|4.21|4.91|5.2X|5.21|7.11|
|Net l'tl<br>Reseves Stk(USS.)|-554.1|.614.0|-769.6|-889.2|-1010.6|-1131.8|
|(in months fwports)|-2.47|-3.10|*3.61|-4.52|-4.36|*4.37|
|Change fn I1t1Reserves Stk|-336.0|-59.9|-155.6|-119.6|-121.4|-121.2|
|TotalExternal Debt_Ratfo_|63.9X|72.51|76.11|82.91|76.91|76.31|
|Piubtl<br>DebtRatio|85.9X|97.4X|106.6X|117.0X|<br>116.3X|<br>120.6X|
|Memo:|||||||
|Residual PS8R (M)|0.0|0.0|0.0|0.0|0.0|0.0|
|Externat Finamcing Cap CUSS.)|30.0|(SO.1)|CSO.4)|CS1.2)|<br>(M2.6)|30.0|
- 37.-

interest rates, adopted an appropriate exchange rate policy, and generally managed<sup>exenal</sup> finance have begun to remove structural constaints and to foster an eninm<sup>ent which Is more</sup> conducive to efficient resource use.

4.13 Ihe simulations discussed in paras. 4.24.12 sugges **t** hat exchange rate, interest<sup>rate and</sup> fiscal policy have an important role to play in managing future macroeconomic<sup>imbalances in</sup> Kenya. A _5_ percent devaluation of the real exchange rate appears to reduce<sup>the current deficit</sup> by about one percent of GDP. However, it also appears to have a negative impact<sup>on the fiscal</sup> deficit Likewise, in a constrained credit envivonment, every one percentage<sup>point (of GDP)</sup> increase in domestic borrowing to finance the iscal deficit appears to increase<sup>the real domestic</sup> loan rate by around 0.5 percentage points. However, the required increase<sup>in the real domestic</sup> interest rate falls as domestic inflation rises.

4.14 In summary, the simulation **s** uggest the need for joint exchange rate<sup>and interest rate</sup> flexibility in managing the macroeconomic imbalances in Kenya. More important perhaps, aggressive exchange rate action is necessary if the economy is o reduce<sup>its dependence on</sup> foreign savings. On the fiscal front, greater discipline is warranted since it<sup>would reduce the</sup> public sector borrowing requirement, lower the equilibrium real interest rate<sup>and accommodate</sup> a higher level of investment in the private secmr.

# V. Limitations and Future Extensions

_5.1_ The model is only as useful as the accuracy of the response functions. The coefficients used in the simulations reported in Chapter IV are based on our econometric<sup>analysis using</sup> Kenyan data (import elasticities, the demand for financial assets), the econometric studies of other
-38 -

researchers on Kenya and comparable economies, and judgment based on casual empiricism (export elasticities, private investment elasticities). But the most sophisticated quantiative techniques are still guty of projecdng the future on the basis of past behavior. nhis approach is particularly uncomfortable because current adjustment policies in Kenya are changing,.however slowly, the macroeconomic Incentives and the scope for responding to them. Estimates of import eldasticities deal with these changing circumstances explicitly. As observation points become available, this would need to be done especially for exports and private investment.

_S.2_ The interest rate and exchange rate adjustments required for solving the model are cumulative. That is, the adjustment required in any given year is based on the interest rate and exchange rate level in the previous year and not to some fixed point in the past. In contrast, the gaps are dealt with annually, not cumulatively. As a result, the adjustments in the policy variables could be large fxom year to year if the gaps exhibit large annual fluctuations. For example, to finance a large public sector borrowing requirement in a given year, the model may produce a large increase in the real domestic loan interest rate. Because interest rate adjustments are cumulative, the real interest rate may actually fall or even become negadve in the next year If the public sector borrowing requirement is small. The economic logic of this solution is that the previous year's high real interest rate must fall if private sector investment is to absorb the additional domestic credit which is no longer required to finance the public sector. Similar results obtain for the exchange rate when there are large fluctuations in the external gap. Such drastic adjustments in policy variables from year to year are not likely to occur in practice. Still, this is not a problem for the model to deal with as much as a signal about how to frame the policy questions and interpret the policy solutions. When the gaps fluctuate widely from year to year, it may be appropriate to ask the model to solve for the average annual gap over the period. Another approach would be to treat the solution for the largest annual gap as an indication of the upper limit of the policy adjustnents needed during the projection period.
- -39

5.3 Ihe model treats the residual<sup>public sector borrowing requirement and the external</sup> fundlg gap as mutually exclusive<sup>and independen. This simplifies the exposition of the model.</sup> However, the residual public sector<sup>borrowing requirement may be a component of the external</sup> financing requirement. Under<sup>this scenario, closure of the exteral gap would amount to</sup> elimination of the public sector<sup>borrowing requirement. Reality is somewhere between the two</sup> extremes, one in which the extenal<sup>gap includes the residual public sector borrowing requirement</sup> and the other in which they are<sup>completely independent. To capture this reality, a simple</sup> specification would be required<sup>to indicate the relationship between the public sector borrowing</sup> requirement and the external<sup>financing gap. The model could then solve for the interest rate</sup> and/or the exchange rate<sup>which closes the net gap.</sup>

**_5.4_** Recent economic work on Kenya<sup>recognizes the need for data on the consolidated public</sup> sector but this information<sup>is only just being gathered and coUated by the Central Government</sup> In time, this data should be<sup>used to extend the coverage of the public sector accounts in the</sup> model. Parastatal imports also need<sup>to be disaggregated from private imports and a more reliable</sup> series on government imports<sup>obtained. As progress is made in public sector investment</sup> programming, the recurrent<sup>expenditure implications of capital outlays should also be captured</sup> explicitly.

5.5 With relatively few modifications,<sup>the model could endogenize economic growth (at</sup> factor cost). At this stage<sup>however, it may be more rewarding to concentrate on refining the</sup> response functions and to widening<sup>the coverage of the public sector finances. Econometric</sup> work should also be done on<sup>the income and price elasticities of exports, the interest elasticity</sup> of private investment and the behavior<sup>of private consumpdon.</sup>
**-40-**

# ANNEX I

# **DESCRIPTION OF MODEL**

# Overview

1. The model comprises six data input worksheets, a debt module for pipeline and new external debt, and output tables. There is also one central worksheet wh contains key behavioral assumptions and macroeconomic targets.

7782. The data input worksheets are similar in fornat, units of account and coverage to standard tables produced by the Government. These input worksheets are: (a) Original Data: CB (b) Original Data: BOP (c) Original Data: Fiscal Data (FY) (d) Original Data: DRS (e) Original Data: National Accounts (t) Original Data: Trade (GOK) (GOK) (GOK & IM) (World Bank) (GOK) (GOK) 3. The debt module comprises two files which are separate from the central model, the first file is analogous to the Input Debt file for the LOTUS-based RMSM. Historical data are entered in millions of US dollars. Medium and long-term debt is subdivided into multilateral and bilateral donors and financial markets, including commercial banks and suppliers credits. The standard definitions of the World Bank's debtor reporting system are used. The second file is analogous to the Debt file of the LOTUS-based RMSM. Projected commitment of loans together with their termsinterest rate, maturity, grace period and disbursement profie-and grants are entered individually or by donor ty,e. The module calculates annual disbursements and debt service of ihe projected commitments and aggregates them by donor types in a manner which is consistent with the pipeline data. It also aggregates the projected debt variables with the historical pipeline data. A building block is then used to import this combined pipeline and projected debt data into the central model.

# 4. There are eleven output tables covering:

- (a) National Accounts (percentage of GDP) (b) National Accounts in Constant Prices (c) Private Sector Account (d) Balance of Payments (e) Fiscal Accounts (f) Financeable Fiscal Deficit (g) Monetary Survey (h) Monetary Authority Accounts (i) Commercial Bank Accounts (j) External Debt (k) Flow of Funds Consistency Check

Most variables in the output tables, apart from growth rates, are expressed as percentages of GDP at market prices but could be easily expressed in levels. These levels would generally be denominated
- 41 -

in million of Kenya pounds, with the exception of balance of payments data which are in million of US dollars. The model produces a flow of funds consistency output table. The sectoral aggregates in these tables allow easy inspection of the consistency between the capital and current sources and uses of funds in the central government, the balance of payments, the monetary sector-disaggregated into the monetary authority and commerical banks-the national accounts, and the prvate sector. The key flow-of-funds identities and the projection rules for the important variables are summarized in Table 1.

# Inputting Historical Data

5. For convenience, the input worksheets closely resemble the format and presentation of data by the key data-generating government agencies. Information on banking comes from the Central Bank's Quarterly Economic Review and is expressed in millions of shillings as in the original source. Assets and liabilities are disaggregated and entered separately for the central bank, the monetary authority, commercial banks and the monetry survey. The model checks for intemal consistency across these historical accounts and adjusts other liabilities" when there are imbalances in individual accounts. A more difficult problem arises when the inconsistencies are found between the monetary survey and its components, the accounts of the monetary authority and the commercial banks. The rule of thumb used is to treat the monetary survey as accurate and adjust "other liabilities" of the monetary authority if the source of the discrepancy is not obvious.

6. The source of the balance of payments data, in millions of Kenya shillings, is the Balance of Payments (BOP) Unit within the Ministry of Finance. The format and sequence of data items are identical to the standard table generated by this government agency. For ease of comparison with other data sources, the worksheet routinely produces a table in millions of US dollars which is identical to the original input table in all other respects.

7. Data on stocks of medium and long-term and short-term external debt come from the DRS system of the World Bank and accords with that system's nomenclature and definitions. DRS is also the source of historical data on debt disbursements, IMF purchases, and interest and amortization payments. Information on grants comes from the BOP Unit of the Ministry of Finance.

8. The fiscal data input worksheet is a composite of standard tables produced by the IMF and is designated in millions of kenya pounds in fiscal years (July to June). Only data on central government finances are currently available. Sources of revenue are identified in a way which allows easy transcription of data from the standard data sources and allows revenue projections to respond to policy simulations. For similar reasons, recurrent expenditure is subdivided into wages and salaries, other goods and services, interest payments on foreign and domestic debt, etc. Fiscal data is converted from fiscal to calendar year, on the recommendation of the Budget Department of the Ministry of Finance, by using a factor of .351.65. For example, government expenditure in 1990 would comprise 35 percent of the expenditure in FY1989/90 and 65 percent of the expenditure in FY 1990/91.

9. The national accounts data cover gross national product by expenditure and are entered in millions of current Kenya pounds. The source of this information is the Central Bureau of Staistcs of the Government of Kenya. A memo item, showing the breakdown of GDP at factor cost by sector-agriculture, mining, manufacturing, other industry, services-is also compiled from this source and serves as the base year data for projecting GDP growth at factor cost. This breakdown replicates the categories from the national accounts section of the LOTUS-based RMSM, to which many analysts have become accustomed.
<!-- Start of picture text --> TABLE I OENAVIU. -eJATIUSUIP<br><!-- End of picture text -->

# FUol Of mm-DS IDENITY

# **Denvd** for Selected **Ffafact Iawssets**

<!-- Start of picture text --> 3<br>Nd,. I C~16.s1j).C1 t ea).C(g*fc).(t+ * @-.(i))1 aa.(r.)).Cl<br>k-1<br><!-- End of picture text --> where:

- as - stock of currency a - stock of deman **d** eposits

- a, - stock of _quasi money_ (time deposits)

- gdpfc - real GDP (at factor cost) growth

- rd - growth rate of real daomstic deposit rate I - domestic inflation k - 1987* 198B, 1989 a - coefficients

<!-- Start of picture text --> Central fInuEAs<br>levi<br>3<br>I Id<br>k-I<br>Td _ _. GDPfc,<br>3<br>L<br>GDPfc ,<br>k-i<br>ujhere:<br>Td - direct taxes<br><!-- End of picture text -->

- TOTNOCapS a goL * _Ni_ * G TOTNonetpa a Lcg t Ldg t Lp .NFA where:

- TOTHonCepS - swietary survey: total capital sources of funds

- TOTNmeapU monetary survey: total capital uses of fiAsi

- Nol - flow of other liabilities (net) "I flow of currency and demand deposits

- ON - flow of qas-mey (tim deposits) Lcg - flo of net credit from the central bank to the govermmnt

- Lds flow of net lendino frm cinwrcula banks to the govrmnt

- Lap - flow of net credit to the private setor

- UFA - flow of net foreign assts

Cntral nnnt Gow_ement Flnce

- lOTGoiCapS - Sg Lce g dg + Notg Lfg + Lsf*

- TOGovCapU - 19 Lgp TOTGovCurS l Td + Othrm-Sihg TOTGoVCurt - Cg + Tp * lNgp * Ilgf * Sg. llsgf

# ibere:

TOTGOvCa46 - Central gwneruent: total sources of capital funds TOTGovCapU - Central goveranent: total uses of capital ftwds
_TA81E I_ CodT D **wuvEUAVIAL EELATIINSUP** FLOW **OF MNS IDENTITY**

# roernot finences cont'd

## **Central**

<!-- Start of picture text --> 3<br>I Ti ,<br>Tic Sector,<br>3<br>Y. Setor ^<br>k-i<br><!-- End of picture text -->

# **Central** CoveIvaet Finnces cont'd

- **Sg** - current balence Xotg flow of other lisbilities (net) of monetary sector to central goveriment

- Lpg flow of net lending by private sector to central governmont

- Lfg - floa of medi and long term external borrowing (not) (NLT)

- Lsff taflow of external short-term borrowing (net)

- l gross Investnt Lgp - flow of net lending by central govenMent to private sector.

sAere:

- n (t - 5) - correspond to the five min categories of indirect taxes: sales taxes on domestic anufactures, sales taxes on Iqports, datles

- on imports, dutles on exports, and other indirect taxes

- Sector - refers to activity shich generates the taxes

OthrR 1 other governnent revemues Subsg susidies Co central governmnt consumption - Tgp goverrnent transfers - Nga.Ngp interest on dmoestic borrowing Hof - Interest on NLT foreign debt lsgf Interest on short-term forefgn de't <!-- Start of picture text --> 3<br>E wt<br>k-i<br>CApr, _ _ . GDPfc,<br>3<br>I GDPfc 4",<br>k-i<br><!-- End of picture text --> where: CAPr - capital reverne I/ Includescapia ve.
# TAILE I CfTfD ENAIm AL REIATIOU8UIP

Central CovenwMt Ffnwices cont$d Recurrent expaiitsure:

> * V,. wugr

k-I Gds, * . U, 3

**k-1**

where: V waes aN salwies war Gd9S - goods nd services wages and salaries: nominal growth rate target k - 197, 198. 1t89 Int 9 DCD6g#. r I OthREX.. k-I OthiEX, u _ _ _ _ __ _ _ DPIc, 3 I SPfc 5 k-I , where: Into - Interest on debt outstanding and disbursed (foreign DoDg - or domestic Governrent debt outstanding depending on specification of k) and disbursed othREX, - Other recurrent empenditure k - 187, 1988, 1989
TIJ **I** £T1AVWAI D Ilt I &C OF **fUWS IDEIITIIY**

**Central Ginnut** FInenes ant'd

capitat **EDpwituwe** 3 I **k-I leg,** 3 _ _ _ _ INPg,_ **3** I IIPO.. **k-I** where: lcg - capital expenditure of the central governmt IlPg - goverment lworts k 1 1987. 1988, 1989

# 3ialncef PaI

9 Expt I geq ., tl + 4 gdpfc,).t1 **+** a.pd.) **k-i** lapt w I (~l ti + , gcltc).(l + a-.p4) where: exp - 9 categories of exports: coffee, tea, horticulture, petroleus, mile, mmafacturlng, re-exports, other goods, non-factor services Pd - domestic commodity price

|Ut<br>of**Pe**|**mnt**||
|---|---|---|
|TOTOPCpS<br>|a<br>|_NFA_+Sf<br> <br> <br> <br>|
|TOTOPCaIU|<br>a|Lfg<br>+Lsfg<br>+Lfc+Ifd<br>+<br>Lfp+DFI+Lsfp+Kne|
|TOTBOPCur<br>TOTBoPCurU|Sa<br>|Mfg+Vf.Vpf<br>Iap<br>lsfpI+<br>m<br>Ine+Prof+Yrgf<br>-RC<br>*Tfp .Ip+Sf+_IFA_|
|where:|||
|Sf<br>Lfgt<br>Lsfg|-|current<br>account<br>balance<br>net overn<br>ent<br>capital '(NIt)<br>~~~~net<br>boverneent short-term|

/ Ltfg and Mfg are computed In the debt module using available Information on old and new comitments, and their terms. Standard for utae are used.
> TAsLE ~ ~ ~ ~ ~ IIIAElMYIT ~ ~ ~ ~ ~ ~ ~~~~~~~~~~Fl

OFTe RUSStIU Bale **of** Pnts cmtSd

- _1E_ - 8 categories of iprts: food, petroleun, other cnsumption goods, primary Intermediate goods, mafacturfng Intermediate goods, capital goods, non-factor services.

3 I _DFI0_ OFI, (Lfe*Lfp), a I (Lfgttfpl.

here: k - 1987. 1988. 1989

# Bulymie of ha -gnts cntd

|Lfe<br>Lfd|-<br>.|foreign borrowing by the<br>central<br>beatn 03<br>foreignborrorn<br>by the<br>ccmerclat<br>bssks (net)|
|---|---|---|
|Lfp<br>DFI|-<br>-|<br> <br>foreign<br>borrecng<br>bythe<br>private non-finwnclet<br>sector<br>(net)<br>not directforeign<br>investment|
|Lsfp|-|short-termcapital<br>inflows toprivet<br>sector|
|Kel||netcapital<br>notelsere<br>ircluded|
||-|**I**fg<br>nterest<br>on Lfg|
|NsllUpf<br>Isfp<br>Esgf<br>|-<br>-<br>-|interest<br>an foreian borrwing<br>by central<br>_bank_an<br>**cecrclat**<br>**bait**<br>Intereston**Lsfp**<br>Interestan short-tem<br>foreign<br>debt<br>|
|11Wi<br>Prof||interton Knol<br>reittances<br>of profits<br>nddividends|
|C<br>Utp<br>Sf<br>UFA|-<br>-<br>-|rsrce<br>balat<br>trfer<br>to the private sector<br>current<br>ecountbal<br>Interestan NFA|

NMIin

**K=S**

gi4ifc, a gifc, I gdf .(1 . kgr) kIl GDPx% a 0Pfc , Ti - Subg TOTIApS a l *Ip TOTUCFaI a so + Sp; Sf TOTIUCuarS * C + l + Cp. Ip - o TOTUACurU a GDPfc Ti -abg OODg, Lsfp, Lsfg, Prof and Tfp are projected in a similar way.
> .JTA [IfO

uLAT IlP FLOWF FLW O RDS gm tpeII _Redl_ *M cont'd

# al Ac

Ip, Ip,1-C 1 a$.gtcfl.(1 e e,.(r 1 ) where: kgr - refers to growth rate of real value added In the k sector: agriculture, mining, manufacturing. other industries, services.

- gtWfe real growth of iDPfc GDPsp 0P at market prices

TOTUACpS - ational acccnts: capital sxurce of funds TOTCI - natinal accosuts: capital ues of fus TOTNAurS nat onal accounts: current sources of ftun TOTNACuIrU national acosuts: awrrent uses of ud where: 19 - total pltlic Investment - Ip total private investment Sp - private sector savings Cp private censu ptfon mm:

1. Cp. private consumptfon, is the balancing Item In the national accounts.

2. ProJections of export and isport prices. including the maeufacturing Index, and LIBOR are Macroeconomic Indicators, international taken from the Plwning Assuspti4um for Kajor Economic Analysis and Prospests Division, International Economics Departent, irid Bank.

4/ includes increases in stocks.
- 48 -

10. Trade data come from the BOP Unit of the Ministry of Finance. Because<sup>this data comes</sup> from the same source as the balance of payments figures,<sup>they are expected to be consistent. The</sup> trade table provides information on major items in the merchandise<sup>account, including export earnings</sup> of coffee, tea, petroleum, horticulture and manufactured goods as well as<sup>imports of</sup> food, petroleum, primary intermediate goods, manufacturing intermediate<sup>g&. Is and capital goods.</sup> These items serve as the basis for projecting the trade account.

11. Apart from ensuring that columns add up correctly, the model checks for consistency<sup>between</sup> stocks and flows within given worksheets, and identifies inconsistencies aross data input<sup>sheets. For</sup> example, it checks for consistency between the capital flows implied by the<sup>DRS debt data, the</sup> balance of payments, the fiscal accounts and the monetary accounts, and calculates<sup>the adjustments</sup> which are required for consistency between capital and current sources<sup>and uses of funds. Similar</sup> calculations are done after trade data in the nadonal accounts are compared<sup>with the figures in the</sup> balance of payments. Because the national accounts are viewed as the 'umbrella,'<sup>the rule of thumb</sup> is to identify those adjustments which make the input tables internally consistent, reconcile stocks with flows and achieve intersectoral consistency in relation to the national accounts.<sup>The model</sup> specifies these adjustments explicitly.

# Updating Historical Data

12. The model has been designed so that in general, historical data entered<sup>in the data input</sup> worksheets automatically override projected data. The task of updating the model is simply<sup>one of</sup> entering the most recent year's data in the appropriate data entry worksheet.<sup>For example, the</sup> national accounts projected by the model for 1990 could be replaced by the actuals for 1990 when they are entered in the national accounts data entry worksheet. If similar<sup>data is not available</sup> for monetary aggregates or other sectors, the model would continue to apply the<sup>projection rules for</sup> years (including 1990) for which historical data are available. However, the projections<sup>would now</sup> be consistent with national accounts information for 1990.

13. Exceptions to this simple rule for updating the model are projected variables<sup>which use</sup> historical input data for explicidy specified years Mn are programmed to<sup>apply from a given starting</sup> date. Many of these formulae and their calculated variables are time-bound<sup>to avoid simultaneity</sup> which JAVELIN is unable to handle or to anchor the base year of an<sup>index.</sup><sup>_Thetime-bound_</sup> _formulae are presented in Annex V._

# Programming Information

14. The model is programmed in JAVELIN, a spreadsheet and database<sup>management software</sup> package. The program solves the model recursively, subject to the convergence<sup>criteria which the</sup> user of the model could change easily. The solutions reported in this paper<sup>satisfy the criterion of</sup> falling within -5 and 5 units of the target.

15. A 'macro' has been written for each of the solutions discussed<sup>in Chapters mand IV:</sup> exchange rate solution, interest rate solution, monetization, exchange<sup>rate and interest rate solution,</sup> and the exchange rate, interest rate and monetization solution. Each<sup>of these macros operates</sup> sequendally from 1990 through 1996. For flexibility, additional macros<sup>have been written which</sup> activate each of the foregoing solutions one year at a time.
> - 49 -

ANNEXII

# FISCAL DEFICITS AND MACROECONOMIC CONSISTENCY

# A. Introduction

1. Fiscal deficits could be financed through external borrowing, domestic borrowing or/and monetization, that is, creation of base money. Each of these optiom as important macroeconomic consequences. The most frequently discussed of these consequences in applied macroeconomic analysis is the crowding out of private investment which could occur if the budget is financed through domestic borrowing. Often reference is also made to the potential inflationary effect of monetizing the deficit. By this is usually meant the potential impact of increasing the money supply on the demand for goods and services. However, at a given level of output, an increase in the money supply would only raise inflation if it exceeds what individuals would normally hold, other things being equal. Similarly, at a given level of inflation, a money supply increase would only be "excessive' if it exceeds what individuals would normally hold as output increases, other things being equal. Accordingly, the level of inflation and the demand for financial assets limit the extent to which the fiscal deficit can be financed through monetization. One corollary is that there may be a unique "financeable fiscal" deficit which is consistent with a macroeconomic policy package which sets targets for inflation, external borrowing, domestic borrowing and output growth.

2. This Annex explores this issue in the context of Kenya. It uses a simple framework which links the financing of fiscal deficit to domestic borrowing, the interest rate, the inflation rate, output growth rate and the real exchange rate. This approach draws on the methodology developed by Anand and van Wijnbergen (1989) and Catsambas and Pigato (1989) but includes disaggregated behavioral equations for money demand.

3. The' Annex begins by reviewing definitions of the budget and then selects the onerationA concept as the one most suited for determining the financeable deficit. Next, a budget constraint is specified and manipulated to obtain an accoundng idendty which includes money creation, inflation and borrowing. Tbe specification also captures the role of the inflation tax and seignorage in deficit financing. Linkages are then made to selected policy targets, the behavior of money demand and the conditions for consistency between fiscal imbalances and selected macroeconomic objectives.

4. After sketching and discussing the integrated framework, the section assembles data from Chapter 3 to evaluate the consistency of fiscal performance with other macroeconomic parameters.

# B. The Budget Constraint and Macroeconomic Targets

_5._ The operational, primary and cash deficits are three measures of fiscal imbalance. The oerational deficit is expressed in real terms and excludes the inflation component of interest payments by the government. The rationale for using real values is the view that interest payments by the government may contain an inflation premium which is not regarded as income by the recipients but as a restoration of inflation-induced capital losses. In consequence, the inflation component of interest receipts would not be spent, at least not fully, and therefore would not (fully) translate into a claim on resources. The primary budget goes a step further and focuses on the noninterest component of the budgetary accounts. Hence, this concept is useful for analyzing the impact of curren fiscal policy on aggregate demand, since the interest paid on debt is only the result of ps
so.

fiscal policies. **_£_** Finally, there is the cash or observed deficit which is pacticularly useful when tracing the movement of financial resources between the central government and the rest of the er.onomy. 'The view is now widely held that the ogeradjonalg deficit best reflects the abso.pdion of real resources by a government, and thus is the most appropriate measure of fiscal plicy within the famework of stabilization and adjustment." # 6. The analysis which follows Is anchored in the govemnment budget identity which acknowledges that the sum of the real non-interest defcit (d), including the real inerest due on domestic debt (ib) and foreign debt ([be), is equal to the sum of financing from all soum es. Financing could take the form of real external debt (b'), domestic debt (b) or central bank credit to the government (dc). Formally, where i is the real domestic intarest rate, i^ is the real foreign interest rate, e is the real exchange rate, and " ' indicates the change in the specified variable.

7. Eq. (1) would come closer to reality if it were to include deficit financing which may not be reflected in the account of the central government. It is conceivable, for istance, that some foreign debts of the central government could be handled by the central bank without being adequately recorded in the budget. To cover such cases, consider a simplified balance sheet of a central bank. The assets therein are real credit to the central goverment, dc, and real net foreign assets (valued in local currency), nfae. The liabilities consist of currency held by the public, Cu, and commercial bank reserves, RR, so that: M/P **=** (Cu + RR)IP o where P is the domsstic price level and M/P is the real value of the central bank's nominal base money or the central bank's net liability to the p,ivate sector. The balancing item is assumed to be nw, the real net worth of the central bank, where: Eq. (3) indicates that the net worth and base money are used, in this illustration, to extend credit to the central government and to obtain foreign assets. Intuitively,:

# nw ifwe ... (4)

that is, that the real value of interest earnings on foreign assets Increases the central bank's real net woeth.

S. Eq. I can now be rewritten to reflect the inc!usion of the central bank in the budget constraint:

**_I/_** Tis claim makes th simplisic aumpion tha no **idtrs** payments oa deb conttd during the ourent period all due within dha patiod.

**I/ Catamba at i.** (t989). p. **4.**
d + ib + _i(b_ - ab)e = b + (b- -nfale + dc, _+ nfe_ -nw The &eft hand side of eq. S consolidates the defbit of the central govenmuent and the central bank by nettng out the net worth of the latter. On the right hand side, the change in net worth-equivalent in this context to the change in net foreign assets-is introduced (and then subtracted to mainain equality between the right and left sides) to forge a link between the deficit and the money supply, MIP, where: MIP = dc, + nfae - .. ( Eq. (6) is the dynamic form of eq. 3 and permits eq. S to be rewritten as: d + ib + i7(b* - nfa)e = b + (b- -nfa)e + m ... (7) In eq. (7), *m" excludes private sector deposits in the banking system which would be offset in an inflationary situation by the erosion of liabilities outstanding to the private sector. Otherwise, "m" would not represent a U revenue increase-the inflation tax-which partly finances the deficit. 1' A logical extension of this argument is the conclusion that the ggnratonal definition of the budget, the one which excludes the inflationary component of interest payments, is the one most appropriate for this analysis (para. 2).

9. In eq. (7) a link is establisned between the deficits of the cenal government and the central bank, and the money supply. The next step is to find a way to reflect capital losses which arise from real exchange rate changes and which are a part of the cost of servicing the foreign debt. This is done by decomposing the change in real net foreign debt (valued, in local currency) into the impact of the real exchange rate movement on the sto^k and flow of debt; that is,

[(b-nfa)e] - (b-nfa)e + e'(b - nfa)e ... (8) If The appropriate deriniclon of money for this exercise should coincide with the central bankc's aet liabides; tha _is,_ ba money (currency plus commecial bank reevs with the central bank) should exsclude credits which the centna bank may have extended to the ptivae sectot and to commercial benka. This is becas net revenue via the inMadtion tax should exclude revenue derived feom the inflationaty erosion of the priva setom's deposit in the banking system. which Is offset by the inflationary erosion of loans ousanding to the private sactor. What remains is the central bank d non.wnterestbwaring liabilities to the privat sector. For this eaon it would bo neccuay to adjust da reported **as** reserve money in the Interntional Finance Sistics to exclude any loans by the canta bank to the nongovernment setot.
2 2-I where "'" is the percentage change of the variable. Similarly, the change in the real value of the nominal base money may be decomposed into: _MIP_ m + P'm ... _(9_ The first variable on the right hand side of eq. (9) represents ana egL-t change in the real money balances which economic agents hold at a Ma rate of ifation. Conceivably, as national income grows, agents may wish to hold higher real money balances. 1 y be a source of deficit financing in that it would allow the governmen **t** o increase the real money stock (in line with this increase holding of real money balances) without fueling inflation. The second term on the right hand side of eq. (9) represents the inflation tax or the amount by which the nominal money balances have to be increased to keep the real value of the money stock constant.

10. Eqs. (8W) may be substituted in eq. (7) to produce: d *- ib + (i! + e')(b- n)e = b + (be -nfa')e + [(b- nfa)e] + m + P'm .. (10) Eq. (10) restates the budget constraint as the requirement that the operational fiscal deficit, including real interest payments and the real value of the profits of the ceural bank, must equal the changes in the real value of domestic and foreign debt (net of the real value of the profits of the central bank), and revenue from seignorage and the inflation tax.

# C. The Budget Deficit and Macroeconomic Targets: From Design to Application

11. The practical question for the policy analyst is to determine the level of fiscal imbalance which is consistent with the growth target, the inflation target, the real exchange rate and interest rate, and the limits on domestic and external borrowing. The first step towards an answer is to derive the actual annual deficits of the central government in accordance with the left hand side of eq. (10). The second step is to calculate the financeable deficit using the target value for P' and the ratio of debt of GDP a la the right hand side of eq. (10). However, although eq. (10) is useful, it ignores the relationship between exchange rate changes and inflation and vice versa. It also ignores the fact that inflation may have an independent negative impact on the size of the monetary base from which the inflation tax is derived and omits the influence of factors such as interest rates on different financial instruments. e' 12. The econometric results in Tables I and 2 are an input into the calculation of the demand for base money and thereby, an input into the calculation of the seignorage, the inflation tax and the financeable deficit. Tae signs and magnitudes of these results are theoretically plausible and economically sound. The relationship between real income growth and real money balances is positive. Inflation appears to have an understandable negative impact on the growth rate of real

> 11 Finnncial rogulaions-reserve requirenents. cash **ratios,** a-e-would also play a pan in determining the currency held by commercial banks and nonbanic uLancial instiions, and thereby, in determining the finaAceable deficit. Thea factors did not appar to be sazaiaically significant and cconomically meaningful in the esimated money demand functions reported in Table 1. This is probably understandable since flnaeal seatr ratoms were sed only recently In Keya. However. subsequene reserch will analyze the impact of finaneal forms on the demand tor money.
-53<sup>-</sup>

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T he. sam'.e contain a a ' **.** o p peroed: . .: :..: ' i:' .: -|.:T:. h :,igue e e statti Mrefers+ variously: to* thea eavalue. O crrency es a tame deosts by the. Nairobi consumer price index. Al varables are exese&.exq d ir .natul logaFithms. The. dt-mm for the currency equ;tioni. ^sone for119.81-84 and 1-98849(adjustingyears) and. zero,otherwise The dumnmyfor the demand deposits.eqt~ation is one f' h cffeboo er (arnd three er thereafterdandzero otherwise T-he dummy for the timedeposits:equat. t-is.one for8 8 an zera otheswise.

./ nterest rate on. deposits wit .bui.l.ing. societies. lt- Lagged-.one period.-. Untit about 1981 -. there'was:considerable overflap bestween interes -rates on _Most:_ deposits.
_-54._ money demand while the demand for demand deposits and time deposits and their respective interest rates is understandably positive. Currency does not eam interest and is therefore negatively correlated with the interest rate on time deposits which are an alternative asset. Table 2 shows the magnitude of these relationship in the long-nm. These coefficients are used tO simulate the behavior of base money as inflation and real growth change, to esdmate the inflation tax and seignorage and thereby, to determine the fiscal imbalances which are consistent with the stabilization and.t. adjustment objectives.

13. The results in Table 3 are obtained from the financeable deficit shell of the model using the methodology and coefficients in pra. 6-12. The operational and financeable deficits are calculated and the sources of fiacingseignorage, the inflation tax, domestic borrowing and foreign borrowing - are shown. _By disaggregating the sources offinancing, the Table is also able to provide a pardatl_ it ... _equUibrium perspective on what the consistent j0e `:t:>perspective on what the consistent j0e `:t:>`:t:> financeable deficit would be under each scenario {f that source of Jinancing does not materialize_ it ... _equUibrium perspective on what the consistent j0e `:t:>perspective on what the consistent j0e `:t:>`:t:> financeable deficit would be under each scenario {f that source of Jinancing does not materialize ;._ Ol97 .001 14. Generally, the availability of foreign " ' _'''';____>: financing is the largest single determinant of the financeable fiscal deficit when exchange rate and , , . .; Oe.4trora Ta . , . the interest rate policy are used and in the basic projections. The inflation tax is also a . . **..** . significant contributor especially when the fiscal deficit is monetized.

# D. Limitations of the Framework

15. Whereas this framework is useful in calculating the level of fiscal imbalance which is consistent with given macroeconomic targets, it does not deal with the desirability of one form of deficit financing versus another. 2 It also neglects the implications of financial sector reform for money demand.

2/ 'Me model is aiso inappropriate for dealing with the microeconomics of various revenue instruments.
_- 55 -_

|**Tbe Fiancab**|**Tab**<br>**le Fisal De**<br>|**le**3<br>**icit in Sele**|**cted Scena**|**rios**|||
|---|---|---|---|---|---|---|
|Sconario"|I19|**1992**|1993|1994|1995|1996|
|Base Projections Model (%GDP)|||||||
|Operational Deficit (excl. grants)|6.5|S.9|_6.5_|_5.9_|6.3|_6.5_|
|Financeable Deficit|12.7|S.0|2.2|S.S|4.2|4.6|
|Seignorage|0.8|0.9|0.9|0.8|0.7|O.S|
|Inflation Tax|2.7|2.0|1.6|1.3|1.3|1.2|
|Domestic Borrowing|4.7|0.5|-3.4|1.2|0.2|0.6|
|Foreign Borrowing|_4.S_|2.6|3.1|2.2|2.0|2.3|
|**Exchange Rate Soluton**(% GDP)|||_||||
|Oporational Deficit (excl. grts)|_6.5_|**5.9**|6.5|_5.9_|6.3|6.6|
|Financeable Deficit|12.6|4.9|2.1|_5.5_|4.1|4.6|
|Seignorage|0.8|0.9|_09_|0.8|0.7|_0.5_|
|LIflation Tax|2.7|2.0|1.6|1.3|1.3|1.2|
|Domestic Borrowing|4.6|.0.6|-3.5|1.2|0.1|0.6|
|Foreign Borrowing|_4.S_|2.6|3.1|2.2|2.0|2.3|
|**Interest Rate Solutlon (% GDP)**|||||||
|Operational Deficit (excl. grants)|6.5|5.9|6.5|5.9|6.3|_6.5_|
|Fiuanceablo Deficit|12.7|5.1|2.4|_5.8_|4.7|5.4|
|Seignorage|0.8|1.0|1.0|1.0|1.0|0.9|
|Inflation Tax|2.7|2.0|1.7|1.3|1.3|1.3|
|Domestic Borrowing|4.7|_O.S_|-3.4|1.3|_0.4_|0.9|
|Foreign Borrowing|_4.S_|2.6|3.1|2.2|2.0|2.3|
|Monetization (% GDP)|||||||
|Operational Deficit (excl. grants)|6.5|_5.9_|6.4|_5.8_|6.2|6.3|
|Financeable Deficit|12.7|4.9|1.9|S.0|3.6|3.8|
|Scignorage|_0.6_|0.6|0.6|0.7|0.7|-0.3|
|InflaioaoTax|2.9|2.2|1.8|1.4|1.2|1.9|
|Domestic Borrowing|4.7|O.S|-3.6|0.7|.0.3 ||0.1|
|Foreign Borrowing|_4.S_|2.6|3.11|2.2|2.0|2.3|

A deficit carries a positive sign. A negative deficit is a surplus.