Report No. 37688-KE Kenya Unleashing the Potential for Trade and Growth February 2007 Poverty Reduction and Economic Management 2 Country Department for Kenya Africa Region Document of the World Bank KEBS Kenya Bureauo f Standards KEPHIS Kenya Plant HealthInspectorate Service KIHBS Kenya Integrated Household Budget Survey L D C Least Developed Country MFA Multi-Fiber Agreement MFI Micro-Finance Institution MFN Most Favored Nation MSME Micro, Small and Medium Enterprise NCBP National Cereals Produce Board NEPAD New Partnership for Africa NES National Export Strategy NGO Non-Governmental Organization OECD Organization for Economic Cooperation and Development PSDS Private Sector Development Strategy RTA Regional Trade AgreementJArea SACCO Savings and Credit Cooperative Societies SACU Southern African Customs Union SADC Southern African Development Community SPS Sanitary and Phytosanitary SME Small and MediumEnterprises TBT Technical Barriers to Trade Agreements TREO Tax Remission for Export Office TRS Time Release Study UK United Kingdom us Unites States USAID UnitedStates Agency for International Development VAT Value Added Tax WTO World Trade Organization r Vice President: Hartwig Schafer Country Director: Colin Bruce Sector Director: Sudhir Shetty Sector Manager: Kathie Krumm Task Team Leader: Christiane Kraus i TABLE OF CONTENTS ABBREVIATIONS AND ACRONYMS .............................................................................................. i ACKNOWLEDGEMENTS .............................................................................................................. vii FOREWORD AND SUMMARY .................................................................................................... viii ... Objective and Roadmap O f The Report ................................................................................ viii ... ExecutiveSummary.............................................................................................................................xi Export performance and potential............................................................................................. x i The behind-the-border reform agenda (trade facilitation) ...................................................... xii Trade Policy and Institutions xiv Sector specific issues ............................................................................................................... .................................................................................................. xv 1. Kenya's EconomicPerformance and Recent developments ................................................ 1 Economic Developments 1990 - 2001 Poverty in Kenya ....................................................................................................................... Recent Economic Development ................................................................................................. ...................................................................................... 1 1 5 Trade and Poverty ...................................................................................................................... 5 2. Trade and Exportsin Kenya .................................................................................................. 9 Significant Changes in Kenya's Exports and Drivers of Those Changes 9 Issues pertaining to the structure o f merchandise exports .............................................................. 1.......................... 11 Geographic destinations and origins of Kenya's trade 13 Regional Trade ......................................................................................................................... ............................................................ 14 Prospects for Export Expansion and Diversification 17 Diversify .................................................................................................................................. ............................................................... 18 Potential Sectors for Export Diversification in Kenya 18 Dynamic Exports in Sub-Saharan Africa ................................................................................. ............................................................ 19 Potential o f Regional Trade 25 Potential o f AGOA .................................................................................................................. ..................................................................................................... 26 Potential for Trade with Asia ................................................................................................... 27 Summary of key messages that have policyimplications ................................................... 28 3. DOMESTIC CONSTRAINTS TO TRADE ........................................................................ 31 Competitiveness and Commercial Climate for Trade inKenya .............................................. 31 Transport and Trade logistics 31 Recommendations .................................................................................................................... ................................................................................................. 38 Standards and Conformity -Assessment Institutions and Capacities ....................................... 38 Standards for Export Diversification: Horticulture. Flower and Fish ...................................... 38 Standards inother Sectors and the Role o f Institutions 39 Standards inthe Regional Arena ............................................................................................. ........................................................... 39 Recommendations 39 Trade Finance .......................................................................................................................... .................................................................................................................... 40 Recommendations.. .................................................................................................................. 42 Telecommunications services and Power., .............................................................................. 43 iii 4. TRADE POLICY AND INSTITUTIONS ........................................................................... 49 Kenya's Trade Policies ............................................................................................................ 49 Tariff Regime .......................................................................................................................... .49 Incentive Schemes For Exporters ............................................................................................ Recommendations.................................................................................................................... 52 Kenya's Role In Effective Regional Integration...................................................................... 53 53 Recommendations .................................................................................................................... ...................................................................................... 56 Recommendations.................................................................................................................... Interests In Multilateral Negotiations 56 60 Potential Benefits And Risks o f An EPA With The EU 60 Recommendations., .................................................................................................................. .......................................................... 62 InstitutionalFramework For Trade Policy ............................................................................... 62 Recommendations .................................................................................................................... 65 5. ISSUES INKEY TRADE SECTORS .................................................................................. 67 Traditional Cash Crops............................................................................................................ Five Key Export Sectors and One Import Sector ..................................................................... 67 67 Horticulture .............................................................................................................................. 69 Textiles and Clothing 71 Tourism .................................................................................................................................... ............................................................................................................... 73 The Potential o f Business Services (an area for hrther study) ................................................ 76 Sugar ........................................................................................................................................ 76 Recommendations .................................................................................................................... 79 6. CONCLUSIONSAND RECOMMENDATIONS ............................................................... 81 Trade Performance ................................................................................................................... 81 Domestic Constraints ............................................................................................................... 81 Trade Policy and Institutions 83 Issues inKey Trade Sectors ..................................................................................................... ................................................................................................... 83 ANNEX: KENYA TRADE REPORT.ACTION PLAN ............................................................... 85 SELECTEDREFERENCES ........................................................................................................... 108 iv LISTOFTABLES Table 1.1: GDP Growth and SectoralContributionsto Growth 1982-2001 ......................................... 1 Table 1.2: Recent GDP Growth and SectoralContributions 2002-2005 ............................................... 2 Table 1.3: Trade as a Share of GDP and Growth of Trade 1982-2004 Table 1.4: Consumer Price Index Changes 1982-2005 .......................................................................... .................................................. 2 Table 1.5: IncomeandPoverty Levels for Horticulture andNon-horticultureHouseholds .................................................. ...................36 Table 2.1: The Relative Importanceto World Trade of Sub-Saharan Africa and Other Regions..........9 Table 1.6: Textile Exports. Employeesand Wages 1999and2003/04 7 Table 2.2: Value and Share of Kenya's Major Exportsfrom 1964to 2003 ......................................... 10 Table 2.3:ConcentrationIndicesfor Kenya's Exports ......................................................................... 12 Table 2.4: GeographicOrigin and Destinationof Kenya's Trade from 1975 to 2003 13 Table 2.5: The ExportProspects Index for Sub-SaharanAfrican Countries ........................................ ......................... 18 Table 2.6: Fast Growing Exports, ofwhich African CountriesIncreasedtheir Share of World Markets Table 2.7: Changes in SelectedAfrican Countries' Trade inParts and Components, 1990to 2003....21 .............................................................................................................................................................. Table 2.8: Exportsand imports of partsand components 2000 and 2003 ............................................ 23 23 Table 2.9: Exportsof machinery,transport equipment and other manufactures, 2000 and2003 Table 2.10: Contributionof Production-SharingExportsto Export Growth 1992to 2000 ..................24 ........24 Table 2.11: The LargestProducts inKenya's Exportsto EAC and COMESA 1976and 2004 Table 3.1: ContainerThroughoutinTEU ........................................................................................................26 32 Table 3.2: Benchmarkingof KenyanReformsAgainst Thos of Othe Sub SaharanAfrican Countries .............................................................................................................................................................. 33 Table 3.3: PerformanceIndicatorsat Dar es Salaam Container Terminal2000-2003 35 Table 3.4: Distributionof Governmentoversightfor transport and logistics ....................................... ......................... 37 Table 3.5: Key TelecommunicationsCost and PenetrationIndicatorsfor Kenyaand Comparator Countries ............................................................................................................................................... 44 Table 4.1: Binding Overhangin Kenya, Tanzania and Uganda ........................................................... Table 4.2: Selectedtariffs on KenyanGoods: Asian and Other Markets............................................. 51 Table 5.1 Textile and Clothing Exportsto the United States 2004 and 2005...................................... 57 Table 5.2: 1990-2004 Growth inTourist Amvals and Receipts (in %)............................................. 72 Table 5.3: Comparisonof Sugar Prices inthe COMESA CommonMarket,2003............................. 75 77 V LISTOFFIGURES Figure 1.1: KenyaNominalExchangeRateandRealEffectiveExchangeRateIndex 1980-2005 Figure 1.2: Unit Labor Costsby Sector Index(1990=100) ................................................................... ......3 3 Figure 1.3 EstimateofMonthlyEarningsofUnskilledProductionWorkers ........................................ 4 Figure 1.4: Ratio ofTotalWagesto MVA inMedianFirms (KenyaandComparators) 4 Figure2.1: KenyaRegionalImports1995-2004(3 year movingaverage) .......................................... ...................... Figure3.1:TelecommunicationsIndicatorsfor KenyaandComparator Countries Figure2.2: KenyaRegionalNon-petroleumExports 1995- 2004 (3 year movingaverage)...............43 15 16 ............................. Figure3.2: EnergyPrices for GeneralBusiness(low voltage .............................................................. 47 Figure3.3: EnergyPrices for Small IndustrialConsumers 47 Figure3.4: EnergyPrices for Large IndustrialConsumers .................................................................. .................................................................. 48 Figure3.5: TotalTransmissionLossos (% ofGWhsent out) .............................................................. 48 Figure 5.1: Kenya's Coffee andTea Exports 1985-2004 68 Figure 5.2: HorticulturalExports 1985-2004 ........................................................................................ ..................................................................... 69 Figure 5.3: FruitandVegetable Exports 1995-2004 .......................................................................... 70 Figure 5.4: TouristArrivals andReceiptsinKenya 1990-2004 ........................................................... 74 LISTOFBOXES Box 2.1:Implicationsof IndustrylevelLabor-intensiveIndices .......................................................... 19 Box 3.1:Kenya's BusinessClimate-Key Findings ofRecentAnalyticalWork ................................ 31 Box 3.2: Expectedbenefitsof EastAfrica's Trade andTransportFacilitationProject 34 Box 3.3: Time ReleaseStudy ............................................................................................................... ........................ 35 Box 3.4: Issues inTrade Logisticsin KisumuandNyandarua ................................................................... ............................................................. 37 Box 3.5: World Bank RegionalTrade FacilitationProject 42 Box 4.1:TheNeedfor Consistency BetweenEACand COMESA Box4.2: The WTO InformationTechnology Agreement ................................................................... 58 ...................................................... 54 Box 4.3: Kenya's ExistingGATS Commitmentsin Telecoms andBanking 59 Box4.4: Trade DataIssuesinKenya ................................................................................................... ....................................... 63 Box 4.5: ExportPromotion.Counci1(EPC) .......................................................................................... 65 vi ACKNOWLEDGEMENTS This report was preparedby a team led by ChristianeKraus (AFTP2)and comprising Manuel de la Rocha, Sibel Kulaksiz,PraveenKumar (AFTP2), Jean Francois Anis, Paul Brenton, Fernando Hernandez Casquet, Phil Schuler (PRMTR), FrancisNg, Allaeddin Twebti (DEGRG), DonMitchell, Caglar Oezden (DECPG), Victor Abiola (CICIC), Maximilian Doms, Spencer Henson, Winnie Mittullah, RomanusOpiyo, Nihal Pitigala, Wachuka Wachira, Alexander Yeats (consultants); update of the actionmatrixwas providedby NyachiengaNyamache(consultant). The team visited Kenya over a period between July 2004 and November 2005 when a discussion workshop of the report was held. PS Nalo and former PS N'geno from the Ministry o f Trade and Industry advised the team. The report benefited from comments by its peer reviewers Vyjayanti Desai (AFTPS), Bernard Kagira (Keplotrade), Richard Newfarmer (PRMTR) and from AndreaNicolaj (EUCommission).The reportwas desk toppedby Marjorie Kingston(AFTP2). Colin Bruce (Country Director, Kenya), Kathie Krumm (Sector Manager, AFTP2), John Panzer (Sector Manager, PRMTR) and Praveen Kumar (AFTP2) providedguidance. Financialassistance from the EU for the preparation of the report and from the Bank Netherlands Partnership Program for the DiscussionWorkshop is gratefullyacknowledged. vii FOREWORDAND SUMMARY OBJECTIVE AND ROADMAP OF THEREPORT The report "Unleashing Kenya's Potential for Trade and Growth" assesses Kenya's trade performance, and identifies key domestic constraints to its further integration into the global economy. Furthermore, the report advances a set o f recommendations to tackle these constraints, with a focus on how trade can contribute to growth and poverty reduction in the country. Specifically, the report aims to support the Government o f Kenya (GOK) to: realize its Investment Programme for the Economic Recovery Strategy for Wealth and Employment Creation 2003-2007 (IP-ERS), to implement its National Export Strategy (NES); to implementits Private Sector Developmentstrategy and formulate a trade-policy strategy. The IP-ERS, released in2003, marked an attempt to reverse declines that had occurred inthe economy over the previous two decades: GDP growth and standards o f living deteriorated significantly, and the incidence o f poverty increased. During the 199Os, on account o f worsening investment climate and physical infrastructure, business confidence declined, and with it private investment flows, both domestic and external. The ERS objective is to revive growth by focusing on promoting investment and improving competitiveness through a revitalized role for the private sector, improved delivery o f infrastructure services and enhanced security. Inthe IP-ERS, further trade integration and export promotion falls under pillar 1, "Strengthening Economic Growth." For specific action on stimulating exports, the IP-ERS refers to the National Export Strategy (NES); for strategy on trade-policy matters it will refer to the pendingtrade-policy strategy. The focus on trade as an engine o f growth is premised on the fact that trade significantly contributes to growth in a variety o f ways. Domestic factors o f production tend to be more efficient when engaged in export-oriented industries.There are also gains to be realized from technological spillover and learning, and knowledge is sometimes transferred in the form o f traded goods, particularly capital goods. Research has established a positive relationship among trade openness, income growth and poverty reduction.' Furthermore, trade between countries has grown far more dynamically over the past decade than have individual economies2 Therefore, promoting Kenya's further integration into the global economy i s expected to yield positive results in terms o f economic growth. If, as a result o f rational choices on regulation, policy and investment Kenya's exports grow at the average rate o f See WorldBank 2001. InAfrica, tradehas grownby 2.7 percentfrom 1977-87andby 5.4 percentfrom 1987-97;per capitaGDP, on the other hand, declined in the 1980s by 1.1 percent and by 0.2 percent in the 1990s; for all developing countries,the differencebecomeseven more significant: tradegrewby 4.8 percentfrom 1977-1987andby 11.3 percent from 1987-1997while per capita GDP only rose by 0.7 percent in the 1980s and 1.7 percent in the 1990s (source:WorldBank 2004). ... V l l l world trade growth over the past decade, the country will progress considerably towards its vision o f highgrowth rates. The World Bank's Country Assistance Strategy [A More Equitable, Prosperous and Competitive Kenya Country Assistance Strategy (CAS) 2004-20071 is closely aligned with the IP-ERS. It organizes support for Kenya in four areas, trade falling under the second: "Reducing the cost o f doing business and improving the investment climate.'' On trade issues, the CAS focuses on identifying barriers to trade, which GOK can then address in furtherance o f increasing trade andtourism. The World Bank also supports Kenya's trade and export promotion agenda through a regional trade and transport-facilitation project, an initiative to improve the Northern Corridor, and technical assistance for EAC customs union implementation, and trade policy formulation. This report aims to support GOK's implementation of the NES and the Private-Sector Development Strategy and formulation o f trade-policy strategy by providing analysis o f a number of issues where gaps were identified. The report is organized as follows: An executive summary highlights the main messages contained in the report followed by a matrix o f priority actions that have been validated during a workshop held on the report in November 2005. The main body o f the report contains six chapters: The first chapter provides background on Kenya's economic performance and structure, the second chapter reviews Kenya's trade performance. This is followed by an evaluation o f Kenya's so-called behind-the-border constraints to trade in the third chapter. The fourth chapter offers an analysis o f Kenya's trade regime, trade policies and the institutional set-up for trade policy. The fifth chapter addresses issues in Kenya's key trade and export sectors. A final chapter brings together main conclusions and recommendations developed over the course of the report. The analysis in this report complements recent studies done on the legal and administrative costs o f doing business in Kenya, and on skills constraints to productivity. An Investment Climate Assessment for Kenya and a FIAS report on the commercial legal framework and administrative and regulatory barriers to investment are also relevant. The report also builds on the 2003 Country Economic Memorandum for Kenya, which laid out a Policy Agenda to Restore Growth; ongoing research into Kenya's labor market and on drivers o f growth will complement this study and related work. The report's focus is on merchandise trade; analysis o f trade in services is needed to complete the diagnostic o f trade integration for Kenya, but this was not feasible at the time of the report becausethe necessary data was unavailable for Kenya. The report advances a number of recommendations for the GOK that will facilitate tackling constraints and taking advantage o f opportunities for further trade integration and export development; these measures were discussed with Kenyan stakeholders at a workshop in November 2005. Priority actions have been organized in an Action Plan (ANNEX: Kenya Trade Report - Action Plan) based on which the trade and export-promotion agenda can be advanced. i x Between the time analytical work was undertaken for the report and its publication, some o f the findings and recommendations have had a significant and positive impact on programs, strategic documents, sectoral dialogue and projects. Specifically, 0 The Time Release Study produced for this report significantly shaped the customs part o f the Kenya Revenue Authority Reform Programme (which i s supported by several donors). The TRS served to identify the weakest parts o f the customs chain, and as a benchmark for the outcome matrix o f reforms. Since the completion o f the TRS, a number of reforms steps have been undertaken, such as installation o f a fully automated customs system (SIMBA), and automatization o fport processes. 0 The trade report's sections on behind the border issues impacted Kenya's Private Sector Development Strategy, the flagship document o f the MOT1that was recently finalized. After the workshop inNovember 2005, the trade report team was invitedto present to the PSD Strategy team, and afterwards invitedto comment. 0 On the sugar sector, the impact has not been the report itself, but rather the dialogue which was started with the visit by the expert, and the messages he communicated to the policy makers. This work was followed up in March 2006, when the expert traveled to Kenya again to broaden the dialogue by adding poverty and social issues. 0 The work on trade facilitation and transport provided input and background to the World Bank's East Africa Trade and Transport Facilitationproject. An important dimension of this report is its knowledge management. The report and its background papers, as well as studies and references cited and additional material can be found on the Kenya Trade Report website (under www.worldbank/kenya) which i s a resource for policy makers, donors and researchers interested in trade integration and export development inKenya. X . EXECUTIVE SUMMARY Exportperformance andpotential 1. There is tremendous potential for trade to play a key role in driving and sustaining growth and poverty reduction in Kenya. Whilst Kenya has assumed an important role in multilateral trade institutions and in advancing regional integration, domestically, economic growth in Kenya has been largely unimpressive till recently. The ratio o f trade to GDP has fallen sharply from 71 percent in 1995 to the current level o f around 56 percent. Kenya's share o f world trade has steadily declined and is now less than half o f mid-1980s levels. Kenya has lagged faster- growing countries in terms o f the pace o f its integration into the global economy, both interms o f trade and attracting FDI.Thus, there i s significant potential for greater participation in international markets to support growth and poverty reduction. 2. Kenya has had some notable achievements: in cut flowers and fresh vegetables the country has built a competitive supply chain based on its comparative advantage as an off- season producer; in the textiles and clothing sector Kenyan exporters have been able to take advantage o f AGOA preferences. Tourism i s the most important o f Kenya's services exports, and the industry has been booming since the US and UK travel bans were lifted. At the same time Kenya has experienced diminishedcompetitiveness inmany of its exports, coffee being a notable example. 3. While Kenya has expanded its non-traditional natural resource-based exports, a significant share o f exports are still agricultural commodities (mainly coffee and tea), for which prices have declined over the past decade, a trend expected to continue in the medium term. Yet natural resource-based exports, in which Kenya has a comparative advantage, are expected to continue to be the mainstay o f its trade for quite some time. 4. The government should continue to focus on providing an enabling environment to recover, maintain or improve its competitive position in traditional sectors, and non- traditional, natural resource-based industries in which there is potential for growth and poverty reduction. 5. In the medium to long term, the government is rightly encouraging export development and diversification into labor-intensive manufacturingand processing industries through its National Export Strategy (NES). One option that has not yet been properly explored is fbrther integration into internationalproduction sharing, which is fast growing internationally against the backdrop o f declining transport costs. South Africa is emerging as a key player on the continent. Some o f Kenya's trade with South Africa is already in components. Production sharing may also hold potential for regional trade. xi 6. Traditionally, Kenya's main export market has been the EU. Given the sluggish economic growth there in the past decade and the contrastingly dynamic performance o f South and East Asian economies, Kenya would do well to secure access to the latter's markets as well. South and East Asia's populations are likely to maintain strong demand for food items such as coffee, tea, nuts and horticulture, which i s perhaps the sub-sector in which Kenya has the greatest competitive edge. However, Kenyan exports still face relatively high tariffs to enter these markets. 7. Kenya i s deepeningregional trade integration within the EAC, and with COMESA. There is some potential for growth in regional trade for commodities such as maize, dairy, processed food, and cotton and cotton products following the expiry o f AGOA's provision allowing the use o f third-country fabrics; regional trade in finished products, however, holds less growth potential because o f low complementarity among regional partners. 8. The most important obstacles to export expansion and diversification are Kenya's commercial and investment climate, i.e. the cost o f doing business, the weakness o f the legal framework, licensing, complex rules and regulations for exports, and the poor quality and high cost of business services in Kenya. The GOK is addressing many o f these issues in its PSD Strategy and the Investment Climate Action Plan; the priority now is to swiftly implement these initiatives. Also, issues related to infrastructure and utility services hamper exports, in particular high prices for telecommunications services, costly and unreliable power, the high cost o f transport, low quality o f trade logistics, and insufficient capacity for standards compliance. For MSMEs lack o f access to export finance is a barrier to exportation. For trade to play a key role in driving and sustaining growth, reforms and investment need to be put in place to address these behind-the-border issues. The role o f trade policy should be to complement this agenda. The behind-the-border reform agenda (tradefacilitation) 9. A key hurdle for exports is the poor quality o f transport and trade logistics, namely the quality o f roads and delays in administrative procedures along the Northern Corridor, which drive up transport costs. Sector studies in Kenya reveal that 37 percent o f the cost o f sugar cane production goes on transport; for coffee, transport costs are a staggering 69 percent o f total costs. Coffee and sugar production are region specific; improving roads and other transport infrastructure in these areas should be a priority. These problems have been thoroughly analyzed and action plans to address the problems are satisfactory. However, implementation will require: the political will to eliminate rent-seeking activities and vested interests; the capacity to implement, coordinate and supervise the action plans; and the resources to undertake the necessary investment. The first priority should be to increase efficiency at the Port o f Mombasa through the automation o f container tracking, which offers potential productivity gains (as can be seen at the Port o fDar es Salaam) but which has so far has been resisted by vested interests. A second priority is to use the recently completed Customs Time Release Study to benchmark reforms and progress. Private-sector participation in these reforms i s critical; as the main potential beneficiary the private sector can be expected to drive the process forward; close consultation with the private sector will also ensure that new hardware and software i s compatible with the industry's technology xii standard. Apart from improving poor road quality, harmonization o f axle-load regulations within the EAC and COMESA, and improvement o f weighbridges will be vital to reduce transport costs. Phasing in weigh-in-motion bridges and adding mobile bridges to detect overloaded trucks should be a priority. 10. Compliance with food safety and agricultural health standards has been an important factor driving Kenya's diversification into such non-traditional exports as horticulture, cut flowers and to a lesser extent, fish. Public-private partnerships in these sectors, encompassing a suitable regulatory framework and the broad adoption o f good agricultural and manufacturingpractices, should serve as an example to other industries. The development o f such systems i s crucial if Kenya's industries are to meet the evolving challenges associated with competing in developed markets. Three broad priorities are: raising awareness on good agricultural practices; improvement o f pest risk assessment and management capacities; and improving landing sites and environmental management in Lake Victoria. 11. In other sectors, quality, standards and conformity-assessment systems should follow a medium-term strategy o f diversification into new regional and global export markets. With this goal in mind, it i s important that standard-setting and conformity assessment institutions are re-oriented toward facilitation. This will necessitate increased private-sector participation in the regulatory debate and private-sector provision o f services (mainly testing, conformity assessment and consultancy), whenever possible. Regionally, GOK should lead efforts to develop joint SPS-management capacity and share selected resources. The use o f Kenya's pending accreditation system as a regional platform is an obvious starting point. Other promising areas for regional cooperation are: cross-border management o f pests and diseases (a clear public internationalhegional good); food safety, hygiene services and training in the tourism industry; and establishing "regional centers o f excellence" in instances where capacity i s lacking in neighboring coontries and regional markets. 12. For MSMEs, access to finance is a key constraint to export development. The problem is not access to specific export financing products, but rather one o f access to financing or insurance for the amounts necessary in export transactions. MSMEs have to rely on non-banking MFIs, because the Kenyan banking sector does not, in general, provide financing to MSMEs. MFIs, however, cannot finance the amounts o f working capital necessary for export transactions. To improve access `to finance, GOK should create a regulatory framework to increase the flow o f funds between various MFIs so that they can provide larger loans. Furthermore, GOK should develop a credit registry to enable at least some MSMEsto accessbanking and insurance services. 13. Kenya's telecommunications services had been expensive compared with those o f other Sub-Saharan African countries and even more so in comparison with those o f East and South Asia. High telecommunications costs hamper economic growth and exports in particular, as long distance telephone charges are particularly burdensome for the export industry. The reason for Kenya's expensive telecommunications services was a delay in the reform agenda set out in the ERS; according to preliminary estimates based on cross-country XI11 ... regressions, this delay may have resulted in US$l80 million in lost customer savings and increased and an additional US$87 million in forgone revenue. The priority for GOK i s to continue pursuing reforms in the telecommunications sector with urgency to promote open competition inall segments o fthe telecommunications sector. 14. Access to, reliabili@, and the cost of power emerged as a major obstacle to manufacturing firms in the Investment Climate Assessment for Kenya completed in 2004. The poor performance o f the power sector costs firms on average almost lopercent o f annual sales in terms o f lost production; 70percent o f firms were forced to invest in their own generators to bridge blackouts. Power is o fparticular importance for the key export sectors o f textiles and coffee. TradePolicy and Institutions 15. Trade policy can be usedto advance Kenya's trade and export development agenda in a number o f ways: 16. In implementingthe EAC Common External Tariff, Kenya significantly reduced its trade barriers. In general, the three-band CET i s relatively simple and transparent. However, it preserves significant tariff dispersion, and escalation; the latter could be particularly detrimental to production sharing. Furthermore, the CET has an extensive exceptions regime. Reducing tariff dispersion and escalation, and the number o f exceptions should be a priority for the 2009 CET review. 17. Regional integration will bolster Kenya's efforts to address the behind-the-border agenda, in particular in terms o f trade logistics. Kenya should push for speedy implementation o f the EAC customs-harmonization agenda. 18. At the multilateral level, Kenya's key interests would be advanced by usingthe Doha Round to negotiate improved market access to dynamic South and East Asian markets, in which Kenyan exports continue to face relatively high trade barriers. Furthermore, Kenya should use the GATSframework to consolidate domestic reforms, and reduce the cost o f IT and businessservices for its economy. 19. Among Kenya's priorities during EPA negotiations with the EU should be to press for more liberal rules o f origin, and to discuss with the EUrelaxing restrictions on temporary migration o f workers. When the EPA enters into force, GOK must take the necessary actions to avoid trade diversion, especially in the services sector. This may necessitate reduction o f the tariff schedule and liberalization ofthe service sector on an MFNbasis. Depending on the prevailing level o f regional integration, Kenya may not be able to take such actions unilaterally. It may be necessary to begin negotiation on the reform agenda complementing well before full implementation, which i s expectedto take at least a decade. 20. Many constraints to export development and diversification in Kenya are beyond the reach o f the Ministry o f Trade and Industry(MoTI). Therefore, MOTI, as champion for trade and export expansion, must promote close coordination among the various ministries and xiv other public bodies. If the lack o f inter ministerial coordination restricts export trade, addressing this should be a priority. It is equally important that the MOT1 closely consults with exporters so as to remain informed about developments. To that end, the various public- private consultative bodies and committees on trade policy should be consolidated into one such body. Particular attention should be given to ensuring effective private sector participation inthe consulting mechanisms. 21. There i s a critical lack o f reliable trade data on merchandise and services trade in Kenya that must be remedied urgently. Without solid statistical data, assessment o f trade- policy is difficult, and recommendations based on inaccurate information are likely to result in misguided strategies. Three issues need to be addressed: inconsistent and variable processing o f exports originating from EPZs, a decline in the accuracy o f export statistics dating back to the 1980s, and a lack o f coordination in efforts to collect data on service- sector trade. Sector specific issues 22. The National Export Strategy Implementation Action Plan 2005 - 2008 identifies a list o f priority areas for reform and investment to address key constraints for the sectors with the highest potential for export expansion and diversification. Successful implementation of the NES Action Plan should help trade to play a key role in driving and sustaining growth and poverty reduction inKenya. 23. Recent reform o f the coffee sector is expected to yield significant growth in output, exports and increases in coffee farmers' share o f sales proceeds. The 2002 Coffee Act has recently been reformed to allow farmers to either sell their coffee through the central auction, or to sell directly to roasters abroad through a marketing agent. To enable small holders to benefit from this important change Government should take measures to publicize the new regulations widely to the coffee growing community. 24. Lessons from the successful development o f the cut-flower, fresh- vegetable and tea sectors should serve to guide GOK's policy reform. As regards the horticulture industry, much o f the success has been attributed to the "light" regulation and taxation by the Horticultural Crops Development Agency. Tea exports have benefited from the supervision o f the Kenya Tea Development Agency which efficiently manages input provision and collection o f green leaf tea, and fiom allowing smallholders to sell their produce directly to buyers. 25. For the horticulture sector, Government priorities should be to continue improving the enabling environment for the private sector such as upgrading security and transport infrastructure in the key horticulture growing regions. As regards Government intervention, the recommendation is to keep the private sector that has been successful inthis sector inthe driver's seat. 26. As far as the textile and clothing industry is concerned, the removal o f the MFA has not led to relatively small declines in the Kenya's exports under the AGOA so far. However, xv in order for the industryto grow at the rate desiredby the government according to the IP- ERS, constraints in trade logistics need to be removed. For example, the Customs Department should reinstate the practice o f allowing containers destined to EPZs to remain sealed untilthey arrive at the factory. 27. For the sugar sector, Kenya has evoked the COMESA safeguard clause which will expire inFebruary 2008. To avoid a crisis for the sector after that date, the government needs to urgently put in place (i) reform measures such as linking sugar cane prices to domestic sugar prices, and privatizing state-owned factories, and (ii)measures to improve competitiveness o f the industry such as improving transport infrastructure for the sector, and developing higher yielding and faster maturing sugar cane varieties; funds to pay for such investments can be raised through auctioning o f the sugar import quotas. Furthermore, a study on the impacts o f sugar sector reform for producers and workers should be undertaken to identifywhere adjustment may need to be supported by the government. 28. To stimulate further growth of the tourism sector GOK should continue to focus on improving the security situation both domestically and within the region through regional cooperation, and dialogue with governments in the major tourist-generating countries. Recommendations to address other constraints for tourist sector expansion, and attraction o f FDI into the sector will be forthcoming from the currently ongoing World Bank tourism sector value chain analysis. xvi e e e e e c 0 0 3u 52 0r 4 cr 0 a a cr 0 .-XX P r I t- 3 1. KENYA'S ECONOMICPERFORMANCEAND RECENT DEVELOPMENTS Economic Developments 1990 -2001 1.1 Kenya's growth performance in the 1980 and 1990s was lackluster; between 1982 and 2001, average GDP growth never rose above five percent. Further, economic growth did not significantly exceed population growth, with the result that per-capita GNP remained stagnant. 1.2 Insector terms, services grew most significantly, contributing more than halfoftotal GDP growth. Tourism was the largest contributor to the growth o f services sector; finance and business services also grew in the 1990s, benefiting from trade and foreign-exchange liberalization. Agriculture and industry registered lower growth rates; the former remains dependent on climatic conditions. Poor growth in Kenya's industrial sector, especially manufacturing, reflects the country's deteriorating business climate (see Table 1.1) Table 1.1: GDP Growth and Sectoral Contributions to Growth 1982-2001 82-86 87-91 92-95* 97-01 82-01 GDP growth rate 3.6% 4.3% 2.1% 2.3% 3.1% Agriculture growth rate 2.9% 3.1% 0.3% 4.2% 2.8% Industry growth rate 2.8% 4.8% 1.4% -0.2% 2.3% Manufacturing growth rate 4.3% 5.3% 2.2% -0.7% 2.8% Services growth rate 4.4% 4.8% 3.5% 2.2% 3.7% Population growth rate 3.6% 3.1% 2.7% 2.5% 3.O% GNP per capita (Atlas method) growth rate 1.4% 1.5% -5.0% 1.9% 0.2% Contribution to growth Agriculture 1.0% 1.0% 0.1% 1.3% 0.9% Industry 0.6% 1.0% 0.3% 0.0% 0.5% Manufacturing 0.5% 0.7% 0.3% `-0.1% 0.4% Services 2.1% 2.4% 1.8% 1.2% 1.9% Yource: World Bank Live Data Base *This period only covers four years because GDP calculations from 1996are based on a new system Recent Economic Development 1.3 During the past three years, Kenya's growth has accelerated. From less than one percent in 2002, it reached an average in 2003 at 3 percent and has since remained higher, at 4.9 percent in 2004 and 5.8 percent in 2005, driven mainly by continued strong growth in 1 services. The outlook remains positive beyond 2005 with expected growth rates above five percent. While growth has recently been more dynamic than before, it i s still below the level necessary for sustainable poverty reduction, given the highpopulation-growth rate (see Table 1.2). Table 1.2: Recent GDP Growth and Sectoral Contributions 2002-2005 2002 2003 2004 2005 GDP growth rate 0.6 3.O 4.9 5.8 Agriculture growth rate -3.0 4.0 0.8 8.0 Industry growth rate 2.4 6.1 4.1 4.6 Manufacturing growth rate 0.1 6.0 4.5 5.0 Services growthrate 2.4 2.5 5.0 4.8 Populationgrowth rate 2.0 1.8 1.7 1.9 GNP per capita (Atlas method) growth rate -1.4 1.3 2.2 3.3 Contribution to growth Agriculture -1.1 0.7 0.5 2.0 Industry 0.4 1.1 0.7 0.8 Services 1.3 1.3 2.7 2.5 burce: World Bank Live Data Base 1.4 Trade and exports can be an engine for growth-between 1982 and 2001, world trade increased 3.4 fold, which corresponds to an annual growth rate o f 6.4 percent. However, since Kenya's exports have grown only slightly faster than the rate o f GDP growth over this period (see Table 1.3), the country hasnot properly benefited from dynamic growth ininternational trade flows. Table 1.3: Trade as a Share of GDP and Growth of Trade 1982-2004 82-86 87-91 92-95 97-01 82-01 I 2002 2003 2004 Exports(goods and services) as apercentage of GDP 25.5 24.0 34.1 21.6 25.9 24.2 23.8 26.2 Export growth rate 1.7' 3.7 7.8 -0.2 3.0 7.3 12.3 17.5 Imports (goods and services) as apercentage of GDP 27.0 29.1 24.0 28.0 29.3 28.2 28.2 32.0 Import growth rate I -3.3 5.0 12.8 3.2 3.7 I -5.5 13.8 21.4 Source: World Bank Live DataBase 1.5 The macroeconomic environment in Kenya is favorable to more dynamic export growth. Domestic price levels are stable-after periods o f high inflation, in particular in the early to mid 1990s; inflation has since been maintained at single-digit levels. In2004 prices increased more rapidly-partly because o f a relatively loose monetary policy-but the outlook i s for inflation to returnto low single-digit levels over the next few years (see Table 1.4). 2 Table 1.4: Consumer PriceIndex Changes 1982-2005 82-86 87-91 92-95 97-01 82-01 2002 2003 2004 2005 CPI (average) change -0.6% 5.7% 25.9% 8.0% 8.92% 2.0% 9.8% 11.6% I10.3% Figure 1.1: KenyaNominalExchangeRate and Real EffectiveExchangeRateIndex 1980-2005 1.6 Kenya's real exchange rate (REER) slowly depreciated 90 1 I 160 1 over most o f the 1990s but since 2003 the trend has beenreversed (see Figure 1.1). However, this need not necessarily mean a loss o f competitiveness for all o f Kenya's exports. Kenya's main exports to the United States- - - textiles under the American Growth and Opportunity Act- are produced using 1 imported inputs, so appreciation ~ ' NominalER (Sh/US$) Real Effective ER Index (1990=100) 1 o f the real exchange rate is unlikely to have a significant effect. Kenya's regional exports are dominated by petroleum re-exports; again exchange-rate developments do not play a major role. At the same time cut flower exporters are losing their competitiveness to some extent. 1.7 In the short term, domestic factors may push the REER higher due to expected further nominal appreciation and further declines in inflation. A sustained appreciation o f the REER may result in reduced competitiveness for exports produced using predominantly domestic inputs, or exported to countries the currencies of which have lost ground against the Kenya shilling. Figure 1.2: Unit Labor Costs by Sector Index (1990=100) 1.8 Another aspect o f export competitiveness affected by macro- economic conditions are unit labor costs. In Kenya, unit labor costs have increased since the mid 1990s (see Figure 1.2). Unit labor costs increased by 20 percent for the manufacturing sector, by 150 percent in the agri- cultural sector, and by 45 percent for transport and communications, between Agncuiture and foresfq- Manufactunng-6-Tranrport and mmunlcatic& 1990 and 2001. This trend may also I I - - cause diminished competitiveness for Source: CentralBureauof Statistics some exports, inparticular agricultural exports. 3 1.9 Evidence from manufacturing surveys (Regional Program on Enterprise Development (WED) and Investment Climate Assessments (ICA) in Kenya and in comparator countries shows that Kenya's estimated monthly earnings for unskilled production workers are relatively high (see Figure 1.3)' which hinders competitiveness in sectorsthat rely onunskilledlabor. Figure 1.3: Estimate of Monthly Earnings of Unskilled Production Workers 120 100 80 Y ) 3 60 40 20 0 Source: KenyaICA (2005) 1.10 One finding of the 2004 ICA "Kenya: Enhancingthe Competitiveness of Kenya's Manufacturing Sector; The Role of the InvestmentClimate" is that Kenya's wage levels are not matched by labor productivity on a par with those of Asia, although it is competitive within East Africa. A comparison of the ratio of wages to ManufacturingValue Added (see Figure 1.4) shows that Kenya's wage bill is 36 percent, similar to those of Uganda and Tanzania,but higherthan India'sandChina's. Figure 1.4: Ratio of Total Wages to M V A in Median Firms (Kenya and Comparators) 40 35 5 30 25 k 2o 15 10 5 0 Kenya 2003 Tanzania Uganda2003 India 1999 China 2000 2003 Source: KenyaICA (2005) 4 1.11 A World Bank labor market study is currently under way which should shed some light on the effects oflabor market developments on Kenya's competitiveness. Poverty in Kenya 1.12 It is difficult to establish poverty measuresand trends inKenya over the past decades because of a lack o f comprehensive and comparable data. The most recent household data were collected in 1997; a new household survey (the Kenya Income and Household Budget Survey, KIHBS) will be completed in 2006. Based on existing information, it is estimated that has poverty increased in the last ten years, from 48.8 percent in 1990 to about 55.4 percent in 2001. Since then, although there is no newer data, it is generally believed that poverty levels have held steady or even increased slightly. Poor education, misdirected funding of development by the government, the large population, and a lack ofready markets for goods inmore remote areas are among the causes o fpoverty inKenya. 1.13 There is evidence that inequality o f poverty has also been on the rise. A recent World Bank and Ministry o f Planning report shows substantial variability in poverty levels among constituencies and provinces. It appears that poverty levels are influenced by the education levels o f heads o f household. Homes headed by people with a secondary-school education or better are less likely to be below the poverty line than those headed by people with only primary-level schooling. The latter in turn are better off than those headed by people with no formal education. There i s also a gender bias in the distribution o f poverty, since female-headed households are more likely to be poor than those headed by men. There i s considerable geographical variation in the distribution o f poverty within each province and district. Nyanza, with has a poverty level o f 65 percent, i s the poorest province, followed by North Eastern, with 64 percent. Western has 61 percent; Eastern, 58 percent, Coast, 57.6 percent; Rift Valley, 48 percent; Nairobi, 44 percent; and Central, just 31percent. Trade and Poverty 1-14 That trade liberalization and export development have the potential to powerfully catalyze growth and poverty reduction i s not in question. However, there is debate on the short-term effects o ftrade liberalization on the poor. 1.15 Cross-country studies and single-country analyses over time find that trade liberalization has an overall positive impact on growth and poverty red~ction.~ This linkage is, in fact, the main reason for much trade-policy reform. However, many studies find that benefits are distributed unevenly across the population; the economic environment within which trade reform takes place and the specific characteristics o f the poor (e.g. their location, livelihood) are important determinants o f the effects o f trade reform. Furthermore, to assess the effects oftrade-policy reform onpoor Kenyans, empirical analyses are necessary. 1.16 Data collected as part o f the KIHBS undertaken in 2005 will be useful to assess the impact o f trade-policy changes at the individual (consumer, worker) level. In a background 'See Winters, McCulloch and McKay (2004) for a review of the empirical evidence on how trade liberalization * affects poverty. 5 study to this report (under www.worldbank/kenya), we provide an example o f a trade- poverty study usinglocal surveys inLake Victoria fishingcommunities. 1.17 Sectoral studies have revealed a direct link between increased exports and poverty reduction. A recent study4 showed that horticulture exports represent an opportunity to reduce poverty through income generation among smallholders, rural farm laborers, and unskilled or semi-skilledprocessing factory workers. Information was compiled from pack- house workers and non-pack-house workers living in the same sections o f Nairobi, workers on exporter-owned farms, workers on large commercial farms, smallholders engaged in horticulture, and non-horticulture smallholders farming in the same region (see Table 1.5). There is little doubt that horticultural production is significantly more profitable for a smallholder than the traditional intercropping o f maize and beans commonly used by subsistence farmers. Findingsallow the drawing o f conclusions about the extent to which the poor participate inhorticulture, as well as about the impact such participation may have. Table 1.5: Incomeand Poverty Levelsfor Horticultureand Non-horticultureHouseholds Source: McCullochand Ota. (2002). 1.18 The above figures indicate that horticulture smallholders are much better off than non-horticulture smallholders, with an average (mean) income four times as large. Even workers on exporter-owned farms or independent commercial farms do significantly better than non-horticulture smallholders. Significant proportions remain below the poverty line; however, almost 75 percent o fhorticulture-growing smallholders are above the poverty line. 1.19 Analysis o f the impact on poverty o f increased textile exports from Kenya to the United States under AGOA (African Growth and Opportunities Act) reveals that expansion o f the sector had two broad results: creation o f new jobs-more than 33,000 new jobs were created between 1999 and 2003-and an increase in average monthly wages o f 66 percent between 1999 and 2004 (see Table 1.6). McCulloch, Neil and Masako, Ota. 2002. "Export Horticulture and Poverty in Kenya." IDS Working Papers 174. Sussex, UK. 6 Table 1.6: Textile Exports,Employeesand Wages 1999 and 2003/04 1999 2003 2004 Exportsales (US$million) 43 182 Numberofemployees 5077 38199 'YOwomen 59.7 77.6 'YOmen 40.3 22.4 Meangarment-sectorwage (Kshpermonth) 3543 5897 1.20 There is a gap between the average earnings o f men and those o f women in the textile sector; women earn substantially less than men. However, a study o f the causes o f the gender wage gap concluded that there are disparities in the skill levels o f men and women; men and women at the same skill level earn equal wages. Thus, to address the gender wage gap which would ensure that women increasingly benefit from the wage premium paid to skilled workers' will require ensuringbetter access to schooling and training for women. 1.21 The region bordering Lake Victoria (Nyanza) i s characterized by economic and social underdevelopment despite significant development o f the Nile-perch export sector over the past decade. 1.22 Aggregate income to Lake Victoria fishers has increased significantly since the early 1980s as a result o f the Nile-perch export industry. It is estimated that the total economic benefit for the fishers at the end o f the 1990s was around US$92.5 million. Sector developments have also created employment opportunities: an estimated 299,000 people were directly or indirectly employed in 2004. However, income opportunities from fishing and fish exports have drawn many people to the area, so that income increases have been spread across a larger population. Further, recent declines in fish landings have negatively affected income levels. 1.23 A comparison o f two landing beaches for Nile percha6found that fishermen on the beach that was better integrated into the export supply chain have fared better in terms o f income levels and poverty reduction. The disparity between the welfare o f artisanal processodtraders on the two beaches i s less pronounced. 1.24 Thus, while growth and trade integrationinKenya haddeclined over the 1990s, this trend has been reversed over the past several years. With a stable macro-framework inplace, Kenya i s now poised for continued fbrther trade integration. 'In2004, the premiumpaidto skilledover semi-skilledworkers was Ksh623permonth, equivalentto 11 percentofthe unskilledmonthlywage. This comparisonwas done ina backgroundstudy to this report; see www.worldbank/kenya. 7 . 8 2. TRADEAND EXPORTSINKENYA SIGNIFICANT CHANGES INKENYA'S EXPORTS DRIVERS THOSE AND OF CHANGES 2.1 Kenya's share o f world trade declined in the past two decades, as its exports grew only moderately by comparison with the growth o f world trade. Between 1980 and 1985, Kenya supplied 0.65 percent o f world trade; since then, its share o f trade has declined to less than half o f that, although Kenya has maintained its share o f the manufacturing market, The decline i s not so much a Kenyan phenomenon as a Sub-Saharan Afkican one (see Table 2.1). IfAfrica had maintained the share of trade it had in 1975, exports would have been worth more than twice the value in2003 o fUS$l08 billion. Table 2.1: The RelativeImportanceto World Trade of Sub-Saharan Africa and Other Regions Total Expor (USSbill n) )IdTradt %) Group 1995 2003 1975 1985 1995 2003 Australid NewZealand 66.6 87.1 1.8 1.5 1.3 1.2 EastAsia' 39.5 194.2 896.6 1 317.4 5.2 10.5 17.8 20.2 Ofwhich: ASEAN 22.0 72.5 322.8 481.9 2.9 3.9 6.4 6.4 EuropeanUnion(15) 340.6 708.2 2,018.3 2,879.5 44.6 38.1 40.0 38.2 Other WesternEurope 22.2 57.1 147.9 219.8 2.9 3.1 2.9 2.9 East Europe/CentralAsia 24.2 115.9 205.4 404.8 3.2 6.2 4.1 5.4 Japan 55.7 177.2 443.0 473.9 7.3 9.5 8.8 6.3 LatinAmerica 41.7 100.1 229.2 415.7 5.5 5.4 4.5 5.5 Middle East 45.7 99.1 152.1 285.4 6.0 5.3 3.O 3.8 NAFTA 144.6 326.0 853.2 1,160.1 19.0 17.6 16.9 15.4 NorthAfrica 13.2 27.3 28.6 57.2 1.7 1.5 0.6 0.8 SouthAsia 6.5 13.6 46.0 85.8 0.9 0.7 0.9 1.1 Sub-Saharan Africa 17.7 32.4 42.0 108.4 2.3 1.7 0.8 1.4 'WORLDAsiais EXPORTS 762.8 I 1,857.4 5,049.3 7,530.2 100.0I 100.0 100.0 100.0 East defined hereas comprising: Brunc Cambod ,China, I mblic ofKorea, HongKong, Indonesia, Lao PDR, Malaysia, Mongolia,Philippines, Singapore,Taiwan (Chin; Thailand, and Vietnam. Source:InternationalMonetary FundDirectionofTrade Statistics 2.2 The composition o f Kenya's exports has changed significantly structural since 1964.' The export share o f fruits and vegetables, textiles and mineral fuel have each increased by about ten percentage points. Coffee underwent the steepest decline in share o f exports, with a loss o f 25 percentage points; textile fibers export share fell by over 20 percentage points. The latter's losses were largely the result o f substitutions o f synthetic fibers for hard fibers like sisal (see Table 2.2). 'Thechoice o f 1964as the first year is becausethis is the year when the UNstarted its COMTRADE database. 9 Table 2.2: Value and Share of Kenya's Major Exports from 1964 to 2003 Kenya's major one and two-digit 1964 E 3orts 2003 E Borts 1964-03 SITC product-group exports Value Share Value Share Share ($000) (YO) ($000) (YO) Change Foodand live animals(0) 110,163 56.1 937,326 41.3 -14.8 Fruits& vegetables (05) 6,166 3.1 307,892 13.6 10.4 Coffee, tea, & spices (07) 92,323 47.0 486,579 21.4 -25.6 Beverages andtobacco (1) 9 0.0 28,559 1.3 1.3 Crudematerials (2) 67,626 34.5 402,69 1 17.8 -16.7 Textile fibers (26) 43,827 22.3 18,672 0.8 -21.5 Crudevegetablematerials (29) 9,509 4.8 309,978 13.7 8.8 Mineralfuels and lubricants (3) 2,948 1.5 262,066 11.6 10.0 Petroleum& products (33) 2,880 1.5 260,358 11.5 10.0 Animal & vegetableoils (4) 82 0.0 12,334 0.5 0.5 Chemicals (5) 5,491 2.8 108,706 4.8 2.0 Manufacturedgoods (6) 4,02 1 2.0 172,75 1 7.6 5.6 Machinery & transport (7) 3,667 1.9 70,046 3.1 1.2 Misc. manufactures (8) 804 0.4 265,142 11.7 11.3 Clothing(84) 39 0.0 209,197 9.2 9.2 Other goods (9) 1,45 1 0.7 8,345 0.4 -0.3 All goods (0 to'9) 196,261 100.0 2,268,595 100.0 -- urce: UNCOMTRADE 2.3 Kenya has built a successful industryo f non-traditional, agriculture-based products (fresh fruit and vegetables, and cut flowers). The country is now Africa's biggestgrower o f cut flowers and one of the largest exporters o f fresh horticultural produce. 2.4 In the last decade, output of fresh fruit and vegetables, and cut flowers has seen impressive growth, which continues to accelerate. Horticulture exports now comprise approximately 27 percent of Kenyan exports. Exports o f cut flowers and fresh vegetables to the EU grew at annual rates close to 10 percent between 1995 and 2003, far faster than the corresponding rate for total exports, and generating trade gains o f over US$lOO million. 2.5 Kenya's traditional cash crops, coffee and tea have shown much less dynamic growth over the past decades, Coffee, while still an important export sector, has in fact experienced a steep export earnings decline since the mid 1990s. The tea sector has fared far better, with a steady growth o f tea exports until 2000, and a slight decline over the past few years. However, while EU tea imports have remained flat, the value o f Kenya's tea exports fell by almost US$20 million, owing to a loss inKenya's EUmarket share. 2.6 Textile exports rose two hundred-fold between 1976 and 2003. Kenyan exporters have benefited from AGOA preferences: US exports grew by about US$160 million; the gains were achieved in relatively few product lines. In fact, net change in Kenya's other exports to the United States would be negative without apparel goods. 10 2.7 The increased share of energy-product exports i s the result o f increased domestic capacity to refine foreign-produced crude petroleum. Most o f this i s destined for Uganda and Tanzania. 2.8 The data show that the general erosion inKenya's internationalcompetitive position was the cause o f relatively Kenya's relatively modest export growth. Significant increases in exports, as occurred in such sectors as apparel and petroleum products, were unrelated to improved competitiveness or comparative advantage; however many significant declines were due to lost market share. Chapter 5 o f this report looks at more detail at Kenya's key export sectors (tea, coffee, horticulture, textiles, and tourism). Issuespertaining to the structure of merchandise exports 2.9 Kenya's exports are highly concentrated. Over the years, this has not changed, although the composition o f exports has changed. In both 1976 and 2003 the ten most important products (two-digit SITC) accounted for approximately 80 percent o f total export earnings. A slight diversification occurred between 1995 and 2003* (see Table 2.3). The combined share o f the three largest export products to the EU fell from 63 percent to 56 percent, although the actual number o f products exported has remained virtually unchanged since 1976. From 1995 to 2003, the combined share o f the three largest products exported to the United States actually rose by 14 percentage points (to 83 percent), due largely to gains in the apparel sector. Similarly, over this period, the share o f the three largest exports to Uganda almost doubled; this i s almost entirely attributable to refined petroleumproducts. 2.10 The downside o f concentration is over-dependence on traditional exports such as coffee. Kenya's traditional exports face unfavorable long-term global demand prospects due to their low income elasticities.' Demand for traditional products has grown very slowly, much more so than for other traded goods. There has been a long-term decline inreal prices o f tea, coffee, and hard fibers. Recent World Bank projections point to this trend continuing through the present decade. Another problem with traditional products is high price variability, which can lead to economic shocks. *The first index is a count o f the number o f products exported, whereby a product had to account for a least one-half o f one percent o f total exports, to avoid including marginal exports; the level o f aggregation is four- digit SITC; the second index is the share of a country's total exports accounted for by the largest four-digit SITC products. The higher the share o f these products, the higher the level o f export concentration; the third index is the "Hirschmann" index, defined inthe notes to Table 2.3. For example, N g and Yeats (2002) estimate that the global income elasticity of demand for Kenya's tropical beverage crops (tea and coffee) averaged about 0.70 during the last two decades. This means that import demand for these products grew at a rate 30 percent below that o f world-income growth. Elasticity estimates for hides, leather, hard fibers, and other Afiican raw-material exports were even lower. 11 Table 2.3: ConcentrationIndicesfor Kenya'sExports Number of Products Share heldby Top Export Concentration Exported Three Products Index Trading Partner (YO) - 1976 1995 2003 1976 1995 2003 1976 1995 2003 HighIncomeCountries EuropeanUnion (15) 263 252 260 68.5 63.0 56.4 0.54 0.41 0.36 United States 84 123 133 88.1 69.1 83.4 0.61 0.43 0.61 Middle& Low Income Burundi C 118 107 151 35.0 35.1 28.1 0.24 0.25 0.21 Egypt, Arab Rep. 27 13 17 96.5 99.0 99.2 0.75 0.96 0.98 India 26 48 87 88.4 53.4 50.5 0.57 0.37 0.35 Pakistan 18 39 42 92.9 97.3 95.0 0.74 0.95 0.92 SouthAfrica 146 196 83.8 33.3 0.63 0.23 SudanC 221 39 100 51.8 85.6 90.6 0.32 0.71 0.87 402 358 424 21.7 40.4 40.8 0.18 0.29 0.33 Tanzania 389 468 495 47.6 31.4 59.6 0.30 0.21 0.5 1 Uganda d Notes: (I:NumberofproductsexportedatSITC4-digit levelinRevision.1 b: The concentrationindex (Hirschmannindex) is definedas: Hj=d(C(xi/X)' where xi is the value of export productsat SITC 4-digit level and X is the total exports incountry'sj. The value ofthe index rangesbetween0 to 1, with lower values indicating less concentratedexports. c: Due to the missingdata, 2002 statistics are substitutedfor 2003. d Dueto incompletedata, energy productsare excludedfrom the 1995 statistics Source: Computations based on partner import data from UN COMTRADE Statistics. South Africa failed to report trade statisticsto the United Nations in 1976. 2.11 Kenya's export profile i s evolving in a strikingly dissimilar manner to those o f former commodity-exporting countries. Over the past 40 years many o f these countries, such as Brazil, China, India, Malaysia, Mauritius, Pakistan and Thailand have made a successful transition to exporting manufactured goods, even as Kenya's exports continue to be predominantly commodities and raw materials. Put another way, Kenya's current export profile is quite different from those o f its major non-African trading partners. This lack o f complementarity i s an obstacle to broader trade contacts (interms of the number o f products that can be traded with partners). 2.12 Analysis shows that Kenya has a relatively low level o f intra-industry trade. Intra- industry trade, or production sharing, occurs when parts and components of a specific product move in one direction, as trade in the final product occurs in the reverse direction between two countries. World Bank studies indicate many developing countries have a comparative advantage in assembly operations that are relatively labor intensive. Kenya may have potential opportunities inseveral sectors, such as office machinery and electronics. 12 GEOGRAPHIC DESTINATIONSAND ORIGINS OF KENYA'S TRADE 2.13 East Africa and the European Union are the two most-important destinations for Kenya's goods; each absorbs about one-third of total exports. Kenya sources about 12 percent of its total importsfrom East African countries, and another 25 percent from East and South Asia; less than one quarter of its imports originate from the EU. The geographic direction o f trade has been relatively stable from 1975 to 2003 (Table 2.4), with the exception of South Asia and NAFTA, for which share of trade with Kenya rose by four percentage points or more. Growing tea exports to Pakistan account for the increased trade with SouthAsia; the increase with NAFTA is largely the result of increased garment exports under AGOA preferences." Kenya's exports to East Africa are dominated by refined petroleum products. Kenya's major exports to East and South Asia consist o f tea (54.8 percent); other inorganic chemicals (6.5 percent); raw hides and skins (6.0 percent); and fish (6.0 percent). 1I Table 2.4: Geographic Origin and Destination of Kenya's Trade from 1975 to 2003" 1 Share of ExportsDestinedFor (YO) Of I Global Of which: Sub- which: Rest E X D O ~ ~East S EU South Saharan East of Country Year (S Ail.) Asia China ASEAN Japan (15) NAFTA Oceania Asia Africa Africa World 1975 jI Kenya 601.7 3.6 0.6 1.9 2.0 31.5 6.0 0.7 2.7 34.7 33.8 12.7 1.4 0.4 0.9 0.8 47.7 5.8 0.3 7.1 22.0 21.3 7.9 2.5 0.1 1.1 0.7 35.6 3.4 0.3 7.1 41.9 41.5 0.9 3.2 0.3 1.4 0.9 32.6 10.0 0.5 8.8 32.1 31.2 1.6 Share of ImportsComingFrom ;%) Of Global Ofwhich: Sub- which: Rest Imports East EU South Saharan East of Asia China ASEAN Japan (15) NAFTA Oceania Asia Africa Africa World 3.2 0.4 1.3 8.6 42.1 8.8 1.7 2.1 4.1 4.1 1.9 1,436.1 8.5 0.8 6.8 10.3 39.2 5.3 1.2 1.3 1.6 1.6 1.5 13.4 3.5 4.5 9.1 38.2 4.2 0.4 8.8 10.8 10.6 0.0 12.8 6.3 2.8 4.8 23.2 5.4 0.5 7.4 13.2 12.8 0.9 w c e : IMF Directionof 2.14 East Africa increased its import share in Kenya's markets by about nine percentage points, while the EU experienced almost a 20-percentage-pointdecline in market share. In large part, East African trade gains were due to relatively few products like fish and fish preparations, which went from virtually nil in 1995 to a value of US$45 million in 2003. lo An examination of available C0MTIU.DE statistics indicates the increase for South Asia was largely accountedfor by growing tea exports to Pakistan(and to a lesser extent to India),while the increasefor NAFTA i s largely the result o f increased garment exports under United States African Growth and Opportunity Act (AGOA) preferences. I' East Asia here denotes: Brunei, Cambodia, China, Hong Kong, Indonesia, Republic of Korea, Lao PDR, Macao, Malaysia, Mongolia, Myanmar, North Korea, Philippines, Singapore, Taiwan (China), Thailand and Vietnam; Sub-Saharan Africa denotes Angola, Botswana, Burundi, Comoros, Congo Democratic Republic, Congo Republic, Eritrea, Ethiopia, Kenya, Lesotho, Madagascar, Malawi, Mauritius, Mozambique, Namibia, Rwanda, Seychelles, Somalia, SouthAfrica, Sudan, Swaziland, Tanzania, Uganda,Zambia and Zimbabwe.The rest of the world comprises Europe (non-EU), the former members of the USSR, and "bunkers" or loadings of foreignflag vessels. 13 Coffee and tea combined was Kenya's second largest import from East Africa with a trade value o f about US$22 million in 2003 (given the nature o f available statistics, it cannot be determined whether these imports were for domestic consumption, further processing, or re- export). 2.15 Historically, Kenya's main export market has been the EU; however, economic growth there has been sluggish for the past decade. By contrast growth in South and East Asia has been much more dynamic, a trend that seems likely to continue. Surging income levels o f large segments of South and East Asia's population will generate strong demand for food items such as coffee, tea, nuts and horticulture; the latter, in which Kenya has a competitive advantage, has the highest potential. Kenya would do well to focus on securing access to these markets, which still have hightariff barriers for many of its products. Regional Trade 2.16 There i s a general consensus that Kenya's regional trade i s important, and becoming more important as regional trade integration within EAC and COMESA deepens. However, there is uncertainty over the exact magnitude and composition o f Kenya's regional imports and exports. Regional trade flows are difficult to assess because o f a lack of, or inconsistent, data, and informal trade. With this caveat, the following paragraphs assess the recent development o f Kenya's regional trade flows usingevidence from Kenyan customs data.I2 2.17 Kenya's regional trade has intensified over the last decade, in particular since 2000. In2004, Kenya sourced about 5 percent ofits imports from EAC and COMESA (up from 1.4 percent in 1995)' regional exports accounted for about 40 percent o f Kenya's total exports in 2004, up from a low o f 33 percent in 2001, though relatively unchanged compared with percentages inthe late 1990s. 2.18 The three-year moving average13o f regional imports into Kenya depicted in Figure 2.1 shows that COMESA countries are a more important source o f imports into Kenya compared with the EAC. Imports from the EAC have been trending upwards since 2000 when the Treaty for the Establishment o f the EAC entered into force, albeit slowly. COMESA imports have grown faster since 2000, whereby - somewhat surprisingly - imports from the COMESA free trade area (FTA)14that was established in2000 did not grow more quickly than imports from COMESA as a whole. '* Datasubmittedto UNCOMTRADEdatabase, SITC-1series; for this sectionthe periodof 1990to 2004 was analyzed. l3 Usingthe movingaveragerepresentationsmoothes data irregularities to a certain extent. l4 COMESA FTA emergedfromthe COMESA PTA in 2000, and includedthe following countries: Djibouti, Egypt, Kenya, Madagascar,Malawi, Mauritius, Sudan, Zambia andZimbabwe. 14 Figure 2.1: Kenya RegionalImports 1995-2004 (3 year moving average) 160.0 140.0 120.0 -.-'E 5 100.0 80.0 YI to 3 60.0 40.0 20.0 0.0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 +EAC -m-COMESA FTA ALL COMESA Source: Calculationsbasedon UNCOMTRADEdatabase 2.19 Kenya's regional imports mainly consist of textile fibedtextile products, tobacco, beverages, and cereals from the EAC, and iron and steel, paper products, sugar, machinery/transport equipment and chemicals from COMESA. The main drivers of COMESA imports into Kenya are Egypt and Swaziland; in 2004, they accounted for 70 percent of COMESA imports into Kenya, up from 40 percent in 2000. Imports from SwazilandandEgypt are dominatedby sugar and chemicals, other mainimports from Egypt includecereals, paperandpaperproducts, ironand steel, andmachinery/transportequipment. 2.20 Kenya's regional exports first increased between 1993 and 1998, then declined somewhat until 2001, andhave sincebeenrisingquickly. Regionalexports are dominatedby re-exports of petroleum and petroleum products into its hinterland (Uganda, Rwanda, and Burundi). Kenya's non-oilexports are mainly destined for the EAC. Figure 2.2 shows that Kenya exports almost as much into Uganda as it exports into the entire COMESA FTA; exports to Tanzania are not much lower; exports into the COMESA FTA are dominated by exports intoEgypt, Sudan, Rwanda,EthiopiaandBurundi." ~~~ Is Rwanda andBurundi actually becamemembersof the COMESA FTA inJanuary 2004. Howeverto keepthe country groupingsconsistent,Rwanda's andBurundi's hasbeenincludedinthe COMESA FTA inFigure2.2. 15 Figure 2.2: Kenya RegionalNon-petroleumExports 1995- 2004 (3 year moving average) 500 450 400 .- 350 300 g -`E 250 200 150 100 50 0 I 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 +Uganda -m- Tanzania E4C +COhESAFTA +++ COKSA PTA w/o Ug d C O M E S A Source: Calculations basedon UNCOMTRADE database 2.21 Kenya's non-oil exports into the EAC are chemicals and other manufactured products, also mineral products into Tanzania, and cement and metal products into Uganda. Exports into COMESA feature tea (into Egypt and Sudan) apart from manufactures. m 2.22 Kenya's top manufacturing exports into the region are articles o f artificial plastic material, coated iron and steel plates, cement, medicaments, soaps and paper bagdpaperboard boxes (in2004, these 6 exports lines account for 40.6 percent o f all regional manufacturing exports, and 14.6 percent o f total regional exports). Except for medicaments, these are exports for which Kenya's comparative advantage i s the short transport distance, i.e. heavy goods and goods with little value addition.I6 The situation may, however, be different for medicaments. 2.23 Kenya's trade with South Africa, Africa's largest economy i s very one sided: in 2004, US$450 million imports from South Africa far outweighed US$21 million exports;" over the last decade, exports into South Africa declined from US$31 million in 1995 to a low o fUS$6 million in 1999; since then exports to South Africa have been risingsteadily. l6Mirror data indicate that there are no major errors in these categories; products in secondtier o f `top regional exports' (cleaning agents and powders; paper and paperboard; glass carboys, bottles, etc; rubber footwear soles and uppers; pens, pencils and fountain pens) are also mainly low value addedand/or heavy. " Figures quoted from COMTRADE database, using data reported from South Africa. The 2004 figure excludes a US$30 million aircraft export from Kenya to South Africa; this is likely a one-off deal involving a usedairplane. 16 PROSPECTSFOREXPORT EXPANSIONAND DIVERSIFICATION 2.24 Natural resource-based goods, in which Kenya has a comparative advantage, will continue to be the mainstay o f its exports for quite some time. Kenya can attain a Comparative advantage in new sectors through further development o f human capital; however such development i s likely to occur over the long-term. 2.25 One way to gauge a country's growth prospects is to assess the outlook o f a range of its exports. A growth-prospects index was calculated to establish a concordance [correlation] between the share o f exports held by a product, and the recent world-trade growth rate for that product, assuming continuation o f growth trends, and no changes in a country's competitive position.l8 2.26 Kenya has an index of 0.55; thus its exports should expand at a rate just over one- halfthat for world trade. Kenya's index i s close to the average for Sub-Saharan Africa, which i s 0.58 (see Table 2.5). Within Sub-Saharan Africa, the southern cone comprising SACU, Madagascar and Mauritius have the best prospects for growth; Mauritius i s the only country with an index above unity.'g The index is defined as follows: if si, is the current share of product iin countryj's total exports, and Ri is the rateof growth of the product inworld trade, the exportprospects index (Pj) is Pj = [&jxRi]/R, where R, is the rate of growth of world trade in all products. There are several caveats: First, use of this measure is justified by correlations showing longer-term growth rates for trade in most products are relatively stable. A basic assumption of the index is that past trends will continue. As an example, rank correlations of 1980-1989, and 1990-1999 export-growth rates for all four-digit SITC productswere statistically significant at the 99 percentconfidencelevel. Second, information providedby the index differs from ameasurebasedon the growth rate of a country's total exports over a given period. The latter may be biasedby changes in the relative importance of products during the interval. Third, the measure can provide information on the likely influence of a policy-induced change in the composition of exports on trade-growth rates, but it provides no information concerning the costs, or feasibility, of implementing trade changes. Such changes may take the form of governmentincentivesto diversify exports into new product lines. Countries with an index value above unity may be described as having above-average export-growth prospects, while the reverse is true for those with indices below unity. Furthermore, because the index i s measured relative to the growth rate for world trade it shows how relatively favorable, or unfavorable, are a country's export prospects comparedto world trade. For example, an index value of 0.50 suggests a country's exports should grow at one-half the rate of world trade. An index value of 1.50 indicates its exports should grow 50 percentfaster. This observation is subject to qualifications. Mauritius' relatively high export-growth prospects index is due to the high share (53 percent in 2003) of clothing intotal exports. In 2005, Multi-fiber Arrangement quotas on clothing exports are scheduled to be phasedout and Mauritius' exportswill be subject to increasedcompetitive pressure from China, India, Bangladesh and Vietnam. This may cause the share of clothing in Mauritius' exports to decline, which, in turn, would lower the country's export-growth rate. Lesotho and Kenya are other African countrieswith relatively high shares of clothing intotal exports. 17 Table 2.5: The Export ProspectsIndex for Sub-SaharanAfricanCountries Growth Prospects Growth Prospects Country Index Country Index Angola 0.62 Mauritius 1.18 Benin 0.47 Mauritania 0.56 Cameroon 0.46 Mozambique 0.57 Congo, Democratic Rep. 0.70 Nigeria 0.62 Congo, Republic 0.57 SACU 0.8 1 Coted'Ivoire 0.46 Senegal 0.56 Ethiopia 0.40 Sudan 0.50 Gabon 0.46 Tanzania 0.57 Ghana 0.62 Uganda 0.42 Guinea 0.39 Zambia 0.64 KENYA 0.55 Zimbabwe 0.58 Liberia 0.50 Madagascar 0.90 MEMO ITEM IMalawi 0.74 Average 0.58 Mali 0.20 Range 0.20 to 1.18 Source: Ngand Yeats (2005 Diversify 2.27 The above data reinforce the necessity o f diversifying exports. Continuedreliance on current exports will mean continued poor trade-growth rates and thus, continued global marginalization. This is confirmed by long-term price projections for Africa's traditional exports, most o f which face: declining or relatively low growth in global demand; falling real prices; and highprice volatility. Potential Sectorsfor Export Diversification in Kenya 2.28 Efforts to foster export diversification for Kenya must first identify potential export sectors in which the country would have a comparative advantage. Economic theory posits that diversification should be into the manufacture o f goods that demand relatively low- skilled labor intensiveness. What is increasingly clear is that countries like Kenya may have more options for export diversification than is generally recognized, and that the range o f potential new exports extends well beyond footwear, textiles, and apparel products (see Box 2.1). 18 Box 2.1: Implications of Industrylevel Labor-intensive Indices Specific proposals for product diversification should recognize that new export ventures should be highly intensive ina factor Kenya has inabundance, one o f which is low cost relatively unskilled labor. To assist countries like Kenya to evaluate prospects for potential new exports, the World Bankconducted a study aimed at identifying goods normally produced using labor-intensive manufacturingprocesses. Among survey findings was that manufacturing processes ina relatively highnumber o f industries were dependent on highly labor-intensive production methods and, therefore, suitable for manufacture in developing countries like Kenya. Textile and clothing products were often identified as highly labor intensive; the table below lists a few o f the other products that also utilize high labor inputs. The World Bank's analysis indicates the potential for developing countries to engage in these types of activities is fairly high. Further, many o f these products have relatively high growth rates. Also, even though developing countries were increasing their shares in international markets for many o f these products, there is still scope for further expansion. INDUSTRIALPRODUCTSREQUIRINGLABOR-INTENSIVEMANUFACTURINGPROCESSES Industry(Labor Intensity Index) Industry(Labor Intensity Index) Industry(Labor Intensity Index) Poultry and dressing plants(41.7) Wood TV and radio cabinets Women's handbags(48.2) Fresh and frozen fish (59.7) (50.3) Leather glovers (43.0) Curtains and draperies (42.5) Wood kitchen cabinets (67.5) Leather belts (60.5) House furnishings (59.7) Wood office furniture (72.7) Leather tanning(68.9) Textile bags (50.5) Upholstered furniture (57.3) Luggage (62.7) Canvas products (57.6) Bookbinding (53.2) Earthenware food utensils (47.6) Hardwood flooring (45.1) Watches and clocks (66.7) Pottery (57.7) Hardwood plywood (57.4) Musical instruments(64.4) Artificial flowers (59.6) Softwood plywood (55.2) Dolls (66.5) Buttons (57.5) Nailedwood boxes (49.9) Costumejewelry (64.7) Woven carpets (62.0) Folding paper boxes (72.8) Fabricated rubber products (83.3) Cordage and twine (63.7) Envelopes (81.1) Rubber andplastic footwear (47.4) Wood household utensils (65.7) Wood containers (45.2) Boot and shoe stock (52.7) Handbags (67.2) Wood household furniture (50.1) House slippers (46.2) Sewing machines (71.1) Brooms andbrushes(71.1) Men's footwear (54.9) Residential light fixtures (73.5) Women's footwear (53.0) Note: The lower the intensity index, the higher the labor intensity. An ir :x value of 50.0 indicates a product that requires twice the average labor inputs as an averageo f all sectors o f the economy 2.29 Africa i s not exploiting these opportunities; Ng and Yeats (2005) show that labor intensive-manufacturing accounts for less than six percent o f Sub-Saharan Africa's exports (excluding South Africa); this is slightly lower than the corresponding share in the mid- 1990s. Also, textile and apparel production accounts for 80 percent o f all labor-intensive manufactures exported from the region. Dynamic Exports in Sub-Saharan Africa 2.30 Dynamic exports from Sub-Saharan Africa are exports for which world trade grew at above average rates and for which growth o f exports from Africa exceeded global averages." Forty-eight products fall in this category and these had a value o f US$13billion in 2003. Seventy percent o f these are manufactured goods. Passenger motor vehicles are the single 2o N g and Yeats (2005) compiled this list using a metric that enabled categorization o f products according to growth in world-market demand and Africa's market share; see their publication for further details. 19 largest product on the list, with an export value in2003 (primarily from South Africa) of over US$2billion. However, there is a relatively broad range o f products for which world trade grew at above average rates, and in which African countries were able to maintain or improve their international competitive position.21 2.31 A noteworthy point about the African origins of exports in these 48 goods is that most originated in the southern cone o f Africa. SACU accounted for 71 percent o f all exports, followed by Mauritius (16 percent), and Madagascar and Zimbabwe (3 percent each). However, all Sub-Saharan African countries, with the exception o f Reunion and Rwanda, produced some competitive-dynamic goods for export (see Table 2.6). *'Among goods for which trade expanded at above-average rates even as African countries were unable to maintain market share are several textile and apparel products, trade in which may have been strongly affected by AGOA. Other goods in this category are platinum, printing paper, miscellaneousbase metals and toys and games. Goods for which trade expanded, but export growth in Africa actually shrank include palm oil, vegetabletanningextracts andsafety glass. 20 Table 2.6: Fast GrowingExports,ofwhich African Countries Increasedtheir Share of World Markets 2003 GlobalImports Annual Import (US$ m lion) 2003 SSA Growth 19! 8-03 (Yo) Export Product From Market From SITC (Revision2) Africa World Share(YO) Africa World 072.2 Cocoapowder 122 1,287 9.5 46.7 12.8 034.3 Fishfillets 176 2,184 8.1 44.1 12.1 743.6 Filteringmachinery 1,097 14,818 7.4 40.1 8.8 764.3 Radiotelephonicgoods 76 78,562 0.1 36.9 20.3 781.0 Passengermotor cars 2,333 379,276 0.6 36.7 6.7 762.1 Radio receivers 38 8,735 0.4 34.3 5.8 341.3 Petroleumgases 1,445 47,920 3.0 31.4 7.8 776.3 Diodes andtransistors 33 29,247 0.1 31.1 11.7 713.2 Combustion engines 104 38,788 0.3 29.8 7.7 893.2 Toilet articles 34 1381 1.8 29.5 7.2 523.3 Salts ofmetallic acids 112 2,208 5.1 29.2 5.9 551.4 Air fresheners 5s 9,320 0.6 28.7 10.7 511.1 Acyclic hydrocarbons 149 7,402 2.0 28.0 5.O 112.1 Wine of grapes 526 17,690 3.0 26.8 6.0 334.1 Motor spirits 1,807 152,489 1.2 25.7 15.3 122.2 Cigarettes 52 12,227 0.4 24.9 5.1 741.5 Air conditioningunits 39 16,503 0.2 24.2 9.4 625.1 Pneumatic tires 100 15,415 0.6 24.0 6.4 553.0 Perfumery and cosmetics 107 30,3 13 0.4 22.8 10.3 112.4 Spirits and liqueurs 39 13,103 0.3 22.5 4.3 642.8 Articles ofpaper 44 13,411 0.3 21.0 7.8 277.2 Natural abrasives 44 710 6.2 20.8 -0.5 672.7 Ironor steel coils 643 21,568 3.0 20.6 5.3 821.1 Chairs and other seats 460 33,923 1.4 20.5 9.5 533.1 Other coloringmatter 33 6,766 0.5 20.4 5.8 892.8 Printedmatter. 38 11,574 0.3 20.3 5.2 282.0 Scrap metal 163 13,971 1.2 19.7 6.3 761.1 Televisionreceivers 35 34,021 0.1 19.7 6.0 625.2 Tires 69 8,797 0.8 19.5 5.8 098.0 Ediblepreparations 156 21,560 0.7 19.2 8.8 773.1 Insulatedwire 119 39,609 0.3 18.9 9.2 512.1 Acyclic alcohols 285 16,436 1.7 18.6 7.7 081.4 Flours of meat or fish 48 2,368 2.0 18.5 2.2 776.4 Electronicmicrocircuits 37 215,600 0.0 18.4 13.3 246.0 Pulpwood 384 2,657 14.4 18.0 2.2 872.0 Medical instruments 35 34,978 0.1 17.7 10.4 233.1 Synthetic rubber 34 8,434 0.4 17.6 4.5 782.1 Trucks 177 64,34 1 0.3 17.4 5.9 764.9 Parts oftelecommunications 76 77,861 0.1 17.2 9.5 21 Table 2.6: Fast GrowingExports, of which African Countries Increased their Share of World Markets (continued) I 2003 Global Imports Annual Import lion) 2003 SSA Growth 19 -03 (%) Market From SITC Export Product(Revision 2) Africa World Share (YO) Africa World 598.9 Chemical products n.e.s. 145 45,784 0.3 16.6 7.5 843.9 Other outer garments 471 34,949 1.3 16.3 7.4 778.8 Other electrical machinery 79 54,801 0.1 16.2 8.8 541.9 Pharmaceutical goods 34 8,063 0.4 15.8 9.6 743.9 Parts o f centrifuges 71 11,501 0.6 15.8 7.8 714.9 Parts o f engines and motors 55 29,199 0.2 15.8 6.7 784.9 Other motor-car parts 497 170,260 0.3 15.7 6.9 778.3 Electrical motor equipment 43 17,919 0.2 15.6 7.2 845.9 Other knitted outer garments 319 23,639 1.4 15.4 8.1 ALL ABOVE PRODUCTS 13,039 1,904,069 0.7 24.0 8.5 3 to 9 ALL GOODS 109,183 7,189,836 1.5 A 7 T . , 6.1 and average annual growth rates o f at least 15 percent from 1990 to 2003 (excluding armored vehicles) Source: Computations based on world imports from UNCOMTRADE Statistics. 2.32 One unexploited segment is international production sharing. Worldwide, production- sharing activities and the related component-and-finished-product trade have grown substantially in recent years, and are expected to continue to do so. African trade in components is limited to relatively few items. Over 50 percent o f all component imports occur in just three product groups: telecommunications equipment, motor vehicles and switchgear. 2.33 It is difficult to determine what portion o f African component imports are locally processed, and then re-exported. However, evidence from East Asia indicates that domestic assembly o f imported components for re-export is o f major importance. Trade in components will offer African countries an opportunity to export products that they otherwise would not be able to. One example is BMW motor cars, which are assembled in South Africa. 2.34 Over the past 15 years, Kenya has emerged as Africa's third-largest importer o f components, with 2003 trade equivalent to U S 2 5 0 million, or about ten percent o f total trade; South Africa dominates African imports o f components. Trade in parts and components betweenKenya and South Africa has beendeveloping rapidly (see Table 2.7). 2.35 Kenya imports crude petroleum from various sources, refines it, and then exports processed petroleum products to other East African countries. Given the importance o f production sharing, further opportunities should be exploited for processing other primary commodities like foodstuffs, wood and paper products, or metal ores. Initiatives to encourage food processing for export or domestic consumption should be given a highpriority. 22 Table 2.7: Changes in Selected African Countries' Trade in Parts and Components, 1990to 2003 ComponentTradeValues ($000) Share of F t s in Total rade (X) Trade FlowJCountry 1990 I 1995 I 2003 1990 1995 2003 African Countries' Imports Angola 193,772 174,445 589,122 12.42 12.42 13.74 Burundi 21,568 18,626 9,475 13.21 13.21 7.49 Congo, Dem. Rep. 215,273 80,243 72,3 11 17.29 17.29 10.56 Congo, Rep. 74,904 101,766 133,069 12.08 12.08 13.28 Cote d'Ivoire 115,414 204,166 161,991 7.46 7.46 7.66 Ghana 116,417 227,045 244,958 10.39 10.39 8.50 Kenya 326,277 327,202 248,222 18.08 18.08 9.45 Madagascar 83,105 60,072 70,509 12.55 12.55 6.78 Mauritius 89,380 117,885 167,863 8.80 8.80 9.23 Nigeria 845,724 668,632 1,695,592 16.36 16.36 13.57 SouthAfrica 2,918,284 4,684,771 5,104,523 23.70 23.70 18.46 Sudan 99,846 95,301 244,4 12 11.04 11.04 11.00 Tanzania 154,364 198,982 192,735 16.26 16.26 11.25 Uganda 57,056 57,911 84,722 11.37 11.37 8.06 Zambia 127,540 147,154 134,601 19.15 19.15 15.29 Zimbabwe 142,253 261,147 137,071 17.50 17.50 10.94 Source: Computationsbased UT 2.36 An analysis of available trade data reveals that Kenya's participation inproduction- sharing activities and export o f finished goods produced from components are both relatively low. There is also no clear evidence that Kenya's integration into international production chains i s increasing. Kenya exports and imports parts for manufactured products (engines, machinery, refrigerators, telecommunications, appliances). Exports o f such parts and components increased by almost 60 percent between 2000 and 2003 (still account for less than one percent o f Kenya's total exports though); imports o f parts and components declined duringthe same period by 20 percent (see Table 2.8). Table 2.8: Exportsand importsof parts and components2000 and 2003 ' Source: ComputationsbasedUNCOMTRADEdatabase. 2.37 Overall, Kenya's integration into global production chains decreased between 2000 and 2003 since the increase in parts and components exports has been offset by a decline in imports o f same. Kenya's share o f worldwide trade in parts and components was 0.018 percent in2000 and has since declined by almost a quarter to 0.014 percent. 23 2.38 However, Kenya i s integrating into emerging Sub-Saharan African production chains; imports and exports o f parts and components from and to other African countries increased between 2000 and 2003, although levels remain moderate.' 2.39 Table 2.9 shows that Kenya's exports o f finished assembled products (machinery, transport equipment, and other manufacturing) are low, about two percent o f total exports in 2003, but increasing; exports to both OECD and Sub-Saharan African countries increased, and the increase inexports to the former is more pronounced.22 Table 2.9: Exports of machinery, transport equipmentand other manufactures,2000 and 2003 2000 2003 YOchange Exportsmachineryetc. (US$ million) 24.9 44.6 79 to OECD (US$ million)) 5.6 17.8 217 to SSA (US$ million) 17.6 24.5 39 % of all exports 1.4 1.9 Source:ComputationsbasedUNCOMTRADE database. 2.40 Table 2.10 compares production sharing exports' contribution to export growth in Kenya and comparator countries. Kenya lags behind countries in East and South Asia, Latin America, and South Africa. Contribution o f production sharing exports to total export growth i s further broken down in to contribution to export growth by (i)exports that use parts and components, and (ii) exports ofparts and components. InKenya, the latter is by far the more important contributor to export growth. Table 2.10: Contribution of Production-SharingExportsto Export Growth 1992 to 2000 Source:ComputationsbasedUNCOMTRADEdatabase. 2.4 1 Kenya has performed relatively well in exporting intermediate goods (compared with its export o f goods for which it imported intermediate goods). Other countries that are increasingly engaged in intermediate manufacturing (as supposed to the final stage) are 22 The significant increase in exportsto the OECD is largelydrivenby ajump in "Electric sound andvisual signalingapparatus" exportsto the UK (suchexportswere worth US$0.05million in2000, but had jumpedto US$10.4million in2003 beforefallingto US$0.7million in 2004; thus the 2003 number may be inaccurate. 24 Brazil, Chile and South Africa. It may therefore be worthwhile for GOK to study conditions and developments inthese countries. 2.42 There seems to be no particular reason for Kenya's diminished integration into global production chains other than a general erosion o f businesscompetitiveness relative to countries that compete with it in OECD markets. Studies o f production-sharing in other countries show that the following conditions are critical for exporting economies matter: transport infrastructure; reasonable telecommunications costs and networks; access to finance; and minimal or no political risk and corruption. The next section o f this report will more closely examine transport infrastructure, telecommunications and access to finance. However, it i s clear that to achieve further integration into production-sharing networks, policy must not be sector specific but rather should address improving the broader business environment. Potential of Regional Trade 2.43 Regional trade's potential for significant expansion and diversification appears limitedfor a numberofreasons: Gro.wthexpectations for Kenya's existing regional exports is limited since Kenyan imports already zero tariffs inthese markets, so there is no further trade liberalization round that could stimulate exports. Hence, any further demand for Kenyan exports would come from economic growth in the region. Also, the complementarity between the regional products i s low: for Kenya's top exports in horticulture where the country has developed a competitive edge, its regional neighbors are competitors, rather than potential markets. 2.44 A caution should also be sounded at the possibility ofregional exchange ofrelatively highcost manufacturinginputsandproduction equipment for which membercountries do not have a comparative advantage inproduction, and trade i s stimulated by trade preferences. For some o f these products, competitors, inparticular from Asia might soon be able to supply at lower cost. The same may also be true for some o f Kenya's regional manufacturing exports that are competing with exports from Asia, as well as with production capacity elsewhere in the region, financed with FDIfrom Asia.23 2.45 As regards diversification, the historical record is not encouraging. Overall, concentration in Kenya's top five export products increased between 1976 and 2004, from 61 percent to 63 percent for exports to EAC, and from 56 percent to 59 percent for exports to COMESA (see Table 2.11). Petroleum and petroleum products were Kenya's major regional export to EAC and COMESA in 1976 and 2004; the share o f this top export commodity increased for EAC by about 3 percent and for COMESA by about 4 percent over this period. Thus there is little evidence that regional trade facilitated an important expansion o f exports innewproduct lines. 23See below, andinmoredetailWorld Bank (2006). 25 Table2.11: The LargestProductsin Kenya's Exports to EAC and COMESA 1976 and 2004 Value of Imports(US%m) Shareof Total imports(YO) 1976 2004 1976 I2004 TOTAL EXPORTSTO EAC 155.0 II465.8 100 I 100 Source: Kenya's exports as tabulated from the import statistics o f Uganda and Tanzania for the EAC, and COMESAmemberstates for COMESA.The choiceof years inthis table was necessitatedby the fact that many EACandCOMESA countriesdidnot reporttrade statisticsto the UnitedNationsfrom 1977to the mid-1990s. 2.46 However, South Africa should become an increasingly important market for many o f the raw materials and foodstuffs exported by Kenya. Differences in the level o f industrialization and in labor costs between South Africa and Kenya may have positive implications for the development o f regional production sharing in a manner similar to that in East Asia. One possible scenario is that South Africa will increasingly emerge as an exporter o fparts and components for assembly in low-wage, less-industrialized, African countries. Potential of AGOA . 2.47 Kenya provides less than two percent o f US imports under AGOA preferences. This i s negligible, and the scope for increasing exports under AGOA i s limited for several reasons: 26 0 There are few sectors apart from apparel and clothing in which AGOA preferences provide significant advantage (due to the generally low level o f MFN tariffs and existing preferences under the GSP program). 0 It is unclear whether Kenya (and other clothing exporters inAfrica such as Lesotho) can remain competitive exporters o f apparel following removal o f all multi-fiber restrictions. Thus far there has been little impact inthe first six months since removal o frestrictions. 0 Kenya appears to be at a transport-cost disadvantage for exports to the U S vis-a-vis other countries. Kenya's overall nominal transport costs are more than three percentage points higherthan those o f its global competitors. Potentialfor Trade with Asia 2.48 A recent World Bank report24assessing the developments and opportunities of trade between Africa and Asia finds that the volume o f African exports to Asia i s accelerating. It grew by 15 percent between 1990 and 1995, it has grown by 20 percent during the last five years (2000-2005); this growth largely reflects a sharp upturn o f their exports to China and India, However, despite this growth, Africa still remains relatively small from perspective o f Asian economies. African exports to Asia account for only 1.6 percent o f total global imports o f Asian economies. 2.49 Furthermore, the report finds that Africa i s increasingly well-positioned to competitively supply labor-intensive goods and services to today's Chinese and Indian firms and consumers. China and India are not just big potential markets for more diversified and higher valued-added goods and services from Africa, they are real opportunities, especially compared to Africa's traditional export markets inthe North. 2.50 Petroleum i s the leading African export, followed by ores, metals, and gold. But the rapidly growing exports to China and India are not limited to fuels and other mineral and metal products. Raw or semi-processed agricultural commodities that are used for further processing for industrial use (timber, cotton) or for food are also increasingly imported by China and India. 2.5 1 Asian exports to Africa are equally growing rapidly. Duringthe last five years, they have grown by 18 percent, higher than any other region, including the EU. Asian exports to Africa are largely manufactured goods, which have surged into African markets. There are also sizable amount o f imports o f consumer non-durables from Asia which compete against Africa's domestically produced products. However, some o f Asian exports to Africa are also intermediate inputs to manufacturing products assembled in Africa and shipped out to the thirdmarkets such as the EUand US, or providing capital goods (machinery and equipment) for the manufacturing sectors inAfrica. 2.52 So far, Kenya's exports into China and India are minuscule - in 2004, Kenya exported goods worth US$l1 million into China, and US$51 million into India - that i s 24World Bank(2006). 27 comparable with exports into Malawi and Sudan respectively, and combined just slightly over 2 percent o f Kenya's total exports. However, trade with these two countries has been growing rapidly. Since 2000, exports into China increased more than four fold, and exports into India more than doubled. 2.53 Hence, regional diversification into Asia is already under way, and a combination of the low export values to date, and the size and growth o f the two markets, there is considerable potential for further regional diversification into Asia. 2.54 As far as product diversification is concerned, Kenya's top exports into China and Asia confirm Kenya's competitiveness intea which features prominently in exports into both countries. Other important exports that do not feature in Kenya's top export list are nuts which i s another important export into both countries and into China sisal, titanium and natural gums, and into India quartz, leather, soda ash and precious and semi-precious stones. SUMMARY OF KEY MESSAGES THAT HAVE POLICY IMPLICATIONS 2.55 Kenya's sub-par export performance cannot be attributed entirely to the lack of access to developed-country markets. The average level of OECD tariffs for African exports i s much lower than those faced by East Asian exporters at the start o f their industrialization drive. 2.56 There have been some achievements, in such sectors as cut flowers and fresh vegetables, in which Kenya has established a competitive supply chain, and clothing in which Kenyan manufacturers have profited from AGOA preferences. At the same time many o f Kenya's exports have become less competitive, the most salient beingcoffee. 2.57 Natural resource-based exports are likely to remain the mainstay o f Kenya's exports for some time. Lessons from the successful development o f cut flowers, fresh vegetables should serve to guide GOK's policy reform o f other non-traditional natural resource-based sectors. 2.58 There is some growth potential in regional trade for commodities such as maize, dairy, and processed food. Regional trade in finished products however holds less potential because o f low complementarity among regional partners. 2.59 Traditionally, Kenya's main export market has been the EU. Given the sluggish economic growth there in the past decade and the contrastingly dynamic performance o f South and East Asian economies, Kenya would do well to secure access to the latter's markets. South and East Asia's populations are likely to maintain strong demand for food items such as coffee, tea, nuts and horticulture, which i s perhaps the sub sector in which Kenya has the greatest competitive edge. However, Kenyan exports still face relatively high tariffs to enter these markets. 2.60 The government i s right to encourage export development and diversification into labor-intensive manufacturing and processing industries. One sector that warrants close attention is international production sharing, which i s fast growing in part because o f 28 declining transport costs. South Afi-ica and South and East Asian countries are potential partners. The need to improve competitiveness and create a commercial environment conducive to export diversification i s key. The first step towards improving the commercial environment would be to identify the major domestic constraints to international business development. Clearly, the ability to attract foreign investment will be vital if Kenya i s to diversify into new export lines. 29 30 3. DOMESTIC CONSTRAINTSTO TRADE COMPETITIVENESSAND COMMERCIAL CLIMATE FOR TRADE KENYA IN 3.1 The major obstacles to export expansion and diversification are Kenya's commercial and investment climate (Le. the cost o f doing business), a weak legal framework, licensing issues, complex rules and regulations governing exports, and the poor quality and high cost o f business services in Kenya. This i s the conclusion o f a number o f recent analyses undertaken by the World Bank (see Box 3.1).25 The GOK has acknowledged many o f these issues in its PSD Strategy and Investment Climate Action Plan; the priority must now be to swiftly implementthese initiatives. Box 3.1: Kenya's BusinessClimate--Key Findings of RecentAnalytical Work The ICA's findings underscore how manufacturing competitiveness is undermined by high indirect costs pertaining to corruption, crime and infrastructure. Transport services are poor, power services are uncertain, and fixed-line telephone costs uneconomical. These weaknesses negate Kenya's inexpensive, relatively well- educatedlabor force, hamper productivity and discourage investment. Flaws inthe legal system include: cumbersome and expensive procedures to establish a business; outdated, complex and bureaucratic measures relating to key elements o f commercial legislation; lengthy and costly insolvency procedures; a weak framework for secured transactions and difficulties associated with contract enforcement and commercial-dispute resolution due to inefficiencies in the court system. Investment in Kenya i s further severely constrained by corruption and crime. Lastly, a report on growth and competitiveness found that although literacy o f the Kenyan workforce is relatively high compared to its Sub-SaharanAfrican neighbors, the level and quality o f skills development and technical training is inadequate. 3.2 In addition to the above constraints, for MSMEs there is also very limited access to export finance, which i s a key barrier to exporting. For trade to play a key role indriving and sustaining growth, reforms and investment need to be put in place to address these behind- the-border issues. TRANSPORT TRADEAND LOGISTICS26 3.3 Kenya's trade logistics are weak in critical aspects, but have some bright spots. Trade by sea and land routes (98 percent by volume) faces major hurdles and bottlenecks. Kenya's trade logistics chain-with the exception o f air transport-lies along the so-called Northern Corridor which links the port o f Mombasa with Nairobi and the hinterland (Uganda, Northern DRC, and Rwanda). Many cities and economic activities in Kenya and the interior ~~~ 25 World Bank (2003), Kenya-Growth and Competitiveness, report No. 31387-KE, Washington DC, USA; FIAS (2004), Kenya-Improving the Commercial Legal Framework and Removing Administrative and Regulatory Barriers to Investment, Washington DC, USA; World Bank (2004) Enhancing the Competitiveness o fKenya's Manufacturing Sector: The Role o fthe Investment Climate, Washington DC, USA. 26 This is a summary ofthe mainreport inwhich canbe found at www.worldbank/kenya. 31 are located on or close to the corridor. Assessing trade'logistics in Kenya thus focuses on various procedural and physical impedimentsthat occur along the corridor. The quality of much corridor infrastructure i s sub-par because o f very low levels o f maintenance and investmentover the past two decades. 3.4 The ensuing high cost o f transport constitutes a variable burdenfor export industries varies-it i s particularly high for sugar and for coffee. Coffee and sugar production concentrated in particular regions; therefore improving roads and other transport infrastructure in these areas should be a priority. Another sector where transport and trade logistics play a major role is the garments sector, for which turnaround times for production cycles are an important determinant o f competitiveness. 3.5 A positive aspect of Kenya's transport and trade logistics is the existence of an effective private sector able to implement innovative solutions despite a poor investment ' climate. Very efficient air logistics services have been established to provide a first-class link between Kenya and global markets. 3.6 Kenya's poor trade-logistics performance is due to a backlog in investments and reforms. The condition o f some sections o f the main corridor highway i s very poor. Kenya Railways has been essentially defhnct as a provider o f freight services since the 1980s. In addition, transport operators face overly onerous transit and border-crossing procedures that inhibit trade with Ugandaand Rwanda. 3.7 As a result o f dilapidated infrastructure and complicated procedures, especially at Mombasa port, trade facilitation indicators for Kenya are poor. Customs operations are still essentially manual and relatively complex. It takes an average o f about two weeks to clear a container at porta2' The port is congested, a consequence o f mismanagement rather than a lack o f physical capacity. Mombasa's performance is sub-par, compared with the port o f Dar es Salaam, where container throughput has grown much faster (see Table 3.1). Transport logistics are also characterized by a high degree o f unpredictability, due to poor information systems and physical bottlenecks at the port or en route. Uncertainty over delivery times is a considerable cost burden to operators and consignees, especially manufacturers, and is sometimes more damaging than delays. Kenya lags far behind other Sub-Saharan gateway countries in the design and implementation o f core trade and transport facilitation measures (see Table 3.2). Table 3.1: Container Throughput in TEU Source: PMAESA, Liner Trades inEastern and Southern Africa 27Informationon the average dwell time was provided by freight forwarders, rather thanby the port authority because KPA does not collect statistics on dwell times. Thus, in order to benchmark future efforts on improving port performance, it would be necessary to collect statistics on dwell times, broken down hrther ifnecessary. 32 Table 3.2: Benchmarkingof KenyanReforms Against Those of Other Sub-Saharan African Countries Ports Railways Customs Kenya Lack o f investment, lagging Operations and infrastructure Modernization launched, productivity; Grain havebeen neglected; with implementationo f operations have been Concession awarded GAINDE2000 system privatized Cameroon Container terminal Very successful privatization, Undergoing modernization modernized and privatized; with operations now o f high since 2003; New IT Other port operations under quality system installed: Single rehabilitation window in Douala to be automated CBte Good standardofoperations; Very successful privatization; Partially modernized; i'Ivoire Most operations (containers, Operations compromised by the Aging in-house stevedoring, tugging) have ongoing political situation automation system beenprivatized Ghana Very few services privatized; Limitedto domestic coastal and Partially modernized; O f average quality but mining traffic; Not privatized Successful automation services are the least program extended into a expensive in the sub-region community system Senegal Good standard of operations; Privatization complete; Customs successfully Most operations (containers, concessionaire has begun modernized; Locally stevedoring) have been operations developed IT system privatized GAINDE 2000, now being implementedin Kenya ranzania Very efficient container Very poor quality Modernization underway, terminal operation following infrastructure; 25-year including implementation privatization; Other concession awarded in April o fASYCUDA +t operations currently o f 2006 to RITES Co. of India; average quality to be Privatization planned for the privatized rail link to Zambia 3.8 It is not surprising then that international logistics operators have a very negative perception of Kenya's logistical performance compared to that o f other developing economies. Kenya was ranked as the least logistically friendly o f 70 countries in the 2004 Logistics Perception Index, which also includes Nigeria, Ghana, South Africa and ZambiaSz8 3.9 In the last two years, modernization o f trade logistics has accelerated. The current agenda addresses four main issues: improvement o f road infrastructure backed by a consistent maintenance policy; a Customs Reform and Modernization (CRM); concessioning the operations o f the Mombasa-Nairobi-Kampala railway line; and a modernization program for the port including investment in key equipment (gantry cranes) at the container terminal and automation o f the waterfront information system. Implementation of this reform program i s being pushed by a proactive private sector, strong cooperation among stakeholders, and considerable donor support for modernization. The Logistics Perception Index (LPI) measures perceptions o f the logistics environment o f countries. The data for the LPI is gathered from managerial-level personnel o f international freight forwarding firms. worldwide. To date, LPI is the most comprehensive, albeit qualitative, logistical performance index. The index is compiled and published by the Turku School o f Economics and BusinessAdministration in Finland; the most recent index was released in 2004. 33 3.10 The modernization agenda must be implemented effectively to bring about the desired gains. These are likely to be very significant (see Box 3.2). However, successful implementation requires not only new equipment, but also implementation capacity at the level of the port, at the level o f coordination, and at the supervisory level. Also needed is the political will and support from the highest level to eliminate rent-seeking activities that arise from the system's present ineffi~iency.~~The ongoing involvement o f the private sector i s also vital, particularly in freight forwarding and transport, to ensure that public-sector modernization complements technologies already deployed by the private sector. Benefits Benefitsper per measure country II Malababordercrossing Reduceddwelltime Mombasa US$56m Kenya US$46m Transit simplificationinKenya II US$14m Uganda US$2lm US$lOm II Rwanda II US$22m II I Transit simplificationinRwanda I $1Om I Tanzania I $23m I Reduceddwelltime at Dar es Salaamport $22m Tanzania Total $112m $112m 3.11 There must be sufficient capacity and resources to implement, monitor and evaluate the modernization program. Progress on customs-facilitation reforms can be effectively monitored using indicators developed in the Time Release Study (TRS) undertaken by the Kenya Revenue Authority and the World Customs Organization (WCO) (see Box 3.3). 29One importantexample is the intermediariesthat help consigneesor forwardersto track their containers; replacingthe current manualsystemwith a computerizedtrackingsystemwould eliminate the businessofsuch intermediariesandhas thus beenfiercely resisted. 34 Box 3.3: Time Release Study Kenya Revenue Authority (KRA) and World Customs Organization (WCO) prepared a Time Release Study (TRS) to enable KR4 to benchmark its reforms, and to monitor reform implementation and success against a baseline, as well as global benchmarks. The TRS provides information on the time needed for completion o f various stages inthe customs clearance process, from arrival o f goods until their release, and identifieswhere improvements are needed. The study frnds that the time taken to clear goods has to be improved to meeting international standards. Goods at landborder posts inKenya take 20 hours to clear; at seaports clearance takes 10 days, 8 hours; and at the airport, 11.5 hours. Release times are shorter than in Tanzania (2 days, 20 hours at land border posts, 11 days, 9 hours at seaports and 7 days 20 hours at airports), but are very much longer than in the most efficient countries; in Sweden in 2001, landborder crossings took an average o f 11 minutes; at the seaport the release time was 1.4 hours. A TRS conducted at Port Klang, Malaysia, 11 years ago found an averagereleasetime o f only 34.5 hours. To reduce customs release times, the report recommends introduction of an electronic declaration system that will allow the introduction o f a single window at which traders can lodge information with one agency, at the same time hlfilling all import- and export-related regulatory requirements. The electronic SIMBA system was introduced inJuly 2005, and is now fully functional andsupporting a single window. The report also recommends a range o f improvements to avoid duplication and eliminate unnecessary procedures. The most important recommendations o f these: introduction o f a random quality-control provision on receipt o f declaration; introduction o f a single entry-identification number; improved coordination between customs authorities and other agency controls; introduction o f enhancedrisk-analysis techniques by all agencies involved; and introduction o fpost-clearance audits to ensure compliance. Lastly, the report recommends augmenting cooperation between customs authorities and the private sector to improve procedures, and to explore the introduction o f an authorized trade scheme that would permit "frequent traders" to use simplifiedprocedures. 3.12 Implementation o f the reform agenda i s expected to yield significant reductions in transport costs. This report estimates that improvements made along the Northern Corridor and at the port could reduce facilitation times for the garment sector by between 22 percent and 32 percent, and reduce the total textile-production cycle by 4 percent-5 percent. Recent productivity improvements and corresponding reductions in dwell time at Dar es Salaam port following its privatization in 2000 illustrate the benefits o f upgrading port infrastructure (see Table 3.3). 1999 2000 2001 2002 2003 %improvement Service time (daydship) 1.09 1.1 1.1 0.69 0.76 30% Crane productivity (moves/crane/hour) 14 15 19 20 21 50% Dwell time (daydcontainer) 37.7 25.9 16.7 16.7 17 55% 3.13 Kenya's very efficient air logistics are illustrative o f the benefits o f allowing the private sector to take the lead in pushing development. Air transport in Kenya effectively links Kenya and its global markets flower and horticulture markets and sustains the thriving tourist industry. Kenya has become a leader in these industries because private entrepreneurs-both Kenyan and foreign-have developed a very efficient supply chain, leveraging the advantages o f Jomo Kenyatta International Airport (JKIA). Transport cycles from the field to markets in Europe can take as little as 24 hours. Volume o f exports is over 100,000 tons per annum with shipment costs to Europe about 50 percent less than cargo rates 35 elsewhere in Africa. GOK provided the institutional conditions by privatizing the airline and the airport and eliminating conflicts o f interest by separating regulatory functions from those o f service providers. 3.14 JKIA airport has emerged as the dominant hub inEast Africa for passengertransport; almost 90 percent o f regional passengers originating in or destined for Nairobi, and more than 80 percent o f flights from Europe and 75 percent o f flights to Asia going through Nairobi. 3.15 Kenya's road transport and forwarding industries are among the best-organized in Africa. Quality o f service and operating costs are close to levels in Europe. Once again, the private sector has been key ininstigating andpushingthe modernizationagenda. 3.16 Inaddition to the current modernization agenda, this trade report has identified three key issues: development o f a roadmap for electronic data interchange (EDI) that encompasses transit activities (such as cargo tra~king);~'phase out o f the current convoy trucking system and replacement with a less inflexible and expensive alternative; and overhaul o f weighbridge regulations and operations to eliminate delays and regional inconsistency. 3.17 Kenya has not experienced the emergence o fregional third-party logistics services for importers and exporters in East Africa. Logistics in the region are still very much organized along the corridors, reflectingthe segmentation o f markets. However, there i s potential to add value beyondmere point-to-point transportation on the Northern Corridor (e.g. regional hubs for distribution o f products in several countries). The highly professional and competitive operators based inKenya are certainly well positionedto provide these services on a regional basis inthe future. 3.18 The widespread perception that Kenya suffers from high inland cost transportation, and that the lack o f rural roads i s a key constraint for farmers could not be substantiated by the study. Transport infrastructure and logistics were not found to be major constraints for long-distance transport nor for bringingproduce from farms to processing plants or collection centers. Findings from a field study (see Box 3.4) show that rural transportation costs are only a small fraction o f total production cost. 30This is likely to beresolvedby the World Bank EAC Trade andTransport FacilitationProject, which is being negotiatedat the time ofwriting ofthis report. 36 Box 3.4: Issuesin Trade Logisticsin Kisumu and Nyandarua A case study undertaken for this report analyzed rural logistics chain in two districts (Kisumu and Nyandarua). Through extensive interviews and surveys, the study examined how subsistence and cash crops reach markets, and provided cost estimates for the logistics chains. It appears that the typical logistics chain involves a series o f intermediary means o f transportation as well as middle men or brokers who typically have access to motorized means o f transportation. Transportation costs are not particularly high, consistent with observations made along the Northern Corridor, and accounts for about 10percent to 20 percent o f the disparity between farm gate and consumer prices, depending on the distance. More significant is that farmers have little market information or bargainingpower, and the lion's share o f margins is captured by a series of middlemen, a problem correlated with distance from markets. Large commercial organizations that deal directly with farmers offer more favorable conditions, but their reach is limited to the areas close to Nairobi where most are based. Other problems along the supply chain that limit farmers' marketpower or their ability to access export markets are a lack o f cold-storage facilities for horticulture and milk products, and the increased stringency o f standards for horticulture exports. Oversight for transport logisticsis distributedacross various ministries(see Table 3.4). Table 3.4: Distributionof Government oversight for transport and logistics 37 RECOMMENDATIONS 3.19 Effective implementation o f the current modernization programs i s o f paramount importance. The reform agenda must receive continuous high-level political support. The first priority is automation o f container tracking at the port. A second priority i s the development o f a set o f logistics indicators to benchmark reforms and progress. I t is critical that the private sector occupy an important role in driving forward reform, as well as insome advisory capacity. 3.20 The study recommends that technological solutions for sealing or cargo tracking not be considered until a basic information system on goods in transit is in place. The system should rely onjust two components: a carnet system (road manifest attached to the truck) and real-time reconciliation o f transit informationbetween port o f entry and port of exit. Ensuring consistency among regional regulations is vital. Divergence from COMESNEAC recommendations on weighbridges i s highly undesirable and should be addressed by the relevant regional bodies. 3.21 Donors have been active in this area for a relatively long time in Kenya; however, GOK should manage donor support going forward to ensure coordinationofpriority actions. 3.22 There are currently no problems in the air-transport sector, and it is very important that this continues, giventhe importance o f air traffic for Kenya's key export sectors. STANDARDS AND CONFORMITY -ASSESSMENT INSTITUTIONS AND CAPACITIES3 Standardsfor Export Diversification: Horticulture, Flower and Fish 3.23 Kenya's expansion and diversification into horticulture has increased the attention given to meeting standards.32 These were o f little importance in the past; traditional agricultural commodities' competitiveness is driven more by price and quality concerns than by standards-related measures. Yet, the "success story" o f Kenya's fresh produce industry, and the government's and industry's response to the challenges posed by meetingfood safety standards in international markets, illustrate how these can catalyze trade and redefine comparative advantage. 3.24 Attaining a strong market position has come at a cost. Significant industry consolidation and private investment has been required, supplemented by GOK facilitation measures. Major fresh-produce exporters and the Government o f Kenya have embraced a strategy emphasizing output o f value-added products for sale to markets that place highvalue on well-designed and documented systems o f food safety and quality management. 3'This is a summary of the mainreportthat can be foundunderwww.worldbankkenya. 32The term standard, unless otherwise specified, is used in a broad sense, covering technical regulations, i.e. mandatorystandards settledby governments,andprivate-drivenstandards. 38 3.25 The public-private partnerships established in these sectors, encompassing a suitable regulatory framework and the broad adoption o f good agricultural and manufacturing practices, should serve as a model to other industries. The system has been crucial in permittingKenyan industryto meet the challenges o f competingindeveloped markets. Standards in other Sectors and theRole of Institutions 3.26 For other sectors, in which standards compliance i s less advanced, quality, standards and conformity-assessment systems should be strengthened over the medium term, with the aim o f facilitating diversification into new regional and global export markets. At the same time, standard-setting and conformity-assessment institutions should be reoriented to play a facilitating role. This will necessitate greater private-sector participation in the regulatory debate and in provision o f testing, conformity-assessment and consultancy services, whenever possible. Standards in the Regional Arena 3.27 The emergence o f a customs union initiative in Eastern Africa throws up new challenges and opportunities. To achieve free trade within the customs union, harmonization and mutual recognition must advance and be given a legal and institutional framework. So far, regional cooperation inthe field o f standards is very limited,because o f the difficulties o f delegating competence; the disparate capacities of countries involved; the need to streamline national regulations and institutions; and inadequate private-sector participation and political determination. 3.28 At the regional level, GOK should lead efforts to develop shared and joint SPS management capacities, and the development o f a strategy to share selected resources. Inthat context, Kenya's future accreditation system can be used as a regional platform in a pilot regional standards initiative. Other promising areas for regional collaboration might include: (i)cross border management of pests and diseases (a clear public international-regional good); (ii) cooperating in food safety, hygiene services and training to the tourism industry; (iii)sharing resources following the concept of"regional centers of excellence" inareas where capacities are lacking inneighboring counties and markets are seen as regional by the industry(likepesticide regulation, registration, research and awareness). RECOMMENDATIONS 3.29 Priorities for improving the capacity in standards and conformity assessment institutions are Awareness raising on good agricultural practices 0 Improvement inpest risk assessmentand management capacities Improvements o f landing sites and environmental management inLake Victoria 3.30 For a roll-out of the quality standards and conformity assessment system beyond-the horticultural sector, GOK should ensure that the standard-setting and conformity assessment 39 institutions focus on facilitating private sector delivery of the services (testing, conformity assessment, consultancy, etc). 3.31 GOK should lead the development of joint SPS-management capacity and share resources. Using Kenya's pending accreditation system as a regional platform would be a good starting point. TRADEFINANCE 3.32 Access to finance remains a major obstacle to export development for micro, small and medium enterprises (MSMEs) and farmers. A crucial element of Kenya's export growth and diversification strategy must be to increase participation by smaller enterprises and smallholder farmers in international trade. Small firms and smallholders face immense difficulties in obtaining credit, in accessing export-credit insurance and in securing letters of credit. This i s a particularly significant impediment to export diversification away from existing markets such as the EUand US, toward potential new markets in Asia or the Middle East, where links with new buyers must be established and where risks may be higher than in traditional markets. 3.33 Relative to other countries in Africa, Kenya has a well-developed financial sector, and the cost of capital is falling. High levels o f credit are channeled into the Kenyan private sector relative to other Sub-Saharan African countries.33 A recent survey34of manufacturing firms showed that access and cost o f finance "does not currently appear to be a general and severe constraint to business." 3.34 However, the situation is quite different for M S M E S . Only 1.5 percent of credit to ~ ~ MSMEs in Kenya is provided by banks, and about 90 percent of M S M E s have n o access to credit. This is because of the highcost for banks of evaluating and monitoring credit to small producers; the difficulty of assessing risk of an M S M E operation in the absence of rating agencies; and deficiencies in the legal system that make enforcement o f debt contracts difficult and push collaterals too high for small firms. M a n y M S M E s lack the capacity o n to process relatively complicated bank paperwork. 3.35 As a result, MSMEs, the importance o f which has increased significantly over the past decade36for the economy, are forced to rely o n micro-finance institutions (MFIs) and Savings and Credit Cooperatives (SACCOs) for financial services. However, although there are a large number of providers of M S M E credit, the market is segmented and disconnected, 33 Beck and Fuchs (2004), Structural Issues in the Kenyan Financial System: Improving Competition and Access, World Bank Research Working Paper 3363. 34ICA survey. 35The ICA survey finds that access to finance is an "acute problem for a subset o f firms, usually smaller ones." 36Between 1993 and 1999, the contribution o f the M S M E sector to GDP increased to 18.4 percent from 13.8 percent. A new M S M E survey is currently under preparation. Based on other surveys the importance o f the MSME sector relative to GDP is expected to have grown hrther (see Central Bureau o f Statistics, International Center for Economic Growth, and K-Rep Holdings, National Micro and Small Enterprises Baseline Survey 1999, and Central Bureau o f Statistics, Ministry o f Planning and National Development, Economic Survey 2003). 40 which impedes the smooth and rapid flow o f funds across and through institutions, sectors and regions. This results in gaps in access to finance, in particular for growing firms and those needing higher levels o f financing for internationaltrade transactions. 3.36 MSMEs and farmers seeking financing for export transactions will increasingly need to resort to commercial banks for export financing. Most banks in Kenya offer trade and export-finance products; however, transaction-size requirements disqualify most MSMEs. 3.37 Still, most banks active in Kenya do provide some services to MSMEs, typically the larger ones.37 That said, MSMEs encounter the following general problems when attempting to raise funds for international transactions: 0 Highinterest rates and collateral. Banks cover the additional work and risk involved in dealing with a small firm or farmer by increasing the spread, which reduces exporters' profit margins, and increases collateral requirements. 0 Limited regional coverage for Letter of Credit (LoC) financing. Banks avoid financing LoC-which i s the type o f transaction financing preferred by MSMEs- from countries that they perceive as highrisk (e.g., DRC, Sudan, Afghanistan). 0 Non-availability o f structured finance for trade/export financing. Ideally, MSMEs need trade/export financing to be structured in such a way that repayment coincides with export-transaction payment terms and schedule; however, this rarely occurs. Developing a structure specifically for a MSME transaction would be prohibitively expensive. MSMEs inthe export sector encounter the following industry-specific problems: 0 In general, banks are averse to financing agricultural exports because o f the perishable nature o f the product, the high risk o f non-compliance with standards, and price volatility. 0 Tea exporters ship to Pakistan, Egypt, Afghanistan, Yemen and Sudan, which are considered highrisk for banks, and where insurance is often hard to acquire. 0 Small horticulture businesses are often runby one family and have informal business structures unlikelyto clear banks' due diligence, especially when start up financing is required. 0 Banks are reluctant to finance the coffee sector because o f past poor performance and the complicated nature ofwarehousing agreementsthat arepart ofmany transactions. 0 Businesses in the textile sector usually handle relatively large orders and therefore have large financing requirements even as there i s a relatively high risk o f order rejection; banks are thus often reluctant to provide the f;llamount required. 3.38 MSMEs and small farmers also lack the capacity to exercise effective demand because they lack knowledge o f relevant and available products for export financing and 37 Banks dealing with medium-sized firms for trade and export financing often specialize in specific sectors (e.g. Barclays Bank o f Kenya finances the majority o f handicraft exporters, Stanbic is the main financier o f the tea market, Dubai Bank finances Muslim-owned MSMEs, which have specific requirements as to deal structure); in this way banks develop specific knowledge on the business and performance risk in the relevant sectors, or type o f MSMEs. 41 guarantee, and need assistance in preparing funding proposals and in understanding risk and financial-management concepts. Banks might be more responsive to MSMEs if the latter utilized better financial-management systems, or ifthey collaborated to increase the size o f a transaction and spread the risk. The lack o f a well-functioning credit registry means that banks have limited access to information on potential borrowers, which results in higher credit risk and loan loss provisions. 38, 3.39 An additional count against MSMEs is that they have limitedaccess to the insurance market. Purchase o f insurance against performance, diversion and/or political mishap could significantly reduce the spread and collateral required for a loan, but since MSMEs usually have as little access to insurance as to financing, they are trapped ina vicious circle. 3.40 Political risk can effectively scupper a transaction if the perceived risk i s too high, as may be the case inthe MiddleEast, Pakistan, Afghanistan or Sudan. 3.41 However, insurance against political risk is available through a World Bank-financed project, although to date only for large transaction amounts (see Box 3.5). The volume o f transactions usually undertaken by MSMEsi s too low to be covered by this scheme, although there i s no explicit lower limit for transactions, and MSMEs would in principle then be eligiblefor AT1insurance. Box 3.5: World Bank Regional Trade Facilitation Project To address the lack o f access to political-risk insurance for productive transactions and cross-border trade in EAC countries, the World Bank developed a project to cover political risk for short-term trade transactions in seven countries, mainly members o f COMESA (Burundi, Kenya, Malawi, Rwanda, Tanzania, Uganda and Zambia). The project is implemented by the Afican Trade Insurance Agency (ATI). AT1 will use a number o f insurance structures. Eligible transactions will include: exports from one participating country to another; exports from participating countries to third countries; and imports o f goods or capital from anywhere to a participating country, as long as the import is related to a productive activity. The facility covers a wide variety o f trade transactions, including sale o f goods on credit terms, LoC confirmation, financial or operational lease, loans by foreign or domestic lenders, services, and a wide range o f politicahon-commercial risk including embargo, war or civil disturbance, seizure o f goods, expropriation, imposition o fexchange controls, imposition or increase o f import or export taxes. RECOMMENDATIONS 3.42 To address MSMEs' lack o f access to finance in general, GOK should develop a coherent national policy and strategy for micro- and small-business finance. O f particular importance would be the achievement o f better coordination among regulators and the development o f a common legislative and regulatory framework for different finance providers, which would simplifythe flow o f funds between them, and MSMEs. 3.43 Secondly, there i s urgent need to establish a well-functioning credit registry to improve the flow o f information on borrowers. The institutions covered should include commercial banks as well as microfinance institutions and SACCOs, to allow small borrowers to graduate from micro and local finance to bank finance as their business grows. See Beck and Fuchs (2004). 42 3.44 To improve competitiveness, GOK's priority should be to strengthen the enabling environment for the private sector, the legal and regulatory framework, and the general business climate. These issues are covered by the Private Sector Strategy Action Plan. TELECOMMUNICATIONS SERVICES AND POWER 3.45 Kenya's telecommunications services are expensive compared with those of other Sub-Saharan African countries and still more so in comparison with those of East and South Asia (see Figure 3.1). 3.46 Furthermore, between 1999 and 2002 telecommunications costs in Kenya did not fall, as they did virtually everywhere else; it is likely that prices have come down since 2002, but as they probably have elsewhere it is unclear whether Kenya remains at a cost disadvantage. 3.47 Penetration o f services is low given Kenya's per capita income, and lags many Sub- Saharan African countries. Inthe last few years, the number of mobile phones increased from close to zero in 1999to approximately a nine-percent mobile teledensity in 2004; penetration of fixed lines is about 1.5 percent.39 While the improved teledensity has spurred private- sector competition, and significantly improved access, the country is still sub-par in providing services across a range of areas. Table 3.5 shows that compared to its nearest income comparators:' Kenya has fewer fixed lines per capita, less than half the level of international calls per subscriber, and higher Internet charges. Behind these statistics lies considerably lower efficiency in service provision. Figure3.1: Telecommunications Indicatorsfor Kenya and Comparator Countries 200 - 180 -I 160 7 140 A 120 A 100 - 80 1 60 i 40 -I 20 -I 0~ I International Internetcharges Telephone Telephone telecom (US$ month) mainlines (per mainlines(per (outgoing 10,000 people) employee) minutes per subscriber) HKenya HComparators 39Mobile coverage extends far fbrther than that of the fixed network, and prepaid cards and time-reselling makes mobile telephony available to those without credit or their ownphones. As a result, it is mobile service that extendstelecommunicationsaccess to the poor andto rural areas inKenya. 40Bangladesh, Benin, Haiti, Mauritania,Nigeria, Pakistan,Sao Tome andPrincipe,Sudan, Vietnam, Zambia. 43 .- m a2 YL 63 c 3L ea uEP Ue zk a e L 3. ae s$ .- I 0 Y cf U ze a2 U e a t U .- C m 0 .-ae Y 0 -8 EE a2 s4 m a2 3.48 In a series of investment-climate surveys worldwide, the World Bank asked companies to rate the seriousness o f various barriers to doing business. The global average for the percentage of firms that named telecommunications was 9.8 percent. For Kenya, the corresponding figure was 44 percent. Long-distance telephone charges are burdensome for exporters. 3-49 Kenya's telecommunications services are costly because o f delays in implementing the reform agenda laid out in the ERS. The benefits of completing the reform are: an estimated 500,000 additional telephone subscribers; a more than doubling o f international call volumes; and over 100,000 more Internet subscribers. This would translate into about US$180 million in customer savings and increased revenue and an additional US$87 million inforgone revenue. 3.50 Access, reliability and the cost o f power was named as a major constraint for manufacturing businesses in the recently completed I C A for Kenya. The poor and erratic performance o f the power sector costs firms on average almost 10 percent o f annual sales in terms o f lost production; 70 percent o f firm were forced to invest in their own generators to bridge blackouts. Power is o f particular importance for textiledgarments and coffee. Power accounts for 35 percent o f the costs o f garment production at the fabric-dyeing stage, 28 percent o f costs at the fabric cuttingllayering stage, 22 percent at the sewing/assembly stage and 20 percent at the finishing stage. The cost o f electricity for drying coffee beans accounted for more than 25 percent o ftotal costs at the primary processing stage. 3.51 From an analysis of comparative data for electricity prices and performance in 13 southern and East African countries:' Kenyan prices are among the highest inthe region for domestic consumers, general business and small and large industries. This i s a reflection also 3 o f taxes, levies and surcharges on energy inKenya (VAT o f 18 percent plus an electrification levy o f 5 percent and a 3ckWh surcharge), which were the highestinthe region in2003. The sector's technical performance, as measured by transmission losses is worse than that o f many African competitors, and financial performance i s also very poor: KPLC (Kenya Power and LightingCompany Ltd.) in 2003 was the only utility company among the 12 comparator countries that registereda loss. 3.52 For general' business, i.e. low voltage commercial users that consume about 2500 kWhper month, 2003 prices in Kenya were fourth highest, on a par with those o f Tanzania and Uganda, but much higher than corresponding prkes in South Africa, Botswana, Malawi or Namibia (see Figure 3.2). 4'The source o f this information is SAD-ELEC (2003). The 12 comparator countries are: Botswana, Mauritius, Mozambique, South Africa, Malawi, Lesotho, Namibia, Swaziland, Tanzania, Uganda, Zimbabwe and Zambia. 46 Figure3.2: Energy Pricesfor GeneralBusiness(low voltage 0.25 0.2 c 0.15 a z tn a 0.1 0.05 0 Source: SAD-ELEC(2003). 3.53 For small and large industrial consumers,42 2003 energy prices in Kenya were significantly higher than elsewhere in the region (see Figure 3.3); East African neighbors Tanzania and Uganda were also close to the top o f the list. Industrial consumers inhigher per capita income economies such as Botswana, South Africa, Namibia, and Swaziland all face significantly lower energy prices (see Figure 3.4). Figure3.3: EnergyPricesfor Small IndustrialConsumers 0.09 0.08 z 0.07 c 0.06 0.05 f 0.04 3 0.03 0.02 0.01 0 Source: SAD-ELEC(2003). 42 Small industrial consumers denote those with a peak demand of KVAlOO and a load factor of 80 percent; large industrialconsumers denotes those with apeak demandof KVA2500 anda loadfactor of 80 percent. 47 Figure3.4: EnergyPrices for Large Industrial Consumers I 0.08 0.07 0.06 0.05 0.04 0.03 0.02 0.01 0 Source: SAD-ELEC(2003). 3.54 Clearly power costs inKenya are a major inhibitor o f the business climate, especially for energy-intensiveexports such as textiles and garments, and some agricultural products. There is no information on relative performance as relates to brown outs and black outs, but data on relative transmission losses, may be usedas an indicator. Kenya's transmission losses are lower than those o f Uganda, Tanzania and Mozambique, but much higher than those of Mauritius, Namibia, South Africa, Botswana and Malawi (see Figure 3.5). Figure 3.5: Total Transmission Lossos (YOof GWh sent out) 40 35 30 25 20 15 10 5 0 Source: SAD-ELEC(2003). 48 4. TRADE POLICYAND INSTITUTIONS 4.1 Effective trade policies complement and enhance actions taken to eliminate behind- the-border barriers to trade. Domestic trade policies influence the incentive framework for producers and thus the potential returns from engaging in tradable activities. Policies implemented in overseas markets influence the ability o f Kenyan producers to exploit their comparative and competitive advantages in global markets. Successful pursuit o f international integration must unite three inter-linked policy domains-unilateral, multilateral and regional policies-into a coherent trade strategy. This study has identified five areas in which Kenya could more effectively use trade policy to advance its growth and development agenda: national trade policy, regional integration, multilateral negotiations, the Economic Partnership Agreement with the EU, and trade-policy institutions. KENYA'S TRADEPOLICIES Tariff Regime 4.2 Kenya has significantly liberalized its trade regime inrecent decades. Since the mid- 1980s, Kenya shifted away from an import-substitution strategy towards a more outward- oriented growth policy. Prior to 1993, Kenya used administrative controls-mainly import licensing-to manage its balance o f payments and protect local industries. In 1993, the GOK abolished import licensing and foreign-exchange controls, and import tariffs became Kenya's central trade policy instrument, in line with GATT principles. The tariff schedule was gradually simplified from 24 bands in 1988 to 8 in 1994, and the maximum rate was reduced from 170 percent in 1988 to 60 percent in 1994. By 1999, Kenya had reduced the number o f bands to five and lowered the maximum rate to 25 percent. Following formation o f the EAC Customs Union and the introduction o f the Common External Tariff (CET) in 2005, Kenya ' now oversees tariff rates inconjunction with Tanzania and Uganda. 4.3 Adoption o f the CET led to a further reduction in the average applied tariff rate- from 16.8 percent in 2004 to 13.2 percent-a 21 percent downward adjustment on tariffs facing extra-regional imports. Tariffs declined across most sectors, with the exception o f products o f animal origin, precious and semi-precious stones, and miscellaneous manufacturing and works o f art. The highest tariff reductions are those for industrial goods, such as chemical products, ships and boats, mineral fuel and oils, and electrical machinery and equipment. Given that these items are primarily used as inputs for other products this could potentially provide a broad boost to output across the economy. However the tariff regimecan be further simplifiedand rationalized. 4.4 Implementation o f the CET began in 2005 and many problems have already been resolved. However, the current EAC-exemptions regime is complicated. The CET exemptions schedule applies to a large number o f products (56), and 8 different rates are 49 applicable, ranging from 35 percent to 100 percent.43 The top rate o f 100 percent applies to most varieties o f sugar; high rates also apply to rice (75 percent), wheat (60 percent), milk and various milk products (60 percent) and maize (50 percent). 4.5 Adoption o f the CET has increased tariff dispersion. Inother words, the variation o f tariff rates has increased-fkom one product to another, across products within sectors, and across stages o f production. At the sectoral level, tariff dispersion increased in 16 o f 21 sectors, and rose to levels above 100 percent in five o f these sectors.44 Tariff dispersion creates two general problems. A highly dispersed tariff schedule creates incentives to misallocate resources-investment and workers flow to industries with the greatest government protectionand away from where productivity i s highest. Tariff dispersal imposes a heavier economic burden on society than a uniform tariff schedule with the same average tariff rates. In addition, setting different tariff rates on similar products provides an incentive for companies to misclassify imports and facilitates corruption. 4.6 The CET preserves another form of tariff dispersion, escalation o f tariff rates, depending on the stage of processing. Final goods typically face higher tariffs than intermediate inputs and raw materials. Many countries adopted escalating tariffs to promote industrialization through import substitution and through the development o f vertically integrated industries. Tariff escalation magnifies the protection o f the final stage o f value addition, insulating producers from global pressure to innovate and increase productivity at the expense o f producers o f raw materials and intermediate goods. However, policies designed to promote vertical integration no longer make sense in a world economy increasingly characterized by fragmented production or global supply chains, in which firms in different countries specialize in different stages of the production process. Setting tariff rates more uniformly across stages o f production facilitates integration o f the internal chain o fproduction sharing. 4.7 EAC countries have scheduled a CET Review for 2009/10, which in addition to reducing the top rate to 20 percent as agreed, will offer an opportunity to review the exemptions regime, and to reduce tariff variation and escalation. Efforts should focus on reducing the maximum tariff rate across all products, and on additional reductions in apparel, manufacturing, and other sectors with higher-than-average tariffs. Tariff reductions could be replaced by more broadly based taxes that do not discriminate between imports and locally produced items. For example, replacing the high customs duties on tobacco and cigarettes with a trade-neutral excise tax would allow EAC members to rationalize the tariff schedule while continuing to pursue fiscal and social policy objective^.^' 4.8 EAC member states have bound tariffs for different products and at different rates. Following the Uruguay Round, Kenya, Tanzania and Uganda each bound some o f their tariff lines; these tariff bindings currently cover 3 percent (Uganda), 13 percent (Tanzania) and 14 percent (Kenya) o f all tariff lines. Kenya and Tanzania bound tariffs on all agricultural products at ceiling rates o f 100 percent and 120 percent respectively. Uganda 43The rates usedare 35,40,45,50,55,60, 75, and 100percent. 44Dispersion is measured as a coefficient o f variation. 45See Castro et. a1(2004) for more details on Kenya, Tanzania and Uganda's potential to raise revenue. 50 bound 60 agricultural goods at rates between 40 percent and 70 percent. Kenya bound tariffs on seven non-agricultural products, Tanzania on six, and Uganda on about eighty (see Table 4.1). Table 4.1: BindingOverhangin Kenya, Tanzania and Uganda WTO Bound Applied MFN Product(IS headingor code) Rate Rates (2005) Kenya Agricultural products(various)* 100 0-25 Freshfish (0302) 62 25 Frozenfish (0303) 62 25 Medicaments(3003) 35 0 Pharmaceuticalgoods (3006) 18 0-25 Fertilizers (3 105) 31 0 Primary ethylenepolymers(3 109) 31 0 Tractors (8701.90) 62 0 Tanzania Agricultural products(various)* 120 0-25 Silkfabrics (5007.20 120 25 * Woven fabrics of coarseanimal hair (5113.10) 120 25 Hydraulic water turbines (8410.13) 120 0 Diesel electric locomotives(8602.10) 120 0 Dummies andother lay figures (9610.00) 120 25 Antiques (>lo0 years) (9706.00) 120 25 Uganda Agricultural products (60, various)* 40-70 0-25 Various non-agricultural goods (about 80) 40-50 0-25 Notes:Applied rates are the range of CET rates at the tariffline level @-digit) for the particular product category boundduring the Uruguay Round. * The CET providesfor anumber of exemptionsfrom the top tariff rate for selected sensitiveagricultural products. Sources: Kenya's Uruguay Roundgoods schedule; EAC CommonExternal Tariff 4.9 Given that the three countries have formed a customs union, there is a need to consolidate tariff bindings to avoid confusion for potential investors and suppliers as to which tariff lines are bound at which rates. Furthermore, while the wide margin between bound and applied rates and the fact that only few rates are bound at all, offers flexibility to increase tariff rates without the risk o f retaliation from other WTO members, the political benefits o f this flexibility must be weighed against the economic costs. Potential foreign investors and suppliers are likely to be deterred by the prospect that EAC countries can raise customs duties on almost any product. To minimize this problem, and to encourage trade partners to do the same, the EAC could bind all tariff lines within the framework o f Doha Round negotiations, and bind all but politically sensitive tariffs at levels much closer to their applied rates. Doing so would have no impact on applied rates or customs revenues. Furthermore, in the event of a sudden surge in imports that might hurt domestic producers, WTO rules provide flexibility for membersto invoke safeguard measures. 51 INCENTIVE SCHEMES FOREXPORTERS 4.10 Incentive schemes for exporters-duty drawback, manufacturingunder bond, VAT refunds and export-processingzones-are used to offset the anti-export bias in the tariff system. Thus, implementinga lower and more uniformtariff schedule will reduce the need for complex administrative measures to compensate for anti-export biases introduced by tariffs. However, none of these programs can ever fully eliminate disincentives to export. Boththe public andprivate sectorsallocate financial resourcesandskilledlabor that couldbe usedmoreproductivelyelsewhereinthe economy. 4.11 Among incentive schemes for exporters, the VAT refund is least effective and requires the most attention. The administrativeburdenon boththe government and exporters increasedwhen VAT and customs-duty refunds were separated into two different programs. According to the private sector, VAT refunds can take anywhere from six to nine months, with predictableeffects on firms' cash flow. News reportsestimatethe value of arrears to be in excess of Ksh2 billion.46 A delay in refunding VAT paid on imports effectively constitutes a tax on exports,reducingKenyanexporters' ability to competeinworld markets. 4.12 The EPZ program, which formerly worked well, has begun to experience problems at the border. Significant operational problems influence the handling of EPZ products by customs authorities, and this is influencing clearance times. This threatens the competitiveness of products, particularly in the textile and clothing sector, and compounds difficulties arisingfrom phase-outof the MFA. The GOK should reintroduce fast trackingof EPZproductsby the Customs Department,whichwas discontinuedsome months ago. 4.13 Small businesses have difficulty gaining access to these schemes. The duty- drawback and manufacturing-under-bond systems reportedly work reasonably well. Exportersreceive duty drawbacks more expeditiously than VAT refunds in part because the Kenya RevenueAuthority (KRA) has streamlinedand fast-tracked the process, but not that for the VAT refund. Small businesses find it difficult to use either program, however. The Export Promotion Council (EPC) reports that small exporters frequently lack the administrative resources to understandthe duty-drawback program and fulfill the reporting requirements. The manufacturing-under-bond scheme has explicit eligibility requirements that disqualify many small and medium enterprise^.^^ This scheme has largely been marginalizedby export processingzones. 46See, for example, KaburuMugambi,"Manufacturers want KRA to pay interest on Sh2.3bntax refunds, The " Nation (July 12,2005), andBensonKathuri, "VAT refundbackloghits Sh2.2bn mark," TheStandard (February 28,2005). 47Participatingfirms must export $440,000 per year or employ morethan 50 persons. 52 RECOMMENDATIONS 4.14 Kenya and the EAC should prioritize full implementation o f the EAC Customs Union. Furthermore scheduled CET reviews should be used to simplify the exemptions regime by reducing the number o f exemptions and the rates applied. Furthermore, EAC countries should use the 2009/10 CET Review to reduce tariff dispersion and escalation, in addition to reducing the top rate to 20 percent as planned. 4.15 The EAC countries should also: consolidate tariff bindingswithin the framework o f the WTO; andbringboundrates closer to the applied rate. 4.16 A thirdpriority should be to expediteprocessing o f VAT refunds for exporters, and to reinstate fast-track treatment for EPZ containers. One option could be to implement an accelerated clearance process for exporters with good records o f compliance. To eliminate the VAT backlog, the Treasury will needto grant more authority to KRA to pay claims. 4.17 An assessmento f the EPZ program would be useful to determine the aspects that are most cost effective as well as to discern features that could be extended to the rest o f the country. There are currently 37 gazetted export processing zones in Kenya. The program offers a wide range o f both fiscal incentives and non-fiscal incentives (e.g., on-site customs inspections, more liberal employment o f foreign technicians). Participation in the EPZ program expanded sharply following passage o f AGOA. Still, Surveys conducted in other countries have found that a streamlined operating environment, pro-private sector policies, reduced corruption, and quality infrastructure and public services are far more important to investors than tax holidays and most fiscal incentives. 4.18 Donor support should take the form o f provision o f resources for studies on EPZs, and on the impact o f further trade liberalization on the economy. KENYA'S ROLEINEFFECTIVE REGIONALINTEGRATION 4.19 A large, open and flexible regional market can foster growth and stimulate local and international investment. Regional integration will increase the size o f relevant markets and thus expand opportunities for Kenyan firms, workers, and consumers. Effective integration enables local firms to better integrate into global production chains if goods move freely among regional partner states. Effective integration also makes Kenya more attractive to multinational firms as a destination for FDI. The available data suggest that Regional Trade Agreements (RTAs) can have a significant effect on FDI inflows, especially to regions with low inflation, strong institutions, and pro free-trade policies. Within this broad policy spectrum, short- and medium-term priorities should be to create an integrated regional transportation and trade facilitation system, eliminate internal economic borders, and promote measurestowards a common market (see Box 4.1). 53 Box 4.1: The Need for Consistency BetweenEAC and COMESA In addition to the EAC, Kenya is also a member of The Community of East and Central Africa (COMESA). Progress in achieving intra-COMESA integration has been slow because o f the body's large size. However, Kenya will benefit considerably from finalization o f the FTA and the ensuing access to COMESA markets. Other COMESA initiatives (regional transport insurance, the COMESA bond- guarantee scheme) are also very much in Kenya's interest. As COMESA moves toward its ultimate aim o f customs union, The EAC should seek to ensure that obligations under one such union do not contravene those o f the other. One option could be for the EAC C U to become part o f COMESA CU, provided that the CET and all other provisions-including rules o f origin-are consistent. However, Tanzania must first rejoin COMESA and withdraw from the SADC (Southern African Development Cooperation). The principle to which Kenya-as well as its partners-should adhere i s that it can only one set o f common trade policies can be implemented, which calls for consistency among various groups, or the decision to leave one infavor o f another. 4.20 Regional cooperation on transportation and logistics would yield the greatest gains for Kenya and the EAC. As countries seek to diversify their trade into more sophisticated agricultural and manufactured products, logistics requirements become more important-and more costly. Competing in international markets and functioning within global production chains necessitates not only low transport costs and efficient ports, but also short transit times, reliable delivery schedules, appropriate storage facilities, and security. Trade liberalization is unlikely to yield the expected economic benefits as long as transport costs remain very high, and logistical services weak. 4.21 The EAC offers a forum for discussion and definition o f norms and harmonized rules. Private-sector involvement in these discussions i s a prerequisite for effective action. In the mediumterm, it may also be useful to include additional regional partners-Burundi and Rwanda-which have a vital interest in improving transport logistics along the Northern and Central Corridors. 4.22 Implementingnonrestrictive rules of origin would enable firms to buy inputs at the lowest cost and would spur regional integration. In principle, customs union obviates the need for rules o f origin on intra-regional trade. However, the EAC-CU is being phased in with temporary barriers to trade against selected imports from Kenya until 2010, and thus rules o f origin are needed both for extra and intra-regional trade. 4.23 The EAC has largely adopted COMESA's Rules of Origin (ROO), albeit with a number of exceptions for which SADC product-specific rules are used. On paper the COMESA's ROO are fairly simple and liberal. By allowing firms different criteria to satisfy origin, they provide the flexibility for effective sourcing o f inputs. Goods that are not wholly produced in one country can satisfy origin if: inputs imported from non-members do not exceed 60 percent o f the costs o f all materials used in production; or domestic value-added exceeds 35 percent o f the price o f the product as it leaves the factory; or imported inputs are placed in a different tariff category than that o f the product produced. However, in practice, many COMESA members apply only the value-added requirement, and do so without consistency across members (Uganda, for example, imposes a 45 percent value-added requirement). In order to ensure consistency between COMESA and EAC, the latter should adopt COMESA rules without exception; furthermore, it is important that ROO are 54 implemented in their entirety across COMESA to give firms-especially small firms-the flexibility necessaryto effectively source inputs and engage inregional trade. 4.24 Greater integration of regional services markets, particularly for services that facilitate international trade, would be o f benefit to Kenya. Regional integration can lower costs o f services inputs through lower transaction costs, greater competition, and creating economies o f scale. Extending EAC countries' GATS commitments (see WTO section below) is one way to expand services trade. However, to generate real demand for Kenyan services, its neighbors would need to back up GATS commitments with regulatory reforms aimed at harmonizing national regulations. Although harmonization at the level o f COMESA would be preferable, chances for real progress are probably better inthe smaller EAC, which i s more dynamic inits progress toward integration. 4.25 Customs reform and harmonization would also facilitate deeper integration. Many bottlenecks that raise trade costs such as queuing at the border do not generate revenues but simply waste economic resources and constrain productivity. The removal o f these requires policy coordination and ultimately harmonization o f customs administration, standards and conformity assessment, transport regulations and competition policy.48 4.26 The EAC is expected to achieve its common market by 2007, and monetary unionby 2010. A fully integrated regional market will require harmonization of, among other things: tax policy, export incentives (dutyNAT remission schemes, manufacturing under bond, export processing zones), standards, transportation rules, modalities for revenue sharing, competition policy, and mutual recognition o f educational degrees. Though the degree and mode o f harmonization may vary dependingon specific policy areas, the greater the degree o f harmonization, the lower the transaction costs o f intra-regional trade and more competitive EAC countries will be in regional and global markets. This is a long-term agenda that will require attention from numerous government ministries. EAC governments already have formed a number o f committees and working groups to drive forward harmonization i s areas such as capital markets development. Typically, more developed partners in a regional grouping often play the crucial role in pushing and supporting integration. Thus, within the EAC Kenya can be expected to spearhead the integrationprocess. 48 Currently, and for the first phase of EAC-CU, internal barriers will remain for a number of reasons, among these because Tanzania and Uganda are still levying temporary tariffs on selected,Kenyan imports. However, when the first phase of CU implementation is completed in five years, these tariffs will be phased out. At that point, internaltradeborderswill beremovedifcustoms reformandharmonizationhas been completed. 55 RECOMMENDATIONS 4.27 Consistency between the EAC and COMESA rules and their implementation, particularly with respect to Rules o f Origin, is vital. Kenya, as the EAC's most-developed economy, should take the lead in implementingregional integrationthrough liberalization of regional services markets, and strengtheningEAC-wide customs and trade logistics reforms and harmonization. 4.28 Donor support for regional integration can be in the form o f institution and capacity buildingat the regionaland national levels. INTERESTS INMULTILATERAL NEGOTIATIONS 4.29 Kenya's membership in the WTO offers different avenues to advance its trade agenda. Not least o f these are the ongoing Doha Development Agenda negotiations, which potentially grant Kenya better access to foreign markets, particularly in fast-growing-but heavily protected-Asian markets, but also provide a forum to push for reductions in developed countries' agricultural subsidies. In addition, WTO negotiations can be used to reinforce Kenyan reforms and improve the domestic commercial climate. Finally, for Kenya, participation between rounds inthe TBT and SPS Enquiry Point would be important. 4.30 Following establishment o f EAC-CU, all WTO trade-policy negotiations should be coordinated among the three East African countries; As establishment o f a common market is not too far away, coordinated negotiations are evenmore necessary. 4.31 Market access for exports to Asia can be improved through multilateral negotiations.East Asia's share o f Kenyan exports has more than doubled since 1985 from 1.4 to 3.2 percent; the share o f exports going to South Asia has also increased, albeit more slowly, from 7.1 to 8.8 percent. The key feature o f access to Asia's markets i s that it is granted on an MFNbasis, thus negotiations offer the best path. Asian markets are very large, butkey Kenyanproducts face hightariff barriers (see Table 4.2). 56 Table 4.2: Selectedtariffs on Kenyan Goods: Asian and Other Markets Coffee Tea Vegetables Fruit FruitJuice Cut Flowers Applied Rate 31.6 45.3 28.2 39.1 44.1 20.1 China BoundRate 14.3 15 10.6 18.5 19.2 16.5 Applied Rate 100 100 30 30 30 60 India Bound Rate 133.3 150 105.4 96.8 75 150 Applied Rate 4 5 4.9 5 5 20 Indonesia Bound Rate 44.5 52.5 46.7 47.7 54.3 55 Applied Rate 40 45 58.8 56.1 45 60 Thailand BoundRate 90 90 46.5 39.3 37 48 South Applied Rate 2.9 40Ockg 10.6 7.6 19.4 15.6 Africa BoundRate 119 170 34.3 21.1 49.5 U.S. Applied Rate 0 0 4.8 3.4 7.4 4.85 EU Applied Rate 0 0 13 8.1 23.3 9.8 Sources: Calculationsusing tariff schedules submittedto WTO and UNCTAD. Indian tariff data are from the Indian CentralBoardof Exciseand Customs (www.cbec.gov.in). US.and EUtariffs are generallybound at their applied levels. 4.32 For Kenya to achieve greater market access in Asia and elsewhere, WTO negotiations must include all countries and all goods. As developing countries' average bound rates on agriculture imports are often twice as high as their applied rates, Kenya, its EAC partners and other WTO members will enjoy few, if any, economic benefits from liberalization unless they bound tariff rates receive sizeable In industrial countries, protectionism i s sometimes concealed by tariff-rate quotasY5'which some countries have tried to keep off the table during the current negotiations. Kenya and other developing countries would benefit from a liberalization formula that simultaneously relaxes quotas and reduces the tariff rate on out-of-quota shipments. 4.33 One o f the more promising aspects o f the Doha Development Agenda for Kenya i s trade-facilitation negotiations, which at the time o f writing, are moving forward even as other talks are stalled. Negotiators have submitted proposals to: streamline and harmonize port information requirements; employ a "single window" for all border-clearance and revenue collection; reduce the number o f documents needed to import goods; and mandate advance rules. These are highly technical and complex issues, and negotiators will require guidance and advice not readily available in Geneva. Kenya can benefit from these negotiations by identifying border-clearance bottlenecks in its export markets and pushing proposals to address those bottlenecks. Negotiations can also serve to reinforce Kenya's own customs- modernization agenda. Effective participation in talks will require close communication among KRA, TRA (Tanzania Revenue Authority), UR4 (Uganda Revenue Authority) and trade negotiators in Geneva on the one hand, and between these revenue authorities and the wider East African business community on the other. 49KymAnderson and Will Martin, "Agricultural Trade Reform and the Doha Development Agenda," Policy ResearchWorking Paper No. 3607, Washington, World Bank,May 2005. The tariff-quota system introduced during the Uruguay Round has lower tariff rates for specified quantities, and higher (sometimes muchhigher) rates for quantities that exceedthe quota. 57 4.34 The potential for developing countries to use GATS to pursue market access inother countries remains poorly understood. Kenya would benefit from industrial countries' opening their borders to the temporary movement o f unskilled service providers. The remittances sent by such overseas workers are good for the Kenyan economy in the short term, and the acquisition o f skills will be o f long-term use. As a provider o f services to regional markets, Kenya could benefit from neighboring countries' commitments in sectors such as insurance and other financial services, transportation, technical services (e.g., for the provision o f testing and conformity assessment services to firms in neighboring countries), and other business support services-more important forums to push for those, are, however, regional (EAC, COMESA) as mentioned above. Identifying offensive interests for services liberalization is one area where Kenyan trade negotiators would benefit from research and collaboration with current and potential Kenyan services exporters. A couple o f priorities are mentioned inthe next section. 4.35 Kenya and its EAC partners would do well to strengthen the development o f their ICT sectors byjoining the optional WTO Information Technology Agreement (ITA). To join `is to agree to eliminate customs duties on major information technology products (see Box 4.2). Joining would reduce the cost o f ICT inputs and encourage new investment in Kenya and broaden access to IT inputs to include smaller businesses. Given that imports o f many IT products are already subject to exemptions the impact on revenues is unlikely to be significant and it would allow the dismantling o f the exemption scheme with its administrative costs. Box 4.2: The WTO Information Technology Agreement The ITA is a tariff-cutting mechanism with three basic principles: all products listed inthe Declarationmustbe covered; all must be reduced to a zero-tariff level; and all other duties and charges (ODCs) must be boundat zero. There are no exceptions to product coverage; however for sensitive items, it i s possible to have an extended implementation period. Commitments undertaken under the ITA are on an MFN basis, and therefore market access is extended equally to all WTO members. The agreement covers the main categories o f IT products: computers, telecommunications equipment, semiconductors, semiconductor manufacturing equipment, software, and scientific instruments. ITA has 63 members, among them such developing countries as China, Egypt, El Salvador, India, Mauritius, Moldova and Morocco. There are no L D C members. Source: WTO website 4.36 Liberalization o f services trade allows local producers access to service inputs at the lowest possible cost." In particular, participation in global production networks demands access to efficient services, especially transport, logistics, telecommunications and financial services. At the conclusion of the Uruguay Round, Kenya made commitments pertaining to the banking, tourism, telecommunications, and transportation sectors. GOK promisedinmost cases to impose no restrictions on cross-border trade in these services although it did place Liberalization o f the telecoms and banking sector could add as much as 1.5 percent to overall economic growth according to a recent study (World Bank (2004), Global Economic Prospects, Washington DC. 58 limitson foreign ownership oflocally established service providers and refusedto commit on regulations affecting FDIinservices.52 4.37 Inview of the EAC's plans to create a common market, its members need to align their GATS commitments. Box 4.3 is a summary o f Kenya's GATS commitments in the telecoms and banking sector. 4.3 8 Secondly, GOK-in consultation and cooperation with its EAC partners-should consider making a number of additional commitments in the current trade round, among these: commitments in the business-services sector would encourage foreign investment in management consulting, accounting, engineering, marketing, technical testing, and so on. Low-cost access to these services would boost productivity across many sectors. Another option would be to impose no restrictions on foreign commercial investment in transportation. Imposing no restrictions on foreign commercial investment in computer services and IT-related telecommunications services would complement joining the ITA and bolster Kenya's aims of becoming a regional ICT leader.53 Box 4.3: Kenya's Existing GATS Commitments inTelecoms and Banking International trade agreements such as the GATS can be useful mechanisms to enhance the credibility o f domestic policy reforms. Options that may face strong domestic opposition from special interest groups are strengthened by connection to an international commitment mechanism. In the telecoms arena, Kenya has already made some o f the most difficult policy decisions by establishing an independent regulator, and taking steps to introduce greater competition inthe fixed-line sector. Kenya's GATS commitments pave the way f6r foreign competition in fixed-line telecommunications if and when the network is adequate. Key among these commitments are the obligations outlined in the Reference Paper 6n Basic Telecommunications, which focus on pro-competitive regulation, interconnection disciplines and disputesettlement. International competition in the mobile sector is already close to a reality, following the licensing o f Kenya's thirdmobile operator. The increaseduse ofVSATs (very small aperture terminals) would be integral to plansto expand the benefits of mobile telecoms to rural and low-density areas; the licensing of a new VSAT operator would be a step inthe right direction but enhancing competitiveness in the provision of VSAT services should be explored further. Regulatory policy in Kenya's bankingsector has relaxed restrictions on foreign entry. At present, both foreign commercial presenceand cross border trade are permitted. However although regulatory policy currently does not discriminate between foreign and domestic banks, and as Kenyan authorities move toward greater openness, there are no commitments on national treatment (i.e. to not discriminate against foreign-owned financial institutions) in Kenya's GATS schedule. Unless there is a clear policy-based reason for not guaranteeing national treatment, Kenyashould amendits GATS scheduleto amendthis. 52 Kenya's commitments are published in WTO documents WT/SC/47 (April 15, 1994), WT/SC/47/Suppl. 1 (February 26, 1998), and WT/SC/47/Supp1.2 (November 18, 1999). 53 Kent Bressie, Michael Kende, and Howard Williams, "Telecommunications Trade Liberalization and the WTO," paper presented at the 15th ITS Biennial Conference, Berlin, September 5-7, 2004 presents data suggesting that, after accounting for income level and geography, countries that have included the telecoms sector in their GATS commitments enjoy greater fixed-line penetration and telecoms-sector revenues than those that have not; They attribute this to the greater credibility accorded governments committed to maintaining open and competitive telecoms sectors. 59 4.39 Much o f the important work o f the WTO i s conducted outside o f negotiatingrounds. Giventhe limitedcapacity o fthe Geneva based staff, Kenya should participate incommittees and working groups most relevant to its economic interests.54 4.40 TBT and SPS agreements require Kenya to report its new standards and technical regulations to other WTO members. This contributes little to Kenya's economy. However there are economic benefits associated with using the notifications submittedby others more effectively4istributing them to the Kenyan business community, identifyingmeasures that constitute technical barriers to trade and submittingcounter-notifications. Additional benefits will derive from using the enquiry point mechanism to disseminate information about Kenyan standards to Kenyan companies. Using the mechanism in this manner will require shiftingthe mandates of Kenya's TBT and SPS enquiry points to provision o f services to the business ~ornrnunity.~~the long run, EAC members might choose to conserve resources In by managing the enquirypoint function at the regional level. RECOMMENDATIONS 4.41 Kenya and its EAC partners can use their participation in the WTO to better integrate into the world economy. Specific steps would be to focus on negotiating better access to dynamic Asian markets, and to identify offensive interests for the GATS negotiations. Furthermore, Kenya should join the ITA and expand its GATS commitments in terms o f IT-related services, business services, wholesale trade and other sectors critical to export competitiveness. Lastly, Kenya's SPS and TBT enquiry points should be used to enable Kenyanand EAC firms to overcome standards-related trade constraints. 4.42 Donor assistance should take the form of provision o f resources for a thorough study o f trade in services, including the determination o f negotiation priorities for the Doha Round, and for the regional service sector liberalization agenda. Donor assistance would be helpful also inestablishing standards enquiry points. POTENTIALBENEFITSANDRISKSOFAN EPAWITHTHEEU 4.43 Implementingan Economic Partnership Agreement with the European Union would boost Kenya's integration into the world economy. The EPA would replace the existing unilateral preference regime in effect since the 1970swith a reciprocal free trade agreement that would offer Kenya a degree o f access to the European market little different to that enjoyed by LDCs under the EverythingBut Arms (EBA) initiative. The EPA negotiations present several opportunities to advance Kenya's trade agenda, as well as some pitfalls to avoid. The most important aspects o f the EPA for Kenya are rules o f origin and standards recognition, aid for trade, trade diversion, and worker migration. 54For example, the mission in Geneva is listed as participating in a number o f accession working parties for countries that are not commercially important to Kenya (e.g., Belarus, Montenegro, and Serbia). "KenyaoperatesthreeenquirypointsfortheSPSagreement. TheenquirypointfortheTBTagreementisthe Kenya Bureau o f Standards. 60 4.44 For Kenya to profit from expanded access to EUmarkets, the EPA must incorporate more liberal rules o f origin than exist under current preference schemes. The expansion o f African garment exports to the US. under AGOA demonstrates the potential benefits o f liberal rules o f origin:56 Kenya has been able to dramatically expand employment and exports. The EU i s leaning toward rules o f origin that rely primarily on a value-added requirement. Kenya should negotiate for the EPA to allow firms a choice o f a change-of- tariff-heading rule or a uniform value-added rule o f 15-20 percent. 4.45 The EPA should also address mutual recognition in standards and conformity assessment. These agreements provide a useful framework for addressing the need to avoid rules o f origin in Mutual Recognition Agreements. A conformity-assessment certificate issued in Kenya by an EU-recognized body should be accepted regardless o f the good's origin. As KEBS has been recognized by the EU, there should be no need for a conformity assessment inthe EUfor a product carrying a KEBS certificate. 4.46 The EPA should make provision for increased aid to address supply side constraints for trade expansion. Improving logistics, standards compliance and other behind-the-border aspects o f trade i s costly. The EPA should feature some o f "aid for trade" if it i s to be more successful than past preference schemes. To the extent that the EPA introduces commitments that require extensive regulatory, institutional, or administrative reforms, while at the same time significantly curtailing revenueY5'it would only be appropriate to seek additional aid from the EUto implementsuch reforms. 4.47 An EPA, however, also would introducethe risk of trade diversion. Depending on the size o f preference margins, market competitiveness, and the efficiency o f EU suppliers, the EPA may simply spur a change in the supplier rather than a reduction in domestic prices. This is known as trade diversion. Trade diversion would transfer money from the Kenyan treasury (in forgone customs duties on imports from Europe) to European exporters. Consumers fail to gain since prices do not fall. A KIPPRA study estimated that trade diversion would exceed trade creation. To reduce trade diversion, Kenya should seek a reduction in CET before the EPA is fully phased in, which is likely to be between 12 and 20 years after negotiations are concluded. Kenya could also develop a strategy for negotiations that would link domestic reforms and regional integrationto EPA commitments, inparticular with respect to merchandise services trade liberalization. For merchandise trade, a phased and variable geometry o f tariff reductions can be achieved by: eliminating internal barriers to trade within the East and Southern Africa group to promote regional trade; reducing MFN 56Rules of origin are the criteria used to define where a product was made. They are an essentialpart of trade rules becausequotas and preferentialtariffs discriminate betweenexporting countries. Determininga product's origin is complicatedby the fact that increasingly,productsare processedin several countriesbeforebeingsold as a finished product. The purpose o f rules of origin is to prevent trade deflection or simple transshipment, whereby products from non-preferredcountries are redirectedthrough a free-tradepartner with lower external tariffs so as to avoidpaymentof customs duties. ''Eliminating duties on imports from the EU will affect government revenue, given the volume of such imports. A recent KIPPRA study projected that the elimination of all duties on EU imports would reduce Kenyancustoms revenue by aroundKsh9 billion annually (KIPPRA, "The assessmentof the potential Impact from the Economic PartnershipAgreement (EPAs) on KenyanEconomy" on Behalf of Ministry of Trade and Industry,March2005). 61 top rates; and cutting MFNaverage rates before enacting EUpreferences. For services trade, ' one strategy could be to implement a phased, region-specific program o f services sector liberalization to promote wider access to lower cost trade-related services (e.g. telecommunications, electricity and transport); this should be undertaken on an MFNbasis to avoid entrenching highcost monopolies. 4.48 For similar reasons, GOK should ensure that services markets open to European firms as a result o f the EPA are also open to firms from other regions, especially in service sub sectors where EUproviders are not competitive. A sector-by-sector analysis needs to be undertakenbefore full implementationof the EPA. 4.49 The EPA negotiations offer a forum to broach European restrictions on temporary migration. RECOMMENDATIONS 4.50 Priorities include advocating for more liberal rules of origin, mutual recognition o f standards and conformity assessment and to initiate dialogue on temporary migration o f workers. Once the EPA enters into force, GOK should take action to avoid trade diversion, especially in the services sector. This may necessitate reduction of the tariff schedule and liberalization o f the service sector on an MFNbasis. 4.5 1 GOK should undertake a cost assessment of the EPA for use innegotiations with the EU.Kenya shouldpushfor assistanceto finance implementationof EPA measures. INSTITUTIONAL POLICY FRAMEWORKFORTRADE 4.52 Kenya's institutional framework for trade policy has some significant flaws. Firstly, policymaking for trade i s divided among various ministries. Secondly, there i s no comprehensive consultative body covering trade policy with input from the various stakeholders. Trade data with which to undertake trade policy analysis i s scarce, and there i s also a shortage o f analytical capacity necessary to evaluate the impact o f various trade policies and to determine the positions o f the Ministry o f Trade and Industry during negotiation. 4.53 Under the current institutional structure, the Ministry of Planning and National Development nominally takes the lead in formulating trade policy; the Ministry o f Trade and Industry oversees implementation. Inpractice, these roles are not so clear-cut, and as many as 12 ministries are actually involved in developing trade policies and programs. Clearly there should be a mechanism to facilitate communication and coordination among the wide range o f actors involved intrade policy. 4.54 Weaknesses in transportation infrastructure, customs procedures, and the domestic business climate should all be addressed in trade strategy. The trade ministry, through its interactions with the business community, i s well placed to monitor the implementation and success o fmeasures outlined inthe trade strategy. 62 4.55 Trade consultative bodies inKenya are fragmented. For specific trade policy areas- notably WTO and EPA negotiations-consultative bodies exist, and these have private-sector and civil-society representation. Private sector participation in particular i s seen as crucial because exporters are the main force driving integration into the global economy. However, there is insufficient dialogue between the government and the private sector and this must change.58 4.56 Compartmentalization in the Department o f External Trade inhibits the effective formulation o f trade policy and trade negotiation. The department is divided into three divisions: the WTO Division, the Regional Division, and the Bilateral Division. The latter two are further subdivided by agreement. This approach does not facilitate using trade negotiations to advance a country's trade strategy. Most modern trade agreements-whether multilateral, regional, or bilateral-address the same issues, such as: market access for goods and services; intellectual property rights; standards; subsidies; trade remedies; and dispute resolution. It would be advantageous to organize staff according to these functional specializations. This would allow GOK to identify which negotiating forum would be the most appropriate venue for a particular issue. 4.57 There are serious gaps inavailability of trade data on Kenya (see Box 4.4). Interms o f merchandise trade data, this trade report identified two key issues: inconsistent treatment o f exports originating from EPZs and a decline in the accuracy o f export statistics extending back to the 1980s.The situation is much worse with service-trade data; there was insufficient information to undertake even a preliminary analysis. Trade-policy evaluation i s virtually impossible without reliable and abundant data, and recommendations based on inaccurate information may give rise to misguided strategies. Priorities should include improved collection o f data from EPZs on exports and improved reporting on intra-African trade. Demand for services trade data could be championed by the working group on trade in services chaired by the MOTI. Box 4.4: Trade Data Issues in Kenya Merchandise TradeData Any analysis o f Kenya's export performance must confront some very serious data problems. The export and import statistics submitted to the UnitedNations COMTRADE database provide a poor basis for empirical analyses, or for policy formulation. Kenya did not include information on shipments from its export processing zones (EPZs) in its official trade data. Secondly, there are major discrepancies inKenya's trade data for other reasons and statistics frequently understate actual trade. InternationalMonetary FundDirectiono f Trade (DOT) data indicate Kenya's 2001 and 2002 trade statistics undervalued the worth o f exports by as much as US$l.Sbillion. Problems relating to the accuracy of Kenya's export statistics are not new. Statistical comparisons indicate there has been deterioration in data quality that dates back to the early or mid-1980s. Thus, partner country imDort statistics must be used, where possible, for analyses of Kenya's export performance. This works relatively well for trade between Kenya and OECD countries, which compile accurate data. However, given the nonreliability o f African countries' statistics in general, considerable caution must be appliedwhen assessingregional trade flows. 58 See World Bank (2004) Kenya Growth and Competitiveness, World Bank (2004) Enhancing the Competitiveness of Kenya 's Manufacturing Sector: The Role of the Investment Climate: and Morara. (2004) Institutional Framework for Promoting Links between Ministries Involved in Trade Issues and Poverty Reduction Strategy Process. 63 Services TradeData Opening up trade in services is-under the right circumstances-expected to bring lower priced, higher quality and more diverse services to consumers in recipient countries. Given the importance o f infrastructure services such as telecommunications and banking in supporting and facilitating wider economic activity, improving service provision will likely can be expected to produce economic gains. This report set out to analyze the effects o f services trade liberalization in Kenya using a set o f questionnaires to identify and track: key changes in policies outlining the extent and type o f foreign entry allowed; changes in market structure and concentration, and the role o f foreign firms in services markets, over time; and changes inperformance indicators such as price and access over time. However, after a three-week mission and several months o f follow-up, the quality o f data collected was still too poor for any meaningful analysis. The main reason for this is that ministries and regulators collect data based on expressed demand, and the information needed to assess the effect o f services trade in Kenya (e.g. how much did it cost to make a three minute call to London in 1990?) was unavailable. As a result analysis basedon even a very short historical time frame remained frustratingly out o freach. Inmanyother countries datacollectionon servicestrade is stuck inavicious circle: reforms inthe telecoms sector are relatively recent, and there has been little demand for data on them;'the lack o f data in turn means a lack o f interest in addressing analytical questions surrounding services trade liberalization; lack o f demand for data generateslittle incentive to collect data. 4.58 MOT1capacity will need to be upgraded to if the ministry is to manage concurrent implementation o f the NES, trade strategy, regional and multilateral trade negotiation, the Private Sector Development Strategy, the InvestmentClimate Action Plan, and various other planned or ongoing initiatives. There must be adequate technical capacity to evaluate fiscal and economic impacts, both ex ante in the policy formulation process and ex post as part o f monitoring and evaluation. The input o f think tanks should be sought. 4.59 Kenya's Export Promotion Council has not yet been effectively integrated into the MOTI's structure in terms o f coordination and division o f labor (see Box 4.5). Currently the MOTI's Department o f External Trade (DET) carries out a number o f trade promotion activities that should be the responsibility o f EPC. EPC involvement in the recently formulated NES Implementation Plan o f NES was inexplicably limited. Also commercial attaches" in embassies are not being properly used. Currently, they are DET officers with multiple hnctions, and disconnected from the needs of Kenyan exporters. GOK would do well to review the role and responsibilities o f these attaches with an eye toward creating stronger links betweenthemand EPC. 59Kenya has commercial attaches in: eight African countries (DRC, Egypt, Ethiopia, South Africa, Tanzania, Uganda, Zambia and Zimbabwe); six OECD countries (Belgium, Germany, Switzerland, UK,US and Canada); andPakistan andthe Russian Federation. 64 Box 4.5: Export PromotionCouncil(EPC) Kenya's EPC was established 1992 under the jurisdiction o f MOTI, with the primary objective o f promoting exports by assisting exporters and producers o f export good to overcome bottlenecks in order to achieve higher levels o f export performance and foreign earnings. Formerly, EPC's main activities were the provision o f trade information, export-market development, product development and adaptation, and development o f export skills. Inthe past EPC has not been effectively discharged its mandate due to: a limited budget and human resources; insufficient demand for services from exporters; a poor organizational structure and low incentives; duplication o f mandate and responsibilities with other trade-related organizations, such as DET, HCDA, Tea Board; andlack o finformationon EPCamong small andmediumexporters. In2003 a new strategy was adopted to revive the institution, and the EPC is now expanding its activities accordingly, in an attempt to become the "premier institution in the development and promotion o f export trade" and the "focal point for export development and promotion o f activities inthe country." Inparticular the organization's structure has been overhauled to make it more efficient and responsive to the needs o f exporters, which will have to pay for some o f its services. RECOMMENDATIONS 4.60 Many constraints to export development and diversification in Kenya are beyond the reach o f the Ministry o f Trade and Industry. MOTI, as spearhead for trade and export expansion must promote close coordination among the various ministries and other public bodies. M O T I should also consult closely with the actual exporters to remain informed about constraints it may needto address. 4.6 1 Secondly, the various public-private consultative bodies/committees on trade policy should be consolidated into one such body. Particular attention should be given to ensuring effective private-sector participation inthe consulting mechanism. 4.62 M O T I should also supervise the efforts o f agencies (KRA, Ministry o f Transport, Central Bank, Ministry o f Finance, CCK, CBS) tasked to undertake data collection and administration to develop and implement a plan to upgrade data collection for trade in merchandise and services. 4.63 Donor support can be a catalyst for this, by providing technical assistance, and financing for resources, especially in the period when services trade data collection is jump- started. 4.64 Finally, the Department o f External Trade should institute reorganization to more effectively analyze, formulate and implement trade policy and export development strategies. Reorganization should include: restructuring the department along functional lines; improving trade data quality by including information on EPZs and boosting accuracy in export data reporting; and upgrading capacity to evaluate fiscal and economic impacts o f trade policy. 4.65 Donor assistance can be useful in implementing reorganization o f the DET.Thus far, donors have extended their support for capacity building in an opportunistic way, with little coordination. 65 66 5. ISSUES INKEYTRADE SECTORS FIVEKEYEXPORT SECTORS AND ONE IMPORT SECTOR 5.1 In addition to the constraints for all business activities highlighted in Chapter 3, Kenya's key export sectors each face a set o f sector specific constraints. The government and donors can assist key export sector by addressing these specific constraints that have been identified in a serious o f reports and the 2004 National Export Strategy (NES), in addition to driving forward the behind the border agenda outlined above. In the NES, the GOK has identified key sectors for export development which include the traditional export commodities such as tea and coffee and non-traditional, but established export industries such as horticulture and textiles. From the services sectors, the NES' focus i s on tourism which i s well established and highly successful, and business services (financial services, telecommunications, transport services) which have highpotential. 5.2 Below, we highlight the main constraints for key merchandise export sectors tea, coffee, horticulture, and textile exports. As far as services are concerned, the constraints are less well understood. However, this gap i s currently being filled for the tourism sector for which the World Bank i s undertaking work. Business services and the potential o f services liberalization remains an area for further study which we sketch briefly. Finally, this chapter addresses key problems in the sugar sector which at present is still highly protected. However, as protection is due to be phased out, we outline the main constraints for the sector to perform well inthe post liberalization environment inearly 2008. TRADITIONALCASHCROPS 5.3 Kenya's traditional cash crops are coffee and tea, and these two sectors provide a livelihood for more than 750 thousand people, small growers, and plantation employees. Kenya has fared quite differently in its export performance in these two crops (see figure 5.1). Through a combination o f commodity price decline, stiff competition from Latin America and Asia, and country specific conditions, Kenya's coffee exports .have declined over the past two decades, while tea exports have expanded over most o f this period. Kenya's competitive position in coffee exports has dropped from the 8`h largest exporter in 1985 to the 16`h largest exporter in 2004; within the Sub-Saharan African region, Kenya has fared somewhat better, keeping its position in the top four in 2004, after Ethiopia, Uganda and Cote d'Ivoire. As regards tea exports, Kenya has been second largest exporter in 2004 (after Sri Lanka), the same constellation that prevailed in 1985. 5.4 This reflects a collapse incoffee prices as well as declines inthe global value of EU imports, which have fallen by over 50 percent, from US$8.5billion in 1995. However, Kenya's export losses inEuropean markets were worsened by eroded market share, from 3.3 67 percent to 1.8 percent, a loss in value terms o f about US$38 million.60 Coffee production declined from a peak o f 128,700 tons in 1987/88 to 51,700 tons in 2001/02. The cause o f production declines are attributed to the policy environment, government interventions in coffee marketing, and the inefficiency o f cooperatives (see Figure 5.1). Figure 5.1: Kenya's Coffee and Tea Exports 1985-2004 500 450 400 350 300 250 Coffee Y) -.P'E2 E 200 w Tea 150 100 50 0 I 1985 1990 1995 2000 2003 2004 Source:UNCOMTRADE Database 5.5 While international conditions (competitive pressures, demand development, and resulting commodity prices) are have been better for the tea sector, the tea sector has also beenbenefiting from are more advantageous regulatory environment inKenya. Smallholders are under the supervision o f the Kenya Tea Development Agency who manages input provision and collection o f green leaf tea. Small holders are allowed to sell their produce through an auction, or directly to buyers. The situation has been different inthe coffee sector, where market liberalization was incomplete. The Coffee Board o f Kenya is responsible for regulatory and marketing functions, while service delivery i s being performed by cooperatives structures which have lacked the capacity to perform these functions efficiently. Processing and marketing costs for coffee have been much higher than for tea, and have reduced the share o f coffee prices received by farmers. 5.6 The tea and coffee sectors have been studied over the past years, and the constraints are well understood.61 After the restructuring and liberalization of the tea sector, there are few sector specific constraints. However, the economy wide problems o f poor infrastructure 6o According to the International Coffee Organization (ICO), Vietnam increased its global exports of coffee more than threefold between 1995 and the early 2000s. Vietnam now produces more than 13 percent of world exports (as opposed to 5 percent in 1995). Partly as a result of new sources of supply, the I C 0 estimates the price paid to Kenyancoffee exportersfell from about 177 US cents per poundin January 1995 to about 60 cents per pound in December 2002. Preliminary estimates point to a continued decline; Kenyan coffee exporters receivedabout 36 cents per poundinDecember2003. 6'See for example World Bank (2004,2005), and specific sector analyses EuropeanCommission(2003), and Nyangito (2001). 68 prevent an evenbetterperformance. The coffee sector, and inparticular the small holders are still to benefit from the recently introduced reforms to the Coffee Act. While producers are now allowed to sell coffee outside the auction if they wish, this new opportunity is still to trickle downto producers.62 HORTICULTURE 5.7 As seen in the review of Kenya's export performance in Chapter 2, horticultural exports (cut flowers, and fruit and vegetables) are Kenya's second and third largest export commodity, after tea. Cut flowers are the fastest growing export sub-sector in agriculture, growing faster even than fruit and vegetable exports (see Figure 5.2 below). Kenya is world wide the third largest supplier of cut flowers (after Columbia and Ecuador), supplying 4.7 percent of world imp.orts in 2004, mainly to Europe (Netherlands, France, Germany and Switzerland). 5.8 The expansion of horticulture export has contributed significantly to poverty reduction, even as product sourcing of many exports has evolved. Formerly, fresh fruit and vegetables, and cut-flower exports were typically sourced from small-scale farmers; now the majority of these products come fkom large estate farms that employ laborers.63 Overall, horticultural exports have generatedjobs that directly support half a million workers, small farmers andtheir families. Figure 5.2: HorticulturalExports 1985-2004 400 350 .-e0300 -'E 250 200 tft 3 150 100 50 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Cut flowers Fruit and wgetables Source:UNCOMTRADEDatabase 5.9 Fruit and vegetable exports include four sub-categories, namely fresh fruit and nuts, preservedfruit, fresh vegetables and preservedvegetables. Figure 5.3 shows that the growth of fruit and vegetable exports is driven mainly by the export of fresh vegetables to Europe. Four o f the fastest- growing exports to the EU trade were agricultural products in which 62Reuters, September 17,2005. See English, Jaffee andOkello (2004). 69 Kenya has established a competitive supply chain based on its comparative advantage as an off-season producer. Figure5.3: Fruit and Vegetable Exports 1995 2004 - 250 200 -=.-sE150 g 100 3 50 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 '+Fresh fruit and nuts +Preserwd fruit Freshiegetables -+Preserwdwgetables; ~ Source: UNCOMTRADE Database 5.10 Horticultural export growth benefited from sound economic management and political stability during the first post-independence decade, but then had to overcome a deteriorating economic and business environment, and political instability. Today, much o f the success of the horticulture industry can be attributed to "light" regulation and taxation by the Horticultural Crops Development Agency. The driver ofhorticulturalexports inKenya is the private sector which over the decades has learned to successfblly navigate the diverse, risky and fast changing environment. 5.1 1 Exports o f horticultural products critically depend on their ability to strictly adhere to the food safety requirements and environmental standards such as maximum residue levels which are constantly being tightened, in particularly in the EU, Kenya's major exports market for horticulture. The role o f standards in Kenya's export industry has been discussed inthe standardssection ofthe Constraints to Trade chapter ofthis report. 5.12 The cut-flower sector faces competition from other African countries - Zimbabwe and South Africa rank among the top ten cut flower exporters; Ethiopia, a relative new comer, has registered high growth rates, and i s well positioned owing to its climate, proximity to the major market, and relatively cheap cargo fees. Competition in the flower sector i s putting pressure on prices and thus profit margins. In a more competitive environment, hrther expansion o f the cut flower sector Kenya will be constraint by its relatively high transport and freight cost, and high cost o f inputs, in particular sprays and fertilizers, and for security.64 *See World Bank (2005), and UNCTAD andICC (2005). 70 5.13 As current supply, demand and price trends in international h i t and vegetable markets are likely to persist; demand for high-value agro-food i s expected to grow, fueled by higher income demand elasticity for high-value food products, demand toward product differentiation, healthy eating and quality, and demand for year-round supplies. Thus, there will be opportunities for further export growth in this sector. Kenya has still only a small share o f the EU market in vegetables and fruits, and the U S market is almost unexplored, owing to the absence o f direct flights from Kenya to the US. 5.14 At the same time, demand for semi-prepared, and/or ready-to-eat combinations has been progressively increasing, offering opportunities for countries like Kenya for adding value to its exports. Apart from Kenya's ability to keep up with standards requirements in key target markets, expansion in the value added sector will depend on strong ties with supermarket chains, and direct distributors in Europe, to satisfy processing, packaging and labeling according to the specifications. Constraints in the fruit and vegetable export sector are poor infrastructure:in particular transport and complicated bureaucracy. 5.15 The GOK can help the sector best by addressing specific constraints such as providing security in the regions where produce are being grown, improve the transport infrastructure, reduce the bureaucratic burden, and speed up VAT refunds. However, sector analyses caution against a more interventionist stance. The reason i s that horticultural exports critically depend on the high performance o f private sector actors that has been developed over decades in Kenya. The private sector benefits from the experience that has been gained over decades to adapt quickly to new conditions, and to strike partnerships within the country and with foreign importers. TEXTILESAND CLOTHING 5.16 The textile and clothingsector inKenyacan continueto thrive despite the MFA removal, if key behindthe border issues are beingaddressed. As seen inthe performance section o f this report, Kenya's textile and clothing exports have grown impressively over the past years. This growth has been driven by the preferences available under AGOA and the quotas that previously existed under the Agreement on Textiles and Clothing, (ATC). The preferences under AGOA have been fuelled by the third country fabric provision which is due to expire in September 2007. The growth of the clothing sector is likely to have contributed to poverty reduction and especially to have hadpositive gender effects. 5.17 However, there was widespread concern inKenya as well as other countries who had successfully increased textile and clothing exports to the United States that with the removal o f the last MFA quotas by the end o f 2004, their exports would collapse because o f more competitive producers in South and East Asia. A product specific study undertaken for this report, however, comes to a different assessment, and predicts a continuing success for Kenyan textile and clothing exports, at least until the phase out o f the third country fabric provision. 5.18 Analyzing the impact o f MFA quota removal on Kenya, the study finds that East and South Asian countries have a relatively smaller market share in the specific product categories that are exported by Kenya, compared with the overall sector. Kenya's textile and 71 clothing exports to the United States are concentrated in a few categories (cotton non-knitted items), and in these categories, imports entering under binding quotas have been in decline over the past few years, and the market share for quota facing countries has been declining too. The same is true for the categories that Kenyan exporters have started to export more recently, such as knitted sweaters. A final observation relates to the prices that Kenyan exporters have received for their products. Relative prices for Kenyan exports have increased (inparticular for men's cotton and synthetic-fiber trousers), which indicates an improvement in quality and implies that Kenyan exporters should remain successful, especially in these categories after quota removal. 5.19 This assessment is confirmed by the post-MFA experience to date as can be seen in Table 5.1. The value of Kenya's textile and clothing exports to the United States between January and August 2005 is almost identical to the performance in the same period in 2004, despite the MFA quota removal, and an appreciating currency. The same is true for the other African AGOA exporters, apart from Mauritius; in Lesotho and Madagascar exports experienced a very slight decline; in Swaziland they even grew. The Caribbean Basin Initiative (CBI) countries,65 another region where negative effects o f the MFA removal were feared, exported January - August in2005 the same value of textile and clothes to the United States as in 2004. Chinese exports have grown very significantly, as expected, though w e note that exports from Macao and Honk Kong have declined, which indicates that before MFA removal some Chinese textile exports had been channeled through Hong Kong and Macao. The South Asian countries are doing very well with double digit export increases from India, Bangladesh, Sri Lanka and Pakistan. However, demand in the United States textile market is growing strongly, so while some changes in market share are occurring, Kenya's and most other African exports have not taken a hit. Table 5.1 Textile andClothingExportsto the United States 2004 and 2005 Source: Customs Declarations Collected inUS, publishedby ITC. 5.20 To diversify textiles and clothing exports, Kenyan exporters should also explore the opportunities for entering the EU market, in particular if Rules of Origin will become less restrictive. Kenyan exports are currently totally concentrated o n the U S market. Althoughthe ~~ 65Honduras, Dominican Republic, Guatemala, El Salvador, Nicaragua, Costa Rica, Haiti, Jamaica. 72 nature o f the EU market i s less harmonized in terms oftastes than that o f the US, there are still substantial opportunities in the EU market. The value o f exports to the U S is a multiple o f 34 times greater than exports to the EU. At present, Kenya can export duty free to the EU (a margin o f preference lower than the US, but still significant at around 12 per cent) but faces more restrictive rules o f origin requiring production from yarn.66The EU i s reviewing its rules o f origin under the GSP, and for the EPA. AS mentioned inthe last chapter, this i s a priority for Kenya in its EPA discussions with the EU where it should contribute to the discussion pushingfor more liberal rules o f origin, and seeking their immediate extension to trade under the Cotonou agreement. 5.21 Furthermore, if Kenya could provide the quality and reliability o f service demanded by EUbuyersand the security and speedof transport and customs clearance that are required for high value fabrics, then local producers could attract the processing activities o f EU firms. 5.22 To effectively realize the opportunities available in the clothing sector will require progress in reducingthe behind the barriers constraints to exports. The main unit cost items for textile and clothing production is labor. Labor cost is relatively low in Kenya, compared to key competitors, and should thus not be a major constraint. Information on labor cost per shirt produced suggests that costs in Kenya (US$O.18) are below those o f China (US$0.29) and comparable with those o f India (US$0.17),67 two countries who are thriving in the post MFA removal period, The main constraint for late deliveries, cancelled orders, and additional, unforeseen cost (such as having to ship an order by air, rather than by sea) are trade logistics, mainly at Customs and at Mombassa Port. The main problem i s that Customs has discontinued the practice to allow import containers for EPZs to remain sealed untilthey arrive inthe factory which we mentionedinthe preceding chapter). 5.23 Furthermore, after September 2007, the third country fabric provision inthe AGOA no longer apply, and Kenyan exporters will no longer be able to use fabrics imported from Asia, as is currently the practice. It shouldbe noted that the third country fabric provisionhad already been extended once, so the chances for a further extension are slim. The message that the sector can survive without the preferences should be conducive to stimulate the growth o f local fabric and yarn production, especially when coupledwith improvements inthe business climate and infrastructure. TOUFUSM 5.24 Tourism is Kenya's main service export and thus an important source o f foreign exchange earnings (estimated at US$340 million in 2004); it provides direct employment for some 212,000 employees, and for a further 278,000, employed in the informal sector supporting tourism. Tourism in Kenya is built on three pillars, namely safari tourism, beach . 66 These rules of origin are more restrictive for non-knitted than knitted products, which are more often produced in a single stage from yarn. This rule for non-knittedproductsrequires a double transformationand the useof local fabric. Hence, at least initially there would appear to be an opportunity to builduponthe initial expansionofknittedproductsobservedunder AGOA. 67Thesedatacome from CadotandNasir (2001) as reportedinEifert,GelbandRamachandran(2005). 73 tourism along the coast and on the islands, and conference tourism mainly in Nairobi and Mombasa. 5.25 In 2004, Kenya received 1.2 million visitors, and registered US$495 million in tourist receipts. Compared with 814 thousand visitors and US$443 million receipts in 1990. Figure 5.4 shows that receipts declined after 1995 to a low in 2002, after which they picked up again to reach a new record in 2004; tourist arrivals, on the other hand, remained relatively stable over the period, with a slight dip in 2002. These diverging trends in tourist arrivals and receipts in Kenya have two reasons: in the second half o f the 1990s, prices for holidays in Kenya - in particular at the beaches - declined because o f increased competition and crumbling infrastructure in Kenya which squeezed revenues; a further downturn in revenue was triggered by the terrorist attacks on the US Embassy in Nairobi, and on hotels and flights at Mombasa. Secondly, many o f the tourists destined for elsewhere inEast Africa arrived through Kenya because o f low international air fares to Nairobi. This led to an increase intourist arrivals, though many o fthem spend very little duringtransit inKenya. Figure 5.4: Tourist Arrivals and Receiptsin Kenya 1990-2004 I 1400 3e! 1200 -*E.-g1000 800 Y) 3 2.-> 600 400 2 200 - 8 0 0 1990 1995 2000 2002 2003 2004 I -+Animls Receipts 1 Source:WorldTourismOrganization, TourismMarketTrend, 2005 Edition-Annex 5.26 Compared with other countries in Sub-Saharan Africa including its regional neighbors Tanzania and Uganda, Kenya's tourism industry has grown well below average. Table 5.2 below shows average per annum growth rates in Kenya, Sub-Saharan Africa, and selected African countries. Table 5.2 shows that Kenya's tourism industry i s not benefiting from the tourism boom since the 1990s; while in some countries tourism receipts grew more than twice as fast as tourist arrival, Kenya's tourism industry is stagnating, and thus falling back behindits competitors.68 68In 1990, Kenyawas second only to SouthAfrica in tourist receipts; its rank declined to 7 in 2002 and 2003; in2004 it rankedfifth, behindSouthAfrica, Mauritius,Tanzania, andBotswana(WorldTourism Organisation, TourismMarketTrend, 2005 Edition - Annex). 74 Tourist arrivals Tourist receipts Sub-Saharan Africa 9% 9.2% Kenya 3% 0.9% Tanzania 7.9% 19% Uganda 16.7% 28.7% South Africa 15.7% 9.9% Botswana 5Yo 12.6% Namibia 12.4% 12.7% 5.27 Europe is the major source o f visitors to Kenya, especially Germany and the United Kingdom, followed by North America and Africa. The Government aims at diversifying into new markets, with particular attention to the Far East (inparticular China, Japan, and Korea). In2004, KenyaAirways launched direct flightsto fromNairobi to HongKongvia Bangkok. 5.28 Data from the tourism module o f the 2004 I C A and earlier sector studies6' indicate some o f the basic constraints faced by the industry: One o f the main constraints i s the regional and domestic security situation, and steps are already under way to address security issues by strengthening the Tourist Policy Unit, and cooperating with other countries on security-related issues. Other constraints are Kenya's poor road infrastructure, and the deterioration o f the country's tourism infrastructure and other tourism-related services. Investment flows to address these issues are being hampered by a weak institutional and regulatory support framework. Finally, efforts in marketing and promotion of Kenya in key and emerging tourist markets are still considered insufficient. 5.29 Improved performance o f the tourism sector inrecent years has resulted inoptimism within the industryand there is a sense that tourism to Kenya couldbe significantly expanded ifsome ofthe key constraints can be addressedand the Government and private sector work together to make product improvements and enhance competitive advantage. Furthermore, to participate in the growth of the tourism industry elsewhere in Africa, it i s imperative for Kenya's tourist industry to move up the value chain, developing assets and facilities to attract more affluent, high-end tourists. This will necessitate targeted investments in supporting infrastructure, adjustments in the policy and regulatory framework, and a more integrated approach to tourism promotion. To address these issues, a new tourism policy and a tourism development plan are being formulated. The legislation and the regulatory framework affecting private investors are being reviewed to provide a more hospitable environment for investors. 5.30 A World Bank study on the tourism sector is currently under way. The objective of the study is to assist the GOK in developing a strategy to improve the business climate for the tourism sector to attract investment into the industry, and increases Kenya's share in tourism receipts. Secondly, the study will identify how Kenya can access new tourism markets and improve performance in existing markets through innovative marketing and product enhancement strategies. 69Ikiara (2001), Kenya Tourism Federation(2003). 75 THEPOTENTIAL OFBUSINESS SERVICES (AN AREA FOR FURTHERSTUDY) 5.31 Services play an integral role in economic advancement and inefficient provision o f key services, such as finance, telecommunications and transport, limits economic growth. Inefficient domestic production o f services behindtrade and investment barriers acts as a tax on the production o f goods. Indeed, the liberalization o f services may be necessary for industrial sectors to be able to fully benefit from the direct opportunities that are made available by the removal o f trade barriers and to effectively access global markets. In addition, participation in global production networks requires access to efficient services, especially transport and logistics, telecommunications and financial services. 5.32 Both regional and global trade strategies for services are important elements in providing an environment for improved efficiency in services. However, trade policy making i s severely constrained by lack o f information and analysis on the particular sectors in which Kenya has an advantage, the main barriers to trade in those sectors and the implications o f trade restrictions inservices on the capacity o f other goods and services sectors to compete in regional and global markets. This lack o f information makes it difficult for Kenya to formulate effective offers in international negotiations and to pursue effective opening o f overseas markets that can support the growth o f Kenyan services providers. There is therefore a need for a number o f careful studies o f the main services sectors in Kenya, the opportunities for trade and the current constraints. A focus on services i s also important since efficiency o f services is a key factor affecting the scope for expansion o f new sectors and services often are an important source o f new employment to assist adjustment away from declining sectors. SUGAR ' 5.33 Reform of the sugar sector is essential if the sector is to survive. Sugar is a key sector, beingthe largest industry in Western Kenya and providing incomes to about 100,000 smallholder sugar cane growers, a large number o f casual workers and cane cutters, and about 8,600 wage employees o f the sugar companies. However, the industry's cost structure i s relatively high, and i s therefore not able to compete with lower cost producers in COMESA countries. In response the Government negotiated a safeguard provision with COMESA in 2003 to limit duty-free imports to 200,000 tons per year until February 28, 2008. 5.34 A renewed commitment by the Government and the industry to reforms is needed in order to avoid a crisis in 2008. The sugar industry needs to quickly undertake major reforms to reduce sugar production costs in order to compete with imports during the period o f opportunity whilst the safeguard provision is in place. Past efforts to reform the sugar industry have been largely unsuccessful, and the industry has been plagued by mismanagement and corruption. Sugar production costs can be reduced substantially if the Government and the industry address the major problems. Inaddition, value can be added to the industry by cogeneration of electricity, but that addition will not be sufficient to offset highproductioncosts. 76 5.35 Kenya's sugar production costs are about double those o f the world's lowest-cost exporters, and ex-factory prices are more than 50 percent higher than imports prices from COMESA's most competitive exporter (see Table 5.3). Without major reforms, the industry will not be able to compete with duty-free and quota-free imports after the COMESA safeguards expire in2008. Table 5.3: Comparisonof Sugar Pricesinthe COMESA CommonMarket, 2003. Cane Price Ex-FactoryPrice WholesalePrice Retail Price LCper. US$per LCper US$per LCper US$per LCper US $per Ton Ton Ton Ton kg. lb. kg. lb. Kenya 1,800 23.70 40,460 532.82 41,960 25.1 46,090 27.5 Egypt 105 17.64 1.4 10.3 1.6" 11.8 Malawi 19.1 Sudan 113,076 462.89 21.0 Note: Conversion from Local Currency (LC) to US. dollars was at the official exchange rate reported in the IMF's InternationalFinancial Statistics Sources: Kenyan data is from Kenya Sugar BoardYearbook 2003, Table K. Egyptian data is from USDA/FAS Sugar Annual 2003 and 2004. SouthAfrican data is from USDA/FAS Sugar Annual 2004. Sudan's data i s from Kenanasugar company. "TheretailpriceofLE1.6perkg. inEgyptisfor governmentoutletswhile prices inprivate shopsarebetween LE 1.8 and2.3 per kg. 5.36 If major reforms are successfully undertaken, the large private sector factory, Mumias, which accounts for more than half o f Kenyan production, will be internationally competitive: The four Government-owned factories and a smaller private sector factory will face a difficult challenge to compete even with successful reforms, and have almost no chance to compete without reforms. 5.37 Preparing the Kenyan sugar industry to compete with imports from COMESA requires three major reforms and a number o f supporting actions. First, sugar cane prices must be reduced to internationally competitive levels and linked to domestic sugar prices. Cane prices are currently one-third higher than can bejustified by international prices due to large increases during the early 1990s when the Government controlled all sugar prices. These increases were motivated by the change from a single party system to a multi-party democracy and were notjustified by market conditions. 5.38 Lower cane prices will be difficult for sugar cane farmers to accept and this leads to the second major reform which is to improve the roads and invest more inresearch to raise cane yields. This will allow cane price declines to be partially offset by higher yields and lower costs. Cane transport costs currently account for 37 percent o f cane production costs and poor roads contribute to these costs by slowing the movement o f cane hauling equipment and contributing to more frequent breakdowns and equipment deterioration. Faster maturing and higher yielding cane varieties are needed to increase grower incomes and raise the cane suppliesto overcome the frequent factory problem o fcane shortages. 77 5.39 Thirdly, Government-owned factories should be privatized to improve performance and reduce future Government budget exposure. The private sector factories operate about 80 percent o f the available time while the Government-owned factories operate only 60 percent of the time. This difference, plus the more than 20 percent higher sugar extraction per ton o f cane o f Mumias compared to the Government-owned factories, contributes to lower private sector factory costs. 5.40 Funding for these reforms can come from three sources. First, the Government should provide for road repairs in exchange for the 18 percent VAT collected from domestic sugar sales and imports. Roads have not been adequately maintained and poor roads add to the cost o f cane transport. Secondly, the Sugar Development Levy can be directed to the most urgent needs o f the industry which i s research on better cane varieties instead o f being loaned to loss making sugar factories and poorly managed outgrower companies. Thirdly, the sugar import quotas should be auctioned ina transparent system to raise revenue to revitalize the sugar industry rather than being allocated to favored firms for their own gain. The debts o f the Government-owned factories should be partially recovered during the privatization o f the factories and the remainder should be absorbed by the Government rather than carried to accumulate interest with little chance o f repayment. 5.41 The Kenyan sugar industry may benefit from both higher international prices and added value from cogeneration o f power which would make the reforms easier. However, neither o f these developments can be counted on to offset the needs for reforms. International sugar prices have been extremely depressed in recent years because o f the large increase in exports from Brazil. This situation i s moderating as ethanol production increases in response to high petroleum prices and increased number o f ethanol powered cars in Brazil. Despite this, Brazil has substantial capacity to expand production of sugar cane for both ethanol and sugar production and sugar prices may remain depressed. Policy reform in the EU and US may also contribute to higher sugar prices in the medium-term by reducing support to domestic producers and lowering barriers to imports. However, such reforms are uncertain and may not occur by the time the COMESA safeguard provision expires in 2008. Adding value by co-generating electricity for sale to the national power company is attractive in Kenya because o f the highprices o f electricity. However, the immediate impact will be small and substantial investment is required in order to produce enough power to significantly add to sugar company revenues. Thus, it appears unlikely that Kenya will have any alternative except to reform its sugar industryto compete with imports from COMESA Common Market countries or abandon its obligation to free-trade within COMESA. 5.42 Inadditionto the needfor reformsinorder to compete inCOMESA, there is concern within the industry that illegal imports are entering the country and that some legal imports may be cross subsidized by higher priced domestic sales. These concerns should be carefully evaluated and action taken, if warranted, to protect domestic producers from unfair trade practices and illegal imports. However, investigating unfair trade practices and illegal imports should not substitute for the difficult cost cutting reforms which must be undertaken inorder to avert acrisis in2008. 78 RECOMMENDATIONS Cash Crops 5.43 The 2002 Coffee Act has recently been reformed to allow farmers to either sell their coffee through the central auction, or to sell directly to roasters abroad through a marketing agent. To enable small holders to benefit from this important change Government should take measuresto publicize the new regulations widely to the coffee growing community. Horticulture 5.44 For the horticulture sector, Government priorities should be to continue improving the enabling environment for the private sector such as improving security and transport infrastructure in the key out grower regions. As regards Government intervention, the recommendation is to keep the private sector that has been successful in this sector in the driver's seat. Textiles and clothing 5.45 For the textile and garment sector, immediate priorities are to: 0 Extend working hours for Customs Officers both in the EPZs and at the Port which should help factories meeting tight production schedules. 0 Relax the fee requirement for EPZ bound containers at Mombassa port, and allow export bound containers to arrive closer to the actual departure date o f their ship. 5.46 Inthe medium term, Kenyan exporters needto be able to source fabrics from Africa which requires capital and lead time set up knitted-cloth and woven-cloth production. To attract the relevant investment, the GOK needs to drive forward its larger agenda o f improving the investment climate. If there are indications that specific obstacles for investmentsinto the cotton to fabric segment o f the value chain exist, there may be need for further analysis. Sugar 5.47 There are a numbero f specific actions that needto be taken to prepare the sector for market liberalization in 2008. To drive forward these necessary reforms, GOKs need to express clearly its commitment to liberalization and the reform agenda. This will require better knowledge on the precise effects that can be expected from liberalization. Thus, the first step is to: 0 Undertake an analysis of the impact of liberalization and reforms on the industry structure, and o f mitigating actions (policy and institutional reforms, investments) to mitigate potentially negative impacts. The study should cover the value chain, starting from the sugar factory level down to the farmers to identify likely poverty and social consequenceso freform and liberalization inthe sugar sector. 79 Important steps to reform the industry towards liberalization in2008 are: Link sugar cane prices to domestic sugar prices. Cane prices should be linked to domestic sugar prices, which would currently cause prices to decline by about one- third, but it would also allow future price increasesto benefitproducers. Improve roads to reduce cane transport costs. Cane transport accounts for an estimated 37 percent o f cane production costs, and poor roads contribute to these costs. Invest more in sugar cane research. Higher yielding and faster maturing sugar cane varieties would partially offset the decline in sugar cane prices which i s necessary for the industryto compete. Privatize the Government-owned factories to increase eflciency. The private factories perform better than Government-owned factories which should be privatizedand the proceeds from factory sales usedto reduce the factory debt. The Sugar Development Levy collects 7 percent from domestic sugar sales and imports to support industry development. The effectiveness ofthis Levy needs to be evaluated and the Levy reduced if it is not found to be effective. Auction import quotas and invest the revenues in cost-cutting activities. The current quota allocation system allows importers to benefit from the price difference between imports and domestic sugar prices. According to Kenya Sugar Board's data, the price differential is 60 percent and has a value o fUS$30 million per year. Tourism 5.48 The Government should continue to focus on improving the security situation both domestically and within the region through regional cooperation, and dialogue with governments in the major tourist-generating countries. Recommendations to address other constraints for tourist sector expansion, and attraction o f FDI into the sector will be forthcoming from the currently ongoing World Bank tourism sector value chain analysis. Business Services 5.49 To guide government policy on regional and international services integration, studies shouldbe undertakenfor the various service sub-sectors. 80 6. CONCLUSIONSAND RECOMMENDATIONS TradePerformance 6.1 Growth and trade integration in Kenya had declined over the 1990s. Over the past several years, this trendhas beenreversed.With a stable macro-framework inplace, Kenya i s now poised for continued further ,trade integration. 6.2 Natural resource-based exports are likely to remain the mainstay o f Kenya's exports for some time. Lessons from the successful development o f cut flowers, fresh vegetables should serve to guide GOK's policy reform o f other non-traditional natural resource-based sectors. As regards the horticulture industry, much o f the success has been attributed to the "light" regulation and taxation by the Horticultural Crops Development Agency. Tea exports have benefited from the supervision o f the Kenya Tea Development Agency which efficiently manages input provision and collection o f green leaf tea, and from allowing smallholders to sell their produce directly to buyers. 6.3 There is some growth potential in regional trade for commodities such as maize, dairy, and processed food. Regional trade in finished products however holds less potential because o f low complementarity among regional partners. 6.4 Traditionally, Kenya's main export market has been the EU. Given the sluggish economic growth there in the past decade and the contrastingly dynamic performance o f South and East Asian economies, Kenya would do well to secure access to the latter's markets. South and East Asia's populations are likely to maintain strong demand for food items such as coffee, tea, nuts and horticulture, which is perhaps the sub sector in which Kenya has the greatest competitive edge. However, Kenyan exports still face relatively high tariffs to enter these markets. 6.5 As regards further trade diversification, attention should be paid to production sharing, which is fast growing in part because o f declining transport costs. South Africa and South and East Asian countries are potential partners. The need to improve competitiveness and create a commercial environment conducive to export diversification is key. Domestic Constraints 6.6 In the area of transport and trade facilitation, the first priority is to effectively implement the Customs Modernization Programme, which will require continued high-level political support. Particular attention should be given to the automation o f container tracking at the port, and to the development of a set o f logistics indicators to benchmark reforms and progress, It i s critical that the private sector occupy an important role in driving forward reform, as well as in some advisory capacity. 81 6.7 Technological solutions for sealing or cargo tracking should not be considered until the recently implementedinformation system on goods in transit (SIMBA) is working well. Sealingkargo tracking can then rely onjust two components: a carnet system (road manifest attached to the truck) and real-time reconciliation o f transit information between port o f entry and port o f exit. 6.8 Furthermore, ensuring consistency among regional regulations i s vital. Divergence from COMESNEAC recommendations on weighbridges is highly undesirable and should be addressedby the relevant regional bodies. 6.9 Donors have been active in the transport trade facilitation area for a relatively long time in Kenya; however, GOK should manage donor support going forward to ensure coordinationo fpriority actions. 6.10 There are currently no problems in the air-transport sector, and it i s very important that this continues, given the importance o f air traffic for Kenya's key export sectors. 6.11 Priorities for improving the capacity in standards and conformity assessment institutions are: a. Awareness raising on good agriculturalpractices; b. Improvement inpest risk assessmentand management capacities; and c. Improvements o f landing sites and environmental management in Lake Victoria. 6.12 For a roll-out o f the quality standards and conformity assessment system beyond the horticultural sector, GOK should ensure that the standard-setting and conformity assessment institutions focus on facilitating private sector delivery o f the services (testing, conformity assessment, consultancy, etc). 6.13 At the regional (EAC) level, GOK should lead the development of joint SPS- management capacity and share resources, such as using Kenya's pending accreditation system as a regionalplatform. 6.14 Access to finance i s a key problem for Kenyan exporters, in particular for micro, small and medium firms trying to export. 6.15 To address MSMEs' lack o f access to finance in general, GOK should develop a coherent national policy and strategy for micro- and small-business finance. Of particular importance would be the achievement o f better coordination among regulators and the development o f a common legislative and regulatory framework for different finance providers, which would simplify the flow o f funds between them, and MSMEs. 6.16 Secondly, there i s urgent need to establish a well-functioning credit registry to . improve the flow o f information on borrowers. The institutions covered should include commercial banks as well as microfinance institutions and SACCOs, to allow small borrowers to graduate from micro and local finance to bank finance as their business grows. 82 TradePolicy and Institutions 6.17 Kenya and the EAC should focus in implementingin full the EAC Customs Union. The CET review scheduled for 2009 should be usedto simplify the CET exemptions regime, reduce tariff dispersion and escalation, in addition to reducing the top rate to 20 percent as planned. 6.18 As EAC trade integration is deepened, the member states should consolidate tariff bindingswithin the WTO framework, and bringboundrates closer to applied rates. 6.19 Kenya and its EAC partners can use their participation in the WTO to better integrate into the world economy. Specific steps would be to focus on negotiating better access to dynamic Asian markets, and to identify offensive interests for the GATS negotiations. 6.20 Furthermore, Kenya shouldjoin the ITA and expand its GATS commitments in terms o f IT-related services, business services, wholesale trade and other sectors critical to export competitiveness. Lastly, Kenya's SPS and TBT enquiry points should be used to enable Kenyan and EAC firms to overcome standards-related trade constraints. 6.21 Consistency between the EAC and COMESA rules and their implementation, particularly with respect to Rules o f Origin, is vital. Kenya, as the EAC's most-developed economy, should take the lead in implementing regional integration through liberalization o f regional services markets, and strengtheningEAC-wide customs and trade logistics reforms and harmonization. 6.22 A thirdpriority should be to expedite processing ofVAT refundsfor exporters, and to reinstate fast-track treatment for EPZ containers. One option could be to implement an accelerated clearance process for exporters with good records o f compliance. To eliminate the VAT backlog, the Treasury will needto grant more authority to KR4to pay claims. 6.23 An assessment of the EPZ program would be useful to determinethe aspects that are most cost effective as well as to discern features that could be extended to the rest o f the country. This could be done using donor support for studies in the area o f trade and export promotion. 6.24 As regards the EPA Kenya is currently negotiating with the EU as part o f the ESA negotiating group, the negotiating priorities include advocating for more liberal rules o f origin, mutual recognition o f standards and conformity assessment and to initiate dialogue on temporary migration o f workers. Once the EPA enters into force, GOK should take action to avoid trade diversion, especially in the services sector. This may necessitate reduction o f the tariff schedule and liberalization o fthe service sector on an MFNbasis. Issues in Key TradeSectors 6.25 As regards coffee, the 2002 Coffee Act has recently been reformed to allow farmers to either sell their coffee through the central auction, or to sell directly to roasters abroad through a marketing agent. To enable small holders to benefit from this important change 83 Government should take measures to publicize the new regulations widely to the coffee growing community. 6.26 For the horticulture sector, Government priorities should be to continue improving the enabling environment for the private sector such as addressing security and transport infrastructure inthe key out grower regions. 6.27 For the textile and garment sector, immediate priorities are to: extend working hours for Customs Officers both in the EPZs and at the Port which should help factories meetingtight production schedules; and relax the fee requirement for EPZ bound containers at Mombassa port, and allow export bound containers to arrive closer to the actual departure date o f their ship. 6.28 There are a number o f specific actions that need to be taken to prepare the sugar sector for market liberalization in 2008. To drive forward these necessary reforms, GOKs need to express clearly its commitment to liberalization and the reform agenda. This will require better knowledge on the precise effects that can be expected from liberalization. Thus, the first step is to: 0 Undertake an analysis of the impact of liberalization and reforms on the industry structure, and o f mitigating actions. 6.29 Important steps to reform the sugar industrytowards liberalization in2008 are: 0 Link sugar caneprices to domestic sugarprices. 0 Improve roads to reduce cane transport costs. 0 Invest more in sugar cane research. 0 Privatizethe Government-owned factories to increase efficiency. 0 The effectiveness o f the Sugar Levy needs to be evaluated and the Levy reduced if it i s not found to be effective. 0 Auction import quotas and invest the revenues incost-cutting activities. 6.30 To facilitate growth o f the tourism sector, GOK should continue to focus on improving the security situation both domestically and within the region through regional cooperation, and dialogue with governments in the major tourist-generating countries. Recommendations to address other constraints for tourist sector expansion, and attraction o f FDI into the sector will be forthcoming from the currently ongoing World Bank tourism sector value chain analysis. 6.3 1 To guide government policy on regional and international business services integration, studies should be undertaken for the various service sub-sectors. 84 2Y 24 24 24 F 3 8 3 0 s N ry N 33 3 R 2 3 N I m Y c x I e e e e e 'I 2 00 QI 0 0 0 r 4 8 8 . Y Q) U ra 2 a s 24 l- O \o l- 0 0 8 N -4 0 N .a 3 m 3b sb 4-3 m I b b b a I .-ae U 63 c) 8 rg cu 1 % I- O s Y u 8 (0 e, a I, s a d E I_ 8M 0 0 II r- 0 00 0 0 z 0 CI 0CI CI 0 CI . * H a a a * a a 0 rr 0 9 4 9 m 3 I Do 9 E I C PQ = U 9 9 4 x p .p 8 4 9P Lc 0 V 80 hl I I eR : C : C f -e R eC !i I 4 - 4 b b b 0 k 0 I I I ti a a I t- ?0 t Y h e e e e e I 2 g g2 .sbq 5 s 0 ry I I L a a e a a e e a \o 8m e e e e e B 3 U x 0 I 2 e . n 2 * *- e E c, v) se I- P d s SELECTEDREFERENCES Anderson, K. and W. 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