Phyllis Papadavid (Senior Research Fellow – Team Leader of International Macroeconomics, ODI)
19 July 2018
Kenya needs to gear up its macroeconomy to boost its manufacturing sector
Kenya has a compelling story to tell when it comes to its economic diversification. The country has sizeable agriculture and services sectors, which account for a respective 32% and 45% of total value added in the economy, according to the World Bank. And, with the introduction of its Early Oil Pilot Scheme, it is also now an oil-exporting economy, drawing production from its Turkana region.
At the same time, having been identified as a priority sector under the government’s Big 4 Agenda, manufacturing, and the textiles and apparels (T&A) sub-sector in particular, could be a game-changer for economic transformation and job creation – if close attention is paid to the country’s macroeconomic environment.
The time for diversification is opportune, given the current challenging environment for resource-based economies, owing in part to the commodity price downturn since mid-2014: inward foreign direct investment (FDI) into Sub-Saharan Africa (SSA) declined from $53bn in 2016 to $41bn in 2017. For example, Nigeria’s economy in particular continued to be depressed, with FDI down 21% in 2017 relative to 2016. By contrast, the more diversified economies of East Africa have shown more resilience of late. At $3.5bn in 2017, FDI inflows in Ethiopia continue to be nearly double the level seen in 2014 (Figure 1), and the country is the second largest recipient of investment inflows in Africa, owing in part to its apparel sector.
Source: UNCTAD World Investment Report Annex Tables
A conducive macroeconomic environment is key for diversification
Kenya is already the largest exporter of apparels under the African Growth and Opportunity Act, according to the Kenya Association of Manufacturers (KAM), which makes the sector a key one for the future. The country has seen phenomenal growth: US imports of Kenyan apparel products increased 675% between 2000 and 2017. Exports to the US market are also crucial for the sector, given the dominance of textiles compared with other industries. Pursuing further expansion in this largely labour-intensive sector could help reduce Kenya’s youth unemployment rate, which, at 26%, is one of the highest in SSA. Such investment could also catalyse Kenya’s growth at a time when the textiles, clothing and leather sector has doubled its global share of greenfield FDI projects, according to the UN Conference on Trade and Development.
Kenya’s success in diversifying depends in part on its cultivating a conducive macroeconomic environment – and there are three important pathways to follow in this regard (in addition to paying attention to a range of other factors explained in last year’s KAM-ODI booklet):
Three pathways to boost diversification into Kenyan textiles
Kenya’s information and communication technologies (ICT) sector has seen significant growth, with innovations such as M-Pesa leading its domestic financial services development. In 2017, the economy saw a 71% increase in FDI as a result of inflows into ICT. This owed in part to its investment climate and particularly the construction of Konza Technology City, which has attracted major corporations such as Microsoft and Oracle. Despite this, a digital divide persists: although almost 90% of Kenyan manufacturing firms have computers and internet, only 50% have a web presence, only 40% have an IT policy and only 27% use the internet to sell online. Increased use of ICT will enable both large T&A companies and small and medium enterprises (SMEs) to participate in digital supply chains and function more efficiently.
Meanwhile, when it comes to investment inflows, Kenya can leverage its growing domestic retail sector, and domestic growth in consumer demand, to spur local and international investment. This could be important at a time when the return to FDI has halved in SSA, from roughly 12.3% in 2012 to 6.3% in 2017. Additionally, wages for Kenya’s garment workers are cited as much costlier than those in, for example, Ethiopia. This is notwithstanding Kenya’s labour productivity significantly outstripping Ethiopia’s, when looking at the experience of Hela Garment factories in both countries. Expected retail demand growth could mean that Kenya attracts market-seeking FDI, to serve the domestic market, which would offset any weakness in FDI that targets cheap inputs.
Finally, Kenya’s logistics sector, in transporting and warehousing goods, stands to benefit its T&A sector. In particular, upgrading its railway and transport sector closer to international standards will facilitate greater commerce; Kenya’s logistics ‘giant’, Siginon Group, cites this as an obstacle. Together with Kenya’s industrial and technology parks, this will continue to contribute to Kenya becoming a ‘logistics hub’ and creating more logistics companies through clustering. The emergent knowledge economy will have knock-on effects on T&A, as a result of better support to knowledge uptake by Kenya’s industry. This should be founded on wider partnerships, to include universities. The experience of other success stories suggests that successful economic clustering depends on – among other things – the inclusion of research institutes for enhanced innovation and sophistication of local companies.
A reduction in the shilling’s real effective exchange rate
Kenya does not fare well in terms of currency developments. Having a fairly priced trade-weighted exchange rate is important to source affordable imports – which Kenya’s T&A manufacturers have consistently cited as a key cost. In particular, for the larger companies, the high cost of imported material is significant. Although the shilling continues to depreciate against the US dollar – a key export market for Kenya – the real effective exchange rate (REER) is historically high, raising questions around Kenya’s competitiveness. Its REER has appreciated by 27% since 2014, putting it roughly 34% above its long-term average and suggesting overvaluation against its trading partners’ currencies (Figure 2).
Figure 2: Kenyan shilling real effective exchange rate
Source: World Bank World Development Indicators, Bloomberg.
Broader access to finance
Elevated overhead costs in the sector and lack of collateral have also restrained access to finance. High interest rates and the short time horizons available for loans are key obstacles, according to KAM. Equally, Kenya’s current interest rate cap has disincentivised banks to lend to SMEs and to small manufacturers, in that they cannot obtain a high enough return to match perceived risk associated with SMEs. The Central Bank of Kenya reports that banks reduced credit provision to the private sector following the cap, with few expectations of a re-acceleration. A silver lining is that domestic banks, rather than foreign banks, are increasingly driving SME lending.
Targeted programmes, such as those of Equity Bank, instituting the Maridadi Business credit facility of between Sh5,000 and Sh100mn for Kenya’s T&A SMEs, fashion designers and tailors, have been encouraging. The facility’s aim of targeting businesses and entrepreneurs along the entire value chain has been lauded as a particularly strong feature, given Kenya’s need to import fabrics. The higher risk profile of smaller SMEs has led other domestic banks to pair with public institutions, such as the International Finance Corporation, to lend to SMEs. Kenya’s second largest bank – the Co-op Bank – has received a $105mn loan for Kenya’s micro, small and medium-sized enterprises.
Kenya’s macroeconomic challenges and opportunities need to be squared with the government’s ambitious plans in its Big 4 Agenda – which include employing 50,000 young adults and women in the T&A sector, increasing revenue exponentially from the textile industry from Sh3.5bn to Sh2tr and creating 500,000 cotton jobs and 100,000 new clothes jobs by 2022. In order to achieve this, the domestic macroeconomic environment will have to be recalibrated to foster increased competitiveness, more affordable access to finance and continued attention to incentivising diversified investment inflows.
 Banga, K. and te Velde, D.W. (2018) ‘Digitalisation and the future of manufacturing in Africa’. London: ODI, SET Programme.
 Kenyan REER overvaluation is calculated as the percentage deviation of the current REER from its average since 2000. The REER is calculated using the World Bank World Development Indicator database and Bloomberg data.
Photo credit: Brian Snelson via Flickr