Letter of Intent of the government of Kenya

Nairobi, September 27, 2000
Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Köhler,

1. The intense drought affecting Kenya has had a more severe impact than had been envisaged at the time of the preparation of the interim Poverty Reduction Strategy Paper. The need to address the impact of the drought has considerably affected government finances and Kenya's balance of payments in the fiscal year 2000/01 (July-June), even after consideration of important contributions from donors who have responded to the government's drought relief appeal. In this context, the Government of Kenya requests amendments to the quantitative performance criteria and benchmarks of the program for 2000/01 (Table 1) as well as an augmentation of access under the Poverty Reduction and Growth Facility supported program equivalent to SDR 40 million. The Government of Kenya remains committed in all other respects to the policies outlined in the Memorandum of Economic and Financial Policies dated July 12, 2000.

2. The failure of the long rains (March-May) in 2000 in most of the country has compounded the effects of the recurring droughts of the past several years. Moreover, the current drought is among the most severe the country has experienced in living memory. Widespread food, water, and power shortages have raised the specter of famine and other adversities, particularly among farmers in marginal agricultural areas, pastoralists, and agro-pastoralists. Agricultural output has been significantly reduced, and cattle and other stock have moved from pastoral areas into farming areas and forests, creating the spread of contagious diseases, with related losses and veterinary costs. Large segments of the pastoral population have lost, or are about to lose their livestock because of the impact of adverse weather conditions on grazing areas. Although the extent of adverse effects of the drought is still uncertain, it is now estimated that 4.7 million Kenyans1 (16 percent of the total population) face severe life-threatening conditions. Malnutrition and the significant impact of dysenteric diseases and malaria exacerbate the human health problems, and other afflictions such as Kalazar are now being seen countrywide. In addition, the dropout rate from school has considerably increased and an enhanced feeding program is needed in the primary and secondary schools.

3. In this context, the Government launched an appeal to the international community for assistance in July 2000, and has been collaborating since then closely with UN relief agencies, the International Development Association (IDA), donors, and nongovernmental organizations to evaluate the full impact of the drought and to deal with the emergency situation. This effort focuses on the provision of food, health and water/sanitation services, veterinary services, the purchase from the vulnerable pastoral population of livestock that would otherwise die as a result of the drought, the provision of appropriate seeds to farmers, and temporary leasing of emergency electricity generators. In view of the still unfolding nature of the drought and the uncertain outlook for the short rains (October-November), the government, with the assistance of UN relief agencies and donors, will keep the situation under close review. The government has shared its drought relief plans with UN agencies and donors participating in this endeavor to help facilitate the monitoring of service delivery. In particular, the World Food Program (WFP) is coordinating the food relief effort, in collaboration with nongovernment organizations.

4. The macroeconomic implications of the ongoing drought are expected to be considerable in 2000/01. The failure of the long rains is estimated to have reduced agricultural food production by some 25 percent in 2000, and agricultural exports such as tea and horticulture are projected to fall by 7 percent and 4 percent, respectively. These developments, combined with the increased cost of inputs emanating from shortages in electricity and agricultural production, have weakened the manufacturing and the services sectors, with negative ripple effects on overall economic activity. In June-July 2000, electricity generation, which is 70 percent hydro-based, was 25-30 percent below the historical average, resulting in the imposition of power rationing. To help alleviate such rationing and thus lead to some rebound in economic activity, an emergency power supply project loan (financed by an IDA credit of US$72 million and the European Investment Bank, US$3 million) and, together with other measures, should raise electricity generation close to the level of peak demand by November 2000. For 2000/01, real GDP growth is now projected at 0.5 percent, compared with 2.3 percent under the original program. However, excluding the unforeseen 50 percent increase in coffee production, the picture is even worse. The 12-month rate of consumer price inflation, which rose from 4 percent in April 2000 to about 7 percent in July owing mainly to increases in food and fuel prices, is likely to moderate in the coming months, as food relief becomes available. Finally, on the labor market side, a considerable number of enterprises have reduced their personnel as a consequence of power rationing and the decline in domestic demand caused by lower incomes.

5. The revised overall fiscal deficit in 2000/01 (on a commitment basis and excluding grants) is projected to reach 5.8 percent of revised GDP, 4.1 percentage points of GDP higher than in the program2, owing to lower revenue and higher expenditure associated with the drought relief effort. Lower-than-programmed real GDP growth is projected to reduce revenue by 0.9 percent of GDP relative to the program. Corporate income tax collections are forecast to weaken because of lower domestic demand and higher input costs, while personal income tax collections will suffer because of layoffs. Depressed demand for domestically produced goods as well as non-drought related imports are projected to reduce collections from the VAT, excise and import taxes. Although tax administration efforts will not weaken, measures in this area under the program are now expected to yield less revenue, especially arrears collection, given the worsened financial position of private sector firms.

6. Drought-related outlays would raise the ratio of expenditure-to-GDP by 3.2 percent relative to the program. The additional outlays include food relief and associated costs, as well as feeding programs for primary and secondary school children whose families have been adversely affected by the drought and other educational support (2.1 percent of GDP); livestock disease control and the purchase of livestock for slaughter from pastoralists (0.1 percent); the distribution of seeds to farmers and extension services (0.1 percent); health services (such as vaccines, drugs, and support for hospitals and clinics) (0.1 percent); water supply and sanitation services (including the drilling of wells and transportation of water) (0.1 percent); and the subsidy to cover the differential cost of hydro- and fuel-power generation that is envisaged under the emergency power supply mentioned above (0.8 percent). The program continues to provide for a margin of K Sh 4 billion (0.5 percent of GDP) in higher social expenditure provided that additional concessional foreign financing becomes available. Drought-related outlays over and above those described in this paragraph will be considered within this margin; however, the government will save any unspent drought-related resources3.

7. Given the need to avoid increasing domestic debt relative to the program, so as to keep downward pressure on real interest rates, the Government's increased financing requirement resulting from the drought will need to be covered by additional foreign financing.

8. Monetary policy will continue to be focused on keeping inflationary pressures under control and building up the level of foreign reserves. The targets for the net foreign assets of the Central Bank Kenya (CBK), however, will be reduced to the extent of the augmentation of access under the PRGF arrangement. The ceiling on net domestic assets of the CBK will be correspondingly raised to allow for additional financing to the Government in order to cover part of the drought relief related costs. A downward adjustment will be made to the net domestic assets of the CBK to offset the liquidity impact that will be caused by a reduction of the minimum monthly average cash reserve ratio for commercial banks and nonbank financial institutions, from 12 percent to 10 percent, effective October 1, 2000. The change in reserve requirements is aimed at creating the conditions for a reduction in the spread between deposit and lending rates. In practice, the liquidity impact of this change will be offset by repurchase agreements with commercial banks, and hence any easing of monetary policy will be avoided. The CBK will continue to maintain exchange rate flexibility, with intervention in the exchange markets being guided by the need to meet the net foreign assets targets under the program.

9. The external current account deficit is now projected to reach 7.2 percent of GDP in 2000 and 9.8 percent in 2001, compared with 4.6 percent and 7.7 percent, respectively, under the program. This reflects lower exports, particularly tea and horticultural products, and higher imports of food, fuel and energy equipment. After taking into account the emergency power supply project credit (US$75 million) and food and other relief from UN agencies and donors (US$57.2 million), the overall balance of payments for 2000/01 is projected to show a financing gap of about US$452 million. The requested augmentation of access under the PRGF arrangement would cover some US$52 million, and to close the remaining gap, Kenya intends to seek a rescheduling from the Paris Club creditors of its eligible external arrears and debt service falling due in 2000/01. The need to start addressing the drought-related relief and the timing of the Paris Club meeting for November 2000 have put pressures on government finances, causing the accumulation of arrears on external debt service. This has led to the nonobservance of the continuous performance criterion on the stock of external arrears, and therefore we request a waiver for such nonobservance. The financing needs described above will result in a further accumulation of external arrears before the envisaged rescheduling of debt service under the Paris Club takes place. In these circumstances, the outstanding stock of external arrears will be about US$242 million by the end of September 2000, and will be eliminated by end of December 2000, as envisaged under the original program. In the meantime, the Government remains committed to servicing multilateral debt as scheduled, and, in the case of government-guaranteed debt service that is expected to be rescheduled or deferred, it will require that parastatals make payments in full to the government, as per original schedule. No external payment arrears will be incurred after the envisaged rescheduling of debt service under the Paris Club.

10. In view of the still uncertain rain forecast, it would seem premature to modify the medium-term outlook. The government would propose that consideration of Kenya's medium-term outlook be assessed in the context of the first review under the program, when information on the short rains and more reliable data on the long rains would be available.

Very truly yours,

Micah Cheserem
Governor, Central Bank of Kenya

Chrysanthus Barnabas Okemo, EHG MP
Minister of Finance

Table 1. Kenya: Financial and Structural Performance Criteria and Benchmarks Under the First Year Program, July 2000-June 2001