What Drives Current Account Deficit In Kenya? Evidence From Time-Series Data (1980-2014)

Abstract

As a rule of thumb, current account deficit should not exceed 5% of GDP. If it exceeds, it must raise concerns about its sustainability. In Kenya, current account balance deficit increased to 10.5% of the GDP by 2014 and 8.3% in 2015. Empirical evidence shows that there is an unsustainable current account deficit in Kenya. Unsustainable current account deficits are a potential recipe for a currency crisis and current account reversal which have negative implications on macroeconomic stability of a country. In order to design a policy to revert the deficit to sustainable levels, the drivers of the deficits must be empirically established. This study sought to determine the drivers of current account balance and policies that should be put into place to revert the balance to sustainable levels. It used time series data spanning 1980-2014 and employed VAR and VECM models. The estimated long run co-integrating model revealed that financial deepening in Kenya has no effect on the current account balance at 5%, 10% and 1% statistical significance levels. However, trade openness, oil prices, fiscal deficit, output gap, real effective exchange rate, GDP per-capita, dependency ratio and net financial assets significantly affect current account balance. A one percent improvement in trade openness leads to about 4% improvement in CA balance. The policy recommendations drawn from the study are: Kenya needs fiscal consolidation efforts geared towards reducing fiscal deficit to a balanced or surplus budget position. Secondly Kenya needs to adopt oil hedging, reserves and alternative energy policies. Finally, proper fiscal and monetary policy mix to ensure export competitiveness, stable exchange rate and smooth business cycles.