The Impact of External Shocks on Economic Growth and Welfare in Kenya: a Computable General Equilibrium Analysis

Abstract

Kenya is fairly well integrated into the global economy; hence its economy is vulnerable to external shocks. The purpose of this study is to evaluate, from a general equilibrium perspective, the impact of these shocks on the Kenyan economy, which are transmitted via foreign trade and capital inflows. Thus, to analyse the data we employ two different computable general equilibrium (CGE) models that are calibrated on the basis of a social accounting matrix for Kenya. The first model is the International Food and Policy Research Institute (IFPRI) Standard CGE Model that we use to conduct shock simulations that entail changing the world price of food and oil. Further, we use a micro-simulation module linked to the CGE model to evaluate the welfare and distributional impacts of the price shocks. The second model is a supply-side model which we use to evaluate the effects of an up-surge in the inflows of foreign aid, remittances and foreign direct investment. To evaluate the welfare effects of the capital inflow shocks, we compute the equivalent variation based on an indirect Stone-Geary utility function. Our simulations yield different outcomes, depending on the kind of shock the economy is subjected to. For instance, simulating a 100% increase in the world price of food, we find a negative albeit small effect on economic growth, which we attribute to Dutch disease effects. The food price shock is however welfare enhancing, explained by the increase in real incomes resulting from the export boom in the food sector. On the flipside, simulating a 20% increase in the world price of oil yields a major negative effect on economic growth: the spending effect of the oil price shock leads to an expansion of tradable sectors and a shrinking of nontradables, worsening the trade deficit. The welfare effects of this oil price shock are as expected, negative. Simulating a 20% increase in foreign aid, we find mixed outcomes, depending on how the aid is used. Consistent with the Dutch disease literature, we find that if aid is invested solely on the demand side, it results in slower growth and a reduction in welfare. However, if the aid is used productively (used to remove supply side bottlenecks), it is growth and welfare enhancing. Simulating an increase of remittances to a level equivalent to 5% of Kenya’s GDP, our results indicate this to be inflationary, which brings about Dutch disease effects and a reduction in the country’s global competitiveness. Nevertheless, an increase in remittances is welfare enhancing although this effect is dampened by the increase in inflation. Finally, our simulation involving a surge in foreign 2 direct investment spillovers generates a sluggish economic performance, although it’s welfare enhancing. The resource movement effect of the spillovers positively affects non-tradable sectors, at the expense of tradables. The findings of this study have important policy implications. That a positive food price shock improves welfare but brings about Dutch disease effects poses a policy dilemma: should government should encourage food exportation, which reduces poverty but face the risk of a rise in trade deficit in the long run? A way out of this dilemma is to put in place stabilisation measures that endogenize adjustment of domestic expenditure via a shift of resources from the booming food sector to the shrinking cash crop sector. To cushion the economy from the deleterious effects of a negative oil price shock, the government should diversify the energy portfolio by enhancing supply of green energy. To militate against the Dutch disease effects of aid, government should address some of the production constraints of the tradable sectors, for instance by providing extension services and promoting use of new technology to enhance productivity. Another way to militate against Dutch disease- related problems is for government to establish a sovereign wealth fund to reduce the volatility of government revenues and counter the ‘boom-bust cycles' that adversely affect public expenditure. Aid should be invested in projects such as infrastructure development and using a proportion of the aid to finance operations and maintenance. Remittances, if well invested could be welfare enhancing. In this regard, an appropriate macro policy is a prerequisite, which could entail investing excess foreign exchange in a sovereign wealth fund that we have alluded to above. This would in turn control real exchange rate movements. Finally, since foreign direct investment is growth and welfare enhancing, Kenya’s trade and investment policy should be geared towards boosting the ease of doing business.