Kenya—Letter of Intent, Memorandum of Economic and Financial Policies and Technical Memorandum of Understanding

December 6, 2004

The following item is a Letter of Intent of the government of Kenya, which describes the policies that Kenay intends to implement in the context of its request for financial support from the IMF. The document, which is the property of Kenya, is being made available on the IMF website by agreement with the member as a service to users of the IMF website.

Use the free Adobe Acrobat Reader to view Tables PDF file (92 kb). 

Mr. Rodrigo de Rato
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. de Rato:

1. The annexed Memorandum of Economic and Financial Policies (MEFP) describes our performance to date under the program supported by the Poverty Reduction and Growth Facility (PRGF) arrangement and outlines the policies we plan to implement during the remainder of 2004/05 (July/June). Our goal remains that of reducing poverty by creating an environment conducive to the promotion of strong economic and employment growth as outlined in the Investment Program for the Economic Recovery Strategy for Wealth and Employment Creation (ERS).

2. Considerable progress has been made under the program. A rebound in economic growth has begun. The increase in domestic debt has been arrested. However, major challenges remain, which we are addressing in the context of the program for 2004/05. In this regard, to mitigate the negative effect on the balance of payments resulting from the recent sharp rise in oil prices and drought, induced food imports, we would like to request an SDR 50 million augmentation of the access under the PRGF arrangement.

3. All the quantitative performance criteria for end-December 2003 were met, except for the continuous performance criteria on the contracting or guaranteeing of nonconcessional external long-term debt and on the accumulation of external payments arrears. With regard to the former, the nonconcessional external long-term debts that were contracted in contravention of the program understandings have been cancelled. The continuous quantitative performance criterion on the nonaccumulation of external arrears was breached after June 30, 2004 with regard to two categories of arrears. There was a late payment of the nonrescheduled share of Paris Club arrears existing at the time of the January 2004 rescheduling, which was required to be settled by July 1, 2004, but was not fully settled until November 2004. An accumulation of additional external arrears may result from a suspension of payments due to an audit of all central government contracts of commercial external debt that we are undertaking to enhance public expenditure management and good governance. While the audit is on-going, the debt-service due on these loans will be placed in an escrow account. We will use this account to resolve any arrears promptly and fully, once the underlying debt obligation is found by the audit to be legitimate.

4. All but one of the structural performance criteria related to the second disbursement have been completed, albeit two were completed with delays. The structural performance criterion on the completion of an audit on the financial position of the National Social Security Fund (NSSF) by end-December 2003 was completed in February 2004, and that on the submission to parliament of a Banking Act Amendment Bill by end-March 2004 was done in June 2004. Regarding the end-December 2003 structural performance criterion concerning the completion of an audit of the stock of pending bills and the adoption of measures to provide for their clearing, we completed the financial audit, but are awaiting the results of a legal audit of the pending bills before finalizing the clearance plan.

5. We request waivers for the nonobservance of the five performance criteria detailed above. We also request a rephasing of the remaining disbursements under the arrangement. This latter request reflects the delay in completing the first review under the program.

6. The MEFP spells out the quantitative performance criteria and benchmarks, as well as the structural performance criteria and benchmarks to be used in monitoring performance under the 2004/05 program. The end-September 2005 targets are indicative. These performance clauses will be firmed up once a more comprehensive macroeconomic framework, as well as the budget for 2005/06, is developed. The government is taking a number of prior actions to the issuance of the staff report on the first review of the PRGF arrangements.

7. The government believes that the policies set forth in the attached MEFP are adequate to achieve the objectives of its program, but it will take any further measures that may become appropriate for this purpose. Kenya will consult with the Fund on the adoption of these measures, and in advance of revisions to the policies contained in the MEFP, in accordance with the Fund's policies on such consultation. In particular, the government will consult with the Fund if it decides to proceed to implement any program that would result in a modification of the fiscal targets under the program. Kenya will continue to provide the Fund with all the information in a timely manner as required to monitor progress in implementing policies and achieving the objectives of the PRGF arrangement. We expect to complete the first progress report of our ERS by June 2005.

Sincerely yours,

Memorandum of Economic and Financial Policies for 2004/05
Under the PRGF Arrangement

I. Introduction

1. In 2003/04 (July/June), Kenya began to build the foundation for a new liberal democratic order, as well as for lasting economic prosperity. In the political arena, considerable effort was devoted to constitutional reform. The government is committed to completing the constitutional review as soon as possible because as a new constitution is essential to laying the legal basis for strengthening Kenya's governance structures and for sustained peace and stability—key ingredients for promoting strong economic growth and prosperity. On the economic front, an important beginning has been made to tackling Kenya's major macroeconomic vulnerabilities and addressing impediments to strong economic growth and poverty reduction. However, progress in implementing some key economic reforms has been impeded by the large amount of time devoted to constitutional reform, capacity constraints in key ministries, and the slow resumption of donor budgetary assistance.

2. The government is committed to strong reforms, but the approach has been modified to take account of lower budgetary support and capacity constraints. The government remains committed to implementing policies aimed at promoting strong economic growth and poverty reduction, as well as to fostering an environment conducive to private-sector-led growth and the expansion of employment opportunities. The government's approach is spelled out in the Investment Program for the Economic Recovery Strategy for Wealth and Employment Creation (ERS)-Kenya's PRSP, which was considered by the Executive Boards of the Fund and the World Bank (WB) in May 2004. The diagnosis of the main economic challenges facing Kenya, as well as the broad economic reform strategy, remains as outlined in the ERS and Memorandum of Economic and Financial Policies (MEFP) for 2003/04. This memorandum explains how the government reform agenda and the macroeconomic framework underpinning the PRGF-supported program have been modified to cope with the lower donor budgetary assistance now foreseen and the steps that will be taken to address capacity problems.

II. Recent Economic Developments and Progress Under the Program

3. Most of the performance criteria (PC) under the PRGF arrangement were met. All quantitative performance criteria for end-December 2003 were met; the continuous quantitative PC on the contracting or guaranteeing of nonconcessional external long-term debt was breached when two security-related clauses were concluded in December 2003, but these were cancelled shortly thereafter. The continuous PC on external payments arrears was breached after June 30, 2004, on to two classes of arrears. There was a late payment of the nonrescheduled share of Paris Club arrears existing at the time of the January 2004 rescheduling, which had to be settled by July 1, 2004, but was not fully paid until November 2004. Arrears also arose through an audit of all central government contracts of commercial external debt, which the government is conducting for governance and public expenditure management reasons; while the audit is proceeding these loans are not being serviced, resulting in relatively modest external arrears. The structural PC on the completion of an audit on the financial position of the National Social Security Fund (NSSF) by end-December 2003 was completed in February 2004, and that on the submission to Parliament of the Banking Act Amendment Bill by end-March 2004 was done in June 2004. Regarding the PC on the completion of an audit of the stock of pending bills and the adoption of measures to provide for their clearing, the financial audit was completed, but finalizing the clearance plan is awaiting the results of a legal audit of the pending bills that is expected to be completed by June, 2005.

4. The Letter of Intent (LOI) to which this MEFP is annexed requests waivers for the nonobservance of the five performance criteria detailed above and a rephasing of disbursements under the PRGF arrangement.

5. Economic developments in 2003/04 were mixed. Real GDP growth at 2.1 percent was moderately above program expectations, despite the sharp increase in oil prices and the emergence of a drought late in the fiscal year. For the same reasons, overall consumer price inflation was well above projections. Excluding food and oil, inflation, at 4 percent at end-June 2004, was also higher than programmed, reflecting an easing of monetary policy. These outcomes together with only moderate donor inflows and higher oil prices, contributed to the depreciation of the nominal effective exchange rate of the shilling.

6. The easing of monetary policy in 2003/04 to support economic recovery resulted in declining interest rates and rising inflation. Following the reduction in the legal reserve requirement from 10 percent to 6 percent in July 2003, the reserve money multiplier rose from 4.9 to 5.3, resulting in a 13 percent expansion of broad money in 2003/04 against the 7 percent projected under the program. The consequent rise in liquidity led to negative real yields on money market instruments. In response to the decline in interest rates, bank credit to the private sector grew substantially.

7. Net domestic borrowing and the NPV of total central government debt (in percent of GDP) were well within the program targets for 2003/04.This outcome reflected a number of developments:

• Stronger than budgeted revenue performance, which benefited, in part, from the aggressive collection of tax arrears and the implementation of new administrative measures;

• Tightened management of the recurrent budget, in the face of persistent wage pressures;

• Delays in the recapitalization of the National Bank of Kenya, which had been programmed to cost about Ksh 12 billion.

8. Reflecting the slight decline in gross investment and a marked fall in the national savings ratio that was partly attributable to drought-related shifts in expenditure toward increased consumption, the external current account deficit (before grants) expanded relative to 2002/03, but was lower than programmed in 2003/04. The modest fall in gross investment was partly the result of lower public investment, because the pace of execution of the development budget was well below the budgeted level; problems in applying the transitional procurement system introduced early in the year; and lower than expected donor inflows that was partly the result of weaknesses in accounting for donor-funded development projects. A sharper than anticipated decline of private savings was partially offset by a significant increase in public savings. The buildup of foreign reserves was, in dollar terms, lower than the program target; however, it exceeded the target after an adjustment for the shortfall in external donor support.

9. Progress in implementing structural reforms has been mixed. There were some delays in implementing reforms in the public expenditure, financial sector, and parastatal areas. The lack of progress in moving toward a comprehensive medium-term expenditure framework, consistent with PRSP priorities, as well as in instituting a more robust expenditure management system, is largely attributable to organizational and capacity constraints at the Ministry of Finance. Financial sector and parastatal reforms suffered from capacity constraints and a lack of consensus on the objectives and modalities for conducting the reforms that has also delayed the enactment of the Privatization Bill. New wage-setting mechanisms for public employees have now been developed. Significant progress was made in building a robust governance architecture and in enforcing elements of the anticorruption regulations. Notable actions included the enactment of the Anti-Corruption and Economic Crimes and Public Officer Ethics Acts in May 2003, completion of asset declarations by all public officers in November 2003, major restructurings of the judiciary and the police over 2003/04, and the establishment of the Kenya Anti-Corruption Commission (KACC) in May 2004.

III. Medium-Term Framework and Policies

10. The medium-term macroeconomic framework underpinning the reform agenda has been modified to take account of the more difficult environment now foreseen for the medium term. In particular, (a) the terms of trade are now projected to deteriorate moderately instead of the modest gains envisaged earlier; (b) donor assistance would fall significantly short of earlier expectation; (c) capacity constraints in key areas are more severe than assumed under the program; and (d) some key reforms in the financial and parastatal sectors have taken longer to complete, partly because of the crowding out of the legislative agenda, in the recent past, by constitutional reform deliberations.

11. In response to these developments, the government has modified its reform strategy in several respects. The domestic revenue effort has been strengthened and expenditure restructuring and management reforms accelerated. In addition, the domestic borrowing targets have been relaxed somewhat. Although these changes will result in a moderate increase in domestic budgetary resources and in an improvement in the productivity of public spending, public investment will be scaled down over the medium term when compared to the original program assumptions. Partly for this reason, the realization of the economic and employment growth and poverty reduction objectives set out in the MEFP for 2003/04 would take longer to achieve.

12. Notwithstanding the adverse effects of the more difficult foreign environment, the external current account deficit would be lower than projected earlier as investment would be markedly lower than envisaged in the MEFP. On the other hand, the ratio of savings to GDP would be broadly as assumed earlier. The outlook for donor inflows would continue to dominate public investment activity, which is a key factor in promoting private sector activity. Partly for this reason and the slow response of private investment to the reforms, private investment would be significantly below program expectation. Reflecting the above developments, the net foreign reserve targets and the medium term would be somewhat less ambitious than foreseen in the original three-year program. The medium-term inflation objectives would remain as spelled out in last year's Economic Memorandum, although monetary policy will be tightened to correct for some overshooting in 2003/04.

IV. Economic Policies For 2004/05

A. Macroeconomic Outlook

13. A moderate pickup in economic activity is foreseen. Projected real GDP growth at 2.7 percent in 2004/05 would be lower than the 3.1 percent expected in the original program, reflecting in part the negative effects of a more difficult external environment - high oil prices and depressed prices for some traditional exports, as well as the impact of the drought on agricultural production. However, the tourism sector is projected to perform strongly as it recovers from the adverse effects of last year's travel ban. The drought and high oil prices are expected to contribute to a pickup in overall consumer price inflation to well above earlier projections.

B. Fiscal Policy

14. The eventual lowering of the domestic debt ratio to GDP remains the key focus of the program. The budget for 2004/05 that is before parliament targeted an overall deficit (before grants) of 7.2 percent of GDP and implied domestic borrowing of 4.7 percent of GDP (in the event that the envisaged budgetary support was not forthcoming). A revision to the budget announced on June 12, 2004 will be presented to parliament during the first quarter of 2005. Pending this revision, the new fiscal framework will be implemented through quarterly releases of expenditures. The revised budget assumes that domestic borrowing would amount to the equivalent of 2.5 percent of GDP. The fiscal framework envisages a marked decline in both the overall and primary deficits relative to ERS targets, wholly on account of the significant shortfall of donor budgetary support. For the same reason and the need to preserve some essential social and economic programs, domestic borrowing would exceed ERS expectations. Some crowding out of private activity is expected, as the public sector would absorb a sizable proportion of projected financial savings. Reflecting the projected domestic borrowing, domestic debt would remain broadly unchanged at 22 percent of GDP compared with the original program target of 24.7 percent of GDP. The domestic debt-ratio is expected to decline thereafter.

15. New administrative measures are projected to raise revenue collection. The coming into effect on January 1, 2005 of the East African Community (EAC) Customs Protocol involving a lowering of the top tariff rate from 35 percent to 25 percent and the reduction in tariff bands from 5 to 3 is projected to result in revenue losses of 0.3 percent of GDP. The program includes several measures aimed at raising compliance and expanding the tax base. These include:

• Creation of one-stop shops that bring together business licensing and tax payments operations;

• Full integration of the VAT and Income Tax Departments in a single function-based Domestic Tax Department (DTD);

• strengthening and rationalizing the Large Taxpayer Office (LTO);

• Introduction of computerized audits for LTO and DTD;

• Implementation, on a pilot basis, of simplified customs procedures; and

• Modernization of customs computer systems.

These measures, together with the ones implemented in 2003/04, are expected to strengthen revenue performance, significantly raise the efficiency of the tax system over the medium term, and lay the basis for a further reform of the tax system, beginning later this fiscal year. The medium-term goal is to broaden the tax base, as well as simplify and improve the neutrality and revenue-yielding capacity of the system.

16. Government remains firmly committed to the reorientation of public expenditures in favor of growth and poverty-related outlays. In line with this approach, government employment for critical social and economic sectors (including teachers, healthcare, and security personnel) will rise moderately but overall civil service positions would fall by about 2,000 through retrenchments and attrition. Several developments are expected to raise the inflexibility of the budget and thus limit the scope for a more aggressive reallocation of spending to priority areas. These include the projected rise in interest payments; the continuing sharp increase in pension payments that is partly attributable to the recent retrenchment of public servants; and the impact of persistent wage pressures on the wage bill; and the lower-than-expected external budget support. To stay on course with the expenditure restructuring program and move toward fiscal sustainability, the government has initiated several actions that should, over time, result in a significant reduction in noncore outlays. These include developing new wage-setting mechanisms for public employees, rationalizing diplomatic missions with a view to reducing the number of staff, and privatizing parastatals. In addition, the role of the state in the provision and funding of university education is under review. The budget includes a Ksh 2 billion provision for the payment of pending bills in 2004/05 following the completion of a legal audit in December 2004. However, if creditors contest the outcome of the audit, the process could take longer. The remaining bills will be paid off over a two-year period. The budget also includes a provision of Ksh 1 billion for the rehabilitation of stalled projects. Government's objective is to sell most of these projects and to rehabilitate the remaining ones in priority areas in the context of the regular development budget operations. As a result of the ongoing audit of all central government contracts of commercial external debt, some external payments arrears are accumulating. In managing the fiscal program, all the debt-service on these obligations will be paid on the due dates into an escrow account to facilitate prompt payment once the underlying obligations are found to be legitimate.

17. A robust public expenditure management system is essential to putting the economy on a sustainable, rapid, and poverty-reducing growth path and to increasing the transparency of public operations. Government has therefore initiated steps designed to build a sound expenditure management system, including:

• Completing the budget outlook paper for 2005/06 by November 2004 that would provide a link between the budget and ERS priorities;

• Expanding the comprehensiveness of the three-year medium-term expenditure framework (MTEF), as well as the coverage of the programs included in the protected social programs;

• Strengthening the links between the MTEF and the annual budget system;

• Improving budget transparency by adopting the classification system proposed in the Government Financial Statistics Manual for all budget votes;

• Broadening the consultative mechanisms used in the preparation of sectoral programs and medium-term budgets;

• Creating over time, an Integrated Financial Management System, while strengthening the expenditure commitment control system (ECCS) in the interim. Full application of the ECCS will help to prevent a build up of new arrears; and

• Strengthening procurement systems and accounting capacity and practices in line ministries, as well as procedures. The government is doing its utmost to facilitate the enactment of the Procurement Bill by March 2005.

18. Public service reforms have been stepped up. This will help to re-establish control over the wage bill, address capacity constraints in key ministries, and promote the creation of a more efficient public service. To this end, the government has introduced new wage-setting guidelines for public employees, consistent with reducing, over the medium term, the wage bill as a proportion of revenue over the medium term. The terms and conditions of service for top management in the government and state bodies will also be streamlined. Finally, new regulations emphasizing merit as a key determinant for promotion have been established. Capacity building is being emphasized at all levels of government, particularly in ministries essential to the realization of the ERS. In this connection, several steps have been taken to strengthen capacity and streamline the Ministry of Finance, including consolidation of the planning and budget functions within the Ministry, the setting up of a robust debt management unit, and enhancing capacity and mechanisms for managing and monitoring macroeconomic and structural reforms. With the assistance of private consultants, the Ministries of Education, Health, and Agriculture are also being restructured.

C. Monetary Policy

19. The monetary program for 2004/05 is designed to reduce underlying inflation to 3.5 percent. The inflation objective would be sought largely through reserve money targeting, with broad money (M3X) as the intermediate target and open market (repurchase and reverse) operations as the main instrument. Assuming that the money multiplier increases moderately in response to the expected pickup in interest rates, the program is consistent with targeting a growth rate of reserve money of 3.8 percent. To implement the monetary program, the CBK will sterilize, on a timely basis, any excess liquidity, thereby leaving interest rates to be determined by market forces in line with the monetary program. With Fund technical assistance, the auction system for government bonds will be improved. The government will continue to implement a flexible exchange rate system, which has served the economy well in absorbing fluctuations in external conditions. CBK's intervention in the foreign exchange market will be limited to meeting the net foreign assets target under the program and to smoothing disruptive short-term fluctuations.

D. Structural Reforms

20. The measures under the program will reinforce government efforts to promote good governance. The following are the main elements of the strategy:

• Continued strengthening of the governance architecture and enforcement of key anticorruption laws and regulations. This includes full enforcement of the provisions of the Anti-Corruption and Economic Crimes and Public Officer Ethics Acts 2003, as well as implementation of the United Nations Convention against Corruption and Ratification of the African Union Convention on Corruption.

• Enhancing the effectiveness of key anticorruption investigative agencies. These include the Kenya Anti-Corruption Commission, the government's principal investigative body whose capacity has been greatly improved since the swearing in of senior officials in September 2004. An additional step entails the hiring of key personnel, targeted for completion by July 2005.

• Continuing efforts to build adequate prosecution capacity for handling the expected expansion in corruption-related case-loads. The primary focus is on the Department of Public Prosecution, the government's principal prosecuting authority, which has recently established separate units to address corruption, serious crime, fraud, and asset forfeiture. Completion of the capacity-building program is targeted for early 2005.

• Developing systems for annual declaration and verification of wealth, assets, and liabilities of ministers and other senior public officials as provided for under the Public Officers Ethics Act 2003. The strategy includes computerization of wealth declaration forms which has already been initiated; the submission to Parliament by April 2005 of an amendment to the Act to provide for the annual verification of asset declarations by the KACC; and follow-up on the commitment by the Cabinet Committee against Corruption in November 2004 to the voluntary publication of assets.

• Developing a robust program of asset recovery and restitution. The Kenyan restitution strategy is designed to follow the standard three distinct phases, namely, international freezing of assets; restitution and vesting in the aggrieved country; and domestic recovery of returned assets, if nonmonetary. A restitution advisory group comprising the Department of Governance and Ethics, the Kenya Anti-Corruption Commission, and the Department of Public Prosecutions has been established.

• Deepening transparency in the conduct of public operations. Elements of the program include strengthening the public sector budget and financial management system through timely production of accounts by all public institutions, auditing and presentation to Parliament of the accounts, and production of comprehensive annual and medium-term expenditure frameworks, consistent with ERS priorities.

• Improving the procurement system, including those for security-related operations. Key aspects of the program are enactment by Parliament of the Public Procurement and Disposal Bill 2004, which would also provide for the establishment of the Public Procurement Oversight Authority (PPOA), with autonomy on matters of Public Procurement; formulation of new Public Procurement and Disposal regulations to implement the Act; development of a public procurement Directorate/Oversight Authority Strategic Plan 2005-10; preparation of the Training and Capacity-Building Program for procurement personnel in the public sector and an action plan for the proposed public procurement reforms activities, in consultation with stakeholders; and a deepening of the transparency of the procurement process by expanding the participation of stakeholders in the oversight of the public procurement process, and establishing an appeals body to deal with complaints; periodic media publication of the awarding of contracts in the media; and the development of IT capacity to facilitate dissemination of public procurement information to the public.

• Addressing the outcomes of recent initiatives to address past economic crimes. Major areas of focus are the Goldenberg Commission of Inquiry, which has begun to throw light on the single most debilitating series of corrupt transactions in Kenyan history, and the Presidential Commission on Illegal and Irregular Allocations of Public Land.

• Further upgrading key public agencies. The strategy includes the implementation of the recommendations of the task force on reform of the police beginning December 2004, addressing issues of retraining, strengthening oversight mechanisms, and corruption; corruption prevention in the civil service initiated under the auspices of the Public Service Integrity Programme (PSIP) of the Directorate of Personnel Management of the Office of the President in conjunction with the KACC and strengthening the Governance Justice Law and Order Sector Reform Program, a sectorwide development strategy based on recognition of the need for contemporaneous reforms within the sector as a whole.

• Enhancing public interaction with the government on governance. This will involve a Public Complaints Unit (PCU) to serve as a central referral and monitoring and evaluation unit under the aegis of the Department of Governance and Ethics, in conjunction with the Ministry of Justice and Constitutional Affairs.

21. The program will set the stage for an acceleration of parastatal reforms once the Privatization Bill is enacted. The government considers parastatal restructuring and privatization as an important element of its ERS. Pending parliamentary consideration and ratification of the bill-now foreseen by April 2005-that will institutionalize a more transparent mechanism for privatizing public enterprises, the government will initiate by December 2004 a comprehensive review of the financial position of key parastatals. In addition to identifying the contingent liabilities of the government, the information produced by the review will be essential in developing privatization options. Moreover, following the recent setting up of a Bank Restructuring and Privatization Unit in the Ministry of Finance, the restructuring of the National Bank of Kenya has begun. As part of this process, at the next Annual General Meeting of the NBK board around, April 2005, all state nominated Board members of the bank will be replaced by independent professional directors; and pending completion of the restructuring process. NBK will desist from disposing assets, and raising its liabilities with CBK from the end-June 2004 position. In addition, its outstanding loans and advances will not exceed the end-June 2004 level. Moreover, the government will prepare by March 2005 a time-bound plan for divesting public ownership and control of other public banks.

22. The government is implementing measures designed to strengthen the financial system. Amendments to the CBK and Banking Acts, which are before parliament, provide for the transfer of virtually all banking sector regulatory and supervisory authority from the Ministry of Finance to the Central Bank; the removal of a section of the Banking Act requiring prior approval of the Minister of Finance when setting banks' fees and charges; and changes in the definition of a significant shareholder, as well as in the fit-and-proper criteria for managers and significant shareholders. New regulations tightening loan provisioning and classification will be introduced in January 2005. In addition, a review of the management and financial position of the NSSF will be completed by March 2005 that will set the stage for the restructuring of the Fund.

23. Several actions are under consideration to enhance Kenya's competitiveness position. The current practice of raising the minimum wage on a yearly basis will be discontinued. Henceforth, the minimum wage will be reviewed once every two-year period, on the basis of wage trends in the informal sector and formal sector productivity gains for unskilled labor. In addition, new guidelines for wage arbitration by the Industrial Court will be issued by March 2005 that will emphasize productivity change as the key criterion for wage adjustments.

24. The government will continue to emphasize trade reform and regional integration. In the context of the EAC, the external tariff and number of tariff bands will be reduced, which will result in a fall in the average tariff rate from 16.2 percent to 10.9 percent. As a result, and after taking account of the absence of non-tariff-barriers, Kenya's rating under the IMF's trade restrictiveness index is expected to fall significantly, resulting in a more open trade regime. This will also help to foster a more competitive environment. Furthermore, the government will, by December 2004, complete a trade policy strategy that will spell out the reforms needed to enhance efficiency and international competitiveness, including additional trade reforms in the context of the East African Community. Many of the measures covered above are also part of a broad package of reforms that the government is taking to improve the investment climate in Kenya. Capacity building in the government will result in better quality public services. Improved governance and better fiscal management will translate into improved private sector confidence in the Kenyan economy. Many priority projects under the ERS, such as the upgrading of the road network, the concessioning of railway operations, and streamlining of port operations, will feed directly into an improved business environment by lowering the costs of production.

E. Poverty and Social Impact Analysis

25. Poverty and social impact analysis (PSIA) of key policy reforms will be conducted. Terms of reference for a PSIA of the EAC tariff reform and a possible further lowering of the tariff rates within the context of the EAC, is under consideration. The study will assess the likely impact of the trade reforms on the cost of living of the poor, the main economic sectors, employment, and the regions likely to suffer the most. This will help to fine tune the reforms and the development of appropriate mitigating measures.

F. External Financing

26. While lower than projected in the November 2003 MFEP because of the scaling down in projected investment, the external financing requirements for 2004/05 of US$ 1,245 million incorporates the effects of higher import payments stemming from the increase in oil prices and drought-related food imports. The economic reform agenda and the government's commitments under the program that is supported by the PRGF arrangement are expected to assist in mobilizing donor financial support. The World Bank has indicated in its May 2004 Country Assistance Strategy for Kenya a base-case commitment of US$140 million of budgetary support under the Programmatic Structural Adjustment Credit (PSAC) and Financial Sector Adjustment Credit (FSAC) facilities, with a disbursement of US$75 million expected in late FY2004/05, and of US$65 million in early FY2005/06. The AfDB has indicated that it plans to disburse US$21 million of program support in 2004/05, and the European Union is projected to disburse US$60 million of program support in early 2005. Disbursement of these resources, as well as the envisaged project support and private financing in FY2004/05, under the PRGF arrangement and the debt relief of about US$130 million from Paris Club creditors, will cover the estimated financing need of about US$ 1.2 billion in 2004/05.

G. Safeguards and Statistics Issues

27. The government remains committed to protecting the financial soundness of the CBK, and to adhering to the principles of good governance and best practices, including those encapsulated in the IMF's safeguards policy. A safeguards assessment of the CBK conducted in September 2003, found that the Bank had made notable progress in strengthening its safeguards since the December 2000 on-site assessment. The bank is committed to implementing measures to address the remaining vulnerabilities, and to further strengthening the CBK's operations.

28. On statistical issues, the government has released a revised set of national accounts data. The government is also taking steps to improve the monitoring of fiscal data, in particular, the preparation, on a regular basis, of summary statistics on domestic arrears and pending bills. Moreover, the government intends to develop a framework for systematically monitoring productivity changes in the economy, and to produce, on a regular basis, trade data. Kenya participates in the General Data Dissemination System project for Anglophone Africa. A statistics ROSC will be conducted in early 2005.

H. Program Monitoring for 2004/05

29. Technical memorandum of understanding (TMU). The program will be monitored using the definitions, data sources, and frequency of monitoring set out in the accompanying TMU. The government will make available to Fund staff all data appropriately reconciled and on a timely basis, as specified in the TMU.

30. Prior actions. The government is taking a number of actions prior to the issuance of the staff report on the first review of the PRGF arrangement. The prior actions are described in this memorandum (Table 3).

31. Performance criteria and benchmarks. Table 4 shows the quantitative performance criteria and benchmarks to be used in monitoring performance in 2004/05. Structural performance criteria and benchmarks, with corresponding dates, are identified in Table 3.

32. Program review. The second review under the PRGF arrangement will be completed no later than end-June 2005. This review will focus on the restructuring of expenditure in favor of social and economic spending; actions to enhance competitiveness; progress in rationalizing the financial system; progress in improving the auction system for government debt-instruments taking into account the recommendations of the November 2004 MFD technical assistance mission; and the fiscal implications of restructuring the National Social Security Fund. The third review under the PRGF arrangement is expected to be completed no later than end-December 2005.

Technical Memorandum of Understanding

V. Introduction

33. This memorandum sets out the understandings between the Kenyan authorities and the International Monetary Fund (IMF) regarding the definitions of the quantitative and structural performance criteria and benchmarks for the second annual program (for 2004/05, July to June) under the three-year arrangement supported by the Poverty Reduction and Growth Facility (PRGF), as well as the related reporting requirements.

VI. Quantitative Performance Criteria and Benchmarks

A. Net Foreign Assets (NFA) of the Central Bank of Kenya (CBK)

34. Definition. The NFA of the CBK are defined as the average over the calendar month of the test dates of the difference between the Central Bank of Kenya (CBK) holdings of gross official reserves (excluding crown agents and reserve tranche, pledged, swapped, or any encumbered reserves assets, including but not limited to reserve assets used as collateral or guarantees for third-party external liabilities) and its foreign liabilities (including IMF loans and other short- and long-term liabilities) of the CBK. Exchange rates prevailing on September 28, 2001 will be used to convert the NFA into Kenya shillings at the end of each test period. Table 4 in Annex I of the Letter of Intent, dated December 6, 2004, shows the floors on NFA, specified in Kenya shillings, for December 31, 2004, March 31 and June 30, 2005, as well as indicative targets for September 30, 2005.

35. Adjustment clauses. The NFA floors will be adjusted upward (or downward) by the sum of (i) excess (shortfall) in non-project-related external budgetary support relative to the programmed amount; and (ii) excess (shortfall) in privatization proceeds from external sources. Excess or shortfall proceeds are defined as the difference between actual and programmed proceeds. The downward adjustment is capped at the equivalent of US$280 million, converted to Kenya shillings at the program exchange rate prevailing on September 28, 2001. All targets are cumulative from July 1, 2004 onward.

36. Reporting requirements. Data on gross international reserves, encumbered reserves, and foreign liabilities of the CBK will be transmitted to the Fund on a weekly basis within five working days of the end of each week. Detailed data on external project-related and non-project-related budgetary support (by donor/creditor and by currency of denomination) will be transmitted on a monthly basis within five working days of the end of each week.

B. Reserve Money (RM) of the Central Bank of Kenya

37. Definition. RM is defined as the average over the calendar month of the test dates of reserve money, defined as total currency outside banks and bank reserves including till cash with the CBK. Table 4 in Annex I of the Letter of Intent shows the ceilings on RM for September 30, and December 31, 2004, and for March 31, 2005 and June 30, 2005, as well as indicative targets for September 2005. The authorities will consult with the Managing Director of the Fund on any changes in the ratio of reserve requirements.

38. Reporting requirement. The daily balance sheets of the CBK will be transmitted on a weekly basis within five working days of the end of each week.

C. Net Domestic Financing (NDF) of the Central Government

39. Definition. NDF includes financing by the banking system (the CBK and commercial banks), non-bank financial institutions, and the nonbank public of the budget of the central government of Kenya; where the central government is defined as in the Appropriation Accounts and in the parliament approved budget estimates for 2004/05.¹ NDF consists of treasury bills, government stocks and bonds, promissory notes and other domestic debt instruments issued by the government, and loans and advances net of government deposits with the CBK and the banks. For the purposes of the program, NDF excludes privatization proceeds not included in the budget, and government debt issued for any bank restructuring. NDF is calculated as the cumulative change from July 1, 2004 onward in the sum of (i) loans and advances to the government by the CBK, including any interest arrears, minus all government deposits with the CBK, from the balance sheet of the CBK; (ii) loans and advances to the government by the commercial banks, including any interest arrears, minus all government deposits held with the banks, from the balance sheet of the commercial banks; and (iii) the changes in the outstanding stock of treasury bills, government stocks and bonds, promissory notes and other domestic debt instruments issued by the government, including any interest arrears. Table 4 in Annex I of the letter of intent shows the ceilings on NDF for September 30, and December 31, 2004, March 31 and June 30, 2005, as well as indicative targets for September 2005.

40. Adjustment clauses. The ceiling on NDF will be adjusted upward (downward) by the shortfall (excess) in non-project-related external budgetary support; The value of the cumulative excess or shortfall in external non-project-related budgetary support will be converted into Kenya shillings at the exchange rate prevailing at the time of disbursement. The externally caused part of any upward adjustment in NDF is capped at the equivalent of US$ 280 million less any shortfall in external privatization receipt, converted to Kenya shillings at the exchange rate prevailing at the time of disbursement.

41. Reporting requirements. Data on NDF of the central government will be submitted to Fund staff on a monthly basis within four weeks of the end of each month.

D. Central Government Wages and Salaries

42. Definition. Central government wages and salaries consist of all compensation of central government employees (excluding social contributions paid by employer). Table 4 in Annex I of the Letter of Intent shows the ceilings on central government wages and salary payments for September 30 and December 31, 2004, March 31 and June 30, 2005, as well as indicative targets for September 30, 2005. For the purpose of this definition, the central government of Kenya is defined as in the Appropriation Accounts and in the parliament approved budget estimates for 2004/05.

43. Reporting requirement. Data on central government wages and salaries will be provided on a monthly basis within three weeks of the end of each month.

E. Contracting or Guaranteeing of New Nonconcessional External Medium- and Long-Term Borrowing Public External Debt

44. Definition. This performance criterion not only applies to debt as defined in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt (see Decision of the Executive Directors of the IMF No. 12274-00/85, August 24, 2000) but also to commitments contracted or guaranteed for which value has not been received. It applies to debt contracted or guaranteed with original maturities of more than one year by the CBK or the general government of Kenya (as defined by the 2001 IMF Government Finance Statistics Manual). It excludes financial obligations to the Fund, domestically issued Kenya Shilling denominated treasury bonds with maturity greater than a year held by non-residents, and debt subject to debt rescheduling and debt reorganization. The ceiling for new nonconcessional external debt will be zero on a continuous basis throughout 2004/05.

45. For program purposes, a debt is concessional if it includes a grant element of at least 35 percent, calculated using currency-specific commercial interest reference rates (CIRRs) published by the OECD. For debt with maturity of at least 15 years, the ten-year average CIRR will be used, and for debt with maturity of less than 15 years, the six-month average CIRR will be used.

46. Reporting requirement. Data on all new debt and guarantees by the CBK and the general government (including terms of loans and creditors) will be provided on a monthly basis within three weeks of the end of each month.

F. New External Nonconcessional Short-Term Debt Contracted or Guaranteed by the General Government or the Central Bank of Kenya

47. Definition. This performance criterion not only applies to debt as defined in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign debt (see Decision No. 12274-00/85, August 24, 2000) but also to commitments contracted or guaranteed for which value has not been received. It applies to nonconcessional (see paragraph 14 above) debt with original maturities of up to and including one year contracted or guaranteed by the CBK or the general government (as defined by the 2001 IMF Government Finance Statistics Manual) of Kenya. It excludes financial obligations to the Fund, normal trade-related credits, and domestically issued Kenya Shilling denominated treasury bills with maturity of less than a year held by non-residents. The ceiling for new external nonconcessional short-term debt will be zero on a continuous basis throughout 2004/05.

48. Reporting requirement. Data on all new debt and guarantees by the CBK and the general government (including terms of loans and creditors) will be provided on a monthly basis within three weeks of the end of each month.

G. Domestic Budgetary Arrears

49. Definition. Domestic budgetary arrears are defined as the sum of all due and unpaid obligations of the central government of Kenya, where the central government is defined as in the Appropriation Accounts and in the Parliament approved budget estimates for 2004/05, including, but not limited to, payment obligations from procurement contracts for goods and services and other contracts providing for payment in domestic currency, as well as statutory obligations for payment (e.g., of domestic debt, domestic interest, civil service wages, and other entitlements). Changes in domestic budgetary arrears are defined as the stock of outstanding domestic arrears on the test date minus the stock of outstanding domestic arrears as of June 30, 2004. Under the program, the nonaccumulation of new domestic budgetary arrears is a continuous performance criteria.

50. Reporting requirement. Detailed data on repayment and new accumulation of domestic budgetary arrears and the remaining previous-year stock of domestic budgetary arrears will be transmitted on a monthly basis within four weeks of the end of each month.

H. External Payments Arrears (On Nonreschedulable Debt)

51. Definition. External payments arrears are defined as the non-payment of external obligations of the CBK or the general government of Kenya (general government as defined by the 2001 IMF Government Finance Statistics Manual) both with regard to principal and interest that are valid and due, but shall exclude arrears on obligations that are subject to rescheduling or restructuring. Under the program, the nonaccumulation of new external payments arrears is a continuous performance criteria.

52. Reporting requirement. Detailed data on the repayment and new accumulation of external payments arrears by the CBK and the general government and the stock of arrears at the beginning and end of each month will be transmitted on a monthly basis within four weeks of the end of each month.

VII. Other Reporting Requirements for Program Monitoring

A. Public Finance

53. Monthly data on domestic financing (bank and nonbank) of the budget (including treasury bills and government bonds held by the nonbank public), domestic and external privatization proceeds, government debt instruments issued for bank restructuring, and new securitization of expenditure arrears will be transmitted on a monthly basis within three weeks of the end of each month.

54. Data on the implementation of the development budget, with detailed information on the sources of financing, will be transmitted on a quarterly basis within four weeks of the end of each quarter.

55. Public sector external and domestic scheduled debt service and payments will be transmitted on a monthly basis within three weeks of the end of each month.

B. Monetary Sector

56. The following data will be transmitted on a daily/weekly basis within one/five working day of the end each day/week:

• Treasury-bill rates (weekly); and

• Interbank interest rate (daily).

57. The following data will be transmitted on a monthly basis or as specified below within four weeks of the end of the month:

• The consolidated balance sheets of deposit money banks and the individual bank balance sheet, as needed;

• The monetary survey;

• Lending and deposit rates;

• Standard bank supervision indicators for banks and nonbank financial institutions, respectively, and for individual institutions as needed; and

• Net foreign assets of commercial banks and nonbank financial institutions, broken down by instruments.

C. External Sector

58. The following daily buying, selling, and average exchange rates will be transmitted on a weekly basis within five working days of the end of each week: (i) exchange rates used in interbank transactions among the commercial banks; (ii) the average of (i) (official exchange rate, quoted daily based on the transactions of the previous day); and (iii) foreign exchange purchases and sales by the CBK on interbank market and other inflows and outflows of foreign exchange to/from the CBK, separately.

59. Export and import data, including volumes and prices, will be transmitted on a quarterly basis within eight weeks of the end of each quarter.

60. Other balance of payments data, including the data on services, private transfers, official transfers, and capital account transactions, will be transmitted on a monthly basis within four weeks of the end of each month.

D. Real Sector

61. Monthly disaggregated consumer price indices for Nairobi (Central Bureau of Statistics) will be transmitted on a monthly basis within four weeks of the end of each month.

62. Any revisions to the national accounts data will be transmitted within three weeks of the date of revision.

63. Data on real sector leading indicators will be transmitted within three weeks of the end of each month.

64. Data on employment (formal and informal) and wages (including minimum wages and collective wage agreements) will be transmitted within four weeks of the end of each month.

E. Governance and Other Structural Reforms

65. Documentation of all measures undertaken by the government will be transmitted to the IMF's African Department within five working days after the day of implementation.