Discussion Paper No. 93 of 2009 on Determinants of Current Account Balance in Kenya: The Intertemporal Approach

Abstract

This study investigates the determinants of current account balance (CAB) in Kenya using intertemporal approach. By use of time series analytical framework, an error correction model is estimated in order to examine both long and short term relationships. The analysis is based on a structural approach that highlights the role offu ndamental determinants of saving and investment. The study results indicate that Kenya's current account balance is positively influenced by terms of trade, real exchange rate, economic growth and fiscal balance, with terms of trade being the most significant positive determinant. On the other hand, money supply, dependency ratio and foreign direct investment negatively affect CAB in Kenya, whereby money supply is the most significant negative determinant followed by dependency ratio. Cointegration analysis has confirmed existence of a significant long-run relationship in the foreign exchange market. However, current account balance is not part of the cointegrating equation. Therefore,for Kenya to progress towards a favourable current account balance aiming at reducing persistent current account deficits and attaining sustainable levels, the country should strive towards terms of trade improvement. This can be achieved through enhancing export competitiveness by means of diversification, quality improvement and technological upgrading in value addition industries. Export competitiveness efforts should be supported by policy measures that promote productivity growth. Whenever the Kenya Shilling is overvalued, the Government should resort to sterilized intervention in the foreign exchange market. Expansionary monetary policy should be discouraged and domestic savings mobilized through development, innovation and diversification offi nancial markets. Moreover, the problems of poverty, unemployment and income inequality should be addressed as a matter of priority so as to reduce the high dependency burden. Fiscal discipline is indispensable in order to improve and sustain favourable current account and economic performance. Therefore, Kenya Government should contain budget deficits through appropriate fiscal measures and prudent public expenditure management. It should aim at limiting public expenditures to be in harmony with revenue generation. The Government should strive towards increasing revenue collection and improving allocation and efficiency of its expenditure in accordance with national development priorities.