Ratio Magazine :: The Inside Track to East Africa’s Economies - Kenya: Will the New Inflation Rate Methodology Change Investment Patterns?

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Kenya: Will the New Inflation Rate Methodology Change Investment Patterns?

Friday, 12 March 2010

In February 2010, Kenya finally followed EAC neighbours Uganda and Tanzania in introducing a geometric mean for the calculation of its inflation rate. Rachel Keeler looks at the implications.

After much anticipation, Kenya has finally revised its inflation and consumer price index (CPI) calculation methodology to match international best practice and new spending trends.

Statistical shortcomings were flagged in 2008 when Kenya’s post-election violence caused disruptions and hikes in transport costs for the region. Observers noticed that while this effect should have been more pronounced for land-locked Uganda, Uganda’s inflation rates in early 2008 remained lower and less volatile than Kenya’s. That’s because Uganda (as well as other EAC neighbor Tanzania) uses a geometric mean recommended by the International Labor Organisation (ILO) to calculate inflation, while Kenya was using an outdated approach based on an arithmetic mean.

In short, the geometric approach is better at measuring general trends while the arithmetic calculation catches more outliers and results in higher and more wildly fluctuating averages. Thus, the Central Bank of Kenya (CBK) rightly spent most of 2008 and 2009 arguing that the country’s double digit inflation numbers were overstated and out of synch with regional price trends. For example, inflation for January 2009 by arithmetic calculations was 21.9%, but just 14.6% by geometric. For April 2009, the split was even greater: 26% vs. 9.6% respectively. Citing this disparity, the CBK finally convinced the Kenya National Bureau of Statistics (KNBS) to make the switch over to a geometric mean in October 2009.

Revision
In February 2010, KNBS also finally followed up by revising the makeup and weighting of Kenya’s CPI. Inflation calculations are based on price changes within a standard basket of goods and services that makes up the CPI. That basket should be updated every 10 years, but Kenya’s has not been reviewed since 1994. The new basket introduced in February 2010 is based on household budget survey data collected in 2005/06 that reflects significant changes in consumer spending habits in Kenya that have developed since the last survey in 1993/94.

The most notable of these is increasingly widespread spending on cell phone handsets and airtime, and internet services. Communications now has its own category in the basket, as do restaurants and hotels, and recreation, all reflecting the evolving habits of Kenya’s growing middle class. Weighting on the food category was also dropped from 50.5% to 36%.

The first question of course, is why it took Kenya so long to make these important updates, which are not only supported by international standards but also offered the country a chance to show more realistic, lower inflation rates. Eric Kibe, CEO of Sanlam Investment Management, says the problem was classic bureaucratic stubbornness to change: CBK was influential in pushing through the updates, but not influential enough to ensure they happened on time. Lazy bureaucratic forces in Kenya are also much less susceptible than those in Uganda and Tanzania to pressure from the International Monetary Fund (IMF) to follow best practice because Kenya relies on much less foreign aid.

Changing Investment Patterns?
In a recent presentation given in Nairobi, Kibe and his colleague Einstein Kihanda outlined what effects the methodological revisions might have on investment patterns. First, looking back, Kenya’s high and erratic inflation numbers over the past several years probably diverted some foreign direct investment to other countries. Interest rates have also been higher than necessary, which means corporations have had a harder time borrowing, and as a consequence may have held off on some investment projects. On the flip side, those who have been investing in Kenyan financial markets have been making more money in real terms than they thought.

Going forward, the opposite is expected to happen: As the credibility of inflation figures rises and those numbers become more stable and predictable, banks will be under more pressure to respond to signals from the CBK. If the central bank lowers its lending rate, banks should be more likely to follow by lowering their interest rates. This has not been the case in the past. It may still take some time for bank interest rates to come down, as this depends on many other factors as well. But the expanding use of newly licensed credit reference bureaus should also push rates down.

Also, as inflation expectations come down, corporations can access capital from local bond markets at lower interest rates, which will in turn put more pressure on banks to reduce credit costs. In both cases, corporations will have more incentives to invest and expand, which will in turn boost economic growth. Improved corporate performance also bodes well for equity share prices.

Bond Market
Lowered inflation expectations have already significantly affected the bond market in Kenya. Kibe explains that the principle driver for bond prices and yields in the long term is inflation expectations. When the methodology changes kicked in last October, investors realized that real returns on bonds were much higher than previously thought. Investors were soon scrambling to lock in those high real rates. Demand for bonds soared, and over the last several months bond yields have fallen. By January 2010, Kibe says Sanlam was seeing a spike in bond returns for its clients as a result of lowered inflation expectations based both on the new methodology and the arrival of rains in Kenya that are expected to boost agricultural production and keep food prices down. Officials expect these factors will keep inflation rates stable around 5% for the rest of 2010.

Kibe also expects lower inflation to boost the shilling’s strength in the long term. Most promising overall is that the CBK will finally have monetary policy at its disposal that packs a good punch. Investors will be happy that they can have more faith in official inflation figures, and banks will eventually fall in line. One can only hope that stubborn bureaucrats will learn to do the same.

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