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2012

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Working Paper 151 - The Dynamics of Inflation in Ethiopia and Kenya
08/09/2012 23:00
Working Paper 151 - The Dynamics of Inflation in Ethiopia and Kenya
Ethiopia and Kenya have experienced strong economic growth during the last decade. However inflation, which was thought to be under control, reached 40 per cent in Ethiopia and 20 per cent in Kenya during 2011. The rise of inflation in Ethiopia and Kenya was not an isolated event; other African countries also experienced increased inflation. There are many potential causes for these increases, but recent swings in international food and energy prices are likely to have affected inflation in countries that depend on agricultural production and imported energy. Yet, there is no consensus on the causes of the rise in inflation: a common view is that expansionary monetary policy, primarily due to large government expenditures, is the main cause, possibly in combination with negative domestic food supply shocks. This paper presents an econometric analysis of the main drivers of inflation in Ethiopia and Kenya during the last decade. The approach is to apply vector error correction models to different sub-sections of the economies, which in the end are combined into a single inflation equation for each country. The data is monthly and spans 1999:11 to 2010:05 for Ethiopia and 1999:01 to 2011:11 for Kenya.    The contribution of this paper is that it takes into account key sources behind the increase in inflation. There are, in principal, three potential drivers of inflation. The first is excess supply of real money balances. This can be caused by expansionary monetary policy or through central bank financing of government bonds. The second is external (imported) inflation and its effect on domestic prices: rapid surges in international food and energy prices are likely to spill over into domestic prices. The third is domestic supply shocks that create deviations between the current output and the optimal long-run growth path. In developing countries, such as Ethiopia and Kenya, agricultural supply shocks can create large disturbances to the domestic economy and inflation rates.    Our approach is to investigate these three sources separately for each country; first by identifying deviations from long-run equilibrium relations and then bringing the results together in one model of consumer price inflation. For each of the three sub-sectors we formulate vector autoregressive models to test for long-run economic relations. After identifying long-run relations, we use single-equation error correction models to empirically determine the sources of inflation. Our models embed different theoretical propositions through the inclusion of the estimates of deviations from long-run equilibrium relations. This procedure allows us to test various hypotheses concerning the sources of inflation. Two key variables are agricultural production and GDP. Since they are not available at a monthly frequency, we interpolate yearly and quarterly observations to monthly observations. The Hodrick-Prescott filters are used to separate short-run cycles from long-run trends in GDP and agricultural production. The outcome of interpolation is that we can measure trends and annual swings in output gaps (but not within-season changes) and their effects on inflation. To identify the role of money market imbalances we test for basic long-run money demand equations. There exists a long-run money demand expression for Ethiopia but we failed to estimate one for Kenya. Yet, excess money supply does not affect inflation in the final model. Foreign price shocks are investigated through testing for parity conditions between domestic price indices and world market food and energy price indices in local currency. For international food prices, there are strong effects on the inflation rates in both Ethiopia and Kenya. In Ethiopia there is a long-run relationship between the domestic consumer price index for cereals and world grain prices. In Kenya there is a long-run relationship between the domestic consumer price index for food and world food prices. We do not find a significant effect from international energy prices on local inflations rates. This is possibly because the impact is already captured by world food prices, or because the link between world and domestic energy prices is weak due to market regulation and market inefficiencies. Domestic food supply shocks are clearly important in Ethiopia, where large harvests reduce inflation through their effects on domestic food prices. The evidence for Kenya is not as strong, which probably is due to market integration: when the error correction term for world food prices is removed from the model for Kenya domestic food supply shocks become significant. Our results point to a lack of anchor for inflation in both countries, arising from clear and well-functioning monetary or exchange rate policies. This could be due to the manner in which the authorities have chosen to deal with inflationary shocks historically. In both countries there have been periods without firm policy responses. For example, in Kenya the monetary authorities seem to have expected that the commodity price increase in 2011 would soon revert and therefore delayed policy responses. Another possibility is that traditional monetary policy has little power, as might be the case in countries that lack well-functioning financial markets. For example, in Ethiopia bank-to-bank credit ceilings had to be introduced to rein in money supply as some banks had large excess reserves. The main messages of the study are that food price shocks are significant drivers of inflation and that improvements in monetary policy, and possibly financial sector reform, are required to reduce feedback effects and anchor inflation expectations. The differences between Ethiopia and Kenya should be acknowledged. Financial sector reform is needed in Ethiopia, since the monetary policy transmission mechanism is weak due to high concentration among banks and holdings of large excess reserves. In Kenya the Central Bank increased its policy interest rate sharply in late 2011, and the tight monetary policy seems to have reduced inflation, indicating that the monetary authorities have some clout.Read more
Working Paper 146 - Bank Financing to Small and Medium Enterprises in East Africa: Findings of a Survey in Kenya, Tanzania, Uganda and Zambia
26/03/2012 13:56
Working Paper 146 - Bank Financing to Small and Medium Enterprises in East Africa: Findings of a Survey in Kenya, Tanzania, Uganda and Zambia
Various studies have shown the contributions of SMEs to exceed 60 percent of total formal employment in the manufacturing sector in both advanced and developing economies. In Africa, the contribution of the SME sector to job opportunities is even more important with SMEs accounting for about three-quarters of the total employment in manufacturing (including the informal sector). In spite of the importance of the topic, relatively little research exists on the role of bank finance in SMEs around the world. This is partly due to the absence of comprehensive data on SME finance. Nonetheless, existing studies show that, contrary to the conventional perception that financial institutions shun SMEs, banks consider the SME segment strategically important. This paper contributes to the growing literature on SME finance. Its purpose is to shed light on current trends and practices in bank financing of SMEs in four East African countries, i.e. Kenya, Tanzania, Uganda and Zambia. The comparison among these countries is interesting because they are neighbours, they are all growing, emerging economies and they have implemented a number of financial reforms in recent years, with their banking systems becoming increasingly integrated. In particular, this paper forms part of a broader African Development Bank regional project on this topic, whose objective is to identify best practices in SME lending as well as constraints that impede growth in the SME finance market so as to draw relevant policy implications. The study uses tabulated questionnaires followed by on-site interviews with banks’ senior management. The format and the questions of the questionnaire were drawn from previous surveys developed for analysis in different markets and slightly adapted to cover topics not included in the previous surveys but which may have an impact on SME bank financing in East Africa such as micro-prudential regulation. The questionnaire solicits response to 90 questions divided in three broad analytical areas, which are described in detail in this paper. The first area deals with banks’ involvement in SME lending. The second area focuses on the determinants of banks’ involvement with SMEs such as corporate strategy, market structure, government policy and regulation. The third area attempts to understand how banks engage in lending to SMEs, with a special emphasis on the nature of their business models and risk management systems.   The study found SME segment to be of strategic priority to banks in the region. SMEs are considered a profitable business prospect and provide an important opportunity for cross-selling. Banks consider that the SME lending market is large, not saturated and with a very positive outlook. A number of obstacles are, however, constraining further engagement with the SME segment, including SME-related factors such as the lack of adequate information and collateral as well as their largely family-owned structures. Macroeconomic factors, business regulation, the legal and contractual environment, the lack of a more proactive government attitude towards the segment, some areas of prudential regulation and some bank-specific factors are also perceived to negatively affect the SME lending market in the sample countries. Even so, the study shows, banks have adapted to the environment and developed mechanisms to cope with it through innovation and differentiation. Most banks have dedicated units serving SMEs, to which they offer largely standardized products though the degree of personalization is growing. And albeit advanced transaction technologies based on scoring and risk-rating systems remain relatively underdeveloped, banks are gradually automating their risk management frameworks to achieve efficiency gains. On the whole, the findings are broadly consistent with similar studies in other geographical contexts and those suggesting that the strategic interest of East African banks in the SME segment can make an important contribution to closing the “SME financing gap” in the region compared to other developing countries. The growing engagement of formal finance institutions and SMEs should be encouraged through reforms to soften the negative impact of obstacles hindering the involvement of banks SME financing.Read more
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