Future Capital Kenya

Let Engineers Engineer

2012-02-15T19:39:00.000+03:00

I have been awaken from my deep blogging slumber by an extraordinary statement. In my course of regular reading, I came across the Report by the Parliamentary Select Committee investigating the collapse of the Kenyan Shilling. The basis for their eventual tirade on the banking community as well as the Central Bank Governor is summarised in the following statement;

The Committee received a range of the causes of the fall of the Kenyan Shilling which the committee divides into economic, human and institutional failures. The economic causes such as the wide current account deficit, Euro crisis, large import bill of non-essential commodities, the Arab Spring, are still in place even after the shilling recovered its value in Decemeber 2011. The Committee therefore zeroed on institutional and human failures.

This statement is quite shocking. Let me explain. The currency fell to a low of KShs 107.00 to the dollar in mid October 2011. The key driver was simple, investors stopped believing in the fundamentals that underlie the Kenyan Shilling and quickly began to bet against it. I might confess that I suggested to my former boss that we should bet against the shilling. Nonetheless, these opinions on the shilling were not just based on current fundamentals but also, by forward looking fundamentals. Consider for instance an investor who wants to build a bread factory, his analysis will not only include current demand patterns, but primarily, his analysis will include forward looking demand patterns.

A good investor is one who knows where money is to be made, not where it is being made.

My point is simple, in December, forward looking projections for the current account balance changed significantly. Banks and investors alike foresaw less dollar demand due to higher interest rates. Therefore, their demand for currency begun to favour the Kenyan shilling. Basing the whole report on that statement is simply garbage in garbage out.

Indeed, the report has some good recommendations including boosting the export base, improving CBK communication with the banks and boosting the CBK's regulatory tools. Nonetheless, the report comes about as more of a witch hunt than an investigative report.

A walk down memory lane

2012-01-17T20:48:00.000+03:00

Dear reader,

The author of this blog apologises for the infrequent posting. This blog has become like a shelf-company, it exists but it doesn't operate. Anyway, I decided to give links to a few blog posts that have been written before and that explain the structural issues that led to the annus horribilis that was 2011.

http://futurecapitalkenya.blogspot.com/2009/09/agricultural-reform-blind-visionaries.html

(explaining the lack of investment in agriculture and the likely consequences).

http://futurecapitalkenya.blogspot.com/2009/12/house-of-cards_15.html

(explaining that growth in Kenya has been based on capital accumulation rather than factor productivity. This often ends badly).

http://futurecapitalkenya.blogspot.com/2010/02/distorted-civil-service-pay.html

(Highlighting the fiscal flows in the budget. Highly distorted civil service remuneration).

http://futurecapitalkenya.blogspot.com/2010/10/real-estate-really-analysing-demand.html

(Investment in real estate... of most concern being the non-tradeable status of real estate)

http://futurecapitalkenya.blogspot.com/2011/05/capital-account.html

(explaining the dynamics of the current and capital account).

http://futurecapitalkenya.blogspot.com/2011/08/kenya-impressionable-young-banker.html

(General societal mal-investment)

Happy New Year and I hope to blog more often.

Sunday Take-out

2011-11-20T11:15:00.000+03:00

This post will just discuss a few issues that have been happening in Kenya; regards to economics of course.

Exchange Rate - This week we have been treated to a strengthening shilling. The local unit actually closed the week at a three-month low of 92.00/40 to the dollar. It seems that the unit is regaining its strength and this should be good for inflation in the country. However, import bills usually come during the end of the month and we are likely to see the shilling lose some ground towards the end of the month and probably come in at the 95/97 mark. I think we are past the 100 level. Going forward, I expect the shilling to touch the 85 mark during the first quarter of next year. It is too expensive to take positions against the shilling when T-bill rates are at 16%.
Interest Rates - This is the new issue for Kenyans. A month ago all the attention was on exchange rates and inflation and now the issue is solely on interest rates. It was insightful to see Equity Bank raise their rates to 25%. In my view Equity Bank's rate hike will have the biggest effect as they have the highest number of depositors. Higher interest rates are "required" in times of high inflation so as to deal with the inflation. It is based on the classical relationship between inflation and economic growth. Milton Friedman, the father of modern monetary economics commented that "inflation is everywhere a money supply issue". Therefore to deal with high inflation, the regulators have to reduce the money supply. Be that as it may, it is arguable as to whether our inflation was a money supply issue or purely an issue of our political economy. When we have artificial inflation due to poor food distribution and a weak energy infrastructure, all because of our political economy, then the argument for money driven inflation is non-existent. This has been my argument throughout. Nonetheless, we are likely to see growth stall and I cant wait for end year GDP growth figures. I optimistically expect them to come in at 3%- 3.5%. People will suffer.

Euro-zone issues - Europeans are losing their "moral" authority over Africans. Interestingly, the politics that would prevail in Africa is taking centre stage in Europe. By this I mean, procrastination, blame games and nobody willing to take the bull by the horn. Italians and Greeks have decided to appoint technocrats to lead their respective countries to reform. The Financial Times had an interesting name for these technocrats; "vulcans"; referring to the creatures from Star Wars who were characterised by reason and a lack of emotion. Indeed, it could be useful to work with vulcans, but all over the world, politicians are the only people who can effect unpopular decisions. Europe is faced with huge debt and an unwillingness to pick up that tab. In my view, Germany, the surplus nation must pick up that tab for the future of Europe and the rest of the world. Note that 45% of our current account is financed by Europe and 33% of our exports are to Europe.
Syokimau - We live in an interesting country. Technically, the KAA have a very strong argument for those demolitions, but why now?. KAA must have known all along that construction was being done on their land. Syokimau to many real estate dealers has been the place to be. While all this was going on, where was the KAA?. Kenya has to grow up. Interestingly, the NSE is talking up futures exchanges, EFT's and options. If you cant enforce property contracts, how on earth will you enforce promises?.
Election Date - I was expecting our celebrity Chief Justice Mr. Mutunga to finally tell Kenyans when they are expected to vote. Unfortunately we got a purely legal argument suggesting that this decision lies within the remit of the High Court. I guess the buck has now been passed on to the high court. My advice to the High Court is simple, a lot of money is being held up from its efficient allocation due to uncertainty over the election date. Sort that out and let us all move on.

Enjoy your Sunday.

Having a Functional Currency

2011-10-20T09:22:00.000+03:00

A quick post! I read the newspapers this morning and saw that the national carrier Kenya Airways is now charging domestic passengers in dollars. This follows on the heels of other companies such as CMC Motors and Toyota Kenya who are also pricing their products. Together with my biggest foe Multi Choice Kenya, it seems that more and more companies are abandoning the shilling.

This really frustrates me and should work as a wake up call to the CBK governor who has long been an advocate of "private sector solutions to exchange rate volatility".

For a long time, the CBK in their publications have been against having any capital/exchange rate controls as it goes against the ethos of having a free market economy. In their view, the private sector should come up with solutions to exchange rate volatility through financial innovations such as forward exchange rate contracts. In their rather idealistic world, companies like KQ when faced with the prospect of a weak shilling, should contact their bankers and arrange for forward currency contracts to hedge against the weak shilling. Now, the simple question is this; If KQ, a company domiciled in Kenya, which mark you has a functional currency, can charge in dollars; why on earth would they bother taking forward contracts to hedge against a weak shilling? They have a natural hedge as they simply switch their pricing to the more stable currency, and in addition, book decent exchange gains as they report their annual statements in the weaker Kenyan shilling.

In essence, if the CBK and the government want to deal with the currency issue, they should start by making sure that all companies in Kenya are in charge of their own exchange rate risk. Companies like KQ, CMC Motors, Toyota Kenya and Multichoice should all price their products in the Kenyan Shilling. This would first of all ensure that companies take control of their own exchange rate exposures and importantly for the economy, it would allow the exchange rate to perform its most pivotal function; to act as a pressure valve in the face of current account imbalances. A weaker currency always acts to turn trade deficits into trade surpluses and a strong currency does the opposite i.e. turn a trade surplus into a trade deficit. It's simple economics and the CBK should start thinking about making economics work in Kenya. If you travel to South Africa, you will notice that even their duty free products are priced in the Rand. This actually goes a long way in stabilising your currency. To me it seems that the Kenyan economic policy makers follow the Reagan School of Economics, following voodoo economics that clearly don't work.

Dramatic CBK Rate Hike

2011-10-06T21:49:00.000+03:00

Prior to the MPC meeting on Wednesday 5th of October, I had suggested that a rate hike wouldn't be necessary as it is not a key-rate but rather a signal rate. My view is that the CBK want to take control of the process before parliament opens lest we witness currency controls. Over the last 2-3 years we have witnessed fuel price controls and food controls in the face of inflation hikes that arose from supply shocks. It could be a political move to prevent politicisation of the currency.

The economic argument for such a move is that in times of sustained supply shocks, like we are witnessing, it is important to tighten so as to avoid the "second-round" effects of a supply shock. These second round effects are mainly persistent inflationary expectations as well as wage pressures that lead to further inflation. Therefore, central bankers faced with persistent supply shocks decide to forego growth and control inflation by tightening. However, how can the CBK claim that they're tightening while the Cash Reserve Ratio is at such low levels? (4.75% monthly and 3% weekly). My guess is that its plain politics.

I would ask any economist to kindly explain to me how a higher CBR will allay supply driven inflationary pressures and strengthen a weak currency. (I'm talking about the nuts and bolts of a CBR rate hike - inflation - a weak currency). For centuries now a number of people have wrongfully confused economics with politics, I think this affliction is well and truly alive.

Kenyan Shilling - Leave Prof Ndung'u alone

2011-10-02T21:27:00.002+03:00

On October 14th 2003, a young man named Steve Bartman was watching a Major League Baseball match between his favourite team the Chicago Cubs and the Florida Marlins. The Marlins hit a ball that was heading to the stands and particularly it was headed to where he was seated. The young fan like any other fan, took his chances and stretched out his hand so as to catch the ball as it approached. Unfortunately, the Chicago Cubs outfielder Moises Alou was also trying to catch the same ball. Steve Bartman therefore inadvertently impeded Mr. Alou from making the catch and the Marlins got a home run. The Cubs lost momentum and ended up losing both the game and the chance of making it into the World Series. They simply capitulated. However, in retrospect, most Cubs fans realise that the team's capitulation was not down to Bartman, but to their own shortcomings. Steve Bartman was simply in the right place at the wrong time therefore making the perfect scapegoat.

I find myself writing on the Kenyan Shilling, a topic which to me is rather cliche. However, reading, hearing and watching the media has to say, I feel that some grounded and balanced analysis would do. Especially in light of the fact that the currency has already, as expected, been politicised. The Prime Minister Hon. Raila formed a taskforce to "investigate" what is really ailing the currency. Now Hon. Chris Okemo, Chairman of the Parliamentary Finance Committee has entered into the fray. Requesting that the CBK governor explain what is happening to the shilling.

I would simply request that both the PM's taskforce as well as the Parliamentary committee refer to an "Introductory Economics" text book. That would really elucidate their respective tasks and solutions.

To the currency, I'd simply quote an excerpt from the recently released Q2 GDP figures from the Kenya National Bureau of Statistics.

Over the second quarter of 2011, the current account deficit widened to KShs 97.929 million compared to a deficit of KShs 43.839 million recorded in a similar period in 2010

Now, the question that automatically comes to the media is; "Who's to blame"?. The answer to that of late has been that it's Prof Njuguna Ndung'u of the CBK. I beg to differ, indeed the Central Bank has made some mistakes. Particularly their knee-jerk reactions to the current macro-economic climate. However, I opine that we're all to blame. Consider for instance the fact that most people only think of "real estate" when they are thinking of how to invest their hard earned money. Coffee Estates in the outskirts of Nairobi are being sold for real estate. Coffee is one of our biggest forex earners and as such, we are weakening the shilling in the pursuit of quick profits.

A house is a non-tradeable good, it can only be consumed where it is produced and as such can never earn us any forex. Therefore, as long as the country is focused on being less productive, the shilling at 104.00 looks rather cheap to me.

Back to Prof. Ndung'u, what is a Central Bank governor to do, in the face of society wide efforts towards non-tradeable goods? I posit that there is little much he can do. I go further and suggest that even a dream team of Ben Bernanke and a re-incarnated Milton Friedman wouldn't do our currency any good. Who is to blame?, we are all to blame. Prof Ndung'u is just the Steve Bartman of this game, he is at the right place at exactly the wrong time.

On the issue of interest rates being risen to mitigate the fall of the currency; If the South African Rand, Malaysian Ringgit and even the Singaporean Dollar are all facing pressures due to the current global macro climate, what makes anyone think that a 16% yielding shilling will attract global funds? Secondly, haven't interest rates already been risen? What is the point of focusing on the CBR when the real emphasis on the money markets is the Interbank Rate and the 91-day T-bill rate? Haven't these rates already risen?.

To surmise, the Central Bank governor cannot do much about the currency. Furthermore, we are all to blame in our pursuit of super profits from real estate investments, we have weakened the shilling. I suggest that any Kenyan following the current currency situation to read deeply about the causes of the Asian Financial Crisis. You will be spooked!

Thoughts on Monetary Policy Committee Meeting

2011-09-16T11:29:00.000+03:00

The Monetary Policy Committee met on Wednesday 14th of September to discuss the current market volatility. The outcome was an increase in the Central Bank Rate (CBR) of 75 bp to 7.0% from 6.25%. This was done so as to ward off further inflationary pressures. The current inflation rate is at 16.67% against a target of 5%. In addition, underlying inflation (inflation less food and energy inflation) is currently at 7%. The spread of 200 bp (Underlying inflation less inflation target) is a cause of concern for the MPC.

Further to this, the IMF's Extended Credit Facility is conditional upon a change in the composition of the broad money supply. Both M3 and L, with a bias towards Net Foreign Assets. Therefore the CBK, through policy actions should reduce the amount of domestic assets (NDA, in a nutshell shilling denominated assets) and increase the amount of foreign assets (assets denominated in foreign currency). This is being done with a view of shielding the economy from the adverse effects of our poor trade balance. Imports by far exceed exports, in addition our terms of trade are deteriorating. Simply, we are buying more than we sell and in addition the our buying prices by far exceed our selling prices.

To this end, I expect the shilling to further weaken. I think the shilling could hit the 100 mark by year end, although the Infrastructure bond could attract diaspora inflows. I then expect interest rates to rise in the mid-term as the tightening has an effect on money market liquidity. The current spike in T-bills to 12.57% is a pointer towards this.

Those who think that the MPC decision was good, suffer from delusion and probably an existentialist crisis. The famous philosopher Rene Descartes said "I think and therefore I am"... it follows that if you cant think then you don't exist.

If you raise rates and tighten liquidity due to cost-push inflation, you are seriously endangering economic growth. Furhermore, once T-bill and T-bond rates sky-rocket, there will be a serious re-alignment of domestic credit as banks lend more to the government and less to clients. We could see a serious slow-down in the private sector's access to credit going forward.

Note that the decision wasn't motivated by the CBK, but rather the IMF so don't blame Prof. Ndung'u.

Kenya: The impressionable young banker

2011-08-25T15:30:00.000+03:00

Ahhhh, blogging, an art that I often love to indulge in, but more often lack the time for. Yesterday, the Business Daily had an impeccable column from the ever fresh George Wachira. In the article, George Wachira, a petroleum industry analyst did something that a number of economists expressing their views in the media have so far failed to do; explaining what really is ailing our economy. For that; Kudos Mr. Wachira, you have really hit the nail squarely on the head.

To take his points further, I will do what i have developed a knack for; developing analogies. To this end, I write the simple story of a Banker called Ken.

Mr.Ken graduated from high school with some good grades back in 1963. His parents and indeed his whole community had great expectations for him. A man with such undoubted intellect and charisma; a rare mix of resources, would clearly do well in life. Mr. Ken designated himself a career as a banker after some thorough soul searching. Banking, he thought, would be the best way to generate real wealth for himself in the long run.

In his formative years as banker, he caught the common bug that seems to afflict all bankers, the bug is called the "aesthetic fallacy".

The bug works by making the banker think that looking good and working on your appearance are the most critical aspect of making it in the industry. This bug was reinforced into Mr. Ken's mind by his well-heeled superiors from the global head office in London. To this end, Mr. Ken went on a borrowing spree, these loans were taken out so that he Mr. Ken can acquire Italian suits, a German car and hopefully an American wife.

Sappeurs of Congo, dressed to kill, but can't pay your bills.

When it came to his modes of investments, Mr. Ken focused on more exotic investments, he invested in "off-shore equities", "forex" and "global fixed-income" investments. These just sounded sexier at cocktail parties.

His high-school colleagues were mis-informed, they invested in "dumber" investments, his friend Hu, kept chickens. Mr. Saivash on the other hand started a potato farm. Mr. Ken was too good for these, in fact, he had started fiddling in tech stocks. Hu and Saivash were way behind the curve.

However, as time progressed, Mr. Ken found himself in a very compromising situation. His disposable income could barely keep up with his lifestyle and committments, his loans were due and this was exacerbated by the fact that he spent all his credit on consumables and worse still; his investments had all stalled, he was in the red. Meanwhile Hu and Saivash, had simply counted on the tried and tested technique of spending way less than you earn, managing your risks and waiting for compount interest to work its magic.

Mr. Ken then realised in his mid-life, that looking good is not what gets you far as a banker, Indeed it does help to look presentable, but what really cut the grade was hard work and ability. Some of his juniors whilst he was a mid level manager were now senior managers. Now, Mr. Ken was just a very presentable mid-level manager at a local subsidiary of a global bank.

Things didn't turn out well for Mr. Ken, his expenses by far exceeded his income and his investments had backfired. Bank's no longer lent to him and his financial counterparties had lost their trust in him. Hu and Saivash's companies were now global conglomerates, a far cry from their humble beginnings.

Lest I digress further, this is the story of Kenya's current woes and worse still, it's future woes; Moreover, this situation is completely self-inflicted. A look at the 2nd half banking sector report shows that over 44% of all loans and advances were advanced for consumption and real estate. Kenyans are selling their productive land so as to build apartments, the government has totally ignored manufacturing and agriculture and instead, it is focusing on an ICT park in the middle of nowhere "no offence if you hail from Malili". We are Mr. Ken, somehow convinced that external appearance matters more than productivity and work. We are also convinced that "sexy" investments like ICT and "regional financial hubs" are more important than the dull sounding agriculture and manufacturing.

Where has this lead us? Balance of payment woes as our expenditure by far exceeds our income. An 8% trade deficit simply means that we export 8% of our wealth to foreigners each year. This number is growing. ~~Shit~~ stuff has hit the fan!

As a country, we need to focus on agriculture and manufacturing. Simply, there is no other way!

Mythbusters: Kenyan's don't have a savings culture!

2011-08-01T19:58:00.000+03:00

I have read a number of articles that lament about Kenyans lacking a savings culture. To crystallize this point, most people quote the savings ratio, measured as gross national savings as a percentage of GDP. The savings ratio has hovered at about the 12% mark. Compared to other countries, this seems to be rather low when you compare it to countries like China and Botswana whose savings rate has historically been in the 20-40% range. Closer to home, Tanzania has enjoyed savings rates of about 21% with Uganda coming second with 18%. So we do not save, and our East African counterparts save more of their wealth than we do. In essence the savings rate measures how much of our wealth that we save, simply calculated as our wealth less what we consume. The result is that from a national income identity perspective, we get to invest only 12% of our wealth.

Moreover, if we invest more than we save, then by national income accounting identities then the surplus i.e gross savings less gross investments will be equal to the current account balance. In our case, we have a negative current account balance meaning that we invest more than we save. We can only do this by borrowing money. Therefore, we have established two clear factors;

Kenyans don't save nearly enough of their wealth.
Given that we do not save, we have to borrow and thus end up with current account deficits.

So to analyse this matter, one has to be cognisant of the way national savings are calculated. In the economy there are three players, firms and households, government and foreigners. Therefore, our GDP is a function of how much is spent by firms and households, governments and foreigners. It thus follows that our national savings is a function of firms and households, governments and to some extent foreigners,with the only change being that foreigners are not included in the calculation of national savings.

Therefore, savings are a function of how much our firms and households save and how much our government saves. If the latter actually save, or have ever heard of the concept.

Do our firms and households save, the answer to this is a resounding YES! In 1998, the external debt stock i.e. the percentage of national debt owed to foreigners was 87%. In 2010, the external debt stock stood at 50%. The debt stock grew by a compounded rate of 23% during that period to stand at KShs 1.06 trillion shillings from a total of KShs 252 billion. If the composition of external debt has shown such a precipitous decline, all the while the total debt has been growing, it only suggests one thing. The government has been tapping the local market for their debt requirements. As such, the government can only tap into our "savings" to fund their deficits. Our pension funds, unit trusts and banks have lent more of our "savings" to the government.

The conclusion is simple, when analysing national income statistics, it is good to have an innate understanding of how those parameters are calculated. The national savings is low, not because Kenyans don't save, but because the government is constantly running budget deficits. They can only bridge these deficits by borrowing from us or from foreigners. Therefore, Kenyans do save, in fact they are great savers, they just save for the government.

The Exchange Rate Issue!

2011-07-04T11:30:00.000+03:00

Time is a friend to the fundamentalist but a foe to the faddist - Warren Buffett

To understand the current exchange rate dynamics, it is easier to consider a useful analogy. This blog has developed an uncanny reputation for creating wacky analogies over time, but I think they've been useful with regards to getting the message across.

Now everyone, well at least most people, have been in a relationship. These relationships were sometimes built on what romantics would call "real reasons", such as; respect, admiration, compatibility and a pure and warm understanding of each other, telepathy if you will. Others have been built on what pragmatists would also consider to be real reasons, such as; money, a well connected father in law, a nice figure or maybe just pure convenience a "why not?" relationship. Depending on which side you fall on, some of these reasons may be appalling and some may even be disgusting, but it cant be denied that all of them are real.

Now imagine two people who are dating, Mr. X and Ms. Y. Mr. X through his obvious swagger and charm convinces Ms. Y to be his girlfriend. Ms. Y was in a difficult situation in her life and was helpless as Mr. X swooned to win her over. Six months down the line, after the conveyor belt of roses and chocolates starts to chug along slower, it hits Ms. Y that maybe Mr. X wasn't the man for her all along. In retrospect, it may not have been the smartest of choices, in fact "he always used to stare at other girls" and "whenever he hugged my friend Z, the hugs would last a few seconds too long". The tipping point comes when the two lovers decide to meet up for lunch at their favourite restaurant. Ms. Y arrives on time and as has been the case for the last three months, has to wait for longer than is necessary for Mr.X to arrive. In this 45 minute wait for Mr. X, the doubts about their relationship grow stronger and stronger, and in this escalation she decides that enough is enough. Their relationship can no longer work, it's time to call it quits.

Dear readers, this situation as removed as it may be, to a great extent represents the reality with investments and capital flows. Generally they are driven by fundamentals and sometimes they are driven by sentiment. However, as much as this sentiment may seem speculative, it usually is a "starry-eyed" person's awakening to the fundamentals.

Having a weak currency has one major adverse implication for Kenya, with a high urban population, imports become expensive and thus inflation pressures mount. From a national security perspective, this is extremely dangerous. Note that the prices of crude oil have eased off their April high's of $116 per barrel, but your fuel costs haven't adjusted. This is simply down to a weak currency.

Exchange rates are driven by three major factors which are listed below;

1. Trade Balances - When Kenya imports oil for instance, it has to buy dollars as oil prices are quoted as $/barrel. Alternately, when a foreigner buys Kenyan tea, he has to buy Shillings as the price of tea is quoted in shillings. Therefore, by simple deduction, imports result in shilling outflows and exports result in foreign currency inflows. If exports exceed imports, the country has a positive trade balance and thus there is more demand for its currency resulting in a stronger currency. The alternate is true when imports exceed exports. In Kenya's case, imports exceed imports by a whopping Kshs 537 billion (USD 6 billion) or almost a fifth of GDP. In fact, the trade deficit has hovered at around 15% of GDP for the last twenty years. You can now automatically tell that our currency from a trade perspective faces enormous pressures.

2. Capital Flows/Interest Rates - In response to the currency crises that emerged not only in Kenya, but generally in East Africa, heads of EA Central Bank's led by Prof. Ndung'u raised interest rates. The CBK did it by raising the CBR rate (now called the discount rate) from 6.5% to 8.00%. The thinking behind this is that, if you raise rates in Kenya, foreign capital will flow into the country seeking higher yields. Given that the interest bearing instruments are denominated in shillings, the foreigners will have to purchase shillings thus strengthening the currency. Therefore capital flows, through the interest rate mechanism do have a bearing on currency movements.

However, this was not the best of moves. Rising interest rates in an inflationary environment such as ours could kill the economy. Hiking interest rates due to demand-pull inflation works well, however when inflation is cost push such as ours, rising interest rates choke the economy of credit and lead to lower aggregate demand. Major banks have increased their lending rates and they can easily justify this by saying that the Central Bank's rates are much higher than they were this time last year. In macro-economics, such a situation is called a trilemma, where Central Banks can either focus on exchange rates or interest rates and inflation through their Monetary Policy, by trying to affect the exchange rates, the CBK is actually worsening the interest rate/inflation environment.

Moreover, this policy move would work well, if foreigners thought highly of Kenyan debt. Kenyan debt obligations from the Treasury are rated B+ by S&P. This is a whole four grades below the minimum investment grade that dictates global fund manager's investment decisions. Therefore, our structural problems are influencing our macro objectives. For more information about credit ratings look here.

3. Psychological Factors - This feeds back into our analogy, and to a great extent explains our current currency issue. Sentiment does affect the markets and often overlooks the two main fundamentals listed above. If economic agents and owners of capital become wary of the shilling, their actions could lead to a weakening of the shilling. Just like the girl, sentiment could lead to a realisation that the fundamentals are flawed and that this "relationship" is not worth it. In a recent blog post, I identified some flawed fundamentals and suggested that the shilling is bound to get weaker. Indeed it did. All the economic actors took short positions against the shilling and their actions exacerbated the already dire situation.

To surmise, investment decisions, just like relationships reflect both sentiment and fundamentals. Like a lady smitten, sometimes investors and other economic agents may decide to over-look the fundamentals and just ride on sentiment. However, often, in a state of hubris, the man's actions will lead to the lady realising that she is in the wrong relationship. The 45 minute delay will lead to angst and sentiment will turn against the man. He will lose his girlfriend. In Kenya, high inflation, increased political uncertainty and other such factors turned the sentiment against us. This resulted in a currency appreciation that lead to the Kenyan shilling reaching all time lows against the dollar.

Prof Ndung'u once wrote that;

"The policy instruments that matter most for export success lie outside the realm of monetary policy. These include the reliable provision of productivity-enhancing public inputs and the protection of private economic returns from investments"

These remarks can easily be translated to "Kenya will only achieve success, if it focuses on its fundamentals". The CBK's actions were a stop-gap solution, but the country will have to improve its productivity and international standing to reduce the chances of future speculative imbalances that weaken the currency.

Capital Gains Tax

2011-06-19T18:34:00.000+03:00

Just a thought! In the recently read budget (2011/12), an interesting point came out. Hon. Uhuru Kenyatta mentioned that property dealers were from now on to be paying capital gains tax. The proviso was that if it is stated in the company's articles of association and memoranda that the company actively seeks to buy and sell land and other property for profit, then this profit which is a capital gain would be taxed as regular business income.

To my lay readers, capital gains is simply an increase in the value of an asset. For example, if you buy a house for Kshs. 1 million and sell it at Kshs 2 million, then you have made a capital gain of KShs. 1 million. In other countries, this gain is usually taxed at a given rate say 30%, so you'd have to give the taxman Kshs 300,000.

Now at first sight, it seemed like a sensible thing to do. If you tax capital gains to real estate companies, it could both reduce real estate speculation, as well as increase government revenue. My issue is, where does it stop? The treasury has just released a can of worms.

Arguably, capital gains are made by people who are in the business of making capital gains. It doesn't just fall upon some lucky guy walking down the street. Making capital gains is something that businessmen plan for and take advantage of. Therefore, as much as it may make sense to tax real estate companies on their capital gains, the buck, if the treasury is being fair, shouldn't stop there. Asset managers, insurance companies, private equity firms should all be taxed on their capital gains. If the treasury's reasoning on taxing real estate capital gains is to be implemented fairly, then it can be argued that the aforementioned parties are all in the business of making capital gains and as such, their capital gains should be taxed as regular business income. Food for thought for those at the treasury.

Women Rates...

2011-06-16T11:48:00.001+03:00

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After a long hiatus, I thought it prudent to blog once more. It is becoming a rarity these days and for that I apologise to the wonderful people that read this blog. Many of whom are expecting me to blog about the budget, but surely what has not been said? I can't really give any special insights.

Nonetheless, I only have two issues; Analysts, international agencies and the government are usually first to trumpet Kenya's prudent macro-economic management. In all honesty, our macro-economic plans and commitments are first class and for that, we should pat ourselves on the back. However, the real work lies in our micro-economic management i.e. at the ground level. Until we sort out our public procurement systems, staff our implementation bodies and take other steps that will ensure that we can convert plans, proposals and designs into tangible objects, then no fancy budget will fix our woes.

Secondly, it is worth pointing out that from an operational level, our recurrent expenditure is fully funded from our income sources i.e taxes, levies and earnings from parastatals. We are thus only borrowing to fund our development expenditures. This is a positive development and should be followed up by an improvement in our public pensions systems to ensure that we are not funding pensions from the consolidated fund ala the Portugal Ireland/italy Greece Spain.

Speaking of borrowing, the only insight I have to share concerns the cost of borrowing/capital i.e. interest rates. Now, a number of people really don't understand what interest rates are. Even brilliant economists can explain them perfectly in economic and financial jargon, however they do not have a tangible grasp on what interest rates are. To explain them, I decided to put them into perspective, using issues that are removed from the financial markets and with the little or no financial jargon.

To begin with, interest rates are to finance what gravity is to the physical world. Gravity gives objects their weight, whereas interest rates give assets their worth. Whether, it's land, shares, bonds, options, houses and any other productive asset you can think of. Interest rates are what primarily determine their value. The reason this is so stems from the fact that you can invest in an a risk-free asset (T-Bond, as long as its not Greek) and earn a return. This return is the interest you receive from that Bond or Bill. Given that you are earning a risk free rate, then this rate will now determine what you would expect to earn given some risk.

For example, if you earn 12% from a T-bond over say 10 years. Then to take any extra risk, you will require to earn above 12%. In practice, lets say that you want to put up flats to earn rental income. You have Kshs 10 million as capital, if you earn anything less than Kshs 1.2 million per annum as rent, then that is not a good investment given that you can earn the same 12% by investing in a bond. In an efficient market, investors will stay away from the property market and put their hard earned cash into the bonds. This movement away from property will drive property prices down and as such, their worth will have been determined by the 12% interest offered by bonds.

To explain this phenomena, imagine a world where the only assets in the world are wives. Their worth is determined by only one factor, their beauty. Now, forget about beauty being in the eyes of the beholder and just think of beauty as something standardised. The return an "investor" earns from getting a wife will primarily be determined by how beautiful the woman is. Investors will then try as hard as possible, through charm and wit to get the most beautiful woman alive.

However, it won't be that straight forward. A few issues will emerge in the investors mind; how beautiful is the average girl? and importantly how many women are there per investor? If the average girl is very beautiful, and almost as beautiful as the most beautiful woman. Then the investor will infer that firstly, there are very many beautiful women in this land and secondly, he won't break his back to get the most beautiful woman. The latter stems from the fact that he will be getting a girl just as beautiful without much effort. In terms of how many women there are, this factor will determine the investor's willingness to either settle for a homely wife or strive for a very beautiful one. If the ratio of investors to women is 3:1 i.e. there are 3 investors for every woman, then investors will be more likely to settle for homely wives. (NB, just so you know, homely is a nice term for ugly). If the ratio is the other way around, then investors are likely to be more picky and will only settle for very beautiful women.

If you can understand this, then you can begin to understand monetary policy, interest rates and their effect on investments. As much as this analogy is dramatically over-simplified, to me it presents a clear way of thinking about things. If the monetary authorities increase the money supply, like the Fed did with their quantitative easing policy, then there is more money in the system (more investors), thus interest rates fall (investors are more willing to accept homely girls, remember the aforementioned ratios). Given that interest rates have fallen, the demand for alternative assets rises as investors seek higher returns. Prices for commodities, shares, real estate and other assets will rise reflecting more investor demand. In our analogy, our investors become more and more charming and seek all means possible to get beautiful wives.

Again in our analogy, the average girl ends up determining how hard these investors will work to get a beautiful woman. The average girl being the risk-free rate, you can get her without trying. Now before you invest, always consider how beautiful the average girl is. If she is very beautiful then don't bother getting the most beautiful girl. Secondly, consider how many other 'investors' there are. If there are a number of them, then you should consider upping your game, if not don't bother. Primarily though, don't risk ignoring the average girl to get the more elusive beautiful one if you are not charming enough. If you can follow these principles, then you stand a chance of being a more successful 'investor'.

Benefiting from the weak shilling

2011-05-19T10:13:00.000+03:00

In the last two posts I've talked about the balance of payments and their adverse effects on the Kenyan economy going forward if nothing is done to correct the dwindling trade balances. Note that import cover currently stands at approximately 44% i.e. the proceeds we get from selling goods and services to foreigners can only buy 44% of our imports. This is not an ideal situation, in fact it leads to heavy indebtedness.

Weakening by the hour.

Anyone who's been following the forex markets of late, with particular attention to Kenya, has been dismayed by its depreciation against all major currencies. With the dollar, the shilling has depreciated to Kshs 87.15/ dollar from Kshs 80/dollar at the start of the year. With the pound, the shilling was trading at Kshs 126/sterling pound in January, and now it has hit the 140 mark. In terms of the euro, the shilling has depreciated from Kshs 107/euro to a low of Kshs 123/euro. In percentage terms, the shilling has weakened by 8%, 12% and 14% to the dollar, pound and euro, respectively.

Some blame speculators, for hoarding on to foreign currency, thereby weakening the demand for the shilling. Others, put the blame squarely on the Central Bank's shoulders, as in the recent weeks, the CBK has been a buyer of foreign currency.

The reason that they have been buying foreign currency is due to their falling forex reserves. By law, the CBK is meant to maintain 4 months of import cover, i.e. forex reserves equal to the value of 4 months of imports. This is roughly Kshs 3.9 billion, as per their estimates. Hence, the CBK at any one time will have to have the equivalent of 3.9 billion shillings in a basket of foreign currency held in reserve. If you go back to the first paragraph, you will read that Kenya's import cover is 44%.

To make sense of all this data, the key points are simple. The balance of payments going forward will force the central bank to buy more and more foreign currency thereby weakening the shilling. A lack of sound agricultural policy will force Kenya to buy more and more maize, rice and wheat from foreigners weakening our currency. Kenya, faced with a declining export cover, will have to take on more debt from foreigners e.g. the IMF, The World Bank and Chinese lenders so as to finance our imports. The latter may initially represent itself as capital flow and thus demand for the shilling, but the debt payments that will come with it will represent demand for foreign currency, further weakening the shilling. (Notice, I haven't at all touched on the issue of fuel).

In short, my outlook on the Kenyan shilling is rather bearish. Unlike, South Africa, Zambia, Nigeria and other SSA countries, our economy is not based on commodities, therefore our currency is based on Kenya being competitive in terms of our industrial and agricultural output. I don't see these two variables improving.

What to do? If you are worried about the shilling, like I am. Then the only thing to do is to bet against it, by putting your money in financial assets denominated in foreign currencies. For example, you could buy shares or bonds denominated in the South African Rand, or even in U.S treasury securities (although, the dollar is having its own problems, given that the US has maxed out its credit card). All in all, have a portion of your wealth stored in foreign currency, rather than expose yourself to the weakening Kenyan shilling. Unless, there is a drastic change in agricultural policy, or by mere luck, the rains become more consistent and predictable, then there is little hope for the shilling.

Nonetheless, anything can happen with regards to currency movements, thereby making a mockery of my predictions. However, if the currency follows the economic fundamentals, then I am lead to believe that it will be a long shot to have a strong currency.

Capital Account

2011-05-16T11:03:00.000+03:00

In the last post, I suggested that running a current account deficit is unhealthy. Now, this is not necessarily a bad situation as some would say "the capital that is flowing into the country, will offset any negatives that arise from having a current account deficit". This means that when you sell less than you buy, the money that you borrow to finance this gap can be beneficial. In short, there a lot of intellectually dishonest economists (read IMF and the World Bank) who encourage African countries to run current account deficits and capital account surpluses.

Picture: Courtesy of The New York Times

In fact, a recently "overquoted' study by the World Bank entitled "Kenya at the Tipping Point" states that "The Overall Balance of Payments position has been positive in 2010 and the outlook remains positive" (Whatever that means) it further goes on to state that the capital account remains healthy. Economists usually use such vague terms such as "positive, healthy, medium term and outlook" when they are making false claims, or worse still, claims that they don't have any faith in. Imagine if your long-term boyfriend/girlfriend told you that their "outlook on your relationship remains positive". I'm sure you'd be puzzled.

Now that I have vented, let me get to the gist of this post. The gist is that in a country such as ours, we can only prosper in the long run if we alter our Balance of Payments and export more than we can import. Further to this, we should export more goods than we do services.

To start with, having a positive capital account is not a healthy situation to be in, especially in Kenya. A study conducted in 2007 by Rajan, Prasad and Subramanian reached the following conclusion about the effect of foreign capital in underdeveloped nations;

"Indeed an underdeveloped financial system is more likely to channel foreign capital, not to potentially-highly productive but hard to finance investments in the tradeable manufacturing sector, but to easily collateralised non-tradeable investments like real estate". They further state that "The financial underdevelopment and underdevelopment more generally, could exacerbate foreign capital's contribution to a rise in costs in the non-traded sector and the possibility of over-valuation".

These findings are clear to any Kenyan on the street, but are extremely vague to a number of foreign economists living in Kenya. Foreign capital does not find its way into productive segments such as road and rail transport, large scale agriculture and manufacturing. It will find its way into real estate and other easy to exit investments, primarily due to a poor property rights system. Consider that our capital flows are primarily aid and loans to the government, not foreign direct investments. Therefore, these loans and aid flows usually find their way into NGO offices or some lucky government bureaucrats. The NGO people will buy their foreign workers expensive houses or rent the houses at exorbitant rents; the government official will buy a plot!. The money, will not find its way into productive areas. The NGO people will write reports upon reports but will never offer anything towards tangible improvements in our welfare.

If you consider that only 14% of our road network, spanning approximately 64,000 kms is paved and that not a single rail has been added onto our railway system for close to a century, then it is clear that foreign capital is not doing its job. Further, consider a report by Mars group that found that almost 1/4 of our annual budget, heavily funded through capital flows, is unaccounted for; then any honest economist or thinker, cannot suggest that foreign capital is doing its work.

Some will talk about remittances, however, it is almost arguable that remittances are overstated due to a simple fact. As much as people living in the diaspora send money back home, people in Kenya also send money to the diaspora, primarily in the form of school fees and some pocket cash. The CBK statistics show remittances as they are, but do not consider Kenyans sending money to the diaspora to pay for fees and up-keep. If you net these two figures, then the value of remittances would fall dramatically.

Therefore, it is clear that in our case; foreign capital does more harm than it does good. What this means for Kenya is that we should direct our efforts towards enabling a current account surplus. Primarily, this will entail providing for food security and investing huge sums towards agriculture. If one considers that the agricultural sector employs close to 75% of all Kenyans, then it is the only logical thing to do. With a strong agricultural base, then agribusiness and manufacturing will then follow suit enabling an improvement in our current account. Further to this, improved food output will reduce the shocks that have become a norm in modern times enabling steady growth in the economy. In 2008, food inflation in S.Africa, a country with a significant agricultural base was only 1.4%, in Kenya it was well into double figures.

Our policy wonks should steer away from IT and finance as drivers for Kenyan growth. These two form part of the "services" account. IT, finance and Business Process Outsourcing (B.P.O) have what economists call a low multiplier effect. Only skilled employees will benefit from the growth of these sectors and thus income inequality will grow. If you look at the income distributions of India and the U.S.A, they are extremely skewed due to thriving, I.T and financial sectors. The sectors that employ the bulk of the population are not catered for (read manufacturing).

For Vision2030 to bear fruit, approximately 75% of our efforts should be steered toward agriculture. Once we have food, then other things can take care of themselves and the "Perfect Storm" that I alluded to, will be better mitigated. Lastly, improved agricultural production will lead to current account surpluses, and a better balance of payments position.

Follow up on the Perfect Storm

2011-04-27T12:34:00.000+03:00

Last week I touched on a very poignant topic, the devastation the economy is going through due to the rising fuel prices and the weakening shilling. In the post, the discussion was simply that Kenya is going through those situations where all that can go wrong does go wrong. So what really has lead to this situation, high and unmanageable inflation and worse still an unmanageable economy? My answer is simple, our Balance of Payments.

A country's balance of payments is a record of all its transactions with the world, by world I mean all the countries it transacts with. It is divided into two sections, the current or trade account that records its exports and imports, and the capital account that records any capital (money) that flows in and out of the country. With the trade account, there is a surplus when the exports exceed the imports and with the capital account, there is a surplus when the money flowing into the country exceeds the money that is flowing out. From an accounting perspective, the balance of payments should balance i.e. the trade account should offset the capital account.

Ideally, a country should export more than it imports and use the surplus to invest and build the country. If the country's exports exceed its income, then it saves, these savings if re-invested will generate even greater returns and lead to a compounding economy. The history of the world is rich with prime examples of what a country can achieve if it has trade surpluses. From the British empire to America from the 1950's to the late 1970's, to Japan from the 1980's to date and now China. These nations grew and some are still growing by creating things of value that they could sell to their trading partners so as to generate wealth, they then used whatever surpluses they got to invest in their own nation through building schools, roads, hospitals and in general social and physical infrastructure that enabled more growth.

Alternatively, a country that imports more than it exports has a trade deficit, like a family, one can only spend more than they earn if they take on debt, and thus countries that run trade deficits are often indebted nations. Since loans are flowing into the country, the nation records a capital inflow and thus runs a capital account surplus.

In Kenya's case, we have been running ever growing deficits especially since the country's economy was liberalised in the early 90's. This has been further exacerbated during the Kibaki regime, when deficits have grown out of hand. In 1994, exports financed about 74% of the imports, as of 2009, this figure had dropped to just under 44%. Competitively, we are getting weaker and weaker and as a nation, we are getting relatively poorer and poorer.

This situation leads to three dangerous outcomes; a weakening shilling, increased vulnerability to the global economy and more perversely increased indebtedness.

Given that we import more than we export, we demand more foreign currency than foreigners demand the shilling. When we have a weak shilling, then the price of important commodities like oil and wheat rise leading to soaring inflation. Due to political turmoil in the middle east and wheat shortages in Russia, the prices of both commodities have risen dramatically, however a weakening shilling has greatly exacerbated this situation. The trends in the trade deficit show that the shilling will only get weaker in the future leading to even more vulnerability in terms of our import prices and thus our inflation.

As a nation, since we are taking on more debt to finance our expenditures, we are a debtor nation. This leads to a situation where our colonialism comes about through finance rather than through military conquest. As the trade deficit gets bigger and bigger, our sovereignty gets weaker and weaker. More and more creditors can lay claim to our assets and thus dictate any direction that we take as a country. This is the crucial aspect about us running such trade deficits, the dwindling sovereignty. I laugh when the anti-ICC politicians talk of our "Sovereign Nation".

In the next post, I will talk about the effects of the capital account and the solutions to our trade deficit.

The Perfect Storm

2011-04-20T11:17:00.000+03:00

Recently, the Kenyan consumer has been experiencing what can only be called "The Perfect Storm" where everything falls into place to make a bad situation worse. General inflation has been on the rise leading to the typical Kenyan suffering from lower disposable incomes and general misery.

The Libyan crisis has lead to disruptions, albeit statistically inconsequential, in oil supply that has subsequently occasioned a huge spike in fuel prices. The annual average price of Brent Crude oil has risen from an average of $71.84 per barrel in 2009 to a current three month average of $129.61 per barrel. This is an astounding 81% rise, closer to home, the price per barrel of Murban crude oil obtained from the Abu Dhabi National Oil Corporation has rise from $78.30 in March of last year to $112.5 in March this year, a rise of 44%.

To make matters worse, the dollar exchange rate stood at an average of Kshs 76 per dollar last year compared to a high of Kshs 85 per dollar this year. This was a 12% rise, so actually fuel prices have risen by 81% + 12% to arrive at an astonishing 93% i.e. the percentage rise in fuel prices plus the percentage rise in the dollar. It is worth noting that in 2008 when fuel prices went through the roof, the dollar exchange rate was a modest Kshs 66 per dollar, this situation significantly buffered us from the rising fuel prices.

Oil is just a part of the equation, global wheat prices have risen by an average of 56% from 2009 and maize prices have risen by 70% from 2009. In addition, the country is experiencing a biting drought, made worse by the fact that the short rains that were predicted by the weatherman have not really materialised. All these factors collude to create the "perfect storm". Inflation has risen from as low as 3% last year to 9.18% as of March this year, this number is expected to rise. All in all, the consumer and eventually the country is going to have a tough year.

It is interesting to note that last year most analysts predicted GDP growth rates of 5-6% for 2011, with the important caveat of "if no shocks occur". How ironic? This year has been characterised by shock after shock. From Tunisia and the whole mid-east crisis, to Ivory Coast and significantly Japan, who literally provided a shock. It goes to show that we should not heed to much to analysts' forecasts, especially when they are based on "improving global conditions".

It can therefore be said that what we are witnessing and experiencing in the country can be pegged on "increasing commodity prices and a weakening shilling". Sadly, the powers that be have reacted in a manner akin to Marie Antoinette. When informed that the French people lacked bread; she responded by saying "Qu'ils mangent de la brioche" which translates to "let them eat cake". This showed just how detached she was from the suffering of the common man, just like the Egyptians and the Tunisians, the French also revolted leading to Napoleons' rise to rule all of France.

The actions of the finance minister Hon. Uhuru Kenyatta, when he announced that fuel taxes were to be reduced by 30% and 20% for Kerosene and Diesel respectively, were a bit of too little too late. It's like responding to a lion with a tooth pick.We need strong and lasting measures to ensure that such "perfect storms" are not witnessed again.

In the next article, I will discuss what some of those measures are, particularly dwelling on our Balance of Payments.

Who are the middle class?

2011-03-14T10:19:00.000+03:00

For too long we have been reading in the local dailies about an "expanding middle class" especially when journalists and real estate agents are trying to justify the current property boom. However, despite all this attention to the "middle class" no one has actually tried to define or even quantify them. It is important from a decision making perspective for all economic agents be it banks, real estate developers, insurers and others to have a clear picture of the "middle class" and the "poor". Given that they have target markets, they need to know their target before they can sell their products.

The issue of the "middle class" is an elusive concept and at best most definitions given are nebulous. In the U.S.A, the statistical agents describe the middle class very clinically, simply they are the ones in the middle range of income distributions. Therefore as of now, the American middle class consists of people earning roughly between $20,000 and $70,000 per annum. Mind you, these incomes would be for the "landed gentry" in Kenya. However, in Europe especially France and the United Kingdom, the term "middle class" takes on increasing complexity. Issues such as "aspiration, virtues and attitudes" come into play. The term takes on historical connotations of Marxism as terms such as Bourgeoisie are thrown around. Further to this, Patrick Hutber a sociologist says that "the middle class distinguish themselves from the class below them by their general willingness to rely on their own endeavours rather than those of the state".

Clearly the term middle class is both elusive and complex especially if you have a scientific mind. Globally, the middle class have been known to be the engines of growth, election arbiters and bastions of a nation's social values. If one crystallizes all these definitions and conceptions of the middle class, then one clearly gets a picture of the country's journalistic failures in brandishing the term middle class carelessly.

Given the American definition, one needs to get the wage distribution data. From the Kenya National Bureau of Statistics, then mathematically the middle class can be defined as anyone earning between Kshs 8,000 ($100) and Kshs 25,000 ($314) dollars per month. This translates to an earnings range of Kshs 96,000 ($1,200) and Kshs 300,000($3,750) per annum. Now from the dailies we hear that this number is growing, the truth is that it actually is. In terms of wage earnings growth, average wage earnings per employee have risen from Kshs 306,000 per year in 2004 to Kshs 384,000 per year in 2009. Further to this wage employment in absolute terms i.e. in numbers has grown by 13% from 2004 to 2009. Therefore in terms of numbers, the middle class is growing. Nevertheless, average earnings are not a good measure of true earnings because of outliers. To illustrate this, imagine a company of 10 people consisting of one boss and nine subordinates, the boss earns Kshs 2 million per month while the rest earn Kshs 10,000, the average earnings in that company are Kshs 209,000 per month. This figure is deceiving as the earnings are skewed.

From the social perspective, one really has to think clearly about this. Who are the "engines of growth, election arbiters and bastions of social values". In terms of these vague definitions of middle class, I dare to say that it is those same people earning between Kshs 8,000 and Kshs 25,000 per month who fit this description. The growth of Equity Bank, Co-operative Bank, CIC Insurance and Safaricom has been on the back of these people. Many companies have learnt the hard way that you ignore these segment of the population at your peril. Allied to this they are the election arbiters as they form the bulk of the population and thus they are also the bastions of our social values.

Now to answer the journalists, from the analysis, it's true that the middle class is growing. However the middle class they have in mind is totally different from the middle class that actually exists. The middle class they have in mind are the people who earn more than Kshs 100,000 per month, have a car and take their kids to private schools. A vision clearly influenced by western societies through the television. On the ground the middle class is in stark contrast to what they envision. The middle class will not offer the captive market for the exorbitantly priced houses in the leafy suburbs, instead, they will ensure that a developer who puts up apartments in Kikuyu, Kinoo, Kahawa Sukari and Ruiru will have a captive market for his rental income.

Analysis is extremely important from a decision making perspective and our short economic history shows that the companies and businesses who have taken time to understand the "middle class" have thrived.

Time to Save: The Savings and Development Bond

2011-02-08T17:09:00.000+03:00

If you are in the know in all matters finance, you probably are aware of the fact that the Central Bank on behalf of the Government of Kenya is inviting bids for a pioneer 30-year Savings and Development bond. This is the first of its kind in terms of time to maturity with the longest tenor currently available being a 25 year bond. To many a layman, 30 years may seem like a lifetime, but if you consider that in 1993, Walt Disney issued a 100 year bond, 30 years looks like a small blip.

Lest, I digress I want to get back to the crux of this post. I am saddened that the government has not marketed this bond as aggressively as it should have. It is a real shame, let me give a short discourse at why I am angered.

In 1941, the U.S government released the popular Series E bonds. These bonds were also known as war bonds as their main function was to bankroll the war effort. However, they dramatically had an effect on the U.S savings rate as it rose to a high of approximately 11% in the 1960's. Through then president Franklin Delano Roosevelt, the American government aggressively marketed this bonds. In fact, FDR was the first person to purchase a Series E bond. The marketing effort was so successful that Series E-bonds have come to take on an almost legendary status in American financial history. The marketing was precise and direct to the everyday Americans and the denominations at which the bonds sold at were accessible to the common citizen. The lowest denomination was 25$ and the highest being 10,000$. Incidentally the first Series E-bonds were also maturing in 30 years. Through these bonds, the government was not only able to raise money for the war, but the high savings rate laid the foundations for one of America's greatest economic periods; the 1960's to the late 1980's.

Now, the Kenyan government finds itself in the same situation as the American government did in 1941. Nevertheless, the key difference in our situation is that the government is not funding a war effort. However, the massive chasm is that G.O.K has done nothing in terms of publicity, unless I've been under a rock for the last few weeks, I have not seen any substantial T.V ad or any radio campaign urging Kenyans to buy into these bonds. If the government really intends to "boost national savings in line with their Vision 2030 campaign", I feel that they should at least try to sell the bonds to the general public.

The Savings and Development bond offers a great opportunity to save and invest. With a coupon rate of 12% paid semi-annually, an investment of 100,000Kshs would give you annual interest receipts of 12,000Kshs. This to me sounds like a good return given that it is virtually risk free. Allied to this, the fact that the secondary bond market in Kenya has vastly improved, one can sell the bond and recoup his initial investment or even at a profit. The latter is even more likely given the general direction of interest rates in the country. As most investment banks normally do, I give this bond a strong BUY recommendation.

Now that I have extolled it's virtues, the question then becomes; How can I buy one. Well, it is simple. First you need a CDSC (Central Depository and Settlement Corporation) account, this enables you to invest in financial assets such as bonds and stocks at the Nairobi Stock Exchange. To help you in this regard, the Central Bank has appointed five banks namely; Kenya Commercial Bank, National Bank, Equity Bank, Co-Operative Bank and the Kenya Post Office Savings Bank to be their agents. Therefore you can visit any of these banks and ask to open a CDS account. Once you have opened one, the banks will assist you with placing bids and therefore purchasing the bonds. Bids start with 50,000Kshs with denominations of 50,000Kshs upwards. Therefore you can not buy a bond for say 60,000Kshs. The banks will guide you as to how you will make the purchases and how you will receive the coupon payments.

My opinion is that this opportunity is extremely rare. Investors will be getting a guaranteed 12% annual payment and security of principal. Instead of speculating in real estate, the cautious investor should think hard about this chance. With investors still hurting from the bear market that started in 2008 and the illiquidity, risk and speculation witnessed in the real estate market, this bond is a genuine catch. I've done my little bit to advertise it and your comments and questions are welcome.

Is Safaricom toast?

2011-01-24T01:27:00.003+03:00

In the little town of "Denial" there was a company called "Denial Meat Company". This company sold the greatest and best priced steaks in town and had generated an almost religious following amongst the townspeople of Denial. They topped off the steaks with sumptuous servings of Ugali and Kachumbari albeit in small portions. The company was so loved and adored that the people of Denial all bought into the company by means of a public offer. The offer was organised by the brilliant manager of DMC Mr. Hope. A year into their purchase of DMC shares, the townspeople of Denial were given a welcome surprise. The little company next door that offered roast meat was bought by a group of foreign investors who were in the roast meat business. Dismayed by the success of DMC, the foreign investors vowed to tear apart DMC's dominance. They did this by drastically reducing the price of roast meat. The prices were so low, that on warm Denial afternoons, the little children of Denial could be spotted carrying bucketfuls of roast meat purchased with their menial savings. It was an oddity for all the Denial men.

Shocked by the growing influence of this once oblivious roast meat company, the shareholders of DMC organised a meeting with Mr. Hope in the town hall. The key agenda being the next door roast meat company. One shareholder stood up and shouted "Mr. Hope, how will we react to this travesty, all the people of Denial are rushing to the other company to buy roast meat". Mr. Hope stood up, and with unrelenting confidence, he said "not to worry esteemed shareholders, we have a plan" he went on "we will simply increase our servings of Kachumbari and Ugali so as to create value for our customers". Dismayed, the shareholders stared back at Mr. Hope. "You mean we can maintain profitability by increasing our investment in Kachumbari and Ugali preparation?". "Yes" Mr. Hope replied gleefully, "we will simply diversify our product offering to cater for all you Kachumbari lovers". Some shareholders were utterly annoyed by this statement, they headed for the exits of the town hall, each having sold his/her share. They could not imagine the once famous Denial Meat Company now offering Kachumbari and Ugali as it's main product. Some shareholders saw the wisdom of Mr. Hope and continued holding the shares, hoping that one day, DMC would be just as profitable if not more by offering Kachumbari and Ugali.

The above story may sound a tad bit familiar, although the moral of the story is given in the heading of the article.

Bharti Airtel last year introduced what can only be referred to as oligopolistic suicide in the telecomms sector with its entry. The telephony industry works in an oligopolistic structure, what this means is that there are few firms in the industry selling a similar product. Furthermore, the industry has extremely high barriers to entry for any prospective firm. One has to install the physical infrastructure and the organisational infrastructure necessary to run a telecoms company. Given this structure, the only way for firms to gain or increase market share is to lower their prices. If they don't take this route, then the only other way is to collude via a cartel or price fixing. OPEC is the best example of such collusion. However, given that most countries have very strong anti-collusion legislation this avenue is usually shut off. Thus price remains the only weapon in the oligopolists arsenal. However, this weapon is often a double edged sword. Reducing prices may increase the number of your customers, but it will ultimately lead to lower profit margins.

Something must be in place to ensure that you maintain healthy profits.

Surely the abnormal profit margins of close to 60% enjoyed by Safaricom are not those expected of an oligopolist given the preceding discourse on market structures. Well, Safaricom has had an extra weapon that its competitors have lacked. A system that doesn't allow for number portability and M-Pesa. Will these two Knights save Safaricom from the beast from the east. The answer is a simple no. The CCK will from March allow for number portability within the industry, this will enable you to have a 0722 number even though you are an Airtel subscriber. This then means that all those people who didn't want to change to Airtel because they had to change their numbers, will have no reason not to switch to Airtel. The second issue of M-Pesa then seems to be the only Knight in shining armour for Safaricom doesn't it? Well, this could be a fleeting assumption. Tangaza a local company advertised in the newspapers that they have just introduced a service that allows for Money Transfer across all networks, this means that a Safaricom subscriber can send money to an Airtel subscriber. The success of this new initiative is still in the dock, but if successful, then M-Pesa will have no claim to Knighthood for Safaricom.

The future is bleak for Safaricom shareholders, the entrenchment of price wars in an Oligopolistic market structure, the impending introduction of number portability and the introduction of a "universal" money transfer system "tangaza" has shifted the ground for Safaricom. Investment banks heavily dependent on the success of the Safaricom share, will suggest that venturing into Data and internet will provide a cushion against the fall in voice revenue. However, they are like Mr. Hope of Denial. Suggesting that a once great Meat company can generate as much if not more profit by offering Kachumbari and Ugali in stead of meat. This are of course my views, however facts are facts.

A great number of untouchable companies in this industry have fallen at one swoop, AT&T and AOL being prime examples. In a dynamic industry such as the telecommunications industry, dominance and success are far from being granted. Currently, the people shouting at the roof tops as to the greatness and unbridled dominance of Safaricom are like a girl who's just had her heart broken. She goes through the letters, pictures and gifts that her former lover gave her and clings onto the hope that he will come back. Even though her ex is now married with three healthy children to her best friend.

Individual Brilliance but Group Mediocrity

2011-01-14T13:36:00.001+03:00

Could Insurance industry's future profit levels be the same as each fans visibility?

When each person watching a football game decides to stand up to get a better view, the end results are usually disastrous. Everyone stands up and his view is made worse by the tall guy sitting right in front of him. What he thought was a brilliant individual move turned out to be collectively dumb. Could this same scenario be at play in Kenya's insurance industry?.

To this discussion, I would urge anyone who does not have an understanding of the insurance industry to read a previous post on the economics of the insurance industry. However, the recent developments have lead me to worry about it's future profitability.

Just yesterday, Resolution Health announced the sale of a 25% stake in the company to German Private Equity firm African Development Corporation (ADC). The sale left Resolution Health with Kshs 187 million that it will use for its expansion into East Africa. This bodes well for Corporate Kenya's image and for Resolution Health as good management is now being rewarded with deep pocketed investments that enable growth.

Nevertheless, I am slightly concerned by this trend in the insurance industry. Resolution Health has joined a list of other insurers that have recently raised capital for non-regulatory purposes. AAR last year raised 750 million from selling a 20% stake to a Private Equity firm from Netherlands. CIC insurance last year also raised capital and in fact doubled its capital base to 1.2 billion shillings from 600 million shillings. Old Mutual is seeking to raise 700 million shillings and Real Insurance is also seeking to raise a sum in that region.

My last blog post on insurance mentioned two things that work to malign the insurance industry. A commodity product and excess capacity. A commodity product simply means that people's insurance choices are mostly defined by price rather than any unique product specifications. Although this works more in general rather than health insurance. The second issue of excess capacity stems from the fact that insurers simply produce more by either raising capital or a willing underwriter. In this case the former will inevitably lead to the latter.

All the aforementioned organisations are making brilliant financial decisions if viewed from individual analysis. However, they could be making very unwise decisions if viewed from an industry perspective. The increased capital of approximately 3 billion shillings will lead to lower priced premiums and probably lower returns on capital.

The reason I avoid the use of the word profit is because Corporate managers tend to hide behind the implicit nuances that exist within that word. Profit should not be analysed from an absolute perspective but rather a relative perspective. Let's say a company earns 400 million shillings from a capital base of 2 billion and then decides to double its capital to 4 billion. It is expected to earn a profit of 800 million shillings assuming similar management techniques, the owners of that company have not improved performance even though they have injected more capital. The same could play out in Kenya, even though this time the profits are not going to increase proportionately to the capital. In fact they will increase by a lower factor than the capital.

I am adamant about this point simply because the current insurance penetration ratio of 2.5% is more of a demand constraint rather than a supply constraint. If you increase supply (add capacity) via raising more capital, then you will have more money chasing the same demand. Increased supply in the face of static demand equals bad economics. In the Capitalistic society that we live in, the insurers are faced with two options; either follow the route that leads to hell or the road that leads to death either way try and make a smart choice. They can either stick to the maxims of good economics and maintain their current capacities and lose market share or increase capacity and be less profitable. I wouldn't want to be the one making that choice.

Why newspapers can get away with below par editorials, writing and content

2011-01-11T11:40:00.004+03:00

Here is a passage from the 1984 Berkshire Hathaway Chairman's letter. You will find it very pertinent. It should answer all the complaints that many twitterati and others have about the editorial content of our local dailies.

The economics of newspapers are excellent, amongst the very best in the world. Owners, naturally, would like to believe that their wonderful profitability is achieved only because they unfailingly turn out a wonderful product. That comfortable theory wilts before an uncomfortable fact. While first class newspapers make excellent profits, the profits of third-rate papers are as good or better - as long as either class of paper is dominant within its community. Of course product quality may have been crucial to the paper in achieving dominance. We believe this was the case at the news (Buffalo Evening News - owned by Berkshire Hathaway), in very large part because of people such as Alfred Kirchhofer who preceded us.

Once dominant, the newspaper itself, not the marketplace determines just how good or how bad the paper will be. Good or bad, it will prosper. That is not true of most businesses: inferior quality generally produces inferior economics, but even a poor newspaper is a bargain to most citizens simply because of its "bulletin board" value. Other things being equal, a poor product will not achieve quite the level of readership achieved by a first class product. A poor product, however, will still remain essential to most citizens, and what commands their attention will command the attention of advertisers.

Since high standards are not imposed by the marketplace, management must impose its own.

In a nutshell, local newspapers can continue with their wrong grammar, inaccurate representations of facts, poor insight and analysis simply because it doesn't affect their economics.

Random Observation for 2011 and Beyond

2011-01-05T11:42:00.000+03:00

"He will be successful who directs his actions according to the spirit of the time. He whose actions do not accord with the time will not be successful"

Niccolo Machiavelli - The Prince

If we could just marinate on this quote by Italian author, playwright and diplomat Niccolo Machiavelli. His book "The Prince" was and still is a very relevant book on power and politics. His approach was one based on pragmatism and realism and avoided the intellectual idealism of the Scottish Enlightenment thinkers such as Locke and Hume. His message was that people are driven by an end and do whatever it takes to get to power and hang on to it. Success in this case can be regarded as being similar to power.

In the Kenyan situation, it is clear that the above quote is proving very relevant and useful. The recent arrest of former Industrialisation minister Henry Kosgey is the prime example. The aforementioned minister still stuck to his ways of blatant theft and disregard for procedure as minister of Industrialisation. He did this as if he was still in the Nyayo era of information assymetry that led to government looting on a massive scale, not realising that the information assymetry has been dramatically reduced through a new media, a brave and aggressive media at that. He failed to take heed to to the "time" and could pay for it.

What this means for 2011 and beyond for any Kenyan manager, politician and most importantly, aspiring businessman is simple. Take heed to the time, at a time when the KACC has very large and sharp teeth, the judicial process urged on the the ICC case is being reformed and the media is aggressive and cunning in its reporting, theft may not cut it anymore like before.

The success standards of the new "time" will be based on shrewdness, skill and business guile. This is the new dispensation for 2011 and beyond.

Thanks to mobigyaan.com

Other Random observations;

Is Safaricoms share price undervalued or overvalued, financial analysis approves of the latter, but business analysis agrees with the former. A company that comes up with new ideas on a constant basis and accounts for 95% of all internet subscriptions. Could it be that the market has not accounted for the "goodwill" and "intellectual assets" that Safaricom possesses?.
If Uhuru Kenyatta and William Ruto are summoned by the ICC and have their assets frozen, what will the impact be on property prices and the NSE if any?.
Is KCPE a useless exam? I reckon it is. The Kenyan education system is generating droves of graduates and workers who cannot express themselves verbally, have a culture of submission and cowardice to their superiors and lack "thinking skills". Any other blogger would have finished that sentence with "critical thinking skills". However, if you are thinking you have to be critical.
Could the above point also lead to the income differentials in the job market as only outliers do well in the job market, with the average university graduate not being able to command a decent salary?.
Are we going to see a correction in the property market this year or next year? Rental prices are already plateauing.
Are the 2929 and 6969 lotteries legal or even "right". Wouldn't any participant in a lottery like to know how exactly the numbers are generated and thus be able to calculate his odds of winning?. I know I would, how exactly do these lotteries work.

Happy reading and happy new year. I look forward to sharing these insights with the world and wish you all the best for the new year.

FCK

Insurance it's all in the management

2010-12-20T13:17:00.000+03:00

These are interesting times to be a Kenyan, although the times are unrelated to this post, it is still a very interesting time to be a Kenyan. With the ICC, wikileaks and KACC boss PLO Lumumba all with harmonic unison attacking the establishment. It is going to be an interesting two years up till the general election in 2012. For me, one key thing that could be a game changer is the ICC summons. If summons to the six people mentioned in the list are issued, then the ICC has the right to freeze the accounts of the six suspects, this could have interesting effects on Kenya's stock market and real estate industry in large. It will be an interesting event to follow and I will be waiting with both cautious optimism and a tinge of reservation over the next year.

My post today is about insurance. Insurance in essence is the business of hedging risk i.e.transferring risk from the 1st and 2nd parties of a transaction the third party. What this means with an example is in the case of motor insurance, if an accident occurs, the risk of covering the costs of that accident is transferred from e.g the drivers of both cars involved in the accident to an insurance company. However, this transfer of risk is not free as the person who takes out the policy has to pay premiums regularly as stipulated in the insurance contract, the premium can be paid weekly, monthly or even yearly. Furthermore, the insurer has to cede some of those earned premiums to a re-insurer who is the insurance companies insurer.

When the premiums are paid up front to the insurer, the insurer has the advantage of having a lump sum of money without any immediate expenses in the form of claims from the policyholders. Insurers are usually required by regulators to keep some funds to cover claims, the amount is calculated by actuaries who determine the probability of incurring claims and their costs. With the rest of the cash, usually called a float, the insurers invest it in bonds, stocks, real estate, treasury bills and any other fathomable investment given the country they are in. They then reap investment income. In a nutshell insurance companies earn premiums, cede some of those premiums to re-insurers, pay out claims and earn investment income from their float.

However, for someone keen to invest in an insurance company and for the country's welfare in general, it is important to understand the economics of the insurance industry, more so the insurance industry in Kenya. For this some micro-economic concepts would be fitting. To this we turn to "The Sage of Omaha" Warren Buffett in his 1982 letter to his shareholders. Where he characterises the insurance industry in two terms "excess capacity" and a commodity product".

Excess Capacity means that the industry has over-supply, i.e. the industry can produce much more than the demand requires. If a manufacturer of batteries for example has a factory that produces 200,000 lithium iron batteries per year, whereas demand stands at 150,000 batteries. Then there is excess capacity of 50,000 lithium iron batteries. How does this happen with insurers, one may ask?. Well with insurers, excess capacity lies in the underwriters pen. His willingness to underwrite policies. Excess capacity also lies with the insurers ability to raise more capital. However, the former occurs much more frequently than the latter. Underwriters are usually very eager to underwrite policies and earn premiums

The second issue is a "commodity product" or like most economists would say a "homogenous" product. Think of Sugar, when you're sitted at Dormans or Java and would like a bowl of sugar to sweeten your latte, you seldom will ask for a bowl of mumias sugar, you just ask for sugar. There are no defining characteristics that single out a particular kind of sugar from another. Sugar is a commodity product, all sugar producers are producing the same thing and therefore all of them have to by way of marketing, emphasise the uniqueness of their products. All "commodity product" producers have to keep advertising to remind us of the novelty of their product, take Kenyan examples such as crown paints, Safaricom, Zain and most banks who are constantly buying up media space to advertise their goods. The key thing though, is that with commodity products competition is done with price and this is scary for insurers.

The two factors lead to the insurance industry shaping up to be a monopolistic competitive industry. Where a commodity product and excess capacity bring up both price competition and thin margins. What happens now in the insurance industry is that insurers will scamper to lower premiums and incur heavy marketing costs so as to remain competitive. The danger of low premiums is that they often do not cover both the firms expenses and the claims incurred. The combined ratio is a ratio used in the insurance to gauge operational efficiency. It can be calculated as the sum of operational expenses and claims incurred divided by the net earned premiums. A ratio below 100% is healthy whereas one above 100% is very unhealthy. A ratio of 98% shows that the insurer is covering both operational expenses and claims incurred and getting a 2% profit. A ratio of 105% shows that the claims and expenses incurred exceed the premiums earned by 5% and therefore the insurer has to earn an investment income of above 5% to earn a profit.

In Kenya, the industry combined ratio as calculated from the Association of Kenyan Insurers data shows that the combined ratio from 2005 - 2009 are 126.72%, 131.28%, 124.71%, 118.37% and 121.66%. These figures are well above the 100% threshold and are a gauge of mismanagement of the firms. One may question these figures, they were arrived at by dividing (total operating expenses + net claims incurred)/ net premiums earned. The net in this case is adjusting for re-insurance earned and ceded. This further means that insurers have to earn high investment incomes and as the last two years showed, this is risky business given the uncertainty of Kenya's economic and political climate.

What this means is that the overall insurance picture is not at all pretty. Fraudulent claims, over eager underwriters and price competition are all conspiring to weaken our insurance industry. Regulators are constantly changing the rules so as to ensure a better insurance climate, but the cancer still remains.Some of the Kimunya laws such as increasing the capital requirements could help and will take time to produce results. In the mean time, I would urge regulators to take stronger measures to regulate premiums, even if it means reducing competition, as the insurance industry has the capacity to bring the entire financial system to its knees, case in point AIG and the global financial meltdown of 2008. From an investors perspective, invest in insurance companies that have sound underwriting principles and are well managed. At the end of the day, given the adverse nature of the insurance industry's market structure, management is the main competitive edge for Kenyan insurers. Key note, avoid investing in insurers that are heavily exposed to Motor Commercial insurance and WIBA (Workers Injury Benefits Act), both of these are usually very volatile from year to year and are subject to a great deal of fraud.

Family Owned Business

2010-12-07T11:33:00.001+03:00

I have to apologise to the followers of this blog for the long absence. It has been a hectic month filled with traveling and completing my undergraduate studies. I am back in Kenya and enjoying it so far.

Just the other day I was attending an informal interview at a local investment bank, as I waited for the interviewers at the reception, I picked up a copy of "The African Investor". In it, I read an article about family businesses' and their great appeal to Private Equity. The article can be found here is a very interesting read especially the part where the Kenyatta's are given as an admirable example with Uhuru Kenyatta citing his net worth as being approximately 10 billion dollars. If this is the case, then Uhuru could have personally financed the 2009 budget by himself. However, I doubt the figures.

The article raises an important issue, more so about the state of family business ownership and succession issues especially amongst native Kenyans. This is an issue that needs immense research given that most businesses estimated at around 81% of the businesses in developing countries are family owned. With so much of national wealth and livelihoods dependent on the existence and success of these businesses. Kenyans need to be sensitised on this matter. Some of the key issues are;

Succession. It is important to have succession policies or plans in place. Replacing legendary managers such as Warren Buffett of Berskshire Hathaway or Walt Disney of Disney Inc is usually a very tough challenge, it is made worse when the incumbents are caught up in a cult of personality where as Prof Jeffrey Sonnenfeld of Yale University states "They develop such a heroic persona and there is so much legend and myth-making that their identity becomes one with the job: they feel threatened that somebody could come along to erode that persona". However, given prudent planning both by the current business leaders and preferably by a third party should lead to smooth succession. A number of Asian owned businesses in Kenya are having intergenerational problems due to conflicting aspirations with the latter generation often opting to pursue different interest other than the family business. Right now, this issue is offering ripe pickings for investors in Kenya. In true African style, myths exist that succession planning will lead to the death of the founders, such thinking really curtails any planning and often leads to the demise of the business. In S.Africa it has been found that only 25% of family businesses make it to the 2nd generation and only 10% make it to the third generation.
Separating ownership from management. In the early phases of the business, it is often the case that the owner will control all key decisions and functions of the organisation. However, as the business grows, it will get more complex. At this stage, it is advisable for the owners to appoint capable managers who will be more qualified to handle the complex business functions. It is often the case in Kenya that owners will still want to retain control of the business functions such as the accounts, logistics, marketing and others more often than not leading to the demise of the business. There are plenty examples of this, with a prominent Stock Broking firm being the main example.
The other issue is remuneration, with owner managers, there is a tendency for many to use the company as a personal bank account. This is one of the biggest factors that ensure that most family owned businesses never reach the second generation. Remuneration structures are needed so that the business survives. It is advisable and good business practice to pay the family member what the market value of that job is worth. However, in different countries tax considerations come into play that will also affect remuneration.

In a nutshell, it is worth mentioning that before the industrial revolution, there were family businesses, before Wall Steet, there were family businesses and if there is anything certain about our uncertain business environment is that there will be family businesses in the future. Their existence and success is crucial for the economy. Why would you care if you do not and will never have a family business, well, this exposes the great gap that needs to be filled in Kenya's financial circles. The need for dedicated business units in banks, investment firms and asset management firms that will focus solely on family business advice and research. Germany, England and South Africa are well ahead of the curve, it's about time that we got in on the act.

Real Estate. Really? Analysing demand

2010-10-27T04:34:00.001+03:00

The real estate market in Kenya right now, can be said to be booming and booming hard. It was expected that the PEV would put a damper in the growth of this sector but it has proved resilient and come back even harder. Many companies have dedicated new units of their current businesses to focus specifically on real estate, amongst them are CFC Stanbic holdings, NSSF, Liberty Life and Centum. Mega real estate projects have been rolled out and are being rolled out such as Tatu by Reneissance Capital and Thika Greens by Thika Greens Ltd. Such projects are the stuff of ambition, boldness and confidence.

Some of the reasons given by analysts in the real estate sector are that;

Kenya currently has a supply gap of over 200,000 housing units per year as demand annually exceeds supply.
"Capital gains and availability of refinancing options in the home loans market is helping young people reap the value of their initial investments" - Business Daily article.
An emerging middle class that will provide a consistent base of housing demand for the next coming years.
Allied to this is the fact that there is a youth bulge i.e. bulk of the population is aged between 15-24. Potential future home owners.
The property market has over the last 10 years outperformed the stock market in terms of returns.
Government spending on infrastructure will increase value of property.

Allied to this, Analyst at Mavuno Capital Robert Bunyi commented to me that given that Kenyan corporates are small and badly managed, real estate is the best alternative. Furthermore, the fact that only 6% of Kenyans own their homes, only 14,000 mortgages are issued (CBK data) and that Kenya may be seeing average growth rates of 5-6% over the medium term, the real estate market is the place to be over the next 10-20 years.

However, of all these, the most outstanding statement that could form the basis of this article and the ensuing analysis is that "the majority of real estate investors have been buying houses with a view to selling or letting them at higher prices akin to share trading". SHARE TRADING!!!!.

Having given a snapshot of the situation, I guess my two cents comes in here. In any beginner economics class, demand will be defined as the not only the willingness to purchase a good or service but more importantly the ability. A house is a place in which you live in, a source of shelter. Therefore, majority of end-users if I could call them that, are people who are willing and able to buy a house to live in. Does Kenya then, have this demand. The answer to this is a simple NO. Most of the analysis done in local dailies about real estate, have often quoted demand as the people who are in need of shelter rather than the people who are able and willing to buy shelter.

I have blogged before about the distorted civil service pay in which median level employees only earn 1/52 of what top level employees earn. If we assume a ministers salary to be one million shillings (approx $12,500) per month, then that puts the median civil servant salary at approx Kshs 19,500 ($250) per month. From a blogpost by local blogger bankelele, the average monthly mortgage payment for house that is selling for 10 million Kshs (approx $125,000) would be approximately Kshs, 131,447 ($1,643) more than 6 times what the median civil servant earns. How is he expected to pay for such a house.

Given that the private sector pays considerably more, it is still folly to assume that the median employee, can afford a 10 million Kshs house. Which is very modest by Kenyan real estate standards. That price would get you a maisonette in areas such as Lang'ata, BuruBuru and South B. Whereas with the same cash, one can buy a house in a high class suburb in South Africa.

Many other statistics point to the fact that there is minimal demand for houses from potential homeowners (end-users). Such as;

Only 3.6% of Kenyans own computers. (Poverty).
The main sources of incomes for adults in Kenya are, 20% family and friends, 18% food crops and around 10-12% retail businesses, kiosks and shops in toi, Gikomba and the stalls in Nairobi. (Poverty).
32.7% of Kenyans are excluded from finanial access both formal and informal.
51.8% of Kenyans get money for daily usage through internal remittances.
60% of the youth's main income source is from transfers.
Kenya has a gross saving rate of 10%, compared to Ghana with approximately 26%.
And interestingly there are only 15 passenger cars per 1,000 people compared to 108 in S.Africa.

These stats may seem unnecessary but they point to the fact that Kenya is a poor country with weak financial systems that cannot provide the demand for such housing projects.

Creepy parallels can be drawn between what we are witnessing and what recently happened in the U.S.A and other developed countries in terms of real estate. With banks falling over each other to lend to real estate investors, investors treating houses as if they are tradeable stocks, more speculators than home-buyers in the real estate market and ambitious real estate projects. I hate to be a wet blanket, but I would venture to say that if the current trend goes unchecked, these investors will realise that there is no real demand for such houses and stop speculating. This will lead to a dramatic downward correction of housing prices and eventually an inventory overhang in the real estate market. One of my favourite quotes in fiction comes from Thomas Hardy's "Far from the Maddening Crowd" in which he writes that "blandishments and glitter are the female's folly", the current housing market and all the blandishments and glitter could be the investor's folly. Just because stocks and other businesses are underperforming doesn't mean that real estate is a good venture. It is not the better of the two evils.

Opinions?

Would Women Make Better Investors?

2010-10-05T01:15:00.000+03:00

Just a random blog post. However, before I go further, I would like to thank each and every reader of this blog, it is just over a year since I started blogging and thanks for all the support. It has been a real adventure and I sincerely would like to thank each and every reader of this blog.

Today's post is inspired by an arduous process that every man has to go through in his life, the process of going into a shopping mall with someone of the opposite gender. The dreaded F word (Female). The last few years, I have been put through miles and miles of floor space on malls in two continents and women from all walks of life. Despite their differences, one similarity they have is their approach to shopping. When a man wants a tie from a store, the shopping experience will be pretty straighforward. Get into the mall, walk straight to the tie shop or shop most likely to be selling ties and get a tie. Simple, in fact according to my friend, the bulk of the time spent in the mall will be on finding a proper parking space.

For women on the other hand, it is quite different. Women are much more meticulous. For long, I wondered why they walk aimlessly around malls until it hit me, almost as if it was an epiphany. Women are not just walking aimlessly, they are just making sure that they have exhausted their options. A woman will visit all outlets in a mall that sell clothes and shoes, for some they can even give the global coordinates for a particular section of Truworths. Through her constant visits and prying eyes, she constantly makes judgements on price and quality. Many people say that women are too expensive or sometimes they are just cheap while they shop for bargains. I would like to differ on this, most women are neither cheap nor expensive, they just know how to decide on whether to splurge or go frugal. It is almost a quality/price ratio adjustment that they make in their brains. Once they do this, they will most likely go and sit in a corner coffee shop or juice bar and as they chat about, they will simultaneously decide on what they will buy in the second and last phase of their shopping.

Given that they have decided on their quality/price ratio's they then go with their budgets and shop on whatever it is that they wanted. That is if your frown has not persuaded them to give up on shopping. I must add that I am a pretty good frowner and often convince the opposite sex that the shopping is not worth my wrath. The whole process ensures that the woman leaves the store with little or no post-purchase regret. A warm smile then ensues as she walks out of the mall.

You see it is these qualities that lead me to think that if women took to finance the same way they take to shopping, they would by far be the wealthiest people on earth. The same process is useful. With a fixed or variable float (their budget), they would scour the world of stocks and with their mental arithmetic, they would regularly be making value based decisions on the stocks. Like an investor making price/earning ratio calculations mentally, they then add in other factors like how well would this stock fit in with my portfolio, would it be complimentary or not. We have all had women talk about how they don't have anything that can go with these shoes. The value bit comes in as Warren Buffett is often quoted as saying that "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price" what this means is that value is more important than price. Women understand the value of clothes, that is why they wouldn't blink while buying a 2,000 USD Louis Vuitton bag and at the same time haggle for dollar sandles. If most could adjust this orientation of value towards companies, then they would go far. After the analysis and the shopping, they understand that thay have purchased something good and are happy with it.

For the man on the other hand, although it saves you time. If you spent an extra 10 minutes, you may have noticed a similar shop that sells much better ties at half the price. However, in a nutshell. I am simply saying that women are built with the qualities of a good investor, every woman has a Warren Buffett in her, they simply use it in malls rather than in stock markets.

Of Nigerian Pastors and Single Women

2010-09-22T12:52:00.000+03:00

Recently, there has been a lot of drama about the Nigerian Pastor who was in Kenya to give a "talk" to single women about their marital prospects, or lack thereof. To me, it's crazy that a country's fourth estate should stop all other forms of news reporting and concentrate on the Nigerian pastor and his drones of minions. However, it seems to be that marriage is an important component of the society and even the economy. I will try and analyse it as simply as I can, without delving too much into the economics of it.

The first issue I should raise is that, despite the population figures coming out and proving that indeed there is a 1:1 ratio of men and women, the figures can be deceiving. My main qualm is that the figures don't take into account the prison population. There are more men in jail than there are women and as such this could affect the 1:1 ratio of men and women. However, given that Kenya doesn't have a prison-industrial complex like the USA, this should not greatly affect the gender balance.

The second issue is that, the women who throned KICC to hear from Pastor Ojigbani were working women and they seemed to be financially independent, as are a number of women in today's Kenyan society. This is my main point, the young women who were on average in their late twenties, haven't yet analysed their situation and here is where I step in. If the figures are balanced as the media suggests that they are, then every single woman is balanced out by a single man. If there are x single women in their twenties, then there will be x single men in their 20's. Therefore the solitude doesn't affect women only, it's just that it suits men better as they can "enjoy" life as singles more than women.

The women in Kenya should realise that their roles in society have changed. It is not like before where their mothers got married young and took care of them and their siblings. These days women are undertaking tertiary and post graduate studies and are focusing on their work, as is to be expected in a cosmopolitan city like Nairobi. They should then realise that they won't marry as young as their mothers did and in fact they are likely to remain unmarried into their late twenties and early thirties. A number of my friends have whined to me about the fact that they are single and "need" to find a husband, while they are just in their early thirties. The fact is that women will get married later into their lives as school and work take more of their time, especially given the fact that we live in a world of the contraceptive pill.

I guess for the point to hit home, I should refer to "Sex and the City", the quintessential chic flick, which was a syndicated series. The women, Samantha, Charlotte, Miranda and Carrie grapple with their careers and being single women in New York. Through booze-filled nights out in the town, ice cream sleep overs, shopping sprees in the city and a whole load of tears, they slowly discover themselves. Through their self discovery, they then find ways of making their work lives and their love lives work for them. It is a journey. Only later on in their early thirties do most of them get married, mind you Samantha stays single, but it's her choice. Who says in the third sequel (Lord, I pray that it doesn't happen), she won't get married?. However, in a nutshell, my point is that times have changed and as such our approaches to marriage should change. Women can't blame men for living in pre-historic times as is apparent from their expectations of a wife, whereas it is even more apparent through the Pastor Ojigbani incident that they are the ones living in pre-historic times by being so desperate to get hitched.

It should be noted that there is an element of comparative advantage when people are deciding to get married. Given that marriage is a union of two, then it can be analysed in the same way as bilateral trade. The theory of comparative advantage simply states that people should focus on what they are more good (and I don't mean better) at and get what they need through trade. An example is fitting, lets say a lawyer hires a secretary with paralegal training. The lawyer can type faster than the secretary but is by far more skillful in law than the secretary. The theory of comparative advantage states that even though he is a better typist, he should focus on what is much better at and that is law while the secretary does the typing. In the same way, both men and women should focus on doing what they are more suited to and trade it for what they need. I am not implying any specific roles as they will differ from one couple to another, however it is one way of looking at the union of marriage, besides love.

However, before I digress further, it should be observed that the typical Nairobi woman will have to make a trade off, either get married young and give up her career, concentrate fully on her career and never get married or go the Carrie, Miranda and Charlotte way, find a way for both to work together. The third course of action will take time, and as such women will get married in their late twenties and early thirties. Therefore the women should just relax and let it be, they will become Mrs. Somebody someday.

Signing off, I am just reminding you that from tomorrow, the blog resumes it's normal economic and financial analysis.

Moving on up? Or not

2010-09-14T00:41:00.001+03:00

The Jeffersons, the poster family of intergenerational mobility

There are a number of issues, that I feel Kenyans need to have articulated to them in a tangible and understandable manner. It is often the case that a great number of useful articles in economics are in the language of econometrics which is just Greek to most. A language where instead of calling an equation 'simple' they call it 'parsimonious'. I hope to be able to read through these articles and journals and share some of the important findings that they present.

My former econometrics professor Prof Nair once told me that if you can't measure it, you're just guessing, and I totally agree, if public policy is in question. I therefore try not to argue if I don't have the facts. The issue in question is one of intergenerational mobility. What this means is that does your parents education and prestige have an effect on your education and thus prestige?. Does the Kenyan dream exist, where one does what the Jeffersons did in the 70's and 80's, moved from their humble beginnings to the East side?.It is an important question to discuss. In a good society, there should be high levels of intergenerational mobility as people move on up, regardless of their background. So having defined it? how can we analyse it? To this we turn to what I would call Kenya's Chicago School. The University of Gothenburg, the training ground of Kenya's current Central Bank governor. If anyone is in doubt of his abilities and knowledge, I would request them to relax because I don't think there is anyone else in Kenya with such a deep understanding of Kenya's economy.

The Chicago School for Kenyan economists

However, back to the analysis, University of Gothenburg economist Anthony Wambugu, carried out a study in 2000, in which he surveyed 200 Kenyan manufacturing firms from Nairobi, Mombasa, Nakuru and Eldoret and around 800 of their employees. In the study he asked them about how far they went in terms of their schooling, their wage rate, their parents education, proximity to their school (when they were schooling) and years of tenure in that company. His aim was to find out if parents education and therefore by proxy family background had an effect on an individuals wages. Through sound but complex techniques he came up with findings that are against intergenerational mobility.

Firstly he found out that the higher the parents level of education, the more the years of education one is expected to complete. It is worth noting that a fathers level of education had more of an effect than a mothers level of education. Secondly, Mr. Wambugu found that an extra year of education post primary generated a 21% rise in income. To cap this statistics, it was also observed that a person who attended secondary school was likely to have a wage that is 67% higher than a person who did not. The effects of tertiary education are not explicitly stated, however in another paper, Mr. Wambugu finds that attending university had the biggest effect on distorting wage inequality. Therefore it is clear that a parents level of education has a clear effect on the number of years of education that a person completes. It is also clear that there are differences in the number of years of education and the wage rate that one is likely to receive.


Higher education leads to higher wages

The third issue is one directly related to a parents level of education and his/her child's earnings. The study found that when parent's level of education is controlled for i.e. held constant, the returns to education would fall by about 22%. Therefore, a parents level of education is likely to increase your returns to education by about 22%. However, the effect of family background goes beyond education. 40% of the workers sampled were found to have found their jobs through their family contacts. Thus the family effect also plays a hand in terms of contacts and connections.The wage differential due to parents education can be explained in a number of ways. The first reason is that higher education would lead to higher wages and therefore the parents can provide a more suitable environment from which to learn and grow. Secondly, a more prestigious background reduces job search costs, what this means is that a job seeker can have extended periods of unemployment as he has the luxury of waiting for the best job offer. Someone of a worse off background would have to take the first job that comes. The third reason is that the parents can sponsor the child to attain tertiary education and thus improve his/her wage prospects.

In conclusion, the effects of your parents education and by extension their wealth has a material effect on your level of education and by extension your earnings. Higher parents education leads to higher personal education and thus higher earnings. To augment these findings, in a 2002 essay Anthony Wambugu found that education reduced the chances of a persons employment in the agricultural and informal sectors, both notorious for their meager wages. For Kenya, there is thus very little intergenerational mobility as your parents education heavily affects your life prospects. Poverty is therefore a recurring theme across generations and it is very hard to make it out. There are of course, some exceptions but they are just exceptions and not the norm. In terms of public policy, Kenya has already taken a step in terms of free primary education, but as the article suggests the real differences come in terms of post primary and post secondary education. These two tiers are both marred in under enrolment and there is where the most effort needs to be put. Moving on up is therefore more of a dream, the Kenyan dream doesn't exist.

Time to cut the flowers

2010-09-08T12:37:00.001+03:00

A recent article in the East African got me thinking about the flower industry in Kenya. In the article, the chairman of the Kenya Flower Council (KFC) hmmm... Mr. Erastus Mureithi was agonising over the lack of "sector specific incentives" for the Kenyan flower industry, given the discomforting rise in the Ethiopian flower industry. In the article, Mr. Mureithi wants special economic zones with their own special tax treatments and incentives to be set up akin to the Export Processing Zones (EPZ's) that the textile industry benefits from.

I beg to differ on his position, in my humble opinion. The Kenyan flower industry should have the tag "helping unfaithful European men since 1960". What I mean is that the Kenyan flower industry is a good example of our outward looking national psyche. In terms of value addition to the local economy, it is not as significant as they would like you to think. Of course, people in the flower business will suggest that horticulture is one of Kenya's largest single foreign currency earner, however despite that, earning foreign currency is an over hyped statistic in my view. Foreign currency earning is hard to analyse from a welfare perspective, what the KFC should be quoting are the mutliplier effects of their industries and the factor returns to labour and capital. Furthermore, I will want to highlight the effects of import substitution against export substitution in regards to the flower industry.

Data from Kenya Institute of Public Policy Research and Analysis (KIPPRA), suggests that horticulture doesn't measure up to dairy farming as well as beef and poultry farming in regards to the multiplier effect. The multiplier effect measures the effect of a unit increase in the production of one good on the production of other goods, for example if radio production has a multiplier of 4.5, then the production of a radio helps increase productivity in other sectors by a factor of 4.5. This then means that production of a good with a high production multiplier is beneficial since it improves welfare by a higher proportion. From their studies, a unit increase in dairy farming produces a 4.01 increase in production from other sectors, for beef and poultry the multiplier is 3.83 and 3.91 respectively. Horticulture falls behind with 3.70. In terms of the added effect of consumption, the multipliers for dairy farming, beef, poultry and horticulture are 8.44, 7.95,8.86 and 8.46 to be exact. The consumption effect for horticulture therefore is higher than that for beef and dairy production. However, since we are more interested in production rather than consumption, it is clear to see that the government if they are to provide "sector specific incentives" should focus more on livestock than horticulture.

To take the analysis further, one should further analyse the sector given the factor returns to both capital and labour, and for labour we subdivide this into rural and urban labour. A product given our economy would be more beneficial if it had higher returns to labour especially rural labour than higher returns to capital. A higher return to capital shows that only the wealthy capital owners benefit from its production. Given that Kenya is a poor country, higher returns to rural labour are preferred as this will help alleviate poverty. From the Kippra data, horticulture production has higher returns for capital vis a vis livestock production. Furthermore, the labour returns are higher for urban labour rather than rural labour. In terms of livestock production, the return is higher for rural unskilled labour. This then means that livestock production is more beneficial in terms of poverty alleviation as compared to horticulture.

The last issue is one to do with trade economics. The Ethiopian government seems to be more than willing to pump tax payers money to boost their flower industry. If this is the case, then why shouldn't Kenyan flower lovers piggy back on the Ethiopian governments benevolence?. My view is that we should let flower farming be an Ethiopian venture. What Mr. Mureithi is suggesting is what is known as import substitution i.e. setting up trade barriers to replace cheaper imports with local products. By setting up government incentives for local producers, we are locking out cheaper flowers from Ethiopia with more expensive Kenyan flowers. Import substitution is not a good policy. What we should focus on is export substitution, the same policy that has seen the Asian Tiger economies roar as loud as they have over these last couple of decades. The Kenyan government should direct their efforts at developing local industries e.g. manufacturing and Jua Kali so as to increase their exports. This has proven to be a more successful strategy given that international competition demands that we increase our efficiency in production.

In conclusion, we should not spend a dime of tax payer money helping out the flower industry. That would be a waste of resources, if anyone wants to buy flowers, import them from Ethiopia.

How Feasible is Vision 2030

2010-08-23T03:07:00.000+03:00

First of all, I want to wish everyone a great week ahead and if you can, you should attend the Signing of the new constitution ceremony on August the 27th. It is a shame that I cannot attend it. However, having passed the referendum and celebrated in pomp and fanfare as the newspapers suggest, the honeymoon period should end as soon as possible as the daunting task of rebuilding our country lies ahead of us. Luckily we already have a masterplan in the name of Vision 2030.

The Vision 2030 masterplan was drawn up in the middle part of this decade by the National Economic and Social Council of Kenya lead by Dr. Wahome Gakuru and the other directors at the NESC. It is a long term vision aimed at turning Kenya into a middle income country by 2030. It seeks to achieve this through cross-sector reform and targeting key growth sectors such as I.T, Agriculture and Manufacturing that will help drive this vision. The Vision has been adapted by the current government and will likely given the nature of its popularity, be adopted by future governments. In terms of the key vision, turning Kenya into a middle income country is the main objective. However, such objectives as increasing the literacy rate, improving health care provision and improving our national infrastructure are amongst a raft of other metrics that the Vision will seek to improve.

However, how feasible is this plan? Some friends have called me unpatriotic due to my questioning of the feasibility of this program. I don't agree with the term patriotism, how can one be proud of something that he didn't have any control over. I did not choose to be a Kenyan, I am happy to be one but since I had nothing to do with it, I can't be proud of it. It is like being proud of winning a coin toss. I am backed up by Albert Einstein in his assertion that " Heroism on command, senseless violence and all the loathsome nonsense that goes by the name of patriotism, how I passionately hate them". Having said this, I just want to give my views on how becoming a middle income country by 2030 is a tough task and nearly impossible given the variables that Kenya has to deal with.

A definition of what a middle income country is would be a good start. A middle income country is classified into two categories; first is a lower middle income country and second is an upper middle income country. This is according to the World Bank. The lower middle income country category consists of countries whose GDP per capita ranges from $946 to $3,946 and an upper middle income country ranges from $3,946 to $12, 195. Kenya is seeking to be an upper middle income country by 2030 i.e. get a GDP per capita of 3,946 to 12,195 dollars. For the sake of simplicity, we will analyse the situation by using $3,946 as the bulls eye.

Doubts over Feasibility

Now to why I am doubtful of this Vision. Kenya currently stands at a GDP per capita of roughly $468.70. This puts us in the lower income category of countries. Our aim is to improve to around $3,946 per capita. The NESC estimate that we will need annualised growth of 10% from 2006 onwards to reach this target. However two factors present will require us to reestimate this growth rate. Firstly; four years have passed since then and we haven't touched double digit growth rates, 2007 saw 7.1%, 2008 was 1.55%, 2009 saw 2.59% and IMF projections state that in 2010 the growth rate will be 4%. The second factor is the implicit and yet wrong assumption that global growth will be zero during this 20 year horizon. The issue is that, since GDP per capita is a relative measure then $3,946 in 2010 is not going to be the same in 2030. What this means is that since the world will record GDP growth then the income categories for different countries will change. This means that the figures will have to be revised upwards in view of Global growth. In lay man terms, if everyone gets rich then the definition of a poor man in monetary terms will have to be revised upwards.

To make the analysis simple, let us take a conservative scenario where global growth over the next twenty years is 3.5%, this is a conservative but yet slightly plausible scenario given the uncertain nature of our global environment. If the rate is 3.5% then the definition of a middle income country assuming equity of growth should then be a country whose GDP per capita ranges from $7,851 to $24,265. Now to make the analysis simpler, let us stick to $7,851. We will now have 20 years to move our GDP/Capita from $468.70 to $7,851 dollars in twenty years. Mind you 20 years is a very short time. Again, as Einstein would say "I never think of the future, it comes soon enough". Now this would leave us with two choices if we want to hit the bulls eye of upper middle income country by 2030. Either we could restructure our economy so as to hit 15.11% annual growth rates or kill off all our newborn babies so that we can avoid population growth. The latter is not acceptable so we are left with the former. A daunting challenge if ever there was one.

Leading us into the future are the sons of former President and Vice President

The challenge is made worse by the fact that our major trading partners in the West e.g United Kingdom and the United States are facing uncertain futures. It is made worse by the fact that the UK is implementing tough budget cuts that will see the British consumer cut down on discretionary spending e.g flowers. Furthermore, Uganda having discovered oil may well see us suffer as it is our largest single trading partner. Allied to these challenges is the fact that the Kenyan manufacturing sector according to the IMF as well has fallen from contributing 40% GDP in the 1960s to only 26%. All factors bar the signing in of a new constitution will work against us. I am not yet sold to the thought of the new constitution being a panacea to all our woes. I just read an article in the Daily Nation that suggests that Hon. Uhuru Kenyatta will be the running mate to Hon. Raila Odinga in the 2012 presidential elections. Given this and many other combinations for the top two, the dynastic nature of our political landscape leaves us with very few reformers who can genuinely tackle the issue of political, social and economic reform that will see us achieve 15.11% growth and therefore the Nirvana that is Vision 2030. I am not a patriot however, a prosperous Kenya is a situation that I would want and hope for.

Finanial Reform: Time to sink or swim

2010-08-13T02:51:00.002+03:00

I would like to begin by congratulating Kenya on passing the draft constitution through the referendum held on the 4^th of August. It’s a landmark moment for the country and everyone associated with Kenya. I hope it heralds an era of prosperity to the country, I did a piece a long time ago about my thoughts on the draft, but I decided not to comment this year on the draft. The reason being, there was a great deal being said about the likely economic repercussions of passing the draft, I did not want to add to the confusion. Secondly, most people making predictions did not have any quantitative backing to their predictions, to me this was just guesswork and haphazard akin to saying that lightning causes thunder.

As the heading says, this piece will focus on financial reform and ways to improve our financial sector. Through the passing of the constitution as well as some geopolitical changes that are happening around us, Kenya is at the epicentre of immense change. The change is so severe and maybe Kenyans haven’t taken the time to think about it. The new constitution will change our governance structures from the grassroots all the way to the top. Uganda discovered oil and are now about to realize its economic potential, Sudan will hold a referendum regarding the independence of the South and we are now part of the East African common market.

So much is happening and nobody has bothered to communicate this to Kenyans. You may ask what the significance of Uganda exploiting the new oil reserves will mean for Kenya. Well for starters, Uganda accounts for roughly 21.4% of our exports, the bulk of which is oil. For them pumping their own oil will mean that our exports will suffer. South Sudan achieving independence will mean that they will need access to the Sea, this means that Kenya has to open up the North Eastern transport corridor as well as the port in Lamu. The devolved governance structures will bring in a whole set of complications in terms of each county having the mandate to finance its own projects, this will usher in a new wave of changes in our financial systems and our banks will be only so eager. In a nutshell, the next few years will see a very huge change in our economic structure and it will be worthwhile for our policy makers to share with us their plans on achieving the vision 2030 given the dynamics of the next few years.

Having said this, I need to get to the crux of the issue; Financial reform. In this year's budget speech, the Finance Minister Hon. Uhuru Kenyatta mentioned financial reform with the usual mention of Demutualisation of the Bourse. Past that, the rest was just talk about our medium term goals, I guess this is why some times economic lingo makes economists look funny. Looking into the middle distance is never a sign of strategic direction, it's more of a sign of being dazed and confused.

However, getting back to the matter at hand, given the changes that are happening there is more to be done to convert this country into a genuine financial hub. The subsequent surge in commodity demand that will result from our neighbours improved economic fortunes would be well taken advantage of by having a robust commodities exchange platform. This will only happen through a stronger and better coordinated regulatory mechanism from the East African Community. Allied to this, there will need to be coordination in terms of building warehousing facilities for the commodities exchange. Well how would a commodities exchange platform work. In simple terms, a commodities exchange is just like a stock market but instead of trading shares, people trade commodities i.e. Steel, grain, iron and oil. This would improve price discovery and also stabilise prices. This should be augmented by a futures trading platform from which people would trade in commodity futures. Again, how does this work. Well a futures contract just gives the bearer of the contract the right but not the obligation to buy or sell an agreed upon quantity of a commodity at a given future date for an agreed upon price.

I had posted about price controls, well for me this could be the only feasible long term solution to erratic food prices. Having a commodity exchange and by extension a futures trading platform would ease our inflationary pressures arising from food. There would be opposition to this from misinformed middle men and politicians and they may say that a few smart individuals running our financial capitals may distort food prices. However, it wouldn't make sense as this distortions would not last too long, in finance and economics stuff generally reverts to its average. The futures exchange should also be extended for currency futures as a great deal of trade would happen with western nations and to hedge against currency risk, a local currency futures trading platform would be helpful.

To deal with the effect that the devolved governance structures, there will be a great deal of work to be done in regards to strengthening the regulation of our investment banks and stock brokers. In the near future, Kenya may well be treated to the novelty of Municipal bonds, these are bonds sold by local municipalities to finance local projects, drainage, education and the likes. Investment banks and Stock brokers will have to undertake the fiduciary responsibility via regulation of informing their investors as to the risks associated with each of these bonds. I foresee situations of borrowed money being siphoned by corrupt officials thus weakening the abilities of the municipalities to repay the coupons on time. There will need to be stronger regulation from the local government ministry, the treasury as well as the Capital Markets Authority on local borrowing from the counties.

I feel that Kenya has the human capital to furnish this new demand for skilled officials, it is worth noting that Kenya is well known for producing exceptional econometricians and mathematicians as well. In fact the current Central Bank governor Prof Njuguna is a well know econometrics professor. The government should focus part of the Vision 2030 program into turning Kenya into a financial hub and this will only happen through real reform.

CRB's and you...

2010-07-14T21:21:00.000+03:00

The Central Bank just recently rolled out the new Credit Reference Bureaus in an effort to spur both financial inclusion and the economy in general. I guess if you improve financial inclusion, you will improve the economy, that goes without saying. Well what are CRB's? this post is dedicated to young Kenyans as it will have the largest effect on them. CRB's are credit information sharing organisations. Their mandate is to basically collect all information through the respective banks of a borrowers payment patterns and regularity. They then build a shared database (shared between the banks) of each borrower so that banks can get a better picture of the borrowers creditworthiness. It's a thing that should have been implemented a long time ago but well, better late than never.

It's important that the Central Bank are doing this. First of all it will help households borrow more, in the past only large companies have been able to borrow at favourable rates as they can hire finance professionals to project future income and thus paint a good picture of their creditworthiness. Well now, borrowers will be directly responsible for their own financial lives. It is a bit like student life, in high school, if you were well behaved and studied hard, then your transcript and recommendation letters will bear witness to your endeavours. The high school will then share this information with any prospective universities and the university will look favourably at the good students. The two institutions share information so as to make better enrolment decisions and the onus falls on the student to work hard and be diligent so as to get to a good university.

Currently there are issues with the implementation of the CRB's as the CRB's will only share data on non-performing loans (i.e. defaulting on loans). Analysts suggest that good information should also be shared and not only the bad info. Before we get carried away, we should note that as good an innovation as this is, it will not be a panacea to our banking problems. In fact the benefits will take a long while to be felt for most as many will still need a long enough time to develop a good track record.

However, the gist of this post is simple. As a bulk of the country is below 40 years of age, this generation will now be directly responsible for their financial lives. Just like students are responsible for getting into a good university, we are responsible for ensuring that we live responsibly with our finances. This generation should avoid loans for stuff that they don't need, borrow for worthwhile projects rather than mere indulgence as this will all come back to haunt you. Soon, many of us will have a credit score, it will be your responsibility to make it as high as possible to avoid financial ruin.

I think the basic principle behind finance in general is to allocate capital to its most efficient use. Most people have to save for a whole year just to buy a car, well it doesn't have to be that way in finance. If you have a cash flow i.e. a regular salary, the bank can lay claim to your cash flow and thus lend you the money. However without decent information as per your approach to credit, they face great risk by just lending you the cash. Now, CRB's will help more people lay claim to their future cash flows (salaries, wages, rents) to be able to borrow money and improve their lives. Just remember that this will only happen if you are a diligent borrower.

Note to the Kenyan readers of this blog, take your credit seriously and by all means avoid default from now on.

Income Statistics and MP salaries

2010-07-06T19:03:00.000+03:00

Today as I read the Daily Nation (A Kenyan newspaper), the front page headline news was about the MP salaries. It was a piece that tried to explain to Kenyans the severity of the situation in terms of how much of a burden the MP's salaries will be to the treasury, as well as comparing average incomes to the MP's salaries. According to the article, currently MP's earn 79 times the average income in the country and this will rise to 113 times the average income in the country. This is shocking I guess, but I feel that the article has missed an important point. The Daily Nation as well as the Central Bureau of statistics forget that it is statistically incorrect to use average incomes in decision making.

I hope you don't mind a short lesson in statistics. I want you to think back to your high school or even elementary maths where you would, given a sample of numbers, be asked to calculate the average, median and mode of that sample of numbers. The average would include adding the numbers up and dividing them by the number of numbers, getting the mode would be found by getting the figure that appears the most times and getting the median would be found by arranging the numbers in ascending or descending order and finding the figure that appears in the middle. Income statistics are meant to be analysed through the median rather than the mean, the reason is simple. The outlier effect, imagine 20 earners, the bottom 10 all earn 50,000 per month, the following 5 earn 75,000, the following four earn 90,000 while the top earns 600,000. The average income from this sample of earners is 91,750 per month. Is this really representative of the sample? no it isn't it is highly skewed to the person who earns 600,000. The best thing to do if one is to analyse the sample of earners is to take their median income which would be 62,500 per month. This number is more representative of the sample even though it heavily discounts the huge earner.

The Daily Nation article should therefore focus on median salaries instead of average incomes especially due to the severity of Kenya's income inequality that would lead to massive outlier effects. However, I do empathise with them as median income statistics are almost impossible to find in Kenya. I lay the blame squarely on the Central Bureau of Statistics. However before I digress, my point is that the discrepancies would be much more alarming had the article used median incomes rather than average incomes. This extends to house prices to income statistics and other ratio's that measure standards and costs of living. The issue is important as decision making is compromised if people use the wrong statistics as they either get a false sense of security or alarm.

Nightmare Trip to the Airport

2010-07-03T11:20:00.001+03:00

A chilly Friday afternoon, cloud cover, temperature around 16 degrees centigrade and a calm atmosphere around the neighbourhood, today's assignment it to pick the subject from the Airport at 16:30 hours. As simple an assignment as there can be. Due to my prudence, I arrange for a cab to pick me at 15:00 hours, well in advance due to the nature of Nairobi Traffic. I expect to get to the airport latest 15:45 hours. Mind you, the distance from the house to the airport is around 22.5 Kms. Fast forward 10 minutes later, I find myself past Westlands round about and just outside some buildings that are being constructed, if I am not wrong, it is the new headquarters for Standard Chartered Bank. The car comes to a standstill, drivers get out of their cars and start having animated conversations amongst each other as we wait for the gridlock to unlock and for cars to move freely again. As it always happens, we in the middle part of the jam hear that it is the president who is keeping us here, yep, we are waiting for his motorcade to pass. It will be a good 25 minutes before traffic starts moving freely again. 25 minutes is a lifetime to remain in one spot, no movement just stuck in one spot. Finally the cars move again and surely we arrive at the airport late around 16:05 hours. Luckily the flight has been delayed and will arrive at 16:30 hours, it is coincidentally delayed due to a V.I.P's flight having to take off.

Surely at around 16:40, the subject gets out into the departure lounge, I am surprised that the subject managed to negotiate Kenyan immigration in such a short time. We get into the cab with the next stop being the subject's destination and home. However, the subject makes a change to the plan, the subjects wants to pass through Westgate Mall to do some banking as the banks there close late. Sure enough, the change of plans should not worry us much, it will just be a short detour. Flash forward 3 hours and we finally make it to Westgate Mall, yep it took us 3 hours to travel from Jomo Kenyatta International Airport to our intermediate destination Westgate Mall. Luckily we manage to convince the guard that we were delayed by traffic and they let the subject do his/her banking. Forward 35 minutes later and we reach the subjects final destination. A good 5 hours and 35 minutes covering a record distance of 45-48 kilometers in total.

It would be good to understand why I went on talking about my journey to and from the airport. The thing is, it is so sad that the taxi driver had to cancel so many clients and lose out on so much money due to his business environment. When you hear this term "business environment" on T.V as a layman, I want you to remember my story. The story of spending 5 hours in traffic to cover a distance that anywhere else in the world would be covered in 20 minutes. This is what should be thought of as Kenya's business environment. When a trucker can only make 3 rounds a week rather than say 6 rounds, it is because of our business environment, when a local flower delivery shop can only make 2 deliveries per day rather than 7 or 8 it is because of this business environment. When tourists leave Kenya with nightmarish memories and dwindling tourist numbers do not seem to correspond with the vast sums that the Tourist Board are spending on their marketing campaigns, the business environment is to blame. It is criminal that a government whose ministers are currently concerned with raising their salaries, can get away with letting their businessmen and civilians suffer due to a mismanaged transport infrastructure.

I am sometimes a bigger picture thinker, or at least I would like to think of myself as one. Yesterday clearly highlighted the bigger picture in terms of the steps that need to be taken to make Kenya work. The unfortunate cab guy lost at least 4 hours of factor productivity. How many does the average Kenyan lose in a day?

Price Controls???

2010-06-30T19:10:00.000+03:00

I just got back home from half a year in Malaysia, experiencing Asia and continuing my studies. While I was there I had read about Parliament introducing a Price Control Bill to "shelter" the little man from the vagaries of the excesses of Capitalism. Since getting back, there seems to be no real honest opinion being given about the Price Control issue to the public through the media. The only sound opinion being given has been on Business Daily and we all know that the average person doesn't read that publication. Furthermore, the opinion piece despite being well written was long and I know most people who do not have an understanding of the implications of price controls, will find it beyond their scope.

So a discussion of this issue is pertinent. Price controls are usually set below the market clearing price. This market clearing price is the price that equates demand and supply, this is simple economics and should be pretty straightforward. The main reason that price controls are set is because some basic goods or goods that the authorities deem to be necessities, have market clearing prices well beyond the reach of some people who would need the product. They are usually very useful in the sporting world e.g. World Cup tickets, if the ticket prices were left to the forces of demand and supply, a great deal of S.Africans would miss the games because the market clearing prices would be well above what the current prices are. However the dynamics of sporting events are not the same as those for the food market, because firstly food is not a one off event, people have to eat all the time. Furthermore, the supply of world cup tickets is fixed, there are a limited number of games and seats whereas populations grow and mouths to feed usually grow with time.

The key issue for me is that the implementation of price controls firstly; will not achieve its objectives and secondly will be detrimental to the future of this country. To begin with, the reason prices of basic foodstuffs is such an important issue, is because in this country, erratic weather patterns have played a nasty hand in the supply side of the food equation, this has often lead to large swings in food prices, with the swings being upward more often than not. Recently this has become really obvious, the country suffered from severe droughts in 2008 and this lead to the maize shortage and subsequently the maize scandal. This was followed by periods last year where there were such surpluses in the agricultural sector that we saw milk being poured down drains, this clearly caused a huge uproar. The issue then is not with the price but with the supply, when supply situations are good, we see relatively good prices but when the supply is scarce we see the obnoxious prices that we witnessed in 2008.

Price controls will not deal with this instability, they will not take away the volatility of food availability, they will in fact exacerbate the food volatility. With price controls, apart from the political upheavals that will follow naturally from having government offices deciding on food prices, we are likely to see a situation like that in China during the Great Leap Forward, when the price is too low, farmers will not bother to farm because they are not going to earn anything from their efforts, when the prices are high relatively to the costs, the farmers will over supply. This volatility then won't have gone away it will just move from price volatility to supply volatility.

The second issue is to do with innovation, without ready and predictable markets for agricultural commodities, we are not going to create any incentive for scientists and farmers to come up with new crop breeds, new fertilisers and other innovations that will assist in eradicating food insecurity. Price controls will really mess up the food landscape. If people think that the situation is bad right now, they will be in for a shock once the price controls are implemented. The market most of the times makes much better choices than government bureaucrats ever can. The solution to this issue will be addressed on an upcoming blog post.

The Church: Reform Blockers

2010-05-04T10:44:00.003+03:00

It's nearly 41 years ago to the day, Malaysia witnessed a landmark event in its history. The event is known as the May the 13th Incident or the Sino-Malay Sectarian violence of Kuala Lumpur. Malaysia after getting its independence in 1963, Kenyans keep note of that year, saw increasing economic inequality between the Chinese and the indigenous Malay people. The newly formed Malaysia included Malaya (the Malaysian Peninsular), Singapore, North Borneo and Sarawak. However in 1964, race riots brought about by the perceived inequality between the wealthy Chinese and the poorer Malay. Most Malay were angered by the fact that the government was willing to look the other side placating Chinese interests at the expense of the indigenous Malay. These issues persisted up till the elections of 1969.

In the run up to the elections, there was a great deal of racial rhetoric being fanned by the political parties. The elections saw the Alliance party gain majority in the national parliament. This was all well and good but the key thing was that there was a tie with the Democratic Action Party that was predominantly Chinese for control over the State Legislature for Selangor. Selangor is the richest province in Malaysia. The DAP in a sense claimed victory and on 12th May arranged a procession through Kuala Lumpur to celebrate. The rowdy processions went well up till the point where the procession path diverted into Kampung Baru, a predominantly Malay area. The Chinese while passing through this area were carrying brooms in a sense suggesting that they would sweep the Malay off the face of Malaysia. This invariably stirred the existing tensions. On May 13th individual incidents between the two races lead to an all out race war. Many deaths were reported and a State of emergency was called by the government. The National Operations Council intervened to run the country and it is worth mentioning that Parliament didn't intervene till 1971.

The government that took over from here saw that they could no longer placate Chinese interest at the expense of the Malays and they responded by implementing affirmative action policies that were referred to as the New Economic Policy (NEP) of 1969. Some saw this measure to be draconian as it further entrenched very strong Malay priviledges into the constitution. Years on the affirmative action measures have failed to bear any tangible benefits for the Malay as the inequality still exists. It is so bad that the national statisitcs office does not release official income statistics due to their sensitivity. This has lead to the government lead by the prime minister Najib Razak unveiling a New Economic Model.

What has this got to do with Kenya, you may ask yourself. Well, if the similarities are not yet apparent yet, you may need to look at recent events in Kenya. The Post-election violence would be a good place to start. You see, regardless of the efficacy of the steps that Malaysia took after 1969 to reduce economic tensions, the fact is that they responded to a crisis and averted the break down of a Nation. The social cohesion present in the country has lead to the country being a middle income country and it is now planning to be a developed country by 2020. 10 years earlier than 2030 where we plan on being a middle income nation. The Malaysian authorities can be credited for responding rather than just sweeping their issues under the carpet.

In Kenya, we face the similar situation. We have the choice of staying on the current path and facing similar tensions in 2012 or we have the chance at least to take the monumental leap and create a new constitution. However, there is a great deal of noise over this process and as each day passes the chances of getting a new contitution gets slimmer and slimmer as the noise gets louder and louder.

I am really angered by the Church's position on both the Kadhi courts and the abortion debate. They completely lack perspective and someone can serioulsy question their collective memory and compassion for the country. In terms of Kadhi courts, I really don't get how for people who begin their National anthem by 'Oh God of all creation" can refer to the kadhi situation as something that will favour Islam over Christianity. Clearly the anthem already shows a national acceptance of biblical creationism and yet the church conveniently overlooks this fact when arguing against the kadhi courts issue. On the note of abortion, the constitution clearly states that abortion would only be legal, if a medical practitioner deems it to be necessary if the mothers life is in danger. I really don't understand what is wrong with this, would they rather a wife, sister, mother or daughter lose their life in order to uphold biblical teachings? If their relatives were in the same situation, would they rather lose their relatives and maybe also lose the child just to uphold the bible?.

For me the church for too long has gotten away with spiritual blackmail to further their ends. They use this same blackmail to get concessions with their schools, universities, construction permits and so on. It is a sense of "if you deny us this, then curses be upon you". I think it is about time for common sense to prevail and a utilitarian sense of doing for the greater good prevail. Let us learn like the Malaysians did and not drive our country into deep problems. The difference between progress and stagnation is adapting and learning rather than sweeping stuff under the carpet. The new constitution is our chance to adapt and learn and hopefully undo a sense of perceived inequalities. We should not look back and regret that we had a chance to change but we didn't.

Volcanoes, Economics and Avatars

2010-04-21T05:39:00.000+03:00

Recently the world has been treated to the constant images of stranded air travelers in Europe and around the world. Closer to home, we've seen flowers being unpacked and discarded because they can't get to the European markets. All this has happened due to the impossible to pronounce Icelandic volcano whose ashes have been spewing for days. The standstill in global and more devastatingly European transport has lead to a huge bill for travelers, airlines and all the related industries. I am sure Pep Guardiola the Barcelona coach would vouch for this as his team had to travel all the way to Milan from Catalunya by bus, this clearly had an effect on his team's performances. However this is besides the point. The air travel regulatory authorities grounded all the transport due to safety concerns. On the other hand we had the airlines claiming that it could be safe to travel.

The difference between the two in my case boils down to two different approaches to scientific learning. The regulatory authorities were using computer models based on historic data to simulate what would happen if a plane was to come into contact with the ash. From a scientific perspective, it is worth mentioning that volcanic ash is in essence microscopic glass. Therefore if it would come into contact with a jet engine, it would melt immediately. As one would deduce, it would then solidify in the engine leading to pure catastrophe. Hails storms are bad enough, imagine boeing storms across continental Europe.

On the other side of the scientific argument were airlines who posited that they should undertake test flights so as to ascertain the real level of danger posed by the ash clouds. This was an old fashioned approach to science, where observation of real time data would lead to a clear conclusion. The pragmatist in me rooted for the latter approach. The IATA C.E.O. Mr. Giovanni Bisignani was a big advocate of this approach. Luckily some flights have been approved and slowly the world is travelling again.

So where does the economics and finance come in. After studying economics in depth, after sleepless nights trying to not fail advanced econometrics exams, after days in the library reading on stock covariances and correlations, I am of the opinion that it is all misplaced. I struggle to find the practical and real application of most of this issues in real life. It makes me think of the saying "If you give a man a hammer, everything to him looks like a nail". One could seriously make the argument that economists are more interested in applying their knowledge in calculus when studying the maximisation of consumer surplus, than they are in really understanding consumer surplus. A lot of the models have failed miserably in the past and even more so during the last global crisis. Modelling human behaviour is simply impossible and predicting it is even harder. However, economists have made this their life aim. From a statistical perspective, when so many models have failed, we should conclude that we should drop the models, just like statisticians drop variables that are not significant.

On the side of finance, it would take a really strong discussion for me to get the point. Warren Buffet always says that an investor should read annual reports and attend AGM's rather than study formula's with Greek alphabet terms. One example of the irrelevance is when CFA professors teach the Optimal Portfolio Theory. For a better understanding of my opposition to this you can send me an email, but the concept is way beyond lay man understanding. However, it basically makes unrealistic assumptions and even makes more unrealistic conclusions to develop a model that should eventually make money. No wonder the world is up against wall street. Maths should not be used to generate formula's so as to make money. If the Long Term Capital Management crisis of 1998 hasn't taught us anything then nothing will.

I guess where I am getting at is that too much energy is spent on the wrong things, defeating the essence of economics where we should maximise utility. In my view, the curriculisation (new word) of a branch of knowledge has lead to its deterioration. Let's make these two branches of knowledge more practical rather than more theoretical. Theory should be a precursor to knowledge rather than the knowledge itself. Knowledge and observation are the roots of the tree of theory, however nowadays finance and economics theories are like the mountains in avatar, they just float supported by nothing much. We should take the approach of the airlines and not the regulatory authorities.

Looking east? Think twice

2010-04-12T19:09:00.001+03:00

I am sure all the readers of this blog probably know that I am currently in Malaysia. It has been great to come to the far east albeit just for a few months and see a different side of this earth. However, it has also been a great eye opener in terms of my economic thinking.

Most economic articles that chronicle or critique Africa's slow pace when it comes to economic development, often draw parallels with the East Asian tiger economies. These are Malaysia, Singapore, Thailand, Indonesia and so on. In all honesty, readers of this blog will realise that I have also joined in the foray and given the parallels.

These parallels are pertinent in that the East Asian economies started their growth from the same level as the African one's did. They are therefore good candidates for comparative analysis as one can see where we African's went wrong. We can analyse why our tourism numbers are so low given similar or sometimes even better tourism sites, we can analyse why our macro economic environments are so unstable, why our business costs are so high, why we do not have running water and many other factors. It is true that most of the tiger economies are in a far better position that we are in all of these measures.

The Eastwards mentality is becoming so entrenched in our minds, especially when the gains of western style capitalism haven't spread out to everyone. Trickle down economics has not worked, maybe our canopies are too thick and thus the rain hits the canopy, sticks there and later evaporates so as to condense elsewhere. It could be said that this eastward mentality is just another form of anti-capitalism (socialism), in just the same vain as tree hugging is. I have some friends from Zimbabwe who are such staunch supporters of their governments plans to look eastwards when it comes to development, that they can even get violent when one questions the rationale behind it. They often point out to western imperialist designs as to plausible reasons as to why we should favour the east. However as Shakespeare wrote "a rose by any other name would still smell as sweet". The east and especially China is just as imperialist as the West is, maybe just that they are honest about it. However, before I digress this was not the point of the post.

My concerns are that the admiration towards East Asian economies could be misplaced. The socio-political environment here in Malaysia and in most of the surrounding countries would simply not work in any African country. There is a very patronising and paternalistic approach from government towards their citizens. The people are like drones who shall neither speak out nor think for themselves. "Why should they, we give them all they want", seems to be the approach from the leaders. They stay mostly locked up in the government state (Putrajaya in the case of Malaysia) and looked towards like some all knowing demigods. The level of conformity is at times almost tangible. When watching TV a lot of the content is controlled, there are no satirical comedies both in print and visual media that poke fun at the governments. After all that we as Kenyans have fought for in terms of democracy and freedom of speech. So much so that a generation has grown up with people like Gado, Redykyulass and the late Wahome Mutahi who often ridiculed powerful figures in government, are we ready to give it all up, all in the name of looking east?

As my deceased intellectual mentor and role model Milton Friedman (yes, I do set myself lofty standards) would say; "the biggest downfall of the intellectuals is that they undermine the intellect of the common man". The fact is that a self sustaining capitalist and democratic society, in my view and as is attested by history should allow people to pursue their own happiness. In any means possible so long as they do not infringe on their neighbours rights. This is pure speculation, however, the Tiananmen Square crisis of the late 80's according to most historians arose due to the new found wealth of the Chinese that needed expression through increased personal freedoms. This is amongst the many historical examples that underpin the argument that freedom and wealth go hand in hand. In a previous blogpost, I start off with a quote from Adam Smith that also argues about freedom and wealth. Our aim then as a country and generally as a continent is to find a growth formula that starts off with a liberal political base. As hard as this may be, it is the only option. Looking east will mean that we give up a great deal of our basic freedoms, a situation that is untenable in both the short run and the long run.

My F1 adventure

2010-04-05T16:21:00.001+03:00

So I got a chance to tick one thing off my bucket list and I must say it was one hell of an experience. Here are pics from the trip to Sepang International Circuit: Enjoy

The unfortunate case of Makmende

2010-03-29T09:45:00.000+03:00

I am a tad bit late on commenting on Makmende, the current hero of Kenyan internet. He has in record time become a hero and a celebrity not only in Kenya but across the world. All thanks go to Jim Chuchu and Mbithi Masya who are the masterminds behind this project. His acclaim has even gotten as far as the Wall Street Journal in a blog written by Cassandra Vinograd. I am sure that even if the creators of Makmende were extremely confident in their abilities, they wouldn't have even in their wildest dreams, imagined that Makmende would be this big. Their Youtube video above has been watched over 53 thousand times and their group on Facebook has over 30 thousand fans. On Facebook the cult status embodied in Makmende has been made grown with jokes such as "Makmende is the only one who calls Orange customer care and asks for Oranges", "Billie Jean is Makmende's lover" and one of my favourties "Makmende speaks in CAPITAL LETTERS".

I was a big follower of this group up till some shrewd or shameless people started posting their blogs and websites and using Makmende's name in I dare say vain. Therein I saw that if ever there was a perfect example of what I have been waffling about in the Future Capital Series, this was it. As if it had been designed in a Petri dish just for this purpose.

I am sure that Mr Masya and Mr. Chuchu have gotten rights to Makmende and all that is embodied in him. If not then they should. Image rights and all. However, as I have been saying all along, there lacks a well functioning "Property rights" mechanism to protect their hard worked for intellectual rights as the owners of "Makmende". T-shirts, Jerseys, Mugs, Posters and banners will be made bearing Makmende's image. A great deal of money will be made on the back of Makmende's popularity but very little of that cash will go to Mr. Masya and Mr. Chuchu. It is a sad case. In Kenya it takes 418 days to enforce a contract and the costs of enforcing it take 47.5% of the claim. This means that the two gentlemen will be heavily disincentivised from pursuing any justice that they seek. They will thus invariably not get the most from their investment. This would probably not be the case in most developed and East Asian nations where the property system protects an individual's rights.

Future leaders of this country who are probably Makmende fans should use this as an incentive and work towards improving the legal system so as to ensure that property rights are protected so that more people can come up with things like Makmende and brighten up our lives. I would however want to congratulate the two gentlemen for their superb effort and "Just a band".

Images courtesy of Just a band and Makmende's official Facebook page

An Economist's guide to dating

2010-03-15T21:03:00.000+03:00

First of all, to all the followers of this blog, I sincerely apologise for being off the blogosphere so long. A great deal of work on my academic in-tray has really kept me off my laptop. I am settling in albeit just for a few months in Kuala Lumpur, Malaysia and I must say I love it. It's a beautiful city and Malaysia is a wonderful country. However, for guys please don't bring your girlfriends cause they will end up shopping your wallet dry.

Speaking of girlfriends and boyfriends, I will give my opinion on this matter through this post. I know most readers are used to research intensive economic pieces that discuss big issues, but I guess one has to explore his tools to find different subject matter. Sometimes economics or economic concepts can be used to analyse different factors other than just economic growth. Dating is one of these other areas or branches where human interaction which is often incentivised can be analysed through economics.

As someone who has burnt his fingers on a few occasions while dating, it is also of personal importance that I do this. Too bad most of the times theory remains just that; theory. Practice is the hard part. Well enough of pontificating about this.

Relationships are weird things, a lot of the time people do things that you would normally not expect them to do. Typical cases like those where the proud, headstrong girl dates someone who abuses her, where the casanova who nobody thought could be tamed ends up being literally owned by the most unassuming girl or even where there is a perfect match and suddenly things go haywire and you're left wondering; what's the point of this all?

I would like to think of these anomalies or the whole beastly creature of relationships using three concepts which tie in perfectly, well at least in my head. They are, assymetric information, regression to the mean (mean reversion) and probabilities yes, good old probability. An introduction to each would be the polite thing to do wouldn't it?

Information asymmetry simply occurs when one person knows more than the other, it is often the building blocks of a good profit in business as the seller knows more about the product especially its pricing and thus can make some good money off the buyer. Regression to the mean just means that things always tend around their average. A cynical example, which I often apply to my self and a certain friend of mine who knows her self is working out. When one goes to the gym, they either gain weight or lose it. However, often is the case that when someone stops working out they go back to their normal look (weight), this is nature's example of regression to the mean. Your body weight will tend around what your genetics, eating habits and other factors dictate it to be. Therefore when you gym, gym regularly and make it a lifestyle rather than just working out for 3 months and waiting another 4 before you get back to the gym. Advice! oh how we often fail to follow good advice, even when it comes from yourself. The last concept of probabilities is more mathematical than economic, but it has a wide range of applications in economics. The sheer depth and inclusiveness of this concept is central if anyone wants to live life without making many mistakes.

The type of probability pertinent to this post is the relative frequency probability. Let's say that Kenya has been growing at 5% per year for 30 of the last fourty years, then given the same policies, you would predict that the economy has a 75% chance of posting a 5% growth rate next year. Your using the relative frequency (amount of times it has happened) to predict the chances that it will happen again.

So what's the point of all this when it comes to dating. It's simple, most people are constrained by the fact that asymmetric information coupled with a lack of understanding of the natural concepts of regressing to the mean and relative frequency probability, lead to bad choices when choosing who to couple with. An example can be given, let's imagine that I find a girl called Ayn, she is the most beautiful girl ever and I am smitten from the get go. At first, I know nothing about her, all I know is that she's pretty. From the beginning there is a strong degree of asymmetric information. The point is to try and reduce the degree of asymmetry, usually by going on a few dates, talking for long on the phone, meeting her friends and all these other social conventions. Even after all this the asymmetry is still strong. I still don't know about her as much as she does and will never do, but with time the degree of asymmetry will fall.

The problem comes in here, as humans we tend to ignore the other two factors after reducing the asymmetry to bearable levels. When the internet started becoming a strong factor in our lives in the 90's people were overcome by a new era type of thinking, we thought our economies would grow forever and our growth rates would be double digits. However, this hasn't happened because raw human intelligence hasn't increased. When you meet a girl/guy who has irritating habits, say Ayn really likes to smoke and drink and I am really not a fan of smokers and drinkers. However, Ayn really likes me and she wants to make a good impression by quiting. The little ego in me, as hyper rational as I may be, will take this as true and ignore the fact that her habits have a huge chance of regressing to the mean. In my egotism, I ignore simple reality and think that I am an agent of change. Most people make this stupid mistake by living on hope rather than reason. Eventually regressing to her mean she will start smoking again. She may genuinely quit but often that's a long shot.

The second mistake is to underestimate the effect of probability. Let's say that of all the workers in silicon valley, 70% of them are software engineers, if someone describes to you that person A, who hails from Silicon Valley is a right brained person i.e. very creative, likes listening to music and attending art galleries, most people will guess person A to be an artist. However, to stand a higher chance of making the right guess, you should guess person A to be an I.T guy because 70% of Silicon Valley residents are software engineers. Now how does this apply to relationships, rappers usually talk of "turning a (insert farm object) into a housewife", relative frequency probability if applied to Ayn will show that she has cheated on all her past boyfriends and slept with quite a number of people. Added to this she has also dumped all her boyfriends just after valentines day. You should guess that she will also cheat on you and dump you after valentines day. Just saying. Again "new era" thinking clouds our judgement and is often the case when "virtuous" and headstrong women end up dating cruel and abusive boyfriends. In the woman's head, she thinks that she will usher in a new era and bring and end to his abusive ways. Hubris if ever an example was needed.

Therefore we should avoid making typical dating mistakes by thinking probabilistically as well as understanding that stuff always reverts to its mean. However, there's always the chance of making the right but most unlikely guess. After all they say it's better to have loved and been hurt than not to have laughed at all. Well, it's up to you. I'd rather stick to trying to make sense of it all and cover my bases by sticking to the above concepts. What do you think?

Images thanks to graphicshunt.com and "for the love of food"

Street Fighter: Wall Street Version

2010-02-28T14:10:00.002+03:00

Distorted Civil Service Pay

2010-02-24T06:16:00.000+03:00

I remember talking to a colleague of mine at university back in South Africa about my possible moves after I graduate. He asked me the question “state or private?” in other words would I work for the government or would I head out towards the private sector? This question baffled me as I could not ever imagine myself being a civil servant. As a Kenyan, the things that come to mind when I think of the civil service are corruption, bad suits and glaring inefficiency. Why would I want to be a part of that? The notion was preposterous.

From this, I was therefore very surprised to find that the government wage bill as a percentage of both GDP and government expenditures are very high compared to both our East African neighbours and the East Asian Tiger economies, the latter ever so important because we hope to become a middle income country by 2030.

Now on to the data available so as to get a clear picture of what is going on in Kenya. The best way that one can compare the wage bills in different countries and regions is to standardise the data by either measuring the wage bill as a percentage of GDP or expenditure. In Kenya, the government wage bill as a percentage of GDP is approximately 8.4%. As a percentage of total expenditure, this is about 31%. This statistics are ever more glaring when one considers that transfers to universities and the military are not included in the wages that the government reports. In middle income countries, the wages are 6.0% and 22.1% percent of GDP and expenditures respectively. In East Asia the wages are 4.6% and 15.1% and in high income countries the wages are 5.9% and 15.6% of GDP and expenditures respectively.

Kenyan civil servants are clearly well paid if one follows the statistics given by the IMF. However are they? If they are, why then do we see droves of civil servants leaving their jobs and opening stalls in the CBD? Why are they all migrating to the private sector after getting their government sponsored education? This is ever more conspicuous when you consider that the number of workers in the civil service has dropped on average by 4%, this according to both the IMF and the World Bank. Clearly then there is a something incongruous between the rising government wage bill and the diminishing civil service.

When we peer through the data further, we see the missing link. There it is raring it’s ugly head, the simple truth that the high ranking civil servants are extremely well compensated with wages that have outpaced inflation. The middle and lower ranking workers are left behind as the rich get richer. The “mbuta” as our prime minister affectionately named them have been lining their pockets at the expense of their subordinates. According to the IMF, the top to minimum ratio is 118:1. This means that the top officials earn 118 times what the lowest earners are earning. This compared to Uganda, Tanzania and Botswana where the ratios are 25:1, 20:1 and 30:1 respectively. This is really a shocking figure. Added to this the top to median ratio is 53:1 meaning that the highest earner makes 53 times the median income in the service. Again compared to Uganda, Tanzania and Botswana with ratios of 7:1, 5:1 and 4:1, the picture becomes pretty clear and even infuriating.

Our pay structures do not reflect productivity but are more so reflections of status in an elitist government. The thousands of university graduates who would join government as cadres and technocrats are not compensated well enough. Their pay does not reflect their productivity and thus the sharpest minds in Kenya will never ever dream of working for their country. The engineers who would have drafted plans to deal with the rising costs of energy are abroad working for big engineering firms, our economists who would have been implementing plans to steer our economy forward are playing the stock exchange and adding little value to the economy. Our lawyers who would be clearing the backlogs of cases pending at the high courts are company secretaries at the big firms.

The government needs to break with an elitist approach to civil service and have productivity based compensation packages. We need to attract our brightest minds to the government if we are ever to dream of having a robust civil service. Hopefully the draft constitution will deal with this through the mooted salaries and remunerations committee. Until then it is distortion galore at the civil service.

Hernando de Soto: Capitalism at Crossroads

2010-02-16T12:52:00.000+03:00

If you prefer a short video to understand the Future Capital Series, here it is:

Future Capital Series Part 4: Political Failure

2010-02-16T12:00:00.000+03:00

Commerce and manufacturers gradually introduced order and good government and with them the liberty and security of individuals, among the inhabitants of the country, who had before lived in a continual state of war with their neighbours and of servile dependency upon their superiors. (Adam Smith, Wealth of Nations)

The quote above is a good starting point for the discussion. Mr. Smith who is widely recognised as the father of modern economics suggests that improved industry and commerce generally leads to good governance and political freedom. This sentiment is shared by amongst others, the late Prof. Milton Friedman in his book "Free to Choose". I assert that where Kenya is currently in terms of our politics is where England and generally Western Europe and North America was over 300 years ago. In a state where land owners and a few prosperous industrialists run the country to their benefit.

In many cases, we have heard of laws being made to further their commercial interests, government tenders being awarded to friendly businesses as well as just recently when elections are tampered with to the leader's benefit. While the last point could be controversial and even provide fodder for heated debate, there should be widespread consensus that Kenya is run by a few people, our democracy is only semantic and not real. Adam Smith further gives an account as to the political situation back when he was writing his great book circa 1776, in reference to the means of law making and governance he said;

It is a mistake to imagine that those territorial jurisdictions took their origin from feudal law. Not only the highest jurisdictions both civil and criminal, but the power of levying troops, of coining money, and even that of making bye-laws for the government of their own people, were all rights possessed allodially by the great proprietors of land

So far in this series, I have suggested that a lack of formal standardised property rights have been the major cause of widespread poverty in Kenya. There are those within the bell-jar who are connected to each other through standardised property systems and there are those who live outside the bell-jar. Those outside the bell-jar then create as Hernando de Soto calls them "extra-legal" arrangements in terms of building a consensus at to what property means to them. In Kenya this is not new. A perfect example of political failure has been the "Mungiki", a group that was formed out of disillusionment over opportunities offered to the Kikuyu youth in Rift-Valley, that has slowly morphed into a national and even post-tribal organisation that organises business and property in areas in which the government has failed. In some people's estimates it is a multi-billion shilling organisation. In science we are taught that vacuums rarely exists, this also extends to life. Where the government has failed to work or basically ignored, there are people who are willing to intervene.

I am not a fan of Mungiki, but it is hard to see how they can be eliminated. Police have resorted to killings and massacres and this has only strengthened them. The positive thing is that in many countries in the past, such mafia-like organisations have existed. In England in the 17th and 18th century, extralegal establishments in the "suburbs" were organised by mafia-like organisations who through extortion were able to finance their objectives. In Italy, government aloofness in areas like Sicily, helped fuel the growth of the Mafia. It is a case of someone always being willing to do the dirty work that nobody else wants to do. However to me it is a case of political failure.

In most cities in developing countries, mass rural-urban migration lead to people living in the outskirts of the cities. These people often lived in informal settlements and offered informal services and run informal businesses. In Zambia, only 10% of the workforce is legally employed. This rural-urban migration was informed by people seeing opportunities to earn more in the capital cities vis a vis their rural homes. Cities like Nairobi, Cairo, Beijing and Lima mushroomed due to the growing populations. The urban folk (bell-jar people) were not welcoming as the new urban citizens littered the city, build "ugly settlements" and crowded their places. The governments in most instances responded through incentivising urban-rural migration or in our case did not respond at all.

As Hernando de Soto points out, the failure was with the politicians who did not respond well. He gives the example of rural-urban migration in the west as well as foreigners moving to developed countries. In both instances the cities absorb the new inhabitants comfortably without much of a hustle. The key thing is that property systems in the west were able to adjust to the growing populations. This growing extra-legality has given fresh impetus to the growth of organisations such as the Mungiki.

Politicians in Africa and the developing world have no incentive to fix this situation. Adam Smith articulates this very well

In a country which has neither foreign commerce nor any of the finer manufacturers, a great proprietor having nothing for which he can exchange the greater part of the produce of his lands... consumes the whole in rustic spirituality at home. If this surplus produce is sufficient to maintain a hundred or a thousand men, he can make use of it in no other way than by maintaining a hundred or a thousand men... he is therefore surrounded at all times with multitudes of retainers and dependants, who having no equivalent to give in return for their maintenance... must obey him

It therefore becomes clear that politics and political debate is in a state of decay. Furthermore there is little scope for improvement as those in charge have no incentive to improve. The case of disgruntled urban migrants, Mungiki, poor subsistence farmers and extra-legal businessmen is one of despair.

This then informs the argument as to why politics in Africa is so ethnic based and tribal. It should not be thought of as people wanting to vote for people from their tribe, but rather wanting to ensure that your keeper remains there. For if you have nothing to exchange for his/her maintenance, you must pay with political obedience. Politics in Africa for a long time will remain this way. Issues of left-wing, right-wing, conservative, liberal and centrist politics will remain an intellectual's folly. Capitalism or socialism will prove immaterial in Africa for as Hernando de Soto states;

What governments do not take into account... is that when people finally acquire property, they have their own ideas about how to use and exchange it. If the legal system doesn't facilitate the people's needs and ambitions, they will move out of the system in droves.

Our political system has failed and will continue failing unless there is a concerted effort to deal with property issues. Until then we are doomed to more tribal politics and the growth of Mungiki. If the relationship between government and Mungiki continues to be adversarial, we are likely to see more bloodshed.

Commodities to be the end of us

2010-02-15T16:13:00.000+03:00

Watching Kenyan news this last week has really vindicated my beliefs that Kenyan's have a serious case of amnesia. 10,000 litres of milk were poured out with impunity and just yesterday Maize was rotting in Rift Valley. The milk case was just horrible because as my dear aunt told me on Friday evening. It would even have been more prudent for the milk to be put outside the factory gates for the public to come and consume to their discretion. However before I rant further which is clearly not in the spirit of this blog, one must ask themselves; what's the matter? Analysing this can be voluminous, but I'd like to try with some of John Locke's wisdom.

In the Wealth of Nations by Adam Smith, John Locke is quoted as saying;

All other moveable goods are of so consumable a nature, that the wealth which consists in them cannot be much depended on; and a nation which abounds in them one year may, without exportation, but merely by their own waste and extravagance, be in great want the next. Money on the contrary, is a steady friend, which though it may travel about from hand to hand, yet if it can be kept from going out of the country, is not very liable to be wasted and consumed

The meaning of all this is that commodity dependent countries are not good candidates for sustained growth. Due to the consumable nature of commodities especially in countries where impunity and corruption is rife (KENYA!!!), waste and extravagance will stifle growth. This is nothing new in Africa. However, this is not to say that commodity rich countries cannot thrive, this is merely to say that money, and not commodities is the main driver of growth. John Locke then concludes by stating that "increasing money is the great object of a country's political economy".

I still feel that this is too shallow an analysis, I will thus follow this post up with part 4 of the Future Capital Series. However, it is something to digest, we should stop with the notion that the more food, copper, gold and oil we have, the more we'll grow. It's a bit like saying that a person with 100 beers worth 80Ksh each is better off than the person with Ksh 6,000. The consumable nature of the beers is no match to the multipliable nature of the Ksh 6,000.

Image courtesy of Daily Nation Online Edition

Beware!! Inflation on the Horizon

2010-02-11T11:11:00.002+03:00

Recently, I have strongly become of the opinion that economists should legitimize their profession by forming a professional body. Just like the lawyers have the Law Society of Kenya and accountants have CPA and ICPAK. This view was enshrined in me even further after a talk I had with Robert Bunyi of Mavuno Capital. The lack of a professional body leaves the whole profession in the doldrums as there is no sense of accountability over what an economist says in public or even more important who is considered an economist.

The reason I am concerned about this is because of the current economic stimulus programme started by Hon. Uhuru Kenyatta the minister of finance. It is a noble and humane idea to get tax payer money working to build the country, stimulate aggregate demand by filling the hole left by declining private sector demand due to the economic downfall as well as getting money into people's hands. The sad thing though, that economists I feel haven't highlighted, is that the transmission mechanisms for stimulus money in Kenya are broken. The budget was read in June last year and of the proposed Ksh 22 billion, only 3 has been used so far. The rest of the 19 billion is still in treasury waiting for tenders to be completed and signed and a whole lot of bureaucratic procedures to be completed. I am afraid that by the time stimulus money gets into the economy through the projects and ultimately to the people's pockets it could be at least Q2 2011.

What then? By then won't the worst of the downturn have been behind us. Further still won't that mean that we got by the downturn despite the stimulus rather than due to the stimulus? Of the money that gets into the economy, won't it result in unnecessarily high levels of money supply? Won't this then lead to an increase in underlying inflation? Won't CBK then try to reduce money supply to mitigate the increase in underlying inflation? Won't the politicians praise the efforts of the stimulus due to the increased fortunes of their electorate heading into 2012 elections? Won't parliament then have great incentive to pass laws that institutionalise the stimulus and thus lead to an annual fiscal drain of at least 22 billion shillings to the taxpayers?

Won't this all be unnecessary? In my opinion, we need a body of economists who will crystallise debate over such issues and put them in the public domain. In America, stimulus programmes work well because they are quick to transmit to the rest of the economy. They have flexible legislature that can be quickly called to fix the crisis and quicker means to get money to where it needs to be. Here the medicine takes effect way after the patient gets better leaving unnecessary symptoms that when treated will lead to confusion in the patient's body. For me the effects will be high levels of inflation come 2011. Currently we are seeing at least 5% of overall, it could be more then and who knows that coupled with drought could see the level double to 10%. What then?

What's your take?

Talk with Local Investment Manager

2010-02-08T16:35:00.000+03:00

This post has been long over due. I recently had a talk with Mr. Isaac Njuguna of Zimele Asset Management, a local asset management company to discuss various matters pertaining to the local economy, capital markets and investing in Kenya. It was a really pleasure to meet him. He is a unique fellow, very statistical in his thinking as he often would punctuate his sentences with terms such as "mean reversion", "standard deviation" and "multi-collinearity", often to refer to every day issues. I left very impressed by his grasp of the economy and his intellectual honesty. I will just discuss some of the issues we discussed so that I can share them with a wider audience.

Low NSE Participation

As an investment manager I sought his opinion on the level of the NSE. Was it too high, or too low and what issues bedevilled the exchange in Kenya. He was of the opinion that albeit the index was low, there still wasn't enough participation. Often in the media we hear of demutualisation as the key to improving the exchange, dealing with rogue stock brokers as a way to increase investor confidence and other grand schemes. He was of a slightly different opinion. Mr. Njuguna quoted a study carried out by Financial Sector Deepening Kenya (FSD), in their FinAccess Review of 2009 that found out amongst other things, that the NSE was one of the least known financial institutions in the country. The reason then that there was such low investor participation was that the NSE had not marketed itself enough to warrant high investor participation. This then lead to what he thought were sometimes low valuations that discouraged local companies from listing.

Financial Media

Added to this was the fact that financial journalism he thought, was a big disappointment. Mr. Njuguna was of the opinion that business news on local television had a long way to go. It was more of a "PR... or marketing event than business news". I must say that I completely agree with him, very little business is discussed on news and in place of this all we are shown is fanfare and ribbon cutting. Allied to this, is the fact that the media houses do not seem to understand the news and their viewers. Financial reporting is way over the heads of the ordinary mwananchi. He will not understand terms such as the index, market capitalisation, bond turnover etc. The news people need to find a way of explaining market events in a manner that is useful to the lay man. He tied this in with the low participation of the NSE. One is lost for words when you realise that people would rather put their money in low yielding commercial bank saving accounts than invest in stocks, t-bills or treasury bonds.

After this, he introduced the concept of multi-collinearity where just as we have the x's relating to each other rather than relating to the y, in his example we have the professional community talking to each other rather than talking to the ordinary mwananchi so as to warrant his/her interest in the financial markets. Financial journalists according to him are also not well prepared to discuss key issues with our business leaders. Most of them have degrees in journalism and cannot hold their own and pin down interviewees that are misinforming the viewers.

Investing in Real Estate

His take on real estate investing in Kenya was very Grahamite in Nature. Ben Graham to many is considered as the father of value investing as a science. After many years of random speculation in the New York Stock Exchange, Ben Graham with his 1934 book Security Analysis brought a level of scientific thought into the field of investing. In a nutshell, Graham thinks that one should be guided by rationale and complete information before investing in Real Estate. This was the same view shared by Mr. Njuguna well as far as Zimele went. He was of the opinion that real estate in Kenya was plagued by asymmetric information and thus one was never sure as to what value one was getting. Since price is the most fundamental issue according to Ben Graham and Mr. Njuguna, then the information asymmetry really meant that one was never sure as to whether he was being ripped off or striking it gold. When you are investing other people's money as Mr. Njuguna is, you have a "fiduciary responsibility" to safeguard their interests. Investing in real estate was thus a gamble.

Better the goose that lays the golden egg

Mr. Njuguna further went with his analysis. Warren Buffett once mentioned when asked whether he would invest in gold as stocks had taken a battering, he answered by saying that "he would rather buy the goose that lays the golden egg". In reference to real estate, investing in real estate according to Mr. Njuguna does not "organically" provide growth. To add value to your property you must inject more money. In buying a business on the other hand, one buys into a system that organically generates value without the need for further investment. Thus the goose that is laying golden eggs. Warren Buffett quoted Coca-Cola when asked about buying gold, he mentioned that Coke have their own mechanisms through marketing and other operations to generate wealth for their shareholders without the need for extra capital from their shareholders.

Margin of Safety as the Central Concept of Investment

I then asked what had been on my mind throughout. I had decided to want to meet with Mr. Njuguna as I had read that he was a value investor. Due to my great admiration for the simplicity and yet superb success of true value investors such as Warren Buffett, Seth Klarman, Ben Graham and Irving Khan, I needed to know how value investing would work in Kenya. I then asked "how do you decide on whether an investment is good or bad?"

As was expected he immediately quoted Ben Graham author of Intelligent Investor. His notion was that one starts with the risk-free return that the market currently offers. This would be in the form of treasury bonds or bills in Kenya's case. After figuring out your holding period, you then look at the market for a good company that is well enough priced and whose earning ability is the same or better than the risk-free return currently on offer. Earnings power as described in "The Intelligent Investor" is calculated by taking the inverse of the P/E ratio and giving it as a percentage. Therefore a company/stock with a P/E of 11 has a return of 1/11 = 9%.

Now in Kenya, if an investor had a time period of 5 years, he would start with any bond that is maturing within 5 years. Currently there is a bond that is yielding 13.5% maturing in 2015 (FXD1/2007/8YR). This then is the risk free return, to get a stock that is worth investing rather than putting our money in the above bond, it would have to be selling at most at approximately 7.5 times earning i.e. a P/E of 7.5. There are very few noteworthy stocks that are selling so cheap. A lower P/E of maybe 6 would then offer a 3.16% margin of safety.

Conclusion

All in all, it was a very stimulating conversation. A man who understands his stuff and has the honesty to take things for what they are rather than what he wants them to be. In the world of finance especially in Kenya, we have witnessed a lot of self-serving individuals who lack integrity. From the little time I spent with Mr. Njuguna I am happy to say that he has heaps of honesty.

Blame it on the ECONOMY: Obama Spoof

2010-02-07T12:24:00.001+03:00

This too shall pass

2010-02-07T11:17:00.002+03:00

"And this too shall pass away. How chastening in the hour of pride! - how consoling in the depths of affliction! "And this too shall pass away. And yet let us hope it is not quite true"

Abraham Lincoln, Addressing the Wisconsin State Agricultural Society in Milwaukee (1859)

This is such a profound statement, it was actually coined by an Eastern Mornach's wise men. He asked them to come up with a sentence that would be true, relevant and appropriate in all situations of life.

Now to the economics. This too shall pass. The current reprieve customers are facing with falling milk prices... this too shall pass... the current falling food prices... this too shall pass. I don't want to sound like a prophet of doom but considering Kenya's climatic conditions and historical inflation record, this too shall pass. Once the drought is back and the drought will be back for sure, the prices will get to their normal levels. Food inflation according to data that I was privy to from my friends at Herufi House (National Bureau of Statistics) is the biggest driver of overall inflation. I got data that backtracked the new geometric mean inflation data to October 2005 and the effects of the drought were so dramatic. The food index went from 118.67 in December 07 to 158.72 in March of 09. The inflation rate then jumped from 5.6 to 14.6.

Moral of the story, I don't think anyone needs to be told again. "This too shall pass"

Keynes vs Hayek Rap Anthem. Short Guide to the History of Economic Thought

2010-02-02T11:03:00.000+03:00

The Economic Effects of Dead Capital: Future Capital Series Part 3

2010-02-02T10:39:00.001+03:00

The chips in the economic game today are not so much the physical goods and actual services that are most exclusively considered in economic text books, as they are that elaboration of legal relations which we call property... one is led, by studying its development, to conceive the social reality as a web of intangible bonds - a cobweb of invisible filaments - which surround and engage the individual and which thereby organise society... And the process of coming to grips with the actual world we live in is the process of objectivising these relations.

C. Reinold Noyes

Having so far discussed the problem with Kenya's last decade economically and understood what capital is. It is now proper for us to really discuss the effects of "dead capital" or more conservatively undercapitalisation. The above quote is a good start, it implies that property and property systems are like a web of intangible bonds that connect people and create relationships. It thus stands to logic and reason that the more widespread and accepted are the property systems then web of intangible bonds or the cobweb of invisible filaments will be bigger and wider.

Having said this, then it is clear that property systems are connectors. One can imagine them like fibre optic cables, they go from the sea towards the mainland with the objective of connecting more and more people. The more terminals (buildings) that connect to the cables, the more connected and thus prosperous the country is. In Kenya, the problem is that the property systems are both unfair and scattered. Unlike the West where constitutionally the focus of land is on value addition, in Kenya the focus is on land ownership. There are very few other states where land can be given to foreigners and locals on a 999 year freehold basis. Added to this, when one visits a village or town, every land owner may have claim to his or her property. However, the claims may not be similar. Documents will vary and thus one cannot really lay claim or pledge his or her property in a standardised manner. Therefore as Hernando de Soto states; "what creates capital in the west, in other words, is an implicit process buried in the intricacies of its formal property systems".

One then begins to understand why the trade of property is buried in such a bureaucratic morass. If one is to sell his or her land, buildings, companies, mines and so on, how can one lay claim to his property? How can a trader in Turkana ascertain as to whether the fisherman in Kisumu really owns his buildings? How can the merchant from Machakos ascertain that the man in Embu really owns fifty percent of his company? With this, what happens is that trading is then done in closed and relatively small local circles. Circles in which at least there is a cultural understanding of the local intricacies and nuances of their property systems. This then leads to a case of minimal demand and thus low returns. Only in the Nairobi and especially the upper class areas and the CBD is there a semblance of standardised property systems where people are connected.

This situation then leads to a disproportionate accumulation of capital and wealth. In a nutshell the rich keep getting richer not cause they have more capital, but rather cause their capital is better connected to the world and to larger markets due to formal property systems. In the capital city, a father can divide his wealth through shareholding to his sons and daughters. By hiring his team of lawyers and sending them out to Sheria House, he can get past the bureaucracy and draft documents explicitly stating how his property will be held through shares. The same cannot be said of the dirt-toothed farmer in Murang'a who albeit owns hundreds of acres, will have to keep on subdividing his land to cater for his children. This as Hernando de Soto states can only lead to "starvation or stealing".

The consequences are immense, only the well connected (people who are in the bell jar) can access electricity as the power authority KPLC can ascertain their claims to their property and thus provide them with electricity, only the people in the bell jar can get life, educational, medical or property and casualty insurance and thus shield themselves from any eventuality. Only the people in the bell jar can stroll into the bank and obtain unsecured loans or even secured loans after presenting proper evidence of their claims to their property. The poor then are not poor because they are dumber or less shrewd than the rich, no, the poor are poor because the legal morass that complicates the property system disables them from being connected to the world. This then leaves a massive shadow economy which albeit is very wealthy, it is not fully contributing to the economy and also not helping it's participators fully achieve their potential.

I will leave you with this scenario of Bill Gates' wealth property articulated by Hernando de Soto.

How many software innovations could he have made without patents to protect them? How many deals and long-term projects could he have carried out without enforceable contracts? How many risks could he have taken at the beginning without limited liability systems and insurance policies? How much capital could he have accumulated without property records to fix and store that capital? How many resources could he have pooled without fungible property representations? How many other people would he have made millionaires without being able to distribute stock options? How many economies of scale could he have benefited from if he had to operate on the basis of dispersed cottage industries that could not be combined? How would he pass on the rights to his empire to his children and colleagues without hereditary succession?

Once we digest this and internalise it, do we see that our problem is really deep and that we need to solve it, next week we discuss the political effects of dead capital.

Understanding Capital: Future Capital Series Part 2

2010-01-26T11:53:00.003+03:00

As part of the second instalment of the Future Capital Series, I see it fit to discuss what capital is. Once the discussion is made, we can go on to understanding how according to Hernando de Soto, Undercapitalisation or "Dead Capital" is the main encumbrance to our development not only as a continent but as the third world. Through this understanding, I take it that the real causes of our problems will be clearer. It is human nature and condition to look for the easiest excuse or the least demanding excuse and run away from seeking the real truth. The issue of Capital falls under that bracket of human beings intellectual convenience.

Capital is defined by classical economists as "that part of a country's assets that initiates surplus production and increases productivity". Furthermore, The Economist defines capital as "money or assets put to economic use, the life blood of capitalism... one of the four essential ingredients of economic activity, the factors of production along with land, labour and enterprise. Adam Smith goes further and distinguishes between circulating capital now known as "working capital" and fixed capital. The former including money, commodities and raw materials while the latter includes land, buildings and mines.

Capital is very important in a market economy... Adam Smith in his book "Wealth of Nations" gives three clues as to why this is so. The first clue is when he says that " the quantity of industry, therefore not only increases in every country with the increase of the stock (capital) which employs it, but, in consequence of that increase, the same quantity of industry produces a much greater quantity of work". Here he links increasing capital to increasing work and industry. Further he adds that "all the accumulation of stock must, in the nature of things be previous to the division of labour, so labour can be more and more subdivided in proportion only as stock(capital) is previously more and more accumulated". We see now that capital is not only important for increased industry and employment but also for productivity and division of labour. All these factors are important for growth.

The last clue takes on a more personalised note when in reference to an individual "he endeavours, therefore, both to make amongst his workmen the most proper distribution of employment, but to furnish them with the best machines which he can either invent or afford to purchase. His abilities, in both these respects are generally in the proportion to the extent of his stock(capital)". Clearly then we see that capital is important for both the development of society but also for personal economic development.

If this is the case then one wonders, does that mean now that Africa or Kenya lacks capital? If the relationship between capital and growth has been so well articulated, is it then that we lack capital?. A reasonable mind will clearly then see that this is not the case. Africa is one of the most well endowed continents in the world, with arable land, diamonds, gold, rivers, lakes and a healthy population we clearly have bucket loads of capital. Why then cant this capital as Adam Smith put it "increase the quantity of industry and in consequence (increase) a much greater quantity of work"?

Here is where Hernando de Soto comes in. His argument is both simple and elegant. Africa and in general the third world has what he calls "Dead Capital". De Soto adds one element of Smith's argument that I have deliberately left out. This is that "for accumulated assets to become active capital and put additional production in motion, they must be fixed and realised in some particular subject... which lasts for some time at least after the labour is past". Here he brings in the concept of formalised property rules. These rules are the ones that fix the accumulated assets in some particular subject which in this case is law. In the West, the difference is that assets are able to live a parallel life both as assets and as capital. Here in Africa we just have assets.

The notion here is that capital is abstract, like a ghost if you will. An abstraction that lives in people's collective minds, collective in that they are gathered in the law. Simonde de Sismondi, a swiss economist as cited in the Mystery of Capital says that capital is a "permanent value, that multiplies and does not perish... Now this value detaches itself from the product that creates it, it becomes a metaphysical and insubstantial quantity always in the possession of whoever produced it, for whom this value could be fixed in different forms". Capital then to me is like molten iron, it can be moulded and shaped by the blacksmith into whatever form he wants so as to derive extra value from his labour.

The issue is that as a people we have come to think of capital as money. It has become the colloquial definition of capital. For business, we have to "raise capital" so as to start the business. The argument put forward by these great economists is that capital is whatever the owner wants it to be so long as there are standardised rules that allow for these different interpretations.

From this perspective it is clear then that a lack of understanding of what capital is has been part of the problem. African governments have confused capital with money and over inflated their economies by pumping money into the economy. Not realising that money is just one of the many forms of capital. To drive this point home. Imagine a matatu tout who has a brilliant mind, a person who comes up with business ideas at a whim. He gets a salary from the owner of the matatu but cannot formally lay claim to his assets (the salary), he therefore lacks capital as in a formalised system, the collective minds of the country would interpret this salary as a formal regular cash flow towards him. He therefore cannot get a loan from the bank as they cannot formally and in a standardised manner lay claim to his capital as collateral. His business ideas which are his intellectual and human capital remain locked in his brain and therefore do not add value and generate wealth. This is what is called dead capital.

Furthermore, imagine two parties, a maasai herdsman who owns cattle and a rancher who owns lush fields. They both have assets, what if the herdsman could reach an agreement with the rancher that allows him to herd his cows on the ranchers fields in exchange for first options on the proceeds from the sale of the herdsman's cows. They would both have great incentives to cooperate because fatter cows would mean higher prices for the cows, whatever stake the rancher would be getting would be proportionate to the health of the cows. He would even fertilise his grass so as to reach this end. However, this would all be impossible if the property laws of the country are not formal, standard and flexible so as to allow the interpretation from these entrepreneurial minds of their parameters.

Dead capital then is the main issue in the third world. The assets and wealth are there but there are no rights that allow these assets and wealth to live their parallel life. There is no furnace to melt the iron ore so that the blacksmith can create value through his labour.

Next week, the discussion will be taken further. The article will be about the economic and financial implications of dead capital. For a more nuanced explanation, I recommend that you read "The Mystery of Capital" by Hernando de Soto. For me it is the most important book that any third world economist or thinker can read.

The Noughties Future Capital Series Part 1

2010-01-18T11:02:00.000+03:00

As part of a five part series covering the steps that Kenya needs to take to achieve lasting sustainable growth and development. I have decided to undertake a small analysis of the noughties (2000-2009) as they have come to be affectionately named. Following from this analysis will be my ideas albeit shaped significantly by the legendary third world economist Hernando De Soto.

The last decade was a very dynamic one for Kenya. Globally it was welcomed with huge aplomb as it was the beginning of a new millennium. We witnessed the most fancy fireworks displays some live and others on TV as they began in Sidney and ended in Los Angeles. We as a world had great aspirations for this new era especially after the massive economic gains that the developing world had made in the 90's. In Kenya we were slowly preparing to bring an end to the Nyayo era (error) which had ravaged and bankrupted our beloved country. There was great hope and excitement as the new decade began. It felt strange when the calenders showed a year that began with 2 and was followed by three 0's.

For Kenya the decade began in significant fashion as mobile telephony which before was a novelty for the rich began to take root with Kencell and later on Safaricom. I remember my mother had an Ericsson 1018 which was the toast of the household. It was so cool to have a mother who had a mobile phone, almost even a sign of gender empowerment the more I think about it. As things would turn out to be, this was just the beginning of even greater things.

The KANU government led by Moi was swept by the Rainbow tide that was led by Mwai Kibaki with his dynamic team that comprised of Raila Odinga, Charity Ngilu, Michael Wamalwa amongst others. For the first time in Kenya's democratic history, the opposition had united against their greatest foe. Kenyans attended the president's inauguration in droves and the historic event was watched the world over as this tiny African country set the standard for free and fair elections. Euphoria engulfed the country as the collective hopes and aspirations of the country were raised by the new president's speech. I remember attending the ceremony at Uhuru Park with my mother and brother. We found ourselves some good seats and slowly watched the events of the day. From the embarrassing scenes of foreign diplomats lacking chairs at the dais, the constant mud slinging by eager spectators keen not to have their view blocked and the dismay as the foreign journalists tried in vain with some even fainting to get that million dollar shot of Kibaki's first moments as president. In retrospect this should have been a sign that the change was only ceremonial, a change of guard but not a change of circumstance for the approximately 35 million or so Kenyans.

However nine years later and nothing much seems to have changed. The post-election violence of early 2008 made us wonder whether we were the same people at Uhuru Park, the same people who had showed great unity and togetherness to topple Moi. We watched in shock as fellow Kenyan's brutally and I reiterate brutally murdered each other. This was followed by a nose dive in the economy with it's main indicators such as capital inflows, GDP and the stock market index taking a nose dive. What went wrong? The NARC administration offered so much promise?

The decade ended with the NSE going nowhere, the random walk that was expected ended up being a random stop. As of end 09 figures, the stock market index has gone nowhere. An annualised nominal growth rate of 2% is hardly anything to write about. When one factors in inflation which over the years has grown at an annual rate of 10%, the real growth rate of the stock market was -8%. GDP per capita saw only a slight increase of less than 3%. Added to this we saw a worsening of our cash position as Kenya witnessed huge capital outflows in the last two years of the noughties that reversed all the gains of the previous 7 years.

It wasn't however all doom and gloom. Mobile telephony has greatly eased and improved people's lives as they can now communicate with greater efficiency and ease. In fact mobile cellular subscriptions increased from 0 subscriptions per 100 people in 2000 to 42 subscriptions per 100 people in 2008. Added to this the introduction of Mpesa and Zap have made money transfers easier to average Kenyans and have assisted the numerous unbanked Kenyans. Internet users also rose from 0.3 per 100 to 8.7 per 100. Free primary education has somewhat improved the prospects of many Kenyans as it facilitated easier access education. Primary school enrolment was at a peak of 8.3 million in 2007. However this is in jeopardy as the recent FPE scandal lead to a withdrawal of it's main financial backers. On matters of health, Kenya witnessed a slight improvement in life expectancy from 52 years to 54 years mainly due to increased HIV/AIDS awareness programs. The robust albeit shaky property market has also created wealth for many Kenyans.

However, in spite of all this, Kenya still has disturbing poverty levels, high rates of income inequality and significant tribal issues that make for a very shaky nation. What needs to be done to sort out this mess. The government seems to be incapable of solving it in it's current state.

Next week, I continue off from this quagmire. Part 2 will be about further delving into the nitty gritty of the decay in Kenya and analysing it.

Dishonest Financial Reporting

2010-01-07T09:42:00.001+03:00

So, I was reading the Daily Nation online last night and I came across an article on the recovery that Kenya's robust economy is expected to have this year. At first, the points the author made were very reasonable and made great sense. However at this point, I hadn't put on my thinking cap on. The more I read on, the less sense it made. Let me just give some of the few points the author makes in his op-ed and give my two cents.

The first one is that an improved global economy will lead to a somewhat trickle effect that will see Kenya's economy improving. That through increased commodity prices we are likely to see better incomes for our farmers. However this goes against what the data tells us. You see, Kenya has always been a net importer of goods i.e. we import more that we export. Therefore we will continue buying high and passing the high costs to "Wanjiku" so much for global recovery. Already cement prices are likely to see upward pressure due to higher global oil prices. The opinion that a better world economy leads to a better Kenyan economy should be put under a spotlight and thoroughly scrutinised.

Another point he makes is that due to low inflation, we are likely to see lower real interest rates and thus easier access to credit leading to a more robust economy. In my perspective this argument does not hold it's fair share of water. Historical data in Kenya from 1963 does not support any significant relationship between inflation and interest rates. Banks take their operating costs and the costs of handling loans into consideration when deciding on their interest rates and not so much inflation. Classical monetary economic theory does not apply in Kenya and thus don't be misguided to think so. People should understand the reality of Kenya's economy before quoting theory, this is the height of intellectual dishonesty. Therefore in my humble view, we are not likely to see much change in the interest rates unless banks reduce their operating costs and credit information sharing (credit scores) is implemented.

The last point I would make is that he argues that the stock market has bottomed out, i,e reached it's trough and now it can only go up. It could be that the NSE All Share Index (NASI) as well as the NSE-20 Share index will see an improvement, but reasoning that just cause it's been down it will be up is like saying "just caused I tossed heads in my first throw, I will toss tails in my second", it doesn't make sense.

In conclusion, when I read that the author of this op-ed was the former chairman of the Nairobi Stock Exchange, it all made sense. The "conflict of interest" alarm bells were as loud as they could get. It took me back to an advertising feature that I read on the plane to Johannesburg early last year proudly proclaiming an impending market boom on the basis of a two day rise of the index, can someone say "DISHONESTY". When people are serving their own self-interest lies can be told. The aforementioned people want to drive business into their firms because brokerage and asset management have really suffered the last couple of years. They will therefore write very "convincing" articles targeted to the naive reader about the better prospects for the economy laced with the "now is the time to invest talk. Ignore such and if you are to get opinion of where the economy is going, go to KIPPRA or the IMF not a stock broker.

Kenya's Aspirations for 2010

2010-01-04T16:21:00.001+03:00

Happy new year people. I hope you are all working on your resolutions and if you do not have any, well join the club. A new year brings with it new things, new aspirations, new realities and new possibilities. This applies to anyone be it a little child, a teenage girl or a man in the throes of his mid-life. It also extends to non-human entities such as companies, schools, universities and countries. With this in mind, I hope to share some of the things that I would like to see happening as well as some of the things that may happen in our financial world.

To start with, I would really like both the Capital Markets Authority (C.M.A) and the Nairobi Stock Exchange (N.S.E) go ahead with the demutualisation of the bourse. It has been a long time coming and could even be longer before this takes place. With demutualisation, the NSE splits ownership and management with the NSE being offered to the public through an I.P.O. Both aforementioned parties have been waxing lyrical over the past couple of years about demutualisation but we are yet to see it happening. Demutualisation would lead to greater transparency that would hopefully lead to increased investor confidence in the market. The confidence reached a nadir with the 2007 post election violence coupled with the Nyaga and Thuo crises. The index subsequently took a nosedive. Confidence is key if the market is to recover. Another benefit that demutualisation may bring is that the NSE may license more stock brokers and hopefully this would bring about a reduction in brokerage fees. Kenyan stock brokers charge excessive fees of about 2-4% per trade. This may sound like pocket change to the layman, but in South Africa typical brokerage fees range from 0.02% to 0.1%. The high brokerage fees make foreign investors and members of the diaspora to shy away from the bourse.

Secondly, I would like to see the powers at be starting from the Attorney General, enforce the Proceeds of Crime and Money Laundering bill 2009. It was a big step for this country when the bill was passed, but if it is not enforced and taken seriously it will be a huge disappointment. I as well as other commentators have speculated in the past that the lack of proper money laundering legislation has been a boon for terrorists and other criminals to "invest" in the country, pushing out locals of the property market. These days house prices are over the moon and sell at extraordinary multiples of our incomes. I dare speculate that if the bill is taken seriously, we could see a reversal in this trend.

Kenya will witness a momentous change this year as the East African Common Market is established. The free movement of people, goods and services should offer Kenyan entrepreneurs bigger markets and more opportunities to thrive. Kenya is well placed to take advantage of this as liquidity right now is very high and we have for a long time had flexible capital mobility regulations vis a vis our neighbours, especially Tanzania. I urge young Kenyan businessmen to strategise for the unification of the East African Market

Finally, and I know it is a long shot, I would like the draft bill to get the right amendments so that Kenya can finally have the constitution that its people deserves. We have suffered for too long and our economy has suffered for too long due to a lack of a proper and well enforced legal framework. I put it to you that the law is the cornerstone of a good working economy. All the maxims of Capitalism are based on a system of property protection that unfortunately Kenya has lacked. The case of the Mau is a perfect example

Hopefully things will go well in regards to the aforementioned aspirations. Feel free to share with me your aspirations for Kenya for 2010.

Happy New Year from Future Capital Kenya

2010-01-03T19:33:00.001+03:00

Happy new year everyone!!! I would like to wish the readers and guests of this blog a very happy new year and warm wishes for the year ahead. From my side, I want to thank everyone who has visited and commented on this blog and I hope that we can continue with our fruitful relationship.

As you can see, I have embarked on revamping the blog and making it a more interactive place. The year ahead promises more good things for Future Capital Kenya. The blog will have guest authors share their views on a range of topics from business, finance, politics and even sports and their effect on shaping the future of Kenya's economy. There will be news reviews about the latest topics in the world of business and finance with independent analysis encompassing a different nuance to the issues. The blog will also have periodic book reviews and recommendations. This I hope will be a super interactive section where future business leaders and opinion makers will have the opportunity to share their favourite books and even write reviews about them.

From your end, I hope that you as the reader and follower can share the blog with as many people as possible and help make a community of keen minds who want to see a different Kenya.

Thanks a bunch guys and happy new year once more. Please leave comments about the new look, I would greatly appreciate that.

Samora

House of Cards

2009-12-15T18:02:00.006+03:00

The analogy of a house of cards to me is very appropriate in discussing the recent economic growth circa 2003-2007 and pre-Kibaki growth in Kenya. Economic growth is an ideal every country strives for and is usually the intrinsic mandate of all government efforts. Growth leads to jobs, higher standards of living, higher life expectancies, higher education and even less suffering and misery. However in our case, we have to be very careful as to what factors drive this growth. Here I would like to present a very simple growth model, first posited by an eminent MIT economist called Robert Solow. His model was simple:
Y = f(At Kt Lt)

In this simplified model, he stated that growth in output Y was dependent on At which is a measure of productivity at a given time, Kt a measure of the amount of capital (Buildings, machines, cars, trains) at a given time and Labour at a given time.

From the model, it is the At that we should be interested in. In economic terms, it is referred to as Total Factor Productivity (TFP) and basically shows how much we are getting per worker or machine. If TFP is low in relation to other countries, then our workers and our stock of capital produce less than the same workers and the same stock of capital in other countries. The IMF in a recent study show that Kenya's growth and that of other Sub-Saharan countries has been due to an accumulation of factors rather than an increase in TFP. To better discuss this, I feel an analogy is appropriate. Imagine the economy as a lush field of grass and growth is reflected in how much grass we can cut and harvest off the field. We harvest grass by hiring people armed with sickles to cut the grass. Our growth then in this regard has been as a result of hiring more and more people armed with more and more sickles to cut the grass. The worrying fact is that according to the law of diminishing returns this method of growth is not sustainable.

The law of diminishing returns states that as more and more variable factors of production are added to a fixed factor, production will at first increase at high rate then increase at a decreasing rate before eventually dropping. In the grass case, then production of grass will first increase because of more workers then as workers start jostling for space and arguing over whom gets which sickle, the production will start increasing at a decreasing rate before eventually dropping. TFP in our case would be solved by maybe fertilising the grass so that it grows longer thus justifying the number of workers, buying lawnmowers so as to increase the speed of collection and other such measures.

Clearly then TFP is an important and I would dare say the most important factor in creating economic growth. According to the World Development Report of 2005, between 1960-2000 45-90% of cross country differences in GDP growth were attributable to TFP growth. Added to this, TFP growth in Kenya according to the World Bank grew at an average rate of -1.0 between 1990-2000. Slowing TFP in Kenya has then been the main cause of the massive difference between Kenya's growth and the growth of the East Asian economies. Of the cumulative GDP per capita of Malaysia, Singapore, Korea and Kenya in 1964, Kenya's GDP per capita was 10%. In 2006 this had reduced to 1%.

A study of the factors that affect TFP growth is therefore vital. The IMF in a study conducted in June this year show that good governance, education, good health and inflation are amongst the main causes of differences in TFP.

In terms of governance, it is no secret that the governance in Kenya for the last 40 years has been miserable. Corruption, inefficiency, lack of transparency have been some of the main adjectives used to describe the successive regimes that have ruled the country. Good governance is important as through working institutions and regulations, people can invest in the country and technological and financial innovation can thrive. The poor governance has lead to foreign direct investment flows to Kenya being much lower than those of other countries. FDI as a percentage of GDP in Kenya was approximately 5% in 2006 compared to approximately 18% in Ghana, 28% in Uganda, 30% in South Africa and amazingly 158% in Singapore.

Bad governance has also affected Kenya's exports as a lack of improvement in infrastructure and the tax system has lead to domestic demand exceeding domestic production due to high domestic production costs. This leads to Kenya being a net importer of goods and thus creating a current account deficit. This flies in the face of the mid-term strategy of being a net exporter by 2012. The World Bank usually grade a country's government through six measures namely; voice and accountability, government effectiveness, political stability, regulatory quality, rule of law and control of corruption. Kenya did poorly with voice and accountability scoring approximately 36%, Political stability 15%, government effectiveness 24%, Regulatory quality 45%, rule of law 13% and control of corruption 16%.

If this was your report card after the end of the year, your parents would hang their heads in shame especially for rule of law which should be the cornerstone of any economy that is based on capitalism and allocative efficency.

However as a bright spot, I feel that the current Prime Minister Raila Odinga, has shown commendable leadership taking a strong and often politically unpopular stand on many issues such as the Mau evictions, environmental control and his commitment to improving infrastructure.

In terms of education, it is no secret that our education system needs a lot of work and prayers even. Sound educational policy has been lacking and is reflected in the enrolment statistics and the cost of education in the country. Good education often leads to a higher stock of human capital and thus improved labour productivity. Our education system in my humble view is one that is still based on the colonial role of educating a native population the basics of reading and writing so as to serve in clerical roles for the British. The lack of technological innovation has been a big deterrent to improved TFP. The government has clearly forgotten that early childhood education and technical education are an important part of the educational infrastructure.

My mother who has worked in education all her life always stresses that early childhood education both at home and at school is a make or break time for the child in terms of his/hers approach to learning and knowledge. Between fiscal year 02/03 and 07/08, early childhood education got on average 0.17% of total expenditure on education and technical education got on average 2% of total expenditure on education. Free primary school on the other hand got 52.67%. To make matters worse, of the total expenditure recurrent expenditure was about 92% of the total. Added to this the unit costs of education as a percentage of GDP per capita are high compared to other countries. This means that due to inefficiencies, it is more expensive to educate a Kenyan than it is to educate a South African, Indian or Chinese child at each level of education.

The last factor is inflation. Inflation in terms of TFP usually means that high inflation usually leads to lower investments and savings which are major drivers in TFP growth due to lower real earnings. Kenya has seen high inflation usually due to exogenous (external) shocks that have rendered most wages and salaries useless. According to the Kenya Institute of Public Policy Research and Analysis (KIPPRA), food and beverages contribute approximately 80% of inflation and are subject to extreme shocks such as drought and gross mismanagement of food reserves in the country. Sound policy needs to be enacted to deal with the food issue and consequently inflation so as to improve TFP.

Clearly our economy has been a house of cards, growth has taken it higher and higher but one day when the wind blows or someone bumps into the table, the house will come crumbling down. Governance has to improve through a new proper constitution, improved political good will and leadership and zero-tolerance to corruption. Our education system needs to be ridden of the inefficiency and slack reflected in the high unit costs and high recurrent expenditure on education. Furthermore, the bureaucrats in government need to focus more attention to early childhood education and technical education. Finally the government must realise that monetary policy alone will not fight inflation rather a focus on removing the shocks that affect inflation. Through all these measures, Kenya's growth will finally be sound and stop looking like a house of cards.

Due to difficulties in posting tables and graphs I can email the comprehensive article to anyone interested just express your request to my email address at samora365@gmail.com

Don't rely too much on the CBK Measure of interest rates

2009-12-07T08:41:00.005+03:00

Just as a thought, I would like to suggest to Kenyan's as borrowers or potential borrowers not to over rely on the Central Bank of Kenya (CBK) measure of general interest rates. The reason is more mathematical and I would like you to bear with me on this one. The CBK calculates the interest rates you see in news and in the CBK reports using the weighed average method. The formula is

Weighed interest rate = S(Qi/D)ri

Where, S = Summation over all the loans a bank is making

ri = Rate of interest that the ith borrower pays

Qi - The loan amount for the ith borrower

D = Total loan amounts for all the accounts which is the sum of Qi

You probably will not need to understand the above but it could help. The reason I am putting up this post is to advice or warn that the interest rates given in the news are not likely to apply to you when you go and apply for a loan. They may not even be a good guide as to what rate you may get. The reason to this is that the above formula as sound as it is, will inherently tend to have bias towards bigger borrowers who are usually given loans at below prime rates. An example is that if Safaricom want to borrow to expand their network coverage, they will go to the bank and ask for cash. If the interest rate at the bank is quoted at 15%, then they will get prime - say 3% meaning that they get the loan at 12%. This could be due to the fact that they generate good cash and usually earn their interest many times over. However a small borrower could be quoted a rate of prime + 3 meaning that he gets 18%. This then if applied to the formula will tend to lean more to Safaricom's rate as it will take out a bigger loan than you will.

Therefore, be watchful over such discrepancies when you next go to the bank asking for a loan.

Fuzzy Logic That We Must Live With

2009-12-03T23:45:00.003+03:00

I would like to think of myself as a man of science and the scientific way. That means that I follow reason and logic and maybe that is why I have really hit it off with Economics. However, back home I have found it frustrating to be a man of science. Evermore so in the field of finance and investments. As an amateur student of the Nairobi Stock Exchange, I have been puzzled by the valuations that the market places on some of the companies whose stock is traded on the Bourse. I can comfortably say that the market does not follow any fundamentals and maybe this is the reason that many companies choose not to list on the NSE. I will give a short discussion on the basics of the exchange, the meaning of fundamentals and a short analysis with a locally listed company.

In it's essence, a stock exchange is a financial intermediary. This means that it is a place where people who have money and nothing to do with it at the moment give those who do not have the money but have a use for it. It is like a bank but in this case the depositors decide who the bank will loan. When companies need capital for expansion, investment and other productive purposes, they can sell equity (part ownership) of the company to raise funds. The funds raised will be used for profit making but now the profit will be shared with the new part owners. It is a model that was started by the Dutch with the Dutch East Indian Company a very long time ago. Apart from listing, the bourse/exchange is used for investors and speculators to buy and sell the stock of a company when its underlying fundamentals change either raising or lowering its value. The trading is done with a view of making profits.

Now that I have mentioned fundamentals, I think a paragraph or two discussing this matter is deserved. Often, we hear that word and in most cases followed by a plethora of other financial jargon that confuses most investors and potential investors. Ben Graham who was the intellectual mentor of Warren Buffett reminds us that a stock is part ownership of a company and not a symbol that moves up and down a screen (ticker at the time he was discussing this). Most people think of shares as pieces of paper that people trade like cards, most people detach the share from the company and make hazard guesses on where it is going to be in the near future. What Graham posits and what is true is that when you buy a share, you become part owner of that company. I recommend that you should maybe visit the premises of the company whose shares you have bought to really internalise your position as part owner.

With this in mind, a company exhibits fundamentals when the share price reflects the value of the company. A simple example is needed here. Imagine 10 companies all growing and selling mangoes. When buying a share what would we look for? I would look at the soil fertility of each of the farms, the types of farming techniques used, the farm yields, the selling prices of each mango and the management of farms. The management is very important, imagine a farm whose management eats all the nice mangoes and sells the bad ones to us. Its management is not maximising on its profits and therefore does not offer good returns to its shareholders. The fundamentals are therefore the underlying practices and issues that pertain to the business in its efforts to maximise profits.

Now in relation to the Nairobi Stock Exchange, I state that the market does not offer any fundamentals and is driven by pure speculation and insider trading. The case of Carbacid and Safaricom are good examples. With Carbacid, after its suspension was lifted, it's share price grew phenomenally. However, on Tuesday it suffered a 37% drop and on wednesday it suffered a 7% drop. With Safaricom, speculative tendencies saw many people rush to buy only to see their investment suffer. It is the fuzzy logic that I talk about, from a simple analysis if the greater percentage of retail investors is buying in the IPO to sell shortly after the share starts trading, then wouldn't the resultant supply of shares due to the sell off depress the price and thus nullify their earlier reasoning?

The case of Jubilee Insurance can be given for this speculator syndrome. Jubilee Insurance is an insurance company that was set up in 1937. After growing in leaps and bounds it listed in 1984 on the NSE and is currently the second largest insurance in Kenya in terms of Market Share and it is the Largest in terms of operations in East Africa. Insurance companies make money from the concept of pooling of risk. When many people pay up for premiums, the insurance company through the pooling of that cash can cover some expenses as most of the people who paid the premium will not suffer any loss. Therefore they take premiums and pay up claims for losses suffered. Added to this due to the cash they make upfront from the payment of premiums, they invest this cash and earn investment income. The two main sources of earnings then for an insurance company is the underwriting profit i.e. the difference between premiums received and claims paid & Investment income.

Jubilee Insurance at the end of October was selling for around 5 times earnings, it is now selling at around 8 times earnings. This is below the market average of 13.45 times earnings. This surprises me because Jubilee has registered underwriting profits in an industry where most companies have been forced to close down. It has stayed away from motor commercial (PSV) insurance which has been the main reason for the dwindling profits of the industry. Underwriting discipline is a huge virtue in the industry and it is a good gauge of the management in place at Jubilee. The 2007 Association of Kenyan Insurers (A.K.I) report states that "Insurer's profit going forward will become increasingly dependent on investment earnings as underwriting performance steadily deteriorates". Right now very few companies have seen growth in their investments due to the global recession. However, due to the short term nature of the crisis, not too much attention should be paid to this.

The company has over the years also delivered both consistent and growing dividends that from a dividend growth perspective should see the company being valued higher than it is. Looking forward, the Kimunya Finance Bill of 2007 in reference to the Insurance industry dictates that share capital for general insurance companies should rise from KSh 100 million to Ksh 450 million. This will kick out a lot of Jubilee's competition and make the company more profitable.

The implication is that the bourse through a lack of focus on fundamentals has undervalued Jubilee Insurance and over valued a number of others. Consequently this means that you either stay out or get in with a focus on the fundamentals geared towards long term investing.

Further Details on Blog about Parliamentary control of the Central Bank

2009-11-30T14:54:00.002+03:00

If you wish to read further on this matter. The following link gives further details from Ben Bernanke, governor of the U.S Federal Reserve Bank.

http://www.washingtonpost.com/wp-dyn/content/article/2009/11/27/AR2009112702322.html

Another article by Robert J. Samuelson gives further analysis as to why Central Bank should be free from Parliament.

http://www.washingtonpost.com/wp-dyn/content/article/2009/11/29/AR2009112902012.html?sub=AR

Enjoy the read.

Innovate or Perish

2009-11-25T13:51:00.013+03:00

Walking round the Nairobi Central Business District (C.B.D) the other day, I was bemused by just how so many businesses are similar. One is bombarded by cyber cafes, mobile phone shops and clothes retailers. To me it is very amusing that within one bazaar, from out of 12 shops, 7 of them sell mobile phones while the other 5 sell clothes. It is representative of the insatiable entrepreneurial spirit that Kenyans possess as well as maybe a lack of innovation and imagination within society. It could be that low levels of tertiary education and rigid rules concerning small enterprises in Kenya warrant this over indulgence in the aforementioned businesses. They could be thought of as the trinity of businesses amongst I would dare say people who lack a specific personal skill acquired through tertiary education.

Is the situation any different amongst workers who have attained a university degree or beyond? Probably not, most young Kenyan workers educated both home and abroad mostly engage in similar enterprise. A marketing consulting firm, an accounting firm, a corporate communications firm or a media firm are the usual suspects. The breadth of business ideas is very narrow. This is not to say that the businesses mentioned are not profitable. Among the Top 100 Small and Medium Enterprises (SME's), rated by Business Daily and KPMG 12 of them operate within the fields I have just mentioned. Therefore when run well, they can be very profitable enterprises. In the short run, they can be an investor's best dream as they generate good cash flows and have a high Return on Assets (ROA); this is a measure of the profit gained per shilling of assets. Since the value of the asset is the denominator, it is a measure of how well you use your assets to generate income.

The question then is why is this of any significance to someone who is concerned about our economy? My response is based on an analysis of a perfectly competitive industry.

Perfect competition occurs when there are many buyers and sellers of the same product, selling a homogenous (similar product), within a system that has perfect or near perfect information (where buyers and sellers know everything about each other's prices and output) all leading to a situation where firms make zero economic profits adjusted for risk. An example can be given of the wheat industry in our imaginary province Ungaland. In Ungaland, there is an abundance of land where wheat can be grown. In the province, the population has split itself into two groups; wheat growers and wheat buyers. If one farmer were to start growing wheat and everyone else was buying from him, he would make supernormal profits since he determines his output and therefore price. When other Ungaland citizens take cognisance of this, they will all rush to become farmers so as to also make economic profits. This will happen up to the point where they are no longer making profits as they increased supply will see them sell at a point where the price of the bushel of wheat sold at the market is equal to the cost incurred by the farmer to produce that bushel of wheat.

Here the distinction of economic profits is made because in economics, one has to take into consideration of the opportunity cost. This is the cost of the best alternative activity foregone due to undertaking the farming. The farmer could have become a fisherman or maybe would have put the funds he used to start the farm into an interest bearing account. The benefits that would have accrued from these activities are the opportunity cost. Accounting profit on the other hand just reflects explicit (stated) costs and benefits. From this, the implication is that after adjusting for opportunity costs, the farmers are not being compensated for their foregone opportunities.

If one now applies this to the situation with both "skilled" and "unskilled" workers and I call them that with extreme caution since some of the "unskilled" workers are very skilled at a particular vocation, one observes that the markets for their goods and services are either saturated (especially in the case of the former business trinity) or are going to be saturated in the near future (the case of the firms). They sell a similar product, to many buyers and sellers who are well informed about the demand and supply situations of these firms.

Why then is this an issue if the resulting condition is good for the consumer who will benefit from low prices and bad for the seller who will have to make do with zero profits? It is obviously a good thing for the consumer as he will have cheap stuff. He/she will be able to buy cheap clothes, get a cheap phone, access cheap internet and even have someone do his books for him at a low price. The concern in this article is not for the consumer, it is for the firm and the economy at large.

Low profits will add little value to the economy as in the long run, firms will have no incentives to hire new workers and expand their activities. They will pay less in taxes and therefore add little revenue to the taxpayer. There will then be little income for the government to achieve infrastructure expansion and carry out their mandate.

Furthermore, for me it reflects a failure of our educational system. The clear lack of a stimulating and empowering educational system has two effects. A narrow skill base from which more diverse business ideas can emerge and a monkey see monkey do business climate. The country's business environment needs clear innovation or otherwise many of the existing businesses will have to make do with penny pinching from meagre earnings adding no enterprise value to the economy. Imagine one wanted to buy the businesses; the small earnings will lead to low valuations from potential investors as future earnings are limited. Most business valuations are contingent upon valuing future cash flows so as to get a present value of the business. The businessmen in the businesses and firms therefore lose in their investments from both an earnings perspective as well as an asset growth perspective.

We need more innovation through I suggest better education so that we can have a robust business climate within the country.

New Draft Undermining the Role of Powerful Civil Servants

2009-11-19T16:44:00.008+03:00

It has been about two weeks since the last article on inflation measurement in Kenya. Since then I have arrived in the land that inspires the blog and gotten more views on the matter. The content of the article is clearly vindicated by the general consensus from Bankers on their unwillingness to reduce their interest rates. It was expected that with lower inflation figures, there would have been downward pressure on bank lending rates as their real interest rates fall.

One positive development since has been that the draft constitution was released to the public on the 17th of November. It has been welcomed with arms wide open and is seen in most circles as a panacea to the woes that have engulfed our beloved country. I will vote affirmatively for it when the referendum comes around as the benefits that it will bring greatly outweigh its shortfalls.

However, after reading through chapter 15 that talks about public finance. Matters ranging from the office of the Budget Controller and the Central Bank if passed as they are will pose both a great threat to the fundamental market system that the country has embraced as well as being a fiscal drain to the budget.

There are some issues that I will raise amongst many others that can be raised. The first is that Parliament is given a great degree of power when it comes to oversight of our institutions as well as the appointment of both the Governor of the Central Bank and the Controller of Budget. It seems a good "democratic" choice to give parliament most of the powers that Treasury and the Central Bank currently enjoy. The rationale is that with parliament, most of these decisions pertaining to Monetary Policy, Budget control and key decisions pertaining to the regulation and oversight of our financial institutions are better handled by the legislative arm that represent the opinions of the populace. It has escaped the makers of the draft that the general populace does not have an informed opinion on a lot of these issues, especially monetary policy and the regulation and oversight of financial institutions.

In the case of monetary policy which parliament will control through the power they wield on appointing members of the Central Bank's board of directors, we are very likely to see very predictable cycles of monetary stimulation. The draft states in Chapter 15, Article 269, part 3, that the authority of the Central Bank of Kenya vests in a board, consisting of a chairperson, the Governor, the deputy governor and not more than four other members who will be appointed by the government and approved by the National Assembly. Clearly then the members of the board are responsible to the National Assembly. With this situation in place, parliamentarians are very clearly going to dictate matters such as the levels of money supply and the setting of tools such as the repo rate and the bank reserve ratios. Political influence over these matters is extremely dangerous. The debate over the autonomy of the Central Bank has been an important one over the years and has even been devoted a whole chapter in many macroeconomic text books. My opinion on this matter is that the boards of Central Banks will be judged on their effect on the economy whereas politicians are looking towards their next election. From an incentives point of view, then it makes sense to give full discretion and independence to the board of the Reserve bank as they are more likely to make dispassionate choices regarding the main mandate of the Reserve bank and that is to control inflation.

The case of legislative incentives clouding law maker’s judgement can be given. During the sub-prime mortgage boom in the United States of America, a great number of Americans signed up for sub-prime loans. Sub-prime mortgages are loans that are given to people who do not deserve them from a financial point of view. People without employment and with poor credit scores got the mortgages and they clearly lacked the ability to pay them back. House ownership in the States soared and everyone was happy. Senators and congressmen were happy to turn a blind eye to the sub-prime issue because if there voters were happy, the law makers were likely to get voted in during the next elections. Their incentive system disregarded a key economic issue that brought down the world’s economy. Afterwards, they are the ones who tore down Wall Street for their excesses and their insatiable risk appetites. The point to be taken is that a politician’s incentive mechanism will lead to him or her to disregard matters of key economic and financial importance that require unpopular and dispassionate choices because they are incongruent to their political ambitions.

Peering further on this issue, there will be double pressure to disregard inflation and make economic growth the key issue for the Central Bank. Nowhere in the draft does it mandate the Central Bank to actively control inflation. In the current Central Bank Act, it clearly states that "The principal object of the bank shall be to formulate and implement monetary policy directed to achieving and maintaining stability in the general level of prices". In the current draft, the Central Bank is mandated to control amongst others the value of the currency of the republic, issue notes and coins, act as a banker and financial adviser of the government and conduct monetary policy aimed at achieving growth. The focus here then shifts from controlling inflation to stimulating growth.

The Central Bank as well as the National Assembly will thus have a focus on growth instead of having a system of balances where the Central Bank focuses on inflation and the National Assembly focuses on growth. Growth with unbridled inflation is merely cosmetic as in the long run, real growth will be stagnant. This debate is rife in South Africa where some sections of the African National Congress (ANC) contend against the Reserve Banks stance on inflation targeting. The results are clear as South Africa has managed to steer away from a meltdown of their financial system and has avoided the disastrous unemployment that their peers in the middle income countries category have suffered.

One final issue is the congruence of some of the key posts that will be affected by the Draft Constitution. These posts are the posts of the Controller of Budget, the head of the Economic and Social Council as well as the governor of the Central Bank. The latter two already exist. Both the Governor of the Central Bank and the Controller of Budget will be appointed by the president subject to the approval of the National Assembly, the former will only have a six year term without renewal whereas the latter will have a five year term with the option of renewal for only one extra term. In terms of the Economic and Social Council, the draft hasn't made any clear guides concerning their tenure, but it has stated that they will follow the same appointment as the Governor and the COB, the only difference is that they will also have to be approved by Cabinet. My issue with the above is that these people will have to work together on many key issues that will require quick decision making in tough times.

They will have to develop a bond and working relationship that will enable this. The incongruence of their working terms is likely to be a hindrance to their proper working relationships. An example can be given of Trevor Manuel and Tito Mboweni in South Africa and Robert Rubin and Allan Greenspan who worked in the U.S.A. Both teams had discretion and avoided political pressures as well as having similar or near similar working terms in regards to tenure, the same luxury cannot be afforded to the likely holders of the aforementioned posts in Kenya.

In the future, we are very likely to see disjointed policy formulation and rigid decision making if the National Assembly is given so much power. As much as former post holders misused their posts especially as governors of the Central Bank, it is a post that will have to be free from political interference. The makers of the draft should go back to address some of these issues now with consultation from the banking industry and other experts. Maybe the draft was written at the wrong time. When the world is suffering from a deep recession and when the country is reeling from the post-election crisis. We cannot afford to slowly turn socialist in the name of trying to be fair to everyone. As the saying goes "too many cooks spoil the broth” and the National Assembly is the perfect example in our analysis.

Further Details

2009-11-04T08:35:00.002+03:00

Despite it's merits the government has decided that the best way to combat inflation is to change the way we calculate it. Read on the link below...

http://www.businessdailyafrica.com/-/539552/681546/-/59vnwm/-/index.html

For opinion and analysis read:

http://www.businessdailyafrica.com/Opinion%20&%20Analysis/-/539548/681578/-/item/0/-/14118clz/-/index.html

Abbracadabra Inflation

2009-11-02T15:40:00.005+03:00

"Inflation is taxation without legislation"

Milton Friedman

This statement is one of the most profound statements ever made by an economist. At its core it speaks of inflation for what it is, a tax on the residents of a country. Furthermore, it is a tax that in many cases is instituted by government action or inaction. Inflation as is defined in any introductory economics text is the continuous increase in price levels.

Recently the National Bureau of statistics in conjunction with the IMF declared that they will revise their inflation measurement tools. This is because they figured that inflation in Kenya as it is calculated, is currently overstated by a factor of two. This means that the current inflation rate of 18.7 percent actually should be approximately 9.5%. The move as they state, will lead to the country attracting investors who are currently put off by the highest inflation figures in the region. Investors will be buoyed by the fact that their workers will not have to negotiate higher annual increments due to the "overestimated" inflation on which they peg their wage negotiations.

So how exactly is inflation measured?. Inflation in Kenya is predominantly calculated through the Consumer Price Index (CPI). The CPI is like a big basket of goods and the aim is to measure the increase in the cost of the basket given fixed quantities of different goods. Added to this, the goods and services in that basket are given weights which could be thought of as measures of importance. The weights reflect how prominent that good or service is in the consumption habits of the population. In the case of Kenya, food is given a weighing of 50.5% of the overall basket (CPI), meaning that on average according to NBS estimates, Kenyans spend approximately 50.5% of their income on food. Alcohol and Tobacco has a weight of 1.7% and Clothing and Footwear has a weight of 8.8%

The main issue with the new move is that for me it seems to be cosmetic and misleading. The key issues for me is that the NBS want to reduce the weighting of food from 50.5% to 40.3% as well as add new items such as mobile phone airtime and internet costs. If this happens, in the next couple of quarters Kenyans should be seeing lower inflation figures. The key thing is that nobody should be fooled that inflation has reduced, all that has happened is a bit of mathematical magic. Reducing the weighting of food under the auspices that people do not spend as much on food as they used to is both misguided and unfair.

The average resident of Nairobi is even likely to spend all of his/her money on food given that primary education has become free. Most casual labourers earn around Ksh250 per day. With flour going for around Ksh80, a packet of milk and bread both selling for 35 each. The total food bill comes to Ksh 150 which is already 60% of his daily income. The new 40.3% weight is more likely to be felt for middle income earners in Nairobi but not for the bulk of casual workers who furnish Kenyan industry with their labour. Added to this, it is a bit misguided to add mobile phone airtime and internet costs to the basket. It is noted that consumers do purchase these items and they therefore warrant inclusion. However, in their state, they are likely to understate the inflation rate. Take airtime for instance, it is very unlikely that Safaricom faced with higher costs will sell Ksh100 airtime for 105 shillings Ksh100 airtime will remain that way forever. They are more likely to increase the charges on their tariffs. So with this in mind, isn't it wiser for the NBS to include a measure of mobile phone tariff charges rather than the cost of airtime?. Furthermore, internet costs in the long-run are more likely to go down than up. It is the very nature of technological products that due to innovation and obsolescence prices in the industry tend to drop.

All these factors summed will obviously reduce the inflation rate that we see on newspapers and hear about in the media, but they will not reduce the inflation that we feel or encounter in our daily lives. Think of it this way, imagine a typical marathon (42Kms). Due to some grumbling from the competitors about the length of the race, the marathon organisers decide to change their metrics. Instead of measuring a meter as 100 centimeters, they ordain that from now on a meter will be 200 centimeters. The effect will be to reduce the length of the marathon to 21kms. Participants will rush in to sign up due to the fact that the race is shorter, but will soon realise that they signed up for a daunting and long marathon. Investors and the general population will be mislead and will make wrong decisions in terms of their investment, saving and consumption patterns due to the new inflation rate.

This really reflects the general decay in the Kenyan policy environment and is reflected in the inefficiency of Central Bank Policy in its activities such as fighting inflation and stimulating demand through interest rates. One can check the following link for a deeper discussion about the inefficiency of the CBK and policy makers in general.

http://www.businessdailyafrica.com/Opinion%20&%20Analysis/-/539548/644732/-/item/1/-/gll0gez/-/index.html

Summing up, simply watch out for the new figures and take them with a mouthful rather than a pinch of salt.

The Retailer and his advisors

2009-10-18T02:21:00.008+03:00

I would again like to begin by thanking all the people who have had a look at this blog since its inception about a month ago. I have received nothing but positive comments as well as constructive criticism and I would just like to thank everyone. It has been a great confidence boost to have people who have not the slightest interest in economics and finance, come up to me and tell me that they like the blog and are finally beginning to understand some of the hazy concepts found in economics. One of my aims with this blog was to make such matters understandable. This week's article is about the retail investor and how he should approach investment advice. I hope to give a rational account of the human condition and investing as learned from Ben Graham and others like Warren Buffett and Seth Klarman. I do not claim to be a successful investor, all I am doing is spreading the word from these great men and applying it in a localised manner.

During the mini-boom of the Nairobi Stock Exchange (NSE) of circa 2003-2007, share trading and speculation reached an all time high. The NSE was spoken of at dinner tables, bars, restaurants and even was used as bait for some men trying to attract members of the opposite sex. Stories went around of how people had bought homes, acquired new cars and paid for their children's school fees through their "wise investing" in the stock market. People who stayed away or were suspicious about the gains made in the stock market were ridiculed. I remember my Economics teacher in St. Mary's Mrs. Mwangi in 2006 telling me that the stock market did not reflect fundamentals and it was doomed to drop at some point. Her fellow colleagues at school thought she had gone mad. In the newspapers and on TV, we witnessed mammoth lines of individual investors queuing outside the major stock broker's offices to partake in new IPO's as well as to buy shares that are already trading. It was boom time for the NSE and many other regional exchanges. In fact Zambia's LUSE Index sustained an annualised growth rate of 53% over that same period. This is a remarkable figure for any stock exchange. What drove this growth was an increase in individual/retail investors in Kenya. Many encouraged by the new government and a general feel-good vibe around the country decided that it is time to invest.

With the IPO's some even borrowed so as to speculate and many made some gains. Especially during the Kenya-Re, Eveready and Kengen IPO's. However come 2009, many of those retail investors are questioning their participation. The NSE index has dropped from it's dizzying heights of 5234 in 2007 to 3005.41 as of September 09. I remember at it's height the chairman of the NSE proudly proclaiming that it would hit 8,000 in a year's time. It has shed approximately 40% of its value since. Many of the retailer's as they will be called in this article lost copious amounts of money and some of those who borrowed especially for the Safaricom IPO are in negative equity with their banks. Negative equity occurs when the loan repayment exceeds the value of the asset. An example can be found in the USA. With falling house prices, most people's mortgage repayments exceed the value of their houses. Borrowing to speculate is like a game of Russian Roulette, you risk something that you know and are sure of (your life/ liability) for something that you don't know and are unsure of (an empty chamber/stock price movement). The key then is for future investors and how they should approach financial advice. I will give three sources of financial advice and will analyse each in detail.

The first source of financial advice during the boom, especially for those who were "savvy" and understood some basic accounting elements, were the investment banks and technical analysts. Armed with their deep understanding of technical ratio's and mathematical nuances, many of these analysts had devised techniques of telling where future profit opportunities lay. With acronyms such as EBITDA and PE ratios, they advised the smarter retailers about their stock picks. However one folly lay in that many of these ratio's don't offer any information about the real value of the companies that were being traded. It is vital to remember that a share is a piece of a company and not just a symbol that goes up and down computer and TV screens. A lot of these accounting ratio's are very much a construct of the company that is reporting them and are thus open to legal manipulation. A company can be earning a lot of money but not generating any cash therefore the apparent prospects will be good but the company is struggling. As Warren Buffett says... "Some of these analysts can be compared to a man with a hammer, to him everything looks like a nail". The fact that they have the mathematical and intellectual aptitude to analyse things, they tend to come up with analysis that are mathematically sound but irrelevant. Furthermore, as Ben Graham wisely said "nearly everyone interested in common stocks wants to be told by someone else what the market is going to do, the demand being there, it must be supplied". These analysts are thus providing something that the market is demanding.

It should not be taken then, that these analysts are ridiculous. They are a very important element of the financial architecture, but one should make sure that they are being told relevant details not just a raft of mathematical proofs. The Long-Term Capital Management fiasco is one such example of how brilliant minds can make dumb choices by over relying on sound mathematical analyses. http://www.sjsu.edu/faculty/watkins/ltcm.htm

The second group is the stock brokers. Economics teaches us to study incentives. If one analyses the stock brokerage industry, one soon realises that stock brokers make their money out of commissions charged on trading. For them, then the focus is on volume rather than quality. With this being the case, one can quickly see how one should avoid stock brokerage advice and just use them for what they are, people who let you buy and sell. If you approach a stock broker, he/she will in most cases tell you to buy and sell a certain stock. Added to this will be tips or nudges that the stock in question will do well soon. Rarely will one tell you that you should just sit on the fence and hold your money. Reason being? they make their money out of volume rather than quality. Many of the retailers lost a lot of money by listening to some of the stock broker's tips. Stock brokers then are akin to pharmacists, whenever you go to the local pharmacy with a minor problem, rarely will you be told to just go home and rest. Sometimes, they will even sell you sugar pills because like stock brokers they make their money out of volume rather than quality. Clearly then one should avoid investment advice from a stock broker.

The last source of advice is family or friends. I think this was the biggest motivator for most retailers to enter the stock market. Stories at home, at work and at social gatherings about which hot stock to pick or which one to sell were the order of the day. One's affection for family members and friends as well as the human condition of not wanting to be left out made many follow this advice. However if your family members are not skilled investors and have not had a solid track record of success with their investments then stay away from this advice. The thing is that as human beings we are blessed with the extraordinary gift of story telling, through the years; customs, practices, beliefs and ideologies have been passed from one generation to another through story telling. Oration is then an important part of society. However, stories have no place in financial advice.

Let us take the story of commercial aviation. When Commercial aviation was setting off in the late 50's and early 60's the stories were that the industry would change the way we live and would offer an almost infinite contribution to our GDP's as well as making perpetual profits. However, nobody had analysed the business structure and realised that in the long term the industry would be weakened by increased government regulation, would face perennial uncertainty over fuel prices and even face the risk of terrorism. As I write the aviation industry is yet to turn in a profit cumulatively. Usually the sound information is too abstract for retailers to understand and thus they would rather hear stories. Maybe we should tell stories that are analogous to what the abstract relevant data is telling us. Most of the tips about the stocks to pick are based on almost spiritual beliefs and laced with human over confidence and are in their definition doomed to fail for an investor.

It seems so far that I have discredited three main sources of financial advice. There are many others such as your local bank, accountants and independent financial planners. The conclusion is not that we should all just ignore financial advice, a lot of it is useful. The conclusion is that we should be aware of the pitfalls inherent in financial advice. One should know what his aims are and should come up with the fundamental principles that will guide his investments. The conclusion then is that you should let the advisor know your stance about investments and through the ensuing mutual respect, the two of you are likely to make sound financial decisions that are specific to your characteristics and expectations. He/ she should know that you are not easily manipulated and are a focused investor. He is not likely to mislead you if you make your stance clear from the get go.

Dismantling the NSSF: Key to unlocking capital

2009-10-10T16:16:00.001+03:00

I would first of all like to congratulate President Obama on his Nobel Peace Prize, the merits are debatable, but it is a good thing for World Peace that one of it's main drivers gets the award.

It has been a week since my last article on agricultural reform. In that week I have been thinking of what to include in my newest article. It was a tough choice amongst a raft of ideas and even recommendations from some friends and even some lecturers. However, I have stuck on the issue of the National Social Security Fund and it's effects on savings and inevitably capital accumulation in Kenya. My friends and family know that I am a big proponent of dismantling the NSSF in it's entirety and moving the pension system from a publicly funded PAYGO system to a private account system. I hope to give a short discourse on the importance of such a move through its contribution to GDP growth.

The subject of pensions is an important one in any civilisation. Mechanisms need to be in place where employees and workers in general can save some money to avoid old age poverty. Old age poverty is a really regrettable situation in that old people are not as productive as their younger colleagues. Furthermore, after 30 or so years of work, one needs to kick back to enjoy the last years of his/her life without the rigours that have been a constant in their last thirty years of work. Therefore it's a no brainer that pensions and savings are mandatory in any country.

I remember speaking to a friend of mine about the NSSF and its pension system. He told me about his father whom upon retiring went to claim his benefits from the NSSF. To his utter bemusement, he was handed a cheque of 700 shillings ($10) after they processed his case. It took 2 months to process the payment. So, after years of working and two months of processing his payment, he only had 700 shillings to show for it. I remember laughing because after cheque processing fees at the bank, he would only be left with half that amount. Maybe my laughing was tempered by the fact that over the course of his life, he had invested wisely and was even on the board of one of the big corporations whose shares are listed on the NSE. However, if he had just worked and hoped that his pensions would take care of him at the twilight of his life, then it would have been a very sad case. Here, I would like to introduce the concept of replacement ratios. The replacement ratio is the percentage of working income that is received during retirement. Let us posit that he was receiving 500,000 shillings per year (a conservative estimate) during his last few years at work, then this pension would leave him with a replacement ratio of around 0.14%. At this point I would urge you to keep this figure in mind as it may be needed for comparative purposes later on.

Clearly then, the NSSF has failed in its mandate. Further issues arise when we peer further into the system. Its contribution rates are similar to those of the National Hospital Insurance Fund and are pegged to incomes that have yet to be revised since 1988. Therefore, the highest income bracket starts from 15,000 shillings. Clearly the intellectuals at NSSF have failed to keep up with inflation in adjusting its income brackets. The annualised rate of inflation from 1961-2007 as calculated using data from the National Bureau of Statistics is approximately 10% per annum. This means that if you want to maintain your income levels over the years, your employer should be giving you a 10% pay rise each year. However, back to the subject of the NSSF, the administrative inefficiencies that have been apparent over the years eventually leading to the organisation being taken into receivership is a big drag for capital mobility in the country.Furthermore, the minister of Finance Mr Uhuru Kenyatta in his proposed Finance Bill 2010 intends to limit the investments by the NSSF to government bonds and treasury bills. This has been met with opposition from the current head of the NSSF Mr. Kazongo who is the Managing Trustee.

However no amount of reform in the NSSF would improve its efficiency. It is a bureaucratic organisation run by the government "intellectuals". As Milton Friedman would say "Erratic free markets often make better choices than government intellectuals". NSSF has in its portfolio assets worth approximately 90 billion shillings, of which approximately 1/3 is invested in the illiquid real estate market. On top of this, the real estate issue with the NSSF has been a big source of corruption as well connected individuals have benefited from buying the NSSF properties and making clean profits off of them. It is a malignant form of inefficiency that has caused many retirees headaches and eaten into tax payer funds. So what to be done?.

With this in mind, I recommend that Kenya as well as many other African countries take up the Chilean pension reform model instituted in 1981. Chile under General Pinochet who was advised by the Chicago Boys, a group of prominent Chilean economists who had studied under the great economists at University of Chicago, decided that moving from a publicly funded defined benefit program to a privately funded defined contribution program was the best choice to reform its capital markets and improve liquidity which had been a major issue with Latin American economies. Under the reform, new employees had to join the new program and current employees were given the option of remaining in the public system or moving to the private system. It is no wonder that majority of them chose to move to the private program. The public system had proven to be a fiscal drain on the government budget and provided a deadweight loss on the economy. Private administration proved to be much more efficient than the public system.

It is estimated that after the shift, most pension funds averaged a real return of 10% per year. The real return is that adjusted for inflation, in Economics we have to do this to distinguish from nominal/ apparent growth and real growth. What this means for a pensioner is that if you had invested 10000 shillings with them in your first year of work, then after 20 years your 10000 shillings would have grown to 67275 shillings. If we recalculate the above after factoring in the monthly contributions of 1000 shillings, then your money would have grown to about 759,368 shillings after 20 years. Furthermore, economists from the IMF have shown that a change of 100 basis points (1% to the layman) in your real return sustained over your working life would have increased your average pension by 25%. This means that our previously calculated pension would have grown to 949210 shillings if the real return changed to 11%. The statistics are really phenomenal, what's more, stock market capitalisation in Chile grew from 28.4% of GDP in 1988 to about 124.4% of GDP in 2004. Back to the earlier mentioned case of replacement ratios, in the early 90's workers who had worked consistently over their lives enjoyed replacement ratios of 100% meaning that they got their full net annual income at retirement. Compare this with our paltry 0.14% that was handed to our unfortunate pensioner and it speaks volumes. Another issue that could be particularly significant for Kenya is that banks faced with the prospects of increased deposits will have to raise their saving rates to attract the extra cash. This would reduce the interest rate spreads which currently hover at around 13% and increase their supply of loanable funds.

We can really get stuck into the statistics but the picture is clear. Chile's Economy through the pension reform has seen increased capital mobility, better financial systems and sensible savings rates which in turn have lead to Economic growth. The same can be accomplished in Kenya, However for this to be accomplished, Economists from BBVA economic research have shown that policy makers have to ensure that there are strong political and market institutions, sufficient protection of property rights and an adequate and flexible regulatory mechanism for financial markets.

The possibilities for wealth creation and growth would be limitless under such a regime. However factors such as our political climate, erratic and unpredictable labour markets, high levels of informal employment and a lack of strong property protection laws will prove to be a substantial stumbling block to such reform. Too often government intellectuals (a term that readers and followers of this blog will have to get used to) think that they have the best interests of the civilians at heart. However Martin Fieldstein from Harvard University once posited that the industries that are thought to be luxuries and thus left to the market have benefited the poor of those Nations better than the essentials that the governments have kept to themselves. An immaculate example in Kenya is the spread of mobile telephony that has seen more people access the service compared to essentials such as electricity and water. It is clear that erratic markets make better choices than government intellectuals. Pension reform should therefore be seen as a luxury and hopefully the benefits would slowly begin to materialise to hard working Kenyan workers.

Reaffirmation

2009-10-05T22:21:00.000+03:00

It seems that the people at the KNBS have affirmed my earlier assertion that agriculture should be given more prominence than IT.

Follow the link below

http://www.nation.co.ke/magazines/smartcompany/-/1226/668252/-/s7124jz/-/index.html