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
House of Cards
Don't rely too much on the CBK Measure of interest rates
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
Fuzzy Logic That We Must Live With
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.
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