Future Capital Kenya

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

Enjoy the read.

Vs

For opinion and analysis read:

"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.

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.

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.

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