Capital flows in a small open economy: The case of Kenya

Abstract

Capital inflows have been shown to have a major impact on macroeconomic variables, most of which in turn are considered as the determinants of capital inflows. This study goes further than previous studies to examine the determinants and impact of private inflows (short and long-term) in Kenya. Two VAR models are applied to Kenyan data; namely, Granger causality and impulse response models of capital inflows. We start with a comparison of patterns of capital inflows in Kenya, Uganda and Tanzania in an effort to assess existence of spillover inflows into Kenya from the neighbouring countries. Our results show that there is no evidence, to suggest that, capital inflows into either Tanzania or Uganda also encourage capital inflows in Kenya. Thus, investors are concerned with country characteristics rather than with East Africa region in general. We then compare short-term and long-term capital inflows into Kenya. It is found that short-term flows are more volatile as expected. However, contrary to our expectations, short-term flows are more persistent than longterm flows. We also show that the relationship between the two types of flows is that of substitution and not complementarity. Kenya is currently experiencing a major economic instability, worsened by volatile short-term capital inflows. The response of capital inflows to macroeconomic changes on one hand, and the response of macroeconomic variables to changes in inflows of capital on the other had become almost instantaneous in the 1990's, complicating further macroeconomic environment. It is shown that, in order to attract more private long-term capital inflows the external debt burden problem must be resolved and the investment climate in general must be improved. In particular, the country's economic growth must pick up and remain sustainable to encourage long-term inflows. We have traced the source of recent short-term capital inflows to budget deficits, high interest rates and current account deficits. And since budget deficits have a positive effect on interest rates and, to some extent, on current account deficits, budget deficits are responsible to a large extent for recent short-term capital inflows. Hence, it appears that short-term capital inflows have financed recent budget deficits and are being used to finance the country's growing interest payments and to service debt. Consequently, monetary authorities see capital inflows as means for reducing the upward pressure on domestic interest rates. In light of results from this study, policy makers should concern themselves with realigning economic fundamentals rather than trying to use artificial means to bring down interest rates.