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TABLE OF CONTENTS Acknowledgements ....................................................................................................................................................................................................................................................................................... i Chapter 1: Kenya’s Recent Economic Performance and the Growing Role of Services...................................................................................................................... 1 Solid growth, and resilience to the COVID-19 pandemic…............................................................................................................................................................................................. 2 Although growth has been solid, there is scope to bolster inclusion and accelerate growth .......................................................................................................................... 2 Key empirical features of Kenya’s recent growth performance: (1) labor- and capital-input driven growth, not total factor productivity................................. 6 Key features of Kenya’s recent growth performance: (2) the growing role of services in growth and jobs.................................................................................................. 6 A focus on economic transformation by accelerating the development of services ........................................................................................................................................... 8 Chapter 2: SHIFT to Higher Value-added Activities in the Services Sector................................................................................................................................................... 4 The services sector in Kenya............................................................................................................................................................................................................................................................. 15 Global innovator services are important engines for growth.......................................................................................................................................................................................... 18 Digital services: building on the momentum.......................................................................................................................................................................................................................... 23 The importance of skills for global innovator services......................................................................................................................................................................................................... 27 Concluding remarks............................................................................................................................................................................................................................................................................ 30 Chapter 3: LINK Services More Strongly to Enable Industrialization and Economic Opportunities....................................................................................... 31 Services linkages are crucial to support other sectors and foster growth................................................................................................................................................................... 31 There is scope to strengthen linkages in Kenya....................................................................................................................................................................................................................... 34 Strengthening linkages between firms through technology and building ecosystems...................................................................................................................................... 38 Linkages are crucial to grow labor income and jobs........................................................................................................................................................................................................... 41 Concluding remarks............................................................................................................................................................................................................................................................................ 45 Chapter 4: BOOST Productivity through Technology Adoption and Competition............................................................................................................................... 47 The need to increase productivity – within and between.................................................................................................................................................................................................. 47 Kenyan firms need to adopt more sophisticated technologies....................................................................................................................................................................................... 49 Making the services sector more competitive......................................................................................................................................................................................................................... 56 Regulatory restrictions to competition in key services subsectors.................................................................................................................................................................................. 57 State participation in markets, including in key services subsectors............................................................................................................................................................................ 61 Concluding remarks............................................................................................................................................................................................................................................................................ 67 Chapter 5: TRADE Services More by Reducing Trade and Investment Barriers....................................................................................................................................... 70 Services are accounting for an increasing share of exports in Kenya........................................................................................................................................................................... 70 FDI has been increasing, mostly due to global innovator services................................................................................................................................................................................ 74 Removing services trade and investment restrictions in Kenya can yield sizable benefits.................................................................................................................................. 76 The potential benefits of removing services restrictions in Kenya.................................................................................................................................................................................. 77 An ambitious agenda – Kenya’s offer to liberalize services under the AfCFTA ......................................................................................................................................................... 80 Digital trade in services is ever more essential to Kenya’s economic growth............................................................................................................................................................ 82 Concluding remarks............................................................................................................................................................................................................................................................................ 88 Chapter 6: SECURE Inclusion by Making the Services Sector Work Better for All .................................................................................................................................. 89 The role of services in improving inclusion............................................................................................................................................................................................................................... 89 Participation in the services sector differs by gender, location and employment type........................................................................................................................................ 90 Services activities are predominantly informal and take place in small-scale firms............................................................................................................................................. 93 Services solutions to foster inclusion in the wider economy............................................................................................................................................................................................. 95 The importance of mid-level skills and soft skills to take advantage of services opportunities........................................................................................................................ 100 Concluding remarks............................................................................................................................................................................................................................................................................ 101 Chapter 7: Conclusions and Policies to ACCELERATE the Gains from Services for Kenya .............................................................................................................. 103 The urgency and opportunity of seizing the services momentum, and policy implications............................................................................................................................ 103 The role of services in Kenya’s changing economy: main conclusions........................................................................................................................................................................ 104 Seizing the services momentum: what it means for policy.............................................................................................................................................................................................. 107 Next steps in understanding and strengthening services for jobs and economic transformation: Knowledge gaps ......................................................................... 111 LIST OF FIGURES Figure 1.1: Kenya’s economy expanded at a solid pace in the 2010s….......................................................................................................................................................................2 Figure 1.2: …although not as rapidly as those of some other, fast-growing middle-income countries...............................................................................................2 Figure 1.3: Large fiscal deficits have opened up…......................................................................................................................................................................................................................3 Figure 1.4: …driven partly by increased public investment… ..........................................................................................................................................................................................3 Figure 1.5: …increasing Kenya’s public debt burden, and interest costs…...............................................................................................................................................................4 Figure 1.6: …and leaving it with a sizable and costly debt burden ...............................................................................................................................................................................4 Figure 1.7: Both exports and imports have declined relative to GDP…........................................................................................................................................................................4 Figure 1.8: …and Kenya’s economy is less trade-oriented than that of peer economies................................................................................................................................4 Figure 1.9: GDP growth has been domestic consumption-driven..................................................................................................................................................................................5 Figure 1.10: The labor force is growing much more rapidly than formal sector jobs….......................................................................................................................................6 Figure 1.11: …and prime working age adults (20–64) will soon exceed youth (0–19) for the first time.................................................................................................6 Figure 1.12: Growth has relied on capital and labor accumulation, not total factor productivity growth…........................................................................................7 Figure 1.13: …which has been flat, in contrast to some aspirational peers ................................................................................................................................................................7 Figure 1.14: Growth of Kenya’s economy has been concentrated in services…......................................................................................................................................................7 Figure 1.15: …and services have also accounted for the bulk of new jobs..................................................................................................................................................................7 Figure 1.16: Productivity of the services sector has risen and now matches that of industrial sectors.....................................................................................................8 Figure 1.17: In recent years, labor productivity growth of services has exceeded that of industrial sectors in Kenya and of peer countries................8 Figure 1.18: Industrial sectors played a large role in the development of current high-income countries, but much less so in current low- and middle-income countries...........................................................................................................................................................................................................................10 Figure 1.19: Employment growth in services subsectors has been driven by less productive sectors, such as commerce, hospitality and other services (including personal services)........................................................................................................................................................................................................11 Figure 1.20: Five channels to grow in the services sector in Kenya..................................................................................................................................................................................12 Figure 1.21: The contribution of the five different channels to economic transformation differs across services subsectors and also depend on the linkages with non-services sectors..................................................................................................................................................................................................................13 Figure 2.1: Services differ in the degree to which they are traded and their reliance on skills..................................................................................................................16 Figure 2.2: Global innovator services tend to be more productive than other services subsectors…................................................................................................17 Figure 2.3: …but most of the employment is in low-skilled domestic services subsectors.......................................................................................................................17 Figure 2.4: Compared with high-income countries, Kenyan services employment is concentrated in lower-skilled subsectors, with a small role for global innovator services...........................................................................................................................................................................................................................................17 Figure 2.5: Global innovator services represent 19 percent of GDP growth, but only 2% of employment…................................................................................18 Figure 2.6: …and the contribution to GDP growth has been growing over time.............................................................................................................................................18 Figure 2.7: Between 2018 and 2021, global innovator services have outpaced other subsectors in their growth in value added................................19 Figure 2.8: Global innovator services were the least hit during the pandemic....................................................................................................................................................19 Figure 2.9: Many services firms in Kenya are micro or small firms, including in global innovator services.......................................................................................20 Figure 2.10: Returns to scale are low in many of services subsectors, including global innovators.........................................................................................................20 Figure 2.11: Regional concentration of global innovator services....................................................................................................................................................................................20 Figure 2.12: The share of NPLs increased during the COVID-19 pandemic, but has stabilized since.......................................................................................................22 Figure 2.13: The financial subsector is mostly serving the tourism subsector, retail and real estate, and less so the agriculture sector........................22 Figure 2.14: Close to one-quarter of businesses operates in FinTech, followed by e-commerce and software as a service (SaaS)...................................23 Figure 2.15: Exports of digital services grew rapidly between 2005 and 2021........................................................................................................................................................24 Figure 2.16: Growth averaged 15 percent between 2005 and 2021, higher than other East African countries..............................................................................24 Figure 2.17: Kenyan firms’ ability to export and supply foreign firms differs by size, ownership, and sector......................................................................................25 Figure 2.18: While the ICT and the pharmaceutical sectors appear to compete with foreign firms more on price, agri-business and textiles are more able to compete on quality.......................................................................................................................................................................................................................26 Figure 2.19: Global innovator services, especially ICT services, rely on an educated workforce..................................................................................................................27 Figure 2.20: Close to half of employers in global innovator services indicate that graduates from the education system do not meet their skill needs.........................................................................................................................................................................................................................................................................27 Figure 2.21: The lacking skills and work experience are found across all occupational groups..................................................................................................................27 Figure 2.22: Tertiary enrolment in Kenya is at 10 percent, below Ghana and South Africa............................................................................................................................28 Figure 2.23: Of graduated students, 17 percent do so with a degree in science and engineering..........................................................................................................28 Figure 3.1: Agriculture relies only little on services inputs in Kenya............................................................................................................................................................................ 32 Figure 3.2: The largest input in the agriculture sector is by transportation services....................................................................................................................................... 32 Figure 3.3: Technology adoption within formal firms in Kenya’s agriculture sector is ahead of regional peers and some firms are close to the global frontier......................................................................................................................................................................................................................................................... 33 Figure 3.4: There is also a large dispersion in the degree of technological sophistication in agriculture........................................................................................ 33 Figure 3.5: The share of domestic services inputs into Kenyan manufacturing is very low ..................................................................................................................... 34 Figure 3.6: The use of domestic global innovator services by manufacturers is high but still has room for improvement................................................ 34 Figure 3.7: The share of domestic services inputs into Kenyan manufacturing has been growing rapidly................................................................................... 35 Figure 3.8: The share of domestic global innovator services inputs into Kenyan manufacturing has been growing strongly........................................ 35 Figure 3.9: The production network reveals rich patterns on the extent of linkages in Kenya............................................................................................................... 36 Figure 3.10: Trade, transport, ICT, and professional services provide the highest share of total inputs .............................................................................................. 37 Figure 3.11: Administrative and professional services have the largest shares of business-to-business sales................................................................................. 37 Figure 3.12: Most inputs supplied by services subsectors are going toward services in other subsectors....................................................................................... 37 Figure 3.13: Manufacturing mainly receives services inputs from transport and trade, lagging on professional and ICT services.................................. 37 Figure 3.14: The ICT subsector is mostly linked to other ICT subsectors.................................................................................................................................................................... 38 Figure 3.15: Professional services mainly benefit electricity and gas............................................................................................................................................................................ 38 Figure 3.16: Few firms use software services as inputs .......................................................................................................................................................................................................... 39 Figure 3.17: Smaller firms lag larger ones in software use.................................................................................................................................................................................................... 39 Figure 3.18: Services firms are less likely to benefit from linkages through formal associations............................................................................................................... 39 Figure 3.19: But increasing services linkages along the supply chain is an avenue to improve their technology....................................................................... 39 Figure 3.20: Entrepreneurship ecosystems for digital businesses and finance...................................................................................................................................................... 40 Figure 3.21: Services accounted for more export labor income, while for manufacturing most came via inputs from other sectors.......................... 42 Figure 3.22: Services inputs to other sectors’ exports provide a large amount of labor income, especially for the unskilled ............................................. 42 Figure 3.23: Transport and communications have the most export labor income, among services, and part of this income materializes in other sectors that contribute to their exports (backward linkages)............................................................................................................................................ 43 Figure 3.24: Trade and business services have the most indirect labor income thanks to their contributions to exports of other................................. 43 sectors (forward linkages)............................................................................................................................................................................................................................................... 43 Figure 3.25: Kenya’s business services lagged peers in labor income embodied in exports through inputs supplied to others .................................... 43 Figure 3.26: Kenya’s communication services lagged peers in labor income embodied in exports through inputs supplied to others.................... 43 Figure 3.27: Good exports spend on average 5 days at the port before being exported............................................................................................................................. 44 Figure 3.28: Transit times have been increasing since the pandemic.......................................................................................................................................................................... 44 Figure 4.1: Low labor productivity is explained by a low capital intensity, as well as low TFP................................................................................................................. 47 Figure 4.2: Compared with the United States, the services sector has seen little convergence in labor productivity........................................................... 47 Figure 4.3: Drivers of growth of TFP................................................................................................................................................................................................................................................... 48 Figure 4.4: During the pandemic the value of mobile money transactions close to doubled................................................................................................................ 50 Figure 4.5: Firms increased their investment in digital solutions.................................................................................................................................................................................. 50 Figure 4.6: Technological sophistication of production processes in Kenyan firms is far from the global frontier for the average firm, although a few are close to it....................................................................................................................................................................................................................................... 50 Figure 4.7: General business functions measured in the survey................................................................................................................................................................................... 51 Figure 4.8: There is a large heterogeneity in the technological sophistication of Kenyan services firms........................................................................................ 52 Figure 4.9: Kenyan firms are ahead in the adoption of sophisticated technologies for payments, but behind in general business functions... 52 Figure 4.10: The use of technology in GBFs.................................................................................................................................................................................................................................... 53 Figure 4.11: Sector-specific services technologies in retail, banking and accommodation......................................................................................................................... 54 Figure 4.12: Cross-country comparison of sector-specific service technologies in the retail and banking subsectors .......................................................... 55 Figure 4.13: Firm size is an important determinant in the adoption of technologies....................................................................................................................................... 55 Figure 4.14: Lack of demand and finance are given as the main reasons for why more sophisticated technologies are not adopted.........................56 Figure 4.15: Many managers in Kenya self-assess their level of technological sophistication above their actual performance........................................ 56 Figure 4.16: Product market regulations are more restrictive than in many other peer countries.......................................................................................................... 57 Figure 4.17: Regulation in communications, transport, and professional services subsectors.................................................................................................................. 60 Figure 4.18: Importance of BOS and degree of State ownership.................................................................................................................................................................................... 63 Figure 4.19: Distribution of the number of BOS, revenue, and profit and loss, by sector type................................................................................................................... 64 Figure 4.20: Distribution of BOS by sector type........................................................................................................................................................................................................................... 64 Figure 4.21: Distribution of BOS across 2-digit sectors and the percent of 4-digit industries (out of the total covered in the sector) with at least one BOS presence.............................................................................................................................................................................................................................................. 66 Figure 5.1: Net services exports have increased significantly compared with goods.................................................................................................................................... 70 Figure 5.2: The share of services value added that is exported has declined over time ............................................................................................................................. 70 Figure 5.3: Peer comparison suggests scope for Kenya to grow services exports .......................................................................................................................................... 70 Figure 5.4: The share of low-skilled tradable exports has declined over the past 10 years….................................................................................................................. 71 Figure 5.5: …while global innovator services have increased, mostly in ICT and financial services................................................................................................... 71 Figure 5.6: Cross-border service provision (“mode 1”) is the most prominent form of services exports.......................................................................................... 71 Figure 5.7: Cross-border service provision has been rising the most rapidly over time.............................................................................................................................. 71 Figure 5.8: FDI and cross-border imports are the most prominent modes of services imports............................................................................................................. 72 Figure 5.9: Tourism was hard hit during the pandemic....................................................................................................................................................................................................... 73 Figure 5.10: Kenya scores well on price competitiveness, policy prioritization and natural resources, but low on cultural resources, tourist infrastructure and health and hygiene.................................................................................................................................................................................................................. 73 Figure 5.11: Greenfield FDI in services has increased............................................................................................................................................................................................................... 74 Figure 5.12: Most of the increase was due to global innovator services.................................................................................................................................................................... 74 Figure 5.13: There are differences in the employment-intensity of FDI across subsectors, with ICT, real estate, and retail creating the most jobs..... 75 Figure 5.14: Outward FDI peaked between 2013 and 2017............................................................................................................................................................................................... 75 Figure 5.15: Global innovator services formed the largest share of outward FDI................................................................................................................................................ 75 Figure 5.16: Services restrictions create large trade costs..................................................................................................................................................................................................... 77 Figure 5.17: Service restrictions are also related to a reduction of FDI......................................................................................................................................................................... 77 Figure 5.18: Several services subsectors in Kenya are virtually closed and Kenyan service restrictions often exceed those in the rest of the EAC ..... 78 Figure 5.19: Real income gains under the AfCFTA trade scenario compared with the baseline, 2035................................................................................................. 79 Figure 5.20: Simulations of trade liberalization as a result of the AfCFTA suggest sizable increases in output and employment in the services sector......................................................................................................................................................................................................................................................................... 80 Figure 5.21: Kenya’s services sector requires a low degree of face-to-face interactions, implying high tradability..................................................................... 82 Figure 5.22: The low face-to-face score is driven by ICT and transportation services...................................................................................................................................... 82 Figure 5.23: Software development and technology are accounting for an increasing share of online jobs................................................................................. 83 Figure 5.24: Kenya’s performance on network readiness is well above its income level and the African average....................................................................... 84 Figure 5.25: Within Eastern Africa, Kenya is one of the countries providing the most advanced regulations for digital trade........................................... 85 Figure 6.1: Employment patterns in the services sector differ alongside gender, type of employment and contract, as well as location............. 90 Figure 6.2: Labor productivity of the services sector varies significantly across regions.............................................................................................................................. 91 Figure 6.3: Gender wage gap by education and employment type......................................................................................................................................................................... 91 Figure 6.4: Labor force participation by age, education and gender, 2019........................................................................................................................................................... 92 Figure 6.5: Business informality is high in the services subsector................................................................................................................................................................................ 93 Figure 6.6: Formal status explains about 8 percent of the variation in labor productivity of MSMEs, but even after controlling for other factors, much heterogeneity remains...................................................................................................................................................................................................................................... 93 Figure 6.7: On average, unregistered business are less productive, but there is a significant heterogeneity and overlap between unregistered and registered businesses............................................................................................................................................................................................................... 94 Figure 6.8: Enrolment in primary education is close to universal, but secondary education enrolment drops significantly...........................................100 Figure 6.9: The share of students obtaining minimum performance levels is low, especially after the third grade...............................................................100 LIST OF TABLES Table 2.1: Top 10 most important factor for companies’ decision to invest........................................................................................................................................................ 26 Table 4.1: Some changes in Kenya’s product market regulatory environment between 2013 and 2023..................................................................................... 58 Table 4.2: Market share of State businesses in selected services subsectors..................................................................................................................................................... 65 Table 5.1: Kenya’s services restrictions versus the AfCFTA offer................................................................................................................................................................................... 81 Table 5.2: Kenya has advanced regulation relative to its regional partners, including on cybersecurity, personal data protection and intermediary liability........................................................................................................................................................................................................................................................... 85 Table 5.3: Regulations on cross-border data............................................................................................................................................................................................................................. 86 Table 6.1: Classification of informal MSMEs in Kenya.......................................................................................................................................................................................................... 95 Table 7.1: Sector-specific and economy-wide recommendations to increase competition.................................................................................................................108 Table A.1: Sectoral priorities by subsectors................................................................................................................................................................................................................................112 Table B.1: Sectoral classification of services..............................................................................................................................................................................................................................113 LIST OF BOXES Box 1.1 Structural transformation and the role of services....................................................................................................................................................................................... 9 Box 2.1 The financial subsector in Kenya after the pandemic................................................................................................................................................................................. 21 Box 2.2 The international competitiveness of Kenya’s ICT subsector and other value chains.......................................................................................................... 24 Box 2.3 Strengthening the educational sector in support of services-led growth................................................................................................................................... 28 Box 3.1 Strengthening linkages to extension services to harvest agricultural productivity............................................................................................................... 32 Box 3.2 Entrepreneurial ecosystems in Kenya..................................................................................................................................................................................................................... 40 Box 3.3 The importance of logistics for Kenya.................................................................................................................................................................................................................... 44 Box 4.1 Simplifying registration and licensing procedures in Kenya.................................................................................................................................................................. 49 Box 4.2 Measuring technology adoption using the Firm-level Adoption of Technology (FAT) survey...................................................................................... 51 Box 4.3 Measuring the footprint of the state....................................................................................................................................................................................................................... 62 Box 5.1 Tourism after the COVID-19 pandemic: a focus on quality not quantity....................................................................................................................................... 72 Box 5.2 Kenya’s strong services trade potential: the “face-to-face” perspective........................................................................................................................................... 82 Box 5.3 Focus on Kenya’s rules on cross-border data..................................................................................................................................................................................................... 87 Box 6.1 Employment and job outcomes for women and youth........................................................................................................................................................................... 91 Box 6.2 Not all the same: classifying Kenyan informal enterprises....................................................................................................................................................................... 94 Box 7.1 What would it take for Kenya to seize the AfCFTA and digital services trade opportunities?........................................................................................109 APPENDIX Appendix A: Sectoral priorities by subsector..................................................................................................................................................................................................................................112 Appendix B: Sectoral classification........................................................................................................................................................................................................................................................113 Appendix C: Data sources............................................................................................................................................................................................................................................................................114 Appendix D: Regional patterns.................................................................................................................................................................................................................................................................116 References ...........................................................................................................................................................................................................................................................................................................117 ACKNOWLEDGEMENTS T his Country Economic Memorandum was prepared by a team led by Elwyn Davies and Alex Sienaert (task team leaders), and consisting of Besart Avdiu, Tania Begazo, Xavier Cirera, Marcio Cruz, Seidu Dauda, Tasneem Ghauri, Kyung Min Lee, Kripali Manek, Naomi Mathenge, Martin Molinuevo, Philip Schuler, Victor Steenbergen, Elaine Tinsley and Angelique Umutesi. Aaron Thegeya served as adviser and contributor. • Chapter 1 was written by Elwyn Davies and Alex Sienaert, with contributions from Tasneem Ghauri, Naomi Mathenge and Angelique Umutesi. • Chapter 2 (“Shift”) was written by Elwyn Davies, with contributions from Elaine Tinsley and Philip Grinsted (digital businesses), Leah Kiwara (financial sector), Pedro Cerdan-Infantes and Ruth Charo (education) and Sonia Plaza and Victor Steenbergen (competitiveness survey). • Chapter 3 (“Link”) was written by Besart Avdiu, with contributions from Aaron Thegeya (agriculture) and Elwyn Davies (agriculture and logistics). • Chapter 4 (“Boost”) was written by Tania Begazo, Seidu Dauda, Elwyn Davies and Kyung Min Lee, with contributions from Xavier Cirera and Marcio Cruz (technology adoption), Dennis Sanchez Navarro (businesses of the state) and Linda Kirigi (competition). • Chapter 5 (“Trade”) was written by Martin Molinuevo, Victor Steenbergen and Aaron Thegeya, with contributions from Besart Avdiu (on working remotely), Elaine Tinsley (tourism) and Alexandrea Schwind (digital trade). • Chapter 6 (“Secure”) was written by Elaine Tinsley, with contributions from Elwyn Davies (informality analysis). This chapter also draws heavily on the World Bank’s Jobs Diagnostic and Poverty and Equity Assessment for Kenya (World Bank 2023a, 2023b). • Chapter 7 was written by Alex Sienaert, with contributions from the chapter authors. The CEM was guided by Keith Hansen (Country Director), Camille Lampart Nuamah (former Manager, Operations), Asya Akhlaque (Practice Manager), Abha Prasad (Practice Manager), Vivek Suri (former Practice Manager), Philip Schuler (Lead Economist), Marek Hanusch (Lead Economist, Program Leader), and Allen Dennis (former Program Leader). Alwaleed Alabatani (Practice Manager) provided further advice. The team is also grateful to the Peer Reviewers at the concept note and decision meeting stage, including James Cust, Mary Hallward-Driemeier, Aurélien Kruse and Nistha Sinha. The team thanks Anne Bakilana (Manager, Operations), Keziah Muthembwa and Vera Rosauer for their support during the dissemination. The team thanks Alistair Haynes, Aghassi Mkrtchyan, Gaurav Nayyar, Nistha Sinha, Ramya Sundaram, Alessio Zanelli and Precious Zikhali for feedback and comments throughout the process. The team also thanks Verena Wiedemann, Peter Chacha and Bernard Kirui for providing aggregate summary statistics on firm-to- firm transactions and Roberto Echandi for his work on updating the service trade restriction index. Research assistance was provided by Antonio Martens Neto (technology adoption), Javiera Lobos and Eduardo Jiminez Sandoval (competitiveness survey). The report was edited by Peter Milne and designed by Robert Mungai. Administrative support was provided by Evelyn Kagwanjah, Anne Khatimba and Donatter Muema. The team also thanks participants during a workshop conducted in Nairobi in February 2023. This CEM draws on several recently collected data sources, including the Firm-level Adoption of Technology (FAT ) survey, a firm-level competitiveness survey, Business Pulse Surveys (BPS), the digital database of the Finance, Competitiveness & Innovation Global Practice and the Services Trade Restrictiveness Indices (STRI). The firm-level survey on price competitiveness was funded through the IEE-ACP program. KENYA COUNTRY ECONOMIC MEMORANDUM i Kenya’s economy has been growing solidly, but maintaining and increasing growth will depend on increasing private investment and productivity CHAPTER 1 Kenya’s Recent Economic Performance and the Growing Role of Services Kenya’s economy has seen solid growth over recent years, but there is a need to increase productivity and investment. The rapid rise of services could bring new opportunities. K enya’s economy has been growing solidly, but maintaining and increasing growth will depend on increasing private investment and productivity. Between 2010 and 2019, Kenya maintained a steady annual growth rate of 5 percent and the economy was able to rebound relatively rapidly from the COVID-19 pandemic. However, productivity growth did not make much of a contribution to output growth, and growth has been lower than that of some other, fast-growing middle-income countries. This points to the potential for Kenya to increase growth via productivity gains, by expanding the role of the private sector and, especially, accelerating private investment. Doing this has become more urgent as the Government's fiscal space to invest has shrunk, making it crucial also for the sustainability of growth to identify new opportunities for the private sector to contribute. The services sector has been growing rapidly in recent decades, raising fundamental questions about the nature of structural transformation in Kenya, and also about opportunities this sector could offer. Most economic growth has been located in the services sector, with more limited contributions by agriculture and industry. Services now contribute to 54 percent of value added and 45 percent of jobs. The growing role of services raises questions about the process of structural transformation in Kenya, which traditionally for many of the current high-income countries was based on industrial sectors. At the same time, both global and Kenyan evidence highlights that services are becoming increasingly tradable and play an important enabling role in fostering wider economic growth in other sectors. The challenge is to maximize the opportunities emerging from this sector in the most effective manner, especially given Kenya’s ambitions of becoming a regional hub in areas such as digital trade, finance, and education. Within services, the financial subsector in particular will play an important role, including by supporting Kenya’s transition to a low-carbon economy given the need for green, sustainable finance, and by leveraging technological solutions. This Country Economic Memorandum (CEM) focuses on the question of how seizing opportunities in Kenya’s services sector can contribute more effectively to long-term economic growth. This report argues that growing the services sector should not be seen as an alternative to industrialization, but rather as an enabler of economy- wide growth, including in manufacturing, and in agriculture too. It focuses on five channels through which services contribute to jobs, economic transformation and inclusion: (i) the need to SHIFT the services sector to higher value-added activities; (ii) how to LINK services better to other economic activities to grow its enabling role; (iii) how to BOOST the productivity of the sector through technology and increasing competition; (iv) how to TRADE more services through removing regulatory barriers to trade and investment; and finally (v) how to SECURE people’s economic livelihoods better, especially those working in lower-skilled and economically more vulnerable services subsectors. Growing the contribution of services will require a program of structural reforms and complementary efforts. KENYA COUNTRY ECONOMIC MEMORANDUM 1 Solid growth, and resilience to the COVID-19 pandemic… Kenya’s recent economic performance has been relatively strong. Real gross domestic product (GDP) grew at an annual average rate of 5.0 percent in the period 2010–2019. This was enough to lift Kenya into the lower middle-income country (LMIC) category in 2014, and was associated with substantial poverty reduction; the poverty headcount ratio fell by about 10 percentage points over the 2010s, to an estimated 26.5 percent in 2019 at the international poverty line.1 Growth was more rapid than the average for sub-Saharan Africa (SSA) (3.5 percent) and about the same as in LMICs globally (5.1 percent) (Figure 1.1). However, it did lag behind the pace of fast- growing economies that could be considered aspirational peers, such as Bangladesh and India (Figure 1.2). Figure 1.1: Kenya’s economy expanded at a solid pace in the Figure 1.2: …although not as rapidly as those of some 2010s… other, fast-growing middle-income countries Real GDP growth, percent, 2010–2019 Real GDP growth, annual average, 2010–2019 10 12 10 8 8 6 Percent Percent 6 4 4 2 2 0 0 ia sh a ia a sia sia a ria a di an ny ric op an de ge ne ay 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 In Af Ke Gh nz hi la al Ni do h Et Ta ng M ut In Kenya Lower middle income Sub-Saharan Africa Ba So Source: World Bank WDI. Source: World Bank WDI. The economy was also resilient to the COVID-19 pandemic. Real output contracted by a relatively small 0.3 percent in 2020, although given population growth, real per capita GDP shrank more markedly (-2.2 percent). This reflected a sharp fall in activity in many parts of the economy during the first half of 2020 when the COVID-19 pandemic first struck and containment measures were implemented, followed by a broad-based recovery in the second half, helped by swift health and economic policy responses, and the easing of movement restrictions. There was a strong continued rebound during 2021, with GDP increasing by 7.5 percent, helped by mobility levels returning to the pre-COVID-19 baseline, the buoyant construction sector (benefiting from public infrastructure projects and strong residential housing investment), a gradual recovery in tourism, and the uninterrupted expansion of some subsectors such as information and communication technology (ICT) and financial services. This was among the highest 2021 growth rates in the region (SSA average: 4.1 percent, LMICs: 5.6 percent), lifting output up to close where it would have been had the pre-pandemic trend continued. In Kenya, as everywhere around the globe, the pandemic led to a tragic loss of lives and livelihoods, and its long-term adverse impacts, while not yet known, are likely to be large (e.g., due to losses in education). Nevertheless, Kenya’s economic performance in terms of macroeconomic adjustment to the shock and returning to an aggregate output growth path has been strong. Although growth has been solid, there is scope to bolster inclusion and accelerate growth Although growth has been solid, three limitations with respect to the inclusiveness and sustainability of Kenya’s recent economic path can be identified: growth has been associated with: (i) a sharp rise in public debt, eroding fiscal space and raising debt sustainability concerns; (ii) low and declining openness to trade, and weak foreign direct investment, contributing to macroeconomic vulnerabilities including external debt risks, 1 Estimated poverty at the World Bank’s international poverty line of US$2.15 per day, based on 2017 Purchasing Power Parities (PPPs). 2 KENYA COUNTRY ECONOMIC MEMORANDUM and rising concerns regarding Kenya’s productivity and international competitiveness; and (iii) the pace of job creation lagging behind what is needed to productively absorb a fast-growing working-age population, raising inclusion concerns. To match Kenya’s growth rates with those seen in some of its aspirational peers, addressing these constraints is crucial. First, the recent strong growth period has been associated with a growing gap between government spending and revenues, and hence more borrowing and debt. The fiscal deficit grew steadily throughout the 2010s, as overall expenditure drifted higher while revenue declined slightly as a share of GDP (Figure 1.3). The increase in expenditure was driven partly by large increases in debt-financed public investment, peaking at over 7 percent of GDP in 2017 when the Mombasa-Nairobi Single Gauge Railway project was completed (Figure 1.4). The implementation of the devolved system of government under the 2010 Constitution (with 47 county-level governments) may have conferred important benefits, but it also increased recurrent expenditures. By the late 2010s, the Government had recognized the need to reign in fiscal deficits, and had begun to design and implement a program of fiscal consolidation, but this was delayed by the onset of the pandemic in 2020. Through 2022, high deficit-financed public spending supported short-term growth by fueling aggregate demand, and contributed to the economy’s resilience to the pandemic by helping to sustain investment spending and construction activity. Through high public sector investment and spending, the Government aimed to lay a foundation for strong long-term growth by putting in place productivity-enhancing infrastructure and enhancing subnational public service delivery, but this has also sharply increased debt levels and related macroeconomic stability risks. The Government’s debt burden increased sharply from 37 percent of GDP in 2010 to 68 percent in 2021. Interest costs relative to the Government’s revenues roughly doubled over the past decade, to close to 30 percent (Figure 1.5), squeezing the fiscal space available to fund development priorities. The risk of Kenya entering into debt distress has moved up to high, as assessed by the joint World Bank-IMF Debt Sustainability Assessment (DSA), intensifying from medium risk since April 2020 when the COVID-19 pandemic exacerbated pre-existing weaknesses in Kenya’s fiscal position, debt trajectory, and exports. Although many governments have larger debts relative to GDP, the cost of Kenya’s government debt relative to its revenues is high by global standards (Figure 1.6). There are also significant fiscal risks due to the explicit and, especially, implicit contingent liabilities from state- owned enterprises (SOEs). Consequently, to maintain debt sustainability, the size of Kenya’s fiscal deficits and the pace of debt accumulation need to be moderated.2 Figure 1.3: Large fiscal deficits have opened up… Figure 1.4: …driven partly by increased public investment… Government revenue and expenditure, percent of GDP, 2010–2021 Public investment, percent of GDP, 2009–2021 30 8.0 25 7.0 20 6.0 Percent of GDP 15 5.0 10 4.0 5 3.0 0 2.0 -5 -10 1.0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 0.0 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Fiscal balance Revenue Expenditure Source: IMF WEO. Source: World Bank estimate. 2 See Kenya Public Expenditure Review 2020: Options for Fiscal Consolidation after the COVID-19 Crisis. KENYA COUNTRY ECONOMIC MEMORANDUM 3 Figure 1.5: …increasing Kenya’s public debt burden, and Figure 1.6: …and leaving it with a sizable and costly debt burden interest costs… Public debt-to-GDP and interest cost-revenue ratios, percent, 2010–2022 Interest payments, percent of revenue, 2020 70 80 70 Sri Lanka 60 60 50 50 40 Ghana Percent Percent 40 Zambia 30 30 Kenya 20 20 10 10 0 0 2010/11 2013/14 2016/17 2019/20 0 50 100 150 200 250 Public debt/GDP Interest cost/revenues Government debt (% of GDP) Source: World Bank calculations based on data from KNBS and National Treasury. Notes: Global sample of all countries with data (n=127, 2020).3 Source: World Bank calculations based on IMF WEO and World Bank WDI data. Second, despite the investments in infrastructure, trade and foreign investment have underperformed as drivers of growth. Merchandise exports remain heavily concentrated in agricultural products: tea, horticulture (especially cut flowers) and coffee. Services exports are also important and comprise mainly tourism and travel, transportation, and financial services. However, goods and services exports combined have steadily declined as a share of total output to a low of 11.4 percent of GDP in 2019 (Figure 1.7). Similarly, imports of goods and services have shrunk relative to the size of the economy (to 20.3 percent of GDP in 2019). Consequently, Kenya’s economy is much less trade-oriented than is the norm for peer and aspirational peer economies (Figure 1.8), depriving it of a major potential engine of growth and job creation. Tapping export markets would generate opportunities for firms and help to overcome the constraint of the still small domestic market. Net foreign direct investment (FDI) in Kenya has also remained low, averaging under 1 percent of GDP from 2015–2019, compared with about 2 percent for SSA and all middle-income economies. Stimulating more FDI into Kenya would not only augment the limited pool of financing available locally to meet investment needs, but also promote structural transformation through positive knowledge spillovers into the domestic economy from firms with international knowledge, and integration in global value chains.3 Figure 1.7: Both exports and imports have declined relative Figure 1.8: …and Kenya’s economy is less trade-oriented to GDP… than that of peer economies Percent of GDP, 2010–2021 Sum of imports and exports, percent of GDP 40 140 35 120 30 100 Percent of GDP 80 Percent of GDP 25 20 60 15 40 10 20 0 5 ia nd a s a e e ia a ys ila an ne ric m m es ny ala a Gh pi Af co co n Ke 0 M Th ilip th ei n ei n do Ph u dl dl In So 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 id id rm rm Exports (goods & services) Imports (goods & services) we pe Remittances Lo Up Source: WDI. Notes: Trade openness is the sum of exports and imports of goods and services as a share of gross domestic product. Source: WDI. 3 All data for 2020, except for 15 countries for which the latest available data are for 2018 or 2019. 4 KENYA COUNTRY ECONOMIC MEMORANDUM Expenditure-side GDP patterns also point to growth being reliant mainly on domestic consumption, and that the economy could benefit from being rebalanced toward private investment and trade. Historically, the largest contributor to aggregate demand growth in Kenya Figure 1.9: GDP growth has been domestic consumption- has been household consumption, followed by gross driven Contribution to the real GDP growth rate, percentage point, 2000–2019 investment (Figure 1.9). However, the contribution of 7.0 investment fell sharply in the latest 2015–2019 period, 6.0 when it was exceeded by government consumption. 5.0 4.0 Net exports have made a negative contribution to GDP 3.0 expenditure growth on a sustained basis, reflecting 2.0 1.0 weak export growth relative to GDP, as well as rising 0.0 imports due to the high import intensity of infrastructure -1.0 spending. Overall, the demand-side perspective -2.0 2000- 2019 2010- 2014 2015- 2019 points to Kenya’s recent economic growth being (growth=4.5%) (growth=4.6%) (growth=4.7%) Statistical Discrepancy Net Exports domestic demand-driven, mainly fueled by household Investment Government Consumption Households/NPISHs Consumption consumption, with a significant contribution also from Source: World Bank. public consumption and investment spending. Greater international trade and investment integration would bolster Kenya’s macroeconomic position, including its debt sustainability, and growth prospects. The major bright spot in the supply of foreign exchange (FX) has been international remittances, which roughly tripled in US dollar terms, and doubled relative to GDP, in the decade to 2019, and kept growing strongly during the pandemic. However, while remittances are a welcome, growing source of inflows in the balance of payments, they remain a smaller source of FX inflows than exports (being equivalent to about one-quarter of total exports, see Figure 1.7). Overall, the slow growth of external trade and inward FDI relative to more rapid growth of domestic economic activity, including that financed by external debt, has added to the economy’s macroeconomic vulnerabilities. For example, in the joint IMF/World Bank Debt Sustainability Analysis (DSA), Kenya’s public external debt stock is well below solvency risk thresholds in terms of its size relative to that of the economy; however, both solvency and liquidity risk indicators relative to exports breach high-risk thresholds. The Kenyan economy needs to strengthen foreign currency inflows from export earnings and investment, especially long-term foreign direct investments which in addition to financing can contribute global knowledge, technology, and opportunities to participate in regional and global value chains. Third, although poverty declined, strong economic growth did not translate into enough new high-quality jobs. More than 800,000 people join the labor market every year, but formal sector jobs have increased by under 100,000 annually in recent years (before the COVID-19 pandemic). The vast majority of the new entrants find low-productivity, informal work in agriculture and the non-agricultural informal sector (Figure 1.10). Adding to the challenge of creating more high-quality jobs, Kenya is likely to see its largest ever youth cohorts joining the workforce over the next decade, a youth bulge of about 1 million new workers annually. Rapid growth of Kenya’s workforce could be harnessed to boost output and living standards, especially as dependency ratios fall further, such that the number of people supported by each worker’s income declines on average, lifting disposable incomes. Within a few years, the number of Kenyans of prime working age (20–64) will likely exceed youth (0–19), for the first time since records began (Figure 1.11). However, realizing a demographic dividend will depend on the availability of sufficiently remunerative jobs and earning opportunities, without which too many families’ incomes will remain at subsistence levels. The economy will need to generate more high-quality jobs than has been the case in the recent period characterized by relatively high public spending, and a narrow and declining role of trade and foreign investment. KENYA COUNTRY ECONOMIC MEMORANDUM 5 Figure 1.10: The labor force is growing much more rapidly Figure 1.11: …and prime working age adults (20–64) will than formal sector jobs… soon exceed youth (0–19) for the first time New jobs and expected labor market entrants, 2016–2025 Percent of total population by age, 1980–2050 1,500,000 70 60 Percentage of total population 50 1,000,000 40 30 500,000 20 10 0 0 2016 2018 2020 2022 2024 1980 1990 2000 2010 2020 2030 2040 2050 New informal jobs New formal jobs New labor market entrants 0-19 20 - 64 65+ Notes: 2020–2021: estimates; 2021–2025: projections. Notes: 1980–2021: estimates; 2022–2050: medium-variant projections. Sources: World Bank Kenya Jobs Diagnostic (World Bank 2023a). Sources: United Nations, World Population Prospects 2022. Key empirical features of Kenya’s recent growth performance: (1) labor- and capital-input driven growth, not total factor productivity From a long-run growth-accounting perspective, Kenya’s output growth has been driven by accumulation in the stock of both labor and capital, while total factor productivity (TFP) growth has been flat (even slightly negative) over the past two decades (Figure 1.12). This accounts for much of the growth differential between Kenya and aspirational peers such as Bangladesh and India (Figure 1.13). The lack of TFP growth contribution points to an opportunity to lift per-capita incomes by accelerating productivity gains through economic transformation that facilitates the shift of resources, notably labor, into more productive activities. Doing so would help to balance and add to the sources of growth by adding more of a productivity contribution to potential output, complementing growth through capital deepening (increased capital per unit of labor) and through the increasing labor force, which have been the primary drivers of Kenya’s recent economic growth. Key features of Kenya’s recent growth performance: (2) the growing role of services in growth and jobs Most value-added growth has come from the services sector, which has grown at a strong pace off an already large base (Figure 1.14). By contrast, agriculture has made only a modest contribution to the increase in real output. Industry has grown at a significant rate but off a relatively small base, and a significant share of this growth is due to strong construction activity growth linked to public infrastructure and housing investment. Examining the production-side national accounts for 2009–2021 (the maximum period available using the revised and rebased national accounts) confirms that the services sector has been the fastest-growing in terms of real output, with a compound annual growth rate of 4.9 percent, slightly ahead of manufacturing (4.7 percent) and well ahead of agriculture (2.9 percent). 6 KENYA COUNTRY ECONOMIC MEMORANDUM Figure 1.12: Growth has relied on capital and labor Figure 1.13: …which has been flat, in contrast to some accumulation, not total factor productivity growth… aspirational peers Contributions to potential output growth Contributions to potential output growth 8 12 10 6 8 4 6 Percentage points Percentage points 4 2 2 0 0 -2 -2 -4 a sh ia a sia a sia ria a ia ny an di ric -4 op de ge ne ay an In Af Ke Gh hi la al Ni do nz h Et ng M Ta ut In 2000 - 2022 2010 - 2014 2015 - 2022 Ba So Capital Stock Labor Total Factor Productivity Real GDP Capital Stock Labor Total Factor Productivity Real GDP Source: World Bank. Source: World Bank. Services now contribute to 54 percent of value added and 45 percent of jobs.4 As a result of this growth, services now contribute more than half of value added in the Kenyan economy. In terms of jobs, services have also come to dominate employment (Figure 1.15). Between 2006 and 2019, employment shares in agriculture dropped from 58 percent in 2006 to 45 percent in 2019, industry increased from 7 to 11 percent, while services increased by 10 percentage points from 34 to 45 percent. 5 Figure 1.14: Growth of Kenya’s economy has been Figure 1.15: …and services have also accounted for the concentrated in services… bulk of new jobs Annual real value-added by sector, constant 2016 KSh, 2009-2022 Employment share 10,000 70 60 Billion KSh (constant 2016) 8,000 50 6,000 40 Percent 30 4,000 20 2,000 10 0 0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Agriculture Manufacturing Other industry Services Agriculture Industry Services Source: World Bank. Source: Kenya Jobs Diagnostic (World Bank 2023a), based on KIHBS 2005/06 and 2015/16, and KCHS 2019. Alongside the increasing share of employment and value added in services has been increasing labor productivity. Labor productivity as measured by value added per worker is highest in industry, followed closely by services, and lowest in agriculture (Figure 1.16). Although precise annual data on employment in Kenya are lacking due to difficulties in measuring the informal sector, modeled estimates of employment by the International Labor Organization (ILO) combined with national accounts figures suggest that labor productivity in industry and services sectors is about double that of agriculture, meaning that any shift into these sectors is productivity- 4 The value-added share refers to 2021, and the employment share to 2019 (the latest year covered in a labor force survey). 5 There are differences between data sources in their estimates of employment shares in industry, services and agriculture. World Bank WDI, which is based on ILO modelled estimates from January 2021, suggest employment shares of, respectively, 6, 39 and 54 percent in 2019. ILO-modeled estimates from November 2022 suggest employment shares of, respectively, 15, 33 and 51 percent in 2019. KENYA COUNTRY ECONOMIC MEMORANDUM 7 improving.6 There is nevertheless a long way to go in terms of Kenya’s structural transformation; there is scope for large numbers of workers to move out of agriculture into much more productive jobs in both services and manufacturing, and drive rapid growth in productivity and incomes. Labor productivity in services has also been increasing, exceeding that of industry and agriculture in recent years. Estimates of labor productivity, based on national accounts and ILO-modeled estimates, suggest a stagnation of labor productivity in industry, while labor productivity in services and agriculture has been growing. Between 2014 and 2019, labor productivity growth in services was around 2.6 percent, higher than in industry and agriculture (Figure 1.17). Figure 1.16: Productivity of the services sector has risen and now Figure 1.17: In recent years, labor productivity growth of services matches that of industrial sectors has exceeded that of industrial sectors in Kenya and of peer countries Labor productivity, KSh, 2010–2021 Labor productivity growth, percent CAGR, 2014–2019 600 7.5 500 5.9 3.8 400 3.4 3.2 2.6 2.2 Thousands 1.9 300 0.8 0.4 0.5 200 -0.5 -0.2 -1.0 -0.9 -0.7 -1.6 100 -2.9 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 Kenya Ghana Rwanda Tanzania Uganda South Africa Agriculture Industry Services Industry Services Agriculture Note: Labor productivity is measured by value added per worker in constant 2016 Note: Labor productivity is measured by value added per worker in constant local Kenyan shillings. Industry includes mining, manufacturing and construction. currency units (LCU). Source: World Bank WDI and ILO-modeled estimates (2022 vintage). Source: World Bank WDI indicators, for Kenya based on WDI and ILO-modeled estimates (2022 vintage). A focus on economic transformation by accelerating the development of services The rise of the services sector and the lack of increase of the industrial sectors’ shares in output and jobs raises fundamental questions about the applicability in Kenya of the traditional model of structural transformation. For many of the current high-income countries, and also for some countries in East Asia, the process of development was characterized by an initial shift from agriculture to industry and, as countries grew richer, from industry to services. Industrialization was seen as a key steppingstone on the path to development, especially because the industrial sectors could absorb large amounts of employment and earn income, especially through exports. However, Kenya, similar to many developing economies, has seen a much smaller role of industrial sectors together with growth of services at a much earlier stage than that experienced by current high-income countries (see Box 1.1). This raises fundamental questions regarding the role that both industry and services will play in creating more jobs and growth. The development trajectories of countries such as India, Brazil, Indonesia and the Philippines suggest that although there could be scope for increasing industrialization, the services sector will likely play an important role in fostering growth and employment opportunities in Kenya. 6 When calculating labor productivity using numbers calculated based on the latest household survey (KCHS) the productivity gap between agriculture and other sectors is even larger. In these estimates, the services sector is 4.8 times more productive than agriculture and 4.2 times more productive than industry. 8 KENYA COUNTRY ECONOMIC MEMORANDUM Box 1.1 Structural transformation and the role of services Structural transformation has historically often followed a sequenced pattern, from agriculture to manufacturing and then to services. Rising productivity in the agriculture sector—fostered by better technologies and increased trade—allowed labor to be employed in other sectors, traditionally often in (mostly urban) manufacturing. As economies advanced, rising incomes that increased consumer demands for services and the labor-intensive nature of services resulted in a further employment shift from manufacturing to services. As a result, the development pattern of many high-income countries has been characterized by an initial increase in employment in industrial sectors, followed by a more recent decline (Figure 1.18). The trajectory of many of the current developing economies—except for some countries in Asia—looks different: many countries are growing with much lower levels of industrialization and, in some countries, industrial shares have started to decline at a much lower level of economic development, a process called “premature deindustrialization” by Dani Rodrik (2016). Kenya’s growth trajectory looks more similar to other developing economies such as Brazil, India, Indonesia and the Philippines, where services have played a large role, than the historical trajectory of current high-income countries, which was dominated by industrial sectors. The low contribution of industry to growth and the high employment in services has sparked concerns. After all, for the current high-income countries and some Asian countries (e.g., China and Vietnam), industrial sectors played a large role in creating good jobs for many workers, including those with fewer skills. Skeptics of services-led development point out that many services by their nature are inherently unproductive and that any observed productivity increase merely reflects price and wage levels in the wider economy, especially in the case of non-tradable services (also dubbed Baumol’s cost disease, after William Baumol).7 Technological change might be affecting the job creation and growth potential of manufacturing and services. The increased automation in manufacturing, making industrial sectors less labor-intensive, has created worries that the East Asian industrialization model cannot be replicated in other countries (Rodrik 2022). At the same time, technological change in services sectors—mostly thanks to digitization—is changing the way services are delivered and allows them to be more productive. In fact, in low- and middle-income countries, productivity growth in services has matched or exceeded that of manufacturing (Nayyar et al. 2021), including in Kenya (Figure 1.17, above). Trade in services is also growing at a faster pace than trade in goods, including in developing economies. For policy makers, choosing between services and industrialization is a false dilemma. Growing services can be very much in support of further industrialization and enhance its productivity and scope to be traded. As Chapter 3 (on linkages) highlights, services form important inputs to other sectors in the economy. Manufactured goods are also increasingly bundled with services—a process called the servicification of manufacturing. Seizing the services momentum provides growth opportunities for the entire economy, as this report examines. 7 Baumol’s cost disease theory explains how as goods-producing sectors get more productive, wages in these sectors will increase, prompting also increasing costs in labor-intensive sectors that need to keep up with these wages, even if these labor-intensive sectors do not get more productive. This particularly affects non-tradable services sectors with a lower potential for increasing scale. Although this could explain part of the observed productivity gain in services sectors seen in Kenya, as Chapter 2 (“Shift”) shows, much of the growth in the sector has been due to tradable services sectors such as ICT and transportation. KENYA COUNTRY ECONOMIC MEMORANDUM 9 Box 1.1 Structural transformation and the role of services Figure 1.18: Industrial sectors played a large role in the development of current high-income countries, but much less so in current low- and middle-income countries Long-run GDP per capita and industrial sector employment shares, 1801–2021 (for Kenya: 1991–2021) 60 Employment share in industrial sectors 50 40 France 1856-2007 30 Indonesia India 1961-2012 20 1960-2010 United Ghana Brazil United States 1960-2011 1950-2011 Kingdom 1840-2012 Philippines Kenya 1971-2012 1801-2011 10 2006-2019 0 500 5,000 50,000 GDP per capita Note: This chart includes 44 countries and combines historical data from high-income countries with more recent data from emerging economies. For highlighted countries the time period covered: FRA (1856–2007), USA (1840–2011), GBR (1801–2011), KEN (1991–2021), GHA (1960–2011), IND (1960–2010), IDN (1961–2012), PHL (1971–2012), BRA (1950–2011). Source: Our World in Data based on Herrendorf et al. (2014), the GGDC 10-Sector Database and the GGDC Maddison Project (Bolt & Van Zanden 2020); Kenyan data are ILO-modeled estimates based on KNBS statistics. This CEM focuses on the question of how the growing services sector contributes to jobs and economic transformation, and how policies can best seize on this momentum. This focus is based on the fact that services account for a growing share of output. Consequently, Kenya effectively already has a services-oriented economy, with services now accounting for most of GDP, and being where most new labor market entrants are finding work. How should this growing preponderance of services be understood? Is there scope to leverage services activity growth further, especially where there are positive spillover effects from services to the wider economy, including the productivity of both the domestic and tradable (including manufacturing) sectors? More specifically for policy makers seeking to enable rapid, inclusive, and sustainable growth, can enabling further development of the services sector—as part of a comprehensive strategy to facilitate a productive, externally-competitive economy—help to meet the Kenyan economy’s need for more private investment (both domestic and foreign), more international trade, and more good jobs?7 Recent global work conducted by the World Bank and others suggests that the potential for services to deliver on growth and jobs is increasing, thanks to technological change and increased tradability. Labor productivity growth in the services sector has been outpacing that of the manufacturing sectors in most low- and middle-income countries. Technological change has allowed services to become more innovative, achieve higher scale, and contribute more to spillovers to other parts of the economy (Nayyar, Hallward-Driemeier, and Davies 2021). Over the past decade, world exports of services have doubled and growth in trade in services has been outpacing that of trade in goods (World Bank and WTO, forthcoming). FDI in the services sector has been growing faster globally than the manufacturing sectors as well (World Bank Global Investment Competitiveness Report, forthcoming). 7 There are differences between data sources in their estimates of employment shares in industry, services and agriculture. World Bank WDI, which is based on ILO modelled estimates from January 2021, suggest employment shares of, respectively, 6, 39 and 54 percent in 2019. ILO-modeled estimates from November 2022 suggest employment shares of, respectively, 15, 33 and 51 percent in 2019. 10 KENYA COUNTRY ECONOMIC MEMORANDUM The further development of the services sector is not an alternative to industrialization but rather can be an enabler of economy-wide growth, including in manufacturing, and agriculture too. Services provide important inputs to both the manufacturing and agriculture sectors: they provide the logistics to trade goods, including getting agricultural goods to market, they facilitate technologies used in the production process, and they provide the financing for much-needed investments. More sophisticated manufacturing and agriculture will increasingly depend on services. A well-known, homegrown example of how the development of innovative, accessible services can lubricate the economy and open up new opportunities and potential growth is Kenya’s early adoption of mobile money, beginning with the launch of M-PESA in 2007. The services sector is highly heterogenous, covering activities ranging from small-scale retail to high-end digital services, meaning that a granular analysis is needed. On the one hand, the services sector consists of low productivity subsectors, such as small-scale retail and personal services, which have been growing rapidly but often do not provide good earning opportunities and are often operating in the informal sector. On the other hand, some services offer the most productive opportunities Figure 1.19: Employment growth in services subsectors has been on average anywhere in the economy, even as they driven by less productive sectors, such as commerce, hospitality and other services (including personal services). have begun to generate a meaningful number of Employment and labor productivity, 1990–2017 new jobs (e.g., ICT and other high-skilled services). 3,000 2017 $ 2017 On average, workers are now about as productive in $ $ $ $ $$ $ $ services as they are in manufacturing (Figure 1.16). This 2,000 $$$$ Employment $ $$ $ $ follows declines in productivity in manufacturing since $ $ $$$ $$ $ $ $ $ $ $ the 1990s, as employment in manufacturing has risen 1,000 $ $$ $ $ $ $ $$ $$ $ 1990$ from a low base (Figure 1.19). However, as also shown $ $$ $ 2017 $$ $ $$ $ 1990 $$$$ $ $$ $$ $$ 2017 2017 on Figure 1.19, there is a lot of variation in productivity $$$ $$ $$$$ $ $$ $$ $ $ $$$ $ $ 1990 1990 1990 0 across subsectors, pointing to the need for analysis that 0 500 1,000 1,500 2,000 2,500 3,000 Labor productivity goes deeper than the broad sectoral level, and beyond Manufacturing Commerce/hospitality Transport / ICT the traditional paradigm of the most desirable jobs Business and nance Other services being in manufacturing, followed by services, followed Source: GGDC/UNU-WIDER Economic Transformation Database. by agriculture. The CEM focuses on five channels on how the contribution of services to growth, as well as inclusion can be strengthened (Figure 1.20): • SHIFT. Productivity can be increased by moving into higher value-added services activities. Services are highly heterogenous including along productivity and tradability dimensions. Chapter 2 examines the composition of the services sector in greater detail and discusses the challenges and opportunities to progressively shift resources to more productive, growth-enhancing activities, especially in so-called global innovator services (ICT, professional, technical, and financial services; this also includes certain creative sectors). • LINK. Services benefit other sectors through linkages, but these need to be strengthened. Services provide critical upstream inputs to production, including in agriculture and manufacturing, they generate downstream demand, and the classical lines between physical goods and services are becoming increasingly blurred. Chapter 3 assesses linkages between services and other sectors in Kenya’s economy and how these may be strengthened, so that growth in the services sector also enables growth in other sectors. KENYA COUNTRY ECONOMIC MEMORANDUM 11 • BOOST. The productivity of the services sector can be increased through adopting more sophisticated technologies and by increasing competition. Chapter 4 discusses productivity of the services sector, and specifically how technology adoption, including the use of digital technologies, as well as increasing competition in services markets can boost investment and productivity. • TRADE. Although services are contributing more to Kenya’s trade and investment, it can be boosted further by removing restrictions. Chapter 5 discusses how trade and investment is increasingly happening in the services sector, but also how this sector faces significant restrictions to trade. How can Kenya leverage new opportunities, including from new digitally-enabled trading possibilities, to grow the role of trade and investment in its economy? • SECURE. Growth in the services sector can also benefit low-skilled and low-income workers. While the services sector is creating opportunities and growth, for many Kenyans it is also where they earn subsistence income as a matter of necessity. Services are particularly important in more urban counties in Kenya, making lifting services-based incomes a priority for addressing poverty and vulnerability and towns and cities (see Appendix D for the spatial variation in sectoral output contributions). Chapter 6 discusses what policy makers can do to orient a rising services-based economy toward maximizing opportunities for low-skilled, low-income workers. Figure 1.20: Five channels to grow in the services sector in Kenya SHIFT LINK BOOST to higher-value added services more strongly productivity through technology services activities to enable growth of other sectors adoption and better functioning markets TRADE SECURE services more by removing inclusion and livelihoods through restrictions on trade and investment productive opportunities Source: World Bank. Growing the contribution of the services sector to enable growth and job opportunities, including in manufacturing and agriculture, requires a coordinated approach of policy action. Chapter 7 summarizes the above and sets out policy directions on how to accelerate jobs and economic transformation in Kenya, including by recognizing the role of services. Despite the increasing contribution of the services sector, it remains a sector with significant restrictions, including on trade, competition, and the business regulatory environment, harming further growth. Policies should focus on removing these restrictions to domestic and foreign trade and investment, as well as on strengthening skills and encouraging the adoption of technologies, while ensuring inclusion. 12 KENYA COUNTRY ECONOMIC MEMORANDUM Services-focused policies should not replace policies focusing on other sectors, but instead complement them. A better functioning services sector can contribute to better performance of the entire economy, including other sectors. Many of the policy priorities highlighted in this report are not unique to services, but are also relevant to agriculture, manufacturing, and other industrial sectors, where there is a similar need to increase productivity, to expand trade and to create new job opportunities. This report does not call for a removal of policies targeting these sectors, but instead widening the policy perspective to also include services. The analysis here highlights that many barriers to growth in services remain in place, and policies focusing on removing them can have large returns. Policy priorities will also depend on the characteristics of services subsectors. Chapter 2 (“Shift”) discusses the heterogeneity of the services sector, and groups services in four categories: global innovator services (high- skilled and tradable), low-skilled tradable services, low-skilled domestic services and social services (high-skilled and non-tradable, but mostly publicly provided and therefore less of a focus of this report).8 The importance of the five channels differs across these sectors (Figure 1.21). For example, for global innovator services, the priority is to shift more economic activity into this sector, strengthen linkages, boost its productivity, and expand trade and investment, while for low-skilled domestic services the priorities are more on securing economic livelihoods, in addition to boosting productivity. Figure 1.21: The contribution of the five different channels to economic transformation differs across services subsectors and also depend on the linkages with non-services sectors Non-services sectors Social services Global innovators Agriculture Through linkages SECURE TRADE SHIFT LINK BOOST TRADE Manufacturing Low-skilled domestic Low-skilled tradable Other industry BOOST SECURE LINK BOOST TRADE SECURE Source: World Bank. 8 See recent World Bank Public Expenditure Reviews for analysis of Kenya’s public education and health sectors. KENYA COUNTRY ECONOMIC MEMORANDUM 13 14 KENYA COUNTRY ECONOMIC MEMORANDUM CHAPTER 2 SHIFT to Higher Value-added Activities in the Services Sector Global innovator services represent only 2 percent of employment but contribute significantly to economic growth. Further growth in these subsectors is possible. The services sector in Kenya T he services sector is not a monolith, but a heterogenous group of activities. The services sector captures a wide range of activities in the economy—varying from very localized personal services or retail to high-skill intensive traded digital services. While services subsectors tend to have one thing in common—their intangibility— the dissimilarities between services subsectors tend to exceed their similarities. Some of these services can be traded across borders, while others are purely sold domestically. Some are serving mostly as inputs for production in other firms, while others are sold to final consumers. The skill intensity of services varies as well: some services require little to no training, while others require both training and experience. Services can be grouped in four categories, based on their trade intensity, reliance on skills and the degree they are linked with other sectors (Figure 2.1). Based on Kenyan data on trade from the balance of payments, on skills from the household survey and on linkages from supply-use tables, the services sector can be grouped in four clusters that roughly share similar characteristics, similar to the global clustering of subsectors of Nayyar SHIFT et al. (2021): • Global innovator services, such as ICT, professional and technical, as well as financial and insurance services, that are tradable but also rely on higher skilled employment. These include some services related to creative industries as well (e.g., media, publishing). These services also tend to be linked to other sectors by forming important inputs to other sectors. • Low-skilled tradable services, such as accommodation and food services, transportation and storage services and wholesale services. These services are less skill-intensive (in terms of the task involved and the formal qualifications and training required) but can be exported. For accommodation and food services, exports mainly happen through tourism. For transportation and storage services, exports tend to be closely linked to goods exports. • Low-skilled domestic services, such as retail services, personal services, and administrative and support services, are less skill-intensive and serve mostly the domestic market. For retail and personal services, the main buyers are households, while administrative and support services mostly serve domestic firms. • Social services, such as health-care and educational services, are skill-intensive but mostly serve domestic markets. Many of these services tend to be publicly provided. Some opportunities for export in these sectors exist, for example health tourism or foreign students studying in Kenya. KENYA COUNTRY ECONOMIC MEMORANDUM 15 The report will use these four categories to cluster sectors. A detailed sub-sectoral breakdown can be found in Appendix B. Figure 2.1: Services differ in the degree to which they are traded and their reliance on skills Tradability, skill intensity and employment (bubble size), by services sector, 2017 80 Social services Global innovators 70 Education ICT 60 Health Arts / recreation Professional / technical 50 Financial / insurance Skill intensity 40 Low-skill domestic Wholesale Low-skilled tradable 30 Retail 20 Personal services Accommodation / food Admin / support 10 Transport / storage 0 -10 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170 Tradability Note: Skill intensity is proxied by the share of workers in high-skilled white-collar occupations (managers, professionals and technicians) according to the KNOCS occupational classification. Tradability is proxied by the value of services imports and exports (excluding mode 3) over value added in that sector, normalized at the value of ICT. The tradability value of accommodation and food (566) has been truncated. The bubble size represents employment share. Values refer to 2017. Arts and recreation include both publicly provided services (e.g., museums) as well as privately provided services and can therefore fit both the social services and low-skilled domestic categories. See Appendix B for the definition of subsectors. Source: KCHS (KNBS), Economic Survey (KNBS), WTO TiSMoS, ILOSTAT. There are large differences in productivity across services subsectors. Among services subsectors, low-skilled SHIFT domestic services, such as personal services and retail, are about one-third less productive in terms of labor productivity than manufacturing. Firms in these sectors tend to be more likely to be operating in the informal sector. On the other side, global innovator services tend to be multiple times more productive than manufacturing (Figure 2.2). ICT services and financial services see the highest levels of labor productivity. Part of these differences in labor productivity can be explained by differences in capital use across subsectors. Most services subsectors tend to be less intensive in physical capital than manufacturing.9 Among services subsectors, employment tends to be concentrated in the less productive ones (Figure 2.3). Of the four services groups, more than half (54 percent) of services employment is in low-skilled domestic services subsectors, mostly in retail, which contributes to 38 percent of all services employment, followed by personal services (7 percent) and administrative and support services (5 percent). Low-skilled tradable services employ about one-quarter (24 percent) of the services workforce, with transportation (13 percent) as the largest contributor, followed by hospitality (8 percent) and wholesale services (3 percent). Social services, comprising health and education, employ 17 percent of the services workforce. The global innovator services group, which consists of ICT, financial, professional and technical services, only employs 4.6 percent of the workforce. This share is higher than in Tanzania, Uganda and Bangladesh, but lower than in Indonesia, Vietnam, Rwanda, Thailand and Sri Lanka. 9 Total factor productivity (TFP) it corrects for differences in capital use across sectors. Due to a lack of comprehensive data on capital use by sector, sectoral TFP is difficult to calculate. Global data suggests that productivity differences between manufacturing and low-skilled domestic services narrow when correcting for differences in capital use (Nayyar et al. 2021, p. 59). 16 KENYA COUNTRY ECONOMIC MEMORANDUM Figure 2.2: Global innovator services tend to be more Figure 2.3: …but most of the employment is in low-skilled productive than other services subsectors… domestic services subsectors Labor productivity, relative to manufacturing, 2019 Employment shares of services groups, 2019 700 630 100 Index, manufacturing=100" 605 600 90 500 80 42 49 46 45 45 46 56 54 54 Percentage 400 70 60 300 60 223 200 50 136 87 100 40 27 29 100 44 62 33 36 38 26 35 35 25 37 24 25 30 29 19 0 Agriculture Mining and quarrying Manufacturing Construction Commerce Admin and support Other service activities Hospitality Transportation Professional / technical Financial ICT 20 18 21 10 21 17 16 16 14 12 12 12 5 5 6 6 7 7 11 0 3 3 4 ia da h a a sia m da d ka ny an es an an na an an an ne lad Ke Gh ail nz et iL Ug Rw do Th Ta ng Vi Sr In Ba Non-services Low-skill Low-skill Global Global innovator Social services domestic tradable innovator Low -skilled tradable Low -skilled domestic Note: Wholesale services, a low-skilled tradable service, have been grouped with Note: See Figure 2.1 and Appendix B for the definition of services groups. retail services due to the unavailability of disaggregated data. 2019 is the latest Source: ILOSTAT based on KCHS (KNBS) and other countries’ labor force and year with comprehensive sub-sectoral employment data. See also Appendix B for household surveys. definitions of the used subsectors. Source: KCHS (KNBS), Economic Survey (KNBS). Increasing productivity will require a sectoral shift to higher value-added services subsectors. Although the sectoral composition of the services sector is similar to many other countries at similar income levels, compared with high-income countries the services sector in Kenya is dominated by the low-skilled services subsector. The share of global innovator services is roughly five times lower than in high-income countries. Narrowing this gap can bring important productivity gains: if the sectoral composition of the services sector in Kenya were to match that of a high-income country, productivity of the services sector would be 2.3 times higher.10 SHIFT Figure 2.4: Compared with high-income countries, Kenyan services employment is concentrated in lower-skilled subsectors, with a small role for global innovator services Share of employment, 2017 or most recent year. (a) Low-skilled domestic services (b) Global innovator services 90 35 % 80 " 30 " Share employment (%) 70 Share employment (%) " " " " % % 60 " " "" 25 % % " "" "GHA "" " " % TZA " " % % % 50 "" "KEN " IDN % % % "UGA " " " " " " " " "" "" 20 % % %% %%% " % RWABGD VNM % % % % 40 " " " " " " THA "" " " " % % % % " " LKA " % % " " " % " " % % " " " " "" " " " " " 15 % % % 30 " " " " " " "" " " " % % %% % % % " "" """ % " " "" " " """ " LKA %% % % 20 " " " " 10 % % %% % % % % % %% % % % % RWA % %% %% % % % THA % % 10 % % VNM % % % % IDN 5 % KEN % % % %GHA % % % % %% %UGA BGD 0 % % % % % %% TZA % % 0 % GDP per capita GDP per capita Note: Low-skilled domestic services include retail, personal services and Note: Global innovator services include ICT, professional/technical services and administrative and support services (see also Figure 2.1 and Appendix B). financial services (see also Figure 2.1 and Appendix B). Source: ILOSTAT based on KCHS (KNBS; 2017) and other countries’ labor Source: ILOSTAT based on KCHS (KNBS; 2017) and other countries’ labor force and force and household surveys. household surveys. 10 This calculation assumes that services sub sectors maintain a similar level of relative productivity as currently in Kenya (Figure 2.2) but with employment shares similar to the average high-income country (based on ILO data). KENYA COUNTRY ECONOMIC MEMORANDUM 17 Global innovator services are important engines for growth Global innovator services are high-skilled, tradable and important inputs to other sectors. Global innovator services consist of ICT services and financial services, as well as professional and technical services. These subsectors comprise a wide range of activities that tend to be knowledge intensive. Professional and technical services include legal services, accounting, consultancy services, architects, engineers, research and development, veterinary services. ICT includes, besides telecommunications and media services, a wide range of digital services, including computer programming, IT consulting and data processing services. Financial services include banking, but also insurance, pension and fund management services. Many of these services can be traded, although some of them face restrictions (as Chapter 5 on trade will highlight), and many of them form important inputs to other sectors (as Chapter 3 on linkages will highlight). Global innovator services represent only 2 percent of total employment, but 14 percent of value added and 19 percent of value-added growth in Kenya. Despite only employing 2 percent of overall workers and 5 percent of service workers (including both formal and informal employment), global innovator services contribute disproportionately to Kenya’s overall GDP, as well as on GDP growth. They contribute to roughly 14 percent of GDP and 19 percent of GDP growth between 2015 and 2021 (Figure 2.5). The contribution of global innovator services to GDP has been growing over time, from 15 percent in 2016 to 21 percent in 2021 (Figure 2.6). In 2021, its contribution to growth was similar to that of low-skilled domestic services, a subsector that employs 12 times as many workers. Figure 2.5: Global innovator services represent 19 percent Figure 2.6: …and the contribution to GDP growth has of GDP growth, but only 2% of employment… been growing over time Share of employment, GDP and GDP growth, 2015–2021 Contributions to GDP growth, 2016–2021 100 8 SHIFT 11% 13% 90 2% 18% 7 80 12% 14% 6 Social services 70 19% Social services 13% Global innovator 5 Global innovator 24% Percent 60 10% services services 50 4 Low -skill tradable 8% 21% Low-skill tradable Percent services services 40 7% 25% 3 9% Low-skill domestic Low-skill 30 services 2 domestic services 9% 12% 20 35% Other industry Other industry 6% 1 10 20% Manufacturing Manufacturing 10% 0 0 Agriculture Agriculture t -1 th en P GD ow m oy gr of pl -2 P e em GD ar Sh e e ar ar -3 Sh Sh 16 7 18 19 20 1 1 2 20 20 20 20 20 20 Note: See Figure 2.1 and Appendix B for the definition of services groups. Share Note: See Figure 2.1 and Appendix B for the definition of services groups. of employment and GDP refer to 2019, the latest year with comprehensive Other industry includes mining, construction and mining. employment data by subsector. Employment refers to formal and informal forms Source: Calculations based on Economic Survey (KNBS). of employment. GDP growth relates to the period 2015–2021. Social services also include public administration (2.5 percent of employment). Source: Calculations based on Economic Survey (KNBS), ILOSTAT derived from KCHS (KNBS). Growth in global innovator services has been outperforming that of other services, especially in recent years. Between 2018 and 2021, the value added of global innovator services grew by 7 percent, the highest of any services group and also double the level of growth seen in agriculture (2 percent) and in manufacturing (2 percent). Global innovator services—thanks to their ability of being able to be delivered remotely and in digitally enabling other sectors—proved to be particularly resilient during the pandemic. While in 2020 other subsectors saw stagnation or decline, and especially in low-skilled tradable sectors due to the collapse of the tourism subsector, global innovator services grew by 3 percent.   18 KENYA COUNTRY ECONOMIC MEMORANDUM Figure 2.7: Between 2018 and 2021, global innovator Figure 2.8: Global innovator services were the least hit services have outpaced other subsectors in their growth in during the pandemic value added Annual growth rates in value added (%), 2016–2021 Annual growth rates in value added (%), 2016–2021 8 7% 10 7 7% Growth in value added (%) 6% 6% 6% 6% 6 5 5% 5% 5 4% Percent 4 0 3% 3 2% 2% 2% 2 -5 1% 1 0 -10 s es rv ed ic d ce re g ry ic rv le es rin se kill vi st es tu rv se kil ic er du tu ul se tic -s e -s rs ric es Low ac in bl w -15 al to da Lo uf Ag ci er 2016 2017 2018 2019 2020 2021 va So an th no O M m in tra do al Manufacturing Low-skill domestic services ob Gl Low-skill tradable services Global innovator services 2015-2018 2018-2021 Social services Note: Global innovator services include ICT, professional/technical services and Note: See Figure 2.1 and Appendix B for the definition of services groups. financial services (see also Figure 2.1 and Appendix B). Source: Calculations based on Economic Survey (KNBS). Source: Calculations based on Economic Survey (KNBS). Sustaining—and where possible accelerating—growth of global innovator services is key. Compared with other countries, Kenya is already leading the way in some global innovator services subsectors. The country is considered a hub for financial and digital services. At the same time, this group of services faces a series of constraints. Part of these constraints are related to the high skill intensity and the difficulty of firms in these subsectors to find qualified workers in the Kenyan labor market. Other constraints relate to product markets in these subsectors being restricted (especially in subsectors such as professional services and telecommunications) and a potential to further adopt more sophisticated technologies, as Chapter 4 (“Boost”) will discuss further. Services trade restrictions and data trading restrictions further impact growth of this subsector, as Chapter 5 on SHIFT trade will discuss. Much of global innovator services activity takes place in micro, small and medium enterprises (MSMEs). In ICT, financial and professional services, respectively, 94.7, 88.5 and 91.5 percent of formal sector firms employ fewer than 10 workers (Figure 2.9).11 Global firm survey evidence suggests that many services subsectors see lower economies of scale than industrial sectors, especially in higher-income countries, meaning that scale is not a necessary condition to achieve productivity (Nayyar et al. 2021). In Kenya, a similar lack of relationship between size and labor productivity can be seen when comparing micro with small firms (Figure 2.10). Except for transportation services, where labor productivity increases with firm size, for other subsectors smaller firms’ productivity tends to exceed that of slightly larger firms (comparable data for medium and large firms are unavailable).12 11 Within more narrowly defined sectors there are notable differences, for example telecommunications sees a larger share of large firms (1.1 percent) than computer programming (0.3 percent). A more meaningful measure of the size distribution are employment shares across firm size groupings. These data are currently not available. 12 A lacking relationship between size and productivity can also be a sign of misallocation, as it could be the result of lacking growth of productive firms. In the case of services, minimum efficient scale tends to be lower, and even in economies with fewer distortions (e.g., in high-income countries), there is a weaker relationship between size and productivity. KENYA COUNTRY ECONOMIC MEMORANDUM 19 Figure 2.9: Many services firms in Kenya are micro or small Figure 2.10: Returns to scale are low in many of services firms, including in global innovator services subsectors, including global innovators Distribution of firms by firm size, 2016 Output per worker of micro and small firms, 2017 100 16,000 80 14,000 60 12,000 10,000 Percent 40 8,000 20 6,000 0 4,000 Manufacturing Construction Retail Admin Arts Other Transport Wholesale Hospitality Financial Professional ICT 2,000 0 sa d n y T l l or d ia na lit IC tio le an pp n nc le t su in a ita sio ta ho il na sp w eta es or m Fi Ho sp of Low-skill domestic Low-skill Global Ad R Pr an innovator Tr tradable 0 -3 4 -6 6 -9 10 -49 50 -149 150+ Micro (1-4) Micro (5-9) Small (10-49) Note: This only covers formally registered establishments. See Appendix B for the Note: The source for this data only includes MSMEs (with fewer than 100 definitions of services subsectors. employees). Medium-sized firms are not reported due to a small number of Source: Census of Establishments, 2017. observations for each subsector. Labor productivity is measured by monthly sales per worker. See Appendix B for the definitions of services subsectors. Source: MSME Survey 2017. Growing global innovator services can have Figure 2.11: Regional concentration of global innovator services implications for inequality. Many of the global Share of global innovator services as part of services value added, 2020 innovator services tend to be concentrated in the larger cities, especially in Nairobi and Mombasa (Figure 2.11). In Nairobi, global innovator services contribute to one-third (33 percent) of value added in the services sector and in Mombasa about one-fifth (19 percent). SHIFT Much of the employment in global innovator services is high-skilled and wages in global innovator services tend to be much higher than in other subsectors. This means that global innovator services have the potential to increase inequalities. Conversely, if global innovator services expand and absorb more labor from other, less productive sectors, as well as creating more opportunities in other, linked sectors, their continued Note: Global innovator services include ICT, professional/technical services and financial services (see also Figure 2.1 and Appendix B). development may ultimately reduce inequality. Source: National accounts (KNBS). However, global innovator services also provide job opportunities for lower-skilled workers, including through linkages. Global innovator services do not solely rely on high-skilled workers. Data on educational attainment show that two out of five workers (43 percent) in global innovator services do not have a tertiary degree. In addition, global innovator services rely on other subsectors as inputs and in this way create further employment Chapter 3 (“Link”) will discuss this further. In addition, global innovator services also improve the adoption and use of more sophisticated technologies, which can bring new productive opportunities. Digital services also play a role in improving service delivery to the poor (see also Chapter 6, “Secure”). 20 KENYA COUNTRY ECONOMIC MEMORANDUM Box 2.1 The financial subsector in Kenya after the pandemic The financial subsector in Kenya accounted for 6.4 percent of GDP in 2021 and, as such, is the largest subsector within global innovator services. This figure excludes insurance activities, which contribute to another 2.2 percent of GDP. The financial subsector has been growing rapidly, with annual growth of the subsector averaging 4.7 percent between 2015 and 2021. Kenya is also home to the largest stock exchange in the region, the Nairobi Securities Exchange, and many multinational financial corporations have set up their regional headquarters in Nairobi, making it an important financial hub for the region. The banking subsector weathered the COVID-19 shock, helped by the CBK’s emergency relief measures in response to the pandemic. As of end-December 2021, banks’ capital adequacy ratio (CAR) stood at 19.6 percent, well above the statutory requirements. With an ample capital position and strong deposit growth at the system level, the banking subsector as a whole remains well-positioned to meet the economy’s credit needs and support the recovery, including by helping to meet the Government’s financing requirements. The gross non-performing loans (NPLs) ratio stood at a significant 14.0 percent in February 2023 mainly in the trade, personal and household, manufacturing and building and construction subsectors. However, NPLs are mostly attributable to a few borrowers with specific challenges, and banks have continued to provision adequately for loan losses. Careful monitoring remains necessary to reduce key risks and maintain stability. Kenya’s financial subsector has suffered notable shocks over the past few years, including three bank failures, interest rate caps (2016– 2019), the COVID-19 pandemic, the war in Ukraine and a slowdown during the election cycle. As a result, existing financial subsector vulnerabilities such as the high sovereign debt levels, sizable exposures to SHIFT movements in global capital and funding markets, and weak crisis management frameworks are risks that need to be monitored closely. The World Bank has been engaged in helping the Government to strengthen the legal, regulatory, and institutional environment for improved financial stability, access to and provision of affordable and long-term financing. Mobile money solutions, including M-Pesa, have played a large role in facilitating access to financial products. Mobile money platforms, such as M-Pesa, have allowed Kenyans to access financial services and make transactions through their mobile phones, without the need for traditional bank accounts. This has expanded financial access to previously unbanked and underbanked populations, particularly in rural areas. The convenience and low cost of mobile money has also boosted small businesses, allowing them to accept and make payments more easily. The M-Pesa platform has gradually been expanded to include additional functionalities, including the provision of saving accounts, as well as small loans, and has played a large role in widening access to financial products. Nevertheless, there remains a need to increase access to finance further, especially in the following areas: Expanding access to MSMEs. Credit to the private sector has been on the increase since the pandemic— reaching 11.7 percent in February 2023—but the financial subsector struggles in reaching MSMEs. MSMEs were among the worst-hit businesses in Kenya during the COVID-19 pandemic, as shown by World Bank Business Pulse Surveys, and although the financial health of MSMEs has improved, access to finance remains a key challenge. The adoption of risk-based loan pricing models by banks is expected to increase lending, including to MSMEs. KENYA COUNTRY ECONOMIC MEMORANDUM 21 Box 2.1 The financial subsector in Kenya after the pandemic (contd.) Figure 2.12: The share of NPLs increased during the Figure 2.13: The financial subsector is mostly serving the tourism COVID-19 pandemic, but has stabilized since subsector, retail and real estate, and less so the agriculture sector NPL ratio, percentage, 2016–2021 Sectoral distribution of loans, December 2021 3.30% 16 14.40% 27.70% 14 3.70% 12 0.80% 10 3.70% 8 3.60% 17.60% 6 14.10% 4 7.80% 3.30% Agriculture Manufacturing 2 Building and construction Mining and quarrying Energy and water Trade 0 Tourism, restaurants & hotels Transprot & communication Dec-16 Apr-17 Aug-17 Dec-17 Apr-18 Aug-18 Dec-18 Apr-19 Aug-19 Dec-19 Apr-20 Aug-20 Dec-20 Apr-21 Aug-21 Dec-21 Real estate Financial services Personal/household Source: Central Bank of Kenya. Source: Central Bank of Kenya, Bank Supervision Annual Report 2021. Widening available financial products to support private sector growth. There is scope to widen the range of available financial products. Some sectors remain underserved, for example agriculture receives only 3.2 percent of Kenya’s total credit value (June 2022), while contributing 21 percent to GDP. De-risking financial instruments and deepening financial innovation in insurance, credit guarantees, trade guarantees, and blended finance could enhance access to credit in critical sectors such as agriculture, trade and services. However, it is important to consider the impact of any governmental support or guarantees using rigorous fiscal and contingent liability assessments, and to ensure the most efficient use of public funds or concessional SHIFT financing, where the innovative design of funds can help to leverage more private sector finance or credit. Finance for climate adaptation and mitigation. For Kenya to meet its nationally determined commitment (NDC) target of reducing greenhouse gas (GHG) emissions by 32 percent by 2030 requires substantial additional financing, estimated at US$62 billion. To meet these goals, new finance instruments, such as incentive mechanisms for green loans (e.g., through guarantees) and green bonds, could be deployed. The role of the financial subsector in carbon markets could also be enhanced. In addition, climate insurance products could help with climate adaptation, especially in vulnerable sectors such as agriculture. The quality of climate risk assessments should also be strengthened. A 2022 survey by the Kenya Bankers Association highlighted that there is a need for banks to improve their knowledge, expertise and data to perform climate risk assessments. Establishing Kenya as a leading regional investment hub. The Nairobi International Financial Center (NIFC) was established in 2021 to create an efficient and predictable operating environment with the objective of attracting increased domestic and foreign finance and investment. The NIFC is a flagship initiative under the economic pillar of Kenya’s Vision 2030. The core target sectors of the NIFC include supporting Kenya’s transition to a low carbon economy by promoting green and sustainable finance; creating an attractive operating environment to attract investment funds with a pan-African mandate; enhancing Kenya’s potential to deploy FinTech innovations to serve sub-Saharan Africa by supporting Kenya’s FinTech ecosystem; and growing Kenya’s reputation as the regional and African headquarters of multinational organizations by supporting firms to set up in Kenya as their base for doing business in Africa. 22 KENYA COUNTRY ECONOMIC MEMORANDUM Digital services: building on the momentum Kenya already has a large share of digital businesses based on its size and population. According to the World Bank’s global database on digital businesses (Zhu et al. 2022), Kenya boasts one of the highest digital business presences, globally. Businesses have both grown locally, as well as from abroad. It is the third-largest technology incubation and acceleration hub in the region. Digital business models are pervasive throughout main sectors of the Kenyan economy, driven in part by a robust mobile money ecosystem— more than 80 percent of the population use mobile money, and over US$20 billion in mobile money transactions were made in 2021, equivalent to 65 percent of GDP.13 The largest share of businesses in Kenya are focusing on FinTech, followed by e-commerce and software as a service (Figure 2.14). Kenya’s digital businesses have brought in about US$4.8 billion in investments. The mean investment of digital businesses headquartered in Kenya is US$17 million, although skewed by some very large transactions. The median figure is about US$0.3 million, less than in South Africa but more than in Nigeria (US$0.2 million) and Ghana (US$0.1 million). Of the investments in digital businesses, FinTech and e-commerce are the largest recipients, accounting for nearly 50 percent of the funding raised. Figure 2.14: Close to one-quarter of businesses operates in FinTech, followed by e-commerce and software as a service (SaaS) Top 20 digital subsectors in Kenya, Ghana, South Africa and LMICs, by number of firms 25 20 15 Percent 10 SHIFT 5 0 ork h rce 8) ech h ch es h ch ia ech cs ech h ch ech m L h AIM Tec Tec Tec Tec Tec ed ,65 eco lyti vic tTe sTe tTe tw me hT gT tyT ityT lM =1 Fin Ag Ed ure HR Ser na lNe gm en Tel tic alt tin om ita uti bil a (n taA We Ins nm gis cia He rke sM Dig Sec E-C Mo Da Lo ny So tai Ma Bu Big Ke ter En Kenya (n=1,658) Ghana (n=668) South Africa (n=1,361) Lower middle income countries (n=9,958) Source: World Bank Digital Business Database (Zhu et al. 2022). Kenya is an emerging hub for digital services, which are making a growing contribution to trade. Building on the expansion of mobile phone and internet connectivity, Kenya has positioned itself as a regional hub for digital services. The mobile phone subscription rate doubled during the 2010s to 123 per 100 people in 2021, and the proportion of individuals using the internet has been increasing rapidly, from 7 percent in 2010 to 29 percent in 2021. 14 Growing at an annual average rate of 15 percent in the past 15 years, Kenya’s digital services exports now account for about one-third of Kenya’s services exports—up from just above 10 percent in 2005—making the country the second-largest exporter of digitally-delivered services15 in sub-Saharan Africa (Figure 2.15 and Figure 2.16). https://www.businessdailyafrica.com/bd/markets/capital-markets/kenya-s-mobile-money-agent-transactions-hit-sh7-9-trillion-- 13 4116826#:~:text=Mobile%20money%20is%20the%20most,of%20the%20service%20among%20counties. 14 Source: World Bank WDI. 15 Digitally-deliverable services are an aggregation of services that can be delivered remotely over ICT networks (UNCTAD, 2015). KENYA COUNTRY ECONOMIC MEMORANDUM 23 Figure 2.15: Exports of digital services grew rapidly Figure 2.16: Growth averaged 15 percent between 2005 between 2005 and 2021 and 2021, higher than other East African countries Export values, US$ million in current prices Growth in export value, 2005–2021 6,000 35 30 29.2 5,000 25 4,000 Percent 20 3,000 15.0 15 11.5 11.0 2,000 10 9.0 8.0 7.8 7.4 1,000 5 4.2 0 0 2 3 4 5 6 7 8 9 0 1 ria a a ies ia ia n a l 06 07 08 09 10 11 01 01 01 01 01 01 01 01 02 02 ga 05 ny d ric io op an ge an om 20 20 20 20 20 20 2 2 2 2 2 2 2 2 2 2 ne Un 20 Af Ke nz hi Ni Ug Se on h Et Ta an ut Ec ric So Af ng Ethiopia Kenya Nigeria Senegal pi lo ve South Africa Tanzania Uganda De Source: World Bank calculations, based on UNCTADStats. Source: World Bank calculations, based on UNCTADStats. Box 2.2 The international competitiveness of Kenya’s ICT subsector and other value chains A 2023 World Bank survey considers what are the drivers of price competitiveness of Kenya’s ICT subsector and three other priority value chains. These include 286 firms, of which 65 firms are in ICT, and 221 firms in other priority value chains (agri-business, textiles and apparel, pharmaceuticals).16 The survey captures details about firms’ historical performance, the effect of (sub)-national taxes, subsidies and levies on production costs and profitability, their main drivers and inhibiters of price competitiveness, and their biggest challenges with government policies. While the small sample means the results are not nationally representative, the survey provides a helpful reflection on firms’ drivers of price competitiveness, and give a picture of SMEs after the pandemic. SHIFT Kenyan firms’ likelihood of exporting increases by size and is also driven by foreign-owned firms (Figure 2.17a). Overall, 38 percent of firms in the sample reported exporting in 2022. The likelihood of firms exporting increases considerably with firm size, ranging from 13 percent of micro-firms, up to 61 percent for large firms. Ownership relations with foreign companies is also a strong indication of exporting, as only 20 percent of domestic firms exporting, and this goes up considerably for joint ventures with foreign firms (60 percent) and foreign firms (70 percent). Only 22 percent of ICT firms export, which likely reflects the large share of small, domestically owned ICT firms included the survey sample. International supply linkages follow a similar pattern, with larger and foreign-owned firms more likely to source from, and supply other foreign firms (Figure 2.17). One-third of firms are long-term users of a foreign firm’s input, while 16 percent are a long-term supplier to a foreign firm. Medium and large firms report the most significant share of users of foreign firms’ input (41 and 50 percent, respectively) and also report the largest share of firms that are long-term suppliers of inputs to a foreign firm (23 and 17 percent). Joint ventures with foreign firms and foreign-owned firms are also more internationally linked, with 29 percent of such firms using foreign inputs and supplying to foreign firms. By sector, agribusiness is the most input-dependent, with 34 percent of firms using foreign inputs, while only 9 percent supply to a foreign firm. Pharmaceutical firms report the most balanced relationship, with 33 percent using foreign firms’ inputs and 23 percent supplying a foreign firm. 16 The survey includes 80 firms in agri-business, 78 firms in textiles and apparel, 65 firms in information and communication and 63 firms in pharmaceuticals. These sectors were chosen in partnership with Kenya’s Government, and mimic priority areas in IFC’s Kenya Country Private Sector Diagnostic. 24 KENYA COUNTRY ECONOMIC MEMORANDUM Box 2.2 The international competitiveness of Kenya’s ICT subsector and other value chains (contd.) Figure 2.17: Kenyan firms’ ability to export and supply foreign firms differs by size, ownership, and sector (a) Share of survey sample’s firms that export, by type 70% 66% 61% 60% 54% 38% 33% 30% 25% 20% 22% 13% Micro Small Medium Large Domestic Joint Venture Foreign Agri-Business ICT Pharma Textiles & Apparel Full sample Firm size Ownership Sector (b) Share of survey sample’s firms that source from, or supply to foreign firms, by type 50% 50 41% 38% 34% 35% 34% 33% 30% 29% 29% 29% 29% 23% 23% Percent 25 21% 22% 16% 17% 17% 14% 15% 14% 8% 9% 0 Micro Small Medium Large Domestic Joint Venture Foreign Agri-Business ICT Pharma Textiles & SHIFT Apparel Full Sample Firm Size Ownership Sector Long-term user of foreign rms' inputs Long-term supplier to foreign rm Source: World Bank calculations. Notes: ICT = Information and Communication Technology. Interviewed ICT firms indicate that they mostly compete with foreign firms on price and, compared with other sectors, less on quality. Only 34 percent of interviewed ICT companies indicate that they are “strongly” competitive to foreign firms based on quality, instead focusing on price. Six out of 10 ICT firms (59 percent) report that they have lower or comparable prices than their foreign competitors (Figure 2.18a), again reflecting their relatively small size and domestic orientation. Pharmaceutical firms report to being most cost-competitive, with 67 percent having lower or comparable prices to foreign competitors. This reflects the sector’s focus on low- quality, generic drugs. Textiles and apparel firms have a similar margin, with 58 percent at lower or comparable prices, while agri-business has the lowest share of firms reporting comparable or lower prices to foreign firms (53 percent). When considering quality (Figure 2.18b), a majority of agri-business and textiles and apparel firms report being able to be “strongly” compete with foreign firms (51 and 52 percent, respectively). KENYA COUNTRY ECONOMIC MEMORANDUM 25 Box 2.2 The international competitiveness of Kenya’s ICT subsector and other value chains (contd.) Figure 2.18: While the ICT and the pharmaceutical sectors appear to compete with foreign firms more on price, agri-business and textiles are more able to compete on quality (a) Firms’ reported product prices compared with the prices of their foreign competitors (b) Share of firms reporting to be “strongly” competitive to foreign firms based on quality 60 60 40 40 52% 47% 48% 47% 47% 51% Percent Percent 42% 41% 42% 20 33% 20 34% 31% 11% 11% 20% 11% 0 Agri-Business ICT Pharma Textiles & 0 Apparel Agri -Business ICT Pharma Textiles & Lower prices (>-5%) Comparable prices (-5% to +5%) Higher prices (>+5%) Apparel Source: World Bank calculations. Notes: ICT = Information and Communication Technology. The top three drivers affecting companies’ decisions to invest are political stability and security, low tax rates, and a business-friendly legal and regulatory environment (Table B.1). Yet, each sector also has different drivers affecting their investment decisions. For agribusiness, access to local inputs together with macroeconomic stability and exchange rate favorability are also relevant aspects. The ICT and pharmaceutical sectors also care about market size and the availability of a talented and skilled labor force. For textiles and apparel, low cost of labor is critical, as is the size and purchasing power of the market and the availability of local inputs. Table 2.1: Top 10 most important factor for companies’ decision to invest (percentage of firms rating issue as “critically important”) Full Agri Textiles & SHIFT sample business ICT Pharma apparel Political stability and security 71 68 75 62 77 Low tax rates 65 60 65 62 74 Business-friendly legal and regulatory environment 58 53 65 56 60 Size and purchasing power of the market 52 45 63 51 53 Availability to source inputs locally 48 53 43 43 53 Macro-economic stability and exchange rate favorability 47 53 42 46 47 Good physical infrastructure (e.g., transport and telecom) 46 45 49 46 45 Coordination of your company’s supply chain 46 45 46 44 49 Availability of talented and skilled labor force 45 30 55 48 51 Low cost of labor and other production inputs 40 35 35 35 54 Source: World Bank calculations. Notes: ICT = Information and Communication Technology. To strengthen Kenya’s international competitiveness going forward, it will be important to improve the business-enabling environment and consider how Kenya’s different national and sub-national taxes affect price competitiveness. More in-depth analysis is needed for ways to streamline Kenya’s business- enabling environment. Given the private sector’s stated importance of low tax rates, it will also be important to better understand how different taxes at the national and sub-national levels affect price-competitiveness. A forthcoming study will use the new firm survey to consider this in more detail, and will also review how burdensome these taxes are in terms of their tax administrative processes. This study will also identify which firms receive tax incentives, how beneficial such incentives are, and consider ways to improve the cost-effectiveness of tax incentives by balancing Kenya’s limited fiscal space with the desire to improve the international competitiveness of its private sector. 26 KENYA COUNTRY ECONOMIC MEMORANDUM The importance of skills for global innovator services The availability of a well-qualified workforce is crucial for global innovator services. The knowledge intensity of these services means that worker training is vital. The share of workers with a tertiary degree, such as a university degree, vocational degree or diploma, in these services varies from 53 percent in financial services to 72 percent in ICT services (Figure 2.19). This is much higher than in other service categories, with the exception of social services, or in industrial sectors, where workers with a tertiary degree typically are about one-tenth of the workforce. Figure 2.19: Global innovator services, especially ICT services, rely on an educated workforce Educational attainment by worker, 2019 100 2 4 12 10 9 13 11 9 90 16 14 18 16 25 80 26 34 70 26 28 29 31 55 53 52 48 36 28 60 39 26 72 50 Percent 35 40 80 84 21 24 30 62 62 62 58 65 21 30 51 56 49 20 43 15 10 24 17 27 28 31 0 12 Agriculture quarrying Manufacturing Construction Retail Admin and support entertainment Other service activities Hospitality Wholesale Transportation technical Financial Education Health administration ICT Mining and Arts / Professional / Public Non-services Low-skill domestic Low-skill tradable Global innovator Social services Less than secondary Secondary Tertiary Note: Tertiary education includes university degrees (undergraduate and postgraduate), diplomas and vocational education. See Appendix B for definitions of services subsectors. Source: KCHS (KNBS). However, the availability of skills remains an important constraint for firms. Close to half of employers (48 percent) in global innovator services indicate that graduates from the education system are not meeting their skill SHIFT needs (Figure 2.20). This is higher than in other services or in manufacturing. The main constraint does not seem to be formed by a lack of up-to-date knowledge, but mostly because of lacking practical experience (reported by 49 percent of global innovator services employers). This lacking skills and work experience can be found across all occupational groups in the services sector (Figure 2.21). Figure 2.20: Close to half of employers in global innovator services Figure 2.21: The lacking skills and work experience are indicate that graduates from the education system do not meet found across all occupational groups their skill needs Share of employers reporting lacking skills for graduates, 2017 Share of employers reporting problems encountered during recruitment, 2017 60 60 49 49% 50 50 48% 42 39 43%43% 40 29 29 29 2831 30 30 40 30 26 25 35% 22 21 21 Percent 19 1917 31%31% 31% Percent 30% 20 15 30 26% 8 12 10 26% 10 21% 20% 2 2 20 18% 0 16% Clerical Clerical Manager Manager Technical Technical Professional Professional Sales worker Sales worker services worker services worker Other Other 10 0 Do not Lacking Lacking up Lacking Lacking meet skills important to-date practical personal needs skills knowledge experience skills Manufacturing Services Manufacturing Low-skilled Global innovator Lacking skills Lacking work experience Note: Global innovator services include ICT, professional/technical services and Source: World Bank STEP Survey. financial services. Low-skilled services include both low-skilled domestic and tradable services, including retail, wholesale, hospitality, administrative and support services, personal services and transportation (see also Figure 2.1 and Appendix B). Source: World Bank STEP Survey. KENYA COUNTRY ECONOMIC MEMORANDUM 27 The supply of a qualified workforce, and especially graduates with a STEM degree, is crucial. Kenya performs relatively well in measures of human capital (including the World Bank’s Human Capital Index), but there is room for improvement. Tertiary enrolment in Kenya stands at 10 percent, which is slightly above the average of SSA, but below that of South Africa (24 percent) and Ghana (17 percent), and also below South Asia and East Asia and Pacific (Figure 2.22). Of the enrolled students in tertiary education, the share in science and engineering-related degrees is relatively low. Currently, 17 percent of graduates of tertiary education finish with a degree in science and engineering, which is at the average of SSA, but below that of some countries in East Asia, such as Vietnam, the Philippines and Malaysia (Figure 2.23). Figure 2.22: Tertiary enrolment in Kenya is at 10 percent, Figure 2.23: Of graduated students, 17 percent do so with below Ghana and South Africa a degree in science and engineering Tertiary enrolment, percentage, 2019 Graduates in science and engineering 50 35 32 43 29 30 40 24 Percentage of graduates 25 23 32 29 20 30 20 19 24 17 21 15 16 15 14 20 17 11 10 10 9 10 6 3 5 0 0 Sub-Saharan Africa Malaysia Philippines India South Africa Sri Lanka Ghana Kenya Rwanda Tanzania SSA Kenya Rwanda Sri Lanka Vietnam Malaysia Cambodia Colombia Bangladesh Philippines South Africa Note: Tertiary enrolment is the share of the relevant age group (between zero and Source: World Bank Entrepreneurship Ecosystem Diagnostic (2021), based on five years after post-secondary education) that is enrolled in a tertiary degree. Global Innovation Index data. Source: World Bank WDI based on UNESCO data. SHIFT Global innovator services need skills across the spectrum, including more basic skills that are within reach of more people. While some global innovator services, for example, professional services or computer programming, require highly specialized and advanced skills for crucial tasks, there are many tasks that are less skill intensive. Often these tasks still require a basic level of skills, especially as they relate to ICT, for example, the ability to use email or word processing software. Acquiring these skills still requires training and experience, but they might be within reach of more workers than some of the more highly specialized tasks associated with global innovator services. Nevertheless, this requires a strengthening of Kenya’s educational system (see Box 2.3). Box 2.3 Strengthening the educational sector in support of services-led growth The education sector in Kenya is pivotal in meeting the growing demand for skilled labor in productive services jobs, while also serving as a significant source of employment itself. The education sector already employs close to 610,00017 people, and the required expansion of educational services has the potential to create up to 409,000 additional jobs by 2030. These employment opportunities can primarily originate from two avenues: (i) addressing the deficit of teachers from pre-primary to tertiary levels, as access increases while pupil-teacher ratios are appropriately maintained; and (ii) the strategic expansion of tertiary education services, positioning Kenya as a regional hub for international students and expanding the capacity for research, development and innovation RD&I. Reducing teacher shortages in basic education, and growing the teaching force as enrolments grow. More teachers are indispensable to increase access at both pre-primary and secondary level, maintaining or reducing the pupil-teacher ratio (PTR) to recommended standards, supporting the implementation of 17 In both private and public spheres (Economic Survey 2022). Data for 2021 is provisional. 28 KENYA COUNTRY ECONOMIC MEMORANDUM Box 2.3 Strengthening the educational sector in support of services-led growth (contd.) the 100 percent transition to secondary school initiative, and meeting the required skills set for the new technical subjects introduced under the competency-based curriculum (CBC). Estimations by UNICEF show a gap between 181,000 and 336,000 teachers at these levels, if enrolment rates were to be enhanced by 2030, while either keeping the current PTR or improving it to match the top 25 percentile in East and Southern Africa (ESA).18,19 Furthermore, for an effective delivery of services, operational and technical staff are required at county and sub-county levels, which was found to be in deficit in 2018; plans to address the gap have been in place since.20 The expansion of digital literacy programs, teacher training initiatives, and the construction of new schools also lead to indirect job creation in related sectors, such as IT and construction. Strengthening the workforce of the rapidly developing tertiary education. Kenya’s enrolment rate in tertiary education has recently accelerated but it remains very low, placing it as an emerging sector with high potential. Technical and Vocational Education and Training (TVET) has been the main contributor to this expansion, with enrolment increasing fivefold from 2015 to 2020, approaching parity of enrolment against universities.21 This has been driven by heavy government and private sector investments, stressing its strategic position in addressing the country’s skills gap and youth unemployment, by providing training for specialized and emerging industries. Together with university needs, UNICEF has estimated that between 40,000 and 73,000 new teachers would be needed by 2030 if the gross enrolment rate is set to reach the average of LMICs at 24 percent, which is more than twice the current enrolment level in Kenya. Strategic development of tertiary education and RD&I. Government plans have also sought to position the country as an international hub for higher education, with the development of a qualifications’ recognition system and other related restructurings underway.22 Currently, Kenya has the second-largest influx of international students in the ESA region, hosting 6,800 foreign students at tertiary education institutions.23 However, to reach the levels of South Africa, the country on top of the list with 36,000 foreign students, huge SHIFT efforts are still needed. However, the returns will be worthwhile; beyond emerging as an additional funding source for local institutions, international students indirectly promote sector dynamization and institutional cooperation, and can have additional positive spillover effects in other subsectors, such as accommodation, food, and transportation services. In addition, following the goals under the Kenya Vision 2030 of strengthening RD&I, Kenya has established several initiatives to promote it. However, the country is yet to take off.24 This leaves an enormous potential to be maximized with the right investments and cooperation with the private sector. As shown by the rapid recovery after the COVID-19 pandemic, employment in education is proven to be an indispensable source of wage employment, both in the public and private sectors. Reaching national goals will require a large investment, that in turn will contribute to an enhanced human capital in the country given the right conditions are met. This means closing gaps in access, incorporating digital skill training at all levels, enabling technology-driven training, aligning curricula with industry demands, enhancing collaboration with the private sector, and continuing to develop strategies to attract international students and faculty, while reinforcing international partnerships.25 18 Cummins, M. (2021). Estimating the Teacher Gap and Funding Requirements in Eastern and Southern Africa. Available at SSRN 3923276. 19 ESA includes 21 countries: Angola, Botswana, Burundi, Comoros, Eritrea, Eswatini, Ethiopia, Kenya, Lesotho, Madagascar, Malawi, Mozambique, Namibia, Rwanda, Somalia, South Africa, South Sudan, Tanzania (United Republic of ), Uganda, Zambia and Zimbabwe. 20 Teachers Service Commission (2018). Strategic Plan for 2019-2023. 21 In 2015, TVET institutes enrolled over 85,000 students reaching 451,000 in 2020, while the university sector reached 546000 students in 2020/21 (Economic Survey 2022). 22 KNQA (2020), Strategic Plan 2020–2025. http://uis.unesco.org/en/uis-student-flow 23 24 Compared to neighbor countries, Kenya’s higher education system contributes in higher proportions to RDI investment in the country, with close to 40 percent of its Gross Domestic Expenditure (GERD). KIPPRA (2021). Factors Influencing Services Firms’ Investment in Research and Development in Kenya, Discussion Paper No. 278. 25 World Bank support to the further development of higher education elsewhere in Africa includes the Africa Higher Education Centers of Excellence Project, see https://projects.worldbank.org/en/projects-operations/project-detail/P126974 KENYA COUNTRY ECONOMIC MEMORANDUM 29 Concluding remarks As described by this chapter of the CEM, global innovator services (ICT, financial, technical and professional services) are contributing significantly to economic growth in Kenya. Their further success and expansion will require the supply of the skills global innovator firms need, putting into focus the skills agenda to lift the capabilities of new members of the workforce joining from the education system, but also that of existing workers: basic education, tertiary education, and TVET, including soft skills. In addition to skills, other critical inputs will be needed, including digital technology infrastructure. As discussed further in Chapter 4 (“Boost”) and Chapter 5 (“Trade”), global innovator firms need to invest in technology, and knowledge-based industry often needs to be connected to global firms and production networks. This places the spotlight on the prerequisites to encourage the needed investments, and interest from global firms. For this, in turn, survey evidence from this and related chapters points to the importance of stability (political, macroeconomic), and the business environment (e.g., tax and regulatory regime). Global innovator services may be small in terms of their direct employment contribution, but they are driving change and making an outsize contribution to Kenya’s economic growth. The next chapter (“Link”) zooms out to examine the linkages across sectors and subsectors in the economy. It will discuss, for example, evidence on how for every US$10 earned by a high-skilled worker involved in the exports of ICT (i.e., global innovator services), US$15 went to less-skilled workers directly employed and another US$4 go to less-skilled workers indirectly employed through linkages. The ability to attract investment – especially foreign direct investment (FDI) – is also important for the growth of global innovator services. As highlighted in Chapter 5 (“Trade”), FDI has been growing in Kenya starting from SHIFT a small base in the early 2000s. Nevertheless, realized FDI remains low relative to Kenya’s GDP and despite Kenya’s reputation and ambition to be a regional hub for financial and business services, restrictions in these sectors to trade and investment remain. SHIFT: Policy priorities for growing global innovator services High-­ ‐productivity “global innovator services” (ICT, professional, technical and financial services) have been driving a large part of economic growth in Kenya.These services are knowledge-­ ‐intensive and typically depend on digital infrastructure. Policies to grow this sector include: • Improve skills development, especially by increasing access to and quality of secondary and tertiary education, including STEM degrees, and access to and the quality of TVET. • Invest in ICT infrastructure to expand access to digital services, and lower access costs in order to promote universal access to digital services. • Expand ICT and financial ecosystems to bolster Kenya as a regional hub. • Continue public sector digitalization efforts. Shifting into higher value sectors is also closely related to fostering technology adoption and competition (see chapter 4, “Boost”) and increasing trade and investment opportunities (see Chapter 5, “Trade”), including by reforming digital regulations and attracting foreign direct investment (FDI). 30 KENYA COUNTRY ECONOMIC MEMORANDUM CHAPTER 3 LINK Services More Strongly to Enable Industrialization and Economic Opportunities Across the Entire Economy Services are critical enablers to growth in other sectors, including manufacturing and agriculture. A holistic approach to integrate services into the Government’s Bottom-Up Economic Transformation Agenda is essential. Services linkages are crucial to support other sectors and foster growth F ostering industrialization and growing productivity of the agriculture sector are key objectives of the Government. The Government of Kenya is focused on implementing a Bottom-Up Economic Transformation Agenda, geared toward inclusive growth with an emphasis on ensuring food security, increasing employment, and promoting the equitable distribution of income. To this end, five priority sectors have been identified that are envisaged to have the largest impact on households and that have the strongest linkages to other sectors, namely: agriculture, MSMEs, housing and settlement, health care, and the digital superhighway and creative industry. By focusing on enhancing growth in these sectors, the Government aims to rebalance the quality of growth from public sector-led investment to dynamic private sector-led growth, while implementing a growth-friendly fiscal consolidation path that will slow the annual growth of public debt without compromising service delivery. The services sector plays an important role in boosting growth and productivity of other sectors through linkages. Direct linkages between services and other sectors can happen in two important ways, as inputs and as complements: • Services as inputs (“upstream enablers”): Services form important inputs to the production process. For example, a goods exporter will rely on transportation and logistical services to transport goods, which are also becoming increasingly dependent on digital technologies (e.g., tracking). A firm seeking to adopt more efficient technology will require services, such as ICT or engineering services, to implement this technology. A substantial body of evidence across countries shows that the services embodied into manufactured goods have a significant impact on manufacturing productivity (Arnold et al. 2016; Arnold et al. 2011; Bas and Causa 2013; Francois and Woerz 2008) and the ability to charge higher prices (Alfaro & Eslava 2020). • Services as complements (“downstream complements”): Services are often “bundled” with manufactured goods. For example, car manufacturers offer financial services or warranties covering repair services through monthly payment plans or manufacturers of electronical devices provide software that runs on these devices. This increases their value (Vandermerwe and Rada 1988).26 This servicification has been increasing and technological advancements are expected to accelerate this trend even further (Nayyar et al. 2021). The bundling of services and other sectors, however, is not only limited to high-income countries or a few large firms. In India, for example, the share of manufacturers offering services and their share of services revenue have tripled in the period 1994–2013 (Grover and Mattoo 2021). 26 Manufacturers may sell services due to: (i) economies of scope in production; and (ii) consumption externalities, thereby increasing diversification and profits. KENYA COUNTRY ECONOMIC MEMORANDUM 31 As discussed below, linkages between services and other sectors are relatively weak in Kenya, meaning that services contribute less to growth in other sectors than they could. Agriculture’s links to extension services provides a good example (see Box 3.1). Globally, about one-third of the value of manufacturing exports is attributable to service inputs (Nayyar et al. 2021). In Kenya, services inputs to manufacturing are much lower, at 17 percent, and the share of global innovator services that contribute to manufacturing is half of that seen in the United States. In particular, professional and ICT services supply only about 3.1 percent of manufacturing’s inputs. Similarly, only 5.8 percent of all inputs provided by ICT firms go to manufacturing, while this share is only 14.1 percent for professional services. Nevertheless, the importance of services inputs for Kenyan manufacturing is rapidly growing, which is encouraging and in line with global trends. Box 3.1 Strengthening linkages to extension services to harvest agricultural productivity Linkages between services and agriculture can play a large in boosting the productivity of farming activities. Nevertheless, the data on linkages suggest that these linkages are weak. Services form only 12 percent of inputs in agriculture, which is much lower than in higher-income countries, as well as in many Asian countries (Figure 3.1). Transportation accounts for more than half of services inputs (57 percent). Roughly one- third (30 percent) is coming from global innovator services, which includes technical services, as well as ICT and financial and insurance services (Figure 3.2). Figure 3.1: Agriculture relies only little on services inputs Figure 3.2: The largest input in the agriculture sector is by in Kenya transportation services Percent of domestic services inputs into agriculture, 2016 Sectoral composition of domestic services inputs into agriculture, 2016 40 38% 38% Admin Other 35 32% 4% Hospitality 3% 2% 28% Trade 30 28% 5% 26% 26% LINK 25 Finance Percent 20 5% 15 14% 12% ICT 9% Transport 10 57% 5 0 Professional a sia s a es ric ia a am ne d di 15% ny ne an ys at Af In pi tn Ke ala St ail do ilip h Vie ut d Th M In Ph ite So Un Source: OECD Input-Output Tables, Kenya Supply-Use Table (KNBS). Source: Kenya Supply-Use Table (KNBS). Access to intensive agricultural extension support is a key government strategy within the agricultural thematic area of the Bottom-up Economic Transformation Agenda. This is contributing to the objective of improving agricultural productivity and therefore transforming the lives of 2 million poor farmers by increasing their food output from deficit to surplus. Agricultural extension services are an important mechanism that supports the dissemination of information to farmers, improving productivity and enhancing output by providing knowledge on better farming and management practices. It also provides new technologies, including the use of appropriate seeds, identifying and treating crop and animal diseases, weather patterns, input and market prices, and post-harvest management techniques. 32 KENYA COUNTRY ECONOMIC MEMORANDUM Box 3.1 Strengthening linkages to extension services to harvest agricultural productivity (contd.) Figure 3.3: Technology adoption within formal firms in Kenya’s Figure 3.4: There is also a large dispersion in the degree of agriculture sector is ahead of regional peers and some firms are technological sophistication in agriculture close to the global frontier Index of technological sophistication Distribution of technological sophistication Brazil Korea Poland 4 Georgia Kenya 3 Frontier Senegal-Formal Density Ghana 2 Ethiopia Senegal-Informal 1 Burkina Faso 0 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 1.0 1.5 2.0 2.5 3.0 3.5 Technology sophistication Technology sophistication Average rm Top 20% of rms Burkina Faso Ethiopia Ghana Kenya Korea Note: Based on formal firms with more than five employees. Note: Based on formal firms with more than five employees. Source: Calculations based on the Firm-level Adoption of Technology (FAT) survey. Source: Calculations based on the Firm-level Adoption of Technology (FAT) survey. Data from the World Bank’s Firm-level Adoption of Technology (FAT) survey (see Box 4.1), which covers formal firms with more than five employees, highlight that there is a group of firms that sees a high degree of technological sophistication close to the global frontier (Figure 3.3). This indicates that there are pockets of technologically sophisticated agriculture in Kenya already operating, for example in the horticulture sector. Nevertheless, the dispersion in the distribution is large, with a large difference between the leaders and laggards (Figure 3.4). In addition, much of Kenya’s agricultural output is produced in mostly informal LINK smallholder farms, which likely lag even further behind in technology adoption (and are outside the scope of the survey). Only one-fifth of Kenyan farmers access agricultural information (Wanyama et al. 2016). Public extension services have traditionally been the major source of information utilized particularly by small-scale farmers, although over time services have also been introduced by private firms and non-profit organizations. The quality and coverage of public extension services has declined over time due to prolonged under-investment and reduced funding for operations and maintenance, which in turn has also led to a decline in staffing. The uptake of extension services is influenced by demographic factors. Men are four times as likely to access extension services as women, and the use of extension services is higher across wealthier households (Birch 2018). Policies to improve the uptake of extension services are likely to yield significant gains in agricultural productivity, and play an important part in promoting food security. Strengthening linkages between the supply of extension services and other service sectors can lower the cost of providing services while increasing their reachability. For example, increasing the dissemination of agricultural information through mobile phone interfaces, increasing the degree to which these digitally offered services are interactable, and lowering the cost of data access, can take advantage of high mobile phone penetration rates to disseminate extension services, and therefore overcome the low coverage of in-person services. KENYA COUNTRY ECONOMIC MEMORANDUM 33 Through the multiplier effect of linkages, high-skilled and tradable services create growth and job opportunities in other sectors, just as manufacturing and agriculture also have linkages to services jobs. Evidence from other countries suggests that, if one sector grows by 10 percent, then there is a multiplier effect causing growth in linked sectors by 2.3 to 4.3 percent (Avdiu et al. 2022; Frocrain and Giraud 2017; Moretti, 2010). Global innovator services27 and tradable services offer especially large potential for spillovers. For example, Avdiu et al. (2022) find that a 10-percent increase in tradable services employment leads to a 4.2-percent increase in employment in non-tradable services in Türkiye. Through these linkages, growth in sectors that mostly employ high-skilled workers can also create job opportunities for less-skilled workers. For example, Kenyan data suggest that for every US$10 earned by a high-skilled worker involved in the exports of ICT, US$4 go to less-skilled workers linked through inputs supplied to ICT (in addition to US$14.7 going to less-skilled workers directly). Similarly, for business services exports, about US$5.2 would go to less-skilled workers through linkages (in addition to US$7.1 going directly to unskilled workers). Hence, linkages through services will be crucial to meeting the Government’s ambitious goals for employment growth. There is scope to strengthen linkages in Kenya Domestic linkages of services into manufacturing in Kenya are low compared with peers, particularly for less-skilled services. Roughly one-sixth of manufacturing’s domestic inputs are services, which is low compared with most peers (Figure 3.5). For comparison, in some higher-income countries, roughly one-third of inputs are formed by services. Conversely, for global innovator services specifically (consisting of professional, financial and ICT services), the share of inputs into manufacturing is about 4.4 percent, which is high relative to peers, and compares with 8.4 percent for the sampled country with the highest linkages, the United States (Figure 3.6). This is encouraging, as global innovators tend to be more productive and more linked, thereby offering a pathway LINK to overall growth (Nayyar et al. 2021). However, such services also tend to require more skilled labor, on average, meaning that lower-skilled service employees are not as well placed as higher-skilled workers in benefiting from linkages to manufacturing. Figure 3.5: The share of domestic services inputs into Figure 3.6: The use of domestic global innovator services by Kenyan manufacturing is very low manufacturers is high but still has room for improvement Percent of domestic services inputs into manufacturing, 2016 Percent of global innovator services as input for manufacturing, 2016 40 10 35% 8.4% 32% 29% 8 30 24% 5.8% 22% 21% 21% 6 Percent Percent 20 4.4% 17% 3.7% 15% 4 3.4% 2.9% 2.9% 10 2.0% 2 1.7% 0 0 es a s sia a nd sia a m es ca a ia d sia s a m ne ric di ny ne ny di an na ys at na at ay ne la ri In ne In pi Af Ke pi Af Ke St ala ail ai St et al et do ilip do lip Th h Th h Vi M d M Vi d ut ut In ite i In ite Ph Ph So So Un Un Source: World Bank calculation based on OECD Input-Output Tables (2020) and Source: World Bank calculation based on OECD Input-Output Tables (2020) and Kenyan Supply-Use Tables (KNBS 2016) for 2016. Kenyan Supply-Use Tables (KNBS 2016) for 2016. Global innovator services include professional services, information and communication technology services and financial services. 27 Global innovators include professional services, ICT, and finance, which are highly exported, and largely employ skilled workers. 34 KENYA COUNTRY ECONOMIC MEMORANDUM However, domestic linkages of services into manufacturing have been growing rapidly, indicating the growing importance of services inputs in Kenya. Between 2009 and 2016, the share of domestic services inputs into Kenyan manufacturing grew by a yearly average of 10.3 percent, dwarfing growth in all other peers (Figure 3.7). This is partially due to the lower starting point of linkages in Kenya and the space to catch up. Similarly, for the share of global innovator services, Kenya saw the second-highest growth rate among peers, at an average 4.5 percent per year (Figure 3.8). Hence, the importance of services inputs for Kenyan manufacturing is growing. Given the still low level of these domestic linkages and their growing importance, it will be crucial for policy makers to support these linkages. Figure 3.7: The share of domestic services inputs into Kenyan Figure 3.8: The share of domestic global innovator services inputs manufacturing has been growing rapidly into Kenyan manufacturing has been growing strongly Percent change in the share of domestic services inputs into manufacturing, yearly Percent change in the share of global innovator services inputs into averages, 2009–2016 manufacturing, yearly averages, 2009–2016 12 8 10.3% 5.6% 10 6 4.5% 8 4 2.1% 6 Percent 2 Percent 3.8% 0.5% 0.4% 0.3% 4 0.1% 0 2 1.3% 0.7% 0.6% -2 - 1.8% - 2.1% 0 - 0.2% - 0.4% - 1.0% - 1.4% -4 -2 s a d m sia a es ia a ne ny di ric an ys na at ne In pi Af Ke ala ail a a es St et s ny di do ilip ne ia d m sia a Th at h Vi M d In ric an Ke ys ut In na ite St pi Ph ne Af ala So ail ilip et Un d do ite Th h Vi M Ph ut In Un So Source: World Bank calculation based on OECD Input-Output Tables (2020) and Source: World Bank calculation based on OECD Input-Output Tables (2020) and Kenyan Supply-Use Tables (KNBS 2016) for 2016. Kenyan Supply-Use Tables (KNBS 2016) for 2016. Global innovator services include LINK professional services, ICT services and financial services. Examining firm-to-firm transaction data from VAT-registered firms reveals a rich pattern of linkages between subsectors in Kenya. Firm-to-firm transaction data of VAT-registered firms from administrative data of the Kenya Revenue Authority (KRA) can provide a more granular view of linkages between firms. This analysis is based on aggregated data from Chacha, Kirui and Wiedemann (2022), based on KRA data.28 The advantage of this dataset over the analysis presented above, which is based on Input-Output tables, is that it is more recent, and has more detail at the subsector level. However, as only VAT-registered firms are included, it misses large parts of the overall economy and is therefore less suited to the quantitative cross-country comparisons made in the previous section. Nevertheless, the intersectoral patterns in these data should still be representative of the state of linkages within Kenya. Figure 3.9 maps these relations in the production network, with flows between sectors representing the value of transactions. While these data will be subsequently analyzed in more detail, certain patterns are already clear: for example, although firms involved in professional, scientific, and technical services are the most embedded within the domestic production network of VAT-registered firms,29 few of those inputs go into manufacturing. 28 VAT applies to individuals and firms with a turnover of KSh 5 million and above (US$40,500 as of December 2022). Once a firm is VAT-registered and has crossed the threshold, they are required to continue filing VAT returns in years with lower turnover. Firms below the threshold, those offering financial and education services, and to a large extent, firms dealing in agricultural goods, pharmaceuticals, and passenger goods, are exempt from VAT (Chacha, Kirui and Wiedemann 2022). 29 Chacha, Kirui and Wiedemann (2022) report that Close to 80 percent of professional services sales are to parties that are registered for VAT, with the majority being firms within the network of VAT-registered firms. KENYA COUNTRY ECONOMIC MEMORANDUM 35 Figure 3.9: The production network reveals rich patterns on the extent of linkages in Kenya Sector-level trade flows between VAT-registered firms, 2019 Source: Chacha, Kirui and Wiedemann (2022), based on firm-to-firm transaction VAT data. Note: The size of each node is proportional to the sector’s share of purchases and sales relative to the aggregate volume of firm-to-firm trade between formal firms in Kenya. The color of the edges indicates the direction of the trade flow, taking the LINK color of the supplying sector. The width of each edge is proportional to the share of the trade flow with respect to the aggregate volume of trade flows in the VAT data. Other services refer to ISIC Codes S, i.e., 2-digit codes 94–96, while other sectors refer to sectors too small to separate out, such as quarrying and water. Trade, transportation, ICT, professional and administrative services are among the most-linked services in Kenya. One way to see which sectors are the most linked is to look at the share of inputs provided by each sector, as a percentage of all inputs supplied in the economy. Wholesale and retail trade has the highest share, accounting for 16.7 percent of all inputs in the production network of VAT-registered firms (Figure 3.10). A caveat is that this partially reflects the fact that the wholesale and retail subsector is very large and therefore provides many inputs.30 This subsector is followed by transportation, ICT, and professional services. Similarly, linkages can also be assessed as the share of sales that go toward other firms as opposed to final consumers, thereby controlling for the overall size of each subsector. In this sense, administrative services is in first place, with 90.4 percent of sales going toward intermediate use (Figure 3.11). Again, professional services, trade, transport, and ICT are among the most-linked services in this context as well, in addition to finance.31 Services are mainly supplying firms outside of manufacturing, especially other services. Examining the destination of services inputs, as a share of their total supplied inputs, reveals that manufacturing linkages are low (Figure 3.12). Even the most linked services are mainly linked to (other) services. For example, over half of inputs provided by the administrative services sector goes to (other) services, while the share for ICT is over 80 percent. For comparison, agriculture is much better linked to non-services sectors, which use almost 80 percent of the inputs supplied by agriculture. However, the majority of those agricultural inputs are not used in manufacturing either (Figure 3.13). 30 Total sales data to account for the overall size of each sector in this dataset was not available. 31 Financial services were not available in the data for the left panel. 36 KENYA COUNTRY ECONOMIC MEMORANDUM Figure 3.10: Trade, transport, ICT, and professional services Figure 3.11: Administrative and professional services have the provide the highest share of total inputs largest shares of business-to-business sales Inputs provided by each subsector as a share of all inputs supplied, percent, 2019 Intermediate use, as a share of all consumption for each subsector, percent, 2016 Wholesale & Retail 16.7 Admin 90.4% Transport 7.4 Professional 74.4% ICT 4.9 Finance 60.1% Professional 3.9 Wholesale & Retail 54.4% Others 2.6 Transport 45.8% Admin 2.3 ICT 43.1% Real Estate 2.0 Hospitality 30.7% Agriculture 1.9 Real estate activities 28.0% Hospitality 1.5 Other service activities 11.4% Other services 0.9 Public Admin 4.7% Health 0.5 Arts, entertainment & recreation 0.0% 0 5 10 15 20 0 20 40 60 80 100 Overall share of inputs Percent Source: World Bank calculation based on aggregate data from Chacha, Kirui Source: World Bank calculation based on OECD Input-Output Tables (2020) and and Wiedemann (2022), based on VAT-registered firms. Note: Some non-service Kenyan Supply-Use Tables (KNBS 2016). sectors omitted from the chart. All percentages, including omitted sectors such as manufacturing, sum to 100 percent. Other services refer to ISIC Codes S, i.e., 2-digit codes 94–96, while other sectors refer to sectors too small to separate out, such as quarrying and water. Although some services play an integral role for manufacturing, the sector could benefit much more from professional and ICT services. Manufacturing activities are mostly linked to other manufacturing activities. In other words, manufacturing is mostly linked to itself, receiving 43.7 percent of its inputs from manufacturing (Figure 3.13). Nevertheless, cumulatively, services account for a sizable portion of all inputs used in manufacturing, at 38.6 percent. Among services, transport and wholesale and retail trade account for the highest share of inputs used by manufacturing. However, even though professional and ICT services are critical for enabling manufacturing and raising its productivity, these subsectors supply only about 3.1 percent of manufacturing’s inputs. Hence, there LINK is great scope to grow the use of complementary professional services and productivity-enhancing ICT (among others) to boost manufacturing performance. Figure 3.12: Most inputs supplied by services subsectors are going Figure 3.13: Manufacturing mainly receives services inputs from toward services in other subsectors transport and trade, lagging on professional and ICT services Inputs provided by each subsector, as a share of all inputs provided by that Inputs provided by each subsector to manufacturing, as a share of all inputs subsector, percent, 2019 received by manufacturing, percent, 2019 Admin Manufacturing 43.7 Agriculture Transport 13.4 Health Electricity & gas 12.1 Hospitality Wholesale & retail 11.5 ICT Construction 4.4 Admin 3.1 Other services 3.1 Professional Others Others 3.0 Professional ICT 1.6 Real estate Real estate 1.4 Agriculture 1.3 Transport Other services 0.8 Wholesale & retail Health 0.4 Hospitality 0.3 0 20 40 60 80 100 Share of inputs supplied 0 10 20 30 40 Share of manufactuting’s inputs Y-axis shows suppliers To manufacturing To other To services Y-axis shows suppliers Source: World Bank calculations based on aggregate data from Chacha, Kirui and Source: World Bank calculations based on aggregate data from Chacha, Kirui and Wiedemann (2022), based on VAT-registered firms. Other services refer to ISIC Codes Wiedemann (2022), based on VAT-registered firms. Other services refer to ISIC Codes S, i.e., 2-digit codes 94–96, while other sectors refer to sectors too small to separate S, i.e., 2-digit codes 94–96, while other sectors refer to sectors too small to separate out, such as quarrying and water. out, such as quarrying and water. KENYA COUNTRY ECONOMIC MEMORANDUM 37 Despite being among the most linked subsectors, ICT services are mostly linked to themselves and not sufficiently benefiting others, including manufacturing. About 58.9 percent of inputs from ICT firms are provided to other ICT firms (Figure 3.16). Given the importance of ICT services to enable other sectors, there is therefore a clear need to strengthen its linkages, including to manufacturing. As already discussed, very few of manufacturing’s total inputs come from ICT services. A similar issue is revealed when looking at the other side of this relationship; only 5.8 percent of all inputs provided by ICT firms go to manufacturing. Much of the professional services are benefiting the electricity and gas subsectors, while not benefiting other non-services sectors as much. About 44.5 percent of inputs provided by professional services go toward electricity and gas production (Figure 3.15). Hence, other sectors are not strongly benefiting from these crucial enabling services. Only 14.1 percent of professional services inputs go into manufacturing and only 4 percent toward construction. Figure 3.14: The ICT subsector is mostly linked to other ICT Figure 3.15: Professional services mainly benefit electricity subsectors and gas (Inputs provided by ICT to other subsectors, as a share of all inputs provided by ICT, (Inputs provided by professional services to other subsectors, as a share of all percent, 2019) inputs provided by professional services, percent, 2019) ICT 58.9 Electricity & gas 44.5 Wholesale & retail 9.9 Manufacturing 14.1 Manufacturing 5.8 Professional 7.3 Others 4.2 ICT 7.0 Admin 4.1 Wholesale & retail 5.3 Professional 3.8 Construction 4.0 Electricity & gas 2.8 Transport 3.4 Transport 2.5 Others 3.2 Construction 2.2 Admin 2.9 Other services 1.6 Real estate 2.5 Hospitality 1.5 Agriculture 2.0 Real estate 1.2 Hospitality 1.9 Agriculture 0.9 Health 1.3 LINK Health 0.5 Other services 0.6 0 10 20 30 40 50 60 0 10 20 30 40 50 Share of ICT’s inputs Share of professional’s inputs Source: World Bank calculations based on aggregate data from Chacha, Kirui and Source: World Bank calculations based on aggregate data from Chacha, Kirui and Wiedemann (2022), based on VAT-registered firms. Other services refer to ISIC Codes Wiedemann (2022), based on VAT-registered firms. Other services refer to ISIC Codes S, i.e., 2-digit codes 94–96, while other sectors refer to sectors too small to separate S, i.e., 2-digit codes 94–96, while other sectors refer to sectors too small to separate out, such as quarrying and water. out, such as quarrying and water. Strengthening linkages between firms through technology and building ecosystems Firm-level data also highlight that there is scope to strengthen linkages between firms. To further examine linkages, it is useful to go beyond sectoral data. Hence, this section analyzes firm-level data across multiple dimensions. First, it will discuss firms’ use of technology related to linkages. Furthermore, it will analyze the participation of firms in business organizations or associations, which is one avenue that supports inter-firm linkages. Lastly, the section will examine the diversity and quality of firm agglomerations, to identify local entrepreneurship ecosystems for key linking service subsectors. The use of software services by Kenyan firms is low, especially by manufacturing and smaller firms. The software subsector is a key linking subsector that enables growth of other firms. However, less than half of manufacturing firms in Kenya use cloud services or other software and lag other services firms (Figure 3.16). Access to, and affordability of, cloud-based services is affected by current regulatory barriers to cross-border data flows (see Chapter 5, “Trade”). Similarly, only about half of all services firms use any software. The use of software is also strongly correlated with firm size. For example, only 36 percent of small firms in Kenya purchase or lease any software, compared with 90 percent for large firms (Figure 3.17). 38 KENYA COUNTRY ECONOMIC MEMORANDUM Figure 3.16: Few firms use software services as inputs Figure 3.17: Smaller firms lag larger ones in software use Share of firms responding yes Share of firms responding yes 60 100 90 52 48 48 80 80 50 80 40 37 60 57 30 40 35 36 20 20 10 0 0 Use cloud computer Purchase or lease licence Use cloud computer Purchase or lease services for business for software services for business licence for software purpose? purpose? Manufacturing Services Small Medium Large Source: World Bank calculations based on the Firm-level Adoption of Technology Source: World Bank calculations based on the Firm-level Adoption of Technology Survey (FAT) for Kenya (2021). Survey (FAT) for Kenya (2021). There is potential to strengthen firms’ technological capabilities by fostering services linkages through business organizations. Services firms in Kenya are less likely to be members of business organizations: only 31 percent reporting membership compared with 44 percent for manufacturing firms (Figure 3.18). Also, services firms are less likely to receive information, ideas, or advice regarding technological upgrades from such associations, holding their capabilities back. Hence, there is significant room to improve services linkages through business organizations. Services are more likely to receive technology information from their suppliers or customers32 (Figure 3.19). As the supply chain is a more important information source for services, strengthening linkages of services to other firms could intensify this transfer of knowledge. Promoting linkages through business associations or along the supply chain has particularly strong potential for smaller services firms. Smaller services firms are less LINK likely to have linkages through membership in formal organizations. But given their lower level of technological take-up and productivity, they are also the most likely to benefit from collaboration. As such, there is significant space to improve linkages with smaller firms, and this could yield high returns. Figure 3.18: Services firms are less likely to benefit from Figure 3.19: But increasing services linkages along the linkages through formal associations supply chain is an avenue to improve their technology Share of firms responding yes Share of firms responding yes 50 Share of rms responding yes 44 40 40 34 31 30 30 21 20 20 15 17 11 10 11 10 0 Member of Formal Technology Information 0 Organization or Mainly from Business Technology Information Mainly Technology Information Mainly Association? Associations? from Supplier Interactions? from Customer Interactions? Manufacturing Services Manufacturing Services Source: World Bank calculations based on the World Bank Enterprise Survey (2018). Source: World Bank calculations based on the World Bank Enterprise Survey (2018). 32 The likelihood of receiving technological information from all possible sources combined is 100 percent, implying that a larger share of one source would result in a smaller share for another source. Not all sources of information are shown in the charts. KENYA COUNTRY ECONOMIC MEMORANDUM 39 Box 3.2 Entrepreneurial ecosystems in Kenya Entrepreneurial ecosystems provide a key role in fostering linkages between firms. Entrepreneurial ecosystems refer to the spatial organization, structure, and interactions of organizations, firms, institutions, and individuals in a geographic location conducive to entrepreneurship. Incubators, accelerators and venture capital play important roles in fostering these ecosystems. The analysis is based on Cruz and Hernandez Uriz (2022), who identify ecosystems by evaluating the diversity and quality of firms, using the Kenya MSME Survey (2016). Diversity is measured by the number of agglomerations of counties with high establishment density in each subsector, while quality is measured by finding agglomerations of counties in factors related to business dynamism and growth potential. Each is sorted into three categories (multiple, single, or no agglomeration). The overall potential is then determined by combining diversity and quality, resulting in a typology with nine categories. Here, high potential ecosystems exhibit agglomerations in more than one quality indicator and at least one subsector; maturing ecosystems exhibit agglomerations in one quality indicator and at least one subsector; incipient ecosystems exhibit agglomerations in more than one subsector but none on quality. Digital and financial services ecosystems are significantly concentrated across the Nairobi and Kiambu counties and show agglomeration in terms of both quality and diversity. These two counties therefore represent high potential ecosystems for digital and financial services33 (Cruz and Hernandez Uriz 2022). Other agglomerations on digital activities have been concentrated around Nakuru, Nyeri, Homa Bay, and Kericho. However, these counties do not show the same density in terms of the qualitative factors. Hence, despite being a regional leader in the digital economy, there is considerable room for Kenya to expand the reach and benefits of digital technologies to many traditional industries (World Bank 2019). Similarly, Nairobi and Kiambu show the highest concentration of financial sector ecosystems, with agglomerations in both quantity LINK and quality. Other agglomerations are found in Kajiado, Homa Bay, Migori, Kisumu, and Nakuru (Figure 3.20). Figure 3.20: Entrepreneurship ecosystems for digital businesses and finance (a) Digital (b) Financial services Multi-sector - Multi-quality Mono-sector - Multi-quality Multi-sector - Multi-quality Multi-sector - Multi-quality Mono-sector - Multi-quality Multi-sector - Multi-quality Mono-sector - Mono-quality Multi-sector - No-quality Mono-sector - No-quality Mono-sector - Mono-quality Multi-sector - No-quality Mono-sector - No-quality Source: Entrepreneurship Ecosystem Assessment in Kenya, Cruz and Hernandez Uriz (2022). 33 The focus is on these two sectors, because they are key for linkages and a similar analysis for other linking sectors was not possible. 40 KENYA COUNTRY ECONOMIC MEMORANDUM Linkages are crucial to grow labor income and jobs Linkages are critical to creating more job and income opportunities. This can be seen by examining the contributions of forward and backward linkages to the labor income embodied in exports. This section makes use of the Labor Content of Exports Database, developed by Cali et al. (2016). The data consist of the total labor income contained in exports, both directly and indirectly, in 2014. Here, labor income corresponds to the total labor value added, total wages or total compensation to employees, and these terms are used interchangeably. While the data lack information on the number of jobs embodied in Kenya’s exports, total labor income is positively correlated with the number of jobs. Furthermore, some statements can be made on jobs, when examining total income by skill.34 Both forward and backward linkages are examined, where forward links count the value added of a given sector that goes into other sectors, while backward links count all the value added from other sectors that go into a given sector. In other words, a sector’s forward linkages relate to inputs supplied by that sector, whereas backward linkages relate to inputs demanded by that sector. Services had more labor income embodied in exports than manufacturing. The total labor income embodied in exports for Kenyan services in 2014, combining both direct and indirect backward links, amounted to about US$830 million (Figure 3.21). Conversely, the total for manufacturing was about US$500 million. When looking only at the direct contributions, ignoring linkages, services still contributed over twice as much labor income from exports. Although over half the labor income supported by Kenya’s manufacturing exports was via inputs from other sectors, the importance of services for manufacturing was low, especially for less skilled labor. Inputs from other sectors accounted for US$267.4 million of the labor income embodied in manufacturing exports, compared LINK with only US$235 million from direct contributions (Figure 3.21). Nevertheless, services inputs accounted for only one-third of that indirect income. This is in line with the low linkages between services and manufacturing discussed above. Given the substantial importance of inputs for manufacturing, and the low amount of backward linkage to services, there is strong growth potential from fostering these links. Notably, the split between services and non-services inputs is much smaller for skilled labor compared with unskilled. Backward linkages were more important for the labor income embodied in manufacturing exports, while forward linkages were more important for services. The indirect labor income due to backward linkages (i.e., by demanding inputs) was only US$193.6 million for services exports, compared with US$267.4 million for manufacturing exports (Figure 3.21). Conversely, the indirect contributions through forward linkages (i.e., by supplying inputs) were US$320.8 million for services and US$112.8 million for manufacturing (Figure 3.22). This is in line with global evidence, as manufacturers tend to be more important receivers of inputs, whereas services are more important suppliers of inputs (Nayyar et al. 2021; Cali et al. 2016). 34 Higher skilled labor has higher wages than lower skilled labor, on average. Hence, the same labor income for a certain skill level would imply more low-skilled jobs than higher-skilled jobs. KENYA COUNTRY ECONOMIC MEMORANDUM 41 Figure 3.21: Services accounted for more export labor income, while Figure 3.22: Services inputs to other sectors’ exports provide a for manufacturing most came via inputs from other sectors large amount of labor income, especially for the unskilled Labor income of exports, by sector and skill based on backward linkages Labor income of exports, by sector and skill based on forward linkages Labor value added of exports (US$ million) 800 39.6 300 Labor value added of exports (US$ million) 38.1 116.9 99.0 600 200 400 199.8 221.8 634.3 32.1 35.5 8.9 200 100 235.0 103.9 0 Total services Manufacturing 0 Total services Manufacturing Direct VA Unskilled VA indirect services bwd Skilled VA indirect services bwd Indirect VA non-services bwd Unskilled VA indirect FWD Skilled VA indirect FWD Source: Labor Content of Exports Database (LACEX), developed by Cali et al. (2016). Source: Labor Content of Exports Database (LACEX), developed by Cali et al. Data from 2014. (2016). Data from 2014. Note: The direct VA in the right panel would correspond to that of the left panel, as the direct contribution is independent of linkages (and hence invariant to forward vs. backward linkages). Manufacturing’s backward linkages with services in the left panel correspond to services forward linkages to manufacturing in the right panel. Services supported a large amount of indirect labor income from exports through forward linkages, especially through jobs for the unskilled. As discussed, the labor income indirectly embodied in Kenya’s overall exports, due to inputs supplied by services (i.e., forward linkages), was over three times that of manufacturing (Figure 3.22). Nevertheless, policy makers may be concerned that services linkages would primarily benefit higher skilled workers and therefore do not offer a model for inclusive wage growth. However, in Kenya, the forward service linkages attributed to total unskilled wages are substantial and twice that of skilled wages (Figure 3.22). This is LINK partially supported by the transportation subsector, which accounts for a large amount of unskilled labor income (Figure 3.23). The higher total unskilled wages are notable, given that wages per worker tend to be higher for skilled workers. Hence, a very large number of unskilled jobs are supported through forward service linkages. This also shows the large scope for growth in the contribution of skilled labor, which has a higher value added. For every US$10 earned by a high-skilled worker involved in the exports of ICT, US$4 went to less-skilled workers through linkages, implying great scope for skilled services to support unskilled workers. For the communications subsector, about US$43.7 of the labor value added of exports was attributed directly to skilled workers (Figure 3.24). However, US$17.435 was attributed to unskilled workers through indirect (backward) linkages, by providing inputs for the communications subsector. Furthermore, for every US$10 earned directly by a high- skilled worker through ICT exports, US$14.7 went to less-skilled workers directly involved in the ICT subsector and US$4 to less-skilled workers indirectly employed. Similarly, for business services, about US$5.2 would go to less- skilled workers through backward linkages, for every US$10 earned by a high-skilled worker involved in the exports of business services. This is in addition to US$7.1 going directly to unskilled workers involved in business services. Hence, global innovator services have a large scope to support lower-skilled wages, particularly through exports. Transport and communications, which are key linking services, had the most labor income embodied in exports, but trade and business services provide more indirect income through forward linkages. As services are very diverse, it is important to break down the previous results by subsector. Among services, transportation and communication are on top, when combining both direct and indirect export labor income contributions, through both backward (Figure 3.23) and forward (Figure 3.24) linkages. When examining only indirect channels, through inputs provided to other sectors (i.e., forward linkages), trade (about US$90 million) and business 35 This amounts to about 40 percent of the US$43.7 attributed to skilled direct labor value added. 42 KENYA COUNTRY ECONOMIC MEMORANDUM services (about US$60 million) are the top two service subsectors (Figure 3.24). Conversely, transport is in fourth place (about US$45 million) and communications in seventh (about US$20 million). Hence, given their overall importance, transport and communications have large growth potential in terms of forward linkages. Therefore, promoting linkages through these subsectors has strong potential to increase labor income and jobs. Figure 3.23: Transport and communications have the most export Figure 3.24: Trade and business services have the most indirect labor income, among services, and part of this income materializes labor income thanks to their contributions to exports of other in other sectors that contribute to their exports (backward sectors (forward linkages) linkages) Labor income of exports, by subsector and skill based on backward linkages Labor income of exports, by subsector and skill based on forward linkages Transport Transport Communication Communication Education Trade Health Education Financial services Financial services Public admin Business services Business services Electric, gas, water Electric, gas, water Health Real estate Recreation & other Trade Public admin Construction Real estate Recreation & other Construction Hospitality Hospitality 0 100 200 300 400 0 100 200 300 400 Labor value added of exports (US$ mil) Labor value added of exports (US$ mil) Unskilled VA direct Unskilled VA indiect bwd Unskilled VA direct Unskilled VA indiect bwd Skilled VA direct Skilled VA indiect bwd Skilled VA direct Skilled VA indiect bwd Note: Indirect backward linkages mean contributions of other subsectors to Note: Indirect forward linkages mean contributions of this subsector to exports of exports of this subsector. other subsectors Source: Labor Content of Exports Database (LACEX), developed by Cali et al. Source: Labor Content of Exports Database (LACEX), developed by Cali et al. (2016). Data from 2014. (2016). Data from 2014. As of 2014, Kenya was lagging peers in terms of indirect export labor income, through forward linkages, for crucial services subsectors. Given the importance of forward linkages for services, it is important to compare the LINK export labor incomes provided through this channel across countries. Although the situation has likely evolved since 2014 along with the significant growth of its services sector and trade (see Chapter 5, “Trade”), at that time Kenya was lagging behind in both business services and communications, which are crucial to enable other sectors, while also providing a high value added. On business services, Kenya was ranked ninth among peers (Figure 3.23). For communications it is ranked second to last (Figure 3.26). However, such underperformance was not limited to these key subsectors. Kenya also ranked ninth on transportation, which is its subsector with the highest overall export labor income.36 Hence, there is a strong need and potential to improve labor income and jobs by fostering linkages. Figure 3.25: Kenya’s business services lagged peers in labor income Figure 3.26: Kenya’s communication services lagged peers in labor embodied in exports through inputs supplied to others income embodied in exports through inputs supplied to others Labor income of business services embodied indirectly in exports of other sectors, Labor income of communications embodied indirectly in exports of other sectors, by skill, based on forward linkages by skill, based on forward linkages Malaysia Malaysia South Africa South Africa Thailand Thailand Vietnam Vietnam Philippines Indonesia Indonesia Philippines Tanzania Ghana Ethiopia Tanzania Kenya Uganda Uganda Ethiopia Rwanda Kenya Ghana Rwanda 0 500 1,000 1,500 2,000 2,500 0 500 1,000 1,500 Labor value added of exports (US$ mil) Labor value added of exports (US$ mil) Unskilled VA indirect fwd Skilled VA indirect fwd Unskilled VA indirect fwd Skilled VA indirect fwd Source: Labor Content of Exports Database (LACEX), developed by Cali et al. Source: Labor Content of Exports Database (LACEX), developed by Cali et al. (2016). Data from 2014. (2016). Data from 2014. 36 Figure available upon request. KENYA COUNTRY ECONOMIC MEMORANDUM 43 Box 3.3 The importance of logistics for Kenya The transportation and logistics subsector is one of the key enabling subsectors for Kenya’s manufacturing industry. The Port of Mombasa is an important hub for the trade in goods, not only for Kenya but also for other countries in the region, and is part of the Northern Corridor transportation route linking Mombasa with other countries in the region. In 2020, the Port handled over 1.3 million 20-foot equivalent units (TEUs) in terms of containers, an increase of 88 percent compared with a decade earlier in 2010 (Source: UNCTAD). The Government is also investing in a new port in Lamu (with the first phase of this project having been completed). Jomo Kenyatta International airport is an important passenger and cargo hub in the region, with 28 passenger and 13 cargo airlines. The performance of the logistics subsector in Kenya has been improving, but there remains scope for improvement. The median dwell time of Kenyan exports is 5.3 days (Figure 3.27), which is similar rates as other African countries with ports on the Indian Ocean, but nevertheless higher than that of countries such as Singapore (2.2 days), Vietnam (3.2 days) and Ghana (3.8 days). Transit times within Kenya had been decreasing before the pandemic, but increased again during the pandemic. In 2021, the average transit time between the Port of Mombasa and the Malaba border crossing with Uganda was 4.2 days, up from 1.1 days in 2019 (Figure 3.28). Figure 3.27: Good exports spend on average 5 days at Figure 3.28: Transit times have been increasing since the the port before being exported pandemic Median dwell time at ports for exports (days), 2022 Average transit time between Mombasa and Malaba (hours) 12.0 120 11.0 10.0 100 LINK 8.0 Number of days 7.3 80 Hours 6.0 5.4 5.3 5.3 4.5 4.3 60 4.1 3.8 4.0 3.6 3.2 2.2 40 2.0 20 0.0 ria ue ni a ica ya nd i na di a na sia m or e ge bi q a Af r Ke n ail a Ch In a y na ap Ni nz Gh ala Viet g 0 a m Ta t h Th M Sin oz S ou 2014 2015 2016 2017 2018 2019 2020 2021 M Note: The dwell time at ports is the time a container spends at the port before Note: The transit time is measured by the difference between the issuance of a being exported. release order in Mombasa and the issuance of an export certificate in Malaba. Source: World Bank Logistics Performance Index 2023, based on supply chain Source: Northern Corridor Transport Observatory tracking data from TradeLens. 44 KENYA COUNTRY ECONOMIC MEMORANDUM Concluding remarks Strengthening linkages with services in Kenya can help to ensure that the services sector thrives and creates more productive opportunities, as well as enabling other sectors, trade, and promoting overall economic growth. Services are crucial for other sectors, both as an upstream enabler (providing inputs) and a downstream complement as bundled with products from other sectors. However, the extent of linkages in Kenya is low compared with peers, and linkages between services and manufacturing are particularly lacking. Nevertheless, the importance of services inputs for Kenyan manufacturing is growing. This is encouraging, given the increasing importance of services linkages for productivity and growth, while also being in line with global trends. Given the low level of these domestic linkages and their growing importance, it will be crucial for policy makers to support services linkages to help spur the overall development of Kenya’s economy. Kenyan manufacturing could benefit more from professional and ICT services. Professional and ICT services are critical for enabling manufacturing and raising its value added. However, these subsectors supply only about 3.1 percent of manufacturing’s inputs. Similarly, only 5.8 percent of all inputs provided by ICT firms go to manufacturing, while this share is only 14.1 percent for professional services. These low intersectoral linkages are partially because many of the inputs for the manufacturing sector and the ICT subsector come from these two sectors themselves. With services already providing significant inputs to electricity production, their further development could play an important role in supporting the future growth of clean energy and climate-smart economic activity in Kenya. Close to 90 percent of Kenya’s existing installed electricity production capacity comes from clean sources (hydro-, wind-, solar-, and geothermal power). As described above, a sizable share of services output is already geared towards providing inputs to the electricity utility subsector, which includes the generation, transmission and distribution of power. Meeting Kenya’s growing demand for clean power will benefit from the availability and LINK quality of associated services, including the finance needed for private sector investments in the power sector. Kenya is also potentially well-positioned to compete internationally as a low-carbon producer of agricultural products, manufactures, and services, by leveraging its clean energy base and the high potential to further expand both continuous (geothermal) and intermittent, renewable load sources. Given the scale of the private investment that will be required to realize this potential, and the role for new technologies, mobilizing more foreign direct investment to contribute the needed financing and global knowledge is essential. Promoting linkages for digital and financial services puts Nairobi and Kiambu, where the entrepreneurial ecosystems for these subsectors are concentrated, in the spotlight. Digital and financial services are critical for intersectoral linkages. However, such services tend to be concentrated in a few geographic locations. In this case, the most important entrepreneurship ecosystems are located in Nairobi and Kiambu, and this may be where the highest returns from measures to promote linkages in these ecosystems are available.37 Policy makers can support linkages either by directly supporting private sector growth, or through interventions that reduce matching costs and information frictions. Three key constraints may prevent firms from successfully building linkages: (i) a lack of capacity; (ii) high costs to find new buyers or suppliers; and (iii) a lack of information. First, it is important that firms in linking services subsectors have the capabilities to adequately serve their demand, both in terms of quantity and quality. Similarly, non-services sectors require the capacity to appropriately absorb services inputs, such as digital technologies. Hence, supporting firms’ 37 More detail on the relevant policies for Kenya can be found in Cruz and Hernandez Uriz (2022). The main policy directions identified in Cruz and Hernandez Uriz (2022) are improving (digital) infrastructure, enhancing firm capabilities, supporting access to finance, promoting access to new markets, improving regulations, and improving business supporting programs. KENYA COUNTRY ECONOMIC MEMORANDUM 45 capabilities and overall private sector growth, especially for key linking services such as global innovators, is critical to fostering linkages. Furthermore, policy interventions that reduce search and matching costs for firms – e.g. through matchmaking activities – can support linkages. Similarly, interventions can directly promote linkages through supplier development programs. Lastly, sharing information, creating peer-to-peer networks, and providing business training38 can alleviate a lack of information on the usefulness and availability of linking services. LINK: Policy priorities to strengthen linkages Services provide crucial inputs to other sectors of the economy, and a more interlinked economy would increase growth. Linkages are an outcome of the development of services and other sectors, but in some cases the creation of linkages can be expedited or facilitated. • At the macroeconomic policy level, maintain an enabling environment for the private sector to grow and for linkages across and within sectors to increase. • At the microeconomic level, policies can seek to: o Strengthen firms’ capabilities to supply more and better-quality linked services, and non-services firms’ absorptive capacity to take advantage of potentially linked services. o Reduce search frictions through matchmaking or supplier development programs; and o Increase access to information on the usefulness and availability of linking services through information campaigns, peer-to-peer networks, and business training. LINK 38 Business training can help, as firms may “not know what they don’t know” regarding the potential of linking services to support their growth or may not know how to go about benefitting from those services. 46 KENYA COUNTRY ECONOMIC MEMORANDUM CHAPTER 4 BOOST Productivity through Technology Adoption and Competition Despite growth, the productivity of firms in Kenya’s services sector remains low. The adoption of more sophisticated technologies and boosting competition are crucial to boost productivity. The need to increase productivity – within and between L abor productivity in Kenya remains low as a result of limited capital deepening and low total factor productivity. Across all sectors, labor productivity is at 7 percent that of the United States, lower than in Nigeria, Ghana or South Africa. This difference is driven by two factors: limited capital deepening and lower total factor productivity (TFP). The amount of capital that the average Kenyan worker has at their disposal is 20 times lower than in the United States and seven times lower than in South Africa. Macro decompositions suggest that TFP, which is the efficiency in which labor and capital are used in production, is three times lower than in the United States and one-third lower than in South Africa (Figure 4.1). Figure 4.1: Low labor productivity is explained by a low Figure 4.2: Compared with the United States, the services sector capital intensity, as well as low TFP has seen little convergence in labor productivity Labor productivity, capital intensity and TFP relative to the United States (US = 100), 2019 Labor productivity of industry and services relative to the United States (US = 100%) 60 16 55 53 14 50 12 40 36 35 10 30 32 30 8 20 6 9 10 9 4 10 7 7 5 4 4 2 0 Ghana Kenya Nigeria South Tanzania 0 Africa 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Labor productivity Capital intensity Total factor productivity Industry Services Note: No TFP estimate available for Ghana. Figures are PPP-adjusted. Source: Penn Note: Figures are PPP-adjusted. Source: Calculations based on WDI (for value added World Tables 10.0.1 (Feenstra, Inklaar and Timmer 2015). and employment in the United States) and ILOSTAT (for employment in Kenya). Despite growth in productivity levels in services subsectors, convergence remains low (Figure 4.2). Compared to the United States, labor productivity in the services sector is still at the same relative level as in 2010, about at 8 percent. Labor productivity in industrial sectors has seen some convergence between 2000 and 2012, but since 2012 relative labor productivity in industrial sectors has decreased compared with the United States, and is now at roughly 10 percent. The sectoral composition of the services sector only explains part of these observed productivity differences. As highlighted in Chapter 2, on the need to shift to higher value-added services, many of the services sector activities are in lower value-added sectors, such as personal and retail services, with a smaller role for more productive “global innovator” services. Changing the composition of the services sector to match that of higher-income countries could increase labor productivity by a factor of 2.3. This nevertheless leaves a large productivity gap. KENYA COUNTRY ECONOMIC MEMORANDUM 47 Boosting productivity of Kenya’s private sector, including in the services sector, requires a concerted approach of: (i) increasing firm capabilities; (ii) removing allocative inefficiencies; and (iii) fostering productive entry and exit. Aggregate productivity increases when firms increase their individual productivity, when more productive firms increase their market share at the cost of less efficient firms and when more productive firms enter while less productive ones exit. Each of these channels are linked to different, but overlapping processes: • The first channel, representing within-firm productivity growth, is driven by the productive capabilities of firms, which is determined by the technologies that firms use, the organizational practices of firms, and innovative practices. • The second channel, representing between-firm productivity growth, is driven by whether product and factor markets operate efficiently enough to allow growth of more productive enterprises. Inefficiencies in the allocation of resources in factor, for example, a productive firm failing to obtain financing to invest in capital, or product markets, for example, a productive firm facing restrictions to compete on a level playing field, prevent more productive firms from expanding. • The third channel, the dynamic channel, is driven both by the degree that selection takes place in the market (allowing for “creative destruction”), as well as the capabilities of new entrants. Analysis of firm-level data and of the business Figure 4.3: Drivers of growth of TFP environment, despite data shortcomings, suggests Operating environment: removing distortions, resolving market failures that all three processes in Kenya can be strengthened Human capital, innovative capacity to increase productivity of services sector firms. Analyses of the technologies that Kenyan services firms WITHIN: BETWEEN: ENTRY / EXIT: are using suggest that—although there is significant Improved firm Improved factor use across firms and sectors Improved quality of entering BOOST performance firms / creative destruction (reallocation) heterogeneity—firms could improve their productivity (selection) by adopting more sophisticated technologies. Similarly, indicators on product market regulations, and the Total factor productivity growth presence of SOEs suggest that the contestability of the services sector could be improved. Source: Drivers of growth of TFP. Through their linkages, productivity growth in services sector firms can spill over to other sectors, including in manufacturing and agriculture. As Chapter 3, on linkages, highlighted services contribute to productivity of other sectors in a variety of ways. Global innovator services, such as digital services, play an important role in the adoption of more sophisticated technologies. Low-skilled tradable services, such as transportation services, contribute to a more efficient sourcing and delivery of inputs and outputs. Evidence from India (Arnold, Javorcik and Mattoo 2015) and Colombia (Alfaro and Eslava 2020) highlights that the productivity of manufacturing firms is linked with the degree to which services are “embodied” in their production process. Evidence from Czechia and India suggests that liberalizing services improved performance and exports of manufacturing sectors (Arnold et al. 2011, 2015; Bas 2014). 48 KENYA COUNTRY ECONOMIC MEMORANDUM Box 4.1 Simplifying registration and licensing procedures in Kenya Another area for reform is facilitating the establishment of new firms. Establishing a business in Kenya generally consists of two key steps: registering the business at the relevant authorities and obtaining the relevant licenses from the county to operate. In practice, especially the latter step can be complicated for businesses, as requirements differ from county to county. • Registration. The process of registering a business is in most cases straightforward. Steps include the reservation of a company name, a company registration through the Business Registration Service, tax registration and the application for a single or a unified business permit. Many of these steps can be done online and the process is similar across counties. • Obtaining licenses. The requirements for obtaining additional licenses to operate differ significantly between counties. Besides a business registration, businesses also need a variety of licenses, many of them specific to the sector and the county in which they operate. The process of devolution, although it has brought services closer to citizens, has led to a further divergence in regulations around licenses. Licenses cover many services subsectors, including accommodation (e.g., the operation of hotels) but also retailers, including those operating informally (e.g., street hawkers). Some counties have attempted to combine procedures, by creating a unified business permit. For example, in Nairobi, the unified business permit includes food and health permits, fire safety permits and the City Council permit. The County Licensing (Uniform Procedures) Bill aims to further streamline procedures between counties and includes provisions for application procedures to be conducted online. BOOST Kenyan firms need to adopt more sophisticated technologies Technology and innovation are important determinants of productivity and productivity growth. Innovation— the introduction of new technologies, products, business processes and ideas in the market—is a key driver of structural transformation and economic growth. Innovation is often taken as a synonym for invention—the creation of new ideas—but this misses the aspect that, especially in developing countries, the adoption and adaptation of existing technologies in new contexts is a more crucial issue. The returns to innovation through adoption are high in developing countries, and yet many firms fail to adopt productive technologies. This phenomenon was dubbed an “innovation paradox” by Cirera and Maloney (2017). Technological sophistication in developing countries does not necessarily need to be the same as in advanced countries, but there is scope for improvement in some technologies that may not require significant investments but improve the productivity of firms. Technology is playing an ever more important role in the delivery of services. Traditionally, technological change was mostly associated with industrial sectors, for example, improving machines used in manufacturing. Services were seen as being inherently “unproductive” with little scope of technological improvement. New technological developments are changing the way that services are produced and delivered. Many of these technologies are in the digital domain: digitization is allowing for the automation or facilitation of certain tasks that were previously done manually, for example, automated inventory management in sales systems or software that helps engineers in their design process. It is also used for reaching more customers located further away, for example, through online communication. Other “softer” and often intangible forms of technologies, such as organizational practices, are also playing an increasingly important role. KENYA COUNTRY ECONOMIC MEMORANDUM 49 Kenya has been a technological leader in certain areas, especially around mobile money. As highlighted in Chapter 2, Kenya has been a leader in the use and acceptance of mobile money, with the vast majority of businesses accepting mobile money such as M-Pesa (P2P or P2B) instead of cash for transactions. The COVID-19 pandemic has even further accelerated the use of mobile money and other digital financial services, both by households and by firms (Figure 4.4). During the pandemic, more firms also invested in digital solutions, including in sectors where this was previously less commonplace (Figure 4.5). Figure 4.4: During the pandemic the value of mobile Figure 4.5: Firms increased their investment in digital solutions money transactions close to doubled Monthly value of mobile payments Share of firms increasing investment in digital solutions in Kenya 700 60 55% 51% 600 50 40 37% 38% 35% 34% 33% 500 32% 32% 32% Percent 30 KES billions 400 20 300 10 200 0 re g s le n n s T ial es ie ice IC tio io rin sa tu vic nc ilit at rv le tu ta 100 ul na er ut od ho se or ric ac rs Fi n/ m sp w uf Ag od he io co an an nd Fo ct Ot Ac 0 Tr M tru il a ns ta Mar -07 Mar -10 Mar -13 Mar -16 Mar -19 Dec -07 Dec -10 Dec -13 Dec -16 Dec -19 Sep -08 Sep -11 Sep -14 Sep -17 Sep -20 Jun-09 Jun-12 Jun-15 Jun-18 Jun-21 Re Co Jun-Aug 2020 Sep-Oct 2020 Mar-May 2021 Source: Mobile payments transaction data. Note: Results are from an unweighted regression controlling for size, month of interview as well as subsector and could differ from unconditional averages reported in other country reports. See Appendix B for definitions of services subsectors. Source: World Bank Business Pulse Surveys (BPS). In many other areas, World Bank data show that Kenyan firms find themselves further away from the BOOST technological frontier. As part of global efforts to measure the adoption and use of technologies around the world through the Firm-level Adoption of Technology (FAT) survey, the World Bank surveyed 1,305 formal firms, including 815 services firms, in Kenya. Each of these surveyed firms was scored based on the sophistication of the technologies used in key production processes (see Box 4.1 for the methodology). This analysis highlights that the technological sophistication of the average Kenyan firm is far from the global frontier, in both the manufacturing and services sectors (Figure 4.6). Although Kenya is performing better than other countries in SSA where this survey was conducted (including Senegal, Ghana and Ethiopia), the average technological sophistication is still lower than in some other middle-income countries (including Brazil and Georgia). Figure 4.6: Technological sophistication of production processes in Kenyan firms is far from the global frontier for the average firm, although a few are close to it (a) Manufacturing (b) Services Korea Korea Poland Brazil Brazil Poland Georgia Georgia Kenya Frontier Kenya Frontier India Senegal-Formal Senegal-Formal Ghana India Ethiopia Ghana Bangladesh Ethiopia Burkina Faso Burkina Faso Senegal-Informal Senegal-Informal 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 Technology sophistication Technology sophistication Average rm Top 20% of Average rm Top 20% of Source: Kenya FAT Survey. 50 KENYA COUNTRY ECONOMIC MEMORANDUM Box 4.2 Measuring technology adoption using the Firm-level Adoption of Technology (FAT) survey The World Bank’s Firm-level Adoption of Technology (FAT) survey measures the degree of technological sophistication of firms by collecting detailed information on the adoption (extensive margin) and use (intensive margin) of several technologies (Cirera, Comin and Cruz 2022). In Kenya, the survey includes a nationally representative random sample of 1,305 formal firms with five or more employees in agriculture, manufacturing and services. It measures technology adoption through three different angles: • The adoption of general-purpose technologies (GPTs). These include rudimentary ones associated with electricity, more advanced technologies leveraging ICT and more recent technologies, including cloud computing, digital platforms and artificial intelligence (also dubbed as “Industry 4.0”). • The adoption of technologies applied to general business functions (GBFs). These are business functions needed in any firm regardless of the sector, such as business administration, production planning, sourcing, marketing, sales, payments, and quality control. For example, for the payment business function, a firm using online payment systems is deemed to be more technologically sophisticated than a firm only accepting cash for that business function. • The adoption of technologies applied to sector-specific business functions (SSBFs). The survey collects data around the technology use in specific steps in the production process using sector-specific questionnaires. For example, for the transportation subsector, it considers the technology used to manage load plans, dispatch vehicles, monitor deliveries and manage the overall fleet. Services subsectors with subsector- specific questionnaires include retail, banking, transportation, accommodation and health services.39 The survey methodology is standardized across countries and was designed in consultation with industry experts. The survey asks for information on more than 300 technologies associated with almost 50 business BOOST functions. The data for each business function are converted into a technology index. Scores are measured between one, for the most basic technology, and five, for the most sophisticated one. To allow for the fact that some firms have access to a particular technology but do not use it regularly, the scores are measured separately at the extensive margin (whether a firm has adopted the technology, regardless of use) and at the intensive margin (whether a firm is using that technology the most to execute the particular business function). Figure 4.7: General business functions measured in the survey 3. Sourcing, 1. Administration 2. Production or 4. Marketing and procurement and 6. Payment (HR processes, Finance, service operations product 5. Sales 7. Quality control supply chain methods Accounting) planning development management Manual search Handwitten Handwitten of suppliers, Face-to-face Direct sales Exchange of Manual, visual processes processes without centralized chat at the establishment goods or written processes database Computers with Online chat (e.g. Cash Human standard software Computers with Management of Direct sales by standard software WhatsApp or phone or e-mail inspection with (e.g. Excel) suppliers in computers Internet) the support of with standard computers or phones software Cheque, voucher Mobile Apps or Structred Sales through of bank wire Statistical Mobile Apps or social media platforms digital platforms digital platforms consumer surveys process control Online social media, or apps with software specialized Apps Prepaid, credit monitoring and or digital platforms Customer or debit card data management Specialized software Online sales using Computers with for demand planning, Relationship external digital specialized installed demand forecast Supplier Relation Management platforms software Management (SRM) (CRM) software (e.g. Amazon, eBay, Automated Alibaba) Online or systems for not integrated with electronic payment production planning inspection such Big data as laser-based, Enterprise Resouce Enterprise Resouce analytics / Online sales Planning (ERP) or Planning (ERP) or sensor-based, Arti cial intelligence (e-commerce) using voice-control equivalent software equivalent software Supplier Relation its own website Online through integrated with other integrated with other Management (SRM) platform back o ce functions back o ce functions integrated with production planning Electronic orders integrated to Virtual or specialized supply cryptocurrency chain management systems Source: Cirera, Comin & Cruz (2022). 39 Outside of the services sector, sector-specific information is collected for crop agriculture, livestock agriculture, food processing, apparel manufacturing, footwear manufacturing, automotive production and pharmaceuticals. KENYA COUNTRY ECONOMIC MEMORANDUM 51 At the same time, there is significant heterogeneity between firms in the degree of technological sophistication. The top 20 percent of firms in Kenya are much closer to the global frontier than the average firm, in both manufacturing and services (Figure 4.4). The distribution of technological sophistication in Kenya is in fact wider than that in many other countries (Figure 4.6), meaning that there are some firms that are very sophisticated in their technology use while others are not. Figure 4.8: There is a large heterogeneity in the technological sophistication of Kenyan services firms Distribution of technological sophistication of Kenyan services firms (a) Manufacturing (b) Services 4 4 3 3 Density Density 2 2 1 1 0 0 1 1.5 2 2.5 3 3.5 1 1.5 2 2.5 3 3.5 Technology sophistication Technology sophistication Burkina Faso Ethiopia Ghana Kenya Korea Burkina Faso Ethiopia Ghana Kenya Korea Source: Kenya FAT Survey. Among general business functions (GBFs), Kenyan firms are ahead in the adoption of more sophisticated payment methods. GBFs are business functions commonly available across all firms, irrespective of their industries. Therefore, they provide good comparisons across firms, sectors, and countries. Key GBFs covered by BOOST the FAT survey include business administration, production planning, sourcing and procurement, marketing and customer information, sales, payment methods, and quality control. Of all these business functions, Kenyan firms are close to the frontier when it comes to the adoption of payment methods (Figure 4.9). Many firms report having access to digital payment services, such as online banking (57 percent) or the use of online platforms (65 percent), representing the prevalence of mobile money services. Figure 4.9: Kenyan firms are ahead in the adoption of sophisticated technologies for payments, but behind in general business functions (a) Manufacturing (b) Services Business administration Business administration Quality control Planning Quality control Planning 1 1 Payment Sourcing Payment Sourcing 2 2 3 3 4 4 5 5 Sales Maketing Sales Maketing Extensive margin Intensive margin Extensive margin Intensive margin Source: Kenya FAT Survey. 52 KENYA COUNTRY ECONOMIC MEMORANDUM In other GBFs, Kenyan firms do not rely on the most sophisticated technologies. In business administration or operations planning, few firms report using specialized software or enterprise resource planning (ERP) systems. Similarly, in the area of customer relations management (CRM), only close to one in four firms (22 percent) uses CRM software (Figure 4.10). Quality control inspection relies on manual processes in the case of many firms. The cost of ERP and CRM technology upgrading is not as expensive as for some other technologies, suggesting a potential opportunity for Kenyan firms that undertake this. Figure 4.10: The use of technology in GBFs Business administration processes related to account, finance, and HR Customer information for marketing and product development 100 98.5 100 98.0 80 77.0 80 60.2 60 60 55.8 51.1 47.3 39.3 40 34.4 40 31.4 29.4 21.1 21.9 20 20 9.5 1.1 5.0 3.1 5.1 1.8 0.2 0 0 Handwritten Standard Mobile Specialized ERP Handwritten Standard Mobile Specialized ERP software Apps software software Apps software Extensive Intensive Extensive Intensive Source: Kenya FAT Survey. Despite firms having access to some technologies, more advanced technologies are not always used intensively. The FAT survey does not only ask which technologies that firms have adopted, but also which of BOOST the technologies are the most intensively used to execute that particular business function. For example, in production and service planning, despite 76 percent of firms having access to specific software, many firms still rely predominantly on handwritten processes to perform business tasks (44 percent). When it comes to payments, two-thirds of firms indicate that cash remains the most intensively used technology. When looking at technology adoption it is important to take both the intensive and extensive margins into account. When looking at sector-specific business functions (SSBFs) in services subsectors, a similar pattern of low adoption emerges. The FAT survey collects specific data on the use of technology around SSBFs, including for retail, banking, and accommodation in the services sector. In the case of the retail subsector, the SSBFs center around customer services, advertisement, pricing strategies, inventory management and merchandising strategies. For the retail subsector, the SSBFs covered include customer services, operational support, fraud avoidance technologies, loan applications and credit approval. Finally, the SSBFs in the accommodation subsector include booking, pricing, housekeeping, and laundry. Retail. In the retail subsector, technology adoption around inventory management, pricing, and customers relations is low. The intensive margin index varies from 1.1 for customer services to 1.9 for advertising, suggesting a large gap to the frontier (Figure 4.12a). For inventory, 97 percent of retailers use manual processes, either handwritten records (34 percent) or computer databases with manual updates (64 percent). For merchandising strategy, 77 percent rely on manual selection, while 18 percent use category management tools. Only 5 percent apply specialized software that considers turnover, inventory, and space. Pricing by retailers mostly relies on manual costing (66 percent) or automatic markups applied in Excel (31 percent), while less than 3 percent use automated pricing systems. Customer services is mainly at the store. 21 percent of surveyed retailers have online KENYA COUNTRY ECONOMIC MEMORANDUM 53 customer services, less than 1 percent frequently use it. Kenyan firms in the retail subsector are more advanced in the intensive use of technology for advertising than other business functions compared with other peer countries. Relative to India and other African countries, Kenyan firms use more advanced technologies in advertising. The intensive use of more advanced technologies, such as e-commerce platforms, mobile payments, and inventory management systems can help retailers to reach a wider audience and improve their operational efficiency. Figure 4.11: Sector-specific services technologies in retail, banking and accommodation (a) Retail (b) Banking (c) Accommodation Customer service Customer service Bookings Pricing Operrational Fraud Point of Pricing Advertisement support avoidance sales 1 1 1 2 2 2 3 3 3 4 4 4 5 5 5 Inventory Merchandising Credit approval Loan applications Laundry Housekeeping Extensive margin Intensive margin Extensive margin Intensive margin Extensive Intensive Source: Kenya FAT Survey. Banking. In the banking subsector, many financial services providers have access to technologies, but do not use them. The FAT survey technology indices for the banking subsector show a large difference between the extensive and intensive margins of technology adoption (Figure 4.12b). Part of this is related to customer preferences, as BOOST customers may prefer a more basic technology over a more sophisticated one. For instance, while 87 percent of surveyed financial institutions offer mobile banking, only 22 percent highlight that this is the most used method and 73 percent most frequently rely on face-to-face services. Loan applications tend to be paper-based in many cases: 75 percent most commonly use paper-based processes to handle loan applications, although close to half of firms (47 percent) have access to a fully digital process. However, even for business functions that are less shaped by customer preferences, such as fraud avoidance and credit approval procedures, there is a wide gap between firms having access to a certain technology and them actually using it intensively. For instance, only 18 percent of establishments offer biometric identity verification and identification verification most commonly relies on face-to-face identification or online passwords. The use of big data analytics in scoring credit applications remains low, with only 2 percent of financial institutions using this. Accommodation. In the accommodation subsector, many firms have access to certain technologies, but do not use them. The average extensive margin index is about 2 across all SSBFs, including pricing, housekeeping, laundry, and point of sales, while booking is close to 2.5 (Figure 4.12c). For booking, more than 80 percent of accommodation businesses use computers with standard software. This drops more than half for those using dedicated reservation software (39 percent). About 12 percent uses property management software and 8 percent uses cloud-based systems. Kenyan firms use advanced technologies less intensively in pricing, housekeeping, and laundry compared with other peer countries. Providing excellent customer services and ensuring clean, well- maintained rooms with reasonable prices are key to improving customers’ satisfaction and incentivizing them to revisit places. Businesses can benefit from the use of more advanced technologies to enhance the quality of such tasks. But the intensive margin of technology sophistication for pricing, housekeeping, and laundry remains far 54 KENYA COUNTRY ECONOMIC MEMORANDUM away. Upgrading technologies for pricing can improve the efficiency of housekeeping and laundry services. It can also strengthen the price competitiveness in Kenyan accommodation sector, which may attract more price- sensitive travelers. Figure 4.12: Cross-country comparison of sector-specific service technologies in the retail and banking subsectors (a) Retail (b) Accommodation Customer services Bookings Advertisement Pricing Point of sales Pricing 1 1 2 2 3 3 4 4 5 5 Inventory Merchandising Laundry Housekeeping Kenya Ethiopia Ghana Georgia Kenya Ethiopia Ghana Georgia Source: Larger firms are more likely to adopt more sophisticated technologies. Firm size is an important determinant in the use of technologies. Part of this is related to the fixed costs that adoption entails. For example, in the case of the retail subsector, medium and large firms are more likely to have access to more sophisticated technologies, especially when it comes to pricing and merchandising strategies. Interestingly, this increased access does not necessarily translate into these more advanced technologies being used more intensively. In fact, when looking at BOOST the intensive margin of the use of technologies in retail there is very little difference across firm size. Figure 4.13: Firm size is an important determinant in the adoption of technologies (a) Extensive margin – retail (a) Extensive margin – retail Customer service Customer service Advertisment Pricing Advertisment Pricing 1 1 2 2 3 3 4 4 5 5 Inventory Merchandising Inventory Merchandising Small Medium Large Small Medium Large Source: Kenya FAT Survey. Common reasons given by firms for not adopting more sophisticated technologies include a lack of demand, missing financing and lacking capabilities. Almost all firms (95 percent) consider lack of demand and uncertainty the most significant obstacle to technology adoption. This is followed by a lack of access to financing (72 percent) and lack of capabilities (31 percent). Credit is also an important determinant: firms that were able to access loans for purchasing software or machinery, also report higher technological sophistication. Capabilities of the managers and workers also correlate with technological sophistication. Firms with managers that have at least an undergraduate degree or have studied abroad and firms with workers with a larger share of vocational training or KENYA COUNTRY ECONOMIC MEMORANDUM 55 a college degree are more likely to adopt more sophisticated technologies. Interactions with multinational firms, either as buyer or supplier, as well as having a top manager with experience in large firms, is also related to higher technological sophistication. Information asymmetries form an important constraint and many managers overestimate their own technological sophistication. The FAT survey also asks respondents about their perception of their relative ranking compared with other firms in the country. Many firm managers estimate that their relative level of technological sophistication—in both general and sector-specific business functions—is higher than what the technological index indicates. This overconfidence is higher for firms with less technological sophistication. This is an indication that information asymmetries can form an important constraint to the adoption of technologies: if a firm is not aware of its own technological sophistication, it is less likely to take action to improve it. Figure 4.14: Lack of demand and finance are given as the main Figure 4.15: Many managers in Kenya self-assess their level of reasons for why more sophisticated technologies are not adopted technological sophistication above their actual performance Reasons given as the key constraint to technology adoption Self-assessment of technology use in GBFs versus the GBF technology index Lack of demand and 5 uncertainty Self-Assessment of Technology Lack of nance 4 Lack of capabilities 5 Other 2 Poor infrastructure 1 0 25 50 75 100 1 2 3 4 5 Percent BOOST Intesive GBF Tech Index Small Medium Large Red line shows the quadratic t with 95% con dence interval Source: Kenya FAT Survey. Source: Kenya FAT Survey. Making the services sector more competitive Competition is a key enabler of sustainable and shared economic growth. Competition drives GDP growth through several channels, such as prices, investment, consumption, and exports. In the long run, it facilitates GDP gains by fostering improvements in aggregate productivity through productive and allocative efficiencies, as well as the entry of more productive firms and the exit of less productive ones. Competition fosters productive efficiency gains by incentivizing firms to innovate and upgrade production technologies (Aghion et al. 2005; Bloom, Draca, and Van Reenen 2011; Nickell 1996). A recent Firm-level Adoption of Technology (FAT) survey (Cirera, Comin, and Cruz 2022) found that competition was the main perceived factor that motivated firms in several countries, particularly SMEs, to upgrade their technologies. In Kenya, for instance, small, medium, and large firms all mentioned competition as the main driver of technology adoption: across all types of firms surveyed, about 68 percent viewed competition as the key driver of adoption (Cirera et al. 2022). Competition also drives improvements in allocative efficiency by ensuring efficient resource allocation across firms and sectors (Bartelsman and Dhrymes 1998; Olley and Pakes 1996) and ensuring a market selection by forcing the less efficient firms to exit the market, while enticing the more productive ones to enter (market selection) (Eslava et al. 2013; Hopenhayn 1992; Jovanovic 1982). Reforms in key services subsectors can trickle down and boost the performance of firms in downstream industries. The outputs of key upstream services subsectors, such as energy, transport, communications, and professional services are often key inputs for firms in downstream sectors such as manufacturing and agro- processing. Anticompetitive business practices and government interventions that restrain competition in the 56 KENYA COUNTRY ECONOMIC MEMORANDUM services sector can adversely affect the productivity and competitiveness of firms in downstream industries. Several studies show that regulatory reforms that enhance competition in upstream service subsectors can boost productivity and output growth of downstream manufacturing firms (Barone and Cingano 2011; Arnold, Javorcik, and Mattoo 2011; Arnold et al 2016; Shepotylo and Vakhitov 2012; Bourlès et al. 2013; Bas and Causa 2013; Bas 2014; Égert and Wanner 2016; Correia and Gouveia 2017). Regulatory restrictions to competition in key services subsectors Product market regulations in Kenya are more restrictive to competition than in comparator countries. Regulations are needed to address market failures and ensure the right incentives are in place for firms to enter new markets, compete and expand. However, in Kenya regulations restrict market functioning. Indeed, the level of restrictiveness is higher than in other middle-income countries and the average OECD country, as data from the Organisation for Economic Co-operation and Development (OECD) and World Bank Group Product Market Regulation (PMR) indicators between 2013 and 2017 show.40 Regulations are even more restrictive than in the other four African countries with PMR data over the period (i.e., Egypt, Rwanda, Senegal, and South Africa). The restrictiveness of regulations is related to the relatively high degree of direct State participation in markets, and barriers to entry (Figure 4.16). Figure 4.16: Product market regulations are more restrictive than in many other peer countries Product market regulation (PMR) score, 2013–2017 4.50 4.00 3.50 3.00 2.50 Score 2.00 1.50 BOOST 1.00 0.50 0.00 India Honduras China Kenya Brazil Turkey Jamaica Costa Rica Middle income Dominican Rep. Russia South Africa Israel El Salvador Nicaragua Mexico Colombia Romania Peru Bulgaria Chile OECD avg. OECD top 5 avg. Sub-indicators of overall PMR Overall PMR State control Barriers to entrepreneurship Barriers to trade and investment Source: World Bank analysis based on 2013 OECD PMR database and 2013–2017 OECD–WBG PMR database. Note: Scale is 0–6, from least to most restrictive. Overall restrictiveness of regulations (Overall PMR) calculated based on three sub-indicators: state control, barriers to entrepreneurship and barriers to trade and investment. The middle-income country average is based on scores for the following countries: Argentina, Bolivia, Brazil, Bulgaria, China, Colombia, Costa Rica, Dominican Republic, Ecuador, Egypt, El Salvador, Guatemala, Honduras, India, Indonesia, Jamaica, Mexico, Nicaragua, Paraguay, Peru, the Philippines, Rwanda, the Russian Federation, Senegal, South Africa, Turkey, and Ukraine. The OECD average is based on scores for the following countries that were members at the time of the data: Australia, Austria, Belgium, Canada, Chile, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Japan, Republic of Korea, Latvia, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States. Analysis of the current product market regulatory environment suggest little improvement in the past 10 years; on the contrary, additional restrictive regulations have been set. Of the regulatory changes between 2013 and 2023 captured by the product market regulations questionnaire for professional services, communications, and transport subsectors and price controls, only a few show any improvement in the regulatory environment, with many showing that regulations have become more restrictive to competition in Kenya’s services subsectors. Additional restrictions have been imposed on professional services (e.g., exclusive rights for lawyers) and price controls have been extended to other goods and services (e.g., engineering, tea, sugarcane). While some improvements have been observed in some subsectors (e.g., telecommunications), core issues related to price controls in professional services or regulation of operators with significant market power in telecommunications have still to be addressed (Table 4.1). 40 The PMR database provides a set of internationally comparable indicators measuring the extent to which de jure (on the books) regulations limit or foster firm entry and competition in areas of the product markets where competition is viable. The indicators do not reflect the extent to, or manner in, which laws and regulations are enforced or in practice (de facto). Hence, a country that has competition-friendly laws “on the books”, but that does not enforce such laws, would still obtain a favorable score. The maximum score is 6 and the minimum 0. KENYA COUNTRY ECONOMIC MEMORANDUM 57 Table 4.1: Some changes in Kenya’s product market regulatory environment between 2013 and 2023 Reforms for more Reforms that expand Key areas Sector/topic competitive markets restrictions on market pending reform competition Professional services • Advertising/marketing is allowed for • Additional exclusive rights for • Elimination of minimum legal profession, (although restrictions lawyers prices for legal, engineering, on medium and content still exist) • Advertising regulated for architecture, and estate • No longer an exclusive activity of notaries agency services accountants for auditing and engineers • Price controls for services of • Elimination of restrictions on for various services engineers41 advertising and marketing • Right to perform insolvency practice no for legal, notary and estate longer exclusive rights for accountants agency services • Secondary trading of spectrum is • Procompetitive allocation of possible spectrum Telecom • Mobile number portability is now • Regulation of operators with mandated significant market power • Increased State ownership of Transport the national airline • Phase out of price controls • Additional price controls and replace with alternative Price controls on tea, sugarcane, liquified pro-competitive government petroleum gas, interest rates interventions Source: World Bank analysis based on new data collected using the 2018 OECD-WBG PMR questionnaire. The information reflects the situation as of April 2023. Similar to most economies, network subsectors, such as transport and communications, are critical to the functioning of other sectors of the Kenyan economy.41 For instance, input-output table data for Kenya from the BOOST Eora global supply chain database suggest that the outputs of the transport and communications subsectors are key inputs for several other sectors: for example, about 52 and 57 percent of Kenya’s GDP in 2021 were accounted for by other services subsectors that rely more intensely on the outputs of transport and communication subsectors, respectively, as inputs.42 Thus, fostering pro-competition regulation in key network subsectors, including in transport, communications, and professional services, can drive down costs, enhance the quality of services, and boost the performances, not only of firms in these subsectors but also those in other sectors that heavily rely on the outputs of network subsectors. This provides benefits to consumers and enterprises, including through international trade opportunities. However, competition challenges remain in several network industries, ensuring profitability for a few, but negative effects on the cost structure of the whole economy. In telecommunications, despite pro-competition reforms, challenges still prevail. Regulations in the Kenyan telecommunication subsector are more restrictive to competition than in peer countries in Africa, with the exception of Egypt. This is mainly due to the extent of public ownership and market structure of the subsector. A number of reforms have been implemented in the past few years from guidelines to manage spectrum allocation,43 administrative decisions to allocate 4G spectrum to two additional mobile operators, and a framework for secondary trading of 41 While minimum prices provisions still exist these associations, Section 29 of the Competition Act No. 12 of 2010 was amended in 2019 making it an offence for professional associations to implement rules that preventing, distorting, or lessening competition, unless an exemption is provided by the competition authority. 42 The calculations are based on sectors that are highly intensive in their use of the outputs of transport and communications sectors as inputs. Highly intensive sectors are those whose technical coefficients for transport and communication services are in the top quartile or above the 75th percentile distribution of the coefficients across transport and communication sectors. For further details on the Eora global supply chain database, see Lenzen et al. (2013). 43 Communication Authority of Kenya, Frequency Spectrum Management Guidelines, Doc. No: CA/FSM/Guidelines/01/2020, available at https:// www.ca.go.ke/wp-content/uploads/2020/10/Frequency-Spectrum-Management-Guidelines-2020.pdf. 58 KENYA COUNTRY ECONOMIC MEMORANDUM spectrum, to several initiatives to cut call termination rates.44 Other impactful changes include the elimination of porting fees and exclusive contracts between mobile payment providers and agents, and the introduction of interoperability of mobile payment providers. Notwithstanding these changes, competition challenges remain. First, local equity participation rules still hinder investments, with the Kenya National ICT Policy Guidelines (2020) increasing the requirement for Kenyan equity participation from 20 to 30 percent, which should be met within three years of licensing. Second, regulations on infrastructure sharing, while critical given the market structure of the telecom subsector in Kenya, are still under development.45 Finally, implementation of spectrum policy should be overhauled to favor competitive auction of frequencies for 5G mobile technology, rather than administrative assignments, and provide greater transparency on spectrum allocation and fees paid by operators. Although the regulatory framework provides for adequate mandates, the inability of imposing obligations on the dominant operator has implications on competition. The Competition Authority has also supported competition in the subsector through abuse of dominance cases in mobile money, merger control decisions, and advocacy actions on short codes and mobile money interoperability. Issues in telecoms connectivity (e.g., cost, speeds, reliability, and latency) can affect the ability to use digital means to offer innovation services abroad and deliver reliable digital services. Regulatory barriers to competition in Kenya’s transport subsector is also noticeable. In the road transport subsector, regulations are more restrictive in Kenya than in peer countries in Africa, and the average middle- income country (Figure 4.17(a)). Regulatory barriers to competition are also present in the air transport and railways subsectors. For example, there are restrictions on foreign ownership in air transport, which is limited to 49 percent, and there is a lack of clear slot allocation procedure at the main international airport to ensure predictability and competitive neutrality. In rail transport, the law provides for Kenya Railway Corporation (KRC) as a monopoly and BOOST permits concessions for railway services. Besides issues of market structure, government ownership, and enablers for competition that could be explained by market size, the Government directed in 2019 that all cargo from the Port of Mombasa be transported to Nairobi via the sole rail cargo company46 in a bid to channel business to the operator given contractual obligations. Although the directive was withdrawn in 2022, there is the need to ensure fair competition between the rail cargo operator and road freight transport operators for freight transport services from the Port of Mombasa. In the future, as cargo grows, there is need to evaluate whether other operators can obtain a concession to offer transportation services using available railways infrastructure. There is also the need for an independent regulator for railways transportation to set prices and quality-of-service standards. Furthermore, a railway development levy of 2 percent is currently applied on all imports of goods to fund the investment in railways infrastructure, affecting the costs of products, even those that do not use railways transportation services. 44 Since there is an operator with significant market power in the market for the provision of wholesale mobile call origination services, the Communication Authority of Kenya had planned to cut call termination rates, which has since been disputed and has led to the development of draft Kenya Information and Communication (Interconnection) Regulations, 2022. For operator with significant market power, see competition study by the Communications Authority of Kenya available at https://www.ca.go.ke/wp-content/uploads/2018/02/Presentation- on-Telecommunication-Competition-Study-to-Stakeholders-.pdf. For the Communication Authority of Kenya planned to cut call termination rates, see Communication Authority of Kenya (2021), ’Public Notice- Determination on Mobile Termination rates and Fixed Termination Rates- Interconnection Determination No.3 of 2021’, available at https://www.ca.go.ke/wp-content/uploads/2021/12/Determination-No.3-of-2021- on-Mobile-Termination-Rates-and-Fixed-Termination-Rates-2.pdf. For the draft regulation, see Ministry of Information, Communication and the Digital Economy, Draft Kenya Information and Communications (Interconnection) 2022, available at https://ict.go.ke/draft-kenya-information- and-communications-interconnection-2022/. 45 The draft regulations Kenya Information and Communications (access and Infrastructure Sharing) Regulations, 2022 are available through https:// ict.go.ke/wp-content/uploads/2022/05/Draft-Kenya-Information-and-CommunicationAccess-and-Infrastructure-Sharing-Regulations-2022.pdf 46 Rail cargo services on the Standard Gauge Railway (SGR) were operated by the main SGR contractor. However, the Kenya Railway Corporation (KRC) has now taken over most of the SGR operations. The only other private company operates a railway that is mostly used to transport soda ash to Mombasa for export. KENYA COUNTRY ECONOMIC MEMORANDUM 59 Figure 4.17: Regulation in communications, transport, and professional services subsectors (a) Communications and transport (b) Professional services 6.0 6.00 5.00 4.0 4.00 3.00 2.0 2.00 1.00 0.0 Telecom Post Rail Airlines Road 0.00 Communication Transport Accounting Legal Architect Engineer Kenya Egypt Rwanda Senegal Kenya Egypt Rwanda South Africa OECD top 5 avg. Senegal South Africa OECD top 5 avg. OECD avg. (35) Middle income avg. (28) OECD avg. Middle income avg. Source: World Bank analysis based on 2013 OECD PMR database and 2013–2017 OECD–WBG PMR database. Note: Scale is 0–6, from least to most restrictive. The middle-income country average is based on scores for the following countries: Argentina, Bolivia, Brazil, Bulgaria, China, Colombia, Costa Rica, Dominican Republic, Ecuador, Egypt, El Salvador, Guatemala, Honduras, India, Indonesia, Jamaica, Mexico, Nicaragua, Paraguay, Peru, the Philippines, Rwanda, the Russian Federation, Senegal, South Africa, Turkey, and Ukraine. The OECD average is based on scores for the following countries that were members at the time of the data: Australia, Austria, Belgium, Canada, Chile, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Japan, Republic of Korea, Latvia, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States. Regulated professional services also face elevated levels of regulatory restrictions, and this can limit the incentives to compete and their affordability. The services of professionals, such as accountants, lawyers, architects, and engineers, are essential inputs to the activities of several sectors in the Kenyan economy and also to offer business services across borders. However, regulations regarding entry into the professions and how these professionals conduct their activities in Kenya are more limiting to competition than in comparator countries, such as Rwanda and the average OECD and middle-income countries (Figure 4.17(b)). These competition- limiting regulations mainly reflect price controls, restrictions on advertising, restrictions on foreign ownership, BOOST and cooperation across professions that can reduce incentives to compete and reduce the competitiveness of the subsector. For instance, there are mandatory minimum prices prescribed for legal, architecture, quantity surveying, and most recently, engineering. These price controls can limit price competition and incentives for practitioners to improve the quality of their services. Furthermore, other professions are also seeking to update laws and regulations to allow for setting prices.47 That said, there have been significant developments toward preventing the implementation of price rules through the 2019 Competition Law amendments.48 Furthermore, despite advocacy efforts of the Competition Authority of Kenya (CAK), legal and regulatory reforms to eliminate minimum prices are still needed. 47 This includes accountants, auditors, and human resource professionals. 48 This includes the amendment of the Competition Act in 2019 (Section 29) providing for a mandatory obligation on Professional Associations to apply for exemption of their professional rules if they contain a restriction that has the effect of preventing, distorting, or lessening competition in a market in Kenya. This has resulted in the exemption applications of three professional bodies to set minimum prices being declined by the CAK (see Competition Authority of Kenya Submission to the OECD, ‘Regulatory Barriers to Competition in Professional Services Reform Experience, available at https://www.oecd.org/economy/reform/Competition-interventions-in-the-professional-services-sector-and-their- impacts-to-consumers.pdf ). Further, following a high court ruling, the Law Society of Kenya (LSK) developed advertising guidelines (Marketing and Advertising Rules) allowing advertising, albeit under conditions that are still quite restrictive. For the exemption application (for the high court ruling), see Okenyo Omwansa George and Another vs. The Attorney General and 2 others (2014) e KLR, and for the Marketing and Advertising Rules, see Kenya Gazette Supplement No.53 The Advocates (Marketing and Advertising) Rules, available at http://kenyalaw.org/kl/fileadmin/ pdfdownloads/LegalNotices/2014/LN42_2014.pdf ). 60 KENYA COUNTRY ECONOMIC MEMORANDUM As stated above, ensuring that regulations in these key input markets are friendly to competition can result in significant GDP gains to the Kenya economy. Restrictive government regulations in key professional services subsectors render prices of goods and services high and limit productivity of the sectors and others that use these services as inputs. Dismantling regulatory obstacles and aligning regulations with competition principles will contribute to the improvement of the business environment, transmitting into GDP gains through more competitive prices and productivity gains. Previous simulation analysis suggests removing these restrictive regulations in services subsectors, such as professional services, could boost GDP growth by at least 0.39 of a percentage point, equivalent to US$218 million in the first year (World Bank Group 2015). Furthermore, restrictive regulations of professionals that protect underperforming providers can affect the ability to have highly competitive subsectors that can also compete internationally for services outsourcing. State participation in markets, including in key services subsectors The Kenyan State is a direct market player in several sectors of the economy. Data from the World Bank Businesses of the State (BOS) database show that the Government owns stakes of at least 10 percent, either directly or indirectly, in 132 business entities operating across 11 percent of Kenyan markets (i.e., 62 unique 4-digit industries out of the total 563 4-digit NACE industries covered by the database). Together, the unconsolidated revenues of these businesses were equivalent to at least 3.2 percent of Kenya’s GDP in 2019, which is relatively low compared with other African countries (Figure 4.18(a)). Of these business entities, about 44 percent are majority owned, 17 percent are minority owned with stakes of between 25 and 49.9 percent, and the rest are minority owned with stakes of between 10 and 24.9 percent (Figure 4.18(b)).49 The State’s minority stakes in businesses are particularly noticeable when compared with some regional peers (Figure 4.18(c)). Even for minority ownership, regulatory capture might occur if policy makers and regulators representing the Government sit on company BOOST boards, thus potentially affecting competitive neutrality and efficient market outcomes. All the Businesses of the State (BOS), except for two, are owned by the national government. Forty-eight percent have the national or local governments as the direct owner, while the remaining 52 percent are indirectly owned as subsidiaries of other BOS. 49 It is important to note that the domestic BOS revenue share is Kenya’s GDP should be considered as a lower bound figure given that about 48 percent of BOS (or 64 BOS) do not have revenues data or they reported consolidated revenues, which are excluded to avoid double counting and to be consistent with the revenue data of the comparator countries. However, the six largest of Kenya’s BOS that reported consolidated revenues have a total of 56 subsidiaries, 45 of which have majority ownership. If the consolidated revenues of the six BOS are included, then the revenue share of GDP of Kenya’s BOS is at least 9 percent of its GDP. The percent of BOS that do not have revenue data is also likely lower (and close to 15 percent or 19 BOS) if we assume that the consolidated revenues of the 6 BOS also included the revenues of the 45 subsidiaries which they have majority ownership. KENYA COUNTRY ECONOMIC MEMORANDUM 61 Box 4.3 Measuring the footprint of the state The World Bank’s Businesses of the State (BOS) database maps the footprint of the State within the corporate sector and across economic activities based on a uniform definition. The BOS dataset tracks all corporations where national or subnational governments have ownership stake of at least 10 percent, either directly or indirectly (Dall’Olio et al. 2022(a)). In the BOS database, corporations are business entities that are: (i) capable of generating a profit or other financial gain for their owners; (ii) recognized by law as legal entities separate from their owners and with limited liability; and (iii) set up for purposes of engaging in market production. The database was built using data from ORBIS and complemented with data from government sources, such as business registries, central depositories, central oversight bodies, and Ministry of Finance. It tracks several variables such as company names, industrial activity (4-digit NACE code), financial variables such as revenue, employment, and profit and loss as of 2019, percent of the State’s ownership stake, and different layers of the ownership chain. State business entities operating in sectors such as public administration and defense, and activities of extraterritorial organizations are excluded because corporations in these sectors provide public goods, while those operating in education and human health sectors are also excluded because they are characterized by externalities. In addition, some business entities operating in these excluded sectors are either not capable of generating profits or their purpose is not for market production. Thus, government participation in these sectors is justified or firms owned by governments operating in these sectors could not be categorized as State businesses under the above definition. Given that the BOS database uses a lower threshold of 10 percent or more ownership stakes, these business BOOST entities are referred to as the Businesses of the State, rather than State-owned enterprises (SOEs), which tend to be associated with a much higher ownership threshold of 50 percent or more stakes. The information for Kenya is based on publicly available data expanded through information gathered by the country team. All information is for 2019. 62 KENYA COUNTRY ECONOMIC MEMORANDUM Figure 4.18: Importance of BOS and degree of State ownership (a) Domestic BOS revenues share of GDP (b) Distribution of all BOS by level of State participation 18 16.8% 16 14.8% Full participation 14 Minority (37.1%), 49 shares (10-24.9%) 12 (40.2%), 53 10 Percent 8 6.1% 6 5.1% 4.4% 3.8% 4 3.2% 3.0% 2 1.5% 1.3% 0 Blocking Majority a e e i l ian a n da ia minority participation nd ga ric ny qu ag ni an an ed ne Be ru Af Ke er (25 - 49.9%) (9.1%), 12 bi nz Rw Bu M Se Av am h Ta (13.6%), 18 ut oz So M (c) Distribution of BOS by level of State participation in Kenya vs. comparator countries Full patiticipation (100%) Majority participation (50%) Blocking minority (25 Minority shares (10 Unknown (existent 100 Percent 50 0 a la n e n os ire i a o ia cip d l ia a in ga ny an bi rd th ni oo in an an an go BOOST e or at Ivo ne m Be Ve so Ke Gh er rit nz m w An Pr e Za d’ Se m Le m Es au bo Co Ta To te Ca M Ca Co o Sa Source: World Bank analysis based on 2013 OECD PMR database and 2013–2017 OECD–WBG PMR database. Note: Scale is 0–6, from least to most restrictive. The middle- income country average is based on scores for the following countries: Argentina, Bolivia, Brazil, Bulgaria, China, Colombia, Costa Rica, Dominican Republic, Ecuador, Egypt, El Salvador, Guatemala, Honduras, India, Indonesia, Jamaica, Mexico, Nicaragua, Paraguay, Peru, the Philippines, Rwanda, the Russian Federation, Senegal, South Africa, Turkey, and Ukraine. The OECD average is based on scores for the following countries that were members at the time of the data: Australia, Austria, Belgium, Canada, Chile, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Japan, Republic of Korea, Latvia, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States. The State’s footprint in markets is pervasive in competitive sectors where the economic rationale for direct government intervention is weak, with the risk of distorting markets. According to the BOS database, close to two-thirds of BOS in Kenya operate in competitive sectors where the economic rationale (e.g., market failures) for the presence of the State in business activities is weak (Figure 4.19(a)). Generally, State participation is natural monopoly sectors tend to be justified because the market structures of these sectors are characterized by high entry costs, scale economies, or sub-additivity cost structures, features that make it economically inefficient for more than one firm to operate and thus rationalize State participation through the establishment of a business. In addition, there are other sectors, beyond natural monopoly sectors (termed as partially contestable), which feature some weaker forms of market failures (e.g., market power and externalities) that limit market contestability and could be addressed through State participation. As such, State businesses in natural monopoly and partially contestable sectors can be justified when their presence is to address market failures or achieve economic efficiency. However, the State’s reach can extend beyond these justifiable sectors into competitive sectors, where the intrinsic market features (e.g., cost structure, technology, or demand characteristics) do not limit the ability of private players to enter and compete, and thus there is limited economic rationale for government participation in such sectors because private sector participation is viable (Dall’Olio 2022(a)). The businesses linked to the Government generates significant revenues (Figure 4.19(b)). In fact, in several of these competitive sectors, there are active private sector participations and so, there are greater risks that the presence of Government-owned businesses could, among other things, crowd out more private investments. KENYA COUNTRY ECONOMIC MEMORANDUM 63 Figure 4.19: Distribution of the number of BOS, revenue, and profit and loss, by sector type a. Distribution of BOS by sector type b. Distribution of BOS domestic revenue by sector type 4.50 5 4.00 Revenue share of GDP (percent) 3.50 4 Revenues (USD billion) 3.00 3 2.50 2.00 2 1.50 1.00 1 0.50 0.00 0 Competitive Partially Natural contestable monopoly Revenues Revenue share of GDP Source: World Bank Businesses of the State database. The distribution of BOS by sector (left panel) is based on number of firms by 4-digit NACE economic activity. All companies provide information of economic activity. The distribution of BOS revenues and profit/loss by sector type is based on revenues and profit/loss data as of December 2019. Only about 52 and 51 percent of BOS firms have revenues and profit/loss data, respectively, as of December 2019. Therefore, figures are indicative and should be considered as a lower-bound. Some 4-digit NACE codes are excluded from the sector classification of BOS because firms in those industries provide public goods (e.g., public administration and defense and activities of extraterritorial organizations), while others are characterized by externalities (e.g., education and human health activities). In these excluded sectors, government interventions are justified because entities in these services are either not capable of generating profits or they were not set up for market production. Most of the State’s businesses operate in the services sector. Sixty-seven percent of businesses of the Kenyan State (89 of them) operate in about 18 percent of services markets (i.e., 44 unique 4-digit services industries out of the total 240 4-digit NACE services industries covered by the database).50 The rest, about 33 percent, are spread across manufacturing, energy, and water and sewage sectors, with few in the construction, agriculture, and mining sectors (Figure 4.20(a)). A vast proportion—about 73 percent—of the services sector businesses operate in competitive markets where the economic rationale for State participation in those markets is weak (Figure BOOST 4.20(b)), and some of them are quite dominant market players in their industries (Table 4.2). Figure 4.20: Distribution of BOS by sector type a. Distribution of BOS by sector b. Distribution of services sector BOS Services (67.4%), 89 Manufacturing (13.6%), 18 Water and sewage (9.8%), 13 Energy (4.5%), 6 Agiculture (3%), 4 Mining Construction (0.8%), 1 (0.8%), 1 Source: World Bank Businesses of the State database. The distribution of BOS by sector (left panel) is based on number of firms by 4-digit NACE economic activity. All companies provide information of economic activity. The distribution of BOS revenues and profit/loss by sector type is based on revenues and profit/loss data as of December 2019. Only about 52 and 51 percent of BOS firms have revenues and profit/loss data, respectively, as of December 2019. Therefore, figures are indicative and should be considered as a lower-bound. Some 4-digit NACE codes are excluded from the sector classification of BOS because firms in those industries provide public goods (e.g., public administration and defense and activities of extraterritorial organizations), while others are characterized by externalities (e.g., education and human health activities). In these excluded sectors, government interventions are justified because entities in these services are either not capable of generating profits or they were not set up for market production. 50 These services subsectors include wholesale/retail trade (except of motor vehicles and motorcycles; land transport (land, water, and air); warehousing and support activities for transportation; postal and courier activities; accommodation; publishing activities; programming and broadcasting activities; telecommunications; computer programming, consultancy and related activities; financial service activities (except insurance and pension funding); insurance, reinsurance and pension funding (except compulsory social security); activities auxiliary to financial services and insurance activities; real estate activities; activities of head offices, management consultancy activities; travel agency, tour operator and other reservation service and related activities; office administrative, office support and other business support activities; and sports activities and amusement and recreation activities. The construction, energy, and water and sewage subsectors are excluded from the services sector. 64 KENYA COUNTRY ECONOMIC MEMORANDUM The Kenyan State’s businesses in the services sector are prevalent in the financial services and real estate industries. There are 24 financial services firms documented by the BOS database, and they operate in all six of the 4-digit financial services industries covered by the database (Figure 4.21). Of these, eight BOS, including the largest commercial bank (KCB Bank Kenya Ltd), provide monetary intermediation services—a partially contestable subsector where there is some economic rationale for government participation in the markets. Ten State businesses, of which five are majority owned, grant credits but are not monetary intermediaries or institutions. These other- credit-granting State businesses operate in an industry that is generally competitive, is viable for private sector involvement, and thus there is limited economic rationale for government participation. Thirteen firms engage in real estate activities and operate in three of the four industries in the real estate subsector. Industries in the real estate subsector also generally exhibit limited economic rationale for government participation. Besides, businesses linked to the Government operate in key infrastructure subsectors, such as telecommunications and transportation. In the telecommunications subsector, Safaricom PLC, the largest telecommunications provider with a 66 percent market share in active mobile subscriptions and 97 percent of mobile money subscriptions,51 is 35 percent owned by the Government. Safaricom PLC, in turn, has seven local subsidiaries that also engage in other telecom activities. The Government also now fully owns Telkom Kenya Ltd., the third-largest operator and a previously privatized state company.52 The Government is therefore involved in telecommunications business activities that have private sector involvement. There is thus limited economic rationale for the Government to be participating in this subsector. In the air transport subsector, Kenya Airways PLC, which is 30 percent owned by the Government, commands close to a 50-percent market share of international departures, and it operates seven subsidiaries related to air transport, both passenger and freight, subsectors that are considered partially contestable and, hence, there exists some economic rationale for State participation. BOOST Table 4.2: Market share of State businesses in selected services subsectors Govern- Market Rank of Sector BOS ment share market Market share based on ownership 2021 share stake Safaricom PLC 35% 65.9% 1 Active domestic mobile Telecommunications subscriptions Telkom Kenya Ltd. 100% 6.4% 3 Mobile money Safaricom PLC 35% 96.8% 1 Mobile money subscriptions KCB Bank Kenya Ltd. 18% 13.8% 1 Market size index, a weighted National Bank of Kenya Ltd. 50% 2.3% 12 average of total net assets, total Monetary deposits, shareholders’ funds, intermediation Consolidated Bank of Kenya Ltd. 85% 0.2% 34 number deposit accounts, and Development Bank of Kenya Ltd. 89% 0.3% 29 number of loan accounts. Air transport Kenya Airways PLC 30% 48.7% 1 International departure seats Life assurances and group life Reinsurance Kenya Reinsurance Corp Ltd. 60% 58% 1 premium Source: World Bank Businesses of the State database and staff desk research based on data from Safaricom PLC Annual Report and Financial Statements 2022; Communications Authority of Kenya, Sector Statistics Report, Second Quarter Sector Statistics Report for the Financial Year 2022/2023 (October 1 to December 31, 2022); Central Bank of Kenya, Bank Supervision Annual Report 2023; and Insurance Regulatory Authority, Insurance Industry Annual Report 2021. 51 The market share is as of 2022 and is based on data from the Communications Authority of Kenya, Sector Statistics Report, Second Quarter Sector Statistics Report for the Financial Year 2022/2023 (October 1, to December 31, 2022) https://www.ca.go.ke/wp-content/uploads/2023/03/Sector- Statistics-Report-Q2-2022-2023.pdf 52 In October 2022, the Government acquired the remaining 60 percent stake that it did not already own in Telkom Kenya from Helios Investment Partners for US$50.4 million, making the company a wholly state-owned enterprise. KENYA COUNTRY ECONOMIC MEMORANDUM 65 In addition, the State is also indirectly present in several services activities, such as professional services and publishing. The Government, through Kenya Development Corporation Ltd, holds a 23 percent stake in Centum Investment Company Plc.53 Centum is an investment company that has several subsidiaries that provide service activities, including business and other management consultancy, publishing, services incidental to air transportation, fund management, and packaging. Figure 4.21: Distribution of BOS across 2-digit sectors and the percent of 4-digit industries (out of the total covered in the sector) with at least one BOS presence Number of BOS operating in % of 4-digit industires in the sector 0 10 20 30 Financial service activities, except insurance and pension funding 24 in 100% (6 out of 6) of industries Real estate activities 13 in 75% (3 out of 4) Water collection, treatment and supply 12 in 100% (1 out of 1) Telecommunications 10 in 50% (2 out of 4) Air transport 7 in 66.7% (2 out of 3) Electricity, gas, steam and air conditioning supply 6 in 25% (2 out of 8) Accommodation 5 in 25% (1 out of 4) Insurance and reinsurance 4 in 100% (3 out of 3) Activities auxiliary to nancial services and insurance activities 4 in 57.1% (4 out of 7) Publishing activities 3 in 28.6% (2 out of 7) Warehousing and support activities for transportation 3 in 16.7% (1 out of 6) Services Wholesale trade, except of motor vehicles and motorcycles 3 in 6.3% (3 out of 48) Water transport 2 in 50% (2 out of 4) Land transport and transport via pipelines 2 in 25% (2 out of 8) O ce administrative, o ce support and other business support activities 2 in 14.3% (1 out of 7) Remediation activities and other waste management services 1 in 100% (1 out of 1) Programming and broadcasting activities 1 in 50% (1 out of 2) Postal and courier activities 1 in 50% (1 out of 2) Travel agency, tour operator and other reservation service and related activities 1 in 33.3% (1 out of 3) Activities of head o ces; management consultancy activities 1 in 33.3% (1 out of 3) Computer programming, consultancy and related activities 1 in 25% (1 out of 4) Sports activities and amusement and recreation activities BOOST 1 in 16.7% (1 out of 6) Retail trade, except of motor vehicles and motorcycles 1 in 2.7% (1 out of 37) Manufacture of food products 9 in 16% (4 out of 25) Crop and animal production, hunting and related service activities 4 in 12.9% (4 out of 31) Mining support service activities 1 in 50% (1 out of 2) Manufacture of coke and re ned petroleum products 1 in 50% (1 out of 2) Manufacture of motor vehicles, trailers and semi-trailers 1 in 25% (1 out of 4) Non - services Manufacture of beverages 1 in 14.3% (1 out of 7) Civil engineering 1 in 14.3% (1 out of 7) Manufacture of electrical equipment 1 in 10% (1 out of 10) Manufacture of computer, electronic and optical products 1 in 10% (1 out of 10) Manufacture of chemicals and chemical products 1 in 6.3% (1 out of 16) Manufacture of fabricated metal products, except machinery and equipment 1 in 5.9% (1 out of 17) Manufacture of machinery and equipment n.e.c. 1 in 4.8% (1 out of 21) Manufacture of other non-metallic mineral products 1 in 4.2% (1 out of 24) Source: World Bank Businesses of the State database. The distribution of BOS by sector is based on number of firms by 4-digit NACE economic activity. All companies provide information of economic activity. In parentheses are the number of 4-digit industries out of the total with at least one BOS present. Reducing the State’s footprint in competitive sectors of the Kenya economy can reduce the risk of market distortions, enhance efficiency, and stimulate private investment. In this regard, the Kenyan Cabinet recently approved a Privatization Bill 2023, a Bill that once passed by Parliament will provide the regulatory framework for the privatization of State businesses. Under the Bill, a Privatization Authority will be established and tasked with, among other things, implementing the Government’s privatization program, including advising the Government on privatization issues and facilitating government privatization policies. It is expected that the privatization program will start with the sale of non-strategic and non-performing state businesses, particularly in competitive sectors. This is welcome as it can be a vehicle for the entry of more efficient private players 53 The shares were previously held by Industrial and Commercial Development Corporation (ICDC), but a development finance institution, Kenya Development Corporation Ltd. (KDC), was established in 2020 to merge the operations of ICDC, the Tourism Finance Corporation (TFC), and the IDB Capital Limited. 66 KENYA COUNTRY ECONOMIC MEMORANDUM into markets, enhance aggregate productivity, and boost economic growth. However, it is critical to ensure that the privatization process is transparent and competition for State businesses earmarked for privatization is open and fair, and in a manner that does not lead to concentrated market structures and the dominance of certain competitors or conglomerates. In sectors with limited competition, it is also important to ensure that competition- enhancing policies are implemented ex ante or together with privatization to ensure better market function. Besides privatization, ensuring good governance of BOS and fair competition between BOS and their private peers is important. In many advanced economies, the Chief Executive Officer (CEO) in commercial SOEs are appointed by a board that is at an arm’s length from ministries and the political process. This ensures independent decision-making and less risk for potential conflict of interests. However, in Kenya the Cabinet Secretary of the parent ministry, in consultation with the State Corporations Advisory Committee, appoints such CEOs, leading to commercial SOE decision-making being influenced by governmental bodies. Therefore, a more professional or good governance of BOS in commercial sectors, in terms of the structures and processes by which they are directed and controlled, can improve their economic performance. In addition, competitive neutrality in the treatment of BOS—in terms of regulatory enforcement and state support—is essential to avoid crowding out the private sector. However, key gaps remain in ensuring competitive neutrality between SOEs and private firms in Kenya.54 For instance, commercial SOEs can obtain access to financing from government-related entities at better conditions than private firms, as well as access explicit government guarantees on debts that they may contract. Besides, there are no clear legal obligations in place to ensure structural separation or accounting separation for commercial SOEs that also provide services under public service obligations, and there are no requirements in place for such SOEs to be adequately compensated. BOOST These preferential treatments of commercial SOEs can distort the playing field and affect the ability of private firms to enter, compete, and grow. Furthermore, in sectors where economic regulation is important, such as in telecommunications and transport subsectors, ensuring good governance to separate the different roles of the State—e.g., policy making, regulation, and ownership—is critical to ensuring a level playing field between BOS and private-owned enterprises and maintain fair competition in markets. Concluding remarks There is scope in Kenya to boost productivity by adopting more sophisticated technologies and by increasing the level playing field in markets. When it comes to the adoption of technologies, there are large gaps between frontier firms and those that are lagging further behind. While some technologies are skill-intensive and require higher levels of capital to be adopted, other technologies – e.g., on digital payments or platforms – are much simpler and require lower levels of investment to be adopted. Given that Kenya already has a track record in the use of certain technologies (e.g., mobile money), it would make sense to first focus on these less-skill intensive and easier-to-use technologies. Information asymmetries – firms not knowing what technologies to adopt and how to adopt them – need to be overcome. 54 Competitive neutrality is the principle that all enterprises, public or private, domestic or foreign, should face the same set of rules, and where government’s contact, ownership, or involvement in the marketplace, in fact or in law, does not confer an undue competitive advantage on any actual or potential market participant. The effective implementation of this principle is important to limit the risk of economic distortions due to SOE presence in markets. KENYA COUNTRY ECONOMIC MEMORANDUM 67 Creating a better level-playing field in services markets will need a reduction in regulatory barriers. As this chapter showed, regulatory barriers to competition are higher in Kenya than in other middle-income countries (and even some regional peers) and the progress in reducing these barriers has been limited. These barriers do not only affect domestic firms, but also affect trade in services, as the next chapter (“Trade”) will discuss. Rethinking the involvement of the state in certain services sectors is another area for potential reform to boost the competitiveness of services sectors. BOOST: Policy priorities to increase productivity Increasing productivity requires the adoption of more sophisticated technologies, creating a level playing field, and removing barriers to entry of new firms. This requires a stable policy and macroeconomic backdrop to facilitate firms’ investments, as well as securing a level playing field. Policy priorities include: • Provide tax policy clarity and predictability, addressing the coherence of county-level taxation, and avoiding nuisance and implicit taxes (e.g., excessive permitting and licensing costs). • Address information gaps impeding firms’ technology adoption (e.g., facilitating business development services). • Address regulatory restrictions and barriers to vigorous, fair market competition. • Reassess and reform commercial SOEs with a view to ensuring a level playing field, eliminating conflicts of interest, and increasing entities’ performance, including through governance reforms that strengthen SOE management boards. BOOST 68 KENYA COUNTRY ECONOMIC MEMORANDUM CHAPTER 5 TRADE Services More by Reducing Trade and Investment Barriers Services account for an increasing share of trade and investment, but significant barriers to services trade and investment remain in place, including for digital services. C hapter 3 (“Link”) discussed how services are linked to other sectors, including manufacturing exports, and summarized evidence of how exports were generating substantial labor income from services-related work as far back as 2014. Since then, digitalization has only continued to increase the tradability of services through advances in technology that enable easier codification, storage and transmission of services across distance. Historically, a large contribution of Kenya’s services exports has been accounted for by transactions requiring face-to-face interaction, such as tourism exports to foreign travelers visiting Kenya. The digitalization of services and globalization of supply chains has contributed to a greater unbundling of services, enabling activities that are part of a production cycle to be performed in different geographical locations. In addition, improved digital connectivity through internet and telecommunications infrastructure, and improving access to digital financial services, have opened up vast potential opportunities for cross-border trade in the global digital economy, and also increased the ability of the domestic labor force to offer services exports (Hoekman 2018). International trade in services and investment has great potential to boost economic growth and create decent jobs for Kenyans. Kenya has the potential to gain a demographic dividend from its growing working-age population, if the dependency ratio declines quickly enough and incomes per worker are high enough. However, the share of informal sector employment has increased from 40 percent in the early 1990s to over 80 percent as of 2019, with the largest share of jobs being in small-scale agriculture (KNBS Economic Surveys 1995–2020). Jobs in the informal sector, which tend to have lower security and wages, have increased as a residual category due to the inability of other sectors to create opportunities quickly enough to absorb the growing labor force. Other developing and emerging economies face similar dynamics. In contrast, a large number of advanced economies face the opposite challenge: a shrinking labor force due to an aging population and increasing old-age dependency ratios (Rouzet et al. 2019). There is therefore potential for Kenya to provide decent job opportunities by exporting the services increasingly in demand in advanced economies. To do so, it is critical to attract FDI to further stimulate Kenya’s international services sector. This chapter considers the potential ways in which Kenya could stimulate international trade and investment by reducing barriers and providing an enabling regulatory environment. The first section explores the latest trends in Kenya’s cross-border services trade and FDI. The second section then explores the existing barriers that are holding back services trade, and summarizes recent evidence of the potential benefits that could arise from Kenya’s services liberalization in the context of the African Continental Free Trade Area (AfCFTA) agreement. The third section then provides a special focus on digital services trade, and considers what type of regulatory environment best helps to stimulate this sector. KENYA COUNTRY ECONOMIC MEMORANDUM 69 Services are accounting for an increasing share of exports in Kenya Net exports of services have been increasing over time and are now substantially higher than net exports of goods. Net services exports have been increasing over time in nominal US dollar terms. Nevertheless, services exports as a share of gross value added have been declining over time, as services export growth has been outpaced by total output growth. Historically, Kenya has always been a net exporter of services (i.e., services exports have exceeded imports) and, although net services exports have risen only slowly, this still contrasts with net goods exports, which have plunged since the mid-2000s55 (Figure 5.1). On average, services exports have contributed only a modest 7 percent to GDP growth over the past decade. Only 12 percent of total services value- added is exported, less than half that of manufacturing value-added exports, of which 26 percent of the total is exported (Figure 5.2). There is a declining trend of services and manufacturing value-added exports as a share of value-added over time. Figure 5.1: Net services exports have increased significantly Figure 5.2: The share of services value added that is compared with goods exported has declined over time Net exports of goods and services (US$ billion) Share of exports in gross value added (percent) 4 90 2 80 70 0 60 -2 50 -4 40 -6 30 -8 20 -10 10 -12 0 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2010 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 TRADE Net goods exports Net service exports Net service exports Service exports Manufactures exports Source: World Bank calculations based on WDI data. Source: World Bank calculations based on WDI data. Kenya’s relatively low trade intensity suggests scope Figure 5.3: Peer comparison suggests scope for Kenya to grow services exports to increase services exports. Kenya’s share of services in Share of services in exports and value added (percent, relative to peers) value-added is lower than all its regional, structural and 30 aspirational peers, with the exception of Bangladesh and 25 South Africa (Figure 5.3), while it has a relatively higher contribution of services exports to growth.56 However, 20 services exports are generally below 10 percent of GDP 15 in most economies, with only Thailand and Malaysia exceeding 10 percent. 10 5 Kenya’s services exports are dominated by low- 0 skilled tradable exports, although the share of global BGD ZAF ETH VNM UGA KEN TZA LKA IND RWA GHA MYS THA innovator services has increased since the early Source: World Bank calculations, using World Bank WDI data. 2000s. On average, low-skilled tradable exports have historically accounted for 60 percent or more of Kenya’s services exports, although that share has declined over the past 10 years. In particular, passenger and freight transport are the largest contributors to low-skilled tradable 55 This is partly due to Kenya’s large public infrastructure investments during this time, which required sizable increases in goods imports. 56 Regional peers include Ethiopia, Rwanda, Tanzania and Uganda; structural peers include Bangladesh, Ghana, Sri Lanka and Vietnam; aspirational peers include India, Malaysia, South Africa and Thailand. 70 KENYA COUNTRY ECONOMIC MEMORANDUM services exports, in addition to personal travel. The importance of global innovator services57 has been increasing since the mid-2000s, growing its share of total services exports from about 5 percent to above 20 percent by 2019. This is driven mostly by trade in telecom, finance and ICT services (Figure 5.5). Figure 5.4: The share of low-skilled tradable exports has Figure 5.5: …while global innovator services have declined over the past 10 years… increased, mostly in ICT and financial services Services exports by category, 1975–2019 (percent) Global innovator services exports, 2010–2020 (US$ million) 90 1,800 80 1,600 70 1,400 60 1,200 50 1,000 40 800 30 600 20 400 10 200 0 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 Insurance and pension Financial Intellectual property Low-skill domestic Low-skill tradable Global innovator Other Telecom and ICT Other business services Note: The following inaccuracies are introduced while classifying the data: (i) personal travel includes goods and services acquired by individuals abroad, including education and health; (ii) health and education services rendered remotely are included in other personal, cultural and recreational services; and (iii) outsourced services such as call centers are classified by type of service offered (e.g., computer support or trade-related support). Source: World Bank calculations, using IMF Balance of Payments statistics. When broken down by modes, cross-border services (“mode 1” under the GATS framework) account for most of Kenyan services exports. Due to their ability to be offered without physical interaction, cross-border services are the most amenable to benefiting from an expansion of the digital economy. The greatest contributions of cross-border exports are from transport, financial services, ICT and trade-related distribution services (Figure 5.4). TRADE The value of cross-border services exports has increased more rapidly than other modes since 2005 (Figure 5.5).58 Consumption abroad (“mode 2”) is the second-largest contributor of services exports and reflects the importance of tourism and business travel (see Box 5.1). FDI as mode of services (“mode 3”) is increasing, reflecting Kenya’s growing role as a provider of outward FDI. Movement of people (“mode 4”) plays a smaller role.59 Figure 5.6: Cross-border service provision (“mode 1”) is the Figure 5.7: Cross-border service provision has been rising most prominent form of services exports the most rapidly over time Services exports by subsector and mode, 2017 Share of services exported by mode, 2005–2017 1800 5,000 1600 4,500 1400 4,000 1200 (US$ million) 3,500 1000 (US$ million) 800 3,000 600 2,500 400 2,000 200 1,500 0 1,000 n ty ce il l t n es lth T t a or en ta IC tio io ic i c an l ea pp ita Re at i hn m 500 rv ta ur H uc p in su se r ec po os ns ta Ed e/ l/t er H l/i er ns tiv 0 th na ia nt a ra O Tr nc sio /e ist 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 na ts es in Ar Fi of m Cross-border Consumption abroad Pr Ad Cross-border Consumption abroad FDI Movement of persons Commercial presence Natural persons Note: See Appendix B for definitions of services subsectors. Source: World Bank calculations, using WTO TiSMoS data. Source: World Bank calculations, using WTO TiSMoS data. 57 As discussed in Chapter 2, global innovator services include finance, insurance, ICT, professional, scientific and technical services. These services are characterized by a high degree of offshorability and linkages with other industries. The industry also has a high level of capital intensity and high levels of investment in research and development, and the majority of employees in this sector are skilled. 58 The General Agreement on Trade in Services (GATS) classifies services into four modes: Mode 1: cross-border supply, where a service is delivered in another country without movement of persons or commercial presence; Mode 2: consumption abroad, where a service is delivered to a foreigner in a given country; Mode 3: commercial presence, where a service is delivered by a subsidiary or affiliate company in a foreign company (foreign direct investment); and Mode 4: movement of natural persons, when a person travels to a foreign country to deliver a service. 59 Mode 4 under the GATS framework takes a narrow definition of movement of natural persons and excludes most forms of longer-term migration. KENYA COUNTRY ECONOMIC MEMORANDUM 71 Kenya’s services imports are mostly driven by FDI Figure 5.8: FDI and cross-border imports are the most prominent modes of services imports (“mode 3”), representing more than half (54 percent) Services imports by subsector and mode, 2017 of services imports. The role of FDI will be discussed 2,000 1,800 more extensively in the next section. Cross-border 1,600 service imports (“mode 1”) are the second-most 1,400 (US$ million) 1,200 prominent mode, representing more than one-third (38 800 600 percent) of service imports, especially in trade-related 400 subsectors such as distribution and transportation. 200 0 Consumption abroad (“mode 2”) and the movement of e n n l n h T y t es t ica or en lit IC nc tio io io alt vic pp ita ut at hn m ra He rta er uc rib sp in su su ec po rs rta natural persons (“mode 4”) play a smaller role. Ed Ho /in e/ st l/t he s Di te tiv an na l cia Ot en ra Tr sio an ist ts/ es Fin in Ar of m Pr Ad Cross-border Consumption abroad FDI Movement of persons Note: See Appendix B for definitions of services subsectors. Source: World Bank calculations, using WTO TiSMoS data. Box 5.1 Tourism after the COVID-19 pandemic: a focus on quality not quantity Tourism—a form of “mode 2” trade in services (consumption abroad)—constitutes almost one-quarter (22 percent) of services exports. Kenya offers three main types of tourism products: safari, coastal, and business and conference travel. Safari tours vary in quality of service and price. Coastal tourism typically caters to the highly competitive “sun–sea–sand” segment of the global market. The appeal of Nairobi as a business and conference destination has been helped by the 2022 opening of the Nairobi Expressway and the resulting reduction in traffic congestion. Cultural heritage tourism in Kenya is currently quite limited and could have scope to increase. Safari tourism Coastal tourism Business and conference travel TRADE • Based on natural and wildlife assets • Caters to the competitive “sun-sea-sand” • Independent business travelers from • The Kenya Wildlife Service, (KWS) is segment of the global market domestic, regional, & international responsible for management of national • Ranges from mass-packaged tourism of markets, conference and meeting parks and executing plans to protect Mombasa coastal resorts to culturally attendees biodiversity rich destinantions such as Lamu • Kenyatta International Convention Centre (KICC) in Nairobi is the largest conference facility in East Africa Tourism represents one of Kenya’s top foreign exchange earners and one of its largest service subsectors. In 2021, the tourism subsector accounted for about 4.9 percent of GDP, down from the 7.7 percent of GDP in pre-pandemic 2019.60 Tourism jobs accounted for 1.42 million (7.9 percent of jobs) in 2021, just shy of the 1.56 million (8.6 percent of jobs) in 2019. Tourism was hard hit during the pandemic, with international arrivals reduced by 71 percent (Figure 5.9). Since then, the tourism subsector has staged a rebound and, at the current pace, is expected to fully recover by 2024, in terms of both earnings and employment. As the global economy recovers, tourism is becoming a more competitive global field and the fight for tourist dollars means that Kenya will need to position its tourism subsector to be more competitive and attractive to maximize expenditure per visitor. Kenya’s enabling environment for tourism is regionally competitive but compares less well on global metrics. In the World Economic Forum 2021 Travel & Tourism Development Index (TTDI),61 Kenya is ranked 78th out of 117 economies, in the bottom third. However, within sub-Saharan Africa it is ranked number fourth (behind only Mauritius, South Africa and Botswana), with a 3.6 score out of a possible 7.0. The individual components of the TTDI reveal strengths and weaknesses (Figure 5.10). Similar to its peers, Kenya falls short on 60 World Tourism and Travel Council 2022. 61 The TTDI benchmarks and measures a set of factors and policies that enable the sustainable and resilient development of the Travel and Tourism (T&T) sector, covering five subindexes, 17 pillars and 112 individual indicators. 72 KENYA COUNTRY ECONOMIC MEMORANDUM Box 5.1 Tourism after the COVID-19 pandemic: a focus on quality not quantity (contd.) Figure 5.9: Tourism was hard hit during the pandemic Figure 5.10: Kenya scores well on price competitiveness, policy prioritization and natural resources, but low on cultural resources, tourist infrastructure and health and hygiene International tourist arrivals, 2015–2021, thousands Travel and Tourism Development Index (TTDI) components, 2021 2500 7 6 2000 5 4 1500 3 2 1000 1 500 0 ne ice tu rt tu e ce l pa nd tio cy ur ra gi nd ur ral uc vic cu spo iza li so ltu e ss re re s s ct n im a ive Pr so tu hy th a rit Po ce en re em str er re Cu re Na stu an s al su D fra t fra tr in uris He 0 in ir tit A io To pe pr 2015 2016 2017 2018 2019 2020 2021 2022 es m pr co Kenya Eastern Africa Botswana Mauritius South Africa Source: Economic Survey 2020, 2022, 2023 (KNBS). Note: Not all components of the TTDI are shown. Source: World Economic Forum. demand (due to a lack of cultural sites and entertainment venues) and infrastructure assets, but also in health and hygiene (due to the low health resources and sanitation indicators). More positively, Kenya scores well on price competitiveness, demand pressure (ability to spread tourism geographically and throughout the year) and policy prioritization. As Kenya seeks to grow its tourism subsector, it will need to address some of these key constraints. In the wake of COVID-19, Kenya’s new tourism strategy aims to diversify and build greater resilience for the subsector. The New Tourism Strategy for Kenya 2021–2025, has four strategic shifts.62 First, to make Kenya an all- year-round tourism destination, which will help stabilize resource use and improve asset utilization. Second, TRADE to create more diverse customer experiences and products, which will help generate more expenditure per visitor—a preferable outcome than more tourists but lower expenditures per visitor. Third, to refresh Kenya’s brand image and repositioning it as an upmarket, sustainable destination. And finally, to develop enablers, including unlocking innovative sources of funding and optimizing the adoption of digital innovations and new technologies in the subsector to provide a more seamless digital experience for users, e.g., digital payments and ticketing at the national parks. To achieve this, the Government plans to develop new and improved experiences in parks and reserves, strengthen coastal beach tourism, create and promote niche experiences (e.g., marathon running with elite Kenyan athletes), and develop enablers for the sector such as digital systems, sustainability standards, and improved sector financing. The Government is looking to diversify it tourist clientele, by developing new and existing international source markets (such as high-income markets such as China, UAE, and Saudi Arabia), scaling the domestic tourism market and attracting more regional tourists. As such, the New Tourism Strategy addresses many of the key challenges in the subsector, particularly the need to diversify experiences and integrate technology more effectively into the subsector. The new strategy marks a shift from a previous focus on expanding the number of tourists to providing a better quality, higher-valued experience. There are deep risks when the focus is on tourist numbers rather than tourist revenue, as this can undermine the industry and diminish the subsector’s potential. Problems of congestion, overcrowding, and ecosystem degradation will inevitably worsen as more tourists crowd into diminishing and degraded habitats, eventually leading to a decline in visitor experience and reputation. Conversely, Kenya could leverage the global significance of its rich biodiversity and many protected areas. Especially when coupled with its growing digital services capabilities and emergence as a regional hub, Kenya may have an opportunity to develop an international comparative advantage in tourism, further contributing to sustainable, inclusive growth. https://tourism.go.ke/wp-content/uploads/2022/10/New-Tourism-Strategy-for-Kenya-2021-2025.pdf. 62 KENYA COUNTRY ECONOMIC MEMORANDUM 73 FDI has been increasing, mostly due to global innovator services Attracting FDI is critical to further stimulate Kenya’s international services sector, and through linkages helps to boost the productivity of domestic firms. FDI is not only a form of trade in services itself but is also a major driver of sectoral development by raising capital, stimulating exports, and boosting productivity. The role of multinational enterprises (MNEs) is especially pronounced in the exports of knowledge-intensive goods and services, where they account for up to 90 percent of global exports (Qiang, Liu and Steenbergen 2021). This suggests that attracting FDI is essential to stimulating the global innovator services sector.63 Kenya has significantly increased its FDI inflows in services, driven in large part by global innovator services. Analysis using greenfield FDI announcements64 shows that Kenya has seen a significant increase in services FDI (Figure 5.11), rising from 30 percent in 2003–2007 to 52 percent of total greenfield FDI announcements in 2018– 2022, during which time total inward greenfield FDI announcements increased almost sixfold (from US$1.8 billion to US$10.5 billion). Most of this is driven by investment in global innovator services, which made up almost three- quarters of all services FDI in 2008–2012 and 2018–2022 (Figure 5.12). Low-skilled tradable services were initially more than half of FDI in the early part of the period under assessment (2003–2007), but this has since dropped significantly, and more recently constituted less than 20 percent of services FDI in 2018–2022. Figure 5.11: Greenfield FDI in services has increased Figure 5.12: Most of the increase was due to global innovator services Total greenfield FDI announced by sector (percent and US$ million), 2003–2022 Share of FDI in services by category (percent), 2003–2022 100 12,000 100 75 9,000 75 Shaed FDI announced Total FDI announced (USD million) TRADE 50 50 6,000 25 25 3,000 0 0 - 2003-2007 2008-2012 2013-2017 2018-2022 2003-2007 2008-2012 2013-2017 2018-2022 Global innovator services Low-skill tradable services Agriculture Industry Services Total FDI Low-skill domestic services Skill-intensive social services Source: World Bank calculations, based on greenfield FDI announcement from Source: World Bank calculations, based on greenfield FDI announcement from fDi Markets. fDi Markets. Foreign investors are creating significant new jobs in both global innovator services and low-skilled domestic services, though the employment-intensity of investment differs significantly across sectors. When considering services subsectors, much of the FDI from global innovator services is in information and communication, real estate, finance, and professional services (Figure 5.13). However, there is a notable difference in the employment-intensity of such investments. The largest job-creators are in information and real estate (global innovator services) and wholesale and retail (low-skilled domestic services). Many other subsectors, such as finance, transport, and professional services, offer far fewer jobs, although as discussed in Chapter 3 (“Link”) the development of these subsectors may spill over into the performance of other sectors, and therefore jobs and opportunities in the wider economy. 63 For example, Costa Rica’s ability to attract pioneering FDI (such as Intel) allowed the country to transform its exports from primary products to more knowledge-intensive activities, including software and medical devices. For more information, see OECD Development Center “Attracting Knowledge-Intensive FDI To Costa Rica: Challenges And Policy Options” (2012). 64 Data from FDI markets are based on announcements in newspaper articles, and constitute a proxy of FDI flows. 74 KENYA COUNTRY ECONOMIC MEMORANDUM Figure 5.13: There are differences in the employment-intensity of FDI across subsectors, with ICT, real estate, and retail creating the most jobs Greenfield FDI and Greenfield FDI-related jobs announced by subsector, 2018–2022 10,000 Professional, scienti c Information and Real estate activities communication and technical activities Transportation and storage Total FDI announced 1,000 Financial and insurance activities (USD million) Accommodation and food service activities 100 Education Wholesale and retail trade; Administrative and support service activities repair of motor vehicles and motorcycles 10 Human health and social work activities Arts, entertainment and recreation 1 - 1,000 2,000 3,000 4,000 Number of new jobs announced Global innovator services Low-skill domestic services Low-skill tradable services Skill-intensive social services Source: World Bank calculations, based on greenfield FDI announcements from fDi Markets. Kenya is also growing its position as an investor in other countries, both inside and outside the EAC. Outward FDI in services peaked at US$2 billion (2013–2017) and has since decreased to around US$1.3 billion (Figure 5.14). Much of this initial growth was driven by investments in other countries in the East African Community (EAC)—up to 80 percent in 2008–2012. But in recent years, Kenya has invested more in the rest of the world. Overall, between 2003 and 2022 more than three-quarters of outward FDI in services were in global innovator services (Figure 5.15). This is driven by finance, computer programming and information services (at 29, 20 and 6 percent of outward FDI in services, respectively). Figure 5.14: Outward FDI peaked between 2013 and 2017 Figure 5.15: Global innovator services formed the largest share of outward FDI TRADE Total outward FDI in services, US$ million Share of outward FDI in services by category 2,500 100 76% 2,000 75 1,500 Percent 50 1,000 25 500 16% 6% 1% 0 - Global Low-skill Low-skill Social-intensive 2003-2007 2008-2012 2013-2017 2018-2022 innovator tradable domestic social services EAC Rest of world services services services Source: World Bank calculations, based on greenfield FDI Source: World Bank calculations, based on greenfield FDI announcement announcements from fDi Markets. from fDi Markets. KENYA COUNTRY ECONOMIC MEMORANDUM 75 Removing services trade and investment restrictions in Kenya can yield sizable benefits Policy considerations and international evidence on services trade restrictions Governments face complex choices in regulating the services sector. They need to strike the right balance between the benefits of regulation in correcting for market failures, and the costs stemming from the limitation of market entry. Regulation often stems from legitimate aims to stimulate network externalities in scarce distribution networks (e.g., in finance, transport and telecommunications), or to handle problems of asymmetric information related to service provider quality (e.g., the competence of doctors, the safety of transport services, or the soundness of banks) (Francois and Hoekman 2010). Regulation can also impose barriers that protect domestic incumbents from foreign entry. This creates a complex political economy situation (Hoekman et al. 2007). While the benefits from liberalization are diffused among many, the losses affect a small number of producers, which thus are more likely to organize themselves against the policy change (Olson 1965). Policy makers may therefore be inclined to regulatory “overshooting” that offers excessive protection to a small group of (well-connected) firms, at the expense of the country’s other firms and households. Another challenge to liberalization is that policy makers are immediately faced with the costs (increased competition), yet would only see benefits emerge in the medium term (such as job creation in exporting competing sectors) (de Cordoba et al. 2006). This creates a bias in favor of the status quo and can make reform of services regulations politically difficult to engineer (Fernandez and Rodrik 1991). Services restrictions create large costs for firms. Evidence from OECD countries shows high ad valorem trade cost equivalents65 of services restrictions (Figure 5.16). Services market access restrictions (Mode 1) and movement of customers abroad (Mode 2) offer some costs to firms. However, the most important services restrictions arise TRADE behind country borders, and are related to the commercial presence of foreign businesses (Mode 3) and the natural presence of persons (Mode 4), both incurring restrictions that are equivalent to a 10 percent tariff. The main costs are not related to establishment (or formal entry of firms) but to their ability to operate in the market. There is also an important complementarity between the modes, so that all modes jointly capture an average restriction of 28 percent trade cost. Countries should thus aim to liberalize both areas concurrently to maximize the resulting benefits to the domestic economy. Restrictions to (services) FDI may also result in high forgone investment. Shepherd et al. (2022) find that there is a strong negative relationship between a country’s FDI restrictiveness and its overall FDI inward stock per capita (Figure 5.17). Mistura and Roulet (2019) identify similar results, using an augmented gravity model for 60 advanced and emerging countries to find that liberalizing FDI restrictions by about 10 percent (as measured by the OECD FDI Restrictiveness Index) can increase bilateral FDI in stocks by 2.1 percent on average. These effects were largest for FDI in the services sector. Similarly, Borchert, Gootiiz and Mattoo (2012) find that foreign equity restrictions, discrimination in licensing, restrictions on the repatriation of earnings, and lack of legal recourse all have significant and sizable negative effects, reducing the expected value of sectoral foreign investment by US$2.2 billion over a seven-year period, compared with “open” policy regimes. In addition, Kox (2019) uses a gravity model and finds that if the Philippines opened up its services sector, this would bring in almost US$8 billion in FDI. 65 This is equivalent to how high a tariff-like instrument would need to be to produce a similar trade-depressing effect. Ad valorem equivalents are expressed as a percentage of the value of services provided abroad. 76 KENYA COUNTRY ECONOMIC MEMORANDUM Figure 5.16: Services restrictions create large trade costs Figure 5.17: Service restrictions are also related to a reduction of FDI Estimated trade cost by type of service restrictions Relationship between restrictiveness and FDI inward stock 30 15 R^2= 0.20 FDI instock per capita (Logged) 20 10 Percent 10 5 0 All modes Modes 1/2 Mode 3 Mode 4 Establishment Operations 0 0 .2 .4 .6 Mode Type OECD FDI restrictiveness index (Open = 0, Closed = 1) Note: based on firm-level data from Finland, Germany, Japan and the US. Source: Shepherd, Steenbergen and Catangui (2022) for the years 2003, 2006, Source: World Bank adjusted from OECD, 2017. 2010, 2013 and 2017. Services liberalization can help targeted services sector grow. For a sample of 86 developing countries over the period 1985–1999, those which opened their financial and telecommunications subsectors grew, on average, 1.5 percentage points faster than other countries (Mattoo, Rathindran, and Subramanian 2006). Similarly, Eschenbach and Hoekman (2006) find that for a sample of 20 transition economies in the period 1990–2004, enabling entry of FDI in select services subsectors (finance, power, transport and telecommunications) is associated with large new investments in those subsectors, and provides a statistically significant explanatory variables for their post-1990 economic performance. TRADE More recent country-level studies suggest services liberalization can significantly raise total factor productivity.66 Productivity improvements, in turn, enable countries to stimulate a sector’s exports, output and employment (Van der Marel 2012). Arnold et al. (2016) show that for Indian firms, a single standard-deviation increase in the OECD’s Services Restrictiveness Index resulted in a productivity increase of 11.7 percent for domestic firms and 13.2 percent for foreign firms. Similarly, Hoekman and Shepherd (2017) find that a 1 percent decline in the World Bank’s Services Restrictiveness Index is associated with a 0.5 percent increase in the value of bilateral merchandise trade. They estimate that if east African countries liberalized services in line with regional best practice (Ghana), their exports could increase by over 10 percent. In sum, the economic impacts of services liberalization are often both significant and sizable. The potential benefits of removing services restrictions in Kenya The most comprehensive assessment of services restrictions comes from the World Bank and the World Trade Organization’s Services Trade Restrictiveness Index (STRI), which was updated in February 2023. This assessment is based on surveys that are completed by local law offices. It covers 35 services sectors and is available for all African countries. The STRI captures such restrictions in a score from 0–100: • 0 = Completely open; • 25 = Virtually open with minor restrictions; • 50 = Major restrictions; • 75 = Virtually closed with limited opportunities to enter and operate; and • 100 = Completely closed. 66 See for example Arnold et al. (2011) for the Czech Republic, Bas (2014) for India, and Duggan et al. (2013) for Indonesia, as well as for OECD countries (Barone and Cingano 2011; Bourlès et al. 2013). KENYA COUNTRY ECONOMIC MEMORANDUM 77 The STRI suggests that Kenya’s services sector still faces pervasive restrictions that often exceed those in the rest of the EAC. In cross-border supply (mode 1), Kenya’s financial services, business services,67 and tourism subsectors are classified as virtually closed, and significantly exceed EAC average restriction levels (Figure 5.18). Finance and business services are also more restricted than the EAC average in commercial presence (mode 3) and movement of workers (mode 4), often with major restrictions in place. In contrast, telecommunication, and transportation68 services are generally more open in Kenya versus the rest of the EAC, although these subsectors are also subject to important regulatory weaknesses that restrict entry and competition (such as spectrum allocation in the case of telecoms). Figure 5.18: Several services subsectors in Kenya are virtually closed and Kenyan service restrictions often exceed those in the rest of the EAC Services Trade Restriction Index (STRI), by mode of supply, 2022 (higher score indicates more restricted) (a) Mode 1 (cross-border supply) (b) Mode 3 (commercial presence / FDI) (c) Mode 4 (movement of workers) 100 100 100 75 75 75 50 50 50 25 25 25 0 0 0 Financial services Business services Tourism Communication Transportation Financial services Business services Tourism Communication Transportation Financial services Business services Tourism Communication Transportation Kenya EAC Kenya EAC Kenya EAC Source: World Bank calculations using WTO–WB Services Trade Restrictiveness Index, 2022. TRADE Simulations of the implementation of the African Continental Free Trade Area (AfCFTA) suggest that services liberalization could confer significant benefits to Kenya. The AfCFTA is a continent-wide free trade agreement whose main objective is the creation of a single market for goods and services to deepen the economic integration of the African continent. Kenya was one of the first two African countries (along with Ghana), to deposit its instruments of ratification of the AfCFTA in 2018, demonstrating leadership and commitment to the landmark free trade agreement. However, this also comes with key obligations, and realizing the potential benefits would require implementation of an ambitious trade-oriented reform agenda. The agreement aims to progressively reduce tariffs on intracontinental trade. It also sets out to reduce nontariff barriers (NTBs) on goods and services (at minimum on a most-favored nation basis, but countries can provide more ambitious offers). It also mandates countries to adopt trade facilitation measures. Kenya would be one of the biggest beneficiaries from adopting these three sets of measures, with a 12-percent expected increase in income (Figure 5.19). The biggest gains are not from tariff reductions, but from lowering NTBs and better facilitating trade—measures directly affecting services (World Bank 2020). 67 Business services include accounting, architecture, engineering, legal services and computer services. 68 Transportation services include air, road and maritime transport services. 78 KENYA COUNTRY ECONOMIC MEMORANDUM Figure 5.19: Real income gains under the AfCFTA trade scenario compared with the baseline, 2035 16 14 12 Percentage change 10 8 6 4 2 0 -2 . s p. l r i ire e ny a ia ni a ep pi a oo n co as o TA iu sia an a ga an a bi a ria ric a da da ca qu e w Ivo bw ib za .R io oc CF rit Re ni ne ge Af an an as bi ala ’ ba Ke m n h er or aF f au b Tu Gh Se sw Za m Ni Ug Rw g eD m Na Ta em Et am M kin lA M Ar a ot ut h da am M t Zi D C r ta t, B So a oz Co g o, Bu To yp M M C on Eg Tari s, NTBs, and TF Tari s and NTBs Tari s only Source: World Bank 2020. Note: Kenya is highlighted in light-yellow for clarity. AfCFTA = African Continental Free Trade Area; NTBs = nontariff barriers; TF = trade facilitation. Additional simulations, capturing the impact of the AfCFTA on trade and FDI, show even larger benefits for Kenya. Echandi, Maliszewska and Steenbergen (2022) build on the initial World Bank study by simulating additional gains to be reaped if members expand the agreement to harmonize policies on investment, competition, e-commerce, and intellectual property rights. Deeper integration would build markets, improve competitiveness, and attract further FDI flows by reducing political and regulatory risk, and raising investor confidence.69 Overall, deep integration if implemented is found to provide significant benefits to Kenya vis-à-vis a baseline scenario (Echandi, Maliszewska and Steenbergen 2022): • Exports are predicted to be 40 percent higher by 2035; TRADE • FDI stock is predicted to be 92 percent higher by 2035; • Formal jobs are predicted to grow by 2.6 percent by 2035; • Formal wages are predicted to increase by 22.9 percent by 2035; • Income is predicted to increase by 12.8 percent by 2035; and • Real GDP is predicted to be 4.9 percent higher by 2035. Kenya’s services sector is found to be the biggest beneficiary sector of the AfCFTA—with simulations predicting sizable increases in output and employment. The deep integration scenario is estimated to expand Kenya’s output in two main services sectors—other services70 (US$6 billion), and air transport (US$4 billion), as well offering benefits in agriculture (US$4 billion) (Figure 5.20a). The AfCFTA is also expected to have significant implications on where people work, as 450,000 jobs are expected to shift, mostly to other services (+270,000), agriculture (+230,000) and air transport (+51,000). In the case of other services, most jobs are likely to go to higher-educated employees (+229,000), and there would also be more opportunities for lower-educated workers (+42,000) (Figure 5.20b). 69 This is modelled via an FDI gravity model to simulate the impacts of deep trade agreements on all countries on the continent. This is incorporated in a computable general equilibrium (CGE) model and micro-simulations model to identify impacts on output and employment. 70 Other services include a broad set of services, including administrative and support service activities, as well as recreation, health, education, public administration and defense and compulsory social security. KENYA COUNTRY ECONOMIC MEMORANDUM 79 Figure 5.20: Simulations of trade liberalization as a result of the AfCFTA suggest sizable increases in output and employment in the services sector Simulated effect of the AfCFTA on Kenya’s output and employment versus baseline, by 2035 (a) Effect of the AfCFTA on output by sector (US$ billion) (b) Effect of the AfCFTA on employment by subsector (thousands) -6.0 -4.0 -2.0 0.0 2.0 4.0 6.0 8.0 -151 -50 50 150 250 Agriculture 3.8 231 Fossil fuels 0.0 0 Minerals n.e.s. 0.0 0 Processed foods 1.1 -68 Wood and paper products -2.4 -93 Textiles and wearing apparel 1.1 12 Energy intensive manufactuing -3.8 -94 Petroleum, coal products 0.4 0 Chemical, rubber, plastic products -1.9 -47 Manufactures, n.e.s. -2.4 -56 Construction 0.4 22 Trade 0.0 -30 Road and rail transport 0.0 -15 Water transport 0.1 2 Air transports 2.6 51 Communication -1.8 -91 Othe nancial 0.2 -4 Insurance, real estate 0.2 4 Other business services -1.1 -64 Hospitality -0.2 -30 Other services 6.5 270 Female, unskilled Female, skilled Male, unskilled Male, skilled Source: World Bank calculations, based on Echandi, Maliszewska and Steenbergen (2022). An ambitious agenda – Kenya’s offer to liberalize services under the AfCFTA TRADE To realize the benefits from the AfCFTA, Kenya needs to aligns its national laws and regulations with the AfCFTA, which may require significant reform in the case of the services sector. The AfCFTA trade in services protocol is calling for the progressive liberalization of services based on a “WTO plus” positive lists, plus offer exchanges by Member States. The EAC Member States have produced a joint services “offer”, in which each country commits to partially or completely opening its markets in the five AfCFTA priority sectors.71 The draft offer was completed in July 2022 and is expected to be formally adopted by the EAC Council of Ministers in 2023. This will likely have significant implications for Kenya’s national laws and regulations. Table 5.1 compares Kenya’s services restrictions (from the STRI) versus their AfCFTA services offer. This shows that for cross-border supply, there are many sectors that are currently virtually or completely restricted, but for which Kenya is committing to full liberalization (especially in business services, communication, finance and tourism). For commercial presence, Kenya has mostly offered partial liberalization (providing a commitment to liberalize, while maintaining specific restrictions, such as joint-venture requirements, maximum foreign shareholding of 51 percent, or requirements to incorporate locally as a limited liability company). No offer is made for the movement of foreign workers. Kenya has thus committed itself to an ambitious agenda of services liberalization. Going forward, it is vital for the Government to consider reviewing and potentially amending all the relevant laws and regulations that may be restricting the services sector for which it has an offer to partially or completely liberalize. As a first step, a detailed implementation plan should be adopted that includes the timeline for reform, and the key steps to be taken (including legal review, and private sector consultations). This lays the groundwork for starting the difficult but likely rewarding (see Box 5.2) path to stimulating Kenya’s international trade and investment in services. 71 These sectors are Business, Communication, Finance, Transport and Tourism. 80 KENYA COUNTRY ECONOMIC MEMORANDUM Table 5.1: Kenya’s services restrictions versus the AfCFTA offer M1 M3 M4 (Cross-border (Commercial (Foreign AfCFTA sector Detailed sector supply) presence / FDI) Workers) STRI AfCFTA STRI AfCFTA STRI AfCFTA Score Offer Score Offer Score Offer Accounting services 100 Fully Open 45 Fully Open 54 No Change Architecture services 100 No Change 25 Partially Open 57 No Change Business services Computer and related services 50 Fully Open 31 Partially Open 36 No Change Engineering services 100 Fully Open 34 Partially Open 54 No Change Legal services 50 No Change 25 No Change 33 No Change Fixed-line telecommunication 54 Fully Open 42 Partially Open 31 No Change Internet services 52 No Change 39 Partially Open 31 No Change Communication Mobile telecommunication 52 Fully Open 39 Partially Open 31 No Change Postal and courier services 82 No Change 57 No Change 37 No Change Auditing services 100 No Change 45 Partially Open 54 No Change Commercial banking 52 Fully Open 57 Partially Open 31 No Change Financial Services Life insurance 100 No Change 54 Partially Open 31 No Change Non-life insurance 100 No Change 54 Fully Open 31 No Change Reinsurance and retrocession 82 Fully Open 52 Partially Open 31 No Change Air freight international 42 No Change 50 No Change 28 No Change Air passenger international 85 No Change 50 No Change 28 No Change TRADE Maritime auxiliary services 25 No Change 31 Partially Open 31 No Change Transport Maritime freight transport 25 No Change 35 Partially Open 28 No Change Rail: Freight transport 31 Fully Open 77 Partially Open 28 No Change Road: Freight transport 25 Fully Open 32 Partially Open 34 No Change Air freight international 42 No Change 50 No Change 28 No Change Hotel and lodging services 50 Fully Open 31 Fully Open 31 No Change Tourism Travel agencies/tour operators 100 Fully Open 31 Fully Open 31 No Change Source: World Bank calculations using WTO-WB Services Trade Restrictiveness Index, 2022 and EAC AfCFTA Services Offer (22 July 2022). Note: STRI ranges from 0 (fully open) to 100 (fully closed). Red signifies a sector that has major restrictions or is completely closed and for which Kenya has an offer to liberalize, yellow signifies a sector that has minor restrictions and for which Kenya has an offer to liberalize. AfCFTA Services offer “Partially Open” refers to a commitment to liberalize while maintaining specific restrictions, such as joint venture requirements, maximum foreign shareholding of 51 percent, or requirements to incorporate locally as a limited liability company. KENYA COUNTRY ECONOMIC MEMORANDUM 81 Box 5.2 Kenya’s strong services trade potential: the “face-to-face” perspective72 Kenya has strong potential to trade services remotely, as its service sector relies very little on face-to- face interactions with consumers. The relative intensity of face-to-face interactions with consumers among services and other industries can be calculated.71 The resultant score is based on the inherent tasks embodied in a sector and can be interpreted as the potential for tradability, regardless of whether a sector is already engaging in trade. Notably, Kenya has the second-lowest overall score among peers (Figure 5.21). Hence, Kenya’s services sector has great potential to deliver services remotely and trade them across borders. This result is driven in part by the transportation and ICT subsectors, which have a combination of low face-to-face intensity and notable industry shares in Kenya (Figure 5.22). Figure 5.21: Kenya’s services sector requires a low degree of face- Figure 5.22: The low face-to-face score is driven by ICT to-face interactions, implying high tradability and transportation services Average intensity of face-to-face interactions by country Average intensity of face-to-face interactions and industry shares, by Industry for Kenya Hospitality 58 57 .8 Arts & recreation 57 56 Wholesale & retail 56 55 55 Health 54 .6 Other services Finance Education Real Estate F2F score 52 .4 Public services 50 50 Administrative 50 49 49 Transport & warehousing ICT Agriculture 48 .2 Professional 46 Water Construction Electric 0 Mining Manufacturing 44 PHL THA IDN VNM MYS USA IND KEN ZAF 0 5 10 15 20 Industry share TRADE Source: Avdiu and Nayyar (2020), OECD Input-Output Tables (2020) and Kenyan Source: Avdiu and Nayyar (2020), OECD Input-Output Tables (2020) and Kenyan GDP data (2021). GDP data (2021). Digital trade in services is ever more essential to Kenya’s economic growth Kenya stands to gain from more trade in the digital sector. Chapter 2 (“Shift”) highlighted how Kenya is emerging as a hub for exporting digital services, with exports growing at a rate of 15 percent between 2006 and 2021, and now accounting for one-third of Kenya’s services exports. This recent growth of digital trade has been positive for economic performance, expanding high value-added and therefore well-paid jobs and fostering innovation. For instance, Kenya’s increasing outward FDI, led by ICT and financial services, allows Kenyan firms to expand and diversify into markets across the region, boosting sales and facilitating access to new technologies and skills, while also increasing domestic employment and revenue. Untapped potential remains for cross-border services trade to grow further: digital services now account for one-third of Kenya’s services exports, but this is still far below the 60 percent share for South Africa and the 50 percent global average for developing countries (about 40 percent, pre-pandemic). Valuable opportunities likely remain in eastern Africa as well as in international markets (beyond Africa) from the further internationalization of Kenya’s digital subsector. Kenya’s leading services companies are not the only ones engaged in digital trade: Kenyans are also gaining revenue from cross-border services. Kenya is increasingly tapping into the gig economy, where close to half of all online jobs are accounted for by writing and translation. In recent years, the contribution of software development and technology jobs has also increased (Figure 5.23). Online gigs (as opposed to “offline gigs”, that are transacted 71 Here the task-based scores are at sectoral level, using US data. The country-specific data comes the sectoral distributions in each country. 82 KENYA COUNTRY ECONOMIC MEMORANDUM digitally but delivered physically, such as ride hailing) are particularly attractive to young Kenyans, who benefit from such engagements to support studies or complement other sources of income. While Kenyan services providers do face strong competition in global platforms such as Upwork and Freelancer.com, online gigs also foster the expansion of skills by offering opportunities to gain experience and for upskilling, and generating incentives and opportunities to gain qualifications, often leading to workers pursuing further education, either online or offline, to upgrade their digital services (Mercy Corps 2019). Figure 5.23: Software development and technology are accounting for an increasing share of online jobs Kenyan shares of online jobs (percent) 100 90 80 70 60 50 40 30 20 10 0 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 2019 2020 2021 2022 2023 Clerical and data entry Creative and multimedia Professional services Sales and marketing support Software development and technology Writing and translation Source: World Bank calculations, using Online Labor Index data. Kenya can play a leading role on discussions on digital trade governance As digital trade in goods and services grows in value around the world, so does the need for a common rules framework. The naturally global expansion of the internet and the boom of digital trade seen in the past TRADE two decades outpaced the development of a multilateral governance framework for digital technologies. Trade agreements, most following a design of the early 1990s, did not feature specific disciplines for transactions performed over digital channels.72 Building on a 1998 WTO declaration reflecting a temporary commitment not to impose custom duties on “electronic transmissions”, it was only in 2000 that a bilateral trade agreement (Australia– Singapore FTA) included an explicit standalone chapter to address matters related to e-commerce. Since then, chapters on digital trade have multiplied in number to become standard in trade agreements, and have expanded in scope to include provisions on various aspects of digital trade. At the multilateral level, disciplines on digital trade remain work in progress. The WTO’s Joint Statement Initiative (JSI) negotiations on e-commerce is a plurilateral effort involving over 80 WTO member countries, aiming to create a comprehensive framework for global digital trade. Launched in 2017 during the 11th WTO Ministerial Conference, the JSI negotiations focus on key areas such as market access, cross-border data flows, data localization, consumer protection, privacy, and cybersecurity. Highlighting the importance that the Government places on digital trade, Kenya is one of only a handful of African countries to request to join these discussions. While the membership to the JSI e-commerce negotiations has been growing since their launch and some texts are considered agreed, discussions remain open on the most sensitive areas of the agreements. Kenya has an opportunity to shape disciplines on digital trade in Africa. Most African countries, including Kenya, have yet to sign a trade agreement featuring substantial rules on digital trade. However, several initiatives are in place to cover this gap. At the continental level, the African Union (AU) launched in 2020 the Digital Transformation 72 WTO Members agreed in 1998 to a temporary commitment not to impose custom duties on “electronic transmissions”. KENYA COUNTRY ECONOMIC MEMORANDUM 83 Strategy (AUDTS), which ultimately envisions the creation of a single digital market in Africa. Furthermore, with a view to promoting intra-African trade and economic integration, the AfCFTA calls for negotiations of a protocol on e-commerce to provide a comprehensive framework for digital trade across Africa. Beyond these continental initiatives, Kenya is advancing further on digital trade regulation in the Eastern Africa Community (EAC), with the adoption of an EAC E-Commerce Strategy, which calls for the creation of “a regional zone with unrestricted data flows, transferability and protection” through harmonized regulation. Kenya plays a key role leading these sub- regional discussions, which can provide an important platform for agreeing to new policies with a smaller group of like-minded partners that can later inform and influence broader continental efforts. Kenya has advanced substantially in building an enabling environment for digital trade Kenya’s strong performance in digital trade builds on Figure 5.24: Kenya’s performance on network readiness is well above its income level and the African average an environment of reliable connectivity, supportive Network Readiness Indicator scores, 2022 government policies and regulation, and a tech-savvy NRI population. Portulans Institute’s Network Readiness Index (NRI) captures this progress on the different aspects of the digital economy, highlighting that Kenya Impact Tanzania Technology Kenya’s performance is well above its income level and Nigeria the African average, and on a par with South Africa South Africa Lower-middle on most variables (Figure 5.24). Within this composite income countries index, the indicators where Kenya performs particularly Africa well are e-commerce legislation, international internet Governance People bandwidth, and online access to financial accounts TRADE (Portulans Institute 2022). Source: Portulans Institute. Network Readiness Index 2022. The ecosystem for digital trade rests on solid connectivity and supporting policies for the ICT subsector. Over the past three decades Kenya has developed a robust digital connectivity infrastructure, particularly in urban areas, that has resulted in increased internet adoption, uptake of digital devices, and mobile money innovations. Internet penetration in Kenya has grown exponentially over the past 15 years, reaching about 87 percent in 2021. The Government has played a crucial role in fostering the growth of the digital sector, including through the launch of the National ICT Masterplan in 2013, and the establishment of innovation hubs such as Konza Technopolis, which have facilitated a supportive environment for tech startups and digital innovation. Kenya has been among the pioneers of a comprehensive regulatory framework for digital trade. Kenya has been among the pioneers on the continent in passing comprehensive regulations on digital trade. Figure 5.25, based on the assessment of over 90 regulatory solutions across 10 policy pillars, shows Kenya providing the most advanced regulations for digital trade in Eastern Africa (though slightly behind Rwanda and Uganda, which have recently advanced in adopting key regulations for digital trade), and in the top 10 across the 26 reviewed African countries. 84 KENYA COUNTRY ECONOMIC MEMORANDUM Figure 5.25: Within Eastern Africa, Kenya is one of the countries providing the most advanced regulations for digital trade Digital Trade Regulatory Readiness a) African countries b) b) Eastern Africa and selected comparators 0 5 10 15 20 25 30 35 40 45 50 South Africa Rwanda Ghana Uganda Morocco Kenya Egypt Nigeria Tanzania Ethiopia South Sudan Electronic documents Electronic signature & digital ID Paperless trade Electronic payments Online consumer protection Personal data protection Arti cial intelligence Cybersecurity & cybercrime Cross border Intermediary liability Source: World Bank calculations. Ahead of most of its peers, Kenya has advanced in the adoption of rules for digital trade across most of the key policies, but most remain work in progress. A modern and comprehensive regulatory framework for digital trade is essential to establish the legal tools necessary for remote contracts, clarifying the rights and obligations of the multiple actors involved in digital transactions, and promoting trust in digital markets, especially when the TRADE consumer does not know the merchant or when the latter is in a different country (World Bank 2021). Table 5.2 shows that Kenya, together with Rwanda, has advanced regulation in multiple policy areas relative to its regional partners, including on cybersecurity, personal data protection, and the legal liability of platforms for content generated by their users (“intermediary liability”). Kenya has also put in place rules on areas such as artificial intelligence, electronic signatures, and cross-border data flows. Table 5.2: Kenya has advanced regulation relative to its regional partners, including on cybersecurity, personal data protection and intermediary liability Digital Trade Regulatory Readiness scores across policy areas Regulation on electronic transactions Trust-building regulations Platform regulations Cyber security & cyber crime Personal data Process trade Intermediary Cross border intelligence signature & documents Electronics protection protection payments consumer Electronic Electronic digital ID Artificial liability Online Kenya Ethiopia Rwanda Somalia South Sudan Tanzania Uganda Ghana Nigeria South Africa Egypt Morocco Source: World Bank calculations. Note: 0–100% score percentage over full score for that policy area. Size of boxes indicates value of full score in each policy area KENYA COUNTRY ECONOMIC MEMORANDUM 85 Building on existing accomplishments, major efforts are still necessary to offer a modern, enabling regulatory environment for the further development of digital trade Despite its considerable comparative progress, Kenya’s framework for digital trade remains a work in progress. Most of Kenya’s regulations are only partial revised or remain out-of-date with regards to the best regulatory practice in each policy area. In the comparative review, only the regulations on electronic documentation and on the protection of personal data, even if space for some updating remains, offer frameworks that are modern and comprehensive enough to receive over 75 percent of the full score for those policy areas (Table 5.2). All other policies range from about half the full scores (e.g., cybersecurity and rules for cross-border data), to the complete absence of any such rules (e.g., rules on paperless trade), suggesting that major steps are still necessary to enhance Kenya’s regulatory framework for digital trade. For example, Kenya’s framework for online consumer protection includes only provisions setting out some basic safeguards, such as the right to cancel the transaction (“right of withdrawal”), essentially equating online shoppers to in-person ones, but lack protections tailored to the digital markets (e.g., allowing for such cancelations to be done without any explicit reason, an important safeguard when online consumers are not able to physically inspect the goods before purchase). Substantial regulatory barriers to cross-border data flows hamper digital trade and cross-border services. Restrictions on cross-border data flows can be particularly detrimental to international trade. Because trade in services relies on the global movement of data, including personal data, regulations that require the maintenance or processing of data within a country or a particular region (“data localization requirements”) can be a costly impediment. Mandatory localization requirements reduce imports of data-intensive services in the countries imposing them which, in turn, limits cross-border digital trade flows (World Bank 2021). Table 5.3 lists a series of regulatory measures and whether they are captured in Kenya’s legal framework and that of select comparators. TRADE Notably, Kenya, Rwanda, and Nigeria maintain general limitations aimed at keeping data, especially personal data, stored in locally established servers. While these restrictions, as set out by Kenya (and Nigeria; not so Rwanda) do allow to transfer copies of such data abroad (see Box 5.2), they still entail costly requirements for firms that wish to offer digital services in those countries, and limit access to digital services by domestic firms that may not be able to benefit from cloud-based services, which usually rely on data distributed in various servers in multiple locations around the world. Table 5.3: Regulations on cross-border data requirrement for required 65a. Conditions for cross- 62 explicit rules on cross- 63 no general limitations transferred abroad under 65c. Conditions for cross- on cross-border transfers prior to coss-border data 65d. Conditions fo cross- 65b. Conditions for coss- -Binding corporate rules 66. Conditions fo cross- authority not a general localization is requied, copies of data may be of pesonal data (data border data transfers security assessments border data tansfers: border data tansfers: certain conditions (if BY=1, ==> BZ =1) boderdata transfers: boderdata transfers: 64. Even where data bode data transfers: with government 66. Filing of data -Accountability -Government localization) -Adequacy -Consent transfer Kenya Ethiopia Rwanda Somalia South Sudan Tanzania Uganda Ghana Nigeria South Africa Egypt Morocco Source: World Bank. Note: Dots indicate whether that regulatory solution applies in the country. No dots indicate that no such regulation is found. Dot colors orange vs light green depend on whether those conditions for transfer are subject to data localization requirements. 86 KENYA COUNTRY ECONOMIC MEMORANDUM Box 5.3 Focus on Kenya’s rules on cross-border data Kenya’s regulations allow personal data transfers across its borders, but can require data to be stored in Kenya before the data transfer when certain information triggers localization requirements. In Kenya, not all data must be stored locally. Rather, at least one copy of the data must be stored in a data center in Kenya only if the data being transferred across the border meets a localization requirement. However, health-care data might not be able to be transferred even upon proper storage of data. The Kenyan Data Protection Act of 2019 Section 50 gave the Cabinet Secretary the power to prescribe what data would have localization requirements based on the “strategic interests of the state or protection of revenue.” Two years later, the Data Protection (General) Regulations of 2021 Section 26(2) clarified when data localization requirements would be triggered. First, data localization will be required if the data pertain to national civil registration systems and legal identity management systems, the conduct of elections for the Kenyan Government, systems regarding public finances by State organs, systems designated to protect against cybersecurity threats, early childhood education and basic education, and the processing of health data. Second, the data that relate to such strategic interests must be processed through a server and data center in Kenya. Third, the data center must store at least one copy of the personal data before the transfer. Beyond the listed strategic interests that trigger data localization, the Cabinet Secretary also holds the power to require data localization in certain instances. The Cabinet Secretary may mandate data localization to a specific data controller if: (i) the data controller has not taken measures to handle a known data breach or violation of the Act outside of Kenya; and (ii) the data controller failed to comply with the Data Commissioner in handling the violations or neutralizing the effects. After complying with the storage requirement, however, the data controller should be able to transfer the data again. TRADE In one instance, however, data might not be allowed to be exported, even upon compliance: health- care data. In accordance with the Health Information System Policy, health data cannot be stored outside of Kenyan borders unless given approval by relevant authorities. As the document is currently policy, not law, the policy is not binding; however, until provisions in the law directly pertain to the exportation of health data, courts will likely uphold the policy’s intentions as guidance. Thus, health data should not be transferred outside of Kenyan borders until binding regulations or more information comes to light. Source: World Bank. Advancing toward strong safeguards for personal data, complemented by a flexible regime for cross-border data flows, is central to Kenya’s digital services exports. A review of trade flows of digital services (such as telecommunications, computer, and information services) in 116 countries reveals that country pairs that feature regulation focused on open cross-border data flows achieve higher volumes of trade in digital services than those imposing regulatory conditions for transfers, and even more than those with data restrictions such as data localization requirements. However, domestic data regulations are also found to have a significant effect on trade in digital services. Specifically, having a strong domestic data protection regime for personal data is positively associated with trade flows in digital services, compared with regimes that exercise little government regulation over personal data protection and those that apply tight government controls on domestic use of personal data (World Bank 2021; Ferracane and van der Marel 2021). A robust framework for data protection, together with a flexible and harmonized regime for data sharing within eastern Africa and also outside of the EAC, would help consolidate Kenya’s position as a leading digital services hub in Africa. Ultimately, a single data market in eastern Africa would reduce costs to Kenyan investments in the region, especially for data-intensive services such as finance and telecommunications, by facilitating the regional integration of data processing and storage needs. KENYA COUNTRY ECONOMIC MEMORANDUM 87 A harmonized framework for e-commerce would further boost regional digital services, expanding markets for Kenya’s startup ecosystem. As reflected in Figure 5.25, essential policies for digital trade are only at nascent stage in most East African countries, and SSA in general. For example, the EAC E-Commerce Strategy calls for its members to adopt common principles and regulations in areas such as e-signature, consumer protection, personal data, and electronic payments. This offers the opportunity for EAC countries to advance on those regulations in a coherent and harmonized way, fostering integration and reducing compliance costs across the region. A mutually recognized framework for digital signatures, for instance, allows commercial contracts to be completed and signed remotely, thus reducing costs in time and travel. Similarly, harmonized rules and interoperable standards for personal data may allow collecting and processing data across the region in a seamless manner, again reducing costs while boosting productivity. Kenya, as a regional digital hub may seize this opportunity to take a leading role in the development of these digital policies, modernizing its own regulatory framework while fostering compatible polices in the region. Concluding remarks Trade and investment in services is playing an increasingly important role in Kenya, despite restrictions still being present. Much of the increase has been driven by global innovator services. Services-related FDI is also playing an increasing important role, although realized FDI remains low relative to Kenya’s GDP. Trade in services restrictions – which include FDI restrictions – remain high and are often exceeding those of neighboring countries. Reducing these restrictions – in line with the EAC joint services “offer” as part of AfCFTA – is expected to deliver major benefits. The increased importance of digital trade deserves specific attention, especially with respect to regulations around privacy and data protection. TRADE TRADE: Policy priorities to increase trade and investment Despite growing trade and investment, barriers remain high for services, including for digital trade. Removing barriers – including as part of regional trade agreements – can significantly boost growth. Policy priorities include: • Improve the investment climate, including by facilitating FDI and making the playing field more level. • Reduce restrictions on trade in services and investment, especially in restricted services subsectors, and implement the EAC joint services “offer” as part of the AfCFTA. • Review in particular, with a view to limiting, current data localization requirements, to ensure that Kenya can participate in a single regional data market and take advantage of emerging global digital services trade opportunities. • Implement the EAC E-commerce Strategy and regional harmonization measures. • Improve and streamline domestic regulations, especially in areas such as paperless trade and consumer protection. 88 KENYA COUNTRY ECONOMIC MEMORANDUM CHAPTER 6 SECURE Inclusion by Making the Services Sector Work Better for All Many Kenyans, including those at the bottom of the earnings distribution, rely on the services sector for a living. Making the services sector work better for low-earners, and poor and vulnerable households, is key to improving livelihoods, including by leveraging technologies. The role of services in improving inclusion M any Kenyans earn their livelihoods through low-paid informal work in services. Often as a matter of necessity, people rely on low-skilled work in domestic services sectors such as retail trade or personal services. This work is often characterized by low pay or only subsistence-level earnings, unpredictable incomes, and long working hours. It is often informal, comprising informal self-employment or being an informally-employed worker. Low-skilled services sector work is often considered as a “residual” employment category, particularly in urban areas for those unable to secure a scarce formal manufacturing sector job. This dimension of services in Kenya’s labor market stands in stark contrast with that of global innovator services, which provide some of the best job opportunities in the economy. The further development of high-skilled services, as discussed elsewhere in the CEM, remains relevant even for less-skilled workers, through direct and indirect jobs and growth channels, and also if they expand services that are accessible to, and valued by, the poor and vulnerable. Earlier chapters highlight that even high-skilled services subsectors can create good earning opportunities for less-skilled workers. Chapter 2 (“Shift”) shows that many global innovator services also create income opportunities for workers that are not highly-skilled. Chapter 3 (“Link”) discusses how high-skilled services subsectors create further job opportunities indirectly through linkages. Reforms that contribute to the growth of these subsectors can increase job opportunities along the entire skill distribution. In addition, from a macroeconomic perspective, growth of aggregate output, government revenues, and foreign currency earnings, all rely on the further expansion of more productive services. In turn, macroeconomic and growth performance determine the economic resource envelope available for all Kenyans, making growth vital to prospects for the poor, albeit not sufficient on its own for poverty reduction, given the need to also address inequalities. Finally, the continuing development of digitally-enabled services and innovative business models aimed at underserved communities can also help to meet Kenya’s inclusion challenge by expanding the supply or reducing the price of goods and services consumed by the poor and vulnerable. This chapter focuses specifically on inclusion aspects of services. Inclusion is considered along three dimensions: (i) employment inclusion – improving the economic participation and empowerment of low-income populations, particularly women, but also youth, disabled and refugees; (ii) geographic inclusion – enhancing productivity and economic linkages to rural regions; and (iii) firm inclusion – supporting the capacity and growth of small informal firms and entrepreneurs. For each of the inclusion segments—people, geography, informality— this chapter: (i) describes the services sector solutions that are helping to bridge inclusion gaps; and (ii) provides recommendations to help support the expansion of these services. KENYA COUNTRY ECONOMIC MEMORANDUM 89 Participation in the services sector differs by gender, location and employment type There are large differences in how different segments of Kenyan society participate in the services sector. As Figure 1.1 shows, compared with men, women are significantly more involved in the retail subsector—a low- skilled, low-productivity services subsector. Urban residents are more than twice as likely to be involved in the higher-valued global innovator services than their rural and peri-urban counterparts, while the other shares of services employment are relatively similar across urban, peri-urban and rural areas. Wage employees are more active in higher-skilled activities (41 percent) compared with the self-employed (8 percent), who instead mainly work in retail and other lower-skilled services. Among wage employees, there is an even starker contrast between written contracts (a proxy for formality), 60 percent of which are in the higher-skilled subsectors, whereas just 19 percent of people with no written contracts (a proxy for informality) work in skilled subsectors and, of these, most are in the skilled social subsector rather than global innovators. Figure 6.1: Employment patterns in the services sector differ alongside gender, type of employment and contract, as well as location Employment composition of the services sector, 2019 100 6 7 6 6 5 4 9 9 9 10 8 80 14 29 19 36 36 39 46 29 47 60 57 Percent 40 40 44 51 33 35 33 22 34 50 20 34 27 16 19 15 18 19 11 16 0 5 4 7 3 3 7 35 3 10 3 Male Female Urban Peri-urban Rural Wage Self-employed Contributing Written No written employee familiy contract contract member Type of contract SECURE Gender Location Employment type (wage employees only) Global innovator Social Low-skill tradable Retail Other low-skill domestic Note: See Figure 2.1 and Appendix B for definitions of services subsectors. Global innovator services include ICT, professional/technical and financial services. Low-skilled tradable services include transportation, wholesale and hospitality. Low-skilled domestic services include retail, personal services and administrative and support services. Social services include health and education, but exclude public administration. Type of contract only includes waged employees. Source: World Bank calculations based on KNHS. Women and youth are the two key segments the Government targets for inclusive growth and employment (see Box 6.1). These groups often work in low-productivity services jobs with low earnings. In recent years, through legal and regulatory changes, Kenya has made good advances in closing the gender gap, and its gender discrepancy is not as significant as in other countries in the region. However, women, especially rural woman, remain at higher risk of exclusion. Youth unemployment is also a critical concern in the context of the need for the economy to absorb the hundreds of thousands of youth entering the job market each year. Boosting service sector opportunities will be key for this group. On the regional dimension, there are large differences across regions in the productivity of services. The productivity of the services sector is much higher in urban areas such as Nairobi and Mombasa compared with more rural counties. This partially reflect differences in the sectoral composition across regions, as well as differences in relative prices, but also reflects differences in the productive capabilities of firms. 90 KENYA COUNTRY ECONOMIC MEMORANDUM Figure 6.2: Labor productivity of the services sector varies significantly across regions Labor productivity (value added per worker), 2020 1.4 1.2 1 0.8 0.6 0.4 0.2 0 Tharaka Nithi Kirinyaga Kiambu Taita Taveta Nyamira Nyandarua Isiolo Baringo Migori Meru Muranga Kajiado Elgeyo Marakwet Kakamega Nandi Tana River Makueni West Pokot Garissa Vihiga Marsabit Bungoma Kwale Kisii Bomet Wajir Siaya Samburu Homa Bay Mandera Busia Narok Nairobi Mombasa Kitui Embu Nyeri Nakuru Kisumu Turkana Kericho Uasin -Gishu Machakos Trans Nzoia Laikipia Kili Source: KNBS GCP. Box 6.1 Employment and job outcomes for women and youth Despite progress, women still have worse employment and economic outcomes across the board. Women participate less in the labor market, are generally employed in worse quality jobs with lower salaries, and are less likely to own assets and be entrepreneurs than men; this is particularly true for poor women, those with low levels of education, and those living in rural areas and working in agriculture. Some of these gender differences can be traced back to gaps in educational outcomes, with girls dropping out of school earlier than boys, on average. There are also social- and health-related determinants that disproportionally impact girls and women. Women marry sooner, and teen pregnancy rates are significant, contributing to poorer education and health outcomes and higher rates of poverty. Social norms that allow and sustain this situation also affect women’s overall agency, with women participating less in decision-making, from household decisions SECURE to politics. These disadvantages are particularly acute in rural areas and in the poorest counties of the country. Across all education levels, and across almost every employment type, women earn less than men. Women earn about 62 percent of what men earn (with primary and secondary education) and about 76 percent (for those with no education, or those with tertiary education). In formal wage employment, median earnings for women equal that for men. However, for all other types of employment, women earn less than men, as low as 40 percent of what men earn in formal self-employment. Overall, when controlling for education level, sector of employment, and quality of employment, the gender wage gap is 18 percent.75 Figure 6.3: Gender wage gap by education and employment type a. Median monthly earnings by education b. Median monthly earnings by employment type 50,000 Formal wage 38,000 Formal self Kenya Shilling Upper-tier informal wage Upper-tier informal self 14,100 9,000 Lower-tier informal wage 8,000 5,200 4,000 4,950 Lower-tier informal self None Pimary Secondary Tertiary 0 10,000 20,000 30,000 Male Female Male Female Source: World Bank Kenya Jobs Diagnostic (World Bank 2023a). 75 World Bank (2023a). KENYA COUNTRY ECONOMIC MEMORANDUM 91 Box 6.1 Employment and job outcomes for women and youth Figure 6.4: Labor force participation by age, education and gender, 2019 a. By age and gender b. By education and gender 100 93.4 94.7 94.1 100 90.7 92.1 93.7 94.4 86.9 88.9 74.1 85.1 84.3 75 82.3 81.9 75 78.5 76.4 77.2 73.6 72 57.8 50 50 25 25 0 0 Incomplete Primary Incomplete Secondary Post- 15-24 25-34 35-44 45-54 55+ primary secondary secondary Female Male Female Male Note: Incomplete primary includes those with no formal education, ECE, madrassa/duksis, adult education and incomplete primary. Post-secondary includes those with short-cycle tertiary such as certificate, diploma (1-3 years) as well as vocational, or higher education. Sample covers ages 15-60 and excludes those currently attending school. Source: KCHSP 2019. Source: World Bank Kenya Jobs Diagnostic (World Bank 2023a). At the intersection of youth and women, teen pregnancy and early marriage emerge as critical barriers to girls schooling. Nationally, over 20 percent of adolescent girls start childbearing before reaching adulthood. Teen pregnancy rates are particularly high among girls coming from the poorest households (26 percent of teenagers having begun childbearing in the poorest quintile, against 10 percent in the wealthiest), but the difference between urban and rural areas is small (18.5 percent, against 17.3 in urban areas).76 Child marriage remains widespread, with 23 percent of women between the ages of 20 and 24 reporting that their first marriage was before the age of 18. About 38 percent of girls who have dropped out of secondary school SECURE report that this was due to pregnancy, while nearly 40 percent mention early marriage as a reason. During the COVID-19 pandemic, this situation deteriorated further, with a 40-percent increase in the monthly average of teen pregnancies. As a result, there are gaps in learning levels, with girls underperforming in science, technology, engineering, and mathematics (STEM) subjects, particularly at the secondary level. The gender gap in mathematics and science grows as students progress through the system, putting girls at a disadvantage in pursuing the higher-earning STEM fields for their post-secondary education. A large number of youths enter working age each year, many of whom are unemployed, underemployed, or working in low-productivity jobs. A key issue has been for youth to transition smoothly from school to work. Individuals under the age of 18 who join the workforce almost exclusively join informal lower-skilled, low-earning employment. A small fraction of individuals between the ages of 18 and 21 start entering informal upper-tier and self-employment, and it is only above the age of 21 that a small proportion of individuals start entering formal wage or formal self-employment. Overall, a large majority of people stay in informal, low-earning employment even as the school-to-work transition ends. Rural youth, although they enter employment sooner than urban youth, will often remain in poorer quality employment. Economic empowerment is essential for broader empowerment. Economically empowered women not only benefit from higher incomes, but they also tend to play a more active role in household decision-making and have greater bargaining power in financial choices in the household, contributing to better education and health outcomes for their family members. In addition, targeting actions to empower women economically facilitates the shift in gender norms, which reinforces women’s empowerment. 76 DHS (2022). 92 KENYA COUNTRY ECONOMIC MEMORANDUM Services activities are predominantly informal and take place in small-scale firms Services activities mostly take place in the informal sector and within small-scale establishments, either through self-employment or in small-scale firms. There are over 7.4 million MSMEs in Kenya. Of these, 6.4 million (91 percent) are informal micro establishments, of which 4.8 million are one-person establishments. Informality is prevalent in the economy, as well as in the services sector (Figure 6.5), especially in lower-skilled domestic services such as personal services and retail, as well as in hospitality. An estimated 71 percent of MSMEs in the services sector are operating without a business registration, predominantly in the personal services (83 percent), retail (77 percent) and hospitality subsectors (76 percent). Informal firms are three times as likely than formal MSMEs to operate out of necessity, while 14.46 percent of informal firms indicate that they are operating the business out of necessity rather than out of opportunity (for formal MSMEs this is 5.4 percent). Figure 6.5: Business informality is high in the services Figure 6.6: Formal status explains about 8 percent of the variation subsector in labor productivity of MSMEs, but even after controlling for other factors, much heterogeneity remains Share of MSMEs that do not have a business registration, 2016 Share of variation in labor productivity explained by factors, MSME Survey, 2016 90 81 83 20.0 18.5 80 77 76 70 18.0 60 54 16.0 47 48 50 40 14.0 30 22 21 23 12.0 20 10 9 10.0 8.2 0 8.0 7.2 Manufacturing Construction Personal services Retail and wholesale Real estate Hospitality Transportation Financial and insurance Professional services ICT Administrative and 6.0 5.0 5.1 4.0 2.0 0.6 0.0 e or ics on us d siz ne ct at ist gi bi Se st d Re er an m al ct Co rm Non-services Low-skill Low-skill Global e ra SECURE ag ha Fo domestic tradable innovators m rc Fir ne Ow Note: Registration refers to registration at the Companies Register. See Appendix B Note: The variation explained is measured by the R-squared of a linear regression for definitions of services subsectors. of log value added per worker on firm age and size categories, 2-digit industrial Source: World Bank calculations based on the KNBS MSME Survey (2016). sectors, owner characteristics (gender and educational attainment), region and registration status. Source: World Bank calculations based on the KNBS MSME Survey (2016). Nevertheless, informality is only one aspect of performance and often a symptom of other factors, such as lacking capabilities and limited access to finance. Formal status is one aspect explaining differences in labor productivity, but overall, it explains only about 8 percent of the variation seen in labor productivity across MSMEs (Figure 6.6). On average, informal enterprises are less productive than their formal sector counterparts, but the distribution of labor productivity shows significant heterogeneity within unregistered business and also a significant overlap between formal and informal firms (Figure 6.7). This highlights that there are many other factors playing a role in determining firm performance beyond formal status, including factors related to firm capabilities, as well as access to inputs, including financing. MSMEs need a supportive entrepreneurial ecosystem to grow, innovate, and improve their productivity levels and hire people. This includes addressing constraints they face that prevent them from growing, such as: access to finance; access to technology and supporting the adoption of digital technologies; and improving firm capabilities and entrepreneurial skills. KENYA COUNTRY ECONOMIC MEMORANDUM 93 Figure 6.7: On average, unregistered business are less productive, but there is a significant heterogeneity and overlap between unregistered and registered businesses Distributions of labor productivity (monthly value added per worker), KSh, 2016 (a) Industry (b) Services .8 .8 .6 .6 Density Density .4 .4 .2 .2 0 0 10 100 1,000 10,000 10 100 1,000 10,000 Output per worker (log) Output per worker (log) Unregistered Registered Unregistered Registered Source: World Bank calculations based on the KNBS MSME Survey (2016). Careful targeting of programs and policies is crucial to take into account the heterogeneity of the services sector. Experience from policies and programs supporting growth of firms highlight that impacts tend to be heterogeneous among firms, emphasizing the importance of targeting (Grover, Medvedev and Olafsen 2019). An analysis of the informal sector in Kenya classifying informal MSMEs in different types suggests that a majority of MSMEs look very dissimilar from formal sector firms and also underperform. A smaller group of 14 percent share characteristics with formal sector firms, although some of them still underperform. Depending on the objectives of firm support programs, growth-oriented programs likely have a larger impact on the latter group than the former group. SECURE Box 6.2 Not all the same: classifying Kenyan informal enterprises Machine learning classification algorithms can be used to better understand the heterogeneity of Kenya’s informal sector firms, using the 2016 KNBS MSME survey. This algorithm works as follows: first, using a subset of data, the algorithm gets trained to predict formal status based on the characteristics of the owner (e.g., education) and the practices that they apply (e.g., book-keeping, use of mobile money, advertising practices). Second, the algorithm predicts based on these characteristics whether a firm is formal or not (ignoring the actual formal status). Informal firms that are falsely predicted as formal firms can be considered as resembling formal firms more closely than other informal firms. The resemblance of firms can then also be compared with the firm performance. Such techniques have been used in several context to classify different groups of informality (e.g., in Mozambique, Aga et al. 2021; in Benin, Benhassine et al. 2018; in Sri Lanka, De Mel, McKenzie & Woodruff 2010) and understand better how they differ from their formal sector counterparts. Roughly six out of 10 informal MSMEs (58.4 percent) in the services sector are very dissimilar from formal sector firms (Table 6.1), both in their characteristics and performance (measured by whether the labor productivity is higher than the labor productivity of a median formal firm in the same subsector). Roughly one-third of informal MSMEs does not resemble a formal MSME closely, but nevertheless performs better than the median MSME. Then there is a group of roughly 8.7 percent that resembles formal firms but underperform. Finally, there is a group of informal firms that resemble formal firms and are also high-performing. Understanding the heterogeneity of informality is important for targeting purposes. For the group of low- performing firms with a low resemblance to formal firms, formalization programs might not have a large impact, because there could be other constraints that are more binding for these firms. In fact, firms from this 94 KENYA COUNTRY ECONOMIC MEMORANDUM Box 6.2 Not all the same: classifying Kenyan informal enterprises group are three times more likely to indicate that they operate out of necessity. This group could benefit the most from expanded wage employment opportunities. For the group of firms that are low performing but have a high resemblance to formal firms, formalization programs could potentially be effective, as these firms seem to have the characteristics of formal firms, but nevertheless underperform, which could mean that a lack of formal status is a constraint to growth (e.g., in obtaining access to finance). Considering the group of firms that share characteristics with formal firms and are already performing well, bringing them into the formal system could spur further growth. This group could also consist of firms that operate in the informal sector to avoid paying certain fees, creating an unfair advantage when competing with formal sector firms. In Tunisia, the group of informal firms with a high resemblance to other firms saw the highest benefit of a formalization program (Benhassine et al. 2018). This analysis carries lessons for the selection and targeting of policies and programs. Policies and programs that aim to encourage firm growth might obtain higher returns to the program by applying more selective targeting, for example, on the firms that in their characteristics and practices already look similar to formal sector firms. Table 6.1: Classification of informal MSMEs in Kenya Share of services Share of informal firms non-services informal firms These MSMEs share a low resemblance of owner skills Low performing with low 58.4% 50.5% and practices with formal MSMEs and see performance resemblance that is distinctively below that of the formal sector. These MSMEs share a low resemblance with formal High performing with low 27.6% 39.0% MSMEs, although their performance matches that of resemblance formal MSMEs in their sector. SECURE These MSMEs share many characteristics and practices Low performing with high 8.7% 4.5% with formal MSMEs, but their performance is below the resemblance formal sector. High performing with high These informal MSMEs are similar in their characteristics 5.3% 6.0% resemblance and practices to formal MSMEs and also perform similar. Source: World Bank calculations based on the 2016 MSME Survey (KNBS). Services solutions to foster inclusion in the wider economy Another way in which the services sector matters for inclusion is its potential in fostering inclusion by bringing new technologies and opportunities to economically vulnerable people. Such services rely on digital technology to reach and serve last-mile populations more effectively. This is achieved in a variety of ways, including: (i) easier access to real time information, such as pricing, diagnostics; (ii) lowering payment transactions costs (e.g., mobile money removes the prior need for face-to-face interactions) and payment flexibility (such as pay-as-you go, which makes more expensive products such as off-grid solar systems more affordable over time); (iii) providing credit (e.g., many online micro-lending platforms have been set up in recent years to serve hard to reach populations); (iv) market facilitation (such as connecting buyers to suppliers, logistics coordination to allow for bulk purchasing; and (v) improving analytics (such as improving supply chain management in remote areas by responding to consumers’ feedback through their mobile phones). KENYA COUNTRY ECONOMIC MEMORANDUM 95 Services solutions to build human capital (“EdTech”) Improving human skills for better economic inclusion begins by improving human capital, encompassing basic education, soft (behavioral, communication, inter-personal) skills, and more advanced, technical skills. While public schools and government programs are the primary source for skills development, there is also a growing private sector that is developing initiatives and activities that combine skills-development and training with employment, especially for those at the bottom of the pyramid. IT tools to enhance learning and educational outcomes, often referred to as “EdTech”, are increasingly available. In Kenya, there are an estimated 133 EdTech startups, addressing a variety of educational needs. EdTech solutions in Kenya range from online learning, e-textbook rentals, school and pupil assessments, to inform excellence in teaching and learning, tutoring, educational resources for teachers, and gamified educational content. Most EdTech solutions are focused on primary and secondary school education, however, there is also the need to strengthen the skills of people of post-school age. Some EdTech products do help facilitate this, and there are also other private sector enterprises that focus on building the skills of those at the bottom of the pyramid, particularly women and youth. Digital skills training is increasingly available. Impact Sourcing Service Providers (ISSPs) run companies that provide business process outsourcing (BPO) services with the objective of creating social impact. Services range from simple tasks such as transcriptions or data entry to more complex tasks such as programming. ISSPs often add further social value to their propositions by specifically recruiting from disadvantaged populations, including low-income youth, women and persons with disabilities. They provide them with employment in the formal sector, above-average wages, and often social security or health benefits. For example, Tunapanda, a social enterprise SECURE located in the Kibera slums, targets marginalized youth and provides them with digital skills training for about 3 months, after which they work on paid projects to enhance their skill set. From there the youth often set up their own operations or work as freelancers. These types of solutions help mitigate urban youth employment and also raise the digital skill levels of the economy. Integrated entrepreneurship training is another growing area for skills development. Several enterprises have developed micro-franchise business models that integrate entrepreneurship training with the selling of goods or services (such as solar products, health goods, or services such as child care). These enterprises train recruits, often focusing on women, to become independent sales agents and provide them with a “business-in-a-box” type of model, whereby built-in branding and marketing from the parent company assists in establishing the credibility of the microentrepreneur, as well as curtailing startup costs. Services solutions for agriculture to increase rural inclusion (“AgTech”) Services can also help boosting productivity of the agriculture sector through technologies (“AgTech”), one of the main sources of income in rural areas. The poverty gap between Kenya’s rural and urban areas is wide (World Bank 2023b). Raising agricultural productivity is key to improving economic well-being and inclusion of the rural sector. Over the past decade, Kenya has seen strong growth in the number of digital and technology innovations geared toward improving agricultural productivity, particularly for smallholders. Digital and technical innovations are enabling farmers and agribusiness entrepreneurs to increase their productivity, efficiency, and competitiveness, as well as facilitating access to markets, improving nutritional outcomes, and enhancing resilience to climate change. 96 KENYA COUNTRY ECONOMIC MEMORANDUM There are over 100 AgTech firms in Kenya, providing solutions that span the agriculture value chain. AgTech solutions range from mobile phone apps to solar applications, portable agriculture devices, and bio-fortified foods. Disruptive AgTech (DATS) can empower farmers by accelerating agri-food outcomes three- to fivefold or by circumventing the conventions of the value chain to achieve better and/or more efficient results.73 AgTech solutions can be grouped into three main categories: • Increasing productivity. AgTech solutions can improve farm productivity at various entry points. First, market platforms can aggregate farmers demand for seeds and inputs, and pass on bulk savings to farmers. Second, during the growing season, AgTech solutions can provide farmers with digital and just-in-time extension services, making AgTech readily available to them when needed, rather than depending on agriculture extension workers’ availability. Other AgTech solutions can help farmers make more precise decisions about resource management through accurate, timely, and location-specific price, weather, and agronomic data and information, which are becoming increasingly important in the context of climate change. For example, knowing when it will rain prevents farmers from applying fertilizer that would be washed away. Even in poorly connected rural contexts, or with marginalized groups that have lower access to information and markets, sophisticated off-line digital agricultural technologies can provide opportunities to help poor and even illiterate farmers. • Improving access to markets and prices. Agricultural markets have not worked efficiently for smallholder farmers and the lack of market linkages has proved to be a key bottleneck for efficient market access. Poor market linkages substantially increase transaction costs and post-harvest losses. Value chains are characterized by agents and middlemen at every stage, reducing margins that smallholders final receive. In response, the development of marketing platforms has become key in improving smallholders’ income, either covering the final point of sale (direct-from-farm platforms) or the whole value chain (multi-stakeholder platforms from SECURE input to sale). • Improving access to financing. Smallholder farmers challenges accessing adequate financial services. Supply-side challenges, such as lack of flexible credit products and lack of last-mile access, and demand-side challenges, such as low capacity to service debt, hinder credit supply and uptake. Inadequate access to finance and insurance causes smallholder farmers to confine themselves to low-risk/low-yield crops and sub-optimal inputs, which results in lower yield. This makes their produce less competitive in the market and also increases the risk for other upstream value chain players due to low quality and uncertain supply. Lower incomes force cash-strapped farmers into a debt cycle, where they seek credit to repay previous loans. Several enterprises have adopted simple yet powerful innovations to make the delivery of financial services efficient, cost-effective and customized to the needs of smallholder farmers. Access-to-finance solutions include innovative components, such as alternative techniques to assess credit-worthiness, new products to address variable cash flows and ICT-based products to ensure last-mile reach. Most finance providers are structured as banks and MFIs. Some finance providers are also structured as non-profit organizations or social investment funds. Other enterprises act as intermediaries to finance providers to reduce friction in the flow of finance to smallholders and minimize the credit risk traditionally associated with agricultural finance. Financial intermediaries often specialize in particular areas in smallholder financing, such as risk mitigation tools, ICT- enabled delivery and value chain financing. 73 Most DATS are a form of digital services, however there are also non-digital DATS such as energy (solar) providers, producers or suppliers of bio- products for agriculture, or are aquaponics or hydroponics producers; which might not be classified as services (depending on their business model), but for the purpose of the CEM we do not differentiate between the two. KENYA COUNTRY ECONOMIC MEMORANDUM 97 Services solutions to foster inclusion by boosting entrepreneurship and productivity Services also play an important role in providing firms with inputs, market access, and technology, including for low-income MSMEs. This includes providing access to finance, where digital lenders are playing a larger role, market access through e-commerce and, especially important for women entrepreneurs, child-care services. • Access to finance. Access to finance is an important challenge for MSMEs, as traditional financing is difficult to obtain, particularly for informal enterprises. Recognizing this market gap, FinTech companies have innovated solutions to provide digital financial services, particularly digital credit, to this market segment. The widespread use of mobile money in Kenya, and the familiarity with digital money, made the uptake to digital financial services much easier. In additional to FinTech solutions, there are also other innovative financing models to serve low-income MSMEs. Fintech is one of the largest digital business sectors in Kenya. There are over 400 FinTech companies in Kenya, ranging from digital credit, to payment platforms to cross-border remittances to online micro-health insurance. High mobile penetration and the ubiquity of mobile money in Kenya has opened new ways to improve access to financing, particularly for low-income segments. FinTech is seen as the leading contributor to growth in formal financial inclusion from 26.7 percent in 2006 to 83.7 percent in 2021. Kenya’s FinTech success story highlights how global innovator services can be a source of job creation, reduce poverty, and benefit the broader economy. • Access to technology. In line with the discussion on the adoption of technology by firms (see Chapter 4, “Boost”), informal firms can also benefit from access and adoption of digital technologies. There are growing digital divides in use between large formal and micro-size informal enterprises. Lack of finance and a lack of capabilities are some of main barriers to the adoption of technology. Improving access to finance among SECURE firms for technological upgrading could help to increase technological adoption. In addition, firms may need awareness and knowledge on how to acquire new technology, followed by training on how to properly use it. • Market opportunities through e-commerce. E-commerce platforms can play an important role in encouraging technology adoptions to their users. In Kenya, the main e-commerce platforms are Jumia, JiJi (formerly OLX), and Kilimall. In addition, many entrepreneurs use Facebook and WhatsApp as ‘market places’. Aside from matching supply and demand, the networking effects of social media platforms have enabled micro-enterprises to form informal digital trade unions where they trade ideas, negotiate better prices, and advertise assets for rent and sale. Many e-commerce platforms also provide a suite of skills training and financing opportunities to MSMEs. • Child care. Child-care services are another key enabling services sector that can help free low-income women to participate in the economy, including as entrepreneurs. One of the key impediments for women to work or further their training or employment opportunities is the lack of quality affordable child care. Girls are already more likely to drop out of school than their male peers due to pregnancy and early marriages. Young mothers— many who have less education than their male peers—are not able to leave their children for extended periods to attend training that would help boost their skillset and, even if they could, they may be limited in how far they can travel. This can lock them into low-skilled, low-earning jobs. On-site provision of quality child care can remove this barrier to access training. Likewise, nursery or pre-school service providers in low-income neighborhoods or in-home child care should be offered training in early childhood development (ECD) care to raise current standards. 98 KENYA COUNTRY ECONOMIC MEMORANDUM The development of entrepreneurial systems in lagging regions is important. Access to digital and entrepreneurial infrastructure varies widely across the country. Existing support for firms tends to be focused on Nairobi, Kiambu, and Mombasa. In the Frontier Counties Development Council (FCDC), less than 5 percent of businesses have received non-financial support, compared with over 15 percent of businesses in Nairobi and Mombasa. The demand for different types of interventions varies across counties and should be tailored to the specific needs of the local ecosystems, while collaboration within and across counties should be encouraged, such as in obtaining licenses. Developing the local entrepreneurial ecosystem can help provide more opportunities outside Nairobi and the central region. Services solutions to bring new opportunities: the gig economy Another opportunity is formed by the gig economy. The gig economy refers to the market of connecting providers to clients on a short-term or task basis, and is characterized by independent workers, and payment (rather than salaried or hourly wages) for a specific service or task. The online gig economy refers to the segment of the gig economy that uses digital technology, with segmentation based on web-based tasks (higher technical skills, such as mobile app developer) or location-based tasks (low technical skills, such as delivery driver). The online gig economy in Kenya operates across several sectors, from transport services to business processing tasks, to professional services and accommodation. In 2019, the Mercy Corp estimated the size of Kenya’s gig economy at US$109 million and to be employing over 36,000 people, but as this was before the COVID-19 pandemic, and post-pandemic the numbers are likely to be significantly higher. Online gig work can support inclusion by providing work opportunities for youth, women, relatively low- skilled workers, or people in areas with insufficient local jobs. The prevalence of youth in the gig market is high: SECURE in sub-Saharan Africa, about 45 percent of gig workers are in the 15–24 age bracket, compared with 16 percent in the informal sector.74 While part of this is because the youth are more technically savvy and digitally connected, the gig economy also provides them with initial work experience as they transition from school to the workplace. Although women are not as prevalent in the gig economy, its flexible nature is attractive to women, especially single mothers, and can become an important source of income. Surveyed data on SSA75 show that gig jobs are split between capital (41 percent) and secondary cities (42 percent), with tertiary cities (17 percent) further behind, but still significant in regional inclusion. Increasing participation of tertiary cities will also likely depend on improving digital connectivity. On the client side, gig platforms support growth and productivity of MSMEs. Small firms benefit from a flexible workforce and use online gig workers to access a larger talent pool of labor, skills, and expertise, while providing a low-cost alternative to traditional hiring. MSMEs drive demand for gig workers. Not only are they more likely to use gig workers, but they also outsource a larger share of their work through platforms compared with large firms. The self-employed are also more likely to hire gig workers for business and professional support, as well as sales and marketing support. Platforms also support small businesses by providing the technical infrastructure they might not have on their own, for example, platforms such as Jumia Food and UberEats give restaurants that do not have their own food delivery service provide an opportunity to tap into this revenue stream using their network of delivery workers. 74 World Bank. 2021. 75 Surveyed SSA data was based on Kenya, Nigeria and South Africa. KENYA COUNTRY ECONOMIC MEMORANDUM 99 For the Government’s part, providing affordable access to connectivity infrastructure, digital services and devices for all and, in particular, to disadvantaged groups such as youth and women, in rural areas and poor neighborhoods, will help improve the inclusivity of online gig platforms. The Government can also partner with platforms to provide support and training for vulnerable and disadvantaged groups to access these income earning opportunities. Finally, the Government’s own use of the gig economy for digital public works increases opportunities for short-term income generation to low-income populations, while also building digital skills. For example, under the Ajira Digital Project, the Kenyan judiciary were allowed to use local gig workers to transcribe court proceedings, enhancing both the quality of judicial proceedings and creating local job opportunities. Despite the opportunities provided by gig work, governments need to mitigate risks associated with gig jobs, such as low wages, employer pressure, and harassment, ‘geofencing’ to limit access to gig jobs to developing country workers, etc., by extending coverage of social protection and insurance to a broad range of workers outside standard employment, supporting new models of collective bargaining, and by building their own capacity to collect and monitor data. The importance of mid-level skills and soft skills to take advantage of services opportunities The building of basic digital skills and soft skills is crucial for workers and entrepreneurs to take advantage of opportunities in the services sector. Chapter 2 (“Shift”) highlighted the importance of high-end skills for growing global innovator services. However, not all services require high-end skills. For many services mid-level skills are sufficient, combined with soft skills. To be able to adopt technologies or to be employed in administrative and support services, literacy as well as the ability to use basic digital technologies—including mobile apps, office software and email—is important. For customer facing tasks, soft skills are also crucial, including communication SECURE skills, customer service skill and the ability to work in teams. The Kenyan education system seems to be doing relatively well at the primary education level, but underperforms at the secondary education level. Enrolment levels are near universal for the first seven grades of primary education, but rates drop significantly in the eighth grade and in secondary education (Figure 6.8). Many of the intermediate-level skills relevant to the services sector are obtained during secondary education. It is also in the later stages of education that learning outcomes seem to worsen. The share of students reaching a minimum competency level drops after the third grade (Figure 6.9). Figure 6.8: Enrolment in primary education is close to universal, Figure 6.9: The share of students obtaining minimum performance but secondary education enrolment drops significantly levels is low, especially after the third grade Survival rates in primary and secondary education, 2019 Students reaching minimum competency level, by subject and grade, 2018–2019 120 80 70 68 100 60 59 Percent 80 53 50 44 60 40 41 40 37 40 29 30 20 20 20 17 0 10 6 0 Form 1 Form 2 Form 3 Form 4 Grade 1 Grade 2 Grade 3 Grade 4 Grade 5 Grade 6 Grade 7 Grade 8 0 Kiswahili English Mathematics Science* 2009 2014 2018 Grade 3 Grade 7 Grade 10 / Form 2 Source: Kenya Education PER, based on KNBS (2020). Note: Science is not included in Grade 3 as a subject. The graph presents the average for science as the average of chemistry (24%), physics (29%), and biology (8%) in Form 2/Grade 10. Source: Kenya Education PER, based on NASMLA Grade 3 (2018), Grade 7 (2019) and MLA Form 2 (2018). 100 KENYA COUNTRY ECONOMIC MEMORANDUM Concluding remarks From the perspective of inclusion, the challenge for the services sector is how to become a sector of opportunities instead of a sector of last resort. Much services sector growth has been in less skill-intensive areas, often focused on the domestic services subsectors, such as retail and personal services. Many of the businesses in these subsectors are informal, with low levels of productivity and often run by women. Improving firms’ capabilities, encouraging the adoption of technologies, as well as increasing access to finance could improve outcomes for some entrepreneurs, especially those with growth potential. For other entrepreneurs, the optimal solution would be waged employment in a larger firm. As Chapter 2 (“Shift”) and Chapter 3 (“Link”) highlight, growing more productive subsectors and subsectors linked to other sectors, for example, business services or transportation services, can help to bring new employment opportunities, including for workers with fewer skills. The services sector is also a source of new solutions to foster inclusion, especially in last-mile delivery. New technologies around building skills (“EdTech”), agricultural solutions (“AgriTech”) and offering financial services (“FinTech”) can help reach previously underserved groups. Digital platforms and work in the “gig economy” can bring new opportunities for jobs and entrepreneurship. But even more traditional services, such as child-care services, play a key role in removing time constraints for women. SECURE: Policy priorities to increase inclusion Making the services sector work better for low-earners, many of them employed in this sector, and poor and vulnerable households, is key to improving livelihoods. This involves building skills but also increasing the reach of technologies with the potential to increase inclusion. Proposed policy priorities include: • Improve skills development, not only at the tertiary level but also at secondary level, with a focus on basic SECURE digital skills and soft skills, and strengthen TVET. • Expand digital connectivity, including to disadvantaged regions. • Support implementation of extension support services and other technologies in agriculture. • Support the building of firms’ capabilities and the technology adoption of MSMEs, while also ensuring a well-targeted approach. • Improve access to credit, including to MSMEs. Many of the other policies that support growth of higher-productivity sectors and of linked services can also contribute to more employment opportunities for lower skilled workers. Although many of these sectors rely on a larger share of high-skilled workers in service delivery, they also create jobs for lower skilled workers, including through firm linkages. KENYA COUNTRY ECONOMIC MEMORANDUM 101 102 KENYA COUNTRY ECONOMIC MEMORANDUM CHAPTER 7 Conclusions and Policies to ACCELERATE the Gains from Services for Kenya Services play a major role in Kenya’s economy and there is scope for them to grow further, including through ongoing technological change (e.g., digitization) and increasing tradability. The performance of services affects productivity in other linked sectors, and the quality and costs of the goods and services available to Kenyan consumers. There are opportunities for policy makers to leverage the already strong growth of services to accelerate Kenya’s economic development, and for reforms that would lift productivity in services and across the entire economy. The urgency and opportunity of seizing the services momentum, and policy implications T his report has examined the role of services in Kenya’s evolving economy, and this chapter discusses its key findings and the policy recommendations that flow from these. The starting point for the analysis in this report has been the performance of Kenya’s economy in recent years and the question of how to achieve more inclusive, sustainable growth in the years ahead. Services will be one key aspect of this agenda, recognizing the sector’s strong growth, and leveraging recent global work to deliver policy-relevant analysis for Kenya. The report comes at what remains a challenging time for Kenya and the region. While Kenya’s post-COVID-19 recovery has been remarkable in many respects, many of the least well-off firms and households, having been hit hard during the crisis, are likely still struggling to fully recover. Inflation has risen in Kenya as in much of the world, and parts of the country have also faced a severe drought, exacerbating food insecurity and regional inequalities. Externally, higher global interest rates mean that Kenya faces a tight financing environment. Overall, there is still a higher-than-usual degree of uncertainty regarding macroeconomic conditions, both at home and abroad. All of this makes for a difficult backdrop for policy makers making hard choices, and designing and implementing an ambitious agenda, including the needed fiscal consolidation. Seizing on the momentum in services can help, as part of a comprehensive strategy to lift productivity across the entire economy (in agriculture, industry, and services). Kenya urgently needs to chart how to continue its path toward inclusive, sustainable growth, characterized by new job creation and income growth (especially for those at the bottom of the income distribution), while seeking for opportunities to accelerate growth as well. Achieving strong private sector-led growth will be essential to support public revenues and hence contribute to fiscal consolidation and debt sustainability. Kenya’s constrained fiscal and debt environment also means that growth will need to be led by private investment. It is the private sector that will have to absorb most of a rapidly increasing labor force, as recognized by the Government, which is seeking to expand opportunities for entrepreneurs through a bottom-up economic model. To help achieve this, there is an opportunity for Kenya to seize on the momentum of its fast-growing services sector—already where so many Kenyans are earning their living—by reinforcing their performance and ability, through linkages, to drive growth and job creation across the economy. The CEM has explored the applicability and utility for Kenya of global work on how the role of services in economic development is evolving; this should not be interpreted as implying that policy makers should focus their development efforts exclusively on services. The CEM’s emphasis on services is based on the need to better understand Kenya’s recent services-centric economic growth pattern, the critical role of services-related KENYA COUNTRY ECONOMIC MEMORANDUM 103 employment in supporting the growing workforce (while acknowledging the concerns about the productivity and future earning potential of such jobs), and the country’s aspirations to become a regional economic and technology hub. The current administration, which came into office in late 2022, has not (yet) articulated a specific sectoral policy agenda, whereas the previous administration did highlight manufacturing sector growth as part of its “Big Four” policy agenda. Policies that accelerate growth and the opportunities associated with services activities would be expected to be complementary to growth of the other major sectors—agriculture and manufacturing—especially in a context of accelerating technological change and the blurring of traditional boundaries between commodities, manufactures, and “intangible” work. In an era where the lines between services and manufacturing are becoming increasingly blurred, solely targeting manufacturing subsectors without considering the corresponding complementary services subsectors may not be effective. Similarly, lifting agricultural productivity will rely on strengthening extension services and on transport and logistics services to reach domestic and international markets. Therefore, it is advisable to adopt a policy approach that encompasses all the relevant economic activities within a particular value chain to achieve better results. The role of services in Kenya’s changing economy: main conclusions The next sections briefly review the key findings of the CEM, and the policy implications of the analysis. 1. Kenya’s recent economic performance and the growing role of services Kenya’s overall economic performance over the past decade or so has been good, but there is scope for growth to be made more inclusive (i.e., to generate more quality jobs) and more sustainable (i.e., to rely to a greater degree on private investment and trade, shifting away from the public sector dissaving in recent years, which has resulted in a build-up of debt, culminating in overly high debt-distress risks). Despite Kenya’s aspirations to be, and its early emergence in some areas as, a regional economic hub, trade and foreign investment have so far underperformed as engines of growth and job creation. The services sector has emerged as the main locus of growth, accounting for nearly three-quarters of the increase in GDP from 2015 to 2021. Most of the services subsectors showed considerable resilience during the COVID-19 pandemic, including due to rapid innovation and changes to adapt to the crisis (e.g., the surge in mobile money transactions and delivery services) contributing to the economy’s relatively shallow pandemic recession and subsequent strong recovery. In Kenya, as elsewhere, the crisis was unprecedented and severe. The extent of long- term scarring remains uncertain, including due to the disruption to schooling and negative impacts on households and firms, especially small-scale, informal enterprises being damaged. Nonetheless, the resilience of the Kenyan economy overall was notable. 2. The economy’s continued SHIFT toward higher-productivity services can drive growth and jobs Long-term growth is determined by the pace at which productivity per worker rises. In Kenya, total factor productivity (TFP) growth has been low in recent years (even negative). There are also large productivity differences across agriculture, manufacturing, and services, and also within these sectors, of the Kenyan economy. Productivity growth has been highest in services. This means that there is a major opportunity to lift TFP through accelerated structural transformation: shifting resources, including labor, from agriculture into manufacturing and services, into higher value-added activities within sectors, and within services (which vary widely in terms of the productivity and tradability of different services subsectors), 104 KENYA COUNTRY ECONOMIC MEMORANDUM especially into the fast-growing, higher productivity services. How to pick up the pace of Kenya’s ongoing but still incomplete economic transformation is therefore a key question for policy makers seeking to increase growth and jobs. Global innovator services, although still accounting for only a relatively small number of jobs directly, drove almost one-fifth of total output growth (2015–2019), and there is some evidence of important spillovers whereby global innovator services contribute to labor income growth in other parts of the economy indirectly. 3. LINKAGES across sectors, regions, and firms, widen opportunities Understanding and identifying measures to strengthen the linkages across services and activities in other sectors (agriculture and manufacturing) can help to lift the overall performance of, and job opportunities provided by, Kenya’s economy. Services linkages into manufacturing remain low, but have been growing rapidly, and are already significant in the case of global innovator services, in particular. Manufacturing would benefit from growth in the still limited use of professional and ICT services. There is considerable scope to foster more linkages across domestic services firms, and to expand the contribution of services linked to Kenya’s manufacturing exports. Services generate considerable labor income by supporting exports through forward linkages, including for unskilled workers. Services inputs account for more than three times the labor income from exports as manufacturing. The forward service linkages attributed to total unskilled wages are substantial and twice that of skilled wages, hence, a very large number of unskilled jobs (especially in transportation) are supported through forward service linkages. Global innovator services in particular have a large scope to support lower-skilled wages, particularly through exports. 4. Technological adoption and market competition are keys to BOOST firms’ performance Although Kenya is a technological leader in mobile money, in most other services there is tremendous scope for firms to increase their performance by adopting more technologies that bring them closer to the global technological frontier. There is relatively high dispersion of technological adoption among firms in Kenya, showing co-existence of relatively technologically unsophisticated firms with much more sophisticated firms. This points to large potential productivity and international competitiveness gains from measures that encourage more technological take-up by lagging firms, including by stimulating access and competition. According to surveyed firms, limited technological adoption is mainly due to perceived lack and uncertainty of demand, followed by lack of finance, and (to a lesser extent) lack of their own capabilities. From the perspective of digitalization, the cost of devices (computers, smartphones, etc.) is noted as a key barrier from survey data. Regulatory barriers to competition are quite high in Kenya compared with MIC averages and even compared with regional comparators. This is one likely factor that limits the pressure on firms to adopt new technology. Overall, more market competition could unleash stronger productivity growth, as it pushes firms to be more efficient and to innovate, and aids the overall efficient allocation of scarce resources in the economy by driving out poorly- performing, inefficient firms, while rewarding high-performing and more-productive firms. KENYA COUNTRY ECONOMIC MEMORANDUM 105 State involvement in services sector companies is significant, including in competitive subsectors where private sector participation is viable. This could, in some cases, be detrimental to private sector investment, competition, innovation and growth. 5. Increasing TRADE would enable Kenya to seize emerging services trade and investment opportunities, and overcome domestic market size and financing constraints Services exports are growing, with global innovator service exports (especially finance and telecommunications) driving much of the increase. However, there is still enormous scope to grow trade in services, which remains low as a share of total services output and of GDP. Services-related FDI has been growing from a small base, and now accounts for around half of announced greenfield FDI (up from 30 percent in 2003–2007), especially global innovator services-related investments. Overall, however, realized FDI remains low relative to Kenya’s GDP. This points to the scope for growing FDI as a source of finance, know-how, and connections to drive up services exports, especially knowledge-intensive goods and services, where global evidence shows that FDI is critically important. Trade in services still faces pervasive restrictions that often exceed those in the rest of the EAC. These restrictions are most pronounced in Kenya’s financial, business services, and tourism subsectors. Kenya is playing a key role in the AfCFTA and stands to generate large gains from reducing tariffs and, especially, from reducing NTBs and adopting trade facilitation measures, with many of the gains coming from the services sector. Realizing these gains will depend on the implementation of Kenya’s ambitious services trade commitments under the AfCFTA, including through domestic regulatory reform to reduce the currently significant degree of restrictiveness. 6. Paying attention to services to make them work better for all can help to SECURE inclusion Many Kenyans rely on low-paid work in low-skilled domestic services subsectors such as retail trade and personal services (domestic non-tradables). Such employment is usually informal. This places the focus for policy makers on how to support low-skilled services workers, on the labor supply side by increasing their skills and capabilities to move into higher-earning work, and on the demand side through measures that support growth of firms and higher productivity jobs.76 Fostering rapid growth of more skills-intensive services, even if these do not directly employ many poor and vulnerable Kenyans, remains relevant for furthering Kenya’s inclusion agenda. This is because they create income opportunities even for low-skilled workers (including through linkages with other sectors), and contribute to output, public revenues, and foreign currency earnings (hence, resources for quality public services, and macroeconomic stability, which are necessary conditions for poverty reduction). 76 See World Bank (2023a). 106 KENYA COUNTRY ECONOMIC MEMORANDUM Seizing the services momentum: what it means for policy Kenya has a major opportunity to leverage services in order to spur long-term, equitable economic growth. Realizing this potential requires a whole-of-government approach to improve the integration of services across all economic sectors, to embed the enabling role of services in the country’s medium-term economic plans and the Bottom-Up Economic Transformation Agenda, and to build upon the leadership position that Kenya already enjoys in some services sub-sectors. A useful framework upon which to structure policy reforms is to implement priorities that emerge along the following dimensions: shift, link, boost, trade, and secure. A brief overview of policy recommendations along these dimensions follows. Seizing the momentum of services to accelerate productivity and drive growth and jobs will require a deliberate and sustained effort across government, in close collaboration with other key stakeholders, to identify and implement reforms through the lens of this framework. SHIFT – by enabling the further development of high productivity, tradable “global innovator” services: High-productivity “global innovator services” (ICT, professional, technical and financial services) have been driving a large part of economic growth in Kenya. These services are knowledge-intensive and typically depend on digital infrastructure. Policies to grow this sector include: • Improve skills development, especially by increasing access to and quality of secondary and tertiary education, including STEM degrees, and access to and the quality of TVET. • Invest in ICT infrastructure to expand access to digital services, and lower access costs in order to promote universal access to digital services. • Expand ICT and financial ecosystems to bolster Kenya as a regional hub. • Continue public sector digitalization efforts. LINK – by facilitating the use of services across the economy, including in agriculture and manufacturing Services provide crucial inputs to other sectors of the economy, and a more interlinked economy would increase growth. Linkages are an outcome of the development of services and other sectors, but in some cases the creation of linkages can be expedited or facilitated. • At the macroeconomic policy level, maintain an enabling environment for the private sector to grow and for linkages across and within sectors to increase (see also the first recommendation to BOOST, below). • At the microeconomic level, policies can seek to: o Strengthen firms’ capabilities to supply more and better-quality linked services, and non-services firms’ absorptive capacity to take advantage of potentially linked services. o Reduce search frictions through matchmaking or supplier development programs; and o Increase access to information on the usefulness and availability of linking services through information campaigns, peer-to-peer networks, and business training. BOOST – by encouraging more rapid technology adoption and strengthening market competition Increasing productivity requires the adoption of more sophisticated technologies, creating a level playing field, and removing barriers to entry of new firms. This requires a stable policy and macroeconomic backdrop to facilitate firms’ investments, as well as securing a level playing field. Policy priorities include: • Provide tax policy clarity and predictability, addressing the coherence of county-level taxation, and avoiding nuisance and implicit taxes (e.g., excessive permitting and licensing costs). KENYA COUNTRY ECONOMIC MEMORANDUM 107 • Address information gaps impeding firms’ technology adoption (e.g., facilitating business development services). • Address regulatory restrictions and barriers to vigorous, fair market competition. • Reassess and reform commercial SOEs with a view to ensuring a level playing field, eliminating conflicts of interest, and increasing entities’ performance, including through governance reforms that strengthen SOE management boards. See Table 7.1 for more detail on steps that could be considered to reduce restrictive regulations and boost competition, including through SOE-related measures. Table 7.1: Sector-specific and economy-wide recommendations to increase competition Recommendation A. Remove restrictive regulations in key markets and enable competition i. Speed up the approval and implementation of regulations that enable competition on a level playing field (e.g., spectrum management, infrastructure sharing, dispute resolution, competition) Telecommunications ii. Support the implementation of Competition Authority’s decisions that set obligations on the dominant operator (e.g., interconnection) i. Consider lifting restrictions limiting foreign ownership to 49 percent to encourage investment and improve efficiency Air transport ii. Establish an open, transparent, fair, and non-discriminatory slot allocation procedure in cases of congestion to enhance predictability and competitive neutrality i. Ensure a level playing field between road transport and railways for the provision of cargo transportation from/to the Mombasa Port Railways ii. Monitor the performance of the railways monopoly operator to regulate fees appropriately and consider the introduction of competition in railways services as cargo levels increase. i. Eliminate provisions that allow for mandatory minimum prices for professional services (e.g., Professional services lawyers, architects, quantity surveyors, and engineers) i. Increase collaboration between the Competition Authority, market regulators, and other government institutions to identify regulatory restrictions and remove them ii. Ensure effective competition law enforcement to stop and deter anticompetitive practices, prevent mergers that are likely to harm competition, and embed competition principles in the Economy-wide design and implementation of laws and regulations iii. Phase out price controls that eliminate market signals (e.g., on food and agricultural products) and implement alternative pro-competition interventions such as elimination of trade restrictions, increased market transparency on prices and quality, interventions to address underlying market failures) B. Lessen potential market distortions associated with the presence of businesses of the State i. Limit businesses of the state, both majority and minority owned ones, to industries where private participation is not viable by facilitating the privatization of perennial loss-making businesses in competitive sectors with active private sector participation. Businesses of the ii. Subject state businesses to market discipline mechanisms by ensuring that they compete on an State (BOS) equal footing in sectors with private sector participation. iii. Improve the governance of businesses of the state to increase their efficiency by minimizing conflict of interest to ensure competitive neutrality given government representatives sit on boards of both majority and minority BOS. 108 KENYA COUNTRY ECONOMIC MEMORANDUM TRADE – by eliminating the barriers holding back more regional and global trade and investment in services Despite growing trade and investment, barriers remain high for services, including for digital trade. Removing barriers – including as part of regional trade agreements – can significantly boost growth. Policy priorities include: • Improve the investment climate, including by facilitating FDI and making the playing field more level. • Reduce restrictions on trade in services and investment, especially in restricted services subsectors, and implement the EAC joint services “offer” as part of the AfCFTA. • Review in particular, with a view to limiting, current data localization requirements, to ensure that Kenya can participate in a single regional data market and take advantage of emerging global digital services trade opportunities. See Box 7.1 for further description of the opportunity from AfCFTA and digital services trade. • Implement the EAC E-commerce Strategy and regional harmonization measures. • Improve and streamline domestic regulations, especially in areas such as paperless trade and consumer protection. Box 7.1 What would it take for Kenya to seize the AfCFTA and digital services trade opportunities? Seizing the opportunity created by the AfCFTA, in which Kenya is playing a leading role, would entail the task of reviewing and potentially amending all relevant laws and regulations in sectors for which Kenya has an offer to liberalize. Achieving such an ambitious task, in turn, would call for developing a detailed implementation plan, including the timeline for reform, and the key steps to be taken (including, for example, legal review and private sector consultations). This would lay the groundwork for the difficult but rewarding task of stimulating Kenya’s international trade and investment in services. On digital services, Kenya has begun to emerge as a regional hub, and advanced in its regulation; however, the current budding, patchy framework, both in Kenya and in the region, poses challenges to its continued growth. While Kenya has advanced toward an enabling framework for digital trade, the current framework remains only partial, and substantial restrictions are still in place. This is even more the case for Kenya’s regional partners, some of which have essentially not yet adopted policies on digital trade. Kenya thus has an opportunity to lay the groundwork for an integrated digital market in the region, and further expand digital services in the region and abroad. The analysis presented in Chapter 5 points to two policy areas that would bring the greatest benefits: • Upgrade the current Data Protection Act and related instruments (e.g., Health Information System Policy) so as to remove requirements for data localization and adopt compatible and interoperable standards, a prerequisite for a single regional data market. In particular, Kenya may seek to reduce data localization requirements at least for privately-generated personal data within its own legal framework. • Advance on the adoption of regional principles and regulatory guidelines on data governance and e-commerce, including a framework to facilitate regional cross-border data flows, foster the adoption of digital signatures that are recognized across the region, and generally promote regional guidelines on digital trade regulation to ensure harmonized regulation. KENYA COUNTRY ECONOMIC MEMORANDUM 109 SECURE – by leveraging the potential of services to provide better jobs for, and to meet the needs of the poor and vulnerable Making the services sector work better for low-earners, many of them employed in this sector, and poor and vulnerable households, is key to improving livelihoods. This involves building skills but also increasing the reach of technologies with the potential to increase inclusion. Proposed policy priorities include: • Improve skills development, not only at the tertiary level but also at secondary level, with a focus on basic digital skills and soft skills, and strengthen TVET. • Expand digital connectivity, including to disadvantaged regions. • Support implementation of extension support services and other technologies in agriculture. • Support the building of firms’ capabilities and the technology adoption of MSMEs, while also ensuring a well- targeted, results-oriented approach. • Improve access to credit, including to MSMEs. Progress in many of these policy areas would be complementary, yielding gains across multiple dimensions. Macroeconomic stability and economic policy clarity, predictability, and consistent implementation, are foundational to achieving inclusive, sustainable growth, including through the further development of services. Without these, it would likely prove difficult to achieve any of the shift, link, boost, trade or secure dimensions of the agenda. Similarly, making Kenya’s economy more open to regional and global trade and investment is directly relevant to the trade dimension, but is also likely essential to make progress on shifting to higher productivity activities, strengthening linkages, boosting efficiencies, and opening up more and better economic opportunities across the skills spectrum in Kenya’s labor force. Strengthening Kenya’s skills base is another clear, cross-cutting priority. This would enable global innovator services to accelerate, helping to generate needed growth, revenues, and exports, while also reinforcing the secure dimension through increasing the capabilities of lower-skilled workers to work in related areas and to benefit from digitally-enabled services. Measures to increase fair and vigorous competition can also underpin progress across multiple dimensions. Addressing constraints to competition by lowering regulatory barriers and addressing the role of the businesses of the State will not only boost efficiency and encourage innovation, but may address bottlenecks in the shift of Kenya’s economy toward higher productivity activities, and support more trade-orientation and increased private investment. The policy agenda arising from the analysis of the growing role of services in Kenya’s economy is consistent with and contributes to the Government’s “bottom-up” economic strategy. It points to the need for a major focus on skills development, which builds on Kenya’s already considerable progress and regional lead in human capital development (achieving the highest Human Capital Index score in continental sub-Saharan Africa), and is essential in equipping all Kenyans with the capabilities needed to participate in a changing economy. It recognizes that services-related work is already how a growing plurality of the population earn their living, and seeks to uncover the ways to leverage this to further expand opportunities. 110 KENYA COUNTRY ECONOMIC MEMORANDUM Closer examination of the evolving role of services in Kenya’s economy adds to a growing body of research and global evidence showing that choosing between services and industrialization is a false dilemma. Growing services can be pivotal to further industrialization by enhancing industrial productivity and the scope for intermediate inputs and final manufactured products to be traded. Manufactured goods are also increasingly bundled with services – a process known as the servicification of manufacturing. Services are also vital to support livelihoods in agriculture, across the spectrum from small-holders benefiting from extension services to high value-added commercial agriculture producing for export, which relies on sophisticated market information, transport, and logistics. Paying attention to services can help effectively shape inclusive, sustainable growth policies. Overall, services provide key inputs to other sectors, making it important to understand not only how services are developing as a major source of livelihoods and growth, but also their wider role. The Country Economic Memorandum has sought to assess the nature of the services momentum in Kenya, and how to seize on this to accelerate productivity and expand opportunities across the entire, evolving economy. Next steps in understanding and strengthening services for jobs and economic transformation: Knowledge gaps Many data and knowledge gaps regarding services and their role in the economy remain, which future work could aim to address. This CEM has attempted to make maximum use of the available data (see also the Technical Appendix for an overview of data sources used) and, subject to resource and time constraints, generate novel data and analysis, where possible. However, there is much more scope for analysis of services-related economic activity and its role, with Kenya being no exception to what is a global challenge to keep track of activity and value- addition in a rapidly evolving sector, noting that services flows have always been harder to quantify than goods. Key data and knowledge gaps that could be useful to inform economic policy include the following: • More data and analysis on Kenya’s participation in global online jobs platforms and digitally-enabled gig opportunities; • Data on trade in services more widely; • Nationally-representative firm-level survey data and more detailed labor market survey data, as available sources have become dated; • Data from additional, more novel sources, such as from transactions (including mobile transactions) and big data; and • Data and analysis pertaining to Kenya’s growing diaspora, the role of international remittance and knowledge flows in supporting economic activity in Kenya, and potential related policy issues such as those leveraging return migration (e.g., the ease of porting foreign-obtained qualifications back to Kenya). KENYA COUNTRY ECONOMIC MEMORANDUM 111 Appendix A: Sectoral priorities by subsector The importance of the five channels on how services contribute to jobs and economic transformation differ between service subsectors. For example, not all service subsectors can be traded as easily or are linked to other sectors in the economy. Table A1 highlights the relative importance of each channel for services subsectors. Table A.1: Sectoral priorities by subsectors Relative Enabling role of Potential for Presence of Potential for Reliance on low- productivity of this sector for technology BOS and/ tradability skilled labor in sector other sectors adoption or restrictive production product market regulations Low-skilled domestic Retail Low Low Medium Low Low High Personal services Low Low Low Low Low High Administrative and support Low High Medium Low Medium High Low-skilled tradable Wholesale Medium High Medium Low Medium High Transportation and storage Medium High High High High High Accommodation and Medium Low Low Medium High High food services Skill-intensive social services Health Medium Low High n.a. Low Medium Education Medium Low Medium n.a. Low Medium Global innovator services Financial and insurance High High High High Medium Medium ICT High High High High High Low Professional and technical High High High High High Medium services Note: BOS = Business of the State; n.a. = not assessed. Relative productivity is determined by sectoral labor productivity; Enabling role is determined by the degree of forward linkages with other sectors; Potential for technology adoption is determined by the degree that technologies play a role in this sector (based on R&D intensity from Nayyar et al. 2021, Figure 1.6); Presence of BOS and restrictive product market regulations is based on the assessment in Chapter 4; Tradability is determined by the sum of imports and exports divided by value added (see Chapter 2, Figure 2.1); Reliance on low-skilled labor is determined by the share of employees with less than a tertiary education (see Chapter 2, Figure 2.19). See Appendix B for definitions of services subsectors. 112 KENYA COUNTRY ECONOMIC MEMORANDUM Appendix B: Sectoral classification This Country Economic Memorandum groups services in four different groups, following the classification from Nayyar et al. (2021). The classification within this group is based on the Revision 4 of the United Nations International Standard Industrial Classification (ISIC), which is the most commonly used classification of economic activities. The ISIC classification groups economic activities in sections, which are indicated by a letter, and disaggregates this further in a two-digit division. Many figures in Kenya are only available at the section-level, and some data is also reported at the two-digit division level or at the more detailed four-digit class. For this report, only sections G-S of the ISIC classification are considered as services. Sometimes construction or public utilities are also considered as a service. In this report, it is treated as part of industry, in line with definitions used by KNBS. Table B.1: Sectoral classification of services Section (UN ISIC Rev. 4) Global innovator services Information and Publishing (58), audio and video production (59), television and radio broadcasting (60), telecommunications communication (J) (61), computer programming and consulting (62) and information services (63). Information services include webhosting, web portals, data processing as well as news agencies. Financial and Financial services (64), insurance and pension (65) and auxiliary financial and insurance services (66). insurance (K) Auxiliary services include insurance agents, brokerage of security and commodity contracts and fund management activities. Professional, scientific Legal services, accounting (both under 69), activities of head offices, management consultancy (both and technical under 70), architecture and engineering (71), scientific R&D (72), advertising (73), veterinary (75) and other activities (M) professional services such as specialized design, photographic activities and translation activities (74). Low-skilled tradable services Wholesale (part of G) Wholesale (46). Transportation and Various forms of transport, including land (49), water (50) and air (51) transport. Also include logistical storage (H) services, such as storage, warehousing and transport support (52) and postal and courier services (53). Accommodation Hotels and other forms of accommodation (55), food and beverage services (56). Note that establishments and food service selling food products produced at the facility but not consumed on location (e.g., bakeries) are usually activities (I) classified as food manufacturing (10), even though takeaway services are still classified under this section. Low-skilled domestic services Retail (part of G) Retail (47) and vehicles trade (45). Buying and selling of real estate, renting and leasing activities, real estate agencies and management of real Real estate (L) estate (all under 68). Rental and leasing activities (e.g., of goods, equipment or vehicles; 77), employment activities such as Administrative and temp agencies (78), travel agencies and tour operators (79), security services (80), building support support service and landscaping activities (81), office support services (82). Building support activities include cleaning activities (N) activities as well as facility management. Office support services include office administration, call centers, conventions and trade shows, collection agencies and credit bureaus. Arts, entertainment Performing arts, the creation of art (both under 90), libraries, museums, zoos (91), gambling (92), sports and recreation (R) activities such as sports clubs and fitness facilities, amusement and theme parks (93). Activities of membership organizations, such as trade unions, professional organizations and political parties Other service (94), repair of computers, personal and household goods (95) and personal services (96). Personal services activities (S) include hairdressers, beauty treatments as well as laundry services. Social services Public administration Mostly non-market services provided by the government as well as social security (all under division 84). and defense (O) Includes both education services often publicly provided (e.g., primary schools) as private training, e.g. sports Education (P) instruction, music classes, driving schools (all under division 85). Health and social Hospital, doctors, specialized medicine (all under 86), residential care (87), social work activities without work (Q) accommodation (88). Source: Nayyar, Hallward-Driemeier & Davies (2021), based on UN ISIC Rev 4 (United Nations 2008). KENYA COUNTRY ECONOMIC MEMORANDUM 113 Appendix C: Data sources The Country Economic Memorandum makes use of several data sources, including from the Kenyan National Bureau of Statistics (KNBS). Key data sources are summarized below. Statistical sources National accounts (KNBS). This CEM makes use of national accounts as published by KNBS. These national accounts were revised and rebased in 2017. Supply-Use Tables [SUT] (KNBS). As part of the national accounts revision, new Supply-Use Tables (SUTs) was constructed by KNBS. The updated SUTs relates to the years 2016 and 2009. Census of Establishments [COE] (2017; KNBS). The Census of Establishments (COE) was conducted between January to May 2017 and covered all formal sector firms and establishments. A total of 138,109 establishments were interviewed. Currently only aggregate figures are available from this census. Integrated Survey of Services [ISS] (2018; KNBS). The Integrated Survey of Services (ISS) was conducted between December 2017 and April 2018, using a sampling frame derived from the Census of Establishments. Variables covered in this survey relate to 2015 and 2016. Currently only aggregate figures are available from this census. Kenya Continuous Household Survey [KCHS] (2019; KNBS). The KCHS is a household-level survey, which also collects information on employment. Most of the employment figures reported in the CEM are based on the KCHS. The individual-level dataset is based on 86,647 respondents. ILO modelled estimates of employment are based on the KCHS. Microdata is available through KNBS. Micro, Small and Medium Enterprise [MSME] Survey (2016; KNBS). The MSME Survey targeted both formal and informal establishments with at most 99 persons engaged (following Kenya’s definition of a MSME). A total of 24,164 establishments were interviewed. Microdata is available through KNBS. Other key sources used in this report Firm-level Adoption of Technology [FAT] (World Bank). The World Bank’s Firm-level Adoption of Technology (FAT) survey measures the degree of technological sophistication by firms (Cirera, Comin & Cruz 2022). In Kenya, the survey includes a nationally representative random sample of 1,305 formal firms with five or more employees in agriculture, manufacturing and services. Microdata is likely to be made available later in 2023. Firm-to-firm VAT transactions. Chacha, Kirui & Wiedemann (2022) compiled transaction-level tax records from the Kenya Revenue Authority (KRA), covering over four million firm-to-firm relationships of 57,500 formal private sector firms. Given the confidential nature of this data, only aggregated data was used for the analysis in Chapter 3 (“Link”). Business Pulse Survey [BPS] (2020-2021; World Bank). The Business Pulse Survey was conducted during the COVID-19 pandemic to obtain a measure of firm impacts during the pandemic. In Kenya, three waves were conducted, covering 2,070 firms in wave 1, 1,836 firms in wave 2 and 1,787 firms in wave 3. STEP Skills Measurement Program (2016-2017; World Bank). The World Bank’s STEP Skills Measurement Program (STEP) is an initiative to measure skills in low and middle-income countries. The 2016-2017 STEP survey of employers covered 504 respondents. Microdata is available on the World Bank website. Business of the State [BOS] (World Bank). The BOS database maps the footprint of the State within the corporate sector and across economic activities based on a uniform definition across countries. The BOS dataset tracks all corporations where national or subnational governments have ownership stake of at least 10%, either directly or indirectly (Dall’Olio et al. 2022). 114 KENYA COUNTRY ECONOMIC MEMORANDUM FCI Digital Business database (World Bank). The FCI Digital Business database was collected by the World Bank’s Finance, Competitiveness, and Innovation (FCI) Global Practice (see also Zhu et al. 2022). The database is a firm-level database of 200,000 digital businesses in 190 countries and assembled from proprietary data sources on digital firms (CB Insights, Pitchbook and Briter Bridges). Trade in Services by Mode of Supply [TiSMoS] (2005-2017; WTO). TiSMoS is an experimental dataset constructed by the World Trade Organization that disaggregates services trade figures by mode of supply. Data sources for TiSMoS include balance of payment statistics as well as FDI surveys. The latest available year is 2017. Services Trade Restrictiveness Index [STRI] (2022; World Bank/WTO). The STRI provides comparable information on services trade policy measures on five sectors (telecommunications, finance, transportation, retail and professional services) and key modes of delivery. An update of Kenya’s STRI was conducted in 2022 in cooperation with the African Continental Free Trade Agreement (AfCFTA) Secretariat. 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