Determinants of Current Account Deficit and Its Sustainability in Kenya

Abstract

Large and persistent current account deficits are among the most serious problems of developing countriessince they result in economic crises such as currency crises, burgeoning external debts and reduction in the level of international reserves. Kenya's current account deficit rose from 2.9 percent of GDP over 1964-73 to 6.9 percent over 1974-79 on account of the two oil shocks, widening trade balance and overvalued domestic currency. This prompted the country to rely increasingly on risky short term flows to balance the accounts. This has consistently created a financing gap. Hence, the need to find out the determinants and the sustainability of the current account deficit. The purpose of this study was to assess empirically the determinants of Kenya's current account deficit and its sustainability. The objectives of this study were to determine the univariate integration properties of variables; establish the determinants of the current account deficit; analyze its sustainability; and evaluate its dynamic interactions among various macroeconomic variables. Based on the absorption approach, the study established the persistence and determinants of the current account deficit; on the other hand, the Inter-temporal approach was vital in the assessment of the sustainability of the deficit. Time series research design was adopted. Due to the time series nature of the study, Multivariate Vector Autoregressive, Granger causality test together with Variance decomposition and impulse response functions were used to empirically establish the determinants and dynamics of the current account deficit. Sustainability of the current account deficit was investigated by use of the Johansen Maximum Likelihood Cointegration methodology. Augmented Dickey Fuller, Phillips& Perron Test, Dickey-Fuller Test with GLS Detrending and the Kwiatkowski, Phillips, Schmidt, and Shin Test were used to check for the integration properties of the variables. The resultsindicate that current account deficit, gross domestic product growth, inflation and foreign direct investment are 1(0). Degree of openness, terms of trade, external debt stock, foreign exchange, gross domestic savings, fiscal deficit, exports and imports are 1(1) .The results also indicate that exports and imports are cointegrated with the estimated coefficient of 0.21989 indicatingthat current account deficit is not sustainable in the long-run because of faster rise in the Kenyan imports relative to exports. The major determinants of the current balance are the degree of openness, terms of trade, oil price on the international market and inflation. The variance in the current account is better explained by its own shocks followed by shocks from degree of openness, fiscal deficit, terms of trade, external debt of stock, foreign direct investment, growth rate of gross domestic product, and inflation. From. the findings the study recommends the Country to focus on current account targeting policies together with policies that encourage increasing and stabilizing gross domestic product in order to increase exports and its competitiveness and policies that reduce the burden of depending on oil from the world market