With inflation at 19%, commercial lending rates well above 25%, a currency that at its lowest point had depreciated by 30% last year and a on the Nairobi Stock Exchange (NSE) of minus 23% in 2011 - the current state of Kenya’s economy leaves much to be desired. Although the exchange rate has since stabilized, the prognosis in the short-to-medium term does little to inspire confidence as uncertainty continues to grow from;

· an escalating war with Al Shabaab - a militant group that has stubbornly rebuffed invasions by the U.N., Ethiopian and Ugandan forces since 2006;

· imminent results from hearings at the Hague with the potential of resurfacing the animosity that divided our nation in 2008;

· Looming elections in a new constitutional regime that will significantly alter the country’s political landscape.

Despite Kenya’s economic malaise, the country’s aspirations through Vision 2030 remain a beacon of hope. However, recent policy decisions to hike interest rates in a bid to tame inflation have seriously undermined this ambition. The ensuing tightening in liquidity and credit markets is already significantly slowing down capital investment and consumption - critical ingredients for economic growth.

Last year’s drought, arguably the worst in half a century, exposed the weaknesses of our economy. Agriculture currently accounts for about 20% of our GDP and hydro power generation accounts for over 50% of our total power supply, both vital sectors of the economy that are heavily reliant on what are every increasingly unreliable and unpredictable rainfall patterns. This act of nature I believe is the root cause of current inflationary pressure. The bleak outlook for the health of our country’s exchange rate and current account balance largely stem from the subsequent economic impact on these two sectors. Kenya annually imports over 20% of its total food requirements and recent KPLC price hikes are further eroding the competitiveness of our struggling manufacturing sector with electricity prices now over three times that in China and twice that in Egypt.

With a population growing by over 1 million every year and with weather patterns unlikely to improve due to global warming, Kenya is faced with two potentially crippling issues; food security (human energy) and electrical power security (commercial energy). Both of which are fundamental economic drivers that are not receiving the deserved attention through recent monetary and fiscal policy interventions. Effectively upgrading our agricultural and power sectors in-line with Vision 2030 goals no doubt will require significant capital investment, in the order of trillions of shillings over the next two decades. Only 10% of arable land in Kenya is currently irrigated and we are yet to develop our vast geothermal resources estimated at 7,000 to 10,000 MW compared to our current power supply of approximately 1,400 MW.

The question that beckons is; “Where this capital will be sourced with a government that is cash strapped and operating at its debt ceiling, and the scarcity of now risk averse foreign capital in the wake of the sticky Euro debt crisis?” As often said; “charity begins at home”. A closer look at the country’s balance sheet indicates a vast reserve of private capital, currently underutilized and often chasing a limited number of ‘pricy’ opportunities. Casing points are:

· The Safaricom IPO in 2008 that was oversubscribed by 532%, raising over KES 220 billion over an offering period of under one month almost causing a systemic liquidity crisis in our banking sector in the process.

· A real-estate market producing over 30,000 units every year despite there being under 20,000 mortgages in existence today indicating a significant proportion of 100% equity financed purchases.

· Pension funds with total assets of KES 415 billion and a meager allocation of 0.6% (KES 2.5 billion) to Private Equity (PE) compared to the West where fund allocation to PE in the range of 15% to 20% is not unusual. In Kenya, close to 29% is allocated to quoted equities, which has left investors wreathing over the past 5 years with annualized returns averaging a poor 0% underperforming real estate by 14 % and inflation by 9% over the same period.

Having established the investment need, identified investors seeking long-term investment products with stable equity like returns but lower price volatility, and a source of private capital adequate to the fund equity portions of large agricultural and power projects - the emanating million dollar question is; “How can this capital be mobilized and deployed where it is needed most?”

There are four critical success factors required to achieve this need. First, the Government needs to create an enabling policy framework that will reduce investment risk and subsequently improve the attractiveness of Greenfield investment opportunities in these two sectors. In Agriculture, this could be done by providing sovereign off-taker agreements for agricultural produce creating a win-win situation for both suppliers and consumers. In the power sector, actualizing talks of providing sovereign guarantees to reduce dry well drilling risk in the geothermal sector is a key success factor for the development of this resource. I would argue that these ‘setup’ costs are small in comparison to the potentially catastrophic consequences of doing nothing or the Government bursting its borrowing limits to finance capital investment in these sectors.

Secondly, key regulatory bodies e.g. the Kenyan Retirement Benefits Authority that institute checks and balances on the allocation of capital amongst asset classes need to acknowledge that Kenya’s local PE industry has come of age and deserves a larger portfolio allocation. What was once an unfamiliar nascent industry now boasts a wealth of world class local talent and expertise evidenced by; the supernormal returns generated by investment companies such as Britak, TransCentury and Centum, and global recognition of some fund managers e.g. James Mworia, Centum’s CEO who was awarded the 2011 CNBC Africa Young African Business Leader of the Year.

Thirdly, PE managers need to work with technical partners to identify, develop and structure investment opportunities that meet the return expectations and risk profile of private investors, who are increasingly seeking wider diversification beyond quoted equities, fixed income and real estate.  Finally, there is a need for continual engagement and education amongst the key stake holders identified on the PE business model and the benefits and opportunities realised by pooling funds in PE vehicles supported by well aligned full-time investment professionals. A conference such as the Super Return Africa PE Conference held in Nairobi in November 2011 is an example of an effective forum in doing so.

In closing, it would be difficult to argue that PE alone is Kenya’s economic panacea however; there is a strong case to suggest that PE has the catalytic potential to remedy some of Kenya’s economic woes and accelerate the country’s progression in realizing Vision 2030. Better still, all the tools required to unlock this potential are within our grasp today.

The Central Bank of Kenya, in an apparent bid to curb runaway inflation and shore up a weak shilling, has pursued a policy of increasing interest rates and tightening liquidity resulting in a dramatic increase in interest rates. The current environment is reminiscent of the 90's when interest rates touched 40 per cent and beyond and which resulted in a lost economic decade. The Monetary Policy  Committee (MPC) has advanced a number of reasons for the policy stance they have taken.  The first is the need to reduce inflation,  the second is to dampen demand for imports and therefore ease pressure on the exchange rate and the third is to reduce private sector credit and cool down the economy.  In my view, the reasons advanced by the MPC are highly debatable and it is doubtful if the objectives are valid and where they are valid it is uncertain if the measures will achieve the desired outcomes.

Let’s consider the effectiveness of increasing interest rates to reduce inflation.   Low interest rates may fuel inflation if they create demand that cannot be matched by existing supply leading to an unsustainable increase in the price of goods and services.  The theory is that, in times of high inflation the price of money should be increased so at to reduce the demand for goods and services and therefore reduce prices.  For the theory to work, the goods should be those whose demand increases or decreases with income.  There are however certain goods, whose demand does not increase or decrease in line with incomes.   These goods are known as necessity goods, which are goods that we cannot live without and which consumers are unlikely to cut back even when times are tough.  Examples of necessity goods are food, power, fuel, water, housing, and basic transport.  In calculating inflation the Kenya National Bureau of Statistics (KNBS) uses a basket of goods and services.  Within the basket used by the KNBS necessity goods such as food, fuel, housing and transport account for 63 per cent of the basket.   KNBS reported that inflation in the month of November was at 19.72 per cent.  Of that figure, the contribution of inflation by necessity goods, specifically food, fuel and transport, was 14.86 per cent or 75 per cent of total inflation.  It is an established economic fact that the more necessary a good is, the lower the demand will be impacted by the price, as people will attempt to buy it no matter the price.  Given that 75% of our inflation is directly attributable to goods that are completely essential and another 5% - 10% is indirectly driven by the price levels of those necessary goods, It is intriguing how the MPC concluded that by increasing interest rates, people will somehow consume less food and fuel and therefore driven down prices.

If the issue is inflation, let us address the root causes of inflation.  Taking food as an example, agriculture accounts for 22 per cent of GDP and employs at least 70 per cent of the work force.  The contradiction is that for an agricultural country we are a net food importer.  Consider the case of oil and electricity, a significant volume of oil imports goes towards powering diesel powered oil generators yet we have very significant reserves of geothermal and other renewable sources of power.

The second reason advanced by the MPC is the need to strengthen the domestic currency.  It is true that since the Central Bank began its policy of increasing interest rates the domestic currency has strengthened against the major currencies.  The strengthening of the domestic currency has been as a result of two principal reasons. The most significant one in my view, is the increase in the holding cost of any other asset except the Kenya Shilling, forcing the market to liquidate other assets including foreign currency holdings and shares and hold their assets in Kenya Shilling. The attraction of the shilling is due to the fact that the Kenya Shilling interest rate is very attractive. Commercial Banks are willing to pay as much as 30% on fixed deposit.  The increased demand for Kenya Shillings and consequent reduced demand for foreign currency has led to a strengthening of the Kenya Shilling.  The second reason cited by the MPC for the strengthening of the Kenya Shilling is the reduced demand for imports due to the high cost of money.  The bulk (68 per cent) of our imports are oil, machinery and transport mainly related to the ongoing infrastructure development and manufactured goods, primarily intermediate goods.  I have not seen evidence of a reduction in the volumes of imported oil or the slowing down of infrastructure development and so I am inclined to believe that the primary reason the Kenya Shilling has strengthen is the first reason, which is the flight to local currency in pursuit of a high yield.  It is therefore logical to conclude that unless we address the deep underlying causes of our weak currency then the current levels of the Kenya Shilling can only be sustained if interest rates remain high.

The forces of demand and supply determine the value of a currency.  Exports create demand for the domestic currency while imports increase the demand for foreign currencies and therefore increase supply of local currency to purchase the foreign currency.  The weakening of the Kenya Shilling is a function of these forces and is driven by the following factors. The first is that our imports are way larger than our exports and imports are growing faster than our exports.  Our exports are 40% of our imports and this ratio is shrinking. In the year to June 2011, imports grew by 21% while exports expanded by 12%.  The growth in imports is a function of the significant investment in infrastructure and the increase in the price of oil.  The growth in imports is not a bad thing as such because it is necessary if we are to make the necessary investment in infrastructure.   The deficit between what a country imports and exports (current account deficit) is funded by either foreign inflows of capital or the foreign reserves that a country holds.  The crises in Europe, which is Africa’s largest source of foreign direct investment, has trigged a global flight to liquidity and the capital in-flows have diminished and in certain instances reversed putting pressure on the currencies and reserves of emerging markets across the globe.  To the extent that imports remain larger than exports and risks to the global economy persist it is fair to conclude that fundamentally the Kenya Shilling remains under pressure and it is being artificially supported by the high interest rates.  The consequence is that when prices are artificially distorted they create the wrong incentives. I am of the opinion that it may have been preferable to let the Kenya Shilling find its true level and in that way create incentives for the export sector and reduce non-essential imports by making them more expensive. By artificially supporting the local currency we are imposing a tax on exports and a subsidy on imports.  We are in essence taxing a Kenyan farmer who would wish to export and subsidizing a middle class YUPPIE importing a used Range Rover Sport.  What is worse, is the heavy toll the economy is taking offers inly temporary support to the currency.

The third reason advanced for increasing interest rates is that there has been a rapid expansion of private sector credit, which has led to the economy overheating. These are the facts, the average economic growth for Sub- Sahara Africa (SSA) is approximately 5.5 per cent.  The average economic growth for Kenya over the last 5 years has been 3.3 per cent and it is only in 2010 that economic growth was at 5.5 per cent which is the Africa average.  The second fact is that average population growth over the last five years has been 2.55%, implying that real per capita incomes have been growing at less than 1% over the last 5 years.

There is also a view that private sector credit is expanding at an unsustainable rate.  It is true that private sector credit has expanded by 93 per cent since 2007 to Kshs 1,076 billion. But it is also true that private sector deposits have also increased by 65 per cent to Kshs 1,442 billion. The expansion in private sector loans is therefore funded by an expansion in private sector savings. At 75 per  cent the loan to deposit ratio in Kenya is extremely conservative when compared to the 100 per cent plus loan to deposit ratios in the developed world. There is also a perception that consumer borrowing is the primary driver of growth in credit.  In July 2011, credit to private households as a proportion to total credit  was only 11 per cent, which is a decline from 14.7 per cent in July 2008. The building and construction sector has also taken some flak. These sector accounts for a paltry 3.3 per cent of total credit and has also declined from 4.9 per cent in July 2008.  Lending to real estate, which is largely mortgages has increased from 3.8 per cent of total credit in 2008 to 8.8 per cent in July 2011. This is understandable when one takes into consideration the low level of home ownership in the country and the demographics where the rate of new household formation is very high. The high rate of credit growth has in reality been to the productive sectors of the economy.  In the year to July 2011 the average credit growth was at 27 per cent. The sectors that grew above this average were, agriculture, manufacturing, building and construction and finance and insurance. If you take this point and tie it to the fact that we are facing a supply driven inflation it is fair to conclude that we require more capital into these crucial sectors so as to expand productive capacity and reduce the rate of inflation.

The current monetary policy is in my view undermining our economic growth and has distorted economic incentives  which will only make the situation worse.  To illustrate my point, there is little reason to invest in the real economy when the government and commercial banks are offering such high interest rates for passive capital. Investors are therefore being rewarded not to invest and expand the productive capacity of the economy, which is the solution to our inflation problem.  Those who have been unfortunate to have invested are facing a harsh punishment. There cost of borrowing has been increased to unbearable levels and there is a real possibility that this may trigger loan defaults which I hope will not cascade into a banking crises. The local currency has been artificially propped up and therefore creating incentives for importers and punishing exporters, which is not the way to reduce the current account deficit.

An economic crisis of extraordinary proportions is unfolding in the global economy. This is not the time to create uncertainty and conduct monetary experiments.  We need stability and we must ensure that our domestic economy remains robust. It is time to move from economic theory to the practical realities of the current environment.

Last year, the NSE was the best performing bourse in Africa having appreciated by almost 35%, only second to the Ugandan exchange which registered a sterling 62% appreciation.

This year, its fortune tide has reversed direction, moving from the best to the worst performing bourse, except for Egypt, having declined by 22.30% since January. In US dollar terms, the loss has been further magnified to 32.54% by a persistently weakening Kenya Shilling, the worst performing currency in Africa, save for the Ugandan shilling. Indeed, it is a double tragedy for foreign investors who have had to deal with a weakening currency besides the falling value of equities.

Last week, the NSE index touched a new low after breaking the 3,500 mark psychological barrier for the first time in 19 months attributed to stocks constituting the index trending towards their twelve month lows. Safaricom, the largest component of the NSE index, has, for instance, eased by 35% since January and is now trading at its 12 month low of Kes3.00 per share.

The driving force for our stock market has been a gradual deterioration of Kenya’s macro economic conditions rather than performance of individual companies listed at the stock exchange. If you take the performance of KCB, Equity Bank and Cooperative Bank as an example, they recently reported 33%, 57% and 41% earnings improvements respectively, which was impressive judging by the performance of their peers across Africa. Return on equity was also above 20% for the three banks promising a healthy return to their shareholders. Contrary to the expectations of unsophisticated investors, their individual share prices has since retreated stressing the point that institutional investors, the most influential class of investors, are currently concerned about how the local economy is fairing more than anything else.

My personal view is that the Kenyan economy may have just quietly eased into an economic ‘slow down’ phase in the business cycle. The economy is seemingly vulnerable to shocks that could trigger the economy to land into a recession, business confidence is starting to waver, and inflation continues to rise. From a capital market perspective, Treasury bill rates are high and still rising, the yield curve is showing tendencies to want to invert due to decreased activity on the long end and, of course, the stock market is falling. All these are tell tale signs of an economic slowdown.

Having identified where we are on the cycle, two things come to my mind as an investor: will the next phase be a recession or ‘initial recovery’ and when is it likely to kick-in? The government and central bank must intervene to steer this cycle not to transition into a recession. The central bank is in a delicate position of setting short-term rates to levels that will control inflation without inhibiting economic growth rate. Kenya is also in the middle of implementing the ambitious Vision 2030 and a restrictive policy will obviously not be in line with that vision. The Central Bank has appeared reluctant to raise interest rates to curb inflation and weakening shilling because it contradicts its apparent preference for growth policy pursuit. Investors are keenly watching on policy actions and appearance of dilemma will only fuel fear and anxiety in the economy and capital markets posing danger of sliding into recession.

Kenya’s NSE problems have been compounded further by increasing concerns about the US and European economies. Marc Chandler, global head of currency strategy at Brown Brothers Harriman was recently quoted saying that “Global markets have been rattled by a crisis that is fast morphing into a global banking and economic crisis on one side, and a very piecemeal policy approach to contain risks on the other." Global fears and anxiety has sent world markets reeling with global sell-off across the board.

The NSE has not been spared from the brunt of global sell-off as foreign investors flee from stocks to meet redemptions at home or seek shelter in traditional safe havens, including gold. Kenya is one of the most liquid exchanges in Sub-Saharan Africa and hence it is no surprise that it has exhibited a strong correlation with global markets especially in the current global downturn. A slowdown or recession in the United States and European economies could act as an exogenous shock to the Kenyan economy that could prolong the slowdown.

When is all this uncertainty going to end? Relief from the current local and global macroeconomic concerns is not yet in sight and even the most optimistic investor would find it difficult to imagine anything better than equities maintaining at the prevailing prices in the short term. There is also the small matter of next year’s general election to consider.

Kenyan inflation accelerated to 16.7 percent in August, more than triple the central bank’s 5% target, as the worst regional drought in 60 years coupled with a weakening shilling, close to all time low, and high oil prices continue to spike food prices. Analysts are of the view that inflation has not yet peaked and is likely to top out at 18 to 20 percent region.

In an operating environment where inflation is expected to remain above the policy target, fund managers should, by rule of thumb, have a bias for holding cash. Interest rates are likely to continue edging upwards and anyone holding cash is in an enviable bargaining position in an environment where liquidity is only likely to continue tightening. In the last two weeks the discount rate spiraled to over 29% from just 6.25% and the interbank rate to over 26% from 8.3%, creating the appearance of a liquidity crisis within the banking sector. It is no surprise to me that banks are now willing to offer 11 to 12 percent for call deposits, a return that was unimaginable last year and this could still edge further up.

Real estate and other real assets are also likely to do well implying that investors should also increase their asset allocations to this asset class. In a rising inflation environment, asset values and their inherent cash flows and returns are only likely to increase.

Savvy investors who foresaw the inflection point to an economic slowdown are smiling all the way to the bank as they are now invested in the least risky asset class, cash, and yet they are currently outperforming the most risky asset class, equities. Indeed, they have found the cheese.

If you missed the cheese, you must not miss it the next time round. What I know for certain is that the cheese will be back at the bourse and it is only a question of time. Equity investors are hurting from the current downturn but they must not allow fear to blind them to the fact that investment is about the future and the time to position for the next cheese move is now. Investment managers who are currently enjoying the prevailing double digit cash returns saw it coming, and positioned themselves, at least six months ago and will soon be, if not already, positioning themselves for the next kill. The question that is disturbing most investors’ minds is just “how low can the NSE go?” and the moment they start smelling that it is going to be any time soon, there will be a mad rush at the NSE. Unfortunately, that might be too late.

Investors have lost more than Kes230 billion since January for reasons other than the fundamental performance of companies at the NSE and the bourse continues to hit new lows. Everything else remaining the same, it is only rational to expect reversion when macro economic conditions begin to turn. Who will get the most of that Kes230 billion pie, if not more?

Warren Buffet’s popular saying that investors should “be fearful when others are greedy and greedy when others are fearful,” sums up the opportunity we presently face. Global and domestic markets are gripped with fear and anxiety and I sense that the time to be bold and fearless is nigh, if not now. This opportunity may be wrapped in a period of painful waiting but it is almost certain that it will pay off handsomely given the current rock bottom prices. My parting shot to all investors: do not wait to chase the cheese, the magic lies in positioning yourself now and the cheese will surely find you.

The increased interest in Africa exhibited by Private Equity and Venture Capital funds provides a good opportunity for promising entrepreneurs and businesses on the continent to tap into these lucrative sources of capital.

According to statistics released by Emerging Markets Private Equity Association (EMPEA), an independent global membership association whose mission is to catalyze Private Equity (PE) and Venture Capital (VC) investment in emerging markets, 2010 saw PE activity in the emerging markets rebound from a sluggish 2009.

Economic developments over the last 3 months have been, to say the least, incredible and unprecedented and in my view pose a grave risk to the momentum of Kenya’s economic growth. Sustaining economic growth is extremely important because it is the only way we can improve quality of life and lift millions of people out of poverty.

Between February and June 2011, 91 day Treasury bill (T-bill) rates rose by an unprecedented 700 basis points to touch 9%.  This level of interest rates was last witnessed in May 2002. Over the same period, the Kenya Shilling depreciated by close to 10%, touching Kshs. 90 to the dollar, a level last seen 17 years ago.