Effect Of Total Factor Productivity On Economic Growth In Kenya: An Empirical Analysis 1970-2015

Abstract

In view of the challenges stated in the Economic Recovery Strategy Paper for Wealth and Employment Creation (ERSPWEC) 2003-2007, the empirical findings of Kalio, Mutenyo and Owuor (2012) and on the basis of the point of motivation by Parente and Prescott (1996), the purpose of this study was to build a model to explain the effect of Total Factor Productivity (TFP) on economic growth in Kenya using time series data for the period 1970-2015. The TFP components of Foreign Direct Investment (FDI), Foreign Aid (FA) and Financial Development (FD) are used to explain the effect on economic growth after accounting for labour and capital productivity. To achieve the objectives an ARDL bounds test of co- integration is employed and a preliminary unit root test, co-integration test, Error Correction Model (ECM) and diagnostic tests are carried out. The ECM findings reveal that the TFP Components of Foreign Aid and Financial Development have insignificant effect on economic growth in the long run and therefore the null hypotheses are accepted. However, Foreign Direct Investment has a significant effect on Economic Growth and the null hypothesis is rejected.Multidirectional causality is determined due to the Error Correction Terms (ECTs) having statistically significant coefficients for Economic Growth, Foreign Direct Investment and Foreign Aid, while Financial Development is insignificant and there is unidirectional causality. The model passed the diagnostic tests except for presence of omitted variable bias in Foreign Aid and Financial Development. A robustness check is then carried out to determine the consistency of the ARDL findings using the Johansen test of cointegration, vector error correction model (VECM) and post estimation tests. The findings reveal consistency in the ECTs with (-.91) for ARDL and (-.87) for VECM with economic growth as the dependent variable for co- integrating equation one. The post estimation tests show non-normality of data for Economic Growth and the Orthogonalized impulse response functions show that Economic Growth and Foreign Direct Investment have significant effect of transitory shocks on each other from period 0 to 3 beyond which at period 4 the shocks become permanent and insignificant. The other variables show effect of permanent shocks from period 0 to 13 on themselves and on each other. In conclusion, the permanent shocks for Foreign Aid are due to regulatory and structural impediments that hinder the growth of TFP in the economy. Financial Development is affected by fragmented goods and capital markets and weak financial systems which prevent the leveraging of cross border investment opportunities. Foreign Direct Investment is affected by high transaction costs and weak absorptive capacity in the business environment. To realise significant effect of the TFP components on Economic Growth, recommendations for policy action are to improve policies for the adoption of technology, implement structural and economic reforms, lower the transaction costs to businesses, improve governance and strengthen financial systems to world class levels in order to raise the levels of savings and investments in the economy.