In part 1 of this blog series[1], we discussed why Kenyans should be worried about the level of public debt. We argued that the increase in the share of commercial debt in Kenya imposes huge fiscal and welfare costs. In the current blog, we discuss how the changing composition of external debt has contributed to the high cost of public debt. We also discuss how the focus on external debt has distracted the pundits, public, and policymakers to a larger problem in Kenya i.e., domestic debt. The level of external debt in Kenya has seen tremendous growth since 2014. Between 1999 to 2013 the external debt grew at an average annual growth rate of 8.6 percent compared to 22.6 percent between 2014 to 2020. By 2020, Kenya’s external debt was Ksh. 3.79 trillion up from Ksh. 0.31 trillion in 1999. Several developments in external borrowing are crucial to understanding the risk of external debt in Kenya. First, between 2014 to 2020, the share of commercial debt in total external debt increased from 0.07 percent to 31.4 percent. Second, the share of debt from China increased from 5 percent to 21 percent between June 2011 to June 2020. Lastly, the share of dollar-denominated debt increased from 29 percent to 67 percent between June 2011 to June 2020[2]. Figure 1 shows the composition of external debt in Kenya.
Figure 1: The changing composition of external debt in Kenya[3]
The discussion above shows that external debt since 2010 has shifted to commercial debt and become more concentrated in terms of bilateral lenders and currency denomination. This exposes Kenya to several challenges. First, the rapid increase in external debt between 2014 and 2020 also lead to a rapid increase in debt servicing costs. Interest rate payment to external debt as a share of total revenues in Kenya increased from 3.9 percent in 2012/13 to 14.7 percent in 2018/19 while debt redemption of external debt as a share of total revenue increased from 1.2 percent in 2012/13 to 6.1 percent in 2018/19[4]. Second, the high level of commercial debt exposes Kenya to the rollover risk and whims of international financial markets. Third, the high share of dollar-dominated debt increases Kenya’s vulnerability to external shocks that can lead to the depreciation of Kenya shilling against the dollar.
Lastly, although the external debt composition has shifted to commercial debt in recent years, a sizable amount of external debt is still owed to multilateral lenders. A quarter of external debt in Kenya is owed to IDA which usually offers debt in concessional terms. However, the share of commercial domestic debt in total public debt in Kenya was around 46 percent in June 2020 while the share of commercial external debt in total public debt was only 16 percent. Hence, domestic debt is likely to exert more pressure on the government revenues than external debt. The focus on external debt over the years distracts the public, the pundits, and the policymakers from the high level of domestic debt. The high level of domestic debt exacerbates the risk of debt distress.
Wagner’s law of state, also known as the law of increasing state spending, holds that for any country, public expenditure rises constantly as income growth expands. Loosely translated, with economic growth and development, a nation will experience an increase in the activities of public sector, which is generally proxied by sectoral expansion of public expenditure in a country. The underlying claims of this principle, which is named after the German economist Adolph Wagner (1835–1917) is what is of significance for this blog: To begin with, economic growth results in an increase in complexity requiring continued introduction of new laws and development of the legal structure; Additionally, urbanization increases negative externalities, such as congestion and crime, which necessitate intervention; and finally, the goods supplied by the public sector have a high income elasticity of demand. If the elasticity of demand exceeds one, public sector expenditure will consequently rise as a proportion of income.
Since decentralization in 2013, Kenya’s size of the public sector has grown in nominal terms, proxied by the increase in sectoral public expenditure as indicated by figure 1.
Figure 1: National Government Expenditure Trends since 2013/2014.
Source: Author’s Computations
The growth in public sector spending can be attributed to the devolution complexities brought about by the increased fiscal, administrative and governance responsibilities meant to enhance efficiency in public service delivery to the lowest possible units on the periphery. With devolution coming into effect in 2013, it was only rational to anticipate that the national government would fill in size as an ever-increasing number of fiscal resources trickled down stream to county governments. The national government also needed to ensure that county governments align themselves with its priorities of ensuring that public service delivery reaches the grassroots efficiently and cost-effectively. These priorities later became the Big 4 Agenda.
One would expect the National Treasury’s expenditure allocations to prioritize the achievement of the big 4 agenda in their respective economic sectors. Figure 2 depicts the aggregate sectoral allocation of national government expenditure from 2013/14 to 2019/20 in a nutshell.
Figure 2: Sectoral expenditure allocation (in %) by the National Government from 2013/14 to 2019/20
Source: Author’s Computations
From the figure above, Energy, Infrastructure and ICT, Education, Public Administration and International Relations (PAIR), Governance, Justice, Law and Order (GJLO) and National Security sectors represent the greater part of the absolute national government consumption pie, appreciating on average a twofold digit proportions of 23%, 23%, 14%, 13% and 10% respectively over the course of the last 7 years under review. Justifiably, Education is the key to a country’s competitiveness and a solid economy, and continued public investment in education is needed in order to support improvements in student achievement and put the economy on the path to sustained growth. In a sense, a country’s economy becomes more productive as the proportion of educated workers increases since educated workers can more efficiently carry out tasks that require literacy and critical thinking.
In the same breath, in order to maintain a smooth functioning between the agriculture and industrial sectors, a sound socio-economic infrastructure is necessary. Thus, the government must invest substantially in the development of overhead capitals like energy, power, information and communications systems among other infrastructure in order to augment different sectoral growth in the country. Kenya is currently one of Africa’s fastest growing ICT markets where ICTs have increased productivity in all spheres of production process and enabled expansion of skills, contributing to improved standards of living for Kenyans (ITA). With the ICT sector poised for exponential growth in years to come, it would make sense for the government to tap into the gains of the sector through increased investments in ICT infrastructure (structures and systems) in order to enhance the creation of jobs in the domestic economy through the digital market place platform. However, these investments ought to be balanced out between recurrent and development priorities to ensure that exponential and inclusive growth is sustained in the future.
Of major concern is the fact that out of the ten economic sectors in Kenya, none of the big 4 economic sectors features in the first five sectors represented by figure 3.
Figure 3: National Government Expenditure Share across Sectors since Devolution from largest to smallest.
Source: Controller of Budgets Reports
It is on the extreme end of the expenditure allocation continuum that sectors like Agriculture, Rural and Urban Development (ARUD), Health and Social Protection, Culture and Recreation (SPCR) enjoy a meagre share of national government expenditure, despite being the top priority sectors in the big 4 agenda for the government. These three sectors have cumulatively accounted for less than 15% of the aggregate national government expenditure in the last 7 years. The rates of expenditure growth in these three sectors have also been unstable (Figure 4). Consequently, little has been realized in the achievement of the big 4 since their launch in December 2017 and the national government may have to be overly ambitious in order to achieve the same in the remaining one year. This will warrant a shift in the expenditure priorities if the big 4 are to be achieved, especially towards the last leg of the current regime.
Figure 4: Rates of expenditure growth in the big 4 sectors have been unstable since 2013/14.
Source: Author’s Computations
The implied expenditure prioritization will have to reconsider the proportion of total national government expenditure channeled to specific sectors of the economy, bearing in mind that recurrent expenditure across the big 4 priority sectors have always outweighed the development expenditure considerably. There have not been so many hospitals built to achieve universal health coverage, public resources meant for construction of dams to facilitate sustainable agriculture through irrigation have been embezzled and little exists to be shown for affordable housing in the country as a huge population of citizens continue to live in slums.
Based on the above analysis, the realization of the big four agenda remains a facade amid the national government’s public discourse which has been and is being justified through the National Treasury’s huge borrowing to finance the big 4 agenda. The country’s initiative to ramp up public debt on account of financing the priority agenda stands to derive little or no gains, given the fact that a huge proportion of national government expenditure has gone into financing recurrent obligation across most of the economic sectors since devolution.
Policy Recommendations:
Foremost, bearing in mind that high levels of government consumption are likely to increase employment, profitability and investment via multiplier effects on aggregate demand, The National Treasury should consider increasing sectoral allocations of government expenditure, even of recurrent nature, to contribute positively to economic growth. However, the sectoral allocations should prioritize increased spending to economic sectors which not only yield highest returns to the economy in terms of economic growth, but also ensure continuous and sustainable positive returns to the economy in the foreseeable future. These are sectors like Agriculture, Health and Natural Resources which have over the devolution years, experienced very dismal allocation of the national expenditure budgets, and whose increased expenditure allocation will augur well with the realization of envisaged food security and universal health coverage in the country in the long-run.
Additionally, at a time when Covid-19 Pandemic continues to ravage Kenya’s economy through loss of job opportunities both in the formal and informal sectors, the government should prioritize the containment of the virus through revamped expenditure in the health sector. This can be done by hiring more medical personnel and vaccinating the vast majority of the working class so as to forestall the spread of the contagious virus, and also facilitate the speedy recovery of the slumping economy by allowing the working-class Kenyan citizens to return to work. Likewise, the health sector share of development expenditure allocation needs to be ramped up unreservedly in order build more level 3 and 4 hospitals for the in line with the realization of the national government. In doing this, the national government spending will be in line with the realization of universal health coverage in the country, which is among the key agenda for the big 4.
Lastly, the share of expenditure allocation in the social protection, culture and recreation (SPCR) sector ought to be ramped up sizably, in order to facilitate the construction of affordable housing units in line with government’s priority project of providing affordable housing in the country. This will not meet the increased aggregate demand for affordable housing in Kenya, but will also create jobs in the real estate sector in line with the realization of one of the key big four agenda.
A growing concern in the world today is the rising indebtedness of low-income countries. This continues to raise critical questions on debt sustainability. Many countries have elevated levels of debt as the primary concern now is whether they can meet their obligations without upsetting the future structure of revenue and income. Nonetheless, IMF has pushed countries to spend as much as is viable to protect the vulnerable. In May, the IMF provided $739 million in form of an interest-free loan under the Rapid Credit Facility to help Kenya weather the initial shock and balance of payment deficit. This helped to cover the cost of additional spending on health, social protection, and speeding up payments to bolster the economy. Unaided, Kenya would have to aggressively cut spending on investment and social programs, making it more difficult to achieve a durable and inclusive recovery. Debt sustainability has weakened over time with concessional loans and debt suspension have eased the situation with external debt as accelerated economic recovery remains key in returning to the fiscal consolidation path.
SOURCE: AUTHOR ‘S COMPUTATION
Rising budget pressures have been accompanied by a new wave of sovereign debt downgrades, surpassing peaks during prior crises. They have persisted even as major advanced economy central banks have eased credit conditions. Central bank purchases of corporate bonds to provide support for local firms in emerging markets and developing economies have also handicapped their debt ratings.
The debt problem was exacerbated by macroeconomic mismanagement in the 1990’s such as the Goldenberg scandal which fleeced Kenyan’s billions of shillings leading to a reduction of donor inflow. The government thus resulted to occasional debt rescheduling, and short-term domestic borrowing to finance its expenditure. Gross public debt has increased from 48.6% of GDP for some time at the end of 2015 to an estimated 69% of GDP in the final year of 2020 reflecting high deficits partly determined by the past spending on the contemporary Covid 19 shock and large infrastructure projects. 3.1% of GDP is used to capture non-guaranteed debt of State-Owned Enterprises (SOEs) and to Finance public-private partnerships. Notably, the baseline already incorporates the 0.3 percent of GDP assumed for SOE support as well as the amount borrowed directly by the Kenyan Government. At the end of the year 2020, multilateral creditors accounted for about 40% of external debt while debt from bilateral creditors represented close to 33%. Kenya’s bilateral debt of about 63 % is owned to non-Paris club members, mainly loans from China to finance development i.e., construction of the SGR; Roads. Public debt is one of the macroeconomic indicators which configure the countrys’ image in international markets forming an inward foreign direct investment flow of determinants. Prudent public debt management helps economic growth and stability through mobilizing resources with low borrowing costs while limiting financial exposure. Economic growth being a rise in total output, produced by a country which can be either positive or negative (shrinking economy) as negative growth is highly associated with economic recession and economic depression.
Naturally, the government is a special borrower as it is not expected to abruptly disappear any time soon thus there is no bitter end where all debts borrowed should be remunerated. Furthermore, as a state, we also benefit from external transfers to the budget in the form of grants which can be used to pay interest on the existing stock of debt. In addition, the government is sovereign hence there is no bankruptcy procedure giving lenders any claim to its assets, it can also take a stand and make fiat money to fees its obligations or raise vast revenue at discretion by hiking taxes. Due to such aspect, its budget constraints are less easily understandable that applies over an infinite horizon. However, unsustainable debt causes decline in economic output, reduced investment, rise in risk premium, borrowing interest rates and erodes investors’ confidence. Hence, if we do act, the opposite is also true. If our long-term fiscal challenges remain unaddressed, our economic environment weakens as confidence suffers, access to capital is reduced, interest costs crowd out key investments in our future, the conditions for growth deteriorate, and our nation is put at greater risk of economic crisis. Contrarily, our current state of affairs is quite agonizing as we are undergoing crucial challenges in corruption which has led environmental damage, illegitimate leaders, organized crime and it also increased social polarization causing inflation which has grown exponentially high above market value. Governance and Management of taxes have been other demanding aspects as there has been low level of competent contractors handling contractual projects in the country and revenue generated; Moreover, the threshold of governance which shows that the public debt has positive impact on economic growth when the governance level is higher than the threshold and adversely affects the economic growth in the case of low level of governance than threshold through which if such aspects are not looked into our debt unsustainability will prevail.
As an exercise in assessing debt sustainability is no doubt a demoralizing task. In existence, there is no government that has been able to make a credible commitment. The economic environment that affects the evolution of debt ratios is highly variable and uncertain; no government can make a credible commitment for the foreseeable future to adhere to a particular policy stance hence the tendency of the Fund to bail out creditors and to lend into unsustainable debt positions not only aggravates financial instability by encouraging moral hazard but also tilts the balance against debtors in burden-sharing. The government has defended debt procurement as necessary to drive economic development. The president has argued that the government needs debt for development, adding that the country has a significant deficit of critical infrastructure needed to drive economic growth. The national treasury has defended additional borrowing by saying that the government requires the funds to drive the big four policy agenda. The government’s big four policy agenda include expansion of the manufacturing sector, provision of affordable housing and health care, and strengthening food security. If our long-term fiscal imbalance is not addressed, our future economy will be diminished, with fewer economic opportunities for individuals and families and less fiscal flexibility to respond to future crises.
The sustainability of public debt is a hotly debated topic in Kenya. The media and the public sentiment are that the public debt is high, while policy makers – especially at National Treasury believe that the debt level in Kenya is sustainable. The public debate has largely played out on social media with Kenyans expressing anger at the continued government borrowing by starting a petition and a twitter hashtag #stoploankenya to cancel an IMF loan of Ksh 255 billion to Kenya in 2020[1]. The debate on public debt in Kenya is usually anchored on the public debt to GDP ratio, which in 2020 stood at 69 percent[2]. Figure 1 below shows the evolution of debt to GDP ratio for domestic and external debt in Kenya[3]. The figure shows that public debt has been increasing since 2011 and by 2020 had reached the 2001/2002 level. This is quite worrying given the pre-2002 period was characterized by poor economic growth.
Public debt imposes two kinds of costs to a country: fiscal costs and welfare costs. Since public debt must be retired/repaid, it is only possible to repay if economic growth is high enough such that the increase in output is able to pay debt redemption and interest rates. If growth is low, the country faces a fiscal cost, as the government must reduce expenditure in future or increase taxes to repay the debt. A country incurs a welfare cost if debt distorts the incentive faced by private enterprises such that the future level of output or income is lower than it could have without the debt. Excessively high public debt leads to higher interest rates, and can lead to debt crises, and lower future output or income.
To better understand the costs or burden of public debt, we must look at two key issues. First, who is the creditor, and second what is the structure of the debt agreement.
With the first key issue, the creditor matters as different creditors will offer different interest rates and repayment structures. There are three types of creditors that loans to governments: multilateral lenders, bilateral lenders, and commercial lenders. For example, the IMF loan of Ksh. 255 billion is from a multilateral lender, since IMF is an institution formed by a group of countries to guarantee global liquidity and proper functioning of global payments system. On the hand, the loan from China of Ksh. 285 billion to build Standard Gauge Railway (SGR) between Mombasa and Nairobi, is a bilateral loan as it involved only two countries. Commercial lenders are, for example, Kenya Euro bond investors who offered $5.4 billion in 2021 to Kenya for a $1 billion Eurobond issue.
The type of the lender has huge implications for the interest rates, repayment period, grace period and likelihood of restructuring of the loans in case of repayment challenges. Multilateral lenders offer loans at concessional rates and tend to give longer grace periods and repayment periods compared to bilateral and commercial lenders. For example, Nairobi-Thika highway was financed by Africa Development bank (multilateral), China Exim Bank (bilateral) and the Government of Kenya. The African Development Bank offered a loan of $175 million in 2007 at an interest rate of 0.75 percent to be repaid in semi-annual installments starting November 2017 to May 2057. The Chinese Exim Bank offered $100 million in 2009 at interest rates of 2 percent to repaid in semi-annual installments starting from September 2017 to March 2030.
In this example, the bilateral loan was more expensive compared to concessional loan from multilateral lender and has a longer repayment period and grace period than the multilateral loan. Furthermore, as seen during the pandemic, multilateral lenders are more willing to reschedule debt repayment than bilateral lenders. Commercial lenders are even more expensive than multilateral and bilateral lenders. For example, the 2021 Eurobond coupon rate was 6.3 percent, and the 364 days treasury bills average coupon rate was 7.4 percent[4]. Figure 2 below shows the contribution of multilateral, bilateral and commercial lenders to debt stock in Kenya. Here we sub-divide commercial debt into domestic and external debt, as commercial debt can be incurred by issuing debt denominated in local currency or foreign currency like US dollar.
Figure 2: Kenya has shifted government debt composition from cheap to expensive sources[5]
The figure shows the sources of debt has shifted from bilateral and multilateral lenders to commercial lenders since 2014 when Kenya become a lower-middle income country. While in 2000 the share of commercial debt in total debt was around 33 percent, by 2020 the share had increased to 62 percent. This is shift is likely to be accompanied with higher debt repayment obligations because commercial debt, as demonstrated, attracts higher interest rates than multilateral debt. There are several reasons that led to the increase in the commercial debt. First, Kenya rebased its GDP in 2014, which indicated that the economy was larger than previously thought. This led to a reduction in our debt to GDP ratio and made it easier for Kenya to access commercial loans[6]. Second, the rebasing also made Kenya a lower middle-income country and hence, Kenya did not have access to low-cost borrowing. This pushed the Government to look for other sources of financing i.e., commercial lenders.
The second key issue is how the debt is structured. Here the main question here is whether the debt is long term or short term. Most countries prefer long term debt as it is cheaper and less likely to lead to liquidity issues during repayment. Figure 3 below shows the average terms of new external borrowing commitments. The figure shows that the tenor of external debt has reduced from around 36 years in 2005 to 15 years in 2019, while interest rates have increased from 1.3 percent to 3.9 percent in the same period. The grace period (time granted by the creditors before the government can start paying interest rates and repaying the debt) has also declined from an average of 8.6 years to 5.6 years. The shortening repayment period and grace period, and higher interest rates has increased the cost of debt imposed on Kenyans. It implies that Kenyans are required to start paying debt sooner, with a shorter repayment period and higher interest rates. Since debt is used to finance long term infrastructural projects, it is likely that the projects have not generated enough income for repayment. The mismatch between the income generated by the long infrastructural projects and the need to repay the debt, implies that the government either must increase taxes or reduce expenditure.
Figure 3: The average terms of new external borrowing commitments[7].
Figure 2 and 3 indicates that the increasing debt burden in Kenya can be attributed to two shifts in the last 14 years. First, the shift from multilateral debt to commercial debt and second, a shift from debt with long tenor to debt with shorter tenor. These two trends are related as commercial debts is not offered on concessional terms and hence is likely to have a shorter maturity, higher interest rates and a shorter grace period. This development in public debt imposes high fiscal and welfare costs on Kenyans. Therefore, Kenyans should be worried about the current level of public debt because first, the fiscal cost Kenyans are incurring in terms of higher taxes and likely future cuts in government spending in primary services. Second, the wealth cost Kenyans are likely to incur because of crowding out of the private investment. Lastly, the high interest rate payment drains the little foreign reserves available for private investment. This affects the rate of accumulation of capital and technology in Kenya.
[1] As of July 13, 2021, the petition had 236,240 signatures. https://www.change.org/p/imf-executive-board-petition-to-the-imf-to-cancel-the-ksh255-billion-loan-to-kenya
I hear many lamenting about our external debt, and not enough lamenting internal debt. Yes the money stays in the country, but it still takes a significant amount away from what we could be using as budget cover.
Then again if we didnt borrow, we may not even be able to fund some essential services. The debt, by extension, helps us fund key services, BUT the debt by definition means the interest we are paying takes away funds we could have been using for budget cover.
In 2021/22 we will be paying Kshs 905 billion (39% total budget) to our debtors. Most of our debt is domestic (Ksh 507 billion – 63% of total debt), the rest we owe externally. Our internal debt is most comprised of Treasury Bills/Bonds amounting to Ksh 275.5 billion (28% of total debt). Our biggest external debtors are the Sovereign Bond (Ksh 48 billion – 5% of total debt), followed by China (Ksh 33 billion – 4% of total debt).
In 5 years, our total debt will grow by 74%, driven by internal debt redemption (95% growth) and external debt redemption (91% growth).
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