Month: December 2014

The risks of foreign denominated debt for Kenya

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Anyone keeping an eye on the economy will have noted the level of public debt being accrued, particularly foreign denominated debt. Total debt stood at KES 2.37 trillion (USD 26.78 billion) after Kenya’s sovereign bond issue in June. The concern with the debt being accrued is that we are getting into larger foreign denominated debt than previously was the case. Kenya is an import economy so by default, in order to service foreign debt, government has to buy dollars. The assumption being made is that the foreign debt will boost the economy primarily through investment in infrastructure which is expected to generate the capital required to service the debt. It is important to note that although there is support for this hypothesis there are also those who question the logic that infrastructure equals growth. In fact, the London School of Economics states that, ‘empirical estimates of the magnitude of infrastructure’s contribution (to growth) display considerable variation across studies. Overall, however, the most recent literature tends to find smaller effects than those reported in the earlier studies’. This article will not debate this point but instead highlight the challenges Kenya will face should this almighty investment in infrastructure not generate the growth expected. How does payment in shillings affect the economy should the foreign denominated debt fail to yield the returns expected of it? How then, will government raise shillings to service this substantial debt?

Debt The first and most obvious option is for government to raise taxes in order to raise shillings that can then be used to service the debt. But Kenya is already a heavily taxed country and one wonders if we have reached a point on the Laffer Curve where raising taxes further will harm profitability and actually lower revenues. Tax rates that are too high effectively penalize people for engaging in economically productive activities; so government risks harming its own revenue if increasing taxation becomes the main strategy used to raise shillings.

The second option is to borrow shillings locally and use this capital to buy dollars and service the debt. The argument has been made that Kenya entered into foreign debt to ease pressure on local credit and interest rates. But if that investment doesn’t yield what is expected then government may have to borrow locally to service the debt anyway. This borrowing obviously crowds out the private sector and reduces private sector access to credit. One consequence of this it that private sector may not be able to implement activity and developments that were to be debt financed. Further, but borrowing locally, government will put pressure on interest rates possibly pushing them up which again, will make credit less available to private sector borrowers. The economic growth of the country may then be muted because private sector and SMEs would not been able to access the credit they needed to become more productive. Further, borrowing locally does not solve the debt problem but merely rolls it over to be dealt with at a later date.


The third option for government is to implement austerity measures and reduce recurrent expenditure so that more shillings are made available for debt servicing. But in Kenya, this option does not seem feasible. The prevailing climate in the country is one where those being paid by Kenyans always seem to want to increase their salaries not reduce them. This makes it very difficult for government to reduce recurrent expenditure.

The fourth option through which government can ‘raise’ shillings is by printing shillings. Government has done this in the past and this phenomenon is certainly not unique to Kenya. The problem with printing money is that it expands money supply which often drives inflation up. The excess supply of KES can also lead to a further depreciation of the currency making it even more expensive for government to buy dollars and service foreign denominated debt. Therefore if the government prints KES, it will be effectively making the debt more expensive.


Clearly, none of these four options are attractive and each has consequences that could have economic and perhaps even socio-political implications. These options present the risks Kenya faces as it enters into an era of acquiring and servicing foreign denominated debt on a scale far larger than ever before.

This is why interest rates will remain high for Kenyan borrowers

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There are myths told to Kenyan consumers on a regular basis. One myth is that if government does not borrow locally, it should lead to lower interest rates because of the ease of pressure on demand for domestic credit. The second myth is that the Kenya Banks Reference Rate (KBRR) will let consumers know how much credit should cost and thus foster competition in the banking industry which will lead to lower rates. Yet since the introduction of the KBRR only one bank has lowered its interest rates. Further, even after announcements by government clearly signalling that it will borrow from outside Kenya, interest rates have not dipped. Why? Why aren’t banks lowering interest rates in any noticeable manner? There are several factors at play that will not only ensure interest rates do not lower but in fact may push interest rates up. The focus here will be on external factors that inform rate setting rather than internal dynamics of banks (such as riskiness of client, required rate of return on funds/capital etc) as these are harder to influence and ascertain.


The first factor is the cost of borrowing; according to the CBK, during the month of November the interbank lending rate seesawed between 6.39 and 7.6 % but often more long term rates are used and insiders say the real rate can be double this figure. Banks have to on-lend at a rate higher than that at which they borrowed so this borrowing rate is the first rate- hike that hits consumers.

Inflation is another factor that informs rate setting since high inflation devalues the shilling and therefore pushes rates up in order for banks to recover the equivalent value of capital. Calculations on long term inflation demonstrate that the Inflation Rate in Kenya averaged 11.13 % from 2005 until November 2014, well above CBK’s target rate of 2.5-7.5%. Given how unstable Kenya’s inflation rate is year on year, banks would rather err on the side of caution and keep rates up to make sure they get the value of their money back.

Another factor banks have to consider is tax. The Corporate Tax Tate since this obviously eats into profits. Corporate Tax Rates in Kenya currently stand at 30% for residents and 37.5% for non-residents. However, a 2013 report by PriceWaterhouseCoopers found that a company in Kenya on average pays a total tax rate of 44.2%, higher than the global average of 43.1%. Further, it takes a firm operating locally 308 hours to comply with taxes; the global average is 268 hours. These factors lead to a high cost of doing business in Kenya which leads to a higher financial burden in terms of man hours. So it can be understood why some of this financial burden is passed on to consumers in the form of higher interest rates. Additionally, for banks (and any other company) listed on the Nairobi Securities Exchange Withholding Tax on Dividends stands at a rate of 5% for dividends paid to residents of Kenya and on listed shares for citizens of the East African Community; the rate is 10% for other non-residents. To top it all off, the government recently announced the re-introduction of the Capital Gains Tax at 5%. Banks are facing millions of shillings in tax charges on transactions starting January 2015. Such tax burdens increase the cost of funds and puts pressure on banks to find ways to secure profit margins and hiking interest rates is a viable option.


There are also non-financial reasons why banks feel no pressure to reduce interest rates: Kenyans do not necessarily choose banks due to their interest rates and Kenyans do not necessarily leave banks if the interest rate goes up. There are other factors that inform how Kenyans choose banking partners or stay with them. A study by Ernst and Young earlier this year indicated that Kenyans, like millions of others across the world, open and close their accounts due to customer experience and this factor is more important than fees, rates, locations, press coverage or convenience. Add to this the reality that Kenya recorded a higher than average increase in confidence in their banks. In fact, while 44% of customers around the world express complete trust in their banks, this figure is 59% in Kenya; the highest level in Africa.


Given all these factors, why would banks seek to drive down interest rates? It appears as though banks would prefer to reward depositors with higher interest rates and general customers with better services than bring lending rates down. Sadly, no reprieve is in sight for you, Kenyan borrower.


A version of this article was featured in the Business Daily on December 1, 2014. You can read it here.