Why Kenya’s public debt overhang must worry us

Kenya’s National Treasury recently released the 2018 edition of the public debt management report. The report presents interesting reading of national debt statistics. For instance, while the economy grew by only 4.9 per cent in the 2017/18 fiscal year relative to 5.9 percent in 2016/17, public debt grew by 14.5 per cent during the same period, to stand at Sh5,047 billion (Sh5trillion). In simple terms, the country’s indebtedness grew at a faster rate than its income which is its ability to service debt.

The report reveals that debt-to-GDP ratio stood at 57.1 per cent during the 2017/18 year, a marginal reduction from the previous 57.5 per cent. Conventionally, 60 percent debt-to-GDP ratio is the rule-of-the-thumb threshold for debt sustainability. Further, the public debt management report indicates that the country’s debt service-to-revenue ratio exceeds the 30 percent threshold and is projected to remain that way in the medium term. The data therefore appear to indicate that the country is wobbling dangerously in the fringes of a public debt overhang. Economists define public debt overhang as the deterioration of the economy due to excessive public debt.

In ordinary usage, “debt overhang” refers to a situation where a firm is so heavily indebted that it may no longer borrow to finance its profitable investment projects. If such a firm were to incur additional debt, cash flows generated from the new profitable project would be used foremost to service obligations to existing creditors, who would ordinarily rank higher in the firm’s pecking order. Realizing this situation, prospective creditors would tighten their conditions for lending to the firm through higher interest rates and stricter protective covenants to guard against potential losses. Thus, it will be very costly for the firm to raise additional debt.

To contextualize this concept, let us examine some numbers. Since the current national administration took office, Kenya’s total public debt service (total amount paid out to lenders) has grown by a whopping 317 percent, from Sh 145 billion as of June 2013 to Sh460 billion as of June 2018. The latter amount represents 33.8 percent of revenues, of which 23.9percent, or about 70percent of total debt service, went towards the payment of interest.

Two important reasons can partly explain the asymmetry between interest payment and principal retirement. First is the country’s growing use of the more expensive external commercial debt. Since June 2013, the proportion of external commercial debt to total external debt has risen from under two percent to over 34 percent. In contrast, bilateral debt, commonly associated with relatively lower servicing cost, has declined during the same period from 63.5percent to 31.2percent. Second is the greater reliance on the more expensive short-term debt: for instance, the total outstanding Treasury bills grew by 275percent between June 2015 and June 2018.

These numbers speak to the country’s growing cost of public debt. Lenders are signaled to require a higher rate of interest on economic agents whose debt service charges increase faster than revenues. This should explain Kenya’s increasing cost of international debt issuances. The first Eurobond debt was issued in two equal tranches of 5-year and 10-year tenures with coupon rates, 5.875percent and 6.875percent respectively. When the second issuance was announced, it attracted 7.25percent and 8.25percent coupon rates respectively for the 10-year and 30-year tenures. The additional interest charge on the 10-year bond reflects the country’s higher probability of financial distress implied by the growing debt service.

Recurrent expenditure

A key issue emerging from these observations is the question of whether Kenya’s public debt is sustainable. According to the Treasury’s public debt report, the analysis of present value of debt relative to both the GDP and revenue shows that most threshold limits have not been breached, indicating sustainable debt utilization. However, the Treasury’s analysis leaves out several interesting fiscal policy parameters. The country’s nominal public debt to GDP ratio has grown rapidly as explained earlier.

Although Treasury forecasts a decline in this metric going forward, this will only be possible with sustainable growth in revenues. However, revenues have been falling alarmingly in recent years: in 2013/14, the revenue to GDP ratio stood at a modest 18.2percent but has since dropped to a 16.5percent (forecast for 2018/19). There is no convincing reason to believe that these downward trends are going to be reversed sustainably in the medium term. Real GDP is forecast to improve only marginally from about 5.9percent in 2018 to about 6.1percent by 2020.

Further, data from the Central Bank of Kenya shows that the country is struggling to finance its recurrent expenditure. For the first eleven months of 2018, for instance, total (tax and non-tax) revenue stood at Sh 8.604 trillion against recurrent expenditure of Sh 9.116 trillion, a shortfall of Sh512 billion. This implies that the country borrowed partly to pay interest on debt, which constituted 20.4percernt of recurrent spending for the period, having risen from 14.9percent in 2013 when the current administration took office. When an economic agent borrows to service its debt obligations, debt utilization is unsustainable.

Third, in an effort to reduce the crowding-out effect of heavy public sector borrowing, the national government enacted, and implemented in September 2016, a law capping interest rates. However, this law has reduced banks’ ability to appropriately price credit, and has consequently, according to African Development Bank, reduced credit access to the private sector (especially small and medium enterprises). Reduced private sector access to credit inhibits economic growth and revenue collection, and jeopardizes ability to service debt.

These grim statistics must be juxtaposed against the country’s persistent revenue collection underperformance. The 2009 Budget Policy Statement (BPS) recently released by the Treasury, shows that by December 2018, the “cumulative revenue fell short of the target by Sh 61 billion,” of which Sh 52.7 billion, the shortfall in ordinary revenues, was attributed to “depressed performance of corporation tax”. As an indicator of the private sector activity, declining corporation tax yield is suggestive of an economic slowdown. Overall, the BPS shows that total revenue collection by December 2018, including Appropriation in Aid, amounted to only Sh 794.7 billion (equivalent to 8percent of GDP) against a target of Sh 855.7 billion (8.5 percentof GDP) in nominal terms.

Despite this evidence of diminishing economic prospects, however, the Treasury, in the BPS projects economic growth at 6.2percent in 2019 “supported by a strong rebound in agricultural output, steadily recovering industrial activity and robust performance in the services sector.” The optimistic language describing the performance of economic sectors masks the almost nil change in forecast real economic expansion between 2018 and 2019.

Based on the assumed economic expansion, revenue forecast for the year 2018/19 has been pegged at a higher Sh 2.081 billion, which is approximately 12percent above the revised (downwards) revenues for 2018/19. Treasury justifies the optimistic revenue forecasts on basis of the fiscal consolidation measures recently put in place by the national government. Yet, it is difficult to appreciate how an economic expansion of 0.2percent (from 6 to 6.2percent) in an environment of revenue underperformance can generate 12percent more revenues.

Clearly, the national government is going to continue borrowing heavily to fund an ambitious infrastructure drive and to refinance existing debt, driving the public debt level even higher. Soon, lenders, such as China, whose debt are partly guaranteed by strategic public assets, may exercise their right of lien on those assets.