The sharp increase in the Treasury’s borrowing from local banks has exposed the economy to shocks in the financial sector, analysts at global ratings agency Moody’s have warned.
Commercial banks have in the past three years amassed Sh1.509 trillion worth of Treasury bills and bonds, equivalent to 54.1 percent of the government’s total domestic debt, which stood at Sh2.789 trillion at the end of last week.
The lenders built up their stock of the risk-free government securities
in reaction to the August 2016 introduction of control on the cost of loans, which they said blunted their ability to price-in borrowers’ default risk.
"The domestic banking sector – which is the main domestic holder of government debt – remains captive because of the lending rate cap and benefits from robust deposit growth.
However, this increasing reliance on commercial bank financing means the sovereign is highly vulnerable to adverse developments in the sector," said Moody’s in a sovereign note on Kenya.
Moody’s is one of three big global sovereign credit ratings agencies.
The other two, Fitch and Standard and Poor’s, are contracted by the Treasury as Kenya’s official sovereign credit ratings agencies.
Government debt now accounts for 32.8 percent of commercial bank assets of Sh4.59 trillion, compared with 26.4 percent (of bank assets of Sh3.69 trillion) at the onset of the rate cap in 2016.
The rapid build-up of short-term debt in form of Treasury bills has seen high volumes of quick-maturing debt pose a refinancing risk for the government at a time when tax revenue is struggling to hit target.
The build-up of this line of borrowing has partly been encouraged by the falling interest rates on government securities due to competition by banks to lend to the Treasury.
The Treasury bill rates have dropped to the current six-year low levels of 6.6 percent for the three month (91-day) paper, 7.47 percent for the 82-day notes and 8.64 percent (364-day).
The government is also borrowing on long-term bonds at below 13 percent. A substantive policy shift such as a successful repeal of the rate cap law would raise loan costs for both government and private sector, which would raise the cost of the Sh1.5 trillion debt significantly upon refinancing.
"Although this (rise in banks’ debt) demonstrates the system's capacity to provide funding support to the government, an adverse shift in demand would intensify the government's liquidity pressures.
In that respect, the June budget statement that was seeking to repeal the lending cap following a High Court ruling increases the government's re-financing risks," said Moody’s.
"That said, Parliament's desire to retain the cap means any reversal or change to the law will likely be implemented in a gradual way to limit any negative impact on government financing."
The domestic loans, however, do not carry the foreign exchange risk that external debt brings.
Given a near even-split between external and domestic loans on the public debt pot of Sh5.42 trillion, the risk that foreign-currency-denominated debt carries remains significant.
Kenya’s elevation into the lower band of middle-income economies through rebasing of the economy in 2014 meant that the country largely lost access to cheap concessional loans, forcing the shift to commercially priced syndicated loans and Eurobonds to finance budget deficits.
Commercial loans now account for 34.4 percent of total external debt, up from 6.4 percent in December 2013.
In its report, Moody’s has therefore cautioned that this has increased exposure to shifts in global market sentiments and raised external financing costs that eat into the country’s dollar reserves.
Earlier this month, World Bank Vice-President for Africa Hafez Ghanem also raised the red flag over the high cost at which Kenya and other African countries are borrowing commercial loans, warning of future repayment difficulties if the debts are not invested in productive projects.
The Sh76.4 billion debut Eurobond retired last month, for example, cost taxpayers Sh22.5 billion in total or an equivalent of nearly 30 percent of the initial amount.
In total, Kenya’s outstanding Eurobond debt now stands at $6.1 billion (Sh621.6 billion) following the principal payment of the five-year paper.
Annual interest payments on the outstanding debt will continue to gobble up Sh46 billion ($451.5 million) every year until at least 2024, when the 10-year 2014 issue matures.
Accounting for the expenditure of some of the commercial loans has not been clear in the past, given that they are disbursed into the general ministerial expenditure votes where it is difficult to track whether the funds were strictly directed to development and not recurrent spending.
Moody’s has also warned that mounting, unpaid bills owed by government to suppliers could cause a systemic impact on the economy if not addressed.
Moody's lead analyst for Kenya Lucie Villa Thursday said clearing of the unpaid arrears would stimulate the economy but the Treasury will be required to dig deeper into its coffers to clear the bills.
"One of the downside risks to stable growth is arrears," said Ms Villa. "The larger the arrears the more it can have a systemic impact on the economy…There is still a risk of rising and forming a broader macro impact."