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September 20, 2018

Domestic Or External Debt, Which Way Kenya?

BORROWING: Treasury Cabinet Secretary Henry Rotich at State House last year when he announced that the government had successfully launched the $2 billion Eurobond. Photo/File
BORROWING: Treasury Cabinet Secretary Henry Rotich at State House last year when he announced that the government had successfully launched the $2 billion Eurobond. Photo/File

Government or sovereign borrowing is necessary to bridge the resource gap between government receipt and expenditure. There is the option to borrow from the domestic market or abroad (external debt), depending on several considerations. The borrowing from abroad will be the subject of this article while domestic borrowing will be covered in a subsequent article.

However, whichever option a government chooses, debt is a contractual obligation. The borrowed resources have to be used productively and efficiently to build the capacity to service the debt. Moreover, the improvement also has to be commensurate with raising the debt liability. Failure to do so would lead to build-up of debt to unsustainable levels, with consequences that can impede economic growth at best and lead to a debt crisis at worst.

The risk profiles of domestic and external debts are often different with each carrying advantages and disadvantages although in the overall, there is consensus that external debt is more risky. A country has therefore to choose on the most suitable mix, which will minimise its risk exposure and deliver the development plan at the lowest cost possible. The National Treasury website for instance shows that 51.9 per cent of the total public debt is external debt as at August 2015, a sizeable growth from April 2010 when external debt was 45 per cent of total debt. This shows a growing preference for external debt over the period. The dominant currency is the dollar, consisting more than 50 per cent of the external debt.

External public debt takes the form of multilateral or bilateral credits, export credit arrangements and commercial borrowings in foreign currency. The most common currencies for Kenya are dollar, Sterling Pound, Japanese Yen and Chinese Yuan depending on the source of such credit. External debt has the advantage of providing convertible currency that is needed for imports and balance of payment stability. On the flip side though, such debt has to be repaid in foreign currency in which it is denominated, and hence exposes the country to foreign currency risk due to exchange fluctuations. For instance, for the government to repay the obligations, both interest and principal, under the dollar denominated Eurobond, it has to convert the revenue it earns in Kenya shillings to dollars. The amount of Kenya shillings required will therefore depend on the rate of exchange when the amount is required, and it will vary from one repayment time to the other. The arising uncertainty of not knowing how much it will cost in Kenya shillings to repay the dollar obligation is the foreign currency exchange risk. For instance when the Eurobond was initially issued in June 2014, the exchange rate to the dollar was Sh87.5 while rate as at end of August 2015 was Sh103.3. This means holding other factors constant, the principal debt level in Kenya shillings has grown by 18 per cent because of exchange risk in that period.

To reduce debt sustainability risks, the source of funding has to be consistent, and a “good fit” for where the funds are utilised. Multilateral/bilateral credits are more suited for social infrastructure projects such as education and health where returns are by the way of a healthier and more productive population, which cannot be easily quantified. They are also suited for projects such as rural roads and rural electrification, whose aim is to improve rural infrastructure and agricultural production, but may not be commercially viable because their returns are both indirect and long term in nature. This is because these credits tend to come at concessional terms and longer maturities, sometimes at 30-40 years maturity with near zero interest rates. Often, multilateral/bilateral credits carry a grant element, the portion of which is not repayable; although this is perhaps recouped by having the credits tied i.e. the borrower is required to import goods and machinery from the lending country.

Sometimes international financial players such the World Bank and the African Development Bank may borrow from the international capital markets for on-lending to emerging markets. They leverage their AAA-credit rating to obtain funds at lower rates and pass this benefit to sovereign borrowers. Such funds may not be at concessional rates but will carry low interest rates. Such funds are suited for commercial infrastructure projects such as major roads; railway and power projects where services are charged, but such charges have to remain reasonably affordable. The Standard Gauge Railway, Thika Road, and Lamu port are examples of projects that are suited for such credits.

Multilateral/bilateral credit is development oriented and most suited form of external debt for emerging markets.Fortunately, the largest portion of country’s external debt, at 77 per cent, is in the form of multilateral/bilateral credit as at August, 2015. This is however a reduction from 90 per cent in April 2010 signaling a drift from this form of credit.

Export credits provide export finance to overseas buyers on credit terms. The exporter supplies plant and machinery and seeks reimbursement from a commercial bank in their country. The buyer holds a credit contract with the lending bank, and the lending bank is insured against default by a credit insurance agency in the creditor country. Institutions such as Africa Trade Insurance are major players in such transactions. Sometimes export credits may take the form of supplier’s credit where the overseas exporter provides machinery/ equipment to the importer and agrees to be paid over time. Players in this market includ China Import-Export Bank and the Exim Bank of the US. The risk with this form of tied credit is that even when quoted interest rates are low, the prices may be inflated because there is no scope for a competitive tendering process.

Finally there is the commercial debt which is not only the most sensitive, but also the most risky and expensive form of external debt. Commercial transactions are profit motivated and carry high premiums, often tied to the credit rating of the country. They are also characterised by short tenors because longer maturities would carry higher risk, and hence higher rate of credit. Such credit is unsuited to infrastructure projects that carry long gestation and low returns. Because the majority of infrastructure projects in emerging markets are characterised by long gestation and low returns, such credits have to be used sparingly, if at all. Perhaps regional port and oil related infrastructure would be suited for this nature of credit, where usage charges can be at commercial terms or have potential for high tax revenues sufficient to pay back the loans.

The Eurobond issued in June last year was a commercial debt with an average tenor of 8.75 years and average interest rate of 6.625 per cent per year. This changed the profile of external debt for the country from not having any commercial debt to 19 per cent of its debt being commercial as at August 2015. The high interest and short tenor underscores the need for more efficient utilization of the borrowed funds, failing which crisis would loom large. This would call for ring-fencing of the funding, where the funds are targeted to very identifiable projects that have commercial returns, and which can be fast-tracked to match the maturity of the funding.

While debt is necessary to facilitate development, good debt management practices are critical to ensure debt sustainability risks are avoided.

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