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January 21, 2019

Domestic Public Borrowing As A Better Debt Frontier

Jiangxi Zhongmei Engineering construction workers constructing Turbi- Marsabit road. Photo Courtesy
Jiangxi Zhongmei Engineering construction workers constructing Turbi- Marsabit road. Photo Courtesy

Domestic public debt is the portion of government borrowing from the domestic market as opposed to the external market.

In Kenya this is done by the Central Bank of Kenya as a government agent by issuing interest bearing local currency bonds and Treasury bills to the public.

Typically the Central Bank announces the intention to borrow through a prospectus in the local newspapers, indicating the amount on offer and the duration.

When the borrowing is for less than one year, typically 91-day, 182-day and 364-day, the lender is issued with a Treasury bill, which is a money market instrument because it is regarded as short term.

The borrowing can also be for more than one year, in which case it is a bond and a capital markets instrument because it is long term.

Both Treasury bonds and bills are listed at the Nairobi Securities Exchange as tradeable instruments.

This means if the initial borrower needs their money back before the due date they can offer their Treasury bill or bond for sale at the securities market.

Likewise a buyer can choose to buy from the securities exchange, which is also referred to as the secondary market. In this case, the primary market is the original issue by the Central Bank of Kenya.

In Kenya, domestic issues are open to non-residents. Strictly speaking, any Treasury bills or bonds held by non-residents should be classified as part of external debt.

This technical distinction is however often overlooked and all local currency issues are called domestic public debt. Internally, it is a good risk management strategy for this distinction to be made, particularly when debt levels are rising, because a higher external component in domestic debt issues means it is also susceptible to external shocks, and this needs to be both monitored and managed.

The most significant distinction between domestic and external debt is the currency of borrowing. External debt is in foreign currency, and this exposes the country to foreign exchange risk since repayments are in foreign currency and incase the local currency depreciates, debt levels rise.

Domestic debt is however adequately insulated from this risk as it is in local currency. Even when such debt is held by non-residents, the foreign currency risk is borne by the lender and not the government.

Kenya is one of the few developing countries with a developed and robust capital market - the Nairobi Securities Exchange - that allows the free trade of government debt.

The development of the local public debt can be traced to early 1990s when all foreign funding to the country was frozen to arm-twist the government to accept structural adjustment programs spearheaded by the World Bank.

The government had no choice but to tap domestic sources, a move that helped develop the domestic market. This was not only a major success for the government, which now had internal source of funds, but also one for the private sector because the government borrowing is the benchmark against which the private borrowing in the capital market takes place.

Institutional investors are the major players in this market, partly because the minimum subscription stands at Sh50,000 and partly because of a limited distribution infrastructure.

Banks are the largest investors in the domestic debt market, although the investor base of non-banks, comprising pension funds, insurance companies and other private companies is growing.

For instance in April 2010 banks were holding 56 per cent of the domestic debt, this reduced to 50 per cent in August 2015.

The expected introduction of retail trading through mobile banking will be a significant step in diversifying investor base, with the potential for lower borrowing costs.

More significantly, it has the potential to narrow the gap between savings rates and lending rates, with investors getting the opportunity to earn interest on savings that current earn near zero interest rate.

Continued development of the local market is therefore critical, and in particular more issuance of longer term bonds.

There is need for the government to consistently work towards lengthening the maturity profile of its local public debt.

This not only makes it more suitable as a source of long-term funds for infrastructure projects, but also reduces refinancing risk of short-dated paper.

When the government borrows more through Treasury bills, for instance the 91-day bill it means after 91 days it either has to set aside some revenue to repay the debt or if it does not have money it has to borrow further. This is a refinancing risk which can be managed by lengthening the maturity so that if the borrowing is for 10 years the during that period only interest is payable. It is then expected that within that time, the funded projects will be complete and generating income to pay back the amounts.

As at August 2015, 77 per cent of the domestic borrowing was in bonds, an improvement from 67 per cent in April 2004.

However the average length of maturity is about five years, and has remained relatively unchanged in the last five years. This is way too short for funding infrastructure needs and could be lengthened to at least 10 years.

This could mean refocusing on pension funds, mutual funds and insurance companies that have long-term funds and are looking for long tenor instruments to avoid maturity mismatches between assets and liabilities. Another way to lengthen maturity, especially when government credibility is a barrier, is to issue long-term bonds with embedded investor put options.

This would serve to satisfy investor preference for short-term paper with the government's need for lengthening maturity.

A well planned government programme provides the market, and particularly the private sector with a yield-curve, showing the various returns against maturities, which serves as a benchmark for corporate bond is pricing. This is a key factor in stimulating bond issuance by the private sector as an alternative to bank borrowing.

The shape of a normal yield curve is upward sloping, with the returns rising with the increase in maturities.

The current inverted yield curve in the market is an indicator of macroeconomic instability at best or an impending economic decline at worst. It will be noted that in the US, the treasury yield curve inverted before the recessions of 2000, 1991, 1981 and two years before the 2008 financial crisis.

Hopefully, the current inverted yield curve is temporary, but worth noting nonetheless.

Local borrowing is also used as a monetary policy tool to mop-up excess money from the market to manage inflation.

However, excessive local borrowing could create problems by crowding out lending to the private sector thus affecting investment negatively particularly where banks have limited resources and are excessively risk averse.

From the foregoing, the benefits of domestic debt market go beyond raising funds for government expenditure and a well developed and mature capital market is worth refocusing on.

The resulting lengthening, widening and deepening of the market would set the stage for making domestic securities market a viable funding alternative where government could issue paper for varying maturities keeping in view financing, sustainability and liquidity management requirements.

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