Kenya’s National Treasury is taking significant steps to reduce the dominance of banks in the government securities market, aiming to broaden the pool of investors and lower the high interest rates that the country has faced. In its annual borrowing plan for the 2024/2025 fiscal year, the Treasury outlined reforms aimed at expanding access to government bonds for non-banking financial institutions, which could help stabilize the country’s debt costs.

This move comes as the Kenyan government grapples with an ever-growing debt burden, and an increasingly demanding bond market where interest rates have spiked as high as 18%. By diversifying the investor base, the Treasury hopes to tame these high rates while ensuring that it can continue to fund its deficit without overly relying on commercial banks.

Addressing Bank Dominance in the Bond Market

As of June 2024, Kenya’s borrowings from the domestic market through treasury bills (T-bills) and bonds (T-bonds) stood at KSh 5.47 trillion ($42.33 billion), with commercial banks controlling a massive 44.96% of the market. This concentration has long been a source of concern, as banks are seen to be demanding high-risk premiums in exchange for financing the government. In comparison, pension funds held 29.09%, insurance companies 7.1%, parastatals 5.32%, and other investors 13.53%.

Treasury officials have identified this over-reliance on banks as a key issue in stabilizing the country’s domestic debt market. To address this, they are looking to encourage more participation from pension funds, insurance companies, and other institutional investors. Additionally, the government is introducing new financial products, such as post-retirement medical funds, to further attract non-bank investors. Expanding the role of pension schemes is a cornerstone of this strategy, aiming to create a deeper, more diversified bond market.

The Treasury’s efforts to diversify the investor base could reduce the government’s cost of borrowing by fostering competition and reducing the bargaining power of commercial banks. This strategy is aimed at lowering the risk premium on government securities and ensuring that the country’s debt remains sustainable in the long term.

Kenya’s Debt Landscape and Economic Challenges

Kenya’s public debt has continued to grow, reaching KSh 10.56 trillion ($81.73 billion) as of June 2024, a 2.82% increase from the previous year. This debt is split between KSh 5.41 trillion ($41.87 billion) in domestic debt and KSh 5.15 trillion ($39.86 billion) in external debt. A significant portion of Kenya’s external debt is denominated in foreign currencies, predominantly the US dollar (67.9%) and the euro (21.4%), making the country vulnerable to exchange rate fluctuations.

The depreciation of the Kenyan shilling against these major currencies has further exacerbated the debt repayment burden. In 2024 alone, the shilling depreciated by over 10% against the dollar, driven by global economic uncertainties and local inflationary pressures. This has made debt servicing more expensive, as the government needs more shillings to repay its foreign-denominated loans.

According to data from the Central Bank of Kenya (CBK), the country’s debt sustainability is under pressure. Although public debt is technically sustainable, the risk of distress remains high. The country has been using over half of its revenue to service debts, limiting its ability to invest in critical infrastructure and social services.

High Interest Rates and Market Reforms

One of the key drivers of high interest rates on government securities has been investor concerns over the country’s fiscal health. As a result, the government has been forced to pay a premium to attract investment. In some cases, interest rates have soared to 18%, further increasing the cost of borrowing for the government.

In response, the Central Bank of Kenya (CBK) has taken a firm stance by rejecting higher bids from bond investors. This is part of a broader effort to stabilize the yield curve and build investor confidence. The Treasury’s Borrowing Plan for FY2024/2025 aims to maintain a well-priced, stable yield curve, managing the cost of debt more effectively and ensuring that the market remains liquid.

President William Ruto’s administration has been vocal about its commitment to keeping borrowing costs in check. When Ruto took office in 2022, he promised that his government would not borrow from the domestic market at interest rates exceeding 10%. However, with rising inflation, exchange rate pressures, and a widening fiscal deficit, this promise has been difficult to uphold. Nonetheless, the Treasury is making efforts to negotiate better terms with investors by diversifying the sources of government funding.

Government Debt and the Role of Non-Banking Institutions

Non-banking financial institutions, including pension funds and insurance companies, are seen as key players in the effort to broaden the government bond market. The Treasury’s plans to increase the role of these institutions in government securities come at a time when Kenya’s banking sector has become increasingly risk-averse.

Kenyan banks have been reducing their lending to the private sector, largely due to rising credit risks and economic uncertainty. Instead, they have opted to invest heavily in government securities, which are seen as risk-free. This has led to a slowdown in private sector credit growth, which dropped to 1.3% in August 2024, down from 3.7% in July. At the same time, the ratio of gross non-performing loans to total loans increased to 16.7% in August, reflecting the ongoing challenges in the private sector.

Non-banking institutions, particularly pension funds, offer a more stable source of funding for the government. These institutions tend to take a longer-term view on investments, which can help smooth out fluctuations in the bond market and reduce the government’s reliance on short-term, high-interest debt. Additionally, expanding the role of pension schemes and other non-banking institutions could help foster a more sustainable debt management strategy, as these institutions are less likely to demand the high premiums that banks currently do.

Challenges Facing the Treasury’s Reform Agenda

Despite these ambitious reforms, the National Treasury faces several challenges in its efforts to overhaul the bond market. One of the primary obstacles is the high level of skepticism among investors about the government’s fiscal health. Moody’s recent downgrade of the credit ratings of several major Kenyan banks, including KCB, Co-operative, and Equity, underscores the growing concerns over Kenya’s sovereign risk. The downgrade was largely due to these banks’ increased exposure to government securities issued by a government with a weakened credit profile.

Another challenge is the government’s ballooning fiscal deficit, which is projected to reach KSh 768.6 billion ($5.95 billion) in the 2024/2025 fiscal year. The Treasury plans to finance this deficit through a combination of external and domestic borrowing. However, with external debt already at high levels and the cost of domestic borrowing rising, the government’s options are becoming increasingly limited.

To finance the deficit, the Treasury is expected to issue a mix of short- and long-term government securities, including 2, 5, 10, 15, 20, and 25-year fixed-rate bonds. Additionally, a few infrastructure bonds may be issued to fund specific development projects. However, with debt levels already at unsustainable levels, the government will need to tread carefully to avoid further exacerbating its fiscal challenges.

The Road Ahead: Striking a Balance

Kenya’s National Treasury has embarked on an ambitious path to reform the domestic debt market, reduce the dominance of banks, and stabilize the country’s borrowing costs. By expanding the role of non-banking financial institutions and introducing new financial products, the government hopes to create a more diversified and stable bond market.

However, these reforms will not be without challenges. The government will need to balance the need for immediate financing with the long-term sustainability of its debt. Additionally, restoring investor confidence will be crucial, as the country continues to grapple with high inflation, exchange rate volatility, and rising debt levels.

In the coming years, the success of Kenya’s domestic debt market reforms will depend on the government’s ability to implement its borrowing plan effectively, manage its fiscal deficit, and foster a more diversified investor base. If successful, these reforms could help Kenya chart a more sustainable path for its public finances, ensuring that it can continue to invest in critical infrastructure and social services without jeopardizing its long-term economic stability.

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Photo source: Google

By: Montel Kamau

Serrari Financial Analyst

17th October, 2024