Kenya budget: Ambitious targets, but can they deliver?
- Kenya’s recently released 2020/21 budget balances ongoing shocks with ambitious consolidation
- However a history of fiscal slippage calls feasibility into question
- Kenya must act quickly to keep debt sustainable
Last Thursday marked the annual East African Community (EAC) budget day, with Kenya releasing its FY 2020/21 budget alongside its East African peers. Slippage was expected amid the triple shocks of Covid-19, locusts and flooding, with the 2019/20 deficit now slated to expand to 8.3% of GDP from the initial (June 2019) target of 5.6% and updated (February 2020) target of 6.3%. However, the slippage is marginally less severe than predicted under the latest IMF staff report in May, which saw the deficit rising to 8.6% in 2019/20. Further, the projected 2020/21 deficit has been reined in from 7.8% to 7.5%, and the outer target in 2023/24 has narrowed from 4.9% to a more ambitious 3.6%. That said, Kenya has a long history of kicking the can down the road on fiscal consolidation, with the medium-term 3% target delayed in each respective iteration of the budget since at least 2016/17.
Kenya’s economy has proven to be impressively resilient to the myriad shocks it is currently facing, with the real GDP growth forecast revised down from 6.1% to a still-respectable 2.5% in 2020. This compares favourably to a forecast 1.1% contraction across all emerging & developing economies and 1.6% in sub-Saharan Africa, per the April 2020 IMF WEO (a WEO update is due 24 June and is likely to show a deeper global contraction than before). However, the forecast rebound to 5.8% in 2021 and 6.5% by 2024 is ambitious (especially amid concerns over the prospects for a global V-shaped recovery), and downside surprises would jeopardise much-needed fiscal consolidation plans. Discipline will therefore be required if Kenya’s debt is to be placed on a sustainable trajectory.
Revenue & spending plans and Covid stimulus measures
Before taking a step back to look at the big picture, it is worth diving into some of the finer points of the budget. Firstly, to cushion the impact of the pandemic the government has implemented several measures including:
Lowering the VAT rate from 16% to 14%;
Reducing the turnover tax rate from 3% to 1% in order to support SMEs; and
Reducing the corporate and personal income tax rates from 30% to 25% and providing 100% tax relief for those earning less than KES 24k per month.
The IMF estimated that these measures will cost 0.4% of GDP in 2019/20, which combined with stimulus spending of 1% and lost revenue of 0.9% due to slower growth will bring the total fiscal cost of Covid-19 to 2.3% of GDP in 2019/20. This is slightly below the average response of 2.7% of GDP for frontiers and smaller EMs, and well as below the 5% for larger EMs and 20% in the G7 (see our 13 May report comparing fiscal responses during the coronavirus pandemic).
In 2020/21, the tax relief measures are expected to cost KES172bn (1.5% of GDP). In this light, Kenya’s plan to consolidate the deficit by 1.5% of GDP between 2019/20 and 2020/21 is impressive, and compares favourably to the 1% of GDP consolidation the IMF forecasts between 2020 and 2021 across sub-Saharan Africa. To recoup part of the revenue loss the government plans to reduce tax exemptions, a necessary step given their exorbitant cost totalling 6% of GDP and associated economic distortions.
In addition, the government aims to promote exports by increasing import duties across several key sectors and providing tax waivers for imported inputs for sectors in which Kenya is perceived to have a competitive advantage. In total, this will net an additional KES39bn (0.3% of GDP) of revenue. While the extra revenue is much needed and the goal of increasing manufacturing from 8% of GDP to 15% by 2022 is commendable, we think it would be better achieved via positive incentives for exporters rather than protectionist import substitution policies that tend to create perverse incentives.
All things considered, revenue is expected to remain relatively constant in nominal terms but to drop from 18.6% of GDP in 2019/20 to 16.8% in 2020/21. Meanwhile, total expenditure is expected to fall from 27.2% of GDP in 2019/20 to 24.7% in 2020/21. Encouragingly, capital expenditure comprises one-third of the budget envelope, with government achieving the spending reduction by reallocating funds from slow-moving projects to other priority areas and clamping down on unnecessary recurrent spending.
The government also plans to mobilise KES200bn (1.8% of GDP) of PPP financing by 2020/21 by amending the PPP Act to remove unnecessary barriers, helping to reduce the burden placed on government by ambitious infrastructure plans. Other promising structural reforms highlighted in the budget statement include:
Approval of new public procurement regulations and roll-out of a new e-procurement platform by December 2020; and
Creation of a technical team to review the challenges facing SOEs and propose remedial actions with an eye to reducing contingent liabilities (currently c1.6% of GDP) and clearing any existing arrears.
Medium-term fiscal outlook and financing plans
Accounting for everything above, the budget deficit is expected to rise from 7.5% of GDP in 2018/19 to 8.3% in 2019/20. While this is well above the initial target of 5.6% outlined in last June’s budget, it is only 2% of GDP wider than the pre-Covid estimate of 6.3% outlined in the February Budget Policy Statement (BPS) and compares favourably to the deterioration expected across many developed and emerging markets. The IMF expects budget balances to deteriorate by 7.8 percentage points of GDP across advanced economies between 2019 and 2020, 4.2% in emerging and developing economies and 2.7% in SSA, far above the 0.8% slide expected in Kenya. However, this could be partly due to Kenya’s fiscal year running from July to June, with only about three months of post-Covid activity incorporated into the 2019/20 budget compared to nine months for countries with a January to December fiscal year.
To finance the deficit, Kenya will issue KES347bn (US$3.3bn, or 3.1% of GDP) of new external funding with the balance coming from domestic sources, in line with the desired 40/60 external to domestic financing mix outlined in the government’s medium-term debt strategy. Around 60% of external funding will be concessional debt from multilateral sources, including a recently agreed US$739mn Rapid Credit Facility (RCF) from the IMF, US$1bn of direct budget support from the World Bank, and US$210m from the AfDB.
This leaves about US$1.3bn of financing that the government will need to procure from other sources. To help plug the gap, the government will issue its first ever “Sovereign Green Bond” to finance major infrastructure projects in 2020/21. However, that still leaves a likely external funding gap. While Kenya’s stated desire is to shift away from commercial and towards more concessional financing sources, issuance of a new Eurobond in 2020/21 therefore remains a possibility. With Egypt’s US$5bn issuance in May 4x oversubscribed and the issuance pipeline in SSA more or less drying up, there would probably be demand to soak up an issuance. Kenya’s 2024s currently trade at mid z-spread of c680 basis points, a c120bps premium to Egypt’s newly issued 2024 as of close of business on 12 June despite slightly stronger credit ratings (one notch higher, at ‘B+’, per S&P and parity for Moody’s and Fitch).
Looking forward, the government remains committed to narrowing the budget deficit to 6.1% of GDP by 2021/22 and 3.6% by 2023/24 via contained growth in non-core recurrent spending and enhanced revenue mobilisation. While the consolidation plans are encouraging and notably more ambitious than the IMF’s May estimate for the 2023/24 deficit of 4.9%, Kenya has a history of failing to adhere to overly ambitious fiscal consolidation plans and we therefore see achievement of this target as unlikely. An early sign of government's willingness to adhere to targets will be
Over the past decade, Kenya has been able to achieve consistently high rates of real growth averaging 5.9% on the back of its investment-led growth model. However, it is unclear how much of Kenya’s strong growth has been due to public versus private sector investment, and consequently whether that growth can be maintained in the absence of a continually large government spending envelope. The removal of the cap on lending rates in November 2019 has created space for the private sector to pick up the slack (with private sector credit growth rising steadily from 3% at the end of 2018 to 9% in March 2020), but it is unclear if the associated rise in economic activity will be enough to offset a more contractionary fiscal stance.
Further, there is evidence that many of Kenya’s flagship investment projects may by white elephants, with the US$3.2bn Mombasa-Nairobi standard gauge railway project experiencing last-mile constraints that make it more expensive than road transport and therefore economically redundant. If Kenya’s public investment drive fails to yield positive economic returns, then growth and revenue could surprise to the downside as the government begins to scale back spending. In any case, average real GDP growth of 5.9% over the past decade has failed to translate to tangible fiscal consolidation, with the budget deficit averaging 6.6% of GDP over the same period.
Debt sustainability analysis
Government claims that Kenya’s public debt is sustainable and remains committed to its 2020 Medium Term Debt Strategy, which recommends a shift towards concessional external borrowing and a lengthening of domestic debt maturities.
Total public debt is projected by the IMF to have reached 64.7% of GDP by the end of 2019/20, including 33.4% of GDP external debt and 31.3% domestic. Kenya’s external debt stock is almost evenly split between multilateral, bilateral and commercial sources, though almost 75% of bilateral debt is due to non-Paris Club sources (mainly loans from China to finance the standard gauge railway). Rather than pursuing debt relief through the G20’s DSSI initiative, we think it more likely that Kenya will opt for ad hoc bilateral relief with major creditors such as China given its high reliance on commercial debt and the potential stigma attached to DSSI participation that could jeopardise future market access.
The IMF last conducted a DSA on Kenya in May, flagging a high risk of debt distress but saying that it remains sustainable. Public sector debt is projected to rise from 61.7% of GDP in 2019 to a peak of 69.9% in 2022, which – after applying a 5% discount rate per IMF norms – remains below the 70% PV threshold for countries (like Kenya) classified with a strong carrying capacity.
That said, Kenya’s debt service burden remains concerning with debt service rising to 21.3% of revenue in 2019, double the emerging and developing country average of 10.7%. In addition, the premise of debt sustainability is based on what we believe to be overly optimistic fiscal consolidation projections. While our forecast sees debt rising to a peak of c71% of GDP in 2022/23 if the IMF’s fiscal targets are met, it continues rising to 85% of GDP by 2024/25 if the primary balance is held constant at its 10-year average.
Kenya’s debt could potentially become unsustainable at this level, with both the PV of external debt to exports and PV of public debt to GDP indicators breaching IMF thresholds and debt service rising to nearly 40% of revenue by 2024/25. In such a scenario, we think Kenya would risk losing access to the commercial debt markets it has relied on to finance its large deficits in recent years. That said, strong demand for Egypt’s recent external issuance despite a debt burden approaching 85% of GDP shows that Kenya could potentially retain market access in the absence of consolidation for at least several years longer. Likewise, continued access to concessional borrowing sources will likely be predicated on the reversal of the income tax cuts laid out in this budget, which are meant to be a temporary stimulus rather than more 'permanent' revenue measure. With a debt stabilising primary deficit of c1% of GDP (compared to 4% currently), we view a fiscal tightening of roughly three percentage points of GDP as necessary over the medium-term to set debt on a sustainable path.
- 1 Strategy Note/Nigeria Nigeria #EndSARS protests more broadly politicised but low in list of risks
- 2 Strategy Note/United Arab Emirates Dubai real estate prices falling fifth year in a row and still not bottomed
- 3 Strategy Note/Global Saudi and GCC ugly fiscal truth from low oil prices
- 4 Strategy Note/Pakistan Pakistan opposition rally but Army-Imran-China triumvirate to persist
- 5 Weekend Reading/Global BP is leaving Emerging Market oil but could return in new ways
This report is independent investment research as contemplated by COBS 12.2 of the FCA Handbook and is a research recommendation under COBS 12.4 of the FCA Handbook. Where it is not technically a res...