We wrote last July how the external financing projections underpinning Kenya's IMF programme were overly optimistic, opening Kenya up to the risk of an unsustainable reserve drawdown. During the IMF’s latest review in December, it revised its reserve projections down by cUS$3.2bn in 2023 and augmented programme financing by cUS$215mn to plug part of the gap, proving our concerns to be well-founded.
However, at the time we emphasised that the IMF's external financing assumptions still seemed unrealistic, with Kenya's reserve accretion predicated on a sharp rise in public sector borrowing and "private capital flows" from 2024 onward. We argued that, despite continued outperformance on Kenya's fiscal targets, this meant greater exchange rate flexibility and monetary policy tightening were needed to prevent a balance of payments crisis over the medium term.
Indeed, while Kenya has continued to deliver on its fiscal targets, its reserves have remained under pressure in the months since, with the central bank's (CBK) usable FX reserves dropping from US$7.4bn at the end of 2022 to US$6.6bn on 2 March (equivalent to c3.3 months of trailing goods & services imports and c75% of projected gross external financing requirements in 2023). At the same time, undersubscribed Treasury bond auctions in recent months hint at domestic financing constraints.
In the following note, we unpack Kenya's external and domestic financing constraints. We argue that adjustments to Kenya's exchange rate and yield curve management and monetary policy stance are needed to prevent a balance of payments crisis over the medium term.
Budget performance
After years of consistently missing its fiscal targets, Kenya outperformed its IMF target in FY 21/22 (ending June 2022) on the back of a 0.8% of GDP overshoot in tax revenue and a 1.9% undershoot in primary spending. This resulted in a budget deficit of 6.2% of GDP on a cash basis (incl. grants) versus the IMF's 7.8% of GDP target.
However, the primary spending shortfall was driven primarily by a US$1.8bn shortfall in external financing. Of this, 0.6% of GDP will be carried forward to FY 22/23. Combined with 1.3% of GDP of spending pressures earlier in the fiscal year this led to a 1.9% of GDP upward adjustment to spending. However, this will be offset by 1.7% of GDP of spending cuts and a 0.3% of GDP upward revenue revision, resulting in a 5.8% of GDP budget deficit versus the initial 5.9% of GDP target. Kenya's medium-term fiscal consolidation plans were also affirmed in January's Budget Policy Statement (BPS), targeting a 4.3% of GDP deficit in FY 23/24, 3.8% in FY 24/25 and 3.5% in FY 25/26.
However, there is some risk of slippage this year, with total revenue & grants coming in 1.1% (0.1% of GDP) below target in the first half of FY 22/23 and total spending overshooting by 1.4% (0.2% of GDP), with a central government recurrent spending overshoot of 11.6% (0.8% of GDP) offset by shortfalls of 12.1% (0.2% of GDP) for capex and 28.6% (0.4% of GDP) for county transfers. This resulted in a budget deficit of 2.3% of GDP (incl. grants) in the first half of the FY versus the 2% target, while a supplementary budget earlier this month seemingly solidified this slippage by revising total spending up by KES15bn (0.1% of GDP), with recurrent spending increasing at the cost of lower capex and development spending.
In its latest Debt Sustainability Analysis (DSA) in December, the IMF classified Kenya's debt as sustainable but with a high risk of distress. The IMF projects public debt to rise to 67.6% of GDP at the end of FY 22/23 (61.6% in PV terms), above the 55% cap on PV of debt/GDP that the government is in the process of legislating, with debt projected to remain above that threshold until 2026. PV of external debt-to-exports and external debt service to exports are also projected to remain above the relevant DSA thresholds until 2026 and 2028, respectively, while interest payments ate up 27.7% of total revenue & grants in the first half of FY 22/23.
There is also a large stock of KES481bn (3.3% of projected full-year GDP) of unpaid bills by the national government and SOEs as of December 2022 and another KES160bn (1.1% of GDP) of arrears owed by Kenya's 47 county governments, while Kenya's struggling SOEs will continue to pose a contingent risk to the budget (especially Kenya Airways and Kenya Power and Lighting Company, which will require an estimated 0.3% of GDP of direct transfers this year – although efforts are underway to rationalise and possibly privatise key loss-making SOEs). Overall, despite its continued fiscal outperformance, Kenya has little margin for error and must stay the course to keep debt on a sustainable path.
Domestic financing constraints
Despite the strong above-the-line fiscal performance, Kenya has struggled with below-the-line financing of its deficit. In the first half of FY 22/23 (eg from July to December 2022), Kenya received bids for only 87% of what was on offer and accepted only 85% of those bids, corresponding to subscription rates of just 71% amid low domestic demand for T-bills and possible efforts by the government to cap yield increases. Since the beginning of the year, however, the subscription rate has increased to 133%, potentially driven in part by the government's allowance of higher cutoff yields on 12-month T-bills since November.
Bond auctions, however, have remained severely undersubscribed. Since the beginning of the fiscal year, the Treasury has received bids for just 47% of the bonds on offer and accepted 86% of those bids, resulting in a 40% subscription rate. Again, government resistance to higher bond yields could be a driver of these financing issues, with the 10-year auction yield rising from 13.95% in September to 14.15% in February. With inflation running at 9.2% in February this corresponds to a real 10-year yield of nearly +5%, which compares favourably to a -0.75% median across our 30-country emerging market sample, but weak demand still points to the need for a larger upward adjustment.
Overexposure to government debt among Kenyan banks may also be contributing to the financing constraints, with commercial banks' holdings of government securities rising from 18.7% of bank assets in September 2015 to 30.6% in December 2022. This has prompted pension funds to absorb an increasing share of government debt, rising from 25.3% of the total domestic debt stock in September 2015 to 33.2% in February 2023, with banks' share falling from 56.5% to 46.7% over that period. While private sector credit grew at a relatively strong 12.3% yoy in December, a resumption of bank lending to the government would likely cause private borrowing to be crowded out.
Lastly, a preference to hold infrastructure bonds could be contributing to the undersubscribed bond auctions. A 10-year infrastructure bond currently yields 13.45%, just barely below the yield on 10-year Treasury bonds, and interest proceeds are exempt from the normal 10-15% withholding tax. As such, the trading volume of infrastructure bonds was nearly 80% higher than Treasury bonds in December, according to NSE data, and a planned sale of infrastructure bonds next week may attract greater demand than recent bond auctions and help plug some of the financing shortfall.
Whatever the reasons, undersubscribed bond auctions have resulted in a cumulative KES564bn shortfall of bond issuance relative to bonds offered on a fiscal YTD basis. Adding in a KES79bn T-bill shortfall, the total domestic issuance shortfall amounts to KES643bn (4.4% of estimated full-year GDP). Taking a different perspective, the Kenyan Treasury reported a KES109bn (0.8% of GDP) shortfall in net domestic financing in the first half of FY 22/23, with non-bank financial institutions absorbing 95% of gross issuance.
As such, despite relatively strong fiscal performance under Kenya's IMF programme, there is a clear need for further consolidation and less heavily managed government bond yields to prevent below-the-line financing constraints from eventually triggering a domestic debt crisis, and further rate hikes by the CBK may also be required.
Against this backdrop, dovish comments by newly appointed CBK deputy governor Susan Jemtai Koech, who spoke of the need to review the CBK's interest rate regime to make borrowing more affordable during her confirmation hearings this week, are concerning. Koech is likely to take over as acting CBK governor after Governor Njoroge's term expires in mid-June, and a dovish policy shift could exacerbate Kenya's vulnerabilities.
That said, Koech's appointment could also open a window for a more flexible exchange rate policy (see below) with Koech calling for measures to increase FX liquidity and reduce the gap between the CBK's exchange rate quotes and those offered by commercial banks. It remains to be seen if and how policy might shift after Njoroge's departure.
External financing constraints
Kenya's external financing constraints are even more concerning, with gross external financing requirements projected to average a hefty 7.2% of GDP from 2023-27 (including a 5.3% of GDP current account deficit and 1.9% of GDP of public amortisations).
The IMF has already been forced to revise down its reserve projections by US$3.24bn in 2023 due to overly optimistic financing assumptions in its 3rd review that resulted in large downward revisions to projected public borrowing and private capital flows. Kenya is now projected to build its reserves from cUS$8bn at the end of 2022 to cUS$11bn by 2027. However, these targets are still underpinned by unrealistic financing assumptions, in our view.
Public sector external borrowing (excl. eurobond issuance) is projected to pick up from US$1.94bn on average from 2021-22 to US$2.55bn in 2023, US$2.92bn in 2024 and US$4.32bn from 2025-27. Private capital flows are also projected to pick up from US$2.72bn from 2021-22 and US$2.63bn in 2023 to US$4.8bn in 2024 and US$4.14bn from 2025-27, while FDI is projected to rise from US$0.38bn from 2021-22 to US$1bn in 2023, US$1.2bn in 2024 and US$1.73bn from 2025-27. This constitutes a major increase across all three line items, which will put downward pressure on reserves if it fails to materialise.
Lastly, there is a US$2bn eurobond maturing in June 2024 (equal to 30% of reserves) plus another US$300m annually from 2025-27, which the IMF assumes will be rolled over (plus US$900mn of net issuance in 2025). With Kenya's 10-year equivalent eurobond yielding above 10% and uncertainty on how global financial conditions will unfold in the coming 15 months, it is not clear if Kenya will be able to refinance its 2024 eurobond when it comes due (at least without accepting an exorbitantly high yield). Failure to do so would lead to a large drain on reserves in mid-2024, with Kenya's reserves exhibiting a clear pattern in recent years of chunky eurobond-driven increases followed by a steady drawdown until the next issuance.
With the IMF announcing yesterday a temporary increase to its cumulative access limits for Fund lending from 435% to 600% of quota for a period of 12 months, this could provide a way for the IMF to once again augment its financing to offset potential financing shortfalls. With total access projected to reach 435% of quota by the end of Kenya's programme and a quota of SDR542.8bn, increasing funding to the new 600% ceiling could potentially unlock nearly US$1.2bn of new funding. However, this would only kick the can down the road absent a more durable uptick in external funding, with a follow-on programme potentially needed after it expires in mid-2024 to avoid a crisis.
There were also headlines this week that the government has sought US$4.8bn of credit from a variety of private lenders to purchase fuel. The effective nationalisation of fuel imports would be a departure from the current system of private importers, and the government hopes it will limit FX demand related to fuel imports. Still, this too is just a temporary solution and does not change the need for durable financing solutions, and also risks introducing new inefficiencies into the fuel procurement process.
More KES flexibility is likely also needed, with the CBK heavily managing the exchange rate over the past two years. To be fair, the KES has depreciated by c13% over the past 12 months and the CBK has allowed accelerated deprecation of c2% over the past two weeks, potentially signifying an acknowledgement of Kenya's external financing constraints and helping to reverse some of the real appreciation seen over the past decade. However, the REER is still c5% above its 10-year average and c22% above its 20-year average, and more flexibility is still needed to absorb external shocks and prevent a balance of payments crisis.
Investment implications
Since we initiated our Buy recommendation last May Kenyan eurobonds have outperformed the index, with the Bloomberg Kenya Sovereign Index returning +6.4% in total return terms versus -2.5% for the Bloomberg EM Sovereign Index and -0.9% for the B-rated sub-index. The outperformance has been particularly notable since the height of the July 2022 sell-off, with the option-adjusted spread on the KENINT 8 05/22/2032s nearly halving from 1304bps to 666bps on 7 March and bonds rising from US$62.8 to US$85.6 in cash terms (for a total return of 44.7% over that period versus 4.9% for the Bloomberg EM Index).
The Bloomberg Kenya Sovereign Index is now trading at a spread of +82bps to its B-rated peers versus an average of -118bps in 2019, corresponding to a widening of 200bps relative to pre-pandemic levels. However, this widening is justified in part by Kenya's precarious fiscal and external positions (see above), and an OAS of 666bps on the Kenya ‘32s is now far below the spreads on similar duration bonds in Nigeria and Egypt (811bps and 982bps, respectively), which may offer more compelling value (potentially for less risk in Nigeria, but likely greater risk in Egypt). Conversely, Kenya continues to trade wide of other high growth, high debt and high twin deficit countries like Rwanda (604bps) and Senegal (512bps), signalling that there may still be some value in the bonds (although Senegal is likely a stronger credit, and arguably Rwanda as well).
We maintain our Buy recommendation on the KENINT 8 05/22/2032s at US$85.6 (666bps OAS) on a mid-basis at cob on 7 March on Bloomberg. While the ongoing commitment to and delivery of Kenya's fiscal consolidation plans has left Kenya in a much stronger position than it was last year, there is still little margin for slippage and the domestic and external financing constraints discussed above give us reason to worry over the medium term.
Kenya equities are cheap but the cheapest are also illiquid
The change in leadership under President Ruto, elected in August 2022, is resetting some of the unwritten rules of the game for local corporates given the tribal allegiances which dominate politics. Ruto is from the Kalenjin tribe and follows two decades of rule by former presidents Kibaki and Kenyatta, both from the Kikuyu tribe.
The Kenyan equity market arguably already reflects the macroeconomic and FX rate risks ahead and deserves at least its full benchmark weight for FM dedicated funds (c1.7% in the FM100). Kenya is one of the cheapest markets relative to its historical average in Africa Small EM and FM.
Kenya equities, measured by the Nairobi All Share (NSEASI), are down 6% ytd, similar to Egypt (down 9%) and South Africa (down 3%), but well behind Nigeria (up 11%, although this comparison is muddied by its persistent friction in capital repatriation). Kenya trailing PB is 1.1x (for 17% ROE), a 32% discount to the 5-year median – among Africa peers, only sovereign defaulter Ghana and very illiquidly traded Mauritius exhibit larger discounts.
The problem for mainstream EM investors is that the most compelling value is not found in the most liquidly traded stock, Safaricom, but, instead, in the relatively less liquid banks.
Safaricom (50% and 59% of the Nairobi All Share and MSCI Kenya indices, respectively) continues to be the only stock in Sub-Saharan Africa ex-South Africa that is liquidly traded enough for global EM funds, with US$1.2mn of average daily traded value over the past six months. But that is a curse in an environment of de-risking off benchmark exposure. Safaricom shares are down 10% ytd in US$ total return terms. Consensus forward PE at 12.8x, is in line with the five-year median. However, that multiple sits alongside negative 13% consensus earnings growth for 2023 and merely positive 5% for 2024, compared with growth in the range of 20-30% in the early part of that five-year history. A 5.8% forward dividend yield offers some offset, but not for an investment thesis historically built on growth.
For dedicated FM or Africa ex-South Africa funds able to stomach much lower liquidity (nearer US$0.3mn ADV), the banks look more attractively valued. Equity Bank (9.3% of NSEASI, 27% of MSCI Kenya) is on forward PE of 3.6x, a 18% discount to the five-year median, and forward dividend yield of 8.4%. And KCB (6.4% of NSEASI, 0% of MSCI Kenya) is on forward PE of 3.3x, a 13% discount to the five-year median, and dividend yield of 7.9%.
Related reading
IMF caps of 2022 with flurry of activity, January 2023
Kenya: Supreme court ruling reduces political risk, September 2022
Kenya: Uncertainty reins after Ruto declared president-elect, August 2022
Kenya: Elections still close to call (and implications), August 2022
Kenya: IMF review boosts bonds but raises red flags on external accounts, July 2022
Kenyan elections and macro webinar, July 2022 (with Menas Associates)
Kenya: Debt restructuring and debt ceiling comments spark concern, June 2022