- The IMF reached a staff-level agreement on the first EFF/ECF review, with Board approval expected in the coming weeks
- IMF backstop raises likelihood that ambitious fiscal targets are met and debt is set on sustainable trajectory
- But room for slippage is limited, and Kenya has a history of missed targets; retain Hold on Kenyan eurobonds
The IMF completed a staff-level agreement on the first review of Kenya’s EFF/ECF programme on 17 May, which will enable the release of another US$410mn of financing once it is approved by the Executive Board. The review appears to be well ahead of the scheduled 20 June deadline, and though Board approval "in the coming weeks" will push it closer to the originally scheduled date, it will likely still be approved a bit early. We see this as a positive sign of the IMF’s confidence in Kenya's performance.
The substance of the press release was positive as well. The IMF notes that "the economic recovery should be sustained, although the persistence of the pandemic suggests the pickup…will be slightly less strong than anticipated." From a 7.6% projection for 2021 when the programme was agreed in April, the IMF now sees a 6.3% expansion on the year. However, it still sees a rebound to just above 6% over the medium-term.
Kenya has "taken strong efforts to achieve their planned deficit path," which forms the backbone of their 38-month EFF/ECF programme. They have “met the fiscal balance target at end-March by a wide margin and had fully implemented their planned tax policy measures, although with continuing pressures from the pandemic, tax revenue yields were slightly below expectations." With a long history of fiscal slippage, it is encouraging to see that Kenya's early targets have been met.
The Kenyan authorities are also addressing some of the programme's other key priorities by developing a strategy to assess and manage risks to the budget from state-owned enterprises (SOEs) and pushing “forward with their agenda to increase transparency and fight corruption." Reducing debt vulnerabilities with revenue-based fiscal consolidation, strengthening the monetary policy framework and financial stability, and improved SOE governance and anti-corruption efforts represent the three key pillars of the 38-month, US$2.34bn programme approved in April.
Fiscal consolidation is key given high risk of debt distress
Kenya experienced very little fiscal slippage as a result of Covid, with the budget deficit widening from 7.7% of GDP in 2018/19 to 7.8% in 2019/20 and a projected 8.7% of GDP in 2020/21 (ending June). The authorities aim to reduce the deficit to 7.5% of GDP in 2021/22 and below 4% of GDP over the medium-term, which will stabilise debt at c73% of GDP in 2022/23.
Kenya's consolidation plans hinge on its strategy to boost tax revenue from 12.9% in 2020/21 to 15.6% of GDP by 2023/24, which seems ambitious on its face but would bring revenue roughly in line with levels over in the decade preceding the Covid crisis. Newly introduced taxes and the reversal of Covid-related tax cuts implemented in April 2020 (which happened at the beginning of the year) would lead to a 2% of GDP revenue boost in normal times, but the IMF estimates a more conservative 1.3% uptick. Another 0.8-0.9% of GDP of unidentified measures is expected annually in 2022/23 and 2023/24.
Revenue measures will be accompanied by recurrent spending reductions totalling 2.1% of GDP from 2020/21 to 2023/24. But while the IMF is optimistic that targets will be met, a fiscal adjustment of this magnitude would place Kenya well within the top quartile of countries (based on magnitude of 3-year primary balance adjustment under IMF programmes since 1990), with a 3.5% of GDP primary balance adjustment exceeding the 75th percentile of 2.5% of GDP. Kenya's track record of fiscal slippage does not bode well, and a major shift in fiscal attitudes will be required to stay the course.
The IMF deems Kenya’s debt as sustainable based on the envisaged consolidation targets, but with a high risk of debt distress. Several years of falling revenue has pushed up interest payments to 30% of revenue in the fiscal year through March from 25% in 2019/20, while falling exports have also pressured Kenya’s external liquidity ratios. While debt is set to stabilise under IMF targets, maintenance of the budget deficit and growth at pre-Covid levels will see the debt stock rise to c80% of GDP while a one standard deviation shock to the IMF’s primary balance and growth forecasts will see it rise to c75% of GDP (see chart notes for further explanation).
The IMF has sought to manage risks by limiting non-concessional external debt issuance to financing of critical projects and debt management operations, with the remainder contracted on concessional terms. During the first 18-months of the programme, US$4.8bn of public external borrowing will be concessional versus US$2.3bn commercial (ie eurobond issuance) earmarked specifically for high priority projects (though it is unclear which). The programme will allow another US$5bn of commercial borrowing between now and June 2022 to be used exclusively for debt management operations, which could include refinancing of the US$2bn eurobond in June 2024 and early retirement of some of the US$5bn of relatively expensive syndicated loans (with the remainder either rolled over at maturity or refinanced after the restrictions expire – though we note that US$7.3bn of eurobond issuance between now and June 2022 could be a lot for the market to absorb, notwithstanding Kenya’s 2-year absence from the market).
External accounts improving but still fragile
Kenya’s external outlook has improved post-Covid, with the current account deficit narrowing from 5.8% of GDP in 2019 to 4.8% in 2020 on the back of lower imports of oil, machinery, and transport equipment, increased tea and horticultural exports, and strong growth in remittances (which rose 11% yoy in 2020 and another 23% over the first 4 months of 2021). However, higher remittances have been more than offset by rising imports so far this year, which are up 11% yoy in Q1 versus a 1% yoy decline in exports.
As such, Kenya's current account deficit is expected to widen gradually to 5.6% of GDP over the medium term as Kenya's economy recovers, pushing up external financing needs. IMF funding, alongside an estimated US$1.6bn of budget support from other development partners and US$600mn of relief from DSSI, is expected to largely fill Kenya's fiscal and external funding gaps over the first two years of the programme. But risks will remain elevated as Kenya's 2024 eurobond maturity approaches, highlighting the importance of maintaining market access and successfully executing the planned liability management exercise.
Despite sharp REER appreciation (up nearly 60% in the decade leading up to the Covid crisis), the IMF assesses Kenya's overall external position in 2020 to be “broadly in line with the level implied by fundamentals and desirable policies.” After having depreciated c10% since last April, the IMF says that Kenya's REER was only 3-9% overvalued at the end of 2020, which suggests exchange rate misalignment is less severe than implied by a simple analysis of Kenya's REER movements. That said, the IMF highlights the importance of improving Kenya’s competitiveness to reverse recent declines in Kenya’s share of world exports, which is weighing on its external debt servicing capacity.
Against this backdrop, reserves have risen to US$7.6bn (4.6 months of import), and will be supported by the upcoming US$410mn IMF disbursement and a further disbursement of US$270mn in November if the programme stays on track. The IMF said in April that foreign reserves totalled 150% of the IMF’s Assessing Reserve Adequacy (ARA) metric at the end of 2020, but said that there is scope for further exchange rate flexibility to absorb future shocks.
Retain Hold recommendation on Kenyan eurobonds
While Kenya's economic outlook has turned notably positive on the back of its IMF programme and successful first review, risks remain high. Short-term growth risks stem primarily from Covid, with the third wave of cases in March and April giving way to declines over the past month, but slow vaccination progress meaning risks of resurgence will remain high for the foreseeable future. Kenya has managed to vaccinate just 2% of its population and plans to reach c21 million of the most vulnerable Kenyans by mid-2023, but at just c40% of Kenya’s population, this means that herd immunity will not be achieved until well into 2024 or beyond even if Kenya's vaccination targets are met (which will be difficult due to shortages of AstraZeneca vaccines from India, delaying any second dose jabs until at least June).
Political risks also cloud the outlook, with the High Court ruling last week that President Kenyatta’s Building Bridges Initiative (BBI) is illegal and accusing him of violating the constitution by trying to change it through an unconstitutional process. The near-term economic implications are not clear, though it may be positive for the fiscal since county transfers will be held at the current 15% instead of the proposed 35% (which could have stretched local capacity and imperilled federal budget targets due to loss of revenue). However, it will likely increase political jockeying ahead of the August 2022 elections, raising the stakes for Kenyatta’s "Kieleweke" coalition and potentially leading to pre-election fiscal slippage to buy votes and hold onto power.
From a longer-term perspective, Kenya must reverse stagnating private investment to maintain high growth and a healthy growth-interest rate differential even as the government takes its foot off the pedal. Private investment has plummeted by over 10% of GDP since 2014, exacerbated by a 2016-19 lending rate cap that caused a collapse in private sector credit growth. As we have said before, Kenya's elevated debt burden no longer gives the government the ability to fuel growth, and the private sector must take the baton if Kenya is to continue achieving such high growth levels.
With the first IMF programme review now almost in the rear-view and reform efforts progressing at an impressive pace, the outlook for Kenya is much brighter than it was at the beginning of the year. But there is still much heavy lifting to be done to set debt on a sustainable path. The IMF backstop gives us increased confidence, but a history of fiscal slippage calls for caution. We think Kenya's outperformance of the EMBI Africa index over the past year is justified, but will continue to closely monitor programme progress and retain our Hold recommendation on Kenyan eurobonds at an EMBI spread of 444bps, as of cob on 18 May.
Kenya: IMF program boosts prospects, 19 February
Kenya seeks IMF funding and possible debt relief, 25 November
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