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Kenya: IMF review boosts bonds but raises red flags on external accounts

  • The IMF Board approved Kenya’s 3rd programme review, assuaging concerns that it may have fallen off track

  • Stronger than expected revenue collection more than offset rising fuel subsidies, with headline fiscal targets exceeded

  • Rising reserves premised on heroically large external financing assumptions; policy tightening/KES deval likely needed

Kenya: IMF review boosts bonds but raises red flags on external accounts
Hasnain Malik
Hasnain Malik

Strategy & Head of Equity Research

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Tellimer Research
27 July 2022
Published byTellimer Research

Kenyan eurobonds have rebounded sharply over the past two weeks, with the KENINT 8 05/22/2032s rising from a low of US$62.8 (15.5% YTM) on 14 July to US$69.4 (13.77% YTM) on 26 July and the KENINT 6 ⅞ 06/24/2024s rising from US$77.6 (21.7% YTM) to US$84.8 (16.47% YTM) over that same period. This meshes with our view that Kenya’s sell-off had outstripped fundamentals and unlocked value in its bonds (see here and related reading).

Eurobonds

Alongside a broader EM rally (with the spread on the Bloomberg EM Sovereign Index falling by 29bps to 477bps on 25 July after reaching a post-Covid peak of 506bps on 15 July), Kenya’s bonds have been boosted by Executive Board approval of its 3rd IMF programme review on 18 July. This follows a successful staff-level review on 25 April and an initial Board approval deadline of 7 May, which had sparked concern that the programme may have fallen off track due to fiscal slippage.

However, the IMF review and accompanying report and FAQ document painted an overwhelming positive picture, saying that “Kenya has met all the quantitative performance criteria under its IMF programme” and that “The request for waivers relates to the timing of the review, not performance under the programme” because final data was not yet available to evaluate end-June targets (which will now be evaluated in the 4th review in November).

Our concerns over possible fiscal slippage were driven by a supplementary budget at the end of FY 21/22, which introduced tax cuts of 0.2% of GDP and made further provisions for fuel subsidies. However, this has been more than offset by 0.6% of GDP of extra revenue over the first 11 months of FY 21/22, helping push tax collection to an estimated 0.4% of GDP above target on the year (which the IMF says is a conservative estimate) and containing the budget and primary deficits to 7.8% and 3.3% of GDP, respectively, versus estimates of 8.2% and 3.4% of GDP in the 2nd programme review.

Encouragingly, the IMF says that much of the tax overperformance “is likely to reflect permanent improvements” stemming from new tax measures and improved compliance, meaning the additional 0.4% of GDP of revenue will be carried forward to FY 22/23. The government will also introduce new measures to reverse half of the losses from the supplementary budget. Once this is factored in, a package of new tax measures totaling 0.4% of GDP will be needed to achieve the FY 22/23 tax targets (half of what was projected in the 2nd review) and another 0.9% of GDP in FY 23/24.

The IMF also said that “Kenya’s strong fiscal performance provides scope to cushion the adjustment” to rising fuel prices, with Kenya’s decision not to adjust fuel prices in line with previous practices pushing the cost of subsidies to 0.5% of GDP since last July. Under baseline fuel price assumptions (eg in line with WEO estimates) the IMF says fuel subsidies could rise to 0.8% of GDP in FY 22/23. This could reach 1.9% of GDP under a 1 standard deviation increase to the average oil price (eg at US$119/bbl in FY 22/23) or 0.5% of GDP under a 1 standard deviation decrease (eg at US$86/bbl).

While rising fuel subsidies are concerning, the authorities plan to gradually realign domestic and global fuel prices over the course of FY 22/23 to eliminate the fuel subsidy altogether by October 2022, and will examine possibilities for a more targeted social support programme in its place. Contrary to other programmes, like in Pakistan, where energy subsidies have been a line in the sand for the IMF, the Fund has taken a much more conciliatory approach with Kenya and appears satisfied with Kenya’s promise to eliminate future subsidies as long as the overall budget deficit stays below target.

And on this front, the IMF remains surprisingly sanguine. After years of fiscal slippage, it has now exceeded its targets for two consecutive fiscal years. The primary deficit is projected to improve by a further 2.1pp this year on the back of new tax measures and a “further rationalisation of non-priority primary spending,” pushing it to 1.2% of GDP in FY 22/23 before consolidating further to a 0.2% of GDP surplus in FY 23/24 and a 0.6% of GDP surplus in FY 25/26. On this basis, public debt (including guarantees) will rise from 70.2% of GDP in FY 21/22 to a peak of 70.4% in FY 23/24 (implying a debt-stabilising primary balance of around -1% of GDP), then decline slowly to 65.7% of GDP in FY 25/26.

Despite a high risk of distress, the IMF sees debt as sustainable under Kenya’s current fiscal consolidation plans. It also references the recently delayed transition from a nominal debt anchor to a new ceiling of 55% of GDP in PV terms, affirming our previous hunch that the new anchor would be introduced after elections. Overall, despite elevated debt vulnerabilities and eurobond spreads rising into distressed territory, the IMF continues to give Kenya the benefit of the doubt and to paint an incredibly rosy picture that does not mesh with the market’s more cautious narrative. Still, this provides relief from recent concerns that the programme was at risk of being derailed. 

External account projections raise red flags

The IMF also appears to be sanguine on the balance of payments (BOP) front, saying that “The programme is fully financed with firm commitments for the twelve months following the third reviews of the EFF/ECF arrangements and good prospects for the remainder of the programme.” This is despite the postponement of Kenya’s planned US$1bn eurobond in FY 21/22, which was replaced with US$1.1bn of bank loans at a “shorter tenor” and “an interest rate including fees expected to well below 10 percent”, which is planned to be refinanced by a fresh eurobond issuance in 2025.

Kenya’s current account deficit is projected to rise from 5.5% of GDP in 2021 to 5.9% of GDP in 2022 on the back of higher energy imports before moderating to 5.5% of GDP in 2023 and 5% over the medium term. While large, Kenya has historically sustained deficits of an even greater magnitude, averaging 6.75% of GDP from 2010-19. Adding public external amortisations and IMF repayments of US$2.6bn on average from 2022-27 to the projected current account deficit of US$7.4bn over that period results in an annual average gross external financing requirement (GEFR) of US$10bn (7.3% of GDP) from 2022-27.

This is large compared to many EM peers, and comes at a time when Kenya is locked out of the eurobond market (a risk we flagged in a recent cross-country analysis). Indeed, bond issuance has been a cornerstone of Kenya’s balance of payments in recent years, with reserves following a regular pattern of large spikes when eurobonds are issued followed by a steady drawdown until the next issuance. Without access to the markets, and with public external amortisations ramping up to US$2.6bn annually from 2022-27 versus an average of US$750m from 2010-19, Kenya will need to unlock significant external financing from other sources to prevent an unsustainable reserve drawdown.

Usable FX reserves have already fallen from US$8.8bn at the end of 2021 to US$7.7bn on 21 July, but at 4.5 months of import Kenya still has some runway. That said, at just c85% of GEFR for 2022, reserves will continue to drop unless Kenya is able to plug its external financing gap by either bolstering its financing pipeline or reining in its current account deficit. And while the IMF expects gross official reserves to stay at the current level of US$8.8bn through year-end and rise steadily to US$10.2bn in 2023 and US$13.6bn by 2027, these projections rely on some rather heroic financing assumptions that, in our view, are subject to significant downside risks.

While the IMF programme does not pencil in new sovereign bond issuance until 2024, when a new eurobond will be issued to roll over Kenya’s maturing US$2bn obligation, it projects public external borrowing of US$3.4bn in 2022 and US$3.8bn in 2023. This is a notable upward revision from the respective US$2.5bn and US$3.5bn projections in the 2nd IMF programme review, which was conducted in December when external financing conditions were much more favorable, and is well above the US$3.2bn borrowed in 2020 and US$2.2bn borrowed in 2021 (excl. the US$740m SDR allocation).

GEFR

Further, the IMF projects “private capital flows” of US$2.2bn in 2022 and US$4.2bn in 2023, which also represents a notable upward revision from the US$1.8bn and US$3.5bn projected during the 2nd review and from the US$330mn and US$2.5bn of flows obtained in 2020 and 2021, respectively. As such, we think the IMF was only able to characterise the programme as “fully financed” by penciling in an overly optimistic external financing pipeline. This means the risk of a BOP crisis will remain elevated as long as external financing conditions remain tight.

There is, however, one safety valve that could release some of this pressure but that the central bank (CBK), frustratingly, has not allowed to serve as a buffer – the shilling (KES). According to the IMF, the KES was 4-12% overvalued in real effective terms in 2020. While the REER has corrected since its March 2020 peak, it has resumed its upward trend and is now up 7.5% YTD and sits 1% above the 2020 average, pointing to a c5-13% overvaluation. However, the current account deficit has widened since, so this could be an underestimate. Comparing the projected 5.9% deficit this year to the IMF’s estimated 3.6% of GDP “norm” translates to a c25% overvaluation, without adjusting for cyclical factors.

REER

However, the CBK continues to tightly manage KES depreciation, and has only allowed it to drop by 4.6% YTD versus the US$ (versus 4.8% for the JP Morgan EM Currency Index). This has led to FX shortages, which the Kenya Association of Manufacturers (KAM) has warned could force members to suspend operations and lead to the emergence of a parallel market. Rather than trying to limit KES depreciation, the CBK should allow it to depreciate to help restore external balance by lowering import demand and bolstering investment inflows. If the IMF’s ambitious financing pipeline fails to materialise and the CBK doesn’t allow the KES to adjust, then a BOP crisis may become inevitable.

Another tool at the CBK’s disposal is rate hikes. The CBK hiked by 50bps to 7.5% in May in response to rising inflation, which rose above the CBK’s 5% +/- 2.5% target in June at 7.9% yoy. While price pressures are less pronounced in Kenya than many of its frontier market peers and much of the rise has been due to food and fuel prices, core inflation has also begun to edge up and further rates hikes are likely necessary to keep a lid on price pressures and, perhaps more importantly, on import demand. However, the CBK opted against further hikes at today's MPC meeting, saying that its May hike was still translating through the economy and that moderating global commodity prices would translate to lower domestic price pressures in the near term.

We don't necessarily disagree with the CBK's inflation narrative, and Kenya's -0.4% real policy rate is higher than the -3.6% median across our sample of 66 emerging and frontier economies. However, from a BOP perspective, we think further tightening is necessary, with robust private sector credit growth (it rose to 12.3% yoy in June from 8.6% at the end of 2021) likely to exert upward pressure on non-oil imports and prevent a more meaningful rebalancing of external accounts.

Elections create political and policy uncertainty

Kenya’s macro trends are playing out against the backdrop of impending elections, which are now less than 2 weeks away on 9 August (see here for a recent webinar we participated in with Menas Associates on the topic). IMF Mission Chief Mary Goodman said that both candidates “affirmed support for key objectives and main economic policies of fund programme,” which is encouraging. In the most recent poll by Tifa Research, Raila Odinga maintained a narrow lead over Deputy President William Ruto by a margin of 42% to 39% compared to 39% and 35%, respectively, in the previous poll, with the portion of undecided voters dropping from 15% to 10%.

However, the race is still too close to call. While the elections will, as usual, be more about personality than policy, the risks for bondholders are much greater if Odinga wins due to his recent pledge to restructure Kenya’s debt. It is still not clear what the implications of this are (eg is he referring to an NPV-neutral “liability management exercise”, targeted relief from bilateral and multilateral creditors like Kenya received under the DSSI, or a holistic restructuring that includes private bondholders, and if it’s the latter is there a chance that cooler heads prevail and he softens his stance once he is in office and the negative implications of a default are driven home to him).

Ruto, on the other hand, has said “I am not going anywhere near or even having a discussion on restructuring debt” and promised instead to “put the brakes on borrowing” and limit it to funding priority projects. Overall, we think Ruto will be a more investor-friendly candidate. However, despite the IMF’s positive rhetoric, there is a risk that the new administration does not follow through on the IMF-backed reform plans of its predecessor, whoever wins. And, of course, the risk of political violence will continue to weigh on markets for the next two weeks, given Kenya’s history and how close the race promises to be.

Even if both candidates stay true to the government’s reform pledges, there is also a risk that delayed spending in FY 21/22 is simply kicked into the next fiscal year, pushing the FY 22/23 budget off target. Indeed, notwithstanding stronger than expected tax collection, the National Treasury said that financing shortfalls, including the cancellation of the planned US$1bn eurobond issuance, left Kenya with a US$2.16bn “shortfall” of budget resources in FY21/22. While this helped contain spending in FY 21/22, if delayed projects are restarted after elections then this could widen the FY 22/23 deficit (although this, too, seems less likely under Ruto than Odinga).

Fixed income investment implications

Despite a rosy outlook from the IMF and better-than-expected fiscal outcomes in FY 21/22, political uncertainty and external imbalances are cause for concern. That said, Board approval of the 3rd IMF programme review removes a key near-term risk factor and will give Kenya more runway to rein in its external imbalances, bolstering our view that the sell-off of Kenya’s eurobonds has outstripped fundamentals (the Bloomberg Kenya Sovereign Index is down 27.5% in total return terms YTD on a 767bps spread increase versus -19.4% and +141bps for the Bloomberg EM Sovereign Aggregate). 

As such, we maintain our Buy recommendation across Kenya’s eurobond curve at US$69.4 (13.77% YTM, 1,133bps OAS) for the KENINT 8 05/22/2032s as of cob on 26 July on Bloomberg. However, beyond the near term, Kenya needs to lower its external financing needs (via policy tightening and/or KES depreciation) and/or boost its external financing pipeline (via renewed market access and/or new sources of bilateral and multilateral financing) to avoid a BOP crisis.

This will prevent the spread on the KENINT 8 05/22/2032s from falling anywhere near the sub-500bps levels seen a year ago, but with spreads above 1,100bps there is still significant room for compression if the elections pass by uneventfully and the new administration follows through on the current IMF-backed fiscal consolidation plans. Alternatively, if Odinga wins and pushes ahead with his plans to restructure Kenya’s debt, then bonds will likely drop into the 50s to more fully reflect that risk.

Despite the relatively higher yield on the KENINT 6 ⅞ 06/24/2024s (16.5%, down from 21.7% on 14 July but well above the sub-3% levels reached last September), the KENINT 8 ¼ 02/28/2048s are our preferred entry point based on their lower cash price (US$61 versus US$84.8 on the ‘24s), which provides some protection against the downside restructuring scenario.

Equities: Banks over Safaricom, but for Frontier specialists alone

The Kenyan equity market arguably already reflects the macroeconomic and political risks ahead and deserves at least its full benchmark weight for FM dedicated funds (c4%). 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.

Kenya equities, measured by the Nairobi All Share (NSEASI), are down 19% ytd, ahead of Africa peers like Egypt and Ghana (both down c33%), and much worse than commodity exporter South Africa (down 11%). Notional outperformers Nigeria (up 23%) and Zimbabwe (up 59%) are not comparable because of capital repatriation restrictions. Kenya trailing PB is 1.2x (for 17% ROE), about a 25% discount to the 5-year median – compared to a 35% discount to that in Egypt.

Safaricom (57% and 63% of the Nairobi All Share and MSCI Kenya indices, respectively) continues to be virtually the only stock in Sub-Saharan Africa ex-South Africa that is of interest to global EM funds, with just under US$2mn of average daily traded value over the past six months. But that is a curse in an environment of de-risking off benchmark exposure and pressure on EM fund outflows. Safaricom shares are down 26% ytd in US$ total return terms. Yet valuation, with consensus forward PE at 15.7x, is roughly in line with the five-year median. However, that multiple sits alongside negative 10% consensus earnings growth for the current year, compared with growth in the range of 20-30% in the early part of that five-year history – a 5% forward dividend yield offers some offset, but not for an investment thesis normally built on growth.

For dedicated FM or Africa ex-South Africa funds able to stomach much lower liquidity (nearer US$0.5mn ADV), the banks look more attractively valued. Equity Bank (8.5% of NSEASI, 26% of MSCI Kenya) is on forward PE of 3.7x, a 20% discount to the five-year median, and forward dividend yield of 8.2%. And KCB (6% of NSEASI, 0% of MSCI Kenya) is on forward PE of 3.4x, a 15% discount to the five-year median, and dividend yield of 9.2%.

Banks

Related reading

Kenyan elections and macro webinar, July 2022 (with Menas Associates)

Kenya: Debt restructuring and debt ceiling comments spark concern, June 2022

Kenya’s sell-off has created a Buy opportunity, May 2022

Kenya budget: Still on track, but margin for error continues to shrink, June 2021

Kenya: First IMF review points to positive reform momentum, May 2021

Kenya constitutional reform builds and burns bridges, May 2021 (Malik)

Kenya: IMF program boosts prospects, February 2021

Kenya: Bad politics versus good valuations as divided parliament restarts, February 2021 (Malik)

Kenya seeks IMF funding and possible debt relief, November 2020

Kenya politics: Chief justice advice to dissolve Parliament adds to our caution, September 2020 (Malik)

Kenya budget: Ambitious targets, but can they deliver?, June 2020