Until this week’s rally, Kenya’s eurobonds had been among the worst performers this year, with its EMBI spread widening by 386bps through 19 May versus 204bps for EMB Africa and 87bps for EMBI Global. Although it has rallied significantly over the past week alongside a broader EM rally, it remains one of the worst performers year-to-date, with spreads widening 237bps through 26 May versus 118bps for EMBI Africa and 67bps for EMBI Global.
Kenya entered the year with elevated external and debt vulnerabilities, with the IMF classifying its debt as being at a high risk of distress. However, the country is also in the midst of a three-year IMF programme that will run through May 2024, and its growth and inflation outlook is better than that of many of its EM peers. With the yield on its 10-year eurobond still above 10%, this report unpacks whether the recent selloff has been justified or has created an interesting entry point to buy Kenyan eurobonds.
We find that, notwithstanding large risks to Kenya’s fiscal consolidation plans, looming elections, and a need for a genuine shift towards a less debt-fueled growth model, the risks are largely priced in and the recent selloff has overshot fundamentals. We upgrade our recommendation on the KENINT 8 05/22/2032 eurobonds to Buy at US$87.2 (10.06% YTM) as of cob on 26 May on Bloomberg.
Growth and inflation
Kenya’s post-Covid performance has been more robust than that of most of its EM peers, with GDP contracting by just 0.3% in 2020 and rebounding by 7.5% in 2021. A revision to GDP data pushed nominal GDP up by 1.6pp in 2020, resulting in a more favourable denominator for most major macro indicators. However, the revision also caused real growth to be revised down by 0.8pp on average from 2010-19, resulting in a lower estimate for potential growth and prompting the IMF to revise its medium-term growth forecast down from 6.1% to 5.5%.
Inflationary pressures have also been less acute in Kenya than for many peers, rising from 5.6% to 6.5% in April (within the Central Bank of Kenya's (CBK) 5% +/- 2.5% target but above the 5.7% Bloomberg consensus). That said, the IMF expects inflation to rise to 8.7% yoy by the end of the year, and global price pressures will be exacerbated by the worst regional drought in 40 years and a 12% boost to the minimum wage. This will likely force the CBK to hike rates further this year, with the Kenya Bankers Association urging the CBK to tighten policy to reduce pressure on inflation and the shilling ahead of the next monetary policy committee (MPC) meeting on 30 May.
The growth outlook has also softened notably in recent months amid the drought, the war in Ukraine (and associated impact on commodity prices and tourism) and impending elections at home (which will weigh on investment as businesses adopt a wait-and-see approach), with the Parliamentary Budget Office projecting a slowdown to just 4.9% growth this year (more pessimistic than the IMF’s 5.7% April projection and the National Treasury’s rosier 6% projection, but in line with Bloomberg consensus).
Although even Kenya’s downwardly revised potential growth of 5.5% compares favourably with that of many EM peers and its own 2010-19 average of 5%, rapid growth can no longer be taken for granted as a cornerstone of Kenya’s investment thesis, in our view. Private investment has declined over the past decade from c14% of GDP in 2013-14 to c7-8% in 2020-21 and public investment has also declined from c8.5% to c5-5.5% of GDP over that same period amid dwindling fiscal space. While still relatively robust, public investment has not translated into productivity gains and the IMF’s estimated “efficiency gap” of 29% on public investment lags its EAC peers (but is in line with the EM median).
Further, despite a relatively dynamic and diversified economy compared with Sub-Saharan Africa peers and a development strategy focused in part on strong integration into global markets, exports of goods and services have halved from c20% in 2010-11 to c10% in 2020-21. A Selected Issues paper by the IMF in December cites numerous shortcomings with non-price competitiveness, including a focus on products with low technological intensity, value-added, and market growth and a weak business environment, which must be addressed to reverse this downward trend.
Kenya’s strong historical growth performance (averaging 5% from 2010-19) has served as a credit strength in recent years, but the failure to boost private investment and productivity could make it difficult to meet the relatively high expectations of future growth and, against higher debt and reduced fiscal space (see below), could increase Kenya’s economic vulnerability and require a rethinking of its public investment and debt-driven growth model.
Fiscal policy and debt
After many years of slippage on its fiscal targets, Kenya’s post-Covid fiscal performance has been relatively encouraging. Consolidation efforts have been supported by a three-year, US$2.34bn extended credit facility (ECF)/extended fund facility (EFF) programme with the IMF that was agreed in April 2021. The budget deficit reached 8.1% of GDP in FY 20/21 (ending June) versus an 8.6% target under the IMF programme due to reduced non-priority current spending and capex.
The FY 21/22 deficit is projected to be unchanged at 8.1% of GDP versus the original target of 7.5%, but the slippage was driven by spending on vaccines and extraordinary support to state-owned enterprises (SOEs), which has been built into the IMF programme with a cumulative allowance of 1% of GDP of extraordinary SOE support for FY 21/22 and FY 22/23. As such, programme targets have been rephased to accommodate the additional spending and the third programme review was approved at the end of April.
The budget aims to reduce the deficit from 8.1% to 6.2% of GDP this year and 3.2% of GDP by FY 25/26 by boosting tax revenues (from 13.2% of GDP in FY 21/22 to 16.2% by FY 25/26), rationalising tax expenditures (equivalent to 3% of GDP in 2020) and reducing non-priority spending. However, the IMF said in December that additional tax measures of 0.8-0.9% of GDP in both FY 22/23 and FY 23/24 are required to reach Kenya’s revenue targets, and the Parliamentary Budget Office (PBO) has already warned that tax collection targets in FY 22/23 are unlikely to be achieved.
Further, with elections approaching in August (see below), there is likely to be pre-election spending slippage. This will be exacerbated by rising fuel prices, with President Kenyatta signing a US$300mn supplementary budget last month to cover fuel subsidy arrears that were causing shortages. Further, campaign promises include KES200bn of support for small businesses (Ruto) and a KES137bn stipend for poor Kenyans (Odinga), which could cause post-election spending slippage if not accompanied by offsetting measures (Ruto has at least promised to divert money from megaprojects).
Public debt reached 67.8% of GDP at the end of 2021 (34.5% external, 33.3% domestic), or 61.7% of GDP in PV terms. This compares with a newly adopted debt anchor of 55% of GDP in PV terms (equivalent to c60% in nominal terms), which requires the Treasury Secretary to present time-bound remedial actions when the threshold is breached. Based on current fiscal plans, the deficit is not projected to fall below the ceiling until 2026. Further, interest payments have eaten up 28% of government revenue in the first nine months of FY 21/22 and are projected to rise further this year, reducing the space for consolidation.
Beyond the headline figures, there are significant contingent liabilities to contend with. Guaranteed debt is already included in the debt stock, but an assessment of financial vulnerabilities at Kenya’s 18 largest SOEs has identified a cumulative “liquidity gap” of KES383bn that must be filled over the next five years, not including the KES155bn of support that has already been budgeted to restructure the struggling Kenyan Airways. Failure to successfully restructure failing SOEs will pose a continued drag on the budget, while county-level arrears of cUS$800mn pose an additional risk.
The government aims for net domestic and external funding of 4.2% and 2% of GDP, respectively, in FY 22/23. However, plans to issue a new eurobond before the end of this fiscal year (June) could be derailed by tight financing conditions and double-digit yields, which could increase Kenya’s reliance on domestic debt, which already comprises 30% of banking sector assets and will crowd out the private sector (the IMF estimates that a 3pp increase in net domestic financing needs will reduce private sector borrowing by 5pp relative to the baseline). Fiscal slippage would exacerbate the crowd out even more.
Overall, after years of tolerating slippage given manageable debt levels and the perception that spending was being channelled into pro-growth investments, Kenya has reached an inflection point where debt is approaching unsustainable levels (the IMF classifies it as sustainable but with a high risk of distress) and investors are no longer willing to tolerate fiscal slippage (with 10-year yields rising into the double-digits). As such, after the August elections, the new administration will need to keep Kenya’s fiscal consolidation plans on track to avoid a debt crisis.
In addition to large budget deficits averaging 6% of GDP annually in the decade pre-Covid (2010-19), Kenya has also been running a large current account deficit of 6.75% of GDP over that same period. While it moderated to 4.7% of GDP in 2020 and 5.4% in 2021, it is projected to widen this year on the back of higher commodity prices (fuel makes up c20% of imports). The CBK forecasts a 5.9% of GDP deficit in 2022 and the most recent Bloomberg survey has a median forecast of 6% of GDP.
On a 12-month rolling basis, the current account widened to US$5.9bn in March 2022 versus US$4.7bn in the same period last year on a 25% rise in imports versus a 13% rise in exports. However, remittances have served as a valuable buffer, rising 20% yoy to US$3.7bn in 2021 and another 22% yoy in the first four months of 2022.
On the financial account front, Kenya will continue to be reliant on 'other investment' (eg external borrowing) to fund its current account deficit, with negligible portfolio investment and FDI inflows of just 0.5% of GDP in 2021 (down from just 1.3% of GDP from 2010-19, speaking to Kenya’s weak investment environment).
FX reserves have fallen from US$9.9bn in June 2021 after the last US$1bn eurobond issuance to US$7.7bn in March 2022, which is still relatively robust at around four months of import but points to potential problems financing Kenya’s current account if market access is not restored (with a now-familiar pattern of a reserve jump when eurobonds are issued followed by a gradual depletion).
With large external funding needs (the IMF estimates US$8.8bn this year, including a US$6.7bn current account deficit and US$2.1bn of amortisations) and weak financing backdrop, KES will likely need to depreciate to reduce external imbalances. Indeed, headlines last month hinted at worsening FX shortages, with the Kenya Bankers Association citing supply shortages due to elevated fuel imports but denying rumours that the CBK had started rationing dollars. This kind of anecdote belies the relative stability of the currency (it is down just c2.5-3% this year) and hints at severe underlying imbalances.
KES depreciation is, therefore, necessary to restore balance to Kenya’s external accounts, with the IMF estimating that it was 4-12% overvalued in real effective terms in 2020 and the REER broadly unchanged since. Alternatively, the IMF’s estimated current account 'norm' of 3.6% of GDP implies a c20-25% overvaluation based on the 6% of GDP forecast for 2022, although adjustments must be made to account for cyclical factors, so this is only a ballpark estimate.
Over the longer term, Kenya must improve its non-price competitiveness to boost its stagnating exports (see above) and improve the business climate to boost investment and FDI and break the cycle of reliance on commercial borrowing to meet its consumption and external funding needs. Further integration among EAC countries would be a boon for Kenya, but past disputes and elevated non-tariff barriers serve as an impediment to regional trade (notwithstanding some recent progress on trade integration with Tanzania, including an agreement to eliminate 14 identified NTBs over six months).
Kenya’s economic difficulties take place in the context of looming elections on 9 August. Outgoing President Uhuru Kenyatta has anointed long-time rival and opposition leader Raila Odinga as his successor after falling out with erstwhile ally and current Deputy President William Ruto, who will contest under the recently formed United Democratic Alliance (see here for a more detailed look at the political backdrop).
As usual, voting will take place along ethnic lines. Odinga comes from the Luo ethnic group, which comprises 10% of the population versus 13% for the Kalenjin (Ruto) and 17% for the Kikuyu (Kenyatta) groups that have so far held a monopoly on the presidency in the post-independence era. Both candidates have named Kikuyu running mates, and the race promises to be a close one, with the most recent poll from Nairobi-based Tifa Research showing 39% in favour of Odinga versus 35% for Ruto, a swing from 39% for Ruto and 32% for Odinga in the previous poll, but within the margin of error.
We do not think the upcoming elections are likely to give way to ethnic violence as we saw in 2007-08 when Odinga’s supporters clashed with those of President Mwai Kibaki (a Kikuyu) over allegations of electoral fraud, leaving up to 1,500 dead and hundreds of thousands displaced. Today’s system is less winner-takes-all in nature given the devolution of power to county governments, with the 2013 elections taking place under much more peaceful conditions (although not perfectly so, with some low-level violence still taking place).
That said, there is still a risk that unrest could ensue if the election is close and results are open to dispute. The victor must win the majority vote and at least one-quarter of the votes in half of Kenya’s 47 counties, which could send the election to a runoff if a third-way candidate like former DP Kalonzo Musyoka of the Kamba ethnic group (10%) siphons off a meaningful share of the vote, thus heightening the risk of unrest. Further, after trying and failing to become president in four previous elections, Odinga may see this as his last shot, reducing the likelihood that he accepts the outcome if it is a close call.
And even if there is no violence, the election will likely lead to fiscal slippage and delay meaningful reforms until later this year. Beyond the election, it is not clear that there is a meaningful policy difference between the two candidates. Ruto has framed the election as “hustlers versus dynasties”, contrasting his humble beginnings to the political lineage of his opponents (Kenyatta’s father was Kenya’s first post-independence president and Odinga’s a prominent figure in the independence movement), and seeks a move away from ethnically based voting.
Ruto’s key policy proclamation has been a move away from debt-fuelled megaprojects that have been a cornerstone of Kenyatta's “Big Four” policy agenda and shift towards supporting small businesses, which could be a net positive for Kenya’s ability to shift towards a more sustainable private sector-driven growth model. Meanwhile, Odinga seems to be more focused on expanding the social safety net. Overall, we view Ruto as being a slightly more market-friendly candidate. After elections, the reform outlook will likely improve regardless of who wins but, in the meantime, fiscal consolidation and reform efforts will likely stall and investors will continue to price some risk of unrest into Kenya’s eurobonds.
Eurobonds attractive after selloff
Kenya’s 10-year eurobond has sold off sharply this year, with the yield on the KENINT 8 05/22/2032s rising from 6.74% at the end of 2021 to a peak of 11.48% on 19 May (and prices falling 27% over that same period). Although risks are clearly elevated in Kenya, markets appeared to be pricing a higher risk of distress than was justified by fundamentals, in our view (with large twin deficits and debt stock set against an IMF-backed consolidation program and relatively robust external buffers and growth).
Indeed, over the past week, bonds have bounced back considerably, with yields on the KENINT 8 05/22/2032s falling to 10.06% as of cob on 26 May and prices rising by 7.6pts to US$87.2. That said, in contrast to peers like Egypt and Pakistan whose recent accession to the '10%-ers club' reflects a concerning rise in external imbalances, we think Kenya’s sell-off has mainly been a reflection of broader risk-off sentiment and has, notwithstanding the recent rally, outstripped fundamentals.
Kenya’s spread and key macro variables are at or near the median across the board across a group of nine peers. Pakistan trades c450bps wide of Kenya and represents the downside for a post-election Kenya that fails to consolidate, but this would require substantial slippage and a derailment of Kenya’s IMF programme. On the other end of the spectrum, Rwanda trades c200bps inside Kenya and represents the upside scenario.
Overall, we think Kenya’s spreads should be trading somewhere above Rwanda (which has similar fiscal and debt dynamics but with better long-term growth prospects and a wider current account deficit) and below Egypt (which has higher fiscal and external vulnerabilities and similar growth prospects). Notably, we currently have a Buy recommendation on both Rwandan and Egyptian eurobonds.
That said, there is also some supply risk given Kenya’s plans to issue a eurobond by the end of June. Although its prospects looked poor a week ago, this week’s rally could make an issuance feasible if it continues. A new issuance, however, could exert some upward pressure on yields, with the few EM countries that have managed to issue this year generally being forced to offer a premium to their existing curve given the sharp tightening in financial conditions.
Notwithstanding this week’s c120bps rally in spreads and the impending supply risk, we think the KENINT 8 05/22/2032s could rally another 100bps and upgrade our recommendation to Buy at US$87.2 (10.06% YTM, 775bps z-spread) with a spread target of 675bps, 100bps inside of current levels.
Equities cheap enough for Frontier funds
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 liquid stock, Safaricom, but, instead, in the relatively less liquid banks.
Kenya equities, measured by the Nairobi All Share (NSEASI), are down 22% ytd, similar to Africa peers Egypt and Ghana (both down c25%), and much worse than commodity exporter South Africa (down 3%). Notional outperformers Nigeria and Zimbabwe are not comparable because of capital repatriation restrictions. Kenya trailing PB is 1.2x (for 18% ROE), almost a 30% discount to the 5-year median – a similar discount to that in Egypt.
Safaricom (56% and 68% 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 over US$2mn of average daily traded value over the past six months. But that is a curse in an environment of de-risking off benchmark exposure and pressure on EM fund outflows. Safaricom shares are down 30% ytd in US$ total return terms. This has left valuation at a significant discount to the historical average; consensus forward PE is 14.5x, 13% discount to the five-year median. However, that multiple sits alongside negligible 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.
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 is on forward PE of 3.6x, a 23% discount to the five-year median, and forward dividend yield of 9.3%. And KCB is on forward PE of 3.1x, a 22% discount to the five-year median, and dividend yield of 9.4%.
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)