Sep 27, 2015

With the recent developments in Kenya’s interest rate environment i.e. (significant increase in yields on government securities and bank deposit rates), the key question in every investors mind is how this will impact the economy and the investments environment in the country.

This week the government issued a 1-year bond at a yield of 19.1%, and the 91-day T-bill was at 18.6%. It is evident that interest rates have significantly moved higher in the recent past and we expect an increase across all tenors and this will be passed through to the rest of the economy e.g. bank loans. The last time such an interest rate environment was witnessed was in 2011; then the 91-day T-bill peaked at 20.6%. In 2011 the high interest rates had been driven by the weakness in the currency coupled with the high inflation rates where inflation rate reached a peak of 19.7%.

The chart below shows a 5-year trend analysis of interest rates and inflation and of note is that in the current environment there is a significant divergence between the two, an indication that the current increase is driven by other factors and in our view this is due to pressure to finance the budget for the 2015/16 fiscal year and we are yet to see the revenue collections figures versus target.

Below is a quick comparison between the operating environment in 2011 and 2015:

1. Interest rate and Inflation Comparison: In 2011, the 91-day T-bill rose from a low of 2.4% in January 2011, to peak at 20.6% in January 2012, with inflation rising from 5.4% to peak at 19.7% in November 2011. In the current environment, we are seeing relatively lower and stable inflation rates at 5.8% and the 91-day T-bill at 18.6% as at September 2015. We note the difference between these two periods being:
   1. In 2011, the country was experiencing food shortage, which saw prices rise due to the subdued supply,
   2. In 2015, the country has seen relatively higher food supplies given the favorable harvests, combined with the cushion from falling oil prices globally, which have benefited net importers such as Kenya.
2. Exchange Rate Comparison: In 2011, Kenya Shilling reached a low of 107.0 against the dollar; in the current environment we have seen the shilling depreciate by 16% YTD 2015 to stand at 105.5 against the dollar.
   1. We note in 2011, the depreciation of the shilling was as a result of speculative position taking,
   2. In the current environment, the weakening of the shilling has been due to a structurally weak Kenyan economy, and the recovery of the US economy,
   3. In June 2014, the Government issued a Eurobond to fund infrastructural projects. This is an additional dollar obligation, which was not present in 2011, further adding to the headwinds that are facing the Kenya Shilling. Any additional weakening of the shilling increases the government obligation to finance expensive dollar debt.
3. Policy Actions Comparison:
   1. In order to address these macroeconomic challenges in 2011, the Central Bank of Kenya (CBK) intervened by aggressively increasing the Central Bank Rate (CBR) by 11% in 6 months to stand at 18% at the end of 2011. These measures were finally able to contain the inflationary pressures, resulting in the inflation levels declining over the following year, with yields coming down as well. However, the economy was not left unscathed, as the country experienced a drop in GDP growth in 2012 to 4.6% from 2011’s 6.1%. In the current environment, we have seen the CBK responding with aggressive mop-up activities and increasing the CBR rate, so far by 300 bps, to 11.5%.
   2. With a focus on the current environment in 2015, Kenya’s inflation has remained within CBK’s target range of 2.5% - 7.5%, and the high interest rate environment is being propelled by the Government’s efforts to step up its domestic borrowing in order to meet the Kshs 219.0 bn target to fund the 2015/16 fiscal year budget. With the ongoing major government sponsored infrastructural projects like the Standard Gauge Railway, and the current labour wrangles, which will affect the public wage bill, the Government faces significant headwinds in slowing down its appetite for debt, which will keep interest rates high and crowd-out the private sector.

With the high interest rates, below are some of the expected effects:

1. Increase in the cost of borrowing: Higher interest rates will result in an increase in the cost of borrowing, owing to higher interest payments on loans and mortgages. This will lead to higher interest obligations for individuals who already have loans, reducing their disposable income and consumption as well;
2. Slow down in economic growth rate: as the corporates and individuals take a wait and see stand as they do not want to get into expensive borrowings, the economic performance is expected to slow down. We expect the Kenya GDP growth rate for this year to come in at between 4.7% - 4.9%, compared to 5.3% last year;
3. Increase in the non performing loans: given the high increase in cost of borrowing and no increases in the disposable income, banks are likely to experience above average non performing loans on the already issued loans;
4. Slower corporate earnings: The high interest rate environment will negatively affect the earnings of corporates as a result of increased financing costs, and lower consumption in the general economy;
5. Slow-down in the stock market: usually when the less riskier assets like government bonds are yielding higher, investors usually prefer to allocate more to this and shun the more riskier assets like the stock exchange;
6. Real estate might be negatively affected owing to (i) the higher costs of funding projects. This reduces the internal rate of return an investor would otherwise receive from the project on completion when funding using the current interest rates, thus slowing down investment in the sector, and (ii) the expensive borrowing rates brought about as a result of the high interest rate environment will reduce the uptake of mortgages in the market, which diminishes sales uptake;
7. Attracting Foreign Investments: On a positive note, this environment presents an attractive entry point for foreign investors looking to capitalize on the high – yields available in the market, and weaker shilling, which may see their real return rise above what was anticipated in the long term.

This weeks auction results indicates that there is a disconnect between monetary policy, which is the mandate of CBK, and fiscal policy, which is the mandate of Treasury, in Kenya. MPC on one hand is championing price and interest rate stability, whereas from the auction results, it is evident that the Treasury has a significant appetite for expensive funds. This has placed the Central Bank with the delicate balancing act of maintaining price stability and supporting favourable conditions for economic growth while acting as the agent of Treasury to collect funds by issuing government securities.

Cytonn’s recommendation to investors in this challenging environment is:

1. Increase asset allocation to short-term interest earning securities, which include debt instruments and government securities, with an overweight allocation in money-market instruments;
2. As stated in our Cytonn Report – August 2015, we maintain our view that investors should be neutral with a bias to negative on equities, with few pockets of value available to extract return;
3. Increase asset allocation to real estate as this ensures stability in the portfolio return given the inelasticity between inflation and re-pricing of rental incomes. We expect that as institutional investors review their portfolios for the period ending December 2015, those who do not have real estate in their portfolios will see significant erosion of value.

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Disclaimer: The views expressed in this publication, are those of the writers where particulars are not warranted- as the facts may change from time to time. This publication is meant for general information only, and is not a warranty, representation or solicitation for any product that may be on offer. Readers are thereby advised in all circumstances, to seek the advice of an independent financial advisor to advise them of the suitability of any financial product for their investment purposes.