Mar 20, 2016

In our Cytonn Weekly Report #42 (2015), we analyzed the interest rate environment and what was driving the rapid upward trend that we witnessed in Q3’2015. A lot has transpired since then, and the interest rates have declined to levels witnessed at a similar period last year. The aim of this piece is to first give a background of the challenges witnessed in Q3’2015, review the drivers of the high interest rate environment, understand the underlying factors driving the interest rate environment currently, and finally end with what we believe will transpire in the near future.

2015 Recap
The interest rate environment in Kenya witnessed volatility in the last calendar year, with a sharp increase in rates highlighting the challenging economic environment. This was evidenced by the 91-day Treasury bill rising from 8.6% in December 2014, to peak at 22.5% in October 2015. This high interest rates environment was attributed to

1. Aggressive Government borrowing to fund the budget at the beginning of the fiscal year,
2. Monetary and Fiscal policy disconnect where Government expenditure was high,
3. Low liquidity levels in the money market,
4. A rapidly depreciating currency, and,
5. Uncertainty in the banking sector following the closure of Imperial bank and Dubai Bank.

Of importance is that despite the above factors contributing to high interest rates in Kenya, inflation rates remained relatively low, within the CBK’s target of 2.5% - 7.5%, an indication that the challenges were not inflation driven. In order to curb the shilling depreciation, MPC raised the CBR by 300 bps in two meetings, by 150 bps each meeting, to 11.5%.

As per our Cytonn Weekly Report #42 (2015), we noted that a number of policy issues needed to be addressed. We also noted “to address the country's rate challenges, we need to be candid about the key issues. A comprehensive and objective analysis points to a need to enhance executive management of public finances before the rate environment causes irreparable damage to our economy”. Now we try to analyze if the issues have been fully addressed, or we may find ourselves in an all too familiar situation:

• Harmonization of Fiscal and Monetary Policy: Last year, there was a disparity between monetary policy and fiscal policy. Central Bank of Kenya, mandated to run the monetary policy side, was on a tightening path, raising CBR to tame a rapidly depreciating shilling, while Treasury, mandated to run the fiscal policy side, was on an expansive mode, and were aggressively borrowing to fund the budget. Currently the two policies are working in tandem, as Government is not aggressively borrowing to fund a budget gap. However, this might change if Government results to financing the Kshs 200 bn foreign borrowing gap in the local domestic market. The risk is still high since the governments is still in a spending mode and we could still see a huge budget for the next financial year,
• Contain Government Expenditure: Devolution, despite its benefits, requires strict monitoring to prevent high and unwarranted government expenditures, both at the county and national level. Currently, Government is increasing allocation on recurrent expenditure by Kshs. 8.0 bn, which is a step in the wrong direction as this will increase expenditure to the core governmental activities and direct funds away from development expenditure,
• Contain Corruption: Corruption remains a key challenge in our system that needs to be addressed, as it leads to a lot of cash leakages. However, despite the “tough governmental stance on the matter”, even declaring it a “national crisis’, the government is failing on this front given (i) their slow pace in eradicating graft, (ii) the ever emerging corruption cases, and (iii) lack of will to investigate, and prosecute the current corruption cases,
• Moderate Infrastructural Project:  Government is ambitious with its mega infrastructural projects such as the SGR and the LAPSSET project. However, despite these projects coming with advantages such as opening up the transport corridors for easier movement of goods thus facilitating trade, the financing can be spaced out and at the same time look for cheaper ways of financing them other than reliance on debt. However, the progress of the projects has been slow with the LAPSSET project having stalled due to slow disbursement of funds. In the short-term, this will be beneficial to the interest rate environment as the importation of capital goods that lead to the rapid depreciation of the shilling will be delayed,
• Revenue Collection: The government missed revenue target collection for the first half of fiscal year 2015/16 by Kshs. 46.9 bn. We believe that if Government wants to reduce the overreliance of borrowing from the local market, they need to enhance revenue collections. Government is trying to improve on this by expanding its tax net to include the informal sector. Government is behind on its revenue collection, and projects to miss it by Kshs. 93.8 bn, and will have to finance this gap either through domestic or foreign borrowing,
• Inflation: Inflation has been one of the most positive macroeconomic indicators largely within the CBK target of 2.5% - 7.5%, despite a one off spike in December 2015 to hit 8.0%, owing to the excise duty tax. We believe the inflation rate will still remain within the CBK target, a positive for interest rates moving forward,
• Currency: The Kenyan currency having depreciated 12.9% in 2015, owing to a strong dollar globally and high capital goods importation, has been stable throughout 2016, appreciating against the dollar by 0.9%. We expect the shilling to be stable in 2016 owing to (i) a reduction in the number of rate hikes by the US Fed from 4-times to 2-times, and (ii) sufficient forex reserves, currently at 4.5 months of import cover, and (iii) the recent approval of a stand by facility by IMF.

Government has tried to address the issues (though not all) that led to a spike in the interest rates, and most importantly, there now seems to be a rapport between the monetary and fiscal side. 2016 is also on its own a unique year. Elections are coming up and politics is set to draw all the attention. However, it is our view that the elections won’t hinder governmental mandate to address the economic state, as the ones in charge of driving the economy are not political leaders.

Factors Driving Current Rate Environment

The operating environment has changed since 2015 and it is of great importance that we try to predict what direction interest rate will take. We track 6 metrics that dictate the direction of interest rates and try to gauge what the future trend will be and the possible effect on the direction of interest rates, as can be seen in the table below

Drivers	Expectations at Start of 2016		YTD Experience	Going Forward		Effect on Interest Rates
Government   Borrowing	Government expected to borrow Kshs 219 bn domestically and Kshs. 402 bn for the 2015/2016 financial year		Government plans to cut its domestic borrowing by 53 bn for the current fiscal Yr., while increase foreign borrowing by Kshs. 6.0 bn	We expect reduced pressure on Government borrowing based on the proposed reduction in Govt. borrowing by Kshs. 46.9 bn. However there still lies an Kshs 200 bn gap in foreign financing which if they choose to fund locally, will have an upward effect on interest rates
Policy Decisions	The CBR to be maintained but the KBRR to be revised upwards		MPC met in January and retained the CBR and KBRR at 11.5% and 9.87%, respectively	The MPC is meeting on the 21st of March 2016, where we expect the CBR is expected to be maintained at 11.5%
Revenue Collection	KRA to continue missing their collection target		The Authorities are expected to reduce their targets by Kshs. 52.9 bn necessitating a reduction in expenditures	Despite the reduction in the collection target we still expect them to miss their target as they are projecting a loss of Kshs. 93.8 bn for the FY’15/16
Liquidity	Liquidity expected to improve given high maturities of government securities		The market has been relatively liquid evidenced by the low interbank rates of 3.7% in March	With a further Kshs.219.6 bn in maturities to June, the market is expected to remain relatively liquid
Inflation	Above the CBK upper-bound, set at 7.5%		Inflation declined from the high of 8.0% in December through January to February at 6.8%	Expected to remain within the CBK target, averaging at 7.0% despite an uptick in September when additional VAT on petroleum is introduced
Exchange rate (USD/Kshs)	To remain under pressure given a strong dollar and high capital goods importation		The shilling has been stable having appreciated against the dollar by 0.9% YTD	We expect the Shilling to remain stable given support from a strong dollar reserve and improved forex inflows from remittances and tea exports
Positive	Neutral			Negative

 
Conclusion

From the above basis, 3 of our indicators are neutral, 2 are positive while 1 is negative. Generally, there is a lot of uncertainty surrounding sustainability of the current interest rates. Given the sharp decline in rates, investors should relook at their fixed income portfolio allocation and rebalance it to highest returning tenor on a risk-adjusted basis as detailed below.

We are of the view that interest rates have bottomed out at the current levels, and looking out a year from now we believe that on a worst case scenario for reinvestment, the rates shall be at the same levels given (i) the higher levels of borrowing to fund the budget, and (ii) given 2017 will be an election year. We therefore advise investors to lock in their funds in short to medium-term papers, with tenors of between six-months and one-year, as the rates are attractive on a risk-adjusted basis.

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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.