Oct 25, 2015

Interest rates on Government securities in Kenya have been on a steep upward trend and we have also seen the high rates passed on to bank customers. In a report by Business Daily this week, some customers have had as high as 12% revision in their bank rates and some being charged high rates of up to 27%.

After covering the impacts of a high interest rates environment on the Kenyan economy, and the corresponding impact on investments in our Cytonn Weekly Report #38; this week we turn our attention to the key factors that determine the direction of interest rates in an economy, and which of these factors resulted into the high interest rates environment we presently have in Kenya, and finally we address what we need to do in terms of policy action to contain the volatile interest rates environment.

Interest rates in an economy are determined by the below factors:

1. Monetary Policy Action: The Central banks’ in most economies determine whether the economy needs either a loose or tight monetary policy depending on the economic cycle. During the period of loose monetary policy/expansionary fiscal policy, high liquidity levels and a lower interest rates environment characterize the money market. On the other hand, periods of tight monetary policy/contractionary fiscal policy are characterized by low liquidity levels in the money market, which result into a high interest rate environment.
2. Government Borrowing: Most economies with unbalanced fiscal budget, where tax collection is not sufficient to meet expenditure targets, usually resort to either domestic or foreign borrowing to finance their budget deficits. In instances where the government is aggressively borrowing from the domestic market, and also willing to pay a premium due to the demand by the government to finance the budget, such activities result into high interest rates on government securities, which in turn affect the base lending rates.
3. Inflation Rates: During a time of high inflation pressures, and especially demand push inflation, where inflation is caused by excess demand which is not met by supply, most policy decision makers respond by actions aimed at mopping up the excess liquidity in the market. This results in tight liquidity in the money market, and hence an increase in interest rates.
4. Levels of Liquidity: The traditional meaning of liquidity is the amount of money in circulation. During the time of economic stability, which is characterized by clarity in the direction of most macro-economic indicators, most investors have a high appetite for risk, resulting into high liquidity in the market. On the contrary, during an economic period characterized with volatilities and uncertainty in the investment environment, very few investors are willing to take the risk and this results into low liquidity levels in the market. The resulting effect is that investors demand a higher premium for their money, which leads to high interest rates.
5. Exchange Rates: This is the rate at which a unit of domestic currency trades against a foreign currency. For most economies this is measured against the US Dollar. During the time of weakening domestic currency, most economies, and especially net importer economies, respond by mopping up excess liquidity, which leads to tight liquidity in the money market and hence an increase in interest rates. This attracts foreign investors, which results into improved demand and strengthening of the local currency.

Interest rates environment in Kenya have witnessed volatility over the last calendar year, with a sharp increase in rates being the normal trend. This can be evidenced by the 91-day Treasury bill rising from a rate of 8.6% in December 2014, to 22.5% in last week’s auction. In tandem with this, the Central Bank lending rates have also increased by 300 basis points to stand at 11.5%. This high interest rates environment was as a result of;

1. Aggressive Government Borrowing: According the fiscal budget for 2015/16, the Government is expected to borrow Kshs 219 bn from the local market. The Government has been lagging in terms of its borrowing locally, which was brought to the forefront during the first quarter for the fiscal year, where the total domestic borrowing was in fact a net repayment of Kshs 14.4 bn. Of keynote is that the government is carrying out mega infrastructural projects such as the Standard Gauge Railway, and concurrently also facing labour wrangle challenges, which may result into an increase in recurrent expenditures towards the civil service sectors. As a result of this and in a bid to step up its borrowing and meet its obligations towards financing the budget, the Government has been borrowing expensively from the domestic market, which has seen yields increase drastically, resulting in the 91-day T-bill rates increasing to 22.5% as at October 2015.
2. Unrealistic Tax Revenue Estimates: The current year budget was based on aggressive GDP estimates of about 7%, yet our Cytonn estimate is a GDP growth of about 4.8% for the current year, way below the 7% treasury budget estimate that informed revenue estimates. Actual tax collections have been below target. Revenue estimations below budget coupled with aggressive spending means more borrowing, which can only increase rates
3. Policy Disconnect: Both monetary and fiscal policy are supposed to complement each other; however, what we have seen in Kenya, and especially during this fiscal year 2015/16, is two policies have been moving in opposite directions. Monetary policy, which is the role of Central Bank of Kenya through the Monetary Policy Committee, has taken a tight stance, while the fiscal policy, which resides with the Treasury, is on an expansionary mood as they continue with significant expenditure. The disconnect between the two in public policy has resulted into high interest rates in Kenya, due to interest rate uncertainty.
4. Liquidity Levels: the money market has been relatively illiquid as most investors tie in their funds in higher yielding assets. With the uncertainty in the interest rates environment observed in Kenya recently, and going with the meaning of liquidity highlighted above, there is low appetite for risk as few investors are willing to undertake risk. This results into these investors demanding higher premium, which leads to a high interest rates environment.
5. Currency support: Given the expectation that interest rates were to increase in the US, investors started moving their funds to safer currency i.e. the dollar. This lead to a significant depreciation of most emerging market currencies and Kenya was not spared. To maintain Kenya as an attractive investment destination, the central bank increased the CBR by 300 basis points to 11.5%, and also a series of mop up activities to reduce the supply of Kenya Shilling in the money market. Though these policy actions have managed to stabilize the shilling, which is currently trading at Kshs 102.2 against the dollar, and as highlighted above in the fixed income section, the Kenya Shilling remains fundamentally weak. The Government’s appetite for foreign denominated borrowing could further worsen the fundamental status of the shilling.

Of key to note is that despite the above factors contributing to high interest rates environment in Kenya, inflation rates have remained relatively low, within the CBK’s target of 2.5% - 7.5%, standing at 5.9% as for the month of September 2015.

So, looking at the above, inflation is not the issue since it is within target, monetary policy / CBK is not the issue since the core mandate of price stability is under control; the key issues are fiscal policy, which points to treasury and economic management of public finances by the executive.

Consequently, a number of key policy issues need to be addressed in order to contain the current interest rates environment:

1. Harmonization of Fiscal and Monetary Policy: There is a disconnect between monetary policy, which is the mandate of CBK, and fiscal policy, which is the mandate of the Treasury. MPC on one hand is championing for price and interest rate stability, whereas from the auction results, it is evident that the Treasury has a significant appetite for expensive funds and is pursuing an expansionary fiscal policy, which is highly dependent on borrowing. This has placed the Central Bank with the delicate balancing act of maintaining price stability and supporting favorable conditions for economic growth, while at the same time acting as the agent of Treasury to collect funds by issuing government securities. These policies need complement each other and should always be in harmony. Significant disconnect between monetary and fiscal policy creates interest rates uncertainty and investors will demand a premium for the uncertainty.
2. Contain Government Expenditure: With the new devolved system of governance, there needs to be a check on the government spending, both at the county and Central government level. The current aggression in borrowing by the government is aimed at financing its operations at both levels of government. It would be important to limit expenditure to the core activity of the government and reduce wasteful spending.
3. Contain Corruption: We need to reduce corruption levels at both levels of government to reduce on cash leakage, which ends up being too expensive because out flows based on corruption have no corresponding productive returns.
4. Moderate Infrastructural Project: The government is currently carrying out mega infrastructural projects such as the SGR and LAPSSET project, which are very expensive. Though these projects come with advantages such as opening up the transport corridors for easier movement of goods thus facilitating trade, the financing factor modalities of such mega projects need to be relooked at. The projects can be spaced out and at the same time look for cheaper ways of financing them other than higher reliance on debt.
5. Revenue Collection: The government is reported to have missed revenue target for the first quarter of fiscal year 2015/16. In order to reduce the negative impact of high borrowing from the local market, the government needs to enhance revenue collections to reduce over reliance on domestic and foreign borrowing to finance the budget. One of the ways to do this is through the expansion of the tax net to include the informal sector as well.

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.

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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.