New York July 9 2024: Moody’s Ratings (Moody’s) has today downgraded the Government of Kenya’s (Kenya) local and foreign-currency long-term issuer ratings and foreign-currency senior unsecured debt ratings to Caa1 from B3. The outlook remains negative.
The downgrade of Kenya’s rating reflects significantly diminished capacity to implement revenue-based fiscal consolidation that would improve debt affordability and place debt on a downward trend. In particular, the government’s decision not to pursue planned tax increases and instead rely on expenditure cuts to reduce the fiscal deficit represents a significant policy shift with material implications for Kenya’s fiscal trajectory and financing needs. In the context of heightened social tensions, we do not expect the government to be able to introduce significant revenue-raising measures in the foreseeable future. As a result, we now expect the fiscal deficit to narrow more slowly, with Kenya’s debt affordability remaining weaker for longer. In turn, larger financing needs stemming from a wider deficit increase liquidity risk against more uncertain external funding options.
The negative outlook reflects downside risks related to government liquidity. Our updated forecasts continue to assume a narrowing of the fiscal deficit through spending cuts, but at a more gradual pace than we previously assumed. Larger financing needs and/or an increase in borrowing costs would amplify liquidity risks. In particular, slower fiscal consolidation would risk constraining external funding options even more, including diminishing support from multilateral creditors which have been the largest source of external financing since 2020. And larger financing needs would risk reducing domestic appetite for government securities, which would challenge the government’s ability to continue servicing domestic debt.
Kenya’s local currency (LC) ceiling was lowered to B1 from Ba3, maintaining a three-notch difference with the sovereign rating, which reflects relatively weak institutions and policy predictability and moderate political risk set against a relatively small footprint of the government in the economy and limited external imbalances. The foreign currency (FC) ceiling was lowered to B2 from B1, one-notch below the LC ceiling, which reflects relatively low external debt and a moderately open capital account, which reduce, although do not remove entirely, the incentives or need to impose transfer and convertibility restrictions in scenarios of intensifying financial stress.
RATINGS RATIONALE
RATIONALE FOR DOWNGRADE TO Caa1
DIMINISHED CAPACITY TO IMPLEMENT REVENUE-DRIVEN FISCAL CONSOLIDATION HAMPERS DEBT AFFORDABILITY AND DEBT DYNAMICS
Kenya’s previous B3 rating was predicated on the government continuing with a fiscal consolidation strategy that encompassed significant revenue-raising measures that would narrow the fiscal deficit, contain the debt burden and at least stabilize debt affordability. Importantly, these efforts would ensure multilateral support from the IMF and others alleviates financing pressure from Kenya’s large external amortizations. The negative outlook captured downside risks primarily related to liquidity risk and elevated refinancing needs against limited external financing options and reliance on expensive domestic financing of the fiscal deficit.
In response to protests over the past month, the government cancelled planned tax increases included in the 2024 Finance Bill. Tax measures included in the 2024 Finance Bill initially aimed at raising KES346 billion, or 1.9% of GDP. In the current social context and for the foreseeable future, our previous main assumption regarding the government’s capacity to implement revenue-raising measures is no longer plausible. In turn, the government plans to reduce spending by KES177 billion, and increase borrowing and the fiscal deficit to 4.6% of GDP, larger by 1.3% of GDP compared with the original 3.3% of GDP budget for fiscal 2025.
We expect Kenya’s fiscal deficit to average 4.4% of GDP in fiscal 2025 (the year ending in June 2025) and fiscal 2026. Although this represents a smaller deficit compared to 5.9% of GDP in fiscal 2024, it implies a slower pace of fiscal consolidation compared with our previous forecast, with government debt now stabilizing in contrast to our previous anticipation for a gradual decline in debt.
Importantly, an expenditure- rather than revenue-based fiscal consolidation path will bring significantly less support to debt affordability, a key credit weakness for Kenya.
The tax measures included in the 2024 Finance Bill aligned with policy objectives in Kenya’s National Tax Policy and Medium-Term Revenue Strategy and were intended to reverse the underperformance of tax collection in fiscal 2024. In the first nine months of fiscal 2024, total revenue was KES212 billion below target – equivalent to 1.3% of fiscal 2024 GDP – implying an unchanged revenue-to-GDP ratio. Without the planned tax measures, we expect government revenue to remain around 17% of GDP in fiscal 2025 rather than rise.
Overall, even taking into account tax measures implemented outside the 2024 Finance Bill, debt affordability will deteriorate due to an increase in interest payments. We expect the interest-to-revenue ratio will increase to 33% in fiscal 2025 from 30% in fiscal 2024, a level which indicates significant fiscal constraints. Debt affordability should improve gradually beyond fiscal 2025 as domestic borrowing costs decline. The government’s domestic borrowing costs have remained elevated even as inflation has returned to the central bank’s target range and despite an appreciation of the Kenya shilling. We expect domestic borrowing costs will gradually decline, particularly if the central bank begins to ease monetary policy. However, debt affordability will stay weaker, and weak, for longer than we previously expected because of larger fiscal deficits, lower revenue and greater reliance on relatively costly domestic financing.
EXPENDITURE-DRIVEN FISCAL CONSOLIDATION SUBJECT TO SIGNIFICANT IMPLEMENTATION RISK
As mentioned, the government intends to reduce spending by an estimated KES177 billion, or about 1% of GDP, in fiscal 2025. While some measures are likely to be implemented quickly, we foresee significantly hurdles to implementing such large spending cuts.
More than half of government spending in fiscal 2025 falls under Consolidated Fund Services, the category of spending that includes statutory obligations and allocations that are generally non-discretionary. The government has announced it will dissolve 47 state corporations with overlapping functions. A number of measures will also aim to reduce the number of employees in the public sector suspending new hiring for one year, conducting an audit of public payrolls, while accelerating the retirement of workers above the retirement age. However, spending cuts will still fall heavily on discretionary items like operations and maintenance and development spending. Although development spending is more flexible, the development budget has already been reduced significantly. Further cuts will likely have a negative economic impact.
Moreover, Kenya is prone to external shocks, which can increase spending needs throughout the year. In particular, crop failure and reduced agricultural productivity can necessitate increased government spending on emergency relief measures, and extreme weather events can cause substantial infrastructural damage that requires increased spending on repair and reconstruction.
LARGER FINANCING NEEDS INCREASE LIQUIDITY RISK AGAINST MORE UNCERTAIN EXTERNAL FUNDING OPTIONS
Larger fiscal deficits than we previously expected will increase the government’s borrowing requirements, which could add to pressure on domestic borrowing costs and increase government liquidity risks. Additionally, we assume the revised budget will not affect IMF and World Bank funding, which represent the majority of the government’s net external financing.
Our forecast assumes the incremental borrowing by the government, from 3.3% of GDP in the original budget to 4.6% of GDP based on the latest estimates, will be met mainly through increased domestic borrowing.
In fiscal 2024, larger domestic financing needs contributed to elevated domestic borrowing costs. Now again, while the domestic investor base should be able to meet higher domestic financing needs, larger domestic issuance will likely keep borrowing costs elevated. The average interest rate on newly issued Treasury bonds in fiscal 2024 was 17.8%, up from 14.4% in fiscal 2023. On top of borrowing to finance the fiscal deficit, the government will also need to roll over maturing Treasury bonds. We estimate maturing Treasury bonds equal to 1.5% of GDP have an average coupon of 11.7%, implying a substantial increase in the cost of debt.
Uncertainty over the fiscal trajectory is also likely to weigh on investor sentiment and the government’s ability to access alternative sources of external financing at moderate costs. Beyond IMF and World Bank funding, which we expect to represent the main source of external financing, the government’s budget included $1.0 billion in commercial external financing. Potential external financing options include a sustainability-linked bond with the support of the World Bank, or issuance of Samurai bonds in Japan, Panda bonds in China, or even Sukuks. The credibility of the government’s commitment to fiscal consolidation will be important in securing additional external financing without worsening debt affordability.
RATIONALE FOR THE NEGATIVE OUTLOOK
The negative outlook reflects downside risks related to government liquidity over the next few years. Larger financing needs and/or an increase in borrowing costs would amplify liquidity risks further.
The removal of the 2024 Finance Bill de-escalated protests around proposed tax measures, but the consequences for the government’s fiscal policy plans will complicate the existing IMF programs, potentially putting at risk planned external financing. The IMF programs were expected to provide $976 million in external funding in fiscal 2025, or about one-third of the government’s budgeted net external financing. While not our baseline assumption, delays in IMF funding would increase the reliance on the domestic market for fiscal financing even further.
IMF funding was a catalyst for additional concessional funding from multilaterals such as the World Bank between 2021 and 2023, when Kenya’s external funding options were limited. In the near term, refinancing risks are limited, which supports the Caa1 rating. Kenya repaid in full its June 2024 eurobond maturity, returning to the international bond market in February 2024 to complete a partial buyback, with the outstanding balance on the eurobond repaid in June 2024. Further out, Kenya’s external financing needs are significant. Between fiscal 2025 and fiscal 2028, external amortizations will average $2.8 billion, with an additional $1.5 billion in external interest payments per year.
Domestic financing conditions are important for the government’s financing strategy. The capacity of the domestic market to finance larger fiscal deficits is sensitive to confidence over government policies and the ability to deliver on fiscal consolidation. A tightening of domestic financing conditions would likely result in higher borrowing costs and a shortening of the average maturity of Treasury bonds, increasing rollover risk. Over time, an increase in borrowing costs would worsen Kenya’s interest burden, necessitating a larger fiscal adjustment to stabilize debt.
ENVIRONMENTAL, SOCIAL AND GOVERNANCE CONSIDERATIONS
Kenya’s ESG Credit Impact Score (CIS-4) indicates the rating is lower than it would have been if ESG risk exposures did not exist. For Kenya, this reflects its exposure to social risks, as well as environment and governance risks, while resiliency is constrained by the high debt burden.
Kenya’s exposure to environmental risks (E-4 issuer profile score) reflects physical climate risks, water risk and natural capital risks, given the significant risks posed by climate events on economy and government finances. Kenya is vulnerable to shifts in seasonal rain patterns, which can affect the income of a sizeable portion of the population that works in the agriculture sector.
Exposure to social risks (S-4 issuer profile score) captures high levels of poverty as well as health and safety risks, high unemployment rates, and limited access to basic services. High poverty rates result in high levels of undernourishment and high child mortality rates, which constrain Kenya’s human capital.
The influence of governance on Kenya’s credit profile (G-4 issuer profile score) captures Kenya’s weak fiscal policy effectiveness as well as high levels of corruption and weak rule of law. Low wealth levels and an already high debt burden limit the degree of resilience.
GDP per capita (PPP basis, US$): 6,617 (2023) (also known as Per Capita Income)
Real GDP growth (% change): 5.5% (2023) (also known as GDP Growth)
Inflation Rate (CPI, % change Dec/Dec): 6.6% (2023)
Gen. Gov. Financial Balance/GDP: -5.9% (2023) (also known as Fiscal Balance)
Current Account Balance/GDP: -3.8% (2023) (also known as External Balance)
External debt/GDP: 68.8% (2023)
Economic resiliency: ba2
Default history: At least one default event (on bonds and/or loans) has been recorded since 1983.
On 02 July 2024, a rating committee was called to discuss the rating of the Kenya, Government of. The main points raised during the discussion were: The issuer’s economic fundamentals, including its economic strength, have not materially changed. The issuer’s institutions and governance strength, have not materially changed. The issuer’s fiscal or financial strength, including its debt profile, has not materially changed. The issuer has become increasingly susceptible to event risks.
FACTORS THAT COULD LEAD TO AN UPGRADE OR DOWNGRADE OF THE RATINGS
Given the negative outlook, a rating upgrade is unlikely in the near future. The outlook will likely be changed to stable if we conclude with sufficient confidence that fiscal consolidation will limit the deterioration in Kenya’s debt affordability and debt burden. Increased confidence over the government’s ability to meet its financing needs without upward pressure on borrowing costs would also likely return the outlook to stable.
A downgrade would occur if Kenya were to face difficulty meeting its funding needs at manageable costs, increasing the likelihood of a debt restructuring. Reduced access to external financing or an increase in the cost of borrowing that impairs the government’s ability to meet its fiscal financing needs and debt repayment obligations would likely lead to a downgrade.
