Kenya

Highlights Kenyan financial markets will sell off considerably ahead of the presidential elections next August given the backdrop of very weak growth, a rising public debt-to-GDP ratio and growing odds of a shift away from orthodox macroeconomic policies. We do not think that the IMF-imposed fiscal austerity program will stabilize public debt dynamics. Kenya is currently experiencing an unprecedented political change from ethnic politics to class-based confrontation. Such a shift will raise the probability of populist policies following the elections. Besides, both main presidential candidates are advocating for the abandonment of fiscal and monetary austerity. This bodes ill for sovereign credit and the exchange rate. Feature Deflationary forces stemming from substantial fiscal austerity and potential political volatility ahead of the presidential elections next August will produce a major growth disappointment in Kenya in the coming 12 months. Dismal growth will depress share prices. Underwhelming nominal GDP growth and a rising public debt-to-GDP ratio warrants wider Kenyan sovereign credit spreads. The impact on the exchange rate is more complicated. In the short run, the currency could be supported by high real rates and tight fiscal policy. Yet, potential political volatility and associated capital flight amid large twin deficits will weigh on the exchange rate. In the long run, the only way for the nation to stabilize the public debt-to-GDP ratio is to boost nominal growth and bring down interest rates. This will herald currency depreciation. Unsustainable Public Debt Dynamics Chart 1Kenya: Negative Fiscal Thrust Ahead Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now With guidance from the IMF, the government has adopted fiscal austerity that commenced in fiscal year (FY) 2020/21 and is expected to last into FY 2023/24. The primary fiscal thrust will be -1.8% of GDP and -1.6% of GDP for FY 2021/22 and FY 2022/23, respectively, according to IMF estimates (Chart 1). This constitutes an enormous fiscal drag on the Kenyan economy. This fiscal straitjacket has been imposed in response to dire state finances and worsening public debt dynamics. Specifically: Public debt has risen considerably over the past decade from 35% to close to 70% of GDP (Chart 2, top panel). Kenyan authorities have borrowed heavily, in both local and foreign currencies, to finance various development projects (Chart 2, bottom panel). Yet, the government has failed to generate adequate revenues to service its debt. Notably, tax and overall government revenues have been falling relative to GDP (Chart 3). Chart 2Kenya: Public Debt Has Doubled Over The Past Decade Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now Chart 3Kenya: Lackluster Government Revenues Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now More worryingly, interest expenditures on public debt consume 28% of revenues and 18% of government expenditures (Chart 4). Meanwhile, interest on foreign currency debt makes up 15% of total exports. All these ratios are high. Chart 4Kenya: Interest Payments On Public Debt Are High Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now Lastly, debt restructuring among state-owned enterprises1 (SOEs) will further raise public debt. In short, Kenya’s public debt has increased significantly, forcing authorities to enact fiscal austerity measures to appease the country’s creditors. Fiscal Austerity Will Dampen Growth… We do not believe that the fiscal austerity program imposed by the IMF will help achieve fiscal sustainability. Both IMF and government projections for nominal growth, fiscal revenues and public debt are too optimistic given the weak state of the economy and tightening fiscal and monetary policies. Primary fiscal spending is expected to grow by only 1.6% in nominal terms in FY 2021/22. Meanwhile, nominal GDP and government revenue are projected to grow by 10% and 11%, respectively, in FY 2021/22. Consequently, the government expects to improve the primary budget balance from a deficit of 4.6% of GDP in 2021/22 to a primary surplus by FY 2023/24 (Chart 5). Specifically, nominal GDP and government revenues will underwhelm because: First, fiscal austerity amid a feeble economic recovery will materially depress nominal growth and government revenues/taxes. As a result, the nation will not meet its budget balance targets and the public debt-to-GDP ratio will continue to rise. Core inflation measures are at the lower end of the central bank target range of 2.5% to 7.5% (Chart 6). Lower inflation implies that nominal GDP growth will fall short of government projections for next year. Besides, government expectations of improved tax collection in such a short time span are unrealistic. Chart 5Kenya: Dire State Finances Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now Chart 6Kenya: High Headline CPI Will Prevent The Central Bank From Cutting Rates Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now Chart 7Kenya: The Banking System Is In A Dire State Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now Second, interest rates are very high in real terms (adjusted for core CPI) for the current state of the economy. Notably, diverging headline (high due to sharply increased food and energy prices) and core CPI (very low due to very subdued domestic demand) makes it unlikely that the central bank will chose to cut interest rates anytime soon (Chart 6). High government bond yields, large non-performing loans and a weak economy will incentivize commercial banks to buy government bonds rather than lend to the private sector (Chart 7). This will hinder household and business spending. Third, the government has reinstated higher personal, corporate and VAT tax rates to pre-pandemic levels. These de-facto tax increases will hurt both consumer and business incomes and confidence. With tight fiscal policy and high lending rates in real terms, domestic demand will fail to recover. The uncertainty over next year’s election outcomes will entice domestic firms to delay their capital expenditure plans. This also bodes ill for an economic recovery. Fourth, delays in vaccine procurement will allow COVID-19 variants to continue spreading across the country. In addition, vaccination rates in Kenya will remain depressed due to vaccine hesitancy and the significant mistrust of the government. Bottom Line: A substantial growth recovery will fail to materialize under fiscal austerity, high real lending rates and election uncertainty. Nominal GDP growth will underwhelm in the next 12 months. …And Fail To Stabilize Public Debt Dynamics The two pre-requisites to cap the rise in the public debt to GDP ratio – (1) running continuous primary fiscal surpluses and/or (2) having nominal growth above government borrowing costs – will not be met in Kenya for now. First, projected small primary surpluses will not materialize as nominal GDP and government revenue growth underwhelm. Second, as the central bank will be forced to keep high interest rates, nominal GDP growth will remain below government borrowing costs. Chart 8Kenya: Large Current Account Deficit Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now The central bank will be reluctant to reduce interest rates meaningfully despite very low core inflation and weak real GDP growth. The basis is that monetary authorities will fear that the Fed’s tapering and potential political volatility in Kenya could lead to considerable currency depreciation. Notably, dwindling FDI amid political uncertainty will force the central bank to maintain high interest rates to attract foreign portfolio capital. The latter are needed to finance a still sizable current account deficit (Chart 8). Overall, local interest rates will remain higher than is warranted by fundamentals. As a result, the public debt-to-GDP ratio will continue to rise due to elevated interest rates and disappointing growth. Bottom Line: Very low nominal GDP growth amid high government borrowing costs as well as the need to take over SOE debt will result in a wide fiscal deficit and a rising debt-to-GDP ratio. Political Volatility And A (Post-Election) Shift To Populism Chart 9Elections = Currency Depreciation Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now In the next 12 months, the current government is unlikely to abandon fiscal austerity. The fragmentation within the Jubilee coalition government will not produce a shift away from fiscal austerity. Besides, President Kenyatta has been a vocal supporter of orthodox economic policy in recent years. Yet, a key contender for next year’s presidential elections, deputy President William Ruto, is a fierce critic of fiscal austerity (and of the IMF). He has already been running a populist campaign calling for a more equitable society and a redistribution of income and capital in favor of the poor. His campaign slogan “Hustlers nation vs. Dynasties”2 is already gathering support amongst lower income young voters whilst creating socio-political tensions within the country. Similarly, opposition leader Raila Odinga has been a long-time critic of the IMF’s fiscal austerity. His recent comments also call for more fiscal spending. In brief, neither presidential candidate is likely to follow through with fiscal austerity upon being elected. Historically, past Kenyan election outcomes have been determined by “tribal power brokers” who garnered inter-ethnic alliances. This election cycle, however, will be dominated not by ethnic and tribal politics but rather by social and class-based hostilities possibly leading to some violence. This unprecedented shift in Kenyan politics from ethnic to class-based confrontation will raise the probability of populist policies following the elections next August. This will likely cause capital flight from the country’s elites who stand to lose from the more redistributive “neo-Marxist” ideas proposed by William Ruto. Remarkably, Kenya has been mired in violence, political instability, and large gyrations in domestic financial markets both before and after past elections (Chart 9). Investment Conclusions Chart 10Kenyan Sovereign Spreads Will Widen Egypt: Currency Devaluation Delayed, For Now Egypt: Currency Devaluation Delayed, For Now Sovereign credit: Avoid/underweight (Chart 10). We recommend investors go long Egyptian / short Kenyan sovereign credit. The report on Egypt can be found here. Stocks: Avoid/Underweight within an EM equity portfolio. Currency: The currency will depreciate versus the US dollar in the next 12 months.   Andrija Vesic Associate Editor andrijav@bcaresearch.com Footnotes 1 These include, Kenyan Airlines, Kenyan Airport Authority, Kenyan Railways Corporation, Kenyan Power and Lighting Company, Kenyan Electricity Generating Company, Kenyan Port Authority and three of the largest universities. 2 “Hustlers” relates to young, less economically fortunate citizens, while “Dynasties” designates the wealthy families that have ruled the country since independence in the 1960s. Both President Kenyatta and opposition leader Raila Odinga are said to come from the “Dynasties”, whereas William Ruto comes from the “Hustlers” group. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

The Kenyan shilling will depreciate by 15-20% in the next 12 months. The downward pressure on the currency stems from the country’s sizeable current account deficit. In addition, Kenya needs lower local interest rates and a weaker exchange rate to boost nominal growth and stabilize public debt dynamics.  Kenya has gone through an extensive macro adjustment since 2015 when the current account deficit was 10% of GDP and the primary fiscal deficit was 8% of GDP. Since then the current account deficit has narrowed to 6% of GDP as the private sector deleveraged and fiscal policy tightened substantially over the past 3-years (Chart I-1, top panel). Remarkably, the primary fiscal deficit has narrowed to a mere 0.4% of GDP as of June 2020 (Chart I-1, bottom panel). Yet, the macro adjustment is incomplete with a lingering current account deficit and public debt on an unsustainable path. Further, economic growth is extremely weak (Chart I-2). Crucially, core inflation is at 2% - an all-time low, suggesting that low inflation/deflationary pressures is the main problem in Kenya (Chart I-3). Chart I-1Kenya: The Twin Deficits Remains Large Kenya: The Twin Deficits Remains Large Kenya: The Twin Deficits Remains Large Chart I-2Kenya: Tame Domestic Growth Kenya: Tame Domestic Growth Kenya: Tame Domestic Growth   In this context, the optimal policy choice for Kenya is to reduce local interest rates, while allowing the currency to depreciate. This will reduce the interest burden on public debt, boost both economic activity (real growth) and inflation as well as make exports more competitive. Balance Of Payments Strains Persist Kenya’s balance of payments will weigh on the currency in the next 6-9 months. While improving, its exports will remain tame over the next 6-12 months. The volume of tea, horticulture and coffee exports, which account for about 50% of total Kenyan exports, has rebounded. Yet, their prices have failed to rebound meaningfully. Meanwhile, substantial fiscal tightening – an 11% drop in government non-interest nominal expenditures – has led to a collapse in imports (Chart I-4). If and when fiscal policy is relaxed, it will boost imports weighing on the trade balance. Chart I-3Kenya Suffers From Low Inflation Kenya Suffers From Low Inflation Kenya Suffers From Low Inflation Chart I-4Tight Fiscal Policy = Weak Domestic Demand Tight Fiscal Policy = Weak Domestic Demand Tight Fiscal Policy = Weak Domestic Demand Chart I-5Kenya Is Losing Market Share In Export Markets Kenya Is Losing Market Share In Export Markets Kenya Is Losing Market Share In Export Markets The biggest headwind to the balance of payments has been the drastic fall in both tourism revenues and remittances. Combined, they represent around $4 billion (4.2% of GDP). It is unlikely that international travel will resume in the next six months. Remittances will also remain subdued in the coming months as unemployment rates remain elevated worldwide. Kenya has been losing its export market share in neighboring countries such as Uganda and Tanzania (Chart I-5). Hence, this nation needs to improve its competitiveness via tolerating a cheaper currency and undertaking structural reforms to bolster productivity growth. FDI inflows have been subdued. In the near term, FDI inflows will be discouraged by very weak domestic demand. Critically, the outlook for Chinese FDI inflows into the country remains uncertain due to the debacle with previous China-financed projects in Kenya. In particular, Kenyan courts declared the construction contract awarded to the China Road and Bridge Corporation for the Nairobi-Mombasa railway illegal.1 This impasse between Kenyan courts and Chinese companies could for now dissuade financing and investment from China. In the medium term, international organizations such as the IMF and World Bank could step in to fill in for Chinese investments. As recent financing by the World Bank and IMF of $1.74 billion (1.9% of GDP) to Kenya suggest, the US might be enticed alongside European nations to step in to fill the vacuum left by the withdrawal of China’s financial backing. However, this might take some time and there will be shortage in foreign financing in the coming months. Chart I-6Kenya Lacks Foreign Exchange Reserves Kenya Lacks Foreign Exchange Reserves Kenya Lacks Foreign Exchange Reserves Finally, another risk is the considerable amount of foreign debt obligations (FDOs) and the lack of foreign currency reserves at the central bank to meet these obligations (Chart I-6). Kenya’s FDOs in the next 12 months are about $6 billion, while the central bank has only $8.8 billion of foreign exchange reserves. In this case, FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. Bottom Line: The exchange rate will continue facing depreciation pressures. The optimal policy for the central bank will be to allow the currency to weaken meaningfully and to reduce interest rates rather than use high interest rates or deplete its foreign exchange reserves to defend the exchange rate. Public Debt Sustainability Despite substantial fiscal tightening, Kenya’s public debt trajectory remains worrisome. Two prerequisites for capping the rise in the public debt-to-GDP ratio are (1) running continuous primary fiscal surpluses and (2) for local government borrowing costs to be below nominal GDP growth. Neither of these two are presently satisfied in Kenya. Crucially, interest payments are taking up a quarter of overall government revenues (Chart I-7). This necessitates considerably lower domestic interest rates to reduce this ratio. In brief, public debt sustainability hinges on the central bank reducing local borrowing costs, which will both boost nominal growth/government revenues and lower interest costs of public debt. The government of President Uhuru Kenyatta announced a new budget in June (for the period of July 1, 2020 to June 30, 2021) with a projected primary deficit of -3% and -1.8% of GDP, for 2020/21 and 2021/22 respectively (Chart I-1, bottom panel on page 1). Meanwhile, the new budget’s nominal annual growth projections for 2020/21 and 2021/22 are 10.6% and 11.5%, respectively. Chart I-8 presents both the government’s as well as our projections for public debt dynamics until the end of 2022 based on assumptions for nominal GDP, government expenditures and revenues for the next two fiscal years. The public debt-to-GDP ratio will reach 75% of GDP in our scenario and 66% in the government’s scenario. Chart I-7Public Debt Servicing Costs Are High Public Debt Servicing Costs Are High Public Debt Servicing Costs Are High Chart I-8Kenya: Public Debt Will Continue To Rise Kenya: Public Debt Will Continue To Rise Kenya: Public Debt Will Continue To Rise   The key difference between the two projections are expectations for nominal GDP and government revenue growth. If fiscal and monetary policy remain tight, nominal output growth will disappoint. Notably, broad money supply growth is tame (Chart I-9). Sluggish nominal growth risks derailing government revenue projections. Notably, recent comments by finance minister Ukur Yatani suggests that revenues have already begun underperforming government expectations in the first two months of the new fiscal year. On the whole, public debt will rise by more than what the government expects over the next two years as borrowing costs remain above nominal GDP growth (Chart I-10). Chart I-9Kenya: Weak Policy Response To Low Growth Kenya: Weak Policy Response To Low Growth Kenya: Weak Policy Response To Low Growth Chart I-10Kenya: Local Rates Are Above Nominal Growth Kenya: Local Rates Are Above Nominal Growth Kenya: Local Rates Are Above Nominal Growth   Faced with the prospect of rising public debt dynamics over the next two years, the economically less painful response for policymakers is for the central bank to lower interest rates and to instruct domestic commercial banks to buy government domestic debt. This will boost nominal GDP growth and push local interest rates below nominal GDP growth. There is scope for the central bank to cut interest rates and allow the currency to depreciate without feeding into runaway inflation. Notably, core consumer price inflation excluding fuel and food items is presently at an all-time low, running below the lower bound of the central bank’s inflation target (Chart I-2 on page 2). Higher inflation also feeds into higher nominal growth, which is good for public debt dynamics. A weaker currency will augment the cost of servicing foreign debt. The latter accounts for 52% of public debt and 32% of GDP. However, a large share (65%) of foreign debt is owed to bilateral and multilateral creditors. This debt can be renegotiated/restructured, which would in turn benefit private creditors. Bottom Line: To stabilize public debt dynamics, local interest rates should be lowered considerably. This will increase nominal GDP and government revenue growth as well as lower debt servicing costs. In this scenario, currency will depreciate a lot. Investment Implications Faced with very depressed economic growth, very low inflation, unsustainable public debt dynamics and a wide current account deficit, the optimal policy for Kenya is to ease monetary policy dramatically and tolerate material currency depreciation. So long as the central bank does not reduce interest rates, the economy will continue to underwhelm, public debt dynamics will be worrisome and share prices will stumble (Chart I-11). Critically, as the public debt-to-GDP ratio continues rising, sovereign credit will underperform (Chart I-12). Chart I-11Weak Domestic Dynamics = Lower Share Prices Weak Domestic Dynamics = Lower Share Prices Weak Domestic Dynamics = Lower Share Prices Chart I-12Rising Public Debt Burden = Sovereign Credit Underperformance Rising Public Debt Burden = Sovereign Credit Underperformance Rising Public Debt Burden = Sovereign Credit Underperformance   If and when the central bank brings interest rates down substantially, nominal growth will improve and share prices will fare well. Lower domestic borrowing costs and higher nominal GDP growth will help stabilize public debt dynamics. In such a scenario, EM sovereign credit portfolios should overweight the nation’s US dollar bonds. The Kenyan shilling also is set to depreciate materially. If the government embarks on this macro adjustment early, currency depreciation could be gradual. If the government delays this macro adjustment and resists currency weakness by tolerating high interest rates, the exchange rate depreciation could be delayed, but will be abrupt and disorderly. Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 The standard gauge railways project built between the port city of Mombasa and its capital Nairobi has been heavily scrutinized by Kenyan authorities. After only three years of operation, the Kenyan Railways Company (KRC) has already defaulted on its loan from Chinese lenders. Kenyan courts have been arguing that Kenyan government and state-owned enterprises are facing sovereign risk over Chinese debt overhang. More than half of Kenya’s loans from China are attached to the construction of the Mombasa-Nairobi railway project.

Kenya: An Incomplete Adjustment The Kenyan shilling will depreciate by 15-20% in the next 12 months. The downward pressure on the currency stems from the country’s sizeable current account deficit. In addition, Kenya needs lower local interest rates and a weaker exchange rate to boost nominal growth and stabilize public debt dynamics.  Kenya has gone through an extensive macro adjustment since 2015 when the current account deficit was 10% of GDP and the primary fiscal deficit was 8% of GDP. Since then the current account deficit has narrowed to 6% of GDP as the private sector deleveraged and fiscal policy tightened substantially over the past 3-years (Chart I-1, top panel). Remarkably, the primary fiscal deficit has narrowed to a mere 0.4% of GDP as of June 2020 (Chart I-1, bottom panel). Yet, the macro adjustment is incomplete with a lingering current account deficit and public debt on an unsustainable path. Further, economic growth is extremely weak (Chart I-2). Crucially, core inflation is at 2% - an all-time low, suggesting that low inflation/deflationary pressures is the main problem in Kenya (Chart I-3). Chart I-1Kenya: The Twin Deficits Remains Large Kenya: The Twin Deficits Remains Large Kenya: The Twin Deficits Remains Large Chart I-2Kenya: Tame Domestic Growth Kenya: Tame Domestic Growth Kenya: Tame Domestic Growth   In this context, the optimal policy choice for Kenya is to reduce local interest rates, while allowing the currency to depreciate. This will reduce the interest burden on public debt, boost both economic activity (real growth) and inflation as well as make exports more competitive. Balance Of Payments Strains Persist Kenya’s balance of payments will weigh on the currency in the next 6-9 months. While improving, its exports will remain tame over the next 6-12 months. The volume of tea, horticulture and coffee exports, which account for about 50% of total Kenyan exports, has rebounded. Yet, their prices have failed to rebound meaningfully. Meanwhile, substantial fiscal tightening – an 11% drop in government non-interest nominal expenditures – has led to a collapse in imports (Chart I-4). If and when fiscal policy is relaxed, it will boost imports weighing on the trade balance. Chart I-3Kenya Suffers From Low Inflation Kenya Suffers From Low Inflation Kenya Suffers From Low Inflation Chart I-4Tight Fiscal Policy = Weak Domestic Demand Tight Fiscal Policy = Weak Domestic Demand Tight Fiscal Policy = Weak Domestic Demand Chart I-5Kenya Is Losing Market Share In Export Markets Kenya Is Losing Market Share In Export Markets Kenya Is Losing Market Share In Export Markets The biggest headwind to the balance of payments has been the drastic fall in both tourism revenues and remittances. Combined, they represent around $4 billion (4.2% of GDP). It is unlikely that international travel will resume in the next six months. Remittances will also remain subdued in the coming months as unemployment rates remain elevated worldwide. Kenya has been losing its export market share in neighboring countries such as Uganda and Tanzania (Chart I-5). Hence, this nation needs to improve its competitiveness via tolerating a cheaper currency and undertaking structural reforms to bolster productivity growth. FDI inflows have been subdued. In the near term, FDI inflows will be discouraged by very weak domestic demand. Critically, the outlook for Chinese FDI inflows into the country remains uncertain due to the debacle with previous China-financed projects in Kenya. In particular, Kenyan courts declared the construction contract awarded to the China Road and Bridge Corporation for the Nairobi-Mombasa railway illegal.1 This impasse between Kenyan courts and Chinese companies could for now dissuade financing and investment from China. In the medium term, international organizations such as the IMF and World Bank could step in to fill in for Chinese investments. As recent financing by the World Bank and IMF of $1.74 billion (1.9% of GDP) to Kenya suggest, the US might be enticed alongside European nations to step in to fill the vacuum left by the withdrawal of China’s financial backing. However, this might take some time and there will be shortage in foreign financing in the coming months. Chart I-6Kenya Lacks Foreign Exchange Reserves Kenya Lacks Foreign Exchange Reserves Kenya Lacks Foreign Exchange Reserves Finally, another risk is the considerable amount of foreign debt obligations (FDOs) and the lack of foreign currency reserves at the central bank to meet these obligations (Chart I-6). Kenya’s FDOs in the next 12 months are about $6 billion, while the central bank has only $8.8 billion of foreign exchange reserves. In this case, FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. Bottom Line: The exchange rate will continue facing depreciation pressures. The optimal policy for the central bank will be to allow the currency to weaken meaningfully and to reduce interest rates rather than use high interest rates or deplete its foreign exchange reserves to defend the exchange rate. Public Debt Sustainability Despite substantial fiscal tightening, Kenya’s public debt trajectory remains worrisome. Two prerequisites for capping the rise in the public debt-to-GDP ratio are (1) running continuous primary fiscal surpluses and (2) for local government borrowing costs to be below nominal GDP growth. Neither of these two are presently satisfied in Kenya. Crucially, interest payments are taking up a quarter of overall government revenues (Chart I-7). This necessitates considerably lower domestic interest rates to reduce this ratio. In brief, public debt sustainability hinges on the central bank reducing local borrowing costs, which will both boost nominal growth/government revenues and lower interest costs of public debt. The government of President Uhuru Kenyatta announced a new budget in June (for the period of July 1, 2020 to June 30, 2021) with a projected primary deficit of -3% and -1.8% of GDP, for 2020/21 and 2021/22 respectively (Chart I-1, bottom panel on page 1). Meanwhile, the new budget’s nominal annual growth projections for 2020/21 and 2021/22 are 10.6% and 11.5%, respectively. Chart I-8presents both the government’s as well as our projections for public debt dynamics until the end of 2022 based on assumptions for nominal GDP, government expenditures and revenues for the next two fiscal years. The public debt-to-GDP ratio will reach 75% of GDP in our scenario and 66% in the government’s scenario. Chart I-7Public Debt Servicing Costs Are High Public Debt Servicing Costs Are High Public Debt Servicing Costs Are High Chart I-8Kenya: Public Debt Will Continue To Rise Kenya: Public Debt Will Continue To Rise Kenya: Public Debt Will Continue To Rise   The key difference between the two projections are expectations for nominal GDP and government revenue growth. If fiscal and monetary policy remain tight, nominal output growth will disappoint. Notably, broad money supply growth is tame (Chart I-9). Sluggish nominal growth risks derailing government revenue projections. Notably, recent comments by finance minister Ukur Yatani suggests that revenues have already begun underperforming government expectations in the first two months of the new fiscal year. On the whole, public debt will rise by more than what the government expects over the next two years as borrowing costs remain above nominal GDP growth (Chart I-10). Chart I-9Kenya: Weak Policy Response To Low Growth Kenya: Weak Policy Response To Low Growth Kenya: Weak Policy Response To Low Growth Chart I-10Kenya: Local Rates Are Above Nominal Growth Kenya: Local Rates Are Above Nominal Growth Kenya: Local Rates Are Above Nominal Growth   Faced with the prospect of rising public debt dynamics over the next two years, the economically less painful response for policymakers is for the central bank to lower interest rates and to instruct domestic commercial banks to buy government domestic debt. This will boost nominal GDP growth and push local interest rates below nominal GDP growth. There is scope for the central bank to cut interest rates and allow the currency to depreciate without feeding into runaway inflation. Notably, core consumer price inflation excluding fuel and food items is presently at an all-time low, running below the lower bound of the central bank’s inflation target (Chart I-2 on page 2). Higher inflation also feeds into higher nominal growth, which is good for public debt dynamics. A weaker currency will augment the cost of servicing foreign debt. The latter accounts for 52% of public debt and 32% of GDP. However, a large share (65%) of foreign debt is owed to bilateral and multilateral creditors. This debt can be renegotiated/restructured, which would in turn benefit private creditors. Bottom Line: To stabilize public debt dynamics, local interest rates should be lowered considerably. This will increase nominal GDP and government revenue growth as well as lower debt servicing costs. In this scenario, currency will depreciate a lot. Investment Implications Faced with very depressed economic growth, very low inflation, unsustainable public debt dynamics and a wide current account deficit, the optimal policy for Kenya is to ease monetary policy dramatically and tolerate material currency depreciation. So long as the central bank does not reduce interest rates, the economy will continue to underwhelm, public debt dynamics will be worrisome and share prices will stumble (Chart I-11). Critically, as the public debt-to-GDP ratio continues rising, sovereign credit will underperform (Chart I-12). Chart I-11Weak Domestic Dynamics = Lower Share Prices Weak Domestic Dynamics = Lower Share Prices Weak Domestic Dynamics = Lower Share Prices Chart I-12Rising Public Debt Burden = Sovereign Credit Underperformance Rising Public Debt Burden = Sovereign Credit Underperformance Rising Public Debt Burden = Sovereign Credit Underperformance   If and when the central bank brings interest rates down substantially, nominal growth will improve and share prices will fare well. Lower domestic borrowing costs and higher nominal GDP growth will help stabilize public debt dynamics. In such a scenario, EM sovereign credit portfolios should overweight the nation’s US dollar bonds. The Kenyan shilling also is set to depreciate materially. If the government embarks on this macro adjustment early, currency depreciation could be gradual. If the government delays this macro adjustment and resists currency weakness by tolerating high interest rates, the exchange rate depreciation could be delayed, but will be abrupt and disorderly. Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Nigeria: Devaluation As The Least-Worst Policy Choice Chart II-1Nigeria: Poor BoP Position Nigeria: Poor BoP Position Nigeria: Poor BoP Position The Nigerian naira is facing a considerable risk of major devaluation stemming from strains on its balance of payments (BoP). That said, the risk of a sovereign default is very low over the next 12-18 months. Nigeria suffers from large external imbalances in an environment of low oil prices and dreadful FDI inflows. The nation’s current account deficit is wide at 5% of GDP and its foreign currency (FX) reserves are low (Chart II-1). Importantly, oil prices have hit a critical technical resistance – their 200-day moving average – and have relapsed (Chart II-2). Global oil demand weakness stemming from some renewed tightening of lockdown measures will result in lower crude prices. We at BCA’s Emerging Markets Strategy team expect Brent prices to be in a trading range of $35-$45 over the next 12 months.2 An Optimal Macro Adjustment A low oil price environment creates a dillemma for Nigeria’s policymakers given their limited FX reserves. They can either (i) draw down FX reserves to support the exchange rate, or (ii) preserve FX reserves and allow a major currency devaluation. So far, Nigerian authorities have avoided these options by resorting to strict capital controls and limiting imports. Yet, capital controls are derailing much needed foreign capital inflows in general and FDIs in particular. These capital account controls are also restricting the ability of domestic firms to access US dollars to service their foreign debt payments, undermining the confidence of foreign investors and multilateral creditors. Allowing currency depreciation is the least-worst macro policy solution. Propping up the currency by administrative restrictions amid low oil prices will foster various imbalances impeding the nation’s structural adjustments and its potential growth rate. Remarkably, Nigeria’s current account excluding oil has been structurally wide, a sign of weak domestic productivity and a non-competitive currency (Chart II-3). Chart II-2A Relapse In Oil Prices Is Likely A Relapse In Oil Prices Is Likely A Relapse In Oil Prices Is Likely Chart II-3Nigeria Has A Current Account Deficit Ex-Oil Nigeria Has A Current Account Deficit Ex-Oil Nigeria Has A Current Account Deficit Ex-Oil   Bottom Line: Capital controls and import restrictions are impeding FDIs and productivity growth in this most populous African country (Chart II-4). While a steep devaluation will spur inflation in the short run, a cheapened currency and the abolishment of import and capital controls will help to attract foreign capital that the nation desperately needs. Running Out Of FX Reserves Critically, the Central Bank of Nigeria (CBN) is running out of FX reserves: Nigeria’s foreign exchange (FX) reserves are very low at $35.6 billion. That compares with foreign debt obligations (FDOs) of $28 billion in the next 12 months and foreign funding requirements of $47 billion in the next 12 months (Chart II-5). Chart II-4Nigeria: Weak FDI = Low Productivity Nigeria: Weak FDI = Low Productivity Nigeria: Weak FDI = Low Productivity Chart II-5Nigeria: Large Foreign Funding Required In Next 12 Months Nigeria: Large Foreign Funding Required In Next 12 Months Nigeria: Large Foreign Funding Required In Next 12 Months   FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. Meanwhile, foreign funding requirements is the sum of the current account deficit and FDOs. FDI inflows were a mere $2.5 billion in 2019 compared with a $20 billion current account deficit. Along with foreign portfolio inflows, FDI inflows will remain depressed so long as capital controls persist. The FX reserves-to-broad money ratio currently stands at 0.4. A ratio below one indicates foreign currency reserves do not entirely cover currency in circulation and local currency deposits.  How much should the exchange rate be devalued versus the US dollar for this ratio to reach 1? For the broad money supply coverage ratio to be equal to 1, the currency must depreciate by 56% against the US dollar. Bottom Line: CBN’s FX reserves are insufficient to maintain the current de-facto crawling currency peg in the long run. No Worries About Sovereign Credit For Now Chart II-6Nigeria: Low Public Debt Burden Nigeria: Low Public Debt Burden Nigeria: Low Public Debt Burden While the Nigerian government is reeling from lower oil prices, the likelihood of a sovereign default is presently low. Public debt is low, currently standing at 22.5% of GDP. Notably, foreign debt represents nearly 30% of overall public debt or 6.5% of GDP. Moreover, only 40% of external debt (3% of GDP) is owned to private foreign investors (Chart II-6). The rest is split between bilateral and multilateral creditors. Foreign bilateral and multilateral debt is easier to renegotiate. While overall (domestic and foreign) debt servicing costs have risen to 55% of government revenues, foreign currency debt servicing costs only represent 2% of overall revenues. Provided foreign public debt servicing is minimal, even a large currency depreciation will not make public debt dynamics unsustainable. Crucially, a substantial currency devaluation will ameliorate the fiscal position. A large share (about 55%) of fiscal revenues come from oil, i.e., they are in US dollars. Conversely, expenditures are in local currency terms. As a result, currency depreciation will boost revenues but not expenditures, narrowing the budget deficit. According to the newly revised budget for the 2020 fiscal year, fiscal spending will grow by 8.7% in nominal terms but most likely contract in real terms (Chart II-7). Overall, the fiscal balance will widen to 3.65% of GDP in 2020 according to government projections. In nutshell, policymakers refrained from large fiscal stimulus amid lockdown measures earlier this year. This is bad for the economy but positive for the trajectory of public debt. Finally, public debt dynamics are presently not worrisome with nominal GDP growth above local interest rates (Chart II-8). Chart II-7Nigeria Will Run Tight Fiscal Policy Nigeria Will Run Tight Fiscal Policy Nigeria Will Run Tight Fiscal Policy Chart II-8Nigeria: No Public Debt Sustainability Problem Nigeria: No Public Debt Sustainability Problem Nigeria: No Public Debt Sustainability Problem   Bottom Line: The risk of a sovereign default is low in the coming years. The low starting points in both public debt levels and debt servicing costs will allow the government to boost fiscal spending to support the economy. Investment Implications Overall, a currency devaluation will help restore balance of payment dynamics without causing a major stress for sovereign credit. A 25-30% devaluation over the next 12 months will be the least-worst policy choice. Currency forwards are currently pricing a 20% depreciation in the naira versus the US dollar in next 12 months (Chart II-9). Yet, the average black market exchange rate, currently at around 470, implies almost a 25% discount from the current official rate. Sovereign credit spreads are presently tight (Chart II-10). Investors should consider buying Nigerian sovereign credit only after a substantial devaluation takes place. Chart II-9Naira Forwards Discount Will Widen With Lower Oil Prices Naira Forwards Discount Will Widen With Lower Oil Prices Naira Forwards Discount Will Widen With Lower Oil Prices Chart II-10Nigeria: Buy Sovereign Credit After Devaluation Nigeria: Buy Sovereign Credit After Devaluation Nigeria: Buy Sovereign Credit After Devaluation   Finally, equity investors should continue avoiding the local bourse. Due to capital controls, the latter is uninvestable for now. Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 The standard gauge railways project built between the port city of Mombasa and its capital Nairobi has been heavily scrutinized by Kenyan authorities. After only three years of operation, the Kenyan Railways Company (KRC) has already defaulted on its loan from Chinese lenders. Kenyan courts have been arguing that Kenyan government and state-owned enterprises are facing sovereign risk over Chinese debt overhang. More than half of Kenya’s loans from China are attached to the construction of the Mombasa-Nairobi railway project. 2 This differs from BCA Commodity and Energy Strategy service’s expectation that Brent prices will average $65 in 2021.