Moody’s Caa1 downgrade signals tough times ahead for Kenya

Kenya is facing a significantly diminished capacity to implement revenue-driven fiscal consolidation in the financial year 2024/25 and finance growth projects, according to the latest update by global ratings giant Moody’s.

Initially, President William Ruto’s administration had banked on increasing taxes, as outlined in the now-rejected Finance Bill 2024 to enhance revenue collections and narrow the nation’s deficit.

However, due to heightened nationwide revolt against the proposed tax measures amid a tough economy, the tax proposals were scrapped. Instead, the government is opting to cut spending by Kes177 billion while at the same time increasing borrowing in the new financial year.

According to Moody’s, this policy shift poses material implications for Kenya’s fiscal trajectory, as reliance on expenditure cuts over revenue increases tends to be less effective in improving a country’s debt affordability.

Kenya’s fiscal deficit heading 4.4%

Moody’s adds that the decision to abandon planned tax hikes has led to larger fiscal deficits and increased borrowing requirements for the administration in the year under focus. The global ratings company now projects Kenya’s fiscal deficit to balloon to 4.4 percent of the GDP in the fiscal years 2025 and 2026, a slower pace of fiscal consolidation than previously forecasted.

According to Moody’s, this trajectory poses liquidity risks for the country, as larger financing needs and potentially higher borrowing costs could constrain the government’s ability to service its debt.

“The average interest rate on newly issued Treasury bonds in fiscal 2024 was 17.8 percent, up from 14.4 percent 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 percent of GDP have an average coupon of 11.7 percent, implying a substantial increase in the cost of debt,” noted Moody’s.

At the moment, Kenya’s debt affordability remains a critical concern even after settling the final installment of the $2 billion Eurobond debt in June. The country’s debt-to-service ratio is expected to jump to 33 percent in fiscal 2025 from 30 percent in fiscal 2024, indicating significant fiscal constraints for the economy.

Despite Kenya’s efforts to cut spending, the effectiveness of these measures is uncertain due to structural challenges, such as non-discretionary spending obligations and the potential for external shocks that may increase spending needs unexpectedly, Moody’s explained.

Impact on external borrowing

Moody’s downgrade of Kenya’s ratings to Caa1 with a negative outlook score is set to complicate the country’s ability to secure finances from external sources at favourable terms. Moody’s notes that uncertainty over Kenya’s fiscal policy may weigh on investor sentiments in the months ahead and work against the government’s ability to access alternative financing sources beyond the International Monetary Fund (IMF) and the World Bank.

“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,” said Moody’s.

The rating agency noted that the credibility of the government’s commitment to fiscal consolidation will be pivotal in maintaining support from these multilateral creditors.

Read also: Ruto declines to sign Finance Bill 2024

Economic and social implications

Kenya’s downgrade has broader economic and social implications as well. The decision to rely on spending cuts rather than tax increases could negatively impact the provision of public services and the rollout of development projects, potentially exacerbating poverty and the already high unemployment rate, especially among the youth.

Additionally, according to Moody’s, the downgrade reflects broader governance issues such as weak fiscal policy effectiveness and high levels of corruption, which further constrain Kenya’s ability to maintain a resilient economy.

Future outlook

While some domestic borrowing costs are expected to decline gradually, Moody’s noted that significant risks remain. For instance, there is potential for higher borrowing costs, limited external financing options, as well as the need for a larger fiscal adjustment to stabilize debt in the long term.

“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,” said Moody’s statement in part.

“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.”

The downgrade also serves as a stark reminder of the urgent need for Kenya to address its fiscal and economic challenges, restore investor confidence, and ensure sustainable growth.

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