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Budget deficits and perils of domestic borrowing

By | June 7th 2011

By Hussein Warsame Mohamud and Nikhil Hira

The 2010-2011 economic budget was the largest in the country’s history, nearly Sh1 trillion, and by all indicators the 2011-2012 fiscal budget is likely to be even larger.

The Economic Stimulus Package (ESP) was unveiled and development projects were read out by the Minister for Finance.

With the new Constitution in place, the entire administration and political structure is going to be reformed. This raises one question, ‘How is the Government going to finance the 2011 budget?’.

The Government currently has a budget deficit of 6.8 per cent of gross domestic product.

In simple terms, to reduce a budget deficit, the Government can either borrow money or increase tax revenue. With 2012 being an election year and the current public discontent from the rising cost of living, the Government would be very reluctant to increase taxes. This leaves the borrowing option as the preferred alternative. The State has borrowed substantially over the past few years, with a number of Government bonds issued to finance infrastructure projects.

Interest rates

However, domestic borrowing has some negative effects. The most likely implication of the Government borrowing from the local market is that it may ‘crowd out’ the private sector. This will push up interest rates as a result of the significant amounts floated by Government bonds. Increased interest rates in the market would inevitably push up Commercial Bank interest rates, making it more expensive for individuals and companies to borrow money. This could curb spending in the economy as proposed investment projects are postponed due to the high cost of borrowing. Another consequence would be that private sector players would find it more profitable to invest in treasury bonds than to lend to the local market. This would reduce funds available for lending and curb economic activity. When Government borrowing is too high and investor confidence is low, interest rates would spike making it very expensive for the Government to borrow funds, leading to sovereign bankruptcy.

Curb inflation

Although Kenya’s public finances are far from this, with a relatively low budget deficit of less than 10 per cent, continued and excessive borrowing would significantly hamper economic progress and affect the country’s credit rating.

Although increased domestic borrowing has been used to curb inflation by mopping up excess liquidity (too much money chasing too few goods), it has the effect of dampening economic activities. What we need is to increase the goods being ‘chased’ by improving productivity. The Government should also be wary of taxing Kenyans more as this will have the same effect on economic activities in the market.

So, what measures should the Government consider? An alternative means of cushioning the domestic market is by borrowing from foreign markets to finance development expenditure. Issue Eurobonds at foreign bourses to raise the required capital. Although the Government planned to float a Eurobond, it was postponed due to the 2007 post- poll violence and other factors.

Kenya has received favourable credit rating with the rating agencies and has also been lauded by both the World Bank and the IMF for the economic reforms it has carried out. This should boost the Government’s confidence in floating Eurobonds, with institutions in the developed world looking to invest in emerging markets the bond is likely to be well received.

An important and financially prudent aspect of this borrowing would be deciding where best to invest these funds. The country’s borrowed funds should be used on development activities, which would, eventually, generate enough funds to meet the obligations undertaken to finance them. The use of these funds on recurrent expenditure would be wasteful as it would leave the nation and its citizens worse off, having nothing substantial to show for it.

The Government should make use of Public Private Partnerships (PPP) to finance significant parts of the infrastructure development (roads, rails, ports etc) and thus reduce the need to borrow.

However, the Government must also put in place a comprehensive cost cutting exercise to reduce its recurrent expenditure. A significant proportion of the country’s budget goes to recurrent expenditure.

The Government must seek to reduce these excesses by implementing tough reforms. Each ministry, with the oversight of the Treasury, must review their cost structure and reduce costs. Overheads, duplication of roles, bloated labour force and costly bureaucratic red tape must be tackled with the aim of trimming expenditure.

Although politically difficult, the Cabinet size must be trimmed and certain ministries merged. The Government should also fast-track the privatisation of parastatals, to increase their competitiveness and more importantly raise the needed finances.

—Nikhil Hira is Partner and Hussein Warsame Mohamud, Tax Consultant, at Deloitte Kenya.

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