Moody’s changes outlook on Kenya’s rating to negative from stable; affirms the B2 rating

Nairobi (Capital Markets of Nigeria) — Moody’s Investors Service, (“Moody’s”) has changed the outlook on the Government of Kenya’s ratings to negative from stable. Concurrently, Moody’s has affirmed Kenya’s B2 issuer and senior unsecured ratings.

The negative outlook reflects the rising financing risks posed by Kenya’s large gross borrowing requirements, which include amortization of external bilateral debt and the need to refinance a large stock of short-term domestic debt, at a time when the fiscal outlook is deteriorating due to the erosion of the revenue base and a debt structure that exposes Kenya’s fiscal metrics to exchange rate and interest rate shocks. While Kenya does not face acute financing pressures, the severe tightening of financial conditions will challenge the government’s ability to meet larger gross financing needs without an increase in borrowing costs that would threaten medium-term fiscal consolidation efforts.

The rapid and widening spread of the coronavirus outbreak is creating a severe and extensive credit shock across many regions and markets. Weaker growth and larger fiscal deficits will further aggravate Kenya’s already high debt and interest burdens. The decision to affirm the B2 rating balances those pressures against fundamental economic strengths including a relatively large and diversified economy with high growth potential and quite deep domestic financial markets. It reflects Moody’s expectation that Kenya will not participate in any debt relief initiative that requires the participation of private-sector creditors, which could carry further negative implications for the country’s rating, and more generally that Kenya will meet all its debt service commitments to private-sector creditors.

Kenya’s long-term foreign-currency bond ceiling and long-term foreign-currency deposit ceilings remain unchanged at Ba3 and B3, respectively. The Ba2 long-term local-currency bond and deposit ceilings remain unchanged as well.

The rationale for changing the outlook to negative from stable
Heightened liquidity risk given Larger, growing funding needs amid tighter financial conditions
Kenya’s large gross funding needs make it vulnerable to tightening financial market conditions. Contrary to previous expectations of declining borrowing requirements underpinning the rating, Moody’s expects gross borrowing requirement will remain around 22% of GDP in fiscal year 2020/21 (ending June 30, 2020), a relatively high level compared with other sovereigns.

Although Kenya does not have any large principal payments due in the near term — the next Eurobond principal payment is in 2024 — the country is at the start of a more difficult external amortization schedule. In each of the next three years, Kenya will need to repay on average 1.7% of GDP in external principal amortizations, in addition to any potential external financing of the fiscal deficit. This more challenging external amortization schedule coincides with a tightening of external financial conditions as a result of the coronavirus outbreak.

The challenges posed by the external amortization schedule are compounded by a large stock of domestic debt that needs to be rolled over on an annual basis. Treasury bills account for 31% of domestic debt as of December 2019, up from 25% of the domestic debt at the end of 2014. Since September 2016, a cap on bank lending rates incentivized domestic banks to hold government securities relative to riskier lending to the private sector. The removal of the lending rate cap in November 2019 has increased the sensitivity of market yields to the government’s domestic borrowing requirements. Nevertheless, access to a relatively deep domestic financial market somewhat mitigates the immediate financing risk from the tightening in external market conditions.

Moody’s expects that the government will rely on concessional multilateral financing for much of its additional borrowing requirements in fiscal year 2019/20 and fiscal year 2020/21, with the remainder covered through increased domestic borrowing. It is possible that the government may also seek other forms of relief, possibly including on loans from Chinese state-owned banks. Moody’s does not currently expect Kenya to participate in any debt relief initiative that would require the participation of private-sector creditors. A decision to do so could carry negative implications for the country’s rating. More generally, delays or changes in debt service payments owed to private-sector creditors compared to the original terms of the contract could be negative for the sovereign’s rating.

Significant risks to the fiscal outlook
Financing risks are rising at a point when Kenya’s fiscal strength is eroding. The shock to growth and larger fiscal deficit as a result of the coronavirus outbreak will worsen Kenya’s already high and increasing debt and interest burdens.

The combined impact of border closures and measures to contain the spread of the coronavirus, as well as supply chain disruptions, will weigh on almost all sectors of Kenya’s economy. Moody’s expects Kenya’s real GDP growth to slow to 1% in 2020 from 5.4% in 2019, well below the five-year average of 5.6%. Lower growth, combined with recently announced tax measures and increased spending, will result in the government’s fiscal deficit widening to 8.5% of GDP in fiscal year 2019/20 and 9.1% of GDP in fiscal year 2020/21. This follows several years of larger than expected deficits.

The government’s fiscal policy response to the coronavirus shock increases uncertainty over the medium-term fiscal outlook. Stimulus-related revenue measures include a number of permanent tax cuts that will reduce revenue collection even when economic growth recovers and may be difficult to reverse. This will reduce the government’s capacity to service its debt burden. Larger primary and fiscal deficits over the next two years will increase the debt burden to around 70% of GDP by the end of fiscal 2020/21. Moreover, the debt-to-revenue ratio will increase to over 400% by fiscal year 2020/21, a far more significant deterioration than Moody’s expects in most other B-rated sovereigns. Kenya’s already weak debt affordability will deteriorate further with the interest-to-revenue ratio increasing to 27% by fiscal year 2020/21, reducing available revenue to cover primary expenditures.

Kenya’s debt structure increases risks to the fiscal outlook. Foreign-currency debt accounts for around half of Kenya’s general government debt, creating an exposure to exchange rate depreciation. Since the beginning of the year, the Kenyan shilling has depreciated by 5.5% against the US dollar. Moreover, the large stock of short-term domestic debt (mostly Treasury bills held by local banks) heightens the government’s exposure to higher interest rates. An increase in domestic borrowing costs would quickly lead to a higher interest-to-revenue ratio.

The rationale for affirming the B2 rating
The B2 rating incorporates Kenya’s fundamental economic strengths including its relatively large and diversified economy with high growth potential which provides some absorption capacity to economic shocks, as well as its relatively deep domestic financial markets which support domestic, local currency debt issuance. The B2 rating also captures the credit challenges pertaining to the weak fiscal metrics. Government finances have continued to deteriorate due to eroding revenue, high development spending, and the rising cost of debt.

Environmental, social and governance considerations 
Environmental risks inform Kenya’s credit profile primarily through Moody’s assessment of economic strength. Floods and droughts have an adverse effect on the economy, particularly for those who derive income and employment from the agriculture sector. Low wealth levels limit the ability of households to buffer the impact of lost earnings because of weather-related events. Moody’s has identified Kenya as one of those countries whose credit profile is most susceptible to climate change.

Social considerations are important for Kenya’s credit profile. Credit challenges include low wealth levels and high poverty rates, as well as limited access to essential services in certain parts of the country and high crime rates. These are important policy issues for the government, as reflected in the inclusion of improved access to education and housing in the president’s “Big Four” policy agenda. Moody’s regards the coronavirus outbreak as a social risk under its ESG framework, given the substantial implications for public health and Safety.

In terms of governance, Kenya scores poorly on institutional factors, including those measured by the Worldwide Governance Indicators, with control of corruption and public financial management representing particular challenges.

Factors that could lead to an upgrade or downgrade of the ratings
An upgrade is unlikely in the foreseeable future given the negative outlook. Moody’s would change the outlook to stable if the rating agency were to conclude that the government was likely to maintain sufficiently broad funding options to meet its larger funding needs without a significant increase in borrowing costs. The effective implementation of structural fiscal reforms to narrow the fiscal deficit, which would stabilize and eventually reduce the debt burden, improve debt affordability, and reduce liquidity risks would support Kenya’s current rating level.

Moody’s would likely downgrade the rating if it were to conclude that the ongoing deterioration in Kenya’s debt burden and debt affordability was likely to exacerbate liquidity risks, raising questions over the government’s ability to refinance maturing debt. While not Moody’s current expectation, indications that the government was likely to participate in debt relief initiatives which Moody’s concluded were likely to entail losses for private-sector creditors would be negative for the rating. In general, an increasing likelihood that Kenya may delay payments on debt owed to private-sector creditors could be negative for the rating.