Dynamic Relationship between Public Debt and Exchange Rate Misalignment in Kenya

Abstract

Kenya’s sovereign debt has increased throughout the years to reach a figure of above Kenya Shilling 10 trillion. At the end of June 2023, the total public debt, excluding that which is guaranteed publicly and pending bills, stood at around Ksh. 5.39 trillion in external debt and domestic debt of Ksh. 4.90 trillion. As a result, the country is facing a debt crisis and fiscal distress due to high debt service. As the public debt is growing, the fiscal deficit has also been increasing, averaging about 5.2 percent of GDP as of the 2023/2024 fiscal year. The consequence is huge public debt, and more borrowing to refinance the existing debts. The problem is more pronounced on the external debts. This is because Kenya needs to earn more foreign currency to service the debt. This, however, is not happening as the exports continue to decrease and imports continue to expand. Consequently, the country faces a problem in its current account. The rate of exchange has also been observed as overvalued, creating a misalignment in the real exchange rate. This adversely affects trade and generates pressure and volatility in the exchange rate market, consequences that are undesirable for the stability and overall growth of the Economy. The situation leads to depreciation or loss of strength of the local currency. However, the monetary authority constantly intervenes to manage the exchange rate and prevent depreciation. This raises the question of whether the observed misalignment in the real exchange rate is related to the growth in the public debt. The study, therefore, sought to get more information on the dynamic relationship between public debt and the exchange rate misalignments in Kenya. It employed secondary time series data running from the year 1980, when the country adopted the floating exchange rate, to the year 2023. The study made use of the Vector Autoregressive Model to analyze the direction of causality and impact response. It is deduced from this study that the Budget Deficit is a strong determinant of Exchange Rate Misalignments. This means that persistent budget deficits fuel both external imbalances and public debt. Misalignments not only worsen the current account but are themselves affected by fiscal and external indicators. Rising external debt is influenced by fiscal and external sector pressures, necessitating coordinated macroeconomic management.