1
The Impact of External Debt on Economic Growth and Private
Investments in Kenya: An Empirical Assessment
By
Maureen Were
Kenya Institute for Public Policy Research and Analysis
P.O. Box 56445, Nairobi, Kenya
Email:
mwere@kippra.or.ke
August 6
th
Version
A paper to be presented at the Wider Development Conference on Debt Relief
17-18 August 2001, Helsinki
pg_0002
i
ABSTRACT
A group of low income countries classified as HIPCs have continued to experience difficulties
in managing and servicing their huge stocks of external debt. Most of these countries including
Kenya are in sub-Saharan Africa. The relatively high level of Kenya’s external indebtedness and
rising debt burden has serious implications on the country’s development and debt sustainability
initiatives. While the economic performance continue to deteriorate, there have been significant
net outflow of resources to meet the debt obligations in the 1990s. This paper examines the
magnitude and structure of Kenya’s external debt, and its impact on economic growth and
private investment
The findings of the study indicate that Kenya’s external debt is mainly official, of which a
bigger proportion is from multilateral sources. External debt accumulation has been rising over
the years with debt burden indicators increasing steadily in the early 1990s. Using time series
data for the period 1970-1995, the empirical results indicated that external debt accumulation
has a negative impact on economic growth and private investment. This confirms the existence
of a debt overhang problem in Kenya. However, the results also indicated that current debt
inflows stimulate private investment. Debt servicing does not appear to affect growth adversely
but has some crowding out effects on private investment.
Several policy implications emerge from the study. The simultaneous attainment of sustainable
levels of economic growth and external debt appear difficult at the moment and could remain
elusive if aggressive measures are not undertaken. In view of the current economic recession
and the negative net outflows, the results obtained from this study support the need for Kenya to
be considered for comprehensive debt relief measures. The results indicate prospects that
availability of these resource flows can stimulate private investments if used productively. A
key challenge to the Government remains that of ensuring efficiency in delivery of services and
increased productivity of public investments. In addition, creating credibility including political
will to reforms is required to spur investor confidence for both local and foreign investments.
pg_0003
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Table of Content
1. Introduction.............................................................................................................................1
1.1 Background Information .....................................................................................................4
1.2 Size and Magnitude of External Debt in Kenya.....................................................................6
1.3 Structure, Type and Composition of External Debt ............................................................9
1.4 Determinants of External Debt..........................................................................................10
2.1 Theory of debt and economic performance.......................................................................12
2.2 An Overview of Empirical Studies ................................................................................... 15
3.1 Model Specification ..........................................................................................................17
3.2 Time Series Properties....................................................................................................... 19
4 Estimation Results ................................................................................................................21
4.1 Correlation results .............................................................................................................21
4.2 Estimation Results for the Growth Equation.....................................................................22
4.2 Estimation Results for the Investment Equation ...............................................................26
5 Conclusion and Policy Implications ...................................................................................28
APPENDIX .................................................................................................................................37
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LIST OF ABBREVIATIONS
DSR
= Total debt service payments as a ratio of exports of goods and services
EDT
= Totalexternaldebtstocks.
EDT/GDP = Stock of external debt to GDP ratio
EDT/GNP = Total external debt as a ratio of GNP
ESAF
= Enhanced Structural Adjustment Facility
FDGDP
= Fiscal deficit as ratio of GDP
FFGDP
= Net foreign financing as a ratio of total fiscal deficit
GDPGR
= Real GDP growth rate
GEDT
= EDT growth rate
GPUIV
= Real public investment as a ratio of GDP
GTDS
= TDS growth rate
HCD
= Human capital development
INFL
= Rate of inflation
INT/GNP = Interest payments a ratio of GNP
INT/XGS = Interest payments on debt as a ratio of export of goods and services
INTr
= Interest rate (nominal)
LDOD
= Long term debt outstanding
NTR
= Total net transfers on debt
PINV
= Real private investment as a ratio of GDP
PNG
= Private non guaranteed debt
PPG
= Public and publicly guaranteed long term debt
RER
= Real exchange rate
SAF
= Structural Adjustment Facility
SECALs = Sectoral Adjustment Loan/Credit
SSA
= Sub-Saharan Africa
TDS
= Total debt service payments
TDS/XGS = Total debt service payments as a ratio of exports of goods and services
TOT
= Terms of trade
UNDP
= United Nations Development Program
pg_0005
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1.
Introduction
During the three decades beginning in the 1950s, deficits in the current account were considered
normal. Countries were encouraged to borrow abroad and create an environment conducive to
foreign investment to boost their economic growth. In the process little attention was paid to the
liabilities side of the current account deficit which increased the external indebtedness of these
countries, until when Mexico, despite being an oil exporter, declared in August 1982, that it
could not service her debts. Ever since, the issue of external debt and its servicing has assumed
critical importance and introduced the 'debt crisis' debate.
Despite the tremendous improvement made in the debt situation of most middle-income debtor
countries since the onset of the debt crisis in 1982, a group of low income countries classified as
heavily indebted poor countries (HIPCs) has continued to experience serious difficulties in
managing the servicing of their relatively high stocks of external debt. Out of the 41 countries
classified as HIPCs, 33 (or 80%) including Kenya are in Sub-Saharan Africa (SSA). The
majority of these countries also fall under the existing classification of countries with low
income (World Bank) and low human development (UNDP).
There is a wide range of causes of the debt crisis of the Third World. That notwithstanding, the
evolution of the debt problems of SSA countries can be attributed to the following factors
during the 1970s: transitory commodity price booms; expanded access to private finance and
other trade credit following the 'recycling' of the OPEC surpluses and public expenditure
expansion with financing contributions from both of the above. The new developments in the
1980s include world recession and further terms of trade deterioration, high interest rates,
delayed adjustment programs and drought (Krumm, 1985). Other factors include terms of trade
shocks (Brooks, 1998) and lack of prudent debt management policies.
External indebtedness is not harmful per se. Nor does heavy external debt automatically imply
pg_0006
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that growth must necessarily be low. What is detrimental for many African countries is their
inability to meet current debt obligations - compounded by the lack of information on the
nature, structure and magnitude of the external debt. A country may be able to export enough to
generate the foreign exchange needed to buy the increasing imports associated with rapid
growth and still service a high level of debt. Or it may be able to generate the necessary foreign
exchange by borrowing more. But the concept of solvency implies that this is a process that
cannot go on forever (Williamson, 1966). Most of the countries classified as HIPCs not only
face solvency problems, but also face liquidity problems.
SSA is still plagued by its heavy external debt burden. The debt crisis, compounded by massive
poverty and structural weaknesses of most of the economies of these countries has made the
attainment of rapid and sustainable growth and development difficult. It has become widely
accepted that the heavily-indebted countries require debt relief initiatives beyond mere
rescheduling to have a turn-around in their economic performance and fight against poverty. In
the late 1990s, this understanding appears to have stirred the international community to
consider ‘deeper, broader and faster’ external debt relief—the HIPC debt Initiative. Eligibility
has been based on a good track record of reforms, pursuance of sound policies and ability to
translate the resources into better prospects for the poor (IMF2001a and IMF2001b)). By the
end of June 2001, 23 countries, 19 of them in Africa, had benefited from debt service relief
amounting to some $34 billion (IMF 2001b). That notwithstanding, doubts are still being cast
about the ability of the Initiative to solve Africa’s immense debt problems. Basic concerns have
been expressed in regard to adequacy of the debt reduction, eligibility, length of completion
period, performance criteria and the possible conflict of interest arising from World Bank and
IMF, both of which are creditors (ECA, 1999).
Despite the relatively high level of Kenya’s external indebtedness, the country has not been
included in the list of beneficiaries. Although it is stated that Kenya is expected to reach
sustainable levels of debt without special help from the initiative (IMF 2001a), this is unlikely
to happen, given the country’s current economic situation. While the country is grappling with
pg_0007
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high poverty levels (with 56% of the population living below the poverty line), economic
performance continue to deteriorate. For the first time since independence, the country recorded
a negative GDP growth of –0.3% in 2000. In fact, the exclusion of Kenya from the HIPC debt
initiative is likely to have been based on its poor record of reforms and economic performance
rather than its ability to attain sustainable levels of external debt. Kenya’s external debt
indicators— debt to GDP ratio and debt to exports ratio — have risen from an average of
38.5% and 121.1% for the 1970-80 period to 89.2% and 268.2% for 1991 –1999 period,
respectively. Meanwhile, there have been significant net outflows since 1991 to service the
debt obligations. This implies that Kenya has been paying out more funds than it receives,
thereby reducing domestic resources available for development. The huge burden of external
debt constitutes a serious obstacle to growth and employment creation as investment resources
have to be used to meet external debt obligations. At the same time, there are very limited
options for Government to co-finance development activities through domestic debt. Although
domestic debt constitutes less than a third of the total formal debt, it is almost ten times as
expensive as external debt (GoK 1997). In view of the current economic situation and progress
in relief initiatives, this paper examines the structure of Kenya’s external indebtedness and its
implications on economic growth. Specifically, the objectives are to
§ Examine the structure of Kenya’s external debts
§ Empirically assess the debt overhang (that is the effect of debt accumulation) and the
crowding out effects of external debt on private investment and economic growth.
The paper is organised as follows: Section 1.1 provides the background information on Kenya’s
economic structure and performance since independence. Section 1.2 analyses the debt profile
and the magnitude of external debt in Kenya. Section 1.3 examines the structure and
composition of external debt while Section 1.4 describes the determinants of the debt. Section
2 provides a synthesis of the theoretical and empirical literature on external debt and growth.
Model specification and time series properties of the data used are presented in section 3. This
is followed by the empirical results in section 4. Section 5 provides the conclusions and policy
implications of the findings.
pg_0008
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1.1 Background Information
The period from independence (1963) to 1973 is a period when Kenya’s economic growth was
most rapid. It can be regarded as Kenya's 'golden economic period'. The Gross Domestic
Product (GDP) grew at an average of 6.5% and per capita income remained positive despite
high population growth rates. The balance of payments (BOP) position was healthy and the
inflation rate was less than 3%. Exports grew at a commendable rate of 13% per annum. An
examination of the commonly used debt burden indicators in Table 1.1 shows that the debt
servicing ratio (debt service payments as a ratio of total export of goods and services) in the
early 1970s was too low to cause concern when compared with that of African countries as a
whole which was over 10% in 1972. However the oil crisis of 1973/74 changed the picture. It
created severe BOP problems. To meet the BOP crisis, the government resorted to heavy
external borrowing. The external debt stock grew by 45.3% in 1973 from the previous year (see
Table 1.2). The growth rate decelerated to less than 4%, being only 2.9 % in 1975 (see Table
1.1).
The ‘coffee boom’ of 1976/77 led to an abrupt increase in export earnings and therefore a
temporary drop in the debt-servicing ratio in 1978. The coffee boom was however followed by
the second oil crisis and a sharp deterioration in world commodity markets. As Kenya's export
earnings almost stagnated, the debt-servicing ratio began to explode. This was accompanied by
rising debt to GNP ratio as seen from Table 1.1. Drought conditions in the 1980s led to food
imports, made possible by availability of external loan finance. Increased interest rates on
international loans raised the debt service charges substantially. This led to a decrease in net
transfers on debt, being negative in 1981, 1984, and 1986 and have remained negative since
1991 (see Table 1.2). This transfer of capital to foreign creditors pose serious implications on
the economy.
Table 1.1: Kenya's Debt Burden Indicators and Real GDP growth rate (%)
Year EDT/XGS EDT/GNP TDS/XGS INT/XGS INT/GNP GDP growth
rate
pg_0009
5
1970
63
31
5
2
1
6.2
1971
94
29
10
3
1
4.9
1972
100
28
8
4
1
6.4
1973
120
35
9
4
1
4.0
1974
119
40
10
4
1
3.1
1975
128
41
15
5
2
2.9
1976
131
45
15
4
2
4.4
1977
104
39
21
4
1
8.1
1978
141
43
14
5
2
7.7
1979
167
45
18
7
2
4.9
1980
165
48
21
11
3
3.9
1981
180
49
27
13
4
6.0
1982
207
55
31
14
4
3.4
1983
238
63
34
14
4
3.0
1984
211
59
35
14
4
0.4
1985
260
71
39
15
4
5.1
1986
242
66
36
14
4
5.5
1987
333
76
40
17
4
4.9
1988
307
71
39
17
4
5.2
1989
305
74
37
15
4
5.1
1990
316
87
35
15
4
4.2
1991
338
98
33
15
4
2.1
1992
321
91
31
12
3
0.5
1993
305
156
27
11
6
0.3
1994
269
107
33
12
5
3.0
1995
249
85
30
10
3
4.9
1996
228
77
28
9
3
4.6
1997
220
64
22
7
2
2.4
1998
240
62
21
7
2
1.8
1999
244
63
27
7
2
1.4
Source: Global Development Finance (CD) 2001 and series of Economic Surveys
Table 1.1 also shows that three of the four key indicators-- debt to GNP ratio (50%), debt to
exports ratio (275%), debt service ratio (30%) and interest to export ratio (20%)—have been
above the critical levels (the numbers in brackets)
1
since early 1980s. The debt service and the
debt to GNP ratios have been above the critical levels since 1982, except in the late 1990s
where the debt service ratio showed a slight decline. The debt to exports ratio has remained
above the critical level from 1987 to 1994. These indicators show that the external debt problem
began to rise faster in the early 1980s. The GDP growth rate remained below 5% in the early
1
see World Bank, World Debt Tables,1989-1990, vol.1
pg_0010
6
1980s.
Similarly, the significant rise in the debt burden indicators (debt to exports and debt to GNP
ratios) in the first half of the 1990s also coincides with a deterioration in GDP growth rates
during that period. The highest debt to exports and debt to GNP ratios of 338% and 156% were
attained in 1991 and 1993, respectively. Concurrently, the GDP growth rate declined from 4.2%
in 1990 to 2.1% in 1991, before declining further to 0.5% and 0.3% in 1992 and 1993,
respectively. The growth performance has remained depressed to the new millennium. The
growth in total nominal external debt has tended to exceed the growth in average GDP.
Based on this background, the severity of Kenya's external debt crisis cannot be underestimated.
Although the debt burden indicators show a declining trend in the late 1990s, the huge transfers
are alarming. The resources that could have been allocated to consumption and investment are
instead being channelled abroad. This may act as a strong disincentive not only to invest but
also to partake in any adjustment programmes aimed at increasing growth. Unless a country
grows fast enough to sustain debt obligations and maintain domestic investment, indefinite
external indebtedness can have very detrimental effects on the economy's growth and on the
welfare of the citizens.
1.2 Size and Magnitude of External Debt in Kenya
Table 1.2 shows the size of Kenya's stock of external debt and debt service payments for the
period 1970 - 1999.
pg_0011
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Table 1.2: Kenya's external debt stock, debt service and net transfers on debt (million US $)
Year External debt
(million US $)
Debt service
(million US $)
Net
transfers
on debt
(m US $)
Principal
arrears on
Long-term
debt (m US $)
Growth
in debt
(%)
Concessional
debt/Total
debt (%)
1970
477.5
50.0
97.1
0.3
35.6
1971
497.9
52.4
16.5
0
4.3
36.1
1972
581.2
48.3
78.5
0
16.7
34.5
1973
844.7
65.2
194.1
0
45.3
31.4
1974
1152.7
97.6
271.5
0
36.5
27.7
1975
1290.2
151.0
138.5
0
11.9
25.5
1976
1493.3
169.3
198.6
0.6
15.7
25.0
1977
1658.9
326.0
85.1
1.1
11.1
25.1
1978
2173.7
215.7
469.3
1.7
31.0
19.9
1979
2721.0
299.3
403.9
2.3
25.2
20.1
1980
3386.8
433.5
489.2
3.3
24.5
20.2
1981
3228.2
485.0
-214.4
3.8
-4.7
23.6
1982
3367.8
496.9
11.7
4
4.3
27.4
1983
3628.3
515.0
194.3
4
7.7
26.4
1984
3511.5
578.7
-92.1
4
-3.2
30.6
1985
4181.3
621.2
41.4
4.1
19.1
30.3
1986
4603.6
677.3
-252.1
6.2
10.1
33.6
1987
5783.7
691.4
176.8
12.6
25.6
32.4
1988
5809.7
737.6
95
25.6
0.4
35.0
1989
5890.1
708.8
287.4
49.4
1.4
33.7
1990
7058.1
790.9
281.2
71.8
19.8
33.7
1991
7452.9
719.4
-40.4
155
5.6
36.4
1992
6898.1
669.9
-146.5
263.2
-7.4
40.4
1993
7111.3
631.5
-111.4
409.8
3.1
43.4
1994
7202.3
880.8
-651.4
9.3
1.3
47.1
1995
7412.4
901.4
-197.5
6.1
2.9
52.3
1996
6931.0
844.4
-462
29.3
-6.5
56.8
1997
6602.8
669.1
-199.1
76.1
-4.7
57.0
1998
6943.3
611.7
-373.7
174.3
5.2
59.4
1999
6561.5
716.0
-500.9
237.6
-5.5
63.1
Source: Global development finance (CD) 2001
The total nominal debt stock rose from US $ 477.5 million in 1970 to US $ 7412.4 million in
1995 while total debt service payments rose from US $ 50 million to US $ 901.4 million in the
same period. However, the stock of debt and debt service payments have now declined to US $
6561.5 million and US $ 716.0 million, respectively in 1999. As seen from Table 1.2, the
growth in debt stock show some in decline in 1990s.
pg_0012
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Table 1.2 shows that a significant rise in Kenya's external indebtedness corresponds to the
periods 1973-74, 1978-1980, 1985-1987 and 1990 in which increased borrowing was made.
The first and second periods coincided with the first and second oil crises respectively. These
periods also registered a significant growth in debt service payments. The third period
coincided with the funding of structural adjustment programmes. Between 1986 and 1991, the
World Bank approved 6 Sectoral Adjustment Loans (SECALs), while IMF disbursed US $ 360
million of SAF and ESAF (O’Brien and Ryan, 1999).
The decline in growth of external debt in 1988 (0.4%) and 1989 (1.4%) is partly due to debt
write - offs and a decline in bilateral and private debt. In 1989, Kenya was forgiven her external
debt amounting to US $ 463 million. The decline in the 1990s can be attributed partly to the
negative net-repayments and aid embargos resulting in no new external debt contracts. For
instance, the two-year `aid freeze' in official capital inflow in 1991 and 1992 resulted to an
increase in Kenya's external payment arrears. In addition, there was a heavy reliance on
domestic borrowing in relation to external borrowing in the 1990s. A relatively tight fiscal
stance was also witnessed during the period.
Despite the magnitude of external debt in the 1980s, Kenya was able to service its debts without
rescheduling. This is also reflected by the fact that there was zero or negligible accumulation of
arrears in 1970s and a better part of 1980s (see table 1.2). However, by early 1990s, the debt
burden became so acute that Kenya had to reschedule its debt in 1994 for the first time. Table
1.2 shows that there was a significant accumulation of arrears in the early and late 1990s.
Although there was a dramatic build up in nominal aid flows during the 1980s, external
financial support has been slackening in the 1990s. Consequently, the level of external
indebtedness has been falling. Although Kenya may not be as heavily indebted as other HIPCs,
its present poor economic performance and inability to meet its debt obligations has serious
implications on development and debt sustainable objectives.
pg_0013
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1.3 Structure, Type and Composition of External Debt
Like most SSA, low-income countries, a greater proportion of Kenya’s external debt consists of
official debts (multilateral and bilateral). A decomposition of official debt shows that in 1970s,
official debt was mainly from bilateral sources. From early 1980s onwards, however,
multilateral debt constitutes a major proportion of total debt stock. In 1989, this was 37 % of
the total debt compared to bilateral debt, which was only 18%. The share of multilateral debt
increased moderately in 1980s mainly as a result of large disbursements of adjustment lending
from the World Bank (O’Brien and Ryan, 1999). The multilateral aid is predominantly in the
form of concessional loans. Since the early 1990s, the proportion of concessional debt has been
rising. The proportion of concessional debt rose from 20% in 1979 to 34% in 1989 and to 63%
in 1999, respectively (see Table 1.2). This has given Kenya the advantage of contracting loans
on soft terms. This also explains why the interest to exports and interest to GNP ratios have
remained relatively low.
The main lenders have been International Bank for Reconstruction and Development (IBRD)
and International Development Association (IDA). The World Bank Group accounted for
almost 80% of total loans in 1970-1996 (ibid.). Other major Multilateral creditors are the
International Monetary Fund (IMF), European Investment Bank (EIB), the African
Development Bank (ADB) and its soft lending arm the African Development Fund (ADF).
IBRD and IDA are mainly concerned with project lending while IMF is mainly concerned with
policy based lending (budget support). In the bilateral category, Japan has in recent years
become the leader creditor overtaking previous major creditors like USA, Germany and France
who have written off substantial amounts owed to them. There has been a notable decline in the
share of U.K. in 1990s.
Private debt has remained relatively low over the years. The highest percentage of private debt
as a proportion of total debt within the period is 25%, incurred during the early 1980s. Such
pg_0014
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loans are normally obtained on hard terms and conditions implying high debt service payments.
Long-term debt constitutes a major proportion of total debt outstanding. Long term debt can
further be broken down into public and publicly guaranteed and private non-guaranteed debt. A
greater proportion of long-term debt outstanding is contracted by the public sector. This has
profound implications for economic growth—it reflects the significant role the public sector is
expected to play in the socio-economic development of the country. Between 1980 and 1987,
the public sector long-term debt grew by 109% from US $ 2062 million to US $ 4312 million,
respectively. The main debtors are Central Government (GOK), the Central Bank of Kenya and
Parastatals (Annual Report on Debt Management in Kenya 1994). Private non-guaranteed debt
has not only been low, but has also been rising relatively slowly over the years. Short-term debt
has also remained relatively low over the years.
1.4 Determinants of External Debt
The debt crisis has evolved from a complex combination of factors, some of which are external
while others are the direct result of economic policies pursued. However, Ajayi (1991) has
argued that the division of the factors into external and internal /domestic is not correct because
external factors impinge crucially on what happens domestically and vice versa. That
notwithstanding, determinants of Kenya’s external debts can be attributed to both internal and
external factors.
The major external factors include the following. The 1973/74 oil price increases led to
deterioration in terms of trade leading to BOP deficits. The oil shock also contributed to a
tremendous increase in the availability of international credit for developing countries at very
low interest rates. This encouraged oil importing developing countries (including Kenya) to
borrow abroad to pay the higher oil bills (Sachs and Larrain, 1995). Many creditors overstated
the potential capabilities of the debtor-countries to meaningfully absorb and pay for debts
(Ajayi, 1991). In Kenya, like many other African countries, government to government
pg_0015
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(bilateral) loans represented a higher proportion of the debt. The rise in Kenya's external
indebtedness in the periods 1973 - 1975 and 1978 -1979 coincide with the first and second oil
crises respectively. The second period also coincided with the 1979/80 drought which seriously
affected agricultural output necessitating food imports made available through increased
borrowing. In the early 1980s the world interest rates increased sharply as a consequence of
anti-inflationary programs in the industrialised countries. At the same time, the terms of trade
deteriorated for the debtor world as raw materials prices fell. Kenya's growth of export earnings
declined tremendously from 26% in 1980 to about -13% in 1981. The external balance
continuously deteriorated in the early 1980s and was further worsened by the drought of
1983/84 and the early 1990s. The Gulf crisis of 1990-1991 also contributed to heavy external
borrowing. Increased protectionism policies by developed countries has tended to discriminate
against LDC’s exports (including Kenya) thus lowering their earnings.
Besides external factors, Kenya’s external indebtedness can be partly attributed to internal
factors. These mainly refers to the overly expansionary fiscal policies and highly distorted
trade policies especially policies that created a heavy bias against exports. Public sector deficits
have been a major problem since late 1970s. Following the 1976/77coffee boom, the initial
response was to expand public expenditure and, since revenue from taxation did not rise as fast,
the government resorted to foreign borrowing. When commodity prices later fell, expenditures
were not reduced accordingly and previous borrowing was supplemented with new borrowing
to maintain expenditure levels. This borrowing to finance public expenditures partly account
for the big rise in growth of external debt for the period 1978-80. By early 1980s, the public
sector was overextended. A number of parastatals drained the budget. At the same time the
civil service had expanded tremendously. The over-extension of the public sector showed up in
economic inefficiency. The overall budget deficit as a percentage of GDP rose from 7.1% for
the period 1974 -78 to 9.4% for the period 1979-83. It then fell to about 4.7% for the period
1988-1990 and peaked again to 7.1% in 1990/91.
pg_0016
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Other factors were an overvalued exchange rate
2
, negative real interest rates as well as an
import-substituting industrial strategy, which was characterised by overprotection. The greater
pervasiveness of the import licensing system and regulations on business activities created
enormous opportunities for rent-seeking and for executive discretion. The mismanaged coffee
boom of 1986 also left the economy with a high external imbalance. Manundu (1984)
attributed Kenya’s debt burden to balance of payments, increased imports, low savings and loan
capital.
There is limited empirical work on the determinants of external debt in Kenya. Nonetheless,
Ochieng (1991) and Ng'eno (1991), found unexpected results about the effect of real interest
rates and budget deficits on external debt burden. In Ng'eno's study, the effect of devaluations
on the stock of debt was greater than the effect on exports while the effect of devaluation on
exports was greater than the effect on debt burden in the study by Ochieng (1991). From the
two studies, terms of trade and increase in real value of exports led to a fall in external debt
burden while increase in the real value of imports and growth of industrial countries tend to
raise the external debt burden.
2.1 Theory of debt and economic performance
The crucial role of capital in the production process is well known. The international flow of
capital - borrowing and lending across political borders - dates back at least to the ancient
civilisations of the Mediterranean.
3
At the end of the 1940s the flow of capital to developing
countries was negligible. But the early post-war reflections on the problems of developing
countries led to the identification of insufficient capital stock as cause of their low income.
Among the notable economists who made such suggestions are Hans Singer and Ragner
Nurske. According to Nurske, there was a vicious circle of poverty, which could be broken by
increasing savings. The role of increased savings in facilitating capital accumulation was further
2
An overvalued currency reduces the price of imports and thus worsens the BOP, leading to higher capital
inflows. It can also raise expectations for devaluation leading to capital flight. Currency depreciation can raise the
stock of external debt.
pg_0017
13
advocated by Arthur Lewis (1954) and Rostow (1985) (see Degefe, 1992). It was noted that the
volume of savings in developing countries was too low on account of the low income and
therefore, domestic savings should be supplemented by foreign resources. This shifted the issue
from whether external resources are useful to developing countries, to how much was sufficient
to help them realise their growth potential (see Degefe, 1992).
The need for foreign resources in developing countries has been justified by the two-gap
approach developed by Hollis B. Chenery and others. They conclude that "in the short run, the
effectiveness of external resources depends on their use to relieve shortages of skills, savings
and imported commodities “while the long run fate of these countries depends on “the use that
is made of the initial increase in the output.”
That notwithstanding, both economists and policy makers have had doubts about the beneficial
impact of foreign resources on the economies of developing countries, especially since 1970s.
The presumed positive impact of foreign resources on the volume of savings is not supported by
empirical evidence, neither is the presumed growth. In SSA, acute economic crises have led to
poor growth performance. Most SSA countries have continued to experience serious difficulties
in managing the servicing of their relatively high stocks of external debt (Claessens et al, 1996).
Although the literature on debt hardly explains why these countries have not been able to use
the borrowed funds to generate sufficient increase in output, those critical of foreign aid in
general have maintained that it does more harm than good. On the extreme, Bauer (1991)
argues that aid increases resources to the government and therefore its patronage and power in
relation to the society. This has enabled many governments to pursue policies that retard
economic growth. As cited by White and Lensink (1999), Griffin (1970, and Griffin and Enos
1970) argue that aid can harm growth by a combination of savings displacement and increase in
the incremental capital-output ratio as a result of the lower productivity of aid-financed
investment. It has also been argued that aid might to used to finance capital intensive projects
and could even encourage corrupt government policies (White and Lensink, 1999). Greene and
3
See Hughes (1979) for a detailed history of growth of foreign capital.
pg_0018
14
Khan (1990) use statistics to show that SSA have over-borrowed, but have not been able to
generate sufficient growth and export earnings to meet their real debt obligations.
The question that needs to be answered is whether the large debt burden in HIPCs is one of the
factors contributing to the weak economic performance and the uneven pace of economic
reform in these countries. The debt overhang theory
4
"is based on the premise that if debt will
exceed the country's repayment ability with some probability in the future, expected debt service
is likely to be an increasing function of the country's output level. Thus some of the returns from
investing in the domestic economy are effectively 'taxed' away by existing foreign creditors and
investment by domestic and new foreign investors is discouraged" (Claessens et al., 1996;
p.17). Under such circumstances, the debtor country shares only partially in any increase in
output and exports because a fraction of that increase will be used to service the external debt.
The theory implies that debt reduction will lead to increased investment and repayment capacity
and, as a result, the portion of the debt outstanding becomes more likely to be repaid. When this
effect is strong, the debtor is said to be on the "wrong side" side of the debt laffer curve. In this
case, the debt laffer curve refers to the relationship between the amount of debt repayment and
the size of debt.
5
However, the idea of debt laffer curve also implies that there is a limit at
which debt accumulation stimulates growth (Elbadawi, et al., 1996). In reference to an aid laffer
curve, White and Lensink argue that there is a threshold at which more aid is detrimental to
growth. Greene and Khan (1990) assert that foreign direct investment is now negligible in
HIPCs and future prospects are worse. Fiscal deficits have led to rampant inflation thus
undermining savings incentive and more reliance on foreign funds.
The scope of debt overhang is much wider in that the effects of debt do not only affect
investment in physical capital but any activity that involves incurring costs up-front for the sake
of increased output in the future. Such activities include investment in human capital (in terms
of education and health) and in technology acquisition whose effects on growth may be even
4
The paper adopts the definition of debt overhang as discussed by Claessens et al (1996).
5
For detailed information about debt overhang and debt laffer curve, see Claessens (1990), Cohen (1988) and
pg_0019
15
stronger over time. How a debt overhang discourages private investment depends on how the
government is expected to raise the resources needed to finance external debt service and
whether private and public investment are complementary. For example, if a government resorts
to inflation tax or to a capital levy, private investment is likely to be discouraged.
Other channels through which the need to service a large amount of external obligations can
affect economic performance include the 'crowding out' effect, the lack of access to
international financial markets and the effects of the stock of debt on the general level of
uncertainty in the economy (Claessens et al., 1996). In the crowding out effect, a reduction in
the current debt service should lead to an increase in current investment for any given level of
future indebtedness (Cohen, 1993). If a greater portion of export revenue is used to service
external debt, very little is available for investment and growth.
Claessens et al (1996) argues that where foreign assistance is related to the debt and debt
service of HIPCs, the effects of a debt overhang on economic performance is a more complex
question. Debt servicing difficulties lead to a deterioration of relations with creditors, thus
reducing the amount of finance a HIPCs can access (Khan and Villaneuva, 1991).
2.2 An Overview of Empirical Studies
There have been several attempts to empirically assess the external debt-economic growth
link—the debt overhang and crowding out effects—mainly by using OLS. Most of the empirical
studies include a fairly standard set of domestic, debt, policy and other exogenous explanatory
variables. The majority find one or more debt variables to be significantly and negatively
correlated with investment or growth (depending on the focus of the study). For instance,
Borensztein (1990) found that debt overhang had an adverse effect on private investment in
Phillipines. The effect was strongest when private debt rather than total debt was used as a
measure of the debt overhang. Iyoha (1996) found similar results for SSA countries. He
concluded that heavy debt burden acts to reduce investment through both the debt overhang and
(1993)
pg_0020
16
the 'crowding out' effect. However, Cohen’s (1993) results on the correlation between
developing countries (LDCs) debt and investment in the 1980s showed that the level of stock
of debt does not appear to have much power to explain the slowdown of investment in
developing countries during the 1980s. It is the actual flows of net transfers that matter. He
found that the actual service of debt ‘crowded out’ investment.
Elbadawi, et al. (1996) also confirmed a debt overhang effect on economic growth using cross-
section regression for 99 developing countries spanning SSA, Latin America, Asia and Middle
East. They identified three direct channels in which indebtedness in SSA works against growth:
current debt inflows as a ratio of GDP (which should stimulate growth), past debt accumulation
(capturing debt overhang) and debt service ratio. The fourth indirect channel works through the
impacts of the above channels on public sector expenditures. They found that debt accumulation
deters growth while debt stock spurs growth. Their results also showed that the debt burden has
led to fiscal distress as manifested by severely compressed budgets. Using data for Cameroon,
Mbanga and Sikod (2001) found that there exists a debt overhang and crowding out effects on
private and public investments respectively. Other studies that have found a negative effect of
external debt on growth include Degefe (1992). Some studies simply use the simulation analysis
to show the impact of the debt burden indicators on economic growth under different scenarios
(e.g. Ajayi, 1991; Osei, 1995 and Mbire and Atingi, 1997).
From the literature, the channels through which indebtedness works against growth are
identified as: current stock of external debt as a ratio of GDP, which may stimulate growth; past
debt accumulation, which captures the debt overhang and therefore deters growth; and debt
service ratio to capture the crowding out effects. Debt service payments reduce export earnings
and other resources and therefore retard growth. According to Elbadawi, et al.(1996), these
debt burden indicators also affect growth indirectly through their impact on public sector
expenditures. As economic conditions worsen, governments find themselves with fewer
resources and public expenditure is cut. Part of this expenditure destined for social programs
has severe effects on the very poor. Most studies confirm debt overhang/crowding out effects.
pg_0021
17
Studies that have shown favourable effects of external debt are rare. As quoted by Mutiso
(2001), they include World Bank (1988) study for the period 1980 –86 and Chowdhurry (1994)
for Bangladesh, Indonesia and South Korea.
Most of the studies reviewed are cross-sectional in nature. While the findings are quite
revealing, there is need for case-by-case studies in view of each country’s unique characteristics.
This is particularly important given the stringent conditionalities for debt relief initiatives. In
spite of that, very few empirical studies on Kenya’s external debt exist and, even then, they do
not focus on the analysis of external debt and economic growth ( for example: Ochieng, 1991;
Manundu, 1984; Gulamhussein, 1987; and Ng’eno,1991). This study attempts to fill this gap.
The paper adopts a methodology used by similar studies (particularly the model by Elbadawi, et
al. 1996) to assess the debt overhang and crowding out effects in Kenya. Apart from the debt
variables, this model also includes policy, fundamental and shock variables. It therefore has
more channels through which indebtedness works against growth in SSA.
3.1 Model Specification
It is argued that growth in investment facilitates economic growth through the accelerator
principle. Fosu (1996) argues that debt can additionally influence economic growth via effect on
the productivity of investment. And even if debt service payments do not reduce savings and
investments significantly, they could still decrease output growth directly by diminishing
productivity as a result of the adverse change in investment mix. The impact of external
indebtedness, therefore simultaneously affects investment and economic growth. In other
words, estimating only the growth equation would underestimate the effect of external
indebtedness on economic growth since investment has been found to be a key determinant of
growth. As a result, this study assesses the impact of indebtedness on both private investment
and economic growth. The channels through which the indebtedness affects growth have been
identified as: stock of external debt as a ratio of GDP which should stimulate growth; past debt
accumulation (lagged debt-GDP ratio) which impact negatively on growth; the debt-service
pg_0022
18
ratio, which captures the crowding out effect. The final indirect channel incorporated in this
paper is net foreign financing as a proportion of the deficit. As the stock of debt and cost of
external debt servicing rise, there is little left to finance public development projects and social
services. This leads to severely compressed budgets and/or fiscal deficits. These fiscal deficits
aggravate further external borrowing as a source of financing the deficits. Therefore the net
foreign financing is negatively related to growth. Besides these variables, the model also
incorporates other policy, fundamental and shock variables. The model adopted is based on
Elbadawi et al’s (1996) model specification.
Growth Equation:
The regression equation is specified as:
GDPGR = (EDTGDP, EDTGDP
t-1
, DSR, FDGDP, FDGDP
t-1
, PINV, PINV
t-1
,
TOT, RER, HCD,INFL, GPUIV, GPUIV
t-1
)
Where GDPGR = Real GDP growth rate.
EDTGDP = Stock of external debt to GDP ratio.
EDTGDP
t-1
= Stock of external debt to GDP ratio lagged by one period (reflect
debt accumulation).
DSR
= The debt service as a ratio of export earnings (reflect the
‘crowding out’ effect).
FDGDP
= Fiscal deficit to GDP ratio.
PINV
= Current real private investment as a ratio of GDP (captures the
accelerator principle).
PINV
t-1
= Lagged private investment as a ratio of GDP.
TOT
= Terms of trade (captures external shocks).
HCD
=
Human capital development.
INFL
=
Rate of inflation (reflects macro- economic stability).
RER
= Movements in real exchange rate (reflects incredibility of
policies)
GPUIV
= Real public investment as a ratio of GDP.
GPUIV
t-1
= Lagged public investment as a ratio of GDP
Private investment is included in the model to capture the accelerator principle. The shock
variable is captured by terms of trade. The macroeconomic policy variables are captured by
inflation rate and by real exchange rate. These variables show the extent of vulnerability of the
pg_0023
19
economy to external factors and consequently to reliance on foreign resource financing. They
also show the extent of credibility of policies and their effect on economic growth. In contrast
to Elbadawi, et al.(1996), the current study assumes that the role of human capital development
is more important in explaining growth than just population growth.
Investment Equation
Interest rate as a variable is included in the investment equation to capture its effect on private
investment. The investment equation is specified as:
PINV = f(EDTGDP
t-1
, EDTGDP, GDPGR, DSR, FDGDP, FDGDP
t-1
,TOT,HCD, GPUIV,
INT
r
INFL, RER)
where INT
r
= Interest Rate (Treasury bill rate). The other variables are as defined before.
Before estimating the above equations, a test for simultaneity between investment and growth
equations was carried out to ascertain whether simultaneous equation-bias exists. The test
showed that only weak simultaneity exists. This was handled by normalizing the variables
through the error correction process. Therefore the two equations are estimated independently,
each incorporating an error correction term.
3.2 Time Series Properties
Non-stationarity of time series data has often been regarded as a problem in empirical analysis.
Working with non-stationary variables lead to spurious regression results from which further
inference is meaningless. The first step was therefore to test for stationarity of the variables. The
conventional Dickey-Fuller (DF) and Augmented Dickey-Fuller (ADF) tests were used to test
for stationarity of the series. The results of the test for the variables in levels are presented in
Table 3.1.
Table 3.1: Unit Root Tests (Variables in Levels)
pg_0024
20
Variable
DF
ADF (2)
Order of
integration
GDPGR
-2.816
-3.631
I(0)
EDTGDP
-1.419
-1.133
I(1)
TOT
-2.471
-2.319
I(1)
DSR
-1.809
-0.3838
I(1)
INT
-2.461
-1.795
I(1)
GPUIV
-2.270
-2.030
I(1)
PINV
-3.485
-2.030
I(0)
RER
0.6729
0.4319
I(1)
HCD
-4.332
-4.364
I(0)
FFGDP
-2.06
-4.249
I(0)
INFL
-2.604
-3.433
I(0)
critical values
at 5%
-2.985
-3.622
The ADF test included two lags (the number in parenthesis)
The tests show that the variables HCD, GDPGR, INFL, FFGDP and PINV are stationary
(integrated of order zero) at 5% level of significance. A graphical analysis of GPUIV showed
stationarity. The rest of the variables were found to be stationary after differencing them once.
The variables are therefore integrated of order one (I
~
I(1).
The next step after finding out the order of integration was to establish whether the non-
stationary variables are cointegrated. Differencing of variables to achieve stationarity leads to
loss of long-run properties. The concept of cointegration implies that if there is a long-run
relationship between two or more non-stationary variables, deviations from this long-run path
are stationary. To establish this, the Engel-Granger two step procedure was used. This was done
by generating residuals from the long-run equation of the non-stationary variables, which were
pg_0025
21
then tested for stationarity using the DF and ADF tests. The residuals were found to be
stationary at 5% level of significance for both tests. Consequently, an error correction
formulation was adopted.
Both the investment and growth equations were re-specified to include the error correction term.
GDPGR = a
0
+a
1
DEDTGDP + a
2
DDSR + a
3
FDGDP + a
4
PINV +a
5
DTOT + a
6
HCD +a
7
INFL
+a
8
GPUIV +a
9
DRER + a
10
ECT
t-1
+e
1t
...........................................................
Where
ECT = EDT - c
o
-c
1
DSR + c
2
TOT - c
3
RER..................................................
PINV = b
o
+b
1
DEDTGDP + b
2
DDSR + b
3
FFGDP + b
4
DTOT + b
5
DINTr + b
6
HCD + b
7
DRER
+b
8
INFL + b
9
GDPGR + b
10
GPUIV + b
11
ECT
t-1
+e
2t
.................................................
ECT is the error correction term. This term captures the long run relationship. It reflects
attempts to correct deviations from the long run equilibrium path and its coefficient can be
interpreted as the speed of adjustment or the amount of disequilibrium transmitted each period
to economic growth. The c’s can be interpreted as parameters of equilibrium relationship about
which economic theory is informative (Ndung’u 1993).
The above models with their associated lags were estimated using OLS for time series data
covering 1970-1995.
4 Estimation Results
The results of data analysis and estimation were obtained using the Generalised Instrumental
Variables Estimators econometrics computer package [PCGIVE (version 8.0].
4.1 Correlation results
pg_0026
22
Table 4.1: Correlation Matrix of Variables in levels
GDP-
GR
PINV EDT-
GDP
DSR FD-
GDP
TOT INFL INTr GPUIV RER
GDP-
GR
1.000 .613 -.560 -.293 -.143 .518 -.592 -.585 .328
-.49
PINV
1.000 -.556 -.271 -.325 .421 -.380 -.514 .318
-.60
Table 4.1 shows that there is relatively high negative correlation between economic growth
(GDPGR) and external debt (EDTGDP) and between private investment (PINV) and external
debt. There is negative correlation between private investment, interest rate (INTr) and real
exchange rate (RER). The relationship between private investment and economic growth is
relatively high and positive. Terms of trade (TOT) has positive relationship with both growth
and investment.
4.2 Estimation Results for the Growth Equation
Using the general to specific estimation procedure, the preferred model for the growth equation
is reported in Table 4.2. An impulse dummy for 1984 was added after critical analysis of
residuals, which showed a shock to the system during that year.
pg_0027
23
Table 4.2: Regression results for the growth equation
Variable
coefficient Std.
Error
t-value t-prob Partial R
2
Constant
-3.996
0.9018 -4.433 0.0044 0.7661
INFL
-0.053
0.013 -4.093 0.0064 0.7363
INFL
t-1
0.101
0.016 6.285 0.0008 0.8681
GPUIV
0.727
0.100 7.283 0.0003 0.8984
GPUIV
t-1
-0.514
0.107 -4.809 0.0030 0.7940
PINV
0.303
0.036 8.417 0.0002 0.9219
PINV
t-1
0.285
0.032 8.866 0.0001 0.9291
FFGDP
t-1
-0.045
0.007 -6.465 0.0006 0.8745
HCD
0.039
0.008 4.881 0.0028 0.7988
DEDTGDP -0.055
0.014 -3.805 0.0089 0.7070
DEDTGDP
t-2
-0.064
-0.011 -5.790 0.0012 0.8482
DDSR
0.090
0.026 3.399 0.0145 0.6581
DSSR
t-1
0.085
0.028 3.056 0.0223 0.6089
DTOT
0.035
0.004 8.563 0.0001 0.9244
DTOT
t-1
0.049
0.004 11.757 0.0000 0.9584
ECT
t-1
-0.308
0.050 -6.158 0.0008 0.8634
D1984
-2.966
0.407 -7.284 0.0003 0.8984
Note: ‘D’ before the variable symbol implies first difference of the variable
R
2
= 0.996
F[16,6] = 88.748[0.000]
s
= 0.2514 DW = 2.45
RSS = 0.379 for 17 variables and 23 observations.
Model tests
AR 1 -2F(2,4) = 2.5724[0.1913]
ARCH 1 F(1,4) = 0.17225[0.6985]
Normality chi
2
(2) = 2.3681[0.3060]
RESET F(1,5) = 0.29745[0.6089]
The diagnostic test outcomes are satisfactory— that is, AR for autocorrelated residuals, the
ARCH for heteroscedastic errors, normality test for the distribution of the residuals and the
RESET test for the regression specification. In addition to the above tests, Chow test for
pg_0028
24
establishing stability of parameters was also done. The test statistic obtained revealed that the
parameters were stable. We now proceed with discussion of the results.
Most of the variables considered in the determination of economic growth in Kenya in Table 4.2
have their hypothesised. The coefficient of current debt flows (DEDTGDP) was expected to be
positive but it’s negative. A rise in current debt flows as a ratio of GDP leads to a decline in
economic growth. This implies that even current debt flows deter economic growth. This is a
short run effect. On the other hand, the coefficient of past debt accumulation (debt lagged twice)
is negative as expected. These results confirm the existence of debt overhang problem as earlier
postulated. The results tally with the findings of similar studies (e.g. Elbadawi, et al., 1996).
However, the magnitude of the coefficients is quite small.
The positive effect of debt service ratio (both current and lagged) on economic growth was
unexpected. Both coefficients are highly statistically significant. However, the debt service ratio
for Kenya has not been overly high compared with other low-income countries. Moreover, this
is a short run effect.
Net foreign financing of deficit as a ratio of fiscal deficit (lagged once) has a negative impact on
economic growth. Rapid growth in external debt can lead to increased fiscal deficit as more
resources have to be used to service and repay the debt. This has a negative effect on economic
growth. Increased fiscal deficits further lead to increased external borrowing. Terms of trade
(current and lagged) have a positive effect on growth in the short-run. In other words,
favourable terms of trade promote growth.
A rise in private investment as a ratio of GDP (both current and lagged) has positive effect on
growth as would be expected. According to the accelerator principle, growth in investment
facilitates faster economic growth. A 1% rise in current private investment (PINV) and past
private investment (PINV
t-1
) leads to 0.30% and 0.29% rise in the rate of economic growth
respectively. Similarly, current public investment (GPUIV) promotes economic growth but
pg_0029
25
unexpectedly, past public investment (GPUIV
t-1
) was found to have a negative impact on
economic growth. That notwithstanding, current public investment promotes growth by the
highest magnitude.
Investment in human capital development proxied by primary school enrolment rate has a
positive effect on growth. An increase of 1% in investment of human capital promotes growth
by 0.04%. However, this is negligible when compared with the impact of private investment on
growth.
It has been said that inflation may stimulate growth at low and containable levels but can impact
negatively on growth at high levels. The results show that current inflation rate (INFL) deters
economic growth while past inflation rate (INFL
t-1
) stimulates economic growth. The impact of
variations in real exchange rate on growth was found to be highly statistically insignificant and
dropped from the model. A dummy to capture shocks in 1984 was found to have had a negative
impact on growth. This is due to the severe drought that occurred during that year, leading to
massive food imports.
The lagged error correction term (ECT
t-1
) included in the model to capture the long-run
dynamics between the cointegrating series is correctly signed (negative) and statistically
significant. The coefficient indicates a speed of adjustment of 31% from actual growth in the
previous year to equilibrium rate of economic growth. This is a very low speed of adjustment
implying that all errors/deviations are not corrected within one year and most of the time the
economy is operating out of equilibrium. A further discussion of what ECT entails is
worthwhile as it reveals long run relationships of the non-stationary variables. ECT is specified
as:
ECT = EDT - 42.960 - 0.386DSR + 0.095TOT - 1.73RER.............................
It can be seen that although debt service ratio had unexpected positive sign, it enters the error
correction term with the expected sign. Debt service rises with growth in external debt. The
pg_0030
26
effect of debt service ratio on economic growth is negative in the long-run. Similarly although
the coefficient of variations in real exchange rate (RER) was positive and statistically
insignificant, it enters ECT with a high coefficient of -1.73. The sign is as expected. The ECT
also shows that deterioration in terms of trade is associated with a rise in external debt.
4.2 Estimation Results for the Investment Equation
Table 4.3: Regression results for the investment equation
Variable
coefficient Std.
Error
t-value t-prob Partial R
2
Constant
11.139
3.696 3.014
0.0108 0.4308
INFL
t-1
-0.278
0.074 -3.737
0.0028 0.5379
DEDTGDP 0.361
0.093 3.871
0.0022 0.5553
DEDTGDP
t-1
-0.203
0.066 -3.068
0.0098 0.4396
HCD
0.060
0.044 1.351
0.2016 0.1320
DINTr
-0.492
0.144 -3.421
0.0051 0.4939
FFGDP
t-1
0.057
0.032 1.811
0.0952 0.2147
DDSR
-0.245
0.150 -1.632
0.1285 0.1817
DDSR
t-1
0.366
0.158 2.320
0.0387 0.3097
DRER
0.521
0.372 1.401
0.1867 0.1405
ECT
t-1
0.936
0.220 4.264
0.0011 0.6024
GPUIV
0.335
0.426 0.786
0.4474 0.0489
R
2
= 0.849 F(11,12) = 6.1471[0.0020]
s
= 1.8098 12 variables and 24 observations.
Model Tests
AR 1 -2F(2,10) = 1.5035[0.2686]
ARCH 1 F(1,10) = 0.49461[0.4979]
Normality Chi
2
(2) = 3.4464[0.1785]
RESET F(1,11) = 0.93786[0.3536]
Most variables have coefficients with their hypothesised signs. Current debt flows (DEDTGDP)
stimulate private investment while past debt flows (DEDTGPD
t-1
) deter investment. These
results are as expected. Foreign borrowing can help relieve resource shortages and if used to
pg_0031
27
finance productive investment activities, will stimulate investments and therefore promote
growth. It should also be noted that the magnitude of the impact of debt on investment is higher
than in the growth equation.
A rise in current debt service ratio (DDSR) negatively affects private investment. This confirms
the ‘crowding out’ effect of debt service on private investment. However, the coefficient is
statistically significant only at 12%. Contrarily, variation in past debt service ratio (DDSR
t-1
)
has a positive effect on private investment and the coefficient is significant at 3%.
The results in Table 4.3 show that past inflation (INFL
t-1
) discourages current private
investment. This implies that economic agents expect the previous year’s high level of inflation
rate to persist in the current period thus discouraging current private investment. Similarly, high
interest rates (DINTr) discourage private investment.
Public investment (GPUIV) crowds in private investment but the coefficient is not statistically
significant. Human capital development has a positive coefficient but is statistically
insignificant.
Foreign financing of the deficit as a ratio of total fiscal deficit (FFGDP) has a positive and
statistically significant effect on private investment. This outcome is unexpected. But it can
argued that this is likely to be the case if such financing is used for investment in public
infrastructure or other sectors that have crowding in effects on private investment.
Changes in real exchange rate (DRER) have positive but insignificant effect on private
investment. Variations in terms of trade (TOT) showed a negative but a very insignificant
coefficient and was therefore excluded from the final model. The GDP growth rate was also
found to be insignificant.
The error correction term lagged once (ECT
t-1
) has the expected sign (positive). This coincides
pg_0032
28
with the hypothesis that current stock of debt stimulates private investment. The model reports
a speed of adjustment of around 94%, which is relatively high. This implies that the deviations
/errors from the long-run equilibrium path are almost corrected in one period. The ECT
equation shows a negative and significant effect of debt service and real exchange rate on
private investment in the long run.
5 Conclusion and Policy Implications
The central focus of this study was to establish the impact of Kenya’s external indebtedness on
economic performance, specifically on economic growth and private investment. The paper also
examined the structure, magnitude, composition and determinants of Kenya’s external debt.
External debt problems in Kenya, as in most of the SSA countries, are more a concern of donor
governments and international institutions than commercial banks. A greater proportion of
Kenya’s external debt consists of official debts mainly from multilateral sources—mainly in the
form of concessional loans.
The causes of external debt in Kenya can be attributed to both internal and external factors.
Internal factors are mainly overly expansionary fiscal policies and highly distorted trade policies
especially policies that created a heavy bias against exports. The external factors include
deterioration of terms of trade leading to BOP deficits, high world interest rates and increased
protectionism by developed countries, which tended to discriminate against LDCs exports. The
limited empirical work suggests that the real value of imports and growth of industrialised
countries tend to raise the external debt burden in Kenya. In addition to these factors, drought
conditions have also contributed to external debt burden.
Using an error correction formulation, the estimation results showed a debt overhang problem
in both the growth and investment equations. These results tally with results from similar
studies (e.g. Elbadawi, et al.1996, Mbanga and Sikod, 2001). The estimation results for the
growth equation showed that not only does past debt accumulation deter growth but so do
pg_0033
29
current debt flows in the short run. The error correction term also showed that external debt had
negative implications on growth. Both private and public investments are key determinants of
economic growth. Net foreign financing as a ratio of the total deficit (lagged once) had a
negative impact on economic growth while terms of trade had a positive impact on growth.
Investment in human capital development promotes economic growth while current inflation
rate deters growth. A dummy for 1984 to capture the effect of drought , which led to reliance on
external borrowing, showed a negative effect on economic growth in Kenya. This was also the
period around which the debt burden indicators started rising significantly.
In the private investment equation, it was however found that current debt flows stimulate
investment while debt accumulation deters investment. The idea of the laffer curve implies that
there is a limit beyond which external debt ceases to promote investment. Current debt flows
will stimulate investment but over-reliance on external debt deters investment as more
resources have to be used to repay and service the debt. The magnitude of the impact of debt
directly on private investment appear to be much higher than on growth. The investment model
also showed that there is some ‘crowding out’ of current investment as a result of servicing
relatively large amounts of external debt. In contrast, debt servicing do not appear to have a
direct negative impact on economic growth. This is not surprising as such, since debt service
ratios for Kenya are relatively lower compared to other low income, HIPCs.
As indicated earlier, past attempts to resolve SSA’s external debt crisis has not borne much
fruit. The only hope now lies in the current HIPC debt Initiative, which is expected to relieve
the HIPCs of their debt burdens, with positive implications on poverty. In as much as external
debt burden is a reality in Kenya, it is also true that the country cannot achieve her goal of
becoming an industrialised nation by the year 2020 without external assistance in form of
foreign funds. Moreover, the results show some indications that additional external resources
could stimulate private investments. In view of the current economic recession and the negative
net outflows, the results obtained from this study support the need for Kenya to be considered
for comprehensive debt relief measures. The simultaneous attainment of sustainable economic
pg_0034
30
growth and external debts appear difficult at the moment and could remain elusive if aggressive
measures are not undertaken. The government could play an important role in stimulating the
economy if the resources obtained from the debt relief initiatives are targeted at productive
public investments with the resultant crowding in effects on private investment, and social
spending for the poor. In the past, most public investments have been highly uneconomical and
inefficient.
Being the key source of indebtedness, the challenge to the Government remains that of ensuring
efficiency in delivery of services and increased productivity of public investments. Efforts are
already being directed towards this direction through privatisation of parastatals and down-
sizing of the civil service, but more has to be done to revamp the economy to a higher,
sustainable growth path. In the long run, foreign savings should supplement but not replace
domestic savings.
Proper macro-economic management of the economy as a whole is important since it also
determines the volume and servicing of external debt, as well as the credit rating. Availability of
external finance should be consistent with a policy framework that is credibly maintained
(fiscal stance, exchange rate policy, interest rate policy, pricing policy etc.). It is important to
create credibility including political will in order to spur investor confidence for both local and
foreign investments. Commitment to re-building credibility is a key challenge for Kenya.
Development activities could also be financed through increased export earnings spearheaded
by an export-led growth strategy. It is high time the strategy of export diversification away from
the traditional exports was made a reality since there have been limited measures to achieve
this goal. As part of broader strategy to assist the HIPCs out the debt crisis, the international
community should provide a conducive environment for exports from the low-income countries
including Kenya. Efforts to increase exports have been frustrated by protectionist strategies
taken by industrialised countries, quota system and low world prices for LDCs’ products. More
strategies similar to the current African Growth Opportunity Act should be encouraged. Kenya
pg_0035
31
still has a chance of overcoming her external debt problems by cultivating the right policies and,
through the debt relief/reduction support.
pg_0036
32
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APPENDIX
DEFINITION OF TERMS
The World Bank's Debtor Reporting System (DRS), International Monetary Fund (IMF), the
Organisation for Economic Development and Cooperation (OECD) and the Bank for
International Settlements (BIS) formed a Working Group which has published a common
definition of external debt as defined below:
Gross External debt is the amount, at any given time, of disbursed and outstanding contractual
liabilities of residents of a country to non residents to repay principal, with or without interest,
or to pay interest, with or without principal (Klein, 1994; P. 56).
Contractual Liability: It is an obligation to make payments to an agreed schedule. (Equity
participation is excluded).
Disbursed and Outstanding: Means that debt includes only committed amounts drawn-down,
not yet repaid, or cancelled. It does not include future interest payments. Undisbursed amounts
are exceeded. Disbursed debt outstanding equals to the cumulative disbursements, less
repayments, amount cancelled and amount restructured.
Disbursements: Are drawings on loan commitment during the year specified. That is, the
amount of a loan that is utilised in the accounting period.
Interest: The amount paid to the lender during the accounting period as compensation for use of
his capital.
Total debt service payments: The sum of amortization and interest payments.
Write offs: The annulments of disbursed debt.
Restructuring: Are the amount of principal or interest payment due but deferred, rescheduled,
refinancing or exchanged as a result of debt-restructuring agreement. Rescheduled principal
involves a transfer of the amount from the original loan to a new loan. Debt relief as debt
cancellation is treated as a write-off.
Arrears: Arrears in total debt service at the end of any period equals the arrears in total debt
service at the end of the previous period plus the debt service scheduled to be paid, but minus
debt service paid, in the period.
pg_0042
Publicly Guaranteed External Debt: Is usually defined as an external debt obligation of a
private debtor which a public entity guarantees for repayment.
Net Flows (or net lending or net disbursements) are disbursements minus capital repayments.
Net transfers are net flows minus interest payments of disbursement minus total debt service
payments.
Creditworthiness: Refers to a country's acceptability for further credit by virtue of its record of
repayment of past debts. It reflects the performance on external debt management. If it is
positive, the creditworthiness rating of the country is high on the international capital market.
Flows: These are transactions in a defined period, such as a calendar year. Flow concepts are
loan commitments received, disbursements, amortization payments, interest payments, debt
cancellations, debt write-offs, and amounts restructured.
Stocks: Relate to amounts outstanding at any particular time. Stock concepts are disbursed and
outstanding debt, undisbursed balances, and arrears of principal and interest.
Liquidity problem refers to the inability of a country to service its debts now in the amount
initially contracted (Osei, 1995).
Solvency: Relates to whether the value of a country’s liabilities exceeds the ability to pay at any
time. A country is insolvent when it is incapable of servicing its debt in the long run
(Ajayi,1991;Osei,1995).
Short-terms debts are those with original maturity of one year or less.
Long -term external debt is defined as debt that has an original or extended maturity of more
than one year and that is owed to non residents and repayable in foreign currency, goods or
services.
Variable interest rate LDOD is long term debt with interest rates that float with movements in
a key market rate such as the London interbank offer rate(LIBOR) or the U.S. prime rate. This
item conveys information about the borrower’s exposure to changes in international interest
rates.
Use of IMF credit denotes repurchase obligations to the IMF with respect to all uses of uses of
IMF resources (excluding those resulting from drawings in the reserve tranche) shown for the
end of the year specified. Use of IMF credit comprises purchases outstanding under the credit
pg_0043
tranches, including enlarged access resources and all special facilities,trust fund loans, and
operations under the structural adjustment and enhanced structural adjustment facilities.
Official debts are those obtained from national governments or their agencies or from
international agencies like the World Bank and IMF.
Private debts consist of those obtained from private creditors which include the Euro-dollar
loans, supplier credit experts and loans from private commercial banks.