The role of bond markets in financing domestic debt in Kenya

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The role of bond markets in financing domestic debt in Kenya

Deficit Financing

1.0 Background

Deficit financing of public spending remains at the heart of academic debate and policy making in less developed countries (LDCs) throughout post colonial era. The development of a budget deficit is traced to the Keynesian inspired expenditure led growth theory of the 1970s. The concept behind the model is that the government has to initiate the aggregate demand side of the economy in order to stimulate economic growth. Keynes (1936) argued that government spending in excess of revenue aimed at reversing economic decline and/or accelerating economic growth and employment is justified.  This model states that an increase in the government spending stimulates the domestic economic activities and crowds in private investments through provision of legal infrastructure that ensures physical and intellectual property rights and by undertaking investments that deepen the physical and human capital infrastructure in the country. If government increases its expenditure it will lead to an increase in private investment through multiplier effect. The Keynesian proposition can be illustrated by denoting change in government expenditure as ∆G and the corresponding change in national income as ∆Y.  Thus the multiplier of government expenditure is given by ∆G/∆Y where ∆Y>∆G. This implies that the government expenditure multiplier is larger than 1 because according to Keynesian consumption function C=C(Y-T)………1. When a government increases spending in infrastructure, education health and technology this will create an enabling environment for private investment which in turn increases national income.


The budget or fiscal deficit is the amount by which the government’s expenditures exceed its receipt during some specified time period normally one year .Countries have different ways of determining which items to include in the expenditure and receipt side of the budget. For example, in United Kingdom, a budget deficit is defined as the excess of current expenditure over current revenue while in United States of America (USA) a fiscal deficit refers to the gap between budgetary expenditure. In Kenya the overall budget deficit is the difference between receipts (revenue plus foreign grants received) and recurrent plus development expenditure.

There are three types of fiscal policy which include: neutral policy where the economy is balanced and all the government spending is fully funded by tax revenue, an expansionary fiscal policy where government spending exceeds tax revenue and contractionary fiscal policy where government spending is lower than tax revenue collected. Majority of the Sub Saharan Africa (SSA) countries have always had an expansionary fiscal policy where government expenditure exceeds its receipts.


Budget Deficit Trends in Kenya

Source: Central Bank of Kenya, Monthly Economic Review issues.

The fiscal account in Kenya has been in deficit for many years with the fiscal deficit exceeding 5% of the Gross Domestic Product (GDP) in some years. In the recent years (2008 and 2009) the budget deficit has risen to – 77.2 billion and -110.6 billion respectively due to increase in government expenditure from 405.2 billion in 2007 to 621.9 billion in 2009.

Over the years SSA countries had relied on foreign borrowing to cover for their budget deficit. This is because SSA countries could access foreign financing at very low interest rates and for very long maturity periods. As the global crisis continued to persist, concerns have emerged that donors’ funds may turn out to be scarcer and therefore having sufficiently liquid domestic bond markets is becoming increasingly important. The global crisis has left majority of SSA countries highly indebted making then unable to borrow internationally. Eichengreen and Hausmann 1999 used the term ‘’original sin’’ to refer to the inability of developing countries to borrow abroad in their own currencies.  They argued that if a country’s external debt is denominated in a foreign currency, this result in a currency mismatch such that in the event of a currency crisis a depreciating domestic currency leads to balance sheet problems which become a key source of financial instability and possibility of huge loans.  Also the supply of foreign financing is determined by the aid agencies that impose many conditions to funds given to these economies and since these aids are often linked to project financing they cannot finance a government’s recurrent expenditures or capital projects.

To bridge the gap left by the scarce external funding there was need to develop domestic market to offer alternative method of financing. Government securities market development through issuance of government securities like treasury bonds and treasury bills is one of the alternatives. The only essential difference between Treasury Bonds and T-Bills is the tenor or commitment period between investment and maturity. T-Bills by definition must have a tenor of less than 365 days, whereas Treasury Bonds have a tenor of more than one year. Treasury Bonds in Kenya can be trades in the secondary market more easily with the establishment of Automated Trading System (ATS) making them more attractive and they also offer higher return than Treasury Bills.

A bond is a debt instrument and it represents an agreement on the part of the borrower (issuer) to make a series of regular payments (coupons) to the lender (holder of the bond) plus final repayment of the principal on maturity date. The government securities market is at the core of financial markets in most countries. It deals with tradable debt instruments (Treasury bills and Treasury bonds) issued by the government for meeting its financial requirements. The development of the primary segment of this market enables the managers of public debt to raise resources from the market in a cost effective manner with due recognition of the associated risks.

Kenya’s bond market traces its origin back to the 1980s when the Government of Kenya first launched a bid to use treasury bonds to finance government deficit. However, the Kenyan bonds market remained inactive and the government issued Treasury bill when they wanted to borrow domestically (Rose N & Justus A). During 1990s the Kenyan economy experienced increased government expenditure outweighing increase in revenue. The decline in revenue was partly due to bad relationships with both bilateral and multilateral donors which led to drastic reduction in foreign aids (Beatrice 2010). In 2001 the Kenyan bonds market experienced a turn around when the government re-launched treasury bonds. Since then the government bond market have played a very big role in financing the government budget (Rose N & Justus A.) Currently the government has an auction every month where they reopen an existing issue or open a new tender. The maturities have also been increased and in year 2010 CBK issued the first Treasury bond for 30 years. The government aim in increasing the duration of bonds is to reduce the rollover and other market risks in the debt stock.

The government securities market is  regarded as the backbone of fixed security as it provide the benchmark yield and imparts liquidity to other financial markets. The government securities market acts as a channel for integration of various segments of the domestic financial market and helps in establishing inter-linkages between the domestic and external financial markets. A vibrant secondary segment of the government securities market helps in the effective operations of monetary policy through application of indirect instruments such as open market operations for which government securities act as collateral.

Herring and Chatusripitak (2001) and PECC (2004/5) argued that bond markets are central to the development of an efficient economic system and therefore there is need to develop these markets. They provide greater investment opportunities for both retail investors and financial institutions and help deepen financial markets. The government bonds market belongs to a larger financial services sector which in 2010 contributed 70 per cent to gross domestic debt.  Table 2 shows the composition of domestic debt by instruments from year 2000 to 2010. As the government debt continue to increase from Kshs.1, 959,908 Million in 2000 to Kshs 7,989,837 Million in 2010 treasury bonds have the highest growth from Kshs. 350, 646 Million in 2000 to Kshs. 5,570,148 in 2010.

Table 2


      (shillings million)


Treasury Bills*

Treasury Bonds

Government Stocks

Overdraft at Central Bank

Advances from Commercial Banks

Other Domestic Debt**

Total Domestic Debt***

































































































* The stock of Treasury bills includes Frozen Government Debt

** Other domestic debt includes Items in transit,Securities rediscounted and Tax Reserve Certificates

*** Gross Domestic debt excludes IMF funds on-lent by CBK to Government which are accounted

     for under External Debt

Source: Central Bank of Kenya

The government securities market has witnessed significance transformation across countries over years in terms of instruments issuance, trading and settlement infrastructure and investor confidence in the market.  In the recent past the Kenya’s bonds market has become more vibrant resulting to government shifting from only issuance of treasury bills to long maturity debt with the duration increasing up to 30 years. The government aim in increasing the duration of bonds is to reduce the rollover and other market risks in the debt stock.

In the recent past this market has turned to be one of the biggest avenues of investment by commercial banks, pension scheme and insurance companies. Some of the things that have seen rapid growth of the bond market in Kenya are the capital market reform processes which include tightening the regulatory framework and establishment of a fixed income securities trading segment at the Nairobi Stock Exchange (NSE) which saw a successful introduction of Automated Trading System (ATS) for bonds enhancing efficiency. The ability of these firms to have two proprietor books Hold to Maturity (HTM) and Available for Sale (AFS) have increased liquidity of government which is an incentives for investment. The ability of commercial banks to use the secondary market as an avenue of borrowing and restating bond prices through sale buy backs have increased liquidity in this market. The government has also made the investment more attractive to large investors such as banks and pension schemes by exempting them tax on coupon received. Diversification of the maturities with the longest issue being 30 years which has reduced risk and the reopening of existing bonds and has also played a role as an incentive since the liquidity of these bonds have increased.

Brian Kahn (2005) argues that generally there is a positive relationship between economic growth and financial sector development, although there may not always be agreement on the direction of causation. He says that “original sin” has led to development of bond market where the government prefers borrowing from within hence being in control of what to finance with these funds. The objective of the government has been to maintain stability in treasury securities interest rates, lengthen the average maturity of the domestic debt through sustained efforts to restructure the debt away from the short tenor treasury bills to longer tenor treasury bonds, and develop a yield curve to provide a basis for pricing corporate bonds.

There exists a direct relationship between fiscal deficit and significant issuances of government debt securities, the development of the bonds market is inextricably linked to the direction and management of fiscal policy. The extent to which fiscal spending is financed through the sale of government bonds in open competitive markets and the degree to which this sustains a critical level of supply of government debt securities has important implications to the development of a country’s economy.

Why develop Bond markets?

There are several good reasons for developing government bond market. According to E. Mohammed (2009) government bond act as a guide for the investment of all financial securities and stock since it forms the backbone of a modern securities market. The government bonds perform the following critical roles namely:

Financing channel- The government uses treasury bonds to fund budget deficits. According to Brian Kahn domestic debt markets  helps to reduce overreliance on aid flows. Domestic debt has increased because of a need to fill the shortfall caused by the decline in the supply of foreign aid and inability of these aids to finance capital expenditure.

Generator Channel- Central Bank (CB) uses the government bonds to conduct Open Market Operations (OMO) for the management of liquidity and interest rates. As a monetary tool they play the role of stabilization of supply of money in the economy. The enhanced ability of the government to raise resources from the market at market determined rates of interest reduce monetization as the government does not borrow directly from CB.

Motivational channel – Government bond act as a guide for the investment of all financial securities and stock since it forms the backbone of a modern securities market. Herring and Chatusripitak (2001) and PECC (2004/5) argue that bond market are central to the development of an efficient economic system, and there would be additional significant benefits if bond markets are developed. They provide greater investment opportunities for both retail investors and financial institutions and help deepen financial markets. By providing an alternative source of financing, they reduce conc.............

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