Getting off the debt treadmill not easy

Mueni and Mwikali are workmates. They have each taken a Sh3 million loan. Mueni earns Sh100,000 and Mwikali earns Sh300,000 per month.

Who has the bigger debt burden? Mueni will be indebted to the tune of 250 per cent of her annual income, while Mwikali’s debt will just be more than 80 per cent of her annual income.

It may appear that Mueni is more indebted, but this could be very misleading. Mueni’s loan is a 20-year mortgage, while Mwikali’s is a three-year car loan. Mueni’s repayment works out to about Sh30,000 per month, and Mwikali’s to Sh100,000 per month, in effect to a third for their respective incomes.

This information is more helpful. Mueni has the smaller debt burden since she does not pay rent and with every instalment, her wealth increases. Mwikali’s car depreciates. In effect, Mueni is saving, while Mwikali is consuming. Mueni seems to be the more responsible borrower.

But this conclusion would be hasty as we do not know anything else about Mueni and Mwikali other than that they are workmates.

It turns out that the women work for Kenya Airways. Mueni is a mid-career flight attendant, while Mwikali is a young pilot. In effect, Mwikali’s future earning potential is much higher than Mueni’s.

Mwikali’s car loan does not look as imprudent as we might have presumed without knowing a little more about the two debtors. Moreover, if they were to be laid off, Mwikali’s prospects would be considerably better than Mueni’s. She could easily sell her car and move on to Gulf airline, while Mwikali would have a harder time getting a well paying job.

ASSESSING INDEBTNESS

This illustration captures the complexity of assessing indebtedness, be it across consumers, businesses or countries. What this tells us is that numbers without context tell us very little, if anything at all. To assess our debt situation, we need both numbers and context.

Many people, for instance, wonder why our debt, which is only 50 per cent of GDP, should be a concern, while many industrialised countries’ debt to GDP ratios are more than double ours, yet they are not in distress.

Take the US, with a debt equivalent to 107 per cent of GDP. The US spends only eight per cent of revenue to service this debt. We on the other hand are spending more than a third of our revenue to service debt which is less than half that of the US relative to income. What explains this?

All US federal public debt is in dollar denominated government securities (bills and bonds) that the rest of the world wants to hold.

They only pay interest on it. Our foreign debt is predominantly bank debt. We pay both interest and principal. Second, as long as the US dollar is the world’s reserve currency, the US can print money to pay its debt. Because these dollars circulate abroad, they do not fuel inflation in the US.

The more global trade expands, the more dollars the US can print (we call this seigniorage revenue). We could also print money to pay our domestic debt, if we want to go the Zimbabwe route. For these reasons, the US gets to borrow at the lowest rates in the world. In fact, the interests on US securities are often used as the reference global “risk free” rate. When it comes to debt, the devil is in the detail.

DEBT INCREASED THREE TIMES

As at end of September 2016, our national public debt stood at Sh3.6 trillion (US$35 billion) up from Sh1.5 trillion (US$18 billion) at the end of 2012, that is, the debt has increased 2.3 times. The outstanding debt is made up of Sh1.7 trillion foreign and Sh1.85 trillion domestic debt. Both have increased at about the same rate.

However, the composition of debt has changed a lot.

Four years ago, 60 per cent of our foreign debt was owed to multilateral lenders (World Bank, IMF, African Development Bank) and one third to bilateral lenders (i.e. government owned development finance institutions).

We had very little commercial debt. Today, 26 per cent of our foreign debt is owed to commercial creditors, namely bondholders and commercial banks. The share of multilateral has fallen to 42 per cent. Bilateral debt has remained at 32 per cent.

However, China now accounts for close to 60 per cent of bilateral debt, up from 25 per cent four years ago. Commercial borrowing and Chinese debt account for close to 70 per cent of the foreign debt increase.

On the domestic front, there is a marked increase in short term borrowing. The share of Treasury bills (less than a year maturity, but typically three and six months) has doubled from 17 to 33 per cent of the domestic debt.

In summary, the Jubilee administration’s debt strategy has entailed not just a huge increase in debt but also a shift from cheaper to more expensive foreign debt and from longer term to short term on both the domestic and foreign borrowing.

WEAK SHILLING

Public debt is paid out of government revenue. This year, our budget for foreign debt service is Sh97 billion up from Sh36 billion four years ago. This is a 170 per cent increase, as compared to an 80 per cent increase in government revenues. But this is the thin edge of a wedge.

Next financial year’s foreign debt service bill will shoot up to Sh183 billion, representing a 400 per cent increase in five years.

Government revenue has grown by just over 11 per cent per year over the period, which works out to a doubling of revenue over the period, against a five-fold increase in debt service outlays. This is akin to Mueni’s salary doubling to Sh200,000 and her monthly mortgage payment increasing to Sh150,000. Some Kenyans who had mortgages in the 90s will be familiar with this predicament.

What explains this escalation in foreign debt service outlays? Three things.

First, commercial debt is more expensive than multilateral and bilateral debt. If for argument’s sake the Eurobond debt was a World Bank “IDA” loan on the most favourable terms (40 years, 10 year grace 0.5 per cent interest), our annual repayment would be $80 million (Sh8.3 billion) per year, and we would only have started paying the principal in 2025. By contrast, we are paying double that amount ($182 million) in interest on the Eurobond per year.

The second is the exchange rate movement, specifically, the weakening of the shilling against the dollar and other hard currencies. In 2014, the annual interest charge on the Eurobond was in the order of Sh15.7 billion at Sh87 to the dollar. At Sh103 to the dollar, the same dollar amount is Sh18.5 billion close to Sh3 billion more.

The third and most significant is the change in structure of the debt. You may recall that $605 million (Sh62.7 billion) of the Eurobond proceeds was used to pay-off a “syndicated” bank loan.

Syndication means co-financing of a loan by many banks principally to reduce the risk exposure to a single borrower. These loans are similar to bonds in structure, that is, the borrower pays only interest during the tenure of the loan and the full principal in a single payment at maturity.

The government had taken out the loan two years earlier and the principal due in June 2014. In fact, its repayment was the original purpose for which the Eurobond issue was conceived.

CHINESE RAILWAY DEBT

Since then, the government has taken out two similar loans for $750 million (Sh77.8 billion) and $600 million (Sh62.2 billion) respectively. The step jump of the foreign debt service outlays from next year reflects the effect of the structure of these loans on our repayments.

The government has not been forthcoming with the terms of the Chinese railway debt. Independent sources indicate that we took out two loans of $1.6 billion each, a 15-year one with five-year grace and a 20-year one with seven-year grace period.

This means that we begin paying the principal amounts in 2018 and 2020. Both will add $280 million (Sh29 billion) at current exchange rate) to our annual debt service.

The Treasury has recently disclosed that it is in the process of syndicating another $1 billion this financial year. Evidently, short term commercial debt has become a regular source of deficit financing. It is the new normal. The $750 million syndicated loan taken out in October 2015 falls due in October this year.

INVESTOR CONFIDENCE

The only way to pay it off is either to raise another Eurobond, which is unlikely, or to refinance it with yet another syndication. The syndication they are arranging now will fall due early in 2019. The five year tranche of the Eurobond, another $750 million, also falls due in 2019. This is what I described in a previous column as a debt treadmill.

Getting on the debt treadmill is easy, getting off not so. There are three ways of going about it. We can grow out of it, that is, economic growth generates more government revenue which in turn reduces the burden of the debt service relative to the government’s income.

But since growth is the expectation that the borrowing is predicated in the first place, an onerous debt burden is indication that the investment gambles are not paying off.  To pay for itself, the railway will have to generate as much cash as Safaricom.

It is a very tall order. A heavy debt burden also undermines investor confidence because investors anticipate it will have to be resolved painfully at some point.

The second remedy is austerity. Austerity means downsizing government and using the money saved to reduce debt. Typical austerity measures include reducing the government workforce, scaling down capital spending, privatisation, removing subsidies and raising taxes.

The problem with austerity is that it can cause the economy to contract which in turn reduces the government revenue and in effect, its capacity to service the debt. This is Greece.

The third option is debt restructuring which entails refinancing debt that is falling due now with debt that will be repaid much later, or short term debt with long term debt, or bank debt with market debt, whatever it is that will reduce the current debt service outlays.

The challenge here is that the prime candidates for refinancing our expensive debt are the multilateral lenders such as the World Bank and IMF and their money comes with austerity strings attached.

Sooner or later, our debt ladder will run out of rungs. You can take that to the bank.