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Moody’s has downgraded Kenya’s sovereign rating into junk territory, citing the country’s diminished capacity to implement a fiscal consolidation strategy, amid political and social unrest.

The rating agency says the downgrade of Kenya’s creditworthiness from B3 to Caa1 is a result of several factors, primarily linked to the withdrawal of planned tax hikes by President William Ruto.

The tax hikes, which were to be implemented through the Finance Bill 2024, to raise an additional Sh346 billion, were met with mass protests that turned violent and claimed at least 40 lives.

“The downgrade of Kenya’s rating reflects significantly diminished capacity to implement revenue-based fiscal consolidation that would improve debt affordability and place debt on a downward trend,” Moody’s said.

Both B3 and Caa1 ratings indicate significant credit risk, but they fall into different categories within Moody’s rating scale. While both B3 and Caa1 ratings indicate speculative and high credit risk, a B3 rating is somewhat more favourable than a Caa1 rating, suggesting a slightly weaker ability to meet financial commitments and a significant risk of default.

Budget deficit

The rating signals that Kenya has significantly weakened its fiscal position, making it more challenging for the government to reduce its budget deficit and state borrowing.

To close the fiscal gap, the government has directed state agencies to cut expenditures by up to 15 per cent of their approved budgets until a supplementary budget is passed. President Ruto has emphasized that this reduction in expenditure will be borne equitably by both the national and county governments.

“Kenya’s domestic funding conditions have deteriorated considerably over the past two months, with very low net domestic issuance contributing to financing shortfalls and delays in government spending,” Moody’s said. This has led to delays in salary payments, transfers to county governments, and an increase in government arrears.

Without access to international bond markets, Kenya will have to rely primarily on concessional financing from multilateral institutions and commercial syndicated loans to meet its external financing needs. This limited financing flexibility will spike the government’s liquidity pressures.

It is a combination of these factors which have significantly increased the government liquidity risks, ultimately leading to the Caa1 rating downgrade by Moody’s, a downgrade that highlights the urgent need for the Kenyan government to address its fiscal and financing challenges to stabilize its economic conditions and reduce risks for investors.

Even with the proposed spending cuts by the Ruto administration to compensate for lost revenue, Moody’s expects this gradual fiscal consolidation to occur at a slower pace than previously anticipated, leading to weaker debt affordability for a longer period.

The agency noted that in the context of heightened social tensions, it does not expect the government to be able to introduce significant revenue-raising measures in the foreseeable future. This downgrade reflects heightened risks for investors and underscores the country’s struggling fiscal outlook and revenue challenges. The move signals increased financial risks for Kenya, affecting both government finances and investor confidence.

Moody’s expects Kenya’s interest-to-revenue ratio to peak at 28 per cent in fiscal year 2023, remaining at 26 per cent in the subsequent two years, further exacerbating the country’s debt affordability issues.

Significant challenges

With a negative outlook, Kenya faces significant challenges in narrowing its fiscal deficit. The government needs to explore funding options carefully, considering the impact on debt sustainability.

This may involve relying more heavily on concessional financing from multilateral financial institutions. Investors may become more cautious about lending to Kenya or investing in its bonds, leading to higher borrowing costs for the government. This could result in increased interest rates on debt, impacting the broader economy.

In the near term, the downgrade is expected to have several implications for ordinary citizens, including higher interest rates and borrowing costs, inflation and currency depreciation, job market uncertainty and reduced investment, challenges in social services and public spending, and overall erosion of confidence and well-being.