The relationship between budget deficit financing and private investment in Kenya
The large budget deficit and its financing from the sale of government securities in the open market has rekindled debate on the possibility of crowding out of private investment in Kenya. The debate is especially relevant given that the Economic Recovery Strategy Paper (2004) has put emphasis on the private sector and private investment as sources of growth. This study examines the relationship between budget deficit financing through selling of treasury bills and bonds in the open market and private investment to establish the possibility of crowding out. Two schools of thought exist on the crowding out phenomenon. One school of thought believes that excessive domestic borrowing from the open market to finance the budget deficit reduces private investment through making interest rates to increase and thus making borrowing expensive. The Ricardian equivalence on the other hand, through its assumptions disputes the existence of a relationship between private investment and budget deficit financing. To carry out the study, data from IFS, February 2005 CDROM and various Statistical Abstracts were collected and used. Data were tested for stationarity and cointegration after which a cointegrated VAR model was estimated. The results of the VAR estimation show that private investment is significantly affected by its first lag and the first lag of domestic debt to GDP ratio. From the impulse response analysis, private investment responds to innovations of domestic debt, public investment, and growth in GDP and interest rates within the first 10 to 15 years. In light of the findings, it can be noted that government domestic borrowing from the open markets crowds out private investment.