Impact of External Debt on Inflation and Exchange Rate in Kenya
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Date
2020
Authors
Arisa, Gibson Marienga
Journal Title
Journal ISSN
Volume Title
Publisher
Kenyatta University
Abstract
External financing is necessary for many low-income countries to achieve their development
objective. External borrowing compliments savings and permits an economy to carry out
investment activities. It is expected to provide financing necessary for investment in
infrastructure and productive economic activities thus contributing to economic growth and
macroeconomic stability. Kenya has depended to a great extent on external borrowing to finance
its budget. Data from National Treasury and Central Bank shows that Kenya’s external debt
surged from 18.8 per cent of GDP in 2013 to 30 percent of GDP as at December 2017. At the
same time, exchange rate depreciated by 30.52 percent between 2010 and 2017 while inflation
rose from 5.72 percent in 2000 to 8.0 percent in 2017. These show that although external debt is
expected to help achieve macroeconomic stability (low inflation and stable exchange rate), this
has not been achieved. There is a need to study the influence of Kenya’s foreign borrowing on
macroeconomic indicators. Therefore, this study sought to examine the impact of external debt
shocks on inflation and exchange rate. The objectives of the study were achieved using the
structural vector auto regression model. Quarterly data from Central Bank of Kenya, Kenya
National Bureau of Statistics, National Treasury, World Bank and International Monetary Fund
database for the period 1993 to 2018were used. Diagnostic tests such as autocorrelation and
normality were carried out to ensure robust results. The results show that a one standard
deviation shock of external debt to GDP ratio results in a negative effect on inflation for about
four quarters, after which the impact recovers slowly. This impact then improves consistently up
to the eleventh quarter when it starts to level off. The impact does not decay even after the 12th
year. A one standard deviation shock of external debt to GDP ratio depreciates real effective
exchange rate. The exchange rate depreciates for the first six months, but the impact remains
negative. The impact turns positive after six quarters and improves slightly for the rest of the six
quarters. Therefore, an increase in external debt leads to a rise in inflation and weakening of
domestic currency in Kenya. This study recommends that external borrowing should be
prudently used in productive activities that can raise investments, reduced inflation and improve
the country’s exchange rate. In addition, proper debt management policies should be designed to
ensure a balance between bearable and durable external debt.
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Description
A Research Project Submitted to the Department of Economic Theory
in the School Of Economics in Partial Fulfilment of the Requirement
for the Award of a Degree of Master of Economics of Kenyatta
University
Keywords
External Debt, Inflation, Exchange Rate, Kenya, External financing, External borrowing