Domestic Debt, External Debt, and Inflation: A Case of Public Debt Liquidation Using Inflation in Kenya
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Date
2025-06
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Kenyatta University
Abstract
In the period between 2009 and 2021, Kenya’s debt rose from 32.2% in 2009 to 67.3% in 2022 relative to the gross domestic product. High indebtedness has led to negative economic consequences including slowed economic growth, inflation, depreciating exchange rates, income inequality, private sector crowding-out, low capital formation, and debt overhang. Kenya adopted Medium Term Debt Strategies in 2001 with concerted policies to decrease external borrowing while allowing access to external concessional debt, slowing down the accumulation of domestic debt, longer maturities, and adopting debt ceilings. This notwithstanding, concerns about Kenya’s public debt sustainability persists. This necessitates continuous exploration of different strategies to ensure its sustainability. Shock inflation has been demonstrated to contribute significantly to public debt liquidation in developed countries. Though a potential tool for public debt management, the effectiveness of shock inflation in liquidating public debt has neither been established nor considered for developing countries like Kenya. This study used 1983–2022 Kenyan data to investigate the possibility of public debt liquidation using shock inflation, making a distinction between domestic and external debt. Following appropriate time series methodology, the autoregressive distributed lag was adopted to model domestic debt to gross domestic debt ratio as the autoregressive distributed lag error correction model was adopted to analyse external debt to gross domestic debt ratio. Five- and ten-year dynamic baseline forecasts were drawn up and investigated against the debt level after a 2% shock inflation treatment. The findings of this study suggested that two% shock inflation had a minimal impact on domestic debt in five years and only decreased by 0.024% in ten years. In contrast, it increased the external debt level by three and a half percent in five years and decreased external debt level by 282% in 10 years, possibly eliminating it. This is consistent with global findings that longer-term debt is more sensitive to shock inflation. Further, the inflationary effect may need a prolonged period to realise its benefits. Results will contribute to new literature to inform fiscal policy on the role of inflation in public debt management in developing countries like Kenya
Description
A Research Project Submitted to the Department of Economic Theory in the School of Business, Economics and Tourism in Partial Fulfilment of the Requirement for the Award of a Degree of Master of Economics (Policy & Management) of Kenyatta University, June 2025.
Supervisor
Julius Korir