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.