Delicate balance between fiscal space and economic expansion

Across many emerging economies, fiscal space remains constrained as governments grapple with rising expenditure pressures, increasing debt obligations, and macroeconomic uncertainties. Kenya is no exception.

The trend among developing economies has been one of expanding debt, largely driven by infrastructural investment, social spending, and efforts to buffer against external shocks.

This has resulted in a growing stock of public liabilities that often outpaces asset accumulation, leading to increasingly negative International Investment Position (IIP) balances.

A persistently negative International Investment Position (IIP) often reflects deep structural imbalances, linking closely to fiscal deficits, current account debt, and broader macroeconomic vulnerabilities.

Countries with sustained fiscal deficits often finance their budget shortfalls through external borrowing, increasing foreign liabilities and worsening the IIP over time.

Simultaneously, current account deficits, driven by weak export performance or high import dependence, require continuous capital inflows, further exposing the economy to external shocks.

When fiscal and current account deficits persist, the growing reliance on foreign debt intensifies vulnerability to exchange rate fluctuations, capital flight, and higher debt-servicing costs. A depreciating domestic currency amplifies these risks by raising the real burden of external debt, worsening the debt-to-GDP ratio, and putting pressure on foreign exchange reserves.

The interaction between a negative IIP, twin deficits (fiscal and current account), and external borrowing creates a cycle of increasing external dependence, making the economy susceptible to global interest rate shifts, credit downgrades, and sudden reversals in capital flows, further complicating debt sustainability and economic stability.

For countries in this position, managing debt dynamics becomes critical, with fiscal consolidation often cited as a necessary path forward. Fiscal consolidation, in essence, refers to policies aimed at reducing budget deficits and stabilising public debt.

This is typically achieved through tighter fiscal policy—cutting government spending, increasing taxes, or a combination of both. However, fiscal consolidation carries its own trade-offs. In some cases, aggressive tightening measures can slow economic growth, dampen aggregate demand, and even push an economy toward recession.

For instance, Greece’s severe austerity measures post-2010, including deep spending cuts and tax hikes, resulted in a prolonged economic contraction, where GDP shrank by over 25 percent and unemployment soared beyond 27 percent, ultimately worsening its debt-to-GDP ratio.

Similarly, Argentina’s IMF-backed fiscal tightening in the late 1990s exacerbated a recession, leading to a financial collapse and debt default in 2001.

The delicate balance between fiscal restraint and economic expansion calls for innovative approaches to financing development without placing excessive strain on public debt. Portugal, after suffering from stagnation due to austerity measures in the early 2010s, shifted toward pro-growth policies in 2015, which helped reignite economic recovery.

These cases highlight the risks of over-reliance on fiscal consolidation and the need for policies that ensure both fiscal stability and economic growth.

One promising avenue lies in harnessing private sector investment to complement public sector financing. Kenya’s private sector has demonstrated a strong ability to attract capital, largely due to its efficiency, profitability, and diversified investment avenues.

Over the past decade, venture capital (VC) inflows have surged, with Kenyan startups raising over Sh82.5 billion ($638 million) in 2024, the highest in Africa.

Even during economic downturns, investor appetite remained strong, as evidenced by the Sh80 billion ($676 million) in VC deals closed in 2022. Private equity firms have also aggressively expanded their footprints in Kenya, investing in sectors such as fintech, logistics, and agribusiness.

Beyond equity financing, Kenya’s financial markets have seen strong deposit growth, increased institutional investor participation, and a rising stock of private savings.

Kenya’s constrained fiscal space demands innovative financing approaches. While external debt has traditionally filled budget gaps, rising repayment costs and global financial tightening necessitate a greater shift toward domestic financing.

A macroeconomic approach that strengthens domestic capital formation, supports financial sector deepening, and enhances the government’s ability to mobilize internal resources is the key to achieving sustainable fiscal stability.

As of mid-2024, fixed deposits in Kenya’s banking sector stood at Sh1.97 trillion, growing by Sh224 billion year-on-year, reflecting strong investor preference for stable, interest-earning instruments.

The pension sector, which includes both public and private retirement funds, now manages over Sh1.8 trillion in assets, a figure projected to grow significantly in the coming years.

Deposit-taking Saccos collectively hold close to Sh1 trillion in assets, while unit trust funds reached Sh316.4 billion in 2024, with money market funds comprising 62 percent of total unit trust assets. The insurance industry assets crossed the Sh1 trillion mark, underscoring the depth of long-term capital pools available in the economy.

The challenge, however, lies in how the government can create investment vehicles that efficiently channel these private savings toward national development. While Kenya has a range of public debt instruments, the key to unlocking greater domestic capital lies in enhancing accessibility, predictability, and investor confidence.

One of the biggest barriers to increased public-private investment collaboration is the need for more efficient financial management and reliable instruments that align with private sector investment standards. The private sector consistently attracts capital due to its structured governance, accountability, and focus on returns.

Public investment vehicles can achieve the same by ensuring transparent issuance frameworks, predictable repayment structures, and attractive returns.

Rwanda offers a useful case study, having successfully mobilized domestic capital by fostering trust in its bond market.

The Rwandan government has ensured transparency in bond issuance, introduced retail-friendly bonds with lower entry thresholds, and maintained fiscal discipline—resulting in consistent oversubscription in its debt markets. Kenya can take a similar approach by refining its retail bond offerings, introducing infrastructure-specific securities, and strengthening the secondary market for government debt.

Additionally, enhanced fiscal reporting and accountability would help attract long-term institutional investors, including pension funds, Saccos, and insurance firms, into infrastructure financing.

If the government successfully channels domestic capital into structured investment vehicles, the macroeconomic benefits could be transformative. When local investors finance infrastructure projects through government-backed Public-Private Partnerships (PPPs), the resulting economic activity generates jobs, enhances productivity, and strengthens economic resilience.

Unlike external borrowing, the returns remain within the domestic economy, reinforcing Kenya’s long-term wealth accumulation. When citizens directly invest in government securities or infrastructure projects, they earn returns on national development, reducing capital flight and encouraging domestic wealth retention.

Tapping domestic financing minimizes dependence on volatile global capital markets, where Kenya has historically faced currency depreciation risks and unfavorable borrowing terms. With local financing, repayment risks are lower, as the country avoids exposure to exchange rate fluctuations.

A practical example is Kenya’s expressway project, which was largely financed through private capital under a toll concession model. While private financing reduced the government’s immediate fiscal burden, the fact that a significant portion of the returns is remitted to foreign investors weakens the domestic wealth effect.

If similar projects were funded using structured domestic financial instruments, much of the earnings would circulate within the local economy, reinforcing a self-sustaining development model.

This highlights the need to ensure that local capital is leveraged for national projects in a way that maximizes domestic economic benefits.

A key concern with increasing government reliance on domestic financing is the risk of crowding out private sector investment. If the state absorbs too much domestic capital, interest rates could rise, making it more expensive for businesses to access credit.

This is especially critical in a country where private sector credit growth has been historically constrained by factors such as high lending rates and risk aversion among commercial banks. However, research indicates that well-executed government investment programs can actually “crowd in” private sector activity.

For instance, when governments invest in productivity-enhancing infrastructure such as roads, power, and logistics networks, they reduce business operating costs and stimulate private sector expansion. Properly designed PPP frameworks ensure that government and private sector financing complement rather than compete.

By matching long-term institutional funds from pension, insurance, and Sacco capital with infrastructure investments, the government can finance growth without excessively straining private credit markets.

Kenya’s constrained fiscal space demands innovative financing approaches. While external debt has traditionally filled budget gaps, rising repayment costs and global financial tightening necessitate a greater shift toward domestic financing.

The good news is that Kenya’s private sector is already a thriving hub for investment, with billions flowing into private equity, pension schemes, money market funds, and Saccos. By structuring credible, transparent, and liquid financial instruments, the government can harness this capital to finance infrastructure, drive economic growth, and reduce external vulnerabilities.

A macroeconomic approach that strengthens domestic capital formation, supports financial sector deepening, and enhances the government’s ability to mobilise internal resources is the key to achieving sustainable fiscal stability.

Cyrus Muthuka Mutuku is a Research Macroeconomist, Kenya Revenue Authority. Email: [email protected]