Domestic Debt, External Debt, and Inflation in Kenya: An ARDL-ECM Approach

Derrick Gathiga; Charles Kithandi

doi:10.59413/amsj/v1.i1.5

Authors

Derrick Gathiga Daystar University Author
CPA, Charles Katua Kithandi Daystar University Author

DOI:

https://doi.org/10.59413/amsj/v1.i1.5

Keywords:

Public Debt, Shock Inflation, Debt Liquidation, Domestic Debt, External Debt, ARDL, Kenya

Abstract

Kenya's public debt climbed from 32.2% of gross domestic product (GDP) in 2009 to 67.3% by 2022, reviving questions about how sustainable that debt trajectory really is. Heavy borrowing in Kenya has gone hand in hand with weaker growth, rising prices, a weaker shilling, wider income gaps, less room for private firms to invest, thin capital formation, and a growing debt overhang. Successive Medium-Term Debt Strategies (MTDS) dating back to 2001 have not stopped debt ceilings from being breached. This paper looks at an option Kenya has not previously tested: deliberately letting inflation run ahead of expectations as a way of eroding the real value of public debt, treating domestic and external obligations separately. Drawing on annual Kenyan figures from 1983 to 2022, an Autoregressive Distributed Lag (ARDL) model was fitted to domestic debt as a share of GDP, while an ARDL Error Correction Model (ARDL-ECM) was used for the external-debt share. Baseline forecasts running five and ten years out were then compared with a parallel scenario in which a one-off 2-percentage-point inflation shock was applied in 2022. The shock barely moved domestic debt, it nudged the ratio slightly upward over five years and trimmed it by just 0.024% after ten. External debt told a different story: the same shock pushed the external ratio up by roughly 3.5% within five years, yet by year ten the trajectory had swung to a 282% relative decline, in line with the broader finding elsewhere that debt with longer maturities responds more strongly to inflation surprises. Taken together, the evidence points to an inflation-liquidation channel in Kenya that, where it operates at all, takes years to show up and matters far more for external than domestic obligations. The paper adds a developing-country, sub-Saharan African data point to a literature dominated by advanced economies, and offers early-stage thinking for how fiscal and monetary authorities might coordinate around this channel.

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