Commercial banks in Kenya face a drastic decline in opportunities for risk-free investments if Treasury follows through on President Uhuru Kenyatta’s pledge to cut domestic borrowing by half in a bid to make credit more affordable.

Coming after Kenya’s successful Eurobond, which raised $2 billion, a further reduction in government appetite for local debt would encourage banks to lend more to the private sector. Kenyan banks are the largest holders of government securities, having 53 per cent of all Treasury debt.

If Treasury borrowing fell from Ksh190 billion ($2.14 billion) to Ksh100 billion ($1.13 billion), the banks would — based on the current 91-day T-bill rate of 8.2 per cent — lose opportunities of making revenues of about Ksh3.6 billion ($40.7 million) from new debt. The total stock of domestic debt was Ksh1.32 trillion ($14.9 billion) at the end of July.

Although the government may find it difficult to meet its revised borrowing target, analysts say the subsequent drop in yields on state- issued securities would encourage banks to lower interest rates.

READ: Interest rates in Kenya yet to decline

Banks use yields on T-bills as benchmarks in pricing money but this will now be moderated by the Central Bank Rate following the introduction of a standard base for flexible lending — the Kenya Bank Reference Rate (KBRR).

“If they manage to cut down on borrowing, we expect interest rates to fall, which will result in cheaper lending costs as well as a rise in the equity market,” said Parshv Shah, an investment analyst at AIB capital.

READ: Will Kenya’s reference bank rate lower interest? on loans?

President Kenyatta said on the eve of the US-Africa Summit that the government aimed to reduce its borrowing through Treasury papers from Ksh190 billion to Ksh100 billion this fiscal year.

“The extra supply of cash will, therefore, hopefully help to bring down bank lending rates to the productive sectors of the economy,” said President Kenyatta.

According to the 2014/15 budget, Kenya has a funding deficit of Ksh340 billion ($3.84 billion), which is expected to be bridged through domestic and international borrowing.

“We expect a decline in yields in the short term. This may accelerate once the Treasury executes its strategy of a reduction in domestic borrowing. We advocate a buy and hold strategy to ensure the investor rides the wave and extends his portfolio tenor,” said analysts at Sterling Capital, a Nairobi based brokerage and investment firm.

Broad economic trends such as inflation and exchange rates are also expected to have a say in the extent of government borrowing.

“We expect the set target to depend primarily on inflation. If inflation stabilises, we then expect Treasury to reduce government borrowing. We, however, expect this to be difficult with the increase in food prices due to the poor distribution of rainfall and the increase in energy costs. However, we expect a cut in borrowing in the medium term as inflation stabilises,” said Mr Parshv.

In the past few months, inflation has edged up, driven by increased food and energy prices. In July, inflation rate rose to 7.67 per cent, up from 7.39 per cent in June, and analysts say the outlook looks even grimmer.

“Going forward, we anticipate inflation to remain above the National Treasury upper band of 7.50 per cent possibly approaching the eight per cent level. This will largely be driven by high electricity costs and increased probability of higher oil prices as renewed violence in Iraq and Libya poses a threat,” said Sterling Capital.

A rise in inflation past the government upper target of 7.50 per cent could push the country’s Monetary Policy Committee to tighten the rate at which the Central Bank lends to the banking sector. The MPC meets later this month.

“The output of the formula points out the possibility of an increase in the CBR to a target range of 8.75 per cent and 9.50 per cent this year. The decision will largely revolve around inflationary pressure rather than stimulating GDP. That is, the MPC will be more concerned about taming inflation rather than stimulating the economy,” said Sterling Capital.