Kenya is considering entering into contracts with both local and foreign banks to buy dollars at agreed prices in order to pay its external debts in the wake of a weakening shilling and higher interest rates.

National Treasury Cabinet Secretary Henry Rotich said technocrats were thinking of signing contracts with banks to pay the loans, which are denominated in dollars, whose repayment price largely hinges on changes in the exchange rate. This is technically referred to as hedging.

Hedging is a risky undertaking because it exposes borrowers to losses depending on the actual movement of the exchange rate.

When the reading of the market is that the local currency will depreciate, the borrower commits to a future depreciated rate for a period. The reverse obtains if the reading is that the local currency will gain.

Should the exchange rate move against expectations, largely due to external factors, the borrower loses out.

To mitigate such risks, borrowers are increasingly signing agreements where the applicable exchange rate is reviewed periodically, say half-yearly, to inform payments for the next period. Others create a foreign exchange reserve from where money for absorbing unexpected repayments can be drawn, stabilising government expenditure, while cushioning it from losses when market realities change.

“We are considering hedging mechanisms, but this is still premature at this stage,” said Mr Rotich without giving timelines or details of the proposed framework.

Economists at Standard Chartered Plc said hedging loans would provide significant reassurance about Kenya’s ability to repay any commitments that are due with “relative ease” but it will come at a cost.

According to Razia Khan, chief economist and head of African research at Standard Chartered Plc, a significantly weaker shilling  would result in a greater threat to Kenya’s external-debt sustainability and perhaps even complicate the country’s efforts to increase offshore borrowing.

“Given that Kenya’s external debt commitments could rise significantly with pronounced Kenya shilling weakness, it makes sense for Kenya to be thinking of hedging its external debt obligations,” said Ms Khan.

“This should help preserve Kenya’s creditworthiness, and signals a prudent approach towards debt management. One would expect any corporate with external debt commitments to hedge its exposure, so why not a sovereign as well?” asked Ms Khan.

Ms Khan pointed out that Kenya is unlikely to tap into the precautionary $688.3 million International Monetary Fund financing facility because of the weakening currency except in the event of an external shock.

“Instead, we expect the Central Bank Rate (CBR) to be raised further, if it should become necessary to safeguard the  Kenya shilling,” she added.

Amish Gupta, a director-in-charge of investment banking at Standard Investment Bank (SIB) argued that while hedging is a good idea, it may on the other hand plunge the country into a precarious debt position, particularly when the local currency strengthens.

“Hedging is always useful but the government must be extra careful not to be on the losing side,” said Mr Gupta.

Kenya’s external debt obligations have increased 12 per cent in the past eight months alongside the weakening of the Kenya shilling against the greenback.

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Data from Central Bank of Kenya shows that the shilling fell 12 per cent from Ksh90.79 on January 2 to Ksh101.32 against the dollar by August 4.

“We are working with the central bank on our borrowing programme for this financial year. When we finish, we will make a decision depending on our exposure, but we will come up with a strategy that will reduce the cost of borrowing,” Mr Rotich told The EastAfrican.

Kenya plans to increase its reliance on external financiers to fund its 2015/2016 budget estimated at Ksh2.1 trillion ($20.27 billion).

The overall budgetary shortfall of Ksh526.3 billion ($5..49 billion) is to be financed through net external financing of Ksh 340.5 billion ($3.28 billion) and domestic financing of Ksh 229.7 billion ($2.21 billion).

IMF, through its debt sustainability analysis report for Kenya in April 2013, predicted  that the biggest risks to the country’s  external debt sustainability would  come from exchange rate shocks and less favourable terms on new public sector loans.

The report argued that the move by the National Treasury could see the government reduce external borrowing in favour of domestic borrowing through Treasury bills and bonds.

Given the prevailing high interest rate regime in the country triggered by central bank’s decision to retain lthe CBR to rein in the weak currency, local borrowing would not be a better option either.

According to CBK, Kenya’s public and publicly guaranteed debt rose by Ksh372.1 billion ($3.59 billion)  to close at Ksh2.74 trillion ($26.45 billion), 51.2 per cent of gross domestic product in April 2015 from Ksh2.37 trillion ($22.88 billion), 44.2 per cent of GDP in June 2014.

Kenya’s spending on public debt repayment was 70 per cent higher than its spending on development in 2013, according to a report by the United States Agency for International Development.

Interest payments on external debt from the consolidated fund during the past financial year stood at Ksh29.73 billion ($287.06 million) and the figure is expected to rise to Ksh30.51 billion ($294.59 million) in the current financial year.

According to financial estimates for the 2015/2016 fiscal year, interest on domestic debt in 2014/2015 financial year stood at Ksh137.63 billion ($1.32 billion) and the figure is expected to increase to Ksh 154.81 billion ($1.49 billion) in the current financial year. The figures are likely to rise due to the depreciation of the shilling.

The government plans to diversify financing sources by continuing to access commercial sources of financing in the international financial market.