Exchange Rate Volatility and Kenya’s Debt Sustainability

Abstract

The rising debt burden compounded by significant exchange rate volatility raises concerns on the sustainability of Kenya’s debt. Analysing the effect of exchange rate volatility on Kenya’s debt sustainability is crucial as some of the country’s debt sustainability indicators have been breached. The objectives for this study were to analyse historical trends in exchange rate volatility and debt sustainability in Kenya, assess the causal relationship that exists between exchange rate volatility and debt sustainability and evaluate the impact of exchange rate volatility on Kenya’s debt sustainability. Anchored in the Marshall-Lerner condition and supported by the Debt Overhang theory and the Purchasing Power Parity Theory, the study employed the Structural Vector Autoregression framework on monthly data time series data from 2000 to 2024. The researcher adopted causality, descriptive and correlational research design. At level, real exchange rate volatility, Garch volatility, and inflation are stationary while nominal exchange rate volatility, real interest rate, imports, exports, GDP, and the debt indicators are stationary at first difference. The model was homoscedastic, and the modulus lay within the unit root circle indicating stability. The Jarques-Bera test confirmed the presence of non-normality in the residuals. This model allows for identification of structural shocks and analysis of dynamic relationships among macroeconomic variables. The Granger causality tests confirmed that real exchange rate volatility and exports granger cause public debt-to-GDP ratio and external debt-to-GDP ratio. While GDP and imports have a significant predictive power on external debt-to-exports ratio and debt-service to revenue ratio respectively. The impulse response function (IRF) revealed that real exchange rate volatility shocks last up to twenty months before converging to zero, suggesting that the shocks are rather short-term. The response of external debt-to-exports ratio to real exchange rate volatility shocks is less pronounced compared to the response of public debt-to-GDP to the same shock. After accounting for variable’s own innovation, the variance decomposition identifies GDP and exports as the most important drivers of public debt-to-GDP ratio and external debt-to-exports ratio respectively. From the empirical findings, the study recommends a coordinated policy framework that integrates domestic growth, export competitiveness and exchange rate management to safeguard debt sustainability.