Fiscal and monetary policy nexus: re-examining the effect of government borrowing on interest rates and interest spreads in Kenya

Abstract

The Kenyan economy has experienced an increase in budget deficit and public debt since independence. In the recent past, the government has shifted its focus in financing its deficit from external funding sources to targeting the domestic financial markets. In light of this, this study sought to re-examine the effect of government domestic borrowing on interest rates and interest rate spread. There is limited research on the interactions between fiscal policy variables such as budget deficit and public debt and monetary variables such as interest rates and interest rate spreads. This study sought to fill this research gap. Secondary data from 1989 to 2018 was used for this study comprising of public domestic debt, net credit to government ratio, interest rate spread, interest rates, liquidity ratio, advance to deposit ratio, inflation and GDP growth rates. The study used Autoregressive Distributed Model (ARDL) to investigate the relationship between the dependent and independent variables. The findings indicate that in the long run, there is a negative and significant relationship between net credit to government ratio and interest rates and interest rate spreads. In the short run, net credit to government ratio was found to be positively and significantly related to interest rates while the relationship was negative and significant for interest rate spreads. Public domestic debt was found to be positively and significantly related to interest rate spreads in the short run. The implication of the findings is that public debt should be maintained at a reasonable level so that private sector growth is not hindered. Additionally, better coordination between fiscal policy authorities and monetary authorities is recommended.