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Living on the edge

Antifragility is beyond resilience or robustness. The resilient resists shocks and stays the same; the antifragile gets better.
In Antifragile: Things that Gain from Disorder, Nassim Nicholas Taleb, the Distinguished Professor of Risk Engineering at the New York School of Engineering, acclaimed author and essayist, philosopher, former option trader and avid Twitter user puts it forcefully that debt “fragilizes economic systems,” that is, makes them weaker. 

As our society has grown richer, we have grown more indebted. This is not unique to Kenya. The richest countries in the world are also the ones with the most government debt relative to GDP (link). Nobel-winning economist Paul Krugman has often argued that government debt is beneficial to the economy. In “Debt is Good” (link), Krugman makes the case for government debt, stating that it provides a safe asset for investors who use government securities to manage risk and hold them as a substitute for cash. By issuing debt, governments can raise the money required to pay for useful things. This line is frequently used in Kenya when the public debt is being discussed. In trying to be a good student of economics, I wholeheartedly agree. If debt is used to fund productive investments such as transport infrastructure, the direct (say a new road where once was none) and indirect benefits can be astonishing (from the increase in land prices after completion of the new road, to the farmers who spend less to transport their produce, to the transporters who spend less on maintaining their vehicles, and so on). I am not a betting man, but I would confidently wager that that the Thika Superhighway has generated exponentially more than the KES 34 billion that was spent to construct it. So what is the problem? 

I know better than to argue with Krugman, so I will not. Mine is about risk. Specifically, the economic fragility and increased exposure to risk that is caused by an increase in government debt. In truth, not all government debt is equal. If debt is denominated in the local currency, it is easily manageable. The government can issue bonds (which are basically pieces of paper or entries in a computer) and collect money from investors, promising to pay the principal and any interest back. When payments fall due, the government has at least 2 options: issue more bonds (or treasury bills) to pay for previous interest and principal payments, or print money to pay back investors. This can theoretically go on forever, a point Krugman makes (link) when he describes domestic debt as “money we owe to ourselves”. But it doesn’t go on forever. Simply, the demand and supply of money causes the price of money (interest rates) to fluctuate. Too high an interest rate and money can become too expensive for borrowers; too low an interest rate and it can make money too cheap, potentially causing the prices of goods to rise (inflation) as consumers make higher bids for a finite number of goods. For these and other reasons, governments complement local borrowing with external borrowing, in foreign markets and in foreign currencies. Because the debt is borrowed in foreign markets, the demand-and-supply effect on local interest rates is not as strong as it is when debt is issued domestically. 

However, external debt is serviced in foreign currency. If Kenya holds US$ 1 billion in debt, it must pay interest and principal in US dollars. And herein lies the worry. What happens if Kenya holds US$ 1 billion worth of debt, and the US dollar appreciates relative to the Kenya shilling? Kenya has to pay more to honour the same debt, since more Kenyan shillings will be required to make US$ 1. Just as less Kenyan shillings would be required if the US dollar lost value relative to the Kenya shilling. In good times (i.e. when the shilling is strong against foreign currencies), more foreign-denominated debt is a good thing for Kenya, since the debt portfolio loses value and it becomes cheaper to service external debts. But when things take a negative turn, it could spell doom.

debt

As of the 2017 Medium Term Debt Management Strategy Report (link) by the National Treasury, 49% of Kenya’s total public debt is external debt. In fact, the 2014 Eurobond accounts for 7.9% of Kenya’s total public debt. A sustained 2% appreciation in the US dollar would make the interest and principal payments on the US$ 2 billion Eurobond more expensive by US$ 44 million dollars. A sustained 2% appreciation in the bundle of currencies in which Kenya’s external debts are denominated would make the external debt portfolio more expensive by about US$ 340 million, or KES 34 billion. Imagine what could happen if the bundle of currencies appreciated by 5% or 10%.

If this was to happen, Kenya would probably first make use of the Central Bank reserves to try and stabilise the exchange rate prices by allowing more US dollars into the economy. As reserves dwindle the National Treasury and CBK would probably turn to the IMF for a dollar credit line with which to shore up the Kenya shilling. Remember that as this is happening, the price of imported goods would have risen sharply as the Kenyan currency depreciated. So fuel and all the other imported goods (Kenya is a net importer) and commodities would be much more expensive, with inflation rising and the cost of living shooting up. Depending on the level of interest rates, the CBK could try to arrest inflation by raising interest rates, and making the cost of money in the economy rise. With higher interest rates, access to credit by borrowers slows down and the economy cools off. However, because the inflation is mainly imported, this does not have the desired effect on inflation. With the economy growing slower, there are less jobs to go around, less money for everyone and less taxes collected by the state. This means that the government would have to reduce development spending to meet external debt obligations. This is a rather macabre vision of the future, but with the American and North Korean nuclear face-off escalating by the day, who knows what could happen to the US dollar and other reserve currencies.

Government debt is good, and can be a potent tool for fast-tracking infrastructural development. But there is a dark side to it; external government debt fragilizes the economy by increasing its exposure to foreign exchange rate movements.
There is, thankfully, a silver lining for Kenya. Tullow Oil, an oil and gas exploration company, estimates that there could be over 750 million barrels of oil (link) in the South Lokichar Basin. If Kenya could extract and export oil, it could develop some much-needed antifragility. If the oil is exported in US dollars, yes, Kenya would receive less per barrel if the US dollar depreciates relative to the Kenya shilling. But this would also make Kenya’s imports, such as oil, and the external dollar debt portfolio cheaper. If the US dollar appreciates, yes, imports would be more expensive. But the earnings from Kenya’s oil exports would increase as well, offsetting the rise in the costs of servicing external debt.

If Kenya could be able to export just 100,000 barrels of oil per day, and be able to earn a net profit of just KES 20 per litre (a barrel contains about 159 litres), the country could be earning up to KES 316 million a day (about US$ 3 million). In the medium-to-long term, if such resources could be used prudently, Kenya could theoretically pay all its current external debt (KES 1.72 trillion as of the 2017 Medium Term Debt Management Strategy Report) from the South Lokichar Basin alone. This is a huge “if” and would depend on how well Kenya -through its political class and state technocrats- uses the oil dollars, and how well it can stave off the resource curse (link), yet another source of fragility. Whatever the case, Kenya is likely to continue borrowing from domestic and external markets to fund infrastructure projects and try to close the infrastructure deficit caused by decades of underinvestment. The infrastructure that such debt pays for is an important and necessary catalyst for sustained economic growth, but the fragility that external debt introduces into the economy is a growing strategic weakness.
The gods have given us black gold, and with it an opportunity to strengthen (add some antifragility) our economy and pay for much-needed infrastructure. What will we do?

 

 
Thanks to Faith Nyawira for reading a draft of this.

 

Categories
Thinkpieces

Elections unexpected: complexity in the real world

For any person who relies on the behaviour of others for their well-being — politicians, big businesses and their executives, oil producing and commodity-exporting countries, people holding floating-rate mortgages, etc. — the last year has been a crash course in complexity 101.

You think? Not so.

Virtually all pollsters in the USA predicted a win for Hillary Clinton last November. Every big-name publication in America endorsed Hillary, and tenured Republicans like former presidential candidates John McCain and Mitt Romney stopped short of campaigning against their party’s presidential candidate. What was supposed to be an easy, straightforward campaign for the former First Lady (1993 - 2001), New York Senator (2001 - 2009) and Secretary of State (2009 - 2013) turned out to be the most challenging, and whose outcome is probably the toughest to accept. Following the US election, all eyes turned to France. Marine Le Pen’s popularity surged as her (so-called) populist anti-EU, anti-immigration, nationalist rhetoric soared. Her most compelling rival was a political upstart; an ex-cabinet minister in the immediate former Hollande government, a former Rothschild banker, all of 39 years and with zero elective political experience. Drawing a straight line from an “unlikely” Trump victory to a “likely” Le Pen victory would be easy and, I admit, understandable. But a convincing 20%+ margin majority victory later and things do not seem so straightforward. Prime Minister May said that she wanted a stronger mandate as the UK went into Brexit negotiations. What wasn’t said (except by the pundits, professional prognosticators and commentaria) was that the Conservative Party’s most formidable competitor, the Labour Party, was reeling from Jeremy Corbyn’s poor (they said) leadership of the party and Mrs. May could expect a bigger majority (and more subdued opposition) in the House following last year’s “Brexit setback.” Oh! Not so. Labour has done impressively well and has emerged from being a thorn in the side of the Prime Minister to a dark cloud hanging over Conservative Party heads. Expectations have changed: from a larger majority in the House, to a coalition with the DUP, a party that won just 10 seats in parliament. In addition, the Scottish National Party performed terribly poorly at the polls, losing tens of seats in an election that could have been ideologically described (for SNP incumbents) as a confirmatory vote on the SNP’s Brexit policy.

What in the world is going on?

We could place all the blame on foreign governments meddling in elections. We could point to the influence of dark and powerful corporations and individuals determining the fate of nations in smoke-filled rooms, or meetings held at midnight in remote locations (preferably valleys, deserts or mountains) where songs are chanted and deals struck. George Orwell’s 1984 has always provided fodder for narratives explaining unexpected events. Or we could just admit that we don’t know, quickly orient our minds to a President Trump, a President Macron, a weaker Prime Minister May with a hung parliament and emboldened opposition, and prepare ourselves for more “surprises” in the future. Yes, we all have our hypotheses based on (extremely narrow and limited) personal experiences, preferences and cognitive biases, our personalised view of history and the future, our interpretation of trends and events (narrative fallacy), and our desire to be correct/right/win (confirmation bias). We may sometimes be right — if you asked 100 two-year old toddlers to choose who will win the 2017 Kenyan presidential election between the two leading candidates, we can expect that many of them will be proven correct in August. But does that mean that two-year old toddlers possess a special ability to peer into the future?

We do not know the future

History is neither a foretaste of the future, nor does it repeat itself (some say that it rhymes with the past). The closest thing to the future is the thing immediately before it, that is, today, now. If one must predict, that, I submit, is the most accurate predictor of the future.

As we go into the polls in August, allow me to make just one prediction: one of the two major presidential candidates and their multi-billion shilling campaigns will be quite disappointed by the August 8th election outcome. One will lose and the other will win, or the result will require a re-run. One of the major political parties will gain seats in parliament, or have its position weakened, or be forced to form a coalition with a smaller party or a set of independent MPs. Not only that, voting patterns will not be as linear and predictable as TV talking heads may suggest (because voters are people, and people are not linear and predictable). Presidential candidate A may win a particular constituency convincingly, but Governor/Senator/MCA/MP/Women’s Representative X (who was endorsed by presidential candidate A) will be soundly defeated in that constituency. Some of the candidates who win their elections will not be ‘true’ winners (that is, win the mandate of the people) but will in fact be a protest vote against incumbents that constituents want out (and hence they will be on a 5-year clock to win the hearts of the electorate otherwise they are likely to face the same fate).

In this world, the only sure things are death and taxes. And complexity. Things are not always as they appear, or as we think, or as we expect… It would be wise to expect the unexpected — that way we’ll be alright however things turn out.

 

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First published on Medium