Effect of Public Debt on Financial Development in Kenya

Abstract

Safe asset view and lazy bank view have been suggested for the interaction between public debt and financial development. Lazy bank view suggests that banks with greater public debt instruments increase their profitability but decrease their efficiency and in turn lowers financial depth in time. On the other side, safe asset view asserts that limited amount of public borrowing supports financial development. So, the net influence of public borrowing on financial sector development depends on public borrowing level and country specific characteristics. The objective of this research was to determine the effect of public debt on Kenya’s financial development. The study was anchored on debt overhang theory and supported by crowding out effect theory and functional finance theory. The independent variable was public debt operationalized using debt service to revenue ratio and debt service to export ratio while the control variables were; interest rate and inflation. The dependent variable that the research attempted to explain was the financial development in Kenya. The data was collected on a quarterly basis over a period of twenty years (from January 2002 to December 2021). A descriptive research approach was employed in the research, with a multivariate regression model used to examine the connection between the study variables. The study's findings yielded an R-square value of 0.282, indicating that the chosen independent variables could explain 28.2 percent of the variance in Kenya’s financial development, while the other 71.8 percent was due to other factors not investigated in this study. The F statistic was significant at a 5% level with a p=0.000. This suggests that the model was adequate for explaining financial development in Kenya. Further, the findings demonstrated that debt service to revenue ratio, debt service to export ratio and interest rate had a positive and significant influence on Kenya’s financial development. Inflation had no significant influence on Kenya’s financial development. The study recommends the need for practitioners and policy makers to ensure to develop target debt service to revenue ratio and debt service to export ratio that will promote financial development. The policy makers should also ensure that both the government revenue and exports keep increasing with a rise in debt service. Future studies can focus on other determinants of financial development in Kenya such as financial literacy, unemployment among others. Future studies can also focus on a longer study period to confirm the findings.