Effect of Domestic Public Debt on Financial Development in Kenya

Abstract

The effect of domestic public borrowing on the development level of financial sector has not been extensively investigated in finance literature. Two views, safe asset view and lazy bank view, have been suggested for the interaction between public borrowing 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 domestic public debt on Kenya’s financial development. The study was anchored on crowding out effect theory and supported by debt overhang theory and neoclassical theory. The independent variable was domestic public debt operationalized as the ratio of domestic public debt to GDP while the control variables were; interest rate, inflation and unemployment rate. 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 0.642, indicating that the chosen independent variables could explain 64.2 percent of the variance in Kenya’s financial development, while the other 35.8 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 domestic public debt, inflation and unemployment rate had a negative and significant influence on Kenya’s financial development. Interest rate had no significant influence on Kenya’s financial development. The study recommends the need for practitioners and policy makers to develop target domestic public debt level that will promote financial development. The policy makers should also ensure that inflation levels are stabilized and unemployment rate is reduced. Future studies can focus on other determinants of financial development in Kenya such as financial literacy and economic growth among others. Future studies can also focus on a longer study period to confirm the findings.