The World Bank and IMF (2001) found that the rise in the domestic interest rates is more pronounced if the investor base for domestic debt is relatively narrow as the government may be held hostage by a particular group of investors. A wider investor base reduces the monopolistic tendencies of certain investor groups such as commercial banks and brings down borrowing costs. It also minimises potential rollover risks associated with short term borrowing. Broadening of the investor base can be achieved through promoting investment by retail investors and introducing relevant reforms in the financial sector mainly comprising of insurance companies and pension funds to encourage their investment in
government securities.

Excessive domestic borrowing could also crowd out private sector investment as the government competes with the private sector for private savings. This is more so in developing countries like Kenya
where national savings are quite low compared with those of developed countries. Increased demand for limited financial resources from commercial banks and other non-bank investors’ driving interest rates up. This increases the cost of borrowing and hence reduced credit to private sector which eventually undermines private investment. Christensen (2005) examined the domestic debt crowding-out effect on private sector credit for 27 sub-Saharan countries, including Kenya, and found significant evidence for the
period 1980 to 2000.

East African currencies are likely to weaken further should European banks sell off assets in the form of stocks and government securities that they hold in emerging markets like Kenya.

Jose Vinals and Peter Dattels of the IMF pointed out that the banks are under pressure from the European Central Bank (ECB) to increase their capital.

This could see the banks sell the assets it owns in emerging markets to the tune of $2.6 trillion by the end of next year.

When the banks sell these assets, they will hold more cash thereby improve their capital requirements as demanded by ECB last year.

Foreign assets held in US dollars across several emerging markets are highly targeted in the asset reduction programmes, something that could ignite severe shocks similar to those witnessed following the collapse of Lehman Brothers in 2008, according to Mr Dattels.

The effect was also felt at the stock markets with the Nairobi Securities Exchange losing by 30 per cent in 2011. But the trend reversed in the first quarter of 2012 with considerable offshore dollars, which mainly benefited East Africa’s government debt markets.

For instance, huge offshore inflows, supported by sharp increases in interest rates earned on government securities between August 2011 and January helped the Uganda shilling appreciate against the dollar.

In spite of the looming shocks, market analysts remain defiantly optimistic, insisting volatility from asset cuts poses small danger to market performance.