Domestic Debt, External Debt, and Inflation in Kenya: An ARDL-ECM Approach

Kenya's public debt climbed from 32.2% of gross domestic product (GDP) in 2009 to 67.3% by 2022, reviving concerns about the sustainability of the country's debt trajectory. Rising public debt has coincided with slower economic growth, increasing inflation, currency depreciation, widening income inequality, reduced private investment, lower capital formation, and an expanding debt overhang. Despite successive Medium-Term Debt Strategies (MTDS) introduced since 2001, debt ceilings have repeatedly been exceeded. This study investigates whether inflation can reduce the real value of Kenya's public debt by examining domestic and external debt separately. Annual data covering the period 1983–2022 were analysed using an Autoregressive Distributed Lag (ARDL) model for domestic debt as a share of GDP and an ARDL Error Correction Model (ARDL-ECM) for external debt. Baseline five-year and ten-year forecasts were compared with a scenario incorporating a one-off two-percentage-point inflation shock in 2022. The findings indicate that the inflation shock had only a marginal effect on domestic debt, slightly increasing the debt ratio over five years before reducing it by only 0.024% after ten years. In contrast, external debt responded more strongly, initially increasing by approximately 3.5% within five years before declining substantially by 282% over the ten-year horizon. These findings suggest that the inflation-liquidation channel operates only gradually in Kenya and has a far greater effect on external debt than on domestic debt. The study contributes empirical evidence from a Sub-Saharan African economy to a literature dominated by advanced economies and provides policy insights into the coordination of fiscal and monetary strategies for sustainable public debt management.