Abstract

Devolution forms one of the key outstanding features of the newly adopted Kenyan Constitution whose implementation and realization wholly depends on a well laid out framework whose core lies in clear and effective policies on fiscal and general financial devolution. This paper seeks to discuss the laws governing devolution of revenue and national resources, the laws allowing for alternative ways or raising revenue for county governments and narrowing down to specific laws allowing for the raising of revenue through dealing in Capital Markets products. The paper will further discuss in detail, capital markets products available for utilization by county government towards enhancing their revenue raising powers and furthering development with a special focus on newly adopted Real Estate Investment Trusts (REITs) and finally analyzes how utilization of the said products can be key in the realization of the objects of devolution. Lastly the paper proposes policy as well as developments in the legal framework governing the utilization of capital markets products by county governments towards the realization of devolution.

Introduction to the Capital Markets Authority

Whereas financial capital refers to accumulated wealth available for the creation of further wealth, capital markets are places where those who require additional funds can seek out others who wish to invest their excess or where participants can manage and spread their risks[1].

The Capital Markets Authority on the other hand is an independent public agency established in 1989 and is charged with the prime responsibility of regulating and promoting the development of an orderly, fair and efficient capital markets in Kenya. It is a body corporate with perpetual succession and a common seal.

The Authority derives its powers to regulate and supervise capital markets industry from the Capital Markets Act Cap 485A of the Laws of Kenya and the Regulations issued there under.

The functions of the Authority include the following:

• Licensing of the capital markets institutions;
• Supervision of conduct of all licensed persons and firms;
•  Regulating the issuance of capital markets products;
•  Promoting market development through research on new products and institutions;
• Championing investor education and public awareness;
• Surveillance of the trading of publicly issued securities and the Nairobi Securities Exchange;
• Protecting investor interest;

The Authority licenses or approves the following category of market intermediaries:

•  Securities Exchange (Nairobi Securities Exchange);
• Central Depository (The Central Depository And Settlement Corporation Ltd);
•  Investment Banks;
•  Stock Brokers;
•  Fund Managers;
•  Dealers;
•  Investment Advisors;
•  Authorized Securities Dealers;
•  Authorized Depositories (Custodians)
• Credit Rating Agencies &
•  Venture Capital Companies

The Authority aims at promoting market confidence, investor protection and access to financial services within capital markets in Kenya and the region through effective regulation and innovation.

Towards the Effective Realization of Devolution: The Capital Markets Perspective

1.     Introduction

Chapter 11 of the Constitution of Kenya provides for devolved governments. It envisions the granting of not only greater political responsibility but more so greater fiscal responsibilities to counties and the performance of more government functions at the subnational level. County governments exist, not as agents of the central government but rather as entities with real and clearly set out authority as well as extended financial autonomy[2].

The constitution recognizes the right of communities to manage their own affairs and to further their social and economic development[3]. To this end and so as to ensure availability of minimum resources to achieve this, the constitution further provides for equitable sharing of national revenue to enable the county governments have a reliable source of revenue to enable them govern and deliver services effectively[4]. The constitution sets revenue allocated to counties at a minimum of 15% of the national revenue and further sets out considerations to be had by the Commission on Revenue allocation when allocating revenue.

Further, the county governments are allowed to raise taxes through imposition of property rates, entertainment taxes as well as any other taxes as may be authorized to impose under an Act of Parliament[5].

The above two sources of fiscal resources notwithstanding, great potential towards the realization of devolution and furthering individual community development lies in the effective utilization of capital markets products to fuel development. The consequent allocations made from the national revenue has been termed as insufficient hence making it difficult for counties to effectively address all development concerns within their jurisdictions using the minimal resources provided[6].This necessitates the adoption of more efficient ways of increasing the county resource base.

This paper shall discuss among other issues:

1. Whether there is law that provides for and regulates alternative forms of raising revenue[7] for county governments?
2.  Whether there is law governing the utilization of capital markets products by county governments
3. Are there capital markets instruments that can be utilized to facilitate development and the realization of devolution by increasing revenue to the county governments?
4. How the county governments can utilize capital markets products to meet the objects of devolution
5.  Is the law providing for and regulating the issuance of capital market products by county government sufficient.

1.Is there Law that Governs Alternative Forms of Raising Revenue for County Governments

Article 211 as read with article 212 of the constitution provides for borrowing by county governments. This gives the county governments the power to borrow loans from entities as well as the public to facilitate development provided the same is guaranteed by the national government and approved by the county assembly.

Article 207 (1) of the constitution moreover establishes a revenue fund for each county government, into which shall be paid all money raised or received by or on behalf of the county government whose expenditure shall be authorized by an appropriation by legislation of the county and shall be under the oversight of the controller of budget this bestows upon the county governments the power to raise and receive money for its purposes. Further, Article 207(4) provides for the establishment of other funds and the laying out of provisions for their management by an act of parliament. Other funds in this case would mean funds earmarked for alternative forms of raising revenue such as funds to facilitate borrowing and loaning of money by the county governments.

Article 216 establishes the commission on revenue allocation whose functions among others is to make recommendations on other matters concerning the financing of, and financial management by, county governments, as required by the constitution and national legislation. In this process, the commission shall seek, when appropriate, to define and enhance the revenue sources of the national and county governments and to encourage fiscal responsibility[8]. The fact that the commission can make recommendations regarding the financing of county governments as well as defining and enhancing revenue sources for county governments, allows the county governments to explore new and alternative ways of raising revenue.

Moreover, county government budgets are required to contain proposals for financing any anticipated deficit for the period to which they apply as well as proposals regarding borrowing and other forms of public liability that will increase public debt during the following year[9]. This gives room for the respective county governments to present for approval with the budget alternative ways of raising revenue including through various forms of borrowing.

Lastly, there is established a county treasury amongst whose roles is the mobilization of resources for funding the budgetary requirements of the county government and putting in place mechanisms to raise revenue and resources[10]. As such, the county treasury can as well on its own initiative engage in alternative means of raising revenue for the county governments.

Limitations to the Revenue Raising Powers of the County Governments

Article 209(5) of the constitution provides that the taxation and other revenue-raising powers of county governments shall not be exercised in a way that prejudices national economic policies, economic activities across county boundaries or the national mobility of goods, services, capital or labour.

    

2.Is there Law Permitting County Governments to Deal in Capital Markets Products

Section 140 of the Public Finance Management Act allows the County Executive Committee member for finance to raise loans on behalf of the county government. Section 144 on the other hand provides for issuance of securities[11] as well as for secondary trading of securities, whether for money borrowed or for any other purpose by the county government in accordance with the Act and a laid out criteria prescribed by regulations made for that purpose. Further, county governments are allowed to lend money in accordance with the Act or any county legislation[12].

Section 161 however apart from providing that county governments when implementing measures of raising revenue should ensure that the measures conform to article 209(5) of the constitution and any other legislation further requires the county governments to seek the views of the cabinet secretary and the commission on revenue allocation.

3.Capital Markets Products Available to the County Governments

The Capital Market products available for access by the county governments include among others:

a.                  Real Estate Investment Trusts (REITs)

b.                  Treasury bills and

c.                   Treasury bonds

a. Real Estate Investment Trusts (REITs)

REITs are a form of collective investment scheme, either a company or a trust, whose business basically focuses on real estate. The investment may take the form of buying, managing, selling and leasing real estate; purchasing shares in publicly listed property companies or investing in debt securities of property companies[13]. A REIT enables persons to collectively contribute money or money’s worth as consideration for the acquisition of rights or interests in a trust that is divided into units with the intention of earning profits or income from the real estate as beneficiaries of the trust.

A REIT is required to be established under a trust deed and structured as an unincorporated common law trust divided into units. It is required to have a trustee, a REIT manager and a promoter.

Characteristics of REITs

The Company or trust

1.                Must have most of its assets and income tied to real estate investment
2.                Must distribute at least 90% of its taxable income to shareholders annually in the form of dividends
3.                Enjoys corporate tax exemption on income if minimum distribution is observed
4.                 Is governed by a board of trustees

Types of REITs / REIT Structures

A REIT can be structured as a D-REIT, an I-REIT or an Islamic REIT[14]:

                    i. D-REIT

This is a type of REIT in which the investors pool their resources together for purposes of acquiring real estate with a view of undertaking development and construction projects and associated activities.[15] An offer or issue in a D-REIT may only be made as a restricted offer to professional investors. The main objectives of a D-REIT include[16]:

a.                  The acquisition of eligible real estate, investment in eligible investments and undertaking of real estate development and construction projects which among others include housing projects as well as commercial and other real estate related development and construction projects.

b.                  Marketing and sale of real estate as well as

c.                   Retention and management of the real estate assets of the trust with the objective of earning income from the assets.

Once development is complete, a D-REIT may convert to an I-REIT.

                  ii.I-REIT

This is a type of REIT in which investors pool their resources for purposes of acquiring long term income generating real estate including housing, commercial and other real estate. It can have either restricted or unrestricted offers. The objectives of an I-REIT are limited to-

a.                  The acquisition, for long-term investment, of income generating eligible real estate and eligible investments including housing, commercial and other real estate;

b.                  Marketing and sale of real estate assets;

c.                   Retention and management of the real estate assets of the trust with the objective of earning income from the assets;

iii.                        Islamic REITs

This is a unique type of REIT in that it invests primarily in income-producing, Shari’ah-compliant real estate and/or single purpose companies whose principal assets comprise Shari’ah compliant real estate[17]. A fund manager is required to conduct a compliance test before investing in real estate to ensure it is Shari’ah compliant and that non-permissible activities are not conducted in the estate and if so then on a minimal basis.

Advantages of REIT Investments

1. Liquidity – Shares in REITs can be readily purchased and sold.
2. Tax transparency – given that capital profits are not taxed, full dividends accrue to shareholders, who pay tax according to their personal rates
3. High dividend yields – REITS are typically required to distribute at least 90% of their income to investors.
4. Diversification – persons who deal in REITs broaden their investment portfolio and as well diversify risk.
5.   Professional management of the investments 

b. Treasury Bills

A treasury bill, also known as a “T-bill”, is a paperless short term borrowing instrument issued by the Government through the Central Bank of Kenya (as a fiscal agent) to raise money on short term basis -  for a period of up to 1 year[18]. These do not pay interest as such but are instead issued and traded at a discount to their face or par value[19]. The bank discount method used allows them to earn yields upon maturity in form of the discounted amount. These are issued on a weekly basis.

In part they serve to help smooth out the flow of cash from tax receipts as well as to control the supply of money in the banking system and hence the economy at large.

Both resident and non-resident individuals and/or corporate bodies who hold an account with a local commercial bank and have a CDS account with the Central Bank of Kenya can trade in treasury bills. Applications are placed either as competitive or non-competitive (average) bids with guaranteed placements for non-competitive bids given their subjection to the market outcome. Investors are exempt from paying withholding tax on presentation of Tax Exemption Certificate from the Kenya Revenue Authority.

Treasury bills are however not traded in the secondary market (Nairobi Stock Exchange). However, investors may pledge them as collateral (or for lien creation) security against credit facilities and may also be transferred among holders of CDS accounts. Non-listed Treasury bills are however tradable Over The Counter (OTC) with transactions processed at the CBK.

Treasury bills can be resold back (rediscounted) to the Central Bank as a last resort for investors who do not wish to hold their investments until maturity. This however may result in the investor getting less than the par value, a practice aimed at discouraging rediscounting by investors.

On maturity, the investor, instead of receiving the total par value amount on his bill, may choose to roll over their securities into a new forthcoming issue. The bank therefore only remits a refund generated from the new investment rather than sending all maturing proceeds. The proceeds as well can be remitted to the account of the lien holder if the security is still held under lien on the maturity date.

c. Treasury Bonds

A treasury bond is a medium to long term debt instrument, usually longer than one year, issued by the government to raise money in local currency with maturities ranging from 1-30 years[20]. The bonds are initially sold through auction after which they can be sold in the secondary market (Nairobi Stock Exchange). Treasury bonds are issued monthly.

The most commonly issued bonds are fixed coupon bonds which pay fixed interest amounts semiannually on the face value held during the life of the bond. These can be bought at a discount which capital gain is important for purposes of secondary market trading as well as regular interest payment.

Infrastructure bonds on the other hand are issued with proceeds being channeled towards funding infrastructure projects among others specified in the issuing prospectus.

Both resident and non-resident individuals and/or corporate bodies who hold an account with a local commercial bank and have a CDS account with the Central Bank of Kenya can trade in treasury bonds. Non-Kenyan investors not domiciled in Kenya as well can invest in Kenya Government Treasury bonds as a nominee of either a local commercial bank, an investment bank or a stock broker.

4.    How the County Governments Can Utilize Capital Markets Products to Meet the Objects of Devolution

County governments are able to make use of the capital markets products by engaging in both debt and equity markets as a means towards raising the required revenue to facilitate development.

Given that county governments have the power to borrow money under the constitution[21] and further given that they have been mandated to issue securities and to as well engage in secondary trading of securities[22] they hence are able to engage in both debt and equity markets as a means towards raising revenue. This can be done through the above mentioned capital markets products discussed in detail below.

a.            Real Estate Investment Trusts (REITs)

REITs form a fertile ground towards ensuring that communities manage their own affairs and as well further their development[23]. REITs and more specifically D-REITs give communities a chance through the county governments to be able to invest in real estate, more so with regard to the provision of housing which can be built for rent among other purposes[24]. This will go a long way in ensuring the provision of other constitutional rights such as the right to accessible and adequate housing under reasonable standards of sanitation[25], given that such houses shall be built under D-REIT structures and later can be converted to I-REITS for rent or to let  and shall as well be professionally managed[26]. The issuance of shares in the D-REITS as well as secondary trading of the shares in the ensuing I-REITs will go a long way as well in ensuring that the county governments raise adequate revenue to facilitate other government uses.

Islamic REITs of the other hand can be adopted in predominantly Muslim counties such as Isiolo to ensure that such counties as well benefit from the utilization of REITs. This will entail the issuance by the county government of securities to fund Shari’ah compliant REITs which will as well accrue the aforementioned benefits to the residents of the said counties.

Malaysia for instance (one of the leading countries in the implementation of REITs) has been on the forefront of global initiatives and efforts towards the establishment of viable, sustainable and feasible Islamic capital markets through the provision Islamic REITs aimed towards catering for the needs of Muslims as well as ensuring that its products and services are attractive to all investors and issuers regardless of religion[27].

b.            Treasury Bills

Proposals for the issuance of treasury bills can be incorporated in the county government budgets as a means towards financing anticipated deficit for the given financial year[28].  These can be used a means towards raising short-term loans to facilitate county government expenditure. This moreover opens doors for investment in the counties by the residents of the given counties through trading in treasury bills. With investment in treasury bills, investors and lenders will care how well county governments are managed because they have money at risk, and their scrutiny drives greater transparency and efficiency at the county level[29]. Further, the fact that the accruing securities or amount owed by the investor can be rolled over into new forthcoming issues guarantees continued funding for the county governments for its activities. Furthermore, the non-restriction of treasury bills to residents allows room for greater investments even from non-residents hence further increasing the resource pool received from treasury bills.

The above will go a long way in ensuring that the social and economic development of the communities in the said counties is secured[30].

c.            Treasury Bonds

The length of time taken by treasury bonds to mature (1-10 years) provides a conducive opportunity for the county governments to be able to maximize use of the revenue raised through the issuance of the said bonds towards development of the counties. 

Most significant is the infrastructure bonds which can be issued towards improving the infrastructure in the specific counties. This will go a long way in ensuring that development in counties with great potential and resources is not hindered for poor infrastructure. Turkana County for instance goes on record as one county whose potential for resources has been on a rising trajectory. It as well goes down as one of the most inaccessible counties due to poor infrastructure. Availability of infrastructure bonds for issue, furthered by the fact that even non-Kenyans not resident in the county can as well bid for the said bonds provides a great opportunity for development for the said county.

5.                 Conclusion

From the foregoing, greater realization of devolution lies in greater fiscal and general financial autonomy granted to the county governments to enable them to tap resources. Engaging in the capital markets as county government provides a great opportunity for the county governments to be able to raise revenue and further their development. 

However, given the great difficulty in coordinating government actions, more so where fiscal policies are concerned, the challenge lies in the designing of a system that will allow for greater fiscal devolution while maintaining fiscal discipline nationally and at the county level. This is so due to the fact that the national government has to play an oversight role on the borrowing and expenditure of the county government to avoid the impact of excessive borrowing and the assumption of county government debt by the national government given it guarantees the loans issued[31]. This as well as the need to ensure macroeconomic stability by the national government form a few of the challenges to the realization of the above discussed.

6.                 Recommendations

For the effective utilization of Capital Markets products by the county governments towards achieving the objects of devolution, the following recommendations are made:

1.  That there be formulated regulations on the issuance of securities by county governments which shall as well provide for their secondary trading by the cabinet secretary through the Capital Markets Authority as required under article 144 of the Public Finance Management Act.
2.  That rules for borrowing and grant of loans by counties be clearly formulated and an effective monitoring system be established for loans raised towards particular uses so as to ensure accountability.
3. That there be laid down clear procedures for dealing with defaulting county governments
4.  That fiscal policies be formulated aimed towards ensuring a balance between fiscal autonomy to county government and macroeconomic stability
5. That the REIT regulations be reviewed to seal lacunas such as regards the conversion of I-REITs to D-REITs

7.                 References

1.      Constitution of Kenya.

2.      Capital Markets (Real Estate Investment Trusts) (Collective Investment Scheme)

3.      Commission on Revenue Allocation Act, 2011 (No. 16 of 2011)

4.      Public Finance Management Act, 2013

5.      Chisholm, A.M. (2009). An Introduction to International Capital Markets: Products, Strategies, Participants. United Kingdom: John Wiley & Sons Ltd.

6.      Peterson, J. , & Mila, F. Political, Legal and Financial Framework.

7.      Saeed, M. (2011) The Outlook for Islamic REITs as an Investment Vehicle. Gulf One Lancaster Centre for Economic Research; Lancaster University Management School.

8.      Dusuki, A. W. Practice and Prospect of Islamic Real Estate Investment Trusts (I-REITS) in Malaysian Islamic Capital.

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[1]      Chisholm, A.M. (2009). An Introduction to International Capital Markets: Products, Strategies, Participants. United Kingdom: John Wiley & Sons Ltd.

[2]      Peterson, J. , & Mila, F. Political, Legal and Financial Framework.

[3]      Article 174, Constitution of Kenya.

[4]      Ibid, Art 175 as read with art 202

[5]      Ibid, 209(3)

[6]      This evidenced by county governors’ recent push for a constitutional amendment to increase allocations made to counties from total revenue raised by the National Government from 15% to a minimum of 40%. http://www.standardmedia.co.ke/?articleID=2000092212&story_title=push-for-referendum-still-on-says-governor-ruto

[7]"revenue" has the same meaning assigned to it in section 2 of the Commission on Revenue Allocation Act, 2011 (No. 16 of 2011) read mutatis mutandis to apply to county governments; “revenue” means all taxes imposed by the national government under Article 209 of the Constitution and any other revenue (including investment income) that may be authorized by an Act of Parliament, but excludes revenues referred to under Articles 209(4) and 206(1)(a)(b) of the Constitution;

[8]Article 216(3) of the Constitution of Kenya

[9]Ibid, Art 220

[10]Section 103, Public Finance Management Act

[11]Section 2, Public Finance Management Act;  "county government security" means a security issued by the county government under section 144 and includes a treasury bill, treasury bond, treasury note, government stock and any other debt instrument issued by the county government “county government security" means a security issued by the county government under section 144 and includes a treasury bill, treasury bond, treasury note, government stock and any other debt instrument issued by the county government

[12]Ibid, section 145

[13]Saeed, M. (2011) The Outlook for Islamic REITs as an Investment Vehicle. Gulf One Lancaster Centre for Economic Research; Lancaster University Management School.

[14]http://www.africalegalnetwork.com/wp-content/uploads/2013/02/AK-Final-REIT-slides.pdf

[15]Regulation 2  Capital Markets (Real Estate Investment Trusts) (Collective Investment Scheme)

Regulations, 2013

[16]Ibid, Regulation 10

[17]Above, n12

[18]http://www.centralbank.go.ke/index.php/financial-markets/treasury-bill

[19]Above, n1

[20]http://www.centralbank.go.ke/index.php/financial-markets/treasury-bonds

[21] Article 211 and 212

[22] Section 144, Public Finance Management Act

[23] As an object of devolution; article 174(d)

[24] Regulation 10.

[25] Article 43(b) of the constitution.

[26] Regulation 27, requires that offers of securities in D-REITs be issued to professional investors

[27] Dusuki, A. W. Practice and Prospect of Islamic Real Estate Investment Trusts (I-REITS) in Malaysian Islamic Capital.

[28] Article 220 of the Constitution provides for the same

[29]Above, n2.

[30]Ibid, article 174 provides for this as an object of devolution.

[31]Above, n2.