FY2026/2027 Budget Highlights Strain on MSME Financing and Banking Sector Lending

Kenya’s FY2026/2027 national budget has triggered fresh debate among economists, lenders, and business owners over what it could mean for access to credit in the private sector. At the centre of the discussion is a growing concern that Micro, Small and Medium Enterprises (MSMEs) may find it increasingly difficult to secure affordable loans as the government turns heavily to domestic borrowing to finance a widening fiscal deficit.

The budget paints a picture of an economy balancing between revenue needs, debt obligations, and the need to sustain growth. However, the financing choices being made have raised questions about their long-term impact on private sector lending, investment, and economic competitiveness.

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A Rising Deficit and a Shift Toward Domestic Borrowing

The FY2026/2027 budget projects a fiscal deficit of approximately Sh1.146 trillion, a gap that the government must finance through borrowing.

A significant shift in strategy is already evident. Instead of relying more on external lenders, the government now plans to raise a larger portion of its financing from the domestic market.

Treasury figures indicate that out of the total financing plan:

• Sh1.03 trillion will be sourced locally

• Sh116.2 billion will come from external borrowing

This marks a strong pivot toward domestic debt markets, which include commercial banks, pension funds, and other local financial institutions.

While domestic borrowing is often seen as more stable and less exposed to foreign exchange risks, economists warn that it can also have unintended consequences for private sector credit availability.

Why Banks May Prioritise Government Borrowing

Commercial banks operate on a risk-return calculation. Government securities are often considered low-risk investments because repayment is guaranteed by the State.

According to tax expert and KPMG Associate Director James Kimani, this dynamic could reshape how banks allocate lending.

He explained that as government borrowing increases, financial institutions may increasingly prefer lending to the State rather than to individuals and businesses.

In simple terms, when the government competes for the same pool of money available in banks, private borrowers may be pushed to the back of the queue.

This phenomenon is commonly referred to as credit crowding out, where public sector borrowing reduces the amount of credit available to the private sector.

What Credit Squeeze Means for MSMEs

Micro, Small and Medium Enterprises form the backbone of Kenya’s economy. They employ a large portion of the workforce and contribute significantly to economic activity.

However, MSMEs already face challenges such as:

• High interest rates

• Strict collateral requirements

• Limited access to long-term financing

• Informal business structures

A tightening credit environment could make these challenges worse.

If banks increasingly channel funds into government securities, MSMEs may experience:

• Reduced loan approvals

• Higher borrowing costs

• Shorter repayment terms

• Lower expansion capacity

For many small businesses, access to affordable credit determines whether they expand, survive, or shut down.

Interest Payments and Fiscal Pressure

A major component of Kenya’s budget is debt servicing.

Approximately Sh1.2 trillion is expected to go toward interest payments on existing debt. This significant allocation limits the fiscal space available for development projects, infrastructure expansion, and productive sector investment.

High debt servicing costs often create a cycle where governments must borrow more simply to meet past obligations, increasing reliance on both external and domestic borrowing.

This pressure contributes to the current fiscal strategy that prioritises domestic funding sources.

Revenue Collection and Tax Expansion Measures

To support revenue generation, the Kenya Revenue Authority (KRA) is expanding its digital tax systems, including the Electronic Tax Invoice Management System (eTIMS).

The system aims to:

• Capture more informal businesses

• Improve tax compliance

• Reduce revenue leakage

• Increase transparency in business transactions

While these measures may improve government revenue collection in the long term, they also increase compliance pressure on small businesses, many of which operate informally.

Tax Amnesty: Relief or Temporary Breathing Space?

The Finance Bill introduces a tax amnesty programme designed to ease penalties and interest for taxpayers with outstanding obligations.

Tax experts view this as a positive step for encouraging compliance.

According to James Kimani, tax amnesty allows businesses that may have fallen behind on payments to regularise their status without facing overwhelming penalties.

However, analysts caution that while amnesty provides short-term relief, it does not address structural challenges facing small businesses, such as high operating costs and limited access to credit.

New Tax Measures and Their Impact on Businesses

Beyond borrowing concerns, the budget introduces additional tax changes that could influence business costs.

One key proposal is a 10 per cent excise duty on locally manufactured plastic products. Industry stakeholders warn that this could:

• Increase production costs

• Reduce competitiveness of local manufacturers

• Encourage import reliance

If imported products remain cheaper, local manufacturers may struggle to compete in both domestic and regional markets.

Another major change affects Kenya’s electric vehicle (EV) sector. The proposed shift from zero-rated VAT status to VAT-exempt classification could have significant pricing implications.

Under VAT-exempt status:

• Manufacturers cannot reclaim input VAT

• Production costs increase

• Final consumer prices may rise

This could slow down adoption of electric mobility at a time when many countries are promoting cleaner transport solutions.

The Growing Compliance Push

The Kenya Revenue Authority is also increasing enforcement efforts through digital communication channels such as SMS, email, and WhatsApp alerts.

Businesses are being encouraged to ensure full compliance with tax obligations to avoid penalties and enforcement actions.

While improved compliance strengthens revenue collection, it also increases pressure on small businesses that may already be struggling with limited cash flow.

Broader Economic Implications

The combination of rising domestic borrowing, increasing tax enforcement, and new fiscal adjustments creates a complex economic environment.

Key potential outcomes include:

• Reduced private sector lending

• Higher cost of doing business

• Slower MSME expansion

• Increased reliance on informal financing

• Greater government presence in financial markets

At the same time, government borrowing supports public spending, infrastructure projects, and debt refinancing, which also play a role in economic stability.

The challenge lies in balancing fiscal needs with private sector growth.

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What This Means Going Forward

The FY2026/2027 budget reflects a broader structural reality in Kenya’s economy: the tension between financing public debt and supporting private sector growth.

MSMEs remain central to employment and economic resilience, but their ability to access credit may depend heavily on how financial markets respond to increased government borrowing.

If domestic borrowing continues to rise, credit conditions could remain tight unless alternative financing channels or policy interventions are introduced.

Final Perspective

Kenya’s budget strategy highlights a familiar economic balancing act. On one side is the need to finance a large fiscal deficit and meet debt obligations. On the other is the need to ensure businesses—especially MSMEs—can access affordable credit to drive growth.

The outcome will depend on how effectively policymakers manage this balance in the months ahead, and whether financial institutions can maintain adequate lending to both the public and private sectors without creating a structural credit squeeze.