Capping bank interest rates will harm market

Central Bank of Kenya Governor Patrick Njoroge (left) and Diamond Trust Bank chief executive officer Nasim Devji at a press conference on interest rates at Kenyatta International Convention Centre in Nairobi on August 10, 2016. PHOTO | SALATON NJAU | NATION MEDIA GROUP

What you need to know:

  • The long-term strategy of effectively dealing with the problem of high interest is to enforce competition in the financial sector.
  • This would entail the enforcement of the Competition Act.
  • Reducing barriers to entry into the financial sector and controlling anti-competitive practices would likely yield quantifiable benefits.

hile the parliamentary call to cap interest rates may be politically viable, it could be economically distortive and constraining. Indeed, Kenya’s perpetual high interest rates is a manifestation of underlying credit market failures due to competition and information asymmetry.

Kenya’s monetary policy aims at taming inflation and has achieved notable success. However, the achievement has come with the cost of systematic credit starvation of the private sector and this has relegated Kenya’s economic growth to single digit. One consequence of this is that the economy is not able to create enough jobs for the youth.

Despite the financial reforms that started in 1990s, high interest rates have persisted. The high cost of credit has locked millions of Kenyan investors out of the credit market, denying them an opportunity to engage in productive economic activities. The high cost of credit is a major contributor to the persistence of the informality of small and medium enterprises, the stagnation of the manufacturing sector, and credit market failure.

We cannot hope to achieve double-digit economic growth if only one out of 2,000 Kenyan has a mortgage. It is inconceivable to entertain the idea of becoming an industrialised country when the manufacturing sector has no access to adequate credit.

INCREASE CREDIT

The government has in recent times embarked on several policy interventions in a bid to increase credit. First, it has introduced the Kenya Bank’s Reference Rate (KBRR), a credit pricing framework. The banking sector is obligated to set the cost of credit using the KBRR as the base and must transparently report to the Central Bank any deviations.

Secondly, the government issued a Eurobond as an alternative source of fiscal deficits. It was supposed to be a strategic government exit as a major borrower in the domestic credit market to make more credit available to the private sector.

Evidently, these interventions have not had the desired impact as the cost of borrowing remains high.

It is against the background of the ineffectiveness of such policies that the capping of interest rates has gained currency, with Parliament approving the Banking (Amendment) Bill. If the President vetoes the Bill, the status quo remains, with high interest rates.

The loan and deposit markets are governed by forces that are premised on the fact that borrowers and financial institutions are the best judge of when to borrow, lend, save, or accept deposits.

From an efficiency point of view, the policy to cap interest rates would be justifiable if it would mimic market lending and deposit rates. However, in reality, achieving such noble objectives would be an insurmountable task for the government because it lacks adequate market information of the demand and supply of credit and deposits for timely intervention. Such information is privately held by the consumers and financial institutions.

The government should adopt a less disruptive short-term strategy, allowing the financial institutions to change market rates at subsidising rate.

The long-term strategy of effectively dealing with the problem of high interest is to enforce competition in the financial sector. This would entail the enforcement of the Competition Act. Reducing barriers to entry into the financial sector and controlling anti-competitive practices would likely yield quantifiable benefits.

Instead of capping interest rates, Parliament should promote enforcement of competition in the financial sector. However, if such intervention is inevitable due to high unemployment, Parliament should adopt a less disruptive policy of subsidising interest rates for key sectors.

Prof Joseph Kieyah is a policy analyst at the Kenya Institute for Public Policy Research and Analysis; [email protected].