Prior to 2016 and for over 20yrs, commercial banks in Kenya enjoyed high interest rate spreads of about 11.4% on average, way above the world average of 6.6%. This margin enabled banks to report super-normal profits in billions of shillings, even as other sectors of the economy were faltering. Before I illuminate why the interest rate capping is not the problem, let me give a background that led to the capping in 2016.
The draft Donde Bill of the year 2000 sought to have the government rein in interest rates that banks could charge their customers. Donde argued then that at 24%, the interest rates charged by the banks then had made borrowing out of reach of many households and equally on firms in terms of the cost of capital. The bill therefore proposed to have the rates pegged on the 91-day Treasury bills with a margin of 4%.
In a memorandum sent to parliament and which sought to make amendments to the bill, the retired President Moi reminded the legislators that state control of interest rates would be contrary to financial liberalization policy. Through Kenya Bankers Association, the banks went to court and the High Court ruled that an Act capping the lending rate was unconstitutional. In 2015, the National Assembly Deputy Minority Leader, Jakoyo Midiwo announced plans to cap bank interest rates through an amendment to the Finance Bill 2015. His proposal was that the maximum interest rate that a bank could charge for a loan should not exceed 3%. Healso wanted banks or financial institutions to pay depositors not less than 70% of the Central Bank Rate (CBR) rate. But his attempts to cap bank interest rates flopped after the Budget and Appropriations Committee argued that the Finance Bill was inconsistent with Article 114 of the Constitution.
While President Mwai Kibaki had supported the Donde Bill by prevailing upon Moi not to be intimidated by commercial banks, he also failed to tame the high interest rates when he took office. While some Kenyans turn to courts when banks attempt to auction their property, in most cases, courts ruled that the Banking Act gave banks the right to increase rates without informing the borrower—or without approval of the Finance minister.On 24thAugust, 2016 President Uhuru Kenyatta signed into law a Bill capping bank interest rates at 4% above the Central Bank Benchmark Rate. Accordingly, commercial banks could charge no more than four per cent above the base rate set by the Central Bank and depositors to receive a minimum of 70% of the CBR rate.
In a competitive market, the forces of demand and supply can determine the equilibrium interest rates. There is no market failure. But in an ogolipolistic market structure such as Kenya’s banking industry where 6 banks control 70% of bank assets this cannot be realized. This leads to few banks controlling the market resulting to skewed liquidity and higher lending rates. What used to happen in the banking industry before the capping was a replica of the petroleum industry before parliament established Energy Regulatory Commission (ERC). Crude oil prices would fall but oil firms would not reciprocate. And did the oil firms shut down after ERC came into force? No! The petroleum and banking industries are both highly oligopolistic (near monopoly).That’s why regulation is important. If the bill coming into force would have been counterproductive, why would developed nations such as France, Canada, Germany and even over half of Sub-Sahara economies including South Africa cap interest rates? All West African Economic Monetary Union (WAEMU) member states have capped interest rate.
Those opposed to capping of interest rates base their argument on Joseph E. Stiglitz, Andrew Weiss (1981) article Credit Rationing in Markets with Imperfect Information published in the American Economic Review. But this is theoretical work based on an ideal competitive market. They argue that banks will ration credit and lock out SMEs. Prior to the interest rate capping, credit to the SMEs was available but at what cost? If a bank lends to SME at 25%, it implies that the firm must make a return of more than 50% so that it is able to pay the cost of loan and operational costs which includes salaries and other overheads. Which business would post such a return under the prevailing economic environment in Kenya? Jubilee government promised Kenyans low interest rates during the 2013 campaigns. Businesses cannot grow and even the economy at interest rates that prevailed before the capping. Has the finance parliamentary committee carried out credible research to establish why capping has been successful in countries that control more than 80% of the GDP?
So what’s the problem with capping? The elephant in the room is high appetite for government borrowing in the domestic market. Since the capping of interest rate back in 2016, the government has borrowed a whopping Kes 900 billion from the domestic market and mainly from the banks through treasury bills. Ideally any bank would find it worthwhile to lend money to the government since its risk free rather than the private sector. This essentially crowds out private sector which is the engine of growth. Put differently, if the banks did not lend the Kes 900 to the government in 3 years, the implication is that this money would have been lent to the private sector in order to spur investments and ultimately economic growth. What would the banks do with this kind of money if the government doesn’t borrow? Simply lend to the private sector and households. And banks must lend in order to survive.And if at the end of the year, they are holding a lot of liquidity which doesn’t generate revenue, what shall the management tell shareholders during the annual general meeting when they expect dividend payout? The CBR rate has already factored in the risk component. Moreover, banks have Credit Reference Bureaus where they can access information on borrowers’ credit worth.
President Mwai Kibaki operated on a balanced budget where the government expenditure was equal to government revenue. The implication was that the government then was not borrowing from the money market. The excess liquidity in the banks led to the lowest levels ever witnessed in this country. The ratio of credit to the private sector went up and Kenya witnessed a booming economy. The cost of capital for firms went down and therefore more firms could borrow cheaply with prospects of business expansions and higher employment. Households were also affected positively. This translated to higher investments and therefore higher economic growth.
The other implication was that there was also flow of funds from the money market to the stock market which led to NSE being ranked as the best performing by IFCin 2003. For infrastructure projects, Kibaki government went for external concessional loans whose tenor spread into many years and whose interest rates were very low. That’s how Thika superhighway was built from concessional funding from Africa Development Bank. Concessional loans from institutions such as World Bank, ADB, EADB, Bilateral loans from friendly developed countries such as Japan attract an interest rate of 1%. On the contrary the current government has been borrowing at commercial interest rate of 9%with short tenor and therefore expensive to service.Who bears the cost of these expensive loans? The taxpayer.Why would the government shun concessional funding? There is no room for kickbacks.
The tragedy is that since 2013 the government has been borrowing its own money also. There are huge commercial bank deposits by government institutions such as parastatals and quasi government agencies and authorities. And when government borrows domestically via the treasury bills, it is essentially borrowing its own deposits from banks and paying a cost for it as interest rate. And what makes the parliamentary finance committee believe that if the law is repealed government won’t borrow anymore? On the contrary, it will borrow more in order to undertake infrastructure projects, thus crowd out more private sector investments. And this will be at a higher cost as the interest rate goes up. Why? The government will offer the treasury bills at higher than the Central Bank Rate in order to attract buyers. But there are several options that the government can turn to rather than borrowing. One is to offload the government shareholding in several state corporations and commercial banks(e.g KCB, NBK,Consolidated bank etc)also known as divestiture or privatization. Take for instance, the government shareholding of 35%in Safaricom. The proceeds from such a sale can build another Thika superhighway. Repealing the interest rate capping is therefore not a solution. Deal with the high appetite for domestic borrowing.
The author, Peter Muriu, holds a PhD in Financial Economics, from University of Birmingham in Britain. He is a senior lecturer in Monetary and Financial Economics at the School of Economics, University of Nairobi. He has taught and published widely on interest rates.