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Kenya Economy: Interest rate cap may fail to spur economic growth

On 24th August 2016, seating President Uhuru Kenyatta accented to capping of interest rates and flooring of deposit rates by signing into law the Banking (Amendment) Bill 2015. The amendment puts a cap on commercial banks lending rates at 4.00% above Central Bank Rate (CBR) and a floor on commercial banks deposit rates at 70% of CBR.

Two months down the line, the interest rate cap seems to have had minimum effect in the local economy. In theory, the following should have transpired after interest rates were capped and deposit rates floored.

Companies and individuals would have been more willing to take loans from financial institutions due to lower prevailing rates. The excess money borrowed would then increase consumer spending which would boost production. On the other hand, savings would increase due to higher deposit rates from financial institutions. The increased savings would then encourage financial institutions to lend more to the economy creating a vicious cycle which would eventually spur economic growth.

The above stated scenario has failed to transpire in the local domain. Several reasons can be fronted as to why this is the case but government borrowing may take the lion’s share in this debate.

Also Read: Political Risk and Interest Rates Capping Effects Points to a Shrinking Economy

Governments usually borrow to fund expenditures by issuing securities (treasury bills and bonds) to the general public. The borrowing can either be internal or external depending on the credit worthiness of the country. Kenya government borrowing seems to be the major impediment to the interest rate cap effectiveness in the local economy.

During this week’s auction, Treasury bill rates of the 91 days and 364 days increased to 8.03% and 10.576% respectively. T-bill rates seem to have halted their downward trend. The latest infrastructure bond IFB1/2016/15 was issued with a coupon rate of 12.00% and average yield of 13.177%.

Essentially, the government is borrowing at over 10% to fund its current and future expenditures. At the same time, commercial banks deposit rates have been floored at 7.00% (70% of CBR currently at 10.00%) and interest rates have been capped at 14.00% (4.00% above CBR).

Commercial banks cannot afford to offer deposit rates above 10.00% which the government is offering. Further more government borrowing is risk free hence any rational investor would lend money to the government rather than placing a deposit in a commercial bank.

Also Read: Why Kenya Government Borrowing is Starving The Local Economy of Funding

On the lending side, the risk premium afforded to commercial banks is not sufficient to cover their exposure to lend to the real economy. Why would a commercial bank lend to a client at 14.00% exposing the bank to liquidity and credit risk while the same funds can be invested in risk free government securities at over 10.00% return?

The Kenya economy is experiencing an inverted pyramid scenario where all the funds would be directed to government borrowing for both clients and commercial banks. This beats the whole point of having an interest rate cap and deposit rate floor. Did the regulation just shoot its foot or is there an anterior motive that we are not aware about?

The situation can be remedied by implementation of the following policies by the regulator. The regulator may lower government borrowing rates by rejecting expensive bids on securities. This may lower the cost of funding for government expenditures and may encourage investors to lend to the real economy. The only catch is that the Kenya shilling exchange rate would be exposed to depreciation due to inverse relationship between interest rates and exchange rates.

Alternatively, the regulator may opt to raise the CBR rate. Raising the CBR by about 2.00% would make returns on commercial bank lending attractive to investors. Deposit rates would also rise hence commercial banks would be able to offer better rates to clients. The catch here is that interest rates would rise in the local economy negating the benefits of the interest rate cap.

Another option for the regulator would be to increase money supply in the local economy by injecting liquidity via reverse repos to encourage banks to lend to the economy. The only draw back to this solution is that the injection of liquidity would be short term whereas lending interest rates are supposed to be lowered for the long term.

The regulator is in a catch 22 situation since the best alternative would be to lower government borrowing rates which would be difficult since the government requires the funds to cover current and future expenditures. This means that the interest rate cap effectiveness in the local domain would be dampened for the foreseeable future.

Also Read: Kenya Economy Vulnerable to Over Reliance on Monetary Policies


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Posted by Timothy II Aperit

True believer in numbers. Statistics never lie. Bsc Financial Engineering MBA Finance ACCA