Interest Rate Capping a Risky Move

Posted on

This article first appeared in my weekly column with the Business Daily on August 7, 2016

Kenyans are in the process of debating whether interest rates in Kenya should be capped at 4  percent above the Central Bank of Kenya Rate. The motive behind this push by Members of Parliament is informed by the general feeling that interest rates in Kenya are too high, leading to low access to finance which dampens economic growth; and I broadly agree with this sentiment. However, the move to cap interest rates is gnarled in risks that need to be understood.

The general perception, indeed the populist position, is that lowering interest rates will mean that more Kenyans will be able to access more credit thereby enabling them to make more economically productive investments and drive up GDP growth. This is not what will happen; more on this later. But let’s say that lowered interest rates did lead to more Kenyans being able to qualify for debt and more had access to more money. What would likely happen in this scenario is that the increase in money supply into the economy would place significant upward pressure on inflation. So there is a real risk that the sudden increase in money supply facilitated by lower interest rates would drive inflation upwards. Two things would then happen: first the cost of goods and services for Kenyans would go up and dampen the ability of the money they borrowed to drive forward investments made through the debt. The lower rates would lead to a situation where the money they borrowed would be less profitable than would be the case if inflation had remained stable at current rates. So what Kenyans are risking here is that increased access to money through lower interest rates will drive up inflation which reduces the value of the money they borrowed thereby inhibiting the ability of that money to drive up profits and economic growth.

(source: http://letscrowdsmarter.com/wp-content/uploads/2016/03/Interest-Rates.jpg)

This leads to another point; forcibly low interest rates may drive inflation up so high that Kenya will be in the ludicrous position of the Central Bank of Kenya (CBK) being pressured to raise interest rates to control the inflation caused by lower rates.  So the irony is that rates being lowered will lead to rates later being raised to address the problems caused by rates that were artificially lowered.

This leads to the other risk I alluded to earlier; an increase in money supply due to lower rates is likely not to happen. What will actually happen is a contraction in lending and money supply. Capping interest rates will put banks in the position where an entire segment of the population is disqualified from lending because they pose more risk than the interest rate cap allows. Banks will simply not lend to individuals and businesses whom they think cannot service the debt credibly at that capped ceiling. So what will actually happen if interest rates are capped is reduced lending, not increased lending. So an additional risk is that capping interest rates will reduce access to credit which will make economic growth even more sluggish than is the case with current interest rates.

(source: http://blogs.worldbank.org/psd/files/psd/kenya-smes.jpg)

The elucidation  above is not rooted in a desire to make access to finance more difficult for Kenyans; the explanations merely provide a considered opinion of what will likely happen if interest rates are capped. If Kenyans are of the view that engaging in this gamble is worth it, then so be it. But let us not, as Kenyans, deceive ourselves into thinking that the proposal to cap interest rates is risk free.

 Anzetse Were is a development economist; anzetsew@gmail.com

Advertisements

2 thoughts on “Interest Rate Capping a Risky Move

    wahomej said:
    August 8, 2016 at 6:52 am

    I couldn’t agree more, capping the rates sounds like a 2017 political stance!

    kimemiamaina said:
    August 8, 2016 at 7:12 am

    I also think this focus on capping rates ignores that there is more to the eventual interest rate that a Kenyan borrower pays than simply the cost the bank incurs borrowing funds from CBK. There is the covering for risk of bad debts from dodgy borrowers and so on.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s