This seems to be the most important question in the market right now. There are many compelling reasons for removing the interest rate cap. For instance, banks are incapable of taking additional risk as a result of the interest rate cap and have chosen to lend mostly to the government instead. This has led to a credit rationing leaving the private sector, and especially the risky borrowers, left out.
In a related development, the Kenyan government is increasingly straining its financial position. To give an illustration of the problem, the government finds that more than 40% of its revenues are going towards debt servicing and the number is growing fast. To protect itself and the Kenya Shilling from a speculative attack, it has sought the help of the IMF through a stand-by facility. Access to this facility was suspended in June 2016 after it was deemed that the Kenyan Government was in breach of some terms.
The facility was to end in March 2018 and the government wanted to extend the facility. To achieve this, the IMF had a raft of conditions it wants met as it extended the facility for sixmonths. The IMF wants the government to reduce the budget deficit and has proposed a number of tax measures to achieve this. It has also asked for the interest rate caps to be removed or substantially reformed towards this end.
This recent action by the government of Kenya has brought the law back to the spotlight. Why does the IMF want the law repealed?
It is no secret that the private economy has seen a significant slowdown. In a recent communique by the Central Bank of Kenya’s Monetary Policy Committee, the CBK governor observed that “Private sector credit grew by 2.1% in the 12 months to February 2018, slightly lower than the 2.4% in December 2017” and that “economic output was below its potential level”.
The deceleration of credit recorded by the CBK is obviously related to CBK’s argument that the economy is operating below its potential which means the economy is probably being held back by the law. It is clear that the law is deflationary in the sense that it discourages banks from lending as it limits benefits as a result of taking on more risk. If banks cannot fund risky businesses then entrepreneurs stand hamstrung.
However, I want to offer another reason. Question:were the interest rates too high?
I want to bring into focus the role of prices, and therefore, the role of markets in an economy. According to Economist Friedrich August Hayek, in his essay The Use of Knowledge in Society, prices carry important information that entrepreneurs and consumers can act on. For instance, in a normal unhampered market, when there is a shortage in a commodity, its price will naturally rise. The natural response of the market is that this will lead to conservation efforts by consumers and increased investment in alternatives on the supply side.
In the context of the loanable funds market, when there are high interest rates, we expect that borrowers will pare back borrowing to conserve scarce resources and savers will be incentivized to save more as the interest rates rise, it becomes more beneficial to defer consumption in order to invest more for higher returns.
That is the ideal. However, when it is the government borrowing, this brings in different dynamics. Governments are usually able to borrow quite large amounts as the lenders are comfortable with lending to governments asthey don’t have the same default risk that private entities have. This allows governments the capacity to over-borrow. Therefore, because governments do not have the same disincentive to borrow that private corporations do, market prices become more important. The natural reaction to over-borrowing in the market is higher interest rates as resources that are available for borrowing reduce.
In order to hide this perverse outcome, governments usually choose to legislate against high interest rates. The outcome is the same in the sense that the government laws will lead to credit rationing as lenders will not be incentivized to lend to risky investments at lower rates as a result of government mandates.
The move also interferes with the working of the market as it alsodisincentivizes savings as lower rates means banks are less able to pay better interest rates and this will means lower supply of loanable resources.
In this sense, as we have seen, interest rate price controls has led to three things namely, lower incentives to lend, lower incentives to save and credit rationing. In a nutshell, the law interferes with the natural operations of the market and therefore needs to be scrapped.
By Johnson Nderi
The writer is the Manager, Corporate Finance and Advisory at ABC Capital Ltd
Johnson has a wealth of Capital markets experience having previously been the Head of Research and Head of Corporate Finance at Suntra Investment Bank.
Johnson has advised many transactions ranging from bonds to shares both in the public and private space. He has participated in a number of private and public issues such as IPOs, Public Issues of unlisted companies, Private Placements and Over The Counter (OTC) transactions.
Johnson is also a media commentator on investments, financial and economic issues. He has regularly featured in various local and foreign TV stations including NTV, CCTV, and CNBC. Johnson holds a Bachelor of Arts degree from Egerton University. He also has concluded Part I&II of the Investment and Securities Analyst program as well as ACCA part I.