Interest rates must not be capped

The call to cap interest rates as embodied in the Banking (Amendment) Bill is a form of price control policy.

While such a policy may be popular and with good intentions, its implementation will likely lead to distortion of markets, which will eventually restrict economic growth in the long run.

The Bill is a manifestation of recent tightening of credit policy intervention by Central Bank to contain rate inflation and the depreciation of the Kenyan Shilling by hiking the Central Bank Rate. CBR is the price that commercial banks pay when they borrow funds from the Central Bank, which is set by the Monetary Policy Committee.

In tandem with the CBR hike, the banking sector in turn increased the lending rates for existing and future loans, triggering a public outcry.

If Parliament approves the Bill, the interest rates for both loans and deposit markets will be capped.

In the loans market, a bank or a financial institution will not charge interest rate beyond four per cent over and above the Central Bank Rate (CBR).

For deposits market, the minimum interest rate payable to deposits held in interest earning accounts shall be at least 70 per cent of the CBR.

As the saying goes, it is the wearer of the shoe who knows where it pinches most. Analogously loans and deposits markets are dedicated to the principle that borrowers and financial institutions are the best judge as to when to borrow or to lend and to save or to accept deposits respectively.

From an efficiency point of view, the policy to cap interest rate would be ideally justifiable if such capping would mimic the market lending and deposit rates.

However in reality, achieving such a noble objective would be an insurmountable task for the government because first, 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.

Secondly, capping interest might be the wrong prescription to deal with inflation pressures caused by the exchange rate volatility coupled with local, regional and global shocks.

The temporal nature of these shocks may render the policy ineffective as evidenced by the downward trend of prices of crude that has reduced the domestic oil and commodity prices.

If there is a legitimate policy concern over the escalating lending rates, the government should adopt a less disruptive short-term strategy that entails allowing the financial institution to change market rates at a subsidisedrate. Such interventions are manageable and less disruptive to the economy as a whole than capping the interest rate.

The long-term strategy of effectively dealing with the problem of high interest among others is to enforce competition in the financial sector.

Enforcement of the Competition Act to promote and protect effective competition in financial sector services is a necessary condition that would guarantee low interest rates.