Opinion & Analysis

How interest cap has thrown monetary policy into chaos

Central Bank of Kenya Governor Patrick Njoroge. FILE PHOTO
Central Bank of Kenya Governor Patrick Njoroge. FILE PHOTO 

Last year, I opposed the interest rate cap before it was approved and came into effect.

I opposed it because I knew it would lead to a contraction of liquidity, particularly for SMEs who are often viewed as high risk by mainstream banks.

A few months later, the fears I had have become a reality. Last week this paper reported that Kenya’s private sector growth moved towards stagnation in February partly due to a decline in private sector credit growth to the lowest level in a decade.

As this paper reported, Treasury data indicates that lending to businesses and homes grew just 4.3 per cent in the year to December, down from 20.6 per cent in a similar period in 2015.

The 4.3 per cent credit increase is well below what the Central Bank of Kenya (CBK) says is ideal loan growth of 12 to 15 per cent which is required to support economic growth and job creation.

The irony of this situation is two-fold. Firstly, the interest cap did not expand lending, it contracted it, particularly for SMEs.

Strathmore Business School indicates that most SMEs in Kenya still struggle to raise capital from banks. With rate caps, refinancing of credit from financial institutions has become even more of a challenge.

Second, even with the interest rate cap, most SMEs find current interest rates unaffordable. Credit is still too expensive. So what did the interest cap achieve?

Firstly, it has made it even more difficult for SMEs to get access to credit and to be honest, it is an effort in futility as credit is still too expensive for most, even with the cap.

This is where monetary policy would usually come in to try and address the situation. In a normal scenario with no cap, a contraction in liquidity would usually lead to a drop in interest rates to encourage banks to lend.

However, the CBK cannot do this due to two reasons. First, the ongoing drought is already placing upward pressure on inflation—the overall inflation rate for February this year was 9.04 per cent—well above the preferred ceiling of 7.5 per cent.

The CBK is therefore unlikely to drop rates as this would place further upward pressure on inflation. This is also an election year where billions enter the economy in an almost artificial manner, putting further upward pressure on inflation.

The interest cap has thrown monetary policy into chaos.

In the current situation, the CBK cannot drop interest rates to encourage lending as this would engender further contraction in liquidity, shutting even more people and businesses out from access to credit.

Lowering interest rates would make banks even more reluctant to lend. So the irony of the situation is that it appears that an increase in interest rates may encourage more lending from banks as it would raise the risk ceiling of those to whom banks are comfortable lending.

Kenya is in an interesting position where increasing interest rates may actually expand lending; monetary policy has to work upside down.

However, if the increase in interest rates were effected to try and address the contraction in liquidity and worked, it may then exacerbate the inflation—by increasing the money in people’s hands.

In this upside down world there are compelling reasons against raising interest rates as well as dropping them. Raising interest rates would likely expand liquidity and exacerbate inflation and dropping rates would likely engender a further contraction in liquidity.

The world is watching this experiment with interest rate capping going on in Kenya, and thus far it is making the case against interest rate caps even stronger.