Why capping bank interest rates is a big gamble

Parliament in session. FILE
Parliament in session. Parliament endorsed a Bill capping interest rates and is now awaiting Presidential ascent. PHOTO | FILE 

Kenyans are debating whether bank interest rates should be capped at four per cent above the Central Bank Rate (CBR).

The motive behind this push by MPs is informed by the general feeling that interest rates are too high, leading to low access to finance that in turn dampens economic growth.

I broadly agree with this sentiment. However, capping interest rates poses some risks that need to be understood.

The general perception, indeed the populist position, is that lowering interest rates will mean that more Kenyans will improve access to credit thereby enabling them to make more economically productive investments and drive up growth in the gross domestic product (GDP). This is not what will happen; more on this later.

But let’s say that lowered interest rates did lead to an increased number of Kenyans being able to qualify for loans.


What would likely happen in this scenario is that the increase in money supply in 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 push 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.

Additional risk

So what Kenyans are risking here is that increased access to money through lower interest rates will drive up the price level, which reduces the value of the money they borrowed thereby inhibiting the power of that money to generate higher profits and economic growth.

This leads to another point. When interest rates are forced downwards, inflation may rise so high that Kenya will be in the ludicrous position of the Central Bank of Kenya (CBK) being pressured to raise the price of money in order 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 not likely 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 receiving loans 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 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.

The reason for the elucidation above are not rooted in a desire to show that access to finance will become 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, so be it. But let us not, as Kenyans, deceive ourselves into thinking that the proposal to cap interest rates is risk-free.

Ms Were is a development economist; [email protected]