Kenya is healing from an unintended setback erupted from violation of the law of economy. Government of Kenya’s attempt to control interest rate backfired as economy drifted towards slow lane due to slower private sector credit growth and reduced signalling effects of monetary policy. Kenya is learning and so are many economies from their policy failures. In this video I dig into the causes and effects of interest rate controls and it’s inevitability of failure. I took help from IMF’s working paper titled “Do Interest Rate Controls Work? Evidence from Kenya” and some other articles on the topic.
In October 2019, Kenya’s parliament repealed its cap on lending rate as majority went with president’s refusal to keep the cap intact. It finally makes way for central bank of Kenya to play an active role in the Economy after being in the hibernation for three years. This case of capping lending rate far below from the existing market rate is a prime example where Economy falls apart when laws of economy are disrupted and market is neglected.
In a time when credit growth was already on the downward slope, budget deficit widening, and banks’ profitability narrowing; Government of Kenya thought of a plan to stimulate the Economy. And finally law on interest rates became effective in September 2016 with unanimous support from parliament. Similar attempts in the year 2001 and 2011 failed. But this time the government was adamant. This law had two implications: (a) A ceiling on lending rate by banks and financial institutions and (b) a floor on interest rates for time deposits. There were two objectives in lawmakers’ mind while making this law: (a) Expand access to credit and (b) increase return on savings. But a completely different picture came into the frame.
To lay the context, let’s look at the scenario of the banking sector of Kenya when the law was coming into effect. 60% of outstanding loans charged interest rates above the lending rate ceiling. It’s important to point out that overall share of bank’s loans to small and medium enterprises was about 18.0% while small banks had around 40.0% exposure to small and medium enterprises segment. To understand the essence of it, we need to know that these small and medium enterprises are less creditworthy compared to other big corporate clients. To compensate for the higher risk, banks usually charge higher interest rates on loans to small and medium enterprises. It has some serious implications for banks that have higher exposure to small and medium enterprises. On the other hand, 50% of bank deposits offered interest rates below the stated floor deposit rates.
So, there were three important consequences that took place after the law was introduced:
- Shrinking of loan book of banks especially in the small and medium enterprises segment
- Banks’ increasing appetite for government securities
- And ineffectiveness of central bank’s policy tools
Following the enforcement of the law, large and medium sized banks remained unaffected in terms of loan growth. But small banks faced the brunt as their loan book declined by 5% in 1 year after the law was enforced. The reason small banks had to take such toll is their heavy exposure to small and medium sized enterprises. Small and medium enterprises are deemed to be risky borrower. A ceiling on lending rate prevented small banks to compensate for such risk. Hence, they squeezed their loan book as giving loans to small and medium enterprises turned loss making.
In the deposit book, there were disproportionate effect on growth. Demand deposits grew faster than time deposit. Banks increasingly looked for demand deposits to cut down their cost of fund which also led the banks increase their short-term loan book since depositors can withdraw their demand deposits any time. So, banks also had to cut down the tenure of their overall loan book.
Moreover, banks increased fees and commissions to compensate for their lower interest rate income which put borrowers in a confusing situation. Borrowers found it hard to gauge their true cost of borrowing.
To make the situation even worse, at the time when the law was enforced the Government of Kenya was borrowing heavily from banks to finance their budget deficit. The rate offered by the Government also remained unchanged following the enforcement of law. So, banks found it profitable to lend to Government in terms of risk return spectrum. As a result, banks cut down their credit to private sector and increased their lending to public sector.
Finally, the law led central bank of Kenya sit idle and watch it all unfolded from the spectators’ gallery. Central bank of Kenya kept their policy rate unchanged even though credit growth was on the lower side. The central bank feared that lowering the policy rate would squeeze the loan book of banks especially in the small and medium enterprises since the Policy rate is the reference rate with which the ceiling on lending and floor on deposit rate was adjusted.
As credit growth continued to slowdown and economic activities started taking a dip; Government of Kenya heard the alarm.
Finally, in September 2018, the floor on deposit rate was removed and in October 2019 ceiling rate was repealed. Now Government of Kenya expects the economy to heal from an unintended setback that produce a lesson for other economies too.