Lower interest rates make it cheaper to borrow and this encourages spending and investment leading to higher aggregate demand and economic growth.
By ROBA ADAN
The Consumer Federation of Kenya moved to the Supreme Court in 2011 seeking a reversal of a decision that removed controls on interest rates under a legal amendment in 2000. The controls had been imposed through the Central Bank of Kenya (Amendment) Bill 2000, popularly known as the Donde Act after former Gem MP Joe Donde successfully moved the proposals in Parliament. On the other hand, the law specified that the deposit rate was also supposed to be no less than four percentage points below the prevailing T-bill rate. The clauses were meant to stop profiteering by banks at the expense of firms and individuals who were then in financial distress and were being declared bankrupt.
Despite the inapplicability of Donde Bill in the current financial environment, the Jubilee government has been keen on ensuring that interest rates reduce to single digit. In its August report on the state of the economy, the Parliamentary Budget Office (PBO) — the agency that advises Kenya’s lawmakers on how the economy is performing — said banks have been reluctant to raise rates on deposits while they continued charging high interest rates on loans. Parliament is proposing that the country pegs interest paid on deposits as a fraction of the rate banks charge customers for loans, reigniting the debate on introducing interest caps. Part of its report stated; “The high interest rate spread in commercial banks remains a source of concern, with banks making supernormal profits at the expense of depositors. In order to narrow the spread and protect the welfare of depositors, deposit rates could be set as a specified proportion of a bank’s base lending rate”.
The relationship between interest rates and economic growth is derived from the use of interest rates as a means for achieving desired economic conditions. That is to say that interest rates are tools used to make the economy more stable by limiting undesirable factors like inflation and rapid consumption by consumers. Central banks use interest rates to steer price increases towards a publicly announced goal. Inflation, a rise in the overall level of prices, is often bad news. It erodes savings, discourages investment, stimulates capital flight (as domestic investors put their funds into foreign assets, precious metals, or unproductive real estate), inhibits growth, makes economic planning a nightmare, and, in its extreme form, provokes social and political unrest.
Governments consequently have tried to squelch inflation by adopting conservative and sustainable fiscal and monetary policies. In recent years, many central banks, the makers of monetary policy, have adopted a technique called inflation targeting to control the general rise in the price level. In this framework, a central bank estimates and makes public a projected, or “target,” inflation rate and then attempts to steer actual inflation toward that target, using such tools as interest rate changes. Because interest rates and inflation rates tend to move in opposite directions, the likely actions a central bank will take to raise or lower interest rates become more transparent under an inflation targeting policy. Advocates of inflation targeting think this leads to increased economic stability. The mid-term inflation target for Kenya currently stands at 2.5+ 5 per cent. Many central banks adopted inflation targeting as a pragmatic response to the failure of other monetary policy regimes, such as those that targeted the money supply or the value of the currency in relation to another, presumably stable, currency.
The months of April and June saw inflation rates almost bust government ceiling to 7.5 per cent. The reaction was increase in Central Bank Rate (CBR) by 150 basis points to 10 per cent. The CBK Monetary Policy Committee met again in July and further reviewed CBR by 150 basis points to 11.5 per cent in view of increasing inflationary risks attributed to falling shilling against the greenback and major trading currencies in the world. In the same meeting, MPC revised Kenya Bankers Reference Rate (KBRR) from 8.54 per cent to 9.87 per cent, effectively increasing the lending rates at which commercial banks lend to members of the public. These developments in the financial markets and the regulatory environment make single digits lending rate unattainable in the near future.
Another aspect to the interest rate dynamics remains dominance of the market by few large commercial Banks, which control the market share, profitability and credit market. As per Central Bank of Kenya statistics, the banking sector recorded a mild increase of 2.7 per cent in the profit before tax during quarter one of 2015, to stand at KSh37.3 billion against KSh36.32 billion in December 2014. Out of these massive profits, few large lenders control more than half of it. As per the Annual CBK Bank Supervision Report, 2014, 22 banks control 91.6 per cent of the market share leaving less than 10 per cent to the remaining 21. This will affect the initiative to reduce lending rates significantly. Large lenders can lend at reduced rates and sustain their huge profitability compared to majority of the mid-sized and small lenders. This is despite almost similar operational and other costs in the industry.
As per Financial sector Deepening (FSD) April 2015 brief, a survey by CBK found that all banks are in breach of a deal agreed with the regulator not to include profit margins in the premiums they add to the standard base lending rate as this frustrates the regulator’s efforts to bring down the cost of loans. The survey found that banks are loading premiums larger than KBBR, a practice partly blamed for the persistence of high interest rates. Loans to small and medium sized enterprises are priced at an average 20 per cent, including KBRR and a premium of 11.5 per cent. Central Bank of Kenya has stated that removal of the extra elements such as profit and other unclassified elements would leave the lending rate at 3.3 percentage points lower than the current average.
Attaining single digit interest rates may seem unlikely in the short run. Higher interest rates will tend to reduce consumer spending and investment. This will lead to a fall in Aggregate Demand (AD). A lower AD will tend to cause lower economic growth (even negative growth – recession) and higher unemployment. If output falls, firms will produce less goods and therefore will demand less workers. However, it will lead to improvement in the current account. Higher rates will reduce spending on imports and lower inflation will help improve the competitiveness of exports. However, as a net importer, the current high interest rate environment has not helped Kenya improve its balance of payment and current account deficit. Lower interest rates make it cheaper to borrow and this encourages spending and investment leading to higher aggregate demand (AD) and economic growth. This increase in AD may however also cause inflationary pressures, posing a challenge of tricky balance. Interest rates remain a key macroeconomic variable the country will tussle with many years to come.