Why Kenya's interest cap law won't help

A few days after Kenya’s President Uhuru Kenyatta signed a law introducing a ceiling on interest rates in East Africa’s largest economy, the World Bank ‘withdrew’ from its website an interesting research paper titled, ‘Interest rate caps around the world: still popular, but a blunt instrument.’

A few days after Kenya’s President Uhuru Kenyatta signed a law introducing a ceiling on interest rates in East Africa’s largest economy, the World Bank ‘withdrew’ from its website an interesting research paper titled, ‘Interest rate caps around the world: still popular, but a blunt instrument.’

Uhuru’s new law means that Kenyan Commercial Banks cannot charge more than 4 percentage points above the central bank’s benchmark rate, which is currently 10.5 percent; in other words, moving forward, interest rates in Kenya can’t exceed 15 percent.

 

The President said his decision came after wide consultations and a realisation that ‘Kenyans are disappointed and frustrated by the lack of sensitivity within the banking sector.”

 

Kenya’s interest rates are currently the second highest in the region after Uganda whose government is debating whether to bailout over 60 companies that are struggling with bank loans allegedly because of high interest rates.

 

But President Uhuru’s consultations should also have focused on whether caps actually work or simply create more difficulties for borrowers to get credit from banks as evidenced in many countries that have walked down that road.

If you believe that President Uhuru’s action this week was about macroeconomic management and not politics, rethink.

The President reminded me of Philosopher Nicolle Machiavelli’s teachings to young leaders in medieval Italy, about the importance of perception in leadership.

In politics, you don’t have to be a good person. Instead, do things that make you appear to be good; that is what matters most to the gullible masses.’

By passing the new law, Uhuru will be seen by Kenyan masses, to be addressing the issue of high interest rates and whether the law actually works or not, he’ll have vindicated himself ahead of re-election in a few months’ time.

As one of the leading players in Kenya’s private sector, and a former finance minister of his country, President Uhuru knows that market forces of demand and supply determine interest rate movements in free market economies, of which Kenya is an example.

The President acknowledged that fact in the last sentence of his statement issued shortly after signing the new law. “We also reiterate our commitment to free market policies in driving sustainable economic growth, to which we owe much of our success.”

So why pass a law that is clearly in conflict with principles of a free market economy to which the President attributed the country’s sustainable growth in the past? Because politics prevailed over macroeconomics; the president must be seen to be doing something.

But political dividends aside, the new law will do little to influence how banks actually trade their money. The Kenya Bankers’ Association has already indicated their hatred for the new edict and has vowed to fight it.

In the meantime, some interesting things are going to happen in the Kenyan banking sector and shall most likely be felt in other economies, including Rwanda.

Every time a law is passed, companies have one problem; how do they operate normally without being seen to be incompliant? It is normally a headache for well-paid company lawyers.

In Kenya, banks are going to ask, how do we continue lending at a rate that makes business sense without breaking the new law?

An obvious solution is not to lend. Simply procrastinate with clients until they either finally give up or agree to sign somewhere agreeing to borrow at a rate above the decreed interest. This will simply frustrate borrowers even more.

The other scenario is what we could call ‘proxy lending.’ Kenya being Rwanda’s largest source of foreign direct investment; we are likely to see a phenomenon where, banks will be lending to Kenyan firms through their subsidiaries in the region where there are no caps on interest rates.

Here is where the missing World Bank research paper would have been useful; I accessed it on Wednesday night but it was missing Saturday afternoon, perhaps withdrawn for updating to include the Kenyan case.

Anyway, the missing paper found at least 76 countries around the world currently used some form of interest rate caps on loans — all with varying degrees of effects.

In most cases, financial institutions withdrew from poor segments of the market and where they stayed, increased the total cost of the loan through additional fees and commissions, calculated outside the interest rate figure.

Here is what Kenya is about to witness: “As a result of lower caps on interest rates in Japan, the supply of credit appeared to contract, acceptance of loan applications fell, and illegal lending rose (Ellison and Forster 2006; Porteous, Collins, and Abrams 2010).”

Should other countries in the region feel tempted to follow Kenya’s example, they should read the conclusion provided by the missing World Bank paper.

“There are more effective ways of reducing interest rates on loans and improving access to finance over the long run, than caps: measures that enhance competition and product innovation, improve financial consumer protection frameworks, increase financial literacy, promote credit bureaus, enforce disclosure of interest rates, and promote microcredit products. Such measures should be implemented in an integrated manner.”

In a reconciliatory outré, the paper however provides caveats that countries such as Kenya can follow if caps are to be a useful policy tool for reducing interest rates on loans.

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