Interest rate caps: Budget office proposes review of law

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Kenya’s Parliamentary Budget Office has proposed a review of the interest rate cap law to boost lending to households and businesses, and give the Central Bank the freedom to use its policy rate to control money supply, inflation and exchange rates.

Kenyan banks have been unwilling to lend to the private sector, preferring the government through risk-free Treasury-bills and bonds.

Improving monetary policy

The Central Bank is unable to adjust the central bank rate (CBR) as it will simultaneously change deposit and lending rates, leading to volatility and instability in the financial markets.

“The interest rate controls have affected the flexibility of the key monetary policy tool, the CBR itself,” said the Parliamentary Budget Office in a report released last month.

“This law may require further streamlining to ensure that the profitability of banks is not compromised and to improve Monetary Policy flexibility.”

However, analysts say that while the proposal to lift the cap is important, a new interest rate framework should be developed to ensure that banks respond to monetary policy signals from Central Bank since they have been reluctant to do so even before the interest rate caps.

“CBK’s monetary policy instrument was not effective because there was no linkage between CBR and lending rates and so the banks could not respond even if CBK adjusted its policy rate,” the analyst said.

CBR

The Banking (Amendment) Act of 2016 came into force in September of that year. It fixed lending rates at four percentage points above the CBR, and a floor on term deposit rates equal to 70 per cent of the CBR. Since then, CBK has retained its policy rate at 10 per cent.

According to the World Bank, interest rate caps undermine monetary policy transmission and implementation, with implications for CBK’s independence and its ability to steer the economy.

“With caps linked to the CBR, changes in the policy rates could be counterproductive,” says the World Bank. “Furthermore, pegging the interest rate cap to the CBR has fundamentally affected the effectiveness of monetary policy, and the signalling and relevance of the CBR.”

For example, if the CBK were to reduce its policy rate to stimulate the economy there would be a decline in the interest rate ceiling which would in turn make it less profitable for banks to lend, particularly to smaller or higher risk customers, thus potentially offsetting the impact of the rate cut.

According to the World Bank, the interest rate cap has negatively affected small borrowers and small and medium-sized enterprises.

With risk-free 364-day Treasury bills and five-year government bonds at about 11 per cent and 12.5 per cent respectively, a cap of 14 per cent effectively prices out several borrowers and encourages investment in government securities at the expense of lending to the private sector.

“Removing the interest rate cap can help re-boost domestic credit to the private sector and allow the Central Bank to effectively implement monetary policy, a key role in fostering growth,” World Bank says.^  (East African)

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