Does cap on interest rates make economic sense?
By XN Iraki | August 2nd 2016
In the long- forgotten age of price controls, I was once sent to buy sugar at a local shop. To my surprise, the shopkeeper demanded that to buy sugar, I must buy tea leaves, a match box and a few other things we did not need.
Without the benefit of a mobile phone, I walked home, 4km away, to report that I needed more money to buy sugar at the same price.
Aside from this ‘bundling’, shop keepers and distributors hoarded the products whose prices were controlled, from cigarettes to beer and petrol, a few days before budget day when the Finance minister announced new prices. We even had a commissioner for the control of prices and monopolies.
The Bill to cap loan interest rates now awaits presidential assent. Former MP Joe Donde unsuccessfully tried capping rates more than a decade ago.
But why should we return to the pre-liberalisation age before the 1990s? Has the price control mentality never faded from the national psyche? It is instructive that economic and political liberalisation came around the same time.
There is no doubt that interest rates are high in Kenya. In Europe, North America and Japan, an interest rate of 5 per cent would be considered catastrophic.
In Kenya, paying 15 per cent on a mortgage is considered normal. In some countries, a mortgage rate of 2.5 per cent is considered exorbitant.
Some of the reasons attributed to high rates include high risks of default among borrowers, and a lack of information on them. One would have thought that with the creation of credit reference bureaus, default risks would reduce and interest rates fall because of better credit history on individuals.
The rise of microfinance banks and investment clubs/chamas does not seem to have made a dent on interest rates as expected.
If Kenya is overbanked, why are rates so high? Should this not naturally lead to competition for deposits and borrowers and lower rates? But rates remain high. Is Kenya’s banking sector an enigma?
A closer look at the sector yields some interesting findings. About five banks control 70 per cent of the market. In the microfinance sector, three institutions have a market share of about 93 per cent, Central Bank of Kenya data shows.
Most of the loans go to manufacturing, trade, real estate and personal loans; basically, a few sectors.
The banking sector is not as diversified as expected. Could this be the reason behind high interest rates? Since most banks are privately owned, some suggest that some collusion or cartel-like behaviour is not a remote possibility. Is that why the CBK governor is demanding banks list key shareholders on their websites?
Banking is profitable in Kenya, going by publicly available data. Some have speculated that the Bill to cap interest rates is a last resort after all other measures have failed.
Others suggest it is a scare tactic designed to make banks act as CBK rate cuts have failed to dent interest rates. Others argue that the market has failed, and the Government should move in to correct it. Ask Adam Smith ....
If other measures have failed, will interest rate caps work? Some argue it has worked in the oil sector. This, however, is speculation as we cannot tell what the prices would be if the market were free — but I have a hunch oil prices would be lower.
Interest rate caps will lead to a shortage of funds just as price caps led to a shortage of sugar and other essentials. Bankers will have no incentive to lend because their profits will be lower. To keep their profits up, they will raise their service charges, getting free money from us instead of giving us that money to invest.
If well connected, why can’t I get money from a bank at the lower rate that is capped and lend it on at a higher rate? Does the Bill cover shylocks who lend money at higher rates than banks?
But more importantly, why should we settle economic issues politically? If we let politicians cap interest rates, they will cap other things like the number of children you should have or dowry prices.
The decision to cap interest rates is likely to be politically popular, but its consequences will reverberate throughout the economy. Is it true some politicians have stakes in banks?
If rates are lowered by law, a rush for loans will follow. Personal networks will replace price (interest rates) as the basis of getting loans. That is bad for the economy.
A better alternative to capping rates would be to unleash more competition in the sector. That has worked well in the matatu and higher education sectors. What is the view of the Competition Authority on interest rate caps?
Do we need a disruptor in the banking sector to force banks to become more efficient and competitive? Why can’t we start virtual banks? With ICT, banks should be more efficient and pass these savings to customers. Some have argued that consolidating banks will lead to economies of scale and reduce costs further.
The decision to cap interest rates looks at the interests of borrowers, not lenders. It should be revisited. It makes lots of political sense, but not economic sense.
The writer is senior lecturer, University of Nairobi. [email protected]
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