The Central Bank of Kenya (CBK) raised interest rates by two per cent after its latest Monetary Policy Committee (MPC) meeting last week.
That was a huge percentage by any standard. Why such a huge raise? What are the intended and unintended consequences?
The banks will respond by raising interest rates, mostly on loans, and maybe a little on deposits. Banks often respond quickly. They will make more money, with loans a big source of their revenues. Will shylocks do the same?
The only problem with banks’ reaction is that the
default rate will go up. Most loans are on a floating rate, meaning they are subject to the market. Like other prices, interest rates are quick to rise and slow to fall.
If you recall the Kibaki era, which the Kenya Kwanza government is benchmarking with, interest rates went down; Kenyans borrowed more and the economy boomed.
Banks even pitched tents on the streets to lend. I used to get calls requesting me to borrow money from banks.
Any economist, even a lazy one, will confess to you that lowering the interest rate will stimulate the economy. We saw that happen during the Kibaki era. Why then do the opposite?
There are four possible explanations. One, It seems inflation is a worse evil than joblessness and loan defaults that result from high interest rates.
By raising rates, we shall borrow less to invest or consume. That reduces demand for goods and services, leading to a fall in prices.
But inflation has been within the CBK defined bands of 2. 5 per cent to 7.5 per cent. It was last reported as 6.8. The focus of rate hike might not be inflation. Let’s speculate by awakening some ghosts.
In the aftermath of the Goldenberg scandal, and KANU expensive election in 1992, interest rates went through the roof to suck out the excess liquidity in the market. Is there something like that today?
Two, which has CBK alluded to, is the weakening shilling. It is a bigger worry than inflation but the two are connected.
A weak shilling leads to expensive imports and fuels inflation, more so when our imports exceed exports. Our key import is oil and a rise in its price has repercussions across the economy. It is also easily politicised.
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A weak shilling’s worst effect is on the national debt, which is denominated in hard currencies, particularly the dollar.
A weak shillings makes our debt more expensive. A loan of $1 million is equivalent to Sh150 million at the exchange rate of 1$ to Sh150. It would have been Sh100 million if the shilling remained at $1 to Sh100. Where do you get the extra Sh50 million to pay the debt?
Either borrow now (with higher rates) to pay past debt, or raise taxes. You can also reduce your expenditure. If you saw MPs walking out over the scrapping of the Constituency Development Fund (CDF) and an attempt to control their pay, you know why the third option is a political hot potato.
MPs’ pay was easy to control when the president could threaten them with the dissolution of Parliament. He had powers to do so in the old constitution.
Raising rates will attract more foreign currencies (hopefully dollars); investors love higher returns either in stock markets or just deposits in banks.
This would create demand for the shilling as foreign currency is converted into local currency, leading to its appreciation.
A more stable shilling will also attract foreign direct investment, usually in dollars and further strengthen the shilling. Except for speculators, serious investors love predictability.
Three, by “shocking” the financial system with a higher rate, the CBK hopes to initiate a domino effect. Those hoarding dollars would realise the government is determined to shore up the shilling and they will lose if the dollar depreciates against the shilling.
They will flood the market with dollars and shore up the shilling, starting a cycle. But let’s accept shock therapy has not always worked.
Four, the government despite its disdain for debt has to raise money through treasury bonds and bills. One way to attract money using these instruments is through higher rates. When the government gets the money, it reduces inflation and shores up the value of the shilling; that sounds like a magic bullet, but will it work?
In whispers; high rates reduce the value of the bonds. Will that affect the capitalisation of the banks that hold large quantities of such assets? About Sh1.6 trillion. Did I read that one bank had reduced its quantity of bonds? Does it mean the rate hike was not a surprise?
The CBK rate hike is a bold move. Is there a life wire to the International Monetary Fund (IMF)? But the emotional and sentimental part of the market matters. Why are we hoarding dollars? What we are fearing?
Why is foreign direct investment (FDI) slowing down? How much confidence do we have in our economy? Why are we blaming past regimes? Scapegoating works in our traditional ceremonies (you know them), not in economic turnarounds.
Will the market demand such bold decisions in fiscal policy too? Can the government reduce its expenditure despite the political costs? Can such boldness apply to corruption and deal-making, the soft underbelly of our economy?