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Interest rates should be kept low to promote investment, spur economic development

By Eliud Owalo | December 13th 2017 at 12:00:00 GMT +0300

(Photo: Courtesy)

The interest rate debate has dominated Kenyan commercial and economic circles in the past few years. Interest rate is the proportion of a loan that is charged as interest to the borrower, typically expressed as an annual percentage of the loan outstanding.

Interest rates are a critical element to economic activities because they affect the level of macro and micro-economic activities such as GDP, price levels, employment rate, balance of payments, exchange rates, and economic growth. There is a close correlation between interest rates, savings, investment and economic growth.

When interest rates go up, prices of bonds go down and when the interest rates go down, bond prices go up. It also plays a critical role in efficient resource allocation meant to enable economic growth and development as well as a demand-management practice for attaining internal and external balance with specific attention paid to deposit mobilisation and credit creation for improved economic growth.

Policies

High interest rate increases the cost of capital and thus diminishes the investment level, while poorly managed financial sector and insufficient credit access means that investment in the private sector is challenged by domestic savings. We can best explain this by the relationship between marginal efficiency of capital (MEC) and the rate of interest. MEC is the result of the supply price and the prospective yield of the capital asset while rate of interest is the price paid for loanable funds and is determined, like any other price, by the demand for and supply of loanable funds.

The formulation and management of sound monetary policies that boost investment-friendly interest rate is therefore essential for promoting economic development by encouraging savings and mobilising funds for borrowing. From a demand side, this will positively affect aggregate demand with ripple effect on employment opportunities and level of income.

As part of the initiative to spur economic growth and development, the Government  introduced interest capping at 4 per cent above the Central Bank of Kenya rate in August 2016. The assumption was that caps would protect customers by making loans more affordable, and increase access to credit. Critics, however, pointed out that this would from a supply side discourage innovations aimed at high risk/low scale credit segment given that banks would prefer to lend to Government than households and businesses; credit rationing and distortions to the detriment of the perceived risk entities, such as SMEs, low income and first time borrowers thereby encouraging informal mechanisms and hence negating the strides realised in terms of financial inclusion through formal systems.

Following the implementation of the law, the impact manifests in the 2016 full-year financial results for some banks with many witnessing a drop in their profits as compared to what they witnessed in 2015 with all pointers towards interest capping. For instance, Equity Bank recorded a 4 per cent drop in profits after tax for the year with Ksh16.6 billion shillings in profits recorded, a drop from 17.3 billion shillings in 2015 attributing this to the interest rates capping.

The results compares to Barclays Bank of Kenya which recorded a drop-in profit by 10 percent to 10.8 billion shillings for the year 2016. Joining the list was NSE which recorded a drop-in profit by 40 per cent again attributing this to the capping law. On the other hand however, Co-operative Bank of Kenya, seemed to have beat all the odds to witness a rise of 8.5 per cent in profits after tax for the 2016 financial year. This represents a paradox that requires an objective research.

Other effects reported were exiting of foreign investors in the market putting the local currency under pressure with the attendant instability challenges, branch closure; staff reduction; relocating shared function for some international banks; spill-overs to the market: manufacturing sector especially motor assembly hit by low sales largely attributed to limited credit to households and small business to buy vehicles; construction sector has seen a slowdown due to low credit for development; and  low housing demand on account of limited credit.

Maintain rates

The question that conspicuously begs for an answer is why the situation, yet from a scholarly perspective, we anticipate that low interest rates would facilitate increase in investment, economic growth and eventually improved per capita income. 

My hypothesis is that the statistics could be a ploy that banks are trying to utilize to push the agenda that interest capping was wrong in the first place, yet empirical statistics support the notion that the banks were hitherto reporting supernormal or abnormal profits by exploiting the borrower. Interest rates should be kept low to promote investment and spur economic growth and net social welfare.

 

Eliud Owalo is a Management Consultant with an Economics Background.


interest rate Interest rates GDP price levels economy
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