What does the future hold for the economy with end to interest rate caps beckoning?

BY DAVID WANJALA

The recommendation by President Kenyatta to repeal the interest rate cap in a memorandum to Parliament in which he declined to assent to the Finance Bill, 2019 into law is the strongest directive thus far by the Government on the repeal of the interest law and could mark the abolishment of the current regulated loan-pricing framework.

The interest rate cap, according to Cytonn Investment, an investment management firm based in Nairobi, has had adverse effect on the economy.

Popular but unwise

Cytonn Investment had called the move to control rates on loans, right from its inception in 2016, as ill advised even as it excited Parliament and a majority of Kenyans. Free markets, they noted, tend to be strongly correlated with stronger economic growth. There is no compelling evidence of an economy where interest rate capping was successful, as evidenced by the World Bank report on the capping of interest rates in 76 countries around the world. In Zambia, for example, interest rate caps were introduced in December 2012 and repealed three years later, in November 2015, after the impact was found to be detrimental to the economy.

Banking stocks lost 15.6% in two days after the interest rate cap Bill was signed into law in August 2016. It wasn’t long before it was evident that the law had inhibited access to credit by SMEs and other smaller borrowers whom banks cited as being risky and were undesirable to be fitted within the 4% margin imposed. It also subdued the private sector credit growth, which was recorded at 4.0% in March 2017.

The law also squeezed private sector credit growth and lending by commercial banks especially due to the fact that the total cost of credit was higher than the legislated 14% as banks loaded excessive additional charges. The large banks, which control a substantial amount of the banking sector loan portfolio, were the most expensive. 

Effects thus far

There has been a huge private sector credit crunch. In the first year following the introduction of the interest rate capping, Cytonn Investment reports, the stock of credit to MSMEs declined by 10% y/y on account of difficulty for banks to price the SMEs within the set margins, as they were perceived ‘risky borrowers’. Banks thus, the investment firm notes, invested in asset classes with higher returns on a risk-adjusted basis, such as government securities. Lending to the public sector increased sharply with a growth of over 25% y/y over the same period. Private sector credit growth touched a high of 25.8% in June 2014, and averaged 11.0% over the last five-years, but dropped to below 5.0% after the implementation of interest rates controls, rising slightly to 6.3% in August 2019. 

Additionally, loan accessibility reduced. Even though banks recorded a rise in demand for loans on account of borrowers attempting to access cheaper credit, the banks did not meet this demand as evidence by: Reduced loan growth: According to the Bank Supervision Annual Report 2017, the Net Loan growth declined since the implementation of the interest rate cap law, having come from a growth of 11.2% in 2015 to a decline of 7.7% as at December 2017. Decline in number of loan accounts: The number of loan accounts in large banks (Tier I) declined by 27.8%, the largest among the three tiers, followed by Tier II banks with a decline of 11.1% between October 2016 and June 2017. Increase in average loan size: Despite a 26.1% decline in the industry’s number of loan accounts between October 2016 and June 2017, the average loan size increased by 36.0% to Sh548, 000, from Sh402, 000 between October 2016 and June 2017. This points to lower credit access by smaller borrowers, while also demonstrating that credit was extended to larger and more ‘secure’ borrowers, and: Decrease in average loan tenures: The average loan tenure declined by 50.0% to 18-24 months compared to 36-48 months prior to the introduction of the interest rate cap. This is due to banks increasing their sensitivity to risk, thereby opting to extend only short-term and secured lending facilities to borrowers, rather than longer-term loans to be used for investments, according to the latest survey by the Kenya Bankers Association (KBA) on the effects of the Banking (Amendment) Act, 2015.

Banks also changed their operating models to mitigate the effects of the law, especially to compensate for reduced interest income. They achieved by, among others, increasing focus on non-funded income (NFI), increasing non-interest income to total income to 37.2% for listed commercial banks in H1 2019 from 28.4% in September 2016: Increased lending to the Government as evidenced in the growth in allocations to government securities by 15.1% in the year after implementing the law, compared to 7.7% decline in loans, as government securities roseto 24.9% of total banking sector assets in FY 2017, from 23.4% prior to the caps. This trend has persisted, with allocation to government securities rising by 12.1% as at H1’2019, faster than the 9.8% growth in loan allocations, given the higher risk-adjusted returns offered by government debt: Cost rationalisation by increasing the use of alternative channels, mainly leveraging technology such as mobile money and digital banking to improve efficiency and reduce costs associated with the traditional brick and mortar approach. This led to closure of branches and staff layoffs: Focus on niche segments where larger banks ventured into small banks’ niche markets such as SMEs. Consequently, small banks have suffered dwindling top-line revenue, increased inefficiency and operating losses with the inevitable capital depletion that has heightened consolidation in the sector in the recent past. 

There has also been a proliferation of alternative credit markets as a result of the private sector credit crunch. This is evidenced by the rise mobile financial services to become the preferred method of access to financial services in 2019, with 79.4% of the adult population using the channels, up from 71.4% in 2016. According to Global Digital, in 2018 there were about 6.1 million digital borrowers in the country coupled with 28.3 million unique mobile users. Players in this segment charge exorbitant interest rates varying from 132% and 152% in annualized rates. 

The other effect of the law has been reduced effectiveness of the monetary policy. Before the interest rates were capped, the CBK was able to adjust the Central Bank Rate (CBR) in relation to changes in inflation and growth. This is mainly because any alteration to the CBR would directly affect credit conditions. Expansionary monetary policy is difficult to implement since lowering the CBR has the effect of lowering the lending rates and as a consequence, banks find it even more difficult to price for risk at the lower interest rates, leading to pricing out of even more risky borrowers, and hence further reducing access to credit.

Emerging issues

The National Assembly passed the Finance Bill, 2019, retaining the interest rate caps. The President has however declined to assent to the Bill. Instead he has sent it back to Parliament with a recommendation to repeal the interest rate cap, citing the following reasons: Reduction of Credit to the private Sector, particularly the Micro, Small and Medium Enterprises (MSMEs); a decline in economic growth; weakening effectiveness of policy transmission; reduction in loan accessibility; and emergency of shylocks and other unregulated lenders. 

Recommending a repeal of Section 33 b of the Finance Bill, which pertains to the interest rate cap in the memorandum to Parliament, the President noted that the capping of interest rates had not met its intended objective particularly in expanding credit access. The President also noted that the negative effects from the capping of interest rates had curtailed the government’s efforts at addressing the concerns of affordability and availability of credit from banks especially to the vulnerable sectors including MSMEs, Women and Youth. 

Given that the President has referred the Finance Bill, 2019 back for reconsideration, Parliament, according to article 115 of the Constitution, has the option to amend the Finance Bill, 2019 fully accommodating the President’s recommendation by deleting Clause 45 of Section 33 B of the Bill, effectively doing away with the interest rate capping. The Speaker of the National Assembly would then resubmit the Bill to the President for assent in seven days. Should the seven days pass with the President assenting to it, the Bill will be assumed to have been assent to. Alternatively, it would pass the Bill a second time with amendment, or with amendments that do not fully incorporate the changes suggested by the President. This has to be supported by two thirds (233 MPs) where if the number is not raised, the President’s recommendations would carry the day and the law capping interest on loans will stand repealed. Given the Finance Bill, 2019 is a critical legislation that would ensure government revenues through the incorporation of additional tax measures, it is expected Parliament will move with haste to debate and vote on the recommendations.

National Assembly

The decision on whether to repeal the interest rate cap is now again in the hands of the lawmakers. Historically, the President’s reservations on Bills have been passed with minimal to no alteration. 

When, for instance, the Finance Bill, 2018, was referred back to Parliament with the President recommending the introduction of a VAT charge on fuel, the general preference by MPs was to delay the tax to September 2020. MPs eventually passed the Bill with an amended lower rate of 8% as opposed to the intended 16%, and the Bill became law. However, given the high public interest around the interest rate capping and the vocal proponents supporting the interest rate cap, we expect heated discussions. Besides, MPs are heavily invested in this Bill given they are among, if not the most heavily indebted lot in the country and past trends on passing of Bills in the National Assembly in the past cannot be a yardstick on this will go.

During the initial discussions and reading of the Finance Bill, 2019 MPs expressed strong opinions on why the cap should remain in place, among them being that banks continue to record high profits, which is evidenced by the 9.0% increase in core earnings per share growth in H1’2019 for the listed banking sector, and that the high borrowing appetite by the government needs to reduce as it is crowding out funds to the private sector. The government recently raised the debt ceiling to Sh9 trillion, from a debt to GDP ratio target of 50%, indicating the growing appetite of the government for taking on additional debt.

Cytonn Investment believes Government will wield political capital and convince MPs to amend the Bill to remove the capping. The firm says should that come to pass, various benefits will accrue to the economy including growth in private sector credit especially to MSMEs as banks will have sufficient margin to compensate for risks. The other benefit would be seen in higher GDP growth. Credit and economic growth, the firm says, are positively correlated and they expect that with increased access to credit by MSMEs, the economy is bound to expand. According to data from the KNBS, Micro, Small and Medium Enterprises (MSMEs) 2016 survey, MSMEs account for approximately 28.4% of Kenya’s GDP, and that monetary policy effectiveness will increase.

In the view of Cytonn Investment, the rate cap legislation should be repealed. A free market, the firm argues, where interest rates are set by the forces of demand and supply coupled with increased competition from non-bank financial institutions for funding, will see a competitive environment where the cost of credit reduces, as well as increase access to credit by borrowers that have been shunned under the current regulated loan-pricing framework.  

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