Interest Rate Cap Bad For The Economy – IMF

The International Monetary Fund (IMF) has once again warned Kenyan against the interest rate cap that introduced in September 2016 saying it is weakening the economic performance.

According to IMF, the interest rate controls have reduced the profitability of commercial banks, which have been forced to adjust their deposit and lending facilities with the controls, significantly reducing their net interest income.

The IMF also noted that the interest rate cap had led to lower credit growth, reduced financial inclusion, weaker tax revenues, and higher financial stability risks.

The estimated decline in growth due to the interest rate controls in 2017 is estimated at 0.25 – 0.75 percent points. Key to note, the recent removal of the floor rate on deposit due to the assent of the Finance Bill 2018 could increase banks profitability without necessarily increasing lending to SMEs, as it would lead to reduced cost of funding.

Whether the amendment will translate to higher lending will be dependent on the “risk-free” rate of government securities. If yields on government securities remain high, banks will continue to be incentivized to lend to the government rather than customers perceived to be riskier, and with a lower cost of funds for the banks, return on equity could be higher.

However, were yields on government securities to decline, the combination of greater spreads from the lower funding costs and diminished attractiveness of government securities could reignite lending to the private sector.

IMF says that the interest rate controls and interbank market volatility have hampered monetary policy effectiveness.

The report stated that the Central Bank Rate (CBR) has lost its signaling role as interest rate controls have weakened the link between the CBR and bank lending and deposit rates.

Prior to the introduction of interest rate controls, the CBK had been changing the CBR with respect to developments in inflation and growth.

However, since the implementation of the rate cap, the impact of the CBR cuts has not been clear. The weighted average interest rate in the interbank market has ranged between 3.0 percent and 10.0 percent during 2017 and early 2018.

The wide range has entailed significant day-to-day volatility, which has had adverse effects on bank lending rates, incentivizing banks to retain excess liquidity, and weakened the monetary policy transmission mechanism.