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Will capped interest rates benefit Africa's economies? 08 Nov 2016

When Kenyan President, Uhuru Kenyatta, signed a law that capped bank lending rates on August 24th, he justified his decision by stating that Kenyans have long been frustrated by the high cost of credit that was prevalent in East Africa's largest economy. His position was that banks ought to do more to ensure that their customers benefit from the financial sector by reducing the cost of credit.
    
The new law, which came into force on September 14th, capped bank lending rates at 4 percent above the central bank's benchmark rate – which is currently at 10 percent. The same law also capped deposit rates at 70 percent of the central bank's rate.

Critics – including the Central Bank of Kenya, bankers, and the International Monetary Fund – have warned that the law would reduce the flow of credit to key sectors of the economy, as well as threaten the country's reputation as a regional free-market financial centre. But Kenyans have largely welcomed the new law. Kenya's leading newspaper, The Daily Nation, declared: “Why low bank rates are good for your family”; The Star, another major newspaper, also declared: “Law to cap interest rates welcome.”

Given the situation in the country's credit market, it is not hard to understand why Kenyans have embraced the new law. In Kenya, over 60 percent of the country's adult population lack access to formal credit, while about 40 percent of the population patronize informal financial groups such as rotating savings credit associations (ROSCA). Furthermore, most Kenyan small businesses – which account for 75 percent of the general employment and contribute 18 percent to the country's GDP – struggle to access bank loans at interest rates of over 18 percent.

The Kenyan situation helps to illustrate why interest rate caps remain a populist monetary policy tool for consumer protection against high interest rates. According to a 2014 World Bank report, at least 76 countries around the world still use some form of interest rate caps on loans. These countries range from developed economies – such as United States, Germany, United Kingdom and Japan – to less developed economies, such as China, India, Brazil, and Turkey.

In Sub-Saharan Africa (SSA), interest rate caps exist in 24 countries including Nigeria, South Africa, Ghana, Zambia, and Namibia. Interest rate caps in Nigeria doesn't exist as a blanket ceiling on loans and deposits as is the case in Kenya. However, the Central Bank of Nigeria (CBN) periodically publishes “guidelines” for banks relating to commissions, fees, and rates for various products and services such as loans, deposits, electronic banking, overdrafts, commissions on turnover, current account maintenance fees, mortgage loans, foreign exchange charges, etc.

These regulatory rules ensure that bank services in Nigeria, particularly credit facilities, are offered to customers at rates engineered by the CBN. Beyond this, the CBN also has a number of intervention funds, which are disbursed by some government-sponsored development finance institutions, as well as commercial banks. These funds are usually mandated to lend at single-digit interest rates. A recent example is the N500 billion Export Stimulation Facility, which is being managed by Nigerian Export-Import Bank.

In South Africa, the interest rate cap came by way of the 2005 National Credit Act, which went into effect in 2007. The Act introduced a cap of 5 percent per month on short-term loans and re-imposed a cap on small loans, which was earlier abolished in 1993. Furthermore, the Act recognized seven credit subsectors with different maximum interest rates linked to a benchmark rate set by the Reserve Bank of South Africa.
    
Countries under the West African Economic and Monetary Union (WAEMU) have a maximum interest rate of 15 percent for commercial banks and 24 percent for microfinance institutions. All this goes to show that interest rate cap is extensively used in SSA countries.

The main reason for the prevalence of interest rate caps, particularly in Africa, is that governments want to keep interest rates low in order to improve access to credit. This is a noble intention. Several studies have found that expanding credit to urban or rural households raise their economic welfare, as they are able to engage in small and medium enterprises and also save. A survey by the International Development Association and the Bangladesh-based Palli Karma Sahayak Foundation found that micro-credit programmes improved borrowers' income by 98 percent; quantity and quality of food intake by 89 percent; clothing by 88 percent; housing condition by 75 percent; children's education by 75 percent; sanitation condition by 69 percent; and overall quality of life by 95 percent.

Nevertheless, some other studies have established that interest rate caps make it harder – not easier – for poorer consumers to access credit. This is because banks reserve the most expensive credit for high risk borrowers, such as poor people without credit histories or SMEs without high-quality collateral. When banks can no longer charge high rates to offset their risks because of an interest rate cap, they shun such riskier borrowers. This behaviour has been observed around the world.

According to the World Bank, the imposition of interest rate caps on microfinance loans in WAEMU countries caused microfinance institutions to withdraw from poor and more remote areas as well as increase the average loan size to improve efficiency and returns. In Japan, the supply of credit contracted, acceptance of loan applications fell, and illegal lending rose when interest rates were capped. Even in France and Germany, interest rate caps resulted in a decrease in the diversity of products for low-income households.

With credit from the formal banking system drying up owing to interest rate caps, poorer consumers often turn to loan sharks and unregulated lending institutions charging exorbitant rates. This creates an underground credit market that could threaten a country's financial stability. In China, the government has been cracking down on the country's massive underground loan market – which grew rapidly when banks priced SMEs and poorer families out of formal credit – to prevent a looming banking crisis.

Given the avowed counter-productive nature of interest rate caps, governments must seek better strategies to reduce lending rates and improve access to credit. However, they must maintain the liberality of their credit markets even as they purse affordable rates. In this regard, the World Bank advises countries to adopt a mix of policies such as enhancing competition and product innovation in the banking system, improving financial consumer protection frameworks, increasing financial literacy, promoting credit bureaux, enforcing disclosure of interest rates, and promoting microcredit products.

With these measures in place, the authorities need to ensure credit markets accommodate as many suppliers as possible. More recently, the options have included crowdfunding. But given the supply by government agencies and central banks, it is important that these interventional facilities are not too large to cause large-scale distortions in the credit market. Efforts should also be made to ensure that the funds are well targeted and monitored to prevent interest rate arbitrage.

But the real challenge is to curb nepotism and cronyism, which have dogged a lot of the CBN's intervention funds. In some cases, such credit facilities have been reportedly used for patronage, resulting in high levels of impairment. There is also the need to measure impact. Although the CBN says it has loaned out N2 trillion through its intervention funds in seven years, the impacts of such facilities have been difficult to see.

The development case for interest rate cap is compelling. A number of industries require development financing to fund early stages of their development. Such industries can hardly afford commercial credit at prevailing, double-digit rates. Also, the last global financial crisis compelled even treasury instruments that created special credit instruments, in addition to quantitative easing programmes of central banks – which have artificially held interest rates at near zero level.

However, high interest rates are often driven by macroeconomic factors such as inflation rate. Since the central banks have the mandate to anchor inflation, they should not seek to compensate for their failure to achieve inflation target by creating a separate segment in the credit market.