Nairobi, Kenya| August 17th 2016. Copyright  @haiyay

On Monday 16th August 2016, the speaker of the National assembly was scheduled to present to the president the bill that aims to cap the interest rate that banks can charge customers for loans. The president Uhuru Kenyatta has exactly fourteen days to either approve or return to the parliament with proposed amendments.

Many economists have written articles  in the dailies and in blogs  and they seek to support the view that interest rates caps will harm the economy through credit rationing, but none seem to offer a very tangible solution. This article attempts to achieve this and at the same time shedding some light on all aspects of the debate.

We are at a situation where the president has no luxury to just sit and ignore, if he does so, the bill automatically becomes law. We cannot deny that the bill has good intentions in its spirit but the debate is so heated that is hard to separate fact from fiction. I aim to objectively look at the real issue behind high interest rates and seeks a way forward in terms of possible amendments to the bill and as well look at the real solutions to this problem of high and volatile rates.

Money lenders have been very unpopular since the time when Jesus walked on this planet and even in one parable, the money lender is scolded for unfair treatment because after receiving a bailout, he fails to pass the benefit to his borrowers. This is exactly what happened in the financial Crisis of 2008, banks were bailed out but they did not extend the bail out to their borrowers.

In this article, I intend to argue from both sides, the good things about capping and the bad, and also possibly illuminate some options not yet explored to date. A lot has been said by all and sundry and this is the best time to evaluate all views and see the best way forward.

I review the situation given my background in economics, accounting, as a borrower and a saver , as an investor in stock exchange, as a holder of an annuity in a pension fund,  as a potential investor in the new opportunities that the bill would bring.

A little bit of the background to the current situation, three previous attempts to cap the rates have been successfully fought off by all parties; members of parliament, banks, central bank and the Treasury; The last successful attempt to block the bill was in 2015 and Jakoyo Midiwo, the honorable MP did not manage to get the parliament to pass the bill.

This time, there was unusual camaraderie and consensus across both sides of the political divide and the MPs from both opposition and government demonstrated rare sign of unity to deal with the issue and the bill passed in the august house.

Granted, we have had numerous unfortunate experiences of people who borrowed and ended up paying more than 50 times what they borrowed and their assets were still put under the hammer. These stories have served to give credence to the issue that rates ought to be addressed and not tomorrow, but now. One story that is in everyone’s mind is the case of the borrower who had their interest rates increased to 45%. The author of the story forgot to mention the time that this happened and given the sad history of interest rates in this country, it most likely happened when the Treasury bill rate rose to 70% around the goldenberg era. In that dark era, even banks could not pass all the costs to the customer; such escalation of debt happens in inflationary economies and they factor in the real opportunity cost of investment;

Even without a runaway inflation or interest rates, not servicing a loan can have a terrible effect on the borrower. take a simple illustration, if you took a loan of 1 million shillings 20 years ago and fail to pay even one installment, the loan will balloon as fast as the value of an investment you would have undertaken to grow the money and more so in periods of high inflation like the goldenberg era when money printing was the norm. The runaway inflation affects all aspects of the economy inflating prices of everything but also the price of all assets including the collateral offered to secure the loan.

In fact in 20 years, with interest rate of just 14% as proposed by the bill, the loan taken and the borrower fails to pay and fail to pay even one installment will balloon to 16 million. That is 16 times! This is high compared to the borrower who diligently pays every month without fail and they end up paying 2.9 million shillings in total. But also don’t forget what a million worth of investment can turn into in 20 years, it can easily become 20 million, or nothing.

That is the brutal truth about compound interest; this escalation even baffled the most intelligent man who ever lived in our times, the one and only Albert Einstein. He is quoted to have said that ‘compound interest is the eighth wonder of the world, he who understands it, earns it, he who doesn’t, pays it’ .

I need not go into lengths to say how the majority of the borrowers feel about the banks. For most Kenyans, it is a personal experience and these are Kenyans from all walks of life, including legislators, accountants ordinary Kenyans, except most, but not all economists who seem not to care much. They are stuck with the theory and in principle it makes sense.

Now I examine the arguments from both sides of the divide.

If you have been following the debate, there was a debate on one of the media houses where the honorable MP Mr. Njomo and Habil Olaka the CEO of Kenya Bankers association were interviewed. During the debate the strongest argument that came from the honorable MP is that it is impossible to finance a profitable SME business that have margins of around 25% in this country of the bank rates at an annual rate of 20% . This seems to make sense until you examine the math; First, it assumes that the SME business takes a whole year to be paid by their customer and that they do not get credit from their supplier; To a seasoned analyst, the argument falls flat; Typically most SMEs would be paid in three or four months, hence their annual yield is roughly 75%;

Without dismissing the argument from the honorable MP and others, it should be noted that some customers of these SMEs take months to pay, including the most credible buyer, being the government at all levels central and local government, taking over 7 months to pay as noted in the papers and sometimes you need to know someone to get paid, or part with a bribe  and this adds to cost of doing business; (shouldn’t  we also legislate a cap on bribes payable to government officials and make I tax deductible).as part of the solutions, there is need to reform the credit culture and one columnist ,Sunny Bindra has decried the poor treatment of small enterprises by big companies, who fail to pay on time. These delays escalate the interest costs that SMEs pay. The  poor credit culture has something to do with our attitude towards time in general, there is no urgency not only to pay debs but no urgency to get things done in general and this is probably why local contractors are losing jobs to Chinese contactors who work around the clock to deliver in time.( and the respect of time generally leads to lower costs and lower bids by Chinese contractors)

The CEO of KBA, the Kenya Bankers argued the negative consequences of capping interest rates, being credit rationing to poor quality customers and a general reduction in financing available to borrowers and SMEs in general. Professional bodies like the ICPAK, the accountant’s professional body agree with this view but differ on the prescription.

Granted, the ease of access to credit is one good thing that Kenya is credited for by World Bank and this is acknowledged by World Bank in its latest report dated 2016 on ease of access to credit in Kenya. Kenya ranks position 28 globally, an improvement of over 90 up from previous year. But clearly the ease of access to credit is not enough, the cost continues to be a major issue.

Read here http://www.doingbusiness.org/data/exploreeconomies/kenya#getting-credit

A key negative impact that the government cannot easily admit is that the tax revenue paid by bankers in the range of Kenya shilling 60 billion would drop to almost half because tax on interest savings is much lower than tax on profits while profits drop and interest earned grows, the net effect is negative; this is before we consider the borrowers who go underground to informal channels that cannot be taxed.

Another interesting view by one newspaper columnist observes and rightly so that credit will be rationed to the point that to get a loan, you need networks with a banker. He sees the economy going back to the era when the banker was like a god. This is not far from the reality since the balance sheets of banks are so restricted by law in terms of liquidity limits and capital limits, provisioning for bad debts ,these fears are not unfounded. Indeed, Cytonn Investments did a very good research on this topic and they found that across a number of countries that introduced the interest rates caps, the lending to higher risk segments and micro finance dropped. see the article here Interest Rates Cap is the Kenya’s Brexit – Popular But Unwise, & Cytonn Weekly #33

The most shocking response to support the bill was from the chairman of ICPAK, the accountants body; that credit rationing is fine as long it limits access of credit to some impaired and low income because they impose social harm; This seems very Darwinist and selfish approach that completely ignores the consequences of kicking out small traders and the poor from accessing credit through formal channels. In effect the bill will push these consumers of credit to informal channels where there is no protection at all and loan sharks will have a field day to charge even higher than the current ridiculously high rates that exceed 200% annualized rates. Note that high rates are fine for very small amounts like the ‘okoa jahazi’ or ‘okoa stima’ , the products of safaricom which has an effective annual rate of 364%!, yes, three hundred and sixty five percent. It is fine for small loan amounts when the loan amount gets to levels equivalent to a month’s salary or equivalent to what an average household spends a month, the trouble begins for the poor guy.

I don’t blame the accountants, their statement underscores the frustration with high rates. But we need a solution.

On 16th of August , After the presentation of the bill to the president, the minister seems to have become economical with words; his statement as quoted by Reuters website  now refers to the initiatives to improve the KBRR, the Kenya bankers reference rate to make it reflect the true costs and improve the overall structure of collateral management by establishing the central registry of collaterals; this in his view would reduce the cost of transferring loans between banks and make switching banks easier ; it would reduce the transaction costs. it is true that this will help, but clearly according to the Bill sponsor he called it ‘kizungu mingi’, or to translate loosely, those are unnecessary details,; my view is that this initiatives in this statement,  it will only help large borrowers and more established SMEs.

Resistance to the proposal to cap interest rates have also been echoed by the central bank governor. In a press statement , the central bank stated , in part, that

“while appreciating the underlying sentiments about the need to lower the overall cost of credit, we continue to express concern on the adverse consequences of capping interest rates.  These would include, inefficiencies in the credit market, credit rationing, promotion of informal lending channels, and undermining the effectiveness of monetary policy transmission.”

Obviously to a borrower who has suffers from high and volatile rates, this is irrelevant.

I recall the latest and worst episode of high and rising interest rate was in 2011/2012. The government, the treasury and central bank were all in agreement that rates were to go up to contain inflation and also manage exchange rate depreciation; the borrowersa agony was well caricatured by Gado the cartoonist on the daily nation; the CBK seemed to ask the borrower facing a guillotine aimed at chopping his hand or legs, the governor poses the question, ‘hand , or leg, and how high should I raise the blade?’

With this level of dissatisfaction with banks, policy makers, central bank, the general public has every right to seek help of the elected representatives for protection against the high and volatile rates, whatever the cause of the rise or volatility. This is precisely the role of the elected representatives.

Against all odds, in this discourse everyone is right; banks tend to charge quite high rates and rates increase often. Banks are right that capping interest rates is harmful to the economy and it hurts 80% of the banks who usually have very high cost of funds. Only that we do not have the consensus on the solution to the problem. We cannot underestimate the role played by smaller banks in terms of vetting borrowers and they are able to lend to some customers that are deemed too risky for bigger banks and in a way bring them to the formal lending channels and eventually they enjoy lower rates; that is the story of how equity bank was born; need I say more?

Now, let us look at the ‘Kizungu mingi’  or the details that most people affected by the high rates want to dismiss.

Early in the year 2016, the Cabinet Secretary for Treasury seemed to put the blame on high interest almost squarely where the blame belongs; In March 2016 he said that the government borrowing is to blame with big budget deficit pushing the rates up with banks having appetite for risk free treasury bills and bonds leaving little liquidity for businesses; This view is also heed by most economist including the think-tank, Institute of Economic affairs (IEA). The CEO of IEA agreed with this in his opinion piece running on one of the media houses. Other fears about the negative impact of the bill were echoed by the chief executive of Nairobi Stock exchange mentioned the negative impact of the bill on  investors who are predominantly pensioners; this of course is bad for all other bank investors. But one can argue that the impact of lower rates would lead to a general improvement in the economy; that cannot be simulated in a lab until the full impact is seen and given the regulatory controls in terms of liquidity and capital ratios, banks may not lend as much as they are used to;

It is worthwhile to mention the many initiatives that have been initiated by the banks themselves and others by the central bank toward making credit accessible; The introduction of CRB regulations have made it easy for borrowers lend to customers of competitors without fear.

In an attempt to find a solution to this problem, The CEO of Kenya bankers highlighted the initiatives already undertaken within the sector to make affordable credit available to SMEs which include; a 30 billion shillings fund, the implementation of APR; the annual percentage rate to make cost of loans comparable across banks; This according to the honorable member, is too little too late and action has to be taken and the MP pleaded with the president to assent to the bill.

The introduction of the induplum rule also helps to protect the borrower from escalating to disproportionate levels. It restricts the maximum recoverable from a non-perfoming debt to twice the balance at the time when the loan is 90 days overdue

The introduction of KBRR rate by CBK has made It easy for customers to compare offers for loan rates across banks; This is a major achievement in my view. It is deficient because it only covers the flexible rate loans while some loans advanced to small enterprises are not covered by KBRR

KBRR has weaknesses; first; KBRR does not consider the real underlying factors in the economy; the central bank governor was quoted as saying that the KBRR needs improvement to factor in other variables he key one being the interbank rates. This statement alludes to the real problem behind the KBRR rate;

First, the way the rate is derived is not objective; KBRR is computed as an average of the central bank rate CBR and the two month weighted moving average of the 91 day Treasury bill rate; KBRR is reviewed by the Central bank monetary committee every six months. That is the theory; in practice, the monetary policy has failed in at least one instance to adjust KBRR when the rate appeared to increase meaning that the rule is not followed to the letter; it was for the benefit of the borrower, but the borrowers never gave credit to CBK.

Secondly the CBR is a monetary policy tool to help the CBK achieve its objectives of inflation is defective because the actual rates often deviate from the CBR target rate due to the inherent weaknesses in the management of liquidity and exchange rate policies by central bank; To keep inflation within its target; The central bank basally sets out its objective of maintaining inflation within a target of 7.5% or minimum of 2.5% ; To give credit to the central bank, since 2011, there is realization that old inflation target was unrealistic and they were revised upwards especially given that most inflationary pressures come from food and fuel items that cannot be managed by monetary supply; (other central banks around the world are stills tuck to old theories that no longer work and they are faced with an equally daunting challenge but of lower rates not higher).

The current governor, in my view is also quite pragmatic on this issue and I recall that in one interview, he said that the CBK should not be expected to react to meteorological forecasts by raising rate every time there is drought.

The challenge with the old policies with regard to the management of money supply is that the central bank has explicitly been targeting inflation to keep it at below 7.5% but at the same time trying to manage the exchange rate to keep the shilling relatively stronger.

In basic economics, these two policy objectives, of controlling inflation on one hand and managing exchange rate on the other hand are at loggerheads and one must give way to the other. This is precisely behind volatility in the interbank rates. Interbank rates are the rates at which the banks lend to each other to help bridge their own daily cash shortfalls. One may ask why a bank may need to borrow from each other yet they have depositors funds; banks need to lend to each other because on a given day, one bank may find that its customers are having large transfers to another banks and since banks don’t keep idle cash in the bank, they invest in treasury bills, there comes a time that you need a small short term overdraft from the next bank repayable within a short time. The interbank market helps to smooth out the short term liquidity needs for banks.

The problem with interbank rates is that the market is also affected by the actions of central bank. Central bank in its attempt to stop depreciation of the Kenya shilling, often intervenes to reduce the liquidity in the interbank markets by offering good rates to entice the banks to lend to it and stop banks from speculating in the currency markets. It also spills over to the treasury rates since the same banks would have no liquidity to invest in treasury bills;

This action of withdrawing the liquidity from the market to prop up the shilling by CBK affects the banks cost of funds, and Kenya has a tight liquidity in the interbank markets unlike our peers in terms of size of economy, this means that the liquidity mop ups affect banks cost of funding especially the smaller ones, being 80% in number; the impact of interbank rates is not considered to the KBRR rate and a working paper by IMF noted this anomaly. This one would speculate is the issue that the governor refers to when the governor is quoted to say that interbank rates needs reform. The big seven banks control 80% of the liquidity; this leads to excessive rates being charged by big banks to small banks. Nothing can be done about this monopoly. It is a global phenomenon and even in the west, the larger banks some banks like Citibank enjoy this monopoly as they are deemed safer. And since banks are custodians of depositors funds and their shareholders money you cannot force them to lend to parties they deem too risky; TO compound the problem, the CBK discount window rate for struggling banks who cannot get liquidity form the market currently is 16.5% almost 100% higher than KBRR.

This distortions and lack of coherence in policy presents a challenge to monetary policy in that the actual rates can never be near the CBR policy rate which currently stands at 10.5%. This also means that the CBR rate used in the calculation of KBRR is also defective. Add this to the spiraling budget deficit the point that the CS alluded to and it’s a perfect recipe for high rates for borrowers.

It is noted that in 2015 private sector has slowed down in hiring as noted by Kenya revenue authority as one of the reasons for missing revenue target under the income tax section and this is also attributed to high rates that make most investment opportunities to expand unviable.

With regard to the structure of KBRR ,one may pose the question whether we need more than one index, one KBRR rate for short term and another for long term loans; note that long term rates for government bonds to be much higher and this need to be factored in the loan pricing for banks also.

It is worth to note that KBRR has CBR rate as a major component and it is a potentially a political tool and it has gained prominence in the management monetary policy in the major economies; with an economy such as ours where politicians would like to promise cheap credit regardless of the state of management of the budget deficit or the state of the economy or even the other competing policies that tend to raise rates such as liquidity mop ups, the CBR tool is subject to a political process and with a small economy such as Kenya, the political process can introduce uncertainty for investors affecting not only the interest rates but also exchange rates making It harder to attract or retain foreign investors who are needed to create employment. Foreign investors are needed to create jobs and also bring about technology transfers to propel our economy to the next level.

What options do we have? Very limited; the president has to make a decision and assent to the bill or return to parliament with recommendations;

If I were to advise the president, of course I am not, I would consider a few options;

  1. Commit to a coherent monetary policy based on inflation targets and avoid exchange rate interventions; If currency volatility is caused by external factors affecting all countries, such do not need intervention of central bank; This typically happens when the US treasury raises the rates sending all emerging and poor countries in turmoil as investors flee these market to go to safer US bonds or the ‘Brexit’; Note that when the country had surpluses in 2003-6, the bank rates had dropped precipitously low and the completion was good for the customer.
  2. Commit to balancing the budget from the beginning of the budget planning cycle. use the previous tax collections to allocate the funds to all ministries and counties; At worst the last few months of the fiscal year when the supplementary budget is considered, the deficit should not be more than 2% of the GDP; this stabilizes the rates and reduces the cost of money and treasury bill rates drops, effectively reducing cost of funds for borrowers. This seems like an easy target but given that the public debt which the government has accumulated is already high and a significant portion of it in the volatile foreign currency, causing unease even going by IMF standards, there is need to slow down on increases on the debt. On a separate note regarding the fiscal policy side, do not hope to collect more tax revenue than the previous year. Change the approach to having supplementary budgets used to allocate additional tax collected over and above the previous year’s actual tax collections; the budget should not be based on optimistic projections which are not likely to be met; note that the overly optimistic targets usually become promises to counties and the cannot understand why treasury is unable to release the funds in time, yet the reality is that when tax collections are slow, release of funds to counties also slow down and this has an adverse trickle-down effect on SMEs doing business with counties and the economy at large due to delayed salaries for county government workers. IMF has confirmed that our tax collections as percentage of GDP are at optimal levels and we are doing better than our peers.
  3. Demand that banks give a discount to good borrowers with good credit history, at least 1% using CRB data or borrower’s credit history with the bank. This can be given after demonstration of full repayment in a previous 12 months.
  4. The bill should also address inherent weaknesses in the credit culture in the country; Kenyans have a habit of borrowing with no intention to every pay; This was the observation by analysts about borrowers to took loans from banks with an intention of not paying and it lead to near collapse of state banks in the 1990s; The government , consumer protection lobby groups, and the members of parliament out to address this through legislation;
    • The government should commit , in law, to set a good example and commit to pay bills within 30 days of presentation of invoice and if unpaid bills exceed 90 days, pay interest at same rate as any other borrower would in the market; KBRR rate applicable
    • The large companies to commit to pay bills within 30 days of presentation of invoice and if unpaid bills exceed 90 days, pay interest at same rate as any other borrower would in the market; KBRR rate applicable
  5. If MPs push for the bill to go, assent but this is the nuclear option; if you decide that route;  a).  put a maximum cap on rates that a bank can pay for savings not just the minimum for savings;b) Allow an exception to allow smaller banks that are faced with higher cost of funds to transfer the cost and price to loans. This should be an exception. This respects the spirit of free markets and the innovation that comes with it c)Increase the tax on interest income from banks to d) Include microfinance banks to the bill

As a conclusion, I hope that the bill doesn’t pass in its current form or shape. It is very defective.

The President , and only the president can calm the situation by writing a commitment to the house budget committee and to Kenyans at large that he will commit to a balanced budget from this financial year. A show of commitment should be to revise the budget for 2016/17 and base it on actual tax collected last year. In case KRA collects more than last year, he can present a supplementary budget to the parliament to spend the additional collected.

The president should also give a written commitment not to intervene in the foreign exchange where the fluctuations, the currency should float freely . These interventions make our manufacturing base quite uncompetetive making it hard to export to our neighbors.

The August house has its role; from now, the honorable Njomo should lead the way and decline any budget proposals that show a budget deficit, or that show that planned expenditure exceed the previous year’s actual tax collections. This will guarantee sanity of the financial sector.

As an investor in the stock exchange, I hope that it gets shot down completely but the reforms on the fiscal policy mentioned above and monetary policy need to be addressed without further delay as they cause undue pain on borrowers, especially the recent experiences of 2012, we cannot wish away the consequences of an incoherent monetary and fiscal policy. If the nuclear option is taken, it presents a great opportunity for anyone ready to do money lending outside the banking act with little prohibitions.

I have nothing to add and for those who were expecting me to include the cap on cost of bribes to government officers, sadly, I cannot include that; bribes are illegal ab initio.

comments and criticism welcome;

twitter handle @haiyay

 

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