Interest Rates Should Be Kept Low To Promote Investment And Spur Economic Growth

OPINION ARTICLE
BY ELIUD OWALO

As a student of Economics, I am compelled to wage into the Interest Rates debate which 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 paid on funds obtained by way of loan can therefore be described as the specific amount of money that is compensated by one on the use of funds for a particular period of time. Common rates applicable in the money market include the lending rate, saving rate and discount rate. 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, among other integral parameters.

From an economic perspective, we can therefore argue that there is a close correlation between interest rates, savings, investment and economic growth. When the 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 mobilization and credit creation for improved economic growth.

The influence of interest rates on saving is explained by the compensation that the creditor gets when he lends out his saving. This compensation is the interest rate that is paid to the lender; the higher the interest rates on amount borrowed the more one will take the opportunity on savings to offer credit in the market in order to earn more interest rate in the form of returns. On the other hand, interest rates affect investment in the sense that borrowers will shy away from taking credit if the interest rate is high to an extent that it denies them adequate returns in terms of profit. However, with low interest rates, investors will be encouraged to borrow because there are opportunities to invest with high returns.

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. A potential investor will weigh the MEC on new investment against the rate of interest. As long as MEC is more than the rate of interest, investment will continue to be made, till the MEC and the rate of interest are equalized. Once the MEC becomes equated to the rate of interest, equilibrium investment level is determined. Consequently, for investment levels to be increased either the rate of interest should fall or MEC increase.

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 mobilizing funds for borrowing for investments purposes. From a demand side, this will positive affect aggregate demand with ripple effect on employment opportunities and level of income in an economy. As part of the initiative to spur economic growth and development, the Kenya Government in August 2016 introduced interest capping at 4 percent above the Central Bank of Kenya rate. 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 realized 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 of Kenya recorded a 4 percent 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 percent 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 percent in profits after tax for the 2016 financial year. This represents a paradox that requires an objective research.

Other evidence on the impacts of the capping have been witnessed in the credit growth to the private sector was much slower at the end of 2016 tracking at around the lowest since the end of 2003. Analysis at Central Bank reported decline in loan approvals by 6% between December 2016 and February 2017, while the Bank’s Monetary Policy Committee suggested that SMEs have been disproportionately affected by the capping. We can view this as a consequence of rigid credit standards, with banks gravitating towards lending to safer borrowers, such as the government or large corporations rather than small riskier borrowers. 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.

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. More worrying is a recent statement attributed to Treasury Cabinet Secretary, Henry Rotich that capping of interest rates was a temporary measure. 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.

The Writes is a Management Consultant with an Economics Background.