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November 18, 2018

Inefficiencies in the financial industry need addressing to rein in high interest rates

Treasury Cabinet Secretary Henry Rotich. Photo/File
Treasury Cabinet Secretary Henry Rotich. Photo/File

It is apparent the economy is going into a high interest rate regime, disrupting business cycles, budgets and literally everything in the economy.

The impact will not only be felt in unrealised economic growth forecasts, but also in a rising cost of living. With interest rates surging to over 30 per cent business prospects remain unreal.

Many fundamental questions remain unanswered, including how long the high interest rate regime will last and whether rates have peaked or will continue on the rise. The current rates border more on loan-sherking than business rates, and while the impact on business will be widespread, each business will be affected differently.

At rates of over 30 per cent, most businesses that rely on credit will need to revise both operational and strategic plans to survive.

For businesses that have borrowed for the short-term to meet working capital needs such as to buy raw materials, stocks and inventories it is advisable to reduce the purchased quantities as a way of cutting down on the level of borrowed funds in anticipation of dry spells in profits.

This is the logical thing to do unless they are confident they can pass a large percentage of the extra costs to the consumer by revising selling prices without significantly affecting the sales quantities.

Some businesses may increase prices to cover the increased cost of borrowing, but it’s unlikely they will be able to pass the whole cost of borrowing to buyers without affecting the buyers behavior.

The cost of selling goods on credit will also increase, as funds held in receivables could be utilised to reduce the level of borrowing. It may therefore be time to revise the credit policy to incentivise early payments, and to monitor repayments closely to reign on bad debts.

Businesses plans that require long term borrowings such as for plant and equipment installation and residential housing may be better off shelved until interest rates are more favorable.

However for those with unfinished projects, the decision whether to continue with the project and incur more expensive debt or stop the projects until conditions become more favourable presents a difficult business decision. The bottom line of either option is higher project costs than anticipated, with significant business consequences.

That said, the impact on the economy depends on how long the interest rates persist. This is because businesses may weather temporary rises in interest rates, by introducing cost cutting measures for instance to offset the high interest rates, and relying on revenue reserves to avoid bankruptcy.

But this can only persist in the near term. The longer the interest rates persist the harder it is for businesses to sustain intervening measures that are adequate to sustain business operations.

Besides, as high interest rates are left to persist long enough, the downturn in business gathers momentum, and business prospects dim even further with remnants of optimism fading. Some businesses may close some lines of business, while others may close shop altogether.

More importantly, even when interest rates get much lower, it may take time for businesses to recover. Investment undertakings previously held back by high interest rates may no longer appear attractive, while closed businesses may not open shop again.

And it’s not only private investors that are negatively impacted by high interest rates, government is affected too. When businesses face higher costs of borrowing, profits take a downturn and so does the tax paid to the government, thus affecting government revenue collection. The general price increase often leads to reduced demand for normal goods, and overall reduced business activity in the economy.

The resulting high inflation, reduced production and loss of jobs are the recipe for economic depression.

Granted, this calls for very decisive actions on the side of the government, with a thorough review of how exactly we found ourselves in this state of affairs, but more importantly on how we can get out of this state as soon as possible.

The sooner the interest rates normalise, the less the damage caused to the economy, and the easier it will be for the economy to return to a positive growth path.

Which bring us to one of the important areas that must form part of the interest rate discussion; net interest margins and the efficiency of financial intermediation.

The high cost of intermediation in Kenya, often reflected in the difference between what banks charge to lend money and what they pay to borrow - often referred to as net interest margins or spread should be a point of concern for policy makers.

The spread is widely considered, and often used, as a proxy for the efficiency of financial intermediation. The larger the inefficiencies are, the wider is the spread. As banks allocate society’s savings, the efficiency of financial intermediation has substantive repercussions on economic performance. This is more so when an economy is faced with a high interest rate regime as is presently the case in Kenya.

According to data available from the World Bank website on net interest margins, Kenya has one of the widest interest margins ranking 31 out of 117 countries included with margins of 8.1 per cent in 2014.

Research has shown that institutional and regulatory (micro-) factors are the main drivers of spreads across the world, while the other two factors, macroeconomic factors and banking competition factors jointly contribute much less.

This finding suggests that the first point of call for policy makers targeting to rein bank spreads is the reduction of microeconomic frictions in the banking sector and in particular the economic cost of holding reserves, credit risk, and implicit interest payments.

A candid dialogue between the regulator and the banking fraternity is needed to address these factors, and also challenge the apparent overpricing of credit risk that has kept the margins high.

One of the lessons learnt post the global financial crisis is that regulatory capture in a capitalist business environment is real and the regulator can ill-afford to wine and dine at Wall Street.

Regulatory capture occurs happens when a regulatory agency, formed to act in the public interest, eventually acts in ways that benefits the industry it is supposed to be regulating, rather than the public. Spreads above five per cent are a real barrier to attainment of meaningful economic development and vision 2030.

The new Central Bank governor has a responsibility and an opportunity to leave a lasting legacy by tackling market inefficiencies that have kept net interest margins and interest rates high.

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