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September 19, 2018

Implications of changing the base rate

The Central Bank of Kenya. Photo/Monicah Mwangi
The Central Bank of Kenya. Photo/Monicah Mwangi

The Central Bank Rate is the official base rate for purposes of implementation of the Banking Amendment Act 2015 as announced in a CBK circular on Tuesday this week. This puts to rest the question as to whether the applicable rate is the Kenya Banks’ Reference Rate (currently 8.9 per cent) or the CBR (currently 10.5 per cent). It also effectively makes the KBRR, previously the base lending rate, irrelevant to the industry. This has several implications, but first, what exactly are these rates? The CBR is the lowest rate of interest that CBK charges on funds it loans to banks as a “lender of last resort”. Banks are expected to borrow from each other in the inter-bank market mainly for purposes of maintaining the required ratios such as liquidity – availability of funds should a customer need to withdraw. In the rare occasion that a bank is unable to access credit from other banks, the CBK acts as the lender of last resort. The CBR is one of the tools of monetary policy. Others are the open market operations (buying and selling of government securities), and the reserve requirements (the amount of money banks are required to deposit with Central Bank). A lower CBR is regarded as expansionary; it encourages lending and spending by consumers and businesses thus increasing the money in circulation. A higher rate is contractionary and does the opposite, discouraging lending and spending, and therefore reducing the money in circulation. Through the lowering and raising the CBR, money in circulation is regulated and inflation is kept within target.

 

The Monetary Policy Committee previously met every two months to review the CBR. However, the circular issued by the CBK provides that this rate will be reviewed annually. While this will promote stability in interest rates, it comes at the expense of inflation targeting because monthly changes in inflation will not be reflected on time. The previous base rate, the KBRR, was an average of the CBR and the weighted two-month moving average of the 91-day Treasury-bill rate. Consequently, by virtue of its composition, it directly linked the base lending rate to the rate the government borrows from the public through issuing Treasury bills. With the shifting of the base rate from KBRR to CBR, this direct link to government borrowing is lost. The implication of this is that government borrowing will not be directly reflected in lending rates, but will instead take a delayed transmission through other market dynamics. Whether this is good or bad for the market will perhaps depend on the amount the government decides to borrow. Nevertheless, it does mean that limiting domestic borrowing in order to avoid crowding out the private sector, and consequently raising lending rates, may no longer be a major constraint in the government borrowing programme.

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