THE CAPPING DEBATE

Africa needs a common policy on interest rate capping

Since interest rate capping has worked well in some African countries, the question is, why does it fail in others?

In Summary

• The reason advanced by countries who have abandoned interest rate capping is that banks could not lend to high-risk entrepreneurs and SMEs. What is the logic in this argument?

•  If an SME is a high risk, then it can only be granted a loan at a high-interest rate. But this will only make them uncompetitive in the market.

Central Bank Governor Patrick Njoroge presents his views before the parliamentary Finance Committee during a session to review the interest rate regulations. April 12, 2018/
Central Bank Governor Patrick Njoroge presents his views before the parliamentary Finance Committee during a session to review the interest rate regulations. April 12, 2018/
Image: JACK OWUOR

African countries are reading from different scripts when it comes to interest rate capping at a time when some regional economic communities have already implemented the monetary union, a requisite pillar of AU’s Agenda 2063.

The reason advanced by countries who have abandoned interest rate capping is that banks could not lend to high-risk entrepreneurs and SMEs. What is the logic in this argument?

If an SME is a high risk, then it can only be granted a loan at a high-interest rate. But this will only make them uncompetitive in the market.

So, if they have a five-year loan, they might survive the first three years struggling to service the high interest, where the installments are on a reducing balance, meaning a big portion of the installment goes to offset the interest, not the principal amount. Then if they default the fourth year, the bank will auction them and make more money. Are these the African financial institutions to accelerate the integration and socio-economic development of the continent?

Since interest rate capping has worked well in some African countries, the question is, why does it fail in others?

The West Africa Economic and Monetary Union (WAEMU- eight countries) have been implementing interest rate caps since 1997, Ethiopia since 1998 and South Africa since 2007, while the Monetary Community of Central Africa (CEMAC-six countries) s has capped since 2012. All these countries have managed the process successfully.

However, Zambia started in 2012 and abandoned the effort in 2015. Kenya followed in 2016 and is in the process of quitting. Nigeria began in 2017 and quit in September 2019. So, where is the problem?

A policy research paper published last year by Aurora Ferrari, Oliver Masetti, Jiemin Ren under the title Interest Rate Caps, The Theory and Practice, has a novel taxonomy that classifies interest rate caps according to seven features.

The first is the scope-a primary form of a variation i.e the type of credit instrument/institution/and/or borrower they apply to.

Second is the number of ceilings. Countries use either a single blanket cap for all transactions or multiple caps based on the type of loan or socio-economic characteristics of the borrower.

The third is the type of interest cap. The level of the cap can be either defined as a fixed absolute cap or as a relative cap that varies based on the level of a benchmark interest rate.

Then fourth is the methodology used, where the level of the relative cap can be either defined as a fixed spread over the benchmark, or as a multiple of the benchmark rate.

The fifth feature is the benchmark where it can be applied in two ways. Those using a relative cap can link it to the level of an average market rate. Alternatively, the ceiling can be defined as a function of the central bank’s policy rate.

Sixth is the binding. Caps can be binding or non-binding, where they can be below or above market rates. Lastly is the feature of fees. Some caps can also regulate non-interest fees and commissions of the loan.

A review of the failure in Zambia and WAEMU's success reveals two very different routes. 

The analysis by Ferrari, Masetti, and Ren, Zambia followed the model of broad scope, multiple ceilings, relative cap, fixed spread, central bank rate, below-market rate, and regulated fees.

On the other hand, WAEMU followed a broad scope and multiple ceilings, and below-market-rate binding, just like Zambia, and then a totally different model. They went for an absolute cap: Methodology was N/A, the benchmark was N/A, and fees were not regulated.

Kenya followed a similar model to Zambia except for the number of ceilings, where Kenya opted for a single ceiling. It would have been prudent for Kenya, knowing the Zambian model had failed a year earlier to innovate on it.

As per the analysis by Aurora, Masetti, and Ren, today there are at least 76 countries around the world, representing more than 80 per cent of global GDP and global financial assets, imposing some restrictions on lending rates.

Ethiopia is implementing minimum deposit rates; South Africa is pursuing different loan sub-categories with their own interest rates, and CEMAC is capping on maximum interest rates charged by MFIs.

A review of Interest rates for the last 5,019 years confirms that targeted interest rate capping and directed credit policies can fuel rapid industrialisation.

Recent developments in Japan, Korea, and China, confirm that in the early stages of industrialisation, and subsequent modernisation, subsidised interest rates and government involvement in directing credit is justified and inevitable under several circumstances.

In conclusion, therefore, interest rate caps have existed from the very dawn of civilisation.

Targeted interest rate capping is necessary, depending on a country’s development stage, and the features of the rate caps depend on a country’s development trajectory.

For Africa, we need to hit the pause button, scratch our heads, and look East. There is no doubt Africa needs a coherent and clear African policy on Interest rate caps.

Ambassador Ngovi KITAU

First Kenyan Ambassador to the Republic of Korea (2009-2014)

[email protected]