Interest rate increase poses a grave risk to Kenya’s economic prospects

Economic developments over the last 3 months have been, to say the least, incredible and unprecedented and in my view pose a grave risk to the momentum of Kenya’s economic growth. Sustaining economic growth is extremely important because it is the only way we can improve quality of life and lift millions of people out of poverty.

Between February and June 2011, 91 day Treasury bill (T-bill) rates rose by an unprecedented 700 basis points to touch 9%.  This level of interest rates was last witnessed in May 2002. Over the same period, the Kenya Shilling depreciated by close to 10%, touching Kshs. 90 to the dollar, a level last seen 17 years ago.

The large and rapid increase in interest rates will, to my mind, have an immediate and significantly negative impact on our economic prospects.  Expansion of the economy is driven by increases in consumption, investment, exports and improvements in productivity.

Low interest rates are very strongly linked to economic growth because they increase the availability of affordable credit for investment and consumption and result, therefore, in an increase in the overall rate of economic activity in a country.  Banks have already begun increasing lending rates in response to the recent increase in interest rates.

The low interest rate regime has been a crucial driver of economic growth and has contributed, consequently, to marked improvement in both formal and informal employment and to an enhancement in the quality of life.  2004 was the first year in very many years in which the rate of economic growth at 5.1% exceeded annual population growth, which stood at 2.54%.

This was a notable development because it meant that, for the first time, income per person had increased at an average rate of 2.56% (that is the economic growth rate less the population growth rate). The economic growth rate in 2004 was preceded by a sharp decline in interest rates with the T-Bill rate falling to 1% and lending rates declining from more than 18% in 2003 to 14% in 2004.  Interest rates have remained relatively low and, as a result, credit to businesses and households has increased tremendously.

According to information available from the Central Bank of Kenya website, between June 2004 and December 2010 credit to the private sector expanded by a massive 212% to top Kshs. 888 Billion.  One of the biggest beneficiaries of the credit expansion has been private households, with credit expanding by a massive 339% to Kshs. 123 Billion.  Other beneficiaries were Small and Medium Sized Enterprises, micro enterprises, informal business activities and other previously non-banked segments of the population.   In a nutshell Wanjiku has been a major beneficiary of the low interest rate regime over the last 7 years and she should therefore be very concerned about current developments.

So what has triggered this sudden and arresting reversal in the trend of interest rates? The Central Bank has felt compelled to increase interest rates to control inflation, which has risen from 5.4% to 12.95% in the five months to May 2011. The Central Bank has a statutory objective to formulate and implement a monetary policy directed at achieving and maintaining stability in the general level of prices.  In March 2011, the Monetary Policy Committee increased the Central Bank Rate (CBR) by 25 basis points.

The rate of increase of the T-Bill rate has been considerably more brutal because the market is aware that the government has to borrow to finance its budget deficit and, therefore, it is demanding its pound of flesh.

The Bretton Wood’s institutions (the IMF and the World Bank) have also actively advocated a policy of increasing interest rates.  In a series of recent publications they have called for tighter monetary policy in emerging markets to control what they consider to be overheating economies.  Analysts and economic commentators have also argued that increasing interest rates will reverse the depreciation of the Kenya shilling against major currencies by increasing portfolio flows.

I am deeply concerned about the appropriateness, effectiveness and desirability of a policy of increasing interest rates to stem the particular inflation that we are facing and to stem the continued weakening of our currency .  It is my considered view that the policy we are pursuing will neither control inflation nor halt the decline of the Kenya shilling but will instead considerably slow down economic growth, increase unemployment and make it even more difficult for the population to cope with the high cost of living.

The rate of inflation jumped to almost 13% in May 2011, driven primarily by increases in the cost of food, transport and electricity.  The increase in the cost of food is a function of a drought both in Kenya and in some of the major grain producing nations across the globe.  The increase in the price of transport is a function of the significant increase in the price of oil, which is 60% higher than it was a year ago.

The increase in the cost of electricity has also been driven by the drought, which has reduced hydroelectric power production whose capacity has been replaced by thermal power generation whose cost, in turn, is affected by the high cost of oil.

High interest rates are meant to control price increases by raising the cost of money hence reducing the spending capacity of households and businesses.  Kenya, like most African countries, has one of the lowest per capita consumption of energy  in the world. We also have some of the most under-nourished populations in the world.  It is therefore nothing short of tragic to prescribe a policy that desires to reduce prices by reducing the ability to afford energy and food, in one of the most needful populations in the globe.

The real drivers of the current inflation rates are global adverse environmental changes and the high global prices of commodities such as oil. These drivers are outside of Kenya’s control. I am therefore astonished at the orthodoxy that has pervaded most of the economic analyses where it has become generally accepted that the Central Bank must raise interest rates to control inflation.

What is even more astonishing is that current thinking on this issue flies in the face of established economic precedents. One being that numerous studies have established that there is a substantial time lag of between (2-3 years) between increases in interest rates and reduction in inflation.  The second, it is an established economic fact that periods of sharp deceleration in money supply have generally been followed by economic recession. 2010 was the first year since the post election crises that the Kenyan economy has grown at a rate faster than the population growth rate and I am baffled that many analysts have concluded that this “over-heating economy” should be checked.

The other argument for increasing interest rates is that it will encourage portfolio flows by investors and therefore bolster the Kshs.  The truth of the matter is that investors make investment decisions based on a broader set of factors.   The key considerations are the outlook on economic growth, stability of the macro economic environment and the attractiveness of the political and governance environment.  The futility of the current policy direction in encouraging portfolio flows is probably best illustrated by the recent report by the Nairobi Stock Exchange (NSE) that in April and May 2011, foreign investors were net sellers of securities on the NSE to the tune of Kshs 6.35 billion, putting further pressure on the local currency.

High inflation is hugely destructive to the long-term economic growth prospects of any economy and it ought to be urgently addressed.  The solution however lies not in constraining affordability of basic goods by increasing the cost of credit. This will only succeed in exacerbating the suffering of the ordinary person and runs the risk of creating social unrest.  A feasible solution may lie in what the authorities have begun by reducing the tax rates of key commodities (food items and kerosene).  This I think should go further and deeper but this also needs to be accompanied by a reduction in government borrowing to rein in surging interest rates.

A reduction in government borrowing is however unlikely to take place.  Government spending in 2011/2012 is projected to increase by 15% to Kshs 1.15 Trillion, which is 44% of the 2010 GDP and this implies a greater appetite by the government to borrow.   I will share my views on the role of fiscal policy in addressing the challenges we face in my next article.