In August, Kenya president Uhuru Kenyatta signed into law a bill that caps interest rates. Interest rates charged on loans were capped at four percentage points above the Central Bank base rate, while deposit interest rates will have to be at least 70% of the benchmark rate.
There have been calls for a similar law in Uganda, where interest rates are seen as being very high, ever since. Lending rates for shilling denominated loans were at an weighted average rate of 23.5% in June 2016 according to the central bank. Our recent survey of commercial banks found that the lowest prime lending rate is 22%. The central bank rate, on the other hand, was reduced to 14% in August.
It should be noted that the debate about high lending rates has been around for some time. Not just in Uganda, but also Kenya where the parliament’s vote was its third move on the issue after two previous attempts ended in negotiations with banks. There were noises about the adverse effects of expensive borrowing this year, before the Kenya parliament decision, not least of all from the president.
In this year’s state of the nation address, President Museveni used high interest rates to justify the capitalisation of the Uganda Development Bank. “Even when the inflation rate is 5%, the banks lend at 23.5% as of now,” Museveni said, adding that experience has shown that it was wrong to believe that liberalising the banking sector would help modernise agriculture and industrialise the country because they cannot lend at the low rates players in the sectors need.
A recent workshop organised for members of Parliament by the Civil Society Budget Advocacy Group, a coalition of civil society groups, pointed its guns at commercial banks. The MPs and their hosts were aligned in their conviction that banks are not committed to keeping interest rates reasonably low. They are always eager to raise rates when the CBR goes up, but drag their feet when it comes down, it was pointed out. In the end, it was agreed that a bill to amend the Financial Institutions Act and introduce an interest rate cap at five percentage points above the CBR was should be introduced in parliament.
The most vocal opposition to such a bill has not come from commercial banks, but from their regulator, the Bank of Uganda. (Kenya’s central bank was also against the interest rate cap bill.) The central bank’s core argument, as expressed by its governor, is that controlling interest rates would be moving away from economic liberalisation, which is one of the main reasons Uganda is an “attractive investment decision.” The other argument, strongly emphasised at a workshop the bank organised for MPs last Friday, is that the current interest rates are fair given the setup of Uganda’s financial system.
Two senior central bank officials said that Uganda’s financial system is still shallow, at least compared to Kenya’s. Louis Kasekende, the central bank deputy governor, laid out a number of statistics to prove the point. The ratio of total banking assets ($41 billion) to GDP ($63 billion) – a measurement of financial depth – in Kenya is 65% to Uganda’s 27% (total banking assets are $7.2 billion, while GDP is $26.37 billion). Kenya has 1263 pension providers with total assets worth $6.2 billion to Uganda’s one, NSSF, with total assets worth $1.1 billion.
Financial depth tends to correlate with income levels, which makes Kenyan borrowers less risky than Ugandan borrowers. As a result, Uganda’s lenders will set higher interest rates as a way of managing their higher risk.
Pension funds and insurance companies, according to Kasekende, are the major sources of medium and long-term lending, and also support long term lending by banks. As long as there are few institutions to provide medium and long term funding and the responsibility is largely left to commercial banks – which are channelling savers’ deposits to lending, yet deposits are by nature short-term – they will price the loans expensively.
The cost of lending to banks in Uganda is also higher, Kasekende said. The average cost to income ratio of banks in Kenya is 50%, and 70% in Uganda; as such, there are narrower margins on the interest rates charged.
Adam Mugume, the director research at Bank of Uganda, focussed on why a policy response that caps interest rates would not work. Capping interest rates “automatically means that with the financial system still at infancy, you are likely to restrict its growth,” he said. It also “means that risky borrowers will be rationed out of the market,” and banks will prefer lending to the government through treasury securities. And if such a bill targeted only shilling-denominated loans, commercial banks would start giving mostly forex loans, which have an added risk of exchange rate pressures.
Mugume also pushed back against the claim that interest rates are too high. Lending rates averaged 22.8% in the two years to July 2016, he said, while the interest rate on the 364-day treasury bill averaged 17.3%. The difference between the rate on the risk-free government security and the bank’s average lending rate is 5.5%; that difference pays for the risk banks are taking in lending to individuals and enterprises. Non-performing loans in the same period averaged 5.3% of total loans, which justifies the 5.5% difference, he said.
He also said that external borrowing is “tricky” for government, in answer to those who say it should reduce its participation in domestic markets. It needs to fund infrastructure, but the global environment is “hostile;” the central bank has also ruled out participating in the international debt market due to the high interest rates.
But the bank knows that concerns about the high rates are not going away any time soon. Mugume said the bank has instituted several measures it believes will lower risk for the banks and deepen financial inclusion. These include developing financial consumer protection guidelines and financial literacy campaigns, licencing credit reference bureaus, and enforcing disclosure of interests and bank charges. However, he said the benefits from the measures will only be felt in the long-term.
Kasekende, on the other hand, said the bank has “been pushing for the liberalisation of the pensions sector so we have more pension funds.” He also pointed at capitalising the Uganda Development Bank as another option in the works.
And, even as he criticised banks for keeping their rates high, president Museveni did not indicate that he thinks a rate cap is the answer. Like Kasekende, he thinks the solution – at least in the near-term – is capitalising Uganda development bank “so that it gives low-interest loans to agriculture and industry (manufacturing).” In a speech last year, he ruled out government control of the “market-determined” interest rates, saying they will fall in the long term as “our economy expands and banks are able to realise greater economies of scale in their operations, thus reducing their costs.”