Why you can’t cap interest rates down

Two weeks ago, a policy think tank, the Institute of Economic Affairs (IEA), proposed that Bank of Ghana (BoG) considers regulating lending rates to help address the persistent high cost of interest rates in the country.

It said the market dynamics and moral suasion had, over the years, failed to bring the rates down, resulting in a wide gap between the policy rate and the lending rates.

It went further to propose that a five percentage points ceiling be imposed as the gap between a bank’s lending rate and the central bank’s policy rate.

With the policy rate now at 13.5 per cent, it means that no bank would be allowed to charge interest above 18.5 per cent on a loan, when this proposal is accepted and implemented. Interest rates currently average 21 per cent although some customers pay as high as 25 per cent, depending on their risk profiles.

Bolted horse

While the proposition sounds convincing, especially given the contentious and seemingly intractable nature of the issue of lending rates in the country, it is unpopular with the times.

The era of regulating or capping interest rates has passed with all the lessons it brought. The most recent example is in Kenya, where a rare attempt by the state to regulate interest rates in a free market economy was reversed under four years and a comprehensive plan now underway to right the wrongs.

Just as the case is being made in Ghana, Kenya viewed the action in September 2016 as its perfect response to the pernicious high interest rates regime. But in November 2019, the Kenyan government removed the law after series of backlash and pockets of praises.

Elephant in the room

The lessons from Kenya aside, regulation of interest rates sounds to me as a short-term, artificial, easy and unsustainable approach by an authority that fails to admit that it is part of the problem.

Lending rates, which measure the cost of funds to borrowers, is the result of the actions of the government, the central bank, the lender and the borrower. Any attempt to find solution to the problem must include all actors proportionately.

When it comes to the government, the fiscal deficit and the debt situation are the biggest concerns. Large deficits fuel high debt and increased borrowing deprive the private sector of productive funds.

Known as crowding out, increased government borrowing is counterpart productive as it starves productive ventures of funds, fuels more debt through repeated deficits and jacks up interest rates, inflation and currency depreciation.

Zero deficit financing

Interestingly, large deficits and the accumulation of arrears have become entrenched; meaning that the government has had to borrow more from domestic and foreign sources on yearly basis. But as the government finds need for more funds, coincidentally from the same financial institutions that lend to private borrowers, it is forced to offer attractive rates on its risk-free bills.

These yields – not the central bank’s policy rate – then become the benchmark rates for banks when it comes to the pricing of funds. The reason is simple: if the government, which will literally never default, is willing to pay, say 19 per cent for three years, why should a bank lend to a corporate or an individual, which can easily default, at the same rate or lower?

The impact on the rates aside, increased government borrowing from domestic sources forces banks to treat private sector borrowers as second options, especially during uncertain times. As a result, private borrowers wishing to borrow are often forced to pay higher to be able to access credit.

This is currently playing out in the country. Banks have had to meet the government’s increased appetite for funds with a corresponding increase in their holding of government paper. Expectantly, the private sector has been the loser, receiving only 5.5 per cent of new loans as of June compared to the 28.8 per cent growth in investments in government securities.

Proposed solutions

While the push for the capping of rates is understandable, it will struggle to resonate with even BoG, which has found the cause of the problem.

In my mind, such a proposition would have only garnered tremendous support from BoG about 20 years to 30 years ago, when state controls were the order of the day; not in this 21st Century, when liberal economics have taken roots even in once sate-captured economies.

In this current dispensation, market forces, supported by targeted state interventions are the most favoured, popular and productive options.

When effectively and efficiently implemented, market forces bring out the best in economies and their players by fueling competition and rewarding the most diligent efforts.

In that regard, the first and the most expansive solution is to smoothen out macroeconomic imbalances to avoid the need for crowding out.

Once that is done, banks would be forced to lend mainly to the private sector at rates that are commiserate with risks.

The market for long term funding needs to be developed and deepened to help ease the cost of funds to banks. To this end, efforts to establish a development bank are timely.

Again, BoG has to be more interested in the operations of banks. More often than not, inefficiencies, executive largesse and lack of innovation are passed on to unsuspecting customers as cost, leading to higher prices of loans.

The legal regime on delinquent borrowers also needs improving. Delayed resolution of cases and foreclosure raise the default rate, which is passed on to borrowers.

All in all, regulation of interest rates is not an option, given the unintended impact on credit to SMEs and the general economy.

The solution lies in fiscal discipline, efficient supervision and a more responsive system that also takes and keeps record of all borrowers and their history.