Why the dropping central bank rate does not benefit small borrowers

Eng John Oryono, an investor with the Stanlib Asset fund asked the fund managers why the bank lending rates were still high.

“This does not reflect the Bank of Uganda (BoU) rate, which was adjusted recently. Why are they not coming down?” he asked.

Mr Oryono says the commercial bank lending rates have never come down, despite the Central Bank continuously revising it downwards.

BoU recently reduced the Central Bank Rate (CBR) from 9.5 per cent in December 2017, to a record low of 9 per cent for February 2018.

In spite of the Central Bank reducing the CBR in a space of two years by 8 per cent from 17 per cent in February 2016, to 9 per cent in February 2018, commercial banks have not similarly adjusted theirs, instead, they have remained sticky downwards averaging at 20.28 per cent.

The high interest rates are however, affecting mainly micro borrowers such as Eng Oryono who are subjected to interest rates, which are as high as 28 per cent compared to the large corporates who enjoy rates which are more or less with in the CBR, a commercial bank benchmark lending rate.

Mr Wilbrod Owor, the executive director of the Ugandan Bankers Association, an umbrella body for all banks in Uganda, says the micro borrowers can never be the same as corporates because of their (micro borrowers) risk profile.

“A corporate borrower has a better risk profile because it is a big operating company, it has collateral, reputable banking history and as such its risk profile will be lower than the micro borrower on the street,” he says.

And a bank will not just get interest income from corporates but also makes money through bank charges on its accounts, salary loans to its employees, and trade finance using letters of credit through them.

“So there are more benefits a bank gets through corporates and therefore, can afford to price lower that’s why they enjoy better rates,” he explains.

Mr Fred Muhumuza a researcher and economist, says the CBR does not work for those in lending because it is a signal for the long term yet lending is based on short term considerations.

“In lending, you gauge the risks of the borrower but the CBR does not address that. You also gauge the risks within the economy such as whether people have not been paying their loans, and if banks have a lot of non-performing assets and the risks of the sector the person is coming from. And then finally they factor in their own costs of mobilising risks,” he says.

When you look at all those factors at the end of the day, the CBR is very insignificant in determining the final interest rates.

“Corporates are basically prime clients, no bank wants to lose a corporate,” he says. Adding that, “…banks reduce the prime lending rate more or less for publicity because they are expected to do so.”

Muhumuza says that’s why they call it the prime lending rate because it is for its prime borrowers. Each bank determines who its prime borrowers are and in most cases it is the corporates.

Corporates get good rates because they have the ability to negotiate a rate. Mr Muhumuza also says CBR is basically a signal for the long term and can be changed on a monthly basis. And as such there is no bank that is going to take it seriously unless it continues to move in one direction which then makes it a signal for the commercial banks because the Central Bank is then signalling.

Mr Wilbrod says the CBR is a pure benchmark. However, iIt is not the only yard stick used.

“The corporates enjoy the benefit of enjoying that benchmark. But other banks tend to add overhead costs, Non-performing loan ratios to get the final rates pricing,” he says.

There are a few banks that track it because it is a benchmark used to start the computation of the final interest rate. However, Mr Owor says this does not mean CBR is not impactful. The CBR impacts government securities, which are used to either allow more public expenditure or also signal to commercial banks. For instance, treasury bills are impacted directly because their rates depend on the CBR.

Credit uptake

Statistics from BoU indicate that the growth of private sector credit remains at historic lows with 2017 recording an annual growth of 5.8 per cent a slight recovery from a negative 1 per cent contraction in 2016, even though as recent as 2012, private sector credit growth was in the excess of 20 per cent.

This is expected to increase as commercial banks revise the risk profile due to reduction in the non-performing loans or assets. The non-performing loans as a percentage of gross loans have declined from a peak of 10.5 per cent in December 2016 to 5.6 per cent in December 2017, which should support credit extension.

This credit gap can grow if the CBR transmission from monetary policy was effective.

Monetary policy transmission

According to Mr Adam Mugume, the executive director Research at BOU, while speaking on the role of the Central Bank in ensuring macro-economic stability, monetary policy is set with the future in mind.

“Monetary policy influences inflation with a significant lag, so when setting the policy rate the bank takes into account its views about the likely future path of the economy. BoU forecasts the future path of inflation and compares it with the target inflation rate. The difference between the forecasts and the target determines how much monetary policy (CBR) has to be adjusted,” he said.

So rather than focusing on achieving the target at all times, Mr Mugume says the approach has emphasized achieving the target over the medium term typically over a one-year horizon.

The CBR is set bi-monthly by the BoU’s Monetary Policy Committee (MPC) in line with a 12-month outlook for core inflation, an estimate of the productivity gap (the difference between the economy’s actual and the potential or average productivity) and qualitative judgments. And as such Mr Mugume says if the monetary policy committee believes that over the 12-month forecast period, these considerations are tilted on the upside, it will usually raise the CBR and vice versa.

“Ideally, an increase in the CBR would aim to slow down demand and consequently reduce inflation while a decrease in the CBR would be intended to increase demand and boost the overall level of economic activity in the economy,” he explains.

In the past two years to February 2018, the CBR has been reduced by a cumulative 8 percent, from 17 per cent in February 2016 to 9 per cent as of February 2018.

In brief he says, the monetary transmission via the interest rate channel can be described as follows. The Central Bank raises the policy rate. First, money market interest rates will rise as a result of the central bank’s open market operations. Second, the term structure of interest rates will change according to expected future short-term interest rates.

Third, retail interest rates of commercial banks will rise in accordance with the term structure of interest rates. Fourth, given price stickiness in the short run, long-term real interest rates will rise. It is this final development that will slow down consumption and investment of households and firms because of the increased opportunity cost.

Rates will reduce eventually

Mr Simon Ikua, investment manager at Stanlib East Africa, however, says the bank lending rates will come down eventually as the banks seek to diversify their sources of income.

“This usually happens when the Central Bank adjusts the CBR to a level that is below inflation, this eventually makes treasury bills less attractive and as such pushing banks to turn to creditors,” he says.

This he says is because banks do not make interest income in a low interest rate environment, which makes government securities less attractive, especially if the CBR goes below the inflation rate.

Therefore each commercial bank sets its prime-lending rate after calculating and factoring in their risks and profit. But given the risky nature of the small or micro borrowers, the interest rate always remains higher than that of corporates.

In a nutshell, the rigidities structural and otherwise by which central bank intends through its CBR like it is now, to bring down lending rates makes banks seek to lend those with perceived low risk who happen to be the corporates. This deepens the problem of the CBR’s lack of sufficient power to affect a large part of the economy who are the micro and small borrowers whose businesses affect household incomes. This thus creates a problem for tomorrow in which something must be done to aid credit access for the small borrowers who affect most households.

Constraints of monetary policy

One of the main constraints of monetary policy transmission is underdeveloped domestic financial markets. The banking sector has expanded significantly over the past decade, but domestic financial markets remain shallow and constrained by structural impediments.

For example, the domestic money market does not generate enough cash and on average, compares unfavourably with those of other developing countries. As a result, the underdeveloped state of the domestic financial market has a bearing on not only interest rate and availability of monies for lending, but also all other channels of monetary policy transmission.

GROWTH OF PRIVATE SECTOR

Statistics from BoU indicate that the growth of private sector credit remains at historic lows with 2017 recording an annual growth of 5.8 per cent a slight recovery from a negative 1 per cent - a contraction in 2016, even though as recent as 2012, private sector credit growth was in the excess of 20 per cent.

This is expected to increase as commercial banks revise the risk profile due to reduction in the non-performing loans or assets. The non-performing loans as a percentage of gross loans have declined from a peak of 10.5 per cent in December 2016 to 5.6 per cent in December 2017, which should support credit extension.

KENYA SITUATION

Interest rate cap impact

The interest rate cap on loans will soon be reversed to allow the market to determine the pricing of credit, the Central Bank governor of Kenya told the Standard Newspaper recently.

According to the Kenyan newspaper, he was speaking after meeting investors, mostly in the equity and fixed income segment, Dr Patrick Njoroge said banks will be handed back a free hand in pricing the cost of loans since the impact has been ‘problematic’.

“It is in our interest as a country and CBK to work to reverse these measures and go back to a regime with freely determined interest rates but in a disciplined environment,” he said. “It is clear to us that this has been problematic in many ways. I can tell you the direction but I cannot tell you when.”

The Kenyan parliament passed an amendment to the Banking Act in 2016, that set the maximum interest rate on loans at four per cent above the Central Bank rate. Interest on deposits was fixed at minimum seven per cent of the benchmark rate.

To cap or not?

According to Bank of Uganda (BoU) statistics, the interest rates charged by commercial banks have averaged at 21.3 per cent since the start of the millennium and about 21.7 per cent since July 2011.

Before the 1990s, Uganda’s economy, just like many other economies in the region, was controlled. Almost all economic indicators including prices, interest rates, exchange rates were controlled by government.

Dr Ezra Suruma, the former finance minister and chancellor of Makerere University, in an interview with Prosper Magazine, says back in the 70s and 80s, the interest rates were set by the Minister of Finance during the budget speech reading.

This rate would then be used throughout the year until the next budget reading.

However, he says, the controlled regime did not deliver much.

“It is not right to say that controlled interest rates worked in the 70s and 80s because the economy that we inherited in 80s was completely broken down. There was no economy. We had controlled rates announced by the government but we did not have an economy at that time,” Dr Suruma says.

Monetary policy transmission

In simple terms, Dr Mugume says monetary policy transmission mechanism means the process through which monetary policy actions eventually impact on the policy objectives of low inflation, 5% in our case, and economic growth.

Although central banks have policy objectives of low and stable inflation, and sustainable economic growth rates, the monetary policy actions have no direct impacts on these policy objectives.

But monetary policy actions will affect these policy objectives indirectly by first impacting on the banking sector’s behavior in terms of the interest rates, supply of loans and risks associated with lending. Secondly, on exchange rate dynamics. Third, public expectations, expenditure and borrowing behaviors, and eventually the policy targets. Usually this process takes 12-24 months to be completed and that why monetary policy is set in a forward looking manner.