Policy  Brief
No. 10, Oct. 2004
KENYA ECONOMIC AND POLITICAL TRANSITION PROJECT FOR ECONOMIC RECOVERY
Interest Rate Management and Monetary Policy in
Kenya
Introduction and Monetary policy operations in Kenya. The studies are
a response to proposals made in the ERS aimed at
he Economic Recovery Strategy (ERS) for the
T revamping the monetary policy especially as it relatesperiod 2003-2007 emphasizes on the role of the to interest rate management.private sector as the engine for economic
growth, while the Investment Programme (2003) points
out the need to enhance private sector investment. In Main Findings
the ERS, the government emphasizes the need to a) Interest rate structure
achieve an interest rate structure that promotes
financial savings and ensures efficient allocation of the Table 1 shows a kink around June 2003 when interest
same. To meet these objectives, bank interest rates rates drastically declined following implementation of
should reflect the true cost of capital in order to enhance changes in interest rates management by the
mobilization and efficient allocation of financial capital. government. While low lending rates are desirable to
Consequently, management of the liberalized interest enhance investment by the private sector, the declining
rates must be strengthened. The Central Bank of Kenya interest rates settle at a comparatively high level.
has the responsibility to manage the liberalized interest Deposit rates drop significantly but become negative
rates. However, the effectiveness of doing so depends in real terms as inflation ensues. The low deposit rates
on operations of the monetary policy and the are sustained by limited competition in the financial
competitiveness of the financial sector. In this regard, asset market, especially with low Treasury bill rate and
the government proposes various monetary policy declining currency-deposit ratio, which does not put
reforms to enable the Bank gain independence, public any pressure on banks to raise the deposit rate to
confidence and become more effective. maintain the ratio. Therefore, the deposit rate is very
low and this, to some extent, has led to a wide interest
The financial sector in Kenya has marginally gained
spread.
the expected outcome in the post-liberalization period.
The sector, for example, is characterized by high The spreads between maturities of banking sector
lending rates, which are undesirable for investment interest rates make it difficult to determine the risk
growth. Low deposit rates, which become negative in structure in the market. For example, the maturities of
real terms when there is slight inflation, sustain a wide deposit rates portray a U-shaped relationship while the
interest spread, which reflects inefficiency in the lending rates reveal an inverted U–shape, which makes
financial sector. it is impossible to determine whether it is profit
maximization motive or maturity preferences that
This policy brief is based on three studies carried out
drives the behavior of banking institutions.
by KIPPRA, namely: Understanding interest rate structure
Consequently, this hinders the response of banking
in Kenya; Determinants of interest rate spread in Kenya;
institutions to monetary policy actions.
Table 1: The structure of interest rates narrowing the spread to be made, the credit
Under Overall Deposit Lending Real Real Spread Inter- Treasury market must attain a significant level of
inflation inflation rate rate deposit lending bank rate bill
rate rate rate competitiveness.
Jan-03 2.6   2.5 4.7 19.0 2.2 16.2 14.3 9.0 8.4
Feb-03 2.7   3.0 4.4 18.8 1.4 15.4 14.4 7.1 7.8 In summary, the factors that explain the wide
Mar-03 2.8   3.6 4.0 18.5 0.3 14.3 14.5 6.2 6.2
Apr-03 2.9   4.5 4.1 18.6 -0.5 13.4 14.5 5.9 6.3 interest rate spread in Kenya include:
May-03 3.0   5.7 3.7 18.5 -1.8 12.2 14.8 5.7 5.8
Jun-03 3.0   6.6 4.8 15.7 -1.6   8.5 10.8 1.6 3.0 (i) Inefficiency in the credit market where
Jul-03 3.2   7.3 4.5 15.3 -2.6   7.4 10.8 0.5 1.3
Aug-03 3.3   7.9 3.4 14.8 -4.1   6.4 11.4 0.4 1.2 presence of non-performing loans signals
Sep-03 3.4   8.4 3.1 14.8 -4.8   6.0 11.7 0.5 0.8
Oct-03 3.5   9.0 3.1 14.8 -5.4   5.4 11.7 0.7 1.0 credit risk to which the banks respond by
Nov-03 3.6   9.5 3.3 14.1 -5.6   4.2 10.8 0.7 1.3 charging a high premium, which keeps the
Dec-03 3.6   9.8 3.3 13.5 -5.9   3.4 10.2 0.8 1.5
Jan-04 2.7 10.0 3.12 13.5 -6.3   3.1 10.4 0.8 1.6 lending rates high.
Feb-04 2.7 10.2 2.47 12.7 -7.0   2.2 10.2 0.9 1.6
Mar-04 2.6 10.1 2.32 13.1 -7.0   2.8 10.8 1.3 1.6
Apr-04 2.5   9.7 1.98 12.7 -7.1   2.7 10.7 1.7 2.1 (ii) Capital requirements, where results
May-04 2.5   8.8 2.22 12.6 -6.1   3.4 10.3 2.1 2.9 support the argument that when capital ratio
Jun-04 2.5   8.2 2.2 12.2 -5.5   3.7 10.0 1.3 2.0
is endogenously determined to protect against
Source: Central Bank of Kenya Monthly Economic Reviews
credit risk, it results in high interest spread as
the cost of holding such is borne by
customers.
The money market interest rates show significant
(iii) The burden of operational costs, which is
relationships among them. For example, the rediscount
shared with bank customers.
and discount window rates are defined as Treasury bill
rate plus a premium, which reflect on monetary policy (iv) Excess liquidity; when banks hold liquid
action. With a tight monetary policy, the premium assets, this reduces the liquidity risk premium.
charged is high, discouraging the use of such markets However, if the opportunity cost of holding
by commercial banks in liquidity management. In such idle reserves is high, banks tendto maintain
a situation, pressure is exerted on the interbank market wide spreads. This explains why banks sustain
such that there is an indicated positive relationship a high spread despite the reduced cash ratio.
between the monetary policy signal and the interbank
rate. Interbank rate is generally lower than discount c) Commercial banks interest rates and
window rate but higher than the repurchase monetary policy operations
agreements (REPO) market rate, indicating a deliberate
effort by the Central Bank of Kenya to maintain its An unstable financial sector weakens the monetary
position as a lender of last resort as banks use the policy transmission mechanism, constraining the
interbank market as a priority in their liquidity effectiveness of monetary policy actions. Commercial
management. The REPO rate level encourages growth banks’ interest rates trace monetary policy actions with
of the secondary market for government securities. a lag and less proportionately. For example, all interest
rates rise with tight monetary policy and take a general
b) Financial intermediation downward trend as monetary policy is relaxed. When
penalties on the discount window and the overnight
The interest rate spread is wide despite the efforts made lending are increased, banks lending rates rise to reflect
to narrow it (Figure 1). For example, the revision of the increased cost of liquidity management.
cash ratio downwards to reduce the implicit cost that Furthermore, high statutory requirements push interest
feeds into the spread led to a marginal decline in the rates up as they represent an implicit tax and therefore
interest spread. When interest spread is decomposed a cost to the banks.
into the prime spread (base lending) and the credit risk Banks have for some time now invested heavily in
spread, results show that credit risk constitutes 89% of Treasury bills as the credit market became more risky.
the spread while the prime spread constitutes 11%. This This has earned them substantial revenue but at the
implies that decline in prime rates only narrows the expense of their intermediation role. Presently, the
interest spread marginally. For significant gains in government is making the Treasury bill market
2
Figure 1: Relationship between cash ratio, interest spread, liquidity and position of the Central Bank of Kenya in
private sector credit demand managing interest rates.
25 1.2
Private sector credit demand 1.0 e) Reserve money programme
20 Cash ratio
0.8 While the ultimate goal of monetary policy
Spread
15 is to ensure price stability, monetary
0.6 authorities adopt varying monetary policy
rules. In Kenya, the monetary authority
10
0.4 uses the monetary target framework to
Average liquidity
manage liquidity. For this framework to
5
0.2
work effectively, it requires a strong and
0 0 reliable relationship between the goal
variable (inflation) and the targeted
aggregate (reserve money). It also requires
Period a stable money velocity and money
multiplier. Further, the monetary authority
should have control over the monetary aggregates. For
example, it is argued that while the monetary authority
can control the narrow monetary aggregates, it may
unattractive to banks by keeping a very low Treasury not be the case with broader monetary aggregates.
bill rate. While this is appropriate in promoting Central Bank of Kenya uses the reserve money
financial intermediation, banks profitability and the framework and has shifted from the narrow monetary
stability of the banking sector is threatened in the short aggregates (M2) to broader monetary aggregates
run. Such a move requires that efforts be made to (M3X).
enhance the competitiveness of the credit market.
There is a positive relationship between reserve money
and inflation. However, the responsiveness of inflation
d) Monetary authority independence to reserve money is low, an indication of weakening
relationship. The money multiplier and velocity show
The independence of the Central Bank of Kenya and
instability. For example, although some stability was
the level of confidence the public has with it is
indicated immediately after the changes implemented
important for effectiveness of monetary policy
in 1996/97, this was not sustained (Figure 2). A positive
operations. The proportionate share of government
relationship is indicated between inflation, the volatility
borrowing from the Bank dropped drastically from 56%
of multiplier, and the velocity, implying that a weak
between 1991 and 1996 to 38% between 1997 and 2004.
monetary framework makes it difficult for monetary
There is a positive link between the government
authority to achieve its goal variable. The money
borrowing from the Bank and the level of inflation,
demand function indicates a money-income elasticity
therefore supporting the argument that financing
of 0.79 and money-interest rate elasticity of negative
government deficit through borrowing from the Central
0.18. When there is dis-equilibrium in the money
Bank is inflationary, and makes it difficult for the Bank
market, the real money demand adjusts by 40%.
to meet its goal.
Further, the stability of money demand function
The government has for some time now used the changes over time, an indication that monetary
Treasury bill rate as a signaling interest rate for authority temporary looses on liquidity management.
monetary policy actions. However, given that to some This means that assumptions that support the monetary
extent this interest rate reflects on the fiscal policy framework are weakening, reflecting developments in
operations, the signals may distort monetary policy the economy and the financial system.
objectives. Having a signaling interest rate that is
independent of fiscal operations would enhance the
3
Values
Jul-91
Jul-92
Jul-93
Jul-94
Jul-95
Jul-96
Jul-97
Jul-98
Jul-99
Jul-00
Jul-01
Jul-02
Jul-03
sharing; restructuring of failing banks
Figure 2: Volatility in the money multiplier and velocity to enhance competitiveness; and
0.14 tightening the enforcement of financial
contracts by undertaking legal reforms
0.12 Multiplier and strengthening the capacity of
commercial courts.
0.1
◆ Supporting efforts aimed at
0.08 rationalizing the operational costs by
individual banks. Although in the
0.06
short-run customers bear part of the
Velocity
0.04 restructuring costs, reduced
operational costs sustain narrow
0.02 interest spread in the long-run.
Rationalization through closing up
0
branches, though, may raise the
proportion of the population with no
Period access to financial services.
◆ Encouraging development of
capital and money market by strengthening the
Conclusions and policy institutional structures, including the trading
recommendations system, to reduce the transaction period and
expansion of the financial assets basket. This will
Sustainability of an attractive interest rate structure allow for diversification of risk among investors and
with effective monetary policy operations depends on enhance competitiveness in the financial market.
the developments in the money market, the Competitiveness in money market will bring down
relationship between fiscal and monetary policy the cost of liquidity management by banks and
operations and competitiveness of the banking sector. enhance the effectiveness of monetary policy.
This calls for the need to sustain a comprehensive ◆ Establishing a signaling interest rate that has no
reform process for the financial sector by: direct relationship with fiscal operations. This will
◆ Enhancing the competitiveness of the credit market allow the monetary policy to give signals specific
in order to keep the credit risk low and therefore to its objectives. However, because the Central Bank
narrow the interest rate spread substantially. This of Kenya uses Treasury bill securities in its monetary
could involve restructuring the balances of banking programme, a good cash management system at the
institutions facing high non-performing loans; Treasury will enhance liquidity management by
strengthening the institutional structure of giving the monetary programme a better forecast.
information capital to ensure timely, accurate and
reliable information, and facilitate information
About KIPPRA Policy Briefs
KIPPRA policy briefs are aimed at a wide dissemination of the Institute’s policy research findings. The findings are expected to stimulate discussion
and also build capacity in the public policy making process in Kenya.
This work was carried out with the aid of a grant from the International Development Research Centre (IDRC), Ottawa,
Canada through a KIPPRA/IDRC Kenya Economic and Political Transition Project for Economic Recovery. The aim of
the project is to enable KIPPRA embark on activities that will help the Kenya government in formulation of transition
policies in three broad areas: Jumpstarting economic growth, fiscal reforms, and financing free primary education.
For more information contact: Kenya Institute for Public Policy Research and Analysis, PO Box 56445, Tel: 2719933/4,
Nairobi; email: admin@kippra.or.ke; website: http://www. kippra.org
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Values
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Jul-92
Jul-93
Jul-94
Jul-95
Jul-96
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Jul-99
Jul-00
Jul-01
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Jul-03