IN an effort to open up its banking sector for competition, Tanzania introduced the Banking and Financial Institutions Act, 1991.
Later, however, this Act was repealed and replaced with the 2006 Act which gives broad regulatory and supervisory powers to the Bank of Tanzania (BoT) over banks and other financial institutions.
The sector has undergone dramatic changes over the past 26 years and is, today, more competitive, with the total number of banks currently standing at 55 after the BoT closed 5 banks in January 2018.
However, despite reforms undertaken to open up the banking sector, Tanzania is still confronted with high levels of interest rates. And there have been calls from some quarters for a law that caps (or limits) the interest rates charged by banks on loans extended to borrowers.
President John Magufuli reiterates call for lowering interest rates
In response to the high interest rates, President John Magufuli reiterated his call for banks to lower their lending rates during his official opening of CRDB Bank’s main branch in Dodoma just last month.
And, even as he reiterated his call for banks to lower interest rates on loans, President Magufuli did not issue a directive for the BoT to introduce a law capping interest rates as the answer.
Although some measure of macro-economic stability has been achieved, high bank lending rates inhibit investment and economic growth and, by increasing production costs, lead to high prices of goods and services.
The BoT’s stand against capping interest rates
Quoting BoT’s deputy governor (financial stability and deepening) Dr Bernard Kibesse, local media reported that the BoT was concluding a policy on capping interest rates charged on loans extended by banks to borrowers and that such policy would be ready by March 2018.
However, in a brief statement offered to the media on the same day, the BoT clarified that the rate to be targeted is the interbank cash market rate—that’s to say, the rate at which banks lend to each other—and should not be confused with interest rate capping.
Whereas the statement from the BoT clarifying its stand on capping interest rates is in the right direction, some voices from political parties, civil society, and activist and advocacy groups support interest rate capping.
Therefore, this article seeks to contribute to the debate over whether enacting a law that caps how much interest banks can charge for loans is the answer to the problem of high interest rates in Tanzania.
A cap on interest rates is a form of government financial control. It can either be linked to the Discount Rate (i.e. the rate charged to banks on loans they receive from the BoT as a lender of last resort: presently, 12 percent) plus a limit of say 5 percent, or it can be expressed as an absolute interest rate – such as a maximum interest rate cap of 25 percent.
In my view, enacting a law that sets the maximum interest rate chargeable on loans is not an enduring solution to the problem of high interest rates.
As many contemporary economists would agree, the enduring solution for reducing interest rates is to ensure that the crucial causal factors behind the high interest rates are constructively addressed.
These factors include, among others, the perceived high risk of the business ventures being financed by banks and the lack of sufficient collateral; the high incidence of loan defaults and the costs relating to banks’ bad debts; as well as higher levels of government borrowing which push up interest rates in the economy.
Capping interest rates may be viewed as a populist move even if proponents claim that such law will help protect borrowers from high loan prices by guaranteeing access to affordable credit; the reality, however, is that it will not in the long-term.
Before delving into more details about why enacting interest rates cap law is not a lasting solution, it’s useful to consider, albeit briefly, the role banks play in the Tanzanian economy, how banks make money, and what determines interest rates.
The role banks play in the Tanzanian economy
As a bank CEO friend reminded me this week, banks have been at the heart of economic activity for more than 800 years. They contribute to the economic development of Tanzania and the improvement, in living standards, of Tanzanian people by reallocating money from savers, who have a temporary surplus of it, to borrowers, who can make better use of it.
By providing payment and settlement services, banks help individuals and businesses fulfil transactions. They also avail financial products, such as Letters of Credit, which make it possible for importers and exporters to reduce risk while continuing to do business.
Banks act as a repository for savings deposits, on which they sometimes pay interest, and then transform the savings into illiquid assets e.g. mortgage loans and cash flow loans (working capital) – in times of hardship and financial difficulty.
With the interest rates capping debate in mind, and noting the critical role banks play in the economy, in the BoT’s Monthly Economic Report for October 2017 the stock of credit extended by banks in Tanzania to the private sector was Sh16,356.3 billion as at September 2017.
It should be underscored that in 2016 domestic credit to private sector by banks amounted to 14.2 percent of percent of Tanzania’s GDP, according to the 2016 edition of the World Bank’s World Development Indicators (WDI).
How do banks primarily make money?
As we all participate in the debate on capping interest rates, it is very vital to understand how banks make money in order to make well-informed views and decisions.
The plain fact is that a bank is, in any case, a business. It incurs various operational expenses e.g. employee salaries and wages. And like any other business, a bank needs cash to meet expenses for effective conduct of banking business.
Banks take in money as deposits, on which they at times pay interest, and then lend it to borrowers for financing investment or consumption. Banks primarily make money by lending money to individuals, businesses and the government of Tanzania at rates higher than the cost of the money they lend.
This difference in rates, called the net interest spread in banking parlance, is what comprises a portion of the funds earned by banks and out of which operational expenses are financed and dividends to shareholders are paid.
Factors determining loan interest rates
Besides the factors such as the high incidence of loan defaults and the costs relating to banks’ bad debts as well as higher levels of government borrowing, the interest rate that a bank charges on loans is a factor of the demand and supply of credit.
An increase in the demand for credit will raise interest rates, while a decrease in the demand credit will decrease the rates.
The Discount Rate (currently at 12 percent) at which the BoT, as a lender of last resort, lends to banks, influences the lending behaviour of banks – and ultimately, interest rates charged by banks on loans to borrowers. As the Discount Rate is set and adjusted by the BoT, banks have no control over the Discount Rate which influences banks' lending behaviour.
In addition, the requirement to maintain a daily interest-rate free minimum cash balance (i.e. statutory minimum reserve) with the BoT, now at 8 percent of a commercial bank’s total deposits (liabilities), influences interest rates as more fully set forth herein.
When determining how much interest to charge for loans, banks also take into consideration the lending risk. Lending money is a risky business, and the repayment of a loan can never be predicted with any certainty.
Why are interest rates on loans in Tanzania high?
True, every Tanzanian borrower’s hope is for a reduction in interest rates, which are as high as 20 percent in some banks.
One of the most apparent reason for high lending rates in Tanzania is the enormous national debt (also called, public debt or sovereign debt) which, as of June 2016, was Sh45.6 trillion, according to the Tanzania National Debt Sustainability Analysis (DSA) published in November 2016 by the Ministry of Finance and Planning.
To illustrate how the national debt pushes up interest rates in the economy, let us consider the domestic debt component of Tanzania’s national debt stock.
According to the BoT’s Monthly Economic Report for October 2017, domestic debt stood at Sh12,376.76 billion as at September 2017 with most of the debt accumulated from the issuance of Treasury bills (T-bills) to finance government budget.
As borrowing increases, the government has to pay higher interest rate payments on T-bills in order to attract more bids from auctions of T-bill.
These higher interest rate payments arise due to the market’s nervousness about the government’s ability to honour its obligations on the maturing T-bills.
It is this state of play, some economic studies have determined, that leads to higher interest rates elsewhere in the economy and crowds out private sector spending and investment, because as banks and other financial institutions buy these T-bills they are not able to use the money to fund investment and consumption.
Note that banks use a portion of customer deposits (liabilities) to buy assets in the form of T-bills and other government securities. And, as highlighted above, the BoT requires commercial banks to maintain a minimum cash balance with the BoT of not less than 8 percent of each commercial bank’s total liabilities base in order to ensure that the bank will be able to satisfy demand deposits.
This requirement implies that although commercial banks must pay interest on deposits, these banks only keep 92 percent of the deposits for lending – as the BoT does not pay any interest to the banks on the 8 percent deposited with it. Consequently, commercial banks have to make up for the interest that they have to pay in satisfaction of demand deposits.
This means incurring high operational costs in today’s competitive environment. These costs, coupled with the overall cost of doing business in Tanzania, have made it difficult for commercial banks to cut interest rates.
The 2017 edition of the World Bank’s Doing Business report, which compares conditions for doing business in 190 countries of the world, says that it takes a period of 67 days to complete the standard property transfer process in Tanzania.
This is lengthy and prohibitive for the banking industry – although, now, the banking securities department at Isidora & Company Advocates sees some notable improvements in the processing of land transactions done in the Ministry of Lands, Housing and Human Settlements Development and, in particular, the Office of Registrar of Titles.
High interest rates have persisted because banks have to manage the cost of judicial processes: it takes banks in Tanzania 6 to 12 months, or even more, to go to court and sell an asset pledged as collateral on a loan while in Ethiopia, reports from there indicate, it takes 1 day; yes, 1 day.
Is enacting interest rates cap law an enduring solution?
Fixing a cap on interest rates through legislation will, in my opinion, not solve the high interest rates problem for the long-term. In order to bring interest rates to a level that supports domestic production, the BoT, government policymakers, banks, and other stakeholders need to work toward solutions that can tackle the crucial causal forces behind the problem of high interest rates.
For example, to bring down the high cost of doing business, the Tanzanian government needs to introduce meaningful reforms that include swift resolution of all court cases of bad loans and that overcome collateral security challenges and ease property registration.
As well, the government needs to make an effort to maintain the national debt at a sustainable level. This is important because a high debt-to-GDP ratio tells investors that a country might have problems repaying its loans and hence the increased cost of new government borrowing that, as discussed above, leads to higher interest rates elsewhere in the economy.
Enacting interest rate cap law would be tantamount to going back to the pre-1990s era when the government controlled all economic indicators, including interest rates and foreign exchange rates.
Those who support the capping of interest rates argue that such capping protects borrowers from exorbitant interest rates by guaranteeing access to credit at reasonable rates. They also argue that where banks have high ‘market power’, capping interest rates is justified to protect borrowers.
In a World Bank policy research working paper No. 7070 titled ‘Interest Rate Caps around the World: Still Popular, but a Blunt Instrument’, authors Samuel Maimbo and Claudia Gallegos report that there is empirical evidence for the success of interest rate caps on loans in the Republic of Korea from 1956 to 1994.
Notwithstanding these advantages, the Tanzanian government should not introduce a law seeking to cap interest rates on loans extended by banks to borrowers, but rather continue to maintain a free market in interest rates and, in that regard, the BoT should be keen to maintain a disciplined environment.
Such a law would limit access to credit for low-income Tanzanians, as a low cap on interest rates would not only make it costly for banks to design innovative products and services that meet demand in rural and remote areas of Tanzania, but also reduce competition in the Tanzanian banking industry.
Moreover, limiting by law how much interest banks can charge for loans could cut the demand for formal credit in Tanzania and affect business productivity.
What can Tanzania learn from Kenya’s interest rate cap experience?
In September 2016, Kenya became the only country in the East African Community region to enact a law, the Banking (Amendment) Act, 2016, that capped interest rates on bank loans at 4 percent above the Central Bank Rate (CBR), which today stands at 10 percent.
Prior to enacting the Act, the Kenya Bankers Association (KBA) warned that the capping of interest rates would cause more harm than good to the Kenyan economy but this warning fell on deaf ears in Parliament.
A year later, however, Kenya’s Business Daily newspaper edition of September 14, 2017, in a story titled ‘Central bank sets stage for repeal of interest rate caps’, reported that the Central Bank of Kenya (CBK) was planning a return to the freely market-determined regime because of the negative effect the interest rate cap has had on the Kenyan economy.
“It is in our interest as a central bank to work to reverse these measures and go back to a regime with freely determined interest rates,” CBK governor Dr Patrick Njoroge said, adding that, “banks will have to be more disciplined in the pricing of loans.”
All of Kenya’s biggest banks posted a drop in their earnings as the cap limited the amount the banks could charge for loans. In 2016, Barclays Bank of Kenya saw third quarter profits drop by 12 percent, and fees and commissions from loans halved from Ksh1 billion to Ksh532 million in the third quarter.
Besides squeezing profits for lenders, 1,933 staff employed in banks in Kenya lost their jobs in the 12 months since the law on capping interest rates was introduced, according to a recent survey by the KBA.
As Kenyan President Uhuru Kenyatta defied opposition from the CBK and KBA and signed the legislation for capping interest rates, we learn that presidents and parliaments can outrightly threaten the independence of central banks. This, in turn, questions the credibility of central banks and negatively influences a country’s investment potential.
But, I am confident that Tanzanian President Dr John Magufuli will not look the way of his Kenyan counterpart Mr. Uhuru Kenyatta and issue a directive to introduce a law capping interest rates in Tanzania. Such a law, if introduced, will hurt the Tanzanian economy.
Although it is in Tanzania’s best economic interest that more affordable credit is available to individuals and businesses from across the country, the overarching focus of the BoT, government policymakers, banks, and other industry stakeholders should, therefore, be on collectively tackling the crucial causal forces behind the problem of high interest rates in Tanzania.