Interest is the cost pegged on borrowing money usually a percentage of the amount borrowed. The past one year has seen interest rates charged by banks on loans increase by more that 10% points to about 25% in December 2011 from 14% a year earlier. This was attributed to the economic slowdown the country experienced in the period pushing Central Bank of Kenya to act in normalizing the situation. This period saw inflation rates hit highs of over 19% in December 2012.
Inflation rates have since dropped to 6.09% in August 2012 and in the same wake CBK has lowered its base lending rate to 13% in August from 18% in May prompting commercial banks to adjust their rates downwards. Commercial banks put their base lending rates based on the Central Bank Rate (CBR) set by the industry regulator.
Why Rates Change
As Daniel Kurt (Investopedia) reckons, with any good or service in a free market economy, pricing ultimately boils down to supply and demand. When demand is weak, lenders charge less to part with their cash; when demand is strong, they’re able to boost the fee. Demand for loans flows with the business cycle. During an economic slowdown, fewer people are looking for new mortgages or loans for their businesses or personal use. Eager to increase lending, banks put their money “on sale” by dropping the rate.
The situation in Kenya is as such with lenders lowering their rates to encourage more borrowers to take up new loans. However the rates still remain high at between 18.5% and 22.5% for most banks discouraging borrowers from taking loans. Small and Medium Enterprises were worst affected by the expensive loans as many business opportunities passed them by as they could not access sufficient funds to bid for deals.
Kurt says it is important to note that short-term loans and long-term loans can be affected by very different factors. For instance, the buying and selling of securities by t he central bank has a much greater impact on near-term lending, such as car loans. For lengthier notes, such as a Treasury bond, the prospects for inflation can be an important factor. If consumers fear the value of their money will rapidly decline, they’ll demand a higher rate on their “loan” to the government.
Monetary Policy
Another factor in interest rate changes is the the governments “monetary policy”. If the government loosens monetary policy, this means that it has “printed more money”. Simply put, the Central Bank creates more money by printing it. This makes interest rates lower, because more money is available to lenders and borrowers alike. If the supply of money is lowered, this “tightens” monetary policy and causes interest rates to rise. Governments alter the “money supply” to try and manage the economy.
Inflation
At all times investors want to preserve the purchasing power of their money. If inflation is high and risks going higher, investors will need a higher interest rate to consider lending their money for more than the shortest term. This is what resulted to banks pushing interests from 14% in early 2011 to 25% in December 2011.
(Courtesy: Investopedia, Financial Pipeline)