Central Bank’s Move on Cash to Raise Interest Rates

Business Daily (Nairobi)

Geoffrey Irungu

2 June 2011

The withdrawal of Sh3.2 billion from circulation in the financial system following Central Bank’s policy action on Tuesday is likely to pile pressure on banks to increase lending rates, analysts have said.

The Central Bank of Kenya (CBK) increased by 0.25 percentage points the cash reserve ratio for commercial banks, increasing the cash that lenders are supposed to hold as deposits with the regulator.

Analysts said the raise gives banks a new impetus to increase lending rates to cover for the resultant fall in liquidity and a further rise in interest rates on Treasury securities.

Tuesday’s action changed the cash reserve ratio (CRR) for the first time since September 2009, when it was reduced to 4.5 from five per cent to allow flow of credit to the economy then suffering from the triple effects of the global economic crisis, spill-over of the post-election violence and drought.

A source familiar with the Central Bank of Kenya decision-making process said the change in CRR was designed to have a bigger impact than the Sh3.2 billion withdrawn from the system due to the frequency at which money circulates in the population – technically called velocity of money.

Mobile phone money transfer services are, however, said to have reduced it as cash did not necessarily move from the banking system, the source said.

The Monetary Policy Committee would have raised interest rates by an even higher margin had it followed the recommendations of the International Monetary Fund (IMF), he added.

“It would have been a one percentage point increase on CBR and on the CRR, if IMF was driving the action,” said the source who spoke on condition of anonymity since his interaction with CBK is intended to be confidential.

He said the increasing IMF unease with the rising inflation – that rose for the seventh consecutive month to 12.95 per cent in May – and the suspicion that the money supply may have begun to affect domestic prices of goods that had only marginal relationship with the fuel, food and transport prices.

The discussions going on the Kenya’s macroeconomic management in donor circles also pointed to growing unease with the fact that the CBK had been rather tolerant of rapid credit expansion that saw lending of more than Sh20 billion every month during the first few months of this year compared to only Sh10 billion at the beginning of last year.

Multilateral donors were of the view that the increase in the level of domestic prices was not only a result of the supply shocks relating to oil and foodstuff but also presence of “too much money chasing too few goods” – the classic explanation for persistent inflation. The IMF mission concluded its recent visit to Kenya by calling for containment of “demand pressures.”

“This rise in interest rates will have a negative impact on the economy. It will spread to lending rates, especially now that the CRR is affected. The impact of CRR will be bigger than that of reducing CBR,” said Fred Mweni, a member of the Market Leaders Forum, an informal advisory group to the Central Bank.

In an interview, Razia Khan, the head of Africa region research at StanChart, said that there was a case for higher T-bill yields if the government was keen to deal a blow to import-generated inflation. “At this point, policy would be best focused on stabilising the forex rate to deal with this inflation shock, that is, arguing for higher T-bill yields,” said Ms Khan.

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