Published on Africa Can End Poverty

How price controls can lead to higher prices

This page in:

ImageThe Kenyan parliament just passed a new finance bill and there is one important good news: interest rates will not be capped. Prior to this, there was a risk that Kenya would embrace unconventional economic policies, and there were heated debates regarding price controls over the last months.

Many policy makers and Kenyans think that interest rates ought to be capped at a certain level, especially following their sharp rise since the end of 2011. People are affected by high prices, and inflation has only started to come down over the last few months. Borrowers want cheaper loans. 

The Kenyan debate around price controls reminded me of Germany in the 1980s, as I was growing up.  At that time, my country was still split in two. While West Germany followed a “social market economy”, East Germany opted for a state-led model in line with Soviet and communist philosophies.


One core economic policy of the East was price controls on all possible goods. Food, rent and services all had fixed prices. Also, the currency was set at parity with West Germany’s “Deutsche Mark”. But this exchange rate was unrealistic; given West Germany’s economic success, and East Germany’s relative stagnation.  


In May 1989, I went on a high school trip to the East—a special treat at that time, because access there was limited and highly regulated. My friends and I were approached by black market traders offering a ratio of 5:1. You probably remember what happened in the six months following my trip: The Eastern Block collapsed, and the Berlin Wall came down.


When travelling through Africa in the 1990s, I had many similar experiences: many goods in the shops were scarce, and black markets were vibrant.


Economists may not know a lot but, as Nobel Prize winner Milton Friedman put it: “we do know how to create a shortage”. Price ceilings are the easiest way to create one. Evidence around the world demonstrates that attempts to control prices, in fact often leads to higher prices (in a parallel market). And usually, the hardest hit are the poor! 


Capping interest rates could have resulted in similar unintended outcomes. Any interest rate ceiling means that credit has to be rationed. In that case, there is no guarantee that the most productive investment receives the credit.


Often, credit is rationed on political grounds, which undermines investment productivity. Worse still, the banks which give-out these politically-charged loans, often don't get repaid, putting their balance sheet in jeopardy.  


So how can price rises be avoided and poor families protected from price rises? Aren’t bank charging disproportionate fees and benefitting from high interest rates, at the expense of the common man?


The frustration vis-à-vis some banks is understandable. They seem to be making large profits in times when others are having a hard time to make ends meet. I also never understood why I needed to pay a large sum of money each month, just to have my bank manage my money in most countries, you add to your savings each month because banks pay interest on your deposits. However, most Kenyans seem to be losing out continuously, as many banks charge higher fees than they give their clients in interest.


Reforms are clearly needed to protect Kenya’s consumers better. But don't kill the goose that lays the golden eggs! A strong economy needs strong and liquid banks.


Many global companies consider Nairobi their hub and entry-point for Africa, not least because of Kenya’s strong services, including in banking. Over the last few weeks, the main area of contention has been the “interest rate spread” which is the difference between the interest the bank charges you for a loan (“lending rate”); and the money they give you for keeping your money with them (“savings rate”). For about a year, Kenya’s spread has been above ten percentage points, and with higher overall interest rates, it can become very expensive to borrow. However, the “spread” is not equivalent to the bank’s profits. A large share of the banks’ income is actually spent on operational costs, which are higher for banks which are present in rural and remote regions (see figure).


Figure: About a third of Kenya’s interest rate spread is profit
Source: Central Bank of Kenya, World Bank Kenya Economic Update


What can Kenya do to reduce interest rates and keep the financial sector strong?


First, try to bring down inflation further. Food remains the key driver of inflation, and better food policies would help everyone. Consider this: Kenya’s inflation is about 2 percentage points higher, because last year, Kenyans paid almost double for maize, and triple for sugar; than they should. This is not just bad for poor consumers but also for the macro-economy. With lower inflation, interest rates could also come down.


Second, Kenya still has a strong reputation for sound macroeconomic policies, and a strong financial sector. This is a lifeline to the economy. But you still need strong institutions which make sure that there is an equal playing field for firms to compete.


A key concern is the slow implementation of regulations to address the flow of illicit funds. Progress in Anti-Money-Laundering may have not gotten the needed attention. If Kenya continues to make only limited progress, it risks weakening the reputation of its financial system, thus prompting enhanced scrutiny on all financial transactions, and increasing their costs in the country.


Third, competition and innovation are the best medicine against high prices. The telecoms sector has demonstrated that prices can come down dramatically, if well-regulated competition unfolds. More transparency of banks’ financial products, and increased consumer protection, would lead to more competition, and better services for everyone.


If the banking sector would follow the model of Telecoms—and there is already a lot of overlap due to mobile money—Kenya could get the best of both worlds: A stable financial system and cheaper loans!


Note: This contribution follows on John Zutt’s (World Bank Kenya Country Director) commentary on interest rate controls in March 2012, and builds on the work by the World Bank’s financial sector and economic teams.


Follow Wolfgang Fengler on Twitter@wolfgangfengler


Join the Conversation

The content of this field is kept private and will not be shown publicly
Remaining characters: 1000