Politics will not fix economic problems

There are few subjects as exasperating to economists as media punditry on matters money, interest and credit.

I had successfully avoided the interest capping debate until early afternoon on Wednesday when the teacher in me succumbed to a temptation to wade into a Twitter discussion.

The debate was on whether demand for credit was price elastic or inelastic, with the intention of only providing a reference, a seminal 1981 paper by economics Nobel Laureate Joseph Stiglitz and Andrew Weiss titled “Credit Rationing in Markets with Imperfect Information”. The exchange was still going on when the newsflash came that the President had assented to the interest rate capping Bill.

Price elasticity refers to how responsive the demand or supply of a good is to a change in price. Price elasticity is high if a small change in price leads to a big change in demand. Price is inelastic is if change in price has little effect on demand.

In general, goods that are necessities have low price elasticity and luxuries have high price elasticity. The reason why the debate was still raging when the newsflash came was because I was trying to convince the pundits that they were using the wrong tool for the job.

I read a story in the newspapers sometime ago about mobile phone loans. The story featured an out-of-work mason and a boda boda rider, who have learned how to survive by juggling mobile phone loans. The mason had just borrowed Sh5,000 from KCB-MPesa to repay a Sh3,000 M-Shwari loan leaving him with a balance of Sh2,000 to survive on. By clearing the M-Shwari loan, he became eligible for a bigger loan, enough to clear the KCB-MPesa one when it fell due, and leave a small balance to survive on, which in turn made him eligible for a slightly bigger KCB-MPesa one, and so on.

The rider said: “For me, that is where I go for my salary advance although I’m not in formal employment. I mostly borrow mid-month from M-Shwari to clear a loan with KCB-Mpesa and vice versa.”

The two men are reportedly not in the least bothered about the cost of the loans, which is quoted in the story as “between five and 10 per cent, paid at one go”, which works out to annual interests rates of between 60 and 120 per cent.

STIMULATE ECONOMY

For the longest while now, the Bank of Japan has done everything it can to stimulate the economy to no avail. The policy rate has been zero since 2011 until the beginning of this year, when it was reduced to -0.1 per cent, effectively charging banks for holding money. This was supposed to stimulate credit and weaken the Yen so as to stimulate exports. Still, the economy refuses to respond, and the Yen has strengthened. “Every day is like being Alice in Wonderland,” says Tomohisa Fujiki an investment banker quoted by TheWall Street Journal. “Interest rate levels are having little effect on credit demand, the market function is declining. You can’t expect everything to go according to plan.”

The latest anti-deflation big idea is “helicopter money”. Helicopter what? The term was coined by Milton Friedman making a point about money and inflation by using an example of a helicopter flying over a village scattering a bundle of cash. In monetary policy parlance, helicopter money refers to proper money printing, that is, Central Bank injecting money directly into the economy instead of using “open market operations”, that is, buying and selling of bonds.

Earlier this month, the markets were anticipating that the Bank of Japan would launch helicopter money but it didn’t. Still the markets think it’s a matter of time.

Poor Kenyans happily borrowing at 60 per cent per year, while in wealthy Japan, you can’t get takers for interest-free loans. How to square this circle.

The import of the Stiglitz and Weiss paper is that in credit and labour markets, prices do not play the market clearing role that they play in normal goods markets. We have a lot of involuntary unemployment, put differently, an oversupply of workers. If labour was a normal market good, oversupply would depress wages until all the workers are absorbed. Yet, wages continue to rise even as unemployment increases. Similarly, demand for credit exceeds supply. In a normal market, interest rates ought to rise until there are no more loan applicants.

But loans are not goods like potatoes. Loans, and indeed bank deposits are risky investments. The risk adjusted value of a loan is the principal multiplied by interest to be earned, multiplied by the probability of repayment. The value of a one year Sh100 loan at 15 per cent interest with a 20 per cent default risk is Sh92. It is not worth making. One with a 10 per cent default risk has a risk adjusted value of Sh103.50. It is only worth making if the cost of funds is very low.

DEFAULT RISK

With cost of funds at say 7.5 per cent, the break-even interest rate of a loan with a 20 per cent default risk is 35 per cent. The key insight from Stiglitz and Weiss is that offering loans at such high interest rate is counterproductive. The higher the interest rate the more risky the entire portfolio becomes. Why? Loan applicants consist of prudent people as well as gamblers. At 15 per cent chances, only two out of ten applicants are gamblers. As the rates rise, prudent borrowers drop out. At 30 per cent chances, eight out of ten applicants will be gamblers.

Credit is one business where the customer willing to pay more is not your best customer. Not too long ago, some heroic bankers thought they had cracked this one—mix up high risk mortgages with good ones, give the mix a fancy name (Collateralised Debt Obligations), garnish with a credit derivative or two, and flog to gullible or greedy third parties. Property boomed. Even hitherto down and out diaspora Kenyans became property millionaires overnight. The rest is history.

The point I was trying to impress on the Twitter pundits about using the wrong tools is readily apparent. Prices, that is interest and wage rates, do not clear credit and labour markets. Even in market equilibrium, demand is not equal to supply—labour supply exceeds demand, and credit demand exceeds supply. Normal demand/supply analysis is not helpful.

The implications of capping interest rates also begin to become apparent. The lending rate capped at 15 per cent, and cost of funds at eight per cent, the break-even default risk is six per cent, meaning that customers deemed to have a default risk higher than six per cent will be deemed unprofitable. Given that the non-performing loan portfolio of the entire banking industry is of this order of magnitude, and we know that small and medium-sized enterprises (SMEs) have above average default risk, we can discern that the SME segment as a whole has a default risk higher than six per cent. It stands to reason that SMEs access to credit is going to become harder than it already is.

Whether mobile phone micro-loans survive will depend on whether banks can get away with disguising interest as fees. If, however, the regulators enforce strict compliance, the product may become unviable. This would be a big blow to the micro-enterprise economy. The political blowback would be vicious.

LENDING RATES

Much of the public attention has been on the lending rates. The law also fixes interest rates on deposits to no less than 70 per cent of the benchmark rate. This works out presently to a rate of 7.35 per cent if the rate is pegged to the Central Bank Rate or 6.2 per cent if pegged to the Kenya Bank Reference Rate which is 8.9 per cent presently. Interest rates paid on term deposits have hovered around seven per cent this year, so it may appear at first that the peg may not be too consequential. Not so.

Deposit accounts are bank products, and they have discretion on their features, which products to pay interest and which ones to charge fees on. Since banks have not been cured of the desire to maximise profits, it stands to reason that the product offerings will be reconfigured to minimise the cost of funds. We can expect that interest-earning accounts for small depositors will become rare, and fee-charging ones common.

The President’s assent to the Bill appears to have caught the media pundits, as well as the banking lobby, by surprise. Evidently, the smart money was on him not signing. Indeed the sentiment is that it is a case of politics stumping sound economics. Very true.

Data from the 2016 Finaccess Survey shows that 18 per cent of Kenyans reported business as their main source of income, compared to 12 per cent reporting employment. Thirty-two per cent reported agriculture, which brings to 50 per cent the population whose main source of income is profit as opposed to wages. If you adjust for dependents (16 per cent), the percentage of profit earners rises to close to 60 per cent.

Conventional wisdom has it that distributional politics are all about how production surplus is to be shared between labour (wages) and capital (profits). This data shows the conventional wisdom is no wisdom at all—it is an artifact of western economies that many of us apply uncritically.

When “labour” also earns profits, distributional politics will be about sharing of the production surplus between big business and small business, and herein lies President Uhuru Kenyatta’s political problem.

Were the President not so obviously personally conflicted, he could have had the credibility to persuade his constituency that capping interest rates was not sound economics or in their interests. But this is one time that even his otherwise dependable ethnic base was openly threatening consequences. As one trader from my village quipped the other day, if he votes with his pocket, he can forget our vote.

Japan has vexing unprecedented economic challenges. It has over-accumulated capital, a shrinking labour force and an aging population. Deflation transfers wealth from debtors to creditors (inflation does the reverse), and makes cash more valuable tomorrow than today. The most sensible thing for Japanese to do with helicopter money would be to (a) pay off debt and (b) save.

In Kenya, as in Japan, simple solutions don’t solve complex problems.

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