FACTORS AFFECTING LENDING INTEREST RATES IN KENYA BY MWANGI MAURICE NGUGI A THESIS SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTERS OF ARTS OF THE DEPARTMENT OF ECONOMICS SCHOOL OF BUSINESS AND ECONOMICS

The lending interest rates in Kenya have a great impact on the performance of the economy. There is a need to evaluate the various factors affecting lending interest rates and their impacts on the general performance of the economy. The problem of this study was the determination of the factors affecting the lending interest rates in Kenya. After the liberalization of interest rates in Kenya in 1992, there has been an upward trend in the interest rates. However, macroeconomic policies from the onset of year 2002 led to the stabilization of interest rates. The study focused on the factors that have contributed to the variation in Kenyan lending interest rates from the year 1980 to the year 2010. The specific objectives of the study were to: determine the effects of budget deficit financing on lending interest rates; secondly, to investigate the effects of international interest rates on local lending interest rates in Kenyan economy since 1980 to 2010; third, to determine the effects of inflation on lending interest rates in Kenya since 1980 to 2010; fourth, to determine the effects of demand for credit on lending rates in Kenya since 1980 to 2010 and finally, to determine the effects of supply of money on interest rates in Kenya since 1980 to 2010. Annual secondary time series data from the World Bank annual reports, IMF annual reports, annual government publications and reports and other relevant publications were used to collect data. The EVIEWS software was used to conduct descriptive analysis as well as inferential statistics. Specifically, unit roots, cointergration tests and the Error Correction Model (ECM) were carried to investigate the dynamic behavior of the model. Results of the study indicate that the impact of budget deficit on interest rates of Kenyan economy was positive and significant. In addition, findings indicate that the effect of inflation on lending interest rates in Kenya was positive. Therefore, monetary and fiscal policy initiatives that aim to reduce inflation will also reduce the lending interest rates. Results indicated that the effect of money demand/National Income (GDP) on the lending rate was negative. Therefore, an increase in the demand for real balances for transactional balances leads to a decline in the lending interest rate. Therefore, macroeconomic policy that is expansionary may lead to a reduction in lending rates. The study found that the effect of the money supply on the lending rates is negative but insignificant. The study also found that the effect of international interest rates on local lending rates is negative. However, the impact is insignificant. The study recommends that policy makers need to consider the effect of the variables under study when designing policies aimed at reducing or increasing the lending rates. For instance, it is recommended that the policy makers should pursue expansionary policies aimed at increasing the national Income /GDP in an effort to reduce the interest rate. Such policies can be achieved through fiscal policies such as reduction in taxes or increased in government spending. It is also recommended that policy makers should pursue expansionary monetary policies by enhancing the money supply in the economy. This would reduce the interest rates. Policy initiatives that wish to keep the lending interest at a low level should also take into consideration the need to reduce the budget deficit. Furthermore, policy makers should design policies aimed at reducing inflation. Such policies would be through addressing structural and non structural causes of inflation. For instance, the policy makers should enact policies to reduce the cost of doing business in Kenya and effectively reduce the effect of cost push inflation.