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The International Monetary Fund opposes a proposal by parliamentarians in Kenya to cap interest rates for banks because the plan could lead to a credit squeeze, its resident representative in the east African nation said on Friday.

Ragnar Gudmundsson said if the plan were adopted into law, it would risk undermining recent financial sector gains, including widening access to financial services and limiting the development of financial markets.

“The biggest concern is that those measures might lead to credit rationing. If we have caps on lending rates, there is clearly a risk that banks will simply be inclined to extend less credit,” he told Reuters.

Parliament is set to debate a motion brought by Martin Ogindo, a legislator from western Kenya, who is seeking a law to set the minimum deposit rate at 70 percent of the central bank rate and cap lending rates at no more than 400 basis points above the rate.

The proposal has some populist support, and businesses and officials have long complained of high commercial lending rates, which they say hinder economic growth. Analysts say other lawmakers could latch onto the issue especially in an election year. In Uganda there have already been strikes over the high cost of credit.

Gudmundsson said promoting competition and enhancing consumer protection measures and empowering credit reference bureaus could lower borrowing costs.

Credit to the private sector has surged in recent years, reaching 1.161 trillion shillings ($13.54 billion) at the end of last year, up from 888 billion shillings at the end of 2010.

But an aggressive tightening cycle since October last year to stabilise the exchange rate and fight inflation, now at 18.9 percent, has given rise to concerns about what will happen to the quality of credit. Kenya's benchmark interest rate is at 18 percent.

“The financial system in Kenya is in a strong position but because of the high interest rate environment there are some concerns linked to credit quality,” he said.

Non-performing loans as a proportion of gross loans in the sector fell to 4.9 percent by September last year from 10.6 percent at the end of 2007.

While the plunge in bad debts was good news, the very rapid credit growth was partly blamed for a steep weakening of the shilling last year that was accompanied by high inflation, and this is still a cause for concern.

“A key priority is to bring domestic demand under control and to contain inflation,” said the resident representative.

Lending to the private sector grew by 30 percent in December from a year earlier, slowing only slightly from 36 percent growth in September despite the start of aggressive monetary tightening.

“Growth in credit to the private sector should be coming down to 20 percent by June 2012 and this is a much more reasonable and sustainable rate of growth,” said Gudmundsson.

TIGHTER POLICY

The IMF expects Kenya's economy to grow 5.6 percent in 2012 after expanding by an estimated 4.5-5 percent last year.

“One can reasonably expect growth for 2011 to come to 4.5-5 percent and for 2012 to be 5.6 percent,” Gudmundsson said.

Growth this year would be driven by the agriculture and services sectors, including tourism, trade and the financial sector, he said.

The outlook assumes the implementation of tighter monetary and fiscal policies, good rains, global growth staying on course and a stable security situation. Kenyan forces are pursuing al Shabaab rebels in neighbouring Somalia and there are concerns that the rebels could retaliate and disrupt economic activity.

It is also dependent on the election, scheduled for late this year or early 2013, running smoothly, following deadly clashes after the last poll that was disputed in 2007.

Gudmundsson said the IMF was optimistic the election would go smoothly due to constitutional reforms that are being implemented. Kenyan polls have been marred for years by tribal violence, stemming from long-standing land disputes, although the blood-letting after the 2007 vote was by far the worst.

Opinion polls show a majority of people back the International Criminal Court's process of investigating the suspects behind the violence, because they say it could prevent a repeat of election bloodshed.

“There is a strong desire to avoid the trauma that the country experienced in 2007 and this has raised awareness on all sides of the political and social spectrum,” he said.

A stable exchange rate was also fundamental to the growth forecast, after volatility caused price disruptions last year. The shilling has recovered from a record low of 107 hit on Oct. 11, helped by the central bank's tightening stance.

“If we could have an exchange rate around 90 shillings to the dollar remaining stable, that would be a key achievement. We are not targeting a specific exchange rate, what matters more is exchange rate stability,” he said.

The shilling was trading at 85.55/75 to the dollar on Friday. - Reuters