On 15th November 2024, Government of Uganda issued Legal Notice No. 21 of 2024 to introduce interest rates cap for Tier 4 microfinance institutions and moneylenders. The regulation limits interest rates to 2.8 per cent per month, or 33.6 per cent annually.
Although the move is intended to protect borrowers from predatory lending, it may turn out to be a double-edged sword in a country with a narrow credit market, especially for smaller businesses and unbanked individuals. Before the cap, borrowers often faced monthly interest rates exceeding 20 per cent, with annualised rates surpassing 100 per cent.
These predatory practices perpetuated cycles of debt, especially for women in small businesses, smallholder farmers, informal traders, and low-income earners who rely on credit to sustain their livelihoods. President Yoweri Kaguta Museveni rightly likened moneylenders to ‘vultures’ preying on vulnerable Ugandans.
For borrowers, the new policy is a significant step forward. By capping interest rates at 33.6 per cent annually, the government could encourage more Ugandans to turn to formal financial institutions, thereby advancing financial inclusion in a country where informal lending remains dominant.
According to the FinScope 2023 survey, approximately 52 per cent of Ugandan adults, equating to 12.8 million individuals, utilize informal financial services. There are downsides to this well-intended reform. The microfinance sector faces significant operational challenges, including high operational costs, inadequate infrastructure, small loan sizes, and high repayment risks.
Many lenders argue a monthly cap of 2.8 per cent does not adequately cover these costs and the attendant risks, threatening their survival. If lenders withdraw from underserved areas due to financial strain, borrowers may face reduced access to credit, undermining the regulation’s goal of promoting financial inclusion.
Another concern is the potential reduction in credit supply. With limited returns under the cap, lenders may become more risk-averse, opting to exclude borrowers without collateral, proven credit histories, or proof of income. This could disproportionately affect women in small businesses, smallholder farmers, and informal traders who rely on unsecured loans.
Agriculture, which employs many Ugandans, may experience reduced access to seasonal loans, potentially undermining productivity and food security. Additionally, the cap may discourage investment in the microfinance sector. Investors, crucial for funding lending services, may perceive the sector as less profitable and redirect their resources elsewhere.
This could stifle the growth of Tier 4 institutions, particularly those serving high-risk or marginalized groups. Furthermore, the regulation risks pushing borrowers back to underground moneylenders who are not bound by the cap. Many borrowers, particularly in rural areas or the informal sector, lack access to formal financial services due to geographical, infrastructural, or administrative barriers.
Banks and microfinance institutions may not have sufficient reach in underserved areas, leaving borrowers with no choice but to rely on informal lenders. These informal lenders often charge even higher rates and use aggressive recovery methods, exposing borrowers to greater risks. Such an outcome would undermine the government’s efforts to tame predatory lending.
For the policy to succeed, government needs to adopt an approach that balances the needs of both borrowers and lenders. Loan guarantee schemes can mitigate risks for financial institutions, encouraging them to continue lending, especially in underserved areas.
Promoting digital platforms such as mobile banking and automated systems, can lower operational costs and improve efficiency. Capacity-building initiatives can equip lenders with the necessary skills to navigate the new regulatory landscape, while regular policy reviews will ensure that the cap remains effective and adaptable to market dynamics.
Expanding financial literacy programs will empower borrowers to make informed decisions and avoid predatory lending. Extending regulation to cover informal lenders could curb exploitative practices and offer borrowers safer credit options. Providing incentives, such as tax breaks or grants, for rural lenders can help maintain credit flow in high-risk areas.
Lastly, public-private partnerships can foster innovation, bridge gaps in access to credit, and ensure that the financial system remains inclusive and sustainable.
The capping of interest rates for Tier 4 microfinance institutions and money lenders is, without a doubt, a double-edged sword. Experience from countries that have tried it such as Kenya shows that it usually turns out to be a disaster. Uganda hopes its own experience will not mirror Nairobi’s.
The writer is a young professional at Economic Policy Research Centre, Makerere University.