* The central bank has cancelled three auctions in 2017
* Government has raised 117 bln shillings so far
* Has local borrowing target of 236 bln in 2016/17 fiscal
By Duncan Miriri and George Obulutsa
NAIROBI, March 16 (Reuters) - A cap on commercial lending rates by the Kenyan government has hurt its own ability to raise funds in the local debt market as it struggles to keep yields below the maximum threshold.
The central bank has cancelled three auctions of Treasury bills and bonds this year, after investors pushed up yields towards or past the 14 percent, where the commercial cap stands.
"They are in a bit of a straitjacket and something will have to give," said a senior fixed-income trader, referring to the cancelled auctions.
The cap was introduced in September last year. It limits interest rates to 4 percentage points above the central bank rate, which stands at 10 percent.
The government argued that lenders had some of the highest returns on the continent and that borrowers were paying the price. However, commercial banks argue that the cap makes it harder for them to lend to riskier customers.
Nairobi brokerage Kestrel Capital estimated the government has raised only 117 billion shillings ($1.14 billion), out of a target of net local borrowing of 236 billion shillings for the fiscal year to the end of June.
Fixed-income traders said that level was well behind usual borrowing levels at this point in past fiscal years. Officials at the Treasury declined to comment.
Commercial banks have piled spare cash into Treasuries since rates were capped. The cap also slowed already sluggish credit growth to small and medium enterprises.
Private sector credit growth started weakening at the end of 2015 after the central bank toughened supervision. It plummeted to 4.3 percent in December 2016 from 17.8 percent the previous year, worsened by the rate cap.
President Uhuru Kenyatta, who faces re-election in August, called the slowdown unfortunate and said it was an "unintended consequence" of the cap.
"This is an issue that concerns us and is one that I will actively seek to resolve so that credit can start to flow again to the real drivers of our economy," he told parliament.
The Kenyan economy has expanded by an annual average of 5.9 percent in the past four years, but slowing credit growth and fears about potential violence in the run-up to elections are seen as the main risks to further progress.
The rate cap has also pummeled bank shares.
Executives in the banking industry said their institutions would continue to sail in troubled waters
"The market mechanism is not operational in Kenya," said James Mwangi, chief executive of Equity Group, one of the country's biggest lenders by customers. ($1 = 102.9000 Kenyan shillings) (Writing by Duncan Miriri; Editing by Keith Weir)