* Lending rate cap announced in August, effective September
* Government said banks were charging borrowers too much
* Cap spooked markets, sending bank shares tumbling
* Experts said could hurt lending to smaller clients
By George Obulutsa
NAIROBI, Oct 5(Reuters) - A decision by Kenya's government to cap commercial lending rates has stoked appetite for short-term government debt, pushing down yields on 91-day bills to their lowest since July.
Last month, Kenya imposed a cap on commercial lending rates of 400 basis points above the central bank's key rate, which is 10 percent. The government said banks had failed to respond to non-legislative encouragement to lower costs for borrowers.
The rule, announced in August for implementation in September, also set a minimum rate banks must offer depositors of 70 percent of the central bank rate, which equates to 7 percent.
Analysts said that, for the time being, that had set a floor on Treasury bill yields.
The cap spooked investors, sending bank shares tumbling, amid concerns it would restrict lending to small firms and other borrowers deemed risky bets.
With banks concerned about the impact of the cap seeking safer investments, high demand at last week's action saw the 91-day yield slip to 7.816 percent from 8.601 percent in August.
That brought it closer to three-year lows around 7 percent that were touched in July.
Yields on six-month and one-year bills eased to below 10.5 percent from 11 percent or more.
"The new law ... brought demand for Treasury bills and bonds as most banks waited for clarity on its implementation," said Alexander Muiruri, fixed income analyst at Kestrel Capital.
With inflation in the year to September at 6.3 percent, traders said further sharp falls in T-bill yields looked unlikely.
"My sense is that we are almost at the bottom. We can't go any lower, even on the 91-day, relative to inflation. (Otherwise) they start becoming real negative interest rates," said Ignatius Chicha, head of trading at Citibank Kenya.
The central bank's next rate-setting meeting is on Nov 28. It cut its benchmark lending rate by 50 basis points to 10 percent last month. (Editing by Edmund Blair and John Stonestreet)