* Government imposed commercial lending cap in September
* Economists say measure hurts smaller firms deemed riskier
* Credit grew 4.3 pct in year to Dec vs 17.8 pct a year ago (Adds more comments on credit growth slowdown)
By Duncan Miriri
NAIROBI, Feb 3 (Reuters) - Activity in Kenya's private sector increased modestly in January as banks curtailed new lending to firms after an interest rate cap was imposed last September, a survey showed on Friday.
The Markit Stanbic Bank Kenya Purchasing Managers Index (PMI) fell to 52.0 percent in January from 54.1 in December, still above the 50.0 line that divides growth from contraction.
"Since the legislation to cap interest rates came into effect ... we can now see signs of distress within the private sector as ...(survey respondents) lament about cash shortages," said Jibran Qureishi, East Africa economist at Stanbic Bank.
The government capped the lending rate for commercial banks at 400 basis points above the central bank rate, now at 10.0 percent, a measure economists said would hurt economic growth by discouraging loans to smaller borrowers deemed more risky.
"A further slowdown in private sector credit growth and poor weather conditions will most likely lead to a downward trend in the PMI over the coming quarter," Qureishi said.
Private sector credit growth had already started falling at the end of 2015 after the central bank toughened supervision. It worsened from April when mid-sized lender Chase collapsed.
Year-on-year credit growth was 4.3 percent in December, compared to 17.8 percent a year before, central bank said.
But the central bank said the drop in credit growth had bottomed out, with growth hovering near the 4.3 percent level for three months. Governor Patrick Njoroge forecast this week the economy would grow by 5.7 percent in 2017.
Njoroge also said the impact of slower credit growth to firms had been factored in that growth forecast, in part because farming which accounts for a quarter of Kenya's $62 billion gross domestic product (GDP) did not rely on credit.
"The areas where credit moves GDP much more is areas like trade and credit in trade is growing," he said.
The government says the cap aimed to stop banks charging excessive rates on smaller businesses, but economists say smaller firms that are vital to create jobs cannot secure loans.
"It exerts a needless cost on the Kenyan economy, for very little gain, and further complicates any poverty alleviation effort," Razia Khan, head of Africa research at Standard Chartered in London, told Reuters.
The International Monetary Fund said in a report on Jan. 25 that Kenya's economic outlook was positive but rate controls were a drag. "It is essential to remove these controls, while taking steps to prevent predatory lending and increase competition and transparency of the banking sector," it said.
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Editing by Edmund Blair