New rules on the base rate raise questions

Murat TemirkhanovJune 08, 2017

On June 5, the National Bank decided to reduce the base rate by 0.5pp to 10.5%. For the first time in the press release and comments of the head of the National Bank, there was a mention of certain rules on changing the rate. Also, for the first time, the regulator assessed the impact of monetary policy on individual factors of inflation. These novelties raise questions and, in our view, require additional clarifications for greater transparency of decisions taken by the National Bank.

The level of real base rate

Following a decision to reduce the base rate, the head of the National Bank spoke at a media briefing. In particular, he noted: "An important benchmark for the National Bank is the base rate in real terms, i.e. nominal rate minus the target inflation rate. It is planned to keep it no higher than 4% - at a level commensurate with long-term potential economic growth".

Thus, it was announced, that the regulator began to use formalized rules regarding decisions on the base rate. Most likely, these changes occurred on the basis of IMF recommendations published on May 9 this year (Republic of Kazakhstan: Selected Issues). In the document, the IMF devoted a separate chapter to the discussion of the special rules’ use in the monetary policy for setting interest rates (Kazakhstan - Equilibrium real interest rate and monetary policy rules). In this regard, it is said, that formalized rules for determining the level of the base rate are an important tool for the transparency and independence of the regulator in decision-making.

From this point of view, the new approach of the National Bank is a significant progress in the application of the "inflation targeting" policy, but questions arise regarding the rules for determining the real base rate. As noted by IMF, there are quite many rules and their choice depends on many factors. In particular, we note a significant difference between the new rules of the National Bank and the approaches of the Central Bank of Russia (CBR).

In accordance with the IMF's assessment in Russia, in the absence of serious structural reforms, the medium-term potential growth of the economy will be around 1.5%. Inflation in Russia in May this year has already reached 4% yoy and, in the medium term, the CBR plans to keep it no higher, than this level. If we use the new approach of the National Bank, the CBR's key rate should be at 5.5% per annum, whereas today it is 9.25%. Hence, taking into account inflation, the real key rate in Russia is now 5.25%.

In a press release on the latest reduction of the key rate, the CBR notes: "Positive real interest rates are maintained at a level that provides demand for credit, which does not lead to an increase in inflationary pressures and also preserves incentives for saving". Thus, based on official statements of the NBK and the CBR, one can note a fundamental difference in approaches of determining the required level of the real base/key rate.

In our opinion, such serious differences in the rules for determining the required level of the base/key rate in Kazakhstan and Russia require a more detailed explanation from the National Bank. In particular, the IMF emphasizes, that there is a large level of uncertainty in assessing the potential growth of the economy and the equilibrium real exchange rate. Errors in such assessments can be costly to our economy.

The Influence of Monetary Policy on the Level of Inflation

We also note, that for the first time in the last press release on the base rate and in the comments of the head of the National Bank there were explanations on how the monetary policy of the NBK influences inflation. In particular, in his speech, the head of the National Bank noted: "The National Bank does not consider it justified to react by tightening credit conditions to reduce inflation, which is of a temporary nature. In particular, the inflation associated with the growth in factors of production on the supply side has an autonomous character from the point of view of monetary and credit policy". "The change in monetary conditions, which act on the demand side will not have a direct effect on inflation in the planned horizon".

Based on such statements, it can be concluded that, in the opinion of the NBK of Kazakhstan, the change in the base rate does not significantly affect the inflation rate, since it is mainly related to the growth of costs on the supply side, rather than on the demand side of the population and legal entities. This position of the regulator also differs significantly from the opinion of the CBR on inflation drivers in Russia, which also raises a number of questions.

Also, in this regard, we can note some other statements by the NBK: "Business activity in the economy demonstrates a significant recovery, without placing at the same time an inflationary pressure". "There is a gradual resumption of growth in consumer demand. In January-March, real incomes of the population increased by 2.4% yoy, which is explained, mainly, by an increase in budget expenditures for social payments".

From the theoretical point of view, such statements are not very clear, as a significant revival of business activity and growth of real incomes of the population should put pressure on demand inflation. In turn, with the growth in demand inflation, it is possible to counteract it by increasing the real base rate.

It should also be noted that, according to official statistics, the real wage index for the first quarter of 2017 by the corresponding period of the previous year was 98%, or a decrease of 2%. Therefore, NBK has an opposite opinion regarding the real increase in the incomes of the population.

In our opinion, the National Bank does not sufficiently disclose information on the analysis of factors affecting inflation in Kazakhstan. There are also raised questions about the current evaluation of some inflation drivers by the regulator. All this does not allow us to correctly assess the measures taken by the National Bank and the government to reduce the price increase.

Exchange rate, interest rates and credit growth

In the press release, we also note the following statements by the National Bank: "In addition to the undervalued (weak) real exchange rate, which creates price support to Kazakhstan producers, the real interest rate also decreases (i.e., the nominal rate adjusted for the targeted inflation rate - 6- 8% for 2017 and 5-7% for 2018), which serves as a support for the demand of credit resources from banks. Nevertheless, despite the excess liquidity, the limited bank capital is a more significant factor restraining the supply of a loan, than the cost of funding."

Regarding the real exchange rate of the tenge, we would like to note that since June 2016, when the currency interventions of the National Bank have become insignificant, and to date, the real exchange rate of the tenge against the US dollar has strengthened, and has depreciated against the ruble.

According to our estimates, today the nominal and real exchange rate of the tenge is overvalued to the dollar and is underestimated to the ruble. In this regard, such a situation will have a mixed effect on the competitiveness of Kazakhstan producers.

Also, in our opinion, restrained lending in the banking system is not due to a "limited bank capital", but mainly because of overload of debt and lack of qualitative borrowers. A number of banks from the top ten have a high level of excess liquidity and a relatively good level of capitalization. Thus, from the point of view of capital, they have no restrictions of significantly increasing their loan portfolios. On the other hand, the government through a number of government programs provides an opportunity for legal entities and individuals to receive bank loans at low subsidized rates. This supported the lending, but did not lead to an increase in the loan portfolio of the banking system.