On the Base Rate
Translated from Russian with the help of AI. Original: Russian version
Why the base rate matters: how it affects lending, deposits, the tenge exchange rate and inflation.
Yesterday the National Bank of Kazakhstan (NBK) held the base rate at 14%. I will not comment on the level of the rate itself. I am sure that extensive calculations underpin any such decision before it is made. Still, I would like to explain why the base rate matters so much and what role it plays in the economy.
The base rate, together with its target corridor, is the cost of risk-free borrowing from, and placing liquidity with, the NBK. Second-tier banks place any surplus liquidity with the NBK, and if a second-tier bank is short of liquidity, it can borrow from the NBK against collateral in the form of securities, at the corresponding rate.
This sets, roughly, the cost of short-term funding in the market. It serves as a benchmark: rates are unlikely to fall below it, but they may well rise above it. For example, second-tier banks can currently place any excess liquidity with the NBK at 13% and borrow at 15%. As a rule, banks try to place surplus liquidity in the market through repo transactions (against liquid securities), since market rates will lie between 13% and 15%.
Banks, wanting to earn a profit but facing competition, then raise funds within the 13–15% range. That is the real cost of money. Once the margin and the cost of risk are added, the rate for clients comes to 16–20%, and in retail lending it is higher still, where there is no collateral or the risk is high.
Accordingly, when the base rate falls, the cost of borrowing for clients falls too.
The NBK's main mandate is inflation. High inflation is very damaging, so the NBK's rate is a tool for keeping it in check.
How does this tool work? First we need to understand where inflation comes from. Inflation arises when demand grows and supply does not keep pace. It can also be imported: when the exchange rate weakens against other currencies, imports become more expensive in tenge terms, or when prices rise in the exporting country itself.
To contain inflation, therefore, there must be a balance between consumption, production and imports.
The rate works in the following ways:
Lending. When the base rate rises, borrowing becomes more expensive for clients, and lending falls. People borrow in order to buy something; nobody takes out a loan just to hold the money. A decline in lending therefore reduces demand in the country. Lower demand leads to lower prices, because in a competitive market only a fall in demand can bring prices down. Many producers begin to cut prices, or at least hold them steady, in order to sell the goods they have produced or imported.
Deposits. When the base rate rises, deposit rates rise as well. Second-tier banks do not fund themselves with their own money; they raise it in the market through deposits and financial instruments. So when the base rate goes up, deposit rates go up too. As a result, people and companies save more. Higher savings reduce demand, because instead of spending, people and companies hold on to their money. Lower demand leads to lower prices for goods.
Holding the exchange rate. When deposit rates are high, buying foreign currency becomes unattractive even during shocks, because over the long term the depreciation of the currency will be smaller than the return on deposits. In times of shock, people are therefore less inclined to buy foreign currency, so demand for it is driven only by objective factors and puts no pressure on the national currency. With a relatively stable tenge, the cost of imports does not rise, and inflation depends less on the exchange rate.
Incidentally, if anyone calculates the income on tenge deposits over the past five years against the depreciation of the tenge relative to the dollar, they will see that holding tenge turned out to be more profitable than holding foreign currency.
By way of conclusion: today, the stimulation of consumption that fuels inflation is largely the result of state funding and subsidy programs. To make loans affordable for everyone, we need to abandon state subsidies and state funding, bring inflation down to low levels, reduce the cost of risk and develop competition. Only then will rates fall to a level that is affordable for all.