A Reply to Khakimzhanov

I recently wrote an article on the base rate, and Sabit Khakimzhanov, whom I respect, has responded in detail to my points. I take this as a very good sign. Public debate on economic issues improves the quality of communication and helps us find the best solutions, because decision-makers who read such debates will be more objective in the choices they make.

Still, I would like to answer some of Sabit's objections. I disagree with some of them, and in others I think my views were not interpreted accurately.

I will begin with the most important point, which several experts misread entirely. Many assumed that I am in favor of cutting the base rate at a time of high inflation. I am absolutely not. My whole argument was that in our country the base rate has a limited effect, and that inflation requires a comprehensive solution. Let me try to explain why.

The base rate works by letting us regulate supply and demand in the market through changes in the rate, and these in turn directly affect inflation. Regulation of supply and demand through the base rate operates through the following channels:

The credit channel. As money becomes more expensive, demand for loans falls, and with it demand for goods, works and services.

The savings channel. When the base rate rises, tenge-denominated assets such as deposits and bonds become more attractive. The market starts to save more and consume less, which also reduces demand for goods, works and services.

The exchange rate channel. A higher rate makes tenge assets more attractive and strengthens the currency, as economic agents shift from foreign currency assets into tenge assets against the backdrop of higher rates. A stronger currency lowers the cost of imports and pushes down domestic prices.

But each of these channels has its limitations, and unless they are removed, the base rate cannot work to its full potential. Let me explain the main reasons why these channels do not work.

The base rate does not fully affect final interest rates, because the state, for its part, actively subsidizes interest rates. The subsidies cover the difference in interest rates rather than a fixed amount, so for subsidized borrowers the base rate makes no difference. This limits the influence of the base rate on the level of lending.

The cost of funding for banks does not rise in step with the base rate. I have written a great deal about this. The point is that interest on current accounts is prohibited, and roughly 20% of all tenge assets of second-tier banks are held in current accounts. As a result, when the base rate rises, banks significantly increase their income on these balances, while economic agents receive none, and the savings function is disrupted. This is especially true of budget-funded organizations. To put it simply, banks use the balances of budget-funded organizations, placed with them by the Ministry of Finance, to buy Ministry of Finance bonds, which then pay interest to the banks, all of it tax-free.

Kazakhstan has no free foreign exchange market, and there are many restrictions and prohibitions. Legal entities cannot buy foreign currency freely, compliance requirements heavily restrict capital movements, and exchange offices are constrained by the spread. Interest on foreign currency deposits is capped at 1%. All this limits the influence of the exchange rate channel. When the National Bank raises or lowers the rate, the effect on the market is limited, because the signals do not work and economic agents cannot respond to the National Bank's signal in kind. That is why we saw the tenge strengthen only marginally as the rate rose, and then return to its previous range.

So when I write that policy needs to change as a whole, I mean that there must be a comprehensive joint plan with the Government to fight inflation. Here are some examples of what needs to be done:

• Give up the economic growth target for a couple of years. Economic growth is important, but unfortunately the fight against inflation and economic growth pull in opposite directions. Ideally it would be more correct to speak of employment, but in our economy it is better to speak of growth, and I will try to explain why in other publications. This does not mean there will be no growth. There may be, but the current growth of our economy is driven mainly by fiscal stimulus, which needs to be withdrawn.

• Cut back and review the policy of subsidizing the economy. In current realities it will probably be extremely hard to get off the subsidy needle, but at the very least subsidies should be made smarter and more responsive to the base rate. I will also write a separate post about this.

• Remove the distortion created by the ban on interest on current accounts, and bring this product back to the market, thereby equalizing the impact of the base rate on the cost of money for end users. Otherwise, banks will continue to earn trillions of tenge on the balances of budget-funded organizations and individuals.

• Remove the distortions in the foreign exchange market. I understand that this is how the volatility of the tenge is being contained, but volatility is always a response to emerging risks and signals, and it is normal. It is how the market protects itself and eliminates imbalances.

• Take a comprehensive approach to fiscal policy, covering both the state budget itself and quasi-public companies and funds, and fully implement a countercyclical policy.

The list could go on. This has to be a comprehensive program, and without it the problem cannot be solved by raising the base rate alone.

Finally, some very brief answers to several of Sabit's comments:

Under Dutch disease, the exchange rate is on the contrary unjustifiably strong, owing to the influence of export revenue from a highly productive sector, which sharply holds back the development of other sectors, and the REER is usually much closer to the nominal rate. We do not have that situation, so on the basis of our statistics it is hard to say that our country has Dutch disease in the full sense.

Sabit agrees that the rate has a limited effect. With expected inflation plus 3–6% and expected inflation of 10%, the ceiling for the base rate comes to 13–16%, while our current rate is 16.5%.

I consider the 5% inflation target too high, for one simple reason: we have a very large component of deferred inflation, precisely because of the Balassa–Samuelson effect. What we need is a transparent calculation of what level of inflation will not harm economic growth.

As for cumulative inflation, I think it is entirely feasible for the National Bank to check it. It is enough to compare prices in 2010 with current ones using the available data. I have doubts about the inflation statistics, especially for the period when statistics were under the Government, and that was the point I was making.

Overall, without a comprehensive approach and a change of paradigm, it will be extremely difficult for us to escape the zone of high inflation.