On Foreign-Currency Lending

I have long wanted to write about foreign-currency lending. After the crisis of 2009, and then again in 2014–2015, many foreign-currency borrowers found themselves in a difficult position, and the regulator subsequently all but shut down foreign-currency lending. In Kazakhstan, individuals are prohibited from borrowing in foreign currency altogether, while lending to legal entities is constrained through capital risk weighting. In other words, if a loan runs for more than one year and the company has no export revenue, it is weighted at 200%. This means that twice as much capital is required to meet capital adequacy requirements for such loans. Naturally, these loans are unattractive to banks, and they are reluctant to make them. True, the capitalization of the large banks is now enormous, thanks to the bans and restrictions and to these banks' ability to earn super-profits, but there is another problem: the stability of funding. Because deposit rates are capped, foreign-currency deposits have become highly unstable, and the external balance statistics show them leaving the country through various channels in ever greater amounts. This is very bad for the country, and I have written about it before. So when it comes to developing foreign-currency lending, we face two fundamental problems: prohibitive barriers to lending and caps on deposit rates.

Let us now take each of these fears in turn.

The restriction on foreign-currency lending was tied to devaluation risk: when a currency depreciates sharply, borrowers' obligations balloon and they can no longer service them. In fact, this risk exists only under a fixed exchange rate. Under a floating rate, depreciation is offset by the interest rate differential. For example, in tenge we can currently borrow only at 20%, while in dollars the rate is 9%. That means the 11% difference is precisely the premium for currency depreciation. If the tenge falls from 540 to 600 over a year, the effective foreign-currency rate, converted into tenge, will also be 20%. Clearly, the shorter the horizon, the higher the volatility, but over longer horizons, in a market environment, the interest rate arbitrage will always cover the rate of depreciation. That is why this risk has practically disappeared since 2015, when the National Bank moved to a fully free-floating exchange rate.

The problem of funding stability should be solved by lifting the caps on foreign-currency deposit rates. This should be a market instrument that competes with other foreign-currency financial instruments. Higher rates would bring dollar assets back into the banking system, allowing banks to neutralize foreign-currency liquidity risk. In effect, banks now profit from the caps: they take unstable funding and simply reinvest it at market rates, as I have written many times.

The National Bank's reasoning is that if rates on foreign-currency deposits are raised, many clients will start moving their deposits from tenge to dollars, which will put pressure on the tenge as demand for foreign currency rises. This argument does not withstand serious scrutiny today either. First, rates on tenge deposits are now so high that depositors will not be very sensitive to an increase in foreign-currency deposit rates, even to 4–5%. But that is not even the main point. If banks are allowed to lend in foreign currency at the same time as deposit rates are raised, foreign-currency loans entering the Kazakh market will be converted into tenge to pay for goods, works and services, and will thereby offset the population's purchases of foreign currency. And even if that is not enough, the conversion of deposits will increase the foreign-currency balances of second-tier banks on their correspondent accounts at the National Bank. That will automatically raise international reserves, which can then be used in moderation to balance supply and demand on the foreign exchange market.

Why does it matter to develop foreign-currency lending now? Everyone understands that without lending to the real sector, it will be extremely hard for the country to develop, or to defeat inflation. Simply restraining demand will not solve the inflation problem in the long term, so it is vital to increase the supply of goods, works and services, and that requires loans to the real sector and to trade. Rates on tenge loans are very high, whereas foreign-currency loans can now comfortably be issued at 8–9%, and the burden on the sector at this point would be manageable. More foreign-currency lending would increase the supply of foreign currency on the market and, accordingly, strengthen the tenge, which would help in the fight against inflation. Moreover, second-tier banks are today the only private-sector players able to attract investment from abroad in large volumes, since all the large banks have good ratings and the banking sector is highly transparent and reasonably well regulated. But second-tier banks need to be able to on-lend this foreign currency inside the country, and that requires appropriate regulatory relaxation.

We must acknowledge that without external investment, a major leap in real-sector lending will be extremely difficult. If the state genuinely wants to expand real-sector lending, beat inflation and stabilize the tenge, it is necessary to:

• lift the restrictions on foreign-currency deposits and abolish the ban on current accounts, which would stabilize the funding base and create conditions for long-term lending;

• reform foreign-currency lending by reducing risk weights and recognizing as foreign-currency revenue not only exports but also domestic sales of goods pegged to foreign currency;

• improve creditor rights. This is especially important for lending to large projects, where banks should be able to take an active part in influencing and managing large companies. That requires changes to the law on bankruptcy and rehabilitation;

• improve the circulation of collateral, for example subsoil use rights, which make good collateral but are extremely hard to sell and enforce against, since this area of legislation requires complete reform;

• lower the MRP-based reserve requirements on foreign-currency liabilities (I will write a separate post on this), since they hinder lending and, as far as foreign-currency liabilities are concerned, do nothing to help fight inflation, because foreign-currency liabilities do not affect demand.

Many more initiatives could be listed, but implementing all of these measures requires understanding and a comprehensive approach: one does not work without the others.