A 16% Rate, Interventions, and How to Restore Confidence in the Tenge

The base rate has been raised to 16%, yet it has not spared Kazakhstan's foreign exchange market from interventions. Reports say more than $1.3 billion has already been spent, and nothing has changed. The tenge remains under pressure, and this is weighing heavily on the economy.

Meanwhile, nobody knows what the real exchange rate should be. The National Bank of Kazakhstan (NBK) understands that letting the tenge weaken further would create far more economic problems, especially in the very areas for which it is responsible: inflation and the banking sector.

Inflation cannot be contained when imports are large and the tenge is weak. Even tightening tenge liquidity will not solve the problem, because in essence nobody will sell below cost. This is a limiting factor for inflation targeting through the money supply in conditions of heavy import dependence. In effect, the only tool for restraining inflation in this situation is holding the tenge's rate against the dollar through foreign exchange interventions, which is exactly what the National Bank is doing now.

For second-tier banks, a significant rise in the dollar under current conditions will worsen the quality of loan portfolios, because the interest burden will grow by the amount of the devaluation, while income will not rise in step with it. Since businesses will be unable to service their debts, this will again hit the banking system. And against the backdrop of constrained lending (a lack of liquidity and more expensive credit), business activity will shrink and consumer demand will fall. This will cause borrowers' incomes and profitability to decline further, with a knock-on effect on the banks. Second-tier banks that have seen significant asset growth over the past two to three years will be particularly exposed to this risk.

Another problem is that not all banks have balanced currency positions. If a bank's foreign currency liabilities exceed its assets, any further devaluation or depreciation will lead to revaluation losses and, subsequently, capital problems.

Accordingly, further weakening of the tenge is not in the National Bank's interest, and, given this conflict of interests, it is hard to predict how the National Bank will behave. The policy of restricting tenge liquidity in the market will continue, which will in turn affect business activity.

Psychologically, with volatility this high, nobody will move assets from dollars into tenge, and the question of de-dollarization remains open. One can talk endlessly about further weakening of the tenge, but until there are clear exchange rate guideposts, we will not be able to solve the de-dollarization problem even partially.

That is why I think the National Bank should use derivative financial instruments to give guidance on the exchange rate several months ahead. In other words, it is better to sell future dollars now (and it is not certain anyone would exercise such an option), but reserves would stay at the same level. Anuar D. Ushbayev has long been promoting this idea, but it has remained just an idea.

The existing deposit market also raises questions. If the rate rises to 16%, deposit rates should rise too, at least to 14% in tenge. With the National Bank paying 15%, second-tier banks can simply borrow from households at 10% and place the money with the NBK at 15%, earning a 5 percentage point spread without even having to think about what to do, since the risk is zero.

Incidentally, raising deposit rates would also help with de-dollarization: some holders of foreign currency would switch into tenge, seeking an extra 11% a year. And if the NBK announces a depreciation corridor of less than 11% a year, the number of people willing to switch would grow. Roughly speaking, offer an instrument that hedges a tenge decline of less than 11% a year, and many will start converting dollars into tenge. People simply will not believe words.

It was clear that a free-floating exchange rate is simply impossible amid such turbulence, and the move to inflation targeting was made at the most inopportune moment.

A justification for devaluation was needed, so the authorities decided to take advantage of a well-founded and carefully designed policy that had long been planned, knowing that it would not work under existing conditions.

It would have been better to carry out a devaluation and continue introducing gradual depreciation. There would have been fewer problems. As it is, we got what we got.