The Cost of Money, the Base Rate, and Why It Cannot Simply Be Cut

Thinking out loud

Last week I wrote about how a bank calculates its interest rate, about the cost of risk and what affects it.

The largest share of an interest rate, however, is the cost of money: what the bank pays to raise funds.

The cost of money is what a bank spends to attract funds from depositors, current account holders, holders of the bank's bonds, shareholders and other financial institutions.

The cost of money depends on the term of funding: different periods carry different rates. Kazakhstan's market for funding at different maturities is poorly developed, so it is very hard to derive the spread between funding terms.

Last time I wrote that a rate depends either on the cost of funding or on the risk-free return on placing money.

The risk-free rate is, as a rule, the rate on National Bank of Kazakhstan (NBK) notes, on deposits with the NBK, on Ministry of Finance bonds, and the rate on interbank borrowing against government securities (repo). This market depends largely on the NBK base rate. The base rate is the rate set by the NBK. It is the benchmark for calculating rates on short-term NBK notes and serves to sterilize liquidity in order to manage the money supply. But more on that later.

Deposit rates for individuals and legal entities are derived from the risk-free rate. So it can be said that interest rates in Kazakhstan depend to a large extent on the NBK base rate.

But this raises a question: why can't we simply cut the base rate and have everything solved?

Because the base rate depends on inflation in the country: the higher the inflation, the higher the base rate. The real rate is our nominal rate minus annual inflation.

Inflation is, on the one hand, bad, and on the other, good.

To deal with inflation, we need to understand what drives it. We should encourage good inflation and fight bad inflation.

For example, if the cost of education rises because the quality of educational services has improved, that is good inflation; if car prices rise because of growing imports, that is bad.

I will not go too deep into theory, but for inflation to be low, the following are needed:

1. Growth in domestic production of all types of goods, works and services.
2. A reduction in imports of foreign goods, works and services.
3. Growth in exports of goods, works and services.

Broad-based production growth requires diversified production and a sound institutional environment. In other words, there should be no internal barriers to entrepreneurship and no selectivity; there should be equal access to public services, including a fair judicial system and a fair law enforcement system, equal access to infrastructure, and so on.

There must be a fair tax system, a fair customs system, and so on.

I think these are the basics that must be developed first, so that investment in the economy is effective.

Any misguided subsidization, any selective approach to industries and enterprises, creates arbitrary barriers to the efficiency of investment. When subsidies are granted, a particular industry receives a benefit, yet it is not certain that the industry is efficient in the global economy, and scarce investment flows precisely there, while there may be more efficient industries that we do not know about and never will. To find out, you have to try. The same applies when the state allocates money to particular industries without knowing how efficient they are.

For example, suppose there is production X (which no entrepreneur has discovered) and, say, milk production, for which state money and subsidies are available. Most entrepreneurs, to reduce risk and mental effort, will produce milk. Meanwhile, the more efficient business will remain undiscovered. This is a very crude comparison, of course.

Subsidies also prevent the market rate for particular industries from being determined, and thereby affect the base rate as well.

For example, if we subsidized education, the effect would be greater, since education is largely a domestic product and will affect the quality of the workforce across the whole economy.

The state should not stimulate import growth by fueling demand for imported goods, works and services. Unfortunately, this is what happens. For example, we stimulate import-dependent industries, and production appears to grow, but the goods produced often consist of 70–80% imported content. These categories include assembly plants and the construction of certain facilities with heavy import content, especially at the finishing stage. All of this boosts imports, and therefore inflation. Of course, such industries should develop, but they should develop on their own, without preferential conditions being created for them.

The base rate is needed to manage effective demand in the country. When rates are high, people tend to save and forgo consumption (usually of imports) in exchange for additional income. On the other hand, the base rate affects lending rates, and when rates are high, people borrow less and consume fewer imported goods: household appliances, phones, cars, expensive renovations, furniture, and so on. If we lower the rate, we will immediately stimulate imports, which, with exports low, will immediately hit the tenge exchange rate (since rising imports and low exports increase demand for foreign currency), and the exchange rate will in turn push import prices higher. This will affect inflation, because in our case inflation is largely imported.

It is also bad, from a social standpoint, to subsidize the purchase of what is essentially the same good, differing only in some characteristics.

For example, buying housing at reduced rates will in the long run push prices up, while secondary-market housing will be cheaper by exactly the difference in rates on this type of lending. You can compare the average price of new housing and secondary-market housing. The market mechanism has done its work.

To sum up: to bring inflation down, we must first develop an institutional environment for entrepreneurship (fair courts, law enforcement, the tax system, infrastructure and so on) and build the right mechanisms to encourage entrepreneurship. Only then can the base rate be lowered, and the cut should be the result of lower inflation.