How to make loans cheaper and keep deposits from collapsing? Key role of discount rate cuts

The Central Bank of Azerbaijan (CBA) eased its monetary policy for the third consecutive month against the background of reducing external risks, including those related to the imported inflation factor. In particular, the day before, in what can be seen as a signal to market participants about the return to the practice of cheaper borrowed capital, the CBA board decided to lower the discount rate from 8 per cent to 7.75 per cent. Excess liquidity is currently prevalent in the financial sector, supporting a high level of lending.

According to the CBA, by the end of 2023, as excess liquidity is sterilised, the discount rate cut factor will also affect the deposit segment. Will the regulator be able to maintain a balance between the corporate demand for cheap money and the interests of bank depositors?

The unprecedented global inflation of the past two years and other external economic factors have led to a rapid increase in the prices of consumer goods and food. These risks had an impact on the decline in trade activity, the reduction in production and, most importantly, certain risks to social stability in our country. As in many countries of the world, this negative situation prompted the Central Bank of Azerbaijan to implement conservative scenarios in monetary and credit policy.

In particular, the regulatory discount rate in the country gradually increased in 2022-2023, reaching 9 per cent at the peak. Thus, in the current difficult conditions, when choosing between macroeconomic stability and ensuring the economy's need for "cheap" money, the regulator preferred the former, based on the principle of the least evil.

Only last autumn was it possible to reduce inflationary pressure significantly. According to calculations, the number of households expecting inflation to rise in Q4 2023 fell to 69 per cent from 81 per cent in Q3. Overall, Azerbaijan's annual average inflation slowed to 8.8 per cent from nearly 14 per cent in 2022.

In the information released the day before, the CBA said that the annual inflation rate fell due to the impact of both external and domestic factors: "The impact of imported inflation on our economy was limited by the slowdown in global economic activity and the continued decline in global commodity, energy and food prices."

Specifically, the CBA cited World Bank data showing that the commodity price index was down 18.9 per cent year-on-year last December, with energy prices down 24 per cent. Meanwhile, according to the UN Food and Agriculture Organisation (FAO), the food price index for December fell 10.1 per cent from a year earlier.

As inflation expectations in Azerbaijan, as in many countries around the world, have been on the decline, efforts to improve GDP dynamics and reduce the tax burden on companies have become a priority. In line with these developments, the Central Bank cut the discount rate twice - in November and December last year and on 31 January 2024 - from 9 per cent to 7.75 per cent.

The latest amendments also reduced the ceiling of the interest rate band from 9 per cent to 8.75 per cent, while the floor fell from 6.5 per cent to 6.25 per cent.

This move reflects the regulator's confidence that inflation will remain close to the target range (4±2 per cent) this year. Accordingly, the forecast for 2024 remains unchanged, taking into account the current macroeconomic situation. In particular, according to the forecasts of the Ministry of Economy of Azerbaijan, the country's average annual inflation is expected to be 5.3 per cent in 2024.

"Further decisions will take into account the peculiarities of the country's monetary policy, and processes in the financial markets, including the currency market. If likely risks can be avoided, the possibility of a gradual easing of the monetary policy will be taken into account in the following months of this year," the central bank said.

The current trend of lowering the regulator's discount rate will directly affect the debt market: bank lending rates will gradually decrease.

Against the background of the recently dominant CBA policy of raising the refinancing rate, the situation of manat liquidity was quite difficult: receiving money from the regulator at a higher price, banks were not able to reduce interest rates on loans. By way of comparison, the average interest rate on loans in the national currency last year was 14.31 per cent, compared to 14.13 per cent at the end of 2022.

Inflation and other risks also played a role here. In general, the factor of excess liquidity in the country's financial sector observed over the last two years has made it difficult to earn on these funds. Banks have been forced to reduce margins (the difference between the price of buying and selling money) to somehow place liquidity and earn income.

On the other hand, the high-interest rate set by the regulator forced credit institutions to actively attract funds from the population at a higher interest rate: According to the CBA, the volume of household deposits in local currency increased by 21.1 per cent in 2023 to more than $5 billion, or 66.8 per cent of total deposits.

Nonetheless, by end-2023, the average interest rate on deposits and local currency deposits stood at 8.19 per cent, down from 8.6 per cent in 2022. And this appears to be only the beginning of the process. By lowering the discount rate, the CBA has clearly set itself up for cheaper borrowing to support the private sector.

Against the backdrop of last year's GDP contraction to 0.8 per cent, it is clear that growth in the capitalisation of companies and their productive activity in the market is impossible without injections of low-interest and "long-term" money into the economy, including through banking structures.

However, if the process of reduction of the refinancing rate continues in 2024 and the banks' access to low-interest credit lines increases, the population's need for relatively expensive funds placed on deposit accounts is likely to decrease.

Until recently, banks have been dissuaded from lowering deposit rates by high inflation and a psychological factor related to the fact that the exemption from income tax on annual interest on deposits expires on February 1, 2023, and that this income has since been subject to a 10 per cent withholding tax.

This initially caused some confusion among depositors. Banks have therefore been slow to cut deposit rates so as not to exacerbate the negative effect. But these and other factors may soon become irrelevant as the country's monetary regulation paradigm shifts.

"There is currently quite a lot of liquidity in the market. It will take time to sterilise it. The impact of CBA rate changes is not as visible when there is excess liquidity. We need to maintain the volume of funds so their value is within the corridor planned by the supervisor," CBA head Taleh Kazimov said during the press conference on January 31.

According to him, strong coordination of monetary and fiscal policies is necessary to manage liquidity in the market: "It is important and we are working hard on it, we have good coordination with the Ministry of Finance. I believe that the discount rate will start to affect the deposit segment as early as next year".

The CBA's monetary policy for the next year or two should therefore be aimed at maintaining a balance between, on the one hand, reducing the cost of borrowed funds to fuel the economy and, on the other hand, keeping interest rates on household deposits at a level that is acceptable to them. It is a difficult but achievable task.