FROM INDICATOR TO INSTRUMENT

The economic community worldwide is now focused on central bank decisions regarding discount rates, which are one of the most effective tools to influence financial markets and national economies. In times of crisis like the current one, the discount rate is crucial in order to prevent inflationary processes. On the other hand, it is a kind of indicator and a message to businesses about the possible short-term changes in the economy.

Until recently, the decisions of the Central Bank of Azerbaijan (CBA) on the discount rate have been informative only. However, since September 2022, CBA decided to change its policy and achieve at least a partial impact of rate changes on market processes. As the CBA governor Taleh Kazimov said at a press conference, the goal has been achieved and for the first time in Azerbaijan the discount rate is not only an indicator but also is a real instrument.

Key factor

Discount rate is an interest rate at which central banks lend to commercial banks, which in turn distribute these loans to their customers at higher interest rates, of course. For the most part, however, this indicator is a consequence, not a cause, of the current state of the economy. It can be used to stop say inflationary processes. The mechanism is simple - the central bank lowers the rate, with other banks following it later. Businesses and the public community take more loans ensuring liquidity. In other words, the amount of money in circulation increases, which affects the volume of consumption encouraging sellers to sell goods and services at a higher price. Accordingly, in case of negative events impacting on the consumer market and causing abnormally high price increases, the central bank makes the opposite decision, and by raising the rate, can achieve a certain restraining effect on inflation.

Currently the latter is exactly what is going on in all the developed economies. The only difference is perhaps the percentage increase in the discount rate. The US Federal Reserve, the European Central Bank and other major banks have long been using discount rate as their key tool to curb inflation.

As Bloomberg reports, central banks are raising discount rates massively following the highest inflation rate in 40 years, despite the threat of an economic slowdown or even recession. Since the beginning of the year, rates have already been raised in more than 90 countries. And in half of them, regulators have gone for a sharp increase - by 75 basis points (bps) or more at a time. Some have resorted to this measure more than once. Such measures are the biggest monetary policy tightening in the last 15 years.

Perhaps the most striking exception to this rule today is Turkey. Despite record high inflation and depreciating local currency, the central bank is lowering the rate. This is due to the authorities' commitment to alternative economic theory regarding the impact of this parameter on inflation and the stability of the national economy.

Reinforcing effect

But all these effects have not been relevant for Azerbaijan for many years: the objective situation in the banking sector did not make it possible to set a direct connection between CBA’s discount rate and commercial banks. The latter are not particularly interested in borrowing from CBA. No matter how low the interest rate is, CBA’s terms for granting a credit line are quite strict, and requires an impressive guarantee and collateral base, which only large banks of the country can afford. But today they do not have an urgent need for additional money.

Therefore, as already mentioned, the CBA discount rate has been an indicative parameter only, a kind of a signal to the market.

However, since September 2022, a couple of months after Taleh Kazimov was appointed as the CBA governor, the bank announced a new concept of monetary policy instruments. It includes a 7-day repo operation for sterilisation purposes, whereby the rate will correspond to the lower threshold of the discount rate corridor. CBA also announced the release of 1, 3, 6 and 9-month notes (such transactions will be based on the market supply and demand).

In order to provide liquidity on the open market, 7-day reverse repo transactions may be carried out. The rate will correspond to the upper threshold of the discount rate corridor.

In September, CBA drastically (by 2.25%) lowered the lower threshold of the discount rate corridor, as it wanted to activate the interbank money market, because yields on notes and government securities were considerably lower than the lower threshold of the discount rate corridor. "CBA aims at gradually bringing interbank rates closer to the discount rate corridor. At the same time, depending on the macroeconomic and interbank market situation, as well as the impact of new instruments on various segments of the financial market, the width of the discount rate corridor will be narrowed," the CBA statement said.

Also, CBA started the introduction of the one-day deposit operations as part of the sterilisation operation and the reverse repo operations as part of liquidity provision. Again, the main objective is to bring interest rates in the money market closer to the CBA discount rate.

Record indicators

Two months ago not all experts believed in the positive result of CBA's efforts to shake up the money market. But as Taleh Kazimov recently announced at his press-conference, for the first time in the years of independence, interbank rates are formed based on the parameters of the discount rate, its lower corridor.

Moreover, following the introduction of new configurations for unsecured transactions within the Bloomberg trading system, banks concluded transactions among themselves for ₼788m in September and ₼1.4b in October, which is a record for the banking sector. 97% of them were short-term transactions (1-3 days).

"Our ultimate goal is for the discount rate to have a real impact on inflationary processes in the economy. We hope that in the coming months we will be able to engage the transmission to the market and the upper threshold of the discount rate corridor," Kazimov said.

Today, these processes are worrying amid the challenging external factors. For instance, in September 2022 the annual inflation rate was 15.6%, while the core inflation rate was 14.1%. At the same time the prices of food products rose by 21.8%, non-food products - by 10.5%, services - by 11.4%. "Based on our survey, 20% of companies expect inflation to rise. Our analyses show that imported inflation is the main driver of inflation, it affects both us, the region and the global economy. Inflation is forecast to be high until the end of this year," T. Kazimov said.

Indeed, high oil prices have added to Azerbaijan's balance of payments, hence increasing the country’s foreign exchange reserves ($55 billion). The country's oil prices, however, continue to rise.

Therefore, CBA says it will continue its policy of tightening monetary policy, like it did on October 28 by increasing the discount rate by 25 points to 8%. The lower threshold of the discount rate corridor was also raised again, this time to 5%, with the upper limit kept at 9.25%.

"We are trying to pursue policies so that our efforts to keep inflation at the target level does not have a negative impact on Azerbaijan’s economic activities," Kazimov said.

However, numerous factors and forecasts point to a global recession next year, which ultimately means lower inflation expectations. Therefore, CBA also confirmed its forecast regarding the falling annual average inflation rate in 2023. Anyway, CBA has more tools to influence the domestic situation with consumer prices. The market needs to accustom itself to forecast the future moves of the Central Bank and make decisions in accordance with them, as it happens in many advanced economies of the world.