PROFIT OR LOSS?

The decision of the Azerbaijani government not to extend the moratorium on taxation of interest on bank deposits has become perhaps one of the most discussed and controversial topics of the past month. It cannot be called unexpected, as experts have predicted such an outcome earlier. But depositors hoped to the last. However, both bankers and the regulator urge not to interpret the move negatively, assuring that the impact on the market will be minimal. Analysts, on the other hand, see opportunities in the new situation for the development of other investment instruments. 

Time has come

The amendment to the Tax Code, which exempted the interest on deposits from taxation from for a period of seven years from February 1, 2016, has its roots in a very unpleasant incident that shook the Azerbaijani economy earlier—the devaluation of Manat. Thus, under Article 102.1.22 of the Tax Code, annual interest income paid by a local bank and a branch of a foreign bank operating in Azerbaijan on individual deposits, as well as dividends paid by the issuer on investment securities, discount income (a difference due to depositing securities at a price lower than their nominal value) and interest income are exempt from income tax.

The decision was taken as part of a package of measures to prevent the outflow of savings from banks. In addition, the deposits in Azerbaijan were fully insured from March 4, 2016 till April 5, 2022.

As to the impact of the decision, statistics show that over the past period the volume of individual deposits has reached ₼11.4b since 2016, when the changes were adopted and they were slightly over ₼8b. That is, there was a 45% growth. Last year alone bank deposits of population in Azerbaijan (including funds of individuals engaged in entrepreneurial activity) grew by 27.1%. At the same time the set of stimulating measures had a positive impact on the US Dollar/Azerbaijani Manat ratio in the general structure of deposits. The share of Manat deposits rose by 2% last year, to 61% of the total portfolio.

It is most likely that the government adopted the decision judging by indicators, which imply that the banking sector, or rather confidence in it, has strengthened sufficiently over the years, making the extension of the exemption unnecessary.

The regulator of the banking market, the Central Bank of Azerbaijan (CBA), accepted the decision calmly. The CBA administration believes that it is time for the banks to step up to preserve their customer base and introduce stimulus measures.

"We believe that banks will reflect these costs in their deposit rates. We think that in order to avoid deposit outflow and preserve financial stability banks will increase deposit rates considering the 10% tax. Therefore, we do not see this as a big problem," CBA chairman Taleh Kazimov said at his first off-line press conference in early February.

At the same time, he underlined that increasing deposit rates could affect lending rates. "In general, it takes some time to assess the situation," the governor said.

CBA Director General Toghrul Aliyev added that taxation of deposit income is a legal requirement. "It does not pose any threat to financial stability. We thus believe that it will not affect changes in deposit portfolios. As studies show, it will not cause large costs either. Besides, this individual tax will be paid through the banks, which will report calculations and payments to tax authorities," Aliyev said.

Pros and cons

However, a number of experts do not share the regulator's optimism. For example, economist Vugar Bayramov, MP, has originally expressed his negative opinion on social media about the lifting of the moratorium and defended its extension at the Milli Majlis. 

"Rising interest rates on deposits will make loans more expensive. They are not cheap anyway. According to the regulator, the current loan portfolio reaches ₼20b, with an average loan rate of 14.13%, which is 20% in the districts," Bayramov said.

Bayramov believes that the non-extension of tax exemptions may reduce interest in local currency savings. "When these changes were adopted, the share of Manat deposits in the savings portfolio was only 18%. Now this figure is at 61%. Thus, interest in Manat deposits has increased along with such factors as the stability of Manat’s exchange rate, the payment of more dividends on deposits in local currency, as well as tax incentives".

Therefore, Bayramov considers it expedient to extend the grace period for another year, or to exempt from income tax at least insured deposits. "In fact, the interest income on deposits up to ₼100,000 was not taxed, and the exemption still applies on them. This will cover the deposits of the middle class individuals. In other words, a differentiated approach should be applied in this case," Vugar Bayramov said.

Expert opposing the abolition of the exemption also mentioned that the amount raised through taxes will not add much to budget revenues. Thus, throughout 2022 the Azerbaijani banks have paid ₼459m as interest on deposits. 10% of this amount makes about ₼46m. According to the Ministry of Finance, state budget revenues of Azerbaijan in 2022 reached ₼30.7b, of which ₼15.5b came through the tax authorities.

Another opinion is that the decision to abolish the exemption is timely and correct, with no negative impact on the market expected. Bank expert Akram Hasanov pointed out that charging tax from ‘extra money’ is quite fair. "Even citizens with low incomes pay property and land taxes, VAT, and income tax. So why not charge those who earn extra money?" Hasanov wonders. He added that in the long run these taxes will serve to better finance social expenditures through the state budget.

Economist Parviz Heydarov believes that the volume of deposit portfolios in banks will not decrease, as the financial situation in the country is stable and the Manat exchange rate has been stable for quite a long. As for the effect of the decision on the growth of interest rates on loans, this will not happen at least because they are already high in real terms and the main reason is not the level of profitability offered on deposits.

"The main reason is the lack of reliable and stable liquidity. A bank may have a lot of money, but if the cost of money is high, you should not expect a cheap loan offer from that bank," Heydarov said.

President of the Azerbaijan Banking Association, Zakir Nuriyev, made the final point in the arguments for and against the decision. He said that banks do not intend to raise interest rates. This step may be taken only by a few. "Due to the end of the grace period, a number of banks increase the interest rates or pay taxes from their own resources. This could change an interest rate about 1%," a representative of the banking market said.

Which one?

Meanwhile, the expert community has made a few assumptions. They believe by lifting the exemption both the government and the regulator intend to redirect potential savers to other investment instruments, particularly securities.

Analysts believe this is why the regulator is tightening the screws in the banking sector. Even before the decision, the CBA has introduced new reserve requirements for banks, raising them from 4% to 5% for deposits in national currency of individuals and private entrepreneurs, and from 5% to 6% for deposits in foreign currency. At the time, there were also concerns about the negative impact of this decision on interest rates on loans.

However, according to Taleh Kazimov, given the competitiveness of the market, the deposit tax and increase in reserve requirements will only affect banks' margins. "I have already noted that, according to my assessment, the margin is very high, so there is room to squeeze it.

“And, as we can see, interest rates on newly issued loans have not changed after the change in mandatory reserve rates," Kazimov said.

CBA Director General Vugar Ahmedov also added that the impact of the new reserve requirements on Manat liabilities is about 0.16% and on foreign exchange 0.01%. CBA believes that these charges will not affect interest rates on loans. "Interest rates on loans are formed by the market based mainly on four factors: interest expenses (cost of assets), non-asset costs, risks and the margin. Banks have individual internal policies on interest rates, and they do not want to increase rates significantly in a competitive environment," Ahmedov concluded.

However, the decision to exempt from taxation for a period of 5 years starting on February 1, 2023 the dividends, discount and interest income paid on shares and bonds issued by public offer and traded on a regulated market looks very interesting amid all the above increases and cuts. It is noted that the purpose of this move is to stimulate the introduction of securities into the stock exchange through public offering and to increase the interest in securities traded on the regulated market.

Interestingly, Fuad Isayev, director of the CBA Department for the Supervision of Credit Institutions, said at one of the forums that commercial banks in Azerbaijan can issue long-term bonds. According to Isayev, this issue is related to the development of the capital market. "There is another question: do they currently have a customer base for long-term investments in the national currency?" Isayev said.

Experts have already predicted that savers unhappy with new deductions, or those who were thinking about depositing, may start looking for alternative instruments to keep and add to their "extra money". On the other hand, for many years the government has been trying, almost unsuccessfully, to shake up the securities market and to attract new actors. That is, those "offended" by taxes on deposit income can redirect their resources to financial instruments exempt from taxes.

Anyway, regulators, experts and bankers say it is difficult to predict how market participants will behave in the future. It will take a few more months to understand what the profit and loss of the new solutions in the financial market will be.