Berating interest rates

The leaders of the US central bank, the Federal Reserve, may decide today to raise interest rates.  If not today, someday. They worry that the economy may overheat, raising prices; so they want to throw cold water on it, in the form of high interest rates that discourage borrowing.   

How might this affect Kazakhstan?

Well, financial investors want profitable assets.  If a US bond pays a higher interest rate than a Kazakhstani bond (adjusted for risk), then investors will sell the latter and buy the former.  To do this, they must sell tenge and buy dollars, since the prices of American securities are expressed in bucks.   Because the demand for tenge will fall, so will its price.  This is the amount of a dollar that a tenge can buy – the exchange rate.  At the moment, one tenge trades for about 1/284 of a dollar.  This could fall to, say, 1/300 of a dollar.  In short, the tenge would depreciate.

Depreciation makes Kazakhstani goods cheaper for Americans to buy; a buck would now purchase 300 tenge’s worth of our goods, not just 270 tenge’s worth.  So, demand would rise for our exports.  Similarly, since the tenge would buy less of a dollar now than before, US goods would become more costly for us.  So, our demand for them would fall.  We’d sell more exports and buy fewer imports.  Our balance of trade would rise.

But this could take a while.  A lot of international trade is governed by contracts, which take time to rewrite in order to reflect the new exchange rate.  Meanwhile, anyone whose wealth is in tenge – say, the holder of an Almaty bank account expressed in tenge – would lose purchasing power over foreign goods that have prices expressed in bucks.  She would be worse off than before.  Holders of dollar accounts would gain.

Unpegged

Until a few weeks ago, we would have told a different story.  At that time, the National Bank of Kazakhstan tried to hold the exchange rate below 200 tenge per dollar.  Had tenge sales began increasing the exchange rate, the NBK would have countered by buying tenge.  The exchange rate would not have changed. Instead, the interest rate would have risen in Kazakhstan, since otherwise everyone would have sold tenge assets in order to buy the now-more-profitable dollar assets. Even now, the local interest rate could rise somewhat if the foreign-exchange market does not react immediately to the Fed’s move.

When making policy, the Fed usually targets the interest rate on overnight loans involving commercial banks, called the federal funds rate.  It picks this target because the funds market is so fluid that it will quickly reflect any change in the buying patterns of a customer as large as the Fed.  If the Fed sells loans in this market, then the price of a loan will fall, pushing up its rate of return to anyone buying it.  That rate of return is the federal funds rate. 

In contrast, the National Bank historically has targeted the interest rate that it charges on its own loans to commercial banks, called the refinancing rate.  This could cause confusion, because one could interpret a rise in the refinancing rate as either a signal that the NBK wanted to cool off the economy or as an attempt to deny reckless banks easy money.  Side-stepping this problem, the NBK has now adopted, as the benchmark rate, a target that looks like the Americans’ federal funds rate.  This “repo” rate is 12%, more than double the refinancing rate of 5.5%. –Leon Taylor tayloralmaty@gmail.com

Notes

My thanks to Murat Alikhanov for comments.