Sunday, 12 October 2014

Rates down

Most economists expected the Monetary Policy Council to gently set off monetary loosening by decreasing the interest rates in Poland by 25 basis points, while the outcome of its recent session, effective from Thursday 9 October 2014, might be staggering for many. Except for slashing the policy rate (at which the central bank conducts open market operations) from 2.50% to 2.00% (which is another consecutive ever-time low), it also decreased spreads between two other central bank rates that had been stable for many years. Spreads between deposit rate (at which commercial banks may deposit their cash surpluses at central bank) and the policy rate, as well as between lending rate (at which central bank extends to loan to commercial banks to help them meet compulsory reserve requirements) and the policy rate have been narrowed from 1.50 percentage points to 1.00 percentage point, with the former now at 1.00% and the latter at 3.00%. Implications of the latter move are quite fascinating (actually depending on what turns you on)…

The decision to bring down the interest rates was justified by accommodation to extremely low inflation (at times deflation) driven chiefly by depressed prices of foods and beverages and fuels and a response to slower pace of economic growth, suppressed by decline in exports to Russia. By the same token, the disparity between Polish central bank’s policy rate and policy rates set by other European banks (I leave out special-care examples, such as Hungary) has been bridged. The real interest rate in Poland is now near 2.00%, which is perceived by many economist as sound and sustainable level. What raises my concerns is whether the Polish central bank gets its act together to respond swiftly to first signs of rising inflation or unsustainable economic expansion which will sooner or later make themselves felt in the wake of pursuit of easy monetary policy.

In theory, lower interest rates should spur economic growth (hey, parliamentary election is coming) via several macroeconomic channels (increasing consumption and discouraging from saving, lower cost of credit for enterprises and the government, downward pressure on currency benefiting exports, etc.), in practice I believe interest rates primarily provide guidance for economic actors rather than substantially impact their choices. There are plenty of other factors influencing how capital circulates around the economy, other than interest rates, although I do not point out monetary policy should be totally disregarded. The most crucial factor is popularly called ‘sentiment’ and with respect to individuals refers to how secure they feel about the future, while for businesses it has to do with confidence regarding future environment. Whenever future prospects are upbeat, individuals are more likely to consume and to take out loans, while enterprises are less reluctant to launch new investment projects; while when future looms insecure all private-sector economic actors tend to save more, their propensity to incur debts goes down and many plans are put off or given up. Level of interest rates only impacts the costs and profitability of their decisions.

Much more interesting is the impact of low interest rates (in particular the lending rate of tiny 3.00%) for banks. Those institutions, as long as they fit the definition of ‘commercial banks’, raise deposits (liabilities) in order to grant loans (assets) and costs and incomes generated by both sides of their balance sheets are interest-rate-dependent.

Deposits can be broadly divided into: (1) sight deposits or float, i.e. money kept on individuals’ and entrepreneurs’ current accounts to meet immediate liquidity needs and (2) term deposits. Majority of current accounts pay no interest. For banks it means free-of-interest-expense funding, but note when interest rates are lower, spread between the rate at which banks borrow money (0% in this case) and at which they lend it, shrinks, putting pressure on banks’ profitability. Term deposits will also pay less, however their impact on banks’ profits will be less substantial.

Banks’ assets are composed mostly of loans, which in turn can be categorised either as: (1) business / corporate loans, based on variable rate and margin (there is no such thing as fixed rate loans in Poland, in order to get a synthetic fixed loan, a bank and its customer must conclude a hedging transaction), (2) mortgage loans, also based on variable interest rate and margin (without dwelling on FX- and PLN-denominated portfolios), (3) consumer loans, i.e. cash loans, credit cards, auto loans and other products of similar nature (financing current consumption).

Corporate loans and mortgage loans, due to their variable-rate nature, will not largely hit banks’ profits. Banks’ earnings on those products (or maybe services, since bank loan is anything but tangible) are, to put it simply, a function of margin over the variable rate they charge. Corporate clients in Poland can obtain dirt-cheap (in terms of margin over WIBOR) financing, while newly extended mortgages are getting more and more expensive in that respect.

For consumer loans the situation is the most interesting. The anti-usury law in Poland caps the interest rates of granted loans at four times central bank’s lending rate, so currently at 12%. Perplexed? Try finding a consumer loan which will bear an actual cost of 12%. It is impossible, because interest expense is just a component of total borrowing cost, which is also made up of up-front fees, obligatory insurances, pre-payment fees, servicing fees and God knows what else contrived to rip off borrowers. The cap, however will not be circumvented by the banks so they will be attempting to find ways to pass on the cost of missed opportunities to their clients, not necessarily to borrowers but also to depositors. Drop in net interest income will be more than surely to some extent offset by incline in net fees & commissions income. Those who will bear the brunt of slashed interest rates will be ordinary customers of banks. Banks are definitely more powerful than their customers and will try to shield their profitability. Since 2012 many external and regulatory factors have exerted downward pressures on banks’ profits, while the whole banking sector’s net income does not decrease. There are reasons for which banks hold strong, however they are beyond the scope of what can be discussed on this blog ;-) takie życie

If you want to know what I make of loose monetary policy, I recommend you revisit my post on the topic dated December 2009. Five years have passed and again I have not changed my mind. I wonder what would it take to persuade me to change my economic views. Poland’s current leading ultra-liberal, Leszek Balcerowicz forty years ago used to be an avid Keynesian. What would need to happen to make my approach to monetary policy dovish, convince me to embrace pension funds in shape they used to function in Poland since 2009, or forego my belief in free market being the best possible economic environment?


Michael Dembinski said...

Couple of questions...

Firstly - Forex. The zloty hardly budged against the euro and sterling on a shock announcement that analysts didn't expect. Why?

Secondly - real estate. With a lower base rate - is this the ground floor at which to get back into the Polish property market?

student SGH said...

glad you've asked those questions. I run a blog to be challenged - that's the way it should be!

Firstly - my explanation is simple: market expected total scale of decrease of at least 50 basis points. Instead of two cuts by 25 bps, MPC settled for one move. The target of 2.00% was set earlier, only the timeline of reaching it has changed.

Secondly - a great question, but could you pin it down? The answer depends on segment of the market and purpose of coming onto the market.

Commercial properties are driven by interest rates in EUR, as rents are denominated in EUR and bank debt attached to such projects is in EUR.

Residential property market - well, this is a topic for a longer dissertation. I recommend you revert to one more my post dated October 2013. Very little has changed since then. I can only add taking out a mortgage now is delusive, because: (1) in a while interest rates will go up and debt service cost will, (2) borrowers when assessing cost of a mortgage take into account current total cost, which means banks find it easier to add higher margin to lower WIBOR, so in long-term perspective mortgage taken out today might be a trap.