IMF recommends Azerbaijan to accelerate transmission from CBA rate to manat loan rate

The International Monetary Fund (IMF) recommends that Azerbaijan improve the transmission from CBA (Central Bank of Azerbaijan) rate to manat loan rate, reads a Staff Report for the 2023 Article IV Consultation of the International Monetary Fund (IMF), held by the head of the fund’s mission for Azerbaijan, Anna Bordon, in November 2023 in Baku, Report informs.

“Historically, bank lending rates in both manat and foreign currency loans have been rather stable, even as inflation has been rather volatile recently, pointing to a large movement in inflation-adjusted (real) interest rates. Correlation coefficient shows no improvement in transmission from CBA rate to manat loan rate: during July 2019– September 2022, correlation coefficient has been close to zero (0.01) and during October 2022 – October 2023 even turned negative to -0.3. A similar picture shows when we look at the correlation between the CBA refinancing rate and deposit rates: the correlation went from almost nonexistent before September 2022 to strongly negative (-0.78) after,” reads the report.

Over the years, Azerbaijan has been facing a substantial interest rate spread. This pronounced gap between deposit and lending rates exceeds the averages observed in upper-middle income economies. Between 2013 and 2020, the average annual spread in Azerbaijan is 8.2 percentage points, compared to 6.6 percentage points among upper middle-income countries and nearly 5 percentage points among Asian countries.

“The wide interest rate spread poses risks to medium-term growth. The spread signals the flow of funds from savers to borrowers, exerts substantial influence over consumer and business expenditure, and therefore wields critical importance in charting the course and scale of economic growth and price stability. In the context of a competitive and efficient financial system, a wide interest rate spread strongly indicates inefficiency and a lack of competitiveness in the financial sector.

Elevated lending rates correspond to an increased risk premium, which curbs borrowing, while lower deposit rates discourage savings. It reflects the high costs of finance in the economy, and, consequently, has the potential to impede the process of financial deepening,” the IMF added.

Determinants of the interest rate spread include factors such as competition, interest rate risk, risk aversion, market structure, transaction sizes, and interest rate variances. Subsequent research explores credit risk, ownership, taxation, financial leverage, regulatory aspects, accounting standards, and market power in understanding and decomposing interest rate spreads.

Wide interest rate spreads also present a challenge for the transition to inflation targeting. While the correlation between the CBA refinancing rate and the interbank rate has undergone significant changes following the introduction of measures in September 2022, there has been no noticeable improvement in the correlation coefficient between the CBA rate and lending rates for new manat loans.

The literature suggests that underlying factors that lead to wide spreads, such as high banking concentration, also reduce the pressure for banks to pass changes in the policy rates to deposit and lending rates.

Bank concentration in Azerbaijan has been rising, particularly in deposits, assets, and capital. Loans remain relatively less concentrated, given the low credit to GDP in Azerbaijan comparing to the neighboring countries.

“Given the increasing trend in bank concentration, addressing this trend is essential to promote competition and prevent the emergence of monopolistic practices within the banking sector,” the IMF noted.

“The CBA has taken welcome first steps to strengthen monetary transmission, but further effort is needed. Initial data suggest an improved transmission from the CBA policy rate to interbank rates and CBA notes and government securities’ yields. However, improvement in the transmission to bank deposit and lending rate has been slower, and further effort will be needed to address this weak link in the monetary transmission chain.”