Interview of the BNB Deputy Governor in Charge of the Issue Departmentmr. Kalin Hristov

Interview of the BNB Deputy Governor in charge of the Issue DepartmentMr. Kalin Hristov by Svilen Kolev for Investor.bg, 8December 2015

Mr. Hristov, during the deliberations at the National Assembly on the 2016 government budget the finance minister Vladislav Goranov commented that we have in prospect‘a stable and predictable year with the exception of geopolitical factors of instability, which are outside Bulgaria’. What will year 2016 be like, according to you? What challenges will our economy face?

- The geopolitical factors of instability outside Bulgaria generate insecurity for both the global and the Bulgarian economy, which impacts markets and from them spills over onto the behavior of companies in their investment decisions and of households in their consumption-related decisions.

From the point of view of the developments in the world’s large economies and the dynamics of global financial markets, trends are clearly discerned, which will have a significant impact on the Bulgarian economy in 2016.

In the US, the Fed assumes that the American economy has recovered from the 2008 crisis and economic growth is sufficiently sustainable for an interest rate growth cycle to begin. This was confirmed by yesterday’s speech of Janet Yellen and by the data of the American economy (Kalin Hristov was interviewed on 3 December, Thursday, in the morning–author’s note). The Fed can be expected to make a decision in mid-December to increase the target federal funds rate, which will trigger an interest rate hike cycle in the US. The Fed’s intention is to make the hike slow and gradual, which is to generate calm and confidence on the markets, i.e. to result in no volatility surge.

This process of dollar interest rates hike will impact significantly all governments, companies and households with dollar-denominated liabilities. These are mainly the US and the emerging market economies. The Bulgarian economy is to a great extent isolated from its direct effect since it has no considerable dollar credit exposures (compared to Brazil, Turkey and other emerging market economies, for example). In economies where the US dollar is not the national currency, and companies and households have no revenue and income in this currency but have dollar-denominated liabilities, the appreciation of the US dollar will expose them simultaneously to a currency and interest rate shock.

We can rather get the positive effect of the Fed’s policy. The appreciation of the dollar would mean depreciation of the euro, which would, to a certain extent, bring inflation into the euro area, including our economy, where the deflation pressure is still felt. Thus, the Bulgarian economy should be positively impacted by the upward business and interest rate cycle in the US.

At the same time, the euro area economy is still slowly recovering, mainly owing to its structural problems. Today (3 December – author’s note) the ECB is expected to implement additional stimulus measures. The policy of more extensive money supply and more negative interest rates on excess reserves held by banks with the ECB is relatively quickly transmitted over to the highly integrated non-euro area member states, including Bulgaria.

In the euro area itself, it is not clear how large and sustainable impact this ECB policy would have on credit growth rates, economic activity and inflation, but in any case it would help governments acquire cheaper financing. This should not necessarily result in speedier credit growth in the euro area,as it is the function not only of the cost of lending, but also of credit demand, which is not high as owing to the insecurity many companies postpone investments and households postpone consumption outlays.

Generally in 2016 there will be divergence in the policies of the Fed and ECB,and the Bulgarian economy is positioned towards these developments in a manner that would not result in adverse effects.

You mentioned your expectations regarding the Fed’s policy.Do you expect an interest rate hike in December or later in2016?

- It’s not my job to make public comments on the Fed’s future actions, but this is quite probable. Or rather such are the market expectations...

What change do you expect in the monetary policy pursued by the ECB during the meeting of3 December?

- What the market expects is an additional stimulus along four lines. One is extending the period of direct purchases of securities, the second is increasing the volumes purchased, the third is additional reduction,i.e. imposing more negative interest rates on excess reserves, the fourth is expanding the list of securities eligible for purchase. We will see what mix of these four will be opted for this afternoon. Among the four options,the introduction of a more negative interest rate on the deposit facility is considered by the markets as the most probable. I cannot say what the way of thinking is at the ECB, but these are the market sentiments.

Having in mind our decision last week, a decrease in the interest rate on the deposit facility will be directly transmitted into our economy. You are aware that we defined the concept of ‘excess reserves’ – the excess by more than 5% of the banks’ holdings of reserve assets over the minimum reserve requirements held with the BNB. Along with this, for excess reserves we introduced the implementation of the negative interest rate on the ECB deposit facility. This creates a strong market stimulus for banks to minimize their excess reserves held with the BNB. Actually from 4 January 2016 the relevant negative interest rate on the ECB deposit facility will be directly transferred into our banking system.

(After the meeting of the ECB Governing Council on Thursday, 3 December, the ECB reduced the interest rate on the deposit facility to -0.3%, increased the term of the asset-buying program until March 2017 and changed the range of securities eligible for purchase by the ECB. This automatically means that the BNB will charge a rate of -0.3% on the excess reserves of banks in Bulgaria from the beginning of 2016 –author’s note).

Then, with the adoption of Ordinance No 21 BNB intends to implement the interest rate on the ECB deposit facility, rather than have the discretion to decide if the interest rate will be in the range from -0,3% to 0%, for example?

- Yes. The rationale of this change is in the philosophy of the monetary policy in Bulgaria. The BNB pursues a passive monetary policy based on a pegged exchange rate of the lev to the euro under the currency board arrangement. This means we have to mechanically transfer into our economy the monetary policy of the central bank issuing the currency our currencyis peggedto, which is the reserve currency of our monetary regime. This is achieved by the transmission of the interest rate policy of the ECB into the banking system in Bulgaria.

As the interest rates on the excess reserves held by banks with the ECB have been negative since the middle of last year, we should implement this part of the euro area monetary policy into the BNB policy. The BNB Governing Council has decided that we will automatically, with no right of discretion, apply the ECB deposit facility rate, when it is negative, as an interest rate on banks’ excess reserves.

Has the option of discretion been used by other EU central banks?

- The issue of applying the negative rate on the ECB deposit facility faced all central banks pursuing monetary policy based on an exchange rate pegged to the euro, as is ours. By pegging the Swiss franc to the euro, the Swiss National Bank had substantial capital inflows on its balance sheet until January this year. Therefore, at the end of 2014 they reduced their interest rates below zero (on a part of the target interval of the short-term rate on CHF deposits – down to -0.75%). For the same reason early this year Danmarks Nationalbank strongly lowered its interest rates on certificates of depositto -0.75%.

What is different about our approach is that the BNB directly applies the ECB deposit facility rate, while Danmarks Nationalbank and the Swiss National Bank have yet lower interest rates. Their policy aims to deter capital inflows to their economies and they achieve it by a more active monetary policy. The law requires that the BNB follow a passive monetary policy by keeping the Bulgarian lev pegged to the euro and transposing the euro area monetary policy and monetary conditions into the Bulgarian economy.

In this case what is the purpose of introducing negative interest rates on the excess reserves here?

- The purpose is clear – to transpose the euro area monetary conditions in Bulgaria, bearing in mind that we have a pegged exchange rate and a currency board arrangement in place. The secondary effect is on commercial banks as they alone must decide how to re-balance their assets. The banks can continue keeping these excess reserves (now around BGN 7.5 billion) on our balance sheet, because the exposure to the central bank is risk-free, and pay us -0.3% (this would probably be the price from 4 January 2016) or they can make other decisions – they can either buy government bonds (not only those of the Bulgarian government) or provide lending.

The BNB never directly intervenes in banks’ investment decisions. The central bank implements the ECB policy in the Bulgarian economy, as is specified in our monetary policy mandate.

And when will the new Ordinance No.21 be published? When will it be available on the BNB’s website?

- As soon as it is promulgated in the State Gazette, the Ordinance will be published on the BNB’s website too.

(The Ordinance was promulgated in the State Gazette on the day after the interview and now is accessible on theBNB’s website – A/N)

What is the definition of excess reserves given in Ordinance No.21?

- The definition is simple – all reserve assets of banks, recognised as such, minus the legally required reserves. The reporting period will be on an average daily basis, i.e. excess reserves will be computed within the maintenance period on an average daily basis and interest will be charged on the average daily amount. The period is the same as that for the minimum reserve requirements.

The new Ordinance No.21 does not recognise as reserve assets the banks’ balances on their accounts with the national system component TARGET2-BNB. What does this mean?

- The change is very technical. In February 2010 the BNB joined TARGET2 where each central bank has a component, and the commercial banks from the various countries participate in TARGET2 through the national central banks’ components. When we joined TARGET2 in 2010, the subsidiaries of parent banks in the euro area were already participating in TARGET2 through their parents.

In order to incentivise commercial banks to participate in TARGET2 through the Bulgarian component, a part of banks’ balances on their accounts there has been recognised as reserve assets. The appropriateness of this policy showed during the summer this year when the Greek banking system was shut down as the government announced non-business days and imposed capital controls. In that case if the subsidiaries had not participated in the BNB’s component in TARGET2, risks would have been posed to our banking system. Seeking to minimise such risks to our banking system, we encouraged the banks to participate in TARGET2 through the BNB’s component.

This policy has already accomplished its goal because, in practice, now almost all banks participate in TARGET2 through the BNB’s component. At the same time, the funds in TARGET2 being part of the required reserves do not constitute a very large amount – around 1% of banks’ required reserves on an average monthly basis. That is why I consider merely technical the change whereby banks’ balances on their accounts in TARGET2-BNB will no longer be recognised as reserve assets.

How is the negative interest rate on banks’ excess reserves going to affect the balance sheet of the Issue Department in 2016?

- Next year many factors will be influencing the Issue Department’s balance sheet. The first one will be the demand for Bulgarian banknotes, which has been growing rapidly over recent years. The negative interest rates, or virtually the increasingly lower rates on deposits, lead to lower alternative costs of holding banknotes. As a result, companies and households demand and hold more and more banknotes. This is clearly seen in the Issue Department’s liabilities where the amount of banknotes is growing relatively fast. The expectations as to how the interest rates in the euro area and Bulgaria would evolve could push up the demand for banknotes. This factor would cause the BNB’s international reserves to increase.

The second factor will be the amount of the government’s deposit with the BNB. The way the government has structured its issuing policy for next year involves an additional increase in the fiscal reserve on the BNB’s balance sheet.

The third factor - a counteracting one as it would probably bring about a decrease in reserves - will be the banks’ decisions how to re-allocate their excess reserves, if they plan to do so. Considering the weak demand for loans and the fact that on the European money market all instruments of up to one year earn negative yields, including the very low government bond yields in the euro area (even in the heavily indebted economies, such as Italy and Portugal, yields are negative in the one-year horizon), I do not see any good options for banks to quickly re-allocate these excess reserves from the BNB’s balance sheet, without taking on serious credit, interest rate or exchange rate risks. I do not expect that these decisions would cause any quick and significant reduction in reserves.

... Liquidity cannot be used up so quickly...

- … No, it cannot be absorbed so quickly by the economies, and a large part of it also remains on the balance sheets of central banks.

And if we look at the assets on the Issue Department’s balance sheet, how are investments changing?

- The investments of the Issue Department cannot change considerably for one simple reason – the investment mandate is defined by law; it is very conservative. The law is quite clear. Regarding long-term bond ratings, it allows only the two highest ones, i.e. not lower than АА. If we look at the so called investment universe, we will not find many debt instruments that meet this requirement.

Regarding the exchange rate exposure, the law prohibits any open positions. In the liabilities on the BNB’s balance sheet there are no sizable amounts of US dollars or other currencies, so we primarily have euros available for investment purposes. Thus we are unable to use the US higher interest rates by investing more in USD assets. We do not have US dollars in our liabilities, and we cannot borrow an open foreign exchange position (the subsequent hedging of an open foreign exchange position would practically consume yield and would not improve the total return).

In terms of allowed instruments – government securities, supranational and secured bonds – the limit set for rating makes us go to segments which are very secure, such as German securities and securities from euro area core countries. By law, our investment limits do not allow us to invest in securities of the so-called euro area peripheral countries (as for instance Italy and Spain). This investment framework leads to exposures concentrated in the euro area core countries, which on the one hand reflects the desire for safety, while, on the other, it also has a sizeable downward effect on earnings. The exposures to safe securities reduce earnings, however they increase the stability of Issue Department’s balance sheet, hence of the currency board and the economy in general.

How will the negative interest rates on the commercial banks’ excess reserves in our country impact the interest rates on loans and deposits, and the behaviour of households and companies?

- We should bear in mind that the deposits in the banking system are over 63 billion levs, and the banks’ excess reserves – around 7,5 billion levs. That means that the negative interest rates on excess reserves are not the factor that conditions the cost of banks’ financing, hence – the cost of lending. Most of the impact comes from an overall cut in interest rates on deposits, which is actuated by the ECB policy, as well as from the fact that households continue to safe. These two factors lead and will continue to lead to reducing interest rates on deposits. Some of this reduction is also transferred to the cost of lending.

The reduction in interest rates on loans, however, has a limit. After reaching a certain level of interest rates on loans, banks will find it difficult to take account of the actual risk they assume in lending to individual households or companies. Every borrower carries an intrinsic credit risk of their own. The fact that the general environment subdues interest rates should not automatically lead to increasing lending to riskier companies, as this creates the potential for problems in the future when interest rates start to grow. Upon reaching a certain level of interest rates on loans, which I think our banking system is already nearing, the low interest rates will no longer be able to reflect the actual level of borrowers’ credit risk.