How does change in the refinancing rate affect the interest rate on loans and deposits?

Many of you have heard that the refinancing rate has something to do with bank loans. Let’s assume the Central Bank of your country reports on reducing the refinancing rate. Does that mean that interest on loans provided by commercial banks is going to fall as well? And how will the reduction of the rate affect the economy of your country? Let’s figure it out.

1. What exactly does the refinancing rate mean?

This is the rate that regulates percentage in the financial market and at the same time determines the rate of interest applied by the Central Bank on loans to commercial banks.

To put it simply, banks are guided by the refinancing rate when they set interest rates on loans and deposits.

Banks often peg their rate of interest to the refinancing rate. By the way, this provision is usually set out right in a contract between a bank and a customer.

When banks are short on liquidity, they can replenish it by borrowing it from the National Bank at the rate of interest that is pegged to the refinancing rate.

Then, for example, they can give loans to the public at higher interest rates and make money on the interest-rate gap.

The lower the refinancing rate is, the more affordable money is in the financial market. At the same time, low interest rates on deposits become less attractive. In contrast, the higher the refinancing rate is, the more expensive loans are and the higher the interest rate on deposits is.

As a rule, the refinancing rate (as well as the interest rate on loans and deposits) is higher than expected inflation. Otherwise, it doesn’t make sense, since money will depreciate faster than someone will have time to make money in the financial market.

2. How is the refinancing rate being established?

The refinancing rate is established by the Central Bank depending on the economic situation in the country. This rate is determined by such rates as GDP, its projection, the actual and expected inflation rate, stability of the currency market.

It is considered one of the main instruments of monetary policy, and it affects macroeconomic indicators. Particularly, the refinancing rate determines an optimal balance between demand and inflation.

In determining the refinancing rate, apart from being guided by macroeconomic goals, the Central Bank seeks to take into account the interests of depositors and borrowers to keep deposits attractive and loans relatively affordable.

The low refinancing rate indicates that a country’s economy feels comfortable and there has been no monetary and financial crisis recently.

3. Why not just reduce the refinancing rate to the lowest level possible?

Making loans for businesses and the public as accessible as possible may sound like a good idea. In this case a country’s economy will have more money and the economy will be revitalized.

Nevertheless, money is not an infinite resource. At a particular stage, a certain amount of money can be present in the economy, and this money is provided by the level of production and a balance between demand and supply.

If the refinancing rate is being reduced without growth in production, then this increases the possibility of taking out cheap bank loans, and there will be too many of them in the economy. As a result, there will be an increase in demand that the economy won’t be able to meet.

This will inevitably lead to a significant increase in prices. Thus, cheap loans will have precisely the opposite effect.

4. The refinancing rate is declining. Is that good?

As a matter of fact, yes. A decline in the refinancing rate, which has arisen not from the decrees issued by the authorities of a country, but as a consequence of policies being pursued by the Central Bank, indicates that the economic situation is stable.

That means the Central Bank reduces this rate to encourage the flow of investment and facilitate credit access without detriment to macroeconomic stability.

A slight decrease in the refinancing rate doesn’t mean that all banks will make interest rates on loans more attractive.

If financial institutions maintain ample liquidity, they will lower rates, and if not, then they might be maintained at the current level in order to attract deposits and manage current loans.

Moreover, as a consequence of a prolonged decline in the refinancing rate or the maintenance of the rate at a sufficiently low level, along with low inflation, confidence in the national currency and stability in the financial market grows.

As a result, a number of long-term loans is increasing, because there is trust in the monetary policy being pursued by the Central Bank, and with it, confidence in not having to pay extra for their loans.

In fact, people’s interest in credit resources is increasing in this case, since businesses including small ones and start-ups, which have been unable to afford to pay high interest on loans before, begin to actively borrow from banks.

And then these businesses put the money borrowed from the banks into the development of their companies, their business growth and entering new markets and business lines.

All this is an investment in the economy through which it is growing and being revitalized.