Loans with a floating interest rate
What are the advantages of loans denominated in the national currency?
When taking a loan, borrowers should take into account whether the loan is denominated in the same currency as their revenues or not. A large part of the revenues of the population are denominated in the national currency, while the majority of loans are disbursed in a foreign currency. A mismatch in the currencies of loan repayments and revenues exposes a borrower to foreign exchange risk due to exchange rate fluctuations. Therefore, borrowers with GEL revenues will not incur additional costs due to changes in the exchange rate when the loan is denominated in the national currency.
GEL loans are disbursed with fixed and floating interest rates.
What are the floating interest rates that can be used by the commercial banks to link their interest rates on loans?
1. The monetary policy rate of the National Bank of Georgia: http://www.nbg.gov.ge/index.php?m=555&lng=eng
Commercial banks can select any floating interest rate in the country to which it will link the interest rate on loans. The reference rate can be chosen among the interest rates that are available to the financial market and are transparent. For instance:
2. The weighted average interest rate of the primary auctions of either 3-month or 6-month Certificates of Deposit from the National Bank of Georgia.
3. Treasury securities of the Georgian Government with a maturity of one, two, five or ten years.
What is the frequency of changes in interest rates?
Commercial banks determine the necessity of a change in the interest rate depending on the specifics of the loan product and the client. The interest rate can change monthly, quarterly or at other frequencies.
What is the difference between loans with a fixed interest rate and a floating interest rate?
A loan with a floating interest rate exposes the borrower to interest rate risk. In the case of a loan with a fixed interest rate, the bank is exposed to interest rate risk and it incorporates the return on the risk in the interest rate of the loan. Therefore, when taking a loan under the conditions of a steeply upward sloping yield curve, a floating interest rate loan generally has a lower rate compared to a fixed interest rate loan.
When does the monetary policy rate change?
The Monetary Policy Committee of the National Bank of Georgia takes decisions regarding changes in the monetary policy rate based on the current and expected developments in the economy and the financial markets. As the monetary policy is reflected in the economy with a time lag, the inflation forecast is taken into consideration during the monetary policy formation process. If the inflation forecast is above the target level, the National Bank of Georgia will increase the policy rate to curtail the growth of price levels in future. In contrast, when aggregate demand is low and the inflation forecast is below the target level, the National Bank of Georgia will reduce the policy rate.
Depending on the economic conditions, the monetary policy rate can be loose, tight or neutral. In equilibrium, when the economy is free of demand and supply-side shocks, the monetary policy rate is at its neutral level. Thus, the “neutral interest rate” represents a benchmark whereby the monetary policy is neither expansionary nor contractionary, output is at its potential level and inflation is stable. The deviation of the policy rate from the neutral rate is due to the business cycle: booms and busts create the need for monetary policy to deviate from the neutral level. During a boom, the monetary policy rate is above the neutral level, and during a recession it is below it. In the long run, the monetary policy rate is, on average, equal to the neutral interest rate.
At the current stage, considering the target rate of inflation at 5% starting from 2015, the neutral interest rate in Georgia is 6-7%. Depending on economic conditions, the policy rate can either be above or below that. Historically, the monetary policy rate on average equaled 7%, with the policy rate reaching a maximum 10% in 2008.
In future the neutral interest rate will decrease along with a decrease in the target rate of inflation.