Berating interest rates

The leaders of the US central bank, the Federal Reserve, may decide today to raise interest rates.  If not today, someday. They worry that the economy may overheat, raising prices; so they want to throw cold water on it, in the form of high interest rates that discourage borrowing.   

How might this affect Kazakhstan?

Well, financial investors want profitable assets.  If a US bond pays a higher interest rate than a Kazakhstani bond (adjusted for risk), then investors will sell the latter and buy the former.  To do this, they must sell tenge and buy dollars, since the prices of American securities are expressed in bucks.   Because the demand for tenge will fall, so will its price.  This is the amount of a dollar that a tenge can buy – the exchange rate.  At the moment, one tenge trades for about 1/284 of a dollar.  This could fall to, say, 1/300 of a dollar.  In short, the tenge would depreciate.

Depreciation makes Kazakhstani goods cheaper for Americans to buy; a buck would now purchase 300 tenge’s worth of our goods, not just 270 tenge’s worth.  So, demand would rise for our exports.  Similarly, since the tenge would buy less of a dollar now than before, US goods would become more costly for us.  So, our demand for them would fall.  We’d sell more exports and buy fewer imports.  Our balance of trade would rise.

But this could take a while.  A lot of international trade is governed by contracts, which take time to rewrite in order to reflect the new exchange rate.  Meanwhile, anyone whose wealth is in tenge – say, the holder of an Almaty bank account expressed in tenge – would lose purchasing power over foreign goods that have prices expressed in bucks.  She would be worse off than before.  Holders of dollar accounts would gain.

Unpegged

Until a few weeks ago, we would have told a different story.  At that time, the National Bank of Kazakhstan tried to hold the exchange rate below 200 tenge per dollar.  Had tenge sales began increasing the exchange rate, the NBK would have countered by buying tenge.  The exchange rate would not have changed. Instead, the interest rate would have risen in Kazakhstan, since otherwise everyone would have sold tenge assets in order to buy the now-more-profitable dollar assets. Even now, the local interest rate could rise somewhat if the foreign-exchange market does not react immediately to the Fed’s move.

When making policy, the Fed usually targets the interest rate on overnight loans involving commercial banks, called the federal funds rate.  It picks this target because the funds market is so fluid that it will quickly reflect any change in the buying patterns of a customer as large as the Fed.  If the Fed sells loans in this market, then the price of a loan will fall, pushing up its rate of return to anyone buying it.  That rate of return is the federal funds rate. 

In contrast, the National Bank historically has targeted the interest rate that it charges on its own loans to commercial banks, called the refinancing rate.  This could cause confusion, because one could interpret a rise in the refinancing rate as either a signal that the NBK wanted to cool off the economy or as an attempt to deny reckless banks easy money.  Side-stepping this problem, the NBK has now adopted, as the benchmark rate, a target that looks like the Americans’ federal funds rate.  This “repo” rate is 12%, more than double the refinancing rate of 5.5%. –Leon Taylor tayloralmaty@gmail.com

Notes

My thanks to Murat Alikhanov for comments.

Call for papers

Central Asia Business Journal (CABJ)

ISSN 2073-5901 (Print)      

The Central Asia Business Journal, published by KIMEP University twice each year, promotes understanding of business issues (broadly defined) in the region.  As we see it, the region includes the post-Soviet “stans” (Kazakhstan, Kyrgyzstan, Tajikistan, Uzbekistan and Turkmenistan) as well as the post-Soviet states of the trans-Caucasus area (including Armenia, Azerbaijan and Georgia).

Central Asia is a fertile area for research.  It prospers from rich natural resources and high commodity prices as well as from its location at the crossroads of East and West.  But its open economy is vulnerable to such external shocks as the global financial crisis of 2008, and its Soviet legacy complicates its transition to markets. 

Authors may submit research papers, case studies, and book reviews as either completed works or as abstracts and proposals.  We also invite students’ papers.  All submissions must be in English.  Refereeing is double-blind.

The journal is open to all methodologies, but it especially welcomes papers that are conceptually and analytically strong and that relate to the real world.  We prefer papers with new findings but also publish surveys.  All papers should discuss applications to Central Asia. 

The journal’s interests include:

International accounting standards and taxation

Corporate governance

Financial and capital markets and industries

Market structure and efficiency

Human resources management

Leadership

International business and globalization

Business law

Marketing strategies and effectiveness

Tourism and the hospitality business

Logistics and supply chain management

Management information systems

Business cycles and economic development

Market integration and segmentation

Emerging markets

Institutional economics

Microfinance and development     

Multinational enterprises and business strategy

Natural resources and their internationalization

Nongovernmental organizations and entrepreneurs

Mathematical economics

Statistical economics

Risk and uncertainty

Political economy

Behavioral economics

We also welcome contributions to three sections of the journal:

Perspectives.  This features nontechnical surveys of issues in Central Asian business that would interest scholars.  An example is a survey of theoretical and empirical papers about customs unions.  A typical length is 4,000 to 6,000 words.  You should propose your topic to the managing editor before beginning work.

Book reviews.  Reviews should summarize and evaluate books about Central Asian business or about business issues of interest to the region.  Most reviews will concern recent books, but the journal may also publish a retrospective essay about well-known titles in a particular field.  A typical length for a review is 1,500 to 2,500 words.  Please write the managing editor about the book that you propose to review.

Symposium.  This consists of several commentaries on a recent issue of interest – for example, the February 2014 devaluation of the tenge.  A typical commentary may run 1,500 to 2,500 words.  The commentaries are not refereed.  Usually, the journal commissions commentaries, but you may propose a symposium to the managing editor.

Deadline for completed work for the March 2016 issue:  November 15, 2015.  After that date, we will consider submissions for later issues.  We try to give the author a decision in six weeks.

The Journal’s website is www.kimep.kz/CABJ 

For further information and submissions, please write to the Journal at cabj@kimep.kz or to the managing editor, Leon Taylor, at ltaylor@kimep.kz.

Sleepless in Kiev

Conflict in Ukraine: The unwinding of the post-Cold War order

By Rajan Menon and Eugene Rumer

The MIT Press.  2015.

The Ukrainian crisis stemmed from what must have struck the Kremlin as quotidian arm-twisting.  In November 2013, President Victor Yanukovych was on the verge of signing a pact with the European Union that would have made Ukraine an ally, though not a member, of the EU.   

Putin countered with a bouquet of carrots and sticks.  Russia would lend $15 billion, which was the amount that the International Monetary Fund had said it would lend before it backed away, in 2011, when Yanukovych had refused its strict conditions.  The Kremlin would also knock off almost a third of the price of the natural gas that it sold to Kiev -- a $3 billion discount.  And only God knows what goodies were in store for Yanukovych & Friends.  In return, Mr. President need only tell the EU to take a hike and sign up instead with Putin’s customs union.  Kazakhstan and Belarus were already members.  And if Yanukovych refused?  Well… about that natural gas….

Yanukovych had not anticipated that accepting an $18 billion gift, maybe with a little lagniappe, would draw a hundred thousand demonstrators into the streets of Kiev.  In February 2014, when the confrontations had turned bloody, he hightailed it to Russia, which received him with noses held high.  Yulia Timoshenko was released from prison, as the EU had long demanded.  The old outsiders became the new insiders:  The new president, Petro Poroshenko, had been an official under Yanukovych.

The revolution set the scene for the Kremlin’s favorite strategy – divide and conquer.  “Local separatism… had been used and worked well in Transnistria, Abkhazia, and South Ossetia by creating permanent frozen conflicts that became Russian outposts for protecting and projecting Russian power…,” write Menon, a professor at the City College of New York, and Rumer, a director at the Carnegie Endowment for International Peace.  Crimea would make an ideal outpost, since it was already home to a Russian navy and to thousands of retirees from Soviet military life.  The Russians went to work.  By March, Crimea had parted ways with Ukraine.

Frozen treats

To the Kremlin, Crimea was valuable because it could check Ukrainian aspirations to join the North Atlantic Treaty Organization.  As NATO expanded in the early 2000s, doubling its number of member states, Russia fretted.  There was no longer a Warsaw Pact to counter NATO’s encroachments.  To understand Russia’s touchiness, “imagine what the American reaction would have been had the Soviet Union won the Cold War, incorporated Canada and Mexico and the other Central American states into the Warsaw Pact, and declared that Washington had no cause for worry….”

Still, Russia may fret too much.  “Throughout the crisis,” the authors note, “NATO leaders have shown no interest in offering Ukraine membership….[They] have made clear that a military conflict with Russia over Ukraine is out of the question.”  The first secretary-general of NATO, Lord Ismay, once joked that the organization’s aim was “to keep the Russians out, the Americans in, and the Germans down.” Russia was to be out, but not down and out.

NATO’s reluctance miffs the Baltic states – Estonia, Latvia and Lithuania – which draw virtually all of their natural gas from Russia and fear Kremlin coercion in the depths of winter. But the Kremlin might well prefer a frozen conflict in east Ukraine to outright annexation.  A frozen conflict would “spare [Russia] the costs and the uncertainties of a military occupation” and yet enable it to intervene in Ukraine. 

Prudence is the better half of power politics.  In 2010, the US and the EU accounted for nearly half of the global economy (measured as gross domestic product); the EU alone accounted for nearly half of Russia’s trade in 2013, particularly Germany.  You don’t want to mess around for too long with customers like these.  The alternative for the Kremlin – allying with China, with which it shares a 2,670-mile border – could occasion conflicts that, for Russia, are anything but frozen. -- Leon Taylor tayloralmaty@gmail.com    

Going for double broke

Has the National Bank of Kazakhstan blundered?

Nobody has ever accused the National Bank of being dull.  Yesterday, after managing the exchange rate since before the financial crisis of 2008, the central bank abruptly consigned the tenge to the currency market.  The tenge immediately weakened by more than a third.  If it follows its historical pattern, this may be just the beginning.

The float was not inevitable.  The government had plenty of money with which to defend the tenge.  Since December, the National Bank’s net international reserves have been holding steady at $28 billion, enough to cover eight months of imports.  The National Fund, which consists mainly of taxes on oil export revenues, did fall by more than 1% in July but still amounted to $68 billion.  However, people have been expecting devaluation ever since the last one, in February 2014; and the recent weakening of the renminbi reinforced those expectations.  The National Bank didn’t have enough credibility to change them. 

As a result, the tenge has been declining steadily since November, when it stood at 181 to the US dollar.  The rate of depreciation picked up in mid-July, when the exchange rate was 187.  Thanks to the Chinese devaluation, it rose to 190 just before the float.         

How to panic the banks

The immediate worry is that the float may endanger commercial banks.  They never recovered from the collapse of 2008; as late as 2013, loans that had been overdue for more than 90 days still comprised 30% of total bank loans.  (Recently the head of the central bank, Kairat Kelimbetov, said the bad-loan ratio had fallen to 10%, according to the business weekly Panorama.)   So, bank income from interest payments was anemic to begin with.  Now, thanks to the float, the foreign value of their tenge-denominated assets may drop by 35%.  When selling those assets for dollars, the banks will have to absorb a crushing loss.  The banks’ creditors may pull their dollars out, if the National Bank does not impose currency controls.

Also, the float makes imports more costly for retirees living on tenge accounts.  Their standard of living will fall.  

The float may raise interest rates sharply in Kazakhstan.  People expect the tenge to continue to depreciate and thus will hold tenge-denominated assets only if a higher interest rate today will compensate them for the loss of purchasing power over foreign products in the future.  High interest rates may discourage physical investment in Kazakhstan, slowing the economy at a time when falling oil prices are already eroding export revenues.  The benchmark interest rate – the refinancing rate, which the National Bank charges for loans to commercial banks – has been 5.5% since 2013; that may change.

Most troubling of all, the float is a Pandora’s box.  Historically, when the tenge went haywire, it continued to oscillate for several months.  The graph below shows fluctuations in the tenge’s monthly real exchange rate (that is, the exchange rate adjusted for domestic and foreign prices) for January 1995 through March 2014.  The thing to note is that the spikes occur in clusters of several months.  An exchange rate of 257 to the dollar is not likely to be the end of the story.   

The long-run picture is a bit brighter.  After a year or so, the depreciation should boost exports, since the dollar or euro will be able to buy more tenge than before.  Similarly, it should discourage imports, since the tenge can buy less than before of foreign currencies.  Kazakhstan’s trade balance would improve.  In the first quarter of this year, net exports amounted to nearly $4.2 billion.

Policymakers may sigh with relief, since the float frees the National Bank to target income or inflation. For example, it might be able to increase output for a while by creating money, since this encourages spending.  The Bank wasn’t at liberty to do this when it had committed itself to holding the tenge to 190 per dollar or stronger, because creating tenge raises the exchange rate (that is, weakens the tenge).

In short, the float may be more beneficial in the long run than in the short.  Nevertheless, the National Bank is no longer credible, since it had vowed to avoid a drastic devaluation ever since the February 2014 markdown.   

Since people no longer believe what the Bank says, it may have a tough time containing long-run inflation, because this depends on expectations.  If workers think that prices will be 10% higher next year, they will pressure their employers for a 10% pay hike.  The boss will pass on this cost to the consumer by raising prices.  This feeds inflation; that is, the expectation of higher prices is a self-fulfilling prophecy.  Had workers believed that the central bank would avoid inflation, they would not have asked for cost-of-living adjustments, and we would not have gotten inflation.  But the National Bank no longer has that kind of reputation.

The instability stemming from the float may help convince the Eurasian Economic Union, the Russian-led group that includes Kazakhstan, to move towards a common currency (read: the ruble).  Kazakhstan could lose the power to steer its own economy.

No, the National Bank has never been dull.  Unfortunately. – Leon Taylor, tayloralmaty@gmail.com

Notes

    

1.  All statistics cited here are from the Web site of the National Bank, www.nationalbank.kz.  The data for the real exchange rate shown in the graph are also from the National Bank.  I thank Aizhan Smailova and Adilet Danyshpan for help in gathering data.

2.  To generate a measure of volatility, I took logs of the real exchange rate and estimated the first difference (over time) in these logs.  This provided a rate of return, since the differential of a log provides a relative change, dY/Y.  Finally, I subtracted from this measure the mean rate of return over time, in order to identify unusually large increases or decreases in the return.  The graph shows that large changes in the return tend to cluster -- even when the National Bank is trying to steady the exchange rate by intervening in the forex market. 
 

The real exchange rate is prone to what economists call “autoregressive conditional heteroskedasticity,” or ARCH.  This just means that when the exchange rate begins fluctuating, it usually keeps fluctuating for a while.

Reference

Panorama.  Нацванк: "В Казахстане инфляция достигла исторического минимума." [National Bank: "In Kazakhstan, inflation reached its historic minimum."]  Week of April 21, 2015.