Why Astana should read David Ricardo

What this country needs is a good five-cent dollar

Since 2007, the government of Kazakhstan has reneged on its promises, made in the Nineties, to tax only modestly the foreign firms that had come to extract oil and natural gas. Political folklore saith that foreign-owned extractors are so addicted to Kazakhstani black gold that they will put up with virtually any reduction in profits.

In reality, extractors will relocate someday to lands offering higher rates of expected profit. Even those who doubt that they can do better elsewhere will think twice about remaining in a nation where the government rips up contracts.

Those are matters for the long run. Less familiar is a medium-run result of the government’s arbitrary revision of contracts. Being unintended, it may boomerang on Astana.

The situation is this: For most of the past three years, the central bank of Kazakhstan has pledged itself to a particular rate of exchange of tenge for a dollar. Until a few months ago, it was 150 tenge, with a little wriggle room –- roughly 3% -- in either direction. In effect, the real currency of Kazakhstan was the dollar, since the National Bank of Kazakhstan had to accommodate any changes in American dollar policy in order to stick to its announced exchange rate. For example, if the central bank of the U.S., the Federal Reserve, increased the purchasing power of the dollar, in order to hold down consumer prices, then Kazakhstan would have to strengthen the tenge. Otherwise, the exchange rate for the dollar would rise – say, to 160 tenge.

Now consider a sudden rise in Kazakhstan’s tax on oil extraction. To keep its old rate of profits, the extractors must pass on the full tax to customers. In principle, the extractors can do this for a while. Oil is so vital that nations will pay through the nose for it -- until they can figure out how to do without some of Kazakhstan’s fuel.

In principle, customers will pay. In practice, maybe not. To buy the same amount of Kazakhstani oil as before, but at a higher price, customers must have more dollars than before. What if the U.S. doesn’t print them? Then customers won’t be able to pay the higher price. So it won’t rise, and extractors will have to pay the taxes out of their own pockets. The profit rate on Kazakhstani oil will fall.

If the tax hike seems permanent – a safe assumption – then extractors will quietly cut back production, perhaps through such subterfuges as delaying the start date for new wells. (Purely hypothetical, of course.) Cutbacks will continue until the growing scarcity of Kazakhstani oil forces its price to rise to the point of incorporating the full increase in taxes. Since customers will have no more dollars than before, they will have to settle for less oil at higher prices.

That one-two punch may hasten the Western search for new sources of energy. Over time, Kazakhstan’s tax hike may cripple its most valuable industry.

Trivial dollars?

At the moment, the supply of dollars doesn't constrain spending. There are lots of spare dollars to accommodate rising oil prices. Since the financial crisis of 2008, the Fed and the European Central Bank have printed so many dollars and euros that now you can borrow one for free. But this largesse won’t continue. When finally the Fed worries more about inflation than unemployment – i.e., more about the excess supply of dollars than the deficient demand for them – then it will shore up unused bucks. Buyers of Kazakhstani oil might have trouble finding them.

Another solution may be to spend dollars more quickly – i.e., more efficiently. Unfortunately, the annual rate at which a dollar turns over is already eight or nine in normal times -- more than four times faster than for the tenge (say). Moreover, in the longer run, dollar "velocity" (as economists call it) may depend mainly on our inveterate habits of spending. (At least, that’s what Alfred Marshall thought. He was a pioneer of microeconomics, around the turn of the 20th century.) If we doubt that oil prices have risen permanently, then we may prefer to stick to our accustomed rate of spending and wait for them to fall. Such an expectation would be natural for such volatile prices.

A dollar limit on oil purchases may be more important than it seems. Normally, Kazakhstan’s annual revenues from net exports of oil and gas equal a fifth of its tenge supply. True, as a share of the global dollar supply, those revenues (over $31 billion a year) are less than 2%. (Dollar currency and checkable accounts -- the M1 supply -- amount to $1.7 trillion; cash is about half of that.) But Kazakhstan is not the only country that exports oil for dollars. The buck is the standard means of payment in the global market for oil exports, which exceed $700 billion each year, equal to two-fifths of M1 money.

Of course, every exporter trades its received dollars for its home currency. But Kazakhstan's home currency is the dollar. Usually. At the moment, the National Bank lets the foreign exchange market determine the tenge’s value, within a reasonable range. But it will probably dollarize again when inflation rears its smoky head. It always has.

Is this my analysis? Uh…no. The first modern economist, David Ricardo, saw it all in 1817 – except that the vital product then was bread, and the vital form of money was gold.

That’s not all that Ricardo saw. “All taxation…either to the manufacturer or the grower…tend…to lower the relative value of money, and therefore to encourage its exportation.” That is, if taxes make Kazakhstani oil expensive, then we won’t be able to sell it abroad. Instead of exchanging oil for imports, we’ll have to exchange tenge for them. As tenge migrate, the National Bank of Kazakhstan will lose some control over them, and it will come under pressure to print more. These conditions are ideal for a ramp-up in inflation. – Leon Taylor, tayloralmaty@gmail.com


Good reading
David Ricardo. The principles of political economy and taxation. The quote above is from Chapter XV, “Taxes on profits.”

Revised on June 4, 2010