Will it rain on our parade?
Kazakhstan’s economy has two vital determinants: The global price of oil, and financial activity. The government’s recent forecast of 7% growth in real GDP this year seems based on the expectation that oil prices, which have risen about three-fourths from trough-to-peak since early 2009, will always keep the economy afloat.
As a long-run expectation, this may seem reasonable: Oil prices have risen 600% since the late 1990s. But a short-run forecast – say, for six to nine months – must allow for price volatility. Rising oil prices fueled 7% growth in GDP for the first quarter of 2010, compared to the same period in 2009; but oil prices often fall as rapidly as they rise. In 2009, daily futures for light crude oil on the New York markets varied from $50 to $80 per barrel; and even in 2010, a relatively sedate year, they have ranged from $70 to $85. In addition, buyers will eventually substitute cheaper fuels or conservation for expensive oil.
Finally, the government’s forecast is weakened by the fact that it may be based on only one or two months of good performance (March and possibly April).
Astana’s forecasts have ignored the ill health of the financial industry. This month, the World Bank and the International Monetary Fund warned that bad loans were still rising as a share of all loans in Kazakhstan – to one fourth as of May. After visiting Kazakhstan, the IMF staff said the economy should recover “but remains constrained by banking sector difficulties…. Credit expansion is subdued despite ample bank liquidity, and activity in key sectors, such as construction and real estate, remains sluggish.” With “large international reserves and low debt,” the government can spend more to revive the economy, if need be. (In fact, the government has stepped up spending on school construction.) But it should try to strengthen the economy for the years to come, by regulating the finance industry and by avoiding recurrent public expenses such as pay hikes for bureaucrats. Overall, the IMF forecasts 4% growth this year. If all goes well, then the economy may grow 6% annually over the next five years.
The willingness of a family to finance a four- or five-year investment, like a college education, depends partly on its expectations of economic growth, since this determines much of a family’s income. One way to gauge these expectations is to look at leading and lagging indicators of economic activity. Not only are they inputs into expectations; some of them – such as real investment -- are based on expectations themselves.
For leading indicators, let’s look at real investment; for lagging indicators, wages and employment.
Leading indicators
Real investment. Investment in durable goods – especially fixed capital such as office buildings and heavy equipment – discloses primarily the expectations of companies for the national economy for the next few years. In a transition economy like Kazakhstan, few firms have built up enough in retained earnings to see through an investment that will pay off only after many years. They will invest only if they believe that the economy will grow rapidly enough to enable them to recoup investment costs in a few years.
By this indicator, companies in Kazakhstan in 2009 did not seem to expect a strong economic recovery in 2010 or 2011. Adjusting for inflation, total investment in fixed capital for January through August 2009 was down 5% from the same period for 2008. The picture is no brighter for 2010: Nominal fixed investment in the first three months of the year was 622 billion tenge ($4.1 billion), 2.7% below the same period of 2009 and only .3% above the same period for 2008. Adjusting for inflation, which the government estimates (optimistically) at 7% a year, fixed investment was nearly a tenth below that of the same quarter in 2009, although this period had been weakened by recession.
As in 2009, this stagnation is mainly due to pessimism in the city of Almaty, where fixed investment is a seventh below that for the same period of 2009. At least half of fixed investment in the first quarter of 2010 was in the Caspian region, especially in Atyrau, due to rising oil prices. These are continuing trends; for January through September 2009, fixed investment in the city of Almaty was a third below that of the same period of 2008.
Construction. As in 2009, pessimism pervades construction as much as it does fixed-capital investment in general. In nominal terms, home construction in the first quarter of 2010 was only two fifths of 2008. Construction in early 2008 may still have reflected the housing bubble; but even when compared to the first quarter of 2009, when the bubble had disappeared, nominal construction was down by a tenth. The value of home construction in Almaty in the first quarter of 2010 was down 40% from the same period of 2009. Contracted construction work in Almaty was down by nearly half.
Home construction in 2009 had all but collapsed. For January through August, the value of such building was only half of that in the same period for 2008. Data for the first quarter of 2010 indicate no recovery from the collapse. In 2009, decline disproportionately affected Astana, as well as the city and oblast of Almaty, because these areas accounted for three-fourths of home construction in Kazakhstan. Adjusted for inflation, home construction in Astana fell by three fourths; in the city of Almaty, by half.
In physical terms, the discouraging trends in construction of 2009 seem to continue, judging from the performance in the first quarter. In square meters, residential starts in Kazakhstan were down 6% as compared to the first quarter of 2009. The city of Almaty suffered a 15% fall. In terms of apartments, starts in Kazakhstan were holding steady at 12,000 for the first quarter of 2010; but the city of Almaty saw a fall of nearly a fifth from the first quarter of 2009, when the city had performed much better than in 2008. Perhaps apartments had been oversupplied in 2009. In early 2010, the hot spots in the nation for residential starts were Akmola and Pavlodar.
Adjusting for inflation, construction in Kazakhstan for January through August of 2009 was down by a fifth from the same period of 2008. In the three areas that accounted for almost half of all construction – the oblast of Atyrau and the cities of Astana and Almaty – building was down significantly. In Astana, it had decreased by almost half. The hot spots in 2009 for fixed capital, and for construction in particular, were Zhambyl and South Kazakhstan. These accounted for only minor shares of the nation’s stock of fixed capital.
Lagging indicators
Wages. These indicators usually lag the business cycle, since they are often fixed by contract.
Average real wages in Kazakhstan for the first quarter of 2010 were only 1.1% higher than in the same period for 2009, suggesting a glacial recovery. Some industries important to Almaty saw real wages decline: Finance and insurance, down 1.5%; hotel and food services, down 6.2%; education, down 3.1%. Despite the housing crash, wages rose 6.4% in real estate and 7.4% in construction. But in general, workers may have perceived too much excess capacity in the economy to permit them to demand substantial pay raises.
Employment. The employment rate, generally a lagging indicator of recovery, responds more quickly than the wage rate. The unemployment rate in Kazakhstan is seasonal, generally peaking in the first quarter of each year, probably due to weather. Since 2003, it has fallen steadily. The decline continued in the first quarter of 2010, relative to the same period of 2009. The fall in the unemployment rate for youths was twice as steep as that for workers in general. These trends are due to new jobs, not to the withdrawal of discouraged job-seekers. In fact, the number of inactive workers might have fallen slightly in the first quarter of 2010.
The bottom line -- and the silver lining
Kazakhstan is recovering slowly from the global recession that reduced oil demand and deflated real estate values. Its long-term prospects remain strong: Exports rose 70% in the first four months of 2010, relative to the same period in 2009, mainly on the strength of rising oil prices. But this income accrues mainly to the Caspian region. Almaty will benefit mainly from the secondary spending, which generally lags primary spending by a year or so. The silver lining in this thundercloud is that 2011 should be a strong year for Almaty. – Leon Taylor, tayloralmaty@gmail.com
All Kazakhstani data are from the Statistical Agency of Kazakhstan unless otherwise attributed.
Revised on June 22, 2010
Monday, June 21, 2010
Tuesday, June 15, 2010
Tempting targets
Should Tajikistan fix its exchange rate or its volume of currency? Zafar Davronov points out the pitfalls
You know the apocryphal Chinese curse: May you live in interesting times. Last week adumbrated an interesting trend in the exchange rate of the tenge for the dollar: After strengthening for most of the year, in line with rising oil prices, the tenge has been falling steadily this month, roughly from 146.7 tenge per dollar to 147.3T. The most evident reason is that the International Monetary Fund (IMF) released a forecast of Kazakhstan’s economy that was less giddy than the government’s. Astana projects 7% real growth in gross domestic product (GDP) this year; the IMF, 4%. The tenge fell most steeply after June 8, when the IMF report appeared. For most of 2010, the central bank of Kazakhstan has let foreign exchange markets set the value of the tenge, but it must have been tempted to check its fall toward 148T per dollar.
This is one episode in a larger drama: When, if ever, should the central bank fix the exchange rate in a transition economy? This February, the National Bank of Kazakhstan put the exchange rate for the tenge in a corridor from 127.5T to 165T, or 15% and 10% variations respectively from the target of 150T. You could drive a freight train down a corridor that wide. Why doesn’t the Bank save itself all this trouble and just announce that it will let the market determine the exchange rate? With a 25% leeway, that's effectively what it's doing.
As it happens, another central bank in the region has wrestled with this question. Tajikistan, saddled with one of the weakest economies in a weakened global economy, embarked last year on a radical experiment: Flexible exchange rates amid the turmoil of global finance. The plight of the National Bank of Tajikistan may shed light on that of Kazakhstan’s.
Tajikistan consigned its somoni to foreign exchange markets when collapsing national income, and devaluations by major trading partners, made it hard for the central bank to defend its currency. In 2009, the somoni lost a fourth of its value relative to the United States dollar. Half of that loss occurred in May, when it fell to 3.79 somoni to the dollar. It weakened sharply again in May 2010, to 4.57 somoni. Since then, it has held steadily at 4.38 somoni.
When the world economy catches a cold, Tajikistan gets double pneumonia. Repatriated earnings by its emigrant workers, which normally account for half of national income, shrank by nearly a third in 2009 as Tajikistanis in Russia lost their jobs in the regional recession. The relative demand for legal exports from this small once-open economy has been shriveling for years. The GDP share of merchandise exports fell from virtually 100% in 2000 to less than 20% in 2008, according to the World Bank. Despite this trend, national income had grown steadily since 2000, with an average annual gain of about 2.5 billion current international dollars, due partly to migrant earnings in a regional boom. Suddenly, in 2009, Tajikistanis had to tighten their belts. Their rate of income growth halved, according to the National Bank.
The loss of funds put Tajikistani banks in double jeopardy: Households and firms withdrew their money from the banks just as foreign creditors to the banks were demanding payment. Like banks in Kazakhstan, those in Tajikistan had relied heavily on foreign currencies. In 2007, these comprised four fifths of the banks’ deposits and two thirds of their loans.
The central bank’s sudden return to a flexible exchange rate added to bankers’ woes. In a free currency-market, the somoni was heading into a free fall. This would eviscerate the dollar value of bank assets expressed in somoni. And unhedged domestic borrowers of dollars and euros would have trouble repaying bank loans, since their wealth was in somoni, too. Bank defaults would become more likely. Since commercial banks were the key creditors in Tajikistan, firms would shelve expansion plans. Without this spending, the recession would deepen.
Collateral damage
In using the exchange rate as a policy tool, the central bank faces a trade-off. Both fixed and flexible exchange rates are risky. Which is the least risky?
To answer such questions, an American economist, Martin Weitzman at Harvard University developed a general analysis that tries to minimize the damages that uncertainty can wreak. An example from the news may help convey his approach.
To generate electricity, most power plants burn oil or coal, emitting residual carbon to the atmosphere. The accumulating carbon seals in terrestrial heat, threatening to create severe weather. To avert this threat, nations seek ways to reduce carbon emissions. One proposal is to compel any polluter to pay a tax per carbon ton emitted. The other proposal would compel him to buy a permit for each carbon ton emitted.
The two proposals may strike you as essentially the same, but they differ in the uncertainty that attaches to each. The carbon tax limits the environmental costs that a polluter would have to incur. But it doesn’t limit the volume of carbon emissions, since in principle the polluter can emit all that he wants, as long as he pays the tax. On the other hand, the scheme of carbon permits limits the volume of carbon emissions, since governments could agree to print no more than, say, 100 million permits. But the permit policy doesn’t limit the costs that a polluter would have to incur. If he must have a permit in order to operate, then he will be willing to pay any amount for it, up to his total expected profits.
In short, targeting the “price” of the right to pollute (that’s the tax) limits compliance costs. But it doesn’t mandate a given amount of compliance, so we may not get as much cooperation as we had expected. Targeting instead the volume of pollution (that’s the permit scheme) limits environmental damages. But it doesn’t limit how much that firms would have to pay for the right to wreak these damages, so we may find that containing global warming will cost us more jobs than we had expected.
Your choice between the permit and the tax will depend on what you worry most about – unexpectedly high environmental damages or unexpectedly high compliance costs. Since people seem to worry most about the former – melting ice caps, a flooded London, an Amsterdam in shambles – the permit scheme has won the most political support.
Now let’s return to our conversation about money. The same choice – between a price target and a volume target – faces the central bank of Tajikistan as faced environmental policymakers. In principle, the market for somoni determines the price of the currency (i.e., the exchange rate) as well as its quantity (the number of somoni in the world). If the central bank fixes either the price or the quantity of the somoni, then it must leave free the other variable for the market to determine, or no market can exist. (Yes, the bank can try to fix both price and supply. But it cannot predict changes in demand and supply perfectly, so its adjustments will sometimes err. In other words, the bank must live with some sort of market for somoni, whether it wants to or not. It can’t control speculators around the world.) Which variable should the bank fix? That depends on the type of uncertainty that worries it the most – uncertainty in the demand for somoni, or in their supply, suggest Chang and Velasco.
Suppose, for example, that the central bank worries mostly that the demand for somoni will collapse, perhaps because of a world depression. Then the bank may prefer to fix the exchange rate. Fixing the supply of somoni instead may prove to be a costly error, since the exchange rate may have to fall drastically in order to clear the market after an unexpectedly severe decline in demand.
On the other hand, suppose that the central bank is more vexed by the prospect that the commercial banks will call in loans of somoni, reducing their supply in circulation. Then the central bank may prefer to fix the supply of currency, perhaps by creating somoni to replace those that the private banks retire from circulation. The exchange rate would be left free to change until it clears the market. If the bank fixes this rate rather than supply, then it may have to live with disquieting changes in supply, thanks to arbitrage, until the market’s rate of exchange equaled the bank’s.
What now?
What should the central bank of Tajikistan worry about? A small economy that relies heavily on world trade, like Tajikistan’s, would benefit the most from a fixed exchange rate, since it may be buffeted by large and hard-to-predict changes in global demand for its exports, noted Kettell. The lack of diversity in Tajikistan’s exports strengthens the case for fixing the exchange rate, since this sameness magnifies potential changes in the demand for somoni. With respect to legal goods and materials, Tajikistan exports mainly cotton and aluminum, the export revenues of which have declined by 60 to 70 percent since last year. The undeveloped, inflexible nature of Tajikistan’s financial sector also intensifies the potential impact of changes in somoni demand, since few local opportunities for hedges exist. In sum, the central bank should not fix the supply of somoni, because it can’t be sure that people will want them.
Nevertheless, the central bank in 2009 adopted a flexible exchange rate. Why? Because it was running out of dollars with which to defend the somoni. The central bank would have needed to spend $234 million per month to defend the somoni’s high old rate of exchange, said the bank chairman, Sharif Rahimzoda. The country's total reserve of foreign currency was only $198 million in January 2009; it had almost halved in one year. At that rate, defending the somoni for little more than three weeks would have wiped out the entire reserve.
Also, two major trading partners of Tajikistan -- Russia and Kazakhstan -- had already devalued their currencies. Since this increased the relative cost of Tajikistani products, the National Bank was pressured to devalue as well.
In a sense, Tajikistan had to balance economic stability and autonomy. A fixed exchange rate – say, in terms of the U.S. dollar – would have turned over Tajikistan’s monetary policy to the Federal Reserve. That might have satisfied international investors, if not Tajikistanis. Given Tajikistan’s dire straits, a flexible exchange rate was more of an economic gamble. At some point, Tajikistan might have had to appeal to the International Monetary Fund for another stopgap loan; the IMF approved $116 million in April 2009. In exchange, the IMF might require the government to do more to balance its books – and the central bank to be more accurate in its reports.
Thanks to oil, Kazakhstan is not in the same predicament as Tajikistan, but it faces the same dilemma. How much autonomy is the government prepared to give up in order to placate international creditors? Interesting times, indeed. – Zafar Davronov and Leon Taylor
Zafar Davronov is a student in KIMEP’s MBA program. His interests include Central Asian economics and finance.
References
William J. Baumol and Wallace E. Oates. 1988. The theory of environmental policy. Second edition. Cambridge University Press. Applies Weitzman's principle to pollution taxes and permits.
Francesco Caramazza and Jahangir Aziz. 1998. Fixed or flexible? Getting the exchange rate right in the 1990s. International Monetary Fund Economic Issues, number 13.
Roberto Chang and Andres Velasco. 2000. Exchange-rate policy for developing countries. The American Economic Review 90: 2, pages 71-75.
International Monetary Fund. 2008. Republic of Tajikistan: Financial system stability assessment.
Brian Kettell. 2000. What drives currency markets: The signals you need to stay ahead of the game. Financial Times/Prentice Hall.
Martin Weitzman. 1974. Prices vs. quantities. Review of Economic Studies 41:4, October, pages 477-491.
Revised on September 23, 2010.
You know the apocryphal Chinese curse: May you live in interesting times. Last week adumbrated an interesting trend in the exchange rate of the tenge for the dollar: After strengthening for most of the year, in line with rising oil prices, the tenge has been falling steadily this month, roughly from 146.7 tenge per dollar to 147.3T. The most evident reason is that the International Monetary Fund (IMF) released a forecast of Kazakhstan’s economy that was less giddy than the government’s. Astana projects 7% real growth in gross domestic product (GDP) this year; the IMF, 4%. The tenge fell most steeply after June 8, when the IMF report appeared. For most of 2010, the central bank of Kazakhstan has let foreign exchange markets set the value of the tenge, but it must have been tempted to check its fall toward 148T per dollar.
This is one episode in a larger drama: When, if ever, should the central bank fix the exchange rate in a transition economy? This February, the National Bank of Kazakhstan put the exchange rate for the tenge in a corridor from 127.5T to 165T, or 15% and 10% variations respectively from the target of 150T. You could drive a freight train down a corridor that wide. Why doesn’t the Bank save itself all this trouble and just announce that it will let the market determine the exchange rate? With a 25% leeway, that's effectively what it's doing.
As it happens, another central bank in the region has wrestled with this question. Tajikistan, saddled with one of the weakest economies in a weakened global economy, embarked last year on a radical experiment: Flexible exchange rates amid the turmoil of global finance. The plight of the National Bank of Tajikistan may shed light on that of Kazakhstan’s.
Tajikistan consigned its somoni to foreign exchange markets when collapsing national income, and devaluations by major trading partners, made it hard for the central bank to defend its currency. In 2009, the somoni lost a fourth of its value relative to the United States dollar. Half of that loss occurred in May, when it fell to 3.79 somoni to the dollar. It weakened sharply again in May 2010, to 4.57 somoni. Since then, it has held steadily at 4.38 somoni.
When the world economy catches a cold, Tajikistan gets double pneumonia. Repatriated earnings by its emigrant workers, which normally account for half of national income, shrank by nearly a third in 2009 as Tajikistanis in Russia lost their jobs in the regional recession. The relative demand for legal exports from this small once-open economy has been shriveling for years. The GDP share of merchandise exports fell from virtually 100% in 2000 to less than 20% in 2008, according to the World Bank. Despite this trend, national income had grown steadily since 2000, with an average annual gain of about 2.5 billion current international dollars, due partly to migrant earnings in a regional boom. Suddenly, in 2009, Tajikistanis had to tighten their belts. Their rate of income growth halved, according to the National Bank.
The loss of funds put Tajikistani banks in double jeopardy: Households and firms withdrew their money from the banks just as foreign creditors to the banks were demanding payment. Like banks in Kazakhstan, those in Tajikistan had relied heavily on foreign currencies. In 2007, these comprised four fifths of the banks’ deposits and two thirds of their loans.
The central bank’s sudden return to a flexible exchange rate added to bankers’ woes. In a free currency-market, the somoni was heading into a free fall. This would eviscerate the dollar value of bank assets expressed in somoni. And unhedged domestic borrowers of dollars and euros would have trouble repaying bank loans, since their wealth was in somoni, too. Bank defaults would become more likely. Since commercial banks were the key creditors in Tajikistan, firms would shelve expansion plans. Without this spending, the recession would deepen.
Collateral damage
In using the exchange rate as a policy tool, the central bank faces a trade-off. Both fixed and flexible exchange rates are risky. Which is the least risky?
To answer such questions, an American economist, Martin Weitzman at Harvard University developed a general analysis that tries to minimize the damages that uncertainty can wreak. An example from the news may help convey his approach.
To generate electricity, most power plants burn oil or coal, emitting residual carbon to the atmosphere. The accumulating carbon seals in terrestrial heat, threatening to create severe weather. To avert this threat, nations seek ways to reduce carbon emissions. One proposal is to compel any polluter to pay a tax per carbon ton emitted. The other proposal would compel him to buy a permit for each carbon ton emitted.
The two proposals may strike you as essentially the same, but they differ in the uncertainty that attaches to each. The carbon tax limits the environmental costs that a polluter would have to incur. But it doesn’t limit the volume of carbon emissions, since in principle the polluter can emit all that he wants, as long as he pays the tax. On the other hand, the scheme of carbon permits limits the volume of carbon emissions, since governments could agree to print no more than, say, 100 million permits. But the permit policy doesn’t limit the costs that a polluter would have to incur. If he must have a permit in order to operate, then he will be willing to pay any amount for it, up to his total expected profits.
In short, targeting the “price” of the right to pollute (that’s the tax) limits compliance costs. But it doesn’t mandate a given amount of compliance, so we may not get as much cooperation as we had expected. Targeting instead the volume of pollution (that’s the permit scheme) limits environmental damages. But it doesn’t limit how much that firms would have to pay for the right to wreak these damages, so we may find that containing global warming will cost us more jobs than we had expected.
Your choice between the permit and the tax will depend on what you worry most about – unexpectedly high environmental damages or unexpectedly high compliance costs. Since people seem to worry most about the former – melting ice caps, a flooded London, an Amsterdam in shambles – the permit scheme has won the most political support.
Now let’s return to our conversation about money. The same choice – between a price target and a volume target – faces the central bank of Tajikistan as faced environmental policymakers. In principle, the market for somoni determines the price of the currency (i.e., the exchange rate) as well as its quantity (the number of somoni in the world). If the central bank fixes either the price or the quantity of the somoni, then it must leave free the other variable for the market to determine, or no market can exist. (Yes, the bank can try to fix both price and supply. But it cannot predict changes in demand and supply perfectly, so its adjustments will sometimes err. In other words, the bank must live with some sort of market for somoni, whether it wants to or not. It can’t control speculators around the world.) Which variable should the bank fix? That depends on the type of uncertainty that worries it the most – uncertainty in the demand for somoni, or in their supply, suggest Chang and Velasco.
Suppose, for example, that the central bank worries mostly that the demand for somoni will collapse, perhaps because of a world depression. Then the bank may prefer to fix the exchange rate. Fixing the supply of somoni instead may prove to be a costly error, since the exchange rate may have to fall drastically in order to clear the market after an unexpectedly severe decline in demand.
On the other hand, suppose that the central bank is more vexed by the prospect that the commercial banks will call in loans of somoni, reducing their supply in circulation. Then the central bank may prefer to fix the supply of currency, perhaps by creating somoni to replace those that the private banks retire from circulation. The exchange rate would be left free to change until it clears the market. If the bank fixes this rate rather than supply, then it may have to live with disquieting changes in supply, thanks to arbitrage, until the market’s rate of exchange equaled the bank’s.
What now?
What should the central bank of Tajikistan worry about? A small economy that relies heavily on world trade, like Tajikistan’s, would benefit the most from a fixed exchange rate, since it may be buffeted by large and hard-to-predict changes in global demand for its exports, noted Kettell. The lack of diversity in Tajikistan’s exports strengthens the case for fixing the exchange rate, since this sameness magnifies potential changes in the demand for somoni. With respect to legal goods and materials, Tajikistan exports mainly cotton and aluminum, the export revenues of which have declined by 60 to 70 percent since last year. The undeveloped, inflexible nature of Tajikistan’s financial sector also intensifies the potential impact of changes in somoni demand, since few local opportunities for hedges exist. In sum, the central bank should not fix the supply of somoni, because it can’t be sure that people will want them.
Nevertheless, the central bank in 2009 adopted a flexible exchange rate. Why? Because it was running out of dollars with which to defend the somoni. The central bank would have needed to spend $234 million per month to defend the somoni’s high old rate of exchange, said the bank chairman, Sharif Rahimzoda. The country's total reserve of foreign currency was only $198 million in January 2009; it had almost halved in one year. At that rate, defending the somoni for little more than three weeks would have wiped out the entire reserve.
Also, two major trading partners of Tajikistan -- Russia and Kazakhstan -- had already devalued their currencies. Since this increased the relative cost of Tajikistani products, the National Bank was pressured to devalue as well.
In a sense, Tajikistan had to balance economic stability and autonomy. A fixed exchange rate – say, in terms of the U.S. dollar – would have turned over Tajikistan’s monetary policy to the Federal Reserve. That might have satisfied international investors, if not Tajikistanis. Given Tajikistan’s dire straits, a flexible exchange rate was more of an economic gamble. At some point, Tajikistan might have had to appeal to the International Monetary Fund for another stopgap loan; the IMF approved $116 million in April 2009. In exchange, the IMF might require the government to do more to balance its books – and the central bank to be more accurate in its reports.
Thanks to oil, Kazakhstan is not in the same predicament as Tajikistan, but it faces the same dilemma. How much autonomy is the government prepared to give up in order to placate international creditors? Interesting times, indeed. – Zafar Davronov and Leon Taylor
Zafar Davronov is a student in KIMEP’s MBA program. His interests include Central Asian economics and finance.
References
William J. Baumol and Wallace E. Oates. 1988. The theory of environmental policy. Second edition. Cambridge University Press. Applies Weitzman's principle to pollution taxes and permits.
Francesco Caramazza and Jahangir Aziz. 1998. Fixed or flexible? Getting the exchange rate right in the 1990s. International Monetary Fund Economic Issues, number 13.
Roberto Chang and Andres Velasco. 2000. Exchange-rate policy for developing countries. The American Economic Review 90: 2, pages 71-75.
International Monetary Fund. 2008. Republic of Tajikistan: Financial system stability assessment.
Brian Kettell. 2000. What drives currency markets: The signals you need to stay ahead of the game. Financial Times/Prentice Hall.
Martin Weitzman. 1974. Prices vs. quantities. Review of Economic Studies 41:4, October, pages 477-491.
Revised on September 23, 2010.
Wednesday, June 9, 2010
Kazakhstan’s economy: The ins and outs of indicators
Is the recovery as sturdy as it looks?
The government of Kazakhstan estimates that the economy this year would grow by 7%. That rate is respectable. True, it falls short of the torrid 10% pace that preceded the financial collapse in 2008. But it still would double income per person every decade or so.
Two problems are evident in the estimate, however. First, government agencies in Astana often disagree publicly about the rate of increase in economic activity (gross domestic product, or GDP). Estimates from the prime minister have been more generous than those from the Economy ministry.
Second, growth estimates seem based on oil prices, which are notoriously volatile. From the statistics, can we discern signs of the underlying health of the Kazakhstani economy?
Perhaps we can, from leading and lagging indicators of economic activity. For the former, let’s look at real investment (i.e., the amount of new manmade inputs, adjusted of price changes); for the latter, at the labor market. To focus on longer-run trends, let’s compare the performance in 2009 to that of earlier years.
This comparison suggests that real investment remained in the doldrums for Kazakhstan, especially in its two major cities, except in new apartments. Real wages in 2009 were still below 2007 levels and, in Almaty, slightly below 2008 levels as well. But the unemployment rate has fallen steadily since 2003, largely because job-seekers in Kazakhstan usually find work soon. In short, the recession of 2008-2009 affected income more than employment.
Leading indicators
Real investment. Investment in durable goods – especially fixed capital such as office buildings and heavy equipment – discloses the expectations of companies for the national economy for the next few years. Since buildings have an expected life of 40 years or so, this expectancy does not affect the company’s decision of when to start construction; the long-run performance of physical capital is about the same whether construction began in 2010 or 2012. Instead, the company will start construction at the time that minimizes capital costs, which is substantially the present discounted value of the loan. This value, in turn, depends on the prime interest rate, which relates directly to the ratio of expected GDP to potential GDP, for the next few years. I assume a fixed interest rate for a given corporate loan.
By this indicator, companies in Kazakhstan did not seem to expect a strong economic recovery in 2010 or 2011. Adjusting for inflation, total investment in fixed capital for January through August 2009 was down by 5% from the same period for 2008.
This stagnation was mainly due to pessimism in the city of Almaty. This, with the oblast surrounding Almaty as well as the oblast of Atyrau, accounted for more than 40% of the total investment in fixed capital in Kazakhstan. While investment in 2009 was up 10% in Atyrau, and up 41% in the oblast of Almaty, it was down by more than a third in the city of Almaty.
Construction. The pessimism suggested by data on fixed-capital investment is reinforced by data on total construction. Adjusting for inflation, construction in Kazakhstan for January through August of 2009 was down by a fifth compared to the same period of 2008. In the three areas that accounted for almost half of all construction – the oblast of Atyrau and the cities of Astana and Almaty – building was also down significantly. In Astana, it had decreased by almost half. The hot spots for fixed capital, and for construction in particular, were Zhambyl and South Kazakhstan. These were minor shares of the nation’s stock of fixed capital.
Home construction in 2009 had all but collapsed. For January through August, the value of such building was only half of that in the same period for 2008. This decline disproportionately affected Astana, as well as the city and oblast of Almaty, because these areas accounted for three-fourths of home construction in Kazakhstan. Adjusted for inflation, home construction in Astana fell by three fourths; in the city of Almaty, by half.
The bright spot in this dismal picture of investment was apartment construction. Throughout Kazakhstan, builders added as much new residential space in the first eight months of 2009 as in the same period of 2008. Hammers were especially busy in Astana as well as in the city and oblast of Almaty. These areas added half again as much new space in 2009 as in the prior year. They accounted for more than half of all new residential space in the country. The same basic pattern held for the number of new apartments.
Given the lack of economic activity in other industries, one might suspect an oversupply of apartments in the two cities. In that event, we might face another financial collapse in a year or two.
Lagging indicators
Wages. These indicators usually lag the business cycle, because they are fixed for a while. The most important wages are generally set in annual contracts, which then guide more informal wages. Even potentially flexible wages are slow to respond to an incipient recovery, since workers hesitate to risk losing their jobs in an economy with excess capacity, particularly when the social safety net is primitive.
We might interpret these trends most clearly through Keynesian theory. Factor owners won't demand pay raises until the economy is operating close enough to full capacity to enable them to hold up the boss for ransom, as it were. As long as excess capacity is substantial, factor owners won't press employers to raise input and output prices.
The pattern of wages in Kazakhstan in 2009 was largely consistent with this theory. Real wages gained slightly on those in 2008 but remained an eighth below wages in 2007. Probably, contracts in 2008 failed to adjust wages for inflation in that and the prior year. Despite cost-of-living adjustments by 2009, wages remain 12% below those of 2007 due to recession beginning in 2008.
Nominal monthly wages look deceptively strong because of the failure to correct for inflation. In Almaty, real wages in 2009 dropped 3% since 2008. Over the long run, however, pay in Almaty has performed well. Its 2009 premium, relative to national pay, doubled to 20,000 tenge per month since 2002. This was probably due to the importance of finance, real estate, and foreign-owned organizations to Almaty’s economy. Even so, like Astana, Almaty lags the oil regions in nominal pay, by as much as 40%.
Employment. The employment rate, generally a lagging indicator of recovery, responds more quickly than the wage rate.
The unemployment rate in Kazakhstan is seasonal, generally peaking in the first quarter of each year, probably due to weather. Since 2003, it has fallen steadily.
With a first glance at the data, one might think that the unemployment rate is dropping because jobless workers become discouraged and drop out of the labor force. (Recall that a worker is “unemployed” if he is looking unsuccessfully for work. If he isn’t looking, then he is deemed a “discouraged” worker -- not even in the labor force, which comprises the employed and the job-seekers.) In fact, the number of unemployed workers since 2003 had dropped 20% by 2009, while the number of adults no longer in the labor force had risen 10%. Since the number of the inactive is five to six times larger than the number of unemployed, conceivably the unemployment rate is falling because discouraged job-seekers are withdrawing from the labor force. As circumstantial evidence, consider that the number of self-employed workers is subject to increasing volatility but seems to be falling over the long run.
But regressions give the lie to these speculations. The relationship of the number of the unemployed to the concurrent number of the employed is negative and highly significant in a statistical sense. An increase of eight in the number of employed workers corresponds to a reduction of about one in the number of unemployed workers. This suggests that the rate of unemployment may be dropping primarily because of newly created jobs. Had instead the rate of unemployment been dropping primarily because discouraged workers were leaving the labor force, then the number unemployed would not have related to the number employed; instead, it would have related negatively to the number of inactive workers.
The relationship of the number of the unemployed to the number of the economically inactive is positive and somewhat significant statistically. One would expect this direct correlation as a result of the business cycle. During a recession, the number of unemployed workers and that of discouraged workers are both likely to rise. There is no evidence here that many unemployed workers become so discouraged as to drop out of the labor force.
Composition of the economy
In December 2009, the government announced a drive to diversify the economy away from the primary industries. In reality, the private sector is already diversified in terms of employment. The industry that hires the greatest number of workers, agriculture, accounts for no more than a fourth of all employees. Services account for half of all private employment, an unusually large share for a developing economy.
Summary and reflections
Kazakhstan is recovering slowly from the global recession that reduced oil demand and deflated real estate values. But its long-term prospects remain strong, since it continues to create a lot of jobs.
Of course, the crystal ball is not always right. With four banks defaulting, and several smaller ones in danger in 2009, Kazakhstan is still vulnerable to a banking crisis. Some international events, especially a revaluation of the renminbi, can still dispel a fragile recovery. The reason is that China is one of the four largest markets for Kazakhstani exports. A stronger renminbi would reduce Chinese exports and Chinese income, decreasing demand for imports from Kazakhstan. – Leon Taylor, tayloralmaty@gmail.com
For the technical version of the paper, write tayloralmaty@gmail.com
The government of Kazakhstan estimates that the economy this year would grow by 7%. That rate is respectable. True, it falls short of the torrid 10% pace that preceded the financial collapse in 2008. But it still would double income per person every decade or so.
Two problems are evident in the estimate, however. First, government agencies in Astana often disagree publicly about the rate of increase in economic activity (gross domestic product, or GDP). Estimates from the prime minister have been more generous than those from the Economy ministry.
Second, growth estimates seem based on oil prices, which are notoriously volatile. From the statistics, can we discern signs of the underlying health of the Kazakhstani economy?
Perhaps we can, from leading and lagging indicators of economic activity. For the former, let’s look at real investment (i.e., the amount of new manmade inputs, adjusted of price changes); for the latter, at the labor market. To focus on longer-run trends, let’s compare the performance in 2009 to that of earlier years.
This comparison suggests that real investment remained in the doldrums for Kazakhstan, especially in its two major cities, except in new apartments. Real wages in 2009 were still below 2007 levels and, in Almaty, slightly below 2008 levels as well. But the unemployment rate has fallen steadily since 2003, largely because job-seekers in Kazakhstan usually find work soon. In short, the recession of 2008-2009 affected income more than employment.
Leading indicators
Real investment. Investment in durable goods – especially fixed capital such as office buildings and heavy equipment – discloses the expectations of companies for the national economy for the next few years. Since buildings have an expected life of 40 years or so, this expectancy does not affect the company’s decision of when to start construction; the long-run performance of physical capital is about the same whether construction began in 2010 or 2012. Instead, the company will start construction at the time that minimizes capital costs, which is substantially the present discounted value of the loan. This value, in turn, depends on the prime interest rate, which relates directly to the ratio of expected GDP to potential GDP, for the next few years. I assume a fixed interest rate for a given corporate loan.
By this indicator, companies in Kazakhstan did not seem to expect a strong economic recovery in 2010 or 2011. Adjusting for inflation, total investment in fixed capital for January through August 2009 was down by 5% from the same period for 2008.
This stagnation was mainly due to pessimism in the city of Almaty. This, with the oblast surrounding Almaty as well as the oblast of Atyrau, accounted for more than 40% of the total investment in fixed capital in Kazakhstan. While investment in 2009 was up 10% in Atyrau, and up 41% in the oblast of Almaty, it was down by more than a third in the city of Almaty.
Construction. The pessimism suggested by data on fixed-capital investment is reinforced by data on total construction. Adjusting for inflation, construction in Kazakhstan for January through August of 2009 was down by a fifth compared to the same period of 2008. In the three areas that accounted for almost half of all construction – the oblast of Atyrau and the cities of Astana and Almaty – building was also down significantly. In Astana, it had decreased by almost half. The hot spots for fixed capital, and for construction in particular, were Zhambyl and South Kazakhstan. These were minor shares of the nation’s stock of fixed capital.
Home construction in 2009 had all but collapsed. For January through August, the value of such building was only half of that in the same period for 2008. This decline disproportionately affected Astana, as well as the city and oblast of Almaty, because these areas accounted for three-fourths of home construction in Kazakhstan. Adjusted for inflation, home construction in Astana fell by three fourths; in the city of Almaty, by half.
The bright spot in this dismal picture of investment was apartment construction. Throughout Kazakhstan, builders added as much new residential space in the first eight months of 2009 as in the same period of 2008. Hammers were especially busy in Astana as well as in the city and oblast of Almaty. These areas added half again as much new space in 2009 as in the prior year. They accounted for more than half of all new residential space in the country. The same basic pattern held for the number of new apartments.
Given the lack of economic activity in other industries, one might suspect an oversupply of apartments in the two cities. In that event, we might face another financial collapse in a year or two.
Lagging indicators
Wages. These indicators usually lag the business cycle, because they are fixed for a while. The most important wages are generally set in annual contracts, which then guide more informal wages. Even potentially flexible wages are slow to respond to an incipient recovery, since workers hesitate to risk losing their jobs in an economy with excess capacity, particularly when the social safety net is primitive.
We might interpret these trends most clearly through Keynesian theory. Factor owners won't demand pay raises until the economy is operating close enough to full capacity to enable them to hold up the boss for ransom, as it were. As long as excess capacity is substantial, factor owners won't press employers to raise input and output prices.
The pattern of wages in Kazakhstan in 2009 was largely consistent with this theory. Real wages gained slightly on those in 2008 but remained an eighth below wages in 2007. Probably, contracts in 2008 failed to adjust wages for inflation in that and the prior year. Despite cost-of-living adjustments by 2009, wages remain 12% below those of 2007 due to recession beginning in 2008.
Nominal monthly wages look deceptively strong because of the failure to correct for inflation. In Almaty, real wages in 2009 dropped 3% since 2008. Over the long run, however, pay in Almaty has performed well. Its 2009 premium, relative to national pay, doubled to 20,000 tenge per month since 2002. This was probably due to the importance of finance, real estate, and foreign-owned organizations to Almaty’s economy. Even so, like Astana, Almaty lags the oil regions in nominal pay, by as much as 40%.
Employment. The employment rate, generally a lagging indicator of recovery, responds more quickly than the wage rate.
The unemployment rate in Kazakhstan is seasonal, generally peaking in the first quarter of each year, probably due to weather. Since 2003, it has fallen steadily.
With a first glance at the data, one might think that the unemployment rate is dropping because jobless workers become discouraged and drop out of the labor force. (Recall that a worker is “unemployed” if he is looking unsuccessfully for work. If he isn’t looking, then he is deemed a “discouraged” worker -- not even in the labor force, which comprises the employed and the job-seekers.) In fact, the number of unemployed workers since 2003 had dropped 20% by 2009, while the number of adults no longer in the labor force had risen 10%. Since the number of the inactive is five to six times larger than the number of unemployed, conceivably the unemployment rate is falling because discouraged job-seekers are withdrawing from the labor force. As circumstantial evidence, consider that the number of self-employed workers is subject to increasing volatility but seems to be falling over the long run.
But regressions give the lie to these speculations. The relationship of the number of the unemployed to the concurrent number of the employed is negative and highly significant in a statistical sense. An increase of eight in the number of employed workers corresponds to a reduction of about one in the number of unemployed workers. This suggests that the rate of unemployment may be dropping primarily because of newly created jobs. Had instead the rate of unemployment been dropping primarily because discouraged workers were leaving the labor force, then the number unemployed would not have related to the number employed; instead, it would have related negatively to the number of inactive workers.
The relationship of the number of the unemployed to the number of the economically inactive is positive and somewhat significant statistically. One would expect this direct correlation as a result of the business cycle. During a recession, the number of unemployed workers and that of discouraged workers are both likely to rise. There is no evidence here that many unemployed workers become so discouraged as to drop out of the labor force.
Composition of the economy
In December 2009, the government announced a drive to diversify the economy away from the primary industries. In reality, the private sector is already diversified in terms of employment. The industry that hires the greatest number of workers, agriculture, accounts for no more than a fourth of all employees. Services account for half of all private employment, an unusually large share for a developing economy.
Summary and reflections
Kazakhstan is recovering slowly from the global recession that reduced oil demand and deflated real estate values. But its long-term prospects remain strong, since it continues to create a lot of jobs.
Of course, the crystal ball is not always right. With four banks defaulting, and several smaller ones in danger in 2009, Kazakhstan is still vulnerable to a banking crisis. Some international events, especially a revaluation of the renminbi, can still dispel a fragile recovery. The reason is that China is one of the four largest markets for Kazakhstani exports. A stronger renminbi would reduce Chinese exports and Chinese income, decreasing demand for imports from Kazakhstan. – Leon Taylor, tayloralmaty@gmail.com
For the technical version of the paper, write tayloralmaty@gmail.com
Monday, June 7, 2010
Prospects for a common currency in Kazakhstan's new customs union
By Dmitriy Belyanin
Would Kazakhstan gain from a regional currency? Dmitriy Belyanin totes up the pluses and minuses
Introduction
On January 1, Russia, Kazakhstan, and Belarus entered a regional trading agreement. This would abolish tariffs among these countries and to establish common tariffs towards non-members. Controversially, the union someday may introduce a common currency. Let’s look at the pros and cons of doing so.
History of the customs union
The Union of Soviet Socialist Republics had sought to make its members dependent on one another – and most of all on Russia. The habit of dependence contributed to the severity of the recession caused by the Union’s collapse, so governments were pressed to sustain old economic ties.
On the other hand, independence of the former Soviet republics led to an increase in imports from outside the region of the Commonwealth of Independent States (CIS). East Asian and European countries have been among major trading partners of CIS countries. Some of the latter, such as Turkmenistan, attempted self-sufficiency but succeeded only in aggravating their economic problems.
On April 2, 1996, Russia and Belarus formed a union aimed at economic integration. But bickering hindered proposals of a common currency. In June 2009, Russia banned 500 types of dairy products and meat from two plants in Belarus, costing the small trading partner $1 billion.
Kazakhstan too has traded heavily with Russia. About 98% of grain imports into Russia come from Kazakhstan. Russia exports many manufactured products, such as detergents, into Kazakhstan.
The global financial crisis of 2008-09 compelled the three nations to try to enlarge markets and lower costs, especially through economic integration. Talks toward these goals were accelerated by doubts that the dollar would survive as the world reserve currency. The president of Kazakhstan, Nursultan Nazarbayev, proposed a new world reserve currency as well as a regional one, but he admitted that the former would take too much time.
On January 1, the three countries formally agreed to adopt a common customs code by July 1. Igor Shuvalov, deputy prime minister of Russia, proposed a common currency. I turn to the controversies circumjacent to this plan.
How the customs union may help its member states
Now exporters in the union can sell to a combined market of 170 million people, more than 10 times larger than Kazakhstan’s domestic market. In 2008, the three countries had a combined gross domestic product of just under 2 trillion US dollars, 90% of that from Russia, according to the World Bank.
As Adam Smith pointed out more than two centuries ago, an expansion of the market – such as the union makes possible – can make firms more productive. In many industries, producing more reduces average cost, since workers learn by doing and since high rates of manufacturing justify the substitution of machines for costly labor. One modern example is aircraft manufacturing.
The union may also increase government revenues of Kazakhstan and Belarus, via two sources: Expected corporate income from trading within the union; and higher tariffs on non-members.
Local import-competing producers in each country may benefit from higher tariffs if they rely primarily on locally produced raw materials. This may help diversify the home economy. Diversification is critical for Kazakhstan’s economy, which now depends heavily on export of raw materials. Belarus and especially Russia have had stiff trade barriers since long before the union pact was arranged, so the agreement will not affect them as strongly in this regard.
Drawbacks of the customs union
Consumers of goods imported from outside the union may have to pay more (“trade diversion”). In the first quarter of 2010 alone, Kazakhstanis imported more than $1 billion of Chinese goods, according to Saltanat Iskakova, a KIMEP MBA student who has been researching trade issues. Higher tariffs will also hurt some arbitragers who ship goods to Kazakhstan from outside the customs union. Retail stores may be harmed as well.
Also, import-competing producers from Kazakhstan may be unable to compete with those from Russia and Belarus, which both have more diversified economies. The customs union may thus retard diversification of the economy of Kazakhstan.
Finally, states belonging to the customs union must coordinate their monetary policies, which varied drastically before the financial crisis of 2008. It has been proposed that these countries adopt a common currency.
Benefits of a common currency for union members
A common currency would ease trade among the member states by avoiding some costs and risks of foreign exchange. The eurozone may be an appealing example. Also, a regional currency may partially replace the dollar and decrease dependence on the monetary policy of the United States.
Nevertheless, in my opinion, these benefits of a common currency are more than out-weighed by the disadvantages.
Differences among monetary policies of member states
Each country belonging to the customs union has a monetary policy that had succeeded to varying degrees. The common currency will eliminate national autonomy in monetary policy. What harm might result?
First, the central bank can no longer act in the national interest. As the 1998 and 2008 crises made clear, global events affect national economies in varying ways, requiring varying responses. During the late 1990s, of the three union members, Belarus had the highest inflation -- 251% in 1999, according to staff estimates of the International Monetary Fund. The Belarusian ruble weakened sharply. The government of Belarus tried to control food prices; but this resulted in shortages, since an arbitrary fall in price stimulates demand and discourages supply. Later, in early 2009, the Belarusian ruble fell again, due to failing Russian demand for its goods. On the positive side, Belarus retained the real sector of the economy, primarily via protectionism and subsidies.
In contrast, the economy of Russia has been more market-oriented, and its external trade has been more diversified. Its inflation in 1998 and 1999 was lower than that of Belarus – perhaps because the Bank of Russia was more independent politically than its counterpart in Minsk. Nevertheless, political risks in Russia remain high. Terrorist acts, expropriation of corporate assets by the state, and the lack of financial transparency contribute to business risks there.
In 2009, Russia devalued the ruble gradually. According to Anders Åslund (2009), this devaluation helped reduce real GDP by over 10% in the first half of 2009, since it drained international reserves and increased defaults on loans. In general, devaluations eventually propel exports by reducing their prices, but customers need time to adjust.
The economy of Kazakhstan is smaller than that of either of the union partners, and it depends heavily on the export of raw materials. But Kazakhstan’s economy has been more stable, and it performed better during both crises, than its two counterparts. According to government statistics, Kazakhstan’s economy grew in 1998 and 1999 as well as in the current global financial crisis to date. Inflation in Kazakhstan was rampant in 2007 but stabilized in 2008. Though the 25% devaluation of the tenge in February 2009 did contribute to rising food prices that year, the concurrent decline in aggregate demand restrained inflation, which peaked at 7.3% in 2009. The figure for Russia was 8.8%; for Belarus, 10.1%.
According to a Nobel Laureate economist, Joseph Stiglitz, Kazakhstan softened the impacts of the Russian crisis of 1998, because the National Bank of Kazakhstan was more independent politically than the Bank of Russia had been (Kasera and Katz, 2007). The NBK was willing to devalue the tenge in 1999, even though this move may have been unpopular.
Alexander Baranov, of the investment consulting firm North Capital, argues that the immediate devaluation in Kazakhstan in February 2009 was a better policy than the gradual devaluation of the Russian ruble in January 2009. The overall devaluation of the tenge was milder than that of the ruble (which amounted to 40%), so inflation in Kazakhstan was milder during 2009 than in Russia. Also, the positive effects of the Russian devaluation were partly reversed by the appreciation of the ruble in the second half of 2009.
Historical differences in monetary policies can make it difficult for countries to agree on one policy. Furthermore, the effects of the common monetary policy required by the common currency may vary with the country. Given no substantial change in government fiscal policy of any union member, it may be hard for a common monetary policy to always benefit every member.
Analogy of the European Union: The case of Greece
In 1950, Robert Schuman, Minister of Foreign Affairs of France, proposed the European Coal and Steel Community as an economic means to prevent another war between Germany and France. Later, in 1957, the Treaty of Rome established the European Economic Community, which eliminated trade barriers among the member states and thus formed a customs union. The Treaty of Maastricht of 1992 extended and enforced policies common to member states beyond economic policy. The introduction of the euro in 1999 integrated monetary policies of member states.
The removal of trade barriers was welcomed by many economists. However, introducing the euro brought about many controversies. A single currency hinders a nation’s ability to adjust to new economic conditions. It may lead to excessive unemployment in many regions, as well as trade deficits and surpluses. Having a fixed exchange rate and interest rate between the member states removes an important signal to alter economic policy. If a country has to cut spending or raise taxes, it can no longer mitigate the injury to GDP through devaluation.
Also, some countries may face unexpected real estate bubbles, since the common monetary policy may disregard local economic conditions, thus resulting in abnormally low interest rates. Martin Feldstein, of Harvard University, argues that this occurred in Spain and Ireland.
The leaders of the EU member states had neglected the possibility of such effects, being more interested in a political union. Due to the global financial crisis and fiscal deficits in many member states, however, the European Union is facing a recession. Its effects are especially severe in Greece, with a fiscal deficit of 14% of its GDP. Greece has had to accept debt from the International Monetary Fund and other EU member states on burdensome conditions. Reduction of the fiscal deficit will cause the economy of Greece to plunge further. As a member of the eurozone, Greece will not be able to offset the recession by devaluing its currency.
Many have suggested that Greece and some other member states may have to leave the eurozone. Feldstein argues that the adverse effects of having Greece leave the eurozone would be small. They could be offset by the option of devaluation and by autonomy in monetary policy. Greece’s national income in euros would decrease, but this would not be relevant. The most damaging consequence of the devaluation would be an increase in import prices, which seems manageable.
Charles Wyplosz, Professor of International Economics of the Graduate Institute of Geneva, argues that leaving the eurozone and returning to Greece’s original currency would be more costly than beneficial for Greece. Though depreciation can help in the middle of a recession, it can also be harmful when all obligations are set in foreign currencies, which would be the case for Greece. Also, the euro has already fallen by 20% in the past year; Greece too would receive part of the benefits of this depreciation without incurring an increase in its financial obligations.
Furthermore, Wyplosz believes that the European Central Bank has been more independent from political pressures than the central banks of member states had been. Finally, because the member states have no option of devaluing their currency, they are more inclined to install supply-side measures to correct their policies, as is the case with Spain and Greece. Supply-side measures can enhance economic growth by strengthening an economy’s ability to produce.
As members of a customs union, Russia, Kazakhstan, and Belarus are different from the European Union in several ways. These economies are much smaller on average, which will affect the benefits and costs of the union. Although the union has only three members at present, a few very small economies may join it and the common currency area someday. Tajikistan and Kyrgyzstan both have close ties to Russia. Their leaders may seek membership in the customs union as a means to appeal to the pro-Russian attitudes of the population, as well as in hope of strengthening relations in other areas such as defense. For Kyrgyzstan, however, the move may prove to be more difficult than for Tajikistan, since it belongs to the World Trade Organization (WTO). Similarly, many Eastern European countries had applied for membership in the European Union, not only to gain economic benefits but also to appeal to the pro-western attitudes of their populations.
Russia, on its part, may be willing to accept Tajikistan and Kyrgyzstan in the union, both to appeal to the nostalgic pro-Soviet feelings of its people and to facilitate migration of cheap labor from these countries. The latter policy may be popular among the people of Kyrgyzstan and Tajikistan as well, since many families will be able to live on remittances from working in Kazakhstan or Russia.
The European Union proved to be a mixed blessing for new member states. On the positive side, Eastern European workers gained the right to migrate in search of jobs without restrictions. The impact on foreign exchange currency, however, has often been far from desirable. For example, Weisbrot and Ray (2009) argue that because Latvia pegged the exchange rate of its currency to the overvalued euro, it faced a more severe recession than it could have otherwise. As a member of the EU, Latvia was inclined to keep the exchange rate of its currency to the euro fixed, even though allowing it to depreciate could have smoothed the effects of the recession. If they join the union in the absence of a common currency, Kyrgyzstan and Tajikistan may be inclined to peg their currencies to the ruble or tenge. If a common currency is established, all member states will lose the option of devaluation.
Furthermore, while Greece, being a comparatively developed economy, can afford to withdraw from the European Union or the eurozone, small economies, such as Tajikistan and Kyrgyzstan, may become too dependent on the union or the common currency zone to afford such withdrawal. Neither can these countries expect to receive loans at a reasonably low rate of interest from other members of the customs union.
Membership in the European Union required member states to adopt a policy of reasonably low inflation. It is doubtful that the members of the customs union can set the same requirements for each other, having historically been unstable. Neither can they guarantee that the central bank of the Union will be any less dependent on political pressures than their national central banks. While the Central Bank of Europe is inclined to be comparatively unbiased -- since the EU includes many large economies of Western Europe, with conflicting interests -- this will not be the case for the prospective unified central bank. Rather, the interests of larger members will prevail over those of smaller members.
The benefits from depreciating or devaluing the common currency of the customs union may be undermined by trade diversion. Member states may prefer to export within the union, rather than outside of it, so their exporters may be unaffected. Only if these countries join the WTO may such benefits be realized fully. This, however, can make it more difficult for the central bank to intervene in the foreign exchange market in favor of exporters or importers, since it would have to consider too many conflicting interests. The central bank may have to allow the currency to float and face all the subsequent advantages and disadvantages. In this case, it is especially important to develop the market of financial derivatives, to enable investors to hedge against foreign exchange and interest rate risks. This may be difficult given the current absence of financial transparency.
To sum up, although the customs union of Russia, Kazakhstan, and Belarus will bring the member states the benefits of economic integration, its costs and especially the costs of a common currency may be even higher than those of the European Union.
Expected effects of the customs union on monetary policy and GDP growth in Kazakhstan
Joining the union may increase Kazakhstan’s propensity to import inflation – particularly if Russia dominates the union’s monetary policy, as it undoubtedly will. Opportunities for Kazakhstani producers to take advantage of new markets immediately will be hindered by any economic event that reduces the purchasing power of Russians and Belarusians. Furthermore, producers in Kazakhstan must strengthen their reputation among these consumers. Trade conflicts between Russia and Kazakhstan may hurt producers in Kazakhstan the most, since they have a larger market to lose.
On the other hand, some Kazakh producers may take advantage of weak competition from companies in Russia and Belarus – weaker, at any rate, than would have occurred in the absence of a crisis.
Political factors
In spite of the economic drawbacks of joining the customs union, the Kazakhstani government may enjoy political benefits. Increasing ties with Russia is popular because of nostalgia for the Soviet Union – particularly when political instability in Kyrgyzstan threatens to spread. Also, maintaining strong economic ties with Russia may strengthen political and military ties. This can help Astana deal with such issues as terrorism and security.
Even so many Kazakhs fear that the customs union threatens Kazakhstan’s independence. Opposition leaders Mukhtar Shakhanov, Bulat Abilov, and Vladimir Kozlov warned Nazarbayev that joining the union is the “beginning of [the] end of the country’s independent existence.” A common currency may strengthen nationalistic feelings in Kazakhstan.
Conclusions
Though the customs union and a common currency would increase trade among Russia, Kazakhstan and Belarus, it will hurt consumers of imports from outside the union. The immediate benefits to Kazakh exporters from joining the customs union are small, since the purchasing power of Russian customers, both businesses and consumers, may not recover from the global financial crisis for a long time. The union and particularly the common currency may increase Kazakhstan’s penchant to import inflation from Russia and Belarus. Finally, developing a monetary policy that would benefit each of the three countries would be difficult.
The notion of increasing economic and political ties with Russia is popular in Kazakhstan, primarily because of Soviet nostalgia. Nevertheless, these feelings may be overshadowed by Kazakhstani nationalism. – Dmitriy Belyanin, belyanin8@gmail.com.
Dmitriy Belyanin is completing his MBA degree at KIMEP. He has written many articles about financial economics in Kazakhstan.
References
Åslund, A. (2009) “Control inflation, not exchange rates.” Moscow Times. Retrieved March 5, 2010 from http://www.iie.com/publications/sendform.cfm?researchid=1287
Baranov, A. (2009) “Devaluation of the tenge: Kazakhstan chose a non-Russian path.” Retrieved February 10, 2009 from http://www.ncapital.ru/analytic/2009/1019/
Bergman, P. (2010) “Expecting invasion for three years.” Vox Populi Magazine. April 16-30 p. 30-32.
Encyclopedia of the nations (2001) “Belarus – money.” Encyclopedia of the Nations. Retrieved April 27, 2010 from http://www.nationsencyclopedia.com/economies/Europe/Belarus-MONEY.htm
Europa (2007) “Europa: Summaries of EU legislation.” Retrieved June 4, 2010 from http://europa.eu/legislation_summaries/economic_and_monetary_affairs/institutional_and_economic_framework/treaties_maastricht_en.htm
European Central Bank. (2010) “European Central Bank: The euro.” Retrieved June 4, 2010 from http://www.ecb.int/euro/html/index.en.html
Feldstein, M. and Wyplosz, C. (2010) “Economist debates: Euro.” The Economist. Retrieved June 4, 2010 from http://www.economist.com/debate/debates/overview/174?source=hptextfeature&source=features_box3
IMF World Economic Outlook Database. (2010) “Report for selected countries and subjects.” International Monetary Fund. April. Retrieved April 25 from http://www.imf.org/external/pubs/ft/weo/2009/02/data/index.htm7.
Kasera, S. and Katz, B. (2007) “Kazakhstan: Economic policies before and after the 1998 Russian Financial Crisis.” http://www.cs.nyu.edu/~sk1759/Kazakhstan.pdf
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Weisbrot, M. and Ray, R. (2010). “Latvia’s recession: The cost of adjustment with an ‘internal devaluation.’” Center for Economic and Policy Research, Washington, D.C.
Would Kazakhstan gain from a regional currency? Dmitriy Belyanin totes up the pluses and minuses
Introduction
On January 1, Russia, Kazakhstan, and Belarus entered a regional trading agreement. This would abolish tariffs among these countries and to establish common tariffs towards non-members. Controversially, the union someday may introduce a common currency. Let’s look at the pros and cons of doing so.
History of the customs union
The Union of Soviet Socialist Republics had sought to make its members dependent on one another – and most of all on Russia. The habit of dependence contributed to the severity of the recession caused by the Union’s collapse, so governments were pressed to sustain old economic ties.
On the other hand, independence of the former Soviet republics led to an increase in imports from outside the region of the Commonwealth of Independent States (CIS). East Asian and European countries have been among major trading partners of CIS countries. Some of the latter, such as Turkmenistan, attempted self-sufficiency but succeeded only in aggravating their economic problems.
On April 2, 1996, Russia and Belarus formed a union aimed at economic integration. But bickering hindered proposals of a common currency. In June 2009, Russia banned 500 types of dairy products and meat from two plants in Belarus, costing the small trading partner $1 billion.
Kazakhstan too has traded heavily with Russia. About 98% of grain imports into Russia come from Kazakhstan. Russia exports many manufactured products, such as detergents, into Kazakhstan.
The global financial crisis of 2008-09 compelled the three nations to try to enlarge markets and lower costs, especially through economic integration. Talks toward these goals were accelerated by doubts that the dollar would survive as the world reserve currency. The president of Kazakhstan, Nursultan Nazarbayev, proposed a new world reserve currency as well as a regional one, but he admitted that the former would take too much time.
On January 1, the three countries formally agreed to adopt a common customs code by July 1. Igor Shuvalov, deputy prime minister of Russia, proposed a common currency. I turn to the controversies circumjacent to this plan.
How the customs union may help its member states
Now exporters in the union can sell to a combined market of 170 million people, more than 10 times larger than Kazakhstan’s domestic market. In 2008, the three countries had a combined gross domestic product of just under 2 trillion US dollars, 90% of that from Russia, according to the World Bank.
As Adam Smith pointed out more than two centuries ago, an expansion of the market – such as the union makes possible – can make firms more productive. In many industries, producing more reduces average cost, since workers learn by doing and since high rates of manufacturing justify the substitution of machines for costly labor. One modern example is aircraft manufacturing.
The union may also increase government revenues of Kazakhstan and Belarus, via two sources: Expected corporate income from trading within the union; and higher tariffs on non-members.
Local import-competing producers in each country may benefit from higher tariffs if they rely primarily on locally produced raw materials. This may help diversify the home economy. Diversification is critical for Kazakhstan’s economy, which now depends heavily on export of raw materials. Belarus and especially Russia have had stiff trade barriers since long before the union pact was arranged, so the agreement will not affect them as strongly in this regard.
Drawbacks of the customs union
Consumers of goods imported from outside the union may have to pay more (“trade diversion”). In the first quarter of 2010 alone, Kazakhstanis imported more than $1 billion of Chinese goods, according to Saltanat Iskakova, a KIMEP MBA student who has been researching trade issues. Higher tariffs will also hurt some arbitragers who ship goods to Kazakhstan from outside the customs union. Retail stores may be harmed as well.
Also, import-competing producers from Kazakhstan may be unable to compete with those from Russia and Belarus, which both have more diversified economies. The customs union may thus retard diversification of the economy of Kazakhstan.
Finally, states belonging to the customs union must coordinate their monetary policies, which varied drastically before the financial crisis of 2008. It has been proposed that these countries adopt a common currency.
Benefits of a common currency for union members
A common currency would ease trade among the member states by avoiding some costs and risks of foreign exchange. The eurozone may be an appealing example. Also, a regional currency may partially replace the dollar and decrease dependence on the monetary policy of the United States.
Nevertheless, in my opinion, these benefits of a common currency are more than out-weighed by the disadvantages.
Differences among monetary policies of member states
Each country belonging to the customs union has a monetary policy that had succeeded to varying degrees. The common currency will eliminate national autonomy in monetary policy. What harm might result?
First, the central bank can no longer act in the national interest. As the 1998 and 2008 crises made clear, global events affect national economies in varying ways, requiring varying responses. During the late 1990s, of the three union members, Belarus had the highest inflation -- 251% in 1999, according to staff estimates of the International Monetary Fund. The Belarusian ruble weakened sharply. The government of Belarus tried to control food prices; but this resulted in shortages, since an arbitrary fall in price stimulates demand and discourages supply. Later, in early 2009, the Belarusian ruble fell again, due to failing Russian demand for its goods. On the positive side, Belarus retained the real sector of the economy, primarily via protectionism and subsidies.
In contrast, the economy of Russia has been more market-oriented, and its external trade has been more diversified. Its inflation in 1998 and 1999 was lower than that of Belarus – perhaps because the Bank of Russia was more independent politically than its counterpart in Minsk. Nevertheless, political risks in Russia remain high. Terrorist acts, expropriation of corporate assets by the state, and the lack of financial transparency contribute to business risks there.
In 2009, Russia devalued the ruble gradually. According to Anders Åslund (2009), this devaluation helped reduce real GDP by over 10% in the first half of 2009, since it drained international reserves and increased defaults on loans. In general, devaluations eventually propel exports by reducing their prices, but customers need time to adjust.
The economy of Kazakhstan is smaller than that of either of the union partners, and it depends heavily on the export of raw materials. But Kazakhstan’s economy has been more stable, and it performed better during both crises, than its two counterparts. According to government statistics, Kazakhstan’s economy grew in 1998 and 1999 as well as in the current global financial crisis to date. Inflation in Kazakhstan was rampant in 2007 but stabilized in 2008. Though the 25% devaluation of the tenge in February 2009 did contribute to rising food prices that year, the concurrent decline in aggregate demand restrained inflation, which peaked at 7.3% in 2009. The figure for Russia was 8.8%; for Belarus, 10.1%.
According to a Nobel Laureate economist, Joseph Stiglitz, Kazakhstan softened the impacts of the Russian crisis of 1998, because the National Bank of Kazakhstan was more independent politically than the Bank of Russia had been (Kasera and Katz, 2007). The NBK was willing to devalue the tenge in 1999, even though this move may have been unpopular.
Alexander Baranov, of the investment consulting firm North Capital, argues that the immediate devaluation in Kazakhstan in February 2009 was a better policy than the gradual devaluation of the Russian ruble in January 2009. The overall devaluation of the tenge was milder than that of the ruble (which amounted to 40%), so inflation in Kazakhstan was milder during 2009 than in Russia. Also, the positive effects of the Russian devaluation were partly reversed by the appreciation of the ruble in the second half of 2009.
Historical differences in monetary policies can make it difficult for countries to agree on one policy. Furthermore, the effects of the common monetary policy required by the common currency may vary with the country. Given no substantial change in government fiscal policy of any union member, it may be hard for a common monetary policy to always benefit every member.
Analogy of the European Union: The case of Greece
In 1950, Robert Schuman, Minister of Foreign Affairs of France, proposed the European Coal and Steel Community as an economic means to prevent another war between Germany and France. Later, in 1957, the Treaty of Rome established the European Economic Community, which eliminated trade barriers among the member states and thus formed a customs union. The Treaty of Maastricht of 1992 extended and enforced policies common to member states beyond economic policy. The introduction of the euro in 1999 integrated monetary policies of member states.
The removal of trade barriers was welcomed by many economists. However, introducing the euro brought about many controversies. A single currency hinders a nation’s ability to adjust to new economic conditions. It may lead to excessive unemployment in many regions, as well as trade deficits and surpluses. Having a fixed exchange rate and interest rate between the member states removes an important signal to alter economic policy. If a country has to cut spending or raise taxes, it can no longer mitigate the injury to GDP through devaluation.
Also, some countries may face unexpected real estate bubbles, since the common monetary policy may disregard local economic conditions, thus resulting in abnormally low interest rates. Martin Feldstein, of Harvard University, argues that this occurred in Spain and Ireland.
The leaders of the EU member states had neglected the possibility of such effects, being more interested in a political union. Due to the global financial crisis and fiscal deficits in many member states, however, the European Union is facing a recession. Its effects are especially severe in Greece, with a fiscal deficit of 14% of its GDP. Greece has had to accept debt from the International Monetary Fund and other EU member states on burdensome conditions. Reduction of the fiscal deficit will cause the economy of Greece to plunge further. As a member of the eurozone, Greece will not be able to offset the recession by devaluing its currency.
Many have suggested that Greece and some other member states may have to leave the eurozone. Feldstein argues that the adverse effects of having Greece leave the eurozone would be small. They could be offset by the option of devaluation and by autonomy in monetary policy. Greece’s national income in euros would decrease, but this would not be relevant. The most damaging consequence of the devaluation would be an increase in import prices, which seems manageable.
Charles Wyplosz, Professor of International Economics of the Graduate Institute of Geneva, argues that leaving the eurozone and returning to Greece’s original currency would be more costly than beneficial for Greece. Though depreciation can help in the middle of a recession, it can also be harmful when all obligations are set in foreign currencies, which would be the case for Greece. Also, the euro has already fallen by 20% in the past year; Greece too would receive part of the benefits of this depreciation without incurring an increase in its financial obligations.
Furthermore, Wyplosz believes that the European Central Bank has been more independent from political pressures than the central banks of member states had been. Finally, because the member states have no option of devaluing their currency, they are more inclined to install supply-side measures to correct their policies, as is the case with Spain and Greece. Supply-side measures can enhance economic growth by strengthening an economy’s ability to produce.
As members of a customs union, Russia, Kazakhstan, and Belarus are different from the European Union in several ways. These economies are much smaller on average, which will affect the benefits and costs of the union. Although the union has only three members at present, a few very small economies may join it and the common currency area someday. Tajikistan and Kyrgyzstan both have close ties to Russia. Their leaders may seek membership in the customs union as a means to appeal to the pro-Russian attitudes of the population, as well as in hope of strengthening relations in other areas such as defense. For Kyrgyzstan, however, the move may prove to be more difficult than for Tajikistan, since it belongs to the World Trade Organization (WTO). Similarly, many Eastern European countries had applied for membership in the European Union, not only to gain economic benefits but also to appeal to the pro-western attitudes of their populations.
Russia, on its part, may be willing to accept Tajikistan and Kyrgyzstan in the union, both to appeal to the nostalgic pro-Soviet feelings of its people and to facilitate migration of cheap labor from these countries. The latter policy may be popular among the people of Kyrgyzstan and Tajikistan as well, since many families will be able to live on remittances from working in Kazakhstan or Russia.
The European Union proved to be a mixed blessing for new member states. On the positive side, Eastern European workers gained the right to migrate in search of jobs without restrictions. The impact on foreign exchange currency, however, has often been far from desirable. For example, Weisbrot and Ray (2009) argue that because Latvia pegged the exchange rate of its currency to the overvalued euro, it faced a more severe recession than it could have otherwise. As a member of the EU, Latvia was inclined to keep the exchange rate of its currency to the euro fixed, even though allowing it to depreciate could have smoothed the effects of the recession. If they join the union in the absence of a common currency, Kyrgyzstan and Tajikistan may be inclined to peg their currencies to the ruble or tenge. If a common currency is established, all member states will lose the option of devaluation.
Furthermore, while Greece, being a comparatively developed economy, can afford to withdraw from the European Union or the eurozone, small economies, such as Tajikistan and Kyrgyzstan, may become too dependent on the union or the common currency zone to afford such withdrawal. Neither can these countries expect to receive loans at a reasonably low rate of interest from other members of the customs union.
Membership in the European Union required member states to adopt a policy of reasonably low inflation. It is doubtful that the members of the customs union can set the same requirements for each other, having historically been unstable. Neither can they guarantee that the central bank of the Union will be any less dependent on political pressures than their national central banks. While the Central Bank of Europe is inclined to be comparatively unbiased -- since the EU includes many large economies of Western Europe, with conflicting interests -- this will not be the case for the prospective unified central bank. Rather, the interests of larger members will prevail over those of smaller members.
The benefits from depreciating or devaluing the common currency of the customs union may be undermined by trade diversion. Member states may prefer to export within the union, rather than outside of it, so their exporters may be unaffected. Only if these countries join the WTO may such benefits be realized fully. This, however, can make it more difficult for the central bank to intervene in the foreign exchange market in favor of exporters or importers, since it would have to consider too many conflicting interests. The central bank may have to allow the currency to float and face all the subsequent advantages and disadvantages. In this case, it is especially important to develop the market of financial derivatives, to enable investors to hedge against foreign exchange and interest rate risks. This may be difficult given the current absence of financial transparency.
To sum up, although the customs union of Russia, Kazakhstan, and Belarus will bring the member states the benefits of economic integration, its costs and especially the costs of a common currency may be even higher than those of the European Union.
Expected effects of the customs union on monetary policy and GDP growth in Kazakhstan
Joining the union may increase Kazakhstan’s propensity to import inflation – particularly if Russia dominates the union’s monetary policy, as it undoubtedly will. Opportunities for Kazakhstani producers to take advantage of new markets immediately will be hindered by any economic event that reduces the purchasing power of Russians and Belarusians. Furthermore, producers in Kazakhstan must strengthen their reputation among these consumers. Trade conflicts between Russia and Kazakhstan may hurt producers in Kazakhstan the most, since they have a larger market to lose.
On the other hand, some Kazakh producers may take advantage of weak competition from companies in Russia and Belarus – weaker, at any rate, than would have occurred in the absence of a crisis.
Political factors
In spite of the economic drawbacks of joining the customs union, the Kazakhstani government may enjoy political benefits. Increasing ties with Russia is popular because of nostalgia for the Soviet Union – particularly when political instability in Kyrgyzstan threatens to spread. Also, maintaining strong economic ties with Russia may strengthen political and military ties. This can help Astana deal with such issues as terrorism and security.
Even so many Kazakhs fear that the customs union threatens Kazakhstan’s independence. Opposition leaders Mukhtar Shakhanov, Bulat Abilov, and Vladimir Kozlov warned Nazarbayev that joining the union is the “beginning of [the] end of the country’s independent existence.” A common currency may strengthen nationalistic feelings in Kazakhstan.
Conclusions
Though the customs union and a common currency would increase trade among Russia, Kazakhstan and Belarus, it will hurt consumers of imports from outside the union. The immediate benefits to Kazakh exporters from joining the customs union are small, since the purchasing power of Russian customers, both businesses and consumers, may not recover from the global financial crisis for a long time. The union and particularly the common currency may increase Kazakhstan’s penchant to import inflation from Russia and Belarus. Finally, developing a monetary policy that would benefit each of the three countries would be difficult.
The notion of increasing economic and political ties with Russia is popular in Kazakhstan, primarily because of Soviet nostalgia. Nevertheless, these feelings may be overshadowed by Kazakhstani nationalism. – Dmitriy Belyanin, belyanin8@gmail.com.
Dmitriy Belyanin is completing his MBA degree at KIMEP. He has written many articles about financial economics in Kazakhstan.
References
Åslund, A. (2009) “Control inflation, not exchange rates.” Moscow Times. Retrieved March 5, 2010 from http://www.iie.com/publications/sendform.cfm?researchid=1287
Baranov, A. (2009) “Devaluation of the tenge: Kazakhstan chose a non-Russian path.” Retrieved February 10, 2009 from http://www.ncapital.ru/analytic/2009/1019/
Bergman, P. (2010) “Expecting invasion for three years.” Vox Populi Magazine. April 16-30 p. 30-32.
Encyclopedia of the nations (2001) “Belarus – money.” Encyclopedia of the Nations. Retrieved April 27, 2010 from http://www.nationsencyclopedia.com/economies/Europe/Belarus-MONEY.htm
Europa (2007) “Europa: Summaries of EU legislation.” Retrieved June 4, 2010 from http://europa.eu/legislation_summaries/economic_and_monetary_affairs/institutional_and_economic_framework/treaties_maastricht_en.htm
European Central Bank. (2010) “European Central Bank: The euro.” Retrieved June 4, 2010 from http://www.ecb.int/euro/html/index.en.html
Feldstein, M. and Wyplosz, C. (2010) “Economist debates: Euro.” The Economist. Retrieved June 4, 2010 from http://www.economist.com/debate/debates/overview/174?source=hptextfeature&source=features_box3
IMF World Economic Outlook Database. (2010) “Report for selected countries and subjects.” International Monetary Fund. April. Retrieved April 25 from http://www.imf.org/external/pubs/ft/weo/2009/02/data/index.htm7.
Kasera, S. and Katz, B. (2007) “Kazakhstan: Economic policies before and after the 1998 Russian Financial Crisis.” http://www.cs.nyu.edu/~sk1759/Kazakhstan.pdf
Silitski, Vitali. (2009) “The milk spilt by the Milk War.” European Voice.com. http://www.europeanvoice.com/article/2009/06/the-milk-split-by-the-milk-war/65274.aspx
Weisbrot, M. and Ray, R. (2010). “Latvia’s recession: The cost of adjustment with an ‘internal devaluation.’” Center for Economic and Policy Research, Washington, D.C.
Sunday, June 6, 2010
Should Tajikistan fix its exchange rate?
Zafar Davronov looks at what the classics of economics can tell us
Few countries are as vulnerable to a global downturn as Tajikistan. With a daily income per capita of $1.50, households have no savings to draw upon in order to make up for the 30% loss in 2008 remittances from migrants. These had been half of the nation’s income. For an extra dose of salt to the wound, world prices collapsed in the last quarter of 2008 for Tajikistan’s main export commodities, cotton and aluminum. Export revenues fell more than 60% after early 2008.
By late 2009, these prices had regained lost ground, thanks to a China-led regional recovery. But Tajikistan remains in a long-run predicament – relatively small gains in a small income; small, even without adjustments for domestic inflation.
The declines in demand for export labor and commodities eviscerated demand for Tajikistan’s currency. The somoni had nowhere to go but down. It lost a fourth of its dollar value in less than a year.
The central bank of Tajikistan had to go along for the ride. It could not afford to spend all of its dollars and euros to defend an overvalued somoni, so it let the currency crash.
That was in 2008. Maybe things have changed. Tajikistan could steal a page from the Chinese playbook, undervaluing its somoni to boost sales of cotton, aluminum and labor to its booming eastern neighbor. This step may seem too small to matter much. But Tajikistan’s economy is tiny, generating $5 billion of output each year, less than 4% as much as does Kazakhstan’s. Every bit helps. The 64-somoni question is: Should the National Bank of Tajikistan again fix its exchange rate?
One way to answer the question is to see where a flexible somoni would lead us. Only a few decades ago, economists would have had to struggle to answer this question; they were accustomed to thinking of the national economy as isolated from the rest of the world. John Maynard Keynes assumed a closed economy in his General theory of employment, interest and money. So did John Hicks in his mathematical restatement of Keynes’ book. At the time – the mid-Thirties – assuming a closed economy seemed reasonable, since European nations and the United States had erected high protectionist walls against imports during the interwar depression.
After World War II, international trade revived, conspicuously stimulating national economies to grow. Economists began incorporating trade into their national models. Among the most successful were Robert Mundell, who won the Nobel Prize for economics in 1999, and John Marcus Fleming. What can their model tell us about Tajikistan, given a flexible rate of exchange?
Since Tajikistan is minuscule in the world economy, the latter will determine the somoni’s exchange rate. But Tajikistan still controls the supply of somoni. Can its National Bank manipulate this supply in order to boost national income?
Well, income depends on the two sectors of the national economy: One provides goods, and the other provides somoni for producing and buying those goods. The second sector is controlled largely by the National Bank.
Of course, households and banks also affect the supply of somoni, since they decide whether to spend or lend the money – returning it to the economy for further use – or instead to stash it in the sock drawer until better times return. But the National Bank can shape these private decisions. It can create more somoni for private banks to lend out. To attract new borrowers, banks will cut their interest rates. Firms and households will borrow and spend the new money. National income will increase. That, at least, is the usual story told by newspapers.
Mundell and Fleming pointed out the problem with this story: World money markets will fix the rate of interest. Suppose that the interest rate is 5% in Tajikistan and 10% elsewhere. Then speculators will borrow somoni from Tajikistani banks, paying only 5%, and exchange them for dollars in order to buy assets in other countries, earning 10%. That’s a hefty profit. To get a piece of the action in this “carry trade,” Tajikistani banks can and will raise their own interest rates, all the way to 10%.
But suppose, absurdly, that the banks are slow to react. Then arbitrage will continue. Demand for somoni will keep falling, and the somoni will keep depreciating, until domestic prices rise enough to soak up the excess supply of currency.
In short, the central bank of Tajikistan can’t resuscitate the national economy permanently with an adrenalin shot of low interest rates, if it is also intent on a low price level.
The remaining possibility is that the new somoni might increase demand for Tajikistani goods directly, whatever the interest rate. Conceivably, enough new money will tempt timid households and entrepreneurs into spending again. But this psychological argument has a problem: We can’t read spenders’ minds.
It seems that we can’t rely on the National Bank to nurse Tajikistan’s economy to recovery when the somoni’s exchange rate is flexible, if the bank also wishes to avoid inflation. What if we fix that exchange rate?
In a sense, this may cramp the Bank’s style even more than before. Suppose that it sets the exchange rate at 10 somoni for a U.S. dollar. Now, for some reason, the exchange rate on the street strengthens to 5 somoni for $1. (That is, each somoni can buy twice more of a dollar than before.) To return to the exchange rate of 10 somoni, the National Bank must weaken its currency and strengthen the dollar. It must sell somoni and buy bucks. The supply of somoni will increase, eventually raising Tajikistani prices. In short, the National Bank can’t set simultaneously the exchange rate and the domestic price level.
The point has practical importance. Although Tajikistan no longer suffers from Nineties-style hyperinflation), its prices remain dicey, even by Central Asian standards. Such unpredictable inflation can lead producers and consumers into costly errors. A farmer, ebullient over a sudden surge in cotton prices, may double his sowing – only to discover after the harvest that the price surge was just a harbinger of general inflation. Relative demand for cotton hadn’t risen, after all. Instead, the inflation will now boost such input prices as harvest wages. The farmer’s expected profits will erode.
Here’s the problem: As a small, struggling economy, dependent on world trade, Tajikistan needs low domestic prices, lots of foreign money, and a reliable exchange rate. There is no way that the National Bank can deliver all three conditions. That’s what Mundell pointed out. The best that the Bank can do is to determine the condition that the nation can live without – and try to attain the other two. -- Zafar Davronov and Leon Taylor
Zafar Davronov is a student in KIMEP’s MBA program. His interests include Central Asian economics and finance.
Good reading
John Hicks. Mr. Keynes and the ‘Classics’: A suggested interpretation. Econometrica 5, April 1937, pages 147-159. This introduced the IS-LM model as a graphical version of Keynes’ General theory.
John Maynard Keynes. The general theory of employment, interest and money. London: Macmillan, 1936. Keynes’ revision of an earlier, unsuccessful work, A treatise on money (1930), emphasizes how uncertainty affects real investment and money demand.
R. A. Mundell. Capital mobility and stabilization policy under fixed and flexible exchange rates. The Canadian Journal of Economics and Political Science 29: 4, November 1963, pages 475-485. A fun-to-read classic.
Andrew K. Rose. 2000. A review of some of the economic contributions of Robert A. Mundell, winner of the 1999 Nobel Memorial Prize in Economics. Scandinavian Journal of Economics 102: 2, June 2000, pages 211-222. Online at http://faculty.haas.berkeley.edu/arose/Mundell.pdf. An informative survey.
The World Bank. 2009. Global commodity markets: Review and price forecast. Online at http://siteresources.worldbank.org/EXTDECPROSPECTS/Resources/476882-1253048544063/GCM2009Sep.pdf . Pithy summaries of major markets.
Zafar Davronov looks at what the classics of economics can tell us
Few countries are as vulnerable to a global downturn as Tajikistan. With a daily income per capita of $1.50, households have no savings to draw upon in order to make up for the 30% loss in 2008 remittances from migrants. These had been half of the nation’s income. For an extra dose of salt to the wound, world prices collapsed in the last quarter of 2008 for Tajikistan’s main export commodities, cotton and aluminum. Export revenues fell more than 60% after early 2008.
By late 2009, these prices had regained lost ground, thanks to a China-led regional recovery. But Tajikistan remains in a long-run predicament – relatively small gains in a small income; small, even without adjustments for domestic inflation.
The declines in demand for export labor and commodities eviscerated demand for Tajikistan’s currency. The somoni had nowhere to go but down. It lost a fourth of its dollar value in less than a year.
The central bank of Tajikistan had to go along for the ride. It could not afford to spend all of its dollars and euros to defend an overvalued somoni, so it let the currency crash.
That was in 2008. Maybe things have changed. Tajikistan could steal a page from the Chinese playbook, undervaluing its somoni to boost sales of cotton, aluminum and labor to its booming eastern neighbor. This step may seem too small to matter much. But Tajikistan’s economy is tiny, generating $5 billion of output each year, less than 4% as much as does Kazakhstan’s. Every bit helps. The 64-somoni question is: Should the National Bank of Tajikistan again fix its exchange rate?
One way to answer the question is to see where a flexible somoni would lead us. Only a few decades ago, economists would have had to struggle to answer this question; they were accustomed to thinking of the national economy as isolated from the rest of the world. John Maynard Keynes assumed a closed economy in his General theory of employment, interest and money. So did John Hicks in his mathematical restatement of Keynes’ book. At the time – the mid-Thirties – assuming a closed economy seemed reasonable, since European nations and the United States had erected high protectionist walls against imports during the interwar depression.
After World War II, international trade revived, conspicuously stimulating national economies to grow. Economists began incorporating trade into their national models. Among the most successful were Robert Mundell, who won the Nobel Prize for economics in 1999, and John Marcus Fleming. What can their model tell us about Tajikistan, given a flexible rate of exchange?
Since Tajikistan is minuscule in the world economy, the latter will determine the somoni’s exchange rate. But Tajikistan still controls the supply of somoni. Can its National Bank manipulate this supply in order to boost national income?
Well, income depends on the two sectors of the national economy: One provides goods, and the other provides somoni for producing and buying those goods. The second sector is controlled largely by the National Bank.
Of course, households and banks also affect the supply of somoni, since they decide whether to spend or lend the money – returning it to the economy for further use – or instead to stash it in the sock drawer until better times return. But the National Bank can shape these private decisions. It can create more somoni for private banks to lend out. To attract new borrowers, banks will cut their interest rates. Firms and households will borrow and spend the new money. National income will increase. That, at least, is the usual story told by newspapers.
Mundell and Fleming pointed out the problem with this story: World money markets will fix the rate of interest. Suppose that the interest rate is 5% in Tajikistan and 10% elsewhere. Then speculators will borrow somoni from Tajikistani banks, paying only 5%, and exchange them for dollars in order to buy assets in other countries, earning 10%. That’s a hefty profit. To get a piece of the action in this “carry trade,” Tajikistani banks can and will raise their own interest rates, all the way to 10%.
But suppose, absurdly, that the banks are slow to react. Then arbitrage will continue. Demand for somoni will keep falling, and the somoni will keep depreciating, until domestic prices rise enough to soak up the excess supply of currency.
In short, the central bank of Tajikistan can’t resuscitate the national economy permanently with an adrenalin shot of low interest rates, if it is also intent on a low price level.
The remaining possibility is that the new somoni might increase demand for Tajikistani goods directly, whatever the interest rate. Conceivably, enough new money will tempt timid households and entrepreneurs into spending again. But this psychological argument has a problem: We can’t read spenders’ minds.
It seems that we can’t rely on the National Bank to nurse Tajikistan’s economy to recovery when the somoni’s exchange rate is flexible, if the bank also wishes to avoid inflation. What if we fix that exchange rate?
In a sense, this may cramp the Bank’s style even more than before. Suppose that it sets the exchange rate at 10 somoni for a U.S. dollar. Now, for some reason, the exchange rate on the street strengthens to 5 somoni for $1. (That is, each somoni can buy twice more of a dollar than before.) To return to the exchange rate of 10 somoni, the National Bank must weaken its currency and strengthen the dollar. It must sell somoni and buy bucks. The supply of somoni will increase, eventually raising Tajikistani prices. In short, the National Bank can’t set simultaneously the exchange rate and the domestic price level.
The point has practical importance. Although Tajikistan no longer suffers from Nineties-style hyperinflation), its prices remain dicey, even by Central Asian standards. Such unpredictable inflation can lead producers and consumers into costly errors. A farmer, ebullient over a sudden surge in cotton prices, may double his sowing – only to discover after the harvest that the price surge was just a harbinger of general inflation. Relative demand for cotton hadn’t risen, after all. Instead, the inflation will now boost such input prices as harvest wages. The farmer’s expected profits will erode.
Here’s the problem: As a small, struggling economy, dependent on world trade, Tajikistan needs low domestic prices, lots of foreign money, and a reliable exchange rate. There is no way that the National Bank can deliver all three conditions. That’s what Mundell pointed out. The best that the Bank can do is to determine the condition that the nation can live without – and try to attain the other two. -- Zafar Davronov and Leon Taylor
Zafar Davronov is a student in KIMEP’s MBA program. His interests include Central Asian economics and finance.
Good reading
John Hicks. Mr. Keynes and the ‘Classics’: A suggested interpretation. Econometrica 5, April 1937, pages 147-159. This introduced the IS-LM model as a graphical version of Keynes’ General theory.
John Maynard Keynes. The general theory of employment, interest and money. London: Macmillan, 1936. Keynes’ revision of an earlier, unsuccessful work, A treatise on money (1930), emphasizes how uncertainty affects real investment and money demand.
R. A. Mundell. Capital mobility and stabilization policy under fixed and flexible exchange rates. The Canadian Journal of Economics and Political Science 29: 4, November 1963, pages 475-485. A fun-to-read classic.
Andrew K. Rose. 2000. A review of some of the economic contributions of Robert A. Mundell, winner of the 1999 Nobel Memorial Prize in Economics. Scandinavian Journal of Economics 102: 2, June 2000, pages 211-222. Online at http://faculty.haas.berkeley.edu/arose/Mundell.pdf. An informative survey.
The World Bank. 2009. Global commodity markets: Review and price forecast. Online at http://siteresources.worldbank.org/EXTDECPROSPECTS/Resources/476882-1253048544063/GCM2009Sep.pdf . Pithy summaries of major markets.
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