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.


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