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.