The price ain’t right

What’s wrong with cheap bread?

Two weeks ago, the central bank of Kazakhstan weakened the tenge, raising the targeted exchange rate from 150 tenge to the dollar to 185.  This is boosting prices, for several reasons.  The tenge price of imports increased immediately, because a dollar’s worth of goods requires a fifth more of tenge than before. 

Over time, the price of goods produced and sold in Kazakhstan will also rise, for two reasons.  Since imports are more expensive now than before, people will want to substitute domestic goods for them.  This increase in domestic demand will raise domestic prices.  Also, the devaluation will eventually augment foreign demand for Kazakhstan’s exports, because a dollar now buys more tenge.  This will lift the demand for exports, reducing the available supply of domestic goods for residents of Kazakhstan.  As always, the boost in demand will raise prices.

The mayor of Almaty, Akhmetzhan Yesimov, immediately ordered price controls for food and energy, reported TengriNews.  Though popular, price controls make matters worse.  To see why, consider a bread market that initially clears:  At the given price – say, 100 tenge -- the number of loaves that groceries want to sell equals the number that people want to buy.  Comes along the government, which restricts the price to 80 tenge.  At the lower price, people want to buy more, and firms want to sell less.  Demand exceeds supply.

Normally, excess demand raises prices, discouraging demand and encouraging supply until the market again clears.   But this scenario isn’t normal: We now have a price control.  The price can’t rise legally.  But, as a natural tendency, the market must clear, one way or another.  Something must remove the excess demand.  Perhaps the grocer will sell bread only to those who slip him a few extra tenge under the table; or perhaps he will sell only to those who wait in line for three hours.  In either case, the actual price returns to 100 tenge, but it now includes 20 tenge’s worth of bribes or of waiting time (a waste).  If the government cracks down on these practices, too, then buying bread may become so complicated that some buyers will drop out of the market.  Demand falls; excess demand disappears.  Again, the market clears – but fewer loaves than before will sell.

In short, price controls may keep people from getting what they want, even though they’re willing to pay the cost of providing it.

A loaf of bread, a jug of wine, and thou bureaucrat

Of course, people protest soaring prices.  Spikes in energy prices played a role in the Kyrgyzstan revolution of 2010.  But a price control will aggravate the situation.  The longer that the government holds down the price of bread, the larger the price increase will be when it finally must remove the control. 

Should the government always stay out of food and energy markets?  No.  Perhaps the public wants to provide cheap loaves to the poor rather than give them enough money to buy them (or anything else).  In that case, the government can subsidize the bread at the expense of, say, army rifles, by shifting funds.  The point is that the government should recognize the true cost of providing more bread (a reduction in defense).  The price control, however, forces buyers and sellers to absorb the cost of making goods artificially cheap.  The government gets off scot-free.  No wonder Hizzoner prefers price controls. 

--Leon Taylor tayloralmaty@gmail.com 

References

TengriNews.kz.  Mayor of Almaty orders to keep prices down.  February 11, 2014.

The strange case of the pricey pencil

Should Kazakhstani banks compensate mortgage holders for weakened tenge?

Last week, Almaty homeowners asked the banks to reduce the interest rate on their mortgages because the tenge had been devalued.

This may seem to make sense, because the devaluation will lower interest rates.  Here’s how it will happen.  The central bank’s devaluation cut by a fifth the amount of foreign goods that a tenge can buy.  Naturally, this will reduce demand to hold the tenge rather than, say, the dollar.  A fall in demand for any product – including a currency – will reduce its price.  One might think that a tenge has no price, because you can hold it without paying for it.  But a moment’s reflection will show that this is wrong.  When you have a tenge in hand, you give up the interest that you could have earned by putting it into a savings account instead.  So the price of holding a tenge is the interest rate.  This will fall as demand for the tenge languishes.

Most homeowners in Kazakhstan hold mortgages with an interest rate that had been fixed at the time of the signing.  Since the tenge was devalued only two weeks ago, these mortgage holders will not benefit from the fall in interest rates.  Adjusting their rates may seem a matter of simple spravedlyvoct’ (justice).

But matters are not so simple.  Remarkably, mortgage holders will get the benefit of the devaluation (namely, no benefit), despite the fixed rate on their loans.  Read on.

Lenders set the interest rate high enough to compensate themselves for any loss of value that may occur in their money by the time that they get it back.  Suppose that the lender thinks that the price of a pencil will rise from 100 tenge to 110 by next year, when the loan is paid off.  Then he will charge the borrower 10 tenge on a 100-tenge loan – an interest rate of 10%.  (Of course, he will also charge interest to compensate him for the inconvenience of doing without his money for a year, and so on.) 

The lender is not omniscient.  He will not always anticipate inflation.  For example, the price of a pencil may rise to 125 tenge, not just to 110.  In this case, the borrower will gain, because he can buy a pencil for 100 tenge today rather than 125 next year.  For this privilege, he pays only 10 tenge, so he saves 15.

Cheap talk

And that’s what will happen to fixed-rate mortgages.  As lenders, the banks did not anticipate that prices will rise nearly 20%.  But, in principle, that’s what will happen because of the devaluation.  The fixed-rate mortgage will enable its holder to avoid much of this inflation, because he can buy goods now while they’re still cheap.  The loser is the bank, which will be paid back in less valuable tenge than it had lent out.  You bought a pencil for 100 tenge, but the lender will have to pay 120 for one.

Why must prices eventually rise at the same rate – 20% -- that the tenge fell?  Because the devaluation doesn’t really change anything.  The amount that we can produce doesn’t depend on prices like the exchange rate (which is the foreign price of a tenge); it depends on what we use in production – labor, machines, knowledge.  The devaluation doesn’t affect these resources.  If Kazakhstan had 6 million workers before the devaluation, then it will have 6 million after it.  If we could produce 1,000 pencils before the devaluation, then we can produce 1,000 now.

The devaluation cuts the price (in dollars) that foreigners pay for our products, so foreign demand for our pencils will rise.   But we can produce only 1,000 pencils in all, so the amount sold to foreigners must come out of the amount usually sold to Kazakhstanis.  If Russia buys 100 more of our pencils, then Kazakhstanis must buy 100 fewer than usual. The mechanism for this adjustment is the domestic price of the pencil.  It has to rise, because pencils in Kazakhstan are becoming more scarce.

The exception to this argument is when our economy is in recession.  Suppose that we're producing only 800 pencils.  Since we can produce 1,000, we can sell 100 more to foreigners without reducing the amount sold to Kazakhstanis.  In that event, domestic prices won't rise by much.  This argument can hold only for a while, since economies tend eventually toward full capacity.  No recession lasts forever. 

Need a pencil to write up your grocery list?  Better buy it now.  -- Leon Taylor tayloralmaty@gmail.com

  

     

Central banker blues

Does the National Bank of Kazakhstan have any credibility left?

In the summer of 2007, a bank run on Allianz Bank, an unusually aggressive lender, raised the curtain on a near-collapse of Kazakhstan’s banking system in the two years to come.  This week, Allianz faced another run.

In all, three commercial banks fell victim to a warning, apparently bogus, of impending bankruptcy.  It was distributed through the social networks, especially WhatsApp Messenger, reported Kapital, one of the better business weeklies in Kazakhstan.  Kaspi Bank lost a tenth of its deposits.  Almaty authorities arrested a former employee of Bank CenterCredit, said TengriNews.kz.   

An electronic rumor mill is hard to fight, due to what economists call an “information cascade.”  Here’s an example of a cascade.  Aigul, a teen, decides not to go to college.  It’s a bad decision, but her friend Boris doesn’t know that.  He knows little about the value of a degree, so just observing Aigul’s decision convinces him to skip college, too.  The two decisions persuade another friend, Gulnara, not to go either.  The chain reaction continues.  More and more people decide to forego college, so each additional person observing these choices becomes more and more persuaded that she should not go either.  Similarly, a false rumor may gain increasing credibility as it spreads through the social networks. For that matter, bank runs may also comprise a cascade.

People run on a bank because they fear that it doesn’t have their money.  The worrisome thing about a run is that they’re right.  The bank makes money by lending out yours.  Normally, this causes no problems, because the bank can satisfy today’s withdrawals with today’s new deposits.  But in a bank run, all depositors want their money at once.  To raise the cash, the bank must either call in loans early or borrow overnight.  If it calls in loans, then some corporate borrowers will go bankrupt.  This will reduce output and employment – leading, in other words, to a recession.  If instead the bank borrows overnight, then it will have to pay punitive rates of interest, weakening its balance sheet.  As a last resort, the bank can close its doors, but this very visible decision will probably prompt runs on other banks.

Running for the hills

To avert bank runs, the government insures private bank accounts.  In the last panic, in 2008, the National Bank increased the insurance to about $34,000.  The most unsettling thing about the unfolding crisis is that the insurance seems not to have diminished the runs.  People don’t trust the government – especially since the new governor of the National Bank, Kairat Kelimbetov, denied just a month ago that he would devalue the tenge.  As it turned out, his margin of error was about 20%.  (His predecessor, Gregory Marchenko, also denied that a devaluation would occur.  That was in June.)

None of this had to happen.  The National Bank could have started planning for a devaluation last summer, when it became clear that the exchange rate would exceed the Bank’s target.  In public pronouncements, it could have left the door open for an eventual weakening of the tenge.  The commercial banks could have shifted their wealth into dollars over time. 

Even now, the central bank can defuse the situation by announcing that it will increase deposit insurance and offer emergency loans to jeopardized banks at relatively low rates; and, if push comes to shove, declare a bank holiday.  The mere announcement of solid measures will soothe troubled waters.

What is the National Bank actually doing?  It’s begging people to hang on to their tenge.  This may have either of two interpretations.  One: The Bank regards the bank runs as trivial.  Two:  The National Bank can't do anything substantial about the runs, because it has lost control of the money supply (even though it probably hasn’t).  Under either interpretation, the National Bank's blitheness will only increase the runs.

The most likely denouement is that Kelimbetov will be replaced by someone with enough credibility to actually talk to the public.  Will this come in time?  –Leon Taylor tayloralmaty@gmail.com     

       

References

Gumarova, Chulpan.  50 ottenkov ‘chernovo vtornyka.’  (Fifty shades of ‘Black Tuesday.’)  Kapital.  February 20, 2014.

 

Lillis, Joanna.  Kazakhstan’s central bank urges calm amid post-devaluation bank run.  EurasiaNet.org.  February 19, 2014. 

Radio Free Europe/Radio Liberty.  Kazakh devaluation leads to bank run.  February 19, 2014.

TengriNews.kz.  Central bank governor on devaluation of the national currency, the tenge.  June 6, 2013.

TemgriNews.kz.  Kaspi Bank depositors withdraw $212 million in a bank run.  February 20, 2014.

TengriNews.kz.  Bivshy sotrudnyk Bank Tsentrcredit prechasten k SMS-atake na financovie ynstytuti.  (Former employee of Bank CenterCredit is connected to a social-network attack on financial institutions.)  February 22, 2014.     

 

Why 185?

Why did the National Bank of Kazakhstan devalue in such a large leap?

As soon as the central bank weakened the tenge by a fifth last week, commercial banks complained that they had not been privy to the secret, reported the business weekly Panorama. 

Some secret.  The tenge had been losing value against the dollar for three years.  When the exchange rate hit 153 a year ago, predictions abounded that it would soon go to 155, the maximum rate that the National Bank had said it would defend.  At that point, it would either have had to announce a new maximum rate to protect (i.e., to devalue) or make clear that it would draw upon new sources of dollars – like the national welfare fund – in order to hold the line at 155.  (To keep the tenge from weakening, the National Bank can sell dollars and buy tenge in currency markets, if it has the dollars.)  Tapping the Samruk-Kazyna fund would have whipped up a political storm.  The only reasonable course was to devalue.  The commercial banks should have seen that – everyone else did – and should have shifted their wealth into dollars accordingly.  The National Bank is not their guardian angel.           

The only surprise was that the Bank adopted 185 rather than 160 or 165 as the new maximum.  Had it revealed this in advance to the commercial banks, they would have promptly sold tenge and bought dollars until the rate on the street was 185.  The only difference between this scenario and the actual one is that the banks, and only the banks, would have profited by arbitrage.  We’d all love to have a guardian angel.

Still…why did the National Bank go to 185?

There goes the neighborhood

The usual explanation is that the Bank was just keeping up with the Joneses.  Ever since last summer, the central bank in the United States, the Federal Reserve, has publicly mused that it would eventually tighten monetary policy.  This would raise interest rates in the U. S. and might attract rich investors in the Third World who want to park their money somewhere profitable.  To buy dollars, they would sell the local currency.  The exchange rate for that currency, against the dollar, would rise.  Central banks in developing countries might as well prepare for the inevitable by devaluing now.  This way, they may be able to manage events rather than react to them.  They may gain credibility and avoid a free-fall in the currency.          

If this is the story, then it would seem more sensible to devalue in small steps rather than in one fell swoop.  We’re not sure just how a tightening of the dollar would affect international flows of wealth.  Yes, local currencies will weaken, but how much?  What makes 185 the magic number?  The very fact that observers treat the new target as a surpryz is a source of disquiet.

The good news in this tinderbox is that the market exchange rate homed in on 185 within two days of the Bank’s announcement.  The Bank has credibility, probably because its previous governor, Grigorii Marchenko, held the exchange rate close to the old target (150) for two years while restraining inflation to roughly 6% (not bad, by CIS standards).  We’ll see whether the new governor, Kairat Kelimbetov, can stick to his guns.  -- Leon Taylor, tayloralmaty@gmail.com 

References

Panorama.  Natsbank ‘udyvlen’ pretenzyyamy bankov.  February 14, 2014.  

Who appreciates a depreciation?

How might the new exchange rate reshape our economy?

Yesterday, the central bank of Kazakhstan cut the value of the tenge by almost a fifth -- the largest such adjustment in four years.  How might it affect the nation’s economy?

The most evident consequence – and the National Bank lost no time in pointing it out – is that exports should increase.  Foreigners will get a fifth more than before of our products, in exchange for their dollar.  And so they will buy more of our oil and wheat, eventually.

Unfortunately, “eventually” is the operative word in that last sentence.  Exports won’t rise right away, because, like imports, they are usually fixed under contracts lasting one to three months.  In fact, the most immediate result of the devaluation may be a reduction of net exports -- that is, of exports minus imports. 

To see this, suppose that export contracts are in terms of tenge.  Then the new exchange rate will not affect exports.  The contracts have already fixed the number of oil barrels that can be sold, as well as their tenge price-tag, so the devaluation will affect neither quantity nor price right away. 

Now suppose that import contracts are in terms of dollars.  They fix the number of cars imported, as well as their dollar price; but their tenge price will rise by a fifth.  So imports (measured in tenge) will increase, and net exports will fall.  The last time that the central bank devalued the tenge substantially, in February 2009, imports exceeded exports for most of the remaining year.  Admittedly, the global economy was in recession then, so we couldn’t sell many exports. 

Since net exports are part of gross domestic product – which is the annual value of production on Kazakhstani soil – the most glaring consequence of the devaluation may be an economic slowdown.  Ironically, the National Bank cited as one reason for the devaluation a current surge in imports, reported Tengrinews.

Of course, eventually, the trade contracts will expire, and the new ones will take the new exchange rate into account.  Net exports will then rise.  But this probably won’t happen for several months.

Hey, big lender

Meanwhile, the devaluation will jeopardize the wealth of anyone holding tenge assets and dollar liabilities.  The most obvious example is the commercial banks.  They are not as far out on a limb as they were in 2009, but to some extent they still finance long-term loans (denominated in tenge) with short-term borrowing (denominated in dollars).  Marginal banks may go broke.

Consumers want to know whether they will have to pay higher prices because of the devaluation.  Again, the tenge price of imported goods and inputs will rise, quickly and sharply.  This is not the time to be purchasing a Mercedes.  But the prices of domestic goods may prove more resilient.  Yes, a local meat producer may raise his price to match that of the imports.  But he may instead hold it steady in order to increase market share.  In time, he will raise his price, because the devaluation increases the foreign demand for his meat.  But don’t look for that to occur before summer.

Especially vulnerable to the devaluation are local college students.  Their loans and scholarships are in tenge, but the prices of their textbooks are in dollars.  Moreover, universities like KIMEP hire many of their professors from abroad.  To keep hiring, the schools will have to raise their salary offers in terms of tenge, and they will pass on this increase to students by raising tuition.  In short, a devaluation is almost as much fun as a root-canal operation.  –Leon Taylor tayloralmaty@gmail.com

                  

Notes

1.  Thanks to Aisana Bekisheva, Raymond Cheung, and Aigul Izbanova for conversations.

References

Yaroslav Radlovsky.  Currency devaluation in Kazakhstan.  Tengrinews.  February 11, 2014.  Online.