Going for double broke

Has the National Bank of Kazakhstan blundered?

Nobody has ever accused the National Bank of being dull.  Yesterday, after managing the exchange rate since before the financial crisis of 2008, the central bank abruptly consigned the tenge to the currency market.  The tenge immediately weakened by more than a third.  If it follows its historical pattern, this may be just the beginning.

The float was not inevitable.  The government had plenty of money with which to defend the tenge.  Since December, the National Bank’s net international reserves have been holding steady at $28 billion, enough to cover eight months of imports.  The National Fund, which consists mainly of taxes on oil export revenues, did fall by more than 1% in July but still amounted to $68 billion.  However, people have been expecting devaluation ever since the last one, in February 2014; and the recent weakening of the renminbi reinforced those expectations.  The National Bank didn’t have enough credibility to change them. 

As a result, the tenge has been declining steadily since November, when it stood at 181 to the US dollar.  The rate of depreciation picked up in mid-July, when the exchange rate was 187.  Thanks to the Chinese devaluation, it rose to 190 just before the float.         

How to panic the banks

The immediate worry is that the float may endanger commercial banks.  They never recovered from the collapse of 2008; as late as 2013, loans that had been overdue for more than 90 days still comprised 30% of total bank loans.  (Recently the head of the central bank, Kairat Kelimbetov, said the bad-loan ratio had fallen to 10%, according to the business weekly Panorama.)   So, bank income from interest payments was anemic to begin with.  Now, thanks to the float, the foreign value of their tenge-denominated assets may drop by 35%.  When selling those assets for dollars, the banks will have to absorb a crushing loss.  The banks’ creditors may pull their dollars out, if the National Bank does not impose currency controls.

Also, the float makes imports more costly for retirees living on tenge accounts.  Their standard of living will fall.  

The float may raise interest rates sharply in Kazakhstan.  People expect the tenge to continue to depreciate and thus will hold tenge-denominated assets only if a higher interest rate today will compensate them for the loss of purchasing power over foreign products in the future.  High interest rates may discourage physical investment in Kazakhstan, slowing the economy at a time when falling oil prices are already eroding export revenues.  The benchmark interest rate – the refinancing rate, which the National Bank charges for loans to commercial banks – has been 5.5% since 2013; that may change.

Most troubling of all, the float is a Pandora’s box.  Historically, when the tenge went haywire, it continued to oscillate for several months.  The graph below shows fluctuations in the tenge’s monthly real exchange rate (that is, the exchange rate adjusted for domestic and foreign prices) for January 1995 through March 2014.  The thing to note is that the spikes occur in clusters of several months.  An exchange rate of 257 to the dollar is not likely to be the end of the story.   

The long-run picture is a bit brighter.  After a year or so, the depreciation should boost exports, since the dollar or euro will be able to buy more tenge than before.  Similarly, it should discourage imports, since the tenge can buy less than before of foreign currencies.  Kazakhstan’s trade balance would improve.  In the first quarter of this year, net exports amounted to nearly $4.2 billion.

Policymakers may sigh with relief, since the float frees the National Bank to target income or inflation. For example, it might be able to increase output for a while by creating money, since this encourages spending.  The Bank wasn’t at liberty to do this when it had committed itself to holding the tenge to 190 per dollar or stronger, because creating tenge raises the exchange rate (that is, weakens the tenge).

In short, the float may be more beneficial in the long run than in the short.  Nevertheless, the National Bank is no longer credible, since it had vowed to avoid a drastic devaluation ever since the February 2014 markdown.   

Since people no longer believe what the Bank says, it may have a tough time containing long-run inflation, because this depends on expectations.  If workers think that prices will be 10% higher next year, they will pressure their employers for a 10% pay hike.  The boss will pass on this cost to the consumer by raising prices.  This feeds inflation; that is, the expectation of higher prices is a self-fulfilling prophecy.  Had workers believed that the central bank would avoid inflation, they would not have asked for cost-of-living adjustments, and we would not have gotten inflation.  But the National Bank no longer has that kind of reputation.

The instability stemming from the float may help convince the Eurasian Economic Union, the Russian-led group that includes Kazakhstan, to move towards a common currency (read: the ruble).  Kazakhstan could lose the power to steer its own economy.

No, the National Bank has never been dull.  Unfortunately. – Leon Taylor, tayloralmaty@gmail.com

Notes

    

1.  All statistics cited here are from the Web site of the National Bank, www.nationalbank.kz.  The data for the real exchange rate shown in the graph are also from the National Bank.  I thank Aizhan Smailova and Adilet Danyshpan for help in gathering data.

2.  To generate a measure of volatility, I took logs of the real exchange rate and estimated the first difference (over time) in these logs.  This provided a rate of return, since the differential of a log provides a relative change, dY/Y.  Finally, I subtracted from this measure the mean rate of return over time, in order to identify unusually large increases or decreases in the return.  The graph shows that large changes in the return tend to cluster -- even when the National Bank is trying to steady the exchange rate by intervening in the forex market. 
 

The real exchange rate is prone to what economists call “autoregressive conditional heteroskedasticity,” or ARCH.  This just means that when the exchange rate begins fluctuating, it usually keeps fluctuating for a while.

Reference

Panorama.  Нацванк: "В Казахстане инфляция достигла исторического минимума." [National Bank: "In Kazakhstan, inflation reached its historic minimum."]  Week of April 21, 2015.