Black gold as an asset
The relevant measure of an industry’s profitability is not the absolute level of its output price, or even of its price minus the average out-of-pocket cost of production (“net price”). The best measure is its rate of return to capital, relative to the rates of return on alternative assets. The government pondering nationalization is in the same position as a financial investor who is contemplating whether to buy more Google stock: To increase the value of his portfolio, he will shift his wealth to the asset with the highest rate of return. He will buy Google stock only if its rate of return exceeds that of the best alternative asset – another stock, perhaps, or a bond or even money. The current net price of the stock is neither here nor there. Similarly, a government should view natural resources as assets in the nation’s portfolio.
A former newspaper reporter in the United States, Harold Hotelling, explained this 80 years ago. (According to legend, Hotelling had to give up journalism for mathematical economics because he was a slow writer.) The opening of the article could have been written today: “Contemplation of the world’s disappearing supplies of minerals, forests, and other exhaustible assets has led to demand for regulation of their exploitation.”
As Hotelling sees it, the owner of an oil deposit may choose either to leave part of his wealth in the ground or to convert it to some other asset such as a security. Of the two options, he will choose the one with the higher return.
For simplicity, suppose that oil extraction incurs no out-of-pocket costs; the oil price is thus pure profit. The expected return to the oil in the ground is the expected increase in its price over time. If we anticipate that the price of an oil barrel will rise from $100 now to $108 next year, then our expected return is 8%. Suppose that the alternative asset is a savings account with an interest rate of 4%. Then the owner of oil should leave it in the ground, where it will earn the higher return. Extracting and selling the oil now, banking the money at 4% interest, is foolish. The investor could have realized eight cents on a dollar of wealth by waiting until next year to cash in on high oil prices, but instead he has chosen four cents. Whether the current spot net price of a barrel of oil happens to be $1 or $1 million should be of interest only to the newspapers.
The government should not treat oil as just another perishable commodity. Were we talking about apples, then relating the level of production directly to the current price would be appropriate. Apples harvested today will spoil next year; there is no opportunity cost of foregone future use to take into account. Only harvest costs matter. But oil is a durable asset. Forty gallons in the ground will not vanish next year, and they may well be worth more then than now. The current price should not determine the decision of when to extract, since the oil can be sold either now or later.
In our example, owners of oil deposits will leave oil in the ground for another year, since this will earn the higher return. The rate of extraction will fall. The current supply of crude on the spot market will decrease. This scarcity will force up the current price of crude until the expected return on the oil deposit falls to 4%. (This would occur when the current spot price rises to $103.85, given that the price next year will be $108.) At this point, there is no longer an incentive for owners of oil deposits to cancel more plans to extract the crude; the rate of return to holding oil in the ground equals that of the alternative asset. Consequently, we would expect oil prices to rise over time at the rate of interest.
All for the best
This allocation of crude oil to users over time is the most valuable available. Although we assumed away out-of-pocket extraction costs, a vital cost of extracting today still remains – the loss of that oil to future users. To take that opportunity cost into account, current users of oil should pay higher prices than they otherwise would. When oil producers compete for customers, they will bid down the current price of oil to the point that it just covers the costs of producing another barrel. In addition to the out-of-pocket expense of paying workers and buying derricks, we must add the profit foregone by selling another barrel of oil now rather than next year. That opportunity cost is the price that the oil would have fetched in 2012. But the price next year of another barrel of oil must equal its value to the buyer, since otherwise that price must change: Either the price would rise (because the value to a buyer of another barrel is greater than the price that he would pay, which would compel buyers to compete for the barrel by bidding up the price), or it would fall (because the barrel’s value falls below the price that the buyer must pay, generating excess supply). Consequently, the current price of oil equals the value foregone by consuming it now rather than later. If consumers today are willing to pay this price, then they must value another barrel at least as much as would future users. The resulting allocation of oil over time is efficient in the sense that it ensures that each barrel goes to the users who would value it the most.
The real world imposes complications galore. The global oil market is not perfectly competitive, thanks to the Organization of Petroleum-Exporting Countries, and so the OPEC cartel may set the spot price above the cost accruing to another barrel, without fearing that rivals will undercut it in price. Oil extraction may also incur environmental costs – costs that the spot market does not take into account, since neither the buyer nor the seller of oil has to pay them. Incorporating these details into the analysis does not change the tenet that the owner of oil should view it as just another asset.
The model predicts that the net price of oil (adjusted for inflation) should rise over time at the rate of interest. Adjusting for inflation, the global rate of return to physical capital may be roughly 2% to 4% over the very long run.
The interest rate also provides a measure of how rapidly resource prices should rise, remarked Hotelling. “…The rate of interest is set by a great variety of forces, chiefly independent of the particular commodity and industry in question, and is not greatly affected by variations in the output of the mine or oil well in question. It is likely, therefore, that in deciding questions of public policy relative to exhaustible resources, no large errors will be made by using the market rate of interest.” -– Leon Taylor, tayloralmaty@gmail.com
Good reading
Hotelling, Harold. The economics of exhaustible resources. Journal of Political Economy, April 1931.
Solow, Robert M. The economics of resources or the resources of economics. American Economic Review, May 1974. Reprinted in Robert and Nancy S. Dorfman, editors, Economics of the environment: Selected readings. Third edition. New York: W. W. Norton.
Parts of this post draw upon an article of mine published by the Caspian Digest in 2008.
Tuesday, March 29, 2011
Friday, March 25, 2011
Where there’s oil, there’s fire
Is Kazakhstan taking foreign investors for a ride?
The world’s woe is Kazakhstan’s wealth. In the past few weeks, the spot price of an oil barrel on global markets has been above $100 for the first time since September 2008, according to data from the United States Energy Information Administration. For most products, a higher price reduces unit sales, so that revenues do not climb as rapidly as the price. But oil is so vital to production that unit sales decline only a little – until, at least, firms can find a cheaper way to produce. Meanwhile, Kazakhstan’s revenues from exports will capture much of the 28% increase in oil prices that has occurred since early 2010.
The benefits to Kazakhstan don’t stop there. When oilmen respend the export revenues in Kazakhstan, their demand for services will create jobs in one of the country’s fastest-growing sectors. In that sense, the share of oil and gas production in the nation’s economy (roughly 30%) underestimates the industry’s importance here. The back of my envelope says that a 10% sustained increase in the global spot price of oil may relate to a 4% or 5% increase in the size of Kazakhstan’s economy.
As in 2008, $100+ prices may tempt the government of Kazakhstan to cash in assets that have presumably peaked in value. The government has pressed the foreign-dominated consortium at Kashagan to hurry up and produce; and it has moved slowly toward a degree of de facto nationalization by insisting that foreign energy enterprises here turn over more ownership to the state energy firm, KazMunaiGaz. KMG has a pre-emptive right to buy oil assets, and it usually participates in the joint ventures that have replaced production-sharing agreements in the oil and gas industry.
All this should surprise no one. Around the world, developing countries confiscated natural resources from foreign owners in the 1970s, when the prices of those resources were unusually high.
Rebuilding reputation
Still, nationalization may not be sensible. Governments that seize lucrative industries will stop attracting so much foreign-owned capital. They may try to attract it again by promising to forgo taxes, but investors will regard this as cheap talk.
To convince investors that they’re for real, governments may have to show that they’ll penalize themselves in the event of another tax renege. This may help explain why Kazakhstan builds pipelines and Caspian port facilities. KMG is a major shareholder of the pipeline that delivers oil from the Tenghiz field to a Russian port on the Black Sea, Novorossiysk, as well as of the pipeline that runs from a Caspian port, Atyrau, to the Xinjiang region of China, according to the United States Energy Information Administration. If this construction fails to bring in Western investors, then the government may be wasting some of its money, since home industries are not likely to fully use the oil and gas infrastructure. (The main energy fuel for Kazakhstani production is coal).
Government spending on infrastructure comes at the expense of that on health and education. Of course, this expense is essential to the competitive strategy; if the strategy would cost the government nothing, then it is just more cheap talk.
Not only is Kazakhstan’s competitive spending on infrastructure expensive; it probably won’t work. The government’s “forced industrialization-innovation program” might be interpreted in the West -- understandably -- as a new tax on foreign investment. The sprawling legislation for the program, to cost 6.5 trillion tenge (over $43 billion), says it will draw upon funds from “private domestic and foreign investors” as well as other sources. This cryptic statement may undermine any credibility that the government has obtained from building infrastructure for particular foreign investors. -– Leon Taylor, tayloralmaty@gmail.com
References
Government of Kazakhstan. 2010-2014 National Program of forced industrial and innovative development of the Republic of Kazakhstan and cancellation of certain decrees of the President of the Republic of Kazakhstan. Presidential decree. 2010. www.invest.gov.kz
United States Department of Energy, Energy Information Administration. Country analysis briefs: Kazakhstan. www.eia.gov
United States Department of State. Background notes: Kazakhstan. www.state.gov
The world’s woe is Kazakhstan’s wealth. In the past few weeks, the spot price of an oil barrel on global markets has been above $100 for the first time since September 2008, according to data from the United States Energy Information Administration. For most products, a higher price reduces unit sales, so that revenues do not climb as rapidly as the price. But oil is so vital to production that unit sales decline only a little – until, at least, firms can find a cheaper way to produce. Meanwhile, Kazakhstan’s revenues from exports will capture much of the 28% increase in oil prices that has occurred since early 2010.
The benefits to Kazakhstan don’t stop there. When oilmen respend the export revenues in Kazakhstan, their demand for services will create jobs in one of the country’s fastest-growing sectors. In that sense, the share of oil and gas production in the nation’s economy (roughly 30%) underestimates the industry’s importance here. The back of my envelope says that a 10% sustained increase in the global spot price of oil may relate to a 4% or 5% increase in the size of Kazakhstan’s economy.
As in 2008, $100+ prices may tempt the government of Kazakhstan to cash in assets that have presumably peaked in value. The government has pressed the foreign-dominated consortium at Kashagan to hurry up and produce; and it has moved slowly toward a degree of de facto nationalization by insisting that foreign energy enterprises here turn over more ownership to the state energy firm, KazMunaiGaz. KMG has a pre-emptive right to buy oil assets, and it usually participates in the joint ventures that have replaced production-sharing agreements in the oil and gas industry.
All this should surprise no one. Around the world, developing countries confiscated natural resources from foreign owners in the 1970s, when the prices of those resources were unusually high.
Rebuilding reputation
Still, nationalization may not be sensible. Governments that seize lucrative industries will stop attracting so much foreign-owned capital. They may try to attract it again by promising to forgo taxes, but investors will regard this as cheap talk.
To convince investors that they’re for real, governments may have to show that they’ll penalize themselves in the event of another tax renege. This may help explain why Kazakhstan builds pipelines and Caspian port facilities. KMG is a major shareholder of the pipeline that delivers oil from the Tenghiz field to a Russian port on the Black Sea, Novorossiysk, as well as of the pipeline that runs from a Caspian port, Atyrau, to the Xinjiang region of China, according to the United States Energy Information Administration. If this construction fails to bring in Western investors, then the government may be wasting some of its money, since home industries are not likely to fully use the oil and gas infrastructure. (The main energy fuel for Kazakhstani production is coal).
Government spending on infrastructure comes at the expense of that on health and education. Of course, this expense is essential to the competitive strategy; if the strategy would cost the government nothing, then it is just more cheap talk.
Not only is Kazakhstan’s competitive spending on infrastructure expensive; it probably won’t work. The government’s “forced industrialization-innovation program” might be interpreted in the West -- understandably -- as a new tax on foreign investment. The sprawling legislation for the program, to cost 6.5 trillion tenge (over $43 billion), says it will draw upon funds from “private domestic and foreign investors” as well as other sources. This cryptic statement may undermine any credibility that the government has obtained from building infrastructure for particular foreign investors. -– Leon Taylor, tayloralmaty@gmail.com
References
Government of Kazakhstan. 2010-2014 National Program of forced industrial and innovative development of the Republic of Kazakhstan and cancellation of certain decrees of the President of the Republic of Kazakhstan. Presidential decree. 2010. www.invest.gov.kz
United States Department of Energy, Energy Information Administration. Country analysis briefs: Kazakhstan. www.eia.gov
United States Department of State. Background notes: Kazakhstan. www.state.gov
Wednesday, March 16, 2011
A tight spot
How effective can the National Bank be?
The central bank of Kazakhstan, which manages the supply of tenge, is trying to hold the lid on rising prices. At present, prices in general are rising at an annualized rate of 21%. (In contrast, the rate of inflation for 2010 was 7.8%.) Some price increases are due to winter, which increases transport costs; they will fade with the spring. Food prices, which are rising more steeply than others, may also moderate in the next harvest. Even so, Kazakhstan has good reason to worry about inflation.
To avert further inflation, the National Bank of Kazakhstan has raised the interest rate at which it lends money to commercial banks. The idea is that banks will respond by borrowing less from the National Bank. This will leave them with less money to lend to the public – loans that could have expanded the supply of tenge and consequently could have fueled inflation.
The increase in the Bank’s interest rate – the “refinancing” rate – looks steep: From 7% to 7.5% per year. However, note that the new rate is much smaller than that of inflation. If this inflation continues, then those borrowing from the National Bank will be able to pay it back in tenge that are weaker than those borrowed. In other words, the borrowers will be able to spend the loans now on goods while their prices are still low – and then pay the money back later, when prices are high and reduce the money’s purchasing power. The borrowers can borrow good tenge and then pay back bad ones. In that light, the Bank’s new policy is less restrictive than it may seem. The Bank may be pushing on a string: Its new interest rate may not cool off the economy by much.
Toolin’ around
Unfortunately, the National Bank doesn’t have better tools. Western central banks usually fight inflation by selling paper loans, like government bonds, in exchange for cash and checks. These “open market operations” reduce the supply of money available for spending, thus reducing the pressure on prices to rise. Their advantage is in enabling the central bank to change the money supply with some precision. Over the past few years, the National Bank has turned more and more to open market operations. But it cannot rely on them in a big way because Kazakhstan’s market for securities is thin: Few bonds and notes trade here. As Kazakhstan’s fast-growing economy continues to develop, so will its market for securities. For now the market is too small to support major operations.
The remaining possibility for the National Bank is to discourage banks from lending by requiring them to lock up a larger share of their deposits. But at the moment, commercial banks already are sitting on a lot of cash and assets that they can convert easily to cash. They aren’t lending as much as they could. To raise the share of reserves that they must set aside would simply confirm what they already are doing.
The weakness of strength
Not only is the National Bank hampered by weak tools; it also faces a paradox. Over the past year, global oil prices have risen by almost a fourth. To pay these prices, buyers of Kazakhstani oil must have more tenge. This increase in the demand for tenge raises their foreign exchange value. Two years ago, you needed 151 tenge to buy a United States dollar; today, you need only 146 tenge. (The exchange rate last December was 147.5.) This strengthening of the tenge enables Kazakhstanis to buy imports more cheaply than before, since the imports are priced in dollars (or other foreign currencies). To buy more imports, Kazakhstanis will cut back on purchases of domestic goods. Meanwhile, Kazakhstani exports will become more expensive for foreigners to buy, since these goods are priced in tenge that are more costly to buy than before. In short, a stronger tenge reduces the demand, here and abroad, for Kazakhstani goods.
To keep tenge from becoming too strong, the National Bank has been selling them in exchange for foreign currencies, to the tune of a few billion dollars’ worth per month. This may have contributed to the increase of nearly 19% in net international reserves for Kazakhstan from December to February.
The Bank chair, Gregory Marchenko, views these operations as successful. The European euro, the Russian ruble and the Chinese yuan all have been strengthening against the dollar more rapidly than the tenge has, he notes. In fact, the tenge is weakening against the ruble, from 4.85 tenge to the ruble in late December 2010 to 5.05 tenge in late February. And it is weakening against the euro, from 193.8 tenge to 199 over the same period, according to National Bank data.
“That is why we can strengthen tenge against US dollar under the control of the National Bank, which will not adversely affect the competitiveness of Kazakhstan’s economy,” Marchenko says, according to Interfax’s account of a presidential news release this week.
The Bank’s interventions in currency markets are becoming habitual. “We see no need and no sense in sharp exchange rate swings,” Marchenko said last year, according to Silk Road Intelligencer.
The sale of tenge eventually puts more of them in circulation, increasing their overall supply. This, in turn, pressures Kazakhstani prices to rise, since there are more tenge chasing domestic goods than before. The Bank could wind up feeding the very inflation that it has pledged to fight.
Marchenko denies that the operations have increased either the tenge supply or the rate of inflation, according to Interfax. Certainly, banks might have bought many of the tenge sold by the National Bank and stowed them in reserves rather than make them available for spending. But banks won't hold large excess reserves forever; once they regain their confidence, they will put the money to work, in the form of loans.
The Bank is aware of the problem. It offset many of the new tenge by selling short-term notes for tenge, according to Delovoy Kazakhstan. Such sterilization is common among central banks. But once creditors are back in a lending mood, they will sell their notes for tenge to lend –- tenge now being stashed away. Spending will rise, pressuring prices upward.
The long-run monetary trend is clear: A broad measure of the tenge supply (M2) increased 24% in January 2011 over the previous year, according to National Bank data. The supply of money is rising faster than output. Until the Bank mops up the excess tenge, the potential for inflationary spending will exist. The Bank’s dilemma is that more purchases of tenge may strengthen the currency's value in foreign exchange. In monetary policy, all blessings are mixed. – Leon Taylor, tayloralmaty@gmail.com
Good reading
Zhanbota Tolegen. Grigoriy Marchenko: “Tenge snova vstupyl v period ukrepleniya.” Delovoy Kazakhstan. March 11, 2011. Page 1.
References
Interfax-Kazakhstan. Kazakh National Bank has purchased $6 billion in year to date to stabilize tenge exchange rate. Online. March 14, 2011.
Silk Road Intelligencer. Tenge to appreciate against dollar – Marchenko. Online. January 14, 2010.
Silk Road Intelligencer. Kazakhstan raises key refinancing rate. Online. March 10, 2011.
The central bank of Kazakhstan, which manages the supply of tenge, is trying to hold the lid on rising prices. At present, prices in general are rising at an annualized rate of 21%. (In contrast, the rate of inflation for 2010 was 7.8%.) Some price increases are due to winter, which increases transport costs; they will fade with the spring. Food prices, which are rising more steeply than others, may also moderate in the next harvest. Even so, Kazakhstan has good reason to worry about inflation.
To avert further inflation, the National Bank of Kazakhstan has raised the interest rate at which it lends money to commercial banks. The idea is that banks will respond by borrowing less from the National Bank. This will leave them with less money to lend to the public – loans that could have expanded the supply of tenge and consequently could have fueled inflation.
The increase in the Bank’s interest rate – the “refinancing” rate – looks steep: From 7% to 7.5% per year. However, note that the new rate is much smaller than that of inflation. If this inflation continues, then those borrowing from the National Bank will be able to pay it back in tenge that are weaker than those borrowed. In other words, the borrowers will be able to spend the loans now on goods while their prices are still low – and then pay the money back later, when prices are high and reduce the money’s purchasing power. The borrowers can borrow good tenge and then pay back bad ones. In that light, the Bank’s new policy is less restrictive than it may seem. The Bank may be pushing on a string: Its new interest rate may not cool off the economy by much.
Toolin’ around
Unfortunately, the National Bank doesn’t have better tools. Western central banks usually fight inflation by selling paper loans, like government bonds, in exchange for cash and checks. These “open market operations” reduce the supply of money available for spending, thus reducing the pressure on prices to rise. Their advantage is in enabling the central bank to change the money supply with some precision. Over the past few years, the National Bank has turned more and more to open market operations. But it cannot rely on them in a big way because Kazakhstan’s market for securities is thin: Few bonds and notes trade here. As Kazakhstan’s fast-growing economy continues to develop, so will its market for securities. For now the market is too small to support major operations.
The remaining possibility for the National Bank is to discourage banks from lending by requiring them to lock up a larger share of their deposits. But at the moment, commercial banks already are sitting on a lot of cash and assets that they can convert easily to cash. They aren’t lending as much as they could. To raise the share of reserves that they must set aside would simply confirm what they already are doing.
The weakness of strength
Not only is the National Bank hampered by weak tools; it also faces a paradox. Over the past year, global oil prices have risen by almost a fourth. To pay these prices, buyers of Kazakhstani oil must have more tenge. This increase in the demand for tenge raises their foreign exchange value. Two years ago, you needed 151 tenge to buy a United States dollar; today, you need only 146 tenge. (The exchange rate last December was 147.5.) This strengthening of the tenge enables Kazakhstanis to buy imports more cheaply than before, since the imports are priced in dollars (or other foreign currencies). To buy more imports, Kazakhstanis will cut back on purchases of domestic goods. Meanwhile, Kazakhstani exports will become more expensive for foreigners to buy, since these goods are priced in tenge that are more costly to buy than before. In short, a stronger tenge reduces the demand, here and abroad, for Kazakhstani goods.
To keep tenge from becoming too strong, the National Bank has been selling them in exchange for foreign currencies, to the tune of a few billion dollars’ worth per month. This may have contributed to the increase of nearly 19% in net international reserves for Kazakhstan from December to February.
The Bank chair, Gregory Marchenko, views these operations as successful. The European euro, the Russian ruble and the Chinese yuan all have been strengthening against the dollar more rapidly than the tenge has, he notes. In fact, the tenge is weakening against the ruble, from 4.85 tenge to the ruble in late December 2010 to 5.05 tenge in late February. And it is weakening against the euro, from 193.8 tenge to 199 over the same period, according to National Bank data.
“That is why we can strengthen tenge against US dollar under the control of the National Bank, which will not adversely affect the competitiveness of Kazakhstan’s economy,” Marchenko says, according to Interfax’s account of a presidential news release this week.
The Bank’s interventions in currency markets are becoming habitual. “We see no need and no sense in sharp exchange rate swings,” Marchenko said last year, according to Silk Road Intelligencer.
The sale of tenge eventually puts more of them in circulation, increasing their overall supply. This, in turn, pressures Kazakhstani prices to rise, since there are more tenge chasing domestic goods than before. The Bank could wind up feeding the very inflation that it has pledged to fight.
Marchenko denies that the operations have increased either the tenge supply or the rate of inflation, according to Interfax. Certainly, banks might have bought many of the tenge sold by the National Bank and stowed them in reserves rather than make them available for spending. But banks won't hold large excess reserves forever; once they regain their confidence, they will put the money to work, in the form of loans.
The Bank is aware of the problem. It offset many of the new tenge by selling short-term notes for tenge, according to Delovoy Kazakhstan. Such sterilization is common among central banks. But once creditors are back in a lending mood, they will sell their notes for tenge to lend –- tenge now being stashed away. Spending will rise, pressuring prices upward.
The long-run monetary trend is clear: A broad measure of the tenge supply (M2) increased 24% in January 2011 over the previous year, according to National Bank data. The supply of money is rising faster than output. Until the Bank mops up the excess tenge, the potential for inflationary spending will exist. The Bank’s dilemma is that more purchases of tenge may strengthen the currency's value in foreign exchange. In monetary policy, all blessings are mixed. – Leon Taylor, tayloralmaty@gmail.com
Good reading
Zhanbota Tolegen. Grigoriy Marchenko: “Tenge snova vstupyl v period ukrepleniya.” Delovoy Kazakhstan. March 11, 2011. Page 1.
References
Interfax-Kazakhstan. Kazakh National Bank has purchased $6 billion in year to date to stabilize tenge exchange rate. Online. March 14, 2011.
Silk Road Intelligencer. Tenge to appreciate against dollar – Marchenko. Online. January 14, 2010.
Silk Road Intelligencer. Kazakhstan raises key refinancing rate. Online. March 10, 2011.
Wednesday, March 2, 2011
Crunch
Why are Central Asian governments stingy?
Some observers attribute to recession the tightwad policies for social welfare in Central Asia. In 2009, Newsweek explained that “last year's crash in oil prices [led to a] fall in populist spending that Central Asia's petrocrats use to buttress their popularity.” By implication, social welfare spending here is an economic problem, not a political one. In economic slowdowns, governments here have trouble raising money, so they must cut back spending. Don’t blame the petrocrats.
In reality, “populist spending” fell more than 15 years ago, thanks to vicissitudes in collecting tax revenues in the chaotic transition to markets. After independence, income per capita (measured as purchasing power) dropped by 40% or more in this region by 1998, when the collapse of the Russian ruble temporarily curbed export markets here. Torn by civil war, Tajikistan fared the worst, with a drop of 29% in 1992 alone.
As tax revenues fell, government books went into the red. Over the Nineties, governments in Central Asia cut spending in order to reduce their deficits and qualify for Western loans. In Kazakhstan, the share of government spending in national income fell from 26% in 1995 to 19% in 1997. Kyrgyzstan followed a similar pattern (28% to 22%). The fiscal reduction in Tajikistan took longer to play out, but its government became the smallest in Central Asia (13% in 2000), although it probably has the greatest social needs in the region.
Central Asian governments are still lean. A good measure of a government's influence in the national economy is the ratio of its cash payments -- including salaries, purchases and grants -- to the size of the economy (measured by gross domestic product). For Central Asia, World Bank data are available only for Kazakhstan and Kyrgyzstan. From 2006 through 2008, their respective ratios averaged 14.5% and 16.9%. These were far below the ratios for Sweden (32.7%), the United Kingdom (41%), and even of the United States (21.8%), which has a small government by Western standards.
The pink of health?
In short, the size of governments in Central Asia is an economic issue: Governments have trouble collecting taxes and borrowing abroad. But their social welfare spending, given their revenues, is another matter. In 2002, before the global slowdown, the U.S. government spent nearly $4,300 per person on health. Kazakhstan spent $62. Health spending by the other four governments in the region varied from $30 to $11 (Tajikistan). Thanks to public frugality, Central Asians must pay out of pocket for survival. In the United States, 55% of total health spending in 2002 was private. In Tajikistan, it was 72%. Were governments here acting in the interests of their typical citizens, the public share of health spending probably would be far higher in Tajikistan than in the U.S., since Tajikistanis can’t afford a doctor on their own -- their average income is less than 4% that of the U.S.
One could argue that governments in the region are simply following the preferences of their constituents; Central Asians choose not to spend on health. Total health spending as a share of national income here ranged from 3.5% in Kazakhstan to 5.5% in Uzbekistan in 2006. In contrast, the figure in the European Union was 7.3% in 1998, rising to 8.3% in 2008, according to the Organisation for Economic Co-Operation and Development (OECD).
But at times a government should act on information that its citizens don’t have. Life expectancies have dropped significantly since these five nations became independent. Total life expectancy at birth was 78 in the U.S. in 2007. For males in Central Asia, it was 62 to 69. From 1991 to 1998, male life expectancy fell by 5% in Kyrgyzstan and 6% in Kazakhstan. These are sharp changes to occur in such an enduring characteristic over only seven years. Life expectancy for women also declined sharply but remained above that for men, ranging in 1998 from 70 in Uzbekistan to 72 in Kyrgyzstan.
Death rates are especially high for some groups that lack political power. In the U.S., of every 1,000 live births, seven or so result in death within a year. In Kazakhstan and Kyrgyzstan, the respective figures are 31 and 37. In Kazakhstan, the government in the Nineties cut back sharply upon rural clinics and hospitals -- as well as on the number of once-ubiquitous trained midwives in rural areas, known as the feldshari.
To some extent, the government cuts in health spending were justified by the Soviet oversupply of hospitals and specialist doctors. But Central Asian governments may have cut away the bone as well as the fat. Tuberculosis has spread in recent years.
The taxman cometh
One way to judge a government’s commitment to future generations is to look at how much public spending goes into education. In the U.S. in 2000 through 2002, it was about 17%. In Tajikistan and Kyrgyzstan, the shares were similar -– 18% and 19%, respectively. These allocations may fail to recognize that private commitments to education in the region are weaker than elsewhere, putting the ball in the government’s court. In the U.S., total spending on education is nearly 6% of GDP. In Kazakhstan and Kyrgyzstan, the figures are only half as high. Yet education is a vital determinant – probably the most vital –- of sustained economic growth, which matters even more to a poor region like Central Asia than it does to the U.S.
Populism in Central Asia is most evident in the one area where it may hurt the most -– business climate. Averaged over 2008 and 2009, the ratio of business taxes to profits was 92.3% in Uzbekistan and 85.7% in Tajikistan, estimated the World Bank. (As usual, no data were available for Turkmenistan.) In Kyrgyzstan, the ratio was a milder 60.4%, still higher than in Sweden (54.6%), the United States (46.5%), and the United Kingdom (35.6%). To some extent, these ratios may reflect the government’s difficulty in taxing citizens. Even so, the ratios cut off two vital sources of economic growth: Physical capital and technology from abroad. There is not much point investing in a country that will claim 92% of the profits.
The conservative taxer in Central Asia has the most successful economy, Kazakhstan (38.8%). But even Kazakhstan has reneged in recent years on commitments to hold down taxes on foreign investment. The Karachaganak project to extract Caspian oil and gas has been fighting off for months the government’s attempts to become an owner of it. Meanwhile, it faces government claims exceeding $2.5 billion, reports an online portal, Silk Road Intelligencer.
In general, I’m having a spot of trouble identifying the free-handed populism that, according to Newsweek, has kept Central Asian dictators in power. The fiscal patterns suggest instead that governments here may often act contrary to the long-run interests of their constituents. The government budget is a consequence of political power, not a source of it. -- Leon Taylor, tayloralmaty@gmail.com
Statistical sources and notes
a. Government spending as a share of gross domestic product. Sources: Richard Pomfret, The Central Asian economies since independence, Princeton, 2006, page 12, Table 1.4; and the United States Bureau of Economic Analysis, online at www.bea.gov .
b. Government expenses (i.e., cash payments) as a share of GDP. Source: World Bank at http://data.worldbank.org/indicator/ .
c. Life expectancy for males at birth. Sources: The CIA World Factbook, 2008; World Health Organization, data for the Nineties. Life expectancy for females at birth: World Health Organization. Total life expectancy at birth for the United States in 2007: World Bank, World Development Indicators.
d. Government spending on health per capita. Source: The World Bank’s World Development Indicators for 2002. These are 1998 dollars. That is, they are expressed in terms of the purchasing power of a dollar in 1998. The figures are also adjusted so that a dollar would have the same purchasing power in any country when converted into the domestic currency (“purchasing power parity”).
e. Infant mortality rates. Source: The CIA World Factbook, 2005.
f. The private share of all health spending. Sources: The World Health Organization, 2002; William Aaronson, Health care finance, online.
g. The share of total health spending in GDP. Source: World Health Organization, World health report 2006. For the European Union: OECD, Health at a glance: Europe 2010, page 12. http://ec.europa.eu/health/reports/docs/health_glance_2010_exs_en.pdf . 2010.
h. Educational spending as a share of government spending. Source: The United Nations Human Development Programme (UNHDP).
i. Educational spending as a share of GDP. Source: The UNHDP, 2000-2002.
j. Business taxes as a share of profits. Source: http://data.worldbank.org/indicator/
References
A.Maratov. U.S. concerned over revision of oil contracts in Kazakhstan. Trend, online. January 5, 2011.
Owen Matthews. Beware of big ideas. Newsweek. www.newsweek.com . August 1, 2009.
Silk Road Intelligencer. Kazakhstan recovers $143 million from Karachaganak venture - customs committee. Online. January 20, 2011.
Some observers attribute to recession the tightwad policies for social welfare in Central Asia. In 2009, Newsweek explained that “last year's crash in oil prices [led to a] fall in populist spending that Central Asia's petrocrats use to buttress their popularity.” By implication, social welfare spending here is an economic problem, not a political one. In economic slowdowns, governments here have trouble raising money, so they must cut back spending. Don’t blame the petrocrats.
In reality, “populist spending” fell more than 15 years ago, thanks to vicissitudes in collecting tax revenues in the chaotic transition to markets. After independence, income per capita (measured as purchasing power) dropped by 40% or more in this region by 1998, when the collapse of the Russian ruble temporarily curbed export markets here. Torn by civil war, Tajikistan fared the worst, with a drop of 29% in 1992 alone.
As tax revenues fell, government books went into the red. Over the Nineties, governments in Central Asia cut spending in order to reduce their deficits and qualify for Western loans. In Kazakhstan, the share of government spending in national income fell from 26% in 1995 to 19% in 1997. Kyrgyzstan followed a similar pattern (28% to 22%). The fiscal reduction in Tajikistan took longer to play out, but its government became the smallest in Central Asia (13% in 2000), although it probably has the greatest social needs in the region.
Central Asian governments are still lean. A good measure of a government's influence in the national economy is the ratio of its cash payments -- including salaries, purchases and grants -- to the size of the economy (measured by gross domestic product). For Central Asia, World Bank data are available only for Kazakhstan and Kyrgyzstan. From 2006 through 2008, their respective ratios averaged 14.5% and 16.9%. These were far below the ratios for Sweden (32.7%), the United Kingdom (41%), and even of the United States (21.8%), which has a small government by Western standards.
The pink of health?
In short, the size of governments in Central Asia is an economic issue: Governments have trouble collecting taxes and borrowing abroad. But their social welfare spending, given their revenues, is another matter. In 2002, before the global slowdown, the U.S. government spent nearly $4,300 per person on health. Kazakhstan spent $62. Health spending by the other four governments in the region varied from $30 to $11 (Tajikistan). Thanks to public frugality, Central Asians must pay out of pocket for survival. In the United States, 55% of total health spending in 2002 was private. In Tajikistan, it was 72%. Were governments here acting in the interests of their typical citizens, the public share of health spending probably would be far higher in Tajikistan than in the U.S., since Tajikistanis can’t afford a doctor on their own -- their average income is less than 4% that of the U.S.
One could argue that governments in the region are simply following the preferences of their constituents; Central Asians choose not to spend on health. Total health spending as a share of national income here ranged from 3.5% in Kazakhstan to 5.5% in Uzbekistan in 2006. In contrast, the figure in the European Union was 7.3% in 1998, rising to 8.3% in 2008, according to the Organisation for Economic Co-Operation and Development (OECD).
But at times a government should act on information that its citizens don’t have. Life expectancies have dropped significantly since these five nations became independent. Total life expectancy at birth was 78 in the U.S. in 2007. For males in Central Asia, it was 62 to 69. From 1991 to 1998, male life expectancy fell by 5% in Kyrgyzstan and 6% in Kazakhstan. These are sharp changes to occur in such an enduring characteristic over only seven years. Life expectancy for women also declined sharply but remained above that for men, ranging in 1998 from 70 in Uzbekistan to 72 in Kyrgyzstan.
Death rates are especially high for some groups that lack political power. In the U.S., of every 1,000 live births, seven or so result in death within a year. In Kazakhstan and Kyrgyzstan, the respective figures are 31 and 37. In Kazakhstan, the government in the Nineties cut back sharply upon rural clinics and hospitals -- as well as on the number of once-ubiquitous trained midwives in rural areas, known as the feldshari.
To some extent, the government cuts in health spending were justified by the Soviet oversupply of hospitals and specialist doctors. But Central Asian governments may have cut away the bone as well as the fat. Tuberculosis has spread in recent years.
The taxman cometh
One way to judge a government’s commitment to future generations is to look at how much public spending goes into education. In the U.S. in 2000 through 2002, it was about 17%. In Tajikistan and Kyrgyzstan, the shares were similar -– 18% and 19%, respectively. These allocations may fail to recognize that private commitments to education in the region are weaker than elsewhere, putting the ball in the government’s court. In the U.S., total spending on education is nearly 6% of GDP. In Kazakhstan and Kyrgyzstan, the figures are only half as high. Yet education is a vital determinant – probably the most vital –- of sustained economic growth, which matters even more to a poor region like Central Asia than it does to the U.S.
Populism in Central Asia is most evident in the one area where it may hurt the most -– business climate. Averaged over 2008 and 2009, the ratio of business taxes to profits was 92.3% in Uzbekistan and 85.7% in Tajikistan, estimated the World Bank. (As usual, no data were available for Turkmenistan.) In Kyrgyzstan, the ratio was a milder 60.4%, still higher than in Sweden (54.6%), the United States (46.5%), and the United Kingdom (35.6%). To some extent, these ratios may reflect the government’s difficulty in taxing citizens. Even so, the ratios cut off two vital sources of economic growth: Physical capital and technology from abroad. There is not much point investing in a country that will claim 92% of the profits.
The conservative taxer in Central Asia has the most successful economy, Kazakhstan (38.8%). But even Kazakhstan has reneged in recent years on commitments to hold down taxes on foreign investment. The Karachaganak project to extract Caspian oil and gas has been fighting off for months the government’s attempts to become an owner of it. Meanwhile, it faces government claims exceeding $2.5 billion, reports an online portal, Silk Road Intelligencer.
In general, I’m having a spot of trouble identifying the free-handed populism that, according to Newsweek, has kept Central Asian dictators in power. The fiscal patterns suggest instead that governments here may often act contrary to the long-run interests of their constituents. The government budget is a consequence of political power, not a source of it. -- Leon Taylor, tayloralmaty@gmail.com
Statistical sources and notes
a. Government spending as a share of gross domestic product. Sources: Richard Pomfret, The Central Asian economies since independence, Princeton, 2006, page 12, Table 1.4; and the United States Bureau of Economic Analysis, online at www.bea.gov .
b. Government expenses (i.e., cash payments) as a share of GDP. Source: World Bank at http://data.worldbank.org/indicator/ .
c. Life expectancy for males at birth. Sources: The CIA World Factbook, 2008; World Health Organization, data for the Nineties. Life expectancy for females at birth: World Health Organization. Total life expectancy at birth for the United States in 2007: World Bank, World Development Indicators.
d. Government spending on health per capita. Source: The World Bank’s World Development Indicators for 2002. These are 1998 dollars. That is, they are expressed in terms of the purchasing power of a dollar in 1998. The figures are also adjusted so that a dollar would have the same purchasing power in any country when converted into the domestic currency (“purchasing power parity”).
e. Infant mortality rates. Source: The CIA World Factbook, 2005.
f. The private share of all health spending. Sources: The World Health Organization, 2002; William Aaronson, Health care finance, online.
g. The share of total health spending in GDP. Source: World Health Organization, World health report 2006. For the European Union: OECD, Health at a glance: Europe 2010, page 12. http://ec.europa.eu/health/reports/docs/health_glance_2010_exs_en.pdf . 2010.
h. Educational spending as a share of government spending. Source: The United Nations Human Development Programme (UNHDP).
i. Educational spending as a share of GDP. Source: The UNHDP, 2000-2002.
j. Business taxes as a share of profits. Source: http://data.worldbank.org/indicator/
References
A.Maratov. U.S. concerned over revision of oil contracts in Kazakhstan. Trend, online. January 5, 2011.
Owen Matthews. Beware of big ideas. Newsweek. www.newsweek.com . August 1, 2009.
Silk Road Intelligencer. Kazakhstan recovers $143 million from Karachaganak venture - customs committee. Online. January 20, 2011.
Thursday, February 24, 2011
The beggar’s opera
Is global inflation in the offing?
Are nations about to beggar their neighbors?
The question arose when the Group of 20 met in Seoul in November, ostensibly to forge an agreement between the United States and China over a yuan that Americans regard as too weak. Is the most critical undervaluation in Beijing -- or in Washington, D.C.? Dollars newly created by the Fed -– the “Quantitative Easing II” in today’s headlines -– might someday reduce the foreign value of a dollar, just as an increase in the supply of toothbrushes tends to lower their price so that people will buy the new toothbrushes.
Under a pact of the International Monetary Fund –- the Jamaica Agreement of 1976 -– a country should not devalue to try to make its exports cheaper than those of its neighbors, since they could respond by devaluing as well. Beggaring the neighbor could lead to global inflation, in two ways. Since Home’s exports are now cheaper, in terms of foreign currency, foreigners will buy more of them, driving up their prices at Home. Second, the devaluation raises the cost of imports to consumers at Home, so they will buy more Home goods instead, bidding up these prices again. That scenario can occur in every country that plays the beggar. Kazakhstan may worry that a weak yuan can undermine demand for its manufactured exports.
In the long run, an episode of inflation might not matter much. When workers and machines are idle, the natural tendency is to put them to work eventually, regardless of whether most prices are low or high. Over the long haul, the price is just a number on a pricetag. But in the short run, prices that rise more rapidly for some products than for others -– which is what inflation entails for a while -– confuse buyers and sellers alike. They won’t make their best decisions. Global confusion could reduce global output.
Clobber thy neighbor
These days, however, observers worry about a new way to beggar thy neighbor. Return for a moment to the Fed’s “quantitative easing.” Expanding the dollar supply will likely lower the price of holding a dollar. This price is the U.S. interest rate, since the holder of the dollar forgoes the interest payment. In order to express the purchasing power of this payment foregone, let’s adjust the interest rate for changes in product prices. As this “real” interest rate falls in the U.S., interest-bearing assets in other countries will look more attractive to financial investors than before. Why settle for a 1% return on an American bond when you can get a 2% return on a Korean one? Money will flow into South Korea.
This may look delightful for the Koreans, but it isn’t. The extra money will lead to more spending on products in Korea, pushing up prices in an economy that had already been growing 5% annually early this year. To avoid inflation, the Korean central bank might raise its interest rate in order to discourage production -- funded by borrowed won -- that might overheat the economy. But the rise in Korea’s interest rate will make the won look all the more attractive. As financial investors bid higher for the won, its foreign value will increase. Thanks to the Fed, the dollar weakened 8% against the won last year, according to the New York Times. That’s bad news for Korean exporters, since it raises the cost to foreign buyers of their products.
“The recent Korean recovery was mainly due to export growth,” writes Sang H. Lee, an associate professor of finance at KIMEP who studies money supply. “The exporters' margin will be squeezed by the undesirable appreciation of the won.
“Should the Korean government implement restrictions on capital inflows and be blamed as a protectionist? Or should it manage the exchange rate?”
Holding back the tide
Beyond the argument over whether the government should intervene in currency markets, lies a more troubling one: Can intervention work? Its effects are usually ephemeral, because the private foreign-exchange market -– exceeding two trillion dollars of trading each day -- swamps their attempts. If intervention can succeed, then surely it would have done so in 1995, when the two major players in the dollar-yen exchange -- the U.S. and Japan – coordinated to try to shore up the dollar. The U.S. had wanted to avert inflation; Japan had wanted more exports. That August, while speculators were on vacation, the dollar rose for a while; but by September, they were selling dollars on the hunch that the stimulus had ended and thus the yen value of the dollar had peaked. That prophecy fulfilled itself.
Intervention, carried to its logical extreme, implies adopting one monetary rule around the world, such as a gold standard. Global markets have had no such standard since the early 1970s, when the United States abandoned the Bretton Woods system, in which the dollar was backed by gold and other currencies were backed by the dollar.
Under a gold standard, banks would buy and sell gold, and a currency backed by it, at a fixed rate -– say, $500 for an ounce of gold. The central bank’s reserves of gold would limit the amount of paper money that it could issue, since otherwise speculators could exchange worthless paper for gold until the bank ran out of ounces. So constrained, the bank would no longer be tempted to print money and hand it over to the government so that it could buy more than before. (That is, the government could buy more until prices rose to reflect the increase in money supply, reducing the government’s purchasing power to its original level).
Gold can restrain inflation -- brutally. Suppose, with the world on a gold standard, that prices suddenly spike in Kazakhstan. Since the country’s goods become more expensive than before, compared to other goods around the world, global consumers will stop spending gold on Kazakhstan’s products and spend it elsewhere. Kazakhstan’s supply of gold will fall.
To maintain the given rate of exchange between gold and tenge, the National Bank of Kazakhstan will have to withdraw tenge from circulation. If the Bank’s gold supply falls by half, then the Bank must withdraw half of the tenge in circulation. With fewer tenge and ounces of gold making the rounds, product prices in Kazakhstan must fall, reversing the initial inflation.
This is not an arid exercise. The deflation will raise real debt owed by firms and so will bankrupt some of them. Workers at these firms will lose their jobs. Other firms, seeing their output prices falling but unable to cut wages accordingly, will lay off employees. Stabilizing prices can hurt.
John Maynard Keynes pointed this out in 1925, when the Chancellor of the Exchequer, Winston Churchill, decided to strengthen Britain’s pound sterling until it was worth as much gold as before World War I. This implied that the pound would be able to buy more goods than before -– i.e., that product prices would fall. For this to happen, production costs would have to fall, or producers would go bankrupt. The largest cost of production was for labor. But English unions would resist wage cuts. Firms would be forced to lay off employees. Churchill’s deflation would bring about a depression. And it did. In fact, it may have raised the curtain on the Great Depression. –- Leon Taylor, taylorleon@gmail.com
Good reading
Sewell Chan and Martin Fackler. Currency move changes S. Korea plan. The New York Times. November 9, 2010
John Maynard Keynes. Essays in persuasion. New York: Palgrave Macmillan. 2010.
Roy Ruffin and Paul Gregory. Principles of macroeconomics. New York: Pearson. 2001. The seventh edition includes a clear introduction to currency markets and briefly discusses the 1995 intervention.
Are nations about to beggar their neighbors?
The question arose when the Group of 20 met in Seoul in November, ostensibly to forge an agreement between the United States and China over a yuan that Americans regard as too weak. Is the most critical undervaluation in Beijing -- or in Washington, D.C.? Dollars newly created by the Fed -– the “Quantitative Easing II” in today’s headlines -– might someday reduce the foreign value of a dollar, just as an increase in the supply of toothbrushes tends to lower their price so that people will buy the new toothbrushes.
Under a pact of the International Monetary Fund –- the Jamaica Agreement of 1976 -– a country should not devalue to try to make its exports cheaper than those of its neighbors, since they could respond by devaluing as well. Beggaring the neighbor could lead to global inflation, in two ways. Since Home’s exports are now cheaper, in terms of foreign currency, foreigners will buy more of them, driving up their prices at Home. Second, the devaluation raises the cost of imports to consumers at Home, so they will buy more Home goods instead, bidding up these prices again. That scenario can occur in every country that plays the beggar. Kazakhstan may worry that a weak yuan can undermine demand for its manufactured exports.
In the long run, an episode of inflation might not matter much. When workers and machines are idle, the natural tendency is to put them to work eventually, regardless of whether most prices are low or high. Over the long haul, the price is just a number on a pricetag. But in the short run, prices that rise more rapidly for some products than for others -– which is what inflation entails for a while -– confuse buyers and sellers alike. They won’t make their best decisions. Global confusion could reduce global output.
Clobber thy neighbor
These days, however, observers worry about a new way to beggar thy neighbor. Return for a moment to the Fed’s “quantitative easing.” Expanding the dollar supply will likely lower the price of holding a dollar. This price is the U.S. interest rate, since the holder of the dollar forgoes the interest payment. In order to express the purchasing power of this payment foregone, let’s adjust the interest rate for changes in product prices. As this “real” interest rate falls in the U.S., interest-bearing assets in other countries will look more attractive to financial investors than before. Why settle for a 1% return on an American bond when you can get a 2% return on a Korean one? Money will flow into South Korea.
This may look delightful for the Koreans, but it isn’t. The extra money will lead to more spending on products in Korea, pushing up prices in an economy that had already been growing 5% annually early this year. To avoid inflation, the Korean central bank might raise its interest rate in order to discourage production -- funded by borrowed won -- that might overheat the economy. But the rise in Korea’s interest rate will make the won look all the more attractive. As financial investors bid higher for the won, its foreign value will increase. Thanks to the Fed, the dollar weakened 8% against the won last year, according to the New York Times. That’s bad news for Korean exporters, since it raises the cost to foreign buyers of their products.
“The recent Korean recovery was mainly due to export growth,” writes Sang H. Lee, an associate professor of finance at KIMEP who studies money supply. “The exporters' margin will be squeezed by the undesirable appreciation of the won.
“Should the Korean government implement restrictions on capital inflows and be blamed as a protectionist? Or should it manage the exchange rate?”
Holding back the tide
Beyond the argument over whether the government should intervene in currency markets, lies a more troubling one: Can intervention work? Its effects are usually ephemeral, because the private foreign-exchange market -– exceeding two trillion dollars of trading each day -- swamps their attempts. If intervention can succeed, then surely it would have done so in 1995, when the two major players in the dollar-yen exchange -- the U.S. and Japan – coordinated to try to shore up the dollar. The U.S. had wanted to avert inflation; Japan had wanted more exports. That August, while speculators were on vacation, the dollar rose for a while; but by September, they were selling dollars on the hunch that the stimulus had ended and thus the yen value of the dollar had peaked. That prophecy fulfilled itself.
Intervention, carried to its logical extreme, implies adopting one monetary rule around the world, such as a gold standard. Global markets have had no such standard since the early 1970s, when the United States abandoned the Bretton Woods system, in which the dollar was backed by gold and other currencies were backed by the dollar.
Under a gold standard, banks would buy and sell gold, and a currency backed by it, at a fixed rate -– say, $500 for an ounce of gold. The central bank’s reserves of gold would limit the amount of paper money that it could issue, since otherwise speculators could exchange worthless paper for gold until the bank ran out of ounces. So constrained, the bank would no longer be tempted to print money and hand it over to the government so that it could buy more than before. (That is, the government could buy more until prices rose to reflect the increase in money supply, reducing the government’s purchasing power to its original level).
Gold can restrain inflation -- brutally. Suppose, with the world on a gold standard, that prices suddenly spike in Kazakhstan. Since the country’s goods become more expensive than before, compared to other goods around the world, global consumers will stop spending gold on Kazakhstan’s products and spend it elsewhere. Kazakhstan’s supply of gold will fall.
To maintain the given rate of exchange between gold and tenge, the National Bank of Kazakhstan will have to withdraw tenge from circulation. If the Bank’s gold supply falls by half, then the Bank must withdraw half of the tenge in circulation. With fewer tenge and ounces of gold making the rounds, product prices in Kazakhstan must fall, reversing the initial inflation.
This is not an arid exercise. The deflation will raise real debt owed by firms and so will bankrupt some of them. Workers at these firms will lose their jobs. Other firms, seeing their output prices falling but unable to cut wages accordingly, will lay off employees. Stabilizing prices can hurt.
John Maynard Keynes pointed this out in 1925, when the Chancellor of the Exchequer, Winston Churchill, decided to strengthen Britain’s pound sterling until it was worth as much gold as before World War I. This implied that the pound would be able to buy more goods than before -– i.e., that product prices would fall. For this to happen, production costs would have to fall, or producers would go bankrupt. The largest cost of production was for labor. But English unions would resist wage cuts. Firms would be forced to lay off employees. Churchill’s deflation would bring about a depression. And it did. In fact, it may have raised the curtain on the Great Depression. –- Leon Taylor, taylorleon@gmail.com
Good reading
Sewell Chan and Martin Fackler. Currency move changes S. Korea plan. The New York Times. November 9, 2010
John Maynard Keynes. Essays in persuasion. New York: Palgrave Macmillan. 2010.
Roy Ruffin and Paul Gregory. Principles of macroeconomics. New York: Pearson. 2001. The seventh edition includes a clear introduction to currency markets and briefly discusses the 1995 intervention.
Friday, February 18, 2011
Thought for food
Kazakhstan’s farm problem roots in a failed land market
Over the past year, prices have tripled for such staples of the Kazakhstani diet as meat, grain and beets. A large bakery in Petropavlovsk suspended bread deliveries because it could not recover cost increases with higher bread prices, reports a newspaper, Delovoy Kazakhstan.
Immediate causes of the food shortages include bad weather and the growing demand of Chinese consumers. But we went through this exercise in 2008. What are the long-run causes of recurring shortages? What, if anything, should the government do about them?
Although Kazakhstan accounts for nearly a third of the farmland in the transition economies of Europe and Central Asia, the importance to it of agriculture has been shrinking over the decades. While four fifths of our land is agricultural, farming accounted for just 8% of the economy (measured as gross domestic product) in 2005, having dropped 40% in gross output since 1990. After the twin crises of 1998, when the Russian ruble and the price of oil collapsed, agriculture failed to recover as strongly as the rest of the national economy, noted an agricultural economist, Zvi Lerman, and the Food and Agriculture Organization of the United Nations.
This is disproportionately unfortunate for Kazakhstan: Nearly half of its population is rural, and a quarter survives on subsistence farming, according to the World Bank.
Kazakhstani farms can produce more than they do. Farm labor productivity here had led the Soviet states from 1965 to 1990 -- 8,400 rubles of farm output per worker, nearly a tenth higher than Russia could manage, according to raw data from Lerman and coauthors. Why isn’t productivity higher now?
One problem may be the land market. When it works well, entrepreneurs can buy farms losing money and make them more efficient. In Kazakhstan, the farmland market has developed haltingly.
Novel markets
In the early years of the republic, the government owned most farmland. Land reform in the mid-Nineties sought to encourage entrepreneurs to take over the 2,500 soviet farms, including the sovhoz (averaging 95,000 hectares) and the kolhoz (38,000 ha), noted Steven Hendrix. But individuals could own plots of only up to 1 hectare; the government continued as the nominal owner of larger farms, noted Lerman and coauthors.
Belatedly, the government permitted a land market. This enabled family farms to increase their share of agricultural output from 28% in 1990 to 75% in 2000, according to the World Bank. The number of peasant farms increased from 3,300 in 1992 to 58,400 in 1999. At that time, their share of agricultural land, nearly one eighth, was unusually high for the post-Soviet region, noted Max Spoor and Oane Visser. Today, there are more than 91,000 peasant farms. Even this may be an underestimate, since subsistence farms and household plots tend to be unregistered, according to the World Bank. Most rural families surveyed by the World Bank in 1996 reported that they maintained plots on their own, such as a backyard. Of the livestock herd, family farms claimed 90% in 2002, compared to 29% in 1990, according to Lerman and co-authors.
These trends are encouraging. A study of the 23 transition economies between 1992 and 2004 found that agricultural growth increases with the share of land owned by individuals. But corporate farms (including cooperatives and limited-liability farms) still dominate, especially in the north, accounting for 60% of agricultural land in recent years, estimated Johan F. M. Swinnen and Liesbet Vranken.
To some extent, corporate dominance results from geography. Kazakhstan is land-intensive, with 114 hectares of agricultural land per farm worker in even the late Eighties, before the emigrations of the Nineties. The average registered farm here is 10 times larger than in the Czech Republic, according to the World Bank.
Block that market
But the most important reasons for corporate dominance seem institutional. Under the land code, the collective could deny the individual’s claim for land and offer cash instead, Hendrix noted. The code justified such barriers to breakups of estates as protection of the environment.
The unequal distribution of land shares also led to corporate concentration. A 1994 decree of the Cabinet of Ministers permitted closed auctions of state farms to small groups of educated specialists. A presidential decree allowed farm directors of 20 years’ standing to receive a fifth of the capital shares, but this was dropped after public protest, according to the Food and Agriculture Organization. Under the 2003 land code, corporate farms could claim ownership to properties that they had rented, said the World Bank.
To some degree, this could have improved farming. Some collectives reorganized as limited partnerships. Healthy corporate farms in north Kazakhstan – especially grain operations that integrated several stages of production – took over bankrupt properties, said the World Bank. But this vertical integration stemmed from a government decision to let farms buy cheap shares in the enterprises that processed their products, according to the Food and Agriculture Organization. Such control of suppliers may give a farm undue power in the food market – power that it may exercise by restricting output in order to sustain high prices. Soft budget constraints on reorganized farms – politically powerful in their regions -- discouraged efficiency. In the mid-Nineties, large farms in Kazakhstan had about the same yield per hectare as small farms but incurred higher costs, said Hendrix. The farms had yet to replace their old machines.
A farmland market exists, barely. As of 2004, fewer than 5% of rural households and family farms had sold any land. Fewer than 5% of unregistered farms had bought land, and no corporate farm had done so. They rented from farm members, although it is not clear that the latter received payments, noted Swinnen and Vranken. Cash payments to unregistered farms averaged 500 tenge for a fifth of a hectare, estimated the World Bank. Generally, corporate farms paid in-kind rent to households. Nearly half of the farm workers received payment only in kind, according to a World Bank survey in 2000.
More than 70% of farms surveyed in recent years reported difficulties in renting in land, estimated Swinnen and Vranken. More than half of family farms, and 30% of corporate farms, said the main problem was identifying the authority in charge of land rents – a virtually unknown problem in other CIS countries surveyed. Among corporate farms, nearly 30% reported that they didn’t know if they could rent legally; 35% said they couldn’t find anyone to whom to rent.
The creaky operation of the land market is not the only problem. Of family farms surveyed, nearly two-thirds said they didn’t buy more land because they lacked farm tools. Finding spare parts was also troublesome. But such markets may fall into place if the main one – the land market – worked more smoothly. – Leon Taylor, tayloralmaty@gmail.com
Good reading
Kelley Cormier. Farm restructuring in Kazakhstan: An institutional economics approach. Michigan State University, Department of Agricultural Economics, Agricultural Economics Report 612. December 2001. http://www.aec.msu.edu/aecreports/aec612.pdf.
Yulia Dubovytskyx. Tseni vzyaly razgon. Delovoy Kazakhstan. February 11, 2011. Page 1.
Steven E. Hendrix. Legislative reform of property ownership in Kazakhstan, Development Policy Review 15: 159-171. 1997.
Zvi Lerman. The impact of land reform on rural household incomes in Transcaucasia and Central Asia. Hebrew University of Jerusalem, Center for Agricultural Economic Research and the Department of Agricultural Economics and Management. Discussion paper, 9.05, 2005. http://departments.agri.huji.ac.il/economics/lerman-vol.pdf
Zvi Lerman, Csaba Csaki, and Gershon Feder. Agriculture in transition: Land policies and evolving farm structures in post-Soviet countries. Lanham, Md.: Lexington Books. 2004. http://www.agri.huji.ac.il/%7Elermanzv/book/Ch1Heritage.pdf
Max Spoor and Oane Visser, The state of agrarian reform in the former Soviet Union. Europe-Asia Studies 53:6. 2001.
Johan F. M. Swinnen and Liesbet Vranken. The development of rural land markets in transition countries. The Food and Agriculture Organization of the United Nations. http://www.fao.org/regional/seur/events/landmark/docs/swinnen.pdf
United Nations Food and Agriculture Organization. A profile of Kazakhstan’s agricultural reforms. 1995. http://www.fao.org/docrep/v6800e/V6800E0h.htm#A%20profile%20of%20Kazakhstan's%20agricultural%20reforms
World Bank. Untitled book, chapter 3: The role of labor markets and safety nets. http://siteresources.worldbank.org/INTECA/Resources/ch3-poverty.pdf
World Bank. Emerging challenges of land rental markets: A review of available evidence for the Europe and Central Asia region. March 2006. http://siteresources.worldbank.org/INTECA/Resources/EmergingChallengesofLandRentalMarkets_FullReport.pdf
Over the past year, prices have tripled for such staples of the Kazakhstani diet as meat, grain and beets. A large bakery in Petropavlovsk suspended bread deliveries because it could not recover cost increases with higher bread prices, reports a newspaper, Delovoy Kazakhstan.
Immediate causes of the food shortages include bad weather and the growing demand of Chinese consumers. But we went through this exercise in 2008. What are the long-run causes of recurring shortages? What, if anything, should the government do about them?
Although Kazakhstan accounts for nearly a third of the farmland in the transition economies of Europe and Central Asia, the importance to it of agriculture has been shrinking over the decades. While four fifths of our land is agricultural, farming accounted for just 8% of the economy (measured as gross domestic product) in 2005, having dropped 40% in gross output since 1990. After the twin crises of 1998, when the Russian ruble and the price of oil collapsed, agriculture failed to recover as strongly as the rest of the national economy, noted an agricultural economist, Zvi Lerman, and the Food and Agriculture Organization of the United Nations.
This is disproportionately unfortunate for Kazakhstan: Nearly half of its population is rural, and a quarter survives on subsistence farming, according to the World Bank.
Kazakhstani farms can produce more than they do. Farm labor productivity here had led the Soviet states from 1965 to 1990 -- 8,400 rubles of farm output per worker, nearly a tenth higher than Russia could manage, according to raw data from Lerman and coauthors. Why isn’t productivity higher now?
One problem may be the land market. When it works well, entrepreneurs can buy farms losing money and make them more efficient. In Kazakhstan, the farmland market has developed haltingly.
Novel markets
In the early years of the republic, the government owned most farmland. Land reform in the mid-Nineties sought to encourage entrepreneurs to take over the 2,500 soviet farms, including the sovhoz (averaging 95,000 hectares) and the kolhoz (38,000 ha), noted Steven Hendrix. But individuals could own plots of only up to 1 hectare; the government continued as the nominal owner of larger farms, noted Lerman and coauthors.
Belatedly, the government permitted a land market. This enabled family farms to increase their share of agricultural output from 28% in 1990 to 75% in 2000, according to the World Bank. The number of peasant farms increased from 3,300 in 1992 to 58,400 in 1999. At that time, their share of agricultural land, nearly one eighth, was unusually high for the post-Soviet region, noted Max Spoor and Oane Visser. Today, there are more than 91,000 peasant farms. Even this may be an underestimate, since subsistence farms and household plots tend to be unregistered, according to the World Bank. Most rural families surveyed by the World Bank in 1996 reported that they maintained plots on their own, such as a backyard. Of the livestock herd, family farms claimed 90% in 2002, compared to 29% in 1990, according to Lerman and co-authors.
These trends are encouraging. A study of the 23 transition economies between 1992 and 2004 found that agricultural growth increases with the share of land owned by individuals. But corporate farms (including cooperatives and limited-liability farms) still dominate, especially in the north, accounting for 60% of agricultural land in recent years, estimated Johan F. M. Swinnen and Liesbet Vranken.
To some extent, corporate dominance results from geography. Kazakhstan is land-intensive, with 114 hectares of agricultural land per farm worker in even the late Eighties, before the emigrations of the Nineties. The average registered farm here is 10 times larger than in the Czech Republic, according to the World Bank.
Block that market
But the most important reasons for corporate dominance seem institutional. Under the land code, the collective could deny the individual’s claim for land and offer cash instead, Hendrix noted. The code justified such barriers to breakups of estates as protection of the environment.
The unequal distribution of land shares also led to corporate concentration. A 1994 decree of the Cabinet of Ministers permitted closed auctions of state farms to small groups of educated specialists. A presidential decree allowed farm directors of 20 years’ standing to receive a fifth of the capital shares, but this was dropped after public protest, according to the Food and Agriculture Organization. Under the 2003 land code, corporate farms could claim ownership to properties that they had rented, said the World Bank.
To some degree, this could have improved farming. Some collectives reorganized as limited partnerships. Healthy corporate farms in north Kazakhstan – especially grain operations that integrated several stages of production – took over bankrupt properties, said the World Bank. But this vertical integration stemmed from a government decision to let farms buy cheap shares in the enterprises that processed their products, according to the Food and Agriculture Organization. Such control of suppliers may give a farm undue power in the food market – power that it may exercise by restricting output in order to sustain high prices. Soft budget constraints on reorganized farms – politically powerful in their regions -- discouraged efficiency. In the mid-Nineties, large farms in Kazakhstan had about the same yield per hectare as small farms but incurred higher costs, said Hendrix. The farms had yet to replace their old machines.
A farmland market exists, barely. As of 2004, fewer than 5% of rural households and family farms had sold any land. Fewer than 5% of unregistered farms had bought land, and no corporate farm had done so. They rented from farm members, although it is not clear that the latter received payments, noted Swinnen and Vranken. Cash payments to unregistered farms averaged 500 tenge for a fifth of a hectare, estimated the World Bank. Generally, corporate farms paid in-kind rent to households. Nearly half of the farm workers received payment only in kind, according to a World Bank survey in 2000.
More than 70% of farms surveyed in recent years reported difficulties in renting in land, estimated Swinnen and Vranken. More than half of family farms, and 30% of corporate farms, said the main problem was identifying the authority in charge of land rents – a virtually unknown problem in other CIS countries surveyed. Among corporate farms, nearly 30% reported that they didn’t know if they could rent legally; 35% said they couldn’t find anyone to whom to rent.
The creaky operation of the land market is not the only problem. Of family farms surveyed, nearly two-thirds said they didn’t buy more land because they lacked farm tools. Finding spare parts was also troublesome. But such markets may fall into place if the main one – the land market – worked more smoothly. – Leon Taylor, tayloralmaty@gmail.com
Good reading
Kelley Cormier. Farm restructuring in Kazakhstan: An institutional economics approach. Michigan State University, Department of Agricultural Economics, Agricultural Economics Report 612. December 2001. http://www.aec.msu.edu/aecreports/aec612.pdf.
Yulia Dubovytskyx. Tseni vzyaly razgon. Delovoy Kazakhstan. February 11, 2011. Page 1.
Steven E. Hendrix. Legislative reform of property ownership in Kazakhstan, Development Policy Review 15: 159-171. 1997.
Zvi Lerman. The impact of land reform on rural household incomes in Transcaucasia and Central Asia. Hebrew University of Jerusalem, Center for Agricultural Economic Research and the Department of Agricultural Economics and Management. Discussion paper, 9.05, 2005. http://departments.agri.huji.ac.il/economics/lerman-vol.pdf
Zvi Lerman, Csaba Csaki, and Gershon Feder. Agriculture in transition: Land policies and evolving farm structures in post-Soviet countries. Lanham, Md.: Lexington Books. 2004. http://www.agri.huji.ac.il/%7Elermanzv/book/Ch1Heritage.pdf
Max Spoor and Oane Visser, The state of agrarian reform in the former Soviet Union. Europe-Asia Studies 53:6. 2001.
Johan F. M. Swinnen and Liesbet Vranken. The development of rural land markets in transition countries. The Food and Agriculture Organization of the United Nations. http://www.fao.org/regional/seur/events/landmark/docs/swinnen.pdf
United Nations Food and Agriculture Organization. A profile of Kazakhstan’s agricultural reforms. 1995. http://www.fao.org/docrep/v6800e/V6800E0h.htm#A%20profile%20of%20Kazakhstan's%20agricultural%20reforms
World Bank. Untitled book, chapter 3: The role of labor markets and safety nets. http://siteresources.worldbank.org/INTECA/Resources/ch3-poverty.pdf
World Bank. Emerging challenges of land rental markets: A review of available evidence for the Europe and Central Asia region. March 2006. http://siteresources.worldbank.org/INTECA/Resources/EmergingChallengesofLandRentalMarkets_FullReport.pdf
Thursday, February 10, 2011
Monetizing the debt for fun and profit
Does the government lend to itself?
Since 2000, the government of Kazakhstan usually has managed to rack up tidy little surpluses of up to 4.2% of the size of the economy (measured in gross domestic product, or GDP). But when Kazakhstani banks crashed in 2008-9, the government attempted (with some success) to spend its way out of recession. Consequently, it began spending more money than it was collecting in tax revenues. By 2011, this deficit may amount to more than 6% of GDP – judging from the budget approved by the legislature -- although the prime minister vows to reduce it to less than 3%.
Kazakhstan does not have a deficit overhang of Grecian dimensions. (In Greece, where the government spent as if there would be no tomorrow, the deficit in 2009 exceeded 15% of GDP, although the European Union ostensibly limits the deficit of a member nation to 3% of GDP.) Even so, a persistent deficit in Kazakhstan could raise the spectre of higher interest rates, since the government might compete with entrepreneurs for loans by bidding up the price of a tenge loaned – the rate of interest.
To surreptitiously avoid this appearance, the government can quietly borrow from itself. The central bank can buy the government’s bonds, thus holding down the interest rate that Astana must pay on this debt. Because these transactions are inconspicuous, public borrowing might look affordable.
Monetizing the debt is a time-honored trick. In Germany of 1923, the Reichsbank held 190 million trillion marks of bonds sold by the government, wrote Robert Hetzel. When it comes to public deficits, the central bank is often a co-conspirator.
Who does your banker favor?
At the moment, net claims of the National Bank of Kazakhstan on the central government are negative, and the gross value of its government securities generally does not exceed 6 billion tenge. But as of December, net claims of commercial banks on the central government were nearly 400 billion tenge, the equal of more than 5% of their reserves, according to raw data from the National Bank. Claims on public nonfinancial institutions were more than twice as much – over 800 billion tenge (equaling more than 11% of reserves). This, of course, could not possibly have anything to do with the fact that since 2008 the government has become a major owner of large commercial banks.
Curiously, commercial bank loans to local governments – the oblasts and the cities – were less than 6 billion tenge, equaling just one-tenth of one percent of reserves. One would have thought that the banks would take more interest in the condition of their localities. Then again, we have a new owner.
All told, commercial bank loans to the public sector in Kazakhstan were easily more than half as much as their loans to households. To some extent, banks would rather finance the government than a local youth’s education.
Financial gumshoes
How can we tell whether we really can afford the public borrowing? By looking at the market rate of interest. This has two components.
One is the “real” interest rate, which reflects the real return to capital (that is, the return in terms of purchasing power). If people expect a proposed auto-assembly plant to earn 5 cents of profit per dollar spent on construction, then the entrepreneur is willing to pay up to 5 cents of interest to borrow a dollar for building.
The second component reflects the expected rate of inflation, since the lender wants to be compensated for any loss of purchasing power in his funds that is due to higher prices. When prices are twice as high, a tenge will buy only half as much. (Or less. In Argentina, a woman purchased a plane ticket to Lebanon in 1988 – only to find that the refund in 2001 would buy only an alarm clock, reported the Wall Street Journal.)
At present, the annual rate of inflation in Kazakhstan is about 8%. The creditor who lends a dollar for a year can expect to get back a dollar in 2012 that buys 8% less of goods than it would today. To offset this expected loss, the creditor will demand 8 cents of interest.
The expected rate of inflation may seem an evanescent idea. But for many long-term rates of interest -- such as on 30-year home mortgages a few years ago in the United States -- inflationary expectations make up the bulk of the rate. Before 2008, Americans expected prices to rise more and more sharply over time.
The market rate of interest sums the real rate of interest and the expected rate of inflation. The long-run real rate of return to capital per year in Kazakhstan is (very) roughly 8% to 10%, judging from the trend rate of economic growth. The expected rate of annual inflation may be 8%. Thus a typical interest rate on creditworthy corporate loans may be 16% or 18% over the long run.
Government borrowing may affect either component. If the government competes away resources from the private sector, then borrowers will have to propose more profitable projects than before in order to get funds. This increases the real rate of return to capital. Also, new government spending pressures prices upward when the economy already is producing at full capacity. Thus it increases the expected rate of inflation.
At present, the deficit does not have an overwhelming impact on private interest rates. The rate on short-term bank loans of tenge fell from 16.6% in 2008 to 16% in 2009, with rates continuing to fall into 2010, according to the National Bank. The rate on interbank loans rose from 4.67% in 2007 to 6.75% in 2009, but that probably reflected the growing riskiness of banking. All this notwithstanding, in any sustained recovery, one should consider whether government borrowing may contribute to inflation.
This examination would be simpler if we had a simple way to measure expected inflation.
In the United States, you can estimate this expectation by looking at the difference in rates between Treasury bonds that compensate you for inflation (on top of their usual yields) and Treasury bonds that don't. At present, a Treasury security maturing in five years yields .31% per year. That is, the bond would pay you 31 cents for every $100 that you spent on it, and it would also compensate for inflation on top of that. An ordinary Treasury bond maturing in five years yields 2.29% per year, according to data from the Federal Reserve. This suggests that people expected an average of 2.29% – .31% = 1.98% inflation per year until 2016.
Over the short run, this forecasting tool does pretty well: One can use the interest rates on one- to six-month Treasury bills to forecast inflation a month ahead in a way that is statistically reliable, noted economist Stephen Smith. The government of Kazakhstan may wish to give a thought or three to introducing inflation-indexed securities of its own. -- Leon Taylor, tayloralmaty@gmail.com
Good reading
Central Asia & Caucasus Business Weekly. Untitled article on Kazakhstani deficits. October 26, 2010 http://business.highbeam.com/436263/article-1G1-241679918/interfax-central-asia-amp-caucasus-business-weekly
Robert L. Hetzel. German monetary history in the first half of the twentieth century. Economic Quarterly. Federal Reserve Bank of Richmond. Winter 2002, pages 1-35. http://www.richmondfed.org/publications/research/economic_quarterly/2002/winter/pdf/hetzel.pdf
David Luhnow. For Argentina, no panacea in the dollar. Wall Street Journal. December 4, 2001. Page A12.
Stephen D. Smith. What do asset prices tell us about the future? Economic Review. Federal Reserve Bank of Atlanta. Third quarter 1999. http://www.frbatlanta.org/filelegacydocs/smith.pdf
Since 2000, the government of Kazakhstan usually has managed to rack up tidy little surpluses of up to 4.2% of the size of the economy (measured in gross domestic product, or GDP). But when Kazakhstani banks crashed in 2008-9, the government attempted (with some success) to spend its way out of recession. Consequently, it began spending more money than it was collecting in tax revenues. By 2011, this deficit may amount to more than 6% of GDP – judging from the budget approved by the legislature -- although the prime minister vows to reduce it to less than 3%.
Kazakhstan does not have a deficit overhang of Grecian dimensions. (In Greece, where the government spent as if there would be no tomorrow, the deficit in 2009 exceeded 15% of GDP, although the European Union ostensibly limits the deficit of a member nation to 3% of GDP.) Even so, a persistent deficit in Kazakhstan could raise the spectre of higher interest rates, since the government might compete with entrepreneurs for loans by bidding up the price of a tenge loaned – the rate of interest.
To surreptitiously avoid this appearance, the government can quietly borrow from itself. The central bank can buy the government’s bonds, thus holding down the interest rate that Astana must pay on this debt. Because these transactions are inconspicuous, public borrowing might look affordable.
Monetizing the debt is a time-honored trick. In Germany of 1923, the Reichsbank held 190 million trillion marks of bonds sold by the government, wrote Robert Hetzel. When it comes to public deficits, the central bank is often a co-conspirator.
Who does your banker favor?
At the moment, net claims of the National Bank of Kazakhstan on the central government are negative, and the gross value of its government securities generally does not exceed 6 billion tenge. But as of December, net claims of commercial banks on the central government were nearly 400 billion tenge, the equal of more than 5% of their reserves, according to raw data from the National Bank. Claims on public nonfinancial institutions were more than twice as much – over 800 billion tenge (equaling more than 11% of reserves). This, of course, could not possibly have anything to do with the fact that since 2008 the government has become a major owner of large commercial banks.
Curiously, commercial bank loans to local governments – the oblasts and the cities – were less than 6 billion tenge, equaling just one-tenth of one percent of reserves. One would have thought that the banks would take more interest in the condition of their localities. Then again, we have a new owner.
All told, commercial bank loans to the public sector in Kazakhstan were easily more than half as much as their loans to households. To some extent, banks would rather finance the government than a local youth’s education.
Financial gumshoes
How can we tell whether we really can afford the public borrowing? By looking at the market rate of interest. This has two components.
One is the “real” interest rate, which reflects the real return to capital (that is, the return in terms of purchasing power). If people expect a proposed auto-assembly plant to earn 5 cents of profit per dollar spent on construction, then the entrepreneur is willing to pay up to 5 cents of interest to borrow a dollar for building.
The second component reflects the expected rate of inflation, since the lender wants to be compensated for any loss of purchasing power in his funds that is due to higher prices. When prices are twice as high, a tenge will buy only half as much. (Or less. In Argentina, a woman purchased a plane ticket to Lebanon in 1988 – only to find that the refund in 2001 would buy only an alarm clock, reported the Wall Street Journal.)
At present, the annual rate of inflation in Kazakhstan is about 8%. The creditor who lends a dollar for a year can expect to get back a dollar in 2012 that buys 8% less of goods than it would today. To offset this expected loss, the creditor will demand 8 cents of interest.
The expected rate of inflation may seem an evanescent idea. But for many long-term rates of interest -- such as on 30-year home mortgages a few years ago in the United States -- inflationary expectations make up the bulk of the rate. Before 2008, Americans expected prices to rise more and more sharply over time.
The market rate of interest sums the real rate of interest and the expected rate of inflation. The long-run real rate of return to capital per year in Kazakhstan is (very) roughly 8% to 10%, judging from the trend rate of economic growth. The expected rate of annual inflation may be 8%. Thus a typical interest rate on creditworthy corporate loans may be 16% or 18% over the long run.
Government borrowing may affect either component. If the government competes away resources from the private sector, then borrowers will have to propose more profitable projects than before in order to get funds. This increases the real rate of return to capital. Also, new government spending pressures prices upward when the economy already is producing at full capacity. Thus it increases the expected rate of inflation.
At present, the deficit does not have an overwhelming impact on private interest rates. The rate on short-term bank loans of tenge fell from 16.6% in 2008 to 16% in 2009, with rates continuing to fall into 2010, according to the National Bank. The rate on interbank loans rose from 4.67% in 2007 to 6.75% in 2009, but that probably reflected the growing riskiness of banking. All this notwithstanding, in any sustained recovery, one should consider whether government borrowing may contribute to inflation.
This examination would be simpler if we had a simple way to measure expected inflation.
In the United States, you can estimate this expectation by looking at the difference in rates between Treasury bonds that compensate you for inflation (on top of their usual yields) and Treasury bonds that don't. At present, a Treasury security maturing in five years yields .31% per year. That is, the bond would pay you 31 cents for every $100 that you spent on it, and it would also compensate for inflation on top of that. An ordinary Treasury bond maturing in five years yields 2.29% per year, according to data from the Federal Reserve. This suggests that people expected an average of 2.29% – .31% = 1.98% inflation per year until 2016.
Over the short run, this forecasting tool does pretty well: One can use the interest rates on one- to six-month Treasury bills to forecast inflation a month ahead in a way that is statistically reliable, noted economist Stephen Smith. The government of Kazakhstan may wish to give a thought or three to introducing inflation-indexed securities of its own. -- Leon Taylor, tayloralmaty@gmail.com
Good reading
Central Asia & Caucasus Business Weekly. Untitled article on Kazakhstani deficits. October 26, 2010 http://business.highbeam.com/436263/article-1G1-241679918/interfax-central-asia-amp-caucasus-business-weekly
Robert L. Hetzel. German monetary history in the first half of the twentieth century. Economic Quarterly. Federal Reserve Bank of Richmond. Winter 2002, pages 1-35. http://www.richmondfed.org/publications/research/economic_quarterly/2002/winter/pdf/hetzel.pdf
David Luhnow. For Argentina, no panacea in the dollar. Wall Street Journal. December 4, 2001. Page A12.
Stephen D. Smith. What do asset prices tell us about the future? Economic Review. Federal Reserve Bank of Atlanta. Third quarter 1999. http://www.frbatlanta.org/filelegacydocs/smith.pdf
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