The year of the doddering dragon

Will the slowdown in China’s economy endanger Kazakhstan’s?


China buys one-eighth of the oil and gas exported from Kazakhstan (11 million tons per year; Kazakhstan produced roughly 80 million tons per year in 2010 and 2011), according to Robin Paxton of Reuters. Since oil and gas exports account for roughly a fourth of Kazakhstan’s GDP, a slowdown of the world’s second largest economy could affect us substantially.

The Chinese economy is growing less rapidly. GDP in the second quarter of 2012 grew by the annual rate of 7.6%; the corresponding rate in the second quarter of 2011 was 9.5%. Similarly, GDP in the first quarter of 2012 grew at an annual rate of 8.1%, sharply below the rate of that quarter in 2011. In the world financial crisis of 2008-2009, the growth rate of Chinese GDP fell as far as to 6.6% (which is still twice the current rate of global economic growth). Apparently, GDP in Q1 of 2012 was less than 2% higher than in Q4 of 2011, but much of that change might have been seasonal. Finally, China’s economy may be reacting to the globe’s: The International Monetary Fund (IMF) estimates that recession in Europe may reduce Chinese GDP by as much as 4%, reports Rob Minto of The Financial Times.

Indirect indicators of GDP are also murky. On one hand, industrial production is rising at a healthy annual pace, well over 9%. On the other hand, production of electricity, steel and concrete (an indicator of China’s construction market, the world’s largest) is slowing or falling, noted Keith Bradsher of The New York Times. Fixed-asset investment is down sharply this year, and urban housing prices have been falling since late 2009. These trends suggest that the government recognizes that the economy already has excess capacity. In that event, the GDP slowdown may be temporary.


Easy does it


The Chinese slowdown does not seem likely to affect global oil prices as much as the Eurozone crisis will. The Chinese handled well the global crash of 2008 as well as the Asian currency crisis of 1998, and they have improved their management of inflation over the past 20 years.

A soft landing of their economy seems likely. After resisting interest-rate cuts for three years, the central bank -- The People’s Bank of China -- has cut them twice in a month, amid cooling inflation, reported The Financial Times. This year the Bank also reduced the share of deposits that banks are not permitted to lend out.

Half of the GDP growth of 2012 was in capital spending, which Beijing can stimulate by permitting local governments to invest, according to Nick Edwards and Kevin Yao of The New York Times. Private consumption is only just over a third of GDP, so fiscal policy can be relatively powerful. China’s small debt could enable a fiscal stimulus that packs a wallop: The national government’s debt share of GDP is 25%, as compared to 102% in the United States, wrote Bob Davis and Tom Orlik of The Wall Street Journal. (In China, the GDP share of local government debt is another 22%.)

On the other hand, the fiscal stimulus of 2009-10, which focused on infrastructure, increased the debts of local governments and stimulated inflation. The IMF recommends a stimulus to private spending – tax cuts and subsidies for consumption of durable goods, reported Minto. The private sector’s share of the economy may already be growing: 2011 wages were up by 18%, a bit faster than GDP (with no adjustment for inflation), noted Orlik. Disturbingly, an increase in private or public consumption would likely increase the credit-to-GDP ratio, which was 171% in 2010, up from 122% in 2008, said The Economist.


The IMF forecasts that China’s economy will grow by 8% per year for the next five years, noted Ian Johnson of The New York Times. That had been Beijing’s target rate since 2005 until it lowered it to 7.5% this March. Before the financial crisis of 2008-09, Chinese growth rates averaged over 10% per year.

Financial investors may overstate the Chinese slowdown, to judge from circumstantial evidence. Although emerging market economies are growing more rapidly than developed economies, a stock market index for the former performs worse than is average, reported The Financial Times. The MSCI stock market index for emerging market economies has lost 21.7% of its value in the past year. The global version of that index lost 10.7%. Conceivably, stock markets in emerging economies perform poorly because investors over-estimate the Chinese slowdown and its subsequent impact.


Dragon on a cigarette break


To some degree, the Chinese slowdown may be intentional. The overall saving rate in China is 51%, and Michael Pettis, a finance professor at Peking University, argues that China must increase consumption’s share of its economy in order to provide balanced growth. To do this, China must “get household income to rise from its unprecedentedly low share of GDP,” he wrote in The Financial Times. “This requires China to increase wages, revalue the renminbi and, most importantly, reduce the enormous tax that households implicitly pay to borrowers in the form of artificially low interest rates.” If The People’s Bank does not cut market interest rates as rapidly as the expected rate of inflation has fallen, then real interest rates will rise. China could also boost consumption by providing comprehensive health care, for which households today must save, remarked The Economist.

Chinese demand for crude oil remains at a peak despite the fall in the rate of GDP growth, said UniCredit. If Chinese growth slows to 8% per year, then this could directly reduce Kazakhstan’s GDP by .06 of one percent. Conceivably, the indirect impact on Kazakhstan may be more severe: Each change in Chinese GDP of 1% relates to a change in global oil prices of 10% to 30%, claims Ruchir Sharma of Morgan Stanley. Obviously the estimate could hold only for small changes in the size of the Chinese economy; a fall of just over three percentage points in GDP is not going to cut oil prices to zero.  The dragon is not that powerful. – Leon Taylor tayloralmaty@gmail.com



Notes

Chinese purchases of oil and gas directly generate about 3% of Kazakhstan’s GDP ((1/4)*(1/8) = 1/32). A Chinese slowdown of 2% could decrease our GDP by roughly (1/50)*(1/32) = 1/1600.


References

Jamil Anderlini. China cuts rates amid growth fears. Financial Times. July 5, 2012.

Keith Bradsher. Affirming slowdown, China reports second month of scant economic growth. New York Times. June 9, 2012.

Keith Bradsher. After barreling ahead in recession, China finally slows. New York Times. May 24, 2012.

Bob Davis and Tom Orlik. Beijing's growth tools are limited. Wall Street Journal. May 13, 2012.

Economist. How strong is China’s economy? May 26, 2012.

Economist. Not with a bang. July 28, 2012.

Nick Edwards and Kevin Yao. Hand forced, Beijing opts for old fix. Reuters. Published in New York Times. July 16, 2012.

Leslie Hook and Peter Marsh. Sany job cuts signal Chinese slowdown. Financial Times. July 4, 2012.

Ian Johnson. China’s growth rate slowed in the 2nd quarter. New York Times. July 12, 2012.

Rob Minto. IMF: Europe could hit China, hard. Financial Times. February 6, 2012.

Tom Orlik. Numbers show China’s still working. Wall Street Journal. May 29, 2012.

Robin Paxton. Update 3 -- Kazakhstan sees 50 pct oil export growth by 2020. Reuters. October 4, 2011.

Michael Pettis. A slowdown is good for China and the world. Financial Times. July 23, 2012.

Ruchir Sharma. China slows down, and grows up. New York Times. April 25, 2012.

Jochen Hitzfeld and Kathrin Goretzki. Weekly commodity outlook. UniCredit. July 3, 2012.

Wall Street Journal. Economists React: China GDP Growth Hits Three-Year Low. July 13, 2012.

Bettina Wassener. Slow first quarter in China, but recent signs of growth. New York Times. April 12, 2012.

Robin Wigglesworth. China slowdown fears overstated, says Mobius. Financial Times. July 27, 2012.

Beware of chimps bearing darts

Is KASE as chaotic as it seems?


Kazakhstan’s stock market is as changeable as Almaty’s weather. In May, a sudden drop of two-thirds in the price of Kazakhtelecom stock precipitated a swoon in the KASE index of 12%, reported Bloomberg News. The problem may be general. In the first half of this year, the volume of KASE trading had fallen nearly 13% since early 2011, reported the business weekly Kursiv’.

One can interpret such mercurial price movements in one of two ways. First: The stock market here is not efficient. Trades are few and far between, so the price adjustments that would occur daily, and on a small scale, in a more active market tend to pile up in ours. Second: The market here is efficient, in the sense that it responds right away to new information. The price changes are large not because the market tarries in digesting news but because we know so little about Kazakhstan’s emerging economy that recent events can change radically our perception of it.

KASE is not the only stock market to defy characterization. Three or four decades ago, financial economists thought that markets for stocks and bonds absorbed information quickly (the “efficient markets hypothesis”). If, in 2009, you heard that General Motors was about to go bankrupt – and who didn’t – then you need not have bothered to sell its stock short; other investors had already acted on the information, selling the stock and forcing down its price right away. Only unanticipated events – “news” – can affect current stock prices. Since news, by definition, occurs at random, so do changes in current stock prices. These changes will be independent of previous prices.

In that case, technical analysis, which seeks visual patterns in past stock prices, can’t predict the price. One financial economist, Burton Malkiel, called technical analysis “alchemy.” In a 2000 study, Andrew Lo, Harry Mamaysky and Jiang Wang conceded that “the presence of geometric shapes in historical price charts is often in the eyes of the beholder.” To detect patterns more objectively, they permitted random price movements in either direction to cancel out. Working with a 31-year sample, they concluded that “several technical indicators do provide incremental information and may have some practical value,” especially for a U.S. stock exchange favored by computer firms, Nasdaq.


The chimp paradigm


In lieu of technical analysis, one could comb financial information in search of stocks that are under- or over-valued, given the firm’s apparent strength. But such “fundamental analysis” won’t work if stock prices already reflect enduring information about the firm. You might as well buy shares in a good index fund as to speculate. Malkiel writes: “A blindfolded chimpanzee throwing darts at the Wall Street Journal could select a portfolio that would do as well as the experts.”

Malkiel concludes that stock investors cannot earn unusually high returns without accepting unusually high risks. One thinks of the student who espies a $100 bill on the ground and is about to pick it up. “Don’t bother,” says his economics professor. “If it were really a $100 bill, it wouldn’t be there.” Malkiel argues that there are no $100 bills on the trading floor. Market bubbles may sometimes occur; but in the long run, “true value will win out.”

Recently other economists have questioned the efficient markets hypothesis. Robert Shiller, who popularized the phrase “irrational exuberance,” may be the best-known of these critics. They maintain that patterns in past stock prices can enable investors to earn unusually high rates of return, even when adjusted for risk.

Early work on the efficient markets hypothesis looked for correlation across time in stock prices. Such a connection can enable us to predict tomorrow’s price. Many studies of the 1960s and 1970s failed to find correlation.

But some new studies do. They argue that stock prices move in the same direction often enough not to qualify as “random walks,” in which a price is as likely to rise as to fall. In Irrational exuberance, Shiller offered an explanation: “Investors under-react to new information.” If the full impact of news unfolds only over time, then we may observe positive correlation in stock prices: The higher prices of yesterday link to the higher ones of today.


Fiascos, fads and finance


Malkiel doubts these arguments. The correlations observed in stock prices are too small to yield an unusually good return to the investor. Lo and coauthors say that technical analysis provides “incremental information.” As for the behavioral economists, while fads may pop up from time to time, little evidence suggests that they occur systematically. Malkiel cites a 1998 survey of studies, in which Eugene Fama concluded that investors under-reacted to news about as often as they over-reacted. Also, the returns observed depended on how the model was specified: A study that equally weighted the returns of various stocks after some announcement led to different results than did a study that weighted the returns by value.

In his 2003 article, Malkiel asserts that stock-price correlations appearing in the late 1990s had disappeared by 2000. Some patterns may disappear shortly after publications disclose them because investors take advantage of the information. For example, the “January effect,” in which stock prices rose in early January, no longer seemed to exist.

In the long run, high stock returns fall, and low returns rise. Why? In a widely-cited 1985 study, Werner DeBondt and Richard Thaler looked at whether stock investors over-reacted to “unexpected and dramatic news events,” as people seemed to do in experiments by psychologists. The two authors concluded that investors may over-react to recent events. Stock prices rise or fall, then return to the average. “Portfolios of prior ‘losers’ are found to outperform prior ‘winners’.” Maybe you should buy dogs and avoid beach beauties.

In a study of stocks from 1957 to 1971, Sanjoy Basu found that those with low price-earnings ratios generally earned higher returns (adjusted for risk) than did stocks with high P/E ratios. “Contrary to the growing belief that publicly available information is instantaneously impounded in security prices,” Basu wrote in 1977, “there seem to be lags and frictions in the adjustment process.” In 1983, Basu added: “While neither E/P nor [firm] size can be considered to cause expected returns, the evidence lends credence to the view that, most likely, both variables are just proxies for more fundamental determinants of expected returns for common stocks.”

In principle, the price that one would pay for a stock depends on the size of its expected dividends. (Yes, you may sell your stock before collecting dividends, but the price that you receive will depend on the dividends that the new owner expects.  Even if you do not sell the stock, an increase in its price reflects the market's expectation of higher dividends.) Via market competition, the P/E ratio should tend to be the same for all stocks bearing the same risk. A stock with a low P/E ratio is presumably under-valued, so it should attract buyers. They will push up its price. The initial under-valuation may be an over-reaction to temporarily bad news. And likewise for over-valuation: Behavioral economists think that the stock market is subject to fads. For example, initial public offerings of dot.coms skyrocketed in the U.S. stock markets of the technophilic late Nineties.

Malkiel believed that the strongest evidence for a negative correlation in stock prices over time came from the Great Depression, which might not be a typical period. The negative correlations may result from fluctuations in the interest rate, which also reverts to the mean. When the interest rate rises, you would expect stock prices to fall, since investors may sell their stocks in favor of bonds that deliver a relatively higher return than before. When the interest rate falls back to the mean, demand will shift back to stocks and push up their price. – Leon Taylor, tayloralmaty@yahoo.com




Good reading

Burton G. Malkiel. A random walk down Wall Street: The time-tested strategy for successful investing. W. W. Norton. 2003.

Burton G. Malkiel. The efficient market hypothesis and its critics. Journal of Economic Perspectives 17. Winter 2003.

Robert J. Shiller. From Efficient Markets Theory to behavioral finance. Journal of Economic Perspectives 17. Winter 2003.

Robert J. Shiller. Irrational exuberance. Crown Business. 2006.



References


Sanjoy Basu. Investment performance of common stocks in relation to their price-earnings ratios: A test of the Efficient Market Hypothesis. Journal of Finance 32. June 1977.

Sanjoy Basu. The relationship between earnings’ yield, market value and return for NYSE market stocks: Further evidence. Journal of Financial Economics 12. June 1983.

Werner F. M. de Bondt and Richard Thaler. Does the stock market overreact?  Journal of Finance 40.  July 1985.

Eugene Fama. Market efficiency, long-term returns, and behavioral finance.  Journal of Financial Economics 49. September 1998.

Nariman Gizitdinov and Ksenia Galouchko. Kazakhtelecom retreats most ever as dividend date passes. Bloomberg News. May 16, 2012. www.businessweek.com

Andrew W. Lo, Harry Mamaysky and Jiang Wang, Foundations of technical analysis: Computational algorithms, statistical inference, and empirical implementation. Journal of Finance 55. August 2000.

Yurii Valykov. “Punkt naznacheniya” KASE. Kursiv’. July 19, 2012.

Market clout

Does privatization always improve economic performance?



The government’s planned sale of large enterprises, “The People’s IPO,” allegedly would make Kazakhstan’s economy leaner, meaner and competitive. In reality, competitiveness depends not on whether individuals own a firm but on the firm’s clout in the market. Privatizing Kazakhtelecom (the government still owns 51%) wouldn’t make the market for telecommunications competitive in the sense that no seller or buyer would be large enough to affect the market price. Given its track record, Kazakhtelecom will dominate the market regardless of whether it has one owner or many. It has 90% of the fixed-line subscriptions, and it is the only holder in Kazakhstan of a license to Long Term Evolution, an advanced wireless standard, according to OpenNet Initiative and Halyk Finance, respectively.

The government can take one of two courses: Recognize that Kazakhtelecom is a virtual monopoly and regulate it accordingly; or break it up into many firms, each too small to set the market price. The justification for the latter course is that small firms must fight to survive by pleasing consumers, whereas a firm that dominates the market need not cater to anyone.

This course is ill-advised. A national infrastructure for telecommunications, such as fiber-optics links between the cities, costs much to build. Net fixed assets for Kazakhtelecom were 227 billion tenge (about $1.5 billion) in fiscal 2011, 54% of total assets, according to Bloomberg News. There is no point in throwing bad money after good by inducing a new firm to build a duplicate infrastructure, particularly when fiber optics networks tend toward excess capacity.

Perhaps the government could retain control of the infrastructure and carve up Kazakhtelecom into small firms that would lease this network in order to sell services. (Roughly 100 Internet providers have been leasing in recent years, according to OpenNet.) Competition among them would hold down prices.

The first course – regulation – is deceptively simple. As a private firm, Kazakhtelecom would control the infrastructure; but the government would limit its price to consumers, subsidizing it if necessary so that it would earn a normal rate of return. Over time, however, the government may rely increasingly on Kazakhtelecom for market information vital to estimating the size of the subsidy, since its own data – obtained when the firm was a public enterprise -- may become obsolete. Kazakhtelecom may be tempted to fudge the numbers.

Going, going, begone


Here’s a hybrid approach: The government could auction off a lease of the infrastructure to the private firm that bids the lowest price at which it would sell to consumers, for a given subsidy; or the government could specify the consumer price and then grant the lease to the firm that bids for the smallest subsidy. The beauty of the auction is that it induces the firm to provide accurate information about its costs, in the form of a bid. However, the experience of United States governments with auctions in a similar market -- cable television -- has not been ecstatic. A firm might enter an artificially low bid and then, after winning the auction, force government officials to provide a larger subsidy than it had originally requested. In Milwaukee, the winning bid promised to provide 108 channels for a monthly fee of $4.95. What Milwaukee actually got was 54 channels for $11.95, according to regulatory economists Kip Viscusi, Joseph Harrington and John Vernon.

An American drama may shed light on problems that Kazakhstani regulators might face in loosening constraints on the telecommunications market. For decades, American Telephone & Telegraph (AT&T) enjoyed a protected position as a regulated monopoly. It was known as the safest financial investment in the country. But by the 1960s, demand increases as well as cost-cutting innovations were expanding the telecommunications market beyond the point where one firm could serve it efficiently. Gradually the federal government deregulated the submarkets such as the one for a firm providing internal phone services. By the early 1980s, AT&T’s monopoly was confined to the market providing phone services between cities – and it was coming under attack there, too.

The question was whether to let AT&T compete in submarkets that had already been deregulated. On one hand, the company might be able to cut costs for the deregulated good because of synergies with production of the regulated good. For example, experience with local phone service might reduce the cost of long-distance service. On the other hand, AT&T might cunningly use guaranteed profits in the regulated market to pay for price-cutting in the deregulated one; after driving rivals out of the latter market, it could charge the highest price that buyers could bear.

In 1982, a pact with regulators, supervised by the courts, shut out AT&T from deregulated markets. It slipped into a coma. In 2005, it was acquired by one of its own spinoffs, Southwestern Bell.

One problem may be that regulators balk at experimenting, note Viscusi, Harrington and Vernon. Change is politically risky since it may raise prices or cripple an industry. Also, deregulation curtails the agency’s duties, reducing “power, prestige, and income for the regulators.” So we may get too much change too late. – Leon Taylor, tayloralmaty@gmail.com



Good reading

W. Kip Viscusi, Joseph E. Harrington, Jr., and John M. Vernon. Economics of regulation and antitrust. Fourth edition. Cambridge, Mass.: The MIT Press. Chapter 15 discusses the AT&T case.



References

Bloomberg News. Kazakhtelecom JSC. 2012. bloomberg.com

Kazakhtelecom. General information. April 12, 2012. telecom.kz

Timur Omoev. Key takeaways from meeting with managers. May 15, 2012. halykfinance.kz

OpenNet Initiative. Kazakhstan. 2010. opennet.net .

Tele-miscommunications

Does Kazakhtelecom have a future as a private firm?


Kazakhstan’s latest drive to privatize – “The People’s IPO” – is understandably half-hearted. The government would be pleased to be rid of notorious money-losers such as BTA Bank, which it took over in 2009 rather than watch it go down in flames. But the crown jewels are another matter. The oil and natural gas enterprise, KazMunaiGaz, is one of the government’s main sources of revenue. Also profitable is the telecommunications company Kazakhtelecom, of which the government owns 51%. Excluding its KCell sale, its 2012 profit may come to 22 billion tenge (about $147 million), reported Bloomberg News. The firm has said it would pay 210 billion tenge (about $1.4 billion) in dividends, according to Standard & Poor's.

The loss of a cash cow is not the only reason that the government may balk at selling Kazakhtelecom. Another is that the enterprise dominates its market and, left to its own devices, might take advantage of its position by selling too few services to the public at too high of a price. In the telecommunications industry, setup costs – such as building facilities to receive and process satellite signals – are high. A potential entrant would think twice about incurring them. Kazakhtelecom has already paid them (at least, until a new technology creates setup costs of its own) and has only the low costs of hooking up new subscribers to worry about. Free of competitors, Kazakhtelecom could charge whatever price the market would bear.

That price would pique consumers. In principle, a firm should set a price that barely covers the cost of serving one more customer. We want to serve her as long as she values the service by more than it would cost the seller. As a virtual monopoly, Kazakhtelecom would surely bolster its profits by setting the price well above the cost of adding a customer. This stiff price would discourage some households from subscribing even though they value the service at more than its cost.

Two solutions are evident. In one, Kazakhtelecom would charge these additional buyers a price below the one paid by customers of long standing. That would be a PR man’s nightmare.


The price ain’t right


In the other solution, the government would force Kazakhtelecom to charge a low price and to serve all customers willing to pay it. Kazakhtelecom would still be a private firm, albeit a regulated one. But the price may be too low to permit Kazakhtelecom to recover its setup costs. To keep the firm from going broke, the government could subsidize it. Ideally, the grant would enable the firm to earn an average rate of return and no higher. Determining this exact amount, however, may require the government to know more than it does.

This problem may be temporary, since Kazakhtelecom may gradually lose its lockhold on the market. Its market power stems from high setup costs that discourage potential. competitors. But historically, innovations have reduced setup costs (for given capacity) in telecommunications – fiber optics rather than copper wires, for example. Someday, Kazakhtelecom may find that it is no longer a monopoly. Regulating its price then may handicap it permanently. – Leon Taylor tayloralmaty@gmail.com




Good reading

W. Kip Viscusi, Joseph E. Harrington Jr., and John M. Vernon. Economics of regulation and antitrust. Fourth edition. Cambridge, Mass.: The MIT Press. Discusses the regulated monopoly.


References

Nariman Gizitdinov and Ksenia Galouchko. Kazakhtelecom retreats most ever as dividend date passes. Bloomberg News. Online. May 16, 2012

Reuters. Text – S&P summary: Kazakhtelecom (JSC). Online.

Going private

Is privatization the ticket to improving production?



In The People’s IPO, the government of Kazakhstan plans to sell off part of the ownership of such state enterprises as the airline Air Astana and the railway Temir Zholy. How could this affect their performance?

Radically. The incentives facing the private firm differ dramatically from those for the public enterprise.

The manager controls what the private firm does, although stockholders are the owners, since they cannot monitor him continuously – and lack reason to do so, given the small stake of the typical shareholder in a large corporation. The manager works less – and provides more nonmonetary benefits – than owners would wish. Consider that nine-hole golf course on the corporate grounds, which the manager is prone to investigate each weekday at 2pm.

The manager’s incentives for boosting profits might include a bonus as well as a growing reputation that attracts tempting job offers. Those are the carrots. The stick is in the New York Stock Exchange: If the manager does poorly, then the firm’s stock will lose value. A raider might buy up the shares, boot the manager, hire a new team to improve profits, and then sell the firm at a healthy price.

Those incentives don’t apply to public enterprises, as Cotton Lindsay pointed out in 1976. Private and public enterprises behave differently, because they are controlled by different groups.


Gargantuan groves of academe


Consider a private university. Ultimately, it is controlled by the customers – students and their parents. To satisfy them, the school will offer them the desired courses, taught in the desired style.

But a public university is controlled by legislators. They don’t take classes, so they judge the school instead by variables that they do observe: The number of courses, students and professors. Rather than improve the quality of education, the school will increase those observable factors. Prediction: The public university will be larger, and more diverse in offerings, than the private college.

To test his theory, Lindsay compared public hospitals in the United States, run by the Veterans Administration (VA), to private hospitals. The latter will improve care through such attributes as the doctor’s bedside manner, since this attracts patients. But in a VA hospital, bureaucrats and legislators do not observe patient care, so the hospital will increase instead observable characteristics such as the rate of survival. Since this requires only a minimal amount of care, the staff-to-patient ratio should be lower for a VA hospital than for a private hospital where additional staff improves unobservable care. Lindsay did find lower staff-to-patient ratios for VA hospitals.

Similarly, in Kazakhstan, Air Astana might accrete political support by offering sumptuous meals (at least in theory), albeit at a high cost and price.


The price isn’t right


Other economists regard the price itself as an observable factor of the public enterprise. In the early 1970s, Sam Peltzman proposed a model in which the enterprise sets the price below the profit-maximizing one, because voters dislike subsidies. It would not prefer a price that was higher than the profit-maximizing one, since it would lose both profits and votes. Privatizing the airline and railway in Kazakhstan might lead to higher ticket prices.

Also, because it wants political support, the public enterprise is less likely to price discriminate – to charge different prices to different groups of consumers -- than the private firm is. If privatized, Temir Zholy would become more likely to offer cheap tickets to youths – and expensive ones to businessmen.

Why won’t public enterprises discriminate? Suppose that as the government keeps raising the price of, say, airline services, the resulting loss of additional votes among passengers enlarges. The government might mitigate this loss by spreading the cost of services over non-passengers as well.

In general, the government will consider both taxes and demand for a good before providing it. Consider the demand for operas, which is largest among the rich. Since they pay the same tax rate on personal income as do the poor – roughly 10% -- a sharp reduction in the cost of an opera ticket could be politically costly. The rich will respond to the discount by demanding many more operas, increasing the total subsidy. But since the income tax rate is flat, the rich will pay only a proportional share of the tax revenues that finance the operas, although they receive a disproportional share of the benefits. The politically savvy government will cut the price of an opera ticket only slightly.

Peltzman’s main point: Since the public enterprise is political, financial markets cannot discipline it as easily as they can a private firm. When the firm is inefficient, its stock prices will fall, inviting a raid. But for a public enterprise, the “owners” are the voters, who are unlikely to leave the jurisdiction just because they dislike one state-owned enterprise.

In Lindsay’s model, the public enterprise may charge a higher price than private firms do, so that it can afford to offer observable quality. In Peltzman’s model, the public enterprise charges a lower price, in order to attract political support.

What are the facts? A 1970 study in the U.S. by Thomas Moore found that regulated electric utilities charged a price that was 5% or less below that of an unregulated monopoly. But electric utilities that were public enterprises charged prices 10% to 22% below the monopoly price.

In 1971, Peltzman found that among electric utilities, the number of rate schedules for public enterprises – a form of price discrimination -- was much smaller than the one for private firms. The difference exceeded six standard errors, which is a measure of dispersion. A difference of just two standard errors would have been quite unlikely to have occurred by chance; a difference of six almost certainly means that the public utilities differed inherently from private ones. These results raise the possibility that in Kazakhstan privatization may increase both profits and practices, like price discrimination, that many citizens regard as unfair. – Leon Taylor, tayloralmaty@gmail.com



Good reading

Cotton Lindsay. A theory of government enterprise. Journal of Political Economy. October 1976.

Thomas Gale Moore. The effectiveness of regulation of electric utility prices. Southern Economic Journal. April 1970.

Sam Peltzman, Pricing in public and private enterprises: Electric utilities in the United States. Journal of Law and Economics. April 1971.

W. Kip Viscusi, Joseph E. Harrington, Jr., and John M. Vernon. Economics of regulation and antitrust. Fourth edition. Cambridge, Mass.: The MIT Press.2005. Chapter 14 surveys work on private and public enterprises.

The KASE of the missing trades

Is the Kazakhstan Stock Exchange getting any better?

Though it bills itself as the second-largest in the Commonwealth of Independent States, the Kazakhstan Stock Exchange (KASE) suffers from thin trading. While the volume of trade doubled in the stock market over 2011, other KASE markets were less fortunate. The trade in the two largest – for foreign exchange and overnight loans (“repos”) – barely grew. The market for government securities shrank by a fourth. Overall, trade at KASE grew by less than 3% in the first nine months of 2011, less than half the rate of growth of the national economy.

The stock market at KASE illustrates its main problem. Stock purchases are large, few and far between. Consequently, prices are volatile. On August 19 alone, the KASE Index fell by nearly 5%. In a press statement, the Exchange blamed turbulence in global markets. The share price of copper mining alone fell more than 10% that day.

Such tailspins scare off risk-averse investors: Thin trading gets thinner. The volatility may also hinder the national economy. A sudden fall in stock prices reduces wealth and thus national spending. A steep rise may mislead stockholders into thinking that they are rich. Conceivably, they may try to buy more goods than producers can provide. Prices will rise throughout the economy. Hello, inflation.

KASE may seem too small to damage the macroeconomy. In terms of capitalization (the value of stock shares offered), the New York Stock Exchange is 325 times larger. But the volume of trade at KASE in 2011 exceeded the value of Kazakhstani production that year (gross domestic product). While fewer than 10,000 Kazakhstanis may trade at KASE, they include rich citizens who hold a disproportionate share of national private wealth.

Although its listings have been declining since 2009, KASE is in better shape now than in the late 1990s, when it had to suspend trading for a year or longer in government securities and currency futures (essentially bets upon the value of currency on a given date). One of its new rules, however, may handicap it. A firm that wants to list on KASE must offer at least a fifth of its shares there before going to foreign exchanges. This restriction cuts the rate of return to offering stocks. It may lead firms to prefer debt to equity more strongly than before, or perhaps to sell all shares on foreign exchanges rather than mess around with KASE. The Exchange’s trading may diminish again.



Brisk risk



Another reform may have ambivalent effects on KASE. Originally, KASE granted one vote for each share owned by the Exchange’s shareholders. When KASE went commercial in 2007, its general meeting decided to give each shareholder one vote regardless of his number of shares. Indeed, no shareholder can hold more than a fifth of KASE shares, reported Wikipedia. Had these rules not taken effect, a few large shareholders – like the pension funds – could have dominated KASE policy. Now a diverse group may influence what the Exchange does, but most of the decision-makers have too little at stake in KASE to want to gather much information about it. In effect, the new rules empower the management.

More auspicious for KASE is the People’s IPO (initial public offering), in which the government is selling off portions – ranging from 5% to 15% -- of its enterprises. Air Astana and KazTransOil may go public this year. The government estimates that Kazakhstani citizens may demand $100 million to $200 million of state-held shares. Kazakhstani pension funds, already major players in KASE, may snap up $200 million to $300 million of shares.

Now all we need is a People’s Exchange. KASE is caught in an infernal loop: Its lack of investors leads to price volatility, which in turn discourages potential investors. To attract them, KASE needs some relatively safe products, despite their small payoffs. The economic justification for this is the widely-accepted idea that an additional dollar of spending adds less satisfaction than did the dollar before it. A dollar means more to a pauper than to a millionaire because he needs it to survive. Given this assumption, an investor will turn down a “fair bet” – say, a financial investment with a 50% chance of gaining $1,000 and a 50% chance of losing $1,000 – because he likes the gain less than he dislikes the equivalent loss. A major stock that drops 10% in a day does not exactly commend itself to the risk-averse investor. – Leon Taylor, tayloralmaty@gmail.com





Good reading

Michael Quinn. Is the Kazakhstan Stock Exchange efficient? MBA thesis, KIMEP University, 2012.



References

Interfax-Kazakhstan. JSC Kazakhstan Stock Exchange President Kadyrzhan Damitov: New defaults possible. July 2011. Online. Yet another cheerleader interview with KASE’s president, retold in mangled English.

Wikipedia. Kazakhstan Stock Exchange. Online.

World Finance Review. Kazakhstan Stock Exchange: Better years ahead. December 2011. Online. Full of softball questions and grammatical gaffes.

Danger – insurance ahead

Does deposit insurance really insure against trouble?


Even before 2008, banking crises were common around the globe. One study reports 160 calamities in more than 150 countries over two decades. The currency crash of 1997 cost Thailand and South Korea nearly a third of their GDP – and Indonesia, almost half -- thanks to tottering banks.

Small wonder, then, that depositors demand insurance. In 1974, only 12 countries offered deposit insurance; by 1999, 71 did, according to Asli Demirgüc-Kunt and Edward Kane. Kazakhstan has offered deposit insurance since 1999, through the Kazakhstan Deposit Insurance Fund. It’s owned by the National Bank of Kazakhstan, which initially kicked in a billion tenge for the till. The Fund said it had enough to pay for the failures of two mid-sized banks, or 7 billion tenge. That was before 2008-9, when two of the nation’s largest banks collapsed. A deposit had been insured for up to 400,000 tenge ($2,700 at today’s exchange rate). In 2008, the Fund increased coverage to 5 million tenge ($33,800).

Yet insurance may increase the chances of a bank collapse. After all, a fully-insured depositor no longer has reason to monitor the care that the bank takes in lending. The insurance may also make the banks careless about their loans, because they know that most of their depositors can get their money back, regardless of whether the borrower pays back. In the United States, most banks paid no premiums for their deposit insurance, even though the risk of failure was not zero, reported Fred Furlong and Simon Kwan in 2002.

By making the banks careless, the insurance creates a “moral hazard” – that is, a change in behavior, arising from a contract, that hurts one of the signers. For example, in the Eighties, savings and loan associations in the U.S. – which offered home mortgages -- often had little net worth, so they literally bet the bank on risky loans. They figured that if the loans paid off, then they would profit handsomely, because they could charge a high interest rate for risk. And if the loans went bad? No problem: The federal government would pay off the depositors, and the thrifts weren’t worth much, anyway. In 1989 alone, 327 thrifts failed, according to Antoine Martin. The banks were also more likely to take risks in the Eighties when their charter value fell. Less efficient banks took on more risk, more loans per dollar of assets, concluded Thomas Siems in 2002.

In this light, Kazakhstan’s exemption of bank executives and top shareholders from insurance in bank failures seemed to address a special moral hazard. (The Kazakhstan Deposit Insurance Fund didn’t insure deposits of top executives and of shareholders who owned more than 5 percent of the bank’s voting shares. Neither did it insure the so-called VIP deposits – time deposits that exceeded 7 million tenge.) If the bank executive didn’t even have his own money at stake, then why should he object to risky lending that may indirectly push up his salary?

Ironically, the U.S. government offered deposit insurance to try to save the banks, during the Great Depression of the 1930s. If depositors knew that the government would reimburse them, then they might not have reason to run on the bank, all of them demanding their money at once. During the Depression, deposit insurance seemed to work: The number of bank failures fell from 4,000 in 1933 to just over 50 banks a year from 1934 to 1941, wrote Martin.


Branching for safety


Today, as developing countries with undercapitalized banks adopt deposit insurance, the moral hazards are more evident. Statistical studies suggest that banking crises are more likely in countries with extensive deposit insurance, particularly if its institutions are weak – for example, if the government is prone to corruption. You would think that the government of a developing country could stave off a banking crisis by guaranteeing to repay the depositors. But if the government is poor, then its promise is not credible.

We need not insure deposits in order to protect them. The bank could instead diversify its risk by offering branches. For example, YourBank may have a branch in Almaty and another in Astana. When education turns down, due to a booming national economy that attracts potential students into jobs, then the Almaty branch may do relatively poorly; but the Astana branch will be swimming in cash, and this will protect depositors in Almaty. During the 1920s in the United States, banks with branches were less likely to fail than banks without branches, according to economic historians Jeremy Atack and Peter Passell. Even before 2008, the number of bank branches in Kazakhstan was declining, according to First Initiative.

If the depositors will monitor the bank, then it will lend with care. One way to ensure that the depositors keep an eye on their institution is to make them co-pay for deposit losses, suggested Demirgüç-Kunt and Kane.

Otherwise, the government could motivate the bank to exercise caution by charging rates for deposit insurance that rise with risk; that rise, in particular, with the percentage of loans that are bad, since it is hard for the regulator to know exactly which loans are risky. Maybe the bank will promise to extend only safe loans, in order to procure the low premiums, but then lend to risky enterprises, in order to earn high rates of return, suggested Edward Simpson Prescott.

The government can also make clear that the healthy banks must repay the deposits at failed banks. This will give the healthy banks an incentive to monitor its ailing brethren. Finally, the government can close weak banks before they go under. Under a 1991 law in the U.S., the feds could close any bank with a capital-to-asset ratio below 2 percent. That is, if the bank’s net worth is less than 2 percent of its assets, which are mainly loans, then the government can shut it down. This, at the least, avoids the expense of reimbursing the depositors in the event of a bank failure, noted Martin. Canada has a provision like this. As a consequence, when Canada introduced deposit insurance, the banks did not take many more risks. – Leon Taylor, tayloralmaty@gmail.com





Good reading


Charles Calomiris. Is deposit insurance necessary: A historical perspective. Journal of Economic History 50. Pp. 283-296. 1990.

Fred Furlong and Simon Kwan. Deposit insurance reform – when half a loaf is better. Federal Reserve Bank of San Francisco Economic Letter. May 10, 2002. Online.

Asli Demirgüc-Kunt and Edward J. Kane. Deposit insurance around the globe: Where does it work? Journal of Economic Perspectives 16:2, summer 2002, pp. 175-195. Online.

Antoine Martin. A guide to deposit insurance reform. Federal Reserve Bank of Kansas City Economic Review. First quarter 2003. Online.

Thomas F. Siems. Survival and the hump in the CAMELS. Federal Reserve Bank of Dallas Expand Your Insight. October 2, 2002. Online.

Edward Simpson Prescott. Can risk-based deposit insurance premiums control moral hazard? Federal Reserve Bank of Richmond Economic Quarterly. Pp. 87-100. Spring 2002. Online.

Jeremy Atack and Peter Passell. A new economic view of American history. New York: W.W. Norton. Second edition. 1994.

Eugene Nelson White. State-sponsored insurance of bank deposit in the United States, 1907-1929. Journal of Economic History 41. Pp. 537-58. 1987.



References


First Initiative. www.firstinitiative.org

International Association of Deposit Insurers. Member profile: Kazakhstan Deposit Insurance Fund. www.iadi.org

Kazakhstan Deposit Insurance Fund. Otveti na chasto zadavaemie voprosi (FAQ). The Fund does not offer a FAQ for depositors in English. www.kdif.kz