Is the world still running out of oil?

Can Kazakhstan count on the blessing of rising oil prices?


When people forecast continued growth of the Central Asian economy, they usually assume that the prices of natural resources – such as oil, natural gas, and gold – will keep growing, too. How likely is this?

Those who foresee price hikes point out that as population and income keep growing, so will the demand for natural resources. Some resources, like oil, are finite; others, like whales, grow slowly. When demand for a resource grows faster than supply, its price will increase.

How can we tell when we may reach the point of scarcity for resources in general?

This is an old problem. In 1980, the late economist Julian Simon challenged biologist Paul Ehrlich (author of The population bomb) to a $1,000 bet over whether resources were becoming more scarce. Ehrlich invested $200 in each of five metals on the commodities market: Copper, chrome, nickel, tin and tungsten. In 1990, the bettors would assess the new prices of the metals.

Exploration may mitigate oncoming scarcity. The oil firm will spend more money to discover deposits until the additional bit of revenue from another discovery equals the additional cost. Up to that point, exploration tends to be profitable because the firm begins with its best prospects – fields that promise to yield a lot of oil at a relatively low cost.

New technology also delays exhaustion. For example, pelletization lowered the cost of producing steel, noted economist Tom Tietenberg. The producer extracts iron ore from taconite ore of a low grade and processes it at the mine. This cuts labor and energy costs.

Finally, when one resource becomes too costly to extract, we can often substitute a cheaper resource for it. To produce electricity, Kazakhstan has plans to substitute nuclear energy for coal-burning that incurs such environmental costs as air pollution that aggravates lung disease and carbon gases that strengthen global warming. Looking at the big picture, H. Goeller and Alvin Weinberg foresaw that, over the centuries, an “age of substitutability” would dawn in which virtually inexhaustible elements would replace the fossil fuels. “To reach this state without immense social disruption will, however, require unprecedented foresight and planning.”


The good ol’ days of copper


Indeed, the price increase of the exhaustible resource may induce firms to develop its substitute, in order to earn profits. Copper telephone wires today are valuable only to nostalgia buffs.

How can we gauge imminent scarcity? The most popular measure is the ratio of reserves to current consumption. If oil reserves are 40 times annual consumption, then we supposedly would run out of oil in 40 years.

Since the reserve-to-use ratio is a physical measure, it would make sense to count as reserves the entire endowment of the resource. In 1976, Goeller and Weinberg did just that, defining the endowment as the atmosphere, the oceans, and a one-mile-deep layer of earth. They computed reserve-to-use ratios for every element in the periodic table and for some compounds. The common element that would run out first, phosphorous, would last 1,300 years. For most elements, supply was practically unlimited. Exceptions included trace elements used in farming (cobalt, copper and zinc) -- and the fossil fuels (oil, coal and natural gas), “by far the most important scarce natural resource[s].” Some assumptions underlying the study may have been strong: Lower grades contained more of the resource; the economic and environmental costs of extraction were not prohibitive.

The reserve-to-use ratio is easy to interpret -- but inaccurate, because it treats scarcity as a physical concept. In truth, the market determines scarcity if we define it as unsatisfied demand at the given price. Such scarcity raises the price, which discourages consumption and encourages production, obviating the scarcity, be it physical or economic. In this cornucopian perspective, Goeller and Weinberg overstate the need for planning. A drop in the reserve-to-use ratio may predict impending abundance about as well as it does an impending shortage. In 1960, use-to-reserve ratios for gold, lead, mercury, silver, tin and zinc were less than 30 years. But we still have all of these resources.

So why not use movements in the market price to gauge whether scarcity in the near term is rising or falling? Well, markets are not well defined for all resources. The unregulated market for coal takes no account of the illnesses and storms that arise from coal burning, since a particular illness cannot be traced back to a particular power plant. The market price for coal is too low. The “market” for the fishery is a misleading concept, since no fisher owns a migratory school of fish. Since no fisher gains from conserving the school that he happens to be harvesting today, he will overfish. The result is that the price of fish is too low, because it does not represent the loss of fish to future consumers that occurs through overfishing.


Simon says…


Another possibility is to look at the profit rate for extracting, say, oil. The oil producer can choose between drilling and selling the oil today or doing so next year. If oil is becoming more scarce over time, then next year’s price ordinarily would be higher than this year’s, even though we adjust for inflation. To prevent a loss of profits, the oil producer would raise his price this year. The greater the expected scarcity, the greater the boost in the current price. This boost, called “scarcity rent,” thus measures expected scarcity. An example is the stumpage fee that timbermen pay for the right to cut.

Being a price increase, the scarcity rent is subject to the same weaknesses as a measure of scarcity as is the market price. In an unregulated market, an increase in pollution costs over time will not show up in the scarcity rent. And even when the rent accurately measures expected scarcity, it will not indicate whether this arises from an expected increase in demand or an expected decrease in supply.

Despite their flaws, economic measures of scarcity, such as the market price and the scarcity rent, at least account for a dimension that physical measures, like the reserve-to-use index, ignore – human behavior. Which brings us back to Simon’s bet.

In 1990, the market prices for all five metals in the bet had fallen, reported John Tierney. Ehrlich paid Simon $576. Simon then challenged Ehrlich to a $10,000 bet, based on any resources that Ehrlich wished to choose. Ehrlich took a pass. – Leon Taylor, tayloralmaty@gmail.com


Good reading

Harold Barnett and Chandler Morse. Scarcity and growth: The economics of natural resource availability. Baltimore: Resources for the Future. 1963.

H. E. Goeller and Alvin M. Weinberg. The age of substitutability. American Economic Review 68. December 1978. Pages 1-11. Reprinted from Science, February 20, 1976.

J. A. Krautkramer. Nonrenewable resource scarcity. Journal of Economic Literature 36(4). 1998. Pages 2065-2017.

Bjorn Lomborg. Environmental alarmism, then and now. Foreign Affairs. July/August 2012.

John Tierney. Betting on the planet. The New York Times Magazine. December 2, 1990.

Tom Tietenberg. Environmental and natural resource economics. Boston: Addison Wesley. Seventh edition. 2006. Chapter 14 discusses generalized resource scarcity.

Where’s the silver lining?

Are the banks of Kazakhstan long on cash and short on chutzpah?


A stark lesson of the 2008-9 financial crash is that reckless lending in real estate can create a price bubble that perpetuates itself…for a while. The complement may also hold: A lack of lending inhibits future loans. The hesitation of banks to lend conveys a pessimism about the economy that eventually infects potential investors.

Real estate and construction loans still comprise a large share of the loan portfolios of some banks, including 45% of Kazkommertsbank’s and nearly three-fourths of BTA’s, reported the business weekly Delovaya Nedelya. This concentration contributed to Standard & Poor’s downgrade three weeks ago of Kazkommertsbank, from “stable” to “negative.” Real estate prices have fallen by half since the bubble burst in mid-2008, reducing the collateral backing the loans, which themselves are often delinquent, noted Standard & Poor’s.

In general, construction's share of all industrial bank loans in Kazakhstan fell steadily after March 2011, when it was 19.1%, and most sharply after October 2011, falling to 14.9% by January 2012, or 3.2 percentage points lower than in January 2011, according to the National Bank of Kazakhstan.

Is this cooling-off auspicious? The answer is unclear. A rising share of construction in the economy (measured as gross domestic product, or GDP) is not always troubling. In an economy expected to grow rapidly, firms may add buildings in order to house future inputs. At present, investors do not seem to anticipate the 10%-plus rates of annual economic growth that Kazakhstan enjoyed before the financial crisis. Adjusted for inflation, the value of new physical capital in Kazakhstan has grown slowly or stagnated for several years. This hardly signals great expectations for the economy. The IMF projects a rate of economic growth of 6% or so through 2017.

Perhaps the country is still digesting the effects of the construction bubble. Adjusting for inflation, investment in fixed capital (durable and immobile inputs) in Kazakhstan was the same in 2011 as in 2010. New floor area in Kazakhstan more than tripled from 2003 to 2008, from 2.1 million square meters to 6.8 million, before leveling off at 6.4 million square meters in 2009 and 2010, according to the national statistical agency.

The cities dominate new construction. Almaty and Astana account for 38% of all new floor area in the country. This statistic leveled off in Almaty in 2010, at 1.1 million square meters; but it kept rising in Astana, to 1.4 million square meters. Although construction loans endangered the banks in 2008, new floor area kept increasing in the cities and is growing slightly faster in the oblast surrounding Almaty than in the city itself.

Bank credit in Kazakhstan grew 15% over 2011 after stagnating for three years, noted the International Monetary Fund (IMF). The banks still have lots of money that they could lend but don’t. Instead, they park much of it at the central bank (basically, the banks’ bank). The National Bank of Kazakhstan held as much as 5.5% of their assets in 2009, when their dread of risk was understandable, and 3.1% as late as March 2012, according to the IMF.


Pay it again, Sam


Not all of this mattress-stuffing is due to timidity. Some banks can’t lend their excess funds to those short on money, because the interbank market is sketchy. Other banks can’t find good borrowers. Real estate and construction firms propose fewer projects than before the crash.

Finally, the banks are saddled with bad debt. As a share of all loans, “nonperforming” ones (no interest paid in 90 days) quadrupled in 2009 to 21.2%...and kept rising, to 31.9% by March 2012. For BTA, which the government took over, it’s 80%. Moreover, overdue interest has increased from 2% to 7% of all bank assets. For banks like BTA that are trying to recover from bankruptcy – the polite term is that they have “restructured” – the figure rose from 3% to 17%. This suggests that the bad-loan ratio is higher than reported, said the IMF. However, the bad-loan ratio varies considerably from bank to bank. For Halyk, it is 8.3%, said Standard & Poor’s.

In general, the banks’ lack of lending renders them unprofitable. Their rate of return on assets was zero or negative from 2008 through 2010 and was only 1% in 2011, reported the IMF. In addition, a measure of the banks’ inability to cover bad loans – the assets-to-capital ratio – has been rising for more than two years.

“In the end, restoring the banking systems’ health requires recapitalizing viable banks and restructuring or closing unviable ones,” writes the IMF (wisely neglecting to define “viability”). “Capital shortfalls [roughly, the lack of money on hand to cover bad loans] represent public contingent liabilities, given the need to protect depositors and the fact that [Samruk-Kazyna, a government holding company] is the biggest shareholder in several large banks.” The capital shortfall for BTA alone is 2.5% of GDP. The government’s “Too Big to Fail” policy may be leading to another: “Too Big to Do Anything But Fail.” – Leon Taylor, tayloralmaty@gmail.com


Good reading

International Monetary Fund. Republic of Kazakhstan 2012 Article IV consultation. 2012. www.imf.org


References

National Bank of Kazakhstan. Statistical bulletin. Various issues. www.nationalbank.kz

Reuters. TEXT-S&P revises Kazkommertsbank's outlook to negative. July 31, 2012. Online.

Semen Skarga. Kazkommertsbank prodolzhaet “zarivat’sa” v nedvyzhymost’. (Kazkommertsbank continues to “bury itself” in real estate). Delovaya Hedelya.  August 10, 2012. Page 1.

Genuine coin of the realm

The contents of the envelope were thousand-dollar bills, smooth and stiff and new. Spade took them out and counted them. There were ten of them. Spade looked up smiling. He said mildly: “We were talking about more money than this.”

“Yes, sir, we were,” Gutman agreed, “but we were talking then. This is actual money, genuine coin of the realm, sir. With a dollar of this you can buy more than with ten dollars of talk.”


I think of that passage from Dashiell Hammett’s classic detective novel, The Maltese falcon, whenever I hear happy talk about Kazakhstan’s allegedly resurgent economy. The usual story is this: Because foreign investors, in such surveys as Ernst & Young’s, say they believe in Kazakhstan, the nation will surely attract investment dollars that will pump up its economy. That’s not even five dollars of talk. Let’s look at what investors actually do.

Since the financial crisis of 2008-9, investment – which is the addition to manmade inputs of production -- has stagnated in Kazakhstan. Adjusted for inflation, the value of annual investment in fixed (i.e., durable) capital here was 1.8% lower in 2011 than in 2008. An index for the amount of physical investment in Kazakhstan fell steadily, and by nearly a fourth, from 2005 through 2011. Unfortunately, the national statistical agency, which publishes the index, is habitually careless and nowhere explains how it constructed the index or even defines it. But the index conveys a general sense of stagnation. Over the seven-year period, it fell in every oblast and in Almaty.

The exception was Astana, where the index rose by 15% over the period. This may partly reflect the stability of spending by the national government, which could attract lobbyists. As a share of gross domestic product (GDP), government spending in Kazakhstan peaked at 26.9% in the crisis year of 2008 and since has held steady at about 24%, according to the International Monetary Fund. By global standards, Kazakhstan’s government is small, as measured by its share of GDP; but its concentration in Astana makes the city a convenient target for investment. From 2003 through 2011, the real value of annual investment in fixed capital in Astana rose 240%.

Compared to that in Astana, investment in Almaty is struggling. From 2003 through 2011, the real value of investment in fixed capital rose only 75.7%, the second-slowest pace of the 16 areas in Kazakhstan. This annual investment had been about a fourth higher in Almaty than in Astana – until the financial collapse of 2008-09. Astana rebounded; Almaty didn’t. In 2011, investment was 38% higher in Astana than in its older sister city.


Great expectations?

Investment is based on market expectations; for example, a firm will expand its factory only if it believes that more buyers each year will demand its products in the future. Because expectations are ever-changing, investment anywhere is volatile. But it may introduce instability especially into rural oblasts, where the economic base is small. Of the 16 areas of Kazakhstan, from 2005 through 2011, the index of physical investment fell most sharply in the oblasts of Atyrau (38.7%), in the oil-producing region of the Caspian Sea; Kyzylorda (37.4%), east of the decimated Aral Sea; and of Zhambyl (40.9%), a low-income farming area north of Shymkent. Over the period 2003-11, the volatility of the investment index in Zhambyl oblast – where the Asian Development Bank and others are financing a road project worth several hundreds of millions of dollars -- was more than twice as high as in any other region; it also had the highest annual average of the investment index in that period.

In the oblast of South Kazakhstan, the value of investment in fixed capital increased eight-fold. In volume, however, physical investment there fell somewhat more sharply than was average for the nation – by 28% from 2005 through 2011. Perhaps the value of a new unit of fixed capital is rising sharply in the oblast.

In terms of investment, the most quiescent oblast is a rural one -- West Kazakhstan. Only in this area did real investment in fixed capital decline from 2003 through 2011, by 37.9%. It also had the lowest annual average of an index of physical investment from 2005 through 2011.

Judging from what they do – not what they say – real investors are only cautiously optimistic about Kazakhstan and are most enthusiastic about the prospects for political spending. – Leon Taylor tayloralmaty@gmail.com





Notes

All statistics used here are from the national statistical agency unless attributed otherwise.

I used the Consumer Price Index to adjust for inflation, since the CPI measures the opportunity cost of investment in terms of consumption bundles foregone.


Good reading

Dashiell Hammett. The Maltese falcon. 1930.


References

Aleksandr Bogatik. Kazakhstan’s Zhambyl Oblast faces stagnant economy. centralasiaonline.com . July 27, 2010.

Asian Development Bank. CAREC Transport Corridor 1 (Zhambyl Oblast Section) [Western Europe-Western People`s Republic of China International Transit Corridor] Investment Program - Tranche 4 : Kazakhstan. Online.

Economywatch.com . A compendium of economic statistics.

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.