Reading Coffee Grounds

Lately there has been a lot of debate about devaluing the tenge: should it be done or not?

Meanwhile, Kazakhstan is now in a stalemate. If the authorities devalue, people will grow poorer and inflation will accelerate. If they don't, industry will suffer and gold and foreign exchange reserves will melt away.

Here are the main arguments of those in favor of devaluation:

1. Kazakhstani industrial enterprises are suffering from the weak ruble. A huge volume of goods is coming into Kazakhstan from Russia, which affects our producers and erodes their competitiveness. This risk is indeed real. The fall of the ruble is very painful for our manufacturers. We cannot set up an administrative barrier at the border, because we share a single economic space with Russia. The cost of a product is made up of material costs, labor costs and depreciation. Say we grew wheat, milled the grain into flour, baked bread from the flour and sold it. The process used fuel produced from oil extracted in the country. We add eggs and salt from local producers, and so on: production is almost one hundred percent localized. Such a product, if made in Russia, becomes cheaper than ours. So local goods with a high share of labor and materials find it hard to compete with analogues made in a country whose currency has lost half its value. In Kazakhstan we cannot simply cut labor costs, which would mean, roughly speaking, halving wages. However, this effect will be short-lived, because primary commodities will be exported to countries where prices are higher, which will push up the prices of primary goods inside the producing country. Goods made from imported components will also become more expensive. This is especially true in a period of sanctions. The only restraining factor is the cost of labor. But sooner or later wages will still have to be indexed, because inflation in the country will be high, and to preserve the accustomed standard of living pay will have to rise. Naturally, this will take time: a year or more. During that period, if there is no devaluation, tough support measures will be needed for the industries that suffer from the low ruble and from imports from Russia. It is not so difficult for the government to run basic calculations of the cost structure in each industry and assess the possible consequences. That would show what kind of assistance our industries need in order to survive the hard times. Options include interest rate subsidies, tax holidays and tax breaks, subsidized tariffs of natural monopolies, and so on.

2. The currency. It is not only a means of payment but also, to some extent, a commodity with its own supply and demand. In countries that pursue a fixed exchange rate policy, reserves are used to support the value of the local currency. When a crisis begins, the National Bank of Kazakhstan buys tenge and sells dollars to keep supply and demand in balance. In normal times it buys dollars and sells tenge. During a protracted crisis, with devaluation expected, everyone buys dollars. Demand is fueled by a sharp drop in the inflow of foreign currency into the country: oil prices, for instance, have fallen by more than half. In the end, the only dollars left are in the National Bank. This does great damage to the economy: lending to projects stops, because nobody wants to take on currency risk, and tenge interest rates rise. In other words, tenge liquidity shrinks, which is, by and large, what is happening now. If the tenge is devalued, the nervous anticipation of a fall in the exchange rate will give way to certainty, and many counterparties will start moving out of dollars into tenge, which will set things right. But there is a key question: how far should the tenge be devalued? If the tenge is lowered against the dollar with a margin to spare, it will cause a social explosion. If it is not lowered far enough, it will not change the situation, because expectations of a new devaluation will not go away. In this situation we should wait for the ruble and oil prices to stabilize and only then make a decision, so that we don't repeat the experience of the 2014 devaluation. But for the situation to change, we need guarantees that there will be no devaluation. That requires a coordinated, REAL program from the National Bank and the government, one that everyone will believe. The authorities must explain in detail and convincingly why the exchange rate will not change and how they will respond to all the possible challenges facing the economy. This requires good calculations and deep analysis. Alas, so far I have not seen any such analysis.

In my view, it would be logical to resume swap operations. That would signal to banks that the regulator is also taking on currency risk and that they are not alone in the boat, and we would then get a multiplier effect. Tenge deposit rates should be raised so that people can see that even in the event of a devaluation they will protect their savings thanks to high interest.

3. The budget deficit. The state has a revenue side and an expenditure side. When revenue falls by almost half, one must look for additional sources of income or cut spending. Or do both. No one had to look far for a source of revenue: the National Fund. But the National Fund is not a bottomless well, so there is one more way: boosting revenue by devaluing the tenge. Since most budget revenue is, in effect, denominated in foreign currency, a weaker tenge will reduce the deficit. This risks social upheaval, and to avoid conflicts the government will have to index the pay of public-sector workers, pensions, student stipends and so on. Thus the National Fund remains the main, if not the only, source of funding for the budget.

4. The balance of payments. If foreign exchange earnings fall and imports grow, a balance-of-payments deficit may emerge, meaning more dollars will leave the country than come in. The situation is aggravated by the enormous investment projects now being planned. Devaluation will not fully solve the problem of the balance-of-payments deficit; most likely, imports will simply shrink. What is needed here is a program to attract foreign-currency loans and foreign investors. And although a whole program for attracting investors has been created, so far no one is lining up, and there is no word of any large foreign investment.

Opponents of devaluation say the following:

1. Kazakhstan depends heavily on imports. Imports should be divided into three categories:

• imports of goods not produced in the country. There are very many such goods, and after a devaluation they will become more expensive. Given that household incomes will stay at the same level, demand for these goods will fall, imports will shrink, trade will decline, and this will be reflected in GDP;

• imports of raw materials and components. Even where we produce something highly profitable (other than in the food industry), we use foreign materials and raw materials. After a devaluation, the prices of these will also go up, which will also hurt sales;

• imports of fixed assets and intangible assets. Given the mega-programs under the State Program for Accelerated Industrial and Innovative Development (SPAIID), more expensive investment costs in tenge will inevitably affect the financial performance of projects that are already uncompetitive. Payback will take longer, or prices will have to be raised, which will affect demand. Considering that Kazakhstan is only at the initial stage of industrialization, devaluation could play a cruel joke. All projects in Kazakhstan are financed by the state, which fixes its obligations in tenge. In the event of a devaluation, all loan and other investment agreements would need to be revised. Given that approving a single project takes up to six months or more, and that the figures are massaged to obtain a loan for the maximum term, we could forget about new production facilities.

2. Dollar borrowers. There are two categories of borrowers. The first is mortgage holders, who keep trying to have their loans converted from dollars into tenge. There are not so many of them compared with the other categories, but they make a lot of noise. Converting their loans from dollars into tenge is not a big problem for the National Bank, but nobody wants to deal with it. As a result, we have a permanent headache. The second category is companies with dollar liabilities. There are far more such borrowers, especially among subsoil users. On the one hand, devaluation will lower production costs; on the other, it will increase their tenge liabilities. With a substantial drop in oil prices, it is better for them if there is no devaluation, since the losses from devaluation will not be offset by the lower costs. This applies not only to subsoil users but also to all exporters and everyone with dollar liabilities, including national companies, which also have foreign-currency obligations. In this situation a refinancing program is needed; otherwise the tenge exchange rate will have to be held.

3. Inflation. Any devaluation accelerates inflation, which is especially significant given our dependence on imports. Moreover, natural monopolies barely indexed their tariffs after the last devaluation. High inflation will affect everything, including people's real incomes. In Europe the euro lost 20 percent of its value while inflation was only 1 percent, but here things will be different, because our production has very low localization.

4. A fall in demand, including in services, which account for a large share of GDP. After a devaluation, people will first of all cut spending on services: restaurants, cinemas, travel, leisure, beauty salons, fitness and so on, which will strike SMEs hard.

Talking about a possible devaluation is like reading coffee grounds. One can cite arguments for and against endlessly, whereas what is needed is deep analysis and the development of several scenarios. Only after that can a decision be made on whether to devalue the tenge. Whether such analysis is being carried out inside the Ministry of National Economy, I am sorry to say, I do not know…