Using Milk to Explain Why the Tenge Is Doomed to Depreciate

I am asked many questions about the exchange rate. First, let me disappoint everyone: in a developing country with high inflation and low labor productivity growth, currency depreciation will be a permanent feature. So with the economy as it is, we will see the rate at 500, and 600, and 700; it is only a matter of time. It could take two years, or it could take ten. Over the past 15 years the rate has depreciated by 400%. If nothing changes globally, in 15 years the rate could reach 2,000 tenge to the dollar.

This is not a matter of the National Bank or the Government wanting to depreciate the currency. It is a law of economics, and there is no escaping it. What matters is to understand how the economy works and to build it in such a way that the exchange rate does not depreciate.

Let us look at a simplified picture of how the economy works. Suppose a liter of milk costs $1 in a neighboring country, where the cost of production is $0.80. The exchange rate is 450 tenge per dollar. In our country, milk sells for 450 tenge per liter, and the cost of production is 360 tenge. Everything is in equilibrium and works. Then the Government raises salaries for civil servants. Our workers no longer want to work in milk production and try to get jobs in state-owned companies, where pay is high. As a result, we have to raise wages, and our cost of production rises to 420 tenge per liter of milk. Civil servants now have more money and consume more milk. Since production cannot be expanded overnight, prices rise by the amount of the increase in demand in monetary terms. Milk that cost 450 tenge now costs 500 tenge, or $1.11. Producers in the neighboring country see that milk in our market sells for $1.11 and begin importing it in large volumes. Having sold the milk in our market, they need dollars and start buying them from us. But we do not have that many dollars, so the price of the dollar begins to rise. To satisfy the demand for dollars, the rate climbs to 500 tenge, and milk again costs $1. We are back to where we started: milk costs $1 again, only now it costs 500 tenge. Nominally, our civil servants and our workers earn more, but in reality their purchasing power has not changed.

Here is another simplified example, with the same starting data: a free economy, developed institutions, a high level of investment. The neighboring country figures out how to raise cow productivity by 30%, which cuts its cost of production to $0.60 per liter, and, to boost sales, it begins shipping milk to us at $0.90 per liter, or 405 tenge. Milk producers in our country cannot survive or compete, and as a result milk production begins to shrink, while investors in the sector start looking for new opportunities. Producers from the neighboring country begin to replace ours, and they need dollars, which are in short supply. This pushes up demand for dollars and the exchange rate, which rises from 450 to 500. Milk now costs $0.81, a price that is comfortable for our producers. But now they have to win back the market and rebuild production. The rate is now 500, and milk has become cheaper in dollar terms, but in tenge it has stayed at the same level.

As you can see, in this simplified structure the root cause is the growth of unproductive spending: civil servants did not produce more after their pay rise, whereas labor productivity grew in our partner countries.

Therefore, if inflation in our country is 10% and in the neighboring country 2%, the economy will always move toward an equilibrium exchange rate that offsets the inflation differential. That means depreciation of the currency, which has been happening in our country for 30 years and will continue for as long as these conditions persist.

Of course, the economy is far more complex. Different sectors can have different rates of labor productivity growth. In some sectors, productivity growth comes through prices on the international market. When the foreign currency earned by such sectors enters the market and is not absorbed in any way (as is the case with us), it leads to Dutch disease.

To avoid inflation in the long run, we need to raise labor productivity. Productivity is achieved either through innovation or through intensification. Innovation and intensification are very complex matters, but at their foundation lie education, protection of property rights, and developed institutions (courts, parliament, the media, political parties, civil society, and so on), as well as freedom of capital movement and tax and monetary policy. In other words, innovation and intensification are driven by people and entrepreneurs, not by the state. The best thing the state can do is create a level playing field for entrepreneurs. A sound investment environment leads to growth in investment, and growth in investment leads to growth in innovation and intensification.

When the state tries to decide for entrepreneurs what to produce and whom to sell to, nothing good comes of it apart from bottlenecks and unequal conditions for entrepreneurs. Moreover, we must understand that protectionist diversification does not lead to growth in labor productivity, just as it does not lead to sustainable economic growth.

So what we see with the exchange rate is a normal situation, one that reflects the current economic policy of a developing country, which tries to substitute for the true foundations of growth, namely institutional development, with protectionist diversification and the creation of bottlenecks in access to limited state resources.