Five Structural Problems of Kazakhstan's Economy at the Start of 2016

Yesterday I quoted the head of the National Bank, and I was asked what should be done and whether I have any proposals of my own. I promised to answer today.

Let me begin by saying that Kazakhstan's current situation is very, very difficult, and any solution will require sacrificing something.

Naturally, those at the top who make the decisions have their own goals and objectives, and nobody today would envy them their position.

The second point to understand is that making accurate and sound decisions requires more analytical information. A great deal depends on its quality.

First we need to identify the economy's most pressing problems, and only then look for a solution to each of them.

In any case, the current crisis is structural, and no short-term measures will solve these problems; they can only put them off for a while. Solving structural problems requires far-reaching structural reforms that reshape the whole system.

1. The main problem facing the state right now is securing tax revenues for the budget. This is in part the main reason for the weakening of the tenge: the higher the inflation and the larger the nominal revenue base, the more money flows into the budget. Because most government spending is not tied to a foreign currency and is not indexed, expenditure does not grow as fast as revenue in the event of a devaluation of the tenge. Moreover, a weaker tenge produces exchange-rate gains on the National Fund and boosts inflows into it, since the main taxes paid into the Fund are tied to the US dollar exchange rate.

2. The second problem is the banking sector and liquidity. To contain inflation, and under the banner of de-dollarization, the National Bank is restricting tenge liquidity in the banking sector. As a result, banks are not lending to borrowers in tenge, while dollar lending is heavily restricted and not every borrower can get a loan in dollars. Many banks are therefore sitting on dollars and can do nothing with them. In classical banking, a bank's dollar liabilities should equal its dollar assets. Because most economic agents have switched into dollars, an imbalance has emerged: most loans at many banks, especially the older ones, were issued in tenge, while the shift of banks' liabilities from tenge into dollars is happening much faster than the shift of their assets. Many banks may consequently incur exchange-rate losses from devaluation, which will hit their capital. But the banks that managed to pass the devaluation risk on to borrowers will also run into serious trouble, because their NPLs will rise: borrowers' obligations will double in nominal terms while their incomes will not. At the same time, the existing collateral will no longer cover the new obligations, since its value in dollar terms will also fall, and this will push borrowers to hand over the collateral rather than repay their loans. That will trigger a wave of defaults and the kind of problems we saw in 2009. Banks convert any tenge inflows into dollars to match the structure of their assets and liabilities, which puts further pressure on the tenge.

The experience of BTA Bank and Alliance Bank showed that the state does not know how to rescue banks, so no help should be expected from it, and the collapse of even one bank would bring down the entire banking system like a house of cards. This is the biggest risk facing the country, and the National Bank should pay attention to it.

3. The dollarization of the economy. Most individuals and companies hold cash in US dollars, and they immediately convert even the smallest tenge receipts into dollars. The National Bank's statements about the need for a weak tenge discourage economic agents from converting dollars back into tenge. The unofficial peg to the ruble makes many people watch the ruble, and as soon as it depreciates, the pressure on the tenge grows, since many expect the tenge to weaken further in its wake. In general, pegging to anyone else's currency is a bad idea.

4. The country's balance of payments. With the fall in oil prices, the balance of payments is shrinking considerably, and together with capital outflows it is turning negative.

Capital flows are denominated in foreign currency, and changes in the tenge exchange rate do not affect capital outflows. Moreover, in a crisis, foreign investment and borrowing always decline, and given existing obligations, capital leaves the country.

The only way to rebalance is to cut imports, which is possible only through devaluation. The greater the devaluation, the more imports fall as they become more expensive. But we need to examine the elasticity of imports as a whole to determine the point at which devaluation can no longer reduce them.

5. Problems of the real economy. All of the problems listed above lead to problems in the real economy, which stem from the following:

6. Falling consumer demand leads to lower consumption and lower production.

7. A decline in working capital leads to lower production.

8. A decline in related consumption, above all by subsoil users, leads to lower production.

9. The opportunity to earn money by holding foreign currency, compared with producing, leads to lower production. In other words, if an entrepreneur has working capital and a business in which he earns 30% a year, but he can turn that working capital into cash, convert it into foreign currency and earn 500% a year on it, he will have no incentive to produce. He will sell off his inventory (which, incidentally, was most likely one of the factors behind low inflation), convert the money into dollars and sit waiting for the bottom.

10. Kazakhstan does not produce industrial equipment, and given the current situation, a doubling in the price of all equipment simply makes new production unprofitable. All investment projects will therefore now grind to a halt, which will have a very negative effect on the medium-term outlook. We will most likely end up diversifying the economy through manual labor))))

So, we have described the main problems that need to be solved. As for our proposals, Zharas Akhmetov and I have decided to write up our own vision, but that will come a little later.