How to Stimulate GDP in a Crisis: Imports Eat Up State Support

On stimulating the economy – Part 2

The previous part described the best ways to increase budget revenues. In this part, I will try to determine which industries should be supported and which should not.

There are several premises that need to be understood.

First, our expenditures exceed our revenues, and we are now eating through the National Fund. GDP is falling, and the money will not last long.

Second, this means we are in a crisis, and funds must be used right now (this is important to understand) with maximum effect in order to stimulate the economy and expand the tax base.

Support for the economy should not rest on picking individual enterprises, or on a populist desire to develop this or that industry (say, let's become a world-class carmaker, or a producer of modern locomotives, or generate more solar power than anyone else, and so on). It should rest on basic economic principles. There are many of them, and some should be applied over the long term, but right now we are talking specifically about short-term measures. This is also important to understand, and it is an immediate answer to the many people who are about to write to me about alternative energy, high technology, human capital and other trendy industries that add zero value for Kazakhstan. All of that belongs to long-term planning, and I will address it in a separate post.

GDP calculations should be used not for reporting and for painting a comforting picture, but for managing the economy properly.

It is well known that GDP is calculated in three ways. In Kazakhstan the production method, which sums up value added, is the most widespread. But in my view, the income method and the expenditure method are the most revealing.

Let us look at each of them and draw some conclusions for our policy.

The expenditure method: final consumption plus gross capital formation (investment) plus government spending plus net exports.

Looking at what GDP includes under the expenditure method, it is obvious that when consumption falls, GDP falls; when exports fall, GDP falls; when imports rise, GDP falls; when government spending falls, GDP falls.

In Kazakhstan, consumption is falling, government spending is not growing, and net exports are falling.

Suppose the government has KZT 1 trillion that it wants to direct toward supporting GDP.

Here is what the government is doing now:

1. It supports individual semi-bankrupt companies, which use the funds to repay debts, including to foreign partners. The money leaves the country, puts pressure on the balance of payments and brings zero value added. I won't even mention the multiplier. The effect is zero.
2. It supports individual capital-intensive production facilities. What happens then? The enterprise receives money from the state and spends it on expensive foreign equipment. Looking at the GDP formula, the enterprise has increased its assets, and GDP should seemingly grow. BUT the enterprise has also stimulated imports by purchasing the equipment, so the cost of all that equipment is subtracted from GDP. Once again we get a zero effect from this miracle state solution in a crisis, when GDP growth is needed here and now. Perhaps such equipment will deliver results, but not this year; only several years from now.

For example, the state provides a loan of KZT 30 billion to build a car assembly plant. What happens? Roughly 70% will go to buying equipment, and we will use our money to stimulate our manufacturing partners (Russia, France, Korea) and so on. Of the KZT 30 billion, another 20% or so will go to buying spare parts, again stimulating neighboring countries. And we ourselves will get 10% from minor construction work. In total, in support of GDP this year we get 10%, that is, KZT 3 billion. But that is only half the trouble. Since we have created every condition for people to buy only domestic cars, and since 80% of the cost will go to our partners in the form of spare parts, people who buy domestic cars with their wages send 80% of that money to our partners. They stimulate not our GDP but that of our partners, such as Russia, Korea and the like. This is just an example, so do you think this is the right approach to stimulating the economy in a crisis?

Mechanical engineering does need to be developed, but not in a crisis, when every tenge counts. It should be developed in a period of rapid growth, when there is surplus income.

What is to be done?

Let me give an example of an ordinary family, especially for the layperson. Suppose a family suddenly loses its income but has savings. Would such a family buy a television only to sell it half a year later at half price? Of course not. It would try to produce something: say, plant vegetables on its plot of land and buy a cow. In other words, an ordinary family will try to get the maximum effect from its savings.

At the state level it is much the same: in a crisis, one should invest in industries that deliver an immediate return and where the money stays in the economy.

To understand where to invest, we need to look at another method, namely the income method, which equals:

Wages + rent + interest on loans + corporate profits + depreciation + indirect taxes − subsidies − income earned by foreigners

Two items are key here: wages and profit. In other words, if an enterprise is highly profitable, it should be supported; if an enterprise is not highly profitable but labor-intensive, it should also be supported.

Highly profitable enterprises emerge exclusively in the private sector and where state institutions are of high quality. That leaves the state with only one option: to stimulate labor-intensive production.

It follows that public funds should go to industries where the private sector cannot replace the state and where labor costs are high.

In Kazakhstan, I would single out several industries that the state should develop in a crisis:

1. Strange as it may sound, funding for geological exploration should be increased. During the rapid growth of the oil sector, Kazakhstan accumulated substantial experience and equipment in geological exploration. There are many companies that do high-quality seismic work and carry out exploratory drilling.

What this gives us:

1. We support the industry and create a large number of jobs. Money enters the economy in the form of wages, which means GDP growth. People who spend their wages stimulate other producers, who in turn also pay wages. This is what is called the multiplier effect.

2. We create a valuable intangible asset in the form of information. Together with my earlier proposal on developing subsoil use, this is a good incentive for foreigners to enter Kazakhstan as investors in oil production once high-quality geological data is available.

3. The tourism industry should be supported. Tourism is one of the few industries with high labor costs.

In this area, what is needed from the state is indirect support, which consists of the following:

1. The state should build infrastructure for the tourism industry: roads, parks, monuments; supply water, electricity and gas; provide land in recreation zones; and reduce inspections of small businesses in this sector. It should build railway stations, airports and the like.
2. It should take administrative measures to support tourism: expand the list of countries with visa-free entry, abandon the atavism of registration with the migration police, bring order to the work of taxis and public transport, maintain public order, and so on. Unfortunately, we do not even have an overall state strategy for developing tourism, even though Kazakhstan is a unique country with great potential.
3. One of the most significant measures is to hold events in the country, of various scales: concerts by world stars (as in Tbilisi, for example), major sporting events, and some world-class hook that would draw tourists to Kazakhstan.

Infrastructure construction, just like tourism, is quite labor-intensive and will have a fairly high return in terms of GDP.

3. Support for agriculture. Unlike other industries, agriculture is also a basic industry with high labor costs. Agribusiness is very complicated and not the most profitable, but because of its high labor costs it has a good effect on GDP. Agribusiness has many problems, and there is no point in describing them here.

But what should the state do to stimulate the agricultural sector properly?

1. The most important thing is to ensure financing for agriculture. Unfortunately, the current financing system is quite flawed: it is geared toward big business and does not deliver the return it should. In agriculture, the most efficient farms are medium-sized and small ones, and they receive no support. So as many resources as possible should be directed to medium-sized and small farms by lending to them against the future harvest. The principle is very simple, with no paperwork and no pile of analyses. In a given region with a given plot of land, a specialist visits, assesses the quality of the land and determines how much money is needed per hectare. The state provides the money and takes the land and the future harvest as collateral. It insures the harvest and, once the harvest is in, either takes the crop or receives cash.
2. The second measure is organizing sales for agricultural producers. Agricultural products are very sensitive to price, so the state should regulate supply and demand on the market to smooth out price swings. Also, since medium-sized and small enterprises are unable to export, the state should help with exporting their products in every way it can.
3. Subsidizing consumption rather than production. When consumption is stimulated, the subsidies reach the most efficient producers, because consumers prefer to buy quality products. For example, if a small or medium-sized producer sells directly to a retailer, or has its own outlets selling to end customers, such a producer should receive a subsidy of 10–15%. This would encourage retail chains to buy directly from producers, bypassing intermediaries, and more of the value added would stay with the producers.

I wrote about supporting the oil sector in my previous post, so I will not repeat myself here. It should be understood that the oil sector is the most profitable sector even when prices are low, and a firm's profit is one of the sources of GDP. This sector should therefore be supported and developed in order to sustain GDP. Moreover, an inflow of investment improves the balance of payments, which is so important to us.

In the next part, I will set out my view on exchange rate formation and the factors that influence the exchange rate in a normal economy, as well as how to support other sectors of the economy.