Why the Tenge Is Losing Value: Productivity and Hidden Devaluation

Part 3 of the series on exchange rate formation in Kazakhstan

In August 2015, we moved to a free-floating exchange rate. In other words, the rate in Kazakhstan is supposed to be set by the market. In reality, we must admit that there is no free-floating exchange rate in Kazakhstan, there never was, and there cannot be. I have written about this before. There are many reasons for it. In particular, Kazakhstan has no properly functioning money market, and with a limited number of players it is very hard to form a free market. If the market were truly free, our exchange rate would fluctuate in a range of 250–400 depending on oil prices and other factors.

Today we can state that we have a managed exchange rate, one that serves certain government objectives. To be more precise, we are currently seeing a hidden depreciation of the currency, which serves the following purposes:

1. Supporting the state budget. Obviously, to cover the budget deficit in Kazakhstan, nobody has come up with anything better than currency depreciation.
2. Supporting exporters and domestic producers. By devaluing the currency, we devalue the cost of labor, and our producers thereby receive a kind of notional boost to their competitiveness.
3. A weaker exchange rate produces a real-terms reduction in the budget.

However, everyone knows that continuous currency depreciation has its limits, and what looks like a gain can turn into a loss. Depreciation itself should not be an instrument of economic policy, because every depreciation has an underlying cause.

In terms of economic theory, depreciation is the result of a decline in an economy's competitiveness, driven by falling productivity of labor and of available resources.

In Kazakhstan, overall labor productivity has rested solely on high oil prices. As oil prices fall, labor productivity falls with them. All sectors other than mining (which includes oil) are uncompetitive here, for a variety of reasons.

The smaller the share of labor costs in value added, the less the exchange rate is affected.

When the share of labor in value added falls worldwide, goods become more competitive. To catch up in such an economy, labor costs have to be reduced. Since cutting wages outright is difficult in practice, devaluation amounts to a hidden reduction in the cost of labor.

Here is a very simple example for the layperson, to make the point clear.

Say country X and country Y both produce milk. Each has an identical herd of 1,000 head. Both use the same milk production technology and have the same labor costs. Each country employs 100 people to look after the cows, and each worker is paid 300 conventional units. That makes monthly costs of 30,000 conventional units, or 360,000 conventional units per year.

Country X is a developed country and invents milking machines, so it now needs 10 workers instead of 100. Each machine has a service life of 5 years. This herd requires 10 machines costing 50,000 conventional units each. Additional annual costs per machine come to 10,000 conventional units.

A simple calculation shows that country X's annual costs fall from 360,000 to 236,000 conventional units.

This means that for country Y to be competitive, it must devalue its currency by 35%.

Much the same is happening with our industry: we are constantly in catch-up mode.

Nobody will sell us technology cheaply, and if they do sell it, it will be expensive, so our production costs will still be higher.

But as labor productivity declines, the purchasing power of the population falls, and so does the quality of life.

Oil is a resource, and it was our exclusive access to this limited resource that drove the growth in our labor productivity.

Suppose country Y has a limited amount of a resource and country X has demand for it. Since there is no other supplier, country X buys the resource at a high price. But then country Z appears and offers the same resource at half the price of country Y. Labor productivity and the quality of life in country Y fall immediately, because the product is no longer unique.

This applies across the board. But developed countries do not depend on a single product, so if one commodity gets cheaper, the effect on the economy as a whole is minimal, unlike in mono-economies.

Now let us return to our own situation. Since there is a limit to the substitution of capital for labor, devaluation also has a limit, and further depreciation will affect only inflation in the country. In fact, that is what is happening now.

At the end of last year and the start of this year, the government gave a clear signal: when oil prices fall, the tenge depreciates, and when oil gets more expensive, the tenge strengthens. Over the past few months we have noticed that this relationship has disappeared. Now, if oil gets more expensive, the tenge stays where it is, and if oil gets cheaper, the tenge also gets cheaper. In the end, this means we can forget about dedollarization, forget about lower lending rates in the market, forget about inflation targeting, and forget about growth in purchasing power. All we get is a smaller budget deficit and a mythical increase in the competitiveness of certain industrial sectors.

Under depreciation we can also forget about industrialization altogether, because with deferred inflation, new equipment will take a long time to pay for itself.

So what should be done in this situation?

It is a difficult question, but I think we should still let the market determine the value of the tenge while setting a corridor at the edges of which the National Bank of Kazakhstan (NBK) would intervene in the market to support the currency. Given current oil market volatility, the optimal corridor today is plus or minus 15 tenge. This figure is tentative and needs to be studied carefully. In any case, once there is a corridor, and provided it is below current deposit rates, people will be able to switch from dollars into tenge painlessly, and the corridor can then be widened with each quarter.