Why the Depreciation of the Tenge Is Inevitable

I am asked a great many questions about the exchange rate. Let me disappoint everyone first: in a developing country with high inflation and low labor productivity growth, the currency will depreciate continuously. So under the current economic model 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 exchange rate has depreciated by 400%. If nothing changes globally, in 15 years the rate could reach 2,000 tenge per US dollar. If we carry out structural reforms and improve the investment climate, the currency will not be subject to depreciation.

This is not a question of whether the National Bank or the Government wants to devalue 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 an 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 costs 450 tenge per liter, and the cost of production is 360 tenge. Everything is in equilibrium and works.

The Government raises the salaries of civil servants. Our workers no longer want to work in milk production and try to get jobs in state-owned companies, where pay is higher. 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 begin to consume more milk. Since milk production cannot be increased immediately, prices rise by the amount of the increase in demand in monetary terms. And so milk, instead of 450 tenge, now costs 500 tenge, or $1.11.

Producers in the neighboring country see that milk in our market costs $1.11 and start importing it in large volumes. Having sold their milk here, they need dollars, and they start buying them from us. But we do not have that many dollars, so the price of the dollar begins to rise. To meet the demand for dollars, the rate rises to 500 tenge, and the price of milk is again $1. We are back to the starting point, with milk costing $1 again, only now it costs 500 tenge. In nominal terms our civil servants and workers now earn more, but in reality their purchasing power has not changed, and inflation has increased.

Now consider another simplified example, with the same initial data, but in which the neighboring country has a free economy, developed institutions and a high level of investment. The neighboring country figures out how to raise the productivity of its cows by 30%, cutting its cost of production to $0.60 per liter. To increase sales, it starts importing milk into our country at $0.90 per liter, or 405 tenge. Our milk producers cannot survive or compete. As a result, milk production in our country begins to shrink, and investors in this sector start looking for new opportunities.

The neighboring producers start displacing our milk. They need dollars, and there are none to be had, which creates excess demand for dollars and pushes the rate up. The rate rises from 450 to 500. Milk now costs $0.81 in dollar terms, importers raise the price to $0.90, and the price becomes 450 tenge, which is comfortable for our producers. But now they have to win back the market and increase production. The rate is now 500; in dollars milk has become cheaper, but in tenge it has stayed at the same level. All other imported goods have started to become more expensive, and this has caused inflation.

The main causes of the problem

In this simplified model, the root cause is the growth of unproductive spending: civil servants did not start producing more once their salaries were raised. The other cause is the growth of labor productivity in the neighboring country.

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. This means that the currency will keep depreciating for as long as these conditions persist.

Solutions

To avoid inflation, we need to raise labor productivity over the long term.

This is achieved either through innovation or through intensification. Neither innovation nor intensification is possible without:

• quality education,
• protection of property rights,
• developed institutions (independent courts, strong political and civic institutions, free media, etc.),
• freedom of capital movement,
• effective tax and monetary policy,
• developed infrastructure (roads, electricity, water, and so on),
• quality regulation of monopolies, and so on.

In other words, innovation and intensification depend on people and entrepreneurs, not on the state. The state should create a level playing field for business, rather than interfere in the economy by trying to "decide for entrepreneurs" what to produce and whom to sell to.

At the same time, temporary state support (for example, in the form of infrastructure projects) can be useful if it is limited in time and does not create unequal conditions. But protectionist diversification does not, in the long term, lead to higher labor productivity, just as it does not lead to sustainable economic growth.

International experience

The success of countries such as South Korea and Singapore shows that the key to economic stability and development is a high level of investment, a competitive environment and stable institutions. South Korea, for example, was able to become a highly developed economy by focusing on exports of high-tech products and investing heavily in education.

What we see with the exchange rate is a normal situation for a country with the current economic policy, in which, instead of building a market economy with developed institutions, we are building an economy with bottlenecks in the form of access to state resources and protectionism.