June 23, 2015

AccessBank, Deposits, and Me

The CEO of AccessBank (one of the premiere banks in Azerbaijan) - Michael Hoffman - yesterday issued a statement, presumably at a press conference, about the peculiar pricings of deposits in local banks. In particular, he said that interest rates on both local-(AZN) and hard-currency (USD) denominated deposits should not be equal. This erodes any motivation to hold money in local currency deposits, especially considering the 33% devaluation several months ago.

Hoffman is absolutely right. I guess somebody has been reading my blog! I was among the first ones to notice the failure of proper transmission from our devaluation shock to deposit interest rates. Going back 4 months ago, I wrote:
"...because the USD deposit rate is too high, there is an 8.3% annual [pseudo] arbitrage profit on the table. In order to eliminate the arbitrage, banks need to bring down the USD deposit rate to 2.6%, but it’s currently 11%... [to switch to USD deposits] is a perfectly rational decision to make for any concrete individual. But collectively, if every Manat holder will pursue the same dominant strategy, this is a stupid trust-destroying public disaster." [emphasis added now]
I acknowledge that there are difficulties for any particular single bank to move interest rates up or down substantially. Some of us researched this thing a while ago.
"...a considerably incomplete pass-through is present in the case of all banks, the finding consistent with a non-competitive banking sector. The average pass-through effect is 25% and the average period of adjustment is 5 months. Sectoral analysis reveals that pass-through is the strongest for industrial loans and the lowest for consumer loans, suggesting that banks exert more monopolistic pricing powers on consumers while hedging against risks associated with industrial lending."
But there are multiple strategies that banks can implement collectively to move rates in any direction. We are a very, very small market. It should not be rocket science to manage it.

The bigger point to the story is much more depressing. Nobody among serious policy-makers and bankers in Azerbaijan actually reads research papers or informative blog posts that our very own Azerbaijani economists write. I am sort of getting used to it.

June 19, 2015

Emering but Sensitive Markets

In a recent post, I discussed emerging markets equities and the Fed's rate hiking cycles. I also argued that emerging markets are much more sensitive to shocks originating abroad rather then at home:

"... small emerging countries are much more likely to be affected by big economies (not geographically speaking, obviously) through the various international transmission mechanisms. Inflation can be imported, an exchange rate can face depreciation pressures, exports can stall if they are not purchased."

IMF has a nice graph which supports this idea: external factors (such as United States, risk premium on emerging markets, China) account for roughly 50% of the long-term average GDP growth in emerging countries. The original source is the IMF's paper entitled "On the Receiving End? Conditions and emerging market growth before, during, and after the global financial crisis." They derive these numbers, I assume, from their structural VARs which they run over a 20+ year-long sample. While always taking backward looking regressions with a pinch of salt, this is a useful diagram which shows that country-specific idiosyncrasies are roughly as important as external factors; which is, of course, quite amazing.

June 18, 2015

Ramadan Economics 2

It is that time of the year: the month of Ramadan has started. Hundreds of millions of muslims around the world will be fasting for 30 days - not eating or drinking from sunrise to dawn. Ramadan is, of course, a very important economic phenomenon. It affects demographics, and thus is an important factor for policy-makers, economists, investors, etc. I wrote up some ideas about Ramadan's impact on economics and asset prices a year ago, and wanted to revert my readers to that post.

Also, some few additions to the things I have already said. First, productivity. Needless to say, fasting can make your brain operate at below-par capacity, given that your body is low on sugar intake and is basically dehydrated. If a large enough pool of workers simultaneously decides to fast, and if fasting indeed lowers individual productivity (which is not obvious and needs empirical proof), then the aggregate degree of productivity can fall following explicit aggregation. Granted that any normal production function is linear (or not, this is not essential) in productivity for any set of production factors, a negative shock to productivity will lead to a fall in output. Since fasting lasts for just a month, this is clearly a temporary shock. In principle, (disregarding some important details which are beyond the scope of this blog, and at times beyond the scope of my brain), Ramadan can explain some cyclical movements in the business cycle of certain muslim countries.

Naturally, Ramadan is not the only thing happening to major muslim economies during the Summer months. But it is possible to control for a set of external and some domestic factors, to somehow bring fasting-induced productivity decline to the surface. As a caveat, many muslims who fast actually enjoy doing it. Of course, they struggle physically, but mentally and socially this may actually make them more sharp and "engaged". So, it is not that obvious that productivity in the neoclassical sense of the word falls.

Second, I want to restate my point about the potential importance of Ramadan for asset prices. Ramadan is basically a natural temporary exogenous shock to human behavior and preferences. Fasting agents may have a more concave utility function because risk-loving quality is dampened by lack of glucose and general tiredness. Or, they may have a less concave utility function during the month of Ramadan, and especially after they break the fast (the marginal piece of the pizza will taste much tastier than for non-fasting agents, because they are hungry all day long). Thus displaying lower risk-averseness. Exogenous shifts in risk-averseness may explain price fluctuations not only over time, but also across products and services. Fasting agents may reveal their preferences more abruptly and strongly; since they have just 1 chance to eat and drink over the whole 24-hour period, they might as well consume the foods they truly love at a place they enjoy with the a group of people they value.

The morale of the post is not that we are uncovering some mysterious dynamic asset pricing formula and will make a ton of money. The key point is that everything in life, even supposedly unrelated religious events, can be actually very "economical".

June 17, 2015


That's the title of a new introductory textbook, co-authored by Acemoglu, Laibson, and List. It is scheduled for release later this Summer. Based on what I have heard and read on the internet, the book promises to be a real innovation in the approach to teaching economics. Every chapter will start with an empirical, real-world practical question, proceed with some theories and analytical tools, and end with an empirical strategy to answer that question. Laibson (Professor at Harvard) is an LSE graduate; so is Acemoglu, obviously. Very interesting is the fact that both Laibson and List are behavioral economists. List is more on the experimental side, Laibson's sphere of interest spans multiple dimensions. So, I guess the book will be much more real-world oriented than any existing title. Can't wait!

May 29, 2015

Emerging Markets and the Fed

Update: in another post I refer to some empirical results confirming the dominating sensitivity of emerging markets to U.S. and other macro external shocks.
So much of the analysis in macro-finance literature, as well as policy and private sector circles, concerns small open economies, that you might even begin to think that they are important. I am not talking about nation building (or failure) but about asset prices and economic performance. In the long run, governance is probably the factor that differentiates success from collapse, but this is all depending on which camp you belong to. In the short term, or rather in the "convergence to equilibrium phase", a lot of things can happen. Most of the times, these things originate in the U.S. and then transmit to the rest of the world. In particular, equity markets in the rest of the world tend to be particularly volatile and sensitive to funding rates in the source economies (carry trades and all that).

Digression: Obsession with country-specific idiosyncrasies is probably escalated through excessive attention to macroeconomic disasters (Greece, Argentinian default) and has a big behavioral component (Kahnemanian loss aversion). On average though, small emerging countries are much more likely to be affected by big economies (not geographically speaking, obviously) through the various international transmission mechanisms. Inflation can be imported, an exchange rate can face depreciation pressures, exports can stall if they are not purchased.

My question now is the following: how will the emerging markets equity asset class respond to the upcoming rate hikes by he Fed? The fact that the Fed will begin the cycle later this year (or maybe in January 2016, which doesn't change the story) is indisputable. Using this as an initial condition, we can anticipate future performance using historical data. I am interested in 2 things which usually worry economists and financists the most: US Dollar performance, and the reaction of the stock prices in general. It would be interesting to look at interest rates, but perhaps this is a topic for another post.
The idea is that if the Fed hikes the rates, this attracts more capital to the U.S., and the U.S. Dollar appreciates. This, of course, triggers depreciation of vis-à-vis emerging markets currencies. Because capital needs to come from somewhere, and because higher funding rates can increase risk aversion, the obvious sell-off point is emerging markets equity. So, the prediction is that Fed rate hiking cycles produce a stronger Dollar and a sell-off across emerging markets equity as a risky asset class (assume "alpha" mode sell-off due to an exogenous shock to risk aversion).

Below is the table of my results. I look at 15 Fed's previous rate hiking episodes over the past 46 years (1969-2015). I define "rate hike" as at least 3 months (1 quarter) of uninterrupted increases in the Fed’s funds target rate. I calculate the cumulative increase in the fed's funds rate over the duration of the cycle, the cumulative change in the DXY (US Dollar index vs. a basket of currencies), the cumulative change in the MXEF (MSCI Emerging Markets Index). The cumulative increase in the Fed's funds rate also needs to be at least 100 bps (we ignore unimportant, short-term movements).

What we see is the following picture:

1) 9 out of 15 hiking cycles were accompanied by a rise in the U.S. dollar. 6 cycles lead to a decline in the DXY. The mean change over the past 46 years is 0.89%. Basically, the effect of Fed's funds rates on MXEF is statistically indifferent from 0.

2) 4 out of 4 hikes were accompanied by (serious) growth in emerging markets equity (as proxied by the MXEF). Data for MXEF was available only since 1987.

So, the predictions I laid out above basically collapse. Rate hikes in the past didn't lead to large appreciations of the USD, and as far as the data allows us to conclude - emerging markets stocks didn't collapse. Of course, we are not establishing causality, there is a whole of endogeneity to be sorted out, and several negative outliers in the USD cumulative response data (years 1972-1973, 1977-1980) might spoil the picture. Still though, the data is what it is.

Some speculative ideas that may explain the empirical finding above:

1) When the Fed hikes the rates, fixed income securities (bonds) as an asset class become less attractive. So, investors reallocate their fixed income positions towards equities. This should imply that when rates rise, equities will rise across the board and NOT only in emerging markets. This is empirically verifyable and makes sense actually.

2) The reason for rate hikes matters. If the economy is doing well, rate hike is a good thing, not a bad piece of news. This may signal the fact that the Fed is Okay with employment levels, or that inflation is picking up. Both are good for consumption. Consumption, in turn, will spill over imports and thus will benefit small emerging economies that are exporting goods to the U.S. So, rate hikes that are interpreted as signals of growth and inflation may LOWER risk-averseness and make emerging markets look more attractive.

I like the story, but then why wouldn't I. The U.S. economy is booming, which means the consumer is doing well (the American consumer is the holy grail), inflation picks up. The Fed raises rates endogenously in response to the positive growth outlook. This confirms the investors' prior that the economy is doing good. Risk-averseness is lower. Emerging markets equity are more attractive because a) risk-averseness is lower and b) fixed income is unattractive due to rising rates.

The story completely ignores the "beta" because, as I said from the start - individual country factors are dwarfed by the U.S. factor in the short run. In the long run, the Solow story and all that begins to take over the Fed's influence (I have no empirical fact to back this up, actually, which is a shame. But you have to agree that this suits my purpose rather accidentally neatly).

The post above is an example of what happens to people who don't take Friday nights to socialize with people and enjoy life. Also, buying emerging market stocks could be the theme for 2016.

Note to myself: I studied the exogeneity of the Fed's funds rate in my Bachelor dissertation and found striking differences in economic performance and asset price movements across two regimes: when the Fed is exogenously setting rates, and when the Fed is endogenously responding to macroeconomic indicators. Back then I thought that inflation was key; what if the consumer is the one conducting the orchestra? Perhaps it's time to revisit those childish ideas.

May 28, 2015

LBS On My Mind

I have been admitted, among some other places, to the economics PhD program at London Business School. It is really cool because apparently I will be the first Azerbaijani to join the LBS' postgraduate program [emphasis: postgraduate, not graduate such as MBA, MFin, or MiM]. They also offered me a generous fellowship for 5 years, which never hurts! Add to this the possibility of working with some of the best applied macroeconomists (googlesearch: Helene Rey, Portes, Reichlin, etc etc.) in the world, the obvious fact that LBS is a powerhouse in empirical finance, and the decision to join LBS became natural. LBS is home to one of the best MBA programs in the world, and I kinda look forward to my teaching duties. Basically, this is love from first sight and me and LBS will live happily thereafter.

Blogging will continue as usual.

May 5, 2015

The Basket of Last Resort

On 16 February (about two months ago), the Central Bank of Azerbaijan announced that they will switch to a new operational regime - a currency basket peg. A direct peg - fix - is usually between 2 currencies. For example, 1 USD = 1.05 AZN is the new currency fix after the recent devaluation. A currency basket is a multilateral, more complex, relationship between the local AZN and 2 or more other currencies. In the case of CBAR, they said they would construct a basket of USD and EUR - probably in the proportions of 70% and 30%, respectively.

Currency basket is a beautiful policy regime. It allows your local currency to appreciate against one major reserve currency (for example, USD) and at the same time to depreciate against another one (for example, EUR). If you are fixed to the USD and then the USD appreciates against all other currencies - something which we have seen in the past 18 months - then your local currency also appreciates vs. all other currencies. Because you are pegged to the USD.

Looking forward, after the 33% devaluation, the last thing we want to see is another devaluation in 6-12 months. This would be devastating for the population. So, the smart way to go around this is to install a currency basket regime. If, in the near future, the USD begins to gain more strength (growth in the US picks up even more, FED rate hikes approach faster than expected) then the AZN would rise together with the USD vs. all other currencies. This means that AZN would rise vs. the EUR as well. But the reason we devalued the AZN 2 months ago was precisely because AZN was getting very expensive relative to the EUR in the past 2 years. Most of our country's imports come from Europe. So, stronger AZN and cheaper EUR means that the current account is worsening. And if this continues for too long, we need to devalue the AZN again because the USD is too strong in FX markets.

But if you have a currency basket regime (AZN is pegged to USD and EUR simultaneously) then AZN will be stronger vs. all other currencies if USD is rising, and weaker against all other currencies if EUR is falling. Basically, you are hedging your currency risks; if USD is strong then by definition the EUR must be relatively weak. And if your AZN is pegged to both USD and EUR at the same time, you are indifferent and your position will change only based on the proportions in the basket (70% USD power and 30% EUR power).

So, how is the CBAR's currency basket doing since February 16? Below is a graph from Bloomberg. It shows the USDAZN (how much AZN can 1 USD buy), EURAZN, and EURUSD rates.  Note the spike in values on February 21 - devaluation of the manat. Afterwards, the USDAZN was fixed at 1.05. EURAZN was changing because of the EURUSD movements on international markets - yellow and green lines are basically perfectly correlated.

For example, on May 1st (when I took this graph), USDAZN was 1.05 and EURUSD on financial markets was 1.1270. If you convert 1 EUR into USD and then buy AZN you must do a simple arithmetic move: 1*1.1270*1.0497=1.183. The number is slightly different from 1.1864 due to technical reasons, I think.

What we see is that the EURAZN rate is determined basically only by movements in the EURUSD in global FX markets. This means that if tomorrow (or in one year) the Dollar gains more value, EURUSD will be dropping, and so EURAZN will be dropping as well. The FX no-arbitrage will guarantee this. Falling EURAZN means that AZN is getting stronger, the value of imports is rising, and Azerbaijan's trade account balance is worsening again.

I don't see any empirical proof that CBAR is actually doing the currency basket. EURAZN is just EURUSD * AZNUSD. This is not my main point here. Maybe they are just implementing this. Currency basket is not easy to install so I have no problem with that. My fear is that after the 33% devaluation the Central Bank will be like "we have solved the problem so the basket is not needed and we can safely go back to the fixed regime". If this is actually what is happening, then this is a big, big mistake. More precisely, this means we have not learnt our lessons. In 12 months, if USD gets strong enough vs. the EUR, devaluation of the Manat by another 10-20% will become logical once again.

The currency basket is the single most important innovation that the Central Bank needs for this year. Abandoning this idea can create severe problems in the near-to-medium term future.

April 25, 2015

Azerbaijan's Expansionary Austerity

In a recent post, I talked about fiscal multipliers and how cutting wasteful fiscal expenditures (such as on construction) in Azerbaijan should be the most efficient way to fill the budget deficit. The deficit for 2015, based on several official sources, is about $3 billion. The deficit by itself is not really the problem. It is how you finance it which determines your future economic fortunes. A while ago I talked about 4 such possibilities: cutting spending, raising taxes, money transfer from the Sovereign Wealth Fund, issue government bonds (debt financing). I also pointed out that cutting spending is the obvious winner in the discussion. This post briefly highlights another reason why austerity (cutting spending) will work in Azerbaijan.

Crowding-out effect. In economics, when the government overspends, it stretches the demand for money, thus raising the market interest rates. Higher interest rates will discourage private-sector investors, who usually need to take a leveraged position on long-term investments, i.e. they borrow from a bank and then build factories, produce goods and services, etc. The issue, of course, is that Azerbaijan has been in a constant state of fiscal expansion over the past 10 years. Naturally, fueled by oil money. It is no surprise that private investment is in infant stages, and even if there is some sort of investment it is either state-financed or very, very minor and not technologically intensive anyway.

Now, with the budget deficit dominating the policy agenda, filling it with budget cuts seems like an obvious first solution. And so we are looking at a reverse-crowd-out situation. Fiscal contraction (spending cuts) will decrease the demand for money (manats) and so interest rates should in theory go down as a result. Interest rates, by definition, are the price of money. If demand for money goes down, so should the price on it. Lower interest rates, in turn, should create a more favorable environment for private investment. This is a classical investment crowd-out but the other way - government gets smaller, interest rates go down, and private investors take advantage of it.

So, if the Azerbaijani government decides to cut its spending on less useful construction projects, the following should happen:

1) Lower spending will decrease aggregate demand (GDP) but the negative effect will be smaller because of the favorible fiscal multiplier.
2) The investment crowd-out effect will work in exact reverse order, lowering the market interest rates and spurring private investment.

The combined effect of the two forces will be positive for growth. Surely in the long run, since we absolutely must finally switch to an investment and innovation driven growth model, and this could be a good first step. But even in the short run aggregate demand will benefit from both lower interest rates (which will improve bank lending as well) and a more powerful private investment growth.

So, Azerbaijan has potentially a unique chance to balance its fiscal budget, rebalance its state-oriented non-oil sector, lower interest rates, AND have positive economic growth numbers - all in the same year.

April 22, 2015

Demographic Change and Economic Development

I have long beet a closet believer that demographics is the most important thing in social sciences. Long story short, let's imagine a fictitious country (or maybe a real one) with a demographic mismatch: an old, socially and ideologically conservative, short-term oriented, profit-seeking ruling political elite. And a young, socially and ideologically liberal, long-term oriented, intelligence-appreciating labor. Furthermore, imagine that the ruling elite forms a demographic collusion: they collectively protect their own positions in order to practice profit-seeking activities, while not letting any of the younger generation in. This is a crucial component of the model - demographic collusion.

The production function in this economy depends on demographical type of people in control. For example, there are two production alternatives: high amortization but high instant profit investment (real estate, e.g.) or low amortization and long-distant profit investment (ideas, innovation, etc.). The old generation obviously invests in high-instant projects because they know that they will soon die. The young ones prefer the long-distant profit investment for the opposite reasons. A key assumption is that in order to run the production mechanism, one of the 2 demographical groups needs to dominate the governance. Basically, this is a demographic majority rule set-up. For example, if 7 out of 10 elite members are old, and only 3 are young (because they replaced the old ones who died) then the dominant project in the country will be short-term profit oriented investment (like construction of buildings, etc). And there will be nothing the 3 young rulers can do because their collusion is not strong enough to fight the old group's collusion.

This is a big problem. Because the old group is colluding, there is not a chance that 1 or 2 young members of the elite could change anything in the country. You need a total demographic change in order to take control of the production function. But for that you need time... So, my main point here is that economic development models, policies, all sorts of policy proposals to develop long-term profit investments that use technology and ideas intensively, are useless while the ruling party is dominated by the old generation. Basically, in this model you just need to wait until the old generation dies out and the new, young labor can begin doing more productive, long-term oriented things.

This is a depressive scenario but actually relevant to some of the things we see in this world.

April 20, 2015

Fiscal Multipliers

Apart from being fundamentally driven by oil, Azerbaijan's economy is basically state-oriented. The non-oil sector relies heavily on contracts and tenders issued by the government itself or agencies one way or another linked to state institutions. This is actually a good thing, as the example of the Chinese miracle has shown us. Fiscal policy becomes a very powerful, and more importantly - quick - instrument.

The easiest way to think about fiscal impact on the real economy is through the so-called multiplier effect. This is an old Keynesian idea which says that government spending can generate demand equal to or bigger than the amount of the actual spending, if the fiscal multiplier is equal to or bigger than 1. In other words, if the fiscal multiplier is 2 then every 1$ created (spent) by the government can generate up to 2$ in aggregate demand. This happens because money moves around quickly and in the right hands in a high-multiplier economy. How to calculate it in a more or less correct way?

The old-fashioned formula is: K=1/(1-MPC), where MPC is the marginal propensity to consume, i.e. the percentage of income spent on goods and services produced domestically. 1-MPC is usually re-written as 1-MPC=MPS + MPT + MPI, where MPS=marginal propensity to save, MPT=marginal tax rate, MPI=percentage spent on imported goods. So, when MPC is high - multiplier K is high.

One would think that in Azerbaijan, just in any emerging economy, the marginal propensity to spend would be very high. The majority of the population, no matter how you look at it, is not rich. The average wage is just above 400$ per month, so you get the picture. So, a large portion of every marginal dollar earned should be spent on food and necessary services.

I spent 4 hours of my life working with the Azerbaijan's statistical office's website and tried to get at least a rough proxy for the MPC. I get a number which is larger than 1... Anyway, why am I not surprised?

So, let us just assume that the MPC is very high. Probably in the 0.8-0.9 (80-90%) region. This makes sense given the economic and demographic situation. This leaves the fiscal multiplier in the 5-10 range. One dollar injected into the economy by the Ministry of Finance of Azerbaijan will create 5-10 dollars in aggregate demand. Of course, we are making a very wrong assumption that 80-90% is actually spent on domestically produced goods. Because it's crucial that money gets spent on locally produced goods. In the case of Azerbaijan, however, probably 50% if not more of the average consumer basket is spent on goods/services imported from abroad. Anything from quality milk, oil, some agricultural goods, all technology, all industry - imported. So, the fiscal multiplier becomes something like 2-3 (assume that MPC=0.5).

What's the point of these arithmetics? Recently, the government announced a 3$ billion deficit in its budget. Part of the budget will be financed by bond issuance (foreign capital raising), but some of the fiscal expenditure must absolutely be cut. For example, some of our construction projects should be canceled and the money must be saved for more efficient purposes. So, my concern was that when fiscal contraction (austerity) begins, our GDP will suffer because the non-oil real economy relies so much on government contracts. That's why we are trying to calculate the multiplier.

If we go with the first scenario (where we don't distinguish between locally or foreign produced goods), then the multiplier is 5-10. So, every dollar that the government contracts (cuts) will reduce the aggregate demand by a staggering 5-10 dollars. But the second scenario predicts the multiplier-effect on demand decline of just 2-3 fold. So, the smaller the MPC - the smaller the destruction caused by fiscal contraction.

It's interesting that Azerbaijan still doesn't have anything serious (industry, services) in its non-oil economy. But it is amazing that this lack of domestic production and reliance on imports will actually HELP us in these calculations. Because our MPC is lower than most people think, because we spend most of our money on imported things, the multiplier is actually smaller that it would be if we had a fully functioning non-oil economy. So, when the government begins budgetary cutting measures, we should not worry that austerity will create a recession or something. Lack of a diversified non-oil economy, which would substitute imported goods, will actually make austerity much less painful.

Cut the budgetary spending on construction.