February 25, 2015

Stop Having Babies

I am not surprised to hear that Azerbaijan showed the highest birth rate in Europe for the calendar year 2013. On the ground level, practically everywhere you go you can see hoards of children guarded by platoons of biological parents, uncles, aunts, grandparents, and more distant relatives. This is all very nice and I am not against children in principle. What I am against is having irrationally many children.

With an official average wage of just above 500 AZN (thanks to our Central Bank's historical 33% devaluation, this number converts to just 490 USD today as opposed to 600 USD one month ago), poor and middle-income families of 2 struggle to make ends meet. The addition of children creates significant financial pressure on the breadwinner(s). With the purchasing power of the local currency falling due to higher imported inflation, the real disposable income of the population is in the bear market (i.e. having a difficult time). Therefore, I think that postponing the first, second or additional children until better times is a rational decision given the circumstances. This is my micro-economic argument.

The macro-economic point is that Azerbaijan is obsessed with GDP per capita figures and the middle-income country status. I have talked about this in greater detail in the past. Given the lowering oil prices and still developing non-oil domestic economy, the numerator of the GDP/capita equation will not be growing as fast as 3-4 years ago. Meanwhile, the growth in the denominator - the quickest among all European peers by the way - is higher than the growth in the numerator. This naturally implies that GDP per capita will be declining over time.

Assuming that boosting the numerator is difficult in the short run, the only way to sustain the GDP per capita growth is to stop having babies. This is good for the contraceptives industry, and thus the development of the non-oil sector too!

February 22, 2015

Thinking Out Loud

I have taken my time to think and this is what I believe will happen tomorrow. They will come out and say that devaluing AZN by 30% was too much and the population is suffering. So, AZN will be reverted back to 1:1 against the EUR. This means a 15% revaluation and a position of AZN to 0.9 against the USD. I know this doesn't make any sense but I think this will be the next step in the saga. Next, I think they will abandon the currency basket which they adopted ten days ago an...d go back to direct pegging with the USD.

This, if they actually do it, will be a terrible decision since a diversified basket peg provides great flexibility for the Manat. Third, they will go out and punish businesses like Music Gallery who increased prices by as much as 25-40% in one day.

Basically, a lot of politicization of the economic story that was mismanaged horribly.

February 21, 2015

How Not to Run Monetary Policy

The Central Bank of Azerbaijan has showed to the whole world how NOT to run monetary policy. On 21 February, 2015 the Bank has announced that the local currency will be instantaneously devalued by 33% from USDAZN=0.7865 to 1.06. On 16 February, 2015 the Governor of the Central Bank - Elman Rustamov - stated that "any weakening of the currency would be gradual rather than sudden, saying that the central bank would take into account the interests of the population" (source). Not only is devaluation bad in itself (read here, here, and here why), but the way they managed it is even worse.

What's the point in issuing such a public statement and then reversing course in just 5 days? You have been building trust in the financial system, in the currency, in the central bank's power to control inflation, for 15 years. Now, you manage to destroy it by mismanaging a very simple textbook case of an exogenous shock to the current account.

The whole process of devaluation, from conceptualization to execution, has been run absolutely horribly by the central bank and related authorities. Starting from the President's new-year speech that the Azebaijani manat must equal 1 EUR by end of the year. Later, banks and the general population obviously started to short the local currency by converting to the USD. They took the President's promise as credible, and started acting upon it.

Then, the central bank supposedly made a positive contribution by coming out and trying to calm down the markets by ordering banks to convert AZN to USD if the population wants it. They promised that the devaluation will be slow to protect our interests. People believed it. Then, on a Saturday morning, they devalue the currency by 33%. What's the point?

It would have been so much easier if they didn't make a promise that devaluation would be slow and if they just did the sudden devaluation from the start. Why all the drama? Azerbaijan has taught the world a lesson on how to create a financial crisis out of nothing; how NOT to run monetary policy. A few weeks ago I notoriously said on Facebook that they only way Azerbaijani currency can die if we ourselves kill it. Azerbaijan has managed to shot itself in the foot without any real external pressure. This is not even self-fulfilling panic. This is a self-conceived, self-managed, and self-executed panic.

February 19, 2015

What Limits of Arbitrage?

Note: the post's title refers to this.

Recently, the government of Azerbaijan announced the break of the USD-AZN currency peg and beginning of a slow currency devaluation process. *sigh* I have already said enough of what I think about Manat devaluation (here, here, and here) so I will move on to something sexier.

Assume that in 12 months the USDAZN rate will depreciate to 0.85. This is consistent with EURAZN stabilizing at 1:1, which is the official target for the currency by end of 2015.

Imagine 2 alternatives: put money into a bank deposit for 12 months in AZN or USD. We need to know the bank deposit rates on USD and AZN. Sourcing banker.az we see:


Take Bank of Baku, for example. They give 11% for both USD and AZN. We have 2 scenarios:

Scenario 1: Put 1000 AZN deposit in manats, get 11% in 12 months, and then convert to USD at 0.85. You will get = 1000*1.11/0.85=1305.88 dollars

Scenario 2: Put 1000 deposit in USD now (convert at 0.7857 today, which is the FX rate as of 19 Feb, 2015), get 11% in one year and you will get = 1000/0.7857*1.11=1412.7 dollars
In principle, these 2 scenarios should have no arbitrage opportunity (must equalize). But because the USD deposit rate is too high, there is an 8.3% annual 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%.

There is also a stretched possibility of this strategy working if you take a leverage position, i.e. borrow AZN in order to invest in USD deposits. But colleagues have figured that it won't work in practice. In any case, if you happen to have 10-20K manats lying around in your house - go and grab the free lunch.

Paradoxically, this 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. But this is what you get if you manage the current account crisis the way they decided to manage it.

February 18, 2015

The Dogs of Tax

Quite unsurprisingly, following the announcement of a non-trivial budget deficit for 2015
(AZN 2.5-3 billion, depending on some assumptions), I start seeing more and more representatives of Azerbaijan's tax ministry in various shopping malls, grocery stores, and all kinds of shops. It's not that I have never seen them before. But their appearances are more frequent and dramatic; in a rather theatrical way, I must say. Anyway, they are starting to treat tax collection very seriously. I wonder if the same level of professional intensity will be maintained not just against the middle class and small&medium enterprises, but when dealing with the richest 1%.

One way or another, the dogs of tax are out there to get you! The obvious theme song for the occassion:


February 17, 2015

Gross Domestic Statistics (Nerd Alert)

My recent post about how Azerbaijan's state statistical office commited the world's most amazing statistical analysis generated some healthy public attention. From what I have gathered from various comments, two points deserve the most attention:

1. [news link reporting this argument] The monthly GDP data for January, 2015 is in nominal terms. Whereas annual GDP numbers come in real values. This is why it is possible that January '15 GDP grew by 4.4% yet suffering from an 18% decline. Ok... This is an incredible argument and I am very surprised that some people actually think for more than a second about it before dismissing it as nonsense. Here is why:

If January '15 GDP dropped by 18% in nominal terms and somehow grew by 4.4% this means that prices over the same period dropped by more than 20%. Regardless of how you measure that price drop (through consumer price index or the GDP deflator), this is an incredibly unbelievable number. No, seriously, I do NOT believe this number. The local news report (in the link above) suggests that the GDP deflator fell by 21.7%. This implies a 20%+ effective deflation. Let us do a quick data check by visiting the IMF's statistical database and seeing the GDP deflator estimates prepared by the IMF staff. Of course, their numbers are not Gospel from God and could suffer from computational errors as well. But, if the IMF numbers at least confirm a negative deflator then the Statistical Committee has some basis for self-defence.

Below is a table which shows changes in the GDP deflator from 2014 to 2015 for every country in the world (2015 are IMF staff estimates). I just divide the 2015's deflator by 2014's. If the number is <1 then deflator dropped. Azerbaijan is highlighted in yellow.


GDP deflator decreased between 2014 and 2015 only for Brunei, Peru, Gabon, Oman, Equatorial Guinea, Timor, Saudi Arabia, and Qatar. For Azerbaijan the number stands at 1.04. Your degree of trust in this number may vary, but such discrepancies across sources is extremely uncommon. One can argue that lower oil prices preceded domestic deflation in Azerbaijan (Azerbaijan's GDP is basically 50% oil income). But then such juggernauts like Qatar and Saudi should have suffered more. Even for them and, for God's sake, Gabon the GDP deflator didn't fall by more than 4%.

2. GDP data for January, 2015 - which suggests an 18% decline on a year-over-year basis - is incomplete information because the statistical office will revise the data in the future. Data revisions are common in statistics and in countries like the U.S. and the U.K. even figures like GDP growth sometimes get revised by 1-10%. This is to say that the level of GDP gets re-estimated and gets lower or larger by 1-10%. NOT the growth rate itself by such big amounts. In other words, if GDP is at first said to drop from 100 to 90 and then the decline is revised to 93, this is a 30% correction (3 divide by 10). The decline was 10% and now is 7% - this means there was a 30% measurement error (from 10 to 7 means 3) but the decline is still 7% - a 30% measurement error but in "absolute terms" just a 3$ correction.

So, even if the Statistical Office will revise the data and say something like "January '15 data was AZN 3.6 billion but now it is actually 4 billion" this will mean a ((4.359-4)/(4.359-3.6)=0.47) a 47% correction. And the GDP still fell by AZN 359 million which is an 8.3% decline. There is absolutely no way the statistical office can come out in February or March and say that, you know, the January GDP numbers actually meant positive economic growth after the revision.

No matter how you try to defend our statistical committee's unbelievable statistical analyses, an 18% year-on-year decline can not equal an 4.4% growth. Not in Azerbaijan, not in East Timor (whose GDP deflator dropped by only 2%, by the way).

February 16, 2015

The Worst Analysis in the History of Mankind

Update: in a follow-up post I discuss my response to 2 major contra-arguments to my discussion below.

Ok...

The State Statistical Committee of Azerbaijan - our main governing body for all economic and social and financial statistical matters - releases this beautiful official press release (link; click on "Production of GDP in January, 2015" in the Press-releases box):

"13.02.2015  

Production of GDP in January, 2015

In the first month of 2015 GDP in amount of 3.6 milliard manat or more than 4.4 % compared to the same period of previous year of were produced. Growth by 5.5% was registered in non-oil sector, 3.1% in oil-gas production and processing fields.

During January 34.0% of GDP was produced in industry, 10.6% in construction, 10.3% in trade and service fields on maintenance of transport means, 6.6% in transport and warehouse, 3.4% in agriculture, forestry and fishing, 2.9% in accommodation of tourists and in the field of catering services, 2.4% in services on information and communication, 19.8% in the field of social and other types of service, net of tax to the product and import was formed 10.0% of GDP.

Tel: 538 74 50"


So, 3.6 billion (not milliard, by the way) AZN worth of GDP produced in January, 2015. Let's compare it to January, 2014. The statistical committee's website is absolutely impossible to navigate, so I am using the official number from the Central Bank of Azerbaijan's website (link):

January 2014: 4359.0 Million AZN

So, in January, 2014 the country produced AZN 4,359 Billion, and in January, 2015 we produced AZN 3.6 billion. This is one of those moments when you think you have spotted a mistake so gross and obvious that you take off your glasses, scratch your eyeballs with a kitchen knife, put the glasses again, and this is still no way possible that the January 2015 GDP was "more than 4.4% compared to the same period of previous year".

If anything, the GDP has dropped at a whopping 18%. For those of you still struggling to count on your fingers: divide 3600 by 4359. Where did they get the "4.4% increase" from?

Was this just a one-time technical or human-error glitch by the Statistical Office? Or do they really, really think that our general public is so mentally degraded that we are inept at spending 10 minutes on elementary research and statistical comparison? I honestly don't know which of the two truths is more horrifying - a statistical office capable of catastrophic computational errors or a statistical office who thinks that its target audience collectively practice ignorance.

To be honest, this COULD have actually worked 20 years ago when the country was in the stone age in terms of economic and financial literacy. But now, since we have graduates from good universities (like, ugh, myself) working at domestic institutions and doing all kinds of research on the economy, the statistical committee should really know better.

February 10, 2015

Writing with Fear - Personal and Scandalous

I take pride in my writing skills. For a foreigner I write pretty well, and my ambitions don't go any further than that. I also write a lot; usually at least a page every day. Most people think that writing is easy. It isn't. It takes a lot of time to learn how to compress thousands of ideas into a coherent stream of words that another human being (or a robot) can comprehend. The best way to learn writing, contrary to what most books on this topic claim, is to write under pressure. You won't believe the wonders that fear and time pressure do to your brain functioning.

When I started my 2-year spell at the Central Bank of Azerbaijan (back in 2011), I developed a fascination with economic commentary, blogging, and writing in general. I would read hundreds of papers, blog posts, reports, and all sorts of pieces on economics and finance. The writing styles would differ across different mediums, publishers, writers, topics. To be able to switch styles, e.g. write an academic paper in the morning, a policy report after lunch, and blog posts in the evening, is really difficult. The language is not the same, the target audiences are not the same, and so the brain's approach must be accordingly adjusted. At first, my early attempts at writing - regardless of the style - were miserable failures, at least in retrospective. But the learning process, already difficult enough, was exacerbated by a very suspicious and patronizing division chief.

In an office room with 7 or so economists, your computer monitor is practically an open book for anyone casually walking by and glimpsing at it. And one particular division chief in our department, who wasn't even the chief of the division where I worked, would take this casual walk very, very seriously. Blogger has a very peculiar interface, and you can instantly distinct it from, say, an Excel worksheet. This division chief would check on my monitor at least 5 times a day to make sure I am not blogging. His checks were randomly timed, but were highly collinear with the speed of my typing. His thinking was, I can only assume, that the more I typed the more likely it was that I was blogging. His motives were clear to me - fear of me writing something bad about the Bank or about him on the web. At the time, of course, I had no such plans at all. I just wanted to learn how to write about economics in the simplest possible way.

So, I was a very miserable person at the time, feeling like a monkey in the zoo - constantly monitored and controlled. But amidst the depression I learnt an extremely valuable asset - how to write up comprehensive blog posts while the division chief went to the bathroom. On average twice a day, I would have windows of 5-10 minutes (sometimes longer depending on what was on the lunch menu) to write everything in one sitting. That was a fascinating challenge. One needs to first of all type really fast. Second, there is no room for mistakes or even minor textual corrections. No time for Thesaurus or aides like that. And we aren't talking about some purposeless rants (like this particular post) but some moderately serious economic arguments. Yes, this post was written in one sitting and little under 20 minutes.

Another very useful thing I learnt during my fight of wills with the division chief is that you don't actually need the computer to build the text in its entirety. Just laying back in your office chair and carefully crafting the future blog post in your head - paragraph by paragraph - is a time spent efficiently. By the time the division chief would leave the room to mind his natural business, I would already know exactly what and how to write, which statistical graphs to use as support for my argument, etc. This saved me tons of time. The crafting stage can also be performed in the shower, when in public transport, you name it. Usually, the more chaotic the environment is (water noise, chatter, music) the easier it is for me to concentrate on structuring the idea in my head.

Once the post was conceived, written, and distributed on Facebook, the job was just beginning. At first, an equally depressing aspect of blogging was not receiving any views. The Azerbaijani community was in the stone age when it comes to discourse on economics and finance. Few people read my blog back in 2011 and, unfortunately, fewer understood it, and a handful commented or showed any sign of interactive participation.

My conciliation during those frequent times when a 750-word post with 3 graphs, written in 10 minutes and conceived in my head over the previous day's dinner, was met with just over 10 views was the great American comic Stephen Colbert. Colbert started out reading monologues to himself, standing in front of the mirror. He claims that he enjoyed his own performances more than any member of his audience. Even when very few listened to what he said, or even fewer appreciated his passions, he was still having a great time. I am happy that now, 4 years later, the views are better, the comments are more frequent, and the public is getting engaged. My goal is a more active, involved, educated, vibrant Azerbaijani economic community. Not any sort of recognition.

John Kennedy, I think, was the one who advised us to forgive our enemies but never forget their names. While I will probably never forget the name of the curious division chief, nor his looks, I have long forgiven him for the miserable and fearful two years which made me, hopefully, one of the fastest and clearest young economic commentators in Azerbaijan. And yes, shyness is a vice; if you are not for yourself, then who is for you?

February 6, 2015

Time to Build and Aggregate CFAs in Azerbaijan

If you don't catch the reference in the title of this post; read this.

There is a rapidly growing body of finance professionals in Azerbaijan. If 20 years ago we were trying to build a decent banking system and explain to the population the concepts of credit and debit, now people are talking about foreign exchange trading, asset management, and derivatives. In the next 20 years, I envision Azerbaijan having 500 domestically developed companies listed on the Baku Stock Exchange, the financial sector growing to the size of 100% of GDP, and capital markets already displaying signs of derivative trading and active private asset management. But before we get there, we need to have a financially literate society, and particularly a very financially literate and educated base of financists, financial economists, traders, and bankers.

The Chartered Financial Analyst (CFA) exam is very useful for that purpose. It provides a very standardized curriculum and basically everything one needs to know about conventional finance. A lot of Azerbaijanis are taking CFA exams every year, some are already Charterholders, and the network of CFA professionals is growing day by day. And it is time to start bringing them together under an umbrella organization (association) which would provide international conferences, seminars, sponsored networking dinners, trainings, job related events, etc.

My colleague Elnur Babayev, CFA, a senior trader at the State Oil Fund, is working on establishing such CFA Society in Azerbaijan. I encourage all of my Azerbaijani readers who are active finance professionals, and who are taking the CFA path, to join his group on LinkedIn. In several years, this society will be a very big thing in Azerbaijan, and one should rush to join it from the very start.

February 4, 2015

No Need to Panic

Over the past 2 months, the Central Bank of Azerbaijan intervened heavily into the foreign exchange markets and spent USD 2 billion to support the AZN rate. This happens when there are pressures on the domestic currency to devalue. Where is this pressure coming from? This is because cash and deposit holders within Azerbaijan are afraid that the domestic currency will lose its value, and thus their cash and deposit holdings would start to evaporate. Why are they scared?

Following the oil price collapse from 105$ per barrel to around 50-55$ pbl, all the appreciative support for the Azerbaijani manat has been lost. The Manat (AZN) is now trading at 1 AZN = 1.2748. AZN is strong, and there are arguments why it should be let to weaken against the USD. Of course, those arguments are wrong. Meanwhile, the Russian Ruble has lost 40%+ of its value in the past year. Naturally, the public is afraid that the same could happen with the AZN. These 2 factors are having a rather serious external effect on the domestic Azerbaijani monetary market.

How should we deal with the situation? In order to answer that, one must ask another question first - in whose hands is the AZN concentrated? Domestic or foreign?

As it turns out, the market for Azerbaijani manats is very small. The broad money supply (M3) is just around 23 billion AZN, based on incomplete data from the Central Bank. Around half of that amount is held in cash outside of banks; I assume that 75% of it is perfectly liquid and can be moved around without friction. 8 billion AZN are in time and demand deposits stored at commercial banks; 5 billion in USD and other currency denominated accounts. Deposits are held mostly by domestic physical holders (humans) and private/public sector institutions. In any case, deposits almost universally belong to domestic agents.

So, we are talking about roughly AZN 15 billion in liquid circulation, either through cash or deposits, and resting in the hands of local Azerbaijani population and institutions. When there is a threat (whether it is a credible threat or irrationality of the market - is a different story) that the local currency devalues, those holding cash and deposits will rush to the bank and convert into US dollars or Euros. Given that the Eurozone is comfortably sinking down the toilet, the USD is once again the world's first and foremost currency.

What is the worst case scenario? Exactly the 15 billion in AZN that exists in the country. This is an absolute theoretical extreme and would never ever occur in reality. For 15 billion Manats to get converted into USD, you would need to have every citizen, firm, institution to convert EVERY cash and deposit account (including wages) into the Dollar. Considering that public institutions, most private institutions, and consumer purchases are and will always be working through the AZN (even if the currency goes down the Russian path, which it won't), the more realistic number is roughly AZN 7 billion, which is about USD 10 billion.

So, in a very, very bad scenario of a historical cash and bank run, the Azerbaijani market will create a demand for 10 billion USD. In other words, 7 billion AZN will exit the system. The 10 billion USD demand shock must be absorbed by the foreign exchange reserves. In Azerbaijan, either the Central Bank or the State Oil Fund of Azerbaijan can intervene into the market and affect the currency. The Central Bank's currency reserves, although they have lost 2 billion in recent months, are still more than 13 billion USD. The Oil Fund's portfolio is more than 35 billion USD, most of which is highly liquid.

The Central Bank and the Oil Fund therefore have more US Dollars than the entire Azerbaijani domestic monetary base in AZN. There are enough reserves to finance the whole amount of AZNs in circulation. Considering that only about 7 billion AZN (in a very, very bad case scenario) will get converted to the USD, the Bank and the Fund will deal with the problem more than comfortably.

I basically predict that the total amount of the shock can be split 50/50 between the Fund and the Bank, each bearing a roughly USD 3 billion in reserves decline (baseline scenario), and USD 5 billion decline in an extreme catastrophic case.

There really is no need to panic.