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.

April 14, 2015

Monetary Policy and Industrial Diversification

It's very easy to blame policy for everything which is wrong in the country. Everything which is wrong with Azerbaijan's current currency situation is obviously the fault of the central bank - but that's an overeaten subject. But policy is not panacea for long-term problems. Azerbaijan has a legendary overdependence on oil. To the extent that the oil price is probably the most important local statistical number. Unfortunately, our statistical office makes it impossible to track any other economic indicator due to its magic wands keyboards. Anyway, enough digressions for now.

Azerbaijan's structural dependence on oil has brought upon us a miraculous growth record over the 2004-2012 period. Baku - the capital city - is a remarkable location and I am truly enjoying my time here. But, most of material things we see (construction) is tangible for very wrong reasons. The economy has no real comparative advantage, no industry, no services. Most of the non-oil sector is just one huge asset price bubble in the real estate sector. Construction is fueled by oil inflows, which is obviously a depletable resource.

Moreover, one of my papers (book chapter, to be precise) once showed that countries which build their growth models on one key source of growth (such as oil, financial innovation, exports) usually suffer prolonged and painful crises when facing a negative external shock. Over-reliance on 1-2 factors, or in other words lack of proper diversification across industries and other dimensions, leaves you vulnerable when the key factor takes a hit. Furthermore, because macroeconomically you are tied to your growth factor, monetary policy now has to protect that factor, even if this contradicts the actual mandate and strategy of the central bank. Here is the abstract of the paper:
Despite the indisputable fact that the 2008 Global Financial Crisis, the continuous debt overhang, and the everlasting Eurozone problem, constituted the most substantial economic downturn since the Great Depression, this slowdown has not necessarily been equally destructive for all parts of the world. This chapter proposes a case study of four relatively small and open economies which differ in their respective growth design. In each of the four economies growth has been historically heavily financed either by natural resources, influx of foreign investments, external debt, or exportation. Azerbaijan has been chosen to represent the “resource-driven”, Singapore – “investment-driven”, Hungary – “debt-driven”, and Switzerland – “export-driven” model of economic development. A supposedly very broad narrative converges naturally into just a few main talking points. Narrowly designed economic models leave nations dangerously dependent on their respective key factors of growth. Under systemic negative shocks, the factor of dependence impedes policy making and contributes to multiple structural problems that prevent sustainable recovery. Industrial diversification appears to be the chief differentiating factor for success and at least one of the key solutions to systemic financial crises. Monetary policy often becomes restricted by the path imposed by the choice of the growth design; protection of the growth regime becomes a priority for monetary policy makers, either directly or indirectly. Exchange rate management evolves into a key instrument of monetary policy-making in small open economies under large negative external economic shocks.
Basically, those who are monitoring the Azerbaijani story, would notice that everything the abstract is talking about is incredibly relevant. Our problems lie much deeper than just overvalued manat or some sort of currency miscalculations. They are systemic, prolonged, and ultimately leading to a dead end, as the paper demonstrates. Economic diversification is the single most important answer to the question of economic independence. We already have our political freedom. It's finally time to struggle for the economic one.

This also means that standard economics can explain pretty much every aspect of the debate in Azerbaijan - even despite the fact that some people argue that Azerbaijan's economic model is "unique" and cannot be explained by conventional theories. So, I am still waiting for the time when our serious academic economists, who have been educated abroad at reputable economic institutions, will be given the green light to actually have a say on big policy affairs. Maybe economics is better left to be managed by, you know, actual economists?

March 14, 2015

Neo-Transitional Economics - Now Available on Amazon

Neo-Transitional Economics - the book I have co-edited with Dr. Yusaf Akbar (Central European University, Hungary) is now available on The volume is a collection of 13 empirical, theoretical, and policy-oriented articles by scholars from more than 10 countries. It has been published by Emerald Publishing, in their renown International Finance Review. Short summary of our basic idea is below:
Post-transition countries are coming of age and are approaching the status of fully-blown developing states. While the main problems highlighted in a classical transition storyline, such as large-scale privatization, institutional formation, and private sector establishment have largely been solved, the recent financial crisis has revealed fresh challenges which demand maximum differentiated attention. Such important contemporary issues as capital markets formation, monetary transmission mechanism, economic integration, financial sector sophistication, remittance management, social welfare reform, and competitive fringes remain to be tackled in a systematic, policy-oriented manner. 'Neo-Transitional Economics' fills this escalating literature gap by presenting a comprehensive collection of viewpoints from the established scholars and practitioners of the field. The ultimate goal of this book is to offer an all-encompassing policy toolkit for a successful overcoming of all contemporary challenges that lie ahead in the age of neo-transitional economics. 

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

Update: As of today, 03 March 2015, nothing has happened. AZN is still some 33% weaker than 1 month ago. *sigh*

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 senior officials' new-year pledge 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 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 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.