January 14, 2015

Unequally Greedy

The author of the world’s most popular economics textbook, Gregory Mankiw, shares with us an interesting statistical piece from the Congressional Budget Office (CBO). It’s an old snapshot, dates back to 2011, but the general picture is still relevant. I am pasting the JPEG below just for visual convenience.

Note: Columns represent the income quintiles in the United States. The highest quintile includes those Americans who are in the “Top 25% Richest” category. Same logic applies to other columns. Rows indicate simple taxation mechanics on income: base income, transfers, taxes paid, etc. Hopefully this is straightforward enough for any average reader.

Two points worth mentioning:

23.4% is the tax rate on market income + transfers for the rich (top 25%). This amounts to $57,500 (last column, 4th row). Let’s subtract from this the government transfers paid to the top quintile: 57500-11000=46500. And divide this number by the average market income: 46500/234700=19.8%. This number is different from 18.9% that the picture shows (last column, row 7). Am I doing something wrong here?

More importantly, the rich-to-poor income ratio (dividing the highest quintile average market income by the lowest quintile) is = 234,700/15,500=15.1. Roughly speaking, the rich earn 15 times more money, on average, than the bottom 25%. I am OK with that. The rich-to-poor government transfers = 11000/9100=1.2. This means that the richest 25% of Americans receive on average 20% more government transfers than the poor. And they also earn 15 times more money in total income. Now this is very unsettling. 

This really is not the first time I have been puzzled and intellectually paralyzed by the staggering income inequality that persists in the United States and elsewhere (here, here, here, here, and here). Why do I still get those cold shower-like shivers?

January 12, 2015

Curious Taxes

Azerbaijan, namely the Ministry of Taxes, has recently imposed a new tax on deposit income. To be more precise, this tax was practiced by the independent government up until 1999, after which deposits got an indefinite exepmtion (tax holiday, in economic jargon). Now, they are re-instating a 10% tax on interest income earned from deposits. Why are they doing it? Probably to lift revenues and fix the budget deficit issue. Maybe to somehow stimulate more consumer spending by making holding cash in deposits more costly. But then they are actively promoting non-cash payments in the country, and this obviously contradicts with the tax on non-cash holdings that deposits are. Anyway, I have no informational source from the Ministry and, as usual, I am writing this post at home while sipping a latte and watching Star Wars.

In the context of the current economic environment, I don't really know how to think straight about this. On one side, taking a neutral and very macro point of view, we really do need to lift our dependance on the domestic market and relieve the pressure on the budget to generate oil revenues. Tax revenue currently amounts to about 17% of the annual state budget, which is quite a low number. But is this really the type of intervention we currently need? I would argue quite aggressively that the better way to increase the share of taxes in the budget is to curb the informal economy and improve the effectiveness of tax collection in regions. However, let's leave this for a future post.

Let's now look at the arithmetics of this tax. Say you hold 10,000 AZN at a local commercial bank and earn a 10% annualized rate of return, yielding 1000 AZN. This quantity, following the newly adopted regulation, is now taxable at the 10% rate. Before the tax, the bank would spend 100 AZN on your interest and, obviously, you would earn 100 AZN. Now, after the tax, the bank spends 100 AZN, you earn 90 AZN, and the government budget earns 10 AZN.

Now, there is nothing wrong in principle that the budget is collecting those 10 AZN, granted that the money will be spend on socially important things. But notice how the only loser in this game is the middle-class consumer, whose interest income is now reduced by 10%. Effectively, the consumer is sponsoring the new tax in full. This doesn't really reconcile well with the rise of the Azerbaijani middle-income consumer and our decade-long battle to instil trust in the financial system and increase the population's deposit base. But what do I know about life.

Economics is all about incentives and the motives of agents to act the way the system expects them to act. So, how will the new tax affect the incentives of banks and depositors? For the commercial banks, as we saw above, nothing really has changed - they are still paying out the same interest income. For the consumer, however, the effective return on the investment (deposits) has decreased by a substantial 10%. The consumer now has 2 options: reallocate some of her deposit holdings to a new investment mechanism, or to swallow the tax and do nothing.

As I have written extensively in the past (here and here), the financial sector in Azerbaijan is very concentrated in banking. There is pretty much nothing else available for a middle-class consumer to place his cash in except for a bank deposit or under the mattress. Not much activity in capital markets (bonds or stocks), and entrepreneurship is in its infancy. So, being good citizens that most of Azerbaijanis truly are, we have literally no other immediate option but to take the new tax as a given.

January 9, 2015

Budget Holes and Revelations

Azerbaijan's government budget for 2015 is now available. I don't know if it's online yet but it should be very soon: the main document is already approved so we can start talking about its implications. The budget has a lot of points worth talking about, but what is important for the goals of this post is that the country will be running a fiscal deficit in 2015. This deficit is, of course, exaggerated by the decline in Brent oil against which the Azeri lite is benchmarked. Lower oil price -> less petrodollars flowing in -> less convertations into the local currency -> smaller capacity to meet local liabilities like wages, pensions, infrastructure, etc.

The deficit has also grown from last year - a direct consequence of the oil price collapse and that expenditures have not changed (frozen, to use the jargon).

How will the government of Azerbaijan cover the budget hole? There are 4 possibilities that I can think of.

1. More transfers from the Sovereign Oil Fund. Needless to say, this is a terrible idea. Depletion of resources which are stored to preserve intergenerational income equality presents a gigantic social cost compared to the miniscule benefit of filling a hole in one year's budget. I am pretty sure everyone in the economic and political elite in the country understand this.

2. Debt financing. I am very much against more issuances of Dollar-denominated debt. US Dollar is strong, and will probably gain more strength by the end of 2015, after which it will start to lose value again. This is Rudiger Dornbusch's old insight - the currency is appreciating now only to lose value later on. But at this point in time, we don't really need foreign debt denominated in the foreign currency, especially the one that is attracting so much capital from around the Globe. Plus, issuing bonds is very easy. Repaying the principal amounts, and the interest, which is a burden on future budgets, is not. Yes, it is true that Azerbaijan's income is also in the USD (oil dollars), so we are quite different from, say, Argentina or Island. But still, paying obligations in the currency that your central bank cannot control is always very risky.

3. Raising taxes. OK, I am in general in favor of progressive taxation with Pikettian (google search: Thomas Piketty) taxes on the ultra rich. My worry is that in the context of Azerbaijan, any new tax would fall on the shoulders of the middle class - one way or another. In some circumstances, this would be justifiable. But for Azerbaijan - it isn't. We are trying to build a solid middle class with purchasing power in order to rebalance our economic formula and develop a strong consumer base. So, unless any proposed tax explicitly protects the middle class from any additional burdens - I am for it.

4. Cutting spending. Austerity, i.e. cutting fiscal expenditures, is a very ambigious subject. In some cases, fiscal austerity can trim down useless spending, convince financial markets that the government is running a responsible fiscal balance, and lower the interest rate on the debt that the state is repaying back. But sometimes, especially at times of crisis, cutting spending could lead to severe recessive consequences. Multiple commentators and academics have argued that fiscal spending is crucial for supporting economic growth during financial and economic trouble. So, cutting budgetary spending is OK only if designations such as welfare, education, and national security are not getting penalized. Areas such as large construction and urban modernization projects can be postponed or outright cancelled. Based on my estimations, a significant portion of the budget deficit can be compensated by cutting expenditures on various urban construction projects.

So, what should the government do to solve the budget deficit issue? The immediate solution would be to cut non-entitlement spending, particularly on state-financed construction projects. The harder to implement option is to raise taxes on the rich; or on the middle class. But the latter would then hit at economic growth from another angle - taxing the middle class will reduce disposable income and lead to declining private consumption and therefore GDP itself.

January 4, 2015

Why Manat Devaluation is a Terrible Idea. Saga. Part Three (Final): Budget Edition

*For the record, nobody is devaluing the currency, nor is this topic seriously in conversation among the policy and academic elites. At the moment, at least. But considering what is happening to some of the regional currencies, partially in response to the oil price collapse, I thought it was important to revisit some of the basic and not-so-basic points associated with the question.*

And so we are back to Azerbaijani manat devaluation and why it is bad for humanity. Although this important topic merits much more than just three brief and surface-touching posts, I need to move on to some of the other things I want to talk about. The final angle through which we are tackling the question is the government budget. The previous two were export diversification and imported inflation.

The Azeri government will be running a deficit in 2015, which is obvious since oil prices plunged to the lowest levels since 2008. Consider a simple arithmetic example. With the de facto pegged conversion rate of 1 USD = 0.78 AZN, one barrel of oil at the price of 100$ per barrel would yield us 100 US Dollars and, after conversion, 78 AZN (Manats, local currency). Now, say the oil price drops to 60$ per barrel. If the exchange rate remains the same, the incoming flow is now 47 AZN. Thus, less money for domestic expenditures like paying wages or building roads and schools. The breakeven exchange rate, i.e. the exchange rate that keeps the manat inflow constant, becomes 1.3. This implies a 67% devaluation is needed for fiscal rebalancing.

I am finding it difficult to frame the conclusion that "the currency is 67% overvalued", because oil is by far not the only factor influencing currencies. In addition, we are just talking about the depreciation necessary to keep the fiscal books in order; this is nothing concerning actual market forces, which could well support a stronger-than-needed currency even despite the energy price drop.

So, what's the point of all this? Any government, of course, cares greatly about fiscal balances. Even an oil-rich state like Azerbaijan. Deficits must be financed somehow. One possibility, as mentioned in another post, is to arithmetically boost revenues by lowering the exchange rate to its fiscal breakeven levels. The benefits of this proposition are obvious: the budget hole is filled, strategic reserves pile up (because devaluation is achieved through FX market interventions by the central bank, which would sell more manats, buy out dollars in the system and store them in the reserve vaults), tourism can prosper (because foreigners can now exchange the same amount of USDs or Euros into more Manats and buy more of the locally made stuff).

But the negatives would outweigh the gains, in any scenario. First, instantenous importated inflation would hit at domestic consumers. Second, we would quickly lose the nominal psychological anchor that the "strong Manat" represented in the minds of the local population for the past decade. Third, domestic financial institutions (commercial banks), those which finance their capital from abroad, will suffer mightly since their liabilities would naturally swell and put pressure to obtain more USD financing. Fourth, in a related issue, domestic depositors would probably rush to swtich their deposits to US Dollars, which would be a blow to all the efforts to restore trust into the Azerbaijani financial system. The pillar of trust is deposits stored in the domestic currency, the volume of which would certainly drop after a sudden devaluation. Fifth, the international purchasing capacity of the Azerbaijani consumer would deteriorate for obvious reasons.

My view is that the government should and will take the oil price decline, and the resulting budgetary deficits, seriously. And they will try to seek out solutions for the problem. Devaluing the currency to artificially and arithmetically fill the deficit hole is not one of those sustainable, and even short-term viable solutions. For a small, open, resource-rich economy which doesn't export much outside of the energy space, is building trust in the local financial sector, and imports most of the stuff in the consumer spending basket, destroying the anchor that is the Strong Manat is not worth it.

Just cut spending.

January 2, 2015

My Book on Neo-Transitional Economics: Coming Soon

Our book is accepted for publication by Emerald Publishing. The cover image is below. We have compiled, I hope, an interesting volume with a diverse body of empirical, theoretical, and policy-oriented papers. 13 chapters from academic and policy economists representing 10 countries. It took me, and my co-editor Yusaf Akbar, about 2 years to bring this project to its logical conclusion. Needless to say, I am waiting for those lavish, 6-digit royalties (read: self-downplaying hyperbole).

Whenever the book comes out in print I will share that too.

December 31, 2014

Happy 2015 From BakuViews!

Dear Friend,

By the time you finish reading this post, around 25 children under the age of 5 will die from preventable causes. Having celebrated the New Year by spending some of the money we don't have on the things you don't really need, it is time we all take a proactive stance on preventable child mortality and, for once, do the right thing.

Please donate $25 to UNICEF now and help the children in real need.

I have also donated the same modest $25, just like last year. I encourage you to make this a similar tradition for yourself, depending on your budget.

December 28, 2014

Why Manat Devaluation is a Terrible Idea. Saga. Part Two: Inflation Edition

Recently I have talked about the prospects of Azerbaijani Manat devaluation and its potential impact on non-oil export growth in the country. We concluded that devaluing the Manat in order to boost the balance of trade doesn’t make sense economically. Now we will take a look at the flip side of the coin – the biggest detrimental effect commonly associated with a currency value loss. This effect is imported inflation.

Azerbaijan’s domestic industry, like in the case of most post-transition emerging economies is in its infant stages. Certain strategic non-oil areas are being prioritized, such as infrastructure and tourism and agriculture, but the technological intensiveness is very much reliant on external knowledge; and this will continue to remain so for decades to come. Because people need to eat and spend money on something, somebody needs to supply the stuff. And because the stuff is not being produced internally, it must be imported.

Currently, Azerbaijan imports most of the goods that enter our everyday consumer basket. Yes, we do produce some rudimentary things, but import substitution is trivial. Everything from basic foods to TVs to vacuum cleaners and cars is being imported. Needless to say, the proportion of consumers’ disposable income that goes onto imported goods and services is very, very high. This means that prices of imported goods is a socially sensitive matter that policy-makers need to very carefully consider.

Now, if the Azerbaijani Manat is devalued for export competitiveness, this will trigger an instantaneous deterioration in the balance of trade: imports will suddenly become more expensive. Because our consumer basket is basically imported goods & services, devaluation will translate into consumer price inflation across the board. For a country that is struggling to become a full-blown middle-income state with a respectable GDP per capita this should be unacceptable: the purchasing power of the Azerbaijani consumer will suffer a severe hit.

Domestic prices are already under horrendous upward pressures due to the oil inflows, producer price inflation, and competitive markups. Manat devaluation will not help non-oil exports and will cause a massive spike in consumer prices. This is a textbook scenario of imported inflation. Azerbaijan is a country where textbook economic scenarios work quite rarely. But this is that rare case where Manat needs to remain untouched. And this is not only an economically but also politically viable strategy.

December 26, 2014

Why Manat Devaluation is a Terrible Idea. Saga. Part One: Exports Edition

Several people, to my personal Christmas surprise, asked me what I thought about the prospects of the Azerbaijani currency. Especially in the context of an almost 40% year-to-date drop in the nearby Russia's Ruble. I have been working on currencies and international capital flows for several years and have a pretty clear picture of what's going on. Moreover, there are certain things that I am sure should never take place. One of these things is a competitive devaluation of the manat.

Trying to cut a very, very long story short - devaluing the Azerbaijani manat is a horrendous idea.

First, why? Why are we discussing this issue in the first place? For starters, theory dictates that a weaker currency helps boost exports on the competitive level because foreigners can suddenly afford more of your exported goods. 95% of Azerbaijan's exportation is mining and quarrying, i.e. oil. Oil is extracted from the ground, sent to global capital markets, and exchanged to the USD, which then flows back into the sovereign wealth fund (SOFAZ), where I currently work by the way. There is no competitive pricing involved, nothing that the government can do artificially to "boost" exports in the oil sector. Meanwhile, the 5% non-oil exports can arguably benefit from the cheaper currency. This is true. But this does not apply to Azerbaijan, or to any economy which depends grossly on the oil sector.

So far in 2014, Azerbaijan's total exports amount to 23$ billion according to link. 5% of it is non-oil, which is roughly 1.2$ billion. Take this in the context of Azerbaijan's 58$ billion GDP in 2013 (link). So, non-oil exports are less than 2% of GDP.

Will a competitive devaluation of the Manat help the trade balance? In other words, will exports increase and imports decline, on relative terms, in the long run? Yes. My papers on the trade balance in Azerbaijan (here, here, and here) showed that the Marshall-Lerner condition holds for Azerbaijan. ML condition holds when currency devaluations improve exports more than they hit at imports - this is good.

My research has consistently shown that a 10% devaluation of the Manat will trigger a maximum of 4% improvement in the balance of trade in the long run (12-16 months). In absolute terms, this translates to about 300$ mln. at most [The trade balance is currently 5.4$ billion]. This is a trivial number compared to the size of the economy.

Yes, competitive devaluation of the Manat will help non-oil exports. But the net effect will be so small that the benefits of the move will not outweigh the costs of the devaluation that include import goods inflation, consumer inflation, and speculative risk.

There is much more to say on this topic and in the coming weeks I will talk about the Azerbaijani manat in the context of our government budget, inflation, and market speculation.

December 24, 2014

The Russian Bear

I wrote up an informal post on Facebook the other day about the collapse of the Ruble. And I decided to take a moment and lay out my idea on the Blog (yes, I am slowly getting back to normal posting schedules).

Just to recap, the Russian ruble has recently depreciated by about 40% year to date. This led to a big spike in Credit Default Swaps (CDS), MICEX equity wipe-outs, and rising government bond yields.

Note: USDRUB is the price of 1 USD in RUB, INDEXCF is the MICEX (Moscow) stock index, C49610Y is the Russian 10year government bond yield, Russia CDS is self-explanatory.

It’s difficult to classify this event (crisis?) as a balance-of-payments type, financial, or whatnot. To some extent this is a speculative attack by the notorious bond vigilantes (whoever they are). The problem is that those guardians of the fixed income galaxy rarely act merely out of boredom. There is usually something deeply wrong in the underlying macroeconomic fundamentals that makes the scavengers lick their fingers. Partially, this is a reflection of the oil price collapse, sanctions, and the Ukrainian situation. But I think the market is also interpreting the whole Ruble story in reverse.

Russia’s economy is very much resource-dependent. Yes, its major resource is gas but oil’s importance is not trivial. For several years, when crude prices were stuck around the 100$ per barrel magnet, the Russian currency was under constant appreciative pressures. This is quite normal for resource-rich countries. It was and still is very difficult to disentangle the 2 key driving forces for the RUB. First, the appreciation push from oil exportation. Second, depreciation pull from weak macroeconomic underlyings. One can make a case that with massive reserves, and not-so-large levels of public debt, those underlyings are actually good but the whole economic model is obviously not long-run sustainable.

So, once the crude oil price plunged to a new medium-term equilibrium of 55-65 USD per barrel, the oil inflows for Russia suffered a massive hit. One must remember that Russia’s earnings are denominated in the US Dollar. They collect the Dollars in exchange for resources on the global commodities markets. Then, Russians convert the petrodollars in the domestic currency – Ruble – and commit to domestic spendings like on pension, infrastructure, healthcare, etc.

Now, when the oil price was high, there was a constant demand for the Ruble due to regular massive conversions from the USD into RUB. With a lower USD per barrel level, Russia’s revenues take a hit, the exchange rate stays untouched, and you are suddenly facing a massive hole in the domestic budget. You are now supposed to cover the same volume of expenditures with a smaller USD base. More technically, the equilibrium Ruble is now much cheaper. After the oil price fall, the RUB was substantially overvalued. Now that the currency has plunged, the Russian government is getting the same amount in petro-revenues converted into the Ruble than before the oil collapse.

So, from the purely fiscal point of view – collapse of the Ruble is entirely logical and quite beneficial for medium-term contractual obligations and plans of the Government. Who are the losers of this trade? Obviously, the Russian consumer who is now facing imported inflation. Russia imports most of the stuff that regular folks consume on the daily basis, so with a cheaper Ruble the foreign currency is suddenly more expensive, thus the consumer inflation. The second big loser of the event is Russian domestic banks. Consumers, aware of the Ruble purchase power vanishing in front of their own eyes, rush to the banks to convert RUB deposits into USD deposits. This puts more pressure on the banks to keep getting USD capital. Because most Russian banks cannot get any foreign capital with a maturity longer than 1 month, there is suddenly a shortage of Dollars in the financial system as well.

And here we are: a fiscal correction, imported inflation, and financial tightness which could easily spiral into a full-blown economic recession. The needs of the Putin once again outweighed the needs of the many. But this time, I don’t think this is the type of Russian bear Kremlin envisions.

December 19, 2014

Corruption is Important

Now, before you all bombard me with accusations that I support corruption, let me explain myself. I believe in markets. But I also believe that markets sometime fail. This is why the government needs to play an active role in monintoring markets and making sure that such failures are rare and if they do happen - there are policies available to prevent human suffering.

When the human body is operating at normal capacity, it is very difficult to, for example, detect a tumor growing in the brain. But as soon as the body starts showing symptoms (signals), such as severe migranes - the patient goes for a scan and finds the cause of the problem. The problem is, of course, not the headache. No amount of painkillers will kill the cancer; it will just soothe the signal.

Corruption is a signal of a failed market. We can be talking about markets for education, police service, courts, banking, etc. Whenever a market is not functioning properly (such as when the beaurocracy is too tight, salaries are too low), people get an incentive to cheat the system. Once or twice, cheating can go unnoticed. But it doesn't mean that cheating doesn't take place. Until the cheating is detected, nobody suspects a thing. Corruption is suddenly a problem when we catch a corrupt policeman or a doctor or a politician taking a bribe. Policy initiatives targeted at punishing the corrupted officials will not solve the underlying problem - it will just soothe the signal.

Corruption is important because it plays a role of a signal of an underlying failure in a market. Corruption in education primarily means that teachers are earning low salaries or that students can not keep up with education levels and decide to cheat the system by "bribing" the way out. Either way, the problem is not corruption iself - it's either the poor welfare state of teachers or poor preparation of students for college-level courses. To fix corruption we should create a better environment for teaching and learning, which is a structural issue, rather than spend resources on searching for corruption events.

To provide some illustration on the point, consider a basic relationship between GDP per Capita measured at the international PPP dollar level, and corruption. The bigger the corruption score - the better (less corruption). GDP per capita taken from the World Bank, corruption proxied by the Corruption Perceptions Index published by Transparency.org. Both sets of numbers are for 2013. The basic scatterplot is below.

Notice the slight positive correlation.

Now, let's run a simple log-linear regression of the corruption index on log (gdp per capita) with robust st. errors. While obviously we can't explain the variablity of corruption solely by the narrowly defined gdp per capita (low R-squared), we find a strongly significant positive coefficeint on loggdp. It means that a 1% increase GDP per capita, on average, should lead to a 3.35 point improvement in the corruption index. In other words, a 10% increae in GDP per capita should give a 30-point boost to a country's corruption score.

Solving corruption is an issue of secondary importance. Fix the failing markets and corruption will fade on itself.