Plan to mitigate devaluation in Kazakhstan presented by Khudaibergenov, Ushbayev

February has become a ripening season for devaluation rumors in Kazakhstan. The Central Asian economy experienced a 22% devaluation of its national currency - the tenge - in February 2009 and then a one-step 19% devaluation of its currency last year, also in February.

At the moment, in February 2015, pressures on the tenge keep on growing. There are the negative dynamics in the much larger economy of the neighbouring Russia, including the troubles with its ruble that has seen an 80% devaluation in six months, the plummeting global oil prices and Kazakhstan’s own structural problems in the financial sector burdened by bad loans and the overall high debt ratio in the country. With oil and gas being the primary revenue generating products that feed and propel the Kazakhstan economy, the power of persuasion of the Kazakh governmental officials is not enough to calm down the general public and businessmen.

Kazakhstan's national currency - the tenge - is maintained within the corridor of 185 tenge per dollar +3/-15 tenge. It is de facto pegged to a multi-currency basket (10% ruble, 20% euro, 70% dollar), which means that the Russian ruble depreciation puts a downward pressure on the tenge. Moreover, Russia is Kazakhstan’s major trade partner responsible for 36% of its trade turnover. The two share a huge border of nearly 7000 km and both countries rely heavily on exporting hydrocarbons.

With the two countries being part of the same economic union and sharing an open customs border, the present exchange rate of the Russian ruble against the Kazakh tenge has disrupted the competitiveness of Kazakh products with cheap Russian goods flooding the Kazakh market, sending the local producers out of business and making imports of Kazakh goods to Russia unfeasible and unwanted.

In addition, being hit by the falling global oil prices, Kazakhstan experiences direct losses in its revenues. If the situation persists, devaluing the tenge might become essential to compensate for the budget deficit.

Dollarization is another problem in Kazakhstan, which relies primarily on exporting raw materials that it sells for dollars. In fact, this occurrence is quite a common among emerging nations, where the dollar is more stable in its value than the domestic currencies. According to the data of the National Bank of Kazakhstan, 55.5% of all the deposits in Kazakhstani banks were denominated in foreign currency as of December 2014.

Dollarization refers to a widespread usage of dollars in domestic money circulation. Usually, dollarization makes the financial sector vulnerable. In particular, it weakens the mechanisms employed by domestic institutions on monetary policy. It also makes the banking sector vulnerable in the event of any large fluctuations in exchange rates.

The situation is further exacerbated by the lack of trust of the Central Asian country's population in what the National Bank of Kazakhstan is doing. Its past failures and sensational devaluations were a severe blow to the reputation of the financial regulator. The population became wary of any additional shocks to the national currency, so in a bid to protect their savings, Kazakhstanis preferred keeping their money in dollars.

The situation is such that any sharp fluctuations of the tenge will only exacerbate the existing conditions. Therefore, the government has to regain the population’s and the market’s trust in its economic and monetary competence.

Three possible financial scenarios are being studied by financial analysts, economists and even common people in Kazakhstan these days in an attempt to predict the actions of the central bank, forecast the future and be more prepared for new shocks. But Kazakh financial experts Olzhas Khudaibergenov and Anuar Ushbayev say that the three scenarios trying to forecast the government’s actions are all inadequate.

The first popular scenario envisions keeping the tenge exchange rate at the present level, which is already failing. The National Bank has started to let loose the tenge since “maintaining the exchange rate amid the existing conditions will only strengthen the opinion that at some point a sharp devaluation is inevitable, and that the longer the exchange rate is maintain the sharper the fall will be,” Ushbayev and Khudaibergenov say. It is clear that the pressure from the ruble and Kazakhstan’s reliance on exports put a tremendous strain on its national currency.

The second popular scenario revolves around devaluing the tenge, so as to make the currency exchange rate against the ruble the same as it used to before the upheaval – 1 ruble for 5 tenge, meaning a devaluation by 80%. But it is unclear how the ruble will behave, so chasing the ruble is widely seen as a hasty attempt at a solution. If the ruble keeps on falling and Kazakhstan keeps devaluing its currency, many domestic enterprises will go broke, since their foreign currency loans are equal to $16.9 billion at the moment. In addition, there will be a sharp increase in prices because Kazakhstan imports over 70% of its consumer products. Besides, the move would mean transitioning from the dollar to the ruble as the anchor currency for the tenge. “Therefore, the second scenario is radical and represents losses for everybody – the population, the businesses and the state,” Khudaibergenov and Ushbayev say.

The third popular scenario is to make a 20% devaluation in one take. But this will only leave people disappointed, create a pattern and trigger countrywide preparations for the next devaluation in February 2016. Such pattern will dictate the exchange rate instead of economic factors and monetary regulations. Furthermore, devaluing the tenge by 20% will not compensate for the 80% devaluation of the ruble anyway but only serve to inflate the prices on imported consumer products and worsen the situation in the real sector of Kazakhstan's economy.

Besides, all of these three scenarios have one additional common disadvantage: they propose an isolated decision without any accompanying measures. These propositions do not address the dependence of Kazakh economy on the US dollar, because any sharp devaluation of the tenge will trumpet the end of the attempts to de-dollarize the Kazakh economy. Therefore, it is time for a complex solution, Khudaibergenov and Ushbayev say.

“A solution that that avoids a sharp devaluation will clarify the monetary policy for the next few years taking into account all the external factors (so that businessmen can plan investment projects and banks can lend them money), de-dollarize the Kazakh economy, and finally, restore confidence in the tenge,” they claim.

Here is what the two Kazakh financial experts suggest the government of Kazakhstan should do in the next 5 or 6 years.

The proposal

Since the oil prices are falling, export earnings of Kazakhstan do so as well. Ideally, imports should decline in the amounts commensurate to the dwindling of exports, so that there are enough incoming export revenues to cover the country’s currency expenses.

But the problem arises when there is extra demand for foreign currency, which is the case in Kazakhstan. Here, individuals and companies alike hide into the dollar bush at the slightest mention of tenge devaluation. How can this problem be addressed?

Khudaibergenov and Ushabayev contend: “If the conditions are in place that 'zero out' the excess demand, then the reserves will grow, the balance of payments will improve and the exchange rate of tenge will cease to bear the burden of social bias and will be determined by purely economic factors."

The best way to regain trust in the Kazakh currency, according to them, is for the National Bank to introduce guarantees that will stimulate people and companies to keep deposits in tenge. The two financial analysts suggest the Kazakh National Bank provides annual exchange rate guarantees for the period 2015-2020 on tenge deposits with a maturity longer than one year. This guarantee should apply if the tenge weakens by more than 6% during one year, which corresponds to the lowest point of the officially pegged exchange rate corridor of the tenge. In this system of coordinates it is the worst case scenario, and the population is reassured and hedged from the more unfortunate turns.

Since the experts propose these guarantees only if the tenge weakens by more than 6%, they also invite the National Bank to use this number as a benchmark for setting the tenge exchange rate. This means that the maximum allowed tenge devaluation in one year will be 6%., i.e. by the end of 2015, the exchange rate should not exceed 195.0 tenge per 1 USD (against 184.0 in the beginning of the year), 206.7 tenge in the end of 2016, and 206.7 tenge in the end of 2017, etc. Such fixed ranges will reduce volatility of the Kazakh financial market, raise trust and prevent speculations.

To stimulate depositors to turn away from keeping their savings in dollars the ceiling interest rates on dollar deposits should be further lowered. As part of the most recent move, the maximum recommended interest rates on newly accepted deposits in foreign currency were decreased from 4% to 3% by the Resolution of the Board of Directors of Kazakhstan Deposit Insurance Fund No. 6 as of 25 December, 2014 that Kazakhstan's commercial banks are obliged to follow. The maximum recommended interest rates on deposits in national currency - the tenge - remained at 10%.

Khudaibergenov and Ushbayev believe the rate on dollar deposits should be decreased to 2% (and later to 1%) and the difference between rates on deposits in tenge and dollars should be brought to 8% to make tenge deposits much more attractive then dollar-denominated ones. The National Bank's guarantee (against a sharp devaluation) should be extended only to new tenge deposits opened for a term of more than a year or to the old deposits extended for at least a year after the guarantee was introduced.

Later, the National Bank will buy back the excess dollars from the market, filling its reserves and contributing to the growth of financial soundness indicators and rankings of the state. The sold tenge will replenish the cash supply of the Kazakh market and again be actively used in purchases and lending.

As soon as the share of tenge deposits exceeds 70%, it makes sense to provide incentives stimulating the choice of 2 year tenge deposits over 1 year tenge deposits by getting the Kazakhstan Deposit Insurance Fund to increase the guaranteed amount per a deposit from 10 million to 50 million for 2+ year tenge deposits. The experts say 100% exchange rate guarantee will have to be left only for tenge deposits with a term exceeding 2 years, but will be reduced to 50% on deposits ranging between 13 to 24 months.

Khudaibergenov and Ushbayev expect that the above mentioned measures would effectively decrease the share of foreign currency deposits in Kazakhstan. If the market and the population are confident in the National Bank at least in the medium term perspective (1-3 years), the level of dollarization may fall to 10-20%.

But this is not all. It is crucial to take care of the Kazakh banking sector that has a very large share of its loans in dollars and has traditionally been one of the drivers of dollarisation of the Kazakh economy. Between 2000 and 2007 when Kazakh banks were enjoying access to cheap western money they were heavily borrowing dollars abroad and hedging their currency risks by issues loans mostly in dollars in Kazakhstan or pegging tenge-denominated loans to dollar exchange rate. As of February 2009 the share of dollar-denominated loans in Kazakhstan's banking system made 52.2% and with the pegged loans taken into account it made 90-95%. In February 2011 Kazakhstan prohibited the banks from pegging tenge-denominated loans to dollar exchange rate and the share of dollar loans started to decrease gradually. By December 2014 it made 28.9%, but with the old loans taken into account it still made around 35-40%, according to the estimates of the two financial analysts. 

Khudaibergenov and Ushbayev call for the National Bank to provide funds for the banks to refinance all their foreign currency loans: 150 billion tenge towards mortgage loans and 290 billion tenge towards consumer loans. As an option, the National Bank can buy the currency loans that the banks declare in advance. This will give the banks tenge liquidity on repayable terms and the banks will transfer all foreign currency loans into tenge. The banks will be responsible for repayment of loans and will use the funds they receive from payments on the loans to repay their debts to the National Bank.

It is necessary to raise the minimum reserve requirements on foreign currency liabilities for banks to 10% as additional stimulus for the Kazakh banks to build up their tenge volumes (currently it is 6% for terms below 3 months and 2.5% for those above). And also introduce annual 3% interest accrual on the money remitted by banks as part of the minimum reserve requirements on tenge liabilities. 

These measures will help lower Kazakhstan's dependence on foreign currency. Nevertheless, it is not enough to help the entire economy. A significant share of dollars in Kazakhstan goes through its state companies. Restructuring state companies’ loans is, perhaps, one of the most challenging tasks for the Kazakh government.

State companies accounted for about 50-70% of "excess" foreign currency demand in the period from October to December 2014, Khudaibergenov and Ushbayev claim. If the government wants to restore confidence in the tenge, it first has to get the state companies to demonstrate their willingness to sell their dollars and buy the tenge, the two experts say. Even more so because the government, as the compaies' shareholder, announced that it will take all necessary measures to prevent sharp fluctuations in 2015.

"The government should transfer all foreign currency liabilities of state companies into tenge at the expense of the National Fund," the experts say. In addition, the accessibility of external loans to state companies should be limited. They should be allowed to buy only necessary volumes of foreign currency, which will be accomplished by restricting purchases of foreign currency to amounts specified under the nearest three months import contracts. Companies having revenues in foreign currencies can be allowed to pay taxes in foreign currency.

Khudaibergenov and Ushbayev say that their complex of measures should be either realized in whole or not at all. It has other details but these points are the major pillars of their plan.

“In the case of full implementation, it can be expected that the trust will be regained and the monetary policy will become more predictable, mitigating the effect of rumors and reducing the annual devaluation expectations in February," they said.

The February is already here and the National Bank of Kazakhstan has not a minute to lose.

By Dinara Urazova, editing by Tatyana Kuzmina

Olzhas Khudaibergenov - Director of the Center for Macroeconomic Research, ex-Advisor to the Governor of the National Bank of Kazakhstan.

Anuar Ushbayev - Managing Partner at investment and advisory firm Tengri Partners. Used to work at Goldman Sachs and Societe Generale.