Oil exporters do not devalue to boost exports, but to stabilize public finances

Yesterday Azerbaijan’s central bank gave up its pegged exchange rate regime and floated the Manat. The Manat plummeted immediately and was essentially halved in value in yesterday’s trading.

Azerbaijan is not the first oil exporter this year to have given up its fixed exchange rate policy. Kazakhstan did the same thing a couple of months ago and last week South Sudan was forced to devalue by 85%. Angola also earlier this year devalued and Russia has now also given up its attempt to manage the float of the rouble.

And Azerbaijan is likely not the last oil exporter to give up maintaining a pegged exchange rate. Given the continued drop in oil prices and the strengthening of the dollar oil exporters with pegged exchange rate (to the dollar) will continue to suffer from currency outflows.

I have said it before – devaluation is not about competitiveness 

Critics of floating exchange rates and of devaluation of the kind the Azerbaijan i central bank undertook yesterday often say that devaluation just will cause higher inflation and any effects on competitiveness will be short-lived and that “internal devaluation” therefore is preferable.

Furthermore, these critics argue that for a country like Azerbaijan a devaluation will not help as oil is priced in US dollars anyway and that the countries have little else than oil to export.

However, this in my view misses the point completely. Giving up a fixed exchange rate and floating the currency (or introducing an Export Price Norm) is not about exports and competitiveness. Rather it is about avoiding a collapse in domestic demand and more practically it is about stabilizing government revenues.

Hence, for a country like Azerbaijan the majority of government revenues come directly from oil exports – typically directly from a government owned oil company and/or through taxes on oil and gas companies.

This means that if oil prices collapse the government revenues will collapse as well. However, a crucial part of this story that is often missed is that the important thing is what happens not to the oil price in US dollar, but the oil price denominated in local currency as the government’s expenditures primarily are in local currency.

Hence, a government can keep it’s oil revenue completely stable if the government allows the currency to weaken as much as the drop in oil prices (in US dollars).

Therefore, the choice for the government and central bank in Azerbaijan was really not a question about boosting exports. No, it was a question about avoiding public sector insolvency. Of course the Azerbaijani government could also have introduced massive austerity measures to avoid a sovereign default.

However, with a pegged exchange rate regime massive fiscal austerity measures would likely be extremely recessionary – and remember here that under a fixed exchange rate the budget multiplier typically will be positive and maybe even larger than one.

Hence, under a fixed exchange rate regime fiscal policy is at least in the short-term “keynesian” as there is no monetary offset. Said in a more technical the so-called Sumner Critique do not hold in a fixed exchange rate regime.

In that sense we should think of the devaluation in Azerbaijan as a one-off improvement in oil revenues – as oil revenues increases exactly as much as the currency was weakened yesterday.

The alternative to a 50% devaluation was a 20% drop in GDP

Let me try to illustrate this with an example. Let us first assume a oil-elasticity of 1 for Azerbaijani government revenues – meaning a 1% increase in oil prices increases the nominal revenue by 1% as well.

Yesterday USD/AZN jumped from 105 to 155 – so nearly 50%. This of course means that the oil prices denominated in Manat overnight also increases by around 50%.

Given government revenues presently are around 27% of GDP this means that a 50% devaluation “automatically” increases government revenues to around 40% of GDP (27 + 50%).

Said in another way overnight the budget situation was “improved” by 13% of GDP. If the government alternatively should have found this revenue through tax hikes (or spending cuts) without a devaluation then that would have caused a deep recession in the Azerbaijani economy.

In fact if we assume a fiscal multiplier of 1.5 (which I don’t think is unreasonable for a fixed exchange rate economy) then such fiscal tightening could have caused real GDP to drop by as much as 20% relative to what otherwise (now!) would have been the case.

Obviously there is no free lunch here and over time inflation will be higher due to the devaluation and to the extent that is allowed to be translated into higher expenditure some of the impact of the devaluation will be eroded. The extreme example of this is Venezuela or Argentina.

However, there is one very important difference between the two scenarios – devaluation or fiscal austerity – and that is under a fiscal austerity scenario it would be not only real GDP that would drop, but nominal GDP would likely drop even more.

This will not happen in the devaluation scenario where monetary easing exactly means that nominal GDP is kept stable or increases. This means that the debt dynamics will be much more positive than under an “internal devaluation” (fiscal austerity) scenario.

What I am arguing here is not discretionary monetary policy changes, but I am trying to explain why so many oil exporters have chosen to float their currencies this year and to illustrate why this is not about exports and competitiveness, but rather about ensuring government revenue stability and therefore avoiding ad hoc fiscal adjustments that potentially could cause a massive economic contraction.

So once again – I am not advocating “continues devaluations”, but rather I am advocating automatic currency adjustments to reflect shocks to the oil price within a clearly defined rule-based framework and I therefore also continue to advocate that commodity exporters should not peg their exchange rates against the dollar, but rather either float their currencies and implement a nominal GDP target or implement an Export Price Norm, where the currency is pegged to a basket of currencies and the oil price so the currency “automatically” will adjust to shocks to the oil price. This would stabilize not only government revenues, but also stabilize nominal spending growth and over time also inflation.

—-

If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

 

 

 

 

Listen to my new hero Jose Dario Uribe

The turmoil in the Emerging Markets currencies markets continues. Most EM central bankers seem to be very scared by the continued sell-off in Emerging Markets and central banks around the world have moved to hike interest rates and have intervened to curb the weakening of the Emerging Markets sell-off. This means that most EM central banks effectively are tightening monetary policy in response to a negative external demand shock. This is hardly wise in my view.

However, it is not all EM central bankers who suffer from a fear-of-floating. Hence, today the Colombian peso came under pressure after Colombian central bank governor Jose Dario Uribe said the weakening of the peso is “something we view as positive.”  Uribe added that the central bank had “enormous” margin to allow the peso to weaken as inflation continue to be well-below the central bank’s 3% inflation.

Furthermore, it should be noted that given the down-trend in commodity prices Colombian export prices are coming under pressure. Hence, from an Export Price Norm perspective a weakening of the peso is justified from a policy perspective to ensure a stable development in nominal spending.

In recent years the Colombian economy has been a major success story due to significant economy reforms, privatizations and fiscal consolidation. Luckily monetary policy also seems to support the continued positive development in the Colombian economy.

It will be interesting to follow the development in the Colombian economy – where the central bankers seem to understand the value of a floating exchange rate regime – relative to other countries – such as Turkey – where central bankers fear floating exchange rates. Is Colombia the new Australia? And is Turkey the new New Zealand. (See here on Australia and New Zealand in 1997).

PEP, NGDPLT and (how to avoid) Russian monetary policy failure

I am sitting in Riga airport and writing this. I have an early (too early!) flight to Stockholm. I must admit it makes it slightly more fun to sit in an airport when you can do a bit of blogging.

Anyway, I have been giving quite a bit of thought to the Jeff Frankel’s idea about “Peg to the Export Price” (PEP). What Frankel’s is suggesting is that commodity exporters like Russia should peg their currencies to the price of the main commodity they export – in the case of Russia that would of course be the oil price.

This have made me think about the monetary transmission mechanism in an Emerging Market commodity exporter like Russia and how very few people really understand how monetary policy works in an economy like the Russian. I have, however, for more than a decade as part of my day-job spend quite a lot of time analysing the Russian economy so in this post I will try to spell out how I see the last couple of years economic development in Russia from a monetary perspective.

The oil-money nexus and why a higher oil price is a demand shock in Russia

Since the end of communism the Russian central bank has primarily conducted monetary policy by intervening in the currency market and currency intervention remains the Russian central bank’s (CBR) most important policy instrument. (Yes, I know this is a simplification, but bear with me…)

In the present Russian monetary set-up the CBR manages the ruble within a fluctuation band against a basket of euros (45%) and dollars (55%). The composition of the basket has changed over time and the CBR has gradually widened the fluctuation band so one can say that we today has moved closer to a managed or dirty float rather than a purely fixed currency. However, despite of for years having had the official intention of moving to a free float it is very clear that the CBR has a quite distinct “fear of floating”.  The CBR is not alone in this – many central banks around the world suffer from this rather irrational fear. This is also the case for countries in which the central banks officially pursue a floating exchange rate policy. How often have you not heard central bankers complain that the currency is too strong or too weak?

With the ruble being quasi-fixed changes in the money supply is basically determined by currency inflows and outflows and as oil and gas is Russia’s main exports (around 80% of total exports) changes in the oil prices determines these flows and hence the money supply.

Lets say that the global demand for oil increases and as a consequence oil prices increase by 10%. This will more or less lead to an 10% increase in the currency inflow into Russia. With inflows increasing the ruble will tend to strengthen. However, historically the CBR has not been happy to see such inflow translate into a strengthening of the ruble and as a consequence it has intervened in the FX market to curb the strengthening of the ruble. This basically means that that CBR is printing ruble and buying foreign currency. The logic consequence of this is the CBR rather than allowing the ruble to strengthen instead is accumulating ever-larger foreign currency reserves as the oil price is increasing. This basically has been the trend for the last decade or so.

So due to the CBR’s FX policy there is a more or less direct link from rising oil prices to an expansion of the Russian money supply. As we all know MV=PY so with unchanged money-velocity (V) an increase in M will lead to an increase in PY (nominal GDP).

This illustrates a very important point. Normally we tend to associate increases in oil prices with a supply shock. However, in the case of Russia and other oil exporting countries with pegged or quasi-pegged exchange rates an increase in the oil price will be a positive demand shock. Said in another other higher oil prices will push the AD curve to the right. This is also why higher oil prices have not always lead to a higher current account surplus in Russia – higher oil prices will boost private consumption growth and investments growth through an increase in the money supply. This is not exactly good news for the current account.

The point that an increase in oil prices is a demand shock in Russia is illustrated in the graph below. Over the past decade there has been a rather strong positive correlation changes in the price of oil (measured in ruble) and the growth of nominal GDP.

This correlation, however, can only exist as long as the CBR intervenes in the FX market to curb the strengthening of the ruble and if the CBR finally moved to a free floating ruble then the this correlation most likely would break down. Hence, with a freely floating ruble the money supply and hence NGDP would be unaffected by higher or lower oil prices.

PEP would effective have been a ‘productivity norm’ in Russia

So by allowing the ruble to appreciate when oil prices are increase it will effective stabilise the development the money supply and therefore in NGDP. Another way to achieve this disconnect between NGDP and oil prices would be to directly peg the ruble to the oil price. So an increase in the oil price of 10% would directly lead to an appreciation of the ruble of 10% (against the dollar).

As the graph above shows there has been a very close correlation between changes in the oil prices (measured in ruble) and NGDP. Furthermore, over the past decade oil prices has increased around 20% yearly versus the ruble and the yearly average growth of nominal GDP has been the exactly the same. As a consequence had the CBR pegged pegged the ruble a decade ago then the growth of NGDP would likely have averaged 0% per year.

With NGDP growth “pegged” by PEP to 0% we would effectively have had what George Selgin has termed a “productivity norm” in Russia where higher real GDP growth (higher productivity growth) would lead to lower prices. Remember again – if MV=PY and MV is fixed through PEP then any increase in Y will have to lead to lower P. However, as oil prices measured in ruble are fixed it would only be the prices of non-tradable goods (locally produced and consumed goods), which would drop. This undoubtedly would have been a much better policy than the one the CBR has pursued for the last decade – and a boom and bust would have been avoid from 2005 to 2009. (And yes, I assume that nominal rigidities would not have created too large problems).

Russia boom-bust and how tight money cause the 2008-9 crisis in Russia

Anybody who visits Moscow will hear stories of insanely high property prices and especially during the boom years from 2006 to when crisis hit in 2008 property prices exploded in Russia’s big cities such St. Petersburg and Moscow. There is not doubt in my mind that this property market boom was caused my the very steep increase in the Russian money supply which was a direct consequence of the CBR’s fear of floating the ruble. As oil prices where increasing and currency inflows accelerated in 2006-7 the CBR intervened to curb the strengthening of the ruble.

However, the boom came to a sudden halt in 2008, however, unlike what is the common perception the crisis that hit hard in 2008 was not a consequence of the drop in oil prices, but rather as a result of too tight monetary policy. Yes, my friends recessions are always and everywhere a monetary phenomenon and that is also the case in Russia!

Global oil prices started to drop in July 2008 and initially the Russian central bank allowed the ruble to weaken. However, as the sell-off in global oil prices escalated in Q3 2008 the CBR clearly started to worry about the impact it would have on ruble. As a consequence the CBR started intervening very heavily in the FX markets to halt the sell-off in the ruble. Obviously to do this the CBR had to buy ruble and sell foreign currency, which naturally lead to drop in the Russian foreign currency reserves of around 200bn dollars in Q3 2008 and a very sharp contraction in the Russian money supply (M2 dropped around 20%!). This misguided intervention in the currency market and the monetary contraction that followed lead to a collapse in Russian property prices and sparked a major banking crisis in Russia – luckily the largest Russian banks was not too badly affected by this a number medium sized banks collapsed in late 2008 and early 2009. As a consequence money velocity also contracted, which further worsened the economic crisis. In fact the drop in real GDP was the latest among the G20 in 2008-9.

…and how monetary expansion brought Russia out of the crisis

As the Russian FX reserve was dwindling in the Autumn 2008 the Russian central bank (probably) realised that either it would cease intervening in the FX or be faced with a situation where the FX reserve would vanish. Therefore by December 2008 the CBR stepped back from the FX market and allowed for a steeper decline in the value of the ruble. As consequence the contraction in the Russian money supply came to an end. Furthermore, as the Federal Reserve finally started to ease US monetary policy in early 2009 global oil prices started to recover and as CBR now did not allow the rub to strengthen at the same pace of rising oil prices the price of oil measured in ruble increase quite a bit in the first half of 2009.

The monetary expansion has continued until today and as a consequence the Russian economy has continued to recover. In fact contrary to the situation in the US and the euro zone one could easily argue that monetary tightening is warranted it in Russia.

Oil prices should be included in the RUB basket

I hope that my arguments above illustrate how the Russian crisis of 2008-9 can be explained by what the great Bob Hetzel calls the monetary disorder view. I have no doubt that if the Russian central bank had allowed for a freely floating ruble then the boom (and misallocation) in 2006-7 would have been reduced significantly and had the ruble been allowed to drop more sharply in line with oil prices in the Autumn of 2008 then the crisis would have been much smaller and banking crisis would likely have been avoided.

Therefore, the policy recommendation must be that the CBR should move to a free float of ruble and I certainly think it would make sense for Russia also to introduce a NGDP level target. However, the Russian central bank despite the promises that the ruble soon will be floated (at the moment the CBR say it will happen in 2013) clearly seems to maintain a fear of floating. Furthermore, I would caution that the quality of economic data in Russia in general is rather pure, which would make a regular NGDP level targeting regime more challenging. At the same time with a relatively underdeveloped financial sector and a generally low level of liquidity in the Russian financial markets it might be challenging to conduct monetary policy in Russian through open market operations and interest rate changes.

As a consequence it might be an idea for Russia to move towards implementing PEP – or rather a variation of PEP. Today the CBR manages the ruble against a basket of euros and dollars and in my view it would make a lot of sense to expand this basket with oil prices. To begin with oil prices could be introduced into the basket with a 20% weight and then a 40% weight for both euros and dollars. This is far from perfect and the goal certainly should still be to move to a free floating ruble, but under the present circumstances it would be much preferable to the present monetary set-up and would strongly reduce the risk of renewed bubbles in the Russian economy and as well as insuring against a monetary contraction in the event of a new sharp sell-off in oil prices.

…as I am finishing this post my taxi is parking in front of my hotel in Stockholm so now you know what you will be able to write going from Latvia to Sweden on an early Wednesday morning. Later today I will be doing a presentation for Danske Bank’s clients in Stockholm. The topics are Emerging Markets and wine economics! (Yes, wine economics…after all I am a proud member for the American Association of Wine Economists).

%d bloggers like this: