Exchange Rate Regime in Kazakhstan - Essay Example

Exchange Rate Regime in Kazakhstan Kazakhstan is a Central Asian transitional economy which is rich in its energy and mineral resources. In 1999, Kazakhstan is severely influenced by its strongest trading partner and competitors Russias financial crisis"(Ohno and Zhakparova, 1999, p.1).Financial crisis shock transmitted to Kazakhstan through channels which include, "lost competitiveness, shrinking bilateral and global markets, terms of trade shocks and shifting foreign direct investments"(Ohno and Zhakparova, 1999, p.1).With the adoption of floating regime, temporary non-market steps were taken in order to prevent overshooting, protect banks, poor, depositors, and enterprise(Ohno and Zhakparova, 1999, p.1). Kazakhstan has achieved highest economic growth rate amongst its sister countries during 2001-2008.It reached annual GDP of as high as 9.8 percent in 2000 and over 8.5 percent in 2007.Primary resources of higher revenues include: natural gas, oil, zinc, and copper (USAID, 2008, p.3).This paper explores Kazakhstans exchange rate regime over a period of time. Currency Devaluation Pegging Tenge against US dollar, Kazakhstan opted for an unsanctioned policy of a “soft” fixed rate regime in 1993.Soft exchange rate regime as compared to stringent regime refer to a regime that repositions the value of its domestic currency more frequently. Tenge’s initial value was fixed at the rate of T5 for every US dollar. Par value indicates the rate on which the domestic government agrees to defend its own currency in order to keep the fixed ratio between domestic and foreign currency (Burke, 2009).According to Begg, Fischer, and Dornbusch, the commitment to fixed exchange rate may built private sector’s trust on government when it comes to creating inflation, as it only makes the country uncompetitive (2003, p.484). Fixed Exchange Rate Regime In fixed regime, the government agrees to maintain its domestic currency’s value at a fixed rate. The Tenge is convertible, Central Bank of Kazakhstan is able to sell and buy in order to maintain the exchange rate equilibrium (Burke, 2009).Burke (2009) further explains that the Tenge is overvalued as compared to the US dollar. Under fixed exchange rate regime, devaluation means decline in the nominal exchange rate between Tenge and US dollar. However, Blanchard (2006, pp.380-383) warns that devaluation of the nominal exchange rate directs to real depreciation. Instant impact of currency devaluation appears in declining real exchange rate and enhancing the country’s competitiveness. It allows reallocating the resources in order to support domestic industries competing with imports and assist export industries for enabling them to compete in the foreign markets more effectively (Burke, 2009).Burke (2009) further states, " For example, if the Tenge is devalued by 10% against the UD dollar, and the price levels in Kazakhstan and the United States do not change, and then Kazakhstan goods will be 10% cheaper as compared to US goods." This has a three dimensional impact on the trade balance. Exports increase as they are comparatively less priced in foreign markets which lead to a supposed increase in demand of goods manufactured in Kazakhstan. On the other hand, imports decline due to higher price of foreign goods in Kazakhstan. Relative expense of buying foreign commodities increase as compared to domestic goods which increases the import bill because same amount of imports becomes expensive due to devaluation (Burke, 2009). Completion of conventional paradigm needs explanation of interest rate parity, balance of payments, and purchasing power parity (Burke, 2009).On the other hand, in a floating rate system, market forces automatically determine the price of a domestic currency against the price of another currency (Hartogh, 1988, pp.1-2).However, Burke (2009) suggests that central bank must mediate in market in order to make sure that the Tenge holds the right price. As a result, central bank balances the market forces and assists in keeping from seismic transition in value. IMF Stabilization Program IMF stabilization program for Tenge prioritized inflation control in the country and government achieved the task (Burke, 2009).Burke (2009) further states: "During the first year of the currencys existence, the dollar-Tenge exchange rate depreciated from initial T5/$1 to T56/$1 a year later. Thereafter, the currencys value gradually stabilized. The average exchange rate during the year 1995 was T61/$1.The rate in mid-1996 was T 67.2/$1.The currency continued to depreciate over the next two years, dropping sharply following the Russian crisis of mid-1998, when it fell to T81/$1, in large part because trade with Russia accounted for 31.5 percent of Kazakhstans exports and 42.5 percent of Kazakhstans imports." Aftermath of Crisis 1998 A steep decline in commodity prices worldwide triggered a situation of crisis in Asia during July 1997(Fischer, 1998).Gradually, Asian crisis spread to outside of Asia. Kazakhstan was affected in three ways; firstly, foreign direct investment from East Asian Countries and their exports declined, the situation is particularly true for Korea. Secondly, Kazakhstan economy’s revenues relied heavily on extractive industry exports; therefore, the declining commodity prices had directly negative impact on Kazakhstan’s economy. Thirdly, Kazakhstan’s strong ties with Russian Federation after disintegration, therefore, Russian crisis harmed Kazakhstans economy quite seriously (Ohno and Zhakparova, 1999, pp.4-5).The third factor is the major impact that led to the Tenge devaluation (Burke, 2009). Pre-Crisis Economy in Kazakhstan Ohno and Zhakparova(1999,p.46) explain that macroeconomic stabilization was the fundamental concern for Kazakh government since it independence and currency adoption in 1993.NBK declared annual target rates for currency exchange rates and inflation in an effort to boost the confidence of Kazakh people. Sovereign debt market was introduced and expanded.NBK motivated second tier commercial banks to hold more of government securities and lesser foreign exchange reserves. This situation led to the appreciation of the Tenge and illiquidity of real economic sector. Later, Asian and Russian crisis aggravated the situation (Burke, 2009). Russian Crisis and Kazakhstan Kazakhstans economy was dependent on price competitiveness and a strong export market. After Russian financial crisis, both of these factors were undermined. Domestic production of goods was negatively influenced by the availability of cheaper Russian goods. This situation put a downward pressure on the domestic currency and balance of payments.NBK had to consume US$ 1 billion in order to hold Tenge at a stable exchange level. This policy reduced foreign exchange reserves by nearly one half (Burke, 2009). Other External Factors In 1999,Kazakhastan’s was a transition economy as it shifted from a centrally planned to a market system, therefore, it become extremely vulnerable to external shocks. Irrespective of its physical size, the economic size is small. Bad influences from external shocks not only decreased the production but also lowered living standards. Furthermore, a crumbled manufacturing base led to the economic non-diversification (Ohno and Zhakparova, 1999, p.2).Kazakhstans total trade contribution to GDP was about 60 percent. Russia was the major trading partner; therefore, Kazakhstans export structure reflected Russian structure (Ohno and Zhakparova, 1999, p.9). Policy Response to Crisis Russian crisis was perceived differently in central Asia, policy responses to crisis were not similar among Kyrgyzstan, Uzbekistan, and Kazakhstan. For defending its domestic economy, Kazakhstan diverted from its committed to market principle in a partial and temporary way. However, all transitional economies in Central Asia are highly vulnerable to external shocks, such as, smaller economic size; de-industrialization; declining production and living standards during early 1990s; reliance on few commodity exports; and weak and lagging private and financial sectors (Ohno and Zhakparova, 1999, p.2).Holding the peg harmed exports and domestic production alike (Kasera and Katz, 2008, p.5).The government and NBK mutually decided to devalue Tenge (Burke, 2009). Free Floating Exchange Rate Regime Kazakhstan government introduced a free floating exchange rate regime in April 1999.In response to this, the Tenge depreciated by over one third within five months (at the end of September 1999).Some observers argue that it proved positive as it assisted in ending economic recession and contributed to push GDP growth to 17 percent in 1999.However, analysis revealed that favourable weather and rising commodity prices worldwide were the major factors which contributed to the recovery (Burke,2009). Kazakhstan opted for a free-floating exchange rate regime for its currency, the Tenge, after the crisis of 1998.In 2008 when liquidity issue of the banking system call for intervention in order to create equilibrium in exchange rate market; National Bank of Kazakhstan participated in market as the previous year. In 2008, one dollar was sold in 120 Tenge. National Bank of Kazakhstan consumed 25 percent of its total reserves in order to stabilize the value of Tenge (USAID, 2008, p.3). Policies after Free Floating Exchange Regime After adopting free floating exchange rate, Kazakhstan government acquired new policies. Firstly, additional trade and exchange regulations were enforced; on the other hand, limitations and tariffs on imports from Russia, Kyrgyzstan, and Uzbekistan were removed. Imports exports and banking regulations were further empowered. Attractive incentives were offered to people for holding Tenge in order to avert high rates of conversion to dollars and dollar assets. New measures were taken to eliminate poverty. NBK’s reserves demands were decreased and government established and maintained its strict monetary policy. Tenge depreciated by 33 percent during March and June 1999 and settled at nearly 132 Tenge for one dollar (Ohno and Zhakparova, 1999, p.13-17).In this scenario, another devaluation of Tenge in 2009 was unavoidable (Burke, 2009). Vulnerability to Dutch Disease Kazakhstans vulnerability to Dutch diseases is observed by Kutan and Wysan (2005) who analysed real exchange rate equation by integrating oil prices. The results revealed that transition in oil prices have considerable impact on real exchange rate movements. In particular, increase in oil prices directs appreciation of the real exchange rate. They explained their analysis by giving credible reason. Oil price increase improves the term of trade of exporting country which results in increased export revenues. This situation leads to overall increase in spending which increases domestic goods price in comparison to foreign goods and an increased RER. Oil Prices and Kazakh Exchange Rate Korhonen and Mehrotra (2009) examine the impact of oil price shocks on real GDP and exchange rate in Kazakhstan. They identified a positive relationship between oil price and GDP. On the other hand, Gurivich et al. (2009) have observed no significant impact of oil prices on real GDP in Kazakhstan. Results for oil price influence on real exchange rate also differ. Korhonen and Mehrotra (2009) identified that there is no significant association between oil price shocks and movement in real exchange rate. While Kutan and Wysan (2005) identified the significant relation between oil price and movement in real exchange rate. This disparity identifies the need for more research and empirical evidence for the effect of oil price and exchange rate in Kazakhstan (Nurmakhanova and Kretzschmar, 2010). Kretzschmar and Numakhanova (2010) analysed a period from 2000-2010 which is considered to be a comparatively steady monetary policy regime in Kazakhstan. Before financial crisis, both Russia and Kazakhstan adopted nominal exchange rates as nominal anchor which is a frequently practiced in transitional economy (Korhonen and Mehrotra, 2009). However, Russian fiscal policy was incompatible with fixed exchange rate. Kazakhstan had to shift to floating currency with Russia in order to keep the export competitiveness (Nurmakhanova and Kretzschmar, 2010). Nurmakhanova and Kretzschmar (2010) state: "Recent efforts by the Kazakhstan Central Bank to manage the Tenge to a trading band and restore fiscal probity have began to redress the flawed approach of providing unconstrained and expensive downside structural support, to the extent that there is 2009/10 evidence that the government is buying up USD in the domestic market in an attempt to prevent Tenge appreciation and volatility." These factors direct Kazakhstans Tenge to a situation where exchange rate is managed rather tightly. Ohno and Zhakparova (1999, p.18) analysed Kazakhstans changing environment and policy response from independence to the time of Russian financial crisis as a vulnerable economy facing external shocks. They find it difficult to interpret that whether their reaction were always apt. However, their overall balanced approach towards policymaking can be considered favourable for them which can work as a model for other transitional economies engaged in policy debates. Nurmakhanova and Kretzschmar (2010) find, though Kazakhstan has not adopted a fixed exchange rate regime, it can be said that they are managing their exchange rate regime fairly tightly. International Monetary Fund (cited in SRI, 2010) suggests that Kazakhstan should adopt a more flexible exchange rate regime considering its stage of economic recovery. Moreover, IMF appreciated Kazakhstans recent devaluation steps and finds that Tenge has been extremely stable. Works Cited Blanchard, O., 2006.Macroeconomics.4th ed. New Jersey: Pearson Prentice Hall. Begg, D., Fischer, S., and Dornbusch, R., 2003.Economics.7th ed.New York, NY: McGraw Hill. Burke, J.J., 2009.The effects if devaluation of the Tenge upon the Kazakhstan economy: KZT. [Online] EILF J. L. Fin. & Econ. 1.1 (2009): 52.Available at :< http://works.bepress.com/john_burke/4/> Fischer, S.1998.International Monetary Fund, The Asian Crisis-A view from the IMF. [online]Available at:  [Accessed 15 August 2011]. Gurvich, E.; Vakulenko, E.; Krivenko, P. 2009.Cyclicality of Fiscal Policy in Oil-Producing Countries. Problems of Economic Transition, 52(1), pp. 24-53. Hartogh, M.1998The Thai Currency Crisis in Hindsight. Available at SSRN: [Accessed 15 August 2011]. Kasera, S., Katz, B.2008.Kazakhastan: Economic policies before and after the 1998 Russian Financial Crisis 1. [Online]Available at:  [Accessed 16 August 2011]. Kutan A.M., Wyzan M.L.2005. Explaining the Real Exchange Rate in Kazakhstan, 1996–2003: is Kazakhstan Vulnerable to the Dutch Disease? Economic Systems, 29(2), pp. 242–255. Kretzschmar, G.and Numakhanova, M.2010.The real currency and growth challenge for commodity producing countries. [online] Available at :< http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1662346> [Accessed 16 August 2011]. Korhonen, I., A. N. Mehrotra.2009. Real Exchange Rate, Output and Oil: Case of Four Large Energy Producers. Bank of Finland. Institute for Economies in Transition. Discussion Papers 6/ 2009. Ohno, K., & Zhakparova, S. 1999.Responding to Regional Currency Crisis: Kazakhstan in the Aftermath of the 1998 Russian Crisis. In: The French Ministry of Finance Treasury Directorate, International Conference on exchange rate regimes in emerging market economies Session 4: The Regional Dimension. Tokyo, Japan 17-18 December 1999.Japan: CDC & AFB. SRI, 2010. Kazakhstan should allow more exchange rate flexibility-IMF. [online] Available at: [Accessed 15 August 2011]. USAID (United States Agency for International Development), 2008.Kazakhstan: PPP opportunities in a young country. (Chemonics International, Inc.)[Online]Available at: [Accessed 15 August 2011]. Read More