IV. Long-term Prospectsforthe Real Valueofthe Tenge1
1. Sustained rapid economic growth and a sharp increase in oil export earnings were reflected in a real appreciation of the tenge last year, despite large purchases of foreign exchange by the National Bank of Kazakhstan (NBK). Looking forward, the prospect is for continued rapid growth and a further substantial rise in oil receipts. Against this background, this paper seeks to address the following issues:
- Is the real appreciation of the tenge an equilibrating phenomenon that is expected to persist over the longer term?
- To the extent that real appreciation is inevitable and the tradeoff is between nominal appreciation and higher inflation, what considerations are relevant for determining the appropriate rate of inflation for Kazakhstan over the medium term?
A. Exchange Rate and Inflation Developments
2. The tenge has strengthened markedly in real terms against the U.S. dollar over the past half decade. Since 2000, the tenge-dollar real exchange rate—the nominal exchange rate adjusted for changes in the consumer price index (CPI) in both countries—has appreciated by some 28 percent, with most of the appreciation occurring in 2003–04. A large part of the real appreciation took place through higher inflation—Kazakhstan had a cumulative inflation differential of about 17 percent with the United States during 2000–04—but nominal appreciation (about 12 percent on a cumulative basis) also played a role.
3. By contrast, the tenge has depreciated in real terms against the ruble, its largest trading partner currency, although this trend was reversed last year. During 2000–04, Russia’s inflation rate exceeded that of Kazakhstan by a cumulative 32 percent, while the tenge appreciated in nominal terms vis-à-vis the ruble by 11 percent. As a result, the tenge’s cumulative real depreciation against the ruble amounted to about 17 percent over the period.
4. In trade-weighted (effective) terms, the real external value of the tenge has remained broadly flat. This follows a sizable real effective appreciation in the mid-1990s, possibly reflecting an “initial undervaluation” that appears to have characterized the real exchange rates of many transition economies, and an equally sizable real effective depreciation in the aftermath of the Russian crisis in 1998–99. However, measurement of Kazakhstan’s real effective exchange rate (REER) is complicated by the large share of oil in Kazakhstan’s external trade and the substantial changes in trade shares with key partners since the transition to a market economy commenced. Hence, the weights assigned to Kazakhstan’s REER in the Fund’s Information Notice System (INS)—for example, 45 percent for Russia and 3 percent for the U.S.—are subject to significant error and the analysis below focuses on the real value of the tenge against the U.S. dollar.
Real Exchange Rate of the Tenge (1995=100)
Source: INS; and Fund staff estimates.
B. PPP and Relative Productivity Differentials
5. International comparison of price levels is one way of assessing the deviation of a country’s real exchange rate from its long-run level. The theory of Purchasing Power Parity (PPP) holds that prices of an identical consumption basket should be the same in all countries once expressed in a common currency (see Box IV.1.). While departures from PPP can be large and narrow only very gradually, they are indicative of the direction of future real exchange rate developments—toward the equilibrating long-run PPP level—in the absence of other shocks.
6. The comparison of CPI levels across countries needs to account for the presence of nontraded goods and differences in consumption baskets. Nontraded goods—whose prices need not equalize across countries—constitute a sizable share of the overall consumption basket, and nontradables prices tend to be higher in countries with higher wages and incomes. Hence, the relative price of tradables to nontradables—the real exchange rate—will tend to be higher in countries with greater per capita income.
Box IV.1.Absolute versus Relative Purchasing Power Parity
The theory of PPP predicts that the relative price of a common basket of goods between two countries measured in a common numeraire, the real exchange rate, should be equal or equalize quickly following a shock to the long-run relative price. Thus the real exchange rate (q) between two countries under the absolute version of PPP is defined as follows:
where p, e, and P* are the home country price level measured in home country currency, the nominal exchange rate, defined as price of foreign currency in terms of home currency, and the foreign price level measured in its own currency. Thus, absolute PPP means that the purchasing power of a unit of domestic currency is exactly the same as in foreign economy, once it is converted to foreign currency at the absolute PPP exchange rate.
The PPP theory has the following implications:
- In the short to medium run, the home country can experience a real appreciation of its currency if q rises and deviates from 1, which can happen through either a higher domestic price level, a nominal appreciation (a lower e), a lower foreign price level, or all of the above. Since the home country has no influence on the foreign price level, movements in the latter are assumed to be exogenous.
- This absolute version of PPP is often contrasted with relative PPP, a weaker version of the theory, which requires that only changes in national price levels be equal, implying zero inflation differentials when using the same numeraire. Hence, changes in the real exchange rate must be zero or tend towards zero in the long run following a shock. Thus, relative PPP holds when inflation differentials between two countries are fully offset by nominal exchange rate changes.
- CPI-based measures of the real exchange rate use indices that are constructed relative to a base year. They therefore measure the rate of change of the price level from the base year and not its absolute level.
7. According to the Balassa-Samuelson effect, the long-run real exchange rate changes over time in response to relative productivity differentials. Countries with higher productivity growth in the tradables relative to the nontradables sector tend to experience real appreciation (increase in the relative price of nontradables to tradables). In essence, higher tradables productivity pushes up wages in the tradables sector, which leads to higher wages in the nontradables sector and, consequently, to higher nontradables prices. Since tradables prices are set in international markets and do not respond to domestic market conditions, the relative price of nontradables to tradables rises. As the overall (consumer) price level is a weighted average of tradables and nontradables prices, the higher price of nontradable goods leads to an increase in the overall CPI. Moreover, assuming that real per capita GDP differentials across countries are a reasonable proxy for relative productivity differentials,2 the Balassa-Samuelson effect implies a positive correlation between relative income levels and the real exchange rate. It also suggests that as a country’s (relative) income level rises over time, its real exchange rate will appreciate.3
8. Analysis of cross-country data—with the necessary adjustments for comparison purposes—suggests that the tenge was significantly undervalued in real terms in relation to its estimated long-run PPP level in 2000. The data—obtained from Penn World Tables (PWT)—compare the U.S. dollar prices of an identical, quality-adjusted output basket among a large number of countries. As the chart indicates, there is indeed a correlation between countries’ real exchange rate and their income level. The vertical distance from a country’s actual position to the estimated regression line—which provides an estimate of the long-run real exchange level—measures the deviation of the actual real exchange rate from its long-run value.
Price and Income Levels Relative to the United States
Source: Penn World Tables, version 6.1, (2002).
Note: Countries named in the figure are shown by darker markers. The fitted line is the estimated regression in column 1 of Table IV.1.
9. As the chart indicates, Kazakhstan’s actual real exchange rate was 34 percent below its estimated long-run PPP level in the year 2000, implying an undervaluation of 66 percent. Other countries with significant undervaluation include China, oil-exporting countries such as Russia, Azerbaijan, and Algeria, and other transition economies such as the Kyrgyz Republic and Tajikistan.4 Many of Kazakhstan’s major trading partner currencies—notably the Russian ruble, Chinese renminbi, and Ukrainian hryvnia—also appear to be undervalued in relation to their estimated PPP level.
10. Updated estimates of the Balassa-Samuelson effect were obtained by staff. As depicted in the chart, an OLS cross-section regression of relative prices on relative real per capita GDP for 133 countries, where both variables were measured in relation to the United States yields results indicating strong presence of the Balassa-Samuelson effect (Table IV.1.). The estimated coefficient in the table shows that a one percent increase in a country’s real per capita GDP (relative to the U.S.) is associated with a real appreciation (against the US dollar) of about 0.4 percent.5
|Log (relative per capita GDP)||0.394*||0.382*||0.410*||0.317*||0.366*||0.200*||0.200*||0.51*|
|Number of observations||133||118||142||118||over 100||118||118||12|
denotes statistical significance at 1 percent level.
denotes statistical significance at 1 percent level.
11. Based on these estimates, Kazakhstan’s long-run real exchange rate may be expected to appreciate further. Since Kazakhstan’s economy is projected to grow more quickly than the U.S. economy in real per capita terms over the medium term, the Balassa-Samuelson effect implies an appreciation of the long-run “equilibrium” real exchange rate of tenge against the US dollar of about 2¼ percent a year.6
12. A number of caveats and qualifications apply, however, to the estimates of the deviation between the actual and long-run real exchange rate in 2000 and the change in the long-run rate over time. First, deviations of the real exchange rate from PPP are attributable in part to long-term productivity differences (the Balassa-Samuelson effect), but near-term movements in the exchange rate depend on a variety of other factors—including capital flows, cyclical developments, and fiscal policy. Second, the estimated Balassa-Samuelson effect accounts for only about half of the variability across countries of real exchange rate deviations from their “equilibrium” level, implying that other factors have considerable importance. Third, the PPP data in PWT are themselves subject to measurement errors; thus, the estimates for any single country must be treated with caution.
C. Long-run Prospects for the Tenge’s Real Exchange Rate
13. The estimates reported above suggest that the tenge will continue to appreciate in real terms against the dollar over the longer term. During 2001–04, with the tenge appreciating substantially in real terms against the U.S. dollar, almost one half of the estimated deviation from the estimated long-run level in 2000 was corrected. On average half of the estimated deviation between the actual and long-run real exchange rate at any point in time will be closed over the subsequent decade (Frankel, 2005). If one half of the gap remaining at end-2004–52 percent—is to be closed over the next decade, this would imply an annual real appreciation of about 2½ percent.7
14. Since the long-run real exchange rate is also appreciating, the implied long-term real appreciation of the actual exchange rate will be higher. In particular, given the estimated effect of the growth differential, the average annual real appreciation of the tenge would be about 2¼ percentage points higher. Hence, the tenge may be expected to appreciate by an average of 4¾ percent a year in real terms against the dollar over the medium term.
15. The “equilibrating” real appreciation can be achieved through nominal appreciation or higher inflation (relative to U.S. inflation). As the operating exchange rate regime is a managed float, sufficient nominal appreciation of the tenge could be undertaken to achieve the equilibrating real appreciation. Alternatively, if nominal appreciation is resisted, the real appreciation may be postponed somewhat but will eventually take place through higher inflation. Indeed, the estimate above suggests that with no nominal exchange rate flexibility in the nominal tenge-dollar exchange rate, average annual CPI inflation would be over 8 percent in the near term (given current U.S. inflation of about 3½ percent) and over 7 percent over the medium term (given projected longer-term U.S. inflation of 2½ percent), in the absence of other—including cyclical and fiscal—effects. If fiscal policy is expansionary, as at present, or if the economy overheats, the implied rate of inflation in Kazakhstan under a relatively inflexible exchange rate regime could be significantly higher, and may prove very costly to reverse.
D. Costs of Higher Inflation
16. While limiting nominal appreciation may slow the real appreciation of the tenge in the near term, the costs of higher inflation over the medium term need to be assessed. In this context, lessons from past macroeconomic developments in Kazakhstan, as well as experience from other countries, is relevant.
17. The decline in inflation in Kazakhstan over the past decade has been accompanied by strong macroeconomic performance. There has been a brisk rise in money demand, reflected in sustained rapid remonetization. The ratio of credit to GDP has improved considerably (see Chapter III), supporting investment and further economic growth. There has also been a steady decline in dollarization, reflecting increased confidence in the tenge. While it is difficult to assess how much of the improvement in macroeconomic prospects has been due to the improved inflation performance, a marked pickup in inflation could risk a reversal of these favorable trends.
18. Cross-country evidence suggests that high inflation results in lower growth, although the threshold for high inflation in most studies is rather high. Fischer (1993), for example, found that high inflation is harmful to growth, though growth gains are negligible once inflation is brought down to single-digit levels. Bruno and Easterly (1998) found that long-run growth is lower if the inflation rate exceeds 40 percent per annum. Nevertheless, the empirical evidence also shows strong persistence of inflation, and the process of disinflation is costly and takes time.
19. More recent studies find that adverse growth effects can materialize at a much lower inflation threshold. Khan and Senhadji (2001), in particular, found that inflation rates exceeding 1–3 percent in industrial countries and 11–12 percent in developing countries would lower growth.8 While Kazakhstan’s inflation rate under a relatively fixed exchange rate regime would likely remain below the relevant thresholds for growth in the absence of other factors—beyond the long-run equilibrating behavior of the real exchange rate—the presence of cyclical and/or other effects could push up inflation close to (or beyond) the threshold.
20. Recent empirical evidence suggests an even lower threshold beyond which inflation has an adverse impact on financial deepening. Using cross-country time series data, Khan, Senhadji, and Smith (2001) found that, controlling for other effects, countries with annual inflation rates in excess of 6 percent experienced slower financial deepening, measured as the ratio of private credit to GDP. Hence, if Kazakhstan were to adopt a relatively fixed exchange rate regime, the equilibrating behavior of the real exchange rate could push up inflation to levels that can affect adversely the ongoing process of financial deepening.
21. The real exchange rate of the tenge against the dollar can be expected to appreciate toward its long-run “equilibrium” level. Estimates of the deviation of current prices from their long-run PPP level, together with the estimated impact of relative productivity differentials, suggest that the real appreciation of the tenge could average 4¾ percent a year over the medium term, and that expansionary fiscal policy or cyclical pressures would imply significantly greater appreciation. Accepting this real appreciation through higher inflation rather than nominal exchange rate flexibility could be costly, as it would risk affecting the process of financial deepening underway in Kazakhstan and could also result in a negative effect on growth.
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