Our Analytics 4 april — 15:03

How to save Azerbaijani economy (Our analysis, Article two)

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BY MAMMAD EFENDIYEV, ELDAR ALIYEV, ELNUR MAMMADOV, ECONOMICS SECTION

As already noted in the first article, the improvement of the financial sector of the country has been given serious attention in the Strategic Roadmaps of the prospects for the development of the national economy, approved by President Ilham Aliyev at the end of the last year. As the Centre for Analysis of Economic Reforms and Communications informed Azeri Daily, six subgroups on 11 priority sectors did indeed carry out great work on discussing this document abroad and in the country itself. In particular, such discussions have been held with the participation of the economic bloc, including banks, the Central Bank, the Chamber for the Supervision of Financial Markets, the Ministry of Finance, the Oil Fund and other financial institutions. As can be seen from the presented document, the propaganda of this important task covered hundreds of departments, institutions, districts, thousands of people. Our own reasoning shows that in order to improve the situation in the banking sector, not only discussions are needed. It is required to carry out very profound reforms.

According to the Central Bank of Azerbaijan (CBA), today the main goal is to reduce the rate of inflation. But under inflation, judging by these explanations, only the consumer price index (CPI) is understood. This raises a completely logical question: why only the CPI? Maybe it is worthwhile to simultaneously monitor the industrial price index, because the growth of this indicator is also transferred to the CPI? Or, say, the deflator, which is also an index of prices, but on the scale of the entire economy? That is, the CBA subordinates its entire monetary policy exclusively to the achievement of the CPI targets. At the same time, it is not clear which inflation target is acceptable for the CBA and for what period of time it can be achieved.

The Central Bank's actions and the realities of the economy

Politics hurts the macroeconomic situation

Recently, at a meeting in the CBA devoted to the discussion of the macroeconomic situation and monetary policy, it was pointed out that thanks to the measures taken, it was possible to achieve some stabilisation of the CPI and the manat rate. And this, according to the bank, gives reason to hope that by the end of this year, inflation (CPI) will be one-digit. But with all due respect to the CBA, we have not been able to understand what inflation rate it means - 1%, 5% or 9%. It would be nice to indicate some more accurate indicator, for which the financial regulator must make every effort. And also to show what measures will be taken after achieving this goal.

It should be noted that the reduction of inflation has always been one of the main priorities in the activity of the Central Bank, which at the end of each year sets targets for the planned year. Along with the inflation price targets, the CBA also tracks the benchmarks for the exchange rate of the manat, the increase in the money supply. What is the difference between the current inflation targeting policy and the previous monetary policy, aimed more at preserving the exchange rate, which, ultimately, is also aimed at reducing inflation to a certain level?

Judging by the actions of the monetary authorities, it turns out that the peculiarity of the inflation targeting policy is the refusal to establish target benchmarks for the exchange rate of the national currency released into a free float and the use of the refinancing rate as a governing parameter. At the same time, it is not explained how this policy will lead to the achievement of the set goal and to what losses it can lead. It seems that these actions are not subject to discussion by an axiom. But it must be emphasised that the selective capacity (the number of different instruments) of the control system should not be lower than the variety of controlled objects. The state of the monetary-currency system is constantly changing depending on the variable combination of external and internal factors that determine demand and supply in these markets.

The composition of regulatory instruments must correspond to a variety of these factors in order to be able to influence their combination. And why inflation targeting should imply a refusal to control the factor that determines the dynamics of prices for most of the consumer goods through the exchange rate of the national currency remains unclear. This causes a logical comparison with the case when we try to heat a room without window panes in winter, without taking into account that the temperature in the room depends not only on the power of the heater, but also on the air temperature and wind speed outside the window.

In this case, the monetary authorities are adopting a mechanism with one manipulator. True, according to the theory of inflation targeting, in the absence of restrictions on the movement of capital, the national currency rate should be in free float, while for controlling inflation there is only one instrument for regulating the currency and financial market - the interest rate. Such an action of the CBA, it seems, is far from the realities of our economy. The domestic demand of our economy depends heavily on the import of goods and services, as well as technology. With the depreciation of the national currency, prices for imported goods are certainly growing, and prices for domestic goods are also rising because of rising costs, and as a result, inflation is growing. In this case, there is no monetary component in inflation, generated by changes in the parameters of the money market. Our monetary authorities refused such control. But with such self-restraint on the use of instruments for regulating the currency and financial market, its condition becomes vulnerable, and it can also allow players to manipulate the monetary and financial market through speculative actions.

So what happens in the currency and financial market?

Negative consequences of the transition to inflation targeting for the reproduction of the economy were obvious for theoretical reasons too. The rejection of the stability of the exchange rate and a sharp increase in the interest rate lead to a decrease in investment activity in the real sector of the economy. At the same time, the profitability of enterprises is falling, their solvency is significantly reduced, non-payments are growing (total investments from internal sources in 2015 and 2016 fell by 20%, and the volume of non-payments increased in 2015 in comparison with 2014 by 6.5 billion AZN and amounted to 25.5 billion manats). According to the results of 2016, the statistics dos not show the figures on non-payments, but it is not difficult to guess that it should grow. With the increase in the discount rate, the conditions for lending to enterprises consistently worsen, the credit for most enterprises becomes unavailable (the volume of loans to the real sector for this period decreased by 20% or 3 billion manats).

With free floating of the manat, the high amplitude of fluctuations in the exchange rate, which is formed on the basis of a 'spontaneous' correlation of supply and demand in the foreign exchange market, entails destabilisation of the economy. Deregulation of the exchange rate in conditions of the dependence of the balance of payments on oil exports and the high propensity of the economy to dollarisation increases the chaotic nature of this market, and the remaining liquidity in the economy again rushes to the currency market. The flow of capital from the real sector to the speculative spheres of the financial market makes it difficult to ensure manat's stability. The subsequent collapse of the exchange rate becomes a natural result of both manipulation of it and the policy pursued by monetary authorities.

Inflation not caused by monetary components

Inflation targeting cannot produce the expected result in such economies as ours, unless there is, of course, control over the movement of capital. The domestic economy could not take advantage of the increased competitiveness of its products due to the devaluation of the manat due to tight monetary policy. Despite all the calls of the country's leadership for wide import substitution and use of increasing the price competitiveness of domestic products after the devaluation of the manat for expansion of its production and exports, in reality this was not done for a simple reason - due to the lack of acceptable loans. As a result, enterprises, unable to attract loans for expansion of production, preferred to raise prices, taking advantage of the increased cost of competing imports. This increased the trend towards higher prices and further weakened exports.

Indeed, over the past two years, when the manat exchange rate has more than halved, inflation has officially increased by almost 20% and money has risen in price, the costs of enterprises have increased by 30-40% and higher, depending on the share of imported components. The recent increase in the manat rate by more than 10% has led to their price competitiveness relative to imports, respectively, decreased by almost the same level that was established after the first devaluation. Given the growth of domestic prices, the potential for devaluation has declined. In addition, money in the economy compared to the period of devaluation has almost halved, loans are more expensive and less affordable, and prices for goods have risen by 30-40% or more. As a result, instead of the expected growth in exports, we have achieved its decline, as well as reducing imports, and, not as a result of the growth of import substitution, but of a decrease in the purchasing power of the population.

In 2014, the impact on the economy of such obvious factors as the fall in oil prices and the growing level of dollarisation of savings was already objectively felt. And even then it was necessary to oppose them with some tools. But either because of a wrong assessment of the situation, or due to lack of necessary flexibility, or perhaps for other reasons, including for political reasons, no timely steps have been taken. And as a result, the monetary authorities decided on the inevitable February devaluation, while seeking to stabilise the rate of the manat at a new level. In principle, in the current situation there was no other option; this to some extent was a consequence of the ongoing pre-devaluation policy, or rather, an attempt to correct the mistakes made.

Strengthening manat

The problem of choosing an option for managing the exchange rate and the duration of its maintenance is not entirely simple and requires consideration of all internal and external factors that can influence the macroeconomic situation at a given moment and in the future. For this, there are several options - currency management, creeping binding, rigidly fixed exchange rate, currency corridor. Recall that in 2005, after the denomination of the national currency, 1 manat was equal to $1 (before the denomination in 2004, 1 dollar was worth an average 0.9827 manats in new manats). Then manat began to gradually strengthen and in 2012 the dollar on average cost 0.7856 manat. In this period of time, the average annual inflation rate averaged over 10% and only in 2012 fell to 1.1%. Thus, the application of a combination of instruments such as exchange rate targeting (the main instrument), the norm of mandatory reserves of commercial banks and the discount rate positively influenced the decline in inflation. But at the same time, such a policy led to an increase in the nominal and effective rate of the manat, which created favourable conditions for importers, with no proper attention to import substitution. And after the recession of inflation in 2012 and until the February devaluation, the policy of a rigidly fixed exchange rate was implemented (during this period the average annual rate was 1 dollar = 0.7844 manat). Such a policy, combined with growing domestic demand due to the oil boom, proved attractive not only for importers, but also for investors. Investments went mainly at the expense of domestic sources, most of them went to the service sector, and the remainder to produce goods, focused mainly on the domestic market.

In early 2015, before the first devaluation, the volume of foreign exchange reserves at the current exchange rate (1 dollar = 0.7844 manat) did not fully cover the monetary base, their ratio already corresponded to the rate when 1 dollar exceeded 0.83 manat. Therefore, on February 21, 2015, before the oath to the public about the inadmissibility of the depreciation of manat, the head of the CBA announced the devaluation and set a new dollar rate - at the level of 1.05 manats, for which the support was only enough for 10 months. Essentially, this meant that the CBA could at any time change the entire amount of the monetary base to a penny for dollars, which were available at the time in the reserve fund, at the newly announced exchange rate. But in reality such a scenario was impossible, because the population exchanges for the currency only that part of the cash manats that is its savings, since the rest of the money provides it with a daily need for goods and services, and it does not make sense to change it. It was supposed to bring down the hype that had been growing up for the foreign currency, but, unfortunately, it did not give the expected result.

The question arises: why did not this happen? In our opinion, this was influenced by the following reasons. In the structure of the money supply, the share of cash is quite high. Cash serves to purchase goods and services by the population in the consumer market and for savings. In our country the volume of cash money since the crisis has decreased almost twice, but nevertheless, there was no shortage of cash in the turnover. In reality, there was more cash in the market than what economic agents needed. Hence, part of the cash flowed in closed circulation, providing unaccounted (shadow) business, and if there is unaccounted turnover, then there is an unaccounted or shadow economy. The government only in early 2017 began to take steps to ensure the transparency of the financial and business activities of the business by introducing a tax on the withdrawal of cash from bank accounts and a limit on the use of cash, when excess cash is taxed beyond the limit. Such innovations make the work on the former 'grey' mechanism meaningless. But for two years this factor had its negative impact on the currency market of the country

Bubbles in our economy

The measures, of course, were belated, they should have been taken much earlier. But the government did not take this step even on the eve of the devaluation, or even immediately after it. And it is difficult today to understand whether it knew that without such a step, it would be simply impossible to avoid the next devaluation. It is possible that our officials at first decided to make the devaluation in the hope that soon the oil prices will rise and everything will fall into place. And to report back then to the head of state and people that their policy allowed to get out of the crisis with a slight correction of the rate of the manat to the dollar, while all neighbours, big and small, devalued their national currency twice or more. What to expect from officials, even if our grief-propagandists were preparing at this time plots in TV channels, in which the people 'admired' the devaluation, they say, this will enable them to live better.

But the shadow turnover in the economy is a serious factor; in this case it has led to the ability of the banking sector to generate credit emission being narrowed. On the other hand, the budget received less taxes. And less taxes the budget gets, the more we continue to replenish the hole at the expense of the growing transfers from the Oil Fund. And what really aggravates the situation, we direct these transfers not to investment, but simply to consumption, that is, huge amounts of money were flowing from the budget into the sewers.

And money of the oil fund float into the sewer system

Growing bubbles in the economy

Another reason contributing to the disproportionate depletion of foreign exchange reserves and devaluation is the disbursement of budgetary means by the corruption mechanism. Let us cite a fairly recent example with the Azerbaijan Railways under the previous management. We witnessed a corruption mechanism when in 2013 the company purchased its services abroad at the expense of the budgetary funds, and the amount of this transaction exceeded its real value several times. To implement such a transaction at the expense of budget money, it was first necessary to convert the entire amount into dollars and transfer abroad, after which the part that exceeds the real value of the transaction several times will settle on offshore accounts. Such an inflated amount our statistics must take into account as a public investment in the economy, although in reality such a volume of investment is an ordinary bubble. In reality, this is a simple redistribution of budgetary funds in favour of an official or community of officials, but there is no such graph in statistics. You can also consider another option, when a large amount of money is received from the budget every month to repair and purchase by the state of goods and services for servicing the population.

In statistics, this is called 'state consumption of goods and services.' First, these huge money is transferred to the bank accounts of enterprises, and then cashed through 'grey' channels, most of these amounts are appropriated by officials or a community of officials. And again, there is a redistribution of money in favour of an official or a community of officials. And our statistics should also take this excessive amount of money into account at this time as 'state consumption of goods and services.' Again it turns out to be a huge bubble. And the 'impure money' goes on to the cash foreign exchange market. By their nature, such impure earnings people prefer to keep in hard currency and in a 'quiet harbour.' Therefore, they again leave the country by 'grey' channels and settle in offshore. Such operations occur monthly and repeatedly, and each time the 'earnings' of an official or a community of officials grow rapidly, while the statistical bubble also inflates.

Billions sail to offshores

And only the System of National Accounts clearly shows how much our statistics are distorted. So, based on the SNA indicators, we can clearly say that the savings of households, that is, the population of the country, and our officials are also in this category, are about 1.5 billion manats. But such a sum, you must agree, cannot influence the cash foreign exchange market on such a large scale. However, in 2014 and 2015 currency in cash for the sum of 17.9 billion dollars has been bought here. It turns out that a narrow circle of the bureaucratic-oligarchic community in just one year appropriated as much as $14 billion at the expense of unrecorded earnings!

All the above negatives distorted the national statistics. But how can one lead a correct and adequate economic policy with such huge statistical bubbles? All these reasons led the domestic economy to an ugly state. And as a consequence, during the crisis, the imbalance of the balance of payments has exerted pressure on the currency market in its entirety. Here, of course, no foreign exchange reserves will survive, especially at low oil prices.

(to be continued)

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