MACRO ADVISOR: Eurasia currencies set to fall further

MACRO ADVISOR: Eurasia currencies set to fall further
By Chris Weafer of Macro-Advisory November 16, 2015

It is a statement of the obvious to say that 2015 has been a difficult year for the economies in Central Asia and the Caucasus. Those that have built their economic and social models on the back of hydrocarbon exports were badly hit with the big drop in the price of oil and gas, while some suffered collateral damage from the Russia recession. Others that didn't have the benefit of hydrocarbons or became too vulnerable to worker remittances from Russia suffered the effects of regional slowdown and a drop in investment flows. Nobody escaped in 2015; it is only a case of how damaged each country is coming into 2016 and how effectively respective governments will take the now-urgent remedial monetary actions.

As the year-end approaches, the challenges are set to get worse rather than ease. Most governments in the region now face some critical policy decisions that will impact not only the performance of their respective economies, but also have a big influence on whether they come through the next 12 months with their political position intact or have to deal with social instability and political challenges.

One action increasingly looking unavoidable for almost all countries is that they will have to follow the decision by the Kazakh government – which in turn followed the lead of the Russian central bank – and abandon or radically change their currency pegs. That means taking the risk of a free-float, or, at minimum, a more flexible approach to currency management. That, if handled badly, could lead to a hawkish policy response, endanger some banking structures because of the prevailing high level of dollarization in most economies in the region, and raise the threat of a public backlash. On the other hand, if currency action is avoided or delayed, many countries risk a bigger and longer-lasting economic decline and a public backlash as a consequence.

Sooner rather than later

Three of the states, Kazakhstan, Armenia and Kyrgyzstan, are members of the Eurasian Economic Union (EEU). While membership benefits are very clear, they are also more medium to longer term.  Shorter term, ie. in 2016, it means they are more vulnerable to currency contagion from the weakness of the Russian ruble than others. The free movement of goods is one of the core principals of the EEU and that increases pressure on member states to stay competitive with goods and services in other member states.

This, along with the drop in oil revenues, is the main reason why Kazakhstan had to abandon the tenge peg this year; its economy was being swamped by cheap imports from Russia, especially high-end goods such as vehicles. As can be seen from the table below, the tenge has now dropped almost in line with the ruble since the start of 2014, albeit most of that was a late catch-up since the August devaluation. The lesson for others in the region is that when devaluation becomes inevitable do it quickly, as waiting is expensive and damaging to confidence. Kazakhstan left the devaluation very late and is now suffering a loss of confidence that will be expensive to address. The main reason for that delay was because of the need for stability and “promises” made ahead of the early presidential election it held last spring.

Kyrgyzstan has a flexible currency regime and its currency has adjusted to reflect both the drop in ruble remittances and to fight off the loss of competitiveness against neighbouring Kazakh goods and services. Almaty and Bishkek are within easy driving distance of each other. Unless the tenge can be stabilized soon, it is inevitable that the Kyrgyz som will suffer a 10-20% devaluation. Kyrgyzstan has had two colour revolutions over the past 15 years and political stability remains in a state of flux, so the decision as to whether to allow a faster devaluation or try to support the som has significant political considerations as well as economic.

Armenia’s dram has been very stable so far in 2015, mostly because it is tightly controlled by the Central Bank of Armenia. The Yerevan government has faced a lot of public protest this year as a reaction to proposed energy price hikes and also against the backdrop of a very contentious vote, set for next spring, on constitutional change. The last thing the government needs is the fallout from a currency devaluation, which could have led to higher inflation and debt service costs. Armenia is also very focused on trying to boost inward investment into its fast growing hi-tech and pharmaceutical sectors, and considers a stable currency to be key to continued success.

Unlike Kazakhstan, which this year has focused more on plans to diversify its economy away from hydrocarbons, eg. building up financial services or investing in agriculture or transport logistics, Azerbaijan and Turkmenistan remain committed to riding out this period of price weakness in the hope that export revenues will recover. Both are building new gas export capacity, ie. to Europe via the TAP pipeline for the former and via new pipelines direct to China and Iran for the former. Both countries tried to avoid devaluation in 2014, but took action in the first quarter of this year. That is not enough. Turkmenistan is most unlikely to dispose of the currency peg, but could devalue by another 20-25% to stay in line with the oil price. Azerbaijan avoided taking any additional currency decision after the first-quarter devaluation because of the possible impact on the November parliamentary elections. Now it has no choice and either a move similar to Kazakhstan or a 20-25% shift in the peg is required.

Georgia’s economy is more impacted by what happens in Azerbaijan than other regional economies. Hence the lari, which is free floating, has moved in line with the manat. That close relationship should continue, so that when the manat further devalues, expect a similar move in the lari.

Tajikistan has a managed flexible rate mechanism and partially devalued to compensate for the economic impact from the drop in remittances from Russia. Yet a bigger devaluation, or certainly not in one big move, is unlikely because of the contagion to inflation, interest rates and confidence. Tajikistan is a frontline state facing a growing threat from Islamic radicalism coming from neighbouring Afghanistan. The government faces a difficult balancing act in trying to maintain social stability while, in reality, hoping for a strong rebound in the Russian economy so its repatriated and disaffected workers can again migrate.

Uzbekistan has a tightly controlled currency regime. It does not suffer directly too much from the drop in oil and gas prices and the fall in worker remittances is less damaging than for its eastern neighbours. Another one-off adjustment in the currency peg is highly likely if regional currencies weaken (as expected), but a major policy shift is unlikely until the start of the next presidency. Meantime, preserving domestic stability is a greater priority.

Staying positive

The table below shows that all regional economies suffered a decline in growth in 2015 but, unlike Russia, have avoided moving into recession. All will report budget deficits that are either larger than the 2014 deficit or compare with a surplus, because governments did not devalue by enough or fast enough, or have been forced to maintain spending to head off the risk of a public backlash.

All are currently expected to report either similar or marginally better growth rates in 2016 and, except for Kyrgyzstan and Tajikistan, a reduction in budget deficits. That is, however, more biased towards optimism and depends on effective government policy actions, especially concerning their currencies. Much more likely we will have to cut growth and raise budget deficit forecasts across the region in the spring.

Chris Weafer is a founding partner of Macro-Advisory, which helps investors cut though the noise & focus on underlying trends, real political risks, & opportunities in Russia/CIS, Eurasia Union, & Mongolia. Follow him on @ChrisWeafer