Manat: Stability or Sustainability?

On April of last year, I wrote about the then-mounting pressure on Azerbaijani manat (AZN) and concluded that we can expect the currency to be devaluated by the end of the year 2020. However, time has shown that manat managed to preserve its stability. I decided to write this post to analyse why my prediction was inaccurate and to mention couple of relevant points.

With the wide spread of the coronavirus pandemic in 2020, especially starting from March, the global economy undergone severe turbulence. During that time, the Azerbaijan economy was already suffering from the pandemic itself but faced even more pressure due to the oil prices plunging to historical lows. Meanwhile, the demand for foreign currencies in Azerbaijan was on the rise, peaking at 1.9 billion USD in currency auctions of March 2020 (to compare, in March 2019 this indicator was only 600 million USD). This trend naturally led to many people questioning the short-term outlook of the national currency AZN and the talks of devaluation was rekindled among the general populace.

The highest demand for foreign currencies since 2015 was coupled with the speedy dip in oil prices. Considering the dynamic of the currency auctions, assets of the the State Oil Fund, Reserves of the Central Bank of Azerbaijan, limits imposed by the budget rule and a couple of other factors, I concluded that devaluation in 2020 is likely to take place. Yet, it turns out I was mistaken. I hold that the main factors that contributed to my misjudgement are the ones below:

EFFECT OF THE PANDEMIC ON SAVINGS

Even though in my original post I briefly touched upon the expected drop in population’s savings during the pandemic, and the resultant loss in the ability of the population to demand foreign currencies, I was of the mind that this factor cannot significantly alter the overall demand for the foreign currencies. Looking at the same point after one year, the big picture looks rather different. During March-April period of the last year we believed that by summer the coronavirus pandemic will be over and the economic recovery to be well underway. Per contra, the strongest 3 waves (at least for now) of the pandemic were still ahead of us. As preventative measures became tougher and lasted far longer than what we initially thought, its adverse effects on savings of the population were also more forceful than I anticipated. Like my argument in the original post, if people’s savings are low, they cannot demand foreign currencies even if they do not have any confidence in the AZN.

Decline of savings can be seen (more or less) from the public data as well. In the diagram below, you can see the change in real earnings of the population (adjusted for inflation) for the years of 2020 and 2021. It is evident that with the implementation of the stringent quarantine measures, the real income of the population has dropped sharply. Quantitative decrease in the real income naturally leads to the reduction in the overall savings, which puts a compelling constraint on the amount of foreign currency that the population can demand.

Now let us look from a different perspective. In April-December period of 2020 oil prices were exceptionally cheap and devaluation expectations high, yet almost in all these months the amount sold in currency auctions were abnormally lower than the same number of 2019 and 2018. We know that, given that everything else is constant, low oil prices and high expectation of devaluation (due to oil price volatility and coronavirus pandemic) should have been translated into greater demand in currency auctions. It is then perhaps possible that the decline of savings is one part of the missing explanation here.

Diagram 1: change in real income of the population

Graph 1

Source: Statistics committee (Nominal income), Central Bank (inflation) and author’s own calculations (real change)

CENTRAL BANK’S AGGRESSIVE POLICY

Unlike 2015, last year Central Bank of Azerbaijan (CBAR) pursued quite an aggressive policy to prevent the devaluation. It is obvious that the objective of the Bank this time was to delay the devaluation by using all available tools. With this aim in mind, in 2020 a couple of unconventional policies have been implemented. To give an example, people who want to buy foreign currency of more than 300 USD (or its equivalent in other currency) need to fill a special form, which asks them to declare the sources of the funds and the reason for exchanging. Additionally, the maximum amount of foreign currencies a citizen can buy is now limited to its equivalent 20,000 AZN (there is no information about till when this policy will be in place or when the limit will be zeroed). Those who want to buy foreign currency equivalent to more than 20,000 AZN need to present relevant documentation (e.g., a contract, import operation etc.). Also in some banks, foreign currencies are offered only during the first half of the day.

It is coherent why Central Bank follows this policy. As I mentioned in my original post, devaluing AZN during the pandemic would be disastrous for Azerbaijani population. Thus, devaluation needs to be delayed at least till the pandemic is over. As it seems, Central Bank also aims for this delay. We can see it clearly from the diagram below:

Diagram 2: Ratio of the foreign currency bought to the currency sold

Graph 2

Source: Central Bank of Azerbaijan

Vertical bars in the diagram represent the ratio of total currencies bought to the total currency sold in each month since 2014. For instance, indicator being equal to 5 means that, in that month Azerbaijanis sold foreign currencies equivalent to 1 AZN and bought foreign currencies equivalent to 5 AZN. Rest of the demand for foreign currencies (in our example – 4 AZN) has been provided by the auctions of the State Oil Fund, reserves of the Central Bank, and the reserves of the commercial banks.

With oil prices plummeting in 2014, the demand for the foreign currencies in Azerbaijan has surged and as a result the “currency ratio” reached 7.5 in February, which was the month when the first devaluation happened. When the second devaluation took place in December, the indicator was high again, this time equalling 7.2. Now let us look at 2020: in March this ratio peaked at 13.5. Indicator in April was not low either, as it was 7.2. These indicators tell us that if this soaring demand happened during a non-pandemic time, Central Bank would have likely gone for devaluation already in March-April. However, depending on the extraordinary conditions created by the coronavirus pandemic, CBAR was obliged to pursue a more aggressive foreign exchange policy. In my opinion, factors such as decrease of savings during April-December, relative stabilization of oil markets, unconventional methods employed by the Central Bank, as well as its determination at keeping the exchange rate of AZN unaltered during pandemic played a role in restricting the sales of the foreign currencies and led to Manat still being stable.

ON FUTURE OF MANAT

With vaccination process being rolled-out both in Azerbaijan and the world, global economy is slowly recovering. Average price of BRENT crude oil in June of 2021 reached 73.1 USD. Short-term forecasts of the oil prices are clustered around 65-70 USD. Considering the socio-economic situation created by the pandemic we can say that the approach of CBAR to exchange rate of AZN was appropriate. But we must remember that the current exchange rate policy is still eminently unsustainable. It needs to be pointed out that keeping AZN stable during 2020 would have been impossible without the colossal reserves (in relative terms) of the State Oil Fund of Azerbaijan. By keeping in mind the hardships created by 2015 devaluation (which we still continue to feel even in 2021), CBAR needs to shift AZN to a real floating currency regime at the earliest opportunity. SOFAZ managed to support AZN in 2020 by supplying the market with a large amount of foreign currency (and of course running a loss in the process of doing so), but the next time this “solution” may not be viable. When this topic is being discussed certain officials frequently use the argument that “SOFAZ has enough reserves/assets to support AZN”. I consider this approach as fundamentally wrong and irresponsible. That is because the reserves of the Oil Fund, which are formed from a source of finite natural resources, should not be wasted to keep the short-term stability of the national currency. Reserves of the Oil Fund should be used for more long-term, more efficient, and more sustainable objectives, and work towards achieving intergenerational equity, in accordance with the original mission of the Fund.

The longer CBAR keeps the exchange rate of AZN artificially anchored, the next devaluation, as well as its inimical consequences will be even harsher. To avoid this, Central Bank and the relevant state institutions should adopt an appropriate short and medium-term strategy as soon as possible, educate population on this issue and stimulate diversification of financial organizations’ portfolios. All these needs to be done now, when the oil prices are higher, because only when the oil prices are high, the “psychological demand” for the foreign currencies in Azerbaijan does not exist. By the time the next plunge of oil prices arrives, it may already be too late. Exchange rate of the national currency should not be determined by politics and its backward interests, but rather by the forces of the free market. Enough resources have been wasted to keep AZN stable so far, it is now time to move on.

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