Yesterday, the NBK suddenly stopped defending the exchange rate at USDKZT 156 and allowed the bid for USD at 185 to linger.
In its press-release the NBK stated:
- the new target for USDKZT is at 185 plus-minus 3
- the NBK will continue to intervene in the foreign exchange market and manage the exchange rate
- the NBK will continue to provide liquidity through repo market
The press-release listed the following reasons for devaluation:
- devaluation of EM currencies;
- liberalization of USDRUB by CBR;
- weakening of the external accounts;
- the need to restore the competitiveness;
- plans to transition to inflation targeting monetary policy framework.
The fair exchange rate
When an economy lives under managed exchange rate regime, the most watched price becomes the exchange rate. And whether it is in equilibrium, over- or undervalued grows big in the minds of investors. We believe the equilibrium exchange rate depends not only on domestic wages and prices relative to wages and prices of the trading partners, it also depends on interest rates, at home and abroad, current and expected to prevail in future. For example, if short-term rates in Kazakhstan money market were at or higher than NDF rates (7% before the devaluation), and the link between the domestic rates and NDF were expected to persist, then the yesterday's exchange rate of USDKZT=156 would not have been much overvalued. However, at the low interest rates that tended to prevail most of the time and the periodic liquidity crunches, the equilibrium would probably be closer to 165.
Compare and contrast: two devaluations
We compare the yesterday devaluation with the devaluation of 2009. It reveals many differences.
In 2009 the economy was under strong pressure to devalue because of terms of trade shock in 2008, 'sudden stop' in 2007, collapse of the housing bubble in 2007, and high inflation in 2007. Tenge was severely overvalued and the devaluation by 20% returned the real exchange rate back into 'the equilibrium'. The interest rate defense would not have ben credible. The implied interest rates for 1m NDF was close to 30 - 60%, which meant that the short-term interest rates had to be raised and maintained at that level for an extended period of time. The weakened banks would not be able to sustain such interest rates longer than a week. To avert the worst, the central bank had to pour liquidity into the system at very low rates. The choice between a devaluation and a collapse of the banking system was made in favor of the banking system. After 20% devaluation demand for Tenge recovered, but Tenge was not undervalued immediately after the devaluation; it became undervalued only in 2010, when oil prices rose to a record level.
This devaluation was different. External debt of banks was much lower, capital was much higher, fiscal position was very stable, safely cushion of the to National Fund gives the government much freedom to engage in fiscal stimulus. True, the current account was deteriorating, but was not too far from being in balance. At the low interest rates that prevailed in the market, Tenge was overvalued by may be 5-10%. Pressure on the exchange rate was manageable with NDF rates at about 7% for the most part of 2013 and January 2014. The misaligned exchange rate could have been aligned by means of raising the money market interest rates to the level of NDF. Banks were able to sustain such level of interest rates. In other words, all fundamental factors suggested that the interest rate defense would have been credible and would have succeeded in taking the pressure off the exchange rate by gradual decline in inflation. However, as a result of the devaluation, Tenge became undervalued by about 10%. This gap will translate into inflation very quickly, aligning the exchange rate.
Winners and losers: a view
- a normalization of conditions in the liquidity market,
- a recovery in demand for Tenge,
- the yields on most Tenge-denominated instruments will drop,
- NDF rates will fall to under 2%, and maybe even below zero,
- non-residents may try to bet on strengthening of Tenge and very low risk of default by buying KZT-denominated government debt,
- the National Bank will begin buying foreign exchange and wil buy $3-5bn in the next 3-6 month,
But, all of these effects will be temporary. The rates will start to rise again when inflation eliminates the effect of excessive devaluation (about in a year). The long-term Tenge funding on market terms will not become significantly cheaper.
The main loss for the economy and the financial sector is that periodic devaluations have now become pretty much institutionalized as part of the normal conduct of the monetary policy. But of course this is the instrument that can be used once , and at most twice. The credibility of the monetary policy suffered because of the largely unwarranted devaluation.
And the economy missed a great opportunity to change the process and the mechanisms of the monetary policy. During 2013 there have been tremendous changes in the understanding by the market of the importance of liquidity risk and its connection with the devaluation risk. Demand for Tenge began to depend liquidity risk in addition to the traditional risk of devaluation. And the interest rates began to reflect the balance between these two risks. The money market and the deposit market began to link, which made the deposit market more efficient: the spread between foreign currency and Tenge denominated deposit rates widened and the spread between corporate and retail deposits narrowed. Because of this the dollarization of deposits stopped. Liquidity crunches saw a number of corporates to mobilize liquidity from deposits in order to earn through the reverse REPO. The NBK demonstrated its ability to directly influence the money market rates by interventions in the repo market. Inflation declined, although caused mainly by fiscal tightening, rather than because of real appreciation of Tenge.
This prepared the soil for restoring the credibility of Tenge. Only one final step needed to be made - to manage the interest rates in a systematic and consistent fashion. The devaluation squandered this opportunity.
The exporters, of course, are the winners, but the positive impact will be short-term.
The devaluation is positive for Kazakhmys, KMG EP and Nostrum Oil&Gas. Yesterday, Kazakhmys and KMG EP rose by 25% and 7.5%, respectively, on higher earnings outlook. Obvious benefits are lower costs (in dollar terms) on expenses denominated in tenge and possibly lower capex. The positive impact of the devaluation on earnings of exporters is likely to be short-lived as we expect acceleration of inflation to a double digit number. The impact on the net liabilities is neutral for Kazakhmys and Nostrum Oil&Gas as their borrowings are denominated primarily in dollars, while KMG EP has a debt-free balance sheet. We put our recommendation on KAZ, KMG EP and NOG under review.
Meanwhile, the devaluation is neutral for shares of the oil transportation monopolist, KazTransOil, listed on the Kazakhstan stock exchange. The company's revenue is denominated in tenge and the future tariffs should compensate for increased operating costs if inflation accelerates. However, regulatory risks would heighten if the government attempts to control prices by suppressing monopolist's tariffs. We maintain our Buy recommendation and expect total return of 13% on KTO shares over a 12-month period.
Since the already low leverage of Kcell is entirely denominated in tenge, interest expenses will not rise as a result of the devaluation. However, given that more than half of the company's capital expenditures is incurred in foreign currency, we expect the KZT-denominated volume of investments to grow from 14.4% of revenue to 16% of revenue for 2014 and from 32.1% to 35.7% for 2015, when we expect a purchase of assets from TeliaSonera. We do not expect the higher inflation, triggered by the devaluation, to allow Kcell to raise tariffs. Tough position of the regulator, strengthened by the government's commitment to keep inflation under 8%, and intense competition in the market are likely to keep all operators from raising tariffs. The company, as the entire sector, is rather likely to maintain current prices without lowering them for an extended period, than planned before the devaluation. Higher trajectory of prices serves as a base to increase revenue growth forecasts from 1% to 8% in 2014 and from 1.4% to 4.4% in 2015, as well as lift administrative expenses from 15% of revenue to 16.1% in 2014. As a result, our fair stock price estimate amounts to $14.7 for GDR and 2711 tenge for the shares listed on KASE. We also expect a dividend of 317 tenge per share or $1.71 per GDR. We upgrade our recommendation to Buy for GDR, but maintain Hold for KCEL stock on KASE.
Demand for tenge bonds remained subdued during 2013, partly due to the devaluation risk. Now we expect a partial recovery of the demand for tenge corporate bonds and, as a result, tightening of yields. The exception would be for the bonds of issuers, whose balance sheets were less prepared for the devaluation.
Impact of devaluation on the banking sector would not be direct, since banks' open currency position is limited by the regulator, but rather through asset quality. External debt of the banking system decreased from $39.5bn before the 2009 devaluation to $11.5bn at the end of 2013. Banks' currency position is mostly liquid as banks have accumulated enough foreign currency reserves to service their Eurobonds. The major effect of the devaluation would be an increase of burden on borrowers, whose debt is either denominated in FX or secured by real estate, which should depreciate in dollar terms after the devaluation. We expect these factors to boost the share of NPLs. The banks with a significant exposure of loan portfolio to currency risks are Kazkommertsbank and ATF Bank - about 48% of their loans is FX-denominated. According to some regulatory indicators, ATF has reduced its pile of NPLs, while KKB has not. Besides increasing the debt burden on borrowers, devaluation will noticeably reduce purchasing power of the population. This over time would increase pressure on property prices and weaken prospects of recovering bad loans related to real estate. More than half of KKB's loan portfolio is exposed to the real estate and construction sectors. As a result, we expect the devaluation to increase the risks for the banking sector and to raise the yields on their FX-denominated Eurobonds, but the magnitude of the effects makes them insignificant.