DOLLAR AND EURO IN ONE BASKET

Downward trends in the international financial markets have decided the National Bank of Azerbaijan to change its currency exchange policy. By decision of the bank's board, a policy of maintaining the value of the new Azerbaijani manat stable against a double-currency basket of the dollar and the euro is pursued from 11 March.

Manat will become even stronger

The share of the currencies in the basket will change stage by stage. At the final stage, the National Bank intends to achieve the optimum structure of the currency basket, in consideration of the role of the currencies of the countries which play leading roles in international economic relations.

The decision was caused by the falling exchange rates of the US dollar, which has about a 90% share of the total amount of foreign currency flowing into the country. For the same reason, the National Oil Fund switched earlier to the dual-currency structure of assets (55% dollar and 35% euro), which enabled it to avoid a fatal plummeting of the value of its assets in the national currency.

The dual-currency system makes it possible to hedge (hedging means engaging in transactions as protection against the existing market, percentage rate or currency risks - Editor's office) against the contingency of a dramatic fall in one of the currencies and to avert an excessive hike in the value of Azerbaijani manat, which would objectively render the Azerbaijani economy less competitive.

Let us note that, by mid-March, the dollar fell as low as 1.56 for 1 euro. As a result, in Goldman Sachs' assessment, recalculating the national GDPs for 2007 according to the new exchange rate shows that the total GDP of the 15 states of the euro zone already exceeds the GDP of the United States.

The National Bank's decision has already resulted in a strengthening of the official exchange rate of the Azerbaijani manat against the US dollar from 0.8417 manat on 11 March to 0.8407 manat on 12 March, and against the euro from 1.2931 to 1.2924 manat.

Preventing the import of inflation 

Emin Huseynov, head of the National Bank Statistics and Research Department, said that the bank's decision to introduce the dual-currency exchange rate policy pursues the goal of preventing further falls in the nominal effective exchange rate (NEER).  Forming the currency basket with these specific currencies was influenced by the domination of the dollar and euro in foreign economic relations.

"Looking back at 2007, one of the significant factors affecting inflation was imports," Mr. Huseynov noted. "One third of inflation was the result of the increased prices of trading partners' products; this influenced the NEER - the unadjusted weighted average value of a country's currency relative to all major currencies being traded within an index or pool of currencies of the country's foreign economic partners."

Given that imported goods have tobe sold for manats, imported goods are expensive because of the fluctuations of the exchange rate of the leading international currencies.  Last year, the manat-to-dollar exchange rate changed by 3% in the manat's favour, but the euro rose against the manat because of the excessive fall of the dollar, not only against the euro, but also against the currencies of other trading partners. Mr. Huseynov said that to avoid an excessive appreciation of the manat's NEER, the National Bank decided to factor into its calculation not only the manat-to-dollar rate in the domestic market, which had been the case thus far, but also the dynamic of the dollar's exchange rate against the currencies of other foreign economic partners of Azerbaijan on the international currency exchanges.

"To make it easier to influence the NEER, we are beginning to readjust the manat exchange rate toward the euro, which will enable us to better predict the dynamic of the NEER and prevent the importing of inflation into the country," the National Bank official said.

Because of the closer integration of Azerbaijan into the European economic system, many economic entities in the country which transact with euro zone countries are susceptible to currency risks. To avoid a negative impact on the manat-to-dollar rate, we will begin to take into account the US currency's rates compared to other leading currencies.

In Mr. Huseynov's opinion, the transition to the adjustment of the exchange rate using the two-currency basket will stimulate the development and broadening of the local currency market, its participants and economic agents, because they will realize the need to monitor the euro rates and other global processes taking place in the international markets. This will also stimulate market players to use more advanced risk management methods.

Domestic euro market should be created

It has to be said that the National Bank's decision to switch to the dual-currency basket was also endorsed by the Baku Inter-Bank Currency Exchange (BBVB). BBVB manager Farhad Amirbаyov said that the introduction of the dual-currency basket against the backdrop of the rising share of the euro in import operations and dramatic changes in exchange rates on the international markets was a timely decision. "Already, 65% of imports to Azerbaijan come from euro zone countries or from countries which are closely linked to them (including Turkey), which stimulates the growth in the turnover of euro operations in the domestic currency market. As a result, their share has increased from 4% of the currency market in 2006 to 9.9% in 2007. In 2008, the growth of trading operations conducted in the euro at the BBVB was 200%, although the absolute numbers remain small," Mr. Amirbаyov said.

Let us note here that, in 2006, the BBVB turnover of euro trade reached 438,000 euro, in 2007 -- 16.506 million, and in 2008, it has already exceeded 3.44 million euro.

"The introduction of the dual-currency basket will increase the volatility of the manat-to-euro rate and accelerate the fall in the dollar. At the same, currency risks will increase dramatically, and it remains to be seen how low the dollar can fall. The optimum structure of the basket also remains unclear," said Mr. Amirbayov.

The head of the exchange floor maintains that with the change in the structure of imports, the growing demand for euros will lead to a broadening of that segment of the domestic currency market to the level of several billions of euros. However, there are no permanent listings or operators of the euro currency market yet. A significant part of the operations in euros are still inter-bank currency conversion operations.

In these conditions, the country has to create a domestic euro market, and BBVB shareholders, among whom there are National Bank shareholders too, could discuss the issue of admitting non-residents to the currency exchange markets. "This would have a positive effect on euro trade in the country, although it would require changes to the membership rules of the BBVB's currency section. Non-residents are already showing an interest. The National Bank approves the idea of the euro market. There are no permanent euro listings on the domestic market yet, however, and the National Bank will have to use dollar cross rates to calculate the rate of the euro for a long time to come" said Mr. Amirbayov 

In early April, the BBVB will hold a meeting with member banks to discuss the consequences of the introduction of the dual-currency basket and instruments of adjustment to the change of situation in the currency market. "We suggest the banks use the existing instruments of liquidity management, like currency swaps and forward exchange transactions with next-day payment (T+1 or TOM transactions) and money market instruments. For its part, the BBVB is considering the possibility of introducing the instrument of direct dollar-to-euro conversions. This issue will be discussed with the banks to establish how pressing it is for them. The results of the discussion will make it possible to specify the time table for introduction of this instrument.

In the mean time, the BBVB also predicts a growing demand for hedge instruments because the dual-currency basket will increase the demand for currency risks hedging instruments and for information on the situation in the international markets. "In the new situation, it will make sense for banks to coordinate their foreign currency plans with major customers at least 3 months in advance," Mr. Amirbayov said. The plan will make it possible to create currency reserves for customers' needs in a timely fashion. "At the same time, the banks have no instrument which would serve as a 100% guarantee of the safety of the assets. This is why the banks have no other choice but to increase their own capitalization and maintain high liquidity," said Mr. Amirbayov said.

In addition, the BBVB deems it necessary to diversify the mechanisms of liquidity regulation.  "The main instrument in this field today is repurchasing operations with the National Bank's short-term notes. However, 90-92% of the note repurchase transactions are performed by the National Bank itself, whereas the inter-bank (dealer) repurchase agreements do not exceed 10% of the turnover. And in order to effectively refinance the banking system, the National Bank needs other instruments too," Mr. Amirbayov said.

So, the National Bank's decision to adopt a dual-currency basket will play a positive role in the development of the Azerbaijani economy, but for the results of the transition to be effective, a number of additional measures have to be taken.