MANAT IN A RAGING SEA

The Central Bank of Azerbaijan (CBA) has announced switching from 21 December 2015 to a floating exchange rate for the manat. "The Central Bank has decided to switch to a floating exchange rate for the manat from 21 December 2015. On the basis of this decision, the exchange rate of the manat will be determined depending on demand and supply in the foreign exchange market," the statement says.

The Central Bank took this decision given the strengthening of negative foreign shocks, to balance the balance of payments, preserve foreign exchange reserves at a critical level and maintain the competitiveness of the national economy. The Central Bank stresses that oil prices have been on the decline since July 2015. "In some countries, which are Azerbaijan's key trade partners, the national currency has depreciated 100 per cent in comparison with early 2014," the statement says.

50-per-cent devaluation

Therefore, the Azerbaijani currency's exchange rate for 21 December was set at 1.55 manats for one dollar against the 1.0499 manats for one dollar on 18 December. The euro is now 1,685 manats.

There were a plenty of factors that predicted a second round of devaluation this year (the first one was on 21 February 2015, when the exchange rate of the manat fell by 34 per cent to 1.05 for one dollar). These were the rapid decline in oil prices to 10 years' lows, the weakening of the national currencies of neighbouring Russia and Kazakhstan, and the decision of the US Federal Reserve to raise interest rates.

The World Bank had also pointed to the danger of low oil prices for the exchange rate of the manat. "Low oil prices mean low oil revenues for Azerbaijan. In addition, regional currencies such as Russian ruble, Kazakh tenge and Turkish lira have been depreciating strongly in the past year. This forces market participants to sell off their manats. Furthermore, because of manat's appreciation in real terms, the competitiveness of Azerbaijani goods in the regional markets becomes challenging. All these factors trigger the authorities to react to the external developments and adjust the manat exchange rate accordingly. Conseq-uently, the interplay of oil price, regional currencies and the Fed's interest rate decisions will create an environment in which the Azerbaijani authorities will shape their responses," World Bank Regional Director for the South Cau-casus Mercy Tembon told Azernews last week.

Many experts had been discussing since early December whether the CBA would be able to maintain the exchange rate of the manat and pointed to the likelihood of a rapid fall of the national currency in the event of a switch to a floating exchange rate.

According to Report news agency, over the last two weeks the CBA had sold in the market nearly 750m dollars, thus decreasing its foreign currency reserves to 5.5bn dollars.

Furthermore, according to the CBA, the current account surplus of Azerbaijan's balance of payments in January-September 2015 decreased by a factor of as high as 37.7, totalling only 240.5m dollars.

In total, the exchange rate of the manat has almost halved against the dollar in 2015.

By switching to a floating exchange rate the CBA effectively minimizes its impact on the currency market and stops setting the exchange rate through intervention. In the future, we can see the manat both considerably appreciating or falling. The move aims primarily to preserve the CBA's foreign exchange reserves, which have declined a lot. On the one hand, this was due to the fall in global oil prices, which, as mentioned above, led to a significant reduction in the surplus of the balance of payments and, on the other hand, due to an active dollarization of the economy. Most of people's bank deposits were actively changed into dollars in late 2014. As a result, while 63 per cent of all deposits in July 2014 were in manats and 37 per cent in foreign currency, a year later these were, respectively, 28 per cent and 72 per cent.

Federal Reserve chooses increase

The CBA's decision overshadowed for Azerbaijanis the main economic news of last week - the increase in interest rates by the Federal Reserve System from a corridor of 0-0.25 per cent to 0.25-0.5 per cent. The Fed raised the rates for the first time in almost 10 years - the last time the rate went up was in June 2006. The world had long expected this decision, since the Fed rate rise confirms the strengthening of the US economy.

At the same time, of more interest for analysts were statements by the Fed's chief, Janet Yellen, on prospects for the US economy and the direction of the movement of the Fed rate. Yellen confirmed that the economy was developing in a positive way. Unemployment in the United States is 5 per cent, which means almost full employment, economic growth is expected to be 2.1 per cent this year and 2.4 per cent in 2016. Inflation will gradually rise to reach the target level of 2 per cent in 2018.

In accordance with these expectations, the Fed plans to continue to increase interest rates - four times by 0.25 per cent each time in 2016, gradually raising them to 3.25 per cent in 2018.

Pressure on emerging economies

The Fed's decision and forecasts may lead to appreciation in the dollar's exchange rate and an outflow of capital from emerging economies. However, analysts do not expect the decision to lead to a big collapse in the currencies and markets of developing countries - the rate increase had long been expected and current prices at stock markets have taken into account the Fed's decision already.

However, a subsequent rise in the Fed rate will further increase the yield of US treasury bonds and actualize an inflow of capital into the US market. Accordingly, developing countries will be losing, especially, experts believe, the BRICS countries (Brazil, Russia, China and South Africa), as well as Turkey.

On the other hand, the increase in the Fed rate will lead to an increase in the cost of lending around the world, which also affects prospects for the economic development of emerging markets.

According to an EBRD statement, the increase in the Federal Reserve rate may increase market volatility and the cost of funding in countries where the bank conducts operations. According to EBRD analysts, the most affected ones will be countries that are exposed to geopolitical uncertainties, such as Turkey, Russia and Ukraine, and countries with a large share of dollar-denominated liabilities, including Jordan, Ukraine and Turkey.

However, in Turkey's case, this impact will to a certain extent be offset by low oil prices, as Turkey is a major oil importer, and in Russia's case it will be offset by a low foreign debt.

Chiefs of government agencies in charge of the economy in the Russian Federation do not expect the Fed's decision to have a serious negative impact on this country's economy.

According to Russian Finance Minister Anton Siluanov, Russia's "finance will react to this change to a minimal extent, since we have a large amount of reserves, and we have capital outflow decreasing. It will definitely not have an impact on the budget, and will have almost no impact on the ruble's exchange rate".

The minister explained that there could only be an indirect impact on the Russian budget through the price of oil, Interfax reported.

Economic Development Minister Aleksey Ulyukayev echoed Siluanov's views. "Eighty per cent of analysts believed that the US Fed would decide to increase rates. I think that there was high preparedness for this, everybody had been expecting this, everybody is prepared for this, concluding forward contracts and so on, and this has been taken into account in futures oil contracts and other contracts" - this is how the minister substantiated his forecast that the decision would not have a particular impact on the macroeconomic situation in Russia.

20 dollars per barrel

But however it may be, the US Federal Reserve decision and, most importantly, forecasts for future moves will put pressure on both the markets and currencies of other countries and commodity prices. A large blow will be dealt to oil prices, which have "gone" considerably below the boundary of 40 dollars anyway.

At the same time, oil prices are also pressured by the forthcoming lifting of the ban on oil exports from the United States. Although experts do not expect the release of large amounts of oil to the world market, the psychological reaction of the market will be in the form of a decline in oil prices for at least a short period of time. Oil prices will also be moved down by the upcoming lifting of sanctions against Iran. According to experts, these two factors combined may push oil prices down to 30 or even 20 dollars per barrel. However, most experts are still positive with respect to the price of oil next year. Such a low level of prices cannot last too long in view of prospects for sustained growth in the USA and Europe, which is reflected in the growth of consumption. Despite a significant increase in oil production owing to the shale revolution, the United States continues to remain an oil importer.

Analysis of all these factors allows experts and international financial organizations to forecast the average price to be around 50 dollars per barrel in 2016. This means that oil prices will start the year at a low level of around 35-40 dollars and should confidently rise beyond 60 dollars in the second half of the year.

What is to be expected next?

As in Russia's case, of pivotal significance for Azerbaijan is the price of oil and not the Fed's decision. The low level of foreign debt and the underdevelopment of the stock market effectively guard the country from the negative impact of decisions taken by the world's financial centres. In this sense, the Fed's decision has no impact towards an outflow of capital, because Azerbaijani banks and companies do not have freely traded shares at global stock exchanges. But, on the other hand, the change in Fed rates may lead to an increase in interest rates on loans obtained from international capital markets. In this respect, it will become more difficult to reduce interest rates on loans within the country.

In the future, a certain impact on the manat could also come from a Fed rate increase. We should take account of the fact that the exchange rate of the manat is based on a bi-currency basket that includes the euro and the US dollar. Experts have long predicted that the dollar may appreciate to a parity of 1:1 with the euro from the current level of 1.085-1.09 dollars for one euro. In view of the transition to a floating exchange rate, the dollar-to-euro ratio will also put pressure on the exchange rate of the manat.

The Azerbaijani government will now have to strengthen control over prices in the consumer market, first of all, food. After the February devaluation this was largely done. An unjustified price rise was prevented. On the other hand, it is also almost impossible to avoid an impact on prices from the almost double devaluation over one year.

However, new realities stem from the introduction of a floating exchange rate. Based on the example of other countries that have switched to this kind of an exchange rate, (Russia, Kazakhstan), we can predict that if the exchange rate was set at 1.55 manats for 1 dollar today, then in theory it could be even lower a week later. This volatility is quite expected under a minimum intervention in the market by the CBA, and the government needs to prevent sharp changes in prices until the market stabilizes at a certain price level.

On the whole, the World Bank forecasts a difficult period in 2016 for emerging economies. World Bank President Jim Yong Kim said in an interview to Japanese business newspaper Nikkei that 2016 would be "a disappointing year" for the global economy as a whole, and especially for emerging markets, which should make structural reforms. "Pure commodity exporters need to focus more on value-added. Instead of shipping out raw commodities, they need to be involved in processing them. Many economies have to diversify the sources of their economic growth. With oil and gas prices so low, it is also time to remove fossil fuel subsidies," Kim.

Azerbaijan launched such structural changes several years ago. The country's leadership actively invested in the development of transport infrastructure, including the construction of the Baku-Tbilisi-Kars railway corridor, recently decided to intensify work on the North-South corridor, and large investment has been made in port and road infrastructure. Developing in parallel is the manufacturing sector through the creation of technology parks of wide profile. Special attention is also paid to the development of tourism and the information technology sector, which should also make a contribution to the post-oil period of the country's development.

Measures taken to develop the non-oil sector will be the future trend in the development of the country's economy. One thing to be done is weather this period of global economic instability. Azerbaijan does have a cushion for that - no matter how low the CBA's reserves go down, the country's overall capacity, including reserves held by the Oil Fund, allow us to expect a less painful exit from the critical phase.