## _cr05240

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### I. NON-OIL SECTOR GROWTH

- Hydrocarbon production and measurement
  - Hydrocarbon production has more than doubled since 1996; since 2000 other sectors (construction and transportation) expanded rapidly.
  - National accounts narrow definition: hydrocarbon sector = oil and gas extraction only; services directly related to extraction are placed in non-oil sector under the narrow definition.
  - Broad hydrocarbon sector measure: oil extraction value added + inputs from construction, transportation, trade, real estate, financial services, and metallurgical industry; oil refining excluded (accounts for about 5 percent of oil-related output).

- Broad vs. narrow size and growth
  - Under narrow definition: hydrocarbon share rose from 3 percent of (real) GDP in 1998 to 5 percent in 2004.
  - Under broad definition: hydrocarbon share rose from 9 percent of (real) GDP in 1998 to 16 percent in 2004.
  - On average about 40 percent of total value added in the construction sector and 10 percent in the transportation sector represent inputs to oil production.
  - Real non-oil output growth, after adjusting for oil-related services, has averaged over 8 percent a year since 1998, compared with about 9 percent annually without the adjustment.
  - Real output in oil-related transportation has increased by more than 11 percent a year, on average; the rest of the transportation sector has grown by about 8 percent a year.
  - Even with the adjustment, estimated non-oil sector growth in Kazakhstan compares favorably with other CIS economies; non-oil output growth paths in Kazakhstan and Russia have been remarkably similar.

- Trend and sources of growth
  - Trend non-oil output growth over 1998–2004 is estimated at around 8 percent (Hodrick-Prescott filter used over 1998–2004; alternative filters and sample periods give similar results).
  - Non-oil output remained below trend during 1999–2002, but has exceeded trend since then.
  - Growth accounting (Cobb-Douglas, Kt = δ Kt-1 + It; α elasticity to labor):
    - Average annual productivity (TFP) growth over 1998–2004: about 4 percent.
    - Contribution of capital and labor accumulation stronger than for other transition economies.
    - Decomposition suggests steady decline in contribution of labor accumulation to overall growth, indicating approach to full employment.
    - If TFP and capital accumulation rates remain broadly in line with recent past, projected non-oil sector growth of 6–7 percent a year over the medium term.
  - Methodological parameters:
    - Non-oil output defined as total output less value added in mining.
    - Elasticity α assumed 0.5 and depreciation rate δ assumed 5 percent in main calculations; alternatives for α ∈ [0.3-0.7] and δ ∈ [3-10] percent were examined.

- Investment, employment, wages, productivity
  - Investment:
    - Non-oil sector investment increased markedly; transportation and communications account for the bulk of the increase.
    - No direct data attributing transport and construction investment share to hydrocarbon sector; “true” non-oil investment likely smaller than aggregate data indicate.
  - Employment:
    - Employment growth in nontradables generally stronger than in tradables.
    - Employment growth rate in oil and other mining sectors (including metals): about 8 percent.
    - Non-mining sector employment growth: less than 3 percent.
    - Within non-mining: shares of public administration and construction in total employment have grown; share of manufacturing declined significantly.
    - Agriculture’s share rose sharply in late 1990s, then declined in recent years; large increase in agricultural employment in 2000 partly due to better measurement of informal economy.
  - Wages (percent of nominal average monthly wages; series for 1999–2004)
    - Total of economic activities: 100 (1999–2004)
    - Mining: 208, 223, 212, 197, 197, 189 (1999–2004)
    - Agriculture: 39, 39, 40, 40, 42, 42
    - Construction: 134, 146, 155, 160, 146, 136
    - Manufacturing: 116, 123, 115, 109, 107, 107
    - Transport: 124, 131, 141, 143, 148, 147
    - Financial and real estate services: 130, 136, 148, 165, 180, 162
    - Public service: 95, 82, 87, 83, 78, 92
  - Labor productivity (output at constant 1999 prices per worker), average growth 1999–2004:
    - Agriculture: 0.4
    - Construction: 3.3
    - Manufacturing: 13.0
    - Transport: 12.3
    - Other services: 7.8

- Conclusions (non-oil)
  - Adjusting for oil-related services reduces estimated size and growth of Kazakhstan’s non-oil sector; under broad definition hydrocarbon sector substantially larger.
  - Trend-filtering and growth accounting suggest real non-oil sector growth of 6–8 percent a year can be maintained over the near term if past TFP and capital accumulation rates persist.
  - Indicators point to potential capacity constraints and weakening prospects for growth driven by increased labor inputs as unemployment declined from 12.8 percent in 2000 to 8.4 percent in 2004.
  - Structural change: resource shift toward non-tradable activities — share of tradables in non-oil sector declined significantly in value added and employment; services and construction expanded.

*Prepared by Anna Ter-Martirosyan; excerpt from "Republic of Kazakhstan — Selected Issues", International Monetary Fund, June 9, 2005.*

### II. FISCAL MANAGEMENT OF KAZAKHSTAN’S OIL WEALTH — Key findings and projections

- Context and objectives
  - Higher oil revenue and prospects for further rises permitted rapid expansion of public spending and a widening of Kazakhstan’s non-oil budget deficit in recent years.
  - Chapter questions:
    - What level of non-oil deficit can be sustained while maintaining oil wealth?
    - How does near-term fiscal stance compare with sustainable level?
    - What framework can help ensure long-term sustainability?

- Oil production and revenue (observed)
  - Oil and gas condensate output in 2004: 59 million metric tons (about 1.2 million barrels per day).
  - Oil output increased about two-fold since 1999 (29.4 million metric tons).
  - In 2004, oil-related activity estimated to account for about 30 percent of nominal GDP and half of export earnings.
  - About 30 percent of total government revenues derived from the oil sector in 2004, compared to 6 percent in 1999.
  - Oil revenues (definition used by Fund staff): corporate income taxes, royalties, bonuses, and payments from production-sharing agreements.

- Projections and reserves
  - Proven and probable oil reserves: 35 billion barrels; total reserves estimated at around 50–60 billion barrels.
  - Official scenario: oil production expected to double by the beginning of next decade, and triple over the next 10–15 years, reaching 3.5 million bpd; projected to moderate to around 2.5 million bpd by 2030.
  - Government oil revenue projected to grow from $4.2 billion in 2005 to about $16 billion during 2015–30.
  - Oil extraction and transportation costs in Kazakhstan (up to $12 a barrel) are higher than in some other countries.

- Risks and uncertainties
  - Constraints: inadequate transport capacities, environmental considerations, technological challenges (off-shore drilling), and dependence on sizable foreign investments.
  - Example: first phase of Kashagan off-shore field postponed by 3 years till end-2008.

- National Fund of the Republic of Kazakhstan (NFRK)
  - Established in 2001 to reduce impact of volatile oil prices and save oil income for future generations.
  - Rules changed over time; list of companies subject to transfers reduced from 12 to 7 petroleum companies in 2004.
  - Flows: “savings” = 10 percent of budgeted baseline revenue from listed companies (invariant to oil price changes) + “stabilization” component (revenues in excess of receipts at reference oil price fixed at $19 a barrel).
  - NFRK could be drawn down if oil prices fall below reference price (has not occurred).
  - NFRK received privatization receipts, special bonus payments, and royalties; is off-budget, managed by the NBK; all assets invested abroad.
  - Since establishment, about 40 percent of oil sector revenue (including one-off bonus payments) saved; NFRK accumulated over $5 billion in assets.
  - Public spending expanded by 27 percent a year on average during 2000–04; share of capital spending doubled; social spending increased.

- Redesign and integration proposals
  - Consideration to fully integrate NFRK with the budget and adopt a rule linking non-oil fiscal deficit to development spending (public capital spending).

- Sustainable non-oil deficit (PIH framework)
  - Approach: Permanent Income Hypothesis (PIH) — maintain value of oil wealth in real per capita terms by spending expected income from oil wealth.
  - Baseline assumptions:
    - WEO assumptions for 2005−10 and staff projections for 2011−49.
    - Oil production peaks at 3.5 million bpd in 2017−18.
    - Oil prices projected to decline to $40 per barrel by 2020, remaining constant in real terms thereafter.
    - Non-oil economy growth projected to moderate from about 7–8 percent a year in near term to an average of 4.5 percent a year over the long term (after 2020).
  - Baseline PIH result:
    - Non-oil deficit that maintains oil wealth in real per capita terms ≡ 6−7 percent of GDP in the near term, declining markedly relative to GDP over the long run.
  - Sensitivities:
    - Permanent reduction in oil production by 20 percent starting in 2010 would reduce average sustainable non-oil deficit for 2005–10 by 1 percent of GDP.
    - Permanent decrease in oil price by 20 percent (relative to baseline) would reduce average sustainable non-oil deficit for 2005–10 by about 2 percent of GDP.
  - Note: Allowing depletion of oil wealth would imply a higher deficit path.

- Near-term fiscal stance and rule proposals
  - Projected non-oil deficit for 2005: 5.4 percent of GDP (well within sustainable level under baseline).
  - If baseline holds, non-oil deficit would need to narrow to 3−4 percent of GDP over the medium term and to about 1−2 percent of GDP over the longer run.
  - Example formula: Def_t = A + b * F_{t-1}, where F_{t-1} = outstanding NFRK assets at start of year; b could equal expected annual return on NFRK assets; A could be fixed in tenge terms for a period (e.g., three years). Formula yields near-term A-dominated deficit and steady reduction relative to GDP consistent with PIH declining path; should retain flexibility to adjust for major changes.

- Fiscal conclusion
  - Kazakhstan can sustain non-oil deficits of over 5 percent of GDP in the near term without reducing the value of oil wealth; sustainable deficit will decline markedly relative to GDP over the longer term.
  - Sustainable path highly sensitive to unanticipated developments in oil prices, production, reserves, and macroeconomic variables.
  - Fiscal strategy should be cast within a longer-term framework and retain flexibility to respond to major changes in expectations about future oil earnings.

### III. AN ANALYSIS OF BANK CREDIT GROWTH — Profile and key observations

- Objectives
  - Assess sustainability and consequences of rapid bank credit growth (about 50 percent per annum in real terms).
  - Questions: similarity to “catch up” in other transition economies; sectoral and currency composition; key risks and loan-quality evolution.

- Banking sector profile
  - Consolidation: 35 banks operating at end-2004, compared with 71 licensed banks in 1998.
  - Bank branches declined from 458 in 1998 to 377 at end-2004.
  - Three largest banks account for roughly 60 percent of banking sector assets.
  - Foreign banks constitute about one third of banks.
  - Lending interest rates declined markedly over past half decade due to increased competition and, for tenge loans, lower inflation.
  - Foreign currency deposit rates eased with lower global interest rates; tenge deposit rates declined as tenge liquidity increased.

- Remonetization and deposit dedollarization
  - Deposit dedollarization declined markedly since 2001.
  - Ratio of total bank deposits (tenge + foreign currency) = 23 percent of GDP at end-2004.
  - Dedollarization likely reflects growing confidence in the tenge as inflation declined and the tenge appreciated in nominal terms.
  - Pace of dedollarization in Kazakhstan more rapid than in other transition economies.

- Interest rates (weighted period average interest rates; selected series)
  - LIBOR (1 year): 2000: 6.83; 2001: 3.92; 2002: 2.21; 2003: 1.42; 2004: 2.1
  - Foreign currency — Institutions (short-term loans): 2000: 17.1; 2001: 14.2; 2002: 12.3; 2003: 10.2; 2004: 9.2
  - Local currency — Institutions (short-term loans): 2000: 19.7; 2001: 17.7; 2002: 15.6; 2003: 15.5; 2004: 14.5
  - Local currency — Individuals (short-term loans): 2000: 30.6; 2001: 26.2; 2002: 25.0; 2003: 23.3; 2004: 23.6
  - (Full series for demand deposits, term deposits, short-term and long-term loans by currency and sector are provided in the source.)

- Deposits and dedollarization metrics
  - Foreign currency deposits (percent of total deposits), Kazakhstan: 1998: 37.0; 1999: 47.2; 2000: 51.0; 2001: 60.5; 2002: 59.9; 2003: 47.1; 2004: 36.2
  - Total deposits (percent of GDP), Kazakhstan: 1998: 4.6; 1999: 8.5; 2000: 11.3; 2001: 13.5; 2002: 16.0; 2003: 15.9; 2004: 22.6

- Aggregate credit growth and assessment
  - Credit grew by over 50 percent in the most recent year reported.
  - By end-2004 the ratio of bank credit to GDP was about 27 percent.
  - Credit growth outpaced other countries and is close to average of EU accession countries.
  - IMF (2004a) found 18 episodes of excessive credit expansion in 28 emerging market economies in 1970–2002.
  - Median real credit growth in the three years preceding the peak of a typical credit boom: 17 percent; Kazakhstan exceeded that median.
  - Only one fourth of sustained rapid credit growth episodes were associated with a subsequent credit collapse.
  - Rapid credit growth has been sustained for six years in Kazakhstan, longer than typical 3½ year emerging market credit boom duration.
  - Hodrick-Prescott filter on quarterly data 1993–2004 indicates real credit outstanding at end-2004 was slightly below estimated trend.

- Composition of bank lending (percent of total bank credit; selected series)
  - By sector:
    - Industry: 1998: 23.4; 1999: 21.7; 2000: 30.5; 2001: 34.1; 2002: 34.3; 2003: 28.0; 2004: 19.5
    - Agriculture: 1998: 9.9; 1999: 7.9; 2000: 9.4; 2001: 10.3; 2002: 11.4; 2003: 12.0; 2004: 8.4
    - Trade: 1998: 23.7; 1999: 27.8; 2000: 33.2; 2001: 30.9; 2002: 29.4; 2003: 28.3; 2004: 26.9
  - By use:
    - Construction and reconstruction: 1998: 4.8; 1999: 5.3; 2000: 5.4; 2001: 5.6; 2002: 4.6; 2003: 10.9; 2004: 10.3
    - Construction and acquisition of real estate by individuals: 1998: 1.9; 1999: 1.7; 2000: 1.1; 2001: 1.1; 2002: 1.6; 2003: 3.8; 2004: 8.7
    - Mortgage credit: 2001: 0.1; 2002: 0.2; 2003: 0.6; 2004: 1.8
    - Consumer credit: 1998: 1.9; 1999: 2.0; 2000: 2.4; 2001: 3.1; 2002: 4.7; 2003: 6.5; 2004: 9.7
  - Key points:
    - Share of property-related loans rose from about 7 percent in 2000 to 19 percent in 2004.
    - Share of consumer lending rose from about 2 percent to almost 10 percent over same period.
    - Bulk of mortgage loans—almost 90 percent—are foreign currency denominated.
    - Share of foreign currency lending in total bank credit (percent): 1998: 43.2; 1999: 53.9; 2000: 51.0; 2001: 71.2; 2002: 68.5; 2003: 55.5; 2004: 51.9.

- Cross-border lending and external liabilities
  - Credits to borrowers abroad = about 14 percent of banks’ total credit operations at end-2004, vs less than 1 percent in 2000.
  - Banks acquired stakes in banks in Russia, Ukraine, Belarus, and the Kyrgyz Republic.
  - At end-2004, net external liabilities > 35 percent of total assets of commercial banks, vs just over 5 percent in 2000.

- Net foreign currency assets and currency risk
  - Net foreign currency denominated assets of banking system turned negative in the most recent year.
  - Direct currency mismatch relatively small; indirect currency risk significant via foreign-currency lending to borrowers with limited foreign-currency earnings.

- Banking system soundness
  - Capital adequacy and liquidity:
    - Average capital adequacy ratio at end-2004: 15.9 percent (prudential norm: 12 percent).
    - Liquidity ratio (liquid assets to short-term liabilities): over 100 percent (minimum requirement: 30 percent).
    - Banks’ return on assets over past six years: ranged from 1 percent to 2 percent.
    - Banks’ return on equity over past six years: ranged from 8 percent to 14 percent.
  - Loan quality and provisions:
    - Loan losses (percent of total loans): 2000: 2.1; 2001: 2.1; 2002: 2.0; 2003: 2.1; 2004: 2.9
    - Proportion of classified loans: 37 percent at end-2003 → 41 percent at end-2004.
    - Loan-loss provisions: 7 percent of total loans at end-2004, compared with 6 percent at end-2003.
  - Portfolio quality (percent of asset value), 2003 vs 2004:
    - STANDARD: 2003: 61.1; 2004: 56.2
    - CLASSIFIED: 2003: 36.8; 2004: 41.0
    - LOSS: 2003: 2.1; 2004: 2.9
  - Related-party exposures and financial-industrial groups:
    - Substantial cross-relationships and complex ownership structures; progress in monitoring but continued scrutiny warranted.
  - Operational challenges:
    - Rapid credit growth necessitates strengthening internal risk management systems.

- Conclusions (banking)
  - Credit growth rapid even by transition-economy standards, but aggregate data do not clearly indicate it has been “excessive.”
  - Lending and borrowing patterns increased exposure to property sector and international financial markets.
  - Basic indicators of aggregate financial position appear sound, but moderate deterioration in loan quality over the past year suggests need for continued vigilance.

### IV. REMONETIZATION, INTEREST RATES, DEPOSITS

- Remonetization and deposit dedollarization
  - Deposit dedollarization declined markedly since 2001.
  - Total bank deposits (tenge + foreign currency) = 23 percent of GDP at end-2004.
  - Dedollarization likely reflects declining inflation and nominal appreciation of the tenge.

- Interest rate series (selected entries preserved)
  - Foreign currency — Institutions (demand deposits): 2000: 0.0; 2001: 1.1; 2002: 1.2; 2003: 1.3; 2004: 1.0
  - Foreign currency — Individuals (term deposits): 2000: 8.3; 2001: 7.7; 2002: 7.1; 2003: 6.1; 2004: 5.8
  - Local currency — Institutions (term deposits): 2000: 6.5; 2001: 5.7; 2002: 5.2; 2003: 4.2; 2004: 3.0
  - Local currency — Individuals (term deposits): 2000: 15.9; 2001: 14.3; 2002: 11.3; 2003: 10.6; 2004: 9.4
  - LIBOR (1 year): 2000: 6.83; 2001: 3.92; 2002: 2.21; 2003: 1.42; 2004: 2.1

- Deposits and foreign currency shares
  - Foreign currency deposits (percent of total deposits), Kazakhstan: 1998: 37.0; 1999: 47.2; 2000: 51.0; 2001: 60.5; 2002: 59.9; 2003: 47.1; 2004: 36.2
  - Total deposits (percent of GDP), Kazakhstan: 1998: 4.6; 1999: 8.5; 2000: 11.3; 2001: 13.5; 2002: 16.0; 2003: 15.9; 2004: 22.6

### V. LONG-TERM PROSPECTS FOR THE REAL VALUE OF THE TENGE — PPP AND BALASSA-SAMUELSON EFFECT

- Recent exchange rate and inflation developments
  - Since 2000 the tenge-dollar real exchange rate appreciated by some 28 percent, with most appreciation occurring in 2003–04.
  - Cumulative inflation differential with the United States during 2000–04: about 17 percent; nominal appreciation was about 12 percent cumulatively.
  - Against the ruble during 2000–04:
    - Russia’s inflation exceeded Kazakhstan’s by a cumulative 32 percent.
    - Tenge appreciated in nominal terms vis-à-vis the ruble by 11 percent.
    - Resulting cumulative real depreciation of the tenge against the ruble: about 17 percent.
  - Trade-weighted (effective) real external value of the tenge has remained broadly flat after earlier mid-1990s appreciation and post-1998–99 depreciation.
  - Measurement complications for REER due to oil’s large trade share and changing trade patterns; analysis focuses on tenge vs U.S. dollar.

- PPP, Balassa-Samuelson mechanism, and empirical proxying
  - PPP framework: departures from PPP can be large and narrow only gradually; CPI-based REER measures rates of change from base year.
  - Balassa-Samuelson mechanism: higher tradables productivity relative to nontradables → real appreciation via higher nontradables prices.
  - Empirical proxy: real per capita GDP differentials from Penn World Tables (PWT) used as proxy for relative productivity differentials.

- Cross-country empirical finding
  - Staff OLS cross-section regression for 133 countries (relative to the United States) yields a Balassa-Samuelson coefficient of 0.394 — a one percent increase in a country’s real per capita GDP (relative to the U.S.) is associated with a real appreciation (against the US dollar) of about 0.4 percent.

- Kazakhstan-specific PPP finding and adjustment
  - Kazakhstan in year 2000: actual real exchange rate was 34 percent below its estimated long-run PPP level in 2000, implying an undervaluation of 66 percent.
  - Of the 66 percent undervaluation in 2000, 28 percentage points were corrected by end-2004.
  - Half of the remaining estimated deviation at any point is expected to close over the subsequent decade (Frankel, 2005).

- Staff projections for medium-term real appreciation
  - Projected real per capita GDP growth over next decade: Kazakhstan: 8.1 percent (annual); United States: 2.4 percent (annual).
  - Annual growth differential: 5.7 (8.1 minus 2.4).
  - Using coefficient 0.394 × 5.7 → estimated annual appreciation of the long-run real exchange rate: about 2¼ percent a year.
  - If one half of the remaining gap at end-2004—52 percent—were closed over the next decade, implied annual real appreciation ≈ 2½ percent.
  - Combined effects imply the tenge may be expected to appreciate by an average of 4¾ percent a year in real terms against the dollar over the medium term.

- Transmission channels and inflation trade-offs
  - Real appreciation can be achieved via nominal appreciation or higher domestic inflation relative to U.S. inflation if nominal appreciation is resisted.
  - Inflation implications under relatively inflexible nominal tenge-dollar exchange rate:
    - With current U.S. inflation of about 3½ percent, average annual CPI inflation in Kazakhstan would be over 8 percent in the near term.
    - With projected longer-term U.S. inflation of 2½ percent, average annual CPI inflation in Kazakhstan would be over 7 percent over the medium term.
  - Expansionary fiscal policy or cyclical overheating could push inflation significantly higher.

- Costs, thresholds, and risks of higher inflation
  - High inflation risks reversing remonetization and dedollarization gains, slowing financial deepening, and harming growth.
  - Cited thresholds and findings:
    - Bruno and Easterly (1998): long-run growth lower if inflation > 40 percent per annum.
    - Fischer (1993): growth gains negligible once inflation in single-digit levels.
    - Khan and Senhadji (2001): inflation rates exceeding 1–3 percent in industrial countries and 11–12 percent in developing countries would lower growth.
    - Christoffersen and Doyle (2000): transition-economy threshold estimated at 13 percent.
    - Khan, Senhadji, and Smith (2001): inflation > 6 percent associated with slower financial deepening (private credit/GDP).

- Policy implications and conclusions
  - Central quantitative conclusion: estimated medium-term average real appreciation of the tenge against the dollar: 4¾ percent a year.
  - Policy trade-offs:
    - Allow equilibrating real appreciation via nominal exchange rate flexibility to avoid higher inflation.
    - Resisting nominal appreciation would produce real appreciation via higher inflation, with attendant risks: higher inflation, reversal of remonetization, slower financial deepening, negative effects on growth — risks heightened by expansionary fiscal policy or cyclical overheating.
  - Caveats:
    - Balassa-Samuelson effect explains only about half of cross-country variability; PPP data are subject to measurement errors; near-term movements depend on capital flows, fiscal policy, and cyclical factors.

*Prepared by Mariusz Sumlinski and Hamid Davoodi; IMF staff chapter excerpts.*

### 2005. The views expressed in this document are those of the staff team and do not necessarily reflect

### I. NON-OIL SECTOR GROWTH

### A. Introduction
- Hydrocarbon production has more than doubled since 1996; since 2000 other sectors also started to show significant growth, with construction and transportation expanding particularly rapidly.
- National accounts narrow definition: hydrocarbon sector = oil and gas extraction activity only. Services directly related to extraction (construction of extraction facilities, transportation of petroleum, etc.) are placed in non-oil sector under the narrow definition, leading to overstatement of non-oil activity.
- A “broad” hydrocarbon sector measure is constructed by adding inputs from construction, transportation, trade, real estate, financial services, and metallurgical industry to oil extraction value added; oil refining is excluded (accounts for about 5 percent of oil-related output).

### B. Broad vs. Narrow Size and Growth
- Adjustment for oil-related services implies:
  - Under narrow definition: hydrocarbon share rose from 3 percent of (real) GDP in 1998 to 5 percent in 2004.
  - Under broad definition: hydrocarbon share rose from 9 percent of (real) GDP in 1998 to 16 percent in 2004.
- Adjustment significance:
  - On average about 40 percent of total value added in the construction sector and 10 percent in the transportation sector represent inputs to oil production.
- Impact on measured growth:
  - Real non-oil output growth, after adjusting for oil-related services, has averaged over 8 percent a year since 1998, compared with about 9 percent annually without the adjustment.
  - Real output in oil-related transportation has increased by more than 11 percent a year, on average; the rest of the transportation sector has grown by about 8 percent a year.
- Cross-country comparison:
  - Even with the adjustment, estimated non-oil sector growth in Kazakhstan compares favorably with other CIS economies; estimated non-oil output growth paths in Kazakhstan and Russia have been remarkably similar.

### C. Non-oil Growth Trend and Sources of Growth
- Estimated trend growth:
  - Trend non-oil output growth over 1998–2004 is estimated at around 8 percent (Hodrick-Prescott filter used over 1998–2004; alternative filters and sample periods give similar results).
  - Non-oil output remained below trend during 1999–2002, but has exceeded trend since then (sensitivity noted to sample period choice).
- Growth accounting (Cobb-Douglas production function, with α elasticity to labor and capital stock Kt = δ Kt-1 + It):
  - Average annual productivity (TFP) growth over 1998–2004 is estimated at about 4 percent.
  - Contribution of capital and labor accumulation is considerably stronger than for other transition economies.
  - Estimated decomposition suggests a steady decline in the contribution of labor accumulation to overall growth, indicating the economy may be approaching full employment.
  - If TFP and capital accumulation rates remain broadly in line with the recent past, projected non-oil sector growth of 6–7 percent a year over the medium term.
- Specific methodological notes:
  - For growth accounting, non-oil output defined as total output less value added in mining due to data limitations.
  - Elasticity α assumed 0.5 and depreciation rate δ assumed 5 percent in main calculations; alternative calculations for α ∈ [0.3-0.7] and δ ∈ [3-10] percent were carried out.

### D. Investment and Labor Market Trends within the Non-oil Sector
- Investment:
  - Non-oil sector investment increased markedly; transportation and communications (strongest link to oil industry) account for the bulk of the increase.
  - No direct data on share of transport and construction investment attributable to hydrocarbon sector; higher growth of oil-related transport and construction suggests a large part of investment increase relates to oil, so “true” non-oil investment likely smaller than aggregate data indicate.
- Employment:
  - Employment growth in nontradables generally stronger than in tradables.
  - Employment growth rate in oil and other mining sectors (including metals) about 8 percent; non-mining sector employment growth less than 3 percent.
  - Within non-mining sector: shares of public administration and construction in total employment have grown; share of manufacturing has declined significantly.
  - Agriculture’s share in total employment rose sharply in the late 1990s, but declined in recent years (large increase in agricultural employment in 2000 partly due to better measurement of informal economy).
- Wages:
  - Large wage differentials persist: average real wages in mining remain close to twice the level of the average wage in the economy as a whole (including mining).
  - Since 2000 there has been some narrowing of the gap due to rapid wage growth in transportation, trade, and other services.
  - Wages in selected sectors (percent of nominal average monthly wages):
    - Total of economic activities: 100 (1999–2004)
    - Mining: 208, 223, 212, 197, 197, 189 (1999–2004)
    - Agriculture: 39, 39, 40, 40, 42, 42
    - Construction: 134, 146, 155, 160, 146, 136
    - Manufacturing: 116, 123, 115, 109, 107, 107
    - Transport: 124, 131, 141, 143, 148, 147
    - Financial and real estate services: 130, 136, 148, 165, 180, 162
    - Public service: 95, 82, 87, 83, 78, 92
- Labor productivity:
  - Labor productivity defined as output (constant 1999 prices) per worker.
  - Average labor productivity growth 1999–2004:
    - Agriculture: 0.4
    - Construction: 3.3
    - Manufacturing: 13.0
    - Transport: 12.3
    - Other services: 7.8
  - Manufacturing shows strong labor productivity growth; agriculture shows weakest productivity growth, possibly reflecting obsolete capital and extensive manual labor use.

### E. Conclusions
- Adjustments for oil-related services activity reduce the estimated size and growth of Kazakhstan’s non-oil sector; under the broad definition the hydrocarbon sector is substantially larger than under the narrow definition.
- Nonetheless, recent non-oil growth trends have been impressive. Trend-filtering and growth accounting techniques suggest real non-oil sector growth of 6–8 percent a year can be maintained over the near term if past TFP and capital accumulation rates persist.
- Indicators point to potential capacity constraints and a weakening prospect for growth driven by increased labor inputs as the economy approaches full employment (unemployment rate declined from 12.8 percent in 2000 to 8.4 percent in 2004).
- Structural change within the non-oil sector: a resource shift toward non-tradable activities is underway — the share of tradables in the non-oil sector has declined significantly in value added and employment, while services and construction expanded.

*Prepared by Anna Ter-Martirosyan; excerpt from "Republic of Kazakhstan — Selected Issues", International Monetary Fund, June 9, 2005.*

### References

### _cr05240 - References

### II. FISCAL MANAGEMENT OF KAZAKHSTAN’S OIL WEALTH — Key findings and projections

- Context and objectives
  - Higher oil revenue and prospects for further substantial rises permitted rapid expansion of public spending and a widening of Kazakhstan’s non-oil budget deficit in recent years.
  - Chapter questions addressed:
    - In light of oil production and fiscal revenue prospects, what level of non-oil deficit can be sustained while maintaining oil wealth?
    - How does the near-term fiscal stance compare with this “sustainable” level?
    - What framework can help ensure long-term sustainability of the fiscal stance?

- Oil production and revenue trends (observed)
  - Oil and gas condensate output in 2004: 59 million metric tons (about 1.2 million barrels per day).
  - Oil output increased about two-fold since 1999 (29.4 million metric tons).
  - In 2004, oil-related activity estimated to account for about 30 percent of nominal GDP and half of export earnings.
  - About 30 percent of total government revenues derived from the oil sector in 2004, compared to 6 percent in 1999.
  - Oil revenues (definition used by Fund staff): corporate income taxes, royalties, bonuses, and payments from production-sharing agreements.

- Oil production and revenue projections
  - Proven and probable oil reserves: 35 billion barrels; total reserves estimated at around 50–60 billion barrels (industry and official estimates vary).
  - Official scenario: oil production expected to double by the beginning of next decade, and triple over the next 10–15 years, reaching 3.5 million bpd; projected to moderate to around 2.5 million bpd by 2030.
  - Government oil revenue projected to grow from $4.2 billion in 2005 to about $16 billion during 2015–30.
  - Note: oil extraction and transportation costs in Kazakhstan (up to $12 a barrel) are higher than in some other countries.

- Risks and uncertainties
  - Significant uncertainties associated with realizing full production potential: inadequate transport capacities, environmental considerations, technological challenges (off-shore drilling), and dependence on continued sizable foreign investments.
  - Example: introduction of first phase of Kashagan off-shore field postponed by 3 years till end-2008.

- National Fund of the Republic of Kazakhstan (NFRK)
  - Established in 2001 to reduce impact of volatile oil prices and save part of oil income for future generations.
  - Rules complex and changed over time; list of companies subject to transfers reduced from 12 to 7 petroleum companies in 2004.
  - Flows: “savings” component = 10 percent of budgeted baseline revenue from listed companies (invariant to oil price changes), plus a “stabilization” component (revenues in excess of receipts at a reference oil price fixed at $19 a barrel).
  - NFRK could be drawn down if oil prices fall below the reference price (has not occurred).
  - NFRK has also received privatization receipts, special bonus payments, and royalties from certain natural resource companies.
  - NFRK is off-budget, managed by the NBK on behalf of the government; all NFRK assets invested abroad.
  - Since establishment, about 40 percent of oil sector revenue (including one-off bonus payments) saved; NFRK accumulated over $5 billion in assets.
  - Public spending expanded by 27 percent a year on average during 2000–04; share of capital spending doubled; social spending increased.

- Redesign of NFRK rules under consideration
  - Aim to fully integrate NFRK with the budget and devise a rule linking non-oil fiscal deficit to development spending (public capital spending).
  - Development spending, per Budget Law, is key to increasing longer-term capacity and productivity.

- Sustainable non-oil deficit (PIH framework and scenarios)
  - Analytical approach: Permanent Income Hypothesis (PIH) — maintain value of oil wealth in real per capita terms by spending expected income from oil wealth (present discounted value of future oil earnings times expected long-term rate of return adjusted for population growth).
  - Baseline assumptions used:
    - WEO assumptions for 2005−10 and staff projections for 2011−49.
    - Oil production peaks at 3.5 million bpd in 2017−18.
    - Oil prices projected to decline to $40 per barrel by 2020, remaining constant in real terms thereafter.
    - Non-oil economy growth projected to moderate from about 7–8 percent a year in near term to an average of 4.5 percent a year over the long term (after 2020).
  - Baseline PIH result:
    - Non-oil deficit that maintains oil wealth in real per capita terms is equivalent to 6−7 percent of GDP in the near term, declining markedly relative to GDP over the long run.
  - Sensitivity:
    - Permanent reduction in oil production by 20 percent starting in 2010 would reduce average sustainable non-oil deficit for 2005–10 by 1 percent of GDP.
    - Permanent decrease in oil price by 20 percent (relative to baseline) would reduce average sustainable non-oil deficit for 2005–10 by about 2 percent of GDP.
  - Note: PIH framework maintains oil wealth constant in real per capita terms; allowing some depletion of oil wealth would imply a higher deficit path.

- Near-term fiscal stance implications
  - Projected non-oil deficit for 2005: 5.4 percent of GDP (well within sustainable level under baseline).
  - If baseline assumptions hold, non-oil deficit would need to narrow to 3−4 percent of GDP over the medium term and to about 1−2 percent of GDP over the longer run.
  - Adoption of a simple fiscal rule could operationalize the PIH framework:
    - Example considered: link non-oil deficit to budgetary development expenditures; transparent but does not by itself ensure maintenance of oil wealth or guide setting development spending level.
    - Determining non-oil deficit level within PIH-type framework with regular updating is critical.
  - Alternative formula mechanism under consideration:
    - Non-oil deficit financed from oil revenue determined by: Def_t = A + b * F_{t-1}, where F_{t-1} represents outstanding NFRK assets at start of year; b could equal expected annual return on NFRK assets; A could be fixed in tenge terms for a period (e.g., three years).
    - Near term A term would dominate, resulting in steady reduction of non-oil deficit in relation to GDP consistent with PIH declining path.
    - Formula should retain flexibility to alter if oil prices or production prospects change substantially.

- Conclusion (fiscal)
  - Kazakhstan can sustain non-oil deficits of over 5 percent of GDP in the near term without reducing the value of oil wealth; this is broadly in line with staff-projected fiscal stance.
  - Sustainable deficit will decline markedly relative to GDP over the longer term.
  - Sustainable path is highly sensitive to unanticipated developments in oil prices, production, reserves, and macroeconomic variables.
  - Fiscal strategy should be cast within a longer-term fiscal framework and retain sufficient flexibility to respond to major changes in expectations about future oil earnings.

### III. AN ANALYSIS OF BANK CREDIT GROWTH — Profile and key observations

- Chapter objectives
  - Address sustainability and potential consequences of rapid bank credit growth (about 50 percent per annum in real terms).
  - Key questions:
    - Similarity to “catch up” in other transition economies?
    - Sectoral and currency composition of bank lending and changes over time?
    - Key risk exposures and evolution of loan portfolio quality?

- Banking sector profile (observed)
  - Consolidation: 35 banks operating at end-2004, compared with 71 licensed banks in 1998.
  - Bank branches declined from 458 in 1998 to 377 at end-2004.
  - Three largest banks account for roughly 60 percent of banking sector assets.
  - Foreign banks make up about one third of banks.
  - Interest rate environment:
    - Lending interest rates (local and foreign currency) declined markedly over past half decade due to increased competition and, for tenge loans, lower inflation.
    - Foreign currency deposit rates eased in response to lower global interest rates.
    - Tenge deposit rates declined as banks’ tenge liquidity increased.

### References (bibliographic entries included in the unit)

- Agency of Statistics of the Republic of Kazakhstan, 2004, National Accounts of the Republic of Kazakhstan (statistical compedium), 1998–2002.
- Agency of Statistics of the Republic of Kazakhstan, 2004, Statistical Yearbook of Kazakhstan.
- De Broek, M., and Kostial, K., 1998, “Output Decline in Transition: The Case of Kazakhstan” IMF Working Paper 98/45.
- Gurvich, E.T., 2004, “A Macroeconomic Estimate of the Role of the Russian Oil-Gas Sector” (in Russian), Voprosy Ekonomiki, No. 10.
- International Monetary Fund, 2003, Republic of Kazakhstan-Selected Issues and Statistical Appendix, IMF Country Report No. 03/211.
- Loukoianova E., and A. Unigovskaya, 2004, “Analysis of Recent Growth in Low-Income CIS Countries,” IMF Working Paper 04/151.
- Oomes N., and O. Dynnikova, 2005, “The Utilization-Adjusted Output Gap: Is the Russian Economy Overheating?,” IMF, Draft Working Paper.
- Oomes N., and K. Kalcheva, 2005, “Dutch Disease: Does Russia Have the Symptoms?”, IMF, Draft Working Paper.
- Barnett, S., and Ossowski, R., 2003, “Operational Aspects of Fiscal Policy in Oil-Producing Countries,” in Davis, J.M., Ossowski, R., and Fedelino, A., Fiscal Policy and Implementation in Oil-Producing Countries (Washington: International Monetary Fund).
- Davoodi, H.R., 2002, “Assessing Fiscal Vulnerability, Fiscal Sustainability and Fiscal Stance in a Natural Resource Rich-Country,” in Republic of Kazakhstan—Selected Issues and Statistical Appendix, IMF Country Report No. 02/64, pp. 7–31 (Washington: International Monetary Fund).
- Mathieu, P., 2004, “An Analysis of Kazakhstan’s Petroleum Potential,” in Republic of Kazakhstan—Selected Issues and Statistical Appendix, IMF Country Report No. 04/362, pp.17–31 (Washington: International Monetary Fund, 2004).
- Thomas, T., and Kissinbay, T., 2004, “Fiscal Rules and Fiscal Sustainability Analysis,” in Republic of Kazakhstan—Selected Issues and Statistical Appendix, IMF Country Report No. 04/362, pp.50–63 (Washington: International Monetary Fund).
- Wakeman-Linn, J. et al. (2004), Managing Oil Wealth: The Case of Azerbaijan (Washington: International Monetary Fund).

*Source: _cr05240 - References (extracted content). *

### 4. There has been a substantial process of remonetization in recent years,

### 4. There has been a substantial process of remonetization in recent years,

### Remonetization and deposit dedollarization
- Deposit dedollarization has declined markedly since 2001.
- The ratio of total bank deposits—tenge as well as foreign currency-denominated—stood at 23 percent of GDP at end-2004.
- Deposit dedollarization likely reflects growing confidence in the tenge as inflation declined and the tenge appreciated in nominal terms against the dollar.
- Deposit dedollarization has also taken place in other transition economies, although the recent pace in Kazakhstan has been more rapid than in other countries.

### Interest rates (weighted period average interest rates)
- Foreign currency — Institutions
  - Demand deposits: 2000: 0.0; 2001: 1.1; 2002: 1.2; 2003: 1.3; 2004: 1.0
  - Term deposits: 2000: 5.1; 2001: 4.7; 2002: 4.2; 2003: 1.3; 2004: 1.8
  - Short-term loans: 2000: 17.1; 2001: 14.2; 2002: 12.3; 2003: 10.2; 2004: 9.2
  - Long-term loans: 2000: 16.6; 2001: 15.5; 2002: 14.4; 2003: 13.2; 2004: 12.3
- Foreign currency — Individuals
  - Demand deposits: 2000: 1.0; 2001: 0.6; 2002: 0.8; 2003: 0.6; 2004: 0.4
  - Term deposits: 2000: 8.3; 2001: 7.7; 2002: 7.1; 2003: 6.1; 2004: 5.8
  - Short-term loans: 2000: 22.4; 2001: 19.9; 2002: 17.2; 2003: 17.0; 2004: 16.6
  - Long-term loans: 2000: 18.9; 2001: 20.3; 2002: 18.7; 2003: 17.2; 2004: 14.9
- Local currency — Institutions
  - Demand deposits: 2000: 0.1; 2001: 2.7; 2002: 2.7; 2003: 3.2; 2004: 3.1
  - Term deposits: 2000: 6.5; 2001: 5.7; 2002: 5.2; 2003: 4.2; 2004: 3.0
  - Short-term loans: 2000: 19.7; 2001: 17.7; 2002: 15.6; 2003: 15.5; 2004: 14.5
  - Long-term loans: 2000: 17.5; 2001: 16.2; 2002: 15.3; 2003: 15.4; 2004: 14.3
- Local currency — Individuals
  - Demand deposits: 2000: 2.1; 2001: 1.5; 2002: 1.3; 2003: 1.1; 2004: 0.9
  - Term deposits: 2000: 15.9; 2001: 14.3; 2002: 11.3; 2003: 10.6; 2004: 9.4
  - Short-term loans: 2000: 30.6; 2001: 26.2; 2002: 25.0; 2003: 23.3; 2004: 23.6
  - Long-term loans: 2000: 18.8; 2001: 22.4; 2002: 21.8; 2003: 19.8; 2004: 18.5
- LIBOR (1 year): 2000: 6.83; 2001: 3.92; 2002: 2.21; 2003: 1.42; 2004: 2.1

### Bank deposits and foreign currency shares
- Foreign currency deposits (percent of total deposits)
  - Kazakhstan: 1998: 37.0; 1999: 47.2; 2000: 51.0; 2001: 60.5; 2002: 59.9; 2003: 47.1; 2004: 36.2
  - Comparative figures for other countries are presented in the source (Russia, Ukraine, Kyrgyz Republic, Hungary, Latvia).
- Total deposits (percent of GDP)
  - Kazakhstan: 1998: 4.6; 1999: 8.5; 2000: 11.3; 2001: 13.5; 2002: 16.0; 2003: 15.9; 2004: 22.6
  - Comparative figures for other countries are presented in the source.

### Aggregate credit growth — catch up or bubble?
- Credit grew by over 50 percent in the most recent year reported.
- By end-2004 the ratio of bank credit to GDP was about 27 percent.
- Credit growth has outpaced that in other countries and is close to the average level in the EU accession countries.
- IMF (2004a) found 18 episodes of excessive credit expansion in 28 emerging market economies in 1970–2002.
- Median real credit growth in the three years preceding the peak of a typical credit boom was 17 percent; Kazakhstan’s credit growth exceeded that median.
- Only one fourth of sustained rapid credit growth episodes were associated with a subsequent credit collapse.
- Credit growth well in excess of the rapid growth threshold has been sustained for six years in Kazakhstan, longer than the typical 3½ year emerging market credit boom duration.
- Hodrick-Prescott filter applied to quarterly data 1993–2004 indicates real credit outstanding at end-2004 was slightly below the estimated trend level.

### Composition of bank lending
- Sectoral shifts in bank credit (percent of total bank credit)
  - Industry: 1998: 23.4; 1999: 21.7; 2000: 30.5; 2001: 34.1; 2002: 34.3; 2003: 28.0; 2004: 19.5
  - Agriculture: 1998: 9.9; 1999: 7.9; 2000: 9.4; 2001: 10.3; 2002: 11.4; 2003: 12.0; 2004: 8.4
  - Trade: 1998: 23.7; 1999: 27.8; 2000: 33.2; 2001: 30.9; 2002: 29.4; 2003: 28.3; 2004: 26.9
- Credit by use (percent of total bank credit)
  - Construction and reconstruction: 1998: 4.8; 1999: 5.3; 2000: 5.4; 2001: 5.6; 2002: 4.6; 2003: 10.9; 2004: 10.3
  - Construction and acquisition of real estate by individuals: 1998: 1.9; 1999: 1.7; 2000: 1.1; 2001: 1.1; 2002: 1.6; 2003: 3.8; 2004: 8.7
    - Mortgage credit: 2001: 0.1; 2002: 0.2; 2003: 0.6; 2004: 1.8
  - Consumer credit: 1998: 1.9; 1999: 2.0; 2000: 2.4; 2001: 3.1; 2002: 4.7; 2003: 6.5; 2004: 9.7
- Key points:
  - Share of property-related loans rose from about 7 percent in 2000 to 19 percent in 2004.
  - Share of consumer lending rose from about 2 percent to almost 10 percent over the same period.
  - Bulk of mortgage loans—almost 90 percent—are foreign currency denominated.
  - Share of foreign currency lending in total bank credit has been declining but remains high; Kazakhstan: 1998: 43.2; 1999: 53.9; 2000: 51.0; 2001: 71.2; 2002: 68.5; 2003: 55.5; 2004: 51.9 (percent of total credits).

### Cross-border lending and external liabilities
- Credits to borrowers abroad were equivalent to about 14 percent of banks’ total credit operations at end-2004, compared with less than 1 percent in 2000.
- Kazakhstan’s banks have acquired stakes in banks in Russia, Ukraine, Belarus, and the Kyrgyz Republic.
- At end-2004, net external liabilities constituted over 35 percent of total assets of the commercial banks, compared with just over 5 percent in 2000.

### Net foreign currency assets and currency risk
- Net foreign currency denominated assets of the banking system turned negative in the most recent year.
- Potential direct currency mismatch remains relatively small, but banks face indirect currency risk via foreign currency lending to borrowers with limited (or no) foreign currency earnings.
- Net foreign currency assets of the banking system (in percent of assets) showed a decline into negative territory during 1998–2004 in the source chart.

### Banking system soundness
- Capital adequacy and liquidity
  - Average capital adequacy ratio at end-2004: 15.9 percent (prudential norm: 12 percent).
  - Liquidity ratio (liquid assets to short-term liabilities) amounted to over 100 percent (minimum requirement: 30 percent).
  - Banks’ return on assets over the past six years: ranged from 1 percent to 2 percent.
  - Banks’ return on equity over the past six years: ranged from 8 percent to 14 percent.
- Loan quality and provisions
  - Loan losses (percent of total loans): 2000: 2.1; 2001: 2.1; 2002: 2.0; 2003: 2.1; 2004: 2.9
  - Proportion of classified loans rose from 37 percent at end-2003 to 41 percent at end-2004.
  - Loan-loss provisions of the banking system amounted in aggregate to 7 percent of total loans at end-2004, compared with 6 percent at end-2003.
- Portfolio quality (percent of asset value) — 2003 vs 2004
  - STANDARD: 2003: 61.1; 2004: 56.2
  - CLASSIFIED: 2003: 36.8; 2004: 41.0
  - LOSS: 2003: 2.1; 2004: 2.9
  - Subcategories (2003 vs 2004) are detailed in the source (e.g., Substandard, payments current; Substandard, payments in arrears; Unsatisfactory categories; Doubtful).
- Related-party exposures and financial-industrial groups
  - Substantial cross-relationships between financial institutions and industrial groups have contributed to financial-industrial groups with complex ownership structures.
  - Progress reported in monitoring related party exposures and in restricting exemptions from prudential limits, but continued scrutiny is warranted.
- Operational challenges
  - Rapid credit growth points to the need to strengthen internal risk management systems.

### Conclusions (Section E)
- While credit growth in Kazakhstan has been rapid even by transition economy standards, aggregate data do not clearly indicate that such growth has been “excessive.”
- Recent developments in lending and borrowing patterns have increased exposure to the property sector and international financial markets.
- Basic indicators of banks’ aggregate financial position appear sound, but moderate deterioration in loan quality over the past year suggests the need for continued vigilance.

### IV. Long-term prospects for the real value of the tenge — overview (opening)
- Sustained rapid economic growth and sharp increase in oil export earnings were reflected in a real appreciation of the tenge last year, despite large purchases of foreign exchange by the National Bank of Kazakhstan (NBK).
- Key questions addressed:
  - Is the real appreciation of the tenge an equilibrating phenomenon that is expected to persist over the longer term?
  - If real appreciation is inevitable, and the tradeoff is between nominal appreciation and higher inflation, what considerations determine the appropriate rate of inflation for Kazakhstan over the medium term?

### Exchange rate and inflation developments (Section A)
- Since 2000 the tenge-dollar real exchange rate has appreciated by some 28 percent, with most appreciation occurring in 2003–04.
- Cumulative inflation differential with the United States during 2000–04: about 17 percent (part of the real appreciation); nominal appreciation was about 12 percent cumulatively.
- Against the ruble (largest trading partner currency) during 2000–04:
  - Russia’s inflation exceeded Kazakhstan’s by a cumulative 32 percent.
  - Tenge appreciated in nominal terms vis-à-vis the ruble by 11 percent.
  - Resulting cumulative real depreciation of the tenge against the ruble: about 17 percent over the period.
- Trade-weighted (effective) real external value of the tenge has remained broadly flat, following a sizable real effective appreciation in the mid-1990s and real effective depreciation after the Russian crisis in 1998–99.
- Measurement complications for Kazakhstan’s REER include the large share of oil in external trade and substantial changes in trade shares; Fund INS weights cited as an example (e.g., 45 percent for Russia and 3 percent for the U.S.) are subject to significant error; thus analysis focuses on the real value of the tenge against the U.S. dollar.

### PPP and relative productivity differentials (Section B, opening)
- International comparison of price levels via Purchasing Power Parity (PPP) is one method for assessing deviation of a country’s real exchange rate from its long-run level.
- Departures from PPP can be large and narrow only gradually; they indicate the direction of future real exchange rate developments toward the equilibrating long-run PPP level in the absence of other shocks.

*Prepared by Mariusz Sumlinski and Hamid Davoodi; content as provided in the source document.*

### 6.      The comparison of CPI levels across countries needs to account for the presence

### 6.      The comparison of CPI levels across countries needs to account for the presence

### Measurement issues and PPP theory
- Nontraded goods constitute a sizable share of the overall consumption basket; nontradables prices tend to be higher in countries with higher wages and incomes.  
- The relative price of tradables to nontradables (the real exchange rate) will tend to be higher in countries with greater per capita income.  
- Absolute PPP definition (as stated): q = (p* × e) / p and 1 = q.  
- Key implications of PPP theory:
  - Short- to medium-run real appreciation can occur if q rises (deviation from 1) via higher domestic price level, nominal appreciation (a lower e), lower foreign price level, or a combination.
  - Relative PPP requires only changes in national price levels to be equal; changes in the real exchange rate must be zero or tend toward zero in the long run.
  - CPI-based measures of the real exchange rate measure the rate of change from the base year, not absolute levels.

### Balassa-Samuelson effect (mechanism and proxying)
- Mechanism:
  - Higher productivity growth in tradables relative to nontradables leads to real appreciation (higher relative price of nontradables to tradables).
  - Higher tradables productivity → higher wages in tradables → higher wages in nontradables → higher nontradables prices; tradables prices remain set in international markets.
  - Overall CPI (weighted average of tradables and nontradables) rises as nontradable prices increase.
- Empirical proxying:
  - Real per capita GDP differentials from Penn World Tables (PWT) are used as a proxy for relative productivity differentials due to lack of consistent sectoral productivity data.

### Empirical findings (cross-country evidence and Kazakhstan)
- Staff OLS cross-section regression for 133 countries (relative to the United States) yields a strong Balassa-Samuelson effect:
  - Estimated coefficient: 0.394 — a one percent increase in a country’s real per capita GDP (relative to the U.S.) is associated with a real appreciation (against the US dollar) of about 0.4 percent.
- Kazakhstan in year 2000:
  - Actual real exchange rate was 34 percent below its estimated long-run PPP level in 2000, implying an undervaluation of 66 percent.
  - Many of Kazakhstan’s major trading partner currencies (Russian ruble, Chinese renminbi, Ukrainian hryvnia) also appear undervalued relative to estimated PPP.
- Cross-country patterns noted:
  - Other notable undervalued countries cited include China, Russia, Azerbaijan, Algeria, the Kyrgyz Republic, and Tajikistan.

### Projections for the tenge’s real exchange rate (staff estimates)
- Growth differential and implication:
  - Kazakhstan’s projected real per capita GDP growth over the next decade: 8.1 percent (annual).
  - United States projected real per capita GDP growth: 2.4 percent (annual).
  - Annual growth differential (proxy for productivity differential): 5.7 (8.1 minus 2.4).
  - Using coefficient 0.394 × 5.7 → estimated annual appreciation of the long-run real exchange rate: about 2¼ percent a year.
- Adjustment of observed gap and medium-term appreciation:
  - Of the 66 percent undervaluation in 2000, 28 percentage points were corrected by end-2004.
  - Half of the remaining estimated deviation at any point is expected to close over the subsequent decade (Frankel, 2005).
  - If one half of the gap remaining at end-2004—52 percent—were to be closed over the next decade, implied annual real appreciation ≈ 2½ percent.
- Combined effects and final medium-term projection:
  - Long-run real exchange rate appreciation (from growth differential): about 2¼ percent a year.
  - Adding the closure of the gap implies the tenge may be expected to appreciate by an average of 4¾ percent a year in real terms against the dollar over the medium term.

### Transmission channels and alternative realizations
- Real appreciation can be achieved by:
  - Nominal appreciation of the tenge (exchange rate flexibility), or
  - Higher domestic inflation relative to U.S. inflation if nominal appreciation is resisted.
- Inflation implications (under a relatively inflexible nominal tenge-dollar exchange rate):
  - With current U.S. inflation of about 3½ percent, average annual CPI inflation in Kazakhstan would be over 8 percent in the near term.
  - With projected longer-term U.S. inflation of 2½ percent, average annual CPI inflation in Kazakhstan would be over 7 percent over the medium term.
  - Expansionary fiscal policy or cyclical overheating could push inflation significantly higher.

### Costs of higher inflation and policy trade-offs
- Macroeconomic costs of higher inflation:
  - A marked pickup in inflation could reverse favorable trends: remonetization, higher ratio of credit to GDP, and declining dollarization.
  - High inflation is associated with lower growth once beyond certain thresholds:
    - Bruno and Easterly (1998): long-run growth lower if inflation rate exceeds 40 percent per annum.
    - Fischer (1993): growth gains negligible once inflation is in single-digit levels.
    - Khan and Senhadji (2001): inflation rates exceeding 1–3 percent in industrial countries and 11–12 percent in developing countries would lower growth.
    - Christoffersen and Doyle (2000) (transition economies): earlier estimate of threshold at 13 percent.
  - Financial deepening effects:
    - Khan, Senhadji, and Smith (2001): countries with annual inflation rates in excess of 6 percent experienced slower financial deepening (measured as the ratio of private credit to GDP).
  - Hence, if Kazakhstan adopts a relatively fixed exchange rate regime, equilibrating real appreciation via inflation could impede financial deepening and risk harming growth.

### Conclusions and policy implications
- Central quantitative conclusion:
  - Estimated medium-term average real appreciation of the tenge against the dollar: 4¾ percent a year.
- Policy trade-offs:
  - Allowing equilibrating real appreciation via nominal exchange rate flexibility (sufficient nominal appreciation of the tenge) would avoid higher inflation.
  - Resisting nominal appreciation would delay real appreciation but ultimately produce it via higher inflation, with attendant risks: higher inflation over near and medium term, potential reversal of remonetization, slower financial deepening, and negative effects on growth—risks heightened by expansionary fiscal policy or cyclical overheating.
- Caveats and uncertainties:
  - Deviations from PPP stem partly from long-term productivity differences but near-term movements depend on capital flows, cyclical developments, fiscal policy, and other factors.
  - The estimated Balassa-Samuelson effect explains only about half of cross-country variability in real exchange rate deviations; other factors are important.
  - PPP data (PWT) are subject to measurement errors; estimates for any single country should be treated with caution.

*Source: IMF staff chapter on real exchange rate assessment and the Balassa-Samuelson effect (excerpts provided).*

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