TOPIC OF THE WEEK: Continued pressure on Uzbekistani sum should make local currency investments challenging in medium term
The decision last week to devalue the sum in a more forceful manner has led us to think deeper about an argument that we have been consistently making to clients, i.e., that macroeconomic developments that usually tend to influence currency movements will pale in comparison to underlying (and large) relative price movements that Uzbekistan has been experiencing in the aftermath of the 2017 opening of the economy.
This line of thought helps explain, in our view, why the sum has seen only one direction of movement (depreciation) in recent years while other regional currencies have exhibited a much more varied performance that has been more attuned to things like the evolution of the current account, balance of payments, etc. At the same time, this qualitative argument invites another relevant question: for how long will this one-way currency adjustment continue given the evolution of the domestic price level in Uzbekistan?
This is a much harder question to answer. When in doubt, we have found that turning to basics helps. In this case, we have taken recourse to the law of one price, which predicts that, in the long run, exchange rates will reflect relative price level changes. Comparing then the evolution of price changes in Uzbekistan and the US shows that, while prices have risen about 332 percent more in Uzbekistan since Dec 2016, the sum has depreciated only by 258 percent against the US$ over the same time period. Assuming what we think is the normal rate of depreciation that the authorities feel comfortable with given our observations about the past, suggests that it will not be at least until 2025 that the law of one price holds.
Of course, there are a myriad well-known theoretical reasons why this simple relationship may be violated over the long term. In addition, in our case data restrictions related to Uzbekistan also mean that the link between the exchange rate and relative price movements may be too tenuous to rely on. Nevertheless, thinking about the USDUZS exchange rate in this particular way is helpful in providing the minimum time frame, within which one needs to live with non-trivial depreciations.
The investment implication follows naturally from these considerations. Local currency investments in equity, bonds, etc should deliver significantly large returns to justify interest. Should this not be the case, the high growth potential of the Uzbekistani economy (we deem the country to have the highest potential growth in the region) may be best realized by focusing on US$-based assets.
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