Russia finance: How to keep the rouble in check?

FROM THE ECONOMIST INTELLIGENCE UNIT

Russia’s central bank has intervened heavily in current markets and widened the rouble’s trading band recently, in response to strong appreciating pressure on the currency. With oil prices now above US$80/barrel and interest rates high, this is not surprising. However it threatens to undermine competitiveness and the economy’s shaky recovery. More rate cuts look likely to be part of the policy response, but this may not be sufficient–and so capital controls are a distinct possibility. The rouble’s surge has also put back the day when Russia will switch to inflation-targeting and ostensibly a free-floating currency.

The Russian Central Bank (RCB) adjusted the rouble’s trading band against the dollar-euro basket for the third time in two days on March 10th, after buying US dollars in huge quantities in an effort to stem the currency’s appreciation. From August 2009 until September this year, the RCB maintained a trading band of Rb35-38 to the basket. The bank’s guidelines provide for a shift in the band of five kopeks (Rb0.05) whenever its interventions to maintain the currency within the band exceed US$700m. On March 9th the RCB made its tenth adjustment in the space of a month, bringing the target band to Rb34.50-37.50 versus the currency basket. It made two further adjustments to the band during trading on March 10th, according to Reuters and Bloomberg, so that the band now stands at Rb34.40-37.40. In the process, the RCB has bought up to US$2bn in an effort to tether the currency. In one week in February, the central bank purchased US$4bn to check the rouble, according to one of its deputy governors.

Before the global downturn in September 2008, the rouble was trading at around Rb29.3-29.6 against the currency basket, in which the US dollar has a 55% weighting and the euro a 45% weighting. By the end of that year the rouble had slipped to Rb34.8 versus the basket and in the first quarter of 2009 it averaged Rb39.12. Thereafter it was stable, at Rb37.36 against the basket during the second and third quarters, and in the final quarter it appreciated mildly to Rb35.77. It closed on March 10th at Rb34.42.

The reasons for the rouble’s surge in the past month are not difficult to fathom. The price of oil, Russia’s principal export, has risen by 10% over the last month and now stands at over US$80/barrel. In addition, Russia offers a yield advantage over most developed economies: the RCB’s refinancing rate stands at 8.5% at present, despite sizeable rate cuts in recent months.

Strong rouble, weaker Russia

There are some upsides to the rouble’s strengthening. It is positive for the country’s borrowers, as over 23% of loans are denominated in foreign currencies. At a time when unemployment is rising and wage arrears are ticking up too, an easing of the burden for those servicing foreign-currency loans is welcome. A stronger rouble is also likely to encourage households to deposit their roubles in the bank and it should make it easier for domestic companies to raise finance through domestic bond issues.

On balance, however, rouble appreciation is harmful for the economy and is understandably viewed with alarm by the authorities. RCB data show that the real effective exchange rate appreciated by 5% versus the basket in the first two months of this year. In 2008, on the Economist Intelligence Unit’s estimates, the rouble was close to being overvalued. The weakening of the real effective exchange rate in 2009 was welcome, but a continuation of the current trends would wipe out the gains of 2009. Export competitiveness is not the main concern, although non-oil exports might suffer as a result of the rouble’s rise. The bigger concern is over the health of a swathe of the domestic economy which flourished through an import-substitution effect in the wake of the 1998 devaluation.

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Tools at the ready

Throughout the boom years of the last decade, the authorities strove to stem the real appreciation of the exchange rate. By 2008 the real value of the rouble was approximately back to its pre-1998 level. The current worries of currency appreciation will only be intensified by the lacklustre nature of Russia’s present recovery, after a GDP decline of 7.9% in 2009. What then will be the policy response?

Inflation, the major blot on Russia’s macroeconomic copybook in the last ten years, is beginning to look as though it is under control. In July 2009 inflation stood at 12% year on year, but it had fallen to 8% by January this year and was down to just 7.2% in February. This would appear to clear the way for further cuts in interest rates, which would also support domestic business.

Rate cuts alone might not be sufficient, however. There are other tools at the RCB’s disposal–for instance an increase in reserve requirements or further currency-market intervention. Another option would be to reintroduce currency controls.

Control mania

The prime minister, Vladimir Putin, has since the global downturn resisted proposals to reintroduce capital controls; this might be simply because he lifted them and often cites this as one of his principal achievements as a manager of the economy. However, the IMF recently issued a report that represented a u-turn in its thinking: it positively assessed capital controls as a way of dealing with surging inflows for emerging-market economies. The report cited evidence that GDP declines fell less sharply in countries that had capital controls in place, and that the maturity structure of these economies’ debt was longer too. It argued that capital controls could be a better solution than exchange rate appreciation (which could threaten competitiveness), a further accumulation of currency reserves (which might be inappropriate) or interest-rate cuts (that could risk economic overheating). Because the report identifies a correlation between boom and bust performance and high levels of debt, capital controls are arguably particularly relevant forRussia. Furthermore, the current inflows are of portfolio investment, rather than in a form that might assist Russia’s economic recovery. Mr Putin’s pride, and the politically-influential oligarchs’ desire to avoid taxes or limits on foreign borrowing and inward investment, might be the only factors standing in the way of capital controls.

The rouble’s recent surge also has implications for the longer-term development of monetary policy in Russia. The ultimate aim, as the RCB and leading government figures have consistently stated, is to target inflation and let the rouble float freely. In practice, a dirty float is a more likely eventual outcome: a currency that floats most of the time but is occasionally the subject of hefty state intervention. Even this is now a more distant prospect, given the appreciating pressure on the currency and the threat that this poses to domestic industry. Management of the exchange-rate will be more active in the coming months, and additional tools–including capital controls–may well be employed. All these developments will move Russia further away from a rouble float, whether dirty or not.