Russia's Currency Policy Struggles

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Almost 20 years have passed since Russia cast off its Soviet economic model. In the interim, its central bank, like all central banks, has tried to keep inflation under control. But unlike its eastern European neighbors, Russia has had little success. The Central Bank of Russia (CBR) has brought the rate under 10 percent — unacceptably high for any modern economy — just twice in the last 20 years.

The monetary policy the CBR has pursued ever since the Russian financial crisis in 1998 — which may be described by the oxymoron, “a currency board with a floating ruble exchange rate” — has provided mixed signals and limited its capacity to control inflation. Its recent decision to focus on inflation while letting the ruble float could add volatility to the economy, however, and increase Russia’s exposure to current currency tensions.

The Russian Monetary Policy Model

Following Russia’s severe financial crisis in 1998, the government's debt market was essentially frozen and surviving banks lacked assets to offer as security for loans. That left the CBR with one option to manage liquidity: Relying on sales and purchases of foreign currency. Moreover, once the crisis ended, the CBR needed to rebuild its foreign exchange reserves.

As a result, from 2000 until the financial crisis hit in 2008, Russia chose a currency-board approach to monetary policy: Its currency was pegged to a basket — currently 55 percent dollar, 45 percent euro — and all changes in liquidity came from the CBR’s sales and purchases of foreign currency.

The currency-board approach is widely used, and has often helped countries enact macroeconomic stabilization programs when national monetary authorities lacked credibility. But making the currency board official is an important condition for success — a step Russia refused to take, given that the CBR could not decide whether it should focus on controlling the exchange rate or controlling inflation. Also, the currency-board policy has drawbacks under certain economic conditions, all of which characterized Russia.

Currency boards do not function well in countries that depend on a single, volatile commodity export, but more than 60 percent of Russia’s exports are directly linked to oil. Nor does the policy work well for countries that receive big capital inflows — as Russia does from time to time — or those experiencing sudden, negative external shocks, as Russia did during the 2008 financial crisis. Under these circumstances, strict application of the currency board can lead the money supply to spin out of control, rapidly pushing up inflation and placing upward pressure on the real exchange rate when shocks are positive or forcing deflation to the point where the country abandons its currency board and devalues its currency when the shocks are negative.

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Russia’s dependence on oil-related exports is particularly problematic. Any movement in the oil price impacts the current account. And with many foreign investors believing that a rise in the price means an improvement in Russia’s economy and vice-versa, rising oil prices attract speculative capital, while falling prices push capital out. Given the lack of a clearly established fixed exchange rate, big inflows leave monetary authorities with a difficult choice: Either rapidly strengthen the currency or adopt a controlled exchange rate regime along with extra measures — often stringent — to fight inflation, such as increased deposit interest rates or reserve requirements.

The Pre-Financial Crisis Period

During the pre-crisis period (2004-2007), the CBR took a middle approach, combining gradual appreciation with efforts to control excess liquidity and inflation. That was not an easy task, as oil prices rose 30 to 50 percent per year, boosting the current account. And, as is often the case, the middle approach prevented either target — inflation and the exchange rate — from being fully achieved.

In 2004, the Ministry of Finance started to help by absorbing a portion of extra oil revenues in its reserve funds. The Ministry of Finance was relatively successful in sterilizing growing export earnings — the current account balance stayed between $118 billion and $130 billion. Meanwhile, commercial banks’ demand for CBR credit was negligible and they often deposited substantial funds in CBR accounts or purchased CBR bonds.

Nevertheless, the inflow of foreign capital skyrocketed from $2 billion in 2005 to $81 billion in 2007amid Russia’s improved credit ratings, its relatively high nominal interest rates, and the CBR’s policy of steady nominal appreciation. As a result, the CBR lost control of the money supply and prices rose by more than 10 percent a year, forcing the CBR and commercial banks to maintain much higher nominal interest rates than those in other countries. This made investing in Russian debt instruments all the more attractive, and outside investors also obtained informal guarantees from the CBR that the ruble would continue to strengthen if oil prices kept rising, which pushed the ruble even higher.

Facing the Global Financial Crisis

The CBR’s lack of a clear objective, the banking system’s high exposure to foreign-exchange risk, and the economy’s emerging signs of overheating made the CBR’s policy decisions more difficult during the global financial crisis and increased the scale of resources needed to deal with its effects on the banking system. Though Russia avoided a liquidity crunch, authorities nevertheless decided to pump extra liquidity into the banking system, lowering reserve requirements and placing new deposits through the Ministry of Finance.

At the same time, demand for foreign currency surged relative to supply — not simply because of a seasonal rise, but also because of falling export earnings (amid falling raw materials prices) and the global financial market’s problems, which made it impossible for banks and companies to refinance external borrowing. The CBR responded by holding the exchange rate stable against its bi-currency basket in September and October, implying a depreciation against the dollar as the euro weakened.

The CBR also gave the Russian banking system almost unlimited access to its credit, with substantially longer terms. This combination encouraged banks to use almost all of their ruble funds to buy foreign currency, leading the CBR’s currency reserves to decrease rapidly.

With oil prices falling in the fall of 2008, the CBR again had to make a decision about the ruble exchange rate by November. This time, the choice was between stabilizing the ruble by continuing to spend foreign currency reserves or agreeing to its devaluation — a choice made harder by the obvious negative social and political impact devaluation could have. The resulting uncertainty accentuated devaluation expectations, which in turn drove up demand for foreign currency.

In the end, the monetary authorities let the ruble go into what was essentially freefall at the start of January 2009. It stabilized in early February, as soon as the CBR stopped providing the banking system with new liquidity.

The CBR’s work was made easier, however, as world oil prices started to rise again in spring 2009, the global recovery picked up steam, and demand increased for raw materials. First, the earlier devaluation in the ruble and the decrease in bank loans had reduced Russia’s imports and improved its current account balance. Second, banks — deprived of access to CBR loans — raised their deposit interest rates in an effort to solve their liquidity problems, encouraging household savings. By autumn 2009, private savings had essentially replaced CBR loans on banks’ balance sheets. Third, starting in spring 2009, the government turned to cash from the Reserve fund to finance the deficit, giving the economy the ruble liquidity inflow it needed and freeing the CBR to pursue its operations without fear of the liquidity consequences.

After Crisis: Deja Vu

Economic recovery renewed discussion about the CBR’s policy, and the bank finally declared its desire to move toward inflation targeting. Doing so effectively will require a free-floating currency. But letting the ruble float will not give monetary authorities full control over the money supply, which will also depend on the oil price and capital flows. Moreover, volatile oil prices will lead to a volatile current account balance and almost any fluctuation in oil prices will affect the exchange rate. Given that Russia’s economy already depends on the price of oil through its budgetary revenues, increasing this dependence further would hardly help the economy.

In addition, a freely floating currency could more actively subject Russia to today’s heightened currency tensions. So far, Russia’s political uncertainty and worsened investment climate has spared it from the significant capital inflows that have made other countries worry about “currency wars.”

Moreover, significant capital outflows — around $65 billion, or 4.5 percent of Russia’s GDP in 2010, from August 2010 to March 2011 — have cancelled out the appreciation rising oil prices and growing export earnings should cause. But, after elections end and Russia’s political situation stabilizes, capital inflows may recover. And, if the old correlation between the oil price and capital inflows persists, a free-floating exchange rate regime may further cement the dangerous feedback loop mentioned above: the more (less) significant the inflows, the stronger (weaker) the ruble and therefore the more (less) attractive Russia is for short-term financial investment.

As a result, the CBR faces many of the same problems that it did during the pre-crisis period: How can it reduce inflation while keeping only a weak hold over the money supply? How should the exchange rate react to a growing balance of payments or to shifts in capital flows, if at all? How will the CBR react to a possible deterioration in the current account in the medium term? Should it inform economic actors of the principles underpinning its behavior? Does it make sense to raise interest rates as a means of fighting inflation when oil prices are rising and the ruble is thus growing stronger? How can the banking system’s “long-term” appetite for CBR loans be raised?

This is obviously a very complicated list of questions, with many possible answers. Ideally, the CBR should anchor its policy in controlling the money supply — an anchor is needed, and the experience of other countries shows that a fixed exchange rate can hardly play that role. But, regardless of the path it chooses, the CBR must make its positions clear. Otherwise, economic actors will continue to overshoot their expectations or speculate — precisely the two behaviors that limit the CBR’s ability to fight inflation.