Loosening Russia’s Currency Belt

In case you haven’t noticed, the Russian ruble appears to be in a lot of trouble, under tremendous pressure from sellers fleeing to other currencies like monetary refugees.  Although the Central Bank widened the band and allowed the ruble to slip for the third time in four days on Monday (and slip it did down to 33.5 against the euro-dollar basket), there are indications that the government’s strategy of managed devaluation is coming into strong disfavor among institutions and market analysts as the currency falls to a three-year low against the dollar.

Chris Green, chief economist of London-based VTB Bank Europe, tells the AP: “The continued defense of an unsustainable currency is like trying to push water uphill.  The dynamics are suggesting that it’s going to fall back again.“

But the most startling news comes from the World Bank, as reports emerged today that a strongly worded recommendation has been sent from the institution to Russia’s financial authorities asking them to scrap the managed exchange rate regime in order to moderate capital outflow and staunch the leak in the rapidly depleting reserves.

Zeljko Bogetic, the World Bank’s lead economist for Russia, tells the WSJ that if oil averages $30 a barrel over the next two years, the country’s economy would suffer a severe contraction:

“It’s possible even to envisage Russia’s return from a creditor to international organizations to a borrower.“

The market fundamentals present a difficult challenge for policymakers, who are doing everything possible to avoid a repeat of the 1998 liquidity crisis which last crashed the ruble.  In a market overwhelmingly dependent on oil exports for growth, the ruble is often referred to as a “commodity currency,” the value of which can experience swings in parallel with export prices.  Russia’s main export, oil, has dropped by about 70% in value this fall, while a quarter of foreign reserves have been spent defending the currency.  Skepticism on the global market is no longer just political – this is justified by the numbers.

Russia’s current exchange regime uses a managed “band” or “belt” which sets the top and bottom of how much the currency is traded at – and this belt has been widened incrementally (about 1% each time – more than ten times now) to deal with the managed devaluation as opposed to a “free float.”  The ruble trades against a basket of 0.55 dollars and 0.45 euros, and there are plans to move to an inflation targeting regime within three years.

What most analysts are recommending that the government do is a one-time devaluation of the ruble by about 15-20% or so (they have already allowed a 13% managed devaluation since August).  The idea is that the devaluation would jump start the economy, boost consumer spending (which crashed in November), and open the credit taps once again – all contributing toward softening the blow of the coming recession (400,000 jobs were lost last month).

So why the fears of doing the one-time devaluation?  There is a consensus that this is what should be done, and if capital flight can be avoided or minimized, the economy stands a good chance of getting back on track.  The central problem in Russia is the low level of trust in the government to handle the crisis.  This is something that can be observed in the CDS spreads (credit default swap) between Brazil, which shares many characteristics with the ruble, and Russia.  A couple of months ago Felix Salmon at Portfolio had a terrific chart up showing  these differentials – which essentially expressed a greater doubt in the market that Russia would have the political wherewithal to remain solvent – at least compared to democratic Brazil:

Remember, historically Russia has trade through Brazil, as you can see:it’s only been trading wide of Brazil in the past two months. So thefact that it’s now 500bp wide of Brazil is kinda crazy. After all,they’re both mainly commodity plays, and their stock markets have bothbeen devastated. But the credit markets show a huge distinction betweenthe two countries which isn’t easily visible elsewhere.

There are of course a number of other factors accounting for the CDS spread, and I would be very interested for any of my finance readers to post more recent data.  However it seems safe to infer that the difficulties faced by Russia’s well meaning financial authorities are reflective of something we have argued on this blog for some time now:  that authoritarian political systems, plagued by corruption, do not perform well during crises.

Photo:  File photo shows a man walkingpast a currency exchange information board placed near Moscow’s RedSquare. The Russian central bank said Thursday its internationalreserves fell last week by 17.9 billion dollars, as the countrycontinued its fight to prevent sharp falls in the ruble.(AFP/File/Maxim Marmur)