Kudrin gets it half right


There’s a slightly worrying report today in the Wall Street Journal of Finance Minister Alexei Kudrin saying that Russia is a “weak link” in global capital markets while discussing the country’s plans to issue its first Eurobond in a decade this coming February. He’s right that Russia is a weak link; he’s wrong about the reasons why. Let’s look first at what exactly is being said:

Russia is a “weak link” in global capital markets and will be vulnerable to capital flight as other countries see their economies improve and raise interest rates, Finance Minister Alexei Kudrin said on Tuesday.

“For the moment, in this global economy our capital market is still a weak link,” Mr. Kudrin said at an economic conference. As developed economies raise interest rates, “volatility will be felt on our equity markets, in our currency exchange rate and in our trade balance.”

The central bank has said it will limit corporate borrowing abroad by state-controlled Russian companies in an effort to smooth out exchange-rate volatility and develop the country’s relatively shallow local debt market.

And then:

Russia has been hit by a wave of speculative capital in recent months, as international investors have been drawn by higher oil prices and interest rates, benchmarked against the central bank’s 9% refinance rate. That tide of hot money has pushed the ruble higher by 5.5% against the dollar since September, hurting the profits of exporters with expenses in the local currency.

Central bank efforts to fight speculative capital, including nine interest rate cuts since April, have had only limited success.

The ruble weakened Tuesday, falling to more than 30 to the dollar for the first time in more than two months.

Mr. Kudrin called for world-wide regulation of financial markets, which he said would go a long way towards smoothing out volatility.

Lots of problems here. Let’s go in order. First paragraph – the suggestion that higher interest rates are the explicit outcome of improving economic performance goes against a not at all small foundation of economic theory not to mention history. Interest rates make the cost of borrowing money rise. The reason that money is more expensive to borrow in one place versus another or for one borrower versus another is that there is a greater risk of not being paid back. That’s it. It is not any more complicated than that.

Second paragraph: As more developed economies raise interest rates, Kudrin is correct in predicting that will likely mean more volatility for Russia’s equity markets, exchange rate and trade balance. But this volatility will be caused by what was speculative capital to begin with, and not all of it will come to the conclusion that the interest rate differential alone warrants pulling money out of Russia. Aside from that, is speculative capital really the audience to cater to here?

Third paragraph: No disagreements there.

Fourth and fifth paragraphs: This should go without saying but I’ll say it anyway – one of the biggest challenges Russia faces from a macroeconomic standpoint is its overwhelming dependence on energy exports. Tinkering with interest rates is only a band-aid solution at best and really only addresses short-term speculative capital. Furthermore the attraction of higher interest rates relative to other countries for speculators holds only insofar as those very speculators think the ruble will remain strong and/or continue strengthening against currencies from lower-interest rate countries. The unspoken phrase here is “carry trade“. While the influence of the carry trade has certainly gained dramatically in recent years as a short-term driver of global capital movements, it actually goes 100 percent against the theory of interest rate parity, which is a much more integral determinant of longer-term cross-border investment.

So what makes Russia the weak link? Well, apart from the well-known tangle of red tape that greets businesses, to say nothing of its political governance, the other unspoken phrase here is “Dutch Disease“. Entire doctoral theses have been devoted to discussing how to remedy this problem so I will not get into it here this time around but suffice it to say, it cannot be done simply by toying with the interest rate lever.

As for advocating world-wide regulation of financial markets, I’m surprised to see Kudrin jump on this bandwagon, as I’ve never considered it more than a bureaucratic posturing talking point, something that Kudrin has previously indicated a couple of times he has more sense than to support.

So where does that leave us? Might capital controls do the trick? I’ll take this up shortly in a separate post.