Russia Dollar Peg Is a Bad Idea. Here Is Why

  • It's unworkable. It would deplete Russia reserves and collapse as these depleted
  • A free floating ruble has allowed Russia to maintain a budget surplus and a positive trade balance
Sun, Dec 21, 2014
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A peg to an inflated fiat currency? A bad idea

The recent fall in the fall of the rouble has spawned a variety of proposals for a “solution”. On of these is the idea of a currency board idea. The article below by a US economist, Steve Hanke, advocates and explains this idea.

There is little prospect of Russia adopting a currency board solution of trying to fix the Russian currency to the dollar.

Given the immense scale of money flows, on an incomparably greater level than was the case in northern Russia in 1918, the idea would be unworkable.

Hanke in any event misunderstands the nature of the fixed “northern” rouble of 1918. Circulating in an area basically controlled by the British army and under the ultimate supervision of the British Treasury, it was essentially the pound sterling circulating in civil war Russia wearing Russian clothes.

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Not surprisingly, given the state of the rest of Russia at that time, it was a much stronger currency than all the other Russian currencies circulating in Russia at that time - especially the official rouble of Soviet Russia which was going through a period of hyperinflation.

This situation bears absolutely no relation to the situation in the international currency markets that exists today.

Even if a dollar peg could be maintained for a short time it is difficult to see the economic logic. One of the great advantages for Russia of a floating rouble (which currently means a falling rouble) is that Russia is compensated for the fall in oil prices, which as the article actually shows, the rouble’s fall has closely matched. 

The result is that Russia’s budget and trade balance have remained in strong surplus. If the rouble were fixed to the dollar, then since the dollar is currently appreciating and since the price of oil (Russia’s key export) is priced in dollars, Russia’s budget and trade balance would quickly fall into deficit. 

Given the need of Russia’s corporates to pay off dollar denominated debt (the main the reason why the rouble has fallen further than the price of oil and the cause of the brief plunge of the rouble on 16th and 17th December 2014, which was the result of Russian corporates having to pay off $30 billion of dollar denominated debt in December) an attempt to maintain a peg to the dollar would quickly put the Russian economy under intense pressure, which is why the peg would quickly collapse.

In the meantime the effort to maintain the peg would lead to Russia rapidly selling off its foreign currency reserves, as happened in 1998 and (on a lesser scale) as also happened in Britain in 1992 during the so-called ERM crisis (another attempt to maintain a peg - this time to the Deutschmark).

From every point of view a currency peg is a bad idea despite its superficial attractions

As Hanke says, a floating exchange rate at a time of falling oil prices does not create for Russia an ideal situation. Inflation is rising and will remain high for several months (though not excessively high by Russia’s standards). 

It is nonetheless the best solution to a difficult situation, giving the Russian economy the space it needs to adjust to the new situation caused by lower oil prices, which is why the Russian authorities have adopted it.

The text that follows originally appeared appeared at Cato Institute


The specter of currency wars once again haunts the international chattering classes. Remember back in 2011, when Brazilian finance minister Guido Mantega blamed the U.S. for deliberately weakening the greenback to gain a competitive advantage? Well, now the shoe is on the other foot.

The Yen — an important regional currency — recently sank to a seven-year low against the now mighty U.S. dollar (USD). This is putting downward pressure on the Korean won and other Asian currencies.

The situation is similar in Africa where the Kenyan shilling has hit a three-year low against the USD; the Nigerian naira recently set an all-time low against the dollar; the Ghanaian cedi has shed over 25 percent of its value against the greenback this year. The big Latin American loser is the Venezuelan bolivar, followed by the hopeless Argentine peso.

Moving to Europe, Ukraine’s hryvnia has lost over 88 percent of its value against the USD this year, while the Russian ruble has racked up a loss of over 43 percent against the greenback in the same time span.

The list could go on, but let’s focus on Russia and the travails of the ruble.

The ruble, while it has not been hit as hard as the hryvnia, has sharply depreciated because of the Russian-Ukrainian conflict and the sanctions that it has spawned.

The sanctions are, of course, a mug’s game. Indeed, sanctions have almost universally failed to achieve their objectives.

The one thing they do, though, is to impose real costs on many intended and unintended victims, including the international economic system. It is noteworthy just how predictable the unintended consequences are.

While the sanctions imposed against Russia have clearly contributed to ruble weakness, they have massively strengthened President Vladimir Putin’s hand.

Thanks to the sanctions imposed against Russia, President Putin’s support rose to 88 percent in October, according to Russia’s most independent polling group, the Levada Center. Undoubtedly, Putin got another boost in the polls after the shabby treatment he received in Brisbane, Australia at the meeting of the Group of Twenty (G20).

Diplomacy is dead. This is dangerous. As Clifford Gaddy, a Russian expert at the Brookings Institution in Washington, D.C., recently remarked,

“I fear very much that … there is an element of sleepwalking in the policies of key players in today’s world.”

Gaddy was alluding to Christopher Clark’s recent book, The Sleepwalkers, which chronicles the origins of the First World War.

In addition to the Russian-Ukrainian conflict, the ruble has been put under pressure because of the recent slide in the price of oil. As the accompanying chart shows, Russia’s fiscal accounts balance when the price of oil is about $102 per barrel.

If the present price of less than $80 per barrel persists, it will put most oil producers, including Russia, in a fiscal squeeze.

The ruble’s dive has been associated with the plunge in the price of oil, coupled with a series of damaging events.

But, that’s not the end of the story. The ruble’s volatility has soared. Indeed, whiplash collars should be standard issue for the brave souls who are trading the ruble.

The ruble's track looks pretty ugly, but it contains a bit of a silver lining, in the short-term. The depreciating ruble means that Russian imports will be more expensive and exports more competitive. This combination will help keep Russia’s current account positive, which will offset some of Russia’s massive capital flight.

In addition, Russia’s fiscal accounts are denominated in depreciating rubles and its oil exports are invoiced in an appreciating USD. So, the fiscal blow from lower oil prices will be cushioned by a weak ruble. Perhaps it was a weak ruble strategy that Putin was alluding to when he recently stated that Russia was braced for a “catastrophic” slump in oil prices.

But, there are limits to any temporary benefits from a ruble rout. When a currency takes a dive, the specter of inflation is always right around the corner. And with inflation, Putin will see his poll numbers come off their highs. What to do?

Russia should abandon the floating exchange-rate regime, which it adopted on November 10th. Oil and other commodities that Russia exports, are priced and invoiced in U.S. dollars.

By embracing a floating exchange-rate regime, Russia is inviting instability. The ruble’s nominal exchange rate will fluctuate with oil and other commodity prices. When the price of oil rises (falls) the ruble will appreciate (depreciate), and Russia will experience a roller-coaster ride distinguished by deflationary lows and inflationary highs.

To avoid these wild rides, most of the big oil producers — Saudi Arabia, Kuwait, Qatar and the United Arab Emirates — link their currencies to the U.S. dollar. Russia should do the same.

To get things right, Russia should lift a page from John Maynard Keynes’ Russian playbook and establish a currency board.

Under a currency board system a central bank issues notes and coins. These are convertible into a foreign reserve currency at a fixed rate and on demand. As reserves, the monetary authority holds high-quality, interest bearing securities denominated in the reserve currency. Its reserves are equal to 100 percent, or slightly more, of its notes and coins in circulation, as set by law.

A central bank operating under a currency board rules does not accept deposits and it generates income from the difference between the interest paid on the securities it holds and the expense of maintaining its note and coin in circulation. It has no discretionary monetary policy. Instead, market forces alone determine the money supply.

There is an historical precedent in Russia for a currency board. After the Bolshevik Revolution, when troops from Britain and other allied nations invaded northern Russia, the currency was in chaos.

The Russian civil war had begun, and every party involved in the conflict was issuing its own near-worthless money. There were more than 2,000 separate issuers of fiat rubles.

To facilitate trade, the British established a National Emission Caisse for northern Russia in 1918. The Caisse issued “British ruble” notes. They were backed by pounds sterling and convertible into pounds at a fixed rate.

Kurt Schuler and I discovered documents at the archives in the British Foreign Office which prove that the father of the British ruble was none other than John Maynard Keynes, who was a British Treasury official at the time.

Despite the civil war, the British ruble was a great success. The currency never deviated from its fixed exchange rate with the British pound. In contrast to other Russian rubles, the British ruble was a reliable store of value.

Naturally, the British ruble drove other rubles out of circulation. Unfortunately, the British ruble’s life was brief: The National Emission Caisse ceased operation in 1920, after allied troops withdrew from Russia.

Yes, it is time for Putin to lift a page from Keynes and follow what most large non-U.S. oil producers already do: link the ruble to the greenback.


Steve H. Hanke is Professor of Applied Economics at the Johns Hopkins University in Baltimore, MD. He is also a Senior Fellow and Director of the Troubled Currencies Project at the Cato Institute in Washington, D.C.

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