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Russian Central Bank Has Right Strategy - But Lousy Tactics

  • Former Russian Central Banker says overall strategy of floating and devaluing the ruble is sound
  • Identifies errors by the Central Bank as the primary cause of the ruble crash

Preface by Alexander Mercouris.

In discussing the rouble crash on 16th December 2014 (“Red Monday”) this article in the Financial Times, being written by a former Deputy Governor of the Russian Central Bank, has the enormous advantage over all other discussions of what happened, in that it is written by an expert, who knows what he is talking about.

The writer of this article is an opponent of the Russian government. 

Not surprisingly therefore it contains a mandatory paragraph that not only sets the scene for the rouble crash but which contains some very mild and rather veiled criticism of the government.

The fact that the article avoids ad hominem attacks on the government and on Putin specifically and focuses instead almost exclusively on the actions of the Central Bank, however makes its explanation of what happened even more persuasive.

Briefly, the Central Bank was right to float the rouble and to let it decline in line with oil prices. 

As the article says “In order to maintain its balance of payments, Russia needs to cut its imports by more than 50 per cent and this requires a significant adjustment of the rouble’s exchange rate.”

As we have previously said, not only is it in Russia’s economic interests for the rouble to fall in line with oil prices, but the rouble was anyway seriously overvalued a year ago so a devaluation from those excessively high levels would have been necessary even if oil prices had not fallen as they have.

However the Central Bank, perhaps because of political pressure or due to its own inexperience in managing a floating exchange rate or possibly because of a combination of the two, botched its handling of the situation in the critical period between 11th and 16th December 2014. 

On 11th December 2014 it increased the interest rate by too small an amount (and by less than the market had been expecting) and it compounded its mistake by increasing the amount of roubles in circulation in the days that immediately followed. 

To compound these errors, the Central Bank failed to give proper guidance of its intentions to the market after it took its decisions.

We would add that the Central Bank also seems also to have seriously underestimated the banking system’s needs for foreign exchange in order to settle around $30 billion of foreign debt that was due for repayment in December.  

The result was that whilst the Central Bank was increasing the supply of roubles at low interest rates (including a massive $10 billion rouble loan made to the Russian oil major Rosneft), it was simultaneously limiting the supply of dollars to the financial system by refusing to help banks experiencing dollar liquidity issues either through currency interventions or otherwise.  

This set the scene for the crash on 16th December 2014 as a flood of roubles chased a dwindling number of dollars.

We appreciate that this explanation will not appeal to some people who are convinced that the crash on 16th December 2014 was the result of some sort of conspiracy or act of sabotage directed at Russia and orchestrated by the US government to punish Russia for its role in the Ukrainian crisis. 

No one however has provided the slightest evidence that this was the case or if it was has explained how it was done. 

Until such evidence or such an explanation comes forward it is better to stick with simpler explanations that provide in themselves a fully adequate explanation of what happened, especially when, as in this case, they are supported by the opinion of top industry professionals such as the writer of the following article.

We would finish by saying that these sort of events, though rare in the developed world, are by no means uncommon in emerging market economies of which Russia, with a financial system that is weak and small relative to the size of its economy, is one. 

For example in 1997 during the Asian Financial Crisis the South Korean currency the won declined from a rate of 800 to the dollar to 1,700 to the dollar, a fall comparable to that which the rouble has experienced. 

Though the result was a short recession, the South Korean economy quickly recovered and has boomed ever since. 

We expect Russia to follow the same trajectory, just as we expect Russian industry after a period of adjustment to benefit from the rouble’s fall, just as South Korea’s industry did from the fall of the won. 

Never before has Russia’s central bank been so much in the spotlight. In the space of just 29 hours — from 10am on Monday, December 15 to 3pm on Tuesday, December 16 — the price of US dollars in Moscow skyrocketed by 50 per cent.

The plunging rouble invoked memories of Russia’s financial crash of the late 1990s and swiftly prompted speculation of a wider economic crisis.

It has also raised questions about the handling of the crisis by the Central Bank of Russia (CBR), an institution which had established itself as one of the country’s more credible authorities.

There are a number of important factors outside the control of the CBR that have contributed to the crisis.

First, a lack of protection for property rights in the country led to a slowdown in investment and put the economy on the edge of stagnation in the middle of this year.

Second, western sanctions, first announced in May, have eliminated access to the international capital markets required by Russian banks and companies to pay foreign debt.

Third, oil prices have collapsed by 40 per cent since the summer, dealing a significant blow to a country where last year petroleum and refineries accounted for a minimum of 55 per cent of exports by value.

Russia’s strong current account balance and currency reserves are capable of sustaining the economy through either sanctions or a drop in the oil price — but not both at the same time.

In order to maintain its balance of payments, Russia needs to cut its imports by more than 50 per cent and this requires a significant adjustment of the rouble’s exchange rate.

In theory the central bank could use part of its foreign exchange reserves to make this adjustment more bearable. In October however, the CBR lost $30bn trying to smooth the fall of the rouble and has recognised that it cannot oppose the market. The CBR has therefore taken the correct move of announcing its acceptance of a free-floating regime.

But the right decision on the one side was nullified by a dubious decision on the other — despite growing pressure on the rouble, the CBR continued to provide liquidity to the banking system at an interest rate of 9.5 per cent while the rouble tumbled in value.

When the Board of the CBR increased the rate by 100 basis points on December 11, the move came as a surprise to many who had expected a more serious hike. But the CBR chair’s subsequent statement that it would not use the interest rate to fight devaluation demonstrated the central bank’s reluctant balancing of competing monetary and exchange rate considerations.

This strange position of the CBR was accompanied by the injection of another 1.5tn roubles provided as credits to the banking system under the same negligible rate in just two days. So the rouble kept on falling: by 3 per cent immediately after the CBR’s rate increase, and another 5 per cent and 10 per cent over the next two days.

At 1am on December 16 the CBR intervened again. The bank announced another rate hike — this time of 650 basis points — going back on its word and explicitly stating its intention to defend the rouble. Again, it seemed at first that the bank had been unsuccessful. When trading opened the following morning, the dollar jumped by another 30 per cent relative to the rouble in just five hours. Then, however, it began to settle. Traders had begun to recognise that the CBR’s reaction had been excessive, and the supply of foreign currency began to increase. The rouble rose in value, and the panic in the market subsided.

Nonetheless, it is clear that the CBR failed to use its weapons appropriately. The initial rate increase was too small — the second too late. Neither has stopped banks from borrowing roubles and to use them for purchasing foreign currency, meaning that devaluation may not be over. Further, the CBR has failed to intervene verbally explaining its logic and actions, keeping silent at a time when the market most needed guidance that resulted in the loss of confidence in monetary authorities.

Financial crises are a fixture of modern economies. Each has different origins, but the lessons they teach are very similar. A crisis requires that central bank action be timely, appropriate in scale, and accompanied by persuasive guidance. In this case, the CBR has done too little, too late and too quietly.

The writer is a former deputy governor of the Russian central bank

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