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The Rouble, A Perfect Storm

A number of factors, but not sanctions, are causing the Rouble's fall. Here's the breakdown.

This post first appeared on Russia Insider

One of RI's regular contributors, the author is a well known commentator on Russia in the global financial media

The economic sanctions enacted against Russia have proved a spectacular failure, hardening Russian resolve, enhancing Mr Putin’s popularity, but especially, causing greater economic pain to the European Union than to Russia. 

<figcaption>Exchange booths - they're on every corner</figcaption>
Exchange booths - they're on every corner

Although the Russian market accounts for only a few percent of European GDP, at a time when the EU is teetering on the brink of renewed recession  (inter alia, German economic indicators are now falling off a cliff) those few points can spell the difference between muddling-through and collapse.

The tame Western media find themselves desperate to produce a narrative showing the success of the sanctions regime – much as they did for various Washington policy initiatives: from the invasions of Iraq (Mission Accomplished!) and Afghanistan, to the war on “Terror”.

Russian GDP is indeed flat-lining – this predates the sanctions and can be attributed primarily to falling commodity prices and collapsing demand as Russia’s Western export markets slump into recession. If anything, the Russian countersanctions are driving import substitution, providing some support to industrial activity.

The Russian Rouble has depreciated by about 17% against the dollar over the course of 2014, due to a number of factors – the Western sanctions do not happen to being among them:

1. The primary driver is the collapse in oil prices. The rouble is a petro-currency par-excellence and the weakness in oil prices has been almost exactly mirrored by the fall in the rouble. In fact, Rouble weakness provides a vital buffer dampening the impact of falling energy prices on Russian finances.

2.  The global sell-off in emerging markets commodity currencies, most of which are weakening vs the USD. The Turkish Lira, Brazilian real and Australian dollar have taken a similar hit.

3. Dollar strength equals Euro-weakness - the Rouble prices against a basket of USD and EURO, so as the Euro weakens against the dollar, the rouble floats down with it. The Euro-Rub rate was actually slightly higher in March of this year (51.1), before the Crimean annexation, than at present (50.1)

4. The previous overvaluation of the rouble.  While Russia is seeing gradual disinflation - the CPI is still averaging 6-7% vs flat/deflation in Russia’s principal trading partners. Therefore, if the nominal value of the rouble is unchanged over the year, in real terms it revalues by 6-7% with a serious risk of “Dutch Disease” i.e. overvaluation of the currency which squeezes out domestic production.

5. Benevolent neglect. Aware of the risk of overvaluation, and focused on its inflation-fighting mandate, the Central Bank is moving towards a dirty float, in anticipation to a free-float in 2015.

6. Propaganda. Bloomberg recently quoted “unnamed sources” regarding a plan to reimpose capital controls, this despite firm and repeated denials by the Central Bank, the Ministry of Finance, and even President Putin. Their intent was apparently to create panic in the markets and they were not entirely unsuccessful.

Capital controls simply do not work in Russia, and there is no intent to reimpose them – on the other hand, a continued crackdown on money-laundering banks and abuse of offshore structures is vital.

7. Capital flight. Most anecdotal reports of massive capital flight are simply falsified, grouping together everything from domestic purchase of hard currencies for saving purposes, to Russian purchases of foreign assets abroad and the use of offshore structures to shelter Russian round-tripping investment. While there clearly is some true capital flight – represented by the “errors-and-omissions item – this is only a small fraction of the still very substantial trade surplus as well as the large inward FDI (foreign direct investment).

To date, the impact of the devaluation has been largely positive, however Rouble devaluation can be a two-edged sword – when gradual and moderate it is a major net benefit, enhancing the profitability of companies in the resources sector (rouble costs - dollar earnings), greatly improving the budget balance, and stimulating domestic business activity (import substitution, decrease in foreign travel, improved trade balance). 

Against this, domestic companies with large foreign borrowings can be squeezed, and reserve are eroded as the CBR steps in to replace foreign lenders; all things being equal, rouble devaluation has an inflationary effect, although the relative stagnation of GDP growth is anti-inflationary and with interest rates kept high, an inflationary breakout seems most unlikely. 

Finally, since unlike the situation during the American financial crisis of 2008 the Russian corporate sector is a net foreign creditor, financial stability is not threatened.

The principal danger is that, if devaluation were allowed to become excessive and disorderly, there would be the risk of a panicked flight by households out of Roubles into hard currency.  This danger is enhanced by the dual-currency nature of the Russian economy, with exchange booths displaying the dollar rate on every street-corner. The Rouble is now almost certainly slightly undervalued. 

Unfortunately, like non-professionals in every market, the Russian populace has tended to buy dollars at the very top, taking a loss when they must convert them back into roubles. Somewhat surprisingly, the third quarter saw dollar net sales by the populace - perhaps they are beginning to understand the rules of the game.

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