I recently spent a few days in Moscow meeting with a variety of economic and financial officials and analysts, both in the public and private sector.
Until July of this year Russia was growing at an annual rate close to 8%, oil prices were peaking at $140 a barrel, the country was running a large fiscal surplus and a large current account surplus, it had a war chest of $600 billion plus of foreign reserves, its stock market, bond markets and currency values were strong and policy makers were thinking of turning the rouble into a major reserve currency, at least for the CIS bloc. This economic and financial success was leading Russia to flex its geo-political muscle challenging the U.S. on a number of political and military issues, using its energy power as an instrument of foreign policy in its relations with the Eurozone and its former Soviet neighbors. The peak of this geopolitical resurgence of the Russian bear was during the August war with Georgia when Russia flexed its military power while the US looked impotent in its inability to defend an alleged ally.
But what a difference a few months make: six months later Russia is today in deep economic and financial trouble. Let me now explain in detail why…
Today S&P announced it has lowered Russia’s foreign currency credit rating by one notch from BBB+ to BBB. In less than six months oil prices have fallen to less than $50 a barrel (from the $140 plus peak of July); the stock market has fallen by over 60% and in some days it has been shut down to prevent a free fall; the current account surplus has turned into a near deficit and a sure deficit by 2009; the country has experienced a capital flight of over $100 billion and has lost about $150 billion of foreign reserves (now down to about a $450 billion level); it is facing massive external debt financing problems as its banks financed their lending with foreign currency borrowings and its corporate firms financed massive expansion with foreign currency debt; it is now desperately trying to prevent a sharp depreciation of its currency by aggressive forex intervention; it may face a large fiscal deficit (2% of GDP) next year; and its GDP growth rate is sharply slowing down leading the World Bank to predict a growth rate of 3% alone in 2009 while leading local analysts are predicting an actual recession (negative growth of as much as -2%) in 2009 (see the recent analysis by RGE’s Rachel Ziemba for more on the risks of a hard landing in Russia).
Given this sudden change in the Russian fortunes there are several key policy issues that the policy authorities need to deal with: of course given the external shocks (terms of trade worsening and sudden stop of capital and credit) it was important to use the buffer of foreign reserves to avoid a bank run by providing liquidity and capital to banks and by providing a fiscal stimulus to a country that is sharply slowing down. But the key unresolved policy issue is what to do with the exchange rate. Until recently Russia was on an effective basket peg (with 55% for the dollar and 45% weight for the euro). But with oil prices now down over 60% from the peak of the summer and with incipient current account deficits and fiscal deficits and a likely recession in 2009 the currency is obviously overvalued. A reasonable estimate of the needed exchange rate depreciation – with oil at about $50 a barrel in 2009 – is 25%. But until recently the authorities resisted the needed depreciation through aggressive forex intervention.
The reasons for resisting such necessary depreciation were varied: the banks and the corporate sector had massive foreign currency liabilities and a sharp movement of the currency would have led to nasty balance sheet effects and severe financial distress; the incipient bank run of retail depositors could accelerate if the currency were to fall sharply (Russian depositors were wiped out already twice in the transition period in the early 1990s and again in 1998 and they tend to be trigger happy); Putin staked part of his reputation and his view of a strong Russia on maintaining a strong rouble.
But the forex intervention that financed the capital flight out of Russia (a flight initially triggered by the increase in political risk given the Georgia conflict and then exacerbated by the global sudden stop of capital given the US financial turmoil in October-November) exacerbated the flight. Indeed, a good part of the forex intervention was sterilized thus preventing a significant stabilizing increase in domestic interest rates that an unsterilized intervention would have triggered. But, as a perfect case study of Triffin’s “inconsistent trinity”, a country cannot maintain a peg, have no capital controls and, at the same time, maintain monetary independence and avoid an increase in domestic interest rates that an expected depreciation triggers. The sterilized intervention thus led to a persistent bleeding of forex reserves that would continue unless such intervention is allowed to be unsterilized and thus force a rise in interest rates that would however be seriously costly in growth terms.
For a while the Russian authorities tried to skirt this inconsistent trinity inconsistency by introducing capital controls on capital outflows (taking the form of reading the riot act to local and foreign banks and financial institutions and telling them not to speculate against the rouble). But even such controls are leaky as many banks – faced with retail depositors converting roubles into dollars – needed to hedge such currency risk to avoid exacerbating their open currency positions mismatch. So the authorities cannot be too heavy handed against banks that are just hedging rather than “speculating”. And unless capital controls are imposed on retail depositors their demand for currency hedging drives the financial institutions need to hedge in turn this currency exposure. So the conundrum of the inconsistent trinity still holds as there are limits to regaining monetary independence under fixed rates when such capital controls are effectively leaky and implemented partially.
The more appropriate way to regain a modicum of monetary independence and prevent a sharp increase in domestic interest rates that expectations of a rouble depreciation trigger is to let the currency peg go and flexibilize the exchange rate regime. Only after the currency has moved down enough expectations of further depreciation would quiet down. So, the right policy move would be one of a one-step large depreciation of the currency value that reduces significantly the amount of actual overvaluation of the currency. Instead, for the time being, the authorities have reacted by allowing only a gradual and modest depreciation, in a series of four 1% downward steps in the last month. But such small step depreciations exacerbate the capital flight incentives (and ensuing bleeding of reserves) as they lead to further expected depreciation expectations that triggers further flight. Only a relatively large unexpected step depreciation can stop such expectations and reduce the amount of the capital flight and forex reserve depletion.
But so far authorities had resisted such large step move for three reasons: losing face politically; worrying about a run on banks by depositors; and the large foreign currency exposure of financial institutions and corporate firms. These three reasons to resist a larger currency move are now becoming less important for several reasons. First, a continued bleeding of a large stock of reserves could cause a much bigger problem down the line – a real currency crash that would be politically even more damaging – if continued sterilized intervention leads to a sharp fall in reserves at the time when the current account and the fiscal account are likely to move into a deficit in 2009. Second, the risk of a bank run can be better managed via a controlled devaluation when reserves are still high rather than when reserves have been mostly depleted via a self-defeating defense of an indefensible peg.
Third, and most important, by now a significant part of the foreign currency exposure of the financial and corporate has been reduced by using the forex reserve intervention to effectively allow banks and corporate firms to reduce their exposure to foreign currency liabilities and thus avoid severe balance sheet effects when the currency moves by a larger amount.
Effectively Russia has been doing what Brazil did in 1998-99 – i.e. bailing out ex-ante its banks and corporates by allowing them to cover their forex currency exposure via purchase of a large fraction of the reserves of the central bank;. This Brazilian “ex-ante bail-out” prevented the “ex-post bail-out” that would have been necessary if banks and corporates with a massive amount of foreign currency debt had experienced a large currency depreciation before they had the time to hedge such exposure. So now that the forex reserves of Russia have been run down enough to reduce the foreign currency exposure of the private sector the central bank can allow a faster rate of rouble depreciation without worrying about the banks and corporate going bust via the balance sheet effects of a large currency move on the value of their previous large foreign currency exposure.
All these factors suggests that the Russian authorities are now ready to let the currency fall at a faster rate than it the past. They have already moved in that direction by surprising markets with their weekly 1% moves. But since a much larger depreciation is needed and since further expected 1% moves will trigger even greater amounts of capital flight and reserve depletion a broader and large one-step move is now necessary and viable. The rouble may need to fall by about 25% before reaching a new equilibrium value. It is thus better to make a good chunk of that adjustment faster and in an unexpected way rather than keep on bleeding a large stock of forex reserves if small step movements trigger expectations of further depreciation. Now that banks and corporate firms are more hedged than before and the war chest of reserves has not yet fallen to alarming levels it is time to let the currency level take a larger burden of the necessary adjustment that the country needs to cope with lower oil prices, the sudden stop of capital, the increase in investors’ risk aversion and a global economic outlook that signals a sharp recession in advanced economies and a very likely recession in Russia too.
As Chairman of RGE Monitor, Nouriel Roubini provides strategic guidance for RGE Monitor’s business and content. Professor Nouriel Roubini is an internationally known expert in the field of international macroeconomics. He is a Professor of Economics at New York University’s Stern School of Business and is also the co-founder and Chairman of RGE Monitor, an innovative economic and geo-strategic information service named one of the best economics websites by BusinessWeek, Forbes, the Wall Street Journal and The Economist. Two years ago, Professor Roubini predicted the current economic crisis.