It's Time to Float the Ruble

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It is often argued that Russia should quote its oil price in rubles because it would reduce oil companies' volatility of revenues and thus facilitate investment planning. Perhaps it would also strengthen the ruble exchange rate and promote its status as an international transaction currency.

This is a misconception. It is more or less irrelevant whether the oil price is denominated in dollars, rubles, euros or, for instance, the International Monetary Fund's Special Drawing Rights, or SDRs.

Now that oil exporters are flush with dollar assets, they are increasingly diversifying into other currencies. But these are only plausible investment alternatives if these countries have well-developed capital markets. Candidates are the euro zone, Britain, Canada, Japan and Switzerland, but not China, India or Russia. Requirements for net private financial capital inflows are the absence of capital controls, low inflation, an independent central bank and diversified capital markets.

Will the ruble appreciate? As we all know, it would actually appreciate quite significantly if the country's Central Bank stopped buying almost all the dollars offered to it. The surplus in Russia's current account, which mostly reflects the trade surplus, plus private capital inflows create a strong demand for rubles by foreigners. This would normally make the ruble more expensive vis-a-vis the dollar, euro and yen.

As it is, the Central Bank sells rubles at more or less fixed prices against these currencies. This drives up the country's foreign exchange reserves -- presently at $550 billion -- and also increases ruble deposits at banks. This is one of the main reasons why inflation has been accelerating to more than 15 percent on an annual basis.

The ruble is undervalued at this point. To restrain inflation, the Central Bank would probably love to stop creating all these ruble deposits and let the free market decide which ruble/dollar or ruble/euro exchange rate is appropriate. Since the appreciation would be in the order of 20 percent, it is obvious that imports would become correspondingly cheaper and make Russian products outside of commodities -- which have world market prices -- uncompetitive.

Imports of manufactured goods are already booming, with rates of increase in the order of from 20 percent to 25 percent yearly in volume terms. Policy makers fear that all manufactured goods that can easily be traded will then be imported, and large parts of Russia's domestic industry would disappear.

But markets cannot be kept down forever. The steep increase of inflation -- and wages -- makes Russian products less and less competitive in any case, regardless of all of the attempts to manipulate or manage the exchange rate. The result is almost the same as letting the ruble float, but it is more expensive because there are economic costs of letting inflation rip. The costs are seen mainly in an unfair income distribution and an inefficient allocation of resources since too much spending is aimed at hedging against inflation -- and therefore wasted.

As a result, the construction sector, in particular, may get too big and too bubbly. The risk is that the inevitable popping of such a bubble would turn into a shock to home buyers and thus lead to a decline of consumption growth.

We are approaching the day where the government will be forced to stop intervening. After all, Russia's goal is to make the ruble a regional reserve currency. Only currencies that are not pegged to some other currency (or currencies) qualify for such a status. My guess is that the ruble has a 20 percent upside potential against the dollar.

The timing of the ruble appreciation is hard to predict. If it does not take place within the next two years, inflation will accelerate even more and thus become a genuine problem for policy makers. It would lead to social unrest or a serious decline of the administration's popularity.

The main downside risks for the ruble exchange rate are a steep decline of export prices and, at the same time, an ongoing import boom. Both would wipe out, or reduce significantly, the country's balance on current account surplus. This, in turn, would reduce the demand for rubles and lead to its depreciation.

For now, these risks look remote. The current account surplus so far this year has been in the order of 8.5 percent of gross national product and rising. In relative as well as in absolute terms, it is one of the world's largest.

Dieter Wermuth is an economist and partner with Wermuth Asset Management in Frankfurt.