The Risks of a Devalued Ruble

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As oil prices have dropped below key fiscal support levels over the last few months, the outlook for the ruble has become a national concern. The currency rose steadily for five years but reversed course in July. Since then, it has given up most of its gains. After proudly portraying the ruble's strength as a sign of economic resurgence, the government has sent confused messages about its decline. These have ranged from ardent declarations that there would be no devaluation to more earnest admissions that devaluation appears inevitable. In a recent speech at a United Russia congress, Prime Minister Vladimir Putin took a balanced position, stating that there would be no dramatic devaluation.

The prime minister's remarks came after months of reserve depletion and a widely criticized devaluation, when the Central Bank widened the ruble trading range by 2 percent. The market knew that the new level was indefensible, and it subsequently doubled its bets on further devaluation. Sure enough, the Central Bank broadened the trading band again this week, and further steps are likely to come.

It is natural that a country with a history of destructive currency moves is overly cautious in its assessment of currency behavior. But currencies should not be expected to be immobile. Their fluctuations allow for important economic adjustments essential to economic growth. The ruble needs to fluctuate more freely to control the relative cost of imports and exports to keep economic development alive.

For several years, as the price of oil rose, the authorities battled to keep the ruble weak in an effort to minimize the effects of the so-called Dutch disease, the phenomenon by which exports of one product (usually oil) overwhelm a nation's trade balance, causing the currency to rise and making other export sectors less competitive.

The result of keeping the ruble undervalued was a large accumulation of foreign currency reserves, which have helped the nation cope with the counterswing now underway. Financial markets have crashed spectacularly, but the ruble has been relatively protected. So there are grounds for optimism, but prudent investors are considering both the best- and worst-case scenarios. Where the ruble goes next depends on two key factors -- the price of oil and the authorities' behavior.

If the price of oil rebounds from current levels, the downward pressure on the ruble will rapidly ease. Should this happen, the risks could shift sharply back toward strong ruble fears, as the Central Bank is creating more flexibility by widening the ruble corridor at both ends. Ultimately, this will increase pressure on domestic companies with regard to their global competitors.

But a sudden strong rebound of oil prices is unlikely in the face of the most significant economic shock since the Great Depression. More likely, the ruble will remain under downward pressure in the short and medium term. The impact of this process will depend on its severity and the skill with which it is handled.

It is not surprising that the management of the devaluation started badly when the ruble came under pressure sooner than most expected. But it has begun to improve, with the authorities uniting around the idea that the ruble will devalue moderately. If we manage to avert a global depression, a gradual and controlled devaluation is most likely.

Nonetheless, the consequences of devaluation will still be serious -- above all, a rise in inflation as imports get more expensive, and fiscal stress as salaries rise accordingly. But under a gradual devaluation, Russians are not likely to resort to a widespread, panic-driven switch from rubles to dollars, something that would cause a meltdown of the banking sector and the broader economy.

Under the most likely scenario, the devaluation of the ruble is likely to reflect Russia's first stable business cycle in the post-Communist era. The economy will slow and people will adjust their spending habits, but a general stability will remain. As commodity prices rebound, so too will the ruble and the country's economy.

But what are the risks to such an outlook? If the price of oil falls even further or if the government mishandles the devaluation process, the economic situation could rapidly deteriorate and expose a lack of international credibility. For five years, many bullish investors have bragged that there will be no repeat crisis, as the state has pursued fiscally sound policies.

Skeptical investors have adopted a more cautious approach, however. There are ample global cases to demonstrate that it is policies, not reserves, that prevent currency crises. Foreign exchange reserves, however large they may be, are simply a target for the market to pick off. Russia's reserves have dropped more than 20 percent in the last few months. If lower oil prices cause a current account deficit, the ruble devaluation could easily take on a life of its own, and this could easily lead to a crisis of confidence.

Without supportive capital flows, a sharper devaluation would be difficult to prevent. But if that caused the population to lose confidence in the ruble, the progress of the last few years could vanish as swiftly as equity prices have vaporized over the past six months. Russia's gross domestic product is now three times larger than it was in 1997, so there is much more to lose.

Clearly, the government will do all that is possible to avert such a catastrophe, and it is unlikely that the population will panic so easily. After years of strong growth, people implicitly understand that economic consolidation is underway, so it would take a major shock to cause a run on state-owned banks.

The most probable outlook is positive, and Russia is unlikely to suffer a repeat of 1998. But the risks are real. Either way, businesses and consumers should prepare for greater currency volatility, and the government would do well to start building an attractive investment climate.

James Beadle is the chief investment strategist at Pilgrim Asset Management.