Gradual Devaluation Saved Russia

Since the ruble began its dramatic slide in value in August, I have been bombarded with the same question from nervous investors, confused journalists and even my mother: What is happening to the ruble?

As an economist (and a good son), I told them that the devaluation of the ruble is the natural result of the new realities of the world economy and the sharply lower price of oil. We're in a global recession and the prices of commodities, Russia's big exports, have nose-dived. That, along with the machinations of currency speculators who are betting on its decline, is causing the ruble to lose value relative to other currencies. So you might have noticed that, for instance, your ruble salary isn't going to buy you nearly as nice a vacation in Paris or New York that it might have a few months ago.

Then I quickly launched into a critique of the Central Bank's approach of step-by-step devaluation of the ruble, which has cost the country $100 billion in reserves, raising the total reserve loss since the beginning of the crisis to $210 billion. What is needed, I and other economists insisted somewhat self-righteously, is for the Central Bank to step aside and allow a dramatic one-off devaluation. I proposed knocking perhaps an additional 20 percent off the value of the ruble, which, by the time the Central Bank began its policy of gradually letting the ruble slide, had already lost 15 percent versus the dollar on the back of the euro's tumble.

Almost two weeks ago, Central Bank chief Sergei Ignatyev gave in and called an end to the gradual devaluation policy. He set the bank's new basket band at 26 to 41, which at that time represented an additional depreciation allowance of 10 percent. It meant that the bank was "drawing a line in the snow," as one analyst put it, and committing to not allowing the ruble-dollar exchange rate to fall below 36.20 at the then-prevailing euro-dollar rate.

Ignatyev made the important argument at that time: The current exchange rate balances the country's current account. Although that is basically true, it is key to remember that Russian companies have significant foreign debts coming due this year, and they will clearly not be refinanced across the board. The $130 billion net capital outflow from Russia over the fourth quarter of 2008 stands in marked contrast with the $83 billion inflow recorded in 2007. The ruble's 11 percent devaluation against the dollar in the fourth quarter did not stop speculative capital outflows from Russia, but it did reduce import growth. We expect further devaluation to have the same effect in 2009. Therefore, the Central Bank will still have to sell reserves to cover foreign exchange purchases by corporations repaying their external debt. Even if this is done through the existing Vneshekonombank facility, it will still deplete the Central Bank's foreign currency reserves.

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As we look ahead, the financial system looks like it will remain short rubles for now, and I expect the ruble to push the new upper limit of the Central Bank's band in a matter of days. Thereafter, the Central Bank will be forced to conduct moderate-sized interventions, as the capacity for banks and investors to short more rubles remains limited. There is also likely to be some additional short covering, as the Central Bank will likely continue to take occasional punitive action and -- with no obvious immediate upside -- holding short positions will be too risky and too expensive for some investors.

This situation, I believe, can be sustained for two or three months, assuming that there isn't a significant dip in the oil price. For a variety of reasons we can say with confidence that the oil price in the medium term will return to roughly $70 a barrel. The problem is that it is much harder to predict with any certainty what the oil price will do in the short term. Earlier this week, it was down below $40. If it dipped close to $30, the Central Bank would effectively be forced to abandon its defense of the ruble.

We expect oil to recover, and the exchange rate to recover along with it -- to 29 rubles to the dollar by the end the year. If, however, the oil price recovery takes longer than we expect, or worse, if it declines further, a free float of the ruble will become hard to postpone. At present, Ignatyev is targeting a free float of the ruble in 2011, which in these chaotic times is so far off it feels like never.

Some effects of the devaluation are still to be felt, particularly for Russian industry and businesses -- what economists call "the real sector." The devaluation makes the country's producers of products, such metals, food and even automobiles, significantly more competitive on both the domestic and international markets. But it is clear that the benefits to industry will not be nearly as large as what we saw following the 1998 devaluation. Russian industry is much closer to running at full capacity today than it was a decade ago, thus precluding any big pickup in production.

Today more and more economists, including myself, are eating our words to a certain degree. We have to admit that the Central Bank's gradual devaluation policy has largely been vindicated. Yes, it has been costly in terms of reserves, but it looks to have succeeded in insulating the population from the kind of economic shock and pain they have experienced more than once in Russia's modern history. The fact that people have not been changing out of rubles aggressively is proof that it has worked, at least to some degree.

Gradual devaluation has also given people, banks and corporations time to prepare for new economic realities. Most of reserves spent went into the pockets of ordinary Russians or dollar accounts of those better off. They also went to Russian corporate treasuries and banks. Contrary to popular opinion, only a small share left the country in the hands of Western speculators.

This is the first crisis in Russia that hasn't been accompanied by a runs on banks, a collapse of the banking system or the bankruptcy of large corporations. True, we still haven't reached the bottom of the crisis, but barring a prolonged and deep recession that keeps commodity prices low, it looks as if Ignatyev's cool hand may succeed.

Alexei Moisseev is head of fixed income research at Renaissance Capital.