The Value of the Ruble

Over the last six weeks, the value of the ruble has demonstrated phenomenal growth. From the end of April to the middle of June, it increased by 7 percent. During the same period, the rate of inflation, although falling, remained very high: 8.5 percent in April, 7.9 percent in May and no less than 6 percent in June.

There are many indicators that show whether a currency's exchange rate is too low or too high relative to its long-term equilibrium point. First, there is a nation's trade balance and the rate at which it is growing. If the trade balance is positive and growing, then that is a reliable sign that the currency is undervalued. If a positive trade balance is decreasing, that means the currency is overvalued.

Russia's trade balance in 1992, taking into account barter trade, was positive, equaling $5.4 billion per year. In 1993, it was $10.7 billion and in 1994 -- $12.3 billion. Between January and April 1995, this positive trade balance grew to $4.4 billion, 27 percent higher than for the same period in 1994.

Another indicator is the size and dynamic of the country's hard-currency reserves. If they are growing -- assuming all other things being equal -- that indicates a policy of reducing the exchange rate. If the reserves are falling, that means the government is trying to support the exchange rate. At the end of 1991, the Central Bank's hard-currency reserves, not including gold, equaled $16 million. At the end of 1992, they had reached nearly $2 billion and by the end of 1994, the reserves were worth $3.3 billion, with an additional $1.4 billion held by other agencies. In the last two months of 1994, Russia's hard-currency reserves grew by $1.6 billion and then added roughly another $3 billion to $4 billion in the period from February to June 1995.

A third indicator is the dollar value of the average wage and of incomes in general. Increasing real incomes -- again, other things being equal -- indicate a strengthening of the national currency. In 1992, the average monthly salary in Russia expressed in dollars grew 5.5 times, from $7 to $30. In 1993, it grew another 2.9 times to $114. However, in 1994, it fell 9 percent to $104 and it fell again in the first four months of 1995 to $80.

In short, all the indicators show that the present exchange rate of the ruble is low compared to what it should be under conditions of medium-term equilibrium. But how low is it?

As a country's level of economic development increases and its economy becomes more open, domestic prices approach world levels which automatically leads to an increase in the real exchange rate of the national currency. Over the medium term, each country has its own relatively stable price levels, exchange rate and purchasing-power parities.

For Russia, the relatively stable price level is about 70 percent to 80 percent of the price level in the United States. Since this indicator was at about 40 percent between February and April, this meant that the ruble's value was half of what it could be.

From the point of view of theory, it is absolutely unimportant whether the nominal value of the ruble approaches price levels (that is, whether it continues to grow to about 2,500 to 3,000 rubles to the dollar) or whether price levels will increase to correspond to the exchange rate (that is, approximately double). From the practical point of view, it is obvious that inflation will not stop tomorrow. Therefore, it would be most reasonable for the government and the Central Bank to maintain a relatively stable exchange-rate level until domestic prices have more or less doubled. If the government maintains the budgetary policies that it pursued in the first quarter of 1995 and the Central Bank maintains its monetary policies, this process should take about a year.

Why is the ruble undervalued? One reason is the Central Bank's policy of accumulating hard-currency reserves. In order to increase its reserves between November 1994 and April 1995, the Central Bank conducted massive ruble interventions which reduced the exchange rate. An additional release of money increased the ruble money supply, which fueled inflation while the low exchange rate simultaneously fed inflationary expectations. As a result, the seemingly beneficial growth of hard-currency reserves actually did harm to the emerging policy of financial stabilization.

A second reason for the undervalued ruble is the fact that the economy is still not fully liberalized and an unprecedented system of benefits and privileges still exists within it.

The undervalued ruble will have many wide-ranging consequences. For one, it drags out the process of financial stabilization and, if the accumulation of hard-currency reserves continues, could undermine it altogether.

Second, the undervalued ruble means depressed prices for domestic goods. The difference between domestic and world prices will neutralize any measures intended to prevent the mass outflow of raw materials at obviously reduced prices.

Third, reduced prices for domestic goods create a tremendous potential for corruption.

Fourth, an undervalued ruble will close the domestic market to competition from imported goods and services more effectively than any customs duties could. As a result, the economy will be deprived of powerful stimuli to development and will be condemned to prolonged stagnation.

Fifth, consumer spending and demand, expressed in dollars, will remain lowered, meaning that society's consumption levels will be artificially low and consumers will be forced to make do with shoddy domestic and imported goods.

Sixth, the undervalued ruble facilitates the outflow of capital and hinders the inflow of foreign direct and portfolio investment, which blocks the onset of economic growth.

Of course, increasing the real value of the ruble is not the only medicine that is necessary to heal the national economy. But without it, nothing else will do any good at all.

Andrei Illarionov is the director of the Institute of Economic Analysis. He contributed this comment to The Moscow Times.