Ruble Ruckus

[The following post is by Scott Freeman]

Is the Devaluation of the Ruble a Disaster?

The media commentaries seem to be in almost universal agreement. The 50% drop in the value of the ruble is a disaster for the Russian economy. The Russian government is completely dependent on sales of oil, we are told, and now risks being unable to pay its bills. Moreover, in combination with the 50% drop in the oil price and the EU sanctions, the Russian economy is in danger of collapse. Russians are scrambling to find a way to get a hold of US dollars, and the Russian government is scrambling to find a way to stop the run on the ruble.

Some commentators think this just serves Russia and/or its government right; others opine that the fall in the oil price and/or ruble value represents some sort of economic warfare on the part of the United States. Either way however, almost all seem to be in agreement that it is something both bad and unplanned (at least by the Russian government).

But is it true? Is it actually a disaster? If the Russian central bank is actually panicking, why did it buy 600,000 more ounces of gold in November? Is there any evidence at all that the Russian government considers the devaluation to be a disaster? Or is there evidence that something else entirely is going on here?

Is a Currency Devaluation a Bad Thing?

First of all, let’s consider whether currency devaluations are necessarily a bad thing. In a world based on free trade and gold-backed money, in relative terms each region’s price levels would constantly adjust up or down in tandem with changing terms of trade. Nothing terribly problematic there. Are matters significantly different in a system where each country or region has its own fiat currency? In terms of ultimate result, maybe not. But what IS different is the delay factor. In the world of manipulated fiat money, it is quite common for currencies to remain either overvalued or undervalued for significant periods of time. Moreover, the addictive habit of money printing tends to exacerbate the issue, since it results in rates of inflation which differ from country to country and region to region. Thanks to this money printing, interest rate manipulation and other central bank tools, an illusion of stability is created, allegedly to smooth out the rough patches of the business cycle. The problem is that, for political reasons, things easily get out of hand, especially in cultures with relatively high time preferences such as those of Southern Europe. When the adjustment finally comes, it is typically sudden and drastic.

The contemporary economies of Spain, Greece and Italy all suffer from the problem of an overvalued currency, but cannot devalue because Germany and the European Central Bank continue to prop them up by buying their government debt. While their price levels have fallen somewhat, clearly the relative fall in prices has been insufficient to produce a market-clearing result and eliminate their current account deficits. Instead of exporting useful goods and services, they continue to export empty promises to repay debts. The adjustment down to market clearing levels still has yet to take place. 

The Curse of Easy Money

Matters in Russia have been similar for more than a decade, though with the variation that instead of financing the deficit by selling debt, Russia has been selling oil and gas. In nominal terms the Russian economy exploded by almost 10 times since the year 2000; yet during this period average inflation averaged over 10% per year. Despite this inflation, the exchange rate vis-à-vis the US dollar barely budged, falling from 28 in the year 2000 to 32.88 at the end of 2013. Russia went from having a very competitive low price level to a country with one of the highest price levels in the world. Russians traveling abroad went from feeling very poor to feeling very rich. By 2013 prices for all kinds of goods were 20, 30 or even 50% higher in Moscow than, say, in Vienna, not to mention Bangkok or Antalya. 1000 rubles (US$30 at the pre-devaluation exchange rate) may not have bought very much at home, but exchange them one to one into 1000 Thai baht and you could book a night at a beachside hotel. As many visitors to Thailand will recall, this is exactly what millions of Russians did.

Until 2010, the Russian government regularly accumulated budget surpluses amounting to 5-10% of GDP. It used these surpluses to pay back almost of its debt, so that now Russia has one of the lowest government debt loads of any major government around the world. Russia was able to accomplish this hat trick primarily thanks to comparatively tight control over spending and high prices for its energy exports.

While arguably far better than selling debt in terms of its effect on employment at home, part of the profits from energy exports were converted by the Russian central bank into piles of newly printed rubles. The inflationary effect of this “easy money” from the oil and gas sector made it hard for many of Russia’s other industries to compete, especially abroad. This is a common curse suffered by countries rich in natural resources. While the impact has not been absolute, it has been broad and deep. With so much easy money floating around, it simply made more sense to buy BMWs from Germany and computers from China than to produce them at home. That said, to keep matters in perspective it’s important to note that total imports only amount to approximately 15% of GDP, while exports of oil and gas make up less than 20% of Russia’s total economy. In other words, although the currency overvaluation skewed investment patterns somewhat, significant investments continued to be made in a range of industrial sectors. While some remnants of the scrap heap left behind by 70 years of communism can still be seen, in the past 14 years these investments have drastically transformed Russia.

Adjustment Inevitable Sooner or Later

If we consider the historical divergence between inflation and exchange rates, it becomes obvious what happened. If the value of the Russian ruble had been adjusted each year in line with the difference in inflation rates between Russia and its principal trading partners, the exchange rate would have fallen to 60:1 long before December 2014. While one can certainly argue that a gradual adjustment would have been preferable, this does not change the fact that the correction was inevitable and ultimately in the interest of long-term economic development. Certainly the Russians are luckier than, say, the Greeks or the Spanish, who seem to be eternally stuck in a kind of Promethean operating room where their open heart surgery gets repeated over and over again ad infinitum – without anesthesia of course.

Why Did the Devaluation Take Place Now?

Many market commentators have pointed out an apparent correlation between the decline in oil prices and the ruble exchange rate. At first glimpse this would seem to hint at a causal relationship. But does that guess stand up to the facts? The fact is that the Russian Central Bank has ample foreign currency reserves – over US$400 billion in fact – certainly enough to withstand any malicious attack on its currency in the short-term. No single entity inside Russia could borrow even a fraction of this amount without the approval of the central bank, and without those funds no massive ruble short would be possible. No change in the oil price, not even to $1/barrel, would change this. 

In fact, the evidence points to a far more obvious explanation. On October 6^th, 2013 the Russian central bank announced that it planned to float the ruble by 2015 at the latest.  And this is exactly what it did almost exactly 13 months later on November 5^th, 2014. “As a result of the decision, the ruble’s rate will be set by market factors,” the bank said in a statement. This was hardly a surprise, because for years the Russian financial press had discussed the fact that a substantial devaluation was inevitable. The only open questions were speed and timing. 

Moreover, at least in terms of economics, a devaluation is likely to be a net benefit to the Russian government. This is because most of its costs are in rubles, whereas a significant part of its income is in dollars. According to a recent calculation made by the Moscow Times, at least in the short term each additional ruble per dollar translates into 205 billion rubles per year in additional government revenue. 27 rubles x R205b = US$92 billion at 60:1. While such gains are likely to be partially offset by increased inflation, gains are immediate whereas additional costs are delayed. 

Why carry out the devaluation now in the midst of the oil price drop? The answer should be fairly obvious: because the oil price drop provided an excuse – a scapegoat if you will – for something which was both inevitable and planned. According to its own published figures, the Russian government had already expended US$80 billion to defend an unrealistic exchange rate, and anyone with basic math skills could see that a trend reversal was not very likely. It was only a question of timing, and for that, the oil price drop provided an ideal backdrop. The peg was abolished and the rate adjusted. The middle classes tend to be the principal losers in devaluation scenarios, but thanks to the apparent external cause, in this case for the most part they did not blame their government. 

How Was the Deed Done?

After stumbling around a bit in the mid forties, on December 15^th the ruble fell to a low of 64 to the USD. At that point the central bank announced an increase in its prime rate up to 17%. The initial rebound was short-lived, but after spiking down to approximately 77:1 (according to some reports as low as 80:1), the rate recovered to stabilize around the 60:1 level by the 17^th. As of December 24^th the ruble is hovering around 55 rubles/dollar, which represents a recovery of approximately 40%.

For those of us whose memories stretch back to 1980, this particular course of events should sound familiar. At the time it was the US central bank which raised its rates up to similar levels, while gold spiked up to $800+ and silver to $50. Cries were rampant that such high rates would destroy the US economy. We all know what happened after that. Gold and silver soon crashed back down to earth. Following this, despite persistently high levels of government spending, the US economy turned the corner and launched into a new era of prosperity and growth, leaving the stagflation of the 1970s behind. Why? One obvious reason is that high interest rates encourage saving, which in turn increases the pool of resources available for investment. In any case, the doomsday prophets did not fare well; on the contrary. 

Perhaps the reason why this particular case is often forgotten is because central banks frequently raise interest rates as part of a strategy to defend an unrealistic currency peg. A contemporary case in point is this week’s attempt by the Belarusian central bank to defend its currency peg by charging a 30% surcharge on foreign transactions and hiking interest rates to 50%. Such strategies have been shown time and time again to be useless. The promise of obtaining 17% interest a year later is not very attractive when the risk is a 30% immediate loss thanks to a devaluation. Any central bank playing at this game is essentially playing to lose, in all likelihood for the benefit of insiders in a position to take advantage of it.

If, on the other hand, the central bank avoids committing itself to any particular peg, and especially if the currency has already reached a level which is potentially market-clearing, then matters are different. Let’s say, just for the sake of argument, that the Russian Central Bank planned to target a new short-term “floating peg” of around 60:1. This may in fact be the case, but regardless of the exact rate, the principle is the same. If I want to target 60:1, do I just let the rate fall to 60:1 and stop it there? That approach is possible, but also potentially costly – not to mention being rather obvious. A far more economical approach would be to allow (or encourage) a drastic fall to a level which where the asset involved seems to be actually undervalued. In other words, let the exchange rate fall to the point where the currency is clearly a deal. This kind of “overshooting” is standard market behavior and plays a crucial role in reversing sentiment. Not only does a sharp reversal following a short-term spike generate positive market sentiment, but it can also be very profitable for the market maker – in this case the central bank – because it can profit from the people who panic and choose to sell at the bottom. This is what appears to have happened here. 

Profiting from the Game

Though you would never know it by reading the financial press, historical patterns such as these repeat themselves time and time again. While the press would have us believe that these events were unpredictable and happened without advance planning, there is little evidence for such a hypothesis. On the contrary: market participants who acted on the Russian central bank’s October 2013 press release all fared very well. Going forward, if the ruble starts to show stability at 60:1 or 55:1, those 17% interest rates will do what they are supposed to do: attract new capital to the Russian economy. Taking advantage of them is easy – just purchase Russian ruble futures on the Chicago Mercantile Exchange. The current discount for purchasing Dec 2015 rubles is approximately 16%.

Scott Freeman is the CEO of the IT Group, which is a Shanghai-based group of companies focusing on information technology and financial services. He’s always on the lookout for self-starters who bring along creativity, enthusiasm and know-how. He can be contacted at [email protected].

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