Russia’s Rate Hike Is Not Enough

While the Russians were sleeping, the Central Bank of Russia (CBR) quietly changed its main repo rate from an already huge 10.5% to a shocking 17.0% in a desperate attempt to avoid a full-blown currency crisis. But, eventually, they will create a full-blown economic crisis instead…

Yesterday the Russian rouble hit an intraday low against the dollar at 66.01 and closed at 60.67, as lower oil prices and international sanctions piled pressure on the rouble. The dollar is up 84.5% against the rouble in 2014, and no matter what the CBR does it seems nothing is able to prevent a further deterioration of the situation. Having started the year with an interest rate of 5.5%, the chairman of the CBR, Elvina Nabiullina, had no other option but to hike the rate six times to the current 17.0% level… to no avail. Eventually, inspired by the recent extremism in monetary policy action (albeit mostly in the opposite direction), Nabiullina shocked the country with an overnight 650 basis points hike in the CBR’s interest rate, aimed at reverting the current course of capital outflows and seducing depositors and savers. But can she really help sustain the rouble?

The answer to the above question was partially answered by the market in a matter of hours. At first, the CBR’s surprise move led to an appreciation of the rouble to the 58 level but, at the time of writing, the numbers are showing 70, which is not only lower than before the rate hike but also another record low. In the end, the CBR was unable to prevent the downfall and it is seriously undermining growth in Russia, which the bank now expects to be at -4.7% – yes that was a minus – next year if oil prices settle around $60.

The Russian economy is expected to be severely impacted by lower oil prices. It was estimated that with oil prices near $80, growth in 2015 would be sluggish, as the Russian economy derives a large part of its growth from energy exports. But, while that would be a blow, it wouldn’t be tragic or even comparable to the crisis in which Europe is embroiled. Unlike the governments of Europe, the US, and Japan, Russia is not heavily indebted. Debt-to-GDP is very small at 13.5%, as the country has much more assets than liabilities, which means it can very well allow for a few years of Keynesian fiscal policy without undermining the country’s ability to service debt.

The problem is the currency system. In a free float system where currency reserves are based in US dollars, the country is vulnerable to speculation. The downfall of the rouble can lead to double-digit inflation and soaring interest rates, which can seriously undermine growth. At the same time, a depreciated currency makes it more difficult for banks and companies to pay their foreign-denominated debt, which lead to defaults and creates further problems. Lower oil prices negatively impact the economy, but the exposure to currency depreciation could potentially destroy it. How can Russia prevent the collapse?

For now the CBR is desperately attempting to contain the problem with hikes in interest rates. In my opinion, the last hike of 650 bps was so big that I doubt the central bank will continue to follow that route. It seems like desperation. If such a big move fails, then other moves in the same direction will most likely also fail. At the same time, it could create such a big contraction in output as to lead to social unrest. The next trick will certainly be something more unorthodox with capital controls at the top of the list. But is that the best the CBR can do?

No, in fact I believe it isn’t. They can do much better if they get rid of the dollar as the reserve currency. One way to overcome the problem is to peg the rouble to gold. The CBR can fix the value of the rouble in terms of gold. If they do that they will restore confidence and prevent further declines. Why? Because, unlike many states, Russia does have the assets to make the move credible. Russia has enough assets to honour the terms of a fixed conversion between the rouble and gold. That way the CBR would prevent the real economy from suffering from a currency crisis and that would be the biggest possible retaliation against the US sanctions on the country. At a time the dissatisfaction with the dollar as reserve currency is rising, such a move would increase the appetite from the BRICs to depart from the current system. Not that I am suggesting that gold is the best currency system, but at desperate times some strong measures are needed, and breaking the link between the rouble and the dollar is the first step.

PS: While I was writing this blog, I had to change the USD/RUB rate several times as it seems there are no limits to it. Speculation is decimating the rouble, which now trades at 76.90 to the dollar.