Streetwise Professor

January 30, 2009


Filed under: Commodities,Derivatives,Economics,Energy,Politics,Russia — The Professor @ 6:11 pm

No, this isn’t a review of a punk rock CD: It’s the latest installment in an ongoing series on the ruble’s gyrations in the foreign exchange (“FX”) market, and the title is a commentary on what is becoming a more likely outcome by the day.

Well, gyrations is not quite the right word; it connotes movement in all directions, but the ruble has been moving only one way–down.  Today (per MICEX), the ruble closed at 35.4886, about a 1.8 percent move.  Although the currency gained a bit on the Euro (which was down against the dollar), it is approaching the 41 rubles vs. the basket that central bank head Sergei Ignatiev has pledged to defend unless Urals crude plunges to $30 and remains there for an extended period.  Speculators are taking this as a challenge, it appears.  

The behavior of the ruble in the days since the band was widened to 10 percent suggests to me that the government is spending FX to defend the band, even before it is reached.  The currency has been down several days in a row, and is on an extended losing streak since the widening of the band.  Absent intervention, you’d expect the number of losing days and gaining days to be about equal.  Runs of consecutive days with adverse moves can happen, but are relatively unlikely.   In contrast, if the central bank is trying to slow the fall in the currency, and is preventing it from reaching its equilibrium level on a single day, you’d see losses day after day–which is what’s going on.  

Moreover, I’ve looked at the intraday charts on MICEX this week.  Each day the currency has gapped lower (RUB/USD–higher USD/RUB) right at the open, and then hovered there, with at most a slight movement over the remainder of the day.  Again, this suggests that the central bank is effectively setting limit orders at progressively lower levels each day, and then maintaining that level within the day.  

All of this would burn through reserves.  

The central bank–and Putin–have put their credibility on the line.  They have said that 41 vs. the basket is the limit absent a collapse in the oil price.  The market is pushing there very hard.  The conditions for a speculative attack are clearly evident.  The government’s/bank’s credibility is on the line  How much will it spend to defend it?  If it tries, NOFX is a real possibility.

Indeed, other news provides further evidence that the condition is ripe for a speculative attack.  Kudrin stated that government revenues will likely fall 40 percent in 2009.  He states further that most–but not all–of the reserve fund will be spent to cover the budget shortfall.  Of course, if oil prices fall further (and the chronic economic weakness around the world makes that a very real possibility), all of the reserve funds will go down the chute.  It should also be noted that although Kudrin anticipates that the situation will turn around in 2010, government revenues usually lag economic recovery.  Therefore, even if the Russian economy–and the world economy–begins to turn around in late-2009 or early-2010, it is likely that revenues will remain weak well into 2010.  This means that even if some of the reserve fund survives 2009, it may be dissipated in 2010.

It’s of course better for Russia that it has such a cushion than not.  But, as I noted in several posts when the crisis began in the late-summer and early-fall, the existence of the currency stockpile and the reserve funds likely provided a false sense of security, and arguably led to a delayed response to the crisis.  I specifically noted that one thing the crisis proved is how quickly it is possible to blow through $600 billion, and that’s being proven right in the Russian instance.  

The weak government revenue picture is just more blood in the water that will attract yet more sharks to the ruble market.   Given the budget picture, it’s hard to see how the central bank can credibly defend the currency at the 41 level. Trying to do so will (a) waste–waste–the country’s currency reserves, because it will merely delay the inevitable, and (b) exacerbate the weakness in the real economy, particularly the manufacturing sector.  

So, push is coming to shove.  As the FX rate approaches the band, the speculators will test the government’s commitment to maintaining that band absent a further, severe erosion of fundamentals.  Flexing to defend the ruble will be very expensive, and arguably ruinously expensive.  The next week or two should be very interesting.  Although currency and capital controls have not been widely discussed, if the attack is as severe as I expect it to be, I wouldn’t be surprised to see such measures implemented.  

It is no picnic to be a policy maker anywhere in the world right now, but Russia has to be among the worst.  This could explain Putin’s rather bizarre behavior at Davos, where he alternated between giving lectures about the virtues of a free market (!) and delivering testy–nay, ferocious–responses to genuine (if naive) offers of assistance from Michael Dell.  

Putin has essentially placed a huge long bet on the ruble.  He has staked his credibility on avoiding a precipitous drop in the currency, cost what it will.  Like many traders on a losing streak, he is effectively doubling down by stating that the band will not be widened further.  Doubling down can work, but the odds are usually quite unfavorable.

Hence, the coming days could be quite significant, not just economically, but politically.  With Medvedev showing signs of independence, and the ruble battle reaching a climax, the long-anticipated tension–and perhaps rupture–in the diumvirate could be coming.

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  1. The USD is now trading a bit over 36 rubles and the Euro is slightly over 46 ruble. Russia will have to open the vaults once more is they want to keep the ruble within spitting distance of the 41 they set as the outer band for the currency basket.

    Comment by Michel — February 2, 2009 @ 12:43 pm

  2. Hey, Michel–long time, no hear. Welcome back.

    Yeah, they’re on the knife’s edge, and soon will have to make a major choice. Given that they are right on the edge, I am sure that big money speculators are going to test them, to see whether they will defend the ruble. Hobson’s choice for the central bank/government: blow their credibility by letting the ruble fall outside the band in a big way, or blow their bank roll defending their credibility. My guess is that they’ll get the worst of both worlds. They’ll have to cave eventually, but before capitulating they will spend a large sum of money in a futile attempt to look tough.

    The ProfessorComment by The Professor — February 2, 2009 @ 8:30 pm

  3. It will be interesting to see what happens when trading opens in Moscow. My guess is the ruble will be pushed down early in the morning and if later in the day you have a large tick upwards we will know that the vaults have been opened and they will be furiously pumping dollars into the market 😉

    Comment by Michel — February 3, 2009 @ 12:52 am

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