Streetwise Professor

February 8, 2009

On the Horns of a Horrible Dilemma

Filed under: Economics,Politics,Russia — The Professor @ 9:38 pm

Russia is attempting to stem the decline in the ruble (which breached by a hair’s breadth the 41-to-the-basket floor set by the central bank) by means other than selling dollars/euros from reserves.  In particular, it is limiting loans to banks, trying to loan directly to corporations, and trying to use the security services to monitor banks to make sure they are not converting the ruble loans into dollars and euros.  

Limiting loans to banks makes it harder to short the currency; one way to short is to borrow something, and then sell it.  

The dilemma is that Russia is facing a liquidity shortage and a weak (and arguably weakening) banking system.  Raising interest rates and rationing liquidity may stall the ruble’s decline, but exacerbate these other problems.  

Trying to disintermediate the banks, and direct loans directly to corporate borrowings, is likely futile.  Believe me, Russian corporate borrowers certainly know how to work the system to convert rubles into dollars.  

As to oversight, my friend Sergei Guriev, an excellent economist, says it best:

Pressure from the government on banks wasn’t working, he said. “You can send a KGB officer to ensure that the bank which borrows from the central bank lends the money instead of buying dollars, but then the firm it lends to will buy the dollars. You would have to appoint a KGB officer to oversee each transaction in the economy. That is not going to work, so we need to wait for the rouble to find a new equilibrium.”

The last sentence hits the nail on the head.  Why are banks sitting on dollars?  Why are they trying to convert rubles into dollars?  Because the currency has not reached its correct, equilibrium, level.  As long as it is above its equilibrium level, bankers, businessmen, and average Ivans and Natashas will try to circumvent the central bank’s–and FSB’s–efforts to keep it levitating.  

Policy makers around the world face extreme challenges.  Nowhere are these challenges more acute than in Russia.  The currency issue is just one example of these dilemmas.  Inflation is another.  Kudrin announced that the inflation rate for January was at least 2.2 percent–a 30 percent annual rate!   This is all the more remarkable given that the base money supply has been decreasing–10 percent in the 29 December-26 January period.  (Contrast this to the US which has seen falling price levels at the same time base money has skyrocketed.)  This means that the demand for rubles has been plummeting (supply down + inflation up can occur only if demand falls dramatically).  This is no surprise, since the ruble is overvalued.

How can Russia respond?  Raising interest rates and/or letting the currency fall further.  The former will inflict more pain on already reeling manufacturers and other businesses.   Keeping the currency too high is already having that effect .  

Whatever way Kudrin (and Putin and Medvedev) turn, they face a distasteful choice.  I understand their reluctance to let the ruble fall further–for Putin, especially, every decline is a signal of failure–but this policy has already wreaked considerable damage, and continuing it will wreak yet more.  Trying to command the currency is as futile as commanding the tides.  Russia will not be able to work through its other economic problems until the currency reaches its equilibrium level.

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