Vodka is the new Malbec

What the hell is happening in Russia?

Mar 07, 2022

bne IntelliNews - West to sanction Russia&#39;s central bank — Russia’s Central Bank, the Bank of Russia (shocking).

This week, Russia made news - but for no good reasons. After its invasion of Ukraine (or its “security operations” therein, if you’re John Mearsheimer), the entire Western hemisphere imposed sanctions on Moscow - going to the point of excluding the country from SWIFT, the international banking system’s backbone.

The reaction was, ironically, swift too: the Russian ruble plummeted from an exchange rate of around 78 rubles per US dollar in late February to a peak of 108 on Tuesday, settling down in the low 100s. Sanctions also heavily restricted capital flows into Russia, and even made around half of the Bank of Russia’s reserves unusable. To quote another Swift: will the country be able to shake it off?

Perfectly balanced, like all things should be

Let’s start with the basics. Where do sanctions hit Russia? Besides restricting access to, say, international debt markets and reducing investment in the country, which have effects (probably negative) in the economy. But the bigger picture is macroeconomic: big changes in “hard currency” flows are, unsurprisingly, bad (ask anyone familiar with Latin America). To understand, let’s review the basics.

The flow of foreign currency going in and out of a country is called the balance of payments. It has three main components: the current account, capital account, and financial account. The current account has three big parts - the trade balance (exports of goods minus imports of goods), the services balance (exports minus imports, but of services), and the “rents” balance: net wages paid into the economy (say, by and from multinational companies), interest payments, corporate profits, and remittances. The capital account is mostly changes in debt from debt forgiveness and weird stuff like patents, intellectual property, and football player transfers. The financial account includes both foreign direct investment (think, a company buying another company or opening a factory) and portfolio flows (“speculative” investment, aka buying stocks and bonds). When the balance of payments is negative, that means dollars are “leaving the country”, and when it’s positive, they’re “entering” (or balanced when outflows compensate inflows). The balance of payments is reflected on the country’s international reserves, basically a Scrooge McDuck pile of USD a country keeps. The impact on reserves depends on the exchange rate regime.

Exchange rates are the value of a currency measured in another - normally, US dollars. For example, Argentina’s black market exchange rate was 206 pesos, meaning you need 206 pesos to buy a dollar (or can exchange one for slightly less, 202 pesos). That is the nominal exchange rate, because it doesn’t adjust for prices. For example, if the dollar increases 10% in a year but inflation is 15%, then that means the country is getting more expensive for foreigners. The inflation-adjusted exchange rate is the real exchange rate.

The exchange rate regime is defined by who sets the (nominal) exchange rate - the Central Bank or the market. Under a fixed exchange rate (also known as a pegged exchange rate or a currency peg), the currency has a single value, and the Central Bank buys and sells its international reserves to keep the market balanced at that price; whereas a floating exchange rate lets market forces determine whether or not the exchange rate goes up based on supply (i.e. the inflows in the balance of payments) and demand (i.e. outflows in the balance of payments). Normally, demand is just paying for imports and conducting international transactions, but a few countries (notably Argentina) also have domestic demand for USD as a savings instrument. Basically no countries have a totally fixed or totally floating exchange rate, and instead normally let the rate go up and down within a range and intervene when it looks like it’ll go outside the range. Under a floating exchange rate, when there is a balance of payments deficit, then the currency market has excess demand, and therefore the exchange rate goes up. On the contrary, a balance of payments deficit with a currency peg means that the Central Bank has to lose reserves. Ex ante, if the Central Bank is low on reserves, a float is better than a peg, and vice versa.

However, he Central Bank can also “play dirty” and intervene in the market without buying and selling currency. For a variety of reasons, it can also regulate how much money companies are allowed to send abroad, how many imports anyone is allowed to buy, how much currency locals can buy, and how much money you’re allowed to bring into the country. These are known as capital controls, broadly, and they are used both to preserve the stability of the financial system, prevent things like money laundering, and also ration reserves without devaluing the currency. For instance, something like a sudden stop (aka when all capital inflows into the country suddenly leave because of negative expectations) tends to be economically disastrous, and so Central Bankers want to prevent it from happening (look at 2002 Argentina, for that matter).

The rest is commentary

What determines the Balance of Payments? Generally, the (real) exchange rate is the one thing everyone agrees on - a higher makes imports more expensive and exports cheaper, while attracting investment. Additionally, a higher (real) interest rate also increases investment in the country. And lastly, a growing economy both requires more imports but also produces more exports, and might be attractive to investors, which means that GDP growth doesn’t have a clear relation to the balance of payments. The Central Bank controls the first two (interest rates and exchange rates), plus can impose capital controls - so no countries should have difficulties managing, right? Wrong!

Here’s the catch: you can’t have it all ways. Central Banks can only have two of the three options: a domestically determined interest rate (“monetary autonomy”), a currency peg (“exchange rate management”), and no capital controls (“capital mobility”). Why? Well, exchange and interest rates are both prices; if you determine prices, quantities are left to the market - and could make or break the peg. If you want to let capital freely into the country and want to set your interest rate, then the invisible hand would end up determining the exchange rate: otherwise, the peg would break. The same happens for a currency peg and free capital mobility: you need to have rates consistent with the international returns, to maintain capital in the country.

This is known as Mundell’s Trilemma (after economist Robert Mundell), and is considered the cornerstone of international economics. To quote The Economist:

HILLEL THE ELDER, a first-century religious leader, was asked to summarise the Torah while standing on one leg. “That which is hateful to you, do not do to your fellow. That is the whole Torah; the rest is commentary,” he replied. Michael Klein, of Tufts University, has written that the insights of international macroeconomics (the study of trade, the balance-of-payments, exchange rates and so on) might be similarly distilled: “Governments face the policy trilemma; the rest is commentary.”
The Economist, “Two out of three ain’t bad” (2016)

This poses the question: what’s the best side of the triangle to be on? The answer, as with everything, depends. The case for capital mobility isn’t really interesting to me, plus for Russia (and its counterpart, Argentina) it’s basically a non-entity, so the question is whether to peg or float the exchange rate.

Gone, reduced to atoms

“The Crown” season 3 episode 5 (“Coup”) focuses on the political fallout from Harold Wilson’s decision to devalue the pound sterling - considered both a political defeat and a humilliation for the country, plus economically disastrous. As proven by this bizarre 2013 electoral ad, the issue is also unpopular in Argentina. The exchange rate going up (aka “devaluation”) is generally considered bad - why?

As stated above, countries usually have to float their currencies if they don’t have the reserves to peg them. Pegging the currency also provides less ability to respond to international shocks, and in an IS-LM world, makes monetary policy useless - because of the trilemma, you can’t fix an interest rate different than the risk-adjusted international rate. So floating the currency seems like the clear superior choice, right? (even if it does make fiscal policy less useful, since it raises the interest rate in equilibrium).

Countries peg their currencies for a number of reasons. The biggest one is, paradoxically enough, inflation: if a large share of prices are set in international markets, then big fluctuations in the exchange rate can have a proportional impact in inflation. For example, a country that exports food and imports fuel would be terrified of a big devaluation (or not, depending on consumer habits). So right there, the Central Bank can want to keep movements to a minimum to fulfill half of its mandate. In many developing countries, the exchange rate acts as an anchor for inflation expectations (since its value is obviously stable), which means that the impact of a devaluation on inflation can be devastating to price stability. The effect of devaluations on the Central Bank’s other goal, “full employment”, is more complicated and to be discussed later.

There’s also the issue of transitioning from peg to float, which is what you REALLY want to avoid. Imagine a country with a pegged currency and a big BoP deficit, plus regular expansionary monetary policy. What happens is, as long as this keeps going, the Central Bank’s reserves dwindle, while investors accumulate domestic currency in its stead. Eventually, the private sector has enough domestic currency to buy out all of the reserves, which it does, to force a devaluation and profit off of it - known as a balance of payments crisis. This is the worst of both worlds, because you devalue the currency (see above) at whichever rate the market seems fit. In 2002, Argentina abandoned its decade-long “1 to 1” peg and devalued the peso, expecting it to stabilize at 1.4 pesos per dollar (a 40% devaluation); instead, nobody knew what to expect, resulting in a staggering peak of 3.89 pesos per dollar. You can read more about it on a joint post with Joseph Politano (in Spanish as well as English). Countries think that these “bubbles” are so dangerous that they literally lie about whether or not they’re floating the currency - called fear of floating and generally caused by longstanding issues to Central Bank credibility.

You should have gone for the peg

So back to the impact on output - are devaluations contractionary or expansionary? (the greatest thread in international macro history, locked by the moderators after 12,239 comments of heated debate). The answer, as always, is “it depends”.

The traditional Mundell-Fleming model, outlined above, doesn’t really have a definitive answer. If exports plus capital inflows go up more than imports go down, then the devaluation is expansionary (because Y = C + I + G + X - M). In the opposite sense, if imports go down more than inflows go up, then the devaluation is contractionary. This is known as the “Marshall-Lerner condition”, since it depends on the elasticity of imports, exports, and net international payments towards the exchange rate. But it’s not very satisfactory - what about domestic demand?

Explanation 1 (redistribution): Imagine an economy with two “social classes”: capitalists, and workers. Both capitalists and workers consume goods and services that are traded domestically (haircuts, education, healthcare), and goods and services that participate in international trade (oil, cars, Netflix subscriptions). Devaluation is assumed to only raise prices for the second good. Similarly, it’s assumed that capitalists and workers get some fraction of their incomes from the tradables sector, and some fraction from the domestic sector. This means that a devaluation can redistribute money between groups based on whether or not they “earn” more dollars than they spend - for example a country where landowners get all the dollars while workers buy all the food would have highly contractionary recessions - unless the landowners spend all their extra money on domestic products. So the contractionary/expansionary nature of a recession depends on a) who earns “in dollars”, b) who spends in them, and c) whether the first group spends enough to make up the difference. Normally, we expect that the capitalists spend less than the workers, and therefore a devaluation is contractionary.

Explanation 2 (sectors and taxes): Now imagine an economy that has a trade deficit and has two sectors, one that exports and one that doesn’t, and instead imports. The sector that trades internationally has prices in US dollars, and the one that doesn’t, doesn’t. Let’s assume that wages and profits (divided between workers and capitalists, respectively) in each sector are determined the same way. Then, a devaluation expands the exporting sector, and whether most of these gains go to groups with a high chance to spend them on domestic production or not determiens whether or not the economy grows or shrinks. Additionally, if the government taxes exports or imports, then there’s a second round of effects based on what they spend the money. Normally, we can assume that the export sector capitalists spend less than the export sector workers, and therefore a devaluation is contractionary.

Explanation 3 (“external restriction”): Imagine an economy where one sector, let’s say agriculture (run by farmers) exports while another, called “industry” (with workers and capitalists) imports. Imports are either inputs for the industrial sector, or consumption goods for all three classes. Assume that agricultural output doesn’t increase in response of a devaluation, which means that the division of a fixed supply of currency happens between imports for industry (which increase output) or consumption (which does not). Now this brings forth a dilemma - the devaluation can expand or contract the economy based on who spends money on imported consumer goods. Let’s say that workers spend the most on imported goods - then, redistributing income away from them grows the economy, because the other two groups simply save their devaluation windfalls and therefore give industry more “breathing room”.

Neither of these are the be all, end all - after all, all of the assumptions mentioned above are extremely questionable. But it’s fairly likely that, barring bizarre redistributive edge cases, a devaluation doesn’t just cause inflation, but also shrinks the economy as a whole. Ergo, Central Banks would want to prevent them at all costs.

Moskau, tor zur Latein Amerikas Vergangenheit

So what is Russia doing? The sanctions both decimated capital inflows into the country and lobbed off a large chunk of Russia’s reserves. The country responded to this by declaring a financial holiday (aka closing the stock market), imposing capital controls, and raising the interest rate. Weirdly, Russia had a massive stockpile of reserves before this move, which is why the Central Bank acted so drastically and why both the stock market and the ruble dropped by historic levels.

This last move has prompted some debate by confused Americans, who consider it as a bad response - raising rates after a supply shock. The first thing to consider is that the risk that Russian companies and the Russian government simply default on their debts has gone up (imagine, for instance, that Putin is ousted and his successor reneges on the country’s debt) But the problem is that the Russians aren’t really trying to control inflation - they’re trying to prevent a financial crisis. The value of Russian banks in the stock market dropped hardest, meaning that savers might expect their savings to be gone and could cause widespread bank runs. Additionally, sudden stops (which, not through prophecies, but through sanctions, this is) tend to be extraordinarily destructive, since they cripple the financial system and put the Central Bank in extremely awkward positions. The Bank of Russia, then, wants to both keep foreign money in its banks and not weaken its international position further, and also to keep domestic money in ATMs so Russian banks don’t fold like a house of cards.

This kind of dynamic played out in Latin America a lot, especially in the 1980s. Countries tended to peg their currencies to control inflation, but after the Volcker Shock, they had to either raise rates far more than the US, or simply let their reserves drain away. Since the sustainability of the pegs was under question, the risk premium had to go up as well, meaning that the game was rigged from the start. A close analogue to what Russia is going through is Argentina’s 2002 crisis (learn more in English and Spanish!). Even though Russia has a floating exchange rate (technically a “dirty float” where the Central Bank intervenes sometimes) and Argentina had a peg, the mechanics are the same: to not let the currency implode, interest rates must remain sky-high, which harms the economy. Plus, fiscal policy has to act in the same direction, since the bond market tends to be shut off. If the government cannot reduce spending (or raise taxes), very nasty things tend to happen - generally inflation, because the only way to fund the authorities ends up being the inflation tax (or moves that are effectively identical to it, like forcing banks to finance the state at negative rates through regulatory moves).

So all in all, Russia does not have a fun time ahead, since the closest analogue to its current situation is a period of time literally callled “the lost decade”. In the short run, you can expect a massive drop in the stock market and a financial crisis (whenever the Russian stock market reopens), maybe a banking crisis, and possibly a currency crisis. All of these are highly unpleasant, and have extraordinarily negative consequences on inflation, employment, and output. It is therefore in the country’s best interest to reverse course on the recent events that have led to these sanctions.