To have a currency crisis Russia suffered this week, a country needs two things: a local currency tied to a volatile international commodity and some external debt.
In oil exporting countries, the local currency is tied to your-know-what. As for the second condition, oil exporters are not supposed to borrow abroad when oil makes new highs. However, when the central bank let the local currency get stronger as export bucks flow in, borrowing abroad becomes attractive.
This opportunity is exposed when the PPP conversion factor to market exchange rate (PPP/EX) ratio is growing. And the ratio had been growing in oil exporting countries, though most of them escaped the temptation to borrow abroad:
(Russia and many others are missing in the World Bank’s data on debt. Among the remaining countries, red stands for energy producers. Negative changes in debt are due to countries (sometimes) repaying their external debts in 2001–2011. The worldwide average of external debt to GNI halved during this decade.)
And absolute values:
The debt is an important addition to yesterday’s currency overview. A currency may diverge from its “value,” but it’s external debt what creates risk. The Russian debt to GDP ratio stood still around 35% for years, but this level became a problem when the private sector had lost access to western credits. Kazakhstan isn’t under sanctions, but its 80% debt together with dependence on oil put the country in a similar position. Also, some other former Soviet republics, like Tajikistan, depend on dollar-denominated remittances from Russia—it’s their “oil” risks.
Back to the PPP vs exchange rate disparity that occurred in Russia and might explain the recent ruble crisis:
The Russian PPP factor grew faster than the exchange rate, so by 2012 the difference between the indices of the two reached 1.5. A large difference appears in some countries hit by the 1997 Asian crisis:
Indonesia looks very much like Russia. The media report that the rupiah already fell to its post-1998 minimum and that Asian central bankers are concerned about the ruble.
But Asia is not the worst place. Here’s the distribution of the same indicator across countries:
And the countries with the highest accumulated disparity are:
The group consists of former Soviet republics, oil exporters with weak institutions, and poorest African countries. Runner-up Belarus already imposed a 30% tax on currency exchange (that is, added 30% to the dollar’s price) and raised the interest rate to 50%. Russia is in the middle, surrounded by Indonesia and Moldova. Since after this December, Russia’s coefficient is much lower, of course. Ukraine also devalued its currency this summer and drops out of the list.
Why does this problem appear at all? Apart from the economic literature, there’s a good intuition explained, for example, by Lee Kuan Yew. Very much admired by corrupted autocratic leaders, he recollects that the absence of corruption was the number one reason why Singapore handled the 1997 crisis better than its neighbors. Some countries on the list can’t say the same about themselves. And that makes them the next most likely candidates for big troubles.
QEs and zero interest rates made the dollar and the euro very attractive currencies for borrowing.
The ruble appreciated in nominal terms, while its PPP conversion factor (how much rubles you need to buy the stuff worth $1 in the US) grew steadily (Paul Krugman’s point). Here’s the movement between 2000 and 2008:
The ruble becomes de-facto weaker (red line), but the exchange rate (green line) moves in the opposite direction. Russian businesses thought that borrowing abroad at low interest rates was a great idea. A corporation borrows a dollar at 1% per year, exchanges it for rubles in 2004, holds rubles for one year while the exchange rate going down, and returns the principal and the interest to the lender in 2005. Okay, corporations did something else to this money and paid a higher interest, but ruble-denominated debt was still more expensive.
The Russian Private Sector Accumulated $650 bn. of External Debts
About 90% of Russia’s external debt is corporate, though the state owns many of these borrowers:
It Was Time to Pay the Debts
Russian corporations had to pay about $100 bn. of debts by the second half of 2014, when the States and EU lifted the sanctions:
Meanwhile, the oil prices fell to $60 and the currency inflow halted. This led to the shortage of dollars in Russia, so several big borrowers could break the thin market when they started lurking for dollars inside Russia:
The Central Bank of Russia held about $500 bn. in reserves but it didn’t support the ruble much over the year:
It didn’t matter than Russia had a current account surplus of about 5% of GDP throughout the 2000s. These $700–900 bn. were export revenues. Exporters converted them into rubles to pay taxes, wages, and other expenses. So, $500 bn. ended in the central bank.
External Debt Became Expensive
The corporate borrowers panicked in December 2014. The Central Bank didn’t offer enough dollars when the market was running out of them. The exchange rate hiked on December 16. This 10% daily hike meant really large annual returns (try to calculate 1.1^365). The dollar became an attractive investment. Not only corporate borrowers, but the entire population wanted dollars for now. Companies and families bought dollars with their savings or newly borrowed rubles.
People also reasonably expected import to become more expensive and started shopping before retailers adjusted their prices for the new exchange rates. It ended with a daily inflation peak because retailers did react to the new demand.
After the government intervention, the ruble stabilized around 60 RUR/USD. But $720 bn. of external debt remained. Corporations now have to pay about 100% of real interest, adjusted for the exchange rate shift. Though many of them are exporters and sell for dollars, Russian banks naturally earn their revenues mostly in rubles, which makes it difficult to pay forex debts. (Banks can buy the dollars back after the hike, but the financial sector has many other problems now.)
Finally, Weather Forecast
Asian countries had a pretty severe recession after the 1997 currency devaluation:
As Paul Krugman noted, broken balance sheets created troubles for these countries. When you borrow the currency that is different from the currency of your operations, well, you must hedge. Did Russian corporations know the Asian lesson and hedge? We’ll see, soon.
Picking the winners is still up to the government. The Central Bank has plenty of options here. It can use the remaining reserves to bring exchange rates down. It can keep the interest rate high (but not for long because businesses need credit). Or it can pick winners one-by-one.
Bloomberg made the ruble’s collapse look like the end of the world yesterday. It’s not the first collapse of this kind, so let’s put some history together.
The last time the ruble collapsed in 1998, when the Russian government defaulted on its ruble-denominated debt. Economic recovery came immediately. That situation is only tangentially reminds what’s happening now. Right now, it’s the the private sector who is heavily indebted, not the Russian government. Secondly, Russia had several years of recession before 1998, and much physical capital dropped out of production to be available later. As for 2014, physical capital is fully employed and investments are now a huge concern.
In its best years, Russia accumulated forex reserves by running a trade surplus:
The reserves remain in the range from $200 bn. (informal estimates adjusted for “availability”) to $360 bn. (official). The Central Bank provides this liquidity to banks that have to pay their foreign credits and avoids dumping dollars directly into the market. Huge reserves leave an opportunity to wipe out speculators playing against the ruble, but it’d eradicate reserves, which may be needed later to save the Russian financial sector from bankruptcies and their consequences for the economy at large.
That is, the Central Bank ensures forex liquidity for the economy and allows the exchange rates to go up and down. Also, contrary to some media stories, Monday’s interest rate hike addresses inflation, not exchange rates. That’s according to the Head of the Bank.
Twelve countries that had episodes of rapid (and not so rapid) devaluation. The interesting part is (a) what’s happening to output after devaluation, (b) under what conditions the local suggency recovers (hint: low inflation).
In my previous post, I described the agency problem of the Soviet political elite reforming planned economies of the newly formed independent states. The following graph compared the post-1991 transitory period in Russia and a few Eastern European countries, former members of the Eastern Bloc:
The Russian privatization program kept public property away from producers. It redistributed ownership through vouchers, which were securities granting the right to privatized property. After they got these securities from the state, people sold them significantly lower their potential price. Vouchers happened to end in the hands of a few. Much of other public property had been privatized without any vouchers. For instance, through fraudulent shares-for-the-loan auctions organized by the Russian government in 1995.
Such was the essence of market reforms in Russia. Meanwhile, China had their own market reforms started one and a half decades earlier. And the Chinese elite did an interesting thing. No, the central government didn’t act like a benevolent dictator who gives away his power by transferring property to producers. Instead, it allowed independent producers to appear by themselves. First in agriculture, then in industrial production.
The rationale behind liberalization of the economy was the following one. If the government cannot encourage politically stable growth rates, let the market support it, where possible. The government neither competed nor shared property with the private sector. The market delivered additional value, which would otherwise turn out to be a deadweight loss of a centrally planned economy.
The Party not only preserved all of its property, but also gained indirect control over the private sector, which had been intensively growing over the last three decades. Naturally, it emerged as much more powerful interest group than it was under a pure planned economy. And it did so without country’s output falling to 1/2 of its pre-reform level.
That shows how various coalitions within elites lead to different policy decisions and economic outcomes. In a critical moment, the Soviet hierarchy was unable to make forward-looking decisions and balance the interest of intra-elite factions. In contrast, the Chinese counterparts came out of the similar situation as winners, through with a very powerful competitor growing next to them.
The Soviet Union collapsed in 1991. But this 1989 paper by Victor Nee provided an interesting insight that had closely described the forces behind Russia’s market reforms in the 1990s.
Nee outlines two centers of power in a centralized economy: producers and distributors. Producers are Soviet CEOs, running factories and other elementary economic units. Distributors comprise the Soviet government and allocate resources across the economy. Under central planning, the power of producers is weak and that of distributors is strong. Both were in the Communist Party, but producers belonged to a relatively dependent group of the privileged. Distributors from the Government made major economic decisions.
Nee’s point is that the transition from centralized planning to the market economy leads to redistribution of power in favor of producers. Distributors can’t agree with that. And they didn’t. Mikhail Gorbachev and the Soviet leadership had no plan of moving to the market.
In 1991, they had been displaced by Boris Yeltsin. It was a coup. Yeltsin represented local elites, who managed resources at the level of separate Soviet republics and led republican branches of the Party. The power shifted to the leaders of a newly formed independent republics. The 1991 events had little to do with democracy: it was the second-level distributors getting rid of some top-level distributors.
The new republics started building market economies. But the problem with the transition remained the same: distributors don’t want to lose power by introducing markets. And the didn’t. The new old elites did everything to prevent producers from gaining power. They established crony capitalism to become private owners of formerly public property.
The architects of the privatization, which started in the early 90s and still continues in Russia in a somewhat different manner, recently recognized that their main goal was to privatize property as fast as possible to avoid power going to what they called “red executives”—managers of Soviet factories and service units.
An official version sounded like “Red executives would bring communism back, so let anyone get the state property and forget about efficiency for a while.” But red executives had little incentives to bring back communism, which would deprived them of power over their factories. Effectively, the architects prevented a really decentralized market economy, when each factory is a Smithian independent firm that competes with the others and the invisible hand paves the way to wellbeing.
The property didn’t go to anyone, clearly not to the population, but to specific people, including government officials. The schemes were opaque, and it was difficult to distinguish who owned now-private businesses: government officials or their proteges from nouveau riches.
This privatization was followed by an unprecedented fall of output. That how it looks compared to countries with previously planned economies that had more democratic transitions to the market:
Though it’s important to note that the degree of central planning in these states differed, the picture is the same for most former SU countries, which had lost much of GDP before returning to the trend in late 2010s. Many had not returned. The Baltic states had fewer problems. As the Eastern Bloc minus the USSR, they also got rid of communist elites before going back to markets.
Market reforms in the former SU have been conducted by the same officials who were supposed to give away their powers. Just as a typical case of moral hazard, they had designed the transition in their own interests, so that in just five years there were no free market and no economy.