Caught in the Crosshairs of the U.S. Dollar

Once again, Russia is in the crosshairs of U.S. policy. Rather that an intentionally Russia-wary position, it results from a 21st-century form of "benign neglect" by Washington -- a term last widely used to describe the attitude of U.S. Treasury Secretary John Connally regarding the plight of the dollar in 1971.

Russia is in good company. Central Bank head Sergei Ignatyev and his colleagues are the unintended victim of Washington's economic policy, along with the European Central Bank, China and most of the world, which has long relied on the United States for the key currency anchor of the international financial system in the form of a relatively stable dollar.

The rapidly emerging reality in the global economy, not widely anticipated even a few weeks ago, will constrain the choices that a future President Dmitry Medvedev might have desired. Tuesday's decision to further reduce the U.S. Federal Reserve's key interest rate just compounds the process.

As in 1971, the dollar is again the barometer of the problem. Today, with the U.S. current account deficit running at well over 6 percent of gross domestic product, necessitating net financing of about $2 billion per day, the United States is fortunate that Russia, China and other oil-producing nations have continued to return all its payments for imports in the form of loans -- generally, purchases of U.S. treasury bonds. The United States -- and indeed the rest of the world -- must therefore be concerned with the sustainability of what French economist Jacques Rueff called an "absurdity" when this occurred in the 1960s, although then it was the Europeans who were accumulating dollars.


In the absence of restored fiscal prudence, the United States risks undermining the faith foreigners have placed in its management of the dollar -- that it can continue to sustain low inflation without having to resort to growth-crushing interest-rate hikes as a means of ensuring continued high capital inflows. And as the Federal Reserve proceeds to reduce its lending rate to banks, it makes it increasingly difficult for the United States to attract those Russian, Chinese and other savings needed to finance the external deficit.

As U.S. interest rates continue to decline and the U.S. economy heads into a recession, the only way to ensure the financing of a hopefully smaller deficit will be for the price of assets in foreign currency terms to continue to drop. That means a lower dollar exchange rate. And so, the dollar has already declined by more than 5 percent since summer vis-a-vis the ruble, solely because of the change in the dollar-euro rate, as the Central Bank has stuck to its basket peg. The dollar has declined by 7.5 percent against the euro since July 1.

The falling dollar has emerged as a source of profound global macroeconomic distress. The question now is how bad that distress will become. Is the world economy at risk? And what can Russia do?

A gradual deceleration of inflation to world levels was a key objective of the Kremlin and the Central Bank. In 2003, President Vladimir Putin said he wanted to see inflation at 3 percent within a decade. Just over a year ago, a forecast for the country's social and economic development until 2009 prepared by the Economic Development and Trade Ministry projected inflation at 6.5 percent to 8 percent in 2007, 4.5 percent to 6 percent in 2008 and 4 percent to 5.5 percent in 2009. This was to follow the success of finally achieving single-digit rates in 2006.

Instead, we have witnessed a "surprise" acceleration of inflation since the summer. On Friday, for example, Deputy Economic Development and Trade Minister Andrei Belousov said: "Yesterday, I gave a figure of 11.5 percent [for 2007 inflation]. It may be higher, but it will stay under 12 percent. I hope."

This inflation surge has many explanations, including a worldwide boom in agricultural prices. Without going into details, suffice it to say that the Central Bank, like other central banks around the world, is caught between the proverbial rock and hard place. With the United States running large, continuous external deficits -- a cumulative $4 trillion since 2002, when the dollar peaked in terms of the euro -- the dollar's key role is under pressure as the rate declines in terms of floating currencies and inflation remains a longer-term concern.

In these circumstances, those countries that peg to the dollar -- much of Asia, the Middle East and South America -- or manage their currencies to maintain a stable relation to the dollar, as Russia does, face a dilemma. These exchange arrangements are intended to provide long-term stability and facilitate global transactions. With conditions surrounding the dollar in flux, however, the rest of the world is importing U.S. monetary policy.

In effect, the Central Bank's inability to control liquidity stems in part from its unwillingness to let the ruble float more freely. If it continues to manage the exchange rate by mopping up excess dollars, the counterpart of those reserve increases is newly issued rubles. And with ruble money supply growing at close to 50 percent this year, it is hardly surprising that the inflation target is being overshot by a significant margin.

The Central Bank could use the standard anti-inflationary tools, including allowing the ruble to appreciate, as it has tried to do in a rather counterproductive way earlier this year when it triggered large capital inflows, and increasing the refinancing rate and minimum reserve requirements. Experience has shown, however, that ruble appreciation doesn't have a strong effect on inflation in Russia, not to mention the fact that it would increase the risk of capital-inflow acceleration. On the other hand, increased interest rates -- on the repo market, for example -- could exacerbate the situation on the money market, which is not in good shape anyway. Presumably the Central Bank will want to avoid problems in the banking system in light of the forthcoming presidential elections.

The government could help. The most powerful measure would have been to cut planned budgetary expenditures, but in this case, political realities seem to outweigh monetary logic. Inflation will remain a challenge in 2008.

Again, Russia is not alone in its predicament. Late last week, discussions within the Gulf Cooperation Council ended without any action to break the peg to the dollar, which places those countries in an identical inflationary predicament as Russia. Asian countries face similar concerns.

It's clear that Washington is not going to do anything to solve the problem that it has created. As former U.S. Treasury Secretary Connally also famously said, "The dollar may be our currency, but it's your problem." Especially in an election season next year, the United States is focused on how to minimize recessionary risks -- hence lower interest rates and a bigger fiscal deficit.

So will Russia and its economic partners continue to play the victim in order to maintain the dollar as the monetary anchor of the international financial system?

Perhaps the time has come for Moscow to help organize a new cartel. No, nothing to do with energy, but rather a "sound money" cartel among those countries that collectively wish to reassert monetary stability. Of course, as we all know, this is just wishful thinking.

Martin Gilman, a former senior representative of the IMF in Russia, is a professor at the Higher School of Economics in Moscow.