Ignatyev Between a Ruble and a Hard Place

Central Bank Chairman Sergei Ignatyev is a man who is battle-hardened to deal with tough situations. He was, after all, a first deputy finance minister at the time of the 1998 default. Since taking over at the Central Bank in 2002, he has had a relatively easier time dealing with a bulging balance of payments surplus. His burden has been all the lighter because his old friends at the Finance Ministry did the heavy lifting by using taxation to channel a significant portion of oil export earnings into the stabilization fund starting in 2004. He has, in fact, run a very loose monetary policy, as evidenced by negative real interest rates.

This peculiar mix of monetary and fiscal policy made sense. By keeping real interest rates lower than those available elsewhere, net capital outflows continued. This was also a form of sterilization of incoming oil revenues. While you could argue over the merits and longer term costs of this approach, the real problem is that it is no longer working. Ignatyev is now in an uncomfortable position where he is damned if he does, and damned if he doesn't.

In the past year, the ruble has appreciated in nominal terms against the dollar by 6.5 percent, with the Central Bank rate moving from 27.5 rubles per dollar to 25.84 rubles as of Monday, while it appreciated by only 3.3 percent against the euro, which is now worth 35.1 rubles. Criticized recently by the Kremlin for purposely allowing the ruble to appreciate, the Central Bank has become a passive spectator as the relative value of the dollar declines.


In fact, to prevent an even more rapid fall in the dollar's value, the bank was forced to add more than $30 billion to its reserves in April, and from May 4 to 11, the latest reporting week available, it accumulated an unprecedented $14.2 billion in gross international reserves. This was the result of significant foreign capital inflow, and the initial public offering by VTB was clearly not large enough to account for the entire amount. Gross international reserves reached $386.3 billion, bringing the growth in reserves thus far in 2007 to $82.6 billion. As a consequence, the Central Bank's initial forecast of reserves of $396 billion at the end of the year may have already been surpassed when new data become available later this week.

The continuing current account surplus (especially with oil prices edging up again), large external borrowing by Russian companies and banks, and portfolio investments by nonresidents are all contributing to capital inflows, leading to the attempts by the Central Bank to prevent a massive appreciation in the nominal value of the ruble by buying dollars and adding them to its reserves.

This rapid reserve accumulation translates directly into a rapid expansion of ruble liquidity. Indeed, M2 -- a key measure of money supply often used to forecast inflation -- was up 52.7 percent year on year in April (and a staggering 5.7 percent month on month), the fastest rise since early 2004.

Though it might be too early to sound the alarm, it is possible that even a fast-growing economy like Russia's will be unable to absorb a money injection of this magnitude. In this case inflation will accelerate, as already appears to be the case this month. The real ruble rate will then continue to appreciate, and Ignatyev's policy dilemma will grow.

This comes at a bad time. With parliamentary and presidential elections on the horizon, the Finance Ministry is weakening its traditional efforts to sterilize much of the excess liquidity. With a loose monetary policy and looser fiscal policy, it is likely asking too much of the Russian economy to expect it to offset the potential inflationary effects through higher money demand. The government's inflation target of 8 percent for the year is now in jeopardy, and there is little that can be done at this stage to reverse the trend.

It is important to look at why this is all happening. As Ken Rogoff, a Harvard economist and former International Monetary Fund chief economist, noted recently: "Many people have been asking why the dollar hasn't crashed yet. Will the United States ever face a bill for the string of massive trade deficits that it has been running for more than a decade?" He also wondered how long the rest of the world would have an appetite for financing U.S. prolificacy, especially as U.S. borrowing now absorbs more than two-thirds of the combined excess savings of all the surplus countries in the world, including China and Russia.

The fall in the dollar's value appears to be based on economic fundamentals. The basic question is under what conditions will foreigners continue to add to their already considerable stock of dollar assets. The market dictates that the price of U.S. assets must decline to encourage greater demand. This can come about in one of two ways: a fall in the value of the dollar relative to other currencies or a drop in U.S. bond prices. Either of these, or some combination, would make U.S. assets more attractive. In fact, the growth in net dollar purchases began to slow in the fourth quarter of 2006.

So what we are seeing is more a diversification away from the dollar than a rush to the ruble. Most of the movement is actually toward the euro, but there has been some increase in demand for the ruble as well.

Demand for the ruble certainly climbed last year when the Central Bank publicly advocated a stronger currency. While it might make perfect sense from an analytical point of view to use ruble appreciation as a tool against inflation, it defeats the purpose if you announce that this is the posture you are assuming. It is tantamount, in effect, to giving speculators a one-way, guaranteed bet when investing in rubles. At least in the short-run, you can't lose. The bank has now learned this lesson, but too late. If you are moving out of the dollar, the ruble is now an attractive destination.

So what can the Central Bank do?

One modest step to sterilize some of the major capital inflow was announced by the bank on May 14. This was a rise in mandatory reserve requirements from 3.5 percent to 4 percent on ruble-denominated retail deposits, and from 3.5 percent to 4.5 percent on other liabilities. This step is the simplest of the policy tools available to the Central Bank other than letting the ruble appreciate further. I think that we may see more such measures given the rate of growth in the money supply and increasing inflationary pressures in the economy. (China, in a somewhat similar situation as Russia, with a significantly undervalued currency the authorities are trying to keep down and very strong domestic demand growth, has raised the reserve requirements seven times over the past 11 months.)

As long as Russia has portfolio capital inflows in the billions of dollars -- in addition to current account surpluses -- arriving every month, the Central Bank has a strong incentive for clamping down on the rate of ruble-value appreciation to avoid any additional speculative pressures. And when the inflows slacken, the bank has just as strong an incentive to allow some ruble appreciation again. If the Central Bank is forced to choose between the possibility of increasing inflation arising from an increase in reserves in an effort to stabilize the ruble's value, on one hand, and the possibly of unsustainable inflows driven by currency appreciation expectations on the other, I think Ignatyev would opt to risk the inflation and try to prevent the ruble from getting too strong. Either way, I wouldn't want to be in his shoes.

Martin Gilman is a Professor at the Higher School of Economics.