Ivan Tchakarov of Renaissance Capital -
After two long weeks of precipitous declines, the ruble exchange rate has now started to stabilise. Nevertheless, the ruble earned the unenviable title of the emerging market currency that saw the largest swings in the latest episode of market volatility. One- and three-month dollar/ruble volatility spiked to levels unseen since the 2008 financial crisis, sparking fears that possible further falls in the currency could exacerbate the severity of external shocks, and inviting calls for the Central Bank of Russia (CBR) to intervene.
The CBR dutifully obliged, selling foreign currency to stem the ruble's decline. However, the sales have been measured and intended only to stabilise excessive currency volatility. We think this move is commendable, as one key lesson from the 2008 crisis was that keeping the currency heavily managed contributed to the acute fall in real GDP in 2009.
We have also argued that the new monetary policy paradigm adopted by the CBR since the 2008 crisis will serve as an important buffer in the case of a deterioration in US and global growth prospects. In a highly managed exchange rate system, external shocks are transmitted one-for-one to the domestic economy, preventing the exchange rate from acting as a shock absorber. Now that the CBR has taken a course towards loosening its grip on the ruble and increasing its tolerance for more ruble volatility, external shocks will be, at least partially, accommodated by a more flexible exchange rate regime.
While the qualitative appeal of a more flexible exchange rate may seem easy to grasp, it is more challenging to capture the possible benefits on real activity from a quantitative perspective. To investigate this, we use statistical methods and estimate the dynamic effects on Russian GDP of a 1% decline in US GDP growth relative to the baseline under two separate regimes for the dollar/ruble. In particular, we calculate the quarterly year-on-year declines in Russian GDP under a fixed and flexible exchange rate in a dynamic system that includes US and Russian GDP, inflation, policy rates and the dollar/ruble exchange rate.
If we shut out the shock-absorbing capacity of the ruble, Russian GDP contracts by a maximum of 2.5% on year three quarters after the shock, with the average four-quarter (annual) decline at 1.5%. If, on the other hand, we let the ruble take some of the hit by depreciating and supporting economic activity, Russian GDP falls by a maximum of 2.2% year on year in the third quarter, but the annual decline is significantly lower at 0.87%.
A key attendant risk to the prospects of a more flexible exchange rate is higher inflation through increased prices of imported goods. This is a valid concern, in particular when assessed against the fact that food imports make up about 15% of the overall import bill. However, we see a number of reasons why we should not expect a significant acceleration of headline inflation.
First, while the pre-2008 crisis's negative correlation of the dollar/ruble and CPI inflation is indeed robust, the behaviour of CPI inflation during the crisis demonstrates that the 40% ruble depreciation did not translate into higher price growth. This possibly reflects the deflationary nature of the external shock, as declining GDP brought about decelerating inflation.
Second, the most recent increase in inflation was almost exclusively driven by higher food prices for domestically produced goods (bread and bread products) related to the 2010 summer drought. However, with the 2011 harvest now expected to be quite good, we anticipate that food prices will decelerate in a more pronounced fashion over the course of this year and the next. Hence, we do not expect a substantial increase in price pressures, even if the increasingly challenging global environment were to be accommodated by a more flexible domestic currency.
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