One can argue about the extent to which the loose monetary policies of major central banks were responsible for the accumulation of the imb...
One can argue about the extent to which the loose monetary policies of major central banks were responsible for the accumulation of the imbalances in developed economies that finally resolved themselves in the 2008 financial crisis. However, for a relatively small EME central bank such a set of external conditions was obviously too much to handle. For Russia, rapid commodity price growth and an increase in the external trade surplus, given no restrictions on cross-border capital flows, caused significant upward pressure on the rouble, with demand for local currency greatly exceeding supply throughout most of the pre-crisis period. Were the exchange rate to be determined by private market participants alone, the rouble would have appreciated sharply, making for a perfect example of “Dutch disease”. In this scenario, upward pressure on the exchange rate, caused by a temporary rise in world demand for a product in one sector of the economy,
drives the exchange rate high enough to make other sectors of the economy uncompetitive, with no positive implications for the economy as a whole. However, exchange rate stability means a lot for Russia’s economy and population. Not so long ago, the country had passed through another major currency crisis, with foreign exchange, the USD in particular, widely used for household savings. In addition, exports and imports are quite high relative to the country’s GDP, and foreign lending is an important source of funding for investments. So, the Bank of Russia obviously cannot ignore exchange rate dynamics; in fact, exchange rate stability is stated first in the Bank of Russia’s mandate, as set out in “The Law of the Central Bank of the Russian Federation”. Consequently, the Bank of Russia had to try to counter the threat of “Dutch disease”. Given the absence of capital controls, the one effective instrument the Real key rates GDP growth rates, yoy Source:
Bloomberg 300 BIS Papers No 78 Bank could use to combat excessive rouble appreciation was FX intervention in the domestic market. And intervene it did – quite considerably – with FX reserves increasing from less than USD 40 billion in 2001 to over USD 400 billion in 2007. The problem was that the external (upward) pressure on the rouble was so high that the Bank of Russia’s goal of exchange rate stability (and its operations aimed at achieving it) started to conflict with, and even dominate, its other goals and instruments of policy. FX purchases in the domestic market injected vast amounts of liquidity into the financial sector, but local financial markets were fragmented and not deep enough for the Bank of Russia to be able to sterilise these interventions via liquidity-absorbing operations. Large-scale FX purchases created a structural liquidity surplus in the local financial sector. Virtually the entire increase in the money supply during the pre-crisis period was due to FX interventions. The Bank’s liquidity instruments were not used much, and the relationship between market interest rates and the rates on the Bank’s instruments was vague at best.
This was a good example of the classic “impossible trinity” of the central bank: of three possible policy options – free international capital flows, a managed exchange rate and independent monetary policy – the central bank is able to achieve only two simultaneously. In Russia’s case, the measures aimed at achieving exchange rate stability (FX interventions), the volume of which was actually determined by external, uncontrolled factors (world oil prices, demand for risk in world financial markets), outweighed any other instrument the Bank of Russia had to control the money supply and the interest rate level. As a result, under the given policy mix, the Bank had fairly limited potential to use the interest rate channel of monetary policy to Balance of payments structure, bln USD Source: Bank of Russia BIS Papers No 78 301 influence the situation in local financial markets. The volume of liquidity and the price of money were determined to a much higher degree by external conditions than by the Bank’s own operations. And while the Bank of Russia was coping quite well with ensuring nominal exchange rate stability, the rapid growth in the money supply at least partially resulted in higher inflation rates. Persistently higher price growth in Russia than in its main trading partners led to rouble appreciation in real terms, gradually eroding the competitiveness of local producers. However, the risks of such a situation were clearly visible, and the Bank of Russia moved steadily towards resolving them. The general course of action for the Bank, outlined in the Guidelines for the Single State Monetary Policy for 2004, was to shift gradually from a focus on exchange rate targeting to inflation targeting, to increase the role of interest rate instruments and to gradually move towards a freely floating exchange rate. Unfortunately, the world financial crisis in 2008 and the need to take emergency measures to mitigate its effect on the Russian economy forced a delay in this transition, but, on the other hand, it highlighted the drawbacks of the current monetary policy stance. After the crisis, work on the transition to inflation targeting was intensified. During the post-crisis period, Russia’s external conditions changed considerably. After a brief period of rapid growth, oil prices stabilised and have remained at approximately the same level since the second quarter of 2011.
The rouble appreciated sharply in real terms, leading to faster growth in imports than in exports. The upward pressure on the rouble was gone, and automatic FX interventions were no longer the primary source of money growth. Better ways and better instruments of monetary policy were needed, and changes followed. First of all, important changes were introduced to the mechanism of FX intervention, aimed at allowing for greater flexibility in the rouble exchange rate and reducing the amount of interventions needed to smooth excessive exchange rate volatility. Fixed bands for the rouble value of the dual-currency basket were abandoned in favour of the floating operational band, the boundaries of which are automatically adjusted depending on the amount of FX interventions. The current mechanism for smoothing exchange rate volatility allows purchases or sales of FX currency not only on the boundaries of the bands, but also inside the bands. The parameters of the Bank of Russia’s FX operations in the domestic market are determined by taking into account the goal of smoothing exchange rate volatility. As a result, the rouble exchange rate is now determined to a much greater extent by market forces than it was during the pre-crisis period.
No comments