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.
