Sunday, January 4, 2015

John Cochrane on Russia and the Ruble

John Cochrane is a University of Chicago business school professor who works on the borderline between macro and finance.

He’s posted a long piece on the evolving situation in Russia. Read the whole thing.

This is an interesting event on which to test out our various frameworks for thinking about macroeconomics and monetary economics.
There are three basic perspectives on exchange rates.
1. Multiple equilibria. Lots of words are used here, "speculative attacks," "sudden stops," "hot money," "self-confirming equilibria" "self-fulfilling prophecies" "contagion" and so on. Basically, the exchange rate can go up or down on the whims of traders. There is often some news sparking or coordinating the bust.  Some of the mechanism is like bank runs, pointing to "illiquidity" rather than "insolvency" as the basic problem.
This has been a dominant paradigm since the early 1990s. I've been a bit suspicious both on the nebulousness of the economics (lots of buzzwords are always a bad sign), and since the analysis seems a bit reverse engineered to justify capital controls, currency controls, (i.e. expropriation of middle-class savers and poor currency-holders), IMF rescues, and lots of nannying by self-important institutions and their advisers who will monitor "imbalances," "control" who can buy or sell what, and so forth. But models are models and facts are facts.
2. Monetary. Exchange rates come from monetary events, and primarily the actions of central banks. For example, much of the analysis of the dollar strengthening relative to euro and yen attributes it to the idea that the US Fed has stopped QE and will soon raise rates, while the ECB and Japan seem about to start QE and keep rates low.
3. Fiscal theory. Exchange rates come fundamentally from expectations of future fiscal balance of governments; whether the governments will be able and willing to pay off their debts. If people see inflation or default coming, they bail out of the currency, which sends the price of the currency down. Inflation follows; immediately in the price of traded goods, more slowly in others.

I tend to fall in the camp with # 3: exchange rate movements tell us about how people feel about one government’s credibility versus other governments.

Russia’s problems are coming from three sources: oil prices, international concerns about their behavior towards Ukraine, and kleptocracy related to the Sochi Olympics.

Oil price drops are a problem because, unlike developed “Western” nations, most poorer countries government’s own their oil reserves. So the fiscal position of the government depends critically on maintaining high prices. You may have also noticed that a lot of government officials are economically … pretty dumb. It doesn’t have to be this way, but typically governments get into trouble by locking in expensive spending plans when oil prices are high that they can’t unwind when the prices fall.

The situation with The Ukraine is a mess (and the Ukrainians aren’t entirely innocent). What’s important for a macro class a year later is that economic sanctions were put in place on Russia. Now Russia is trying to be a richer more developed country without the thick financial markets that richer developed countries … hmmm … develop as they go through the process of getting richer. So basically, they borrow a lot from foreigners, and repay those loans by borrowing even more. This has been cut off. Keep an eye on any weakening of the sanctions: this probably means that financial interests here are putting pressure on politicians here because Russians over there are threatening default. On the other hand, those same discussions of weakening sanctions are also pretty good evidence that they’re working.

Sochi: the most expensive Olympics ever, put on by an underdeveloped country, in a sub-tropical climate. Sheesh. There’s a ton of evidence that this was a big corruption event: Russia used government budgets to overpay for stuff sold to them by top supporters of the Russian government. Basically, it was money laundering. You can imagine that most of that money ended up in Cyprus, and Switzerland, and London, and even places like Park City.

Interestingly, a few weeks ago I speculated that Russia’s foreign reserves had been looted. Cochrane implies the same thing:

Russia ran big trade surpluses, meaning there are foreign assets somewhere. But those may have all ended up as Russian owned London apartments and Swiss banks and not available to Russian banks and businesses.

The last time I wrote about Russia 3 weeks back, I was unaware of the Rosneft switcheroo. Cochrane explains by quoting The New York Times coverage:

Rosneft, for example, had been clamoring for months for a government bailout to refinance debt the company ran up while making acquisitions when oil prices were high. Because of sanctions, those loans cannot be rolled over with Western banks. Debt payments are coming due later this month.
... With the oil giant in a bind, the central bank ruled that it would accept Rosneft bonds held by commercial banks as collateral for loans.
Rosneft issued 625 billion rubles about $10.9 billion at the exchange rate at the time, in new bonds on Friday. The identities of the buyers were not publicly disclosed, but analysts say that large state banks bought the issue.
When these banks deposit the bonds with the central bank in exchange for loans, Rosneft will have been financed, in effect, with an emission of rubles from the central bank. The deal roiled the ruble on Monday, according to analysts.
The reason for Monday’s currency crash is “well known,” Boris Y. Nemtsov, a former deputy prime minister who is now in the political opposition, wrote on his Facebook page. “The central bank started the printing press to help the Sechin-Putin business, and gave Rosneft 625 billion newly printed rubles. The money immediately appeared on the currency market, and the rate collapsed.”

Oops. One thing you need to recognize about government officials in a crisis is that they’re control freaks. And they think they can pull this stuff off without anyone noticing. When there’s a lot of money on the line, that doesn’t work out so well.

How can you keep an eye on this? Find a site that you like that shows the ruble/dollar exchange rate. Then, make sure it’s one that you can adjust the time axis on; you want to be looking at no less than a 3 month window. Here’s a 12 month window I snapped off of Bloomberg today:


Do note that I can’t scale the vertical axis to have a true zero. So, Bloomberg is distorting our view a bit.

What should you make of this? The sanctions were put into place in the summer. The exchange rate crisis of mid-December is the big spike. The Russian response to that, which quieted markets a big is the trough afterwards. Now note the time scale: the Russians best shot reversed their devolving position all the way back to, maybe, December 1. The slower losses of July to November added up to something larger, and they’re still there. And the exchange rate has started to get worse again since December 25.

This is not going to be fun to watch. The last time Russia had a financial crisis (1998) … we got Putin. The last time they had a crisis before that (80’s and early 90’s) … we got a coup with tanks in the streets of Moscow.

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