Why the Russian economy is collapsing
- At 1:00 a.m. Moscow time, Russia’s central bank announced a dramatic rise in interest rates, from 10.5 percent to 17 percent.
- This is one of the biggest hikes on record, and it is the park of a last-ditch effort to prevent the collapse of the Russian currency.
- In theory, a dramatic rate hike should establish the credibility of Russia’s determination to defend the ruble, persuade investors to stop betting against it, and let the central bank cut rates again in the near future.
- In the early hours of Eastern Time on December 16, the ruble continues to fall.
- If the rate hikes don’t work, Russia will simply face ultra-high domestic interest rates – making mortgages and other loans much more expensive – on top of the economic woes caused by falling oil prices.
Why the ruble is collapsing
The Russian currency is collapsing mainly due to the fall in the price of oil (and, related, natural gas). When fossil fuels are expensive, Russian energy companies are bursting with foreign dollars that they turn into rubles to pay local workers and suppliers. With cheaper energy, there is much less foreign money flowing in. With less foreign money coming in to buy oil, Russia’s official stock of foreign currency is quickly depleting.
Western financial sanctions against Russia following Russian incursions into Ukraine are worsening the ruble collapse. These sanctions make it much more difficult for Russian companies in other sectors to expand to fill the void or to obtain loans to cover temporary problems. Foreign companies are also worried that the growing conflict between Russia and the West will prevent them from investing in it. All of this is combined with the tendency of Russian elites to invest a large part of their money abroad to cause the currency to fall.
How is the rate hike supposed to work?
A little unusual for the recent history of Vladimir Putin, his government’s approach to the currency collapse – not imposing tough new financial regulations, drastically raising interest rates – is classic, orthodox economics. and endorsed by the West.
You can think of this as work through three main channels.
First, it should give the Russians a second thought on the idea of liquidating their ruble-denominated savings and transferring them overseas. The new, higher interest rates mean that keeping your savings at home is suddenly a lot more attractive than it was last week.
Second, it should encourage some foreigners to buy these new high yield Russian bonds.
Third, it should lower the ruble price of some Russian assets. Mortgage interest rates, for example, are about to get much more expensive. This means that the houses will become cheaper. This means that cash-rich investors – maybe real foreigners, maybe wealthy Russians with lots of foreign assets – can bring money to Russian shores in search of bargains.
All three channels would have the same impact: supporting the price of the ruble.
Will it work?
It’s unclear. A sharp rise in rates to restore confidence, followed by slow and steady easing once the situation stabilizes is the classic approach to dealing with a currency crisis.
But the presumption behind this textbook approach is that confidence this is what is missing. Russia’s problem is that nothing else Putin has done is a manual. Getting involved in a war with a neighboring country that results in sanctions from your major trading partners is not a manual. Having an undiversified economy dependent on natural resource exports is not a manual. The fall of the ruble could be an overreaction to a short-term drop in oil prices. But it might also just reflect the underlying weaknesses of the Russian economy.
Winners and losers
One important thing to understand is that Putin’s political choices in this area have important implications for the distribution of wealth in Russia. The collapse in the value of the ruble is a disaster for Russians who have debts denominated in foreign currencies, but it is not necessarily the worst thing in the world for those who do not. Indeed, Russians working in tourism (which admittedly are not that many since Russia is mostly cold and empty) or in the country’s handful of export industries that are not oil and gas. gas in fact benefit to cheap currency.
Conversely, much higher interest rates will have a devastating effect on the fortunes of Russians who need to renew ruble-denominated loans or who depend on rate-sensitive sectors like construction for their jobs.
Many countries facing Russia’s predicament would supplement interest rate hikes with capital controls, financial regulations that make it difficult to withdraw large sums of money from Russia. Such controls would have little impact on the lives of most Russians, but would be extremely inconvenient for ultra-wealthy oligarchs looking to buy property in London and Manhattan or vacation in Italy. Putin is choosing a policy mix that favors oligarchs and people who owe Western banks money over other possible alternatives.