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This
originally appeared in Pravda.ru.
http://english.pravda.ru/russia/economics/24-11-2008/106736-Russia_Currency_Crisis-0
On the
surface, it appears that Russia's central bank is doing what it should to
support the value of the ruble. Rubles are being purchased on the foreign
exchange market, using foreign reserves. The central bank's interest rate
targets have been raised, with the main overnight credit rate now at 12%.
However,
a closer inspection reveals that the central bank -- like most central banks
in these sorts of situations -- is neglecting to address the most important
factor, the number of rubles in circulation. The supply of rubles is largely
unchanged. If the demand for rubles declines, and supply is unchanged, then a
lower ruble value is the inevitable result. Indeed, once market participants
notice that the central bank is not properly managing the supply of rubles,
it is common for demand to fall even more.
The
"supply of rubles" is known as base money. As of November 10, the
central bank reported that ruble base money was 4,416 billion rubles. At 27
rubles/dollar, that is worth about $163 billion. On September 1, the monetary
base was 4,508 billion rubles. We see that, despite the apparent frantic
efforts of the central bank, ruble base money has barely changed.
From
August 29 to November 7, Russia's foreign reserves declined from $582 billion
to $484 billion, a fall of $98 billion.
When
the central bank sells dollars, it receives rubles in return. To support the
value of the ruble, these rubles should disappear from circulation. In other
words, base money should decline by an equivalent amount. If this had been
done, base money would have declined by about 60%, or 2,646 billion rubles.
Only 1,770 billion rubles would remain. If necessary, the central bank could
buy every last remaining ruble in existence with an additional $66 billion.
A 60%
decline in base money is very large. In practice, it would hardly take such a
dramatic effort to support the currency's value, if the central bank is
properly addressing the problem. A 20% reduction should be more than enough.
That would require the use of about $33 billion of foreign reserves, a
relatively small sum.
At
least until the crisis passes, base money should not be allowed to expand via
some other open-market operation, such as an interest-rate target. In
technical terms, the ruble-buying operation should be
"unsterilized."
This
is how a properly managed currency board would operate. When market
participants come to the currency board, with local currency to sell, the
currency board would reduce base money by an equivalent amount. This process
is extremely reliable. According to Johns Hopkins professor Steve Hanke, a
currency board specialist, no properly-managed currency board has ever failed
in practice.
Even
if Russia's central bank had no foreign reserves at all, or did not wish to
use them, it could support the value of the ruble by reducing the monetary
base. This could be accomplished by sales of ruble-denominated debt, or
indeed any sort of asset. The important thing is that the rubles received in
the sale of assets disappear from circulation, shrinking the monetary base.
Instead,
it appears that Russia's central bank is following a path not much different
than that used by certain Asian central banks in 1997 and 1998. This method
has a track record almost as reliable as that of currency boards -- it almost
always fails. A central bank that persists in such a proven policy mistake
becomes a very exciting target to speculators.
A
currency board link to the euro might be very appropriate for those countries
that have recently joined the Eurozone, such as Hungary or Poland. This would
solve most of their currency issues overnight. However, Russia, like China,
may prefer not to take part in the eurozone project.
Last
weekend, leaders from twenty countries gathered in Washington D.C. to talk
about a new monetary system that does not result in the kinds of crises that
continue to erupt around the world. There was even some mention of returning
to a gold-based system, which apparently worked well in the 1950s and 1960s.
These
efforts often founder due to a lack of understanding of the proper methods of
currency management. No central bank wants to make any promises, if it does
not have the means to deliver on those promises. The currency board-type
mechanism of base money adjustment is the method by which central banks
maintain their promises.
It
might be noted that exchange-traded funds work exactly this way. When the popular
gold ETFs receive an excess of selling, the number of ETF shares in existence
is reduced, on a real-time basis. In this way, the value of the ETF matches
the value of gold, as is promised in the ETF's prospectus.
In
other words, the ETFs are pegged to gold, using the automatic currency
board-type mechanism of supply adjustment. If it were possible to trade paper
share certificates in the ETFs, in everyday transactions, they could become
almost indistinguishable from a gold-linked currency.
Nathan
Lewis is the author of Gold:
the Once and Future Money (2007), now available in English,
French, German, Chinese and Korean.
Nathan
Lewis
Nathan
Lewis was formerly the chief international economist of a leading economic
forecasting firm. He now works in asset management. Lewis has written for the
Financial Times, the Wall Street Journal Asia, the Japan Times, Pravda, and
other publications. He has appeared on financial television in the United
States, Japan, and the Middle East. About the Book: Gold: The Once and Future
Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is available at
bookstores nationwide, from all major online booksellers, and direct from the
publisher at www.wileyfinance.com or 800-225-5945. In Canada, call
800-567-4797.
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