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Yesterday was a dark day for the Russian economy as the currency collapsed by more than 10% and the Central Bank of Russia (CBR) was forced to hike rates by 6.5% to 17% following a midnight emergency meeting. This has rightly evoked some comparisons with the UK’s Black Wednesday in 1992, not least because the intervention seems to largely have failed. The Rouble continued its spectacular collapse today, though it was tempered somewhat at the time of writing with the CBR seemingly intervening in the market.
All this has already been analysed and deconstructed. However, the interesting questions now are: where does this leave the CBR? Will it move to capital controls? If so, what could these mean for the Europe?
CBR has been behind the curve and is approaching a last resort
- Last night’s move was all the more surprising given that the CBR met last week and decided to only raise rates by 1%. Clearly, the bank was hesitant about raising rates too far for fear of clobbering the already floundering Russian economy. This acute trade-off has been worsened by the impact of economic sanctions on Russia and has proved too difficult to balance.
- The CBR has tried almost all conventional tools, mostly interest rate increases and managing foreign exchange liquidity (of which it is now providing $5bn per month).
- It has proved to be cautious about using its foreign exchange reserves. This is not as much of a surprise as some suggest. First, as the chart below shows, they have already been falling quickly. Second, it’s almost pointless trying to fight the huge oil market as the price collapses – besides the weaker currency offsets some of the negative impact of this phenomenon. Finally, the reserves may not be quite as liquid or accessible as they have been made out to be. The Peterson Institute of International Economics convincingly argued recently that in fact, because up to $229bn of the reserves are tied up in gold, IMF Special Drawing Rights and two sovereign wealth funds, they have been earmarked for other purposes and may not be easily callable for the CBR if it needed them.
- A deep recession is almost a certainty for Russia next year and given the constraints above there little the CBR can do about it. One final option on the table is the prospect of capital controls. Discussion around this idea is sure to increase after the CBR forecast that capital outflows will reach $138bn this year, as shown in the chart below.
Are capital controls likely?
- The Russian government has so far been sternly against such an option but it is looking increasingly likely. As the price of oil crashes and instability in the Russian economy grows, the country will become increasingly short of cash and capital – due to a likely massive decline in its trade surplus. Furthermore, capital flight will also increase, creating a double whammy.
- To have any hope of maintaining investment in the economy and keeping sufficient liquidity in the system, Russia may adopt capital controls to force investors to push the capital into the domestic economy rather than abroad.
- The leap to capital controls from where Russia is now may also not be as large as some expect. The sanctions have perversely helped in this regard – large parts of the Russian economy are already cut off from international financing either directly due to sanctions or indirectly due to the financial sector cutting Russian exposure due to uncertainty. At the start of the month Russia announced plans to encourage exporters to convert foreign revenue to Roubles – this has been seen by some as a form of capital control since it forces money back into the currency and the economy. Finally, it is possible that by forcing domestic capital (which is fleeing at a net rate of $134bn per year) to stay in the economy, this could help offset some of the costs in terms of foreign direct investment.
Could capital controls actually help at all?
- Capital controls have a mixed record to say the least and have not worked well in emerging markets such as Argentina and Venezuela. That said, Malaysia used them effectively in 1998, while both Iceland and Cyprus used them in the aftermath of serious banking crises. The outcome may not have been positive but their economies managed to survive. Furthermore, China (accepted more likely to be an exception than a rule) still strictly manages capital inflows and outflows, while Russia has over the past two decades used such controls to varying degrees and levels of success.
- Overall, the impact of capital controls is generally negative (see a useful NBER summary here). One crucial problem is that it will make rolling over external debt much harder for Russian firms. In total Russia has $731bn in external debt, of which $354bn is private sector. As mentioned above though, rolling this over is already a serious challenge with limited financing opportunities in the West. Furthermore, the Russian government is keen to avoid raising the prospect of defaults on Russian bonds once again. We could see more firms turning to the state for support as Rosneft has done with its $42bn bailout request.
- If the decline in the oil price and the Rouble continues, I can’t see that Russia has much choice but to introduce some form of capital control. This is unlikely to be as simple or as extreme as in recent cases such as Iceland and Cyprus where movements of capital were almost entirely halted, but it could still be significant. Building on the move to get foreign revenue converted into Roubles is a likely place to start, with other pools of foreign currency also likely to be targeted – options include locking dividends/payments into Rouble accounts.
How could this impact Europe?
- Ultimately, it depends what form the controls take and how effectively they are enforced (a serious challenge). Some investors in Europe could face seeing money tied up in Russia. The already declining foreign trade between the two sides is likely to get worse. We could see capital outflows into safe haven Europe pick up, though again this will depend on when and how the controls come into force.
- The impact is likely to be bigger in political terms. Russia’s position with regards to Ukraine will undoubtedly be weakened. It seems unlikely this will cause Russian President Vladimir Putin to shift his position significantly but it undoubtedly puts him under more pressure than he has been for some time.
- If controls are introduced it is also likely to drive an even larger wedge between Putin and his pro-business advisers and supporters. This gap has already been growing due to differences over sanctions and Ukraine. Such a shift could see the hardliners within Putin's government gain further credence. Such an event would make predicting Russia's next move even more difficult.
