Russia’s central bank raised its interest rates to 17% from 10.5 on December 15, the sixth such raise in 2014.
The announcement was made in the middle of the night as Russian policy makers pulled out all the stops to rein in their freefalling currency.
A mix of western sanctions sparked off by the Ukraine conflict and plunging oil prices caused the rouble to drop to record lows – reaching 74 roubles to the dollar at one point.
Sanctions imposed on Russia by the U.S. and Europe between April and September of this year may have started the slide but the unexpected drop in oil prices only served to squeeze the Russian economy further.
Russia is the third largest oil producer behind the U.S. and Saudi Arabia and the second largest exporter. The energy sector makes up half of the Russian market and oil & gas sales accounted for 68% of Russia’s total export revenues in 2013.
Energy is a big deal in Russia. The energy sector is very much a state-owned enterprise and about half of the government budget is financed through the sale of oil and natural gas.
The government budget submitted in September to Russia’s lower house of parliament detailed a balanced budget – given an oil price of $105. With oil under $60 it is clear that the Kremlin is in a bit of hot water.
Fortunately, Russia has reserves of $454 billion – built up over years of high oil prices – which they set aside to cushion themselves against fluctuations in oil prices.
The only problem – their cliff diving currency is causing them to reach into their piggy bank; money set aside to weather a storm of falling oil prices is now being used to defend the rouble.
The Russian central bank is using a two-pronged approach to prop up the tumbling rouble.
On one hand they have raised interest rates six times in 2014 while also spending more than $80 billion out of their reserves to buy roubles and artificially jack up demand.
Most recently policy makers in Russia raised the key interest rate, or the interest rate at which banks are allowed to borrow money from the government, to 17% from 10.5%.
This means that banks have to pay even more to borrow money than before, which means consumers – regular folks and businesses – also have to pay more. Raising the key interest rate like this acts like a vice grip on an economy – squeezing it by keeping the amount of credit available low.
Why would one want to enact such tightening measures on an economy that is experiencing a drastic selloff of their currency?
People in Russia are actively trying to exchange roubles to dollars to try and preserve whatever is left of their wealth while institutional investors are trying to move their assets abroad. This means demand for roubles is very low.
The value of a currency is, at its most basic, the balance of demand for that currency versus another. Imagine a tug of war rope with two teams: roubles and dollars. As people sell more and more roubles, the dollar team is able to push the balance of demand in their favour and pull the rope further and further onto their side.
If people are selling roubles and buying dollars then demand for dollars is high and the dollar appreciates, or gains in value relative to the rouble.
That’s where the central bank can try to come in and defend the currency. By using money from their reserves to buy roubles they are acting as the buyer of last resort. They are injecting demand for roubles into the system.
Russia could also impose strict capital controls. That is, they can restrict how and when money leaves the country. Basically, if foreign investors who want to take their money out of Russia would be unable to – preserving demand for roubles.
So why would a country raise their key interest rates to try and stop their currency from depreciating?
What an insane raise like this actually does is signal to Russians that the government is serious, in effect saying “listen guys, chill out because we will do whatever it takes”
With the currency reaching ridiculous levels people are worried that their money earned today will be useless tomorrow. Something that cost 30 roubles today might be worth 60 by the weekend.
By raising the key interest rate, or repo rate, you would expect a reduction in business investment as credit becomes more expensive to finance. You would also see a fall in consumption because consumer loans are also more expensive.
Aggregate demand = Consumption + Investment + Government Spending + (Exports – Imports)
If both consumption and investment fall, so does demand, and a fall in demand leads to a fall in inflation.
The other reason is that economic theory tells us that higher interest rates lead to an appreciation of a currency.
In practice…it’s not so clear cut.
The rouble strengthened 12 percent against the dollar following an increase in the one-week repo rate.
Russia tripled key interest rates, at one point reaching 150%, and the rouble collapsed – causing Russia to default on $40 billion worth of debt.
The Latin American country raised rates 5 times to 11.75% which accompanied a 13% decline in the exchange rate.
The central bank increased the repo rate to 10% and the lira appreciated more than 8%
Interest rates were raised by 1.75 percent and the rupiah declined 21% in 2013.
In October 2013, the repo rate was raised to 7.75% from 7.25% and the rupee strengthened by 1.8 percent. Another 0.25% increase in interest rates in January was accompanied by a 1.4% decline in the currency.
Rates were raised to 9.5% from 8% and the currency fell 15% in 2008.