At a recent American Chamber of Commerce conference in Moscow, notable speakers from both Russia’s government and the private sector emphasized the need for economic reform. Echoing other commentators, they repeatedly used the word “institution”, asserting that Russia needs to build at a minimum an independent judiciary, a professional policy-making hierarchy, and institutionalize better protections for investors.
However, commentators failed to mention that Russia already has a competent and credible institution at the heart of its economy: the Central Bank of Russia (“CBR”). In recent years, the CBR’s leadership has been exemplary, providing a clear illustration of how Russia might succeed in building credible economic institutions.
The CBR’s most notable action has been to completely change the role of monetary policy. Pre-2008, monetary policy was mostly out of Russia’s hands. Prices are set on international markets for its main exports – oil, gas, and metals. The CBR had fixed the ruble, targeting a basket of euros and USD. In a pattern typical of a fixed exchange rate regime, the currency was initially underpriced relative to Russia’s major exports, prompting a large and destabilizing inflow of capital and unsustainably high economic growth as oil prices rose during the 2000s.
The opposite occurred when the crisis hit in 2008 – 09: oil prices fell and the CBR spent over $220 billion in reserves to defend the exchange rate, draining liquidity from the banking sector and pushing interest rates to prohibitively high levels. This culminated in a steep devaluation and a 7.9% contraction in the economy in 2009.
To avoid the wild swings in growth and interest rates, the CBR has been transitioning to targeting inflation and running a free-floating exchange rate in stages, gradually widening the band at which it intervenes to slow FX movements. As of now, the corridor is +/-15%, permitting significant fluctuations.
The system faced its first serious test in August/September 2011. The exchange rate basket dropped half as much as during the massive devaluation of 2008 – 09, due to global risk aversion. Interest rates rose slightly and the CBR intervened only modestly; this cost it $7.1 billion but it avoided a systemic crisis.
THE REAL REVOLUTION
While the change in exchange rate policy is more readily noticeable for investors, the real revolution is in the CBR’s new inflation-targeting policy. Now, the CBR targets interest rates instead of the FX rate, in an effort to keep inflation in check. The idea is to manage interest rates and banking sector liquidity to control inflation, similar to how most Western central banks operate.
Since 2009, it has narrowed the interest rate corridor (the difference between its one-day repo rate, seen by money market players as the ceiling, and its one-day deposit rate, seen as the floor) from 425bps to 225bps, using open market operations to keep market rates within that corridor. In June 2012, the CBR intervened through FX swaps to cap local interest rates.
In most cases investors are justified in their skepticism about economic policy in Russia, especially if it is trying to mimic Western policies. However, there is already evidence that the central bank’s policy is proving effective – market rates have stayed within the CBR’s corridor for the past 18 months.
Citing a host of potential inflationary pressures, the CBR hiked rates by 25bp in a surprise move in September, despite softening growth numbers and an unprecedented easing by the Federal Reserve later that day, and emerged as a credible inflation fighter.
The central bank’s longer-term goals behind the change in monetary policy are to create a more stable interest environment and growth profile for Russia, encouraging the development of the financial sector.
Most of the financial crises in Russia have been macro-driven, but exacerbated by a weak financial sector. For instance, the devaluation of 2008 was exaggerated by FX mismatches and poor funding profiles. By getting macroeconomic policy correct, the CBR is creating the preconditions for improving the country’s financial infrastructure. At some point, there is only so much that monetary policy can do; Russia needs micro-level reforms as well. As an example, capital outflows of $92.9 billion in the past year are cited as a serious problem in Russia. In some ways this reflects a strong resource endowment; much of this capital outflow is from exporters that earn hard currency and then keep it overseas.
‘MEGA-REGULATOR’
But it also speaks to the relatively poor investment climate, as companies are unwilling to repatriate their export earnings, and to the relative inefficiency of the Russian financial system, which is unable to intermediate between large pools of export earnings and high demand for credit from other sectors.
Most policy makers, including the CBR, agree that the most effective way to combat capital outflow is to upgrade the financial system and the overall investment climate in Russia.
The CBR is emerging as the institution of choice for accomplishing this. In a surprise move, the Finance Ministry opted to give up its regulatory powers over financial institutions and merge the Federal Service for Financial Markets regulator into the CBR.
The so-called “mega-regulator” will be responsible for both financial markets and banking supervision.
This follows the government’s multi-pronged efforts to upgrade the infrastructure necessary to turn Moscow into an international financial center.
While Moscow will not replace London or New York, the CBR’s efforts to upgrade the functioning of the stock markets are positive f or foreign investors.
For all of the talk about weak institutions, investors should give credit where it is due and recognize the strengths and improvements in the Russian economy and financial system, courtesy of the CBR.
It has emerged as an effective and trustworthy institution—just the kind that Russia needs if it is to make the next step in its development.
- The author is Bruce Bower, partner and portfolio manager, Verno Capital