Case Study of Russia

For a currency to be devalued means that the issuing government has mandated that the price of the
currency (in foreign dollars) is lower than it was before. For example: if the Russian government changes the
exchange rate from 100 rubles = $1 to 150 rubles = $1, then the ruble has been devalued. Now, regardless
of whether a country has a fixed or flexible exchange rate system, there exists a "true" (we say "equilibrium"
or ‘’ market determined’’) exchange rate.

The equilibrium exchange rate is the exchange rate at which everyone who wants to sell the currency can
find a buyer and everyone who wants to buy the currency can find a seller. By definition, a flexible exchange
rate is the equilibrium exchange rate. This is not the case with a fixed exchange rate.

Consider the following analogy. The equilibrium price of a car is $10,000. If the government imposes no
restrictions on car prices (i.e. car prices are flexible), then the free market price of a car will be $10,000.
Further, there will be no surplus or shortage of cars -- everyone who wants to buy a car (at $10,000) will find
one to buy, and everyone who wants to sell a car (at $10,000) will find a customer.

Now, suppose the government imposes a price floor on cars of $15,000. At the official price of $15,000,
many people will want to sell cars, but few people will want to buy cars – there will be a surplus of cars. If the
government wants to avoid ending up hip-deep in unsold cars, it will have to buy the extras itself. (Note: this
is precisely what the government does in the case of farm subsidies.)

In the case of a fixed exchange rate, the Russian government declares that the official price of 100 rubles is
$1. Suppose, the equilibrium price of 100 rubles is $0.75, people would be willing to trade 100 rubles for $1.
At the official price of 100 rubles to $1, many people will want to sell rubles (sellers receive $0.25 more than
the equilibrium price), but few will want to buy rubles (buyers must pay $0.25 more than the equilibrium
price). The result is that there will be a surplus of rubles: there are more people willing to sell than there are
people willing to buy. As in the car example, if the government wants the market to continue, it must take up
the slack. In this case, the Russian government must buy the surplus rubles (at the official price of 100 rubles
to $1). How does the Russian government buy rubles? It pays for the rubles on the market with, for example,
US dollars.

So now everything is fine. The official exchange rate is 100 rubles to $1. The Russian government buys up
the surplus rubles that the market does not want, and life goes on.

Not so fast!! The Russian government is buying these surplus rubles with US dollars. The US dollars are
coming out of a stockpile that the Russian central bank has built up. What happens when the Russian central
bank starts to run out of dollars? When the Russian central bank starts to run out of dollars, it becomes
harder for it to buy up the surplus rubles. If the central bank loses the ability to buy up surplus rubles, then it
becomes powerless to enforce its fixed exchange rate.

The Russian government now has three options:

(1) Revert to a flexible exchange rate (which would cause the price of rubles to immediately fall to 100 rubles
to $0.75), or

(2) Suspend trading in rubles (which is what the government did first), or

(3) devalue the ruble so that the fixed exchange rate is closer to the equilibrium exchange rate (which is what
the government did next).

Among the above which option is better?

.

What is the effect of having a fixed exchange rate which is greater than the equilibrium or market determined
exchange rate?

It makes it less expensive for Russians to buy foreign goods (so Russian imports are greater than they would
otherwise be). It also makes it more expensive for foreigners to buy Russian goods (so Russian exports are
less than they would otherwise be). Because GDP rises when exports rise and falls when imports rise,
having a fixed exchange rate which is greater than the equilibrium exchange rate is bad for the economy. So,
maybe devaluing the ruble is a good thing -- if the ruble is devalued to, say, 100 rubles = $0.75 then

(1) The Russian central bank no longer has to buy up surplus rubles (because there won’t be any surplus),

(2) Russian exports rise (because Russian goods are now cheaper for foreigners),

(3) Russian imports fall (because foreign goods are now more expensive for Russians). According to this
formula, Russia should be on its way to a burgeoning economy.

Generally what kind of exchange rate is better? fixed or floating?

 Floating exchange rate regime, which implies that the exchange rate of the ruble is not fixed and that there are no pre-
established targets for its exchange rate or the pace of its movements. The dynamics of the exchange rate of the ruble
are determined by the ratio of the demand for and supply of foreign currency in the foreign exchange market.
A flexible exchange rate helps Russia to adjust to changing external conditions, smoothing out the impact of external
factors on the economy.

Not so fast!!! Many foreigners have purchased Russian bonds. These bonds are IOU’s that state that the
Russian government promises to pay a certain amount of rubles to the holders of the bonds at some fixed
date in the future. Suppose you are the IMF. Six months ago, you purchased 100 billion rubles worth of
Russian bonds. At the fixed exchange rate of 100 rubles to $1, you paid $1 billion for the bonds. Let us say
that the bonds yield 10% interest and come due tomorrow. You will have earned 5% on the loan. So
tomorrow, you will receive a check for $1.05 billion, right.

No way. Those bonds were denominated in rubles. You will receive back your 100 billion rubles plus 5%, or
105 billion rubles. BUT, now that the government has devalued the ruble, those rubles trade not at 100 rubles
to $1, but at 100 rubles to $0.75. The 105 billion rubles you receive tomorrow are worth $787 million and
change. Because of the devaluing of the ruble, you just lost almost a quarter of a billion dollars -- and that is
after accounting for the interest you earned. Thus, for the Russian government to devalue the ruble is
tantamount to it’s defaulting on a portion of its debt.

Our story is not yet over!!!! Combine all of the above with the fact that the Russian government has been
ineffective in collecting taxes. Because it is ineffective in collecting taxes, the government does not have
enough rubles to either pay off the debt it owes on its bonds or to purchase the products it requires to
continue operating as a government. While the Russian government can devalue the ruble so as to eliminate
some of the debt it owes, devaluation is not a panacea because:

(1) The more the government devalues the ruble, the lower the probability that it will get another loan from a
foreign government in the foreseeable future,

(2) Devaluing the ruble relieves the pressure of having to pay back debt, but it does not provide rubles for
future purchases. In order to obtain rubles for future purchases, the government (absent tax revenue) has no
choice but to "print" rubles. So, the government prints the rubles and buys the products it needs to stay in
business as a government.
Is devaluation good for the economy?

Devaluation of a currency leads to an increase in exports and decrease in imports which helps balance of trade. The
increase in exports boosts the economy by providing demand for the supply of goods and services. But devaluation
is a double-edged sword. While it boosts exports the import of goods and services will go up correspondingly and
this can bring about inflationary pressure in the economy.

Not so fast!!!!! The average prices of products in a country is (roughly speaking) the ratio of the quantity of
currency in the country to the quantity of products produced in the country. When the Russian government
prints rubles, it increases the quantity of rubles without changing the quantity of Russian products produced.
The result is that prices go up by the same percentage as does the money supply. But, because prices will
rise only after the economy is aware that the government has expanded the money supply, if the government
is quick to print and spend the new money, it will be able to buy what it needs with the new rubles before
inflation reduces their value. Like a game of hot-potato, those who pay for the government’s purchase of
product with "printed money" are the people who are holding rubles when the inflation hits.

To summarize: the current economic crisis in Russia is caused by a combination of factors. The government
has been ineffective in collecting taxes which means that the government has to print money to buy what it
needs. In an effort to escape the effects of the nearly world-wide economic collapse, investors want to buy
strong currencies (like the dollar) and to sell weaker currencies (like the ruble). The flight to dollars causes
the equilibrium exchange rate of the ruble to fall. The Russian central bank finds itself forced to sell off almost
all of its stock of dollars in an attempt to support a now untenable fixed exchange rate. As the Russian
government runs out of money to buy what it needs and the Russian central bank runs out of dollars to
support the fixed exchange rate, two things are done:

(1) The Russian government prints rubles (causing massive internal inflation),

(2) The Russian central bank devalues the ruble (effectively causing the Russian government to default on its
loans).

How could this disaster have been averted?

 Floating exchange rates tend to avoid currency crises by ensuring that the market is always setting
the price, as opposed to fixed exchange rates where central banks must fight the market.

 Good relations with other countries.