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263Foreign Exchange Rate Determination CHAPTER 9
dominance of different theoretical principles. As a result, the initial lower value of the dollar of S1 is described as overshooting the longer-term equilibrium value of S2.
This is, of course, only one possible series of events and market reactions. Currency mar- kets are subject to new news every hour of every day, making it very difficult to forecast exchange rate movements in short periods of time. In the longer term, as shown in Exhibit 9.8, the markets do customarily return to fundamentals of exchange rate determination.
SUMMarY pOINtS
■ There are three major schools of thought to explaining the economic determinants of exchange rates: parity conditions, the balance of payments approach, and the asset market approach.
■ The recurrence of exchange rate crises demonstrates not only how sensitive currency values continue to be to economic fundamentals, but also how vulnerable many emerging market currencies are.
■ Foreign exchange market intervention may be con- ducted via direct intervention, buying and selling the country’s own currency, or indirect intervention, by changing the motivations and rules for capital to move into or out of a country and its currency.
■ Many emerging market currencies periodically expe- rience fundamental exchange rate disequilibrium. In the past, the most frequent cause of disequilibrium was hyperinflation, but today the most frequently
experienced challenge is the large and rapid inflow and outflow of non-current account capital.
■ Exchange rate forecasting is part of global business. All businesses of all kinds must form some expectation of what the future holds.
■ Short-term forecasting of exchange rates in practice focus on time series trends and current spot rates. Longer-term forecasting requires a return to the basic analysis of exchange rate fundamentals such as BOP, relative inflation and interest rates, and the long-run properties of purchasing power parity.
■ In the short term, a variety of random events, institu- tional frictions, and technical factors may cause currency values to deviate significantly from their long-term fundamental path. In the long term, it does appear that exchange rates follow a fundamental equilibrium path, one consistent with the fundamental theories of exchange rate determination.
The Russian ruble has experienced a multitude of regime shifts since the opening of the Russian economy under Per- estroika in 1991.2 After a number of years of a highly con- trolled official exchange rate accompanied by tight capital controls, the 1998 economic crisis prompted a movement to a heavily managed float. Using both direct intervention and indirect intervention (interest rate policy), the ruble held surprisingly steady until 2008. But all of that stopped in 2008 when the global credit crisis, which started in the United States, spread to Russia. As illustrated by Exhibit A, the impact on the value of the ruble proved disastrous.
russian Crisis 1998 In an effort to protect the value of the ruble, the Bank of Russia spent $200 billion—a full one-third of its for- eign exchange reserves—throughout 2008 and into 2009. Although the market began to calm in early 2009, the Bank decided to introduce a more flexible exchange rate regime for the management of the ruble.
The new system was a dual-currency floating rate band for the ruble. A dual-currency basket was formed from two currencies, the U.S. dollar (55%) and the euro (45%), for
russian ruble roulette1
M i n i - ca s e
1Copyright © 2015 Thunderbird School of Global Management, Arizona State University. All rights reserved. This case was prepared by Professor Michael H. Moffett for the purpose of classroom discussion only and not to indicate either effective or ineffective management. 2There is no established English spelling for the Russian currency—the rouble or the ruble. There is a journalistic tradition that most North American publications use ruble, while European organizations favor rouble, as does the Oxford English Dictionary.
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264 CHAPTER 9 Foreign Exchange Rate Determination
upper and lower band in Exhibit B) that was only 2 rubles per basket value, the band was expanded to eventually reach 7 rubles.
The ruble’s new-found relative stability was rewarded in October 2013 when the Bank of Russia announced that it was expanding the neutral “no-intervention” zone from 1 ruble to 3.1 rubles. This was followed by an announce- ment in January 2014 that the Bank would begin moving to end daily intervention, with a plan to end all intervention sometime in 2015. (Daily intervention in recent months had averaged about $60 million, a relatively small amount given history.) If, however, the ruble did hit either of its bands, the Bank did acknowledge that it was prepared to reenter the market to preserve stability.
The impetus for moving to a freely-floating ruble was to both allow the changes in the currency’s value to “absorb” global economic changes, and allow the central bank to increase its focus on controlling inflationary forces. Russian inflation has been stubbornly high in recent years, and with the U.S. Federal Reserve announcing that it would be slow- ing/stopping its loose money policy in the wake of the finan- cial crisis of 2008–2009, inflationary pressures were sure to continue. But then the regime shift plan began to unravel.
the calculation of the central ruble rate. Around this basket rate, a neutral zone was established in which no currency intervention would be undertaken. This initial neutral zone was 1.00 Ruble versus the basket. Around the neutral zone a set of operational band boundaries were established; an upper band and lower band for intervention purposes.
If the ruble remained in the neutral zone, no interven- tion would be made. If, however, the ruble’s value hit either operational band, the Bank of Russia would intervene by buying rubles (upper band) or selling rubles (lower band) to stabilize its value. The Bank was allowed a maximum of $700 million per day in purchases of rubles. Once hitting that limit, the Bank was to move the band(s) in increments of 5 kopecks (100 kopecks = 1.00 ruble) per day.3
As illustrated in Exhibit B, the ruble continued to slide (appreciating) against the basket throughout 2009 and into 2010. The dual-currency band was continually adjusted— downward—in an effort to put a “moving floor” under- neath the currency. Finally, in late-2010, the ruble stabilized.
As part of its continual program to allow the ruble to grow as a global currency, the distance between the upper and lower bands has been repeatedly increased over time. Starting with a floating band (the spread between the
3The daily foreign exchange intervention limit has been adjusted downward a number of times since the dual-currency band was instituted. In January 2014 the limit had contracted to $350 million per day.
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Ma r-1
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10
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30
35
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45
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55
60
65
Russian rubles = 1.00 USD (monthly average)
Russian economic crisis of 2008 results in a massive
fall from Ruble 6 to 16 = USD 1 in less than
4 weeks
Global financial crisis of 2008–2009 causes new run on the value of the ruble. In Feb. 2009 Bank of
Russia launches a dual-currency (USD & EUR) floating-band for management of the ruble
Extended period of relative currency calm and stability, managed exchange rate maintained at Ruble 30–35 = USD 1
Relatively stable value with higher volatility as Bank of Russia widens the
band to move toward a true floating rate regime, Ruble ≈ 32 = USD 1
Western sanctions on Russian trade and investment, combined with the collapse in global oil prices, send the value of the ruble to new lows against the dollar
e x h i b i t a the russian ruble: 1995–2015
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265Foreign Exchange Rate Determination CHAPTER 9
But the external shocks were not limited to sanctions. Beginning in the summer of 2014 the price of crude oil (Brent Blend crude is the predominant world price of oil) started falling. Oil was Russia’s primary export; the country, the government, Russian business, all relied heavily on oil and gas export earnings to fund their economy. The pres- sures on the ruble—which many termed a commodity cur- rency because Russia relied so heavily on oil—intensified.
As illustrated in Exhibit C, the ruble’s fall began to accel- erate in the fall of 2014. Sanctions were starting to impose real costs, the price of oil was falling faster and faster, and capital
2014: Western Sanctions and the price of Oil “External shocks” is a phrase few central bankers ever want to hear. In the spring of 2014, however, that was exactly what the Russian ruble experienced. In March 2014 the European Union, the United States, and a host of other Western industrial countries imposed political and eco- nomic sanctions on Russia in opposition to its aggressive activities in Eastern Ukraine and its annexation of Crimea and Sevastopol. This had an immediate impact on restrict- ing Russian exports, as well as shutting down a number of major foreign direct investment projects in Russia.
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Rubles versus dual-currency basket
Dual-currency basket calculated by authors (monthly average exchange rates).
Upper Band
Lower Band
Dual-Currency Basket
e x h i b i t b russian ruble Floating Band (january 2009–january 2014)
120
80
90
100
110
70
60
50
40
30
1/ 2/
20 14
1/ 16
/2 01
4
1/ 30
/2 01
4
2/ 13
/2 01
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2/ 27
/2 01
4
3/ 13
/2 01
4
3/ 27
/2 01
4
4/ 10
/2 01
4
4/ 24
/2 01
4
5/ 8/
20 14
5/ 22
/2 01
4
6/ 5/
20 14
6/ 19
/2 01
4
7/ 3/
20 14
7/ 17
/2 01
4
7/ 31
/2 01
4
8/ 14
/2 01
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8/ 28
/2 01
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9/ 11
/2 01
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9/ 25
/2 01
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10 /9
/2 01
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10 /2
3/ 20
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11 /6
/2 01
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11 /2
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/2 01
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8/ 20
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1/ 1/
20 15
March 2014 The European Union, United States,
and a number of other major Western countries impose sanctions on Russia
related to its annexation of Crimea and activities in Eastern Ukraine
August 2014 Price of oil falls below $100/bbl
for first time since 2009
Summer 2014 Sanctions are increased, cutting travel, visas,
trade, and financing of trade with Russia
Russian ruble (Rubles = 1.00 US$)
December 2014 Russian central
bank raises Bank borrowing
rate from 10.5% to 17%
in one day
Price of Brent Crude (US$/bbl)
e x h i b i t c the russian ruble, Sanctions, and the price of Oil (january 2014–january 2015)
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266 CHAPTER 9 Foreign Exchange Rate Determination
The Bank of Russia’s plan to implement a long-term currency strategy, which had been put in place back in 2009, now appeared to be something of a train wreck. The Bank’s original theory—that by increasingly targeting inflation rather than the value of the ruble, the long-term economic prospects for Russia and the ruble would be improved— made sound economic and financial logic in a world of $100/bbl oil and no Western sanctions. Many inside and outside the Bank now wondered if the ruble could ever move from being a simple “emerging market currency” to a currency of value, a reserve currency.
Mini-Case Questions 1. How would you classify the exchange rate regime used
by Russia over the 1991–2014 period? 2. What did the establishment of operational bands do
to the expectations of ruble speculators? Would these expectations be stabilizing or destabilizing in your opinion?
3. Would Western sanctions alone been devastating to the ruble’s value, or was it the plummeting price of oil that had the larger impact?
began to flee Russia. By December the Russian central bank estimated that more than $130 billion in capital had already left Russia, and another $120 billion in capital outflows were expected in 2015. On December 15, on what became known as Red Monday, the ruble lost more than 10% of its value. The Bank of Russia quickly increased its bank borrowing rate from 10.5% to 17%, the following day to 18%, but the ruble barely slowed. By the end of 2014 the price of oil had fallen to roughly $50 per barrel and the Russian ruble was trading at well over Rubles 60 per U.S. dollar.
Now a new concern rose which all emerging market cur- rencies faced with devaluation and depreciation: could the country pay its foreign currency debts in the near future? It was estimated that Russian borrowers of all kinds, gov- ernment and business, faced more than $120 billion in hard- currency foreign debt (largely dollars and euros) in 2015 alone. Russian businesses of all kinds, including some of the world’s largest oil companies, were now restricted from borrowing internationally. So they borrowed domestically, pumping out ruble-denominated debt at a breakneck pace. What would that mean for borrowers and debt-holders in the coming years?
7. Intervention. What is foreign currency intervention? How is it accomplished?
8. Intervention Motivation. Why do governments and central banks intervene in the foreign exchange mar- kets? If markets are efficient, why not let them deter- mine the value of a currency?
9. Direct Intervention Usefulness. When is direct inter- vention likely to be the most successful? And when is it likely to be the least successful?
10. Intervention Downside. What is the downside of both direct and indirect intervention?
11. Capital Controls. Are capital controls really a method of currency market intervention, or more of a denial of activity? How does this fit with the concept of the impossible trinity?
12. Asian Crisis of 1997 and Disequilibrium. What was the primary disequilibrium at work in Asia in 1997 that likely caused the Asian financial crisis? Do you think it could have been avoided?
13. Fundamental Equilibrium. What is meant by the term “fundamental equilibrium path” for a currency value? What is “noise”?
14. Argentina’s Failure. What was the basis of the Argen- tine Currency Board, and why did it fail, in 2002?
QUeStIONS These questions are available in MyFinanceLab.
1. Exchange Rate Determination. What are the three basic theoretical approaches to exchange rate determination?
2. PPP Inadequacy. The most widely accepted theory of foreign exchange rate determination is purchasing power parity, yet it has proven to be quite poor at fore- casting future spot exchange rates. Why?
3. Data and the Balance of Payments Approach. Statis- tics on a country’s balance of payments are used by the business press and by the business itself, often in terms of predicting exchange rates, but the academic profession is highly critical of it. Why?
4. Supply and Demand. Which of the three major theo- retical approaches seems to put the most weight into arguments on the supply and demand for currency? What is its primary weakness?
5. Asset Market Approach to Forecasting. Explain how the asset market approach can be used to forecast spot exchange rates. How does the asset market approach differ from the BOP approach to forecasting?
6. Technical Analysis. Explain how technical analysis can be used to forecast exchange rates.
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