By Nathan Lewis
On the surface, it appears that Russia's central bank is doing what it should to support the value of the ruble. Rubles are being purchased on the foreign exchange market, using foreign reserves. The central bank's interest rate targets have been raised, with the main overnight credit rate now at 12%.
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However, a closer inspection reveals that the central bank -- like most central banks in these sorts of situations -- is neglecting to address the most important factor, the number of rubles in circulation. The supply of rubles is largely unchanged. If the demand for rubles declines, and supply is unchanged, then a lower ruble value is the inevitable result. Indeed, once market participants notice that the central bank is not properly managing the supply of rubles, it is common for demand to fall even more.
The "supply of rubles" is known as base money. As of November 10, the central bank reported that ruble base money was 4,416 billion rubles. At 27 rubles/dollar, that is worth about $163 billion. On September 1, the monetary base was 4,508 billion rubles. We see that, despite the apparent frantic efforts of the central bank, ruble base money has barely changed.
From August 29 to November 7, Russia's foreign reserves declined from $582 billion to $484 billion, a fall of $98 billion.
When the central bank sells dollars, it receives rubles in return. To support the value of the ruble, these rubles should disappear from circulation. In other words, base money should decline by an equivalent amount. If this had been done, base money would have declined by about 60%, or 2,646 billion rubles. Only 1,770 billion rubles would remain. If necessary, the central bank could buy every last remaining ruble in existence with an additional $66 billion.
A 60% decline in base money is very large. In practice, it would hardly take such a dramatic effort to support the currency's value, if the central bank is properly addressing the problem. A 20% reduction should be more than enough. That would require the use of about $33 billion of foreign reserves, a relatively small sum.
At least until the crisis passes, base money should not be allowed to expand via some other open-market operation, such as an interest-rate target. In technical terms, the ruble-buying operation should be "unsterilized."
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