Central Bank of Russia and Foreign Exchange Rates

Introduction

Statistic Analysis

Many of the patterns found in the data revolve around one major event. On August 17, 1998 the Russian Government and the Central Bank of Russia declared a default on government short-term bonds (GKOs). The event lead to dire results; Russia’s financial system collapsed and the entire economy was essentially struck as dangerous political crisis unravelled. Prior to the 1998 financial crisis Russia had maintained its strong Ruble-dollar peg which eventually dried out the Central Bank’s currency reserves. Much of the analysis will look at how this economic event influenced and changed important Russian statistics.

The Gross Domestic Product (GDP) and Balance of Payments (BOP) dropped at a consistent downward trend at this time. Simultaneously inflation rose and the foreign exchange rate depreciated this is one of the causes of the decrease in GDP and BOP. As the exchange rate continued to depreciated the Republic of Russia were unable to buy goods and services which is demonstrated in the lower GDP. The current account increased from 219 to 24,616 in 1999 and then to 46,839 in year 2000. As the Russian Ruble depreciated, more foreign consumers purchased Russia products thereby bringing in a new flow of cash to Russia. This, however, was not the same situation for investors. Since the financial system crashed outside investors had a lack of confidence in the Russia system which is shown by the increasing deficit in the Financial Account. The overall balance in the BOP decreased as the financial account decreased more than the increase in the current account and the reserves and related items was depleted to a deficit of -16,010. Russia’s reserves were made up of crude oil and metals these experienced a change in value which decreased the reserves account.

The inflation rate and the 3 month T-Bill follow a similar pattern. From 1997 to 1998 the T-Bill rose in value until it defaulted in 1998. After this point there is a decrease in its value until 2005 when the government stopped issuing 3 month T-Bill and started to issue one year bonds. As the T-Bill represents the interest rate, increased inflation leads to higher interest rates that should have a usually has a deflationary effect on GDP. As shown in the paragraph above GDP did in fact depreciate at this time. As we see the in the data the inflation rate follows the movement of the interest rates.

The unemployment rate hit an all time high in 1999. This was another effect from the financial crisis. Many people lost their jobs increasing the unemployment rate two percentage points from 1998 to 1999. The unemployment can also be linked to many of the other figures mentioned above such as inflation. The increased prices lowers the overall demand for Russian products and services. The lower demand causes business to have to layoff employees in order to maintain potential profits. Increased inflation causes increased unemployment as was the case in 1999. This is also reflected in the lower GDP during this time.

There was a second Russian financial crisis in 2008. This crisis demonstrated many of the same trends talked about previously but in a less drastic way as the government had now floated the Ruble to a basket of currencies, where as previously it had been pegged to the US dollar.

Analysis of FOREX

The foreign exchange rate can be analyzed by three different approaches: the International Fischer effect, The Purchasing Power Parity, and the Implied Real Interest Rate.

International Fisher Effect the theory that real interest rates are equal across countries also taking into consideration expected inflation. Russia and the US data were compared and showed that the IFE holds true.

International Fisher Effect

Interest rate USD

Interest rate RUB

Inflation USD

Inflation Russia

IFE us

IFE rub

Expected Spot Rate

The Purchasing Power Parity looks at whether Russia’s currency is considered to be over or under valued. The PPP tend to hold up better over the long term. Looking at Russia’s past performance especially during the Russian crisis this theory is not as relevant to our data. However, looking at today’s rates the PPP predict an exchange rate that is weaker than the one year expected Scotia Bank rate.

Purchasing Power Parity

Spot Rate USD/RUB

Inflation Rate Russia

Inflation Rate USA

t periods (years)

Expected exchange rate in t periods

Implied Real Interest Rate looks at the T-bill rate over the change in the forecasted CPI to predict the future rates based on a differential rate approach. Based on this formula it result in a real interest rate of -1%.

Implied Real Interest Rate

Russia CPI – Prior

Russia CPI – Current

Russia CPI – Forecast

T-Bill Rate

“Real” Rate

These three international parity conditions are complementary to one another, but to understand their relationships amongst one another we must introduce three new theories in addition to the PPP and International Fisher Effect.

The law of one price: States that the identical goods will sell for the same price worldwide. However if after FOREX adjustments the prices were still not equal, arbitrage would eventually bring the prices to equilibrium.

Opportunistic individuals and organizations would be able to take advantage of arbitraged situations by understanding and utilizing the three parity relationships:

Purchasing Power Parity (PPP)

The Fisher Effect (FE)

The International Fisher Effect (IFE)

These three parity relationships are interrelated by various rates, prices and inflation among two or more counties and the fact that “real” money should have no impact on “real” variable as it has been adjusted through the foreign exchange markets. This leads us to what causes changes in inflation and the domestic currency? The law of one price contends that the relationship is related to domestic money supply and its demand. Hence the theory of PPP states that any change in foreign exchange rates between two countries is simply the result of inflationary deferential that arises between the two counties.

In addition absolute PPP states that price levels between counties should also be reflected in the foreign exchange rates therefore purchasing power remains unchanged in any given country.

If absolute PPP holds true then any change in foreign exchange rates are due to unequal price levels, thus giving us the theory of relative PPP that reflects such disparities in the foreign exchange rates. PPP theory further contends that if all else stays the same, the currency with the highest rate on inflation relative to the other will depreciate.

The Fisher Effect (FE) plays an integral in combining these theories together as it states that nominal interest rates are a function of real interest rates plus a risk premium reflected in inflation. If the FE holds true then countries with higher inflation must compensate investors with a higher rate of return to compensate for such risk. This theory further suggests that these changes in interest rates will be reflected in foreign exchange prices giving us the International Fisher Effect.

Intertwined with the PPP that states that changes in foreign exchange rates are due to interest rate deferential and where the IFE states that changes in foreign exchange rates changes are caused by nominal interest rate deferential.

Future Trends

Russia has been trying to recover from their two financial crisis’s. It has been a long and slow road from the early 1990 when the government first changed to a market based economy opening trading to foreign traders. Over the last decade differences have started to smooth out and shall continue to do so. The inflation rate is forecasted to remain between 6%-7% during 2011 with the unemployment rate around 7%. A great improvement from 1999 when unemployment hit 13%. All forecasts point to a strengthening Russian economy in the future. As long as they continue to do what they are doing now they will start to see an even stronger appreciation of their Ruble. Russia has been fortunate lately as an oil exporter as the value in oil has risen so have the GDP and BOP where we have seen decreases in inflation and unemployment.

Conclusion

(NATASHA)

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