Wednesday, June 07, 2006

Russia: Dollar vs Rouble

Last week, the Russian State Duma proposed a law prohibiting the use of prices in foreign currency. For all practical reasons, this would mean that price-setting in dollar and euro would be banned in Russia. The law proposal, which stands good chances of being passed, has been much ridiculed by domestic and international media alike. However, is there really reason for such ridicule if one would only closer consider the general idea?

Russians like to set their prices in dollar for the simple reason that any bigger business transaction in Russia is made in dollar. With inflation rates of up to 2,500% annually in the early 1990's, Russians have grown accustomed not to trust the country's own currency, viz. the rouble. Therefore, most Russians also keep their savings in US dollar. Despite a mere 11% inflation rate last year, people remember the latest great financial crisis in 1998, when the rouble dropped some 86% in the course of a year. Today's relative macroeconomic balance in the Russian economy, not least due to rising oil incomes, is therefore not reflected by greater trust in the rouble. Only this year, the rouble exchange rate has increased by 7% against the dollar. However, this does not seem to change how Russians value the rouble.

Nevertheless, sound scepticism is currently motivated to the dollar as store of value. Earlier this Spring, Russian Finance Minister, Aleksei Kudrin, questioned the US dollar as international reserve currency. In view of how volatile the dollar course has been in recent years, Kudrin's question has some rationale. People and national banks alike have, to an increasing extent, turned to the euro to hedge currency risks. Of course, this challenges the advantage of seigniorage for the US economy, allowing the country its current budget deficit due to the Iraq war. However, US deficit has now reached such levels that trust in the dollar is inevitably dropping. That oil producers are tending to turn to the euro for setting oil prices instead of the dollar, is a worrying tendency for the US. In view of increasingly diverging interests between Moscow and Washington, Russia's increasing scepticism towards the dollar comes at a time when the US economy is vulnerable to critique. Whether Russian initiatives to rid itself of dollar dependency also have a political motive sparked by deteriorating US-Russian relations is too early to say.

For now, the new legislation is interesting enough. So, will such a law actually work? No, of course not. Banning public use of dollar or euro denominations will have absurd consequences. Looking only at president Putin's recent annual address to the State Duma, it would have rendered him a considerable fine, judging from the number of times he used the "d" word. The new law may also create considerable confusion at the upcoming G8 Summit in Petersburg, as the Duma has recommended the Russian delegation only to use rouble denominations when presenting financial data. Former Finance Minister Boris Fedorov argues that the law will make Russia an international laughing-stock. His successor, Aleksei Kudrin, predicts that state officials will become totally confused by amounts "followed by an infinite number of zeros."

Still, is it not quite natural that a state uses its own currency denominations as a measurement of transactions? What would e.g. an American say if all US prices were in euro, despite the fact that payment would be made in dollar? That a reserve currency - such as the dollar or euro - is used in inflatory or crisis economies is quite natural, because people want to be sure of the value of their money. However, the rouble has preserved its value relatively well for such a long time now, that one should perhaps start reconsidering its value also in psychological terms. This will take time, but one has to start somewhere. It is quite evident that an economy the size of Russia cannot in the long-run go on using foreign currency as its financial gauge. The price of this is too great, not least in terms of transaction-costs and non-deposited money with no interest. So, despite the fact that the specific Duma bill and the debate surrounding it may be laughable, Russia has to start somewhere to normalise its economy. In light of this, the Duma may not be all wrong.


An-Lu said...

Interesting analysis. It remains to been seen if this law passes and more important, whether it is going to work at all.

Tobias Ljungvall said...

A similar prohibition was adopted in Belarus years ago. But people still use the "hostile currency" (vrazheskaya valyuta).
Tobias Ljungvall

W. Shedd said...

I shudder when I read "only 11%" inflation. Such rates are considered scandalously high here in the US.

Foreigners shouldn't hold their investments in dollars, as it is the stated policy of US policy makers to continue to weaken the dollar. A strong dollar is helpful when it comes to buy foreign products (oil included) but hurtful in almost any other type of international trade for the US.

Many governments will still continue to hold dollars in reserve, however as a hedge for the security of their own currency. Or at least, this is my understanding based upon reading more intelligent economic analyses than I capable of ..