“Memo to Vladimir Putin: When you are trying to prop up your currency in an environment where the market thinks it is overvalued, interest-rate hikes—even big ones—often don’t work. The only reliable options are to either introduce capital controls or let the currency find its own level.”
If only I’d sent such a note to Moscow on Monday or Tuesday, when Vlad the Bad and his cronies at the Russian Central Bank were deliberating about how to address the plunging ruble. I could have saved them a lot of money and embarrassment. Who knows, they might have rewarded me with an oilfield in Siberia, or perhaps my own English Premier League team. Now I’ll just be dismissed as another pundit who is smart after the fact, which isn’t fair, really.
You see, for anybody who lived in Britain during the early nineteen-nineties, the sight of the Russian Central Bank raising its main deposit rate from 10.5 per cent to seventeen per cent in a desperate effort to save the ruble had an eerily familiar feel to it. And so did the event that followed this drastic policy gambit: another plunge in the Russian currency, which persuaded many people that the government doesn’t know what it’s doing.
On the morning of Wednesday, September 16, 1992, I got to my office at the Sunday Times of London, where I was the business editor, and learned that the Bank of England had just raised its base rate from ten per cent to twelve per cent. This in itself was pretty shocking: the U.K.’s economy had only recently emerged from a deep recession, and higher interest rates were the last thing it needed. But the bank, which in those days was under the direct control of the Chancellor of the Exchequer, Norman Lamont, felt that it had no choice.
A couple of years earlier, Britain had entered the European Exchange Rate Mechanism, the precursor to the euro, at a fixed rate of 2.95 Deutsche marks, which many experts regarded as overvalued. About the only way to persuade foreign-exchange traders to buy pounds sterling, and thereby maintain the pound’s value, was to offer them high interest rates on sterling-denominated assets. But this strategy wasn’t working. During the previous few weeks, speculators like George Soros had been making huge bets against the pound, working on the theory that the Bank of England would eventually throw in the towel. The decision to raise rates to twelve per cent was intended as a signal to the markets that this wouldn’t happen.
But that didn’t work, either. Despite interest rates of twelve per cent, there were still few purchasers for the pound. And the bank, which had been using its own foreign-exchange reserves to buy sterling and offset all the selling, was running out of cash. At lunchtime, I went out to eat with some colleagues. Halfway though the meal, we received a call to say that the bank had just announced another interest-rate rise–from twelve per cent to fifteen per cent. There was nervous laughter around the table. Fifteen per cent! Surely, this was getting crazy.
It was, and, behind the scenes, the authorities knew it. At seven o’clock that evening, Lamont announced that Britain would immediately withdraw from the Exchange Rate Mechanism and allow the markets to determine the pound sterling’s value. The next morning, interest rates were restored to ten per cent, and the value of the pound fell sharply. Lamont was humiliated, and so was the Prime Minister, John Major. Soros made a fortune—up to a billion dollars, according to some accounts.
The parallels with what is happening in Moscow aren’t exact. For example, Lamont and Robin Leigh-Pemberton, the chairman of the Bank of England at the time, were defending a fixed exchange rate. The Russian Central Bank, after being forced to devalue the currency during a financial crisis in 1998, no longer does this. The ruble floats. Putin and Elvira Nabiullina, the head of the Russian Central Bank, are simply trying, as they see it, to prevent the ruble from falling too far, too quickly following a collapse in the global oil price. (Since Russia is a big oil producer, the ruble is widely regarded as a petrocurrency.) Also different is that, over the past few years, the Russian Central Bank has built up a much bigger stock of foreign-exchange reserves than the Bank of England had on hand in 1993. If it decided to spend its reserves, in an all-out attempt to defend the ruble, it could conceivably have more success than the British government did.
But it probably would not, because the basic logic of the two situations is very similar. Once the markets lose confidence in a currency, interest rates are no longer an effective policy tool, and foreign-exchange reserves can be depleted at an alarming rate. The reason is found in simple arithmetic. Even if the Russian Central Bank were to raise rates to a hundred per cent, which is obviously out of the question, the weekly return on ruble-denominated assets would be less than two per cent. In the midst of a panic like the one we are seeing now, a currency can plummet by five or ten per cent in a single day, thus erasing even ultra-high interest-rate yields and leaving holders of the currency with a big loss. Foreign-exchange traders know this all too well, and that’s why they still refuse to buy ruble-denominated assets.
Indeed, far from encouraging the purchase of rubles, the late-night interest-rate hike prompted another round of selling. Fearing further falls in the currency, ordinary Russians rushed to swap rubles for U.S. dollars. Professional speculators joined in, and the Russian currency went into a nosedive. At one point on Wednesday, it had fallen by almost twenty per cent on the day. (It later rebounded a bit.)
So what now? Putin has three choices.
Doubtless, he’ll be tempted to tough it out. However, keeping interest rates at fifteen per cent would plunge the Russian economy into an even worse state than its current one, with no assurance that the ruble will rebound. A second option would be to reverse course and fire Nabiullina, blaming her for the mess. But since she’s widely seen as his sidekick, that wouldn’t spare Putin from bearing all of the responsibility. The third option is to double down and supplement the interest-rate hike with new laws preventing Russians and others from liquidating ruble-denominated assets. During the Asian financial crisis of 1997–1998, Mahathir Mohamad, then the Prime Minister of Malaysia (who in some ways was a Putin-like figure), went down this route. Shunning the advice of the International Monetary Fund, he introduced strict controls on the movement of money in and out of Malaysia. And, lo and behold, the policy worked. With capital flows restricted, the Malaysian government was able to reduce interest rates, and the Malaysian economy recovered faster than neighboring countries that had adhered to I.M.F. guidelines.
Will Putin follow Mohamad’s example? Asked on Wednesday afternoon whether the imposition of capital controls was now under consideration, Russian Minister of Economic Development Alexei Ulyukayev said, “No, they are not being discussed.” That statement wasn't surprising. Raising the prospect of capital controls being introduced could heighten fears that some Russian entities will default on their debts, which is what happened in 1998. But if there’s one thing we know about currency crises, it’s that the situation can change quickly. Ask Lamont, who is now a member of the House of Lords but whose reputation never recovered from what came to be known as Black Wednesday. In fact, that brings me to a final piece of advice for Putin: give old Norman a call. He’ll set you straight about this stuff.
