Wednesday, 17 December 2014

Oil and the Rouble

Last week, I wrote that the fall in the oil price was good for the economy (meaning the global economy) but terrible for financial markets. The heavy falls on stock markets, the sharp rise in yields on junk bonds, and a growing sense of a tightening of credit availability, witnessed for one thing in the action of the Chinese Central Bank to make additional funding available for banks, has shown that to be correct. I will examine the reasons that the fall in oil prices are good for the global economy separately in my series on that topic. The other indication that the fall in the oil price has been terrible for financial markets has been the fall in the value of the Russian Rouble, along with the fall in the value of other currencies which are tied to the prices of primary products.

The Russian government's response has been to try to defend the currency. It increased official interest rates by 60% from 10.5% to 17%, overnight, and the Russian central bank appears to have been intervening in foreign exchange markets to buy Roubles, so as to raise its value, using the country's massive $413 billion of reserves, to do so. In my opinion, such action is a mistake on their part. It represents nationalistic machismo, not sensible economic policy. The Rouble as a petro currency was previously grossly overvalued, which acted as a deterrent to its necessary modernisation. Russia should have followed the example of China, which prevented its currency from rising against the dollar, as the US engaged in Q.E., and was thereby able to continue to attract capital to invest in its economy, and bring about the required industrialisation.

There are good grounds for arguing that Russia, as a result of the huge revenues it obtained from the sale of oil and gas, during a period when primary product prices were rising sharply, suffered from what in the 1970's was termed the “Dutch Disease”. That is that an economy that becomes highly dependent upon a natural resource such as oil, whose high price brings in large revenues, which thereby increase the value of its currency, necessarily sees a diminution of its industrial base. As the currency rises, this makes the cost of imports cheaper, and the price of exports dearer. The country's industrial production becomes increasingly uncompetitive in the global market, and it becomes simpler to just use the foreign currency earnings from the sale of oil and gas, to pay for the now much cheaper imported goods.

But, the opposite also applies. A falling currency makes imported commodities more expensive, and domestically produced commodities become more competitive in the global market. In other words, the market creates automatic stabilising mechanisms to remedy such a situation, and it is usually not a good idea to try to negate those mechanisms. Marxists do not believe that the market is a self-correcting mechanism, other than in the longer term – in other words, the corrections require protracted, and violent disruptions before they work – but, it is usually better to utilise the market as a basis of further action, than to try to work against it. For example, attempts to prevent the value of the Rouble falling, under conditions of a falling oil price would impose all of the disadvantages of a highly valued petro-currency on Russia, without obtaining any of the advantages!

To see this its necessary to separate out the effect of a falling oil price from the effect of a falling Rouble. What is said here in relation to the Rouble applies to other economies in a similar situation, the numbers used, are, therefore, purely for explanation. Suppose the price of oil is $100 a barrel, and that there are 50 Roubles to the Dollar. Because oil is priced on the world market in dollars, when Russia sells a barrel of oil, it obtains $100, irrespective of the value of the Rouble. A Russian oil company, having then sold this barrel of oil at $100, must then convert it into Roubles, so as to pay its workers, suppliers and so on. It obtains, 5,000 Roubles, which it then spends in this way in the Russian economy.

Now, suppose the Rouble falls in value by 50%, so now $1 equals 100 Roubles. This change does not affect the global price of a barrel of oil, which remains $100. The Russian oil producer still obtains $100, for the sale of its barrel of oil, but now, when it converts this $100 into Roubles, it obtains not 5,000 but 10,000! In terms of Roubles, therefore, this fall in the value of the Rouble represents a significant windfall for the Russian oil company. If it continues to pay its workers and suppliers the same amount, its profits must rise in Roubles by a significant amount.

The fall in the value of the Rouble, would then only affect the purchase of foreign imported commodities, which now become twice as expensive as they were. With a large increase in Rouble earnings from oil, due to the fall in value of the Rouble, the combined effect of this is to push a much greater quantity of Roubles into the domestic economy. Firstly, the quantity of Roubles has increased because the dollar price of oil remains the same, but the Rouble price has doubled. Secondly, imported commodities become expensive compared to domestically produced commodities. This means the demand for domestically produced commodities increases substantially, and the increased supply of Roubles into the domestic economy, facilitates a rise in the prices of domestically produced commodities, with a corresponding short term rise in the profits of domestically based capital producing those commodities.

These higher levels of demand for domestically produced commodities, along with the much higher profits now realised from their production, creates a powerful incentive for additional investment of capital in their production. Moreover, the lower value of the Rouble creates a powerful incentive for foreign producers, who wish to take advantages of these higher profits, and higher levels of demand to invest directly in Russia itself, rather than to try to produce externally, and export their commodities into the country. In other words, this market mechanism, thereby creates a powerful mechanism for bringing about an investment of capital in a diversified range of commodities, just as a high currency value, caused by high earnings from oil exports causes the opposite effect.

Russia would then be well advised under current conditions to allow the Rouble to fall, so as to set these mechanisms in place, gain competitive advantage for its domestic industries – especially as Russia needs import little in the way of primary products itself – and to encourage additional foreign direct investment in the development of new industries that substitute for now expensive imports. Given China's success in developing such a range of industrial production, Russia would be well advised to strengthen its strategic relation with China, and to encourage China to invest in such production in Russia. Using Russia's $413 billion of foreign currency reserves would be far better used to facilitate such foreign direct investment, via the creation of joint ventures, and so on than throwing them away on trying to inflate the value of the currency.

The other advantage that Russia and others in a similar situation benefit from due to a falling currency is in relation to debt. Because Russia made large amounts of money from oil and gas sales, when prices were high, it built up huge cash reserves. The same is true of Gulf economies, and other primary producers. Unable to use this cash for immediate productive investment, the money was hoarded in sovereign wealth funds, which invested in global financial assets, particularly in the US.

To the extent that Russia's loans to the US are in dollar denominated assets, Russia benefits from a lower Rouble in two ways. Firstly, it obtains a capital gain on any dollar denominated bond, whose Rouble value automatically rises. In other words, if Russia bought a $100 bond, at the previous exchange rate, it would have been worth 5,000 Roubles, and is now worth 10,000 Roubles. That again is a powerful potential boost for the domestic Russian economy. Secondly, to the extent that such bonds, or other assets are dollar denominated, and the interest on those bonds, shares etc. is dollar denominated, the Rouble income from those assets rises significantly. If a US Bond, or share pays $100 a year in interest, or dividends, this remains the same, irrespective of the fall in the value of the Rouble. But, that $100 of interest is now worth 10,000 Roubles rather than 5,000. It means that again a powerful economic stimulus is provided to the Russian economy, as a result of this influx of Rouble income.

Conversely, to the extent that Russian companies, or the authorities borrow money via Rouble denominated bonds, or shares, the value of those assets falls for foreigners in dollar terms. That is what the US did to its foreign lenders by destroying the value of the dollar via QE. It was able to pay back its foreign lenders in depreciated currency. Rather than removing that possibility, by trying to defend the value of the Rouble, the Russian authorities should embrace it. It means foreign lenders effectively will have simply given money to it for free. But, its also clear why the dollar denominated value of those Russian financial assets, has caused panic in US and other financial markets, for precisely that reason, that these financial assets, fictitious capital, which sit as collateral on the balance sheets of US banks and financial institutions, and even more so on the balance sheets of EU banks and financial institutions, have then become severely devalued, undermining the capital base of those institutions, and contributing to a growing credit crunch.

It is, of course, impossible to actually separate out the fall in the value of the Rouble from the fall in the price of oil, because the former has been caused by the latter. Using the numbers above, if the fall in the dollar price of oil went from $100 to $50, then the actual Rouble income would remain constant at 5,000 Roubles. But, that would mean that there would be no reduction in the quantity of Roubles thrown into domestic circulation from the oil sector, whereas artificially inflating the value of the Rouble under conditions of a falling oil price, would cause the quantity of Roubles thrown into domestic circulation to fall, thereby causing deflation and contraction.

If the value of the Rouble is allowed to fall, then all the advantages of making foreign imported commodities more expensive, and so stimulating domestic capital continue to apply. So, too does the advantage of increasing the Rouble income from investment in foreign financial assets, and a devaluation of the payments to foreigners for interest and repayment of Rouble denominated financial assets.

Russia should embrace the fall in the value of the Rouble, and use it, along with its vast foreign currency reserves, to increase capital investment in import substituting industries in its domestic economy.

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