Will Ruble's Rout Force Capital Controls?

An emergency central bank rate hike did not work in Russia, so the likelihood is growing that it will follow Malaysia's 1998 example and impose capital controls.

Falling currency.

Photographer: Andrey Rudakov/Bloomberg

The failure of an emergency rate hike to stop the ruble's decline against the dollar increases the probability that Russia will introduce capital controls. President Vladimir Putin, who sees Russia's economic woes as the consequence of a Western plot, must be increasingly amenable to the recipes that worked in another country ruled by an anti-Western authoritarian leader: Malaysia in 1998.

The Russian central banks' surprise key rate hike to 17 percent, from 10.5 percent, announced at 1 a.m. Moscow time, seemed at first to have its desired effect: Short sellers paused at the increased expense. Other players, stunned by the boldness of the increase, were forced to consider whether it might not be a good idea now to hold Russian assets. And the ruble bounced back 10 percent against the dollar.

Then the market gave it more thought. For months, the ruble had been faithfully following the falling oil price, and today, Brent crude dropped below $60 per barrel. What's more, in view of the rate rise, the recent opaque deal in which the Russian state oil company Rosneft, run by Putin's friend Igor Sechin, raised 625 billion rubles ($10.8 billion) began to look especially fishy: Rosneft borrowed at 11.9 percent last Friday. The Central Bank did nothing yesterday, potentially allowing Rosneft to pump some of the money into the foreign exchange market. Then early today it raised the rate, causing Russian bond yields to rocket. The current 10-year sovereign bond yields more than 14 percent, compared with 13 percent 24 hours ago. Though Rosneft insisted today that "not a single ruble attracted through the bond program will be used to buy foreign currency," it is impossible to verify that. In any case, the underhanded deal shows that the central bank's rational policies lapse when Putin's friends need to be accommodated.

This is not a situation in which even a 17 percent interest rate makes holding ruble assets appealing: The ruble's downside potential is too high. At the time of this writing, the currency was trading at 72 rubles to the dollar, well above Monday's close of 64.24. The rate hike had fallen flat.

That's also what happened in Malaysia in 1997. Four years later, Harvard University's Ethan Kaplan and Dani Rodrik told the story in a definitive paper

When the Asian financial crisis hit, Malaysia's position looked a lot like Russia's today: It had big foreign reserves and a low short-term debt level, but relatively high general indebtedness if households and corporations were factored in. At first, to bolster the ringgit, Deputy Prime Minister Anwar Ibrahim pushed through a market-based policy with a flexible exchange rate, rising interest rates and cuts in government spending. It didn't work: Consumption and investment went down, and pessimism prevailed, exerting downward pressure on the exchange rate.

So, in June 1998, Prime Minister Mahathir Mohamad, a Putin-like authoritarian figure, appointed a different economic point man, Daim Zainuddin. In September, on Daim's urging, Malaysia introduced capital controls. It banned offshore operations in ringgit and forbade foreign investors to repatriate profits for a year. Analysts at the time were sharply critical of the measures, and Malaysia's reputation in the global financial markets inevitably suffered. 

According to Kaplan and Rodrik, however, the capital controls were ultimately effective. The government was able to lower interest rates, the economy recovered, the controls were relaxed ahead of time, and by May 1999 Malaysia was back on the international capital markets with a $1 billion bond issue.

Some economists have since noted that South Korea and Thailand, which recovered around the same time, had not introduced capital controls, so perhaps Malaysia could have done as well without them. But Kaplan and Rodrick argue convincingly that Malaysia's case was different and that the controls allowed the country to pull through without the International Monetary Fund's help, which Korea and Thailand both used.

That old economic debate is suddenly relevant again. In 1998, following the Asian crisis, Russia's economy collapsed. The country lived through debt default, devaluation, a failed IMF bailout and capital controls all at the same time. Now, Putin must be tempted to control the damage while it's still possible. 

His anti-Western advisers are evidently holding up the Malaysian example. "What can [Central Bank Governor Elvira] Nabiullina do within the market model if she is forbidden to sell too much foreign currency and some of the world's biggest financial players have been ordered to play against her?" Sergei Markov, a pro-Putin academic, wrote in a column on Vzglyad.ru. "Since the reasons for the ruble's fall are political, the response should be political, too. For example, a law that would ban Russian companies from repaying debts to Western counterparties if the ruble has dropped more than 50 percent in the last year. That will immediately lower the pressure on the ruble, many countries have done this, Malaysia is one example. It's in great economic shape now."

Naturally, the specter of capital controls now hangs over the foreign exchange market, pushing investors to get as much money as possible out of Russia. If Putin is worried about public discontent following the ruble's decline, he may follow the advice within days. If he's betting on Russians' patience, Nabiullina's orthodox policies -- rate hikes and other measures to squeeze ruble liquidity -- will be allowed to continue, with breaks for emergency aid to Putin's friends.

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