14.07.23 Review

Rebellious Rate: The sharp weakening of the ruble has exposed the fundamental instability of the economy and may slow its recovery

The brief shock triggered by Prigozhin’s rebellion became a catalyst for the devaluation of the ruble, which was caused by the deterioration of the trade balance. However, this development highlighted two fundamental factors of instability in the Russian economy: high dependence on oil exports and the uncertainty surrounding the ongoing war in Ukraine. Since the beginning of the year, the ruble has depreciated by 20% against the dollar, driven by a decline in revenues from energy exports and an increase in import costs. As a result, the trade balance and current account balance are at their lowest values since the pandemic. The weakening of the ruble will support the budget but fuel inflation, which will prompt the Central Bank to respond by raising interest rates. Tightening monetary policy and increasing import costs have the potential to weaken or even halt the Russian economy’s recovery growth, which has recently gained some momentum.

The fleeting rebellion led by Evgeny Prigozhin has been a trigger for the current cycle of weakening of the Russian ruble. On June 24th, while the official exchange rate set by the Central Bank was 84.5 rubles per dollar, on the applications of major banks, it was priced at over 95 rubles. In the first working day following the rebellion, the national currency strengthened, but then started to weaken again until stabilising at around 90 rubles per dollar, a level that First Deputy Prime Minister Andrey Belousov has previously referred to as the upper boundary of the Russian economy’s 'comfort zone’. As a whole, since the beginning of the year, the ruble has depreciated by 20% against the dollar, which is one of the worst performances among the currencies of developing countries.

In its latest review of financial market risks and monetary conditions, the Central Bank mentions the 'short-term domestic events at the end of the month,' noting that amid the uncertainty, the population purchased 7.1 billion rubles worth of currency on June 24th. However, this total currency purchases throughout the month amounted to only 0.3 billion rubles due to sales on other days. The demand for cash in June, as observed by the Central Bank, led to a liquidity outflow of 0.5 trillion rubles, with 0.1 trillion attributed to the days of the rebellion from June 23rd to 25th. Such a decline in liquidity levels should also be expected to impact the exchange rate. Additionally, the Central Bank states that 'amid the ruble's weakening, some corporate clients of credit institutions started converting foreign currency loans into ruble loans, while credit institutions themselves simultaneously began to purchase foreign currency to balance their open foreign currency positions.' These operations are also affected by the exchange rate.

Further, the Central Bank rightfully identifies the weakness in external trade as the underlying reason for the currency's depreciation, leading to a reduction in export revenues ($7 billion in June compared to $9.1 billion in May) as a result of lower global oil prices and the persistent discount on the price of Russian oil. As a result, the trade balance and current account balance fell to their lowest levels since the COVID-19 pandemic in the second quarter of this year. In June, the current account balance even ended up in the red, recording a negative balance. As the chart below shows, although export earnings returned to 2019 levels in the first half of 2023, import values rose above 2019 levels by 25%. This, incidentally, raises doubts about the widely held thesis that sanctions have led to import substitution as, with comparable income levels, the economy requires a greater volume of imports.

Trade and current account balances of the Russian Federation, 2018-2023, in USD millions

The future dynamics of the ruble, in the absence of new external shocks, will also be determined by the balance between export and import flows. In essence, significant support to the exchange rate can only come from a rise in commodity prices. According to statements by Elvira Nabiullina, the Central Bank does not plan to conduct currency interventions to stabilise the exchange rate.

On one hand, a moderate weakening of the ruble is favourable to the authorities, as it eases the budget deficit problem. On the other hand, a sharp depreciation of the ruble leads to a surge in inflation due to the transmission of exchange rates to prices. This appears even more likely amid the long-awaited revival of consumer demand. In addition, rising inflation will increase the cost of borrowing for the Ministry of Finance, which finances budget expenditures. The Central Bank promises to respond to inflation by raising the key interest rate (the next meeting of the Central Bank's Board of Directors to discuss the rate is scheduled for July 21st). Rate hikes and increased import costs have the potential to, at the very least, seriously weaken, if not halt, the recovery growth of the Russian economy, which has recently been gaining significant momentum, as Re:Russia has already discussed.

While the short-term shock caused by Prigozhin’s rebellion merely acted as a trigger for the devaluation of the ruble driven by changes in the trade balance, such developments point to two fundamental factors of instability in the Russian economy: high dependence on oil exports and the uncertain prospects of the ongoing war in Ukraine, which during this episode amplified one another.