On the Speculative Attack on the Russian Ruble
What Is a Speculative Attack?
A speculative attack on a country's currency generally takes place when speculators believe that the currency is overvalued given the fundamentals of that country's economy.
Accordingly, because they expect the value of that currency to depreciate in the future, speculators try to profit from that trend by a massive selling of the currency they attack. That sell-off depreciates the currency in the foreign exchange markets. After the depreciation stabilizes, those who sold off the currency at the beginning of the process can buy the same currency back, but at a much lower exchange rate, and profit from the difference in a very short time. In the case of the speculative attack on the Russian ruble, those gains were about 100% within the last 3 months.
Why Did Speculators Attack the Ruble?
(1) The fall of oil prices caused a sharp decline in the Russian government's revenue from its state-owned oil and gas industry as well as from taxing private Russian oil companies. This leads speculators to conclude that the government will not be able to balance its budget and will be forced to cut spending, which, in turn, will lead to an economic slowdown and a further decline in tax revenue. (2) Prior to the fall of oil prices, Western financial sanctions imposed on Russia included the freezing of credit to Russian banks, which forced those banks to buy foreign exchange with rubles and placed a downward pressure on the ruble's exchange value. The sanctions also decreased Russian exports to the West, which led to lower demand for the ruble and further depressed its exchange value. (3) Moreover, the political instability resulting from the Russian involvement in the Ukrainian crisis created additional uncertainty, which normally leads to a flight of capital, resulting in currency depreciation. All of these factors combined led speculators to believe that the ruble would depreciate, and therefore they decided to preempt that process and profit from it by selling the ruble high and buying it low later.
The Impact of a Speculative Attack on the Russian Economy
When the domestic currency depreciates, the cost of foreign goods rises. This, other things being equal, will increase inflation. Therefore, the Central Bank tries to restrict the effect of depreciation by buying its currency in the foreign exchange market. This is what the Russian Central Bank tried to do. The Central Bank sold billions of its international reserves of other currencies to defend its own currency and raised the domestic rate of interest to persuade people to hold on to the ruble.
Defending the Currency Does Not Work
Speculators know that this process of defending the currency by selling foreign reserves and withdrawing quantities of the domestic currency from circulation cannot continue for a long time because the Central Bank will eventually deplete its foreign reserves. Therefore, speculators start to sell the domestic currency (rubles), receiving foreign currency (dollars or euros), and anticipate the ruble's fall against the foreign currencies. This increases the expecte drate of return on the foreign assets, thus rendering the ruble even more overvalued. When the ruble depreciates, speculators buy the rubles back at a lower price and earn a profit.
What can be done?
Some regulation-minded economists suggest the imposition of capital controls to limit the flow of foreign capital in and out of the domestic economy through volume restrictions that affect transactions in many assets such as stocks, bonds, and foreign exchange trades. This may be an option if and when Russians want to isolate their economy further from the world's economy. However, international businesses generally do not like government interference and will eventually shy away from countries that are inclined to impose capital controls every now and then when financial markets behave in a manner unfavorable to the national economy.
What should be done?
Instead of squandering the Central Bank's foreign reserves and raising the rate of interest to a level detrimental to domestic investment, the government should take advantage of such foreign-imposed crises to diversify the Russian economy. An economy that is largely dependent on one or two export commodities, such as oil and gas, will always be vulnerable to crises of this sort. The Western sanctions on Russia raised the prices of the imported goods, which now creates an opportunity for local entrepreneurs to shift resources from sectors with lower prices to others with higher prices. This will be a painful process, but it is necessary for Russians to build a more diversified economy. Moreover, such diversification cannot succeed with the current monetary policy that the Central Bank is pursuing to defend the currency. While the Central Bank should keep an eye on inflation, it should also make affordable credit available to entrepreneurs with business plans to venture into new markets, especially in manufacturing. With diversification, Russians can turn their crisis into an opportunity.