The Objectives, Tasks and Instruments of the Exchange Rate Policy

The Bank of Russia implements its foreign exchange policy in the general context of the monetary policy pursued by the Government and Central Bank of the Russian Federation. The major objectives of the Bank of Russia foreign exchange policy are to ensure stability of the national currency and create conditions for the dynamic development of Russia’s foreign exchange market.

In order to create conditions in the foreign exchange market corresponding to the objectives of the exchange rate policy and to manage (to even out) the rouble exchange rate, the Bank of Russia makes use of the following main instruments:
— foreign exchange interventions;
— deposit operations to regulate the level of rouble liquidity in the interbank market;
— shifting interest rates on the Bank of Russia operations in the money market.

The effect of using the market instruments of the exchange rate policy depends on the state of the monetary sphere as a whole and on the general economic situation.

When tendencies emerge in the domestic foreign exchange market, posing a threat of long-term destabiliaztion of the exchange rate, the Bank of Russia may also take additional measures, such as:

— changing the procedure for and the required rate of exporters’ foreign exchange earnings surrendering;

— changing the reserve requirements and other economic and prudential standards of credit organizations;

— modifying the procedure for conducting foreign exchange trading on the authorized currency exchanges and foreign exchange transaction rules.

The Bank of Russia continuously improves the system of control over the main sectors of the foreign exchange market, especially over transactions at the authorized currency exchanges, securing quick and effective use of the foreign exchange policy instruments.

Foreign Exchange Policy in 1998 and the Bank of Russia Policy Response to the Financial Crisis

The main feature of the exchange rate policy in the first half of 1998 was the setting of middle-term targets for the rouble exchange rate dynamics (the so-called “currency band”). The quantitative parameters of the exchange rate policy—the range of possible fluctuations of the exchange rate of the rouble from 5.25 roubles to 7.15 roubles to the US dollar—were established, taking into consideration the rouble exchange rate situation in the domestic foreign exchange market during the preceding period. The decisive factors were a significant surplus in Russia’s balance of trade and large foreign portfolio investments in Russia. In some periods the capital inflow put substantial upward pressure on the rouble rate and enabled the Bank of Russia to significantly increase its foreign exchange reserves.

The crisis that hit more or less all sectors of the Russian financial market had been gradually developing. It is a common knowledge that the most significant achievement of the financial stabilization policy in Russia was the suppression of inflation (in 1997 consumer prices rose only by 11%). However, as budget expenditures continued to exceed revenues, the use by the Government of non-inflationary sources of financing the budget deficit led to significant growth in government debt. The crisis that broke out in East Asian financial markets compelled many foreign investors to review their investment strategy with regard to the transitional economies and emerging markets. As a result, the inflow of foreign investment to the Russian government debt market dwindled, while the government debt-servicing expenditures grew considerably. Decrease in the world prices of oil and some other key Russian exports led to the reduction of Russia’s balance of trade surplus and eventually in the first half of 1998 the current account of the balance of payments slipped into negative ground.

One of the main manifestations of the crisis was recurrent instability in the Russian financial markets, which first occurred in the autumn of 1997 and led to growth in the demand for foreign exchange and increased pressure on the rouble exchange rate. There appeared expectations of a sharp fall in the rouble rate in the financial markets. Selling roubles, participants in the Russian financial markets tried to minimize the possible negative consequences of the deepening financial crisis, which, as world experience shows, result, above all, in a sharp devaluation of the domestic currency. Worried by the developments, foreign investors tried to get rid of investments in Russian financial instruments.

In January-July 1998 the Bank of Russia using instruments of foreign exchange and monetary policy managed to ensure stability of the exchange rate of the rouble, but the exchange rate stability was maintained at the price of foreign exchange reserve depletion. Aid received by Russia in July from international financial institutions provided ground for hopes that the financial crisis would be overcome without substantial damage to the real sector of the economy. However, even with considerable loans it appeared impossible to contain the development of the negative trends and the crisis exacerbated. Demand for foreign exchange had been growing since May 1998 and the Bank of Russia had to spend considerable foreign exchange resources to maintain the exchange rate at the level of 6.10-6.30 roubles to the dollar. In a bid to avoid the decline of the currency reserves below the critical point, the Bank of Russia on August 17 had to abandon the practice of announcing daily buy and sell rates of the dollar in the interbank foreign exchange market and review mid-term targets of the rouble exchange rate dynamics. New limits were set on the rouble rate fluctuations at 6.0 roubles to 9.5 roubles to the dollar, but keeping the ruble/dollar rate within this band was conditioned by successful implementation of anti-crisis measures.

Although it no longer announced daily buy and sell rates of the dollar, the Bank of Russia in the second half of August continued to conduct foreign exchange interventions to check growth in the dollar rate. However, despite the Bank of Russia efforts, the dollar rose quickly. On September 1 the official rate rose to 9.3301 roubles to the dollar, an increase of almost 50% on the August 15 rate of 6.2900 roubles to the dollar. That situation forced the Bank of Russia to give up large foreign exchange interventions at the end of August and let the market locate the exchange rate of the rouble at which demand and supply of foreign exchange would be balanced, confining Bank of Russia’s operations to the task of evening out the exchange rate dynamics. Early in September the Bank of Russia announced the switch to a floating exchange rate regime.

The initial adjustment of the market to the new conditions was complicated with sharp fluctuations of the exchange rate, which were compounded by relatively low aggregate turnover of operations in the foreign exchange market. The rouble exchange rate dynamics was determined not so much by the current state of the Russian economy, as by the expectations of further deterioration of the situation, making forecasting the exchange rate on the basis of fundamental macroeconomic indicators practically impossible. However, the exchange rate fluctuations in September showed the approximate limits of the band within which a balanced rouble rate may be maintained and its relative stabilization was possible. In the last 10 days of September the exchange rate of the rouble volatility diminished significantly. Overall, in 1998 the official exchange rate of the US dollar to the Russian rouble rose from 5.96 to 20.65 rubles to the dollar, or 3.46 times.

To restore the domestic foreign exchange market, ensure the return of export earnings to Russia and create conditions for replenishment of the official foreign exchange reserves, the Bank of Russia in September began to implement a series of measures to tighten foreign exchange regulation and foreign exchange control. Since September 16 exporters are required to sell their export earnings on currency exchanges only and since October 1 export earnings are sold only at the special trading sessions of interbank currency exchanges. On December 31 the proportion of foreign exchange earnings which exporters are required to sell was raised to 75% and the periods during which export earnings must be repatriated and sold were shortened. From January 1, 1999, the limits on the open foreign currency position of banks were lowered.

Domestic Foreign Exchange Market

In the first half of 1998 the interbank foreign exchange spot market functioned without irregularities, and its volume of transactions was almost twice that of the first half of 1997. The crisis in the Russian financial market in August 1998 became the main factor that had significant impact on the structure of the foreign exchange market. Prior to the crisis most foreign exchange operations were conducted in the interbank market, with average monthly volume on both spot and forward (delivery and settlement) rouble/dollar transactions in that period exceeding $140 billion. The average monthly volume of transactions on the authorized currency exchanges during that period made up about 1.5% of the interbank market volume, or $2.2 billion. After August 17 operations on the interbank foreign exchange market were suspended almost completely. The bulk of transactions moved to the authorized currency exchanges (Moscow Interbank Currency Exchange, or MICEX, and seven regional currency exchanges), which guaranteed settlements on deals. On August 26 US dollar trading with rate fixing was suspended on MICEX due to a considerable imbalance between the demand for foreign exchange and its supply, and on August 28 trading with rate fixing was suspended for the same reason on all authorized regional currency exchanges. Electronic lot trading systems of the currency exchanges assumed the role of the main mechanism of conducting conversion operations. The average monthly volume of transactions on the authorized currency exchanges in the post-crisis period was about $3.2 billion.

The foreign exchange forward market registered a sharp fall in transaction volumes and shortening of terms since December 1997 due to the general worsening of the situation in the domestic financial markets and a vast amount of obligations between banks, accumulated in the preceding period. The average daily turnover of forward transactions in 1998 was almost three times lower than in 1997. Non-deliverable forward contracts continued to make up the lion’s share of transactions.

Foreign Exchange Policy in 1999

The floating exchange rate regime will be retained this year. An indispensable condition for stability of the rouble exchange rate in 1999 is balanced monetary policy, ensuring compliance with the targets set for money supply growth. The principal objective of the exchange rate policy pursued by the Bank of Russia in 1999 is to ensure stability and predictability of the rouble exchange rate dynamics and prevent abrupt fluctuations of the rouble rate. To attain this objective market instruments of the exchange rate and monetary policy are used. The Bank of Russia may also introduce changes and modifications of the foreign exchange regulations and foreign exchange controls as well as implement all the necessary measures to ensure that economic agents comply with the Russian legislation regulating foreign exchange operations.

The Bank of Russia sees one of its chief tasks in 1999 in restoring public and corporate confidence in the rouble, which was considerably undermined by its abrupt devaluation. A major task ensuring simultaneously the achievement of other targets and purposes of the foreign exchange policy is that of maintaining the official foreign exchange reserves at the level ensuring stability of the Russian monetary and financial system. Practically the only way of replenishing foreign exchange reserves is the Bank of Russia’s purchases of the foreign exchange sold by exporters in the domestic foreign exchange market in accordance with the regulations requiring exporters to sell a part of their export earnings.

The rouble exchange rate in 1999 will be set as a rate balancing the demand for and supply of Russian roubles in the foreign exchange market. The Bank of Russia will continue with the practice of setting the official exchange rate of the rouble against foreign currencies on the basis of the rouble market rate against these currencies and foreign currencies’ cross-rates in the foreign exchange markets. The Bank of Russia will seek to maintain a unified exchange rate of the rouble in all sectors of the domestic foreign exchange market. It will manage rouble rate mainly by market instruments, such as interventions, shifts in interest rates and deposit operations. The Bank of Russia will resort to administrative action only if there arises the threat of a crisis in the foreign exchange market, which may destabilize Russia’s entire monetary and financial system.

From mid-August to the end of December 1998 the rouble/dollar real exchange rate index declined by more than 45% and there is reason to believe that this level of the real exchange rate of the rouble, which is determined by the correlation of the inflation rate and the pace of change in the exchange rate, will persist in the first half of 1999. A significant surplus in the current account of Russia’s balance of payments, accumulated in the fourth quarter of 1998 and forecasted for 1999, should positively influence the exchange rate dynamics.

The effectiveness of the exchange rate policy will depend on the state of the domestic foreign exchange market in 1999. Foreign exchange operations have dropped in volume dramatically as the solvency of banks — the main participants in the foreign exchange market — have been decreasing. As a result of the plunge of the exchange rate of the rouble after the revision of the fundamental principles of the exchange rate policy in August 1998 many Russian banks which had assumed obligations to deliver foreign exchange under forward contracts found themselves unable to meet their commitments. Volumes in the interbank foreign exchange market may return to pre-crisis levels only if confidence in the banking sector is restored. As the experience of the previous years shows, this process may take a long time and its outcome will depend on the recovery of the country’s banking system as a whole. As the rouble exchange rate dynamics becomes more predictable and the financial markets recover, the necessary conditions will emerge for the development of all sectors of the domestic foreign exchange market, including the forward and derivatives markets.

The main mechanism of conducting foreign exchange transactions in the near future will be the lot trading systems of the authorized currency exchanges. This, in addition to the economic factors described above, will be a result of the regulation requiring exporters to sell 75% of their export earnings at the special trading sessions on the currency exchanges. The Bank of Russia actively participates in drafting and refining rules to conduct currency trading on exchanges, taking into account the interests of different groups of foreign exchange market participants. The principal objectives of the Bank of Russia are to ensure that trading is conducted without interruptions and prevent abrupt fluctuations of the exchange rate of the rouble.

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