Russia must devalue the rouble

On December 15, the central bank undertook a seventh such adjustment since mid-November after devaluing the currency by 1% against a basket that’s 55% US dollars and 45% euros. The move takes the cumulative rouble devaluation since mid-2008 to 11%.

Spooked by the ferocity with which Russia has become engulfed in the financial crisis, Moscow is hoping that its measures will bring a period of calm, especially to the foreign exchange market. The rouble has come under severe pressure in recent months, as nervous locals have rushed to change the currency into dollars.

The central bank’s plan A was to prop up the rouble by deploying its huge foreign currency reserves. Now it has signalled that it will not jeopardize its investment-grade rating by wasting more firepower. Last month, Standard & Poor’s became the first rating agency to downgrade the sovereign’s debt in a decade, largely because of the big decline in the country’s foreign-currency reserves. Since early August, they have shrunk by $160 billion to just under $440 billion.

Still the rouble continued to fall.

The problem is that the authorities’ plan B is not working either. The piecemeal steps that the central bank is taking are only exacerbating capital flight by signalling to the market that more similar moves will be made.

Prime minister Vladimir Putin and president Dmitry Medvedev face a delicate situation. They have staked their reputations on a strong currency as a symbol of Russian power and have vowed not to undertake any radical moves on the exchange rate in case it shakes a public that still has troubling memories of the 1998 financial crisis. But with the oil price down more than $100 since the summer and the economy on the verge of recession, public confidence is already low.

Given that analysts think the rouble is still overvalued by as much as 25%, the authorities need to act fast and undertake a one-off large-scale depreciation. There are risks. A sharp movement in the currency could make the balance sheets of those banks and corporates with hefty foreign-currency liabilities even more vulnerable. A sharp devaluation could also lead to a bank run as retail depositors accelerate their withdrawals.

The authorities have already taken some measures to help mitigate these risks. More to the point, if they act now they do so from a position of strength with reserves still at a relatively high level. Failure to do so could lead to a painful readjustment reminiscent of 1998.