1. The March Foreign Exchange Crisis Analysed
The Belarus Roubel (BRB) is the domestic currency in Belarus. Since 1995, exchange rate policy in Belarus has been based on a policy of administratively adjusted exchange rate, and which has been overvalued in comparison to the market rate. In the beginning of 1998 the BRB suffered an attack on the currency in external bourses, especially at MICEX in Moscow. This led to a fast depreciation of its market rate by 25 % between 2d to 16th of March. Despite intervention by the Central Bank of Belarus (NBB), the MICEX rate for the BRB/USD exchange rate depreciated from 40,790 at the end of December to 58,700 on March 16,1998. Table 1 shows the BRB/USD exchange rates at MICE and MICEX and the gap between the two rates.
Table 1. BRB/USD Exchange Rates at MICE and MICEX and the Gap
(Sources: NBB, MICEX and; B.E.T. Staff Calculations).
The gap or spread between the price of the BRB officially set within Belarus and the prevailing rate outside the country rose spectacularly in late February and early March, and rose to over 50%.
Whilst an exchange rate can be controlled internally through administrative means, it is practically impossible to control the price of the domestic currency outside the country. In order to prevent the BRB/USD rate from diverging more than some notional benchmark from that set in Belarus, the NBB must be able to meet the excess supply of BRB by purchasing it through sale of hard currency reserves. NBB foreign currency reserves have been almost depleted on a net basis (see Figure 1). Without demand from at least the central bank of Belarus for its currency on MICEX, demand dried-up. The central bank of Russia (CBR), acceded, against the wishes of MICEX, to Belarusian requests for the BRB market at MICEX to be suspended. Trading of the BRB on MICEX was halted, for an unspecified period, on March 20th.
Does this action mean that the exchange rate issue is resolved? Holders of BRB internally or externally wishing to exchange it have access to alternative markets. These include the interbank market in Russia, the over-the-counter (OTC) market and alternative markets in Ukraine and the Baltics. The action to suspend trading of the BRB in the most visible bourse did not therefore imply a halt to the desire by asset-holders of BRB to reduce holdings. Moreover, the action of halting trading of BRB at MICEX raised the risk premium of holding BRB, and increased excess supply of BRB, particularly externally. The BRB/USD exchange rate devalued in private interbank deals during one week of March from 53,000-54,000 to 64,000-69,000, or by about 25%.
Figure 1. NBB Hard Currency Reserves (net, USD bn)
(Source: B.E.T. Staff Calculations on data provided by NBB).
The policy response to the speculative attack was one of restricting settlements in BRB between non-residents and payments of imported goods in domestic currency. The aim was to prevent liquidity of BRB traded for foreign exchange at MICEX, but the action represents a short-term solution to a more basic fundamental macroeconomic problem, whilst it is entirely clear whether the basic premise of the problem has been fully grasped. The policy response to the problem has been that there is no problem with the exchange rate policy internally, but there are too many BRB in circulation outside the country. Therefore, the perceived solution is to cut channels that allow for transfer of BRB from Belarus.
Causes behind the exchange rate crisis
1.1 As many local analysts have pointed out, the short-term cause of the exchange rate crisis was the excessive money creation occurred of December 1997. A total of BRB 4.4 trn: BRB 2.9 trn to finance the budget and BRB 1.5 trn of directed credits to banks implied a monetary expansion of 15% in 1 month.
1.2 The contagion from the South East Asian financial crisis impacted financial markets in the region. Equity and bond markets were affected. Commercial banks and intermediaries, particularly, but not exclusively in Russia, heavily reliant on the returns from stock markets were in turn impacted and attempted to raise liquidity partly by off-loading stocks of BRB. The supply of BRB outside Belarus is significant and may represent several billion dollars worth. Banks in Russia had built-up stocks of BRB beyond the need for trade-financing due to (i) payment in some cases for imports into Belarus in BRB, but at the prevailing or above-prevailing contemporaneous official BRB/USD exchange rate in Belarus, and; (ii) in anticipation of possible liberalisation of the Belarusian banking system and/or privatisation.
1.3 These explanations show-up the short-term aspects of the crisis. The deeper underlying cause of the exchange rate crisis is the macroeconomic policy in Belarus. The crisis in March was an instance where excessive money creation led to a credibility crisis of the domestic currency, rising speculation against the BRB. NBB intervention to avoid depreciation led to a loss of 3.8 trn BRB in hard currency from December 1997 through February 1998.
1.4 In March credibility in the BRB deteriorated further, following the announcement of new direct credits to agriculture and housing of BRB 5.5 trn and 2.0 trn respectively.
1.5 Thus the sharp adjustment of the market exchange rate was partly due to internal factors and partly due to exogenous factors. Market expectation for devaluation has strengthened in 1998 because of the harder budget-constraint being imposed by Russian energy suppliers on Belarus, and in particular for demand that the ratio of settlements through hard-currency be raised. The lack of hard currency reserves at the NBB has been common knowledge among market-players. This therefore means that Belarusian authorities, in the absence of external assistance, have no choice but to devalue the BRB in order to raise reserves. Knowledge of this fact accelerated expectations for devaluation. Expectations became quickly self-sustaining when the NBB, in practice the sole buyer of BRB at MICEX withdrew from the market. With the main plank of demand for BRB gone the market rate for the BRB crashed.
Policy Issues
1.6 The underlying problem in the exchange-rate sphere recounts the experience at the end of 1995, when monetary and exchange rate policies became divorced. At that time the exchange rate was fixed at BRB 11,500 to the USD and a tight monetary policy coupled with high deposit rates was attracting foreign capital into Belarus, sustaining the exchange rate and reserves. However, money grew faster than targets, leading to loss of credibility and a reversal of capital movements by the end of 1995. This led to the depreciation of the market exchange rate. In response, monetary authorities introduced capital controls in November 1995, thus weakening the connection between money supply and the exchange rate. Since then monetary authorities have attempted to keep targets for the exchange rate independent of monetary policy.
1.7 However, the isolation allowed by the low mobility of capital is only relative, and the NBB has been forced to abandon all previously announced targets. This happened when the fixed exchange rate was abandoned in February 1996, with successive revisions of the exchange rate bands through 1996 and the faster than announced depreciation path along 1997 and also during the first months of 1998. The current crisis is, then, only one more in a line of mini-crises. What made the March instance pronounced was the impact of factors highlighted in 1.1 – 1.5.
1.8 Although some short-term effectiveness may be obtained by capital controls, economic agents will always find a way of circumventing controls. This means that there is no effective way of pressing down the external value of the BRB. In order to maintain effectiveness for a longer period, capital controls have to become tighter and tighter and the process may end up restricting real trade. The recent rule restricting payments in Roubels for imports illustrates clearly how far this process can go.
1.9 The temporary effectiveness of monetary controls is a well-known property and there is no way of avoiding it. Sooner or later monetary authorities will have to choose between (a) targeting the exchange rate or (b) targeting the money supply. In any of these cases Belarus will be better off under freer capital movement.
1.10 Stabilising under the second option involves progressive reduction in money supply to curb inflation, while the exchange rate is allowed to vary. This type of programme typically has no significant problems on the current account of the Balance of Payments, because the real exchange rate remains more or less constant. To reduce money creation a fiscal adjustment is needed to allow the government to operate without the need for inflation tax. However, there is no enforcement mechanism to assure disinflation under this option. This is why disinflation under this strategy is typically slower than in strategy (a).
1.11 Under strategy (a) the central bank targets a given nominal exchange rate (or exchange rate path, such as a crawling peg) and intervenes in the market to defend the exchange rate. Money creation becomes dependent on these interventions and no targets for the money supply can be announced. Typically such a programme is more effective in reducing inflation, but implies a real exchange rate appreciation during the adjustment that hurts the current account. Precisely because of this such a programme has to be implemented quickly, which in turn requires accompanying fiscal adjustment in order to be credible. This policy is currently the most fashionable and is adopted widely in the world. It was tried in Belarus in 1995, but excessive money creation and insufficient fiscal adjustment undermined the credibility of the exchange-rate anchor.
1.12 Given the current circumstance in Belarus the second option may be preferable. Economic authorities appear to understand this and are more or less re-adjusting the exchange rate targets each time it becomes unsustainable. However, as argued above, strategy (b) does not impose discipline against the rising temptation to resort to inflation tax. This is essentially the current policy: fiscal and quasi-fiscal expenditures are financed by money creation, which then lead to inflation and exchange rate depreciation. Price controls can then be used to disguise inflation, but the result is shortage of goods, leading to authorities to revise the prices and resort to rationing of goods and penalties for export to neighboring countries. Moreover, if price controls mean that producers are not covering costs, then it is possible that supply will be constrained voluntarily.
1.13 So what will the authorities do? Monetary policy at present has a lemmings feel. To posit the lack of a problem is to ignore the policy issue. BET has been arguing for some time the unsustainability of current economic policy in Belarus. Real output growth induced by fast money creation is always temporary. In order to maintain the current levels of production, successive higher money creation is required. This in turn fuels inflation and devaluation of the price of the domestic currency in terms of foreign currencies. Such a policy unless rectified, can lead to hyperinflation.
1.14 Measured consumer inflation (63.1%) in 1997 was higher than in 1996 (39%). Even with extensive price controls, higher inflation is expected in 1998. The country displays deficits on both the internal and external accounts and the financing of the balance of payments has been in recent years through use of barter to settle energy debts, an unsustainable policy. Dollarisation is extensive and officials estimate over $2bn is held outside the banking system in foreign exchange. The banking system itself is reeling given the exchange rate problems and lack of commercially viable lending opportunities. Demand for the BRB is declining, which translates to higher prices (through a rise in the velocity of circulation of BRB or how fast money changes hands).
1.15 The choice for authorities is between continuing nominal instability – through exchange rate in the short-run and thereafter in other macroeconomic variables, and the alternative adoption of a financial stabilisation package. However, the second option cannot be attained without external support. As argued in the February bulletin, current level of savings in Belarus is too low to forecast any significant growth without access to external savings.
1.16 In order to be effective, a stabilisation package has to be accompanied by fiscal adjustment. The latter requires a move toward improved and transparent targeting of budget constraints on enterprises and a credible move to create conditions for a viable private sector. The failure of the 1995 stabilisation plan was the lack of will to accept the need for restructuring of the real sector.