[Revised] QE Tapering and its Effect on EMs: Russia’s Hands-Off Policy

As many have mentioned in their blog posts already, the Federal Reserve did not surprise anybody today by cutting back its bond-purchasing program by $10 billion, just as it said it would. Coincidentally, I had an interview with both Bank of America and Deutsche Bank today. Needless to say, that was a main topic of discussion during the interviews. Thanks to writing these blog posts each week, I was prepared.

One of the things that has been emphasized and is something I talked about a lot in the interviews is the effect QE tapering would have on emerging markets. I expected interest rates would rise after the Fed’s announcement, but due to increased investor demand the yield on 10-year U.S. Treasury bonds hit its lowest point since November (2.685%). The main reason is that investors seem to be shying away from risky investments in troubled emerging markets, in favor of less risky U.S. bonds. Even U.S. stocks took a tumble as the S&P 500 fell 0.38%.

An interesting case study for analysis of the effect of QE tapering on EM’s is Russia. Contrary to most emerging markets who are desperately trying to increase interest rates in order to stabilize their dwindling currencies, Russia isn’t even putting up a fight, letting the markets pull the ruble down without restraint.

At first glance this strategy seems unwise. As the article states, a weaker ruble means:

  1. Russian imports become more expensive, making it difficult for Russian companies to upgrade technology because equipment imports rise in price.
  2. Russian spending power abroad is slashed.
  3. Increased doubt of the ruble could significantly increase demand for foreign currencies, weakening the ruble even further and causing a surge in an already high inflation rate.

However, after closer inspection Russia’s hands-off policy has some validity.

 ‘A weaker ruble acts as a useful shock-absorber,’ said Ivan Tchakarov, economist at Citibank in Moscow, adding that letting the ruble slide gives the central bank a way to ease the impact of slowing global demand for Russia’s main commodity exports without risking higher inflation.”

Not only do Russia’s commodity exports become more attractive abroad, but also one of the main arguments against a weak ruble- high inflation- is avoided. The reason? In an already frail Russian economy, producers cannot afford to pass on the higher costs they are facing to consumers. They’d lose more revenue by increasing their prices than by absorbing the costs of a weak ruble. Although this isn’t by any means sound long-term monetary policy, I can understand why Russia is acting the way it is given its circumstances. A 6.5% inflation rate coupled with a shrinking current account surplus doesn’t give Russia much leeway to pursue quantitative easing or similar policies.