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Explainer: Russia Defends Ruble But Currency Still Struggling

The ruble remained in free fall through December 16, nearing the psychological barrier of 80 to the dollar.
The ruble remained in free fall through December 16, nearing the psychological barrier of 80 to the dollar.

By raising its benchmark interest rate to 17 percent overnight on December 15, Russia hopes to put an end to the dramatic collapse of its ruble, which has depreciated more than 50 percent against the dollar since the start of the year.

But so far the strategy does not seem to be working. The ruble remained in free fall through December 16, nearing the psychological barrier of 80 to the dollar.

Here are four things to know about what is happening.

What did the Russian Central Bank do?

The central bank of Russia (CBR) raised its key rate to 17 percent -- up from a previous 10.5 percent -- to make it more attractive for Russians to put their rubles in Russian banks by offering them more interest in exchange. That, in turn, is intended to reduce the amount of rubles in circulation and thus make it more expensive for currency traders to buy rubles and sell them on the open market for foreign exchange.

The central bank's action makes it more expensive for other banks to borrow money from it, meaning fewer rubles will flow from its coffers into the economy. That, in turn, makes it more expensive for currency traders to buy rubles and sell them for foreign exchange.

But so far the CBR's strategy does not seem to be getting traction. Instead, trade in the ruble risked turning into a rout on December 16 as traders divested themselves of so much currency that the exchange approached the psychologically significant benchmark of 80 to the dollar.

Worse, the new plunge comes just a day after the ruble tumbled more than 10 percent to cross the benchmark of 60 to the dollar -- the event that caused the central bank to raise the interest rate overnight in an unscheduled meeting.

It is too early yet to know if the measure will stabilize the currency over the longer term.

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But the dramatic tumble of the ruble is enough to make analysts talk of a panic in the currency market that is driving the ruble down unpredictably, partly because previous efforts by the CBR have failed to stem the tide.

"It seems to be a bit of a self-fulfilling currency crisis because the ruble has continued weakening no matter what the CBR has done over the past few weeks," says Liza Ermolenko, an emerging market specialist at London-based Capital Economics.

"Obviously, one of the main factors is the drop in the oil price, but even that doesn't fully explain what has happened to the ruble, so it is just the loss of confidence in the CBR and general panic in the market that has caused the ruble to weaken so sharply."

So far this year, Russia has spent some $80 billion of its foreign currency reserves to buy up rubles on exchange markets and slow its steady slide downward. The CBR has also raised its lending rate five times before this year, but only by small amounts, including 1 percent earlier this week.

Could the rate hike still work?

The director of the CBR says so. But Chairwoman Elvira Nabiullina conceded on December 16 that the ruble's value would not be immediately influenced by the rate hike and that it would take the ruble "some time" before it finds a fair value.

It is true that dramatically raising interest rates can bolster a currency by effectively reducing the amount of money in public circulation. But unfortunately for Russia, the move comes at a time when it has a moribund economy.

That is an important difference because a weak economy exerts continuous downward pressure on a currency by encouraging citizens to convert their money into hard currencies that are backed by stronger economies instead.

Under these circumstances, whether the central bank's emergency action will succeed in making them change remains an open question.

Could tightening interest rates hasten recession?

It is a danger because raising the interest rate does not just affect the currency market. It also makes it harder for businesses and households to get the low interest loans and credit they need to keep producing or buying new products.

Russia's economy has already been slowing down so much that economists predict it will go into recession next year. The CBR said before its emergency interest hike that gross domestic product may shrink as much as 4.7 percent in 2015 if oil remains at $60 a barrel.

Now, the added stress of higher interest rates could speed and deepen the process.

"The central bank is trying to stop the avalanche, and such a massive hike may be sufficient,” Slava Breusov, an analyst at Alliance Bernstein LP in New York, told the Bloomberg financial news service on December 15. “No one seems to be thinking what it will do to the economy, as the priority is to stop the ruble plunge."

In effect, Russia could enter into a vicious circle where raising the interest rate further weakens the economy and that, in turn, makes it necessary to take more steps to protect the currency.

Could tougher currency measures lie ahead?

If the ruble continues to fall, further steps are almost certain.

Ermolenko thinks Russia's most likely choice would be to introduce some mild capital controls that limit the free flow of money across its borders.

She predicts that the government would continue with a floating ruble but "perhaps try to implement some mild forms of capital controls, not full blown capital controls but something on a smaller scale" while the CBR simultaneously increases its foreign exchange intervention and perhaps even hikes interest rates further.

Capital controls take immediate pressure off a currency but directly interfere with the functioning of the free market and badly damage foreign investors' confidence in a country. Still, they could appeal to Russian President Vladimir Putin's brand of nationalism.

Sergei Markov, a pro-Putin political analyst, wrote recently in that "since the reasons for the ruble's fall are political, the response should be political, too." He suggested one response could be passing a law forbidding Russian companies from repaying debts to Western partners if the ruble drops under specified thresholds.

But the key to how Russia's economic crisis plays out remains the price of oil. Energy income accounts for about half of the government's budget revenues and the drop in global oil prices to below $60 a barrel today has severely undercut Russia's income.

Russia requires about $100 per barrel of oil to balance its federal budget.

"Things will get quite nasty next year unless oil rebounds very sharply and goes back to $120 or something like that," says Ermolenko. "But otherwise a recession is almost certain next year in Russia no matter what happens, so it's more about the depth of the recession that is coming than about whether it is going to happen or not."