Exchange rate in a resource based economy in the short term: the case of Russia

What should be the appropriate macroeconomic policy to minimize the volatility of output in a resource-based economy, i.e. in an economy that is highly dependent on export of resources with very volatile world prices? This paper examines the sources of volatility of output in Russia as compared to other countries and concludes that in 1994-2004 volatility of Russian growth rates was mostly associated with internal monetary shocks, rather than with external terms of trade shocks. In all countries that export resources with highly volatile prices, like Russia, volatility of economic growth is associated with volatility of RER, which in turn is mostly caused by the inability to accumulate enough foreign exchange reserves (FOREX) in central bank accounts and in stabilization funds (SF). However, in Russia, volatility of RER and GDP growth rates in recent 10 years was associated not so much with objective circumstances (terms of trade – TT – shocks), but with poor macroeconomic policies – despite intuition, volatility of real exchange rate (RER) was caused mostly by internal monetary shocks rather than by external terms of trade shocks. It is argued that the good (minimizing volatility) macroeconomic policy for Russia would be (1) not to generate monetary shocks (2) to cope with inevitable external shocks via changes in FOREX and SF, while keeping the RER stable. 1 New Economic School, Moscow, [email protected]. Assistance of Anatoly Peresetsky in computing time series regressions for Russia is gratefully acknowledged. 1 EXCHANGE RATE IN A RESOURCE-BASED ECONOMY IN THE SHORT-TERM: THE CASE OF RUSSIA Vladimir Popov 1. The problem: options for managing external shocks Usually the issue of the exchange rate in a resource based economy is discussed in the framework of the Dutch disease model – the overvaluation of the exchange rate that undermines non-resource exports and has negative implications for economic growth. Russia definitely developed a Dutch disease prior to the currency crises of 1998 (Montes, Popov, 1999; Popov, 2003a,b) and developed it again recently (the real exchange rate in 2005 exceeded the pre-crisis level of 1998). This paper, however, deals with a different issue – the short term adjustment of the resource based economy to changes in terms of trade. The long run equilibrium level of the real exchange rate and the policy to influence it via foreign exchange reserves accumulation (disequilibrium exchange rate) is a separate issue that is considered elsewhere (Polterovich, Popov, 2004). Back of the envelope calculations. Russia exported in 2005 about 150 million tons of oil and 150 billion cubic meters of gas worth about $100 billion (all numbers are rounded for simplicity). The price of oil and gas varied greatly – only in recent decade oil prices went from $10 to over $60 a barrel ($70 to $400 a ton), and gas price changed accordingly – they are strongly correlated with oil prices. Imagine a pretty bad (for Russia), but not totally unrealistic scenario – oil prices would drop to $10 a barrel and would stay at this level for 5 years. Annual Russian revenues from exports of hydrocarbons would fall to about $20 billion instead of $100 billion, so that in 5 years there would accumulate a $400 billion shortfall (Russian GDP at official exchange rate in 2005 totaled about $600 billion). How could Russia adjust to such a negative trade shock (deterioration in terms of trade)? There are basically three options for the country dependent on export/import of commodities with highly volatile prices to cope with terms of trade (TT) shocks: (1) to adjust by importing/exporting capital, (2) to carry out adjustment via changes in foreign exchange reserves (FOREX) and/or Stabilization Fund (SF) with appropriate sterilization and without changing real exchange rate (RER), (3) to adjust via changes in RER (allowing either an adjustment of nominal exchange rate or a change in money supply altering the rate of inflation). The first two mechanisms (assuming other good macroeconomic policies) are not associated with the adjustment in real trade flows and hence do not entail adjustments in the real sector of the