Despite the growing number of sanctions imposed on Russia’s economy since the invasion of Ukraine in February 2022, the ruble has returned to its pre-war phase. The column argues that the scale of imports on export sanctions and the financial repression imposed on Russia, which has reduced domestic demand for foreign exchange, have led to praise. Despite the adverse effects on exchange rates, restrictions on imports and exports are equal in impact on consumption, welfare and government financial losses. Nevertheless, exchange rate levels remain relevant for imports, savings and monetary policy.
Editors’ note: This column is part of the Vox debate on the economic consequences of war.
A record number of economic sanctions have been imposed on Russia’s economy since the invasion of Ukraine in February 2022. The impact of these restrictions on the real economy will be gradual, perhaps observed months or even years later, by many commentators and policymakers. The ruble is trying to estimate the effect of the ban from the short-term dynamics of the exchange rate (see Pestova et al. 2022). Immediately after the attack and the imposition of sanctions, the Russian ruble quickly lost about half of its value (Figure 1). However, a few weeks later the ruble began to appreciate and was higher than before the war in early May.
Figure 1 Daily ruble exchange rate (per US dollar) in 2022
This confusing dynamics leads to various contradictory and confusing interpretations. Some commentators have concluded that the imposed sanctions are not working. Similarly, the Russian state media uses the return of the exchange rate as an indicator of the resilience of the economy and the short-term effects of sanctions. Other commentators went to great lengths, suggesting that because of all the policy measures and restrictions imposed to stabilize the exchange rate, it has lost its relevance as an allocation value and has become inconsistent from a welfare point of view.
Swing exchange rate
What explains the amazing swings in exchange rates over the last few months? To answer this question, we first notice that the value of the ruble is set on the Moscow exchange, which has been largely disconnected from the international financial market since the beginning of the war. Western sanctions bar foreign banks from transacting the ruble, and Russian capital controls limit Russian residents’ access to foreign markets. As a result, local supply of foreign currency comes from export earnings and government reserves, while local demand is shaped by import costs, foreign liabilities of Russian companies (they exist in limited quantities despite the 2014 sanctions) and the use of foreign currency. As a treasure trove of value. The equilibrium exchange rate adjusts to the local supply and demand of the currency and adapts to inflation.
Itshoki and Mukhin (2022b), we show that a simple equilibrium model of exchange rate determination can explain the ruble dynamics from Figure 1. A significant portion of the government’s foreign reserves are suspended overnight, excluding large banks and corporations from international debt. The market, and the threat of blocking the export of goods caused a sharp devaluation of the ruble. These factors are exacerbated by the sharp rise in home demand for foreign exchange driven by rising inflation expectations and a fall in the supply of alternative vehicles for savings.
The exchange rate reversed in mid-March and gradually appreciated in the pre-war phase the following month. First, the stricter restrictions on Russian imports compared to exports during this period resulted in a large surplus in the current account and the inflow of foreign exchange into the economy (see also Lorenzoni and Warning 2022). Second, with limited access to foreign reserves, the central bank used extensive financial repression, including strict restrictions on the withdrawal of foreign currency deposits, outflows of capital, and a 12% tax on conversion of local currency into dollars and euros. This has limited the domestic demand for foreign exchange. Third, record-high commodity export revenue allowed the Russian government to enjoy a substantial fiscal surplus, thus avoiding the need for monetization of its financial obligations and inducing a monetary-driven depreciation. These three factors are arguably more important in stabilizing the exchange rate than conventional financial instruments, such as raising the policy rate to 20%, the main goal of which is to stop a bank from operating on ruble deposits and to prevent inflation. Nevertheless, in the long run, the possibility of export sanctions and the financial crisis driven by the internal recession could lead to both inflation and devaluation.
Failing the ban?
The perception of the ruble in the pre-war period has been widely interpreted as a sign that sanctions have so far had a limited impact on the Russian economy. As mentioned above, this argument misses the fact that most of the restrictions were imposed on Russian imports, which reduced the demand for foreign currency, thus creating a force for the devaluation of the ruble. This realization, however, cannot offset the increase in the effective cost of imports, especially given their limited availability, or compensate for the associated welfare loss and increased actual cost of living.
More generally, there is no one-to-one relationship between exchange rates and welfare, and therefore the effectiveness of sanctions cannot be inferred from exchange rates. On the one hand, restrictions on imports and exports are equal in their impact on the use of foreign goods – the former increases their relative prices, while the latter reduces the amount of resources available to buy foreign goods – and thus the same welfare effect. On the other hand, the effect on the exchange rate goes in the opposite direction in two cases – import sanctions reduce the demand for dollars and devalue the ruble, while export sanctions reduce the supply of dollars and devalue the ruble.
Significantly, parity extends to revenue: although import restrictions do not directly affect government revenue, changes related to exchange rates reduce nominal and actual revenue in the same way as export restrictions (Amiti et al. 2017). The fact that exports constitute an important source of government revenue does not change the outcome and thus cannot be used as an argument in favor of exports on import ban. Instead, the use of export sanctions can be justified if import sanctions are deemed inadequate, restricted by the trade share of the imposing countries, or reduce the costs of the imposing countries (Storm 2022).
Exchange rate irrelevant?
Equally confusing is the general view that policy restrictions make exchange rates irrelevant to the economy. Despite major government intervention in the foreign exchange market, including multiple restrictions on the purchase and management of foreign currency, the value of the ruble affects the economy through two channels. First, valuation of the exchange rate increases household purchasing power and increases the use of foreign goods by minimizing the negative effects of import sanctions. Importantly, it comes at the expense of families who want to keep foreign currency as a safe asset and thus under the financial repression system used to strengthen the ruble. In other words, monetary policy creates redistributive effects from savers (who tend to be wealthy families) to consumers of foreign goods (mostly poor ‘hands-on’ families).
Second, the nominal exchange rate is a signal about monetary policy, which is especially valuable in an environment of high uncertainty and low confidence of policymakers. The budget deficit puts pressure on the government to monetize its nominal liability. Even before that happens, monetary policy uncertainty could reduce demand for local currency deposits, leading to higher inflation and a rush on banks. In order to restore credibility, anchor inflation expectations and stabilize the financial system, the central bank may adopt a nominal peg to communicate its policy priorities (Athey et al. 2005, Itshoki and Mukhin 2022a).
In short, a strong appreciation of the ruble over the past two months has been driven by import sanctions and monetary repression, both of which have reduced demand for foreign exchange. This does not mean that sanctions do not work – in fact, there is a significant balance between import and export restrictions in terms of welfare effects and government financial losses. Stabilizing the exchange rate allows the Russian government to anchor inflation expectations and support costs but at the expense of the financial repression of domestic savers.
Amiti, M., E. Fari, G. Gopinath and O. Itaskhoki (2017), “Coordinate Borders”, VoxEU.org, 19 June.
Athey, S, A Atkeson and PJ Kehoe (2005), “The best level of prudence in monetary policy”, Econometrics 73 (5): 1431–1475.
Itshoki, O and D Mukhin (2022a), “The Mussa Puzzle and Best Exchange Rate Policy”, VoxEU.org, 17 January.
Itshoki, O and D Mukhin (2022b), “Prohibitions and Exchange Rates”, NBER Working Paper No. 30009.
Lorenzoni, G and I Werning (2022), “A minimalist model for the ruble during the Russian invasion of Ukraine”, NBER Working Paper No. 29929.
Pestova, A, M Mamonov and S Ongena (2022), “The value of war: the macroeconomic impact of the 2022 sanctions on Russia”, VoxEU.org, 15 April.
Sturm, J (2022), “Easy Economy of Tariffs on Russian Energy Imports”, VoxEU.org, 13 April.