How Did Russian Ruble Rally 160% in 3 Months? How Long Will It Last?

The Russia-Ukraine conflict has been ongoing for more than three months. The US and its allies have been escalating their military support to Ukraine. In addition to the intense depletion of Russian military forces, the US and its allies have also imposed unprecedented financial and economic sanctions on Russia. In contrast to the stalemate and the evolving situation in the military conflict, Russia has achieved some milestones in the "defense" of the ruble in the financial field. However, there is still a long way to go to bring the ruble back to an "economically reasonable level" and achieve real long-term stability.

Financial sanctions were the focus of Western economic sanctions. On 21 February, after Russia declared its recognition of the independence of the People's republic of Donetsk and People's republic of Luhansk in eastern Ukraine, the US and Europe introduced accompanying sanctions shortly afterwards, including restrictions on Russia's use of the USD, EUR, GBP and JPY for trade settlements; the inclusion of major Russian banks on the US "Specially Designated National List" (SDNs), which prevented these banks not only from using these currencies but also from trading with US financial institutions; the removal of seven selected Russian banks from the Society for Worldwide Interbank Financial Telecommunication (SWIFT) to ensure their separation from the international financial system; freezing half of the Russian Central Bank's foreign exchange reserves, making it unable to support the ruble exchange rate through foreign exchange intervention; a ban on Russia using funds subject to US jurisdiction to repay debts; halting the operations of US credit cards Mastercard and Visa in Russia and so on. In addition, the US Department of the Treasury has taken steps to prevent Russia from circumventing US sanctions through virtual currencies, the "dark web," and other measures.

The US hopes that the sanctions will cause a significant devaluation of the ruble and capital outflows, leading to hyperinflation and crippling the Russian economy. This will then trigger political turmoil in Russia and a forced delinking of the US from Russia. Furthermore, it will exclude Russia from the international financial and trade system and completely degrade Russia into a second-rate country.

Financial sanctions have had a major impact on the Russian ruble exchange rate and financial market stability, import and export trade and financial transactions, the foreign exchange balance, and even the macroeconomic balance. Russia could be artificially declared to have defaulted on its national debt at any time. The ruble and the stock market have also experienced the biggest crash in contemporary Russian history. On 24 February, the day Russia announced a "special military operation" in Ukraine, the Moscow Exchange Index (MOEX) and the Russian Trading System Index (RTS), Russia's two largest stock markets, dropped by 45% and 40%, respectively. Stocks of major Russian banks and companies fell by an average of 98% on the London Stock Exchange. The ruble exchange rate fell sharply from 70.5-71 rubles to the dollar before the outbreak of the conflict to 150 rubles to the dollar on 7 March.

In response to the sanctions, Russia rapidly introduced a corresponding financial portfolio, which was divided into three main parts: 1. a one-time urgent interest rate hike of 1,050 basis points by the central bank, raising the key interest rate from 9.5% to 20%; 2. Conducting temporary capital controls, requiring domestic exporters to sell 80% of their foreign currency on a compulsory basis; a ban on the sale of securities and other Russian assets by non-residents associated with "unfriendly countries and regions"; Restrictions on businesses and residents withdrawing foreign currency from bank accounts (up to $10,000) and on foreign customers from withdrawing certain foreign currencies; 3. pegging the ruble to gold, with transactions conducted at a fixed price of 5,000 rubles per gram of gold; and requiring "unfriendly countries and regions" to settle Russian gas in rubles instead.

By implementing these three main types of measures, the Russian financial and monetary authorities hoped to offset the expectations of inflation and currency devaluation, increase the attractiveness of holding assets in the national currency, curb capital outflows and stabilize the exchange rate. With these measures introduced, the Russian financial situation was able to stabilize rapidly. By 31 March, the ruble against the US dollar had returned to the levels seen before Russia's special military operation and has continued to strengthen in the following two months. It is estimated that the ruble has gained a cumulative of 20% from the start of the year to late May, a recovery of around 160% from its low of three months ago after the outbreak of the Russia-Ukraine conflict. The ruble has turned from being the world's worst-performing currency at the end of February to the world's best-performing currency.

It should be pointed out that both the US and Russia have been prepared for this financial war of attrition and defense. Since the outbreak of the Ukraine crisis in 2014, Russia has been under sanctions imposed by the US and Europe, which have been long-standing and regular. After 24 February 2022, the US and Europe even increased the intensity and density of sanctions, launching a total of 7,374 sanctions against Russia in the two months until 29 April. The number of sanctions exceeds that of decades of sanctions against Iran, Syria, North Korea, Venezuela, Myanmar, and Cuba combined. The number and pace of sanctions against Russia suggest that the sanctions program has been long in the planning.

Over the past eight years, the Russian authorities have been maintaining bottom-line thinking and preparing for delinking: setting up an independent national payment system (NPS) and System for Transfer of Financial Messages (SPFS) and launching the "Mir" payment system; accumulating large amounts of foreign exchange reserves, continuing the process of de-dollarisation, implementing diversification of foreign exchange reserve assets flexibly, and expanding the scale of local currency settlements with major trading partners in order to prevent external financial risks. At the same time, the Central Bank of Russia has constructed a macro-prudential policy framework and conducts regular compliance reviews of the systemic risks of financial organizations and the banking system. It has also closed a large number of problematic banks, ensuring the safety of the domestic financial system. The Russian financial community believes that the only surprise in the list of financial sanctions is the freezing of the foreign exchange reserves of the Russian central bank. This approach is not only beyond prediction but also gives rise to various problems. It is bound to exacerbate the process of de-dollarisation in major global economies.

The ruble-gas peg has played a crucial role in Russia's response to Western financial sanctions.

An essential feature of Western financial sanctions is that they allow for unforeseen. It bypasses gas and the Gazprom Bank, which carries out the settlement of gas exports. It is this loophole in sanctions and Russia's dominant position as an all-powerful commodities superpower that provides the opportunity for a comeback. According to a presidential decree signed by Russian President Vladimir Putin, oil and gas importers from countries unfriendly to Russia are required to open one euro account and one ruble account at the designated Gazprom Bank. Firstly, the foreign importer credits the euro to a euro account. Gazprombank then sells the euros it receives to the Russian central bank, which converts the euros into rubles and credits them into the importer's ruble account. The payment for Russian gas is then made through this account. Russian economists believe that the measure not only reduces Russian transaction costs and increases the trust of the population in the local currency but also reduces the willingness of international markets to short the ruble and ensures the revenues from the sale of gas are secured. At the same time, this accelerated the process of de-dollarisation and objectively cracked the West's SWIFT sanctions. On 28 March, following the news of the settlement of gas in rubles, the ruble against the US dollar immediately stopped falling and started to strengthen.

Further analysis shows that the logic behind the settlement of gas in rubles lies in the fact that the energy trade, which has been carried on for more than half a century, binds Russia and Europe in a deep way and that most EU member states will not be able to break away from their high dependence on Russian energy in the short term. Following the outbreak of the Russia-Ukraine conflict, a comprehensive embargo on Russian energy is one of the central issues in the coordination of Western sanctions policy. Due to the different levels of energy dependency of the EU countries, there is no uniform timetable for the "de-Russianisation of energy supplies," and the only way to achieve the ultimate delinking from Russian energy is through a gradual process. Although the EU is ostensibly strongly opposed to the "gas settlement in the ruble," an increasing number of European companies are beginning to accept Russia's demands. According to foreign media, by mid-May, 20 European companies had opened ruble accounts with Gazprom Bank to meet the Russian side's request to settle gas in rubles. And a further 14 European companies have asked the bank for information about opening a ruble account. On 30 May, in the EU consensus on the imposition of an oil embargo on Russia, a land pipeline was still left open for Hungary, the Czech Republic, and Slovakia to be exempted from sanctions. It can be argued that as long as Europe fails to achieve a complete delinking from Russian energy, the effectiveness of the sanctions will be greatly diminished.

The balance of payments is the leading factor in stabilizing the ruble's exchange rate. Overall, the escalation of Western sanctions against Russia since the outbreak of the Russia-Ukraine conflict has stimulated a sustained rise in international oil prices. This has greatly benefited Russia, which is primarily an exporter of energy raw materials, and its current account surplus of the balance of payments has increased rather than decreased. According to data from the Central Bank of Russia, from January to April 2022, Russia achieved a foreign trade surplus of US$106.5 billion. The current account surplus of the balance of payments amounted to US$95.8 billion, 3.5 times higher than in the same period last year, with higher oil prices playing an important role. From January to April, the average price of Russian Urals oil rose by 40% year-over-year, while oil export revenues increased by 50% despite a 0.6% decrease in oil exports. The International Energy Agency confirmed that maintaining exports at 8 million barrels per day and night (approximately 1 million barrels less than before the outbreak of the conflict), Russian energy companies are still earning an average of US$20 billion per month. This means that even with reduced export volumes and discounted sales, Russian oil and gas revenues would still increase in the event of a significant increase in international oil prices as a result of the Russia-Ukraine conflict. Some specialist media predict that, given soaring energy prices, Russia could earn nearly US$321 billion from energy exports alone this year, more than a third increase over 2021. This would play an important role in supporting the maintenance of a stronger ruble.

Since the outbreak of the Russia-Ukraine conflict, the ruble exchange rate has undergone a V-shaped reversal. In addition to three major measures by the Russian Central Bank, namely a sharp increase in interest rates, tighter capital controls, and the pegging of the rouble to natural gas, the sharp fall in imports as a result of Western technology and trade sanctions against Russia is also an important cause. According to estimates by different agencies, Russian imports fell by 50-70% in April as an effect and consequence of Western sanctions. This has resulted in a net inflow of balance of payments and a persistently high ruble to the US dollar exchange rate. In the long term, the high-interest rates and strict capital controls are not beneficial to economic development and will increase the likelihood of a contraction in the Russian economy. Meanwhile, an excessive appreciation of the ruble will have a negative impact on the budget and exports. As a result, the question of how to curb the excessive appreciation of the ruble has become a new problem for the Russian financial authorities to deal with.

From the direction of the Central Bank of Russia's monetary policy, the focus of monetary policy has shifted from addressing financial risks to supporting economic development as exchange rate and financial stability risks are no longer on the rise. Within a one-and-a-half month period since 8 April, the Central Bank of Russia has cut interest rates three times in succession, lowering the key rate from 20% to 11%. To enable businesses to adapt to the new market conditions, the Central Bank began making small adjustments to gradually ease capital controls, lowering the mandatory foreign exchange sales standard for raw material exporters from 80% to 50% and to zero for non-raw material and non-energy exporters. At the same time, it began easing restrictions on overseas transfers and lifting the ban on selling foreign currency cash to individuals.

In the future, the Central Bank's monetary policy will aim to strike a balance between the need to defend against financial risks, contain inflation, and develop the economy. The financial authorities hope that a new "easing policy" will gradually bring the ruble exchange rate back to an "economically reasonable level" in the coming months. The aim is to help achieve the key tasks Russia is currently facing in stabilizing economic fundamentals, restructuring external economic relations, and strengthening import substitution for economic transformation.

Overall, Western financial sanctions have hit the Russian economy hard in the short term, but Russia has at the same time the countermeasures and room to game. Russia's superior natural resource wealth and long experience in dealing with sanctions have enabled it to reverse the situation in the financial war, but this is only a phased achievement. In the medium term, the US and the West kicking Russia out of the international financial system and the international trading system will have a profound impact on the Russian economy. How to overcome the isolation in the face of prolonged sanctions will be a long-term test for Russia. What is more noteworthy is that the financial sanctions and counter-sanctions game between the West and Russia in the context of the Russia-Ukraine conflict has overturned the traditional financial mindset and prompted central banks to start exploring reserve diversification beyond the US dollar. As the world's largest foreign exchange reserve holder, it has become imperative for China to adhere to bottom-line thinking and develop a plan to prevent and respond to sanctions.