Day 34 Russian oil crisis

Russian oil crisis

Recently, Russian’s economy is in deep trouble. It was caused by the US retaliatory control over the world crude oil price. Since the mid-2014, US immensely increased its production of oil, along with obtained a guarantee from the oil cartel Opec for not cutting production. As we know, the world Brent oil was monopolized by these cartels, and they adjust the price from cutting or increasing production. Consequently, the US almost doubled its supply of oil in the global market, the price drastically fell from 110 USD per barrel to below 50 USD per barrel. How does America use this economy weapon to against Russia? And why did Russian rouble exchange rate drop enormously?

The Russian has the eighth largest oil reserve in the world, therefore around 16% of its GDP is from the oil and gas sector. It has been 52% of federal budget and 70% of total exports as well. So the estimated loss for Russian by 1 dollar decline in crude oil price is around 2 billion dollars. That is a huge impact over Russian’s economy, because they simply earn less. For the last 20 years, Russian has been one of the country with the most serious capital outflow problem around the world.Which already restrained it economic growth by a large extent. The devaluation in oil price will add more burden on Russian’s economy.

In 2014, Russian rouble depreciated 42% and the economic contraction was the main factor caused it. There are two reasons for people to supply/demand currencies in the foreign exchange market: to purchase foreign/domestic goods or services, and to acquire foreign/domestic assets. When Russia’s GDP decreased due to the tremendous decline in net export revenue, the price of domestic goods/services will increase. Because in fact there are fewer output to be allocated. Hence, people will find foreign products more attractive since they are relatively cheaper. So the supply of Russian rouble is going to increase, due to the increased demand of foreign currency to settle transactions.Moreover, the oil export comprised a substantial portion of demand for Russian roubles. Thus the price reduction made foreigners require less Robles to complete purchases. As a result, the fundamental exchange rate for Robles declined, corresponding to the decrease in demand and increase in supply.

If the Russian government wants to maintain the exchange rate at a high value, there are three methods can be applied. First of all, the government can place barriers on import such as tariff or quota. That will significantly reduce the demand for foreign products, and therefore, the supply of Robles in the foreign exchange market. However, this protectionism policy will reduce the total economy surplus, and that is why Russian chose the following two options. They used international reserves to make balance-of-payments, which means the government purchase the exceeded supply of Robles on the market. Although this can solve the problem in the short-term, Robles still face the downward pressure because of the speculative attack. The foreign investors fear the rouble will devalue in the future, which reduce their investment value. Thereby they will sell of all the investments held in Russian Robles, and that creates additional supply of funds in the market. The excess gap is going to become larger, eventually, the international reserve cannot cover that amount. In order to against the speculative attack and the downward pressure on rouble exchange rate, the government adjusted a tighter monetary policy to hike up the interest rate to 19%. This dramatic interest rate will attract both domestic and international investors. The Russian citizens will save more and spend less on foreign goods. The foreign investors tend to obtain more Robles aiming for the return. Correspondingly, the equilibrium level of exchange rate will rise back. The application of monetary policy will help Russian on the exchange rate, but it also makes the policy no longer available for stabilizing the domestic economy, which can cause alternative problems.

The volatile oil price wounded Russian’s economy deeply, but on the other hand, it may solve the sustained capital outflow problem due to the high interest rate. Furthermore, the Russia still maintains a trade surplus on the balance of payments by the robust market of primary commodities. In my opinion, it is not only a challenge, but also a chance for Russia to reform its economy structure.