Russia: The Latecomer to the G8

8 august 2007

Martin Gilman is a Professor at the Higher School of Economics–National Research University, Moscow.

Resume: Right now, the only serious threat to the U.S. dollar’s international dominance is the euro. Even so, the Russian ruble has come a long way since the 1998 default, and it is about time for the perceptions to catch up with the new reality. If only politics would cooperate, both the international role of the ruble and Russia’s rightful place in the economic G8 would be assured.

When Russia was invited to join the other G7 countries in 1997, it seemed odd. Many in the West sympathized with the political motivation to provide positive reinforcement to President Yeltsin and his hard-pressed government. However, the relevance of Russian membership in that exclusive Club seemed even more tenuous shortly thereafter in the wake of the 1998 Russian financial crisis and of a number of scandals which raised questions about governance.

The oddity stems from the basic raison d’etre of the G7 itself whose origins were, and essence remains, a grouping of the world’s major economic powers. Russia’s membership 10 years ago seemed like a contradiction of the group’s principles.

How ironic then that only recently does an objective basis seem to be emerging to justify belatedly Russia’s membership in the economic G8 – just as some Western critics question whether Russia should still participate in the political G8! The fact is that, within the last year, the Russian ruble has started to acquire the characteristics of an international reserve currency and the Russian economy in 2007 is overtaking two (Canada and Italy) of the G7 using GDP at purchasing power parity.

This article seeks to recall the origins of the G5 as an economic grouping of the major international reserve currencies, and Russia’s seeming misfit within that club. It then goes on to outline the characteristics of reserve currencies and especially the primacy of the U.S. dollar – while stressing the likely decline of the dollar which opens the scope for other currencies like the ruble to achieve reserve currency status. Finally it considers the changes propelling the ruble toward an international role and the likelihood that the ruble will indeed become a reserve currency in the years ahead.

FROM G5 TO G7/8

The Group of Five began as a currency club after President Nixon closed the “gold window” in America in August 1971, effectively undermining the global monetary system. It brought together the representatives of the five major reserve currencies included in the basket of the SDR, a sort of international money created by the International Monetary Fund when the world was concerned earlier with a dollar shortage.

Following Nixon’s unilateral decision about the dollar link to gold, there were several other major economic events in the early 1970s that had a profound effect on the world economic system, including the collapse of the Bretton Woods monetary system based on fixed exchange rates; the first enlargement of the European Community, with Britain, Denmark and Ireland joining the original six members; the first oil crisis, when OPEC placed an embargo on oil supplies following the October 1973 Yom Kippur war; and the 1974 economic recession in OECD countries, in which both inflation and unemployment rates rose sharply (i.e., stagflation).

In these circumstances, the traditional mechanisms of international cooperation like the IMF were no longer seen to be capable of reconciling the differences among the leading Western powers or to give them a sense of common purpose. It was in this evolving context that the finance ministers of the United States, Germany, Britain and France, meeting on 25 March 1973 in the White House library, became known as the Library Group. Later joined by Japan, the group met periodically and came to be known as the Group of Five finance ministers (G5), sometimes joined by central bank governors.

Some two years after the initial get-together of the Library Group, they began to meet formally. France hosted the first summit meeting in 1975 at the Chateau de Rambouillet. By that time, an aggrieved Italy inserted itself. In their first Communiqué in November 1975, the G5 agreed to work for greater stability to international monetary problems, involving efforts to restore greater stability in underlying economic and financial conditions in the world economy. They also pledged to act to counter disorderly market conditions, or erratic fluctuations, in exchange rates.

In the following year Canada was invited to join, as was the European Union in 1977. Over the years, the purview of the G8 has increased. From just economics in 1975, they expanded not only their format and structure, but also the number of issues on which they now take initiatives.

Russia’s participation in this group was clearly a non-economic decision and underscored the dispersion of focus from management of the international monetary system. With politics in mind, the first President Bush proposed to admit Russia as a full-fledged G7 member at the Munich summit in 1992. His suggestion was considered premature, but Russia continued to be invited each year using a G7+1 formula. The June 1997 meeting in Denver was called the Summit of the Eight and Russia officially joined in 1998 at the Birmingham summit.

Even with its membership in the G8, it was understood that Russia, with its weak currency, low reserves, high inflation, extensive dollarization, and the recent memory of the 1998 default, was invited solely for the political side. It was commonly appreciated among the G7 finance ministries and central banks that Russia’s presence wasn’t just odd – it seemed ludicrous, so Russia was effectively excluded from the G7 league of the major international reserve currencies, those effectively managing the international monetary system.

WHAT IS A RESERVE CURRENCY, ANYWAY?

This topic warrants a whole article in itself. Suffice it to say that, historically, there have been around a dozen international currencies used extensively outside the borders of the country issuing them, from the dinari and drachma of ancient Rome and Greece, to the dinar and ducato of the Islamic empire and Venice, through to sterling and now the dollar.

A simple definition of an international reserve currency would be one that is used outside its home country. Reserve currency status is just one aspect when considering the international use of a currency. The others can be thought of as the equivalents of the classic three functions of money domestically – as a store of value, medium of exchange and unit of account. Under each function, government authorities and private actors sometimes choose to use a major international currency that is not their own.

With this concept in mind, let me turn to the general characteristics that tend to denote international reserve currencies. For any currency to serve as an international reserve currency, three features seem especially important: first, the currency must be widely used in international transactions. Second, it has to be linked to deep and open financial markets. Finally, people need to have confidence that the purchasing power of that currency will remain fairly stable.

It is relatively intuitive why countries with a large share of global trade, or with large and active financial markets, would be more likely to have their currency used as a global reserve asset. The larger a particular nation’s role is in international trade, the more cost-effective it will be for other countries to settle their international payments in that nation’s currency.

These benefits are reinforced when these assets can be moved efficiently from savers to businesses and investors. This will happen when financial markets are safe, trading volumes are high, and capital controls are kept to a minimum. A country will make an attractive destination for global financial activity when its rules promote transparency and high standards of risk management. In this regard, a well-functioning regulatory and supervisory environment is especially important in promoting the use of a nation’s currency in international transactions.

There are also network externalities involved in the use of a reserve currency. An individual (exporter, importer, borrower, lender, or currency trader) is more likely to use a given currency if everyone else is doing so. If a currency is widely used to invoice trade, it is more likely to be used to invoice financial transactions as well. If it is more widely used in financial transactions, it is more likely to be a vehicle currency in foreign exchange trading. If it is used as a vehicle currency, it is more likely to be used as a currency to which smaller countries peg.

This networking power is why central banks hold dollars in their reserves in a far greater proportion than the proportion of trade their country conducts with the U.S. While less than 30 percent of international trade is with the U.S., it is estimated that almost 70 percent of central bank reserves are in dollars. It is why most commodities, like oil, copper and coffee are priced in dollars, wherever they are found and traded.

Once a currency is widely used for official and private transactions around the world, and once it is widely held as a reserve currency, its use is likely to continue owing to inertia. However, that situation can change. If a central bank fails to sustain confidence in the future value of its currency, participants in the global market will eventually find substitutes for the currency. One of the consequences of globalization is that substitutes do exist for any currency if policymakers allow its purchasing power to deteriorate.

Even then, historically, changes may occur only with a long lag. For instance, even after the United Kingdom ceded its position as an economic superpower early in the 20th century, the pound remained an important international currency. In the present context, this inertial bias favors the continued central role of the dollar. However, this may not be the relevant precedent as the UK remained a major creditor nation, while the U.S. is now the world’s largest debtor. Doubts about the future soundness of the dollar could trigger a “run on the bank.”

DECLINE OF THE DOLLAR – A ROLE FOR OTHER CURRENCIES?

If it were not for its “reserve currency” status, the value of the U.S. dollar would presumably have collapsed by now. An accumulated trade deficit of $4.4 trillion since 1996, and a heavy reliance on foreign financing to pay for its external imbalances, has severely weakened America’s global economic leadership over the past few years. The U.S. dollar’s strength may result from still favorable factors such as America’s political stability and military might, its large $12.5 trillion economy (28 percent of global GDP), deep and liquid financial markets for bonds and stocks, and not least, positive interest differentials.

And at the end of April, the U.S. dollar fell to an all-time low against the euro, a new milestone in a steep decline that began more than six years ago. The euro hit a record high of $1.3682 on April 27th, up from $1.20 a year ago and as little as 83 cents in October 2000, when the rally against the dollar began.

What if foreign central banks diversified their reserves? A sale of dollar-denominated reserves would depress the value of the dollar vis-à-vis other currencies, resulting in large capital losses and an appreciation of their currencies, which would make their exports less competitive. But it is not even a question of selling existing reserves. The U.S. economy requires net financing from the rest of the world of over $2 billion every day, absorbing almost two-thirds of net global savings. If central banks decide simply to withhold new purchases of dollar assets, the results will be similar.

The willingness of individuals and governments to hold a particular reserve currency depends on how they view the stability of that currency’s long-run purchasing power. A potential loss of purchasing power can erode the economic benefits associated with using any particular currency for international trade. When viable alternatives exist, individuals and governments will gravitate toward the currency with the most stable purchasing power.

The debtor position of the U.S. underscores a key point, which is that a central feature of the next couple of decades could be about the unwinding of the “dollar balances.” The inevitable decline of the dollar as the world’s reserve currency could be a painful one. U.S. consumption and economic activity will be so constrained by the need to repay dollar liabilities owed to foreigners, as to lead to a build-up of social pressures or inflation or both. The U.S. is unlikely to pursue such a painful path willingly and we can expect some recourse to economic, financial, political and maybe even military options to avoid or delay the inevitable.

Over the next decade or two, the dollar will lose its role as the key reserve currency, perhaps to Russia, China or India. Ironically, within this group, the ruble may be well positioned to play an important role, at least as long as it continues to be the world’s largest energy producer.

CAN THE RUBLE BECOME A RESERVE CURRENCY?

What a difference ten years can make for the prospects of a currency. The “hard” ruble – dropping 000 – was introduced on 1 January 1998, at rub. 5.9 per dollar. A year later, it was at about rub. 20 per dollar, and inflation rose by 84 percent in 1998. It was clear that Russians minimized holding rubles, and held their savings mostly in dollars. This aversion to rubles was reflected in the figures for money demand at barely 13 percent of GDP in 1997.

So it’s something of a landmark that, 15 years into its market transition, Russia made the ruble fully convertible on 1 July 2006.

The decision to lift currency restrictions is certainly a symbol of the remarkable turnaround in Russia’s financial fortunes since the country’s financial collapse and dramatic ruble devaluation in 1998. Record-high oil prices are a sign that Russia is earning tens of billions of dollars each year in extra export revenues, fueling the demand for rubles.

At the same time, the government has been pursuing a highly conservative fiscal policy, using a large part of Russia’s oil windfall to pay off debts and build up reserves. Russia’s hard currency reserves, which stood at a meager $15 billion in 1998, recently hit $400 billion. And meanwhile, Russia is becoming a significant creditor country and donor to poor nations and international development institutions.

Meanwhile, ordinary Russians are accepting rubles like never before. Recent weeks have seen Russians heading to the exchange kiosks in droves. Ruble-denominated bank deposits have mushroomed from 300 billion rubles in 1998 to 4.24 trillion rubles ($53 billion) today. This is reflected in the money demand numbers with the rate expected to climb to about 37 percent of GDP this year (a level still well below the rest of Europe).

True, the reason for this stampede has less to do with confidence in the ruble, and more to do with growing concern over the fate of the dollar. In late April, the dollar plummeted below 26 rubles for the first time since 1999.

Nevertheless, it will take more than simply lifting the final exchange restrictions to make the ruble a truly convertible currency – freely traded around the world in liquid 24-hour markets. There would have to be a greater interest in the Russian currency by markets and central banks. Indeed, international interest in trading rubles may only take off when the government reduces inflation (presently around 8 percent) and replaces its current managed-float exchange rate with a free float. Until then, the move toward ruble convertibility is unlikely to make much real difference to ordinary Russians, who will still find it difficult to buy rubles or open ruble accounts outside the country.

In the meantime, initial steps have been taken to make the ruble more attractive to the international market. Russian capital markets have been bolstered via the issuance of ruble bonds, which have helped to broaden the funding base of the Russian market, establish a transparent benchmark for Russia’s debt and provide longer-term financing for the broad economy.

For instance, the EBRD has raised rub.19.5 billion via bond issues, launching a two billion ruble Eurobond in January 2007, following three domestic bonds issued earlier in the local currency market for a total of 17.5 billion. In addition, KfW Group, a German state agency, and the largest issuer of corporate bonds in Europe, and the Nordic Investment Bank have issued ruble-denominated Eurobond.

Likewise, institutional steps have helped to pave the way for the internationalization of the ruble. A key step was the 2003 Securities Market Law that ultimately allowed international borrowers to raise money on the domestic market. Another vital preparatory element prior to actually issuing ruble bonds was the creation of the Moscow Prime Offered Rates (MosPrime), a transparent money market index which is Russia’s equivalent of London’s LIBOR.

Also starting this year, the ruble began trading as an international currency when Europe’s leading clearing system, Euroclear, started settling inter-bank accounts in rubles. And the world’s largest London brokerage, ICAP, has started trading rubles on its electronic trading platform, EBS, in competition with Moscow-based MICEX. These actions by the markets signal that the currency liberalization in Russia has achieved de facto international recognition.

In thinking about the future role of the ruble, a historical perspective is useful. Surely, if asked a 100 years ago about the potential role of the dollar, a London banker may well have been incredulous retorting that the United States did not have the institutional maturity, the air of stability and the depth of economy to possess the world’s reserve currency. And they would have been right, in 1907, some six years before the Federal Reserve Board was established and just two decades after a period in which many states defaulted on their civil war debts. But nothing is pre-ordained. The reality is more mundane. Institutional maturity and economic depth come with economic growth.

AND THE FUTURE?

It is not perhaps coincidental that almost a year ago First Deputy Prime Minister Dmitry Medvedev said that the global economy needed a more stable financial system based not on the single reserve currency, the dollar, but on several currencies. “The current economic situation in the United States, the issuer of the single reserve currency, causes concern,” he noted. Today, he said, new leaders were coming to the foreground, with their stable currencies, which would lead to changes in the financial system. “There are all prerequisites for the creation of this system,” Medvedev stressed, adding that the ruble could well become one of the world’s reserve currencies.

Since the beginning of this year, 50 of the world’s currencies have risen against the dollar while only eight have declined. Behind the falling U.S. dollar is a changing global economy. China and the U.S. are the locomotives in the global economy, accounting for 60 percent of all the global growth in the last five years. But now, the $12.5 trillion U.S. economy is slowing down as a result of the slump in the housing sector, while the $2.5 trillion Chinese economy is overheating, expanding at a blistering 11.1 percent pace in Q1.

India, China and other dynamic economies, such as Russia, are expected to contribute more than 50 percent of world economic growth in 2007, with China’s contribution alone being 30 percent and India’s 10 percent. In comparison, the U.S. contribution to world growth is expected to fall to 12 percent, after its economic output plummeted to 0.8 percent in Q1, the smallest gain in four years.

Every time U.S. year-on-year GDP growth has dipped below 2 percent since 1960, a full-blown recession unfolded. In contrast, the Euro zone economy is expanding at a 2.6-percent clip, its best performance in six years, and the European Central Bank is aiming to lift its interest rate in June, thus making the U.S. dollar less attractive next to the euro. As such, many foreign central banks have been reducing their exposure from the U.S. dollar and acquiring the euro and British pound over the past year.

The scene may be set for other currencies to start the road toward reserve currency status. Certainly, if current trends continue, then both China and India will be by far the largest economic powers within 20 years. If they begin to acquire some of the characteristics that are needed for reserve currency status such as stability, deep financial markets, and high legal/regulatory standards, then the yuan and the rupee could well become dominant in the international monetary system. However, both countries, especially China, have significant political, social, and legislative hurdles to jump in the process and the outcome is not guaranteed, especially within a horizon of the next ten years.

In the meantime, perhaps over the next 5-10 years, the Russian ruble may be well placed to start being used as an international currency. The main obstacle may well be political. The current climate of mistrust in Russia’s foreign relations can certainly impede the internationalization of the ruble, just as it raises serious questions in some Western capitals about Russia’s continued participation in the G8 itself. Whatever the business community may prefer in pursuit of market preferences as one of the viable alternatives to the dollar, it is hard to imagine the widespread use of the ruble outside Russia until there is a rapprochement between Russia and its major economic partners. Such an improvement in good relations is of course important for its own sake, but it is indispensable if the ruble is to play a wider role in global finance.

It may be worth recalling some comments by former Fed Chairman Greenspan last October on the prospects of the ruble as a reserve currency. He said that the ruble is “still far from being a reserve currency. A reserve currency like the dollar and euro should be extremely liquid,” he said. Greenspan added that for the ruble to be an “external currency” it is important that the “rule of law” prevails. “People would want to invest in a country where they feel their money would be safe. In the United States, we have worked on that for over 200 years. It doesn’t happen overnight,” Greenspan said.

Right now, the only serious threat to the U.S. dollar’s international dominance is the euro. Even so, the Russian ruble has come along way since the 1998 default, and it is about time for the perceptions to catch up with the new reality. If only politics would cooperate, both the international role of the ruble and Russia’s rightful place in the economic G8 would be assured.

Last updated 8 august 2007, 13:36

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