Exchange Rate Determinants in Russia: 1992-93


WP/94/66-EA
Exchange Rate Determinants in Russia: 1992-93 by Vincent Koen and Eric
Meyermans


The adoption of a unified exchange regime in July 1992 was a major
step in opening Russia to the world economy and moving toward a market
system. Notwithstanding political turmoil, collapsing output, very high
inflation, large-scale dollarization, and occasional rumors about an
imminent return to a system of multiple exchange rates, this decision has
not been reversed. The expansion of the organized foreign exchange market
has been vigorous, though it started from a minuscule base. By late 1993,
regular spot auctions were being held at exchanges in six Russian cities,
and two futures markets were active in Moscow. Over time, the various
segments of the foreign exchange market have become increasingly integrated,
even if seemingly unexploited arbitrage opportunities have not disappeared
altogether.

Exchange rate policy has evolved roughly through three phases: (1) an
unsuccessful attempt in the spring of 1992 to move to a formal target zone
at the time of unification; (2) a managed float between mid-1992 and mid-
1993; and (3) a system of notional target zones or at least a regime of
large-scale smoothing in the second half of 1993. The real exchange rate
appreciated by more than 150 percent in the 18 months following unification,
thus reducing considerably, or possibly even reversing, what was perceived
by many as the large undervaluation of the ruble in mid-1992. This pattern
was broadly similar to what was observed in some countries in Central and
Eastern Europe at the same stage of the transition.

In order to provide a more formal evaluation of the behavior of the
exchange rate, a simple model of exchange rate determination is developed
and tested on weekly data. The empirical results suggest that the interest
rate differential and the expected inflation differential clearly have
influenced the exchange rate of the ruble vis-à-vis the U.S. dollar in the
short run. Moreover, the evidence seems to imply that market participants
have been aware of the risks associated with high inflation.

The sturdiness of the central exchange rate equation is tested by using
it for an out-of-sample projection. The abrupt depreciation of the nominal
exchange rate in January 1994, in stark contrast to its near-stability in
the previous half year, is well captured by the equation.