A Primer on Russian Ruble Overvaluation

Bloomberg, June 30.

Goldman Sachs Group Inc. exited a bet that the Canadian dollar would strengthen versus the Mexican peso after the trade lost about 5 percent.

“Recent data points have gone against our fundamental views of continued stabilization in Canada and a lagging recovery in Mexico, relative to the global cycle,” analysts at Goldman Sachs wrote today in a note, citing worse-than-expected Canadian retail sales and jobs numbers, and a less-than-forecast drop in Mexican industrial production.

Below is a short and simple primer of how to research fundamental currencies valuation that would allow to come up with better results than with using Goldman Sachs analysts "views". I used more sophisticated versions of this basic method in a number of successful algorithmic currency trading strategies that consistently produce superb absolute returns (20-40% percents per month).

This particular primer is following the article:

"How much is the Chinese currency undervalued?
A quantitative estimation" by
Gene Hsin Chang, Qin Shao
China Economic Review 15 (2004) 366– 371

It is based on Balassa-Samuelson model and cross-sectional estimation of model parameters according to snapshot done in 2001. The numbers in this primer are purely for illustrative purposes and they should not be used in any financial advice or recommendation.

The currency is Russian ruble (RUR), the economic growth and inflation numbers were taken from official Russian Central Bank statistics, the numeraire is US dollar (USD).

For Real Exchange Rate dynamics we have

ΔRER = ΔE + ΔP* − ΔP

where ΔE is the change in the nominal exchange rate , ΔP* is inflation in the country of currency pair numeraire (set at 2.5% for US for simplicity), and ΔP is the inflation in the country of currency of interest.

If ΔE is positive the currency of interest depreciates in relation to numeraire.

Inflation in Russia has been 15.1% in 2002, 12% in 2003, 11.7% in 2004, 10.9% in 2005, 9% in 2006 and 11.9% in 2007 (according to Russian Central Bank).

The rouble nominal exchange rate (to USD) appreciated by -7% in 2002, 3.8% in 2003, 6.5% in 2004, 1.9% in 2005, 4% in 2006 and 6.3% in 2007.

The growth of GDP in Russia was 6.2% in 2002, 7.7% in 2003, 6.6% in 2004, 8% in 2005, 8% in 2006 and 9.5% in 2007.

Initially undervaluation of Russian currency according to paper was 0.4% in 2001.

Actual Russian RER appreciation:

ΔRER2002 = 7% + 2.5% - 15.1% = -5.6%
ΔRER2003 = -3.8% + 2.5% - 12% = -13.3%
ΔRER2004 = -6.5% + 2.5% - 11.7% = -15.7%
ΔRER2005 = -1.9% + 2.5% - 10.9% = -10.3%
ΔRER2006 = -4% + 2.5% - 9% = -10.5%
ΔRER2007 = -6.3% + 2.5% - 11.9% = -15.7%

Total RER appreciation since 2001 is thus

-5.6 - 13.3 – 15.7 – 10.3 -10.5 -15.7 = -71.1%

To get actual RER in 2007 we start with given RER in 2001 (3.32) and chain-link all changes since.

RER2007 actual = 3.32*(1-0.056)*(1-0.133)*(1-0.157)*(1-0.103)*(1-0.105)*(1-0.157) = 1.55

The real Russian GDP per capita in 2007 is

GDP2007 = 7,100*1.062*1.077*1.066*1.08*1.08*1.095 = 11,056

Using coefficients obtained in paper for correlation between RER and GDP we get

RER 2007 predicted = 4.16 - 0.12*11,056/1000 = 2.8256

(RERpredicted - RERactual)/ RERpredicted = (2.8256-1.55)/ 2.8256 = 45.1%

The Russian Ruble became overvalued up to 45.1% in 2007 from being undervalued by 0.4% in 2001.

Those calculations were done in the June of 2008. The ruble collapsed in the Fall of 2008 by 20% following hugely wasteful, badly executed and destined to fail attempts of Russian Central Bank to intervene. Of course, their analysts and international finance specialists are even worse than the ones Goldman Sachs used in the cited newsclip.

After Russian ruble collapse this method was reapplied to the end of 2008 with official inflation 13.6% in 2008, ruble nominal US dollar exchange rate appreciation of minus 20% and 5.9% official GDP growth.

Even after collapse of last Fall the Russian ruble is still fundamentally overvalued by 38.5% at the end of 2008.

In combination with recent data on double digit negative GDP growth in 2009 and high probability of energy price bubble collapse the model predicts further weakening of the Russian ruble according to fundamental factors. Considering that exchange operations are still strictly controlled by the Russian State, this fundamental weakening might again take the form of sudden run on the currency.