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.