Ian answers: McKenzie, the quickest way to answer your question is to argue that the rouble (RUB) fell because more people wanted to sell it than those who wanted to buy it. The mechanics of supply and demand provide an answer.
However, you should not be satisfied with that simplistic explanation.
A more complete answer needs to explain how exchange rates work and the role uncertainty plays in determining supply and demand in investment decisions. When an event such as the Ukraine crisis happens, uncertainty can rise and exchange rates can change very rapidly.
What is the Ukraine crisis?
The Ukraine crisis in early 2014 relates to political decisions around whether the Ukraine will move closer to the European Union and, as the Brookings Institution blogs, the reaction of Russia, a very powerful country in the region. The ramifications of this crisis are serious and widespread, and include loss of life as well as economic challenges.
For those watching financial markets, one of the very obvious effects is the one you have identified – the fall to an all-time low of the Russian rouble against the US dollar (USD).
Exchange rate basics
As many of us know from using bureaux de change when travelling, the price of a currency is expressed as an exchange rate. The exchange rate states the amount of a currency that needs to be paid to buy another currency. The most common exchange rate is against the US dollar.
At the start of 2014, when the situation in the Ukraine was relatively stable, RUB32.8 were needed to buy USD1. By 7 March 2014, with military and political tension heightened, RUB36.4 were needed to buy USD1 – a fall of 9.7% in the rouble.
It is important to note that a fall in the exchange rate of one currency must mean that there is a rise of another. In the example above, the rouble fell but the US dollar rose. This movement suggests that at that moment, many more people would prefer to hold their money in US dollars than roubles than in the past.
Exchange rates can be thought of as a price for a currency. But this price differs from other prices. For example, when buying bread you may pay one dollar. The bread is then eaten and that is the end of the transaction. When exchanging one currency for another, you get nothing directly useful. You cannot eat dollars or roubles. All you are doing is switching the way in which you hold your money. The value of that money exists only in its ability to buy bread or other useful things.
Trust is important to markets
In its simplest form as notes and coins, money is a simple concept. However, once we start to think of money consisting of bank deposits, loans and claims on governments, the concept gets more complicated, as the eZonomics article What is ... money explains. In this more complicated form, money is based on a complex set of relationships between banks, governments and individuals. For these relationships to work, a great amount of trust must exist.
There must be a belief that if a person receives a dollar, a rouble, a euro or another currency, they can then use it to buy something useful. However, if people become less confident that they can exchange the currency they carry for useful things, they may tend to reduce their holdings of that currency for another. In effect they choose to diversify their currency risk.
Large movements in exchange rates are usually driven by companies and investment groups switching their money balances from one currency to another. However, it is not unusual to find people in countries with weak economies or unstable institutions who hold their wealth not only in their domestic currency but also in a foreign currency – typically the US dollar, euros, Swiss francs or even gold.
Can trust make countries richer?
As economist and writer Chris Dillow blogged for eZonomics, trust may also play a role in making countries richer.
Dillow reasoned that without trust, “lots of economic activity simply wouldn't exist”.
He continued: “Not only wouldn't there be a market in used cars, but there wouldn't be insurance markets or banks. And it would be impossible to get people to invest in others' businesses.”
The fall in the rouble is not something to be taken lightly. This perhaps explains why the Central Bank of Russia responded to fall in the currency by raising interest rates to make keeping money in roubles more attractive and intervening in foreign exchange markets buying roubles and selling dollars to offset some of the fall in the currency.
Will the trust come back?
The fall in the rouble could be interpreted as a sign that people, companies and other institutions made a decision to switch at least some of their holdings of currency away from roubles. I do not believe these decisions were made because there was widespread concern that the government of Russia would not be able to support its currency. Rather, I think many people decided at the same time that other people would be less likely to want payment in roubles in the future.
Russia is a wealthy country with resources and energy products many people need and are willing to pay for.
What has been reduced is confidence and trust. The fall in the exchange rate reflects that.