Will the Russian CBR tighten in January?

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This post is a guest contribution by Jacob Nell of Morgan Stanley.

Food prices continue to fuel inflation in 1Q11: 2010 saw inflation of 8.8%, led by food price inflation of 12.9%. Inflation rose by 1.4% during the first two weeks of January to an annual rate of 9%, driven by further increases in food prices and in the price of regulated services, which are usually raised in January.

In addition, there are very high levels of RUB liquidity – just under RUB 1 trillion, or over 2% of GDP – held by commercial banks as deposits at the CBR, following a bigger-than-expected December spending surge, which poses an inflationary threat.  We expect January inflation at 2.5%M, which will push the annual rate to 9.7%Y.

We think the hawks will prevail in January: First Deputy Governors Melikian and Ulukayev’s contrasting statements are a reminder that the costs of inflation and the pace of tightening remain controversial topics within the central bank.  The pro-growth camp are cautious about raising rates because of the negative short-term effect on lending and growth, and the risk of RUB appreciation, and do not see inflation as a major threat.  The orthodox camp believe that the primary task of the central bank is to deliver low and stable rates of inflation. We view the December decision to hike deposit rates by 25bp, despite the commitment given in October not to hike “in the coming months”, as a sign of growing CBR concern that inflation expectations have risen. The accelerating January inflation (particularly for highly sensitive staples such as buckwheat and potatoes), the high level of RUB liquidity and the need to establish the credibility of the move away from exchange rate targeting further strengthen the tightening case.

A Tightening Package, Not Just a Rate Hike

Tightening likely to focus on CBR deposit rather than lending rates: At the moment, reflecting the high level of RUB liquidity, banks are not borrowing in significant volumes from the CBR.  The Lombard facility is practically dormant, the repo facilities are used for c.US$1.5 billion per month versus US$15 billion per day during the crisis, while banks borrow about RUB 1 billion a day overnight from the CBR at the refinancing rate on average.  In comparison, the banks have nearly RUB 1 trillion on deposit at the CBR. Tightening the deposit rate will thus have a larger impact on market rates, which are currently trading at the short end below the CBR’s 2.75% overnight deposit rate.  We expect the CBR to raise deposit rate in an incremental step of 25bp, as usual, but a larger move is possible.

CBR will also use reserve requirements to reduce liquidity, in our view: Given the underlying pressure for appreciation from the strong current account surplus (see below), Russia’s exchange rate sensitivity and the problem of sterilising intervention, we expect the CBR to use additional tools to constrain liquidity.  Both Ignatiev and Ulukayev have mentioned the use of reserve requirements in recent public statements.  Other EM central banks, including China, Turkey and Israel, have recently raised reserve requirements.  Average required reserves held at the CBR are RUB 228 billion at 2.5% RRR, which implies that each 1% increase in the RRR would reduce RUB liquidity by nearly RUB 100 billion.

Pressure for RUB appreciation: We expect a US$70 billion current account surplus in 2011, driven by high oil prices (averaging over US$96/bbl in 2011).  Even allowing for low gas spot prices constraining Gazprom’s ability to raise European sales, and for strong import growth, driven by rising investment and consumption, we forecast a current account surplus in 1Q11, when there is a seasonal slowdown in imports, of nearly US$40 billion, and a surplus of US$70 billion for the full year.

Current account surplus will outweigh potential capital account outflows, we think: Even if there continued to be net outflows on the capital account at the US$30 billion level of 2010, this would be outweighed by the expected US$70 billion current account surplus, and result in an accumulation of reserves of US$40 billion in 2011, and corresponding pressure for RUB appreciation.

In addition, we expect FDI and external lending to Russian corporates and banks to increase in 2011, reflecting factors such as Russia’s improving credit and growth prospects, the recent pick-up in the number of major foreign investment deals (including the US$5.4 billion Wimm-Bill-Dann acquisition by PepsiCo, and the US$7.8 billion Rosneft-BP share swap and South Kara sea exploration JV), a strong pipeline of Russian companies doing IPOs, the government’s US$30+ billion privatisation programme, and Russia’s impending WTO accession.  On the CBR’s forecast, net flows on the capital account will be -US$10-+US$15 billion in 2011, an improvement of US$20-45 billion compared to 2010.

How much higher can it go? Since end-December, the RUB has appreciated by 1.5% in nominal and 2.7% in real terms versus the basket, and it now stands at 34.57 to the basket. With Russia’s strong position on the external account, and the CBR announcing that it will not intervene to maintain a particular exchange rate (see the quote below from Governor Ignatiev), we see strong pressure for further appreciation, which will run into three headwinds:

“The thing is, in previous years we had a “soft” commitment to prevent an increase in the real effective exchange rate of the ruble of more than a few percent.  This commitment constrained us in achieving our inflation target.  Now we no longer have such a commitment – we track neither the nominal nor the real exchange rate.  The floating currency corridor is designed solely to limit sharp fluctuations in the exchange rate”. Governer Ignatiev, Kommersant, December 23, 2010

Technical: The CBR has a floating corridor at around 33-37 RUB to the basket, and has set the cost of moving the corridor at a cumulative US$650 million of intervention for every 5 kopeck shift in the corridor.

Political: As the RUB strengthens, particularly if it strengthens rapidly, political sensitivity to the exchange rate increases.  However, the RUB is now trading at its highest ever level in real terms, without inciting much discussion

Economic: The IMF’s fundamental analysis suggests that the RUB would be fairly valued on a PPP basis at the level of 23.4 to the basket at end-2011.

We see the RUB appreciating up to 34 to the basket by year-end, or by a further 8.4% in real terms.  We compare our year-end forecast against indicative levels at which the headwinds make appreciation increasingly unlikely. The political headwind is assumed to arise at 12% real appreciation, the technical headwind after US$40 billion accumulation of reserves and the economic headwind when the market rate is equal to the PPP rate.

Against the background of the strong external account in 1Q, it is possible that further appreciation could happen rapidly, with this week’s rate hike decision and President Medvedev’s Davos speech, which will emphasise that Russia is now open for investment, as possible triggers.

Source: Jacob Nell, Morgan Stanley, January 25, 2011.

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