Alfa Bank -

Economic and currency policy at a crossroads. Inflation of 0.8% MoM in September reported by Rosstat last week is likely to have a significant impact on many sectors of the economy, ranging from the financial sector and services industry to exporters and domestic consumer producers. We believe that last month's CPI is a clear indication of growing problems in Russia's economy, and a signal that economic policy needs to change.

However, we remain skeptical as to whether the cabinet will respond sufficiently to this issue. The reason being that effective action to rectify the current economic problem would entail wholesale restructuring of the agricultural sector (one of the strategic objectives set out by the government), which is something that the cabinet is unlikely to do before the Duma and presidential election campaigns are concluded.

Inflation risk: avoid banks, invest in food producers. Rising inflation could harm Russia's economic growth, which is also under threat from lower capex and a persistent liquidity problem in the banking sector. We advise caution to those planning to invest in mid- and small-sized Russian banks, which are likely, in our view, to be burdened with a protracted period of high refinance rates. We believe that domestic producers of consumer goods and exporters will encounter stiffer competition due rising local costs. At the same time, we believe that local agricultural and food producers, retail chains, and services companies are likely to encounter a more attractive operating environment following price increases and a continuing shift in consumption preference towards more expensive products. While it is unclear if the latest inflation surge will lead to a new wave of ruble appreciation, we think that the attractiveness of ruble-based investments in comparison to other currencies is definitely on the rise, as currency depreciation risk disappears.

Food prices reflect the liquidity squeeze

Food prices in Russia on the rise ... A Rosstat statement suggests that September's 0.8% MoM rise in CPI stemmed primarily from a significant increase in food prices. Last month, Rosstat registered a price increase in 89% of the total number of surveyed food price groups; which is a record.

This has wiped out the positive seasonal effect that the decrease in fresh fruit and vegetables prices (down 8.8% MoM) traditionally brings during October.

While the rise in food prices is partially attributable to imports - following the removal of price subsidies by the EU - we believe it is also an indicator of a broader rise in agricultural commodity prices globally. Until recently, the rally in industrial commodity prices had very limited impact on agricultural stocks. However, it is unclear how and when the continuous rise in energy, equipment and transportation costs will begin to affect agricultural producers. We believe that September's rise in CPI is an overdue global price adjustment - and is unlikely to be the final one.

Global rates could keep on rising. The surge in food prices - which constitute the largest component of the consumer price index in many transition economies - is clear evidence that inflationary pressure is building up. This build up of inflationary pressure could have a direct influence on future monetary and interest rate policies worldwide. On the same note, we agree with Alan Greenspan's assessment that it is difficult to expect central bankers to continue cutting rates if inflationary pressures rise on all fronts. In other words, upward movements in agricultural prices leave very little room to continue with a soft credit policy; if anything, they send a clear-cut message that global liquidity is well on the road to becoming more expensive.

CBR likely to tighten its monetary policy. While the US subprime mortgage crisis and the ensuing global credit crunch might have somewhat postponed a more vigorous response by central bankers to the growing threat of inflation, the delay means that future responses to anti-inflation response will likely be more painful. For Russia, that means diminishing hope of the Central Bank adopting a softer monetary policy, and will, we believe result in greater problems for higher-risk borrowers and non-liquid entities within the financial and banking sectors. This could herald bad news for Russian corporates, many of which continue to encounter problems finding cheap options to refinance their massive debt of $212bn.

Government options remain limited

Growing inflation a political nuisance for a cabinet ... September CPI has effectively put a damper on the government containing inflation within their forecast of 8%, and is a set back for both the cabinet and the Kremlin in the wake of the looming election battles. Moreover, the positive effects of recent plans to significantly increase state salaries and pensions will likely be wiped away by galloping inflation. This leaves the government in a weak position to resist new populist calls for even higher wage hikes. The current scenario is exactly what President Vladimir Putin's cabinet has tried to avoid over the past few years: a vicious cycle of higher inflation followed by higher budget spending that eventually leads to even higher CPI.

There are basically three ways by which the government and the CBR can respond to the build-up of inflationary pressure. These options are:

! Price regulation. This would appear to be the most straightforward option, which from a Russian perspective - given decades of state regulated prices by Soviet governments - should have no trouble gaining widespread popular support. Even before the release of the latest inflation data there were calls from within the Duma and United Russia that Russia needs a proactive state pricing policy that could include regulating maximum price levels for basic food products, including bread and milk, as well as the introduction of a new export/import duties. While we believe that the possibility of the government adopting fixed prices is low, it cannot nevertheless be fully ruled out. On the other hand, growing inflation will pose a serious obstacle for the more contentious increases in stateregulated tariffs such as domestic gas prices, electricity, rail, and community services.

! Government spending controls. The need to keep more stringent control over budget spending has been a key principle of Russian financial policy over the past 7 years. However, in the past twelve months voices of the more vehement guardians of this policy - notably, that of Finance Minister and now Deputy Prime Minister Alexei Kudrin - have taken a much softer tone after the Kremlin chose to build its next election platform around a more socially-responsive policy that incorporates large budgetary payouts through wage increases and higher investments in a spectre of domestic industries. Since it is unrealistic to expect this policy to be dramatically revised before the Duma and presidential elections have taken place, we believe that any unpopular decision is likely to be postponed for at least another 10-12 months.

! Exchange rate manipulation. Ruble appreciation against other major world currencies has formed the core of the present government's anti-inflation policy for many years. Until recently, this tool seemed to be relatively effective and painless, given that Russia could still utilize currency growth potential stemming from the ruble's massive depreciation in 1998-1999, along with the competitiveness of locally produced goods against more expensive imports. However, over the past two years, the continuation of proactive exchange rate-based anti-inflation policy has become much more difficult, as the real ruble rate has reached pre-crisis levels, while income rises have pushed many consumers towards imported goods, leaving a growing number of domestic producers struggling to compete. While there is heated debate over the future of this policy at all levels of government - including the Kremlin - one thing is clear, in the short-term, manipulation of the ruble rate remains the most effective anti-inflation tool. Ironically, the stronger the ruble is (and, consequently, the greater the population's ability is to purchase imported goods), the more effective it is as a tool to control inflation. Today imports account for 45-50% of all food consumed in Russia, compared to 25-30% in late 1990s. In some metropolitan areas this share is as high as 60-70%.

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