Jacob R Nel of JP Morgan -

The scale and consequences of Russian state support to VTB to cover the losses arising from the Bank of Moscow acquisition are not yet fully clear, but we see a structural impact, including the risk of an increased Russian discount and moral hazard, and a macro impact, including a budget hit of 0.3-0.6% of GDP and a 4% spike in liquidity.

An increased Russian discount? The bailout to cover the reported RUB150bn 'hole' at the Bank of Moscow raises serious questions about the quality of corporate governance/ reporting in general and of banking supervision in particular in Russia. To what extent can investors rely on statements audited in Russia and subject to supervision by the Russian authorities, particularly in cases where the beneficial owner is politically powerful and connected? A high level of disclosure would be beneficial to clarify whether this was a one-off or a systematic problem, and identify appropriate remedies.

Moral hazard of repeated bailouts: The bailout, two years after the central bank last provided large-scale support to VTB, increases the risk of moral hazard at large Russian companies. In particular, since they benefit if a risky decision pays off, and the state bails them out if the risky decision fails, they have an incentive to take excessively risky decisions. At the same time, this discretionary state support creates an unfair playing field, since smaller Russian and foreign companies do not benefit from the same level of support. The likely consequence is less competition and too many risky decisions, leading to lower growth and higher social costs.

Direct fiscal cost of up to 0.6% of GDP: Although the details of the scheme are not clear, with a loan from the CBR to the Federal Deposit Insurance Scheme and a loan from the Federal Deposit Insurance Scheme to the Bank of Moscow, the fiscal cost is substantial at 0.3-0.6% of GDP. In return, we assume that the Russian budget will now receive smaller transfers of central bank profits in 2011 and future years, which in the worst and unlikely case of no repayment could amount to the face value of the RUB295bn loan and in the success case would amount to the reported RUB150bn interest rate subsidy on the 10-year loan. Hence, there is a risk of a budget deficit this year compared to our forecast of a balanced budget.

We suspect, however, that the issue will be fudged, ie. not fully recognised in the fiscal accounts, and only the 2011 interest rate subsidy of RUB5.6bn (7.5% interest rate subsidy for six months on a RUB150bn loan) will be reported, which is small enough to be buried in other items in the supplementary budget currently going through the Duma.

Extra 4% increase in the monetary base: Finance Minister Kudrin has promised that he will act to offset the inflationary increase in the money supply by increasing OFZ issuance and reducing consumption of surplus oil revenues. However, we are sceptical that the liquidity can be fully achieved through fiscal policy. The budget is moving from a contractionary first half which has successfully curbed inflation, with tight controls on spending and aggressive OFZ issuance, to an expansionary period in advance of the elections, with for instance the supplementary budget introducing large increases in pay for the teachers in September, and Budget 2012 introducing large increases in pay and pensions for the military from January 2012.

Against this background of fiscal policy moving sharply from contraction to expansion, we expect an increase in liquidity in the autumn, which would push the CBR, assuming it still remains focused on achieving its inflation target, to resume tightening and to accommodate RUB appreciation pressure by widening the bands again around the central rate rather than buying dollars and creating additional ruble liquidity. The VTB bailout, in our view, will exacerbate these pressures.

Bottom line

Structural: The structural issues of the Russian discount and moral hazard require major structural reform to resolve. In our view, President Medvedev has broadly identified the key issues which need to be tackled in the measures that he has laid out in his key policy speeches at Davos, Magnitogorsk and St Petersburg this year, and a good start has been made with some key issues such as the police reform and privatisation. However, implementation is a medium-to-longterm issue, and subject to a wide range of risks, and success will require, among other things, the willingness to take on vested interests and the strength not to spend windfall resource revenues.

Macro: In terms of the policy stance, we think that we are now in the summer lull, and expect the RUB to trade sideways until the autumn, given the CBR pause in tightening as the new harvest drives food prices and headline inflation down.

However, the additional liquidity from the VTB bailout, on top of the liquidity from the pre-election shift to fiscal expansion, increases the likelihood of monetary tightening this autumn, in our view. We reiterate with higher conviction our view that the CBR will raise deposit rates - which the CBR has called the key monetary policy rate in a situation of excess liquidity - by a further 50bp to 4% by year-end. Moreover, against the background of our view of continued high oil prices and current account surplus, and a diminution in capital outflows due to a moderation in reform-related outflows, we also expect to see the CBR accommodate pressure for further RUB appreciation this autumn - to avoid buying dollars and increasing ruble liquidity - by widening the bands around the central RUBBSKT rate by a further RUB and allowing further appreciation of the RUBBSKT to 32.5 by year-end.