Clare Nuttall in Almaty -

The Central Bank of Russia's (CBR) injections of short-term liquidity into Russia's banks were largely responsible for the $130bn capital flight from the country in late 2008. If these investments continue, the ruble will remain under heavy pressure and Russia is in danger of entering a negative cycle of depreciation and inflation, analysts argue.

From April, the Russian government initiated a series of capital injections to support the banking sector. The CBR stepped up its role in the final three months of the 2008, increasing investments into commercial banks by $60bn in October to December.

The CBR hoped to reboot the corporate and retail lending markets, which had stalled due to banks' concerns about an increase in bad loans. Non-performing loans (NPLs) reached 1.7% in November, compared with the second-half 2008 average of 1.3% and were significantly up to 3.8% in December. With risk sectors such as construction, metals & mining and transportation, accounting for around 20% of total loans (see table below), NPLs could reach as high as 10-15% in the first half of this year.

Unfortunately, the CBR's investments were of little use in stimulating lending, since the majority of funding was provided for just four to five weeks. Moreover, Alfa Bank points out in a report "Ruble Depreciation: A Vicious Circle," the "unstable exchange rate prompted a number of market participants to build foreign currency positions with the available ruble funding."

Russia saw a massive $130bn net capital outflow in the final quarter of 2008 (see graph below). The majority of this exodus was from local banks, companies and individuals; foreign investors are estimated to have been responsible for only around $30bn of the total. "This outflow was so large because the central bank injected a huge amount of liquidity to deal with the liquidity squeeze in October-November," Alfa argues in its report. The authors consider that the depreciation of the ruble is mainly a consequence not of falling oil prices, but of capital outflow. Its report points out that the main negative in the fourth quarter of 2008 was the capital account. By contrast, the economic problems the country has been experiencing have not yet been reflected in the current account to a large extent. A decline in imports during the fourth quarter of 2008 partially offset falling export revenues.

Speculation as to whether the CBR would decide to float the ruble exchange rate came to an end on January 22, when CBR Chairman Sergei Ignatiev announced the bank would merely widen the range, raising the upper limit of the basket to 41. The previous three weeks had seen a dramatic flight to foreign currency after the CBR depreciated the ruble to the basket by 8% in the first working week of the year. The CBR lost $30bn in the week of January 9-16, and bought $7bn-8bn from the market between January 20 and January 23. The CBR's subsequent decision not to float the exchange rate indicates that the bank plans to continue to control the market.

Alfa's report states that the key to maintaining the ruble rate is the amount of ruble liquidity the CBR provides to banks. To date, it has injected a total of RUB1.8 trillion into the banking system, of which around $38bn has been converted by banks and deposited in the CBR's correspondent account. Alfa calculates this is equivalent to the total foreign debt repayments Russian banks will have to make in 2009, and that Russian companies appear to owe a similar amount. "In other words," says the report, "if the CBR does not increase ruble liquidity in the banking system, capital outflow could stop or even reverse."

Alfa forecasts that under favourable economic conditions - oil at above $40 a barrel and the dollar/euro at 1.5-1.6 - the ruble exchange rate could stay at RUB32-35/dollar, if the CBR reduces its liquidity support to the banking sector and the Russian government runs a modest deficit of 1% of GDP. "However, if the CBR continues to support banks at the current level, the fiscal deficit will put additional pressure on the exchange rate market starting in mid-2009," the report forecasts.

"Recent reports that some $38bn of CBR reserves is deposited in banks' foreign currency correspondent accounts are clearly bad news. We estimate that this revaluation of CBR reserves is pushing the value of the ruble exchange rate down by RUB5/dollar. Thus, as the reserves structure is currently deteriorating and we expect the fiscal deficit to be close to 4-5%, the ruble exchange rate may drop to RUB37-40/dollar by the end of the year, in our view."

Alfa further argues that allowing the ruble to depreciate would not benefit the Russian economy, but would merely push up inflation. The data - including a 10.3% on-year drop in industrial output in December - suggests a hard landing for Russia. Alfa's forecast is that GDP will decline by 3 percentage points this year.

Disposable income growth was down to just 5% in the first 11 months of 2008, compared with 7.8% in the first 10 months, showing a significant slowdown in November. However, negative real interest rates on local deposits and the official forecast of 13% inflation in 2009 have caused many households to withdraw their savings and spend their money instead.

Alfa forecasts a lag in the fall of consumption, but says this will be only temporary. "The erosion of savings will play a large role in helping to avoid a sharp drop in consumption in the first quarter; however, such a drop will be inevitable starting in the second," Alfa writes.

"The more volatile ruble and expectations of higher inflation (even the official forecast is 13%) are leading households to reduce saving in favour of consumption. This trend is not sustainable, since the weaker ruble does not increase competitiveness when global demand is declining. The negative consequence of this policy is that Russia, rather than taking advantage of the "lost year" 2009 to increase interest rates and carry out modernisation, will turn into a subsidised economy."

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