Ben Aris in Moscow -
Russia's central bank has been caught on the horns of a nasty dilemma: should it tackle rising inflation with more austerity or do Russian banks still need protection from the global liquidity squeeze via the pumping more cash into the system? Whatever it chooses to do, the growth of the Russian bank sector is going to slow next year. And if it gets it wrong, economic growth could be in danger too.
Both the Central Bank of Russia (CBR) and the government are struggling to fight a problem where they are damned if they do, damned if they don't. The upshot is that the white hot growth of the banking sector of recent years is likely to slow next year and if things go badly, the entire economy could stall. Inflation is only the manifestation of new forces at play in the international financial markets.
"Fundamentally, we are facing not just another bout of financial volatility," says Eric Kraus, the head of Nikitsky Russia/CIS Opportunities fund. "We are experiencing the economic equivalent of 'regime change'."
The stakes are rising as the CBR ponders its options. If the central bank tries to introduce tighter monetary policies, it risks seeing the lack of liquidity in the international markets force a Russian bank into default. But if it over-fluffs the liquidity cushion, it could end up fuelling inflation that will undo much of the progress of recent years. Inflation caught everyone unawares in September with an eight-fold increase month-on-month and it's not going to go away.
For the moment, the CBR is clearly still more scared of bank runs and a financial crisis than it is of rising inflation. It has chosen to support the bank sector and pumped in more money - both directly and by losing various obligatory requirements that affect banks' cash positions - than Russian bankers had been expecting. This also suggests the CBR's attitude to inflation has changed.
"The traditional approach of viewing inflation as the most important social threat is gradually giving way to another view. In previous years, at least a part of the Russian population had access to retail loans. The expectations of declining interest rates and accessible lending resources gradually became an important social consideration. The crisis of expectations for the retail lending market is now seen as a significant threat, affecting the general population's perception of the economic situation," Alfa Bank said in a comprehensive report in November.
Several other factors are at play here too. Previously, the need to invest into things like infrastructure or hike tariffs to provide investment capital was sacrificed to the goal of reducing inflation. However, as Russia's ongoing growth is clearly about to be constrained by the crumbling state of infrastructure, the Kremlin's attitude to spending its windfall petrodollars has started to change.
Analysts say the CBR will have to change tack by the end of the year and start to fight inflation again. While inflation is clearly going to rise in 2008, analysts believe the CBR won't tolerate inflation of more than 11% - about where it is now expected to be by the end of this year.
Worryingly, the state's first response to surging inflation in September was to turn to administrative controls that, at best, will only delay the problem for a few months. The government lent heavily on food producers, forcing them not to pass on the rising prices to customers. The government hasn't used arm twisting as an economic management tool for years and this return to a bad old habit is unsettling, flying in the face of the liberal market-oriented policies that the Putin administration has been following until now.
"The government has attempted to persuade major food producers and retailers to freeze prices on certain socially important, low-margin food products until February. However, we believe the measure will have little impact on the CPI, as price controls affect only a small range of products and only apply to large network retailers, while most food products are sold through smaller stores," says Alfa Bank.
Three factors will continue to drive inflation regardless of what the state forces the food companies to do: electricity and gas utilities need to finance their ambitious capex plans, which will result in continuing tariff increases; the gap between the industrial inflation index (PPI) and the consumer price index (CPI) continues to widen, which will also put upward pressure on prices; under pressure from a shrinking labour force, real salaries have been expanding at a double-digit pace for the past few years; and finally de-dollarization, which helped to reduce inflation last year, is no longer an important factor in the growth of monetary demand.
Foreign currency deposits now account for only 14% of Russians' total deposits, indicating the savings structure's low marginal sensitivity to ruble appreciation.
Bank growth to slow
There were 1,153 banks in Russia at the last count, but the sector's assets are highly concentrated in the top tiers and dominated by three state banks. Russia's largest bank, Sberbank, controls 25% of assets, and the next two - VTB and Gazprombank - control 8% and 7% of the country's banking assets, respectively. However, the rest of the banking system is fragmented, with 15 banks controlling around 1-4% of banking assets, and banks outside the top 30 controlling less than 0.5%.
"The huge number of banking institutions and the fragmented banking market makes the CBR's task of managing liquidity in the system quite complicated," says Erik DePoy, strategist with Alfa Bank.
As most of the most liquid assets are also in the very banks that are most likely to get bailed out by the state during a crash, the danger of a systematic failure of the bank system is less than it was in 1998. Plus, these banks are already being given extra cash as the state deposits budgetary funds in their vaults. But it also means that the CBR is relying on the state banks to channel funds to the smaller banks - VTB has already bought up some $300m of smaller bank loan portfolios and in October said it would by another $200m in a sector that has total liquidity of about $30bn.
The default of a bank - any bank, be it state or private - is the nightmare scenario, as the CBR would have to pump in liquidity across the board.
In order to nip bank runs in the bud, the CBR has been working overtime to make as much liquidity available as possible before things get out of hand. In addition to the $10bn-odd of cash it put into the system at the height of the crisis in August, the CBR has introduced the following changes to puff up the liquidity cushion:
--Expanding the Lombard list (the list of securities used for repurchase agreement, or repo, operations) on October 8 to include securities issued by some 35 additional entities. This is expected to provide banks with access to another RUB150bn ($6bn) in CBR support;
--Temporarily cutting obligatory reserves requirements (FOR) by 1% to 3% for retail ruble deposits and 3.5% for other deposits effective October 11. The CBR expects this measure to provide banks with RUB100bn;
--Cutting as expected the currency swap rate from 10% to 8%, which is used to alleviate interest rate hikes; and
--Direct six-month lending to a number of banks including VTB and URSA bank, which is having a direct impact on banking sector liquidity.
Still in the works, but coming soon are:
--Loans using Eurobonds as collateral;
--Potential amendments to the deposit insurance scheme, either raising coverage from RUB0.4m to RUB0.6-0.7m or cutting contributions from 0.13% to 0.1% of deposits;
--Funds from Treasury accounts currently totalling $60bn could be placed on deposit with banks; and
--Capitalizing the Russian Development Bank, which may also place unvested funds in banking deposits, as at least a part of its $7.2bn could be directed to banks this year.
"Clearly, most of these measures suggest an easing in monetary policy and over time - when the liquidity situation in the banking system is back to normal - will contribute to inflation early next year," says Alfa's DePoy.
The problems with the bank sector will almost certainly result in a slowing of growth in 2008. Bank sector assets grew by a quarter in the first half of this year - driven by the huge volume of IPO and bond issues - but both of these have since ground to halt. Retail deposits also stopped rising in October and as the amount of cash entering the system falls, the pace of bank growth will fall.
"A significant gap between the demand for loans and the supply of resources will materialize in 2008," says DePoy. "On the one hand, we initially expected Russian companies to borrow $60bn abroad, but the tough international market conditions are likely to increase local demand for loans. However, the very same factor suggests that the growth of corporate deposits will slow in 2008."
As a result, Alfa has cut its growth forecast for Russian banking assets to 20% on year in 2008, while the share of local funding (corporate and deposits) will increase from 60% of total assets in 2006 to 63% in 2008. It also cut the annual target for retail lending from $178bn as of the end of 2008 to $140bn, implying growth of only 33%.
The bottom line is that the slowdown in the bank sector's growth will shave at least 1 percentage point off GDP growth in 2008.
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