Ben Aris in Moscow -
After crashing in December, Russia's ruble has made a remarkable comeback since February by rising about 15% against the dollar, making it the best performing currency amongst the 14 in Emerging Europe so far this year, according to Bloomberg. And the appreciation of the ruble is not over, argues Alfa Bank chief economist Natalia Orlova; the ruble could appreciate by as much as a third over the rest of this year if things go well.
You don’t need a PhD in economics to see that the ruble was oversold during its collapse from the mid-50s in November to a low of RUB80 to the dollar in the depths of the panic in December. But it bounced back into the 70s and then 60s very fast.
"Based on this metric the ruble fair value came out at RUB56/$ by the end of 2014, with this indicator providing correct signal of the ruble depreciation. However, and similar to previous benchmarks, it has underestimated the scale of the ruble’s slump, [and] did not justify a drop to RUB80/$ that was seen in December," said Alfa Bank's Orlova in a report entitled, "Ruble 2015: Appreciation Is In The Air", which was released at the end of February, referring to one of several methods she used to estimate the fair value of the ruble.
In general, Orlova concludes that the ruble was overvalued by about 20% in line with other emerging market peers, but the 40% fall in its value was exceptional. Accepting that the ruble was oversold, the difficult part is working out exactly where the "fair value" of the ruble should be now, once investors switch back from judging the situation using their spleens to using their heads.
After falling to as low as RUB70.05 to the dollar on February 1, the ruble has done a lot better since than anyone could have hoped for. By March 4 it had strengthened to 61.718 against the dollar, bringing its loss in 2015 down to only 1.5%. However, the ruble still has a lot more ground to make up, as it remains 41% down on where it was at the start of 2014 when it stood at about RUB34 to the dollar.
The fall of oil prices by 44% in the last 12 months is largely to blame for the collapse of the ruble's value, but it’s not the only culprit; Brent oil was trading at $60.72 on March 4 having recovered from lows of below $50 in December.
The collapse of the ruble has been a nightmare for the Central Bank of Russia (CBR), which is caught on the horns of a choice between fighting inflation and defending the ruble's value by hiking interest rates, and slashing rates to spur moribund economic growth; Russia's economy grew by a pathetic 1.1% in January according to the latest data.
The upshot is the CBR’s carefully laid policy plans, and a switch to inflation targeting in particular, have all gone out of the window. The "free float" of the ruble formally introduced on November 10 has turned into a "dirty float", as the bank has regularly been intervening into the market to "smooth" the excessive volatility of the currency – something it is now trying to avoid.
"Four months [after the debacle in December], it is clear that the ruble exchange rate can exhibit extreme levels of volatility, building a preference for a dirty float approach as opposed to the announced free-float policy," says Orlova. "This is confirmed by the authorities’ decision to force exporters to sell their export revenues on the market, as well as by more active Finance Ministry forex sales. Even if the CBR is not present directly on the forex market, it is very hard to see the current regime as a free-float in the full sense of the word."
Abandoning the exchange rate corridor (a pre-set forex trading banned maintained by the CBR) has always bled Russia of its hard currency reserves in previous crises, as the CBR is obliged to intervene when the exchange rate bumps up against the boundaries, creating a one-way bet for forex traders. Last year in October alone the CBR was forced to spend $30bn to keep the ruble in the band, before finally abandoning the exchange corridor in November, two months earlier than planned. However, the central bank's total absence from the market in December as the ruble crashed was widely criticised, freaking traders out and making the selloff even worse than it might have otherwise been. The ruble/dollar exchange rate plunged from about RUB54 to the dollar in the autumn of 2014 to a low of RUB80, before recovering to the RUB61 it was trading at the time of writing on March 7.
Where is fair value now?
Alfa Bank predicts a possible 30% upside for the ruble over the course of this year. But guessing what will actually happen is fraught with difficulties, simply because so many unknown factors go into the calculation.
There are various ways of estimating the fair value of a currency and comparing it with other emerging markets or other petro-economies is a good place to start.
On this basis the ruble does very well and should have a fair value of RUB50 and RUB45 respectively. "A comparison of the ruble with other EM currencies shows that its depreciation was mostly in line with its peers from 2002 to 2014," Orlova said in her report. "However, mapping a currency against the average is a very vague approach. Russia’s macro fundamentals are strong as opposed to a number of EMs; particularly it has very little state debt of 16% of GDP, suggesting that the ruble should tend to be one of the stronger EM currencies. At the same time, the country’s growth potential is weakening, putting pressure on the ruble’s performance. An additional and new issue is to what extent Russia can be treated as part of this country group under sanctions."
Another way of looking at the value of a currency is to use a purchasing power parity (PPP) approach; equivalent goods should be worth the same in different countries, as made famous by the Economist's Big Mac Index. But this doesn’t work well for Russia, as the Big Mac Index has suggested the currency should appreciate by 70% for most of the last decade – although the numbers are confused by two sharp devaluations in 2009 and 2014.
Alfa also tried the "money metric" approach, which is basically working out what would happen if every single ruble in the country is converted into foreign exchange (a function of M2 and M0 money supply, the value of CBR loans to banks, as well as the size of the hard currency reserves). "Inflation becomes a crucial assumption here: under 10% CPI growth and $60 [oil] the fair ruble value should be RUB61 while with inflation at 15% it should be RUB63 in 2015," Alfa Bank concluded.
Inflation has already climbed to a projected 16.7% in February, the fastest rate since 2002. The CBR’s governor, Elvira Nabiullina, has gone on record as saying that the ruble is oversold and inflation is not being driven up by monetary policy choices but factors outside the control of the CBR, such as Russian President Vladimir Putin's sanctions on the import of EU agricultural products. This "it’s not our fault" logic led Nabiullina to make a surprise cut of 200 basis points to interest rates, bringing them down to the still high 15% on January 30 in the hope of spurring lackluster economic growth without fuelling inflation. Policymakers are weighing whether they can make further cuts at their next meeting on March 13, but clearly the CBR will continue to cut rates aggressively if they think they can get away with it.
Lots of factors are weighing on the exchange rate, but oil prices remain the dominant force; with nearly two-thirds of the federal budget revenue derived from oil export taxes clearly the value of the ruble is heavily dependent on the price of a barrel of oil. With Opec apparently in a fight with US shale oil producers for market share and an uncertain outlook for the global economy, and hence oil demand, this year the prospects for oil prices are very uncertain, although bne IntelliNews' Liam Halligan argued in a recent column that oil is likely to rise towards $100 over the rest of this year.
Orlova calculated the ruble's value on the basis of $60, $80 and $100 oil and estimates the ruble/dollar exchange rates at RUB63, RUB55 and RUB49 respectively. "Both the monetary and the real exchange rate metrics imply that if oil stays above $60/bbl on average in 2015, the ruble has strong upside potential. This take is in line with our current RUB55/$ 2015YE exchange rate forecast, which we reiterate," says Orlova.
Oil was trading at $61 as of March 6, but while a further rise in oil prices by $10 or $20 would be more than welcomed by the Russian exchequer at the end of the day, even this will not help if the CBR cannot get control of inflation as a prerequisite to launching the investment growth needed to increase productivity and drive GDP growth, says Orlova. And that is something the CBR does have control over.
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