Tim Gosling in Moscow -

Russia's foreign exchange markets have been plagued by high volatility in recent weeks as a "return of risk appetite" rally starts to run out of steam. Investors are nervous about Russia's economic prospects amid rising speculation over the chances of another devaluation. Duma deputy and head of the Regional Banking Association, Anatoly Aksakov, was sacked earlier in August for just suggesting a drop of up to 30% was on the cards; but was this just a case of shooting the messenger?

Currently, the ruble remains bound to oil's apron strings. For instance, on August 17, the currency weakened by 0.66% (to 38.15 against the basket) as crude was hit, yet the following day, a small opening gain in oil prices saw it grab back 0.37%. As is common, nervous investors are taking oil prices as a proxy for the Russian economy, but the situation to the end of the year is far from clear.

In short, consensus suggests little danger of a dramatic drop for the ruble in the immediate future; however, opinion then diverges somewhat. In one camp, the anticipation is that exhaustion of the commodities rally, a climbing budget deficit, second wave of trouble for the banks, and extended sloth among domestic producers are almost certain to drag the currency lower by the end of the year. Alternatively, with the current account set to remain in the black (assuming oil prices cling onto at least $50), corporate debt now restructured and select indicators pointing to an economic recovery, others, such as Roland Nash at Renaissance Capital, are actually more concerned that the movement could head in the other direction. "The economy is obviously 11% smaller, but in much better shape," Nash told the Moscow Times. "Right now, there's more pressure for the ruble to appreciate."

While capital flows have been pushing the ruble higher recently, Ivan Ivanchenko, senior economist for VTB Capital, says that based on inflation rates, he sees no theoretical basis for an appreciation against the dollar. He does, however, agree with the danger that a stronger ruble poses for the Russian economy, with the second-quarter GDP reading illustrating that even at current levels, domestic producers cannot be roused to expand activity.

Bear truth

It must be said that the bears appear to have a more compelling case. Should commodities crumble and the banks get hit hard by non-performing loans (NLPs), then its one-way traffic for the ruble. While the volume of bad debt skulking in the cupboard is still anyone's guess, jitters traditionally haunt the populace and could easily spark household demand for hard currency. Meanwhile, based on fundamentals, this year's gains for oil and metals look shaky to say the least. Recent indicators - out of the US and China, in particular - have done much to flag up concern that hopes for the global recovery may have overshot, and sentiment and risk appetite have duly dipped. You'd be hard pushed to find an analyst bullish on commodities to the end of the year.

Meanwhile, although figures for the first seven months of this year (4.3% of GDP) put the budget deficit well ahead of the Ministry of Finance's target of 9.5% for this year, this offers room for loosening the purse strings. Analysts at Citigroup suggest the bulk of the government's stimulus spending will be skewed to the fourth quarter. Alfa Bank writes that, "for the deficit to reach the official forecast, another RUB1.7 trillion [would need to be] withdrawn from the Reserve Fund before year-end. This amount is large enough to keep volatility high on the exchange rate market. Given a budget deficit of 10% of GDP and an oil price of $55 per barrel, we would expect a RUB/USD exchange rate of 36.6 by year-end." Add in an expectation from Nash that the "next two quarters will see the highest amount of ruble debt issuance in the country's post-Soviet history," coupled with a recent trend for ruble debt to head straight into foreign exchange, and the evidence starts to stack up.

Consensus does coagulate again, however, in suggesting that longer term, a lower ruble will help speed the Russian economic recovery. Thus the opposing forces pressing on the currency shift the focus onto policy.

With few worries now over corporate debt, the potential damage from devaluation is political for the most part, with an inflation shock and consequent social concerns top of that agenda. While certainly not issues to be dismissed out of hand, it's hard to square them off against prolonging economic recovery. "You can have one or the other - either fix the FX rate or use monetary policy to help get credit markets running again," says Ivanchenko. "This is the core of the debate. At the moment, the Russian authorities are trying to juggle too many balls."

That's because in the Russian power vertical, it's politicians and not the experts at the Central Bank of Russia that call the shots. Thus the CBR spent about $200bn at the end of 2008 helping the ruble limp as gracefully as possible to a 36% fall against the basket, rather than letting it go with a bump. In reality, it was perhaps the only route to take - a rapid drop would likely have seen a lot more public panic cause a great deal more damage - but that is the result of the mistrust and confusion stirred up by the lack of clarity on the part of the authorities.

That, of course, is a much deeper and longer-term issue, but one that illustrates the knots into which one can tie oneself. "The CBR wants to see stability without intervention if it can - but they're not in the driving seat," says Ivanchenko. "If ordered to push the currency one way or the other, then they will do so. FX reserves maybe wouldn't last long, and then the only option would be to restrict the capital accounts - but that would wreck the aim of making Moscow a global financial centre."

Which way will the wind blow towards the year's end? On the one hand, although the CBR began intervention again in July (reserves dropped $10.6bn during the month as oil prices tested $60), the moves appear to be becoming less certain. For instance, a spike on August 12 saw the basket close at RUB38.53, with Vedomosti reporting that the CBR had held fire until it hit 38.90, with the volume of the intervention $0.5bn at most - four times less than the previous spike in July, according to Citigroup analysts. Meanwhile, interest rates have continued to soften, five cuts since April dropping the refinancing rate towards its limit at 10.75%. In addition, the CBR's armoury is low, with reserves having fallen to just over $400bn. On the other, the removal of Aksakov, and accompanying accusations from Duma Deputy Speaker Vyacheslav Volodin of a proposal "asserting the interests of oligarchs and big business against the people," suggest the politicians are not ready to abandon their interests to the market yet.

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