The ruble has increased in value this year and that’s a problem; it is smothering the nascent economic recovery and the Kremlin has already called on the Central Bank of Russia (CBR) to do something about it.
The Russian currency appreciated by about 10% by the middle of May, making it one of the best performing in the world. While most economists, banks and the government are using a working assumption of an exchange rate of some RUB60 to the dollar by the end of the year, there is considerable uncertainty. The range that the ruble could end the year at against the dollar runs from RUB55 to RUB70, depending on a slew of variables including the CBR’s policy rate, inflation, the current account deficit and, of course, the price of a barrel of oil.
The ruble's value has been extremely volatile in the last two years to say the least. In the depths of the oil crisis in December 2014 the currency collapsed to RUB80 to the dollar, and although it has since come back to around RUB60, this is still nowhere near the RUB35 to the dollar it was in the boom years.
The value of the currency is important as it will directly affect the speed of Russia’s economic recovery. Too strong, and the nascent import substitution is killed off; too weak and foreign machinery is too expensive to buy. Currently the ruble is already seen as too strong and that is hampering Russia’s growth prospects. President Vladimir Putin has already publicly called for a weaker ruble.
At a meeting with entrepreneurs in the Yaroslavl region in April, Putin said the government is looking for “market-based measures” to affect the ruble, and is monitoring what he deemed as the “key” issue of its stability “practically on a daily basis”.
But the central bank’s hands have been tied as it has single-mindedly focused on bringing down inflation to below its 4% target. Now that goal is all but achieved – inflation was 4.1% in May – the CBR has already started cutting rates and intervening on the FX market to weaken the ruble and so boost growth. The CBR already cut rates by a surprise 50bp in May and CBR governor Elvira Nabiullina has suggested there could be another cut of the same size at this month's meeting on June 16.
What underlay the ruble's strength in the first quarter were exceptionally strong exports, which produced a large current account surplus of $23bn that caught analysts completely by surprise.
Non-oil exports have been flat over the last four years, but suddenly thanks to the cheap ruble they soared by 18% in the first quarter y/y. Almost all the key non-oil export products – including metals, machinery and food – also showed noticeable growth.
But this large surplus is likely to evaporate – and soon. The ruble’s crash at the end of 2014 was painful, but the damage it did to Russian reserves was limited by the concurrent collapse in imports. As Russia emerges from its recession imports are rising again fast. After three years of consecutive declines, imports soared 25% y/y in the first quarter, with machinery (44%) leading the charge as firms took advantage of the strong ruble to shop abroad. The import of services also jumped 9% in the first quarter for the first time in three years and this trend is likely to continue as the nascent recovery gets underway this year.
A strong ruble makes equipment imports – already one of the biggest import items – cheaper and more available to businesses, while a weak ruble makes Russia’s non-oil exports more competitive. The Russian budget also has a built in correction mechanism so that as the ruble weakens it has more cash rubles to spend from its dollar-denominated oil tax revenues; the Russian government itself is a big winner from devaluation.
A weaker ruble should boost Russian exports, but the country has exported little in the last two decades other than raw materials and arms. However, following the 2014 devaluation Russian labour costs have become very competitive – the average Russian worker costs less now than his average Chinese counterpart. Companies such as carmakers are starting to talk about exporting their products to the rest of Europe and this trend should start in earnest in 2018.
Moveover, with the summer holiday season coming up and the limitations on holidays to Turkey lifted the current account will also feel more pressure from Russian spending oversees. Turkey has already seen the number of Russians arriving on its sun baked beachs soar by several hundred percent since the ban on package tours imposed after the 2015 downing of a Russian fighter plane by Turkey was lifted earlier this year.
Taken all together that means the current account surplus is expected to narrow from $23bn in the first quarter to $7bn for each quarter in the rest of the year, according to Gazprombank, and could even go into deficit of a few billion dollars.
Having freed the ruble at the end of 2014 the CBR managed to save most of its hard currency reserves during the ruble’s collapse. It was a painful decision, but instead of burning through its stockpile of dollars in an impossible defence of the ruble/dollar exchange rate, not only did the CBR keep most of its hard currency, but the amount of dollars it holds has since started to recover: as of the last week of May the CBR held about $400bn in foreign currency and gold, up from the $320bn nadir, but still off the $596bn peak in 2008.
Over the last two years the CBR has stayed out of the currency markets but that changed in February. The CBR has said that it wants to rebuild its reserves to about $500bn and will also intervene to smooth out the exchange rate volatility.
Analysts expect the CBR to use its interventions to weaken the ruble this year. In the first quarter the regulator’s FX purchases totalled RUB184bn ($3.2bn), with RUB54bn spent in April but less in May. However, the Russian Finance Ministry said on June 5 that it would increase its purchases of foreign currency on the domestic market more than fivefold in June to RUB45.1bn ($797.4 mn). The daily purchases will amount to around RUB2.1bn between June 7 and July 6, up from RUB0.4bn between May 10 and June 6, the ministry said.
These interventions had little impact as they were swamped by the $23bn currency account surplus inflows, but if the economists are right and the currency account surplus falls to $7bn, or even to nothing, then clearly the FX interventions will become significant and affect the exchange rate. The finance ministry has suggested it could spend up to RUB120bn ($2.1bn) a month on interventions.
“According to our forecasts, Russia’s current account surplus will shrink to just $2bn in 2Q17, therefore the FX market is more sensitive to MinFin’s actions, which however, as we understood, will have almost zero impact on the market in May,” VTB Capital said in a note.
The CBR won’t pull the trigger until the ruble reaches an “equilibrium” and policy makers are sure their actions won’t lead to faster inflation, according to Vladimir Tikhomirov, chief economist at BCS Financial Group. But analysts believe that if the ruble falls to RUB50-RUB55 the CBR will intervene. Much will depend on what happens with the oil prices: if oil prices stay at around $50 per barrel then the implied exchange rate should be about RUB57 to the dollar, believes Gazprombank, and a total of RUB900bn ($16bn) will be needed.
Bond investments & corporate capital
The strong ruble and high bond yields have been sucking in foreign investors into Russian bonds, but the CBR has become increasingly worried about a “carry trade” bubble forming that is pushing up the value of the ruble.
Foreign investors now hold a record 29% of outstanding local sovereign debt – RUB1.8 trillion worth of Russian federal OFZ bonds as of the start of April – according to the CBR. Gazprombank calculates this means that foreign investors bought 80% of all the new bonds placed in the first quarter. But with the CBR expected to cut rates later this year and a possible fall in the ruble’s value as the balance of payment surplus falls, that speculative bond investment could disappear, and fast.
Another factor that will push the ruble down is that Russia’s companies have now fully deleveraged and even begun to borrow anew on the international capital markets, which reverses the direction of the capital flows. Last year, companies paid off some $50bn in foreign debt, but in the first quarter bankers calculate they borrowed a net $4bn of new money overseas.
CBR deputy governor Ksenia Yudaeva said earlier this year that the peak in external debt repayments was passed in the first quarter and estimates the gross external debt repayments by the country’s 27 largest borrowers (excluding banks) totalled $10bn in January-March, with another $16.5bn that has to be repaid by the end of this year.
Even without the company debt banks have started to borrow again after two years of deleveraging, raising $17bn in the first quarter, which showed up in the national accounts as a larger-than-expected $15bn outflow in the first quarter.
Taken together all this means that the balance on the capital account will be a finely judged and can be knocked one way or the other by a few big deals and what happens in the banking sector.
“It is difficult to assume that the Russian currency will settle in the range of RUB/$55-60 as the baseline scenario in the medium term,” Gazprom said in a note. “If you assume a $30bn current account surplus in 2017 that will be neutralised by the MinFin’s $15bn-20bn interventions and the $20bn structural capital outflow from the real sector, then the risk of the ruble returning to a fundamental range of RUB/$60-70 is a real one.”