Teething troubles with Russian inflation targeting

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Russia must employ careful persistence in its movement towards a floating exchange rate.

Moscow is full of exotic surprises for the thrifty journalist from western Europe. Advertisements for generous deposit accounts are abundant. Consumer finance outfits offer particularly tempting saving rates: sometimes double the rate of inflation.

Short-term consumer loans have, likewise, never been more widely available in Russia. But the boom has been largely funded by the central bank’s repo facilities, use of which has mushroomed over the past 18 months, even at the largest and most liquid lender, Sberbank.

Increased reliance on central bank repo facilities is partly a result of the Russian central bank’s movement away from a currency peg. The move towards inflation targeting should change the very foundations of Russia’s financial system, and for the better.

Before 2008, foreign-currency borrowing was all the rage, as the currency peg leant the perception of a more stable exchange rate. The crisis showed the importance of greater control over local interest rates.

As oil prices collapsed, and Russia was forced to devalue gradually, there was a rush to replace foreign-currency facilities with rouble loans. Local interest rates soared. Many companies subsequently lost the ability to replenish working capital, eating into inventories, and causing GDP to plummet.

The central bank has since widened the band within which it permits the rouble to trade. As this continues – alongside praiseworthy capital market reforms and the more difficult and more crucial implementation of a new budget rule and sovereign wealth fund – it could serve Russia very well.

Today, the rouble offers a less risky currency for local borrowers. Unfortunately, however, local depositors are still attracted to hard currency, despite their dramatically lower returns. This is also encouraging capital outflow, which, according to Alfa Bank, reached $58 billion in the first nine months of 2012 and is likely to persist at about $50 billion in 2013.

When intervention in the currency market was the central bank’s main instrument for managing the economy, rouble liquidity was at least abundant during times of high oil prices – even if too much might have ended up in local real estate.

But banks seem to lack confidence in the new policy framework. They fear a shortage of repo collateral. Consequently, money market rates are inching up, independently of central bank interest rate changes.

Partly thanks to Russia’s as yet undeveloped capital markets, banks had already pledged some 40% of their aggregate securities portfolio in central bank repos by the end of September, according to VTB Capital. Sberbank also holds a disproportionate amount of eligible collateral.

In 2013, the central bank will have to take bold measures to show it is on top of the situation. If doubt as to the availability of eligible collateral is to dissipate, repos for between three and six months, and a lower rate for using loans as collateral, are inevitable.

But if the central bank is not careful, as Goldman Sachs points out, banks may be more likely to ignore the interbank market and simply use more widely available central bank funding for their own lending. Illiquid banks bereft of eligible collateral will be just as stuck as before.