Central Bank of Russia rate cuts neutral for rouble
The rouble has enjoyed a strong start to the year, shrugging off underlying weakness in the Russian economy, leading the CBR to hike rates by 50 basis points on Friday.
The Central Bank of Russia (CBR) cut rates by 50bp on Friday, its first rate cut in nearly a year, citing the positive trends of more stable inflation, decreased inflation expectations and risks, and hopes of economic recovery.
And the CBR said there would be more cuts to follow if inflation estimates and the broader economic backdrop called for it.
Analysts stress the CBR’s cautious tone, with its oil-price assumptions remaining conservative. CPI inflation is at 7.3% year-on-year in both April and May – the lowest it has been since April 2014.
The move underlines the divergence that has emerged between Russia, which has entered its loosening cycle, and the US and many oil importing countries, which are set to tighten policy in coming months.
Oleg Kouzmin, economist for Russia and the CIS at Renaissance Capital (RenCap) in Moscow, says: “Russia is at a very different part of its cycle to the US and other western economies.
“It hiked rates in 2014 and 2015, and at 10.5% its policy interest rate is likely to remain relatively high among emerging markets (EMs) even if CBR pursues a cautious policy easing.”
That means it retains a slight advantage over some EMs, which have less wiggle room in rates policy, with the shadow of Fed hikes casting a long shadow over EM FX.
However, CBR caution means its loosening cycle is likely to be gradual, says Anna Zadornova, economist at UBS.
“The prospects of a July rate cut in particular look very uncertain at the moment given a lot of event risks between now and July 29 – both external and domestic,” she says.
The rouble is up 12.5% against the dollar in 2016, making it second only to the Brazilian real.
RenCap’s Kouzmin believes this moderate tightening will prove neutral for the rouble.
However, Win Thin, head of EM strategy at Brown Brothers Harriman, questions the market’s logic in driving the rouble to its current levels.
“Our EM FX model shows the rouble to have weak fundamentals, so this year’s outperformance does not seem warranted,” he says.
Others see the rouble’s YTD strengthening in a wider context.
Zadornova at UBS says: “If you only look from the start of the year, the move may look puzzling, but if you look back a little further you can see the rouble is back to November levels. Most of the move came in February and March and it tracks the oil-price moves quite closely.”
Kouzmin agrees the underlying reason for the rouble rally has been the increase in the oil price, with domestic issues playing a supporting role.
“The currency is fairly valued now, and it’s tough to say that the rally was not justified,” he says.
RenCap forecasts the rouble will average 65 against the dollar this year – it’s currently 65.94 – compared with 61 in 2015 and 39 in 2014.
UBS puts it at a slightly weaker level.
“Our oil analysts predict an average oil price of $49 for Brent in Q4 2016, and using that figure I would estimate the rouble will end this year around 67 to the dollar,” says Zadornova.
Source: Haver Analytics
The second most-important factor driving the rouble – albeit a distant second – is the dramatic slowdown in capital flight from the country, which has fallen back below Russian normal levels, says Kouzmin.
Still-high inflation and increasing costs for imports in rouble terms have undermined the spending power of Russian consumers, but they have been less inclined to sell their roubles for foreign currencies this year. In Q1 2015, Russia saw outflows of $33 billion, compared with only $7 billion in Q1 this year.
This is, in part, because many of those that did lost money amid extreme rouble volatility. Some also feared Russian accounts abroad might be frozen, if there were an escalation in hostilities in Ukraine. The ministry of finance has also taken legislative steps to try to prevent capital flight.
Whatever the reason, fewer Russians selling roubles for dollars has cleared the path for its recent strengthening.
It also suggests Russians, like the CBR itself, see a light at the end of the tunnel.
Dmitry Polevoy, chief economist for Russia and the CIS at ING Bank, says: “The worst of the adjustment is in the past now. We don’t see any significant one-way trends for the rouble in the next few years, assuming oil is not far from current levels. It will likely be volatile but trade within a range.
“This should allow inflation to fall, and we think it is quite possible the central bank will achieve its 4% inflation target by the end of 2017. The outlook for wages is not bright, but at least consumers should be no worse off.”
All this serves as vindication for the CBR’s decision in late 2014 to back away from its former regime of active currency management. It has now been a year since it last intervened in the FX markets, and its acquisition of around $10 billion in May and June 2015 was a relatively modest attempt to moderate the pace of rouble strengthening.
Besides that, it has been true to its late 2014 promise to let the rouble float freely.
However, it has left the door open for future currency purchases, indicating it plans to restore its reserve fund to around $500 billion in due course.
Reserves stood at $389 billion in May, up from $353.5 billion in April 2015, indicating the central bank is not rushing its dollar purchases, and it looks set to continue replenishing its reserves back to the half trillion level at a leisurely rate, when market circumstances are favourable.
Polevoy at ING says: “The rouble outlook is asymmetrical. The central bank has shown it will allow the rouble to weaken, but if it starts to appreciate significantly it may step in to manage it, if it feels there is a divergence between the rouble’s market rate and its own assessment of fair value. But it will be in no rush to step in given the still-challenging external backdrop.”
More important for Russia’s longer-term economic prospects will be the country’s willingness to continue its reform efforts. Having registered a success in its experiment with a floating currency, it must now take further steps to liberalize its economy, say economists.
Kouzmin says: “Russia is very good at crisis management. It has gained some expertise in crises over the years; it is a national hobby. But it is less good at development reform. Russia now needs a budget adjustment to reflect the new realities of the oil price, which may mean unpopular measures like big spending cuts, an increase in the retirement age, labour-market reform and measures to support SMEs.”
Its appetite for such reform will depend in large part on what happens to the price of oil in coming years, adds Kouzmin.
“If the oil price stays at or below $70 for the next decade, which I think is quite possible, Russia will have an incentive to pursue these reforms,” he says. “But if it increases to $90 or $100, the old machine will work again and there will be little incentive to reform.”