Devaluation a Good Step Toward Ruble Float

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The Central Bank announced on Nov. 24 that it was widening the band in which the ruble may fluctuate against the dollar/euro basket exchange rate by around 30 kopeks, its second such decision in recent weeks. Unsurprisingly, in an environment of capital outflow and as the current account is moving into negative territory, this "widening" can only mean one thing: a move toward depreciation.

Indeed, the ruble reached 30.93 rubles against the dollar/euro basket on Nov. 24. Two days later, the Central Bank changed the rate to 31 rubles against the basket. Then, on Nov. 28, the ruble depreciated another 30 kopeks, bringing the rate to 31.30 rubles against the basket.

Meanwhile, in early August when reserves were greater and the oil price was still high, the exchange rate was around 29.30 rubles per dollar/euro basket, which suggests a depreciation of about 6.8 percent. The ruble has depreciated against the dollar by some 19 percent since mid-July, while it has appreciated against the euro by around 4 percent over the same period. The depreciation of the ruble against the dollar is more or less in line with the global strengthening of the dollar, while the appreciation against the euro looks quite artificial. Most likely, however, this imbalance will be ironed out.

The Central Bank has announced that by the middle of November, the country's gold and foreign currency reserves had dropped to around $454 billion; during the week from Nov. 7 to Nov. 14, a loss of about $22 billion was registered. The following week, reserves fell to $449.9 billion, clearly pointing to continuous pressure on the ruble. Although reserves grew by $5 billion from Nov. 21 to Nov. 28, this does not change the entire picture.

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The recent moves toward a gradual depreciation of the ruble can be viewed as a step in the right direction but perhaps the wrong step.

The Central Bank is injecting rubles into the system on daily basis (mostly through short-term repo operations), while on a number of occasions the Finance Ministry has held auctions of budget funds for deposit with commercial banks. All this funding was offered at rather negative interest rates. Unsurprisingly, the bulk of this money appeared on the foreign exchange market. In October, for instance, foreign exchange reserves fell by over $72 billion, while the Central Bank acknowledged that it had spent around $45 billion of its reserves to support the ruble during the month. Meanwhile, the money supply contracted in October by 855 billion rubles (about $32 billion), meaning that $13 billion of the contraction was caused by the injection of "new" money at negative real interest rates. (The Central Bank was pumping in over 200 billion rubles daily via repo operations at a rate of about 8 percent, which was raised recently.)

Expectations of a more significant ruble devaluation are creating additional uncertainty about the timing of this event and are encouraging individuals, banks and companies to convert rubles into foreign currencies and hoard the cash. Credit is becoming scarcer and interest rates remain high, meaning that the shrinking ruble money supply -- coupled with the above-mentioned uncertainties -- is negatively affecting economic growth.

In light of these tense conditions on money markets, low oil prices and slowing economic growth, more questions are being raised about Russia's potential growth next year. It appears that in recent weeks analysts have begun competing to see who can paint the gloomiest economic forecast for 2009. Clearly, as the oil price has fallen to below $50 per barrel, it has contributed to the rapid contraction of Russia's trade surplus and current account, which occurred much faster than anyone had expected two or three months ago. As late as June, industry analysts were still talking seriously about an oil price of $170 to $200 per barrel by the end of the year. Now, some mention $20 or $30 per barrel as a possibility. Forecasts have become almost as volatile as the markets themselves. In such an environment, it is very tempting to project either zero or even negative growth for Russia. But this is not warranted.

At the end of the day, it is essential that Russia float its currency regardless of what the oil price will be, which necessarily means a devaluation. While the recent gradual depreciation of the ruble is a move in the right direction, it is still too gradual, and a more decisive step at this early stage could unlock import substitution potential -- at least in some sectors.

At the same time, December is not the best month to float the ruble. Budgetary spending usually increases dramatically at the end of the year. This year will not be an exception, even though the end-of-year injection from the budget this time around may be less impressive than in the past. In January, one will clearly see a contraction of the money supply, meaning that demand for rubles will go up during the long January holiday season. Since economic activity is expected to be very low during this period, this could be a much better environment for floating the ruble.

At the same time, in order to limit the scale of devaluation, any shift to a floating exchange rate should be accompanied by a further increase in interest rates. I also expect year-over-year inflation in January to come down further to about 13 percent. This means that another 100 to 150 basis-point increase in interest rates may bring them much closer to positive territory, which the Central Bank apparently already started doing in November.

The magnitude of the possible ruble weakening -- about 20 percent against the basket from its current level -- does not appear to be too dramatic, assuming that oil prices stay next year at $50 per barrel on average. This will simply bring the real effective exchange rate back to its level in 2005.

There is no need to keep painting an overly gloomy picture of Russia, even though rather disappointing growth numbers are expected in the first quarter of 2009. Once money starts moving after a ruble devaluation, we will clearly see some rebound of the currency -- unless the Central Bank and the government engage in a policy of printing large amounts of rubles and injecting them into the system.

The government's indecisive currency policy and efforts to infuse liquidity into the system have helped reallocate reserves from the Central Bank into the hands of individuals, companies and banks. This was not a bad move, and if it continues there is a good chance of revival in Russia's economic activity. Clearly, growth rates will be more moderate in 2009, but they will most likely remain positive throughout the year. Moreover, on the back of a weaker currency, import substitution will help boost domestic manufacturing.

Yevgeny Gavrilenkov is managing director and chief economist at Troika Dialog.