Rouble, Rates Moves Heighten Russian Economy Risks

The Central Bank of Russia’s increase in its key rate to 17% from 10.5% will deepen the severity of the recession in Russia, while oil prices present downside risks. We calculated before the rate increase that if the oil price averaged around USD66/b next year (20% below our baseline forecast of USD83/b) Russia could experience a real GDP contraction of about 2.8%.

The rouble continued to fall on Tuesday in volatile trading, before recovering on Wednesday after the Finance Ministry said it was selling foreign exchange. The inflationary impact of recent falls (inflation is heading towards double digits) will erode real incomes, further damaging private consumption and domestic demand.

If rates have to be kept high or increased to support the currency at a lower oil price, the impact could be greater still. The CBR has estimated that average oil prices of USD60/b could cause GDP to shrink 4.5%-4.7% in 2015.

The CBR’s move suggests the authorities remain committed to addressing the rouble’s decline via orthodox methods, and Russia’s Prime Minister and Economy Minister have reiterated that capital controls will not be introduced. But very high exchange-rate volatility and possible demand for dollars from Russian households or corporates would keep pressure on Russia’s policy framework, increasing the risk of some kind of capital controls to avert a currency crisis.

Russia’s sovereign and external balance sheets support its ’BBB’/Negative rating, and public finances continue to benefit from rouble depreciation, with the federal government running a budget surplus. International reserves/M2, a measure of the economy’s ability to cope with capital flight, is 65%-70% (although this is sensitive to exchange-rate movements), while international reserves are around 200% of liquid short-term external liabilities.

Nevertheless, renewed intervention to support the rouble, whether directly by the CBR or via the Finance Ministry, eats into international reserves, which have fallen by around USD100bn since end-2013.

We will review Russia’s rating in January, in line with our six-monthly review cycle.

The CBR announced significant regulatory forbearance for banks on Wednesday, allowing them to avoid reflecting market changes in reported financial metrics and reducing the risk of covenant breaches in Eurobond and other funding agreements.

Measures include a temporary moratorium on mark-to-market accounting for securities portfolios; use of average previous-quarter exchange rates to value risk-weighted assets; postponement or relaxation of some restrictions on pricing of retail loans and deposits; and relaxation of some loan reserves requirements. The CBR also said it would provide additional foreign-currency liquidity facilities and prepare recapitalisation measures for 2015.

This will limit the impact on reported capital ratios and liquidity and give banks some flexibility to pass on costs to borrowers. But it will mask their underlying financial position and reduce the usefulness of financial statements prepared under Russian accounting standards. Recession, higher interest rates and the weaker rouble will lead to marked deterioration in asset quality and weaker margins, adding to pressure on Russian bank ratings in 2015. Liquidity and capital provision also demonstrates the private sector’s likely continued demands on the sovereign in response to sanctions and a slowing economy.

The impact on liquidity is the greatest risk for corporates from a falling rouble, particularly domestically focussed companies reliant on dollar funding, as bank financing becomes scarcer and more expensive. Rising interest rates will put pressure on coverage ratio metrics.

Overall, corporates not naturally hedged through hard-currency revenues have cut their reliance on foreign-currency funding compared to the previous big rouble decline in 2008 and risk varies by sector. For example, retailers may face greater risk if they need to pay for some stock at higher prices pegged to a foreign currency, and are unable to pass on costs to consumers as the economy deteriorates. Regulated industries such as rail and utilities may be prevented from increasing tariffs enough to offset rising inflation.