Zurich, 4 March, 2014

The Central Bank of Russia (CBR) decided to temporarily increase the key rate (1-week repo rate) by 1.5 pp up to 7.0%. The cost of other refinancing instruments will increase accordingly (i.e. FX swaps – up to 8%). The decision came as a surprise to the market although many investors considered a monetary policy tightening after the CBR’s meeting on 14 February as a possible scenario.

Emergency measure?

It may be considered as an emergency measure to catch that inflationary risks due to the FX shock (maximum +0.7 pp. to CPI level in 2014) and in order to sustained RUB weakness which could eventually be much higher as the situation with Ukraine is escalating and RUB depreciation has become more acute. This measure should limit RUB depreciation and devaluation expectations. Already today RUB rate was around 36.5/USD and 50.2/EUR despite the fact that during weekend at currency exchange points the rate was RUB 2-3 higher.

The rouble has been depreciating by almost 10% ytd and 18% yoy. In opposition to mid-last year the rouble seemed to be much more in focus and depreciated stronger in comparison to other emerging markets and other major CEE currencies.

Thus the high pressure on the CBR to tighten policy is continuing despite the sluggish economy. In particular this has been the case since several other pressured central banks among global emerging markets chose to act earlier. The Turkish Central Bank hiked in January effectively by +225bp, while Brazil and South African regulators have been in a strong tightening mode for some time.

Outlook

Given that the Russian FX market is currently driven more by political issues rather than economic ones today’s measure could have a limited effect. With the turmoil around Ukraine to persist for some while and given the lack of clear positive shift in fundamentals we remain short term bearish on the rouble, but would see some appreciation potential from elevated levels if the situation around Ukraine calms down. In the short term the upward pressure on the RUB rates will intensify due to cash outflow (ahead of spring holidays and difficult situation on FX market) as well as the CBR’s interventions.There is a lot of concern about the pressure which this measure could put on the money market and the banking system as a whole. On Monday 3 March, the money market rates are at 7-8% compared to 6.3% at the end of the previous week./RLU

3 March, Zurich

Ukraine as Achille’s Tendon

News over the military tensions out of the region during last days are less than encouraging for stock market. They have not been positively taken at the open on Monday by Russian stocks, bonds, and the ruble.

Russia is already paying an economic price for its actions in Ukraine.

The Russian Central Bank was forced to hike interest rates over night from 5.5% to 7% in order to stem the plunging Russian ruble. And the stock market has actually crashed. The MICEX index, the country’s benchmark index, is down 8% in early going.

Source: Bloomberg

The market has already been quite bearish on Russian assets this year, particularly the ruble. But the prospect of sanctions and an expensive conflict are leading to swift punishment in the market.  And it is by far not the best timing.

The latest manufacturing PMI report that came out this morning is not full of hopeful outlook.  Russia is seeing its fourth straight month of contractions, with a reading of 48.5. New business developments and employment in Russian companies both declined, with new orders seeing their fastest contraction since 2009.

The market has already been quite bearish on Russian assets this year, particularly the ruble. But the prospect of sanctions and an expensive conflict are leading to swift punishment in the market. Therefore, a hike in interest rates and a stock market crash is not what Russia would really need today./RLU

Zurich, 26 February

• The recent decision of the National Bank of Ukraine to announce a more flexible exchange rate policy can be seen as first gesture in front of IMF and EU demands
• Ukraine is in need of large-scale and quick financial assistance, expected to be more than USD 35 bn.
• IMF/EU and Ukrainian authorities need make the choice between increasing currency flexibility, fiscal austerity and serious structural reforms.

Key Economic Indicators

Source: IMF WEO as of October 2013, Thomson Reuters

The today move of the National Bank of Ukraine to officially announce a more flexible exchange rate policy can be seen as anticipation of IMF/EU demands. Today the UAH (national currency) slumped even further reaching the level of USD/UAH 10, bringing total depreciation to 20% from the beginning of the year. With markets expecting the IMF to demand more FX flexibility but doubting the sufficiency of reserves, the near term outlook of the currency before external support is in place is highly uncertain, with a substantial risk of overshooting.

Ukraine will need large-scale and quick financial assistance ultimately, possibly more than USD 35 bn. Given both, an unsustainable external and fiscal position, it is no doubt that Ukraine will need large-scale financial assistance going forward. Recent rumored sums in the range of USD 25-35 bn might be sufficient to cover the immediate financing gap over the next 1-2 years.

Market voices presume that even a somewhat larger sum might be needed in order to have sufficient buffers. Any large-scale IMF/EU support package should bring in sufficient buffers for potential downsides (e.g. retaliation measures of Russia, potential recapitalisation needs in the banking sector). In order to reach an overall financing volume of USD 35 bn (or more) EU and European countries (via bilateral loans) have to make sizable important commitments.

IMF/EU and Ukrainian authorities will have to meet the right decision. The challenge will play an important part between increasing currency flexibility, fiscal austerity and structural reforms. There is no doubt that a large-scale joint IMF/EU support package cannot be just about the provision of funding to Ukrainian authorities (i.e. the Ukrainian National Bank and directly or indirectly also the Treasury). Large-scale IMF/EU financial assistance is likely to come with tangible demand for reforms and conditionality attached. The targeted areas for reforms will most likely be similar to previous support packages (as the main vulnerabilities and weakness of the Ukrainian economy are more or less the same compared to previous bail-outs). Therefore, the question of the exchange rate regime will surely be an issue of dicussion.  IMF argued already for years in favour of a higher degree of exchange rate flexibility in case of Ukraine (which was also included in previous IMF deals, but was not implemented).

The question of changes to the Ukrainian exchange rate (regime) has to be seen in context of recent exchange rate developments geographical region. The Russian rouble (RUB) and Kazakh tenge already experienced significant devaluations (in case of the RUB spread throughout 2013 and 2014; in case of Kazakhstan as a large one-off devaluation recently). These developments are logically increasing (market) pressure on UAH. Therefore, from this perspective additional UAH devaluation. /RLU