Next possible steps to stem the RUB slide

Next possible steps to stem the RUB slide

After a brief initial rebound following the significant increase in Russian interest rates this morning, the sell-off in the RUB has accelerated. So far today, it is down 10%, taking losses since the end of September to 45%. While RUB depreciation was previously driven by fundamentals (ie, lower oil prices, weak growth and sanctions), the recent sell-off suggests overshooting. Recent modest FX sales by the CBR have not succeeded in arresting the sell-off either. Now that the recent rate hike has proven insufficient to defend the currency, the CBR has several options, in our view: 1) it could hike interest rates higher; 2) and/or squeeze RUB liquidity forcing market rates temporarily higher; 3) it could supplement with further sizable FX interventions; and 4) it could consider capital controls.

The CBR increased its key rate (1-week repo) by 650bp to 17% at an emergency MPC meeting held early this morning in Moscow. So far defending the currency via interest rates does not appear to have worked, and the RUB has sold off further following an initial rebound. This seems to be a case of too little too late. A stronger rate increase previously might have been sufficient to avert the crisis, but right now it is not enough to stave off panic.

Russia's financial markets are having a crisis of confidence, in our view. Selling the RUB has become endemic and the currency has fallen into a self-fulfilling downward spiral. One cause of the continuing decline in the RUB is the persistent weakness in oil prices, and with oil breaking below $60/bbl currently it is adding further pressure. The international sanctions and weakening growth are also working against the RUB. The combination has made markets vulnerable. The CBR needs to do something special to stabilise market sentiment.

Limiting RUB liquidity

Now that the recent rate hike has proven insufficient to defend the currency, the CBR might consider an alternative approach, freezing or capping RUB liquidity. In our opinion, the CBR has been too generous in its liquidity provision to banks. This was a result of CBR concern that banks need RUB liquidity to offset sanctions that have restricted access to external funding. Indeed, banks have considerably increased the share of CBR funding in their balance sheets to around 15% of total liabilities. Therefore, the CBR is concerned that denying banks further RUB liquidity may result in tighter lending conditions for the real sector, hurting growth as well as worsening the asset quality outlook.

In our view, the generous provision of RUB liquidity has fuelled RUB sales against the USD. The provision of RUB liquidity gives banks the means to bid for FX or indirectly companies to bid for FX via bank lending to companies. At this point, the private sector does not need FX for debt repayments. It has accumulated enough FX to cover near-term FX liabilities (confirmed by the lack of demand at CBR FX auctions). In our view, most of the RUB liquidity provided by the CBR finds its way into the FX market and thereby finances capital outflows under the current setting. Thus, the CBR can limit demand for FX by limiting RUB liquidity. Probably a complete freeze on RUB liquidity would be preferable (so the CBR would only rollover existing RUB credit). Then Russian entities that need RUB liquidity would have to sell FX and that would turn the market around. In our view, banks could trade with each other to reallocate the liquidity. Alternatively, the CBR could place a strict limit on RUB liquidity and then auction it off to banks. Either way, money market rates will increase further. It is possible that some form of quantitative tightening help the CBR gain control of the situation.

FX intervention and capital controls

The government and CBR are probably considering further FX intervention to provide FX liquidity (in fact the CBR sold $2.2bn yesterday). With the CBR freezing or capping its provision of RUB liquidity, FX sales would help reduce RUB liquidity further as the sales would take RUB liquidity out of the system and therefore be doubly effective.

Of course, the CBR is naturally concerned that it has finite FX reserves (currently at $415bn compared to external debt payments of $102bn due in the next 12 months) and it does not want to use them up to finance capital outflows. Thus, when the CBR provides FX, it would naturally want to ensure that the FX is being used for the intended purposes, such as paying down FX debts. We think the CBR may want to limit the selected few who do receive FX to those who use the funds for verifiable FX payment and, further, these entities should not have own resources available to make the payments. Thus the CBR does not want to fund speculative capital outflows. This would be a form of rationing of FX liquidity. Unfortunately, this looks like, sounds like and is in fact, a form of capital controls.

Russia has a current account surplus and the RUB depreciation during 2013-14 has already fed into current account improvements (we expect a surplus $72bn in 2014). Russia does not need capital inflows but rather needs to slowdown capital outflows and avoid domestic dollarisation. It is rare for a country in such circumstances to encounter a currency crisis. That is why selective and well designed capital controls might make sense. Use of capital controls is not necessarily bad in and of itself. Selective capital controls could help force the economy back into RUB transactions, preventing dollarisation.

The CBR and the Russian government have denied that capital controls are under consideration. Although a recently proposed Duma bill would force 50% sales of export proceeds, the government has not supported it. But it is interesting to contemplate what options are available, such as:

·      Forced sales of FX by exporters;

·      Limitations of FX withdrawals from banks;

·      Limitations on FX purchases;

·      Control of bank outflows;

·      Other limitations on outflows, such as import licences.

 

While it is unclear what actions the CBR will take, the ferocity of the RUB sell-off is such that it will need another ‘big-bang’ policy to take control of the RUB markets.