Russian Currency War by Other Means Targets Ruble's Oil Link

TD Bank's McCormick Sees the Ruble as an Oil Play

Russia wants the ruble to stop acting like an oil currency.

A fiscal mechanism unveiled this year, under which the government absorbs all additional revenue when crude is above $40 a barrel, marks a “change in ideology” from the previous mechanism designed to ensure budget stability, according to Deputy Finance Minister Vladimir Kolychev. Given that the central bank is allowing the market to determine the exchange rate, the new approach sets the task of freeing the ruble from oil as the “main goal,” he said in an interview in Moscow.

“It’s an important change in policy,” said Kolychev, 33, who joined the Finance Ministry two years ago from VTB Capital. “It’s especially important under a free float, when there’s no artificial restraint on the ruble.”

The revamp has been among the most far-reaching efforts by Russia to pry the economy out of its reliance on energy and insulate it from the ups and downs in crude after its crash gutted the finances of the government and households alike. And while Russia and OPEC have teamed up to stabilize oil, Kolychev says risks remain that it could again fall below $40, with an equilibrium price seen between $40 and $50 over the next five to seven years.

“The deal between producers over temporary output curbs will help eliminate excess stockpiles,” he said. “But it’s hard to say if the market will rebalance from the point of view of demand and supply at the moment the accord expires.”

As the downturn in commodities rippled through the economies of oil-producing nations, their responses have differed. Saudi Arabia, the dominant OPEC power, is pushing ahead with its blueprint for a post-oil era, which includes subsidy cuts and new taxes as well as a plan to expand its sovereign wealth fund into the world’s largest. Russia, the world’s biggest energy exporter, has kept its fiscal and monetary policy tight, focusing its efforts on trying to unlock domestic investment by reining in inflation and encouraging savings.

Carry Play

Elevated interest rates have also made Russian assets an investor favorite. During the four months that the Finance Ministry conducted its foreign-exchange purchases, which netted 262 billion rubles ($4.6 billion), the ruble has kept up its rally, gaining more than 3 percent in the period. The central bank has attributed its strengthening in the first quarter to sales of foreign revenue by exporters and large tax payments, not its carry-trade appeal.

Should the economy be experiencing any “serious changes,” ruble fluctuations are possible, with the “substantial inflow of capital” since the start of the year pushing the currency from its “equilibrium value,” according to Kolychev.

“We have to comply with the budget rule if we don’t want the ruble’s exchange rate, interest rates and the structure of prices to jump back and forth,” he said. “Now we are no longer just collecting revenue but also defending domestic conditions from volatility in oil.”

Budget Fix

Officials believe Russia has hit on a budget solution for steering the economy through good times and bad. If oil dips below $40 for an extended period, the government can draw down its Reserve Fund to finance the deficit, Kolychev said. But if the sovereign coffer shrinks to 5 percent of gross domestic product, spending from it will be limited to 1 percent of economic output a year, with the rest of the shortfall covered with borrowing or by reducing the non-oil deficit.

The approach has drawn criticism of Alexei Kudrin, the former finance minister who oversaw the creation of a forerunner to Russia’s wealth funds more than a decade ago. The crude-price cutoff at $40 is “too tough,” with $45 being a “reasonable compromise,” he said in an interview.

“The question is whether the country will be able to develop health care, education and infrastructure without an increase in spending,” Kudrin said. “The big danger is that we don’t support those areas that underpin the foundation of economic growth.”

The Finance Ministry projects the fiscal gap will narrow to 2.1 percent this year, from 3.7 percent in 2016, on the back of a surge in revenue that may result in a windfall of more than 1 trillion rubles. Energy contributes about 40 percent to budget income.

‘Conservative Way’

“The budget rule was brought in in a rather conservative way,” Kristalina Georgieva, chief executive officer of the World Bank Group, said in an interview in St. Petersburg. “There is some return to price stability for oil but it’s not anticipated that oil prices will shoot up. That might be the moment in the country’s history when structural reforms take a front seat.”

The ruble’s link with oil is proving resilient. Its 30-day correlation with the price of Brent is now near 0.6, compared with 0.2 on Feb. 7, when the purchases began. A value of 1 would mean the assets are moving in lockstep.

The authorities follow a formula used to calculate monthly operations on the currency market in a “mechanical way,” meaning there’s nothing discretionary about the volumes the Finance Ministry soaks up, according to Kolychev.

“Only by way of strict compliance with rules that are transparent for market participants is it possible to build up the necessary trust,” he said. Success in shielding the economy from oil will “provide a reliable foundation for diversification,” Kolychev said.

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