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July 18, 2006

Russian Central Bank Allows Ruble to Appreciate - Is More To Come?
by Victoria Marklew

News out of Russia this morning was dominated by the (non)decisions and papered-over-disagreements of the G-8 meeting in St. Petersburg. Barely-noticed outside of the currency markets was the fact that the Central Bank of Russia (CBR) made a surprise shift in the ruble's exchange rate this morning, allowing the currency to rise 0.3% against its dollar/euro basket.

The small ruble increase may not seem all important, but the central bank had said back in early June that it saw no need for the currency to rise further in the near-term. Today's shift not only signals an assumption that record high oil prices will bring renewed upward pressure on the ruble, it also implies that the bank foresees a further rise in inflation over the coming months.

With a hefty current account surplus and rapidly-rising international reserves (the result of sitting on the world's eighth-largest oil reserves and largest gas supply), the Russian central bank's main headache is inflation. Last year, President Putin "ordered" his ministers to get prices back under control after CPI climbed toward double digits. However, the central bank has no effective monetary policy tools at its disposal, except for its manipulation of the exchange rate.

The CBR runs a managed float of the ruble by targeting a currency basket - comprising 60% US$ and 40% euros - and can up its intervention limits, so allowing the ruble to rise. The bank does not state where it sees the ruble rate in the future, but has a 9% annual appreciation target for the real effective exchange rate. So far this year, the real effective rate has risen over 6%.

After consumer prices climbed 5% during January-February the central bank allowed the ruble to appreciate somewhat during Q1, with an additional 0.5% increase in its intervention limit in early June. Price rises duly slowed over Q2, with inflation up just 0.3% on the month in June. This brought price growth in the first six months to 6.2%, compared with the government's 8-9% inflation target for the full year.

With petrodollars flowing into the country at a record rate, the country's gold and forex reserves are rising rapidly (reaching $253.2 billion on July 7), as is the Oil Stabilization Fund, which was set up in 2004 and now totals about $77 billion. Russia also lifted its remaining restrictions on currency movements on July 1, paving the way for full ruble convertibility. Although the country still attracts a relatively small proportion of the world's foreign direct investment - in large part thanks to a hostile attitude toward foreign investors and a marked lack of attention to the rule of law - the combination of a rising ruble, soaring energy prices, and further currency liberalization will attract more cash inflows.

Meanwhile, the CBR is caught between conflicting political imperatives. It must keep a lid on inflation, but without allowing too sharp an increase in the ruble, which would annoy exporters; and without curbing the continued strong growth in M2 money supply, a move that could destabilize the precarious banking sector.

All told, the ruble looks set to appreciate further over the course of this year - perhaps by more than implied by the 9% annual appreciation target for the real effective exchange rate. If the CBR tries to hold to that 9%, inflation for the year will be back in double digits.

Victoria Marklew
The Northern Trust Company
Economic Research Department
"The economics of what is, rather than what you might like it to be."
50 South LaSalle Street, Chicago, Illinois 60675

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

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