THE GOR'S ECONOMIC CHOICES: RESERVES AND THE RUBLE

C O N F I D E N T I A L SECTION 01 OF 03 MOSCOW 003582

SIPDIS

DEPT FOR EUR/RUS

E.O. 12958: DECL: 12/11/2018
TAGS: ECON EFIN ETRD PGOV PREL RS
SUBJECT: THE GOR'S ECONOMIC CHOICES: RESERVES AND THE RUBLE

Classified By: CDA Eric Rubin for reasons 1.4 (b/d).

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Summary
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1. (C) As Russia's economic downturn deepens, it is forcing
the GOR to make difficult economic choices. One of the first
of these choices is what to do about the deteriorating ruble,
which has lost roughly 20 percent of its value to the dollar
since August. Initially, the GOR strongly defended the ruble
at the cost of roughly $100 billion in reserves. In recent
weeks, the GOR has moved to a policy of gradual devaluation.
This has slowed but not stopped the rate at which the Central
Bank of Russia (CBR) has expended reserves. Moreover, with
commodity prices continuing to fall the downward pressure on
the ruble remains.


2. (C) There is a growing consensus in the business
community, Russian and foreign, that the GOR should accept
the inevitable and embrace a significant one-off devaluation
to stem further loss of reserves and to help stimulate the
economy. The GOR continues to resist such a devaluation,
which would be politically difficult. However, its ability
to sustain the current policy is limited and, absent a
rebound in commodity prices or a weakening of the dollar, the
Euro or both, a devaluation in the first half of 2009 seems
inevitable. End Summary

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Choosing the Ruble over Reserves
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3. (C) Among the most visible symbols of Russia's economic
revival have been a strong ruble and large foreign currency
reserves. In August, at the height of the revival, buoyed by
strong commodity prices, the ruble was trading at roughly
23:1 to the dollar and Russia's reserves of foreign currency
were approaching $600 billion. Since that time the ruble has
lost 20 percent of its value against the dollar. The slide
began following the capital outflow following the Georgia
conflict and other GOR missteps. It accelerated in the Fall,
as the global financial crisis worsened and the slide in oil
and other commodity prices accelerated in response to falling
demand.


4. (C) As Russia's economic downturn continues to worsen, the
GOR is having to choose between a strong ruble and large
reserves. When the ruble began to weaken, the GOR had three
possible policy choices: a one-off devaluation, a gradual
devaluation, or no devaluation. The GOR's initial policy
choice was to defend the ruble strongly. In early November,
President Medevedev's Economic assistant, Arkadiy Dvorkovich,
told the Ambassador that Russia's strong reserve position
would allow it to continue to support the ruble and DPM
Shuvalov told the Ambassador in a separate November meeting
that the GOR had accumulated reserves for precisely this
purpose.


5. (C) However, by mid-November, with the Central Bank
rapidly burning through reserves, to the tune of close to
$100 billion in less than two months, the GOR began to
rethink its approach. Finance Minister Kudrin's Assistant,
Vadim Grishin, told us in mid-November that MinFin did not
support the policy as enunciated by Shuvalov to the
Ambassador. Grishin said MinFin regarded the reserves as a
source of long-term capital to secure Russia's economic
future and not to be spent defending the ruble, whose value
was in nay event being inexorably pulled down despite the CBR
interventions.


6. (C) Grishin said Kudrin had been in Brazil with CBR head
Ignatiev for the G20 Finance Minister's meeting November 8-9
and had spent the flight back from Brazil trying to convince
Ignatiev to moderate or end the CBR's interventions on behalf
of the ruble. Grishin said Kudrin was only partially
successful. The compromise, and Russia's policy for the past
month, has been a gradual devaluation. The CBR has widened
the band at which the ruble trades three times since
mid-November, each time by one percent. The CBR has,
however, continued to use its reserves to defend the band's
new limit. The burn rate has generally been slower; though
the CBR has reportedly spent nearly $20 billion of reserves
already this week.

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For How Much Longer?

MOSCOW 00003582 002 OF 003


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7. (C) The gradual devaluation of the ruble has been widely
criticized in the country's financial community. In
November, Merrill Lynch's Bernie Sucher called the policy the
&death of a thousand cuts.8 He said the policy was a
signal of weakness and was attracting currency speculators
who were betting that the GOR would not be able to sustain it
over time. JPMorgan's Country Officer, Jeff Costello, told
the Ambassador two weeks ago that if international hedge
funds were not so short of cash, they would have drained
Russia's reserves already.


8. (C) Virtually all of the business community, Russian and
foreign, believes that the only sensible policy Russia can
pursue is a significant devaluation, to as much as 35:1,
where most observers believe the ruble could stabilize. VTB
Head Andreiy Kostin told the Ambassador December 8 (septel)
that the GOR should bite the bullet and devalue. Deutsche
Bank's Chief Economist, Yaroslav Lissovolik, told us in early
December (septel) that "gradualism" never works and that in
the end the ruble will be sharply devalued, the only question
being how much of the reserves are left when it happens.
Troika's Chief Economist, Evgeniy Gavrilenko, has publicly
called for such a devaluation, including in a recent Moscow
Times op-ed. Gavrilenko argued that a significant
devaluation could not only stem the loss of reserves but
could also stimulate the economy, potentially limiting the
downturn in GDP growth next year by several percentage
points.


9. (C) Not everyone with whom we have talked agrees that a
devaluation will stimulate the economy. Uralsib's Chief
Investment Analyst, Chris Weafer, told us that a devaluation
would probably have only a limited effect on the economy,
given Russia's small export manufacturing sector. Moreover,
he said it would be both inflationary and politically
difficult. Weafer noted that in his televised audience with
the Russian people last week, PM Putin said there would be no
one-off devaluation. This was the second time in as many
weeks he has made this promise and Weafer said it rules out a
significant devaluation any time soon.


10. (C) The GOR's concerns about the political consequences
of a devaluation are based on bitter experience, specifically
the 1998 crisis. Lissovolik said the GOR had a genuine and
well-founded fear that a devaluation large enough to
stabilize the ruble's deprecation could backfire and spark
panic among the Russian public, causing the rate to plunge
even further and causing the economy to literally meltdown.


11. (C) Lissovolik said the GOR's policy appears to be to
play for time in the hopes that either commodity prices
stabilize or the U.S. dollar and the Euro weaken and the
downward pressure on the ruble eases. Most observers have
reckoned that with $450 in reserves left, and at the current
burn rate of less than $10 billion a week, the CBR can
maintain the current policy through the first half of 2009.
At that point, the difference between the official rate and
the implied rate could have lessened considerably, and a
one-off devaluation could be more palatable politically.


12. (C) However, these projections may be optimistic. The
$450 billion figure includes the foreign currency assets held
in the Reserve and National Welfare Funds, currently some
$165 billion between them. The former is earmarked to
support government spending should the budget fall into
deficit, which now seems inevitable next year. Kudrin said
two weeks ago that as much as $40 billion, one-third of the
Fund, might need to be drawn down to cover the deficit. That
figure will only grow if oil prices continue to slide. For
its part, some $10 billion of the smaller National Welfare
Fund has already been deployed, in support of Russian
companies through purchasing shares, and more transactions of
this sort are expected.


13. (C) In addition, ONEXIM President and oligarch in
good-standing Mikheil Prokhorev told us last week (septel)
that of the remaining reserves, $50 billion is set aside to
support the refinancing of foreign loans, a policy announced
by the GOR in October, and another $100 billion is held in
rubles as a result of domestic currency swaps. We have not
yet been able to confirm this latter information but, if
true, it could leave the GOR with as little as $100 billion
in liquid foreign currency reserves with which to support the
ruble. That would mean the GOR may have to devalue by the
end of the first quarter in 2009, as Weafer has publicly

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predicted, and perhaps even sooner. Costello said the GOR
needs to maintain enough reserves to keep its investment
grade rating and that this may mean the devaluation could
come as early as January.

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Comment
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14. (C) The GOR has gotten used to good economic times and
being able to satisfy competing interests, within the
government and in the society as a whole. As the downturn
worsens, however, it will no longer have that luxury. It is
going to have to make tough choices, not only with respect to
the ruble and reserves, but also whether to cut expenditures
in order to balance its accounts and if so which ones. And
it must also decide whether the right response to the global
financial crisis is to close the economy and reduce
dependence on foreign capital, or open further. We plan to
explore these other choices in subsequent cables.
RUBIN