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). -------------- Summary -------------- ¶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 -------------- Choosing the Ruble over Reserves -------------- ¶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. -------------- For How Much Longer? MOSCOW 00003582 002 OF 003 -------------- ¶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 MOSCOW 00003582 003 OF 003 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. -------------- Comment -------------- ¶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