RUB: Focus on the fundamentals

This week we received big news from Moscow. It is not about the renewed escalation of military action in eastern Ukraine but rather about Russian monetary and exchange rate policy. On Monday, the Russian central bank (CBR) under the leadership of Elvira Nabiullina effectively let the rouble float freely.

The CBR has allowed the rouble to float increasingly freely since 2008-09 in a widening trading range. The Ukrainian crisis, negative emerging market sentiment and the falling oil price have put the rouble under significant weakening pressure for most of the year and even though the CBR has generally allowed for a significant weakening of the Russian currency, it has also tried to slow the rouble’s descent by raising interest rates and intervening in the FX market. However, it has become increasingly clear that the cost of the ‘defence’ of the rouble was not worth the fight. Therefore, on Monday, the CBR finally announced that it would effectively float the rouble. We have taken a look at the outlook for the rouble under the new regime and at what mainly determines the rouble level.

The sharp sell-off in the rouble over the past year has been attributed to the serious deterioration in the geopolitical situation in relation to the Ukrainian crisis. However, it might be useful when considering the development of the rouble to take a step back and look at more fundamental factors to understand the underlining drivers of the weakness over the past one to two years.

To this end we have created a relatively simple model for the Real Effective Exchange Rate (REER) for the rouble. We have tested numerous variables to explain developments in the rouble REER since 2000. However, it turns out that many variables actually explain the rouble development quite well. Unsurprisingly, the oil price has very significant explanatory power in terms of the rouble REER. Given the very close relationship between the oil price and the Russian REER, it is hard not to think that the sharp drop in the oil price in the past few months has been a major factor behind the (renewed) rouble sell-off in recent weeks and months, both in real and nominal terms. The other important variable in our model is what we have termed the Russian ‘risk premium’. We have measured this by the relative performance of the Russian and US stock markets (measured in the same currency). We believe this variable captures changes in the markets’ perception of ‘Russian risk’ associated, for example, with rising (geo)political uncertainty, but also with banking and public finance concerns. However, we note that our REER model indicates that it is the development of the oil price rather than in ´Russian risk´ that has been a driver of the rouble REER recently. Indeed, we would argue that geopolitical risk has had little impact on the changes in the rouble REER over the past couple of months, while it was probably the key driver in the spring and early summer this year.

To sum up, we say that while geopolitical tension has clearly had a significantly negative impact on the rouble in 2014, the oil price and fundamentals in general have had at least as great a negative impact, and maybe an even bigger one.

Looking ahead, we would continue to stress that the key risks will be the outlook for the oil price and geopolitical tension. Both factors are obviously very difficult to forecast.

However, in terms of geopolitics, overall we believe that the current geopolitical risks are mostly already reflected in the rouble rate. A further unforeseen escalation in geopolitical risks would be clearly negative for the rouble.

However, such risks are best understood as ‘black swans’ – something we, by definition, cannot forecast in any meaningful sense (even though we can hedge against such risk – see below). Therefore, overall we have assumed the status quo in terms of the Ukraine crisis and geopolitics in general in our forecast. This is not because nothing will happen but because we do not believe that such events can be meaningfully forecast.

Therefore, fundamentals take centre stage in terms of our rouble forecast and we particularly highlight the following factors.

• Given the present level of the oil price, the rouble is probably close to ‘fair value’ in real effective terms.

• The Russian economy is very likely to fall into recession and in the coming quarters we are likely to see the crisis deepen given the shocks we have already seen. This is likely to make the CBR reluctant to tighten monetary policy much further – particularly taking into account that the CBR is now officially allowing the rouble to float freely.

• As a consequence, we also believe that the CBR will be eager to avoid a renewed strengthening of the rouble in real terms as this would keep the Russian economy stuck in recession.

• Effectively, the CBR is likely to accept inflation rising up towards 10% temporarily. This also means that to keep an unchanged real effective exchange rate, the CBR will have to allow the nominal exchange rate to weaken enough to ‘make up’ for the loss of competitiveness from higher inflation.

• The debt situation in Russia is becoming increasingly challenging.

FX Outlook for the rouble

All the factors above are likely to weigh on the rouble in the coming year – no matter what happens geopolitically. We expect these factors to be particularly negative on a three-six month horizon rather than a 12-month horizon.

However, our view is that the oil price is likely to bottom out in the coming months and will begin to recover in line with a continued pick-up in global growth in 2015. This means the rouble is likely to get increasing support from a higher oil price throughout 2015. This should help reduce the pressures on the rouble in the medium term.

Our new USD/RUB forecast is therefore 49, 51 and 51 on three-, six- and 12-month horizons. Overall, this is slightly more negative than forwards on a three-six month horizon and fairly ‘neutral’ on a 12-month horizon.