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United States
Inventories Primed for Restocking
February 18, 2011

By David Cho | New York

An inventory trifecta. Despite pulling back sharply to close out 2010, US firms appear primed to restock inventory levels again.  In our view, a confluence of three factors will encourage businesses to let inventories build in relation to sales over the course of 2011.  First, buoyed by the fiscal stimulus bill that was passed in December, the outlook for economic growth and consumption has improved markedly.  Second, as evidenced by rising commodity prices and stabilization in critical categories such as shelter and transportation, inflation is in the process of bottoming and is likely to turn upwards later this year.  Finally, thanks to still-accommodative monetary policies, borrowing costs are low and should remain cheap in the near term. 

 In This Issue
United States
Inventories Primed for Restocking
The Great Rebalancing
United Kingdom
BoE Inflation Report: Nearing a Hike, but in No Rush
The Ruble - How High Can it Go?
View GEF Archive

 The Global Economics Team
 Melanie Baker
Melanie Baker is senior UK economist. She has been on the UK economics team since 2003. Before this, she worked on the currency economics team. She joined Morgan Stanley in 1999. She graduated in 1998 from the University of Edinburgh with an MA in Economics and Politics and has an MSc from University College London in Economics. She is also a CFA charterholder. Melanie is a member of TheCityUK's Independent Economists Group.
Read about other GEF team members

Dissecting the 4Q inventory pause.  In our view, the unusually large 4Q plunge in inventory accumulation, which depressed reported real GDP in 4Q10, set the stage for renewed inventory growth in the next few quarters.  The swing in private stock-building subtracted a massive 3.7pp from US output growth last quarter - the biggest decline in 22 years.  As a result, inventories are now lean in relation to sales, which accelerated in 4Q; this pause took the ratio of non-farm inventories to final sales of goods and structures to a 55-year low of 3.87.  Other inventory-sales ratios, such as the one in the manufacturing and trade universe, show qualitatively similar results in real terms.  

As we see it, this inventory correction primarily reflected four factors.  An unsustainable surge in imported goods in the spring and summer, plus fears of a double-dip fueled in part by the potential expiration of the Bush-era tax cuts, triggered producer caution in 2H10.  With credit availability still an issue and input costs more or less held in check, American firms thus had little incentive to accumulate inventories over the final three months of last year.  Finally, a tremendous surge in sales in 4Q caught businesses by surprise, likely taking inventories below desired levels. 

Confidence and the ‘accelerator' promote stock-building.  How do we know what are desired inventory levels?  The expected pace of sales is critical.  The passage of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 reduced the uncertainty around tax policy and elevated the expected profile for future sales.  Clearly, the legislation provides additional support for the US economy and drastically lowers the downside risks for this year.  Just as significant, the bill's temporary payroll tax holiday and business expensing provisions - both of which expire at the end of 2011 - offer considerable incentives for households and firms to front-load consumption and investment in the near term.  Consequently, we believe that businesses will be less hesitant to build out their inventories in order to meet this pick-up in demand.  Indeed, history suggests that accelerations in demand - especially when they are unanticipated - inevitably lead to corresponding jumps in inventories.  While this ‘accelerator effect' is typically viewed within the context of capital spending, it is equally applicable to stock-building activity.

Rising prices promote a shift to buy-ahead purchasing policies.  Both rising prices for materials and supplies and growing inflation expectations appear to be altering the arithmetic behind firms' purchasing decisions.  We believe that a gradual decline in operating slack and unemployment - and the ‘speed effects' associated with those changes - will push inflation higher in 2011.  In addition, the continuing climb in input costs is reinforcing a move towards higher inflation, especially for firms in industries that have limited capacity and thus have pricing power. 

Courtesy of strong global demand and supply constraints, quotes for raw materials have risen significantly over the past year.  In addition, prices for a variety of imported consumer goods have rebounded since October.  And critically, we anticipate that these pricing trends will intensify in the months ahead.  Thus, despite the prevalence of just-in-time management techniques, we predict that firms will be less inclined to adhere strictly to ‘hand-to-mouth' inventory policies in the current operating environment.   Instead, in response to this new trajectory of stronger demand and faster inflation, we foresee businesses holding reserves ‘just in case' further price increases materialize.

Recent data and anecdotal evidence appear to confirm that such a shift in American companies' purchasing practices is already underway.  In fact, inventory levels are climbing, and higher input costs are starting to filter through to the prices that businesses receive.  We view this change in behavior as a reasonable proxy for firms' inflation expectations.  As an example, for the first time in over two decades, 49% of respondents to the ISM manufacturing canvass reported making commitments to purchase production materials with a lead-time of 60 or more days.  Not surprisingly, this corresponded to a nine-point surge in the prices paid diffusion index.  Likewise, the NFIB Small Business Optimism Index showed that the percentages of respondents increasing inventories and raising average selling prices both continued to gain ground in January.  In addition, this month's Morgan Stanley Business Conditions Index yielded a new 31-month high in the number of survey participants whose firms had charged higher prices relative to a year ago, and over 40% of those analysts who could comment on their companies' inventory policies stated that rising commodity prices had driven their firms to stockpile supplies.  

A ‘carry trade' for inventories.  Favorable financing costs and increased credit availability are the final ingredients in the recipe for a rebound in inventory accumulation.  With the Fed expected to remain on hold until 2012 and fully committed to completing QE2, we expect front-end rates to stay low for most of this year.  Consequently, as rising prices push real borrowing costs sharply into negative territory, we believe that businesses will be motivated to take advantage of this available ‘carry trade' on inventories and purchase supplies on credit.  As important, the Fed's efforts to ease financial conditions generally mean that such funding should remain accessible in the near term.  Previous economic research has demonstrated how monetary policies can influence stock-building by modifying the supply of bank loans.  And according to the Federal Reserve Senior Loan Officer Opinion Survey, lending standards for commercial and industrial loans have loosened substantially over the past two years.  Thus, accommodative credit conditions are likely to spur even greater gains in inventories going forward.

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The Great Rebalancing
February 18, 2011

By Alan Taylor, Manoj Pradhan | New York, London

Global imbalances have been falling. But does this reflect the ongoing impact of the Great Recession, or is it part of a deeper trend? While cyclical factors are apparent, we believe that fundamental drivers are playing a more important part in the global rebalancing story.

Going forward, we expect four key trends: (1) Pent-up DM and EM investment demand will re-surface, though to a lesser extent in DM economies; (2) EM reserves are likely to build at a slower pace once EM central banks feel they have an adequate war chest to protect them; (3) Lower private saving flows in EM economies as strategies to enhance consumption and domestic demand gain traction; and (4) Flat or declining saving flows, even in DM economies. Despite deleveraging, total saving may be flat or falling in the US where deleveraging is more serious, and potentially declining in other DMs.

Global sum of parts - what will it all mean? These trends have major implications, we believe. The slow but steady move from current account deficits to current account surpluses in DM (and vice versa in a large part of the EM world) will likely be accompanied by continued EM currency value appreciation in real terms (i.e., this is likely to happen through a combination of nominal appreciation of currencies as well as a wedge between EM and DM inflation). Finally, global real yields will likely rise as aggregate investment demand booms relative to saving supply.

The next global growth cycle. EM will be looking to push ahead with its investment-growth model, and yet change the mix and magnitude of its current safety-first saving model. DM will be looking to reinvigorate and reinvent its investment-growth strategy and delever, but will face structural headwinds.

How Did We Get Here?

Global trends drove real yields lower... The global imbalances of the last 10 to 15 years reflected trends in underlying saving and investment behaviour at the national, regional and global levels. With the majority of coarse capital controls easing worldwide in the 1980s and 1990s, first in DMs and then in EMs, an increasingly integrated global capital market therefore began to reflect aggregate EM and DM saving and investment trends through the equilibrating movement of a global real interest rates. The message from these yields (proxied by inflation-adjusted real yields) was that saving exceeded investment globally, resulting in a steady downtrend in real yields.

...and exacerbated global imbalances. While both investment and saving worldwide have been on inexorable downward trends since the 1980s, in EM they have been buoyant, and saving has generally been higher, except in the early 1990s. In the DM world, the downtrends in these variables have been sharp, and saving has trended below investment. This resulted in current account surpluses in the excess-saving EM world and current account deficits in the saving-deficient DM world. As the macroweight of DM has been so much larger than that of EM until now, the rising EM saving and investment trends have not yet been outweighed by falling DM trends, but that is already changing.

New trends in town. The new trends we outline below will change the global landscape going forward, with implications for global rebalancing, real yields, exchange rate appreciation and inflation.

Trend 1: Pent-Up Investment Demand - Trend and Cycle?

The drought is over. We can anticipate upward pressure on investment demand from both the EM and the DM economies. We argue that, in the years ahead, the ‘investment drought' epoch of the last 10-15 years may come to an end.

Cyclical rebound. Investment activity was postponed as the uncertainty of the financial crisis made itself felt via a ‘real option' as firms took a wait-and-see attitude towards new capex decisions. Now the EM world is in the capex upswing and the DM world is poised to follow. This aspect of the story is essentially cyclical, but given the prolonged depth and length of the Great Recession, it is a phase that may take several years to play out.

Rising share of EM in global investment demand. The EM share of total global dollar-weighted investment rose from 25% in 1980 to 43% in 2009, just as EM dollar-weighted GDP rose from 24% to 31%. As EM economies continue to grow more rapidly than DM, we expect the EM shares to grow further. In a nutshell, DM investment demand will start to matter less, while EM investment demand becomes more important.

Trend 2: EM Reserve Accumulation - Beyond the Step Change?

One key trend that has helped to drive the EM region's current account surpluses in recent years has been a high level of public saving, whereby policy-makers accumulated substantial foreign reserves as a ‘rainy day' fund.

Mother of all war chests. We understand these developments as reflecting a necessary ‘step change' in reserve holdings following the unpleasant shocks of the 1990s and 1997 Asian Financial Crisis. EM economies were exposed as woefully lacking in reserves, and so had to rely in a crisis on fickle global capital markets prone to ‘sudden stops', or else unsympathetic or inadequate official assistance from the likes of the IMF. The subsequent policy reaction was to steer a course towards ‘self insurance', but this would require time and effort to amass the necessary backstop - and it has. Over the past 15 years, this build-up of reserves has overshadowed the seemingly natural ‘downhill' direction of capital flows from rich to poor countries.

Was this a wise move for the EM economies? FX reserves played a crucial role in demolishing the ‘high-beta' price tag of EM investment. Indeed, we have still not seen any manifestation of any form of crisis in the EM world (banking, currency or sovereign) and the rapid recovery of EM growth stands in stark contrast to the sluggish performance of the DM world. This experience will only reinforce the conviction of EM policy-makers regarding the need to keep reserves on hand, for economic as well political reasons.

But how large a pile of reserves is ‘enough' to provide this kind of insurance to an EM country? The very fact that all EMs had sufficient reserves on hand to survive the worst global crisis since the 1930s probably tells us as much. The 2008 shocks were a very bad tail event - close to or even on a par with the shocks seen in the Great Depression. We suspect that EMs have now mostly ‘caught up' with where they needed to be in terms of reserves - the pace of accumulation is therefore likely to slow down to keep pace with GDP or M2 growth going forward. This represents an important insight into the new dynamics of global imbalances going forward: there will be receding pressure on EMs to acquire reserves; that is to say, reduced official sector saving in EM going forward relative to trend.

Trend 3: Lower Private Saving Flows in EM Economies

The lower flow in the build-up of EM public saving is likely to be mirrored in EM private saving flows as well - for very different reasons. There is likely to be a lower precautionary motive for saving due to gradually improving safety nets, financial development, rising wealth, etc. And consumption growth should also find support in demographic trends as many EMs start to confront some of the same aging populations as the DMs. Economic history shows a tendency for saving rates to climb during early phases of development and then peak as countries transition through the middle income stage, and the EM world now finds itself nearing this critical inflection point.

Trend 4: Flat or Declining Saving Flows in DM Economies

In DM, we already see rapid consumer deleveraging, although in some cases the extra saving of the private sector is being offset by additional borrowing in the public sector. This is especially true in the US but less true in Europe, where austerity is now more the norm. However, much of these patterns are cycle-related and not long term, and we might expect most of these adjustments to taper off as recovery takes hold. In order to be convinced, however, we take a closer look at saving in the major developed economies. 

Several cross-currents will likely net to a flat US saving picture in next 18-24 months.  We expect personal saving as a share of disposable income to rise in 2011 and fall back in 2012 as new fiscal stimulus temporarily adds to saving this year.  However, we don't believe that consumer deleveraging is over - far from it.  Rather, it can now proceed at a much slower pace. We expect the saving rate to rise to a 7-10% range over time.

The fiscal stimulus should also boost after-tax corporate saving (undistributed corporate profits) in 2011 at the expense of 2012.  Apart from that seesaw pattern, however, pre-tax profit margins are flattening, so earnings growth is beginning to converge to growth in nominal GDP. This is a big deal, as the US federal deficit (or dissaving) will likely peak in the current fiscal year, at US$1.3 trillion or 8.9% of GDP, and decline to US$1.15 trillion or 7.1% of GDP in fiscal 2012. Likewise, state and local deficits as measured in the national income accounts have moved into surplus, although the numbers are small (about 0.4% of GDP this year).

Euroland saving declines. In the euro area, where private households have traditionally been much thriftier than their US or UK counterparts, the personal saving rate looks likely to decline slightly over the next year or two. With unemployment having peaked and job prospects improving, households are likely to reduce precautionary saving and consume a larger fraction of their income. Similarly, the corporate sector, which built up large cash balances over the past couple of years, is likely to save less in the next few years as the focus shifts increasingly towards expanding capacity, hiring and returning cash to shareholders through dividends.

Outside the peripheral countries in crisis, we don't see any major fiscal tightening on the horizon. Most governments in Europe are in fairly weak positions domestically, with either slim or no majorities, or major elections on the horizon, which makes it difficult for them to push through tough spending cuts or tax increases, even if they wanted to.

Japan flat. In Japan, the personal saving rate should also decline somewhat this year and next, from 5.8% of disposable income in 2010 to 4.8% next year, on our team's latest forecast. This should be roughly compensated for by lower public dissaving as the budget deficit looks set to shrink.

Global Sum of Parts: What Will it All Mean?

Our three major calls highlight the implications of the great rebalancing story:

1. Global imbalances should continue to moderate. EMs' excess saving (i.e., the excess of saving over investment) is likely to moderate, as their growth dynamics push continued investment demand. The origins of demand will shift from export-led to domestic-driven. National saving will fall as (i) households spend more, with less precaution and more demographic pressure, and (ii) central banks pile up reserves but at a more modest rate. From a longer-run perspective, EMs survived the worst global crisis in 80 years with nothing more than a scare. And with all their backstops in place, we believe that EMs are now positioned to exploit the more robust and less externally dependent growth environment they have created.

In the DMs, the situation is very different, and growth dynamics are more sluggish in the longer term. Investment there should still rebound, and after the urgent deleveraging of the last couple of years we think the augmented saving rate flattens off under demographic pressure and ongoing fiscal policy support. The investment drought and saving glut dynamics of the last decade are therefore likely to reverse.

2. Real EM exchange rates should continue to appreciate... The second call concerns real exchange rates, and it entails a surprise that's more backward- than forward-looking. Despite all the talk that EMs have not been allowing exchange rates to adjust to rein in global imbalances, the data indicate otherwise. Since 2003, real appreciation has been the norm, reversing the prior trend, and we think at a rate that is much larger than productivity alone might suggest. For sure, the crisis and the Great Recession interrupted this aspect of the rebalancing process, via the transitory flight to the US dollar, but the fundamental drivers that started the rebalancing process since 2004 have proven strong enough to re-initiate the longer-term trend.

This trend is likely to intensify as EM takes a greater weight in the global economy and switches to a less export-led model. Now EM will bid for more DM goods, and the DM currencies will depreciate in real terms to permit this: it will not be, and has not been so far, a so-called immaculate transfer, where global imbalances adjust without corresponding price movements.

...but through a different mix. EM economies could achieve real appreciation in their currency values through nominal appreciation or they could allow inflation to stay above DM inflation (or both). While the overall need for global rebalancing is satisfied by real exchange rates being moved by either nominal exchange rates or inflation, the mix is clearly important for markets. The bulk of the movement in the real exchange rate so far has been more through the inflation channel than the nominal exchange rate channel, but that trend might change. To the extent that nominal currency values appreciate, inflation will have less work to do.

The most likely outcome seems to be a combination of nominal appreciation as well as inflation. But EMs face a perfect storm of added inflationary pressures in the near term, owing to cyclical recoveries being inflationary, and given extra-fast relative growth with an DM-EM two-track recovery, transitory food and raw material price shocks, and the added longer-term forces working through the global rebalancing channel. Given the potential for social and political disruption from high inflation, EM policy-makers may be forced to rethink the inflation-appreciation trade-off. Thus, EM nominal appreciation may be closer at hand, especially among surplus economies with very little slack in the economy (read AXJ), with China likely to be the strategic ‘first mover' in that bloc.

3. Global real yields to rise. The last 10 to 20 years of global macroeconomic evolution have been characterised by falling real yields. But this remarkably supportive environment of abundant and cheap global capital could be nearing an end. We highlight the confluence of forces and what they mean.

Our first trend was pent-up DM investment demand. Once this capex cycle is eventually unleashed, the cost of capital will rise as DM economies return to growth and compete with EM economies for investible funds, raising the real interest rate, all else equal. Our second trend was a possible tapering off in EM public saving. Should that occur, as the pace of EM reserve accumulation tapers off, then global saving supply moderates and, specifically, the DM government bonds previously absorbed now start to crowd out global investment by raising the real interest rate, all else equal. Our third trend only exacerbates the first and second: private saving is likely to move lower in some EMs as consumers moderate their precautionary tendencies, and we could see expanding private investment in other EMs - with both factors serving to reduce the excess supply of saving. For all three reasons, the real interest rate seems likely to rise.

Thus, our medium-term prediction is for a reversal of all of the notorious macroeconomic and financial tendencies of recent years: no more saving glut or investment drought, no more bond conundrum or cheap capital. In many ways, then, we anticipate something of a return to the pre-2000s normality, with positive and rising global real yields.


The trends we have outlined have very clear implications: we believe that they will lead to further moderation in global imbalances, further real currency appreciation for EM, and higher real interest rates globally. Higher investment and lower saving in the EM world are likely to draw capital there to pursue higher returns. In our view, these sustained capital flows and EM economic outperformance set the stage for further appreciation of EM currencies in nominal and real terms.

Global imbalances have been falling for some time. While cyclical factors have clearly played a role of late, we believe that deeper fundamental drivers are still the more important factors in the global rebalancing story. The trend in real exchange rates is a key supporting point for our thesis.

Finally, we argue that wider investment-saving gaps in the EM as well as DM economies mean that competition for loanable funds will be more intense. A direct consequence will be higher real rates. Real rates could also rise because of higher macro risk premia, but we highlight the change in investment and saving trends as a benevolent driver of higher real rates. Importantly, this would represent a break from the 30-year trend of falling investment and the consequent fall in real interest rates.

Given that the rise in real yields will represent an increase in productive capacity in EM and DM economies, rather than a rise in macro risk premia, we believe that higher real yields will not prove disruptive for the global economy and will allow the rebalancing we have mentioned to proceed.

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United Kingdom
BoE Inflation Report: Nearing a Hike, but in No Rush
February 18, 2011

By Melanie Baker, CFA, Cath Sleeman | Europe, Johannesburg, London

Today's Inflation Report, in our view, shows that the MPC has moved closer to raising rates. Below, we analyse the bank's new inflation outlook in detail, using five key charts from the Report. Our three key takeaways are:

i)          The bank sees greater inflation pressures over the medium term than it did in November;

ii)         Assuming the BoE ‘has it about right' on the economy, its inflation forecasts look consistent with expecting two rate rises this year from the MPC (and 2% rates by end-2012); and

iii)        There is still a good chance that the first rate rise from the MPC comes in May rather than August (August is our existing central case).

The numbers below correspond to the numbers of the charts/table in Exhibit 3 in the full report.

1.         Inflation Fan Chart Using Constant Interest Rates

Q: How have the BoE's inflation forecasts changed?

A: The MPC's near-term inflation forecasts have been revised up substantially (as had been well flagged by the MPC).  Its medium-term forecasts are also higher (although by not nearly as much).  The single most likely outcome for inflation at the two-year horizon (based on unchanged policy) now looks above target.  This suggests that we should expect rates to rise this year.  Indeed, according to the Inflation Report "under that assumption [constant interest rates] for monetary policy, inflation is more likely to be above the target than below it at the two-year point".

2.         Market Interest Rates Table

Q: How much tightening has the BoE assumed in the other key charts we focus on?

A: The ‘market' interest rate expectations (which underlie the swathes chart and main inflation fan chart) show a 0.7% policy rate in 2Q, 0.8% in 3Q and 1.0% in 4Q.  By the end of 2012, the profile shows the policy rate at 2.1%.  This looks similar to our own central forecast (a first rate rise in August - with a good chance of a first rise in May, 1.0% rates by end-2011 and 2.0% by end-2012).

3.         Swathes Chart (Incorporating ‘Market' Interest Rate Expectations)

Q: Is the ‘market interest rate' profile consistent with hitting the inflation target (part 1)?

A: The swathes chart indicates that the MPC thinks the probability of inflation being above target two to three years ahead is 50%.  Hence, this suggests that the MPC's median inflation forecast is about 2% (i.e., in line with the Bank of England's target) at that horizon, once a ‘market' profile for interest rate rises is incorporated.  So, expecting two rate rises from the MPC this year and interest rates at 2.0% by end-2012 looks reasonable based on this assessment.

4.         Inflation Fan Chart Using ‘Market' Interest Rate Expectations

Q: Is the ‘market interest rate' profile consistent with hitting the inflation target (part 2)?

A: If the MPC is broadly right on the economy, at face value this chart suggests that the market has too much priced in for rate rises. Two to three years ahead, the chart shows that the single most likely outcome (the mode - which lies within the darkest band of the fan chart) is below the 2% target.

5.         Snapshot Inflation Distribution Chart

Q: How do we make sense of the apparent difference in message between charts 3) and 4)?

A: The risks to the bank's inflation outlook are skewed to the upside in the MPC's view. This implies that the median forecast (deducible from the swathes chart) will be higher than the mode (which lies within the darkest band on the fan chart).  The former effectively incorporates an element of risk-adjustment. 

We think that the ‘swathes' chart (3) is more important than the fan chart (4) in identifying a reasonable future path for monetary policy (assuming the MPC has it about right on growth and inflation).  We think that this view is borne out by recent Inflation Reports, where if the emphasis had merely been on the darkest band (mode) of the fan chart, the MPC should have been doing more QE (this part of the fan chart has been below 2% in the forecasts where policy is kept unchanged).  Further, in the press conference today, Governor King said that "we always try to bring inflation back to target with balanced risk around that" (our italics).

Why do we expect a first rate rise in August rather than May? This, admittedly, is now a rather close call.  In our view, growth is likely to disappoint the MPC and unemployment will rise over most of 2011.  "Material downside risks to demand" is one of the main reasons the MPC gave for not tightening rates in January.  Given all this, we think that the MPC will be rather cautious and gradual in raising rates.  However, by August we think that the MPC will prefer to start raising rates rather than risk high levels of current inflation becoming ‘embedded' (through higher inflation expectations and wage growth) and therefore of having to raise rates aggressively.  Given the rather high levels of household leverage and the challenges that banks already face over the next couple of years, the latter outcome would be very unattractive, in our view. 

What would trigger an early rise? In our view, neither the tone of the Inflation Report nor the charts highlighted above look consistent with a rate rise in the next two months.  However, we continue to think that a key trigger for such a rise would be a sharp increase in pay settlements and/or wage growth.  Of course, increases in wage growth may come from rising productivity.  However, sharp increases in wage settlements are more likely to reflect high inflation becoming engrained in wage-setting behaviour, in our view.  This would push up unit wage cost growth.  The BoE's own forecasts assume that unit wage cost growth is likely to remain subdued throughout the forecast period. 

Our forecasts versus the BoE's. The bank's central forecast for GDP growth (the mode) continues to look optimistic compared to our own.  The bank's central forecast for inflation appears similar to our own (if a bit higher) until early 2012.  But beyond that point, our central forecast for inflation looks considerably higher.  It continues to appear that the MPC places greater weight on spare capacity as a significant drag on inflation over the medium term.  The numbers underlying the bank's forecasts will be published next week alongside the Minutes.

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The Ruble - How High Can it Go?
February 18, 2011

By Jacob Nell, Alina Slyusarchuk | Moscow, London

In 2010 the ruble did not live up to expectations: In particular, the weak 3Q10 saw a sharp slowdown in growth (from 5.2%Y in 2Q to 2.7%Y in 3Q), with unexpectedly heavy capital outflows on the balance of payments in 4Q (US$22.7 billion), which, together with a poor harvest in 2010 (37%Y fall in the grain harvest), weighed on the ruble. 

Since November 2010, however, the ruble has been increasing steadily, fuelled by a rising oil price, and the consequent strong position on the current account: As of February 16, the ruble has risen against the basket to 33.95, a rise of 7% in nominal terms and 11% in real terms since the start of November.  How much further could this run continue?

We still expect the ruble at 34 to the basket by end-2011: We looked at this question recently (see Will the CBR Tighten in January? January 24, 2011) when we called for a rise in the ruble to 34 to the basket by end-2011, on the basis of a forecast US$70 billion surplus on the current account, and forecast that any rise above that rate at a US$96/bbl oil price would run into increasing headwinds.  This call translates into the following numbers:

At the moment, based on balance of payments fundamentals and central bank statements, we do not see a strong reason to change this call:

•·   Balance of payments: Although the oil price has been slightly stronger than expected, total reserve accumulation in the year to February 4 was only US$7.6 billion, or about half of what we would have expected from the forecast US$40 billion 1Q current account surplus.  This implies ongoing capital outflows offsetting the current account.  There are some signs that there may be a change of investor sentiment towards Russia and a resumption of capital inflows, including the successful US$3.3 billion VTB share sale and the CBR tightening at end-January by raising reserve requirements rather than rates because of a concern about short-term capital inflows. But, the picture on investor sentiment is mixed, with three recent planned IPOs cancelled - Chelpipe, Koks and NordGold - and Barclays announcing a loss of £244 million on its Russian acquisition and exit from retail banking in Russia.  The next data release on the balance of payments - 4Q10 data due on March 31 - may provide information to revise this view. 

•·   Central bank attitude: The CBR does not like excessive short-term volatility in the exchange rate, and is, we think, currently buying US$300-350 million per day, and will lean further against appreciation as the rate approaches the edge of the intervention bands, which Deputy Governor Ulyukaev said was 33 to 37 on February 1.  Governor Ignatiev's comment, reported by Interfax on February 10, that the CBR intends to further widen the intervention bands around the central rate, as part of the ongoing move to a more flexible exchange rate, later in the year has two implications.  First, it implies that the CBR will not widen the bands in the short term, and will therefore not allow appreciation beyond 33 to the basket.  Second, if the widening later in the year is by a further ruble around the central rate from 4 to 5, similar to the widening by a ruble around the central rate from 3 to 4 in October 2010, it implies that the CBR would allow appreciation up to a maximum of 32.5 to the basket by year-end.

We Forecast a Rate Rise in February 

We expect a 25bp hike in the deposit rate with high conviction, a 50-100bp hike in reserve requirements and a 25bp hike in all other active policy rates (repo, refinancing) in February: Our call is that the CBR will tighten further at the policy meeting at the end of February, given rising inflation (currently 9.6% annual rate versus 6-7% target) and hawkish language (the CBR will "most likely" raise rates in February, said Governor Ignatiev on February 4).  Given Ignatiev's frequent recent references to reserve requirements as an instrument of monetary policy, the high rates of reserve requirements in Russia previously (up to 8.5%) and the current high rates in other key emerging market central banks (for instance, Turkey 6%) trying to tighten in the face of rising inflation without raising rates and provoking capital inflows, we think that the CBR will raise reserve requirements again by 1pp to 4.5% for liabilities to corporate non-residents and by a further 0.5pp to 3.5% for liabilities to residents. However, we think that the CBR will also raise rates, given inflation well above target and robust recent indicators of growth (industrial production in January up 6.7%Y, slightly above our expectations of 6.6%Y and above consensus of 6.0%Y).  In addition, we believe that it is uncertain that raising reserve requirements, which might require banks to increase their reserves at the CBR by RUB 50-100 billion from the current level of around RUB 200 billion, will have an impact on monetary growth when the banks already have huge ruble liquidity of RUB 1.4 trillion at CBR correspondent accounts or on deposit at the CBR.  Given the CBR's incrementalist recent approach, we call for a 25bp hike in the deposit rate with high conviction, a 50-100bp hike in reserve requirements and a 25bp hike in all other active policy rates (repo, refinancing) in February.  In our view, the Ministry of Finance is also behaving as if it expects a rate hike from the CBR in February, since despite running a budget surplus in the year to date, it has been taking advantage of high ruble liquidity and consequent low rates to increase the volume of borrowing in the domestic market.    

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