As Inflation Slows and the Ruble Rallies, Russia Is Hoping to Avoid a Financial Crisis

• Further rises in the coming months are expected to be modest, and the market backs the Central Bank of Russia to continue to unwind its emergency interest rate hike.
• While the headline inflation rate notched its highest since 2002, month-on-month consumer price growth slowed sharply from 7.6% in March to 1.6% in April.
• As of Tuesday morning in Europe, the ruble was trading at just over 62 to the dollar, having plunged to an all-time low of 150 to the dollar on March 7.

Russia believes it has swerved a financial crisis as its currency rallies and economic data improves, but strategists say the numbers mask some ugly truths for Moscow.

Although inflation in the country is running hot, there are signs that price rises are slowing and will continue to do so, while the Russian ruble has gone from an all-time low in March to the world's best performing currency this year.

Meanwhile, economic activity indicators are improving and Russia has thus far managed to avoid defaulting on its foreign currency debt, despite Western sanctions freezing large swathes of its reserves.

Russian inflation came in at a two-decade high of 17.8% year-on-year in April, up from 16.7% in March, but price rises are beginning to show signs of slowing. Consumer price growth slowed sharply from 7.6% in March to 1.6% in April, and non-food goods prices increased by just 0.5%, versus 11.3% in March.

Further rises in the coming months are expected to be modest, and the market backs the Central Bank of Russia to continue to unwind its emergency interest rate hike, possibly with a 200 basis point cut in June.

It comes after the CBR implemented an emergency rate hike that took the country's key interest rate from 9.5% to 20% in late February, several days after Russia's unprovoked invasion of Ukraine, in a bid to rescue the ruble. The central bank has since been able to move the rate to 14% as the outlook for inflation and the currency improved, and Capital Economics sees further changes ahead.

"Today's [inflation] figures will further support the central bank's assessment that the acute phase of Russia's crisis has passed," Emerging Markets Economist Liam Peach wrote in a note last week.

"It's possible that consumer prices rise by less than 1% m/m in May as a whole and that headline inflation ends up peaking at just below 20% later this year."

Ruble resilience

The slowing price increases follow a steep appreciation of the ruble, which in turn reduces import prices.

As of Tuesday morning in Europe, the ruble was trading at just over 62 to the dollar, having plunged to an all-time low of 150 to the dollar on March 7, following the announcement of a suite of international sanctions in response to Russia's invasion of Ukraine.

Despite the dollar's broad strength, owing in part to its perceived safe-haven status amid risk aversion in global markets, the greenback is down almost 17% against the Russian currency year-to-date.

Strict capital control measures from Russia's central bank — which include ordering companies to convert 80% of their foreign currency revenues into rubles — have helped revive the ailing currency. The Kremlin also initially banned Russian citizens from transferring money abroad, and transfers are now limited to $10,000 per month for individuals until the end of 2022.

"The Russian economy continues to recover from the initial shock in late February and early March," Goldman's economist Clemens Grafe wrote in a note earlier this month. "Concerns about financial stability are fading, the RUB has strengthened back to early 2020 levels."

For many analysts, however, Moscow's actions to defend its currency are tantamount to manipulation, in that demand has been created that would not otherwise exist and capital controls have effectively turned the ruble into a "managed" currency.

Charles-Henry Monchau, chief investment officer at Switzerland-based Syz Bank, suggested that while the Russian central bank has deployed a range of tools to make the ruble look valuable, very few people outside Russia "want to buy a single ruble unless they absolutely have to," and traders "no longer see the ruble as a free trade currency."

"If Russia succeeds in finding a solution to the Ukrainian problem with the corollary of withdrawing sanctions and restoring trade relations with the West, the ruble can potentially retain its current value," he said.

"On the other hand, if the measures are withdrawn without a resolution, the ruble could collapse, resulting in an explosion of domestic inflation and a deep economic recession in Russia."

And Russia has also undertaken another measure to shore up its currency. The CBR resumed gold purchases on the domestic metals market after a two-year absence, in the hope of storing value to protect Russian wealth against inflation in the event of a further shock to foreign exchange liquidity.

"Another strong move went relatively unnoticed in the Western media: the Bank of Russia resumed gold purchases at a fixed price of 5,000 rubles per gram between March 28 and June 30," Syz Bank's Monchau said.

As gold is traded in U.S. dollars, Monchau noted that this enables the CBR to link the ruble to gold and set the floor price for the ruble in dollar terms. Further ruble rises could therefore increase the price of gold, and Russia has been accumulating the precious metal rapidly since its annexation of Crimea in 2014, now boasting the fifth-largest stockpile in the world.

Therefore, the move offers further protection for the Russian economy against liquidity constraints resulting from further sanctions, and the deterioration of the country's foreign currency reserves to service dollar-denominated debts.

The closely-watched Purchasing Managers' Index economic indicators are also showing some improvement.

After plunging from 48.6 in February to 44.1 in March — with a reading below 50 indicating contraction — April's figures rose to 48.2. This was mostly on the back of improved output and shorter suppliers' delivery times, according to Goldman Sachs.

"Russian financial conditions have improved mostly on the back of a narrowing CDS (credit default swap) spreads as Russia paid principal and interest on Eurobonds in USD," Goldman's Grafe noted.

Russia successfully made payments to holders of two dollar-denominated Russian sovereign bonds, maturing in 2022 and 2042 and worth a collective $650 million, before the end of a 30-day grace period on May 4. However, analysts still warn there's a high probability of a Russian default within the next two years.

Temporary victory

The collective improvement in the data has led Russian President Vladimir Putin to claim that the West's "economic blitzkrieg" — or "lightning war" — had failed.

Yet while Russia appears to have fended off impending economic collapse, the longer-term outlook is less optimistic, as the knock-on effects from mitigation measures and the threat of further sanctions remain in play.

A survey by the Central Bank of Russia of more than 13,000 businesses recently revealed that many were already running into trouble importing goods into the country.

These included car parts, packaging and microchips, and raw material shortages are forcing some companies to suspend factory operations or seek resources elsewhere, the survey found.

Meanwhile, Elina Ribakova, deputy chief economist at the Institute of International Finance, told the BBC last week that the "superficial" economic indicators would mean little to those on the ground, where job security remains hazy for many Russians.

"Within this year, we will see the effect on Russian economy as companies start to run out of parts or equipment and have to start laying people off or putting them on unpaid leave," she told Grid News in a separate interview this week.