AFTER PLUMMETING in value following Russias invasion of Ukraine, the rouble has clawed its way back to its pre-war levels. But this should be of little comfort to the Kremlin, because the factors that drove the roubles rebound augur additional problems for Russias economic performance.

The West has exhibited nearun precedented unity and resolve in its response to Russian President Vladimir Putins war on Ukraine. Within just three days of the invasion, Western governments had frozen much of the Russian central banks foreign-currency reserves within their respective jurisdictions.

This move triggered financial panic within Russia and spurred a powerful policy response. On February 28, the central bank imposed strict capital controls, tightened currency-trading restrictions, and hiked its key policy rate from 9.5 per cent to 20 per cent.

Russias government then ordered all Russian exporters to repatriate and exchange 80 per cent of their export revenues for roubles, and the central bank introduced a 30 per cent commission later reduced to 12 per cent on foreign-currency purchases. Various categories of buyers were banned from purchasing US dollars, and holders of foreign-currency-denominated bank deposits faced major constraints withdrawing their savings.

Despite this swift policy response, however, the roubles official exchange rate moved from 81 roubles per dollar before the war to 139 per dollar on March 9 though the black-market rate reportedly was much higher. Inflation accelerated substantially, with the growth rate of the official consumer price index rising to two per cent per week or 181 per cent in annual terms in the first three weeks of the war, before slowing to one per cent per week or 68 per cent per year.

The rouble has since returned to the 80-per-dollar range. But its appreciation is not necessarily real. If a currencys trade is severely restricted, its exchange rate does not reflect its market value. During the Soviet era, the Communist Partys flagship newspaper, Pravda, consistently reported that the roubles official exchange rate was 0.6 per dollar, but nobody viewed that as a proxy for the currencys real strength.

To be sure, there are tangible signs that the pressure on the rouble is subsiding. Late last week, the central bank removed the 12 per cent fee for purchasing dollars, relaxed certain limitations for currency denominated deposits, and most importantly cut its policy rate from 20 per cent to 17 per cent, while signalling further easing to come. These actions speak louder than any official statements about the strength of the Russian economy.

BLEAK

Even so, growth projections for Russia this year remain bleak. According to the central bank, GDP will decline by eight per cent this year; before the war, it was expected to increase by 2.4 per cent. The Institute of International Finance predicts a 15 per cent fall in GDP, while the European Bank for Reconstruction and Development, EBRD, and most international investment banks forecast a 10 per cent recession. The head of Russias Accounts Chamber, Alexei Kudrin, agrees.

The roubles recent appreciation does not invalidate these pessimistic views, because the exchange rates recovery is merely a reflection of unprecedented restrictions on imports and higher oil and gas prices.

Western governments have imposed severe sanctions on technology exports to Russia, which have been reinforced by a private-sector boycott, with more than 600Western companies having withdrawn from Russia. Households and enterprises have lost access to many imported consumer goods and intermediate inputs at home, while airspace closures and boycotts by Airbus, Boeing, and major insurers and leasing companies have made it all but impossible for Russians to travel to the West.

Because these restrictions have substantially reduced Russian demand for imports, note economists Oleg Itskhoki and Dmitry Mukhin, they have also lowered demand for dollars which are needed to purchase such goods thereby driving the roubles exchange rate upward. But that is not good news for Russias economy, which is bound to slow down.

Just as the COVID-19 pandemic forced firms around the world to reckon with their dependence on global supply chains, Putins war has shown Russian enterprises that they cannot function without imports. Even those that source their supplies domestically have come to realise that their suppliers depend on imports from the West. That is why Russias automotive industry has ground to a halt, with sales in March falling to a third of their level in March 2021.

Moreover, the demand for dollars has been further reduced by financial sanctions that essentially outlaw Russias use of dollars even to pay off its dollar-denominated debt. These measures have already resulted in a technical sovereign default.

The second factor driving the roubles appreciation is the high price of oil, which has returned to its 2014 levels. Back then, the rouble was trading at 38 per dollar, or 52 per dollar in todays prices, after adjusting for inflation in both Russia and the United States. Todays oil prices thus imply the possibility of further rouble appreciation, save for the fact that geopolitical risk and capital flight have made the rouble weaker than it otherwise might have been.

EXCHANGE RATE

Todays exchange rate indicates that Russias balance of payments is strongly supported by current oil prices, which implies that fiscal performance is holding up well, too. While the early sanctions froze much of Putins stock of cash, high oil prices have ensured substantial daily inflows.

But this, too, could become a problem for Putin. As EU High Representative for Foreign Affairs and Security Policy Josep Borrell recently pointed out, the EU has sent 35 billion (US$38.1 billion) to Russia since the start of the war, but just 1 billion in aid to Ukraine. This appalling disparity has not been lost on European leaders, as the growing support for an oil and gas embargo attests. In fact, Europeans are already speaking about the embargo not in terms of if but rather in terms of when.

An EU-wide decision to stop importing Russian oil and gas will have catastrophic consequences for Russias federal budget and make the roubles recent recovery unsustainable.

QUESTION

1. Assess the pros and cons of the article for an investor and an investment banker.