Fitch: Russia Rate Cuts, Budget Show Shifting Policy Response

The Central Bank of Russia's (CBR) policy rate cut and recent revisions to the 2015 budget come as pressure from external shocks eases but does not disappear, Fitch Ratings says. Economic policy coherence and credibility have been important supports for Russia's sovereign rating in 2H14 and 1Q15.

The CBR on Thursday lowered its key rate by 150 bps to 12.5%, its third cut this year following last December's hike to 17% from 10.5%. The CBR said that high annual inflation (16.5% as of 27 April) was primarily due to short-term factors (currency depreciation in December-January and sanctions). It said annual inflation will fall to the target of 4% in 2017.

The partial recovery in oil prices has been accompanied by a recovery in the rouble from its early-2015 lows and ebbing dollarization pressures. Rouble strengthening has helped stem net capital outflows (although net repayments of corporate external debt persist), while an apparent easing in geopolitical concerns and investors' search for yield have seen foreign money flow into the local currency bond market. This has given the CBR some respite. Further aggressive easing might suggest the central bank is focused less on inflation targeting and more on growth.

Lower interest rates will reduce pressure on the economy and help curb rouble appreciation. The revised 2015 budget assumes an average exchange rate of RUB61.5/USD (versus around RUB69 at end-January and RUB52 currently). A stronger rouble would reduce oil-related budget revenues, trimming the margin provided by a conservative oil price assumption (USD50/b).

The revised three-year budget draft shows fiscal policy adjusting to lower oil prices. The authorities have revised down 2015 revenues by RUB2.5trn and cut spending by RUB300bn. The government has frozen public sector wages and cut the budget to make room for higher contingency and defence spending. Even so, the deficit will be 3.7% of GDP in 2015. The government aims to keep spending flat in 2016, though not all measures have yet been spelled out. Coupled with a forecast recovery in oil prices, this should limit fiscal deterioration.

Key risks to Russia's sovereign credit profile from exchange rate volatility or accelerating reserves depletion have not materialised so far this year, and 2015 outturns are generally consistent with our assumptions when we downgraded Russia to 'BBB-'/Negative in January.

The rating reflects both the sovereign's residual credit strengths and the risks presented by external shocks, which could still put the policy framework under pressure. Outflows have slowed but continued in 2015. International reserves were USD353.5bn on April 24, according to the CBR, down from USD385bn at end-2014 and USD486bn at end-1Q14. Reserves decline is still consistent with our projections and is weakening Russia's sovereign external balance sheet, albeit slowly and from a position of strength.

An imperfect ceasefire in eastern Ukraine has held since mid-February, and sanctions on Russia have not escalated significantly since January. However, geopolitical risks cannot be discounted. In March, the European Council said that sanctions should be clearly linked to implementation of the Minsk agreements on Ukraine and that this was unlikely before the end of 2015.

Fiscal buffers are also being eroded as the bulk of financing of this year's deficit, despite a revival in government debt issuance, will come from the Reserve Fund. The economic outlook remains weak. GDP fell 2.2% in 1Q15 from a year earlier, and the budget assumes a 3% contraction, although recent data indicate the recession may not be as deep as feared.