#10
Strong rouble poses stark choice on Russia economy
By Andrius Vilkancas

MOSCOW, Feb 20 (Reuters) - Strong crude prices and a hefty investment by British oil firm BP are flooding Russia with money and driving up the rouble. That is giving manufacturers a stark choice -- use new found riches to modernise or perish.

Economists say rouble strength is blunting the competitive edge of Russian manufacturers and eroding profit margins of exporters but it could also pave the way for more investment if Russians use their spending power to upgrade old plants.

Russia, the world's second biggest crude exporter, is riding an oil boom as high prices prompt oil companies to hike output.

Christopher Granville, a strategist at UFG investment house, said Russian manufacturers were being forced to become more efficient, raise productivity and streamline their businesses.

"Interest rates will become lower, access to credit will be easier and it will be cheaper for domestic businesses to equip themselves including importing the necessary equipment to produce the goods," Granville said.

But a strong currency would take a heavy toll on any industries that failed to get into shape. And that could lead to stagnation in the economy and increased dependence on oil.

"The rapid nominal (rouble) appreciation is going to hurt both exporters and domestic producers," Al Breach, a chief economist at Brunswick UBS Warburg said.

The Russian currency recently hit a six month high against the dollar. The central bank has recently started to target inflation rather than try to hold down the rouble's value.

And the rouble got a major boost from BP's announcement last week of a $6.75 billion investment in Russia. The pledge was widely seen as a ringing endorsement of President Vladimir Putin's reform policies.

ROUBLE NOT SEEN VULNERABLE IF OIL PRICE FALLS

The news also underscored Russia's dependence on its oil industry. Oil and gas made up 56.4 percent of Russia's total exports to Western countries in 2002 and also generate a big share of government fiscal revenues.

But even if oil prices collapse economists saw little danger of the rouble going into freefall, given Russia's conservative fiscal policy, low volumes of hot money entering the country and plentiful foreign currency reserves.

"If the oil price collapses the rouble is not going to collapse. It is going to depreciate... The risks are all in the opposite direction," Breach said.

Economists say oil prices could plunge if the United States leads a successful campaign to topple Iraqi leader Saddam Hussein and the Gulf nation quickly resumes oil exports.

"The baseline forecast for this year is that oil price will not fall below $20 per barrel and if oil prices get softer, the rouble could ease to 33.0-33.5 by year end," said Stanislav Gelfer, an analyst at London-based economic consultancy 4cast.

The rouble traded at 31.58 to the dollar on Wednesday. Russia's main crude oil export grade, Urals, traded at about $31 per barrel on Wednesday.

ROUBLE COULD STRENGTHEN FURTHER

While oil prices stay strong, economists said the rouble would appreciate further, boosted by capital and current account inflows, and could rise up to 10 percent this year despite central bank resolve to contain gains to less than six percent.

"The increased inflows will only add pressure on nominal appreciation of the rouble and I am sure there will be a big policy debate within Russia about that," said Gelfer.

"Fundamentally there is no way the government or the central bank could affect real rouble appreciation. They can only affect the speed of it to some extent," he added.

BP's bold move could be followed by other investments from abroad, further strengthening the rouble.

"Success breeds success. If things go well, more money will be invested here. As things get better, more money comes here. So you get into a virtuous circle," Breach said.

Russia has lagged behind some other former communist countries in attracting foreign investment despite four years of robust economic growth fuelled by a booming oil industry. Foreign direct investment reached $4.0 billion in 2002.

Meanwhile, Russian exporters could cushion the squeeze on their profit margins through boosting output, economists said.

"Their labour and capital investment costs will rise and that is negative for their margins. That said, the productivity growth that guys like (oil companies) YUKOS and Sibneft are delivering, is offsetting some of that," Breach said.