Tensions further rock Russia

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MOSCOW -- With tensions over Ukraine continuing to mount, Russia is scrambling to stem the economic fallout, as its central bank unexpectedly raised a crucial interest rate Friday.

The move is intended to help halt the slide in the country's currency and stem the exodus of capital, both of which are intensifying the country's economic problems.

Hours earlier, rating agency Standard & Poor's downgraded Russia's debt to the brink of junk status, citing the destabilizing effects of capital flight from Russia. In the first three months of the year, Russian and foreign investors have moved $51 billion out of the country, S&P said. That sum is nearly as large as the average annual outflows of $57 billion over the past five years.

While the downgrade itself is unlikely to fan investor fears, the threat of further sanctions may prompt more outflows. S&P said that would "undermine already weakening growth prospects."

Russia's gross domestic product grew 1.3 percent last year, one of the weakest showings since 1999. If the Ukraine tensions ease, S&P said, growth could average 2.3 percent a year through 2017. But a failure to resolve the crisis would leave a "significant downside risk that growth will fall well below 1 percent."

Even before tensions rose over Ukraine, economists said Russia was suffering from the combination of low growth and high inflation known as stagflation, a devilishly difficult economic problem to crack. The government waffled in its response -- first advocating government stimulus, then shifting to a hawkish policy at the central bank to lower inflation and borrowing costs for businesses.

But the Ukraine crisis hit the Russian economy before the new policy really took hold. Rather than lower rates, the central bank was instead compelled to raise them twice, to make saving money in rubles more appealing and to slow the flight of capital.

The central bank March 3 said it was temporarily raising the benchmark interest rate to 7 percent from 5.5 percent. On Friday, it increased the rate by half a percentage point, to 7.5 percent. The bank cited the inflationary impact of the sinking ruble, and said annual inflation stood at 7.2 percent as of Monday. It said it hoped to hold inflation to 6 percent by the end of the year.

S&P said it viewed the central bank "as being confronted with increasingly difficult policy decisions with regard to addressing inflationary pressures resulting from financial market volatility," while also trying to support growth in the economy.

Reflecting such concerns, the agency cut Russia's sovereign debt rating by one notch, to BBB- from BBB, leaving it at the lowest investment grade level. It said the outlook remained negative and the central bank could lose room to maneuver.

The agency said it could downgrade Russia's debt to junk status if additional sanctions were imposed that would harm the country's creditworthiness by restricting operations of banks or the cash-cow oil companies at the heart of Russia's economy. Fitch and Moody's, the other two major rating agencies, have cautioned about a downgrade but have not yet acted.

While the credit downgrade may not accelerate the country's woes, it complicates matters for the already-troubled economy.

Because of the uncertainty over sanctions, debt markets have been closed to Russian companies. None has managed a major Eurobond placement in two months, even as the firms are compelled to pay off bonds issued earlier. If markets remain shut, Russian companies will have to turn to domestic sources, mostly state banks, to roll over $115 billion in debt to foreign lenders coming due by the end of the year, Merrill Lynch estimated.

Russian markets took the news of the downgrade in stride. The benchmark Micex index, volatile at the best of times, closed down 1.6 percent, and at the end of the trading day in Moscow, the ruble was about flat, at 36 to the dollar.

Still, the continued drumbeat of bad news does not help. Russia has long been a favored investment as part of a wider emerging market strategy, and the tumult is forcing many money managers to rethink.

Stocks in Russia's once-booming technology industry suffered Thursday when President Vladimir Putin casually dropped that he thought the Internet was a tool of the Central Intelligence Agency. Earlier in the week, the founder of Russian social networking site Vkontakte, Pavel Durov, said he had fled Russia under political pressure, raising questions about tech startups' ability to help diversify the economy away from oil dependence.

Obama administration officials have met with fund managers to caution them about Russian investments and warn of possible new sanctions, Merrill Lynch's Moscow office said in a note to investors. Even without additional sanctions, such an informal action could have a chilling effect on investment.


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