UPDATE 2-Russia c.bank vows to defend financial stability, keeps rates on hold

Fri Mar 14, 2014 9:09am EDT

* Central bank keeps key lending rate at 7 pct

* Move indicates monetary tightening more permanent

* Bank says to prioritise financial stability

By Lidia Kelly

MOSCOW, March 14 (Reuters) - Russia's central bank on Friday kept lending rates on hold after raising them two weeks ago and said it would fight for financial stability after the standoff with the West over Crimea, which has sent the rouble and stocks tumbling.

The bank took the emergency step on March 3 of raising its key rate by 150 basis points to 7 percent to stem capital flight after President Vladimir Putin said Russia had the right to invade Ukraine.

Russian troops have already effectively taken control of Ukraine's Crimea region, which is expected to vote to become part of Russia in a referendum on Sunday that the West says is illegal.

The Russian central bank said there would be no easing of rates in the months ahead, suggesting it expects more tough times ahead for the rouble and for stocks, which have lost about a quarter of their value since mid-February.

"Stabilising capital flows is clearly the central bank's number one priority," said Neil Shearing, chief emerging markets economist at Capital Economics in London.

"The tightening of the policy may be more permanent than many seemed to expect. My sense is that unless capital flight eases, a further rate hike is possible."

Analysts widely expect capital flight to reach $50-$55 billion in the first quarter alone, compared with $63 billion in the whole of 2013.

The East-West standoff over Ukraine and the Crimea referendum have hit Russian assets hard.

The central bank has been forced to put on hold a long-promised shift towards inflation targeting, and this risks tipping the economy into recession as it tries to ensure financial market stability.

"The Bank of Russia's priority is to contain the effect of (the rouble's) exchange rate dynamics on inflation and to maintain financial stability," the central bank said on Friday.

The rouble is down 11 percent against the dollar this year , adding pressure on consumer price inflation. The central bank has spent at least $16 billion this month to keep it from falling too fast.

Russian stocks have tumbled since Putin's declaration on the right to invade Ukraine, and the capitalisation of the MICEX index is down $66 billion since March 3, not including the 2.0 percent slide in stocks seen on Friday.

Analysts had said they expected the central bank to keep its rates on hold this time, and many do not see any monetary easing until at least a presidential election due in Ukraine on May 25.

TOUGH TIMES AHEAD

The full response of the West and markets to the Crimea referendum is far from certain.

"We believe (the referendum) might lead to a limited ratcheting-up of sanctions on Russia, but with little direct economic impact," analysts at Renaissance Capital said in a note on Friday. "However, plenty of negative headlines and second-round effects are likely to emerge."

Shearing, at Capital Economics, said nervous anticipation over the sanctions might be having a bigger effect on markets than any sanctions themselves would. But, he said, there was still "no end in sight to the crisis."

Whatever the response, a further slide on Russian markets and more pressure on the rouble are expected, meaning the central bank will remain in crisis mode.

"It is clear that keeping rates at current levels over the long term contributes, first of all, to the (preserving of) financial stability rather than combating inflation," said Alexander Morozov, chief economist for Russia at HSBC in Moscow.

Annual inflation stood at 6.2 percent in February. The central bank's goal has been to bring it down to 5 percent by year-end. On Friday, it said risks to that target remain.

"Inflation rates are unlikely to fall until mid-2014 due to the observed rouble depreciation," it said. It did not say how much the currency's weakening may contribute to inflation or what the impact will be on economic growth.

Vladimir Miklashevsky, an analyst at Danske Bank in Copenhagen, called the central bank's decision on Friday a de-facto tightening of monetary policy.

"These are extremely negative actions for the Russian economy," he said. "The probability of a recession has grown significantly."

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