Russia scrapped a sale of ruble bonds for the second time this month as the prospect of rising interest rates sent yields to the highest in at least four months and threatened plans to double borrowing next year. The Finance Ministry yesterday canceled its last sale of so-called OFZs for 2010, an auction initially scheduled for Dec. 1 and delayed until today, citing “unfavorable market conditions” in a statement on its web site. The government pulled a sale of OFZs due 2016 last week after yields reached 7.78 percent, the highest since the debt began trading Aug. 5, prices on Bloomberg show. Yields are climbing on bets Russia will join Brazil and China in raising interest rates to quell the highest inflation rate in 11 months, with forward-rate agreements signaling an increase of 0.63 percentage points in the next three months. Higher consumer prices are a “worry” and rates may be raised in the first quarter, Bank Rossii Chairman Sergey Ignatiev said Dec. 9. The central bank will next review rates Dec. 24. “The market is taking a cautious stance before the central bank meeting,” Nikolay Podguzov, head of fixed-income strategy in Moscow at VTB Capital, the investment banking arm of Russia’s second-largest bank, said by e-mail yesterday. “The regulator recently sounded quite hawkish and the key rates could be hiked as soon as Dec. 24.” Russia has sold 558 billion rubles ($18.1 billion) of OFZs this year, falling short of its 839 billion-ruble target, according to Bank Rossii data. The Finance Ministry plans to raise 1.3 trillion rubles next year, 1.5 trillion rubles in 2012 and 1.49 trillion rubles in 2013. Budget Gap Russia is stepping up borrowing to help bridge a budget gap that swelled to 911.5 billion rubles through November. The government expects a budget deficit until 2014. Demands for higher yields are hampering efforts to expand issuance in rubles. Russia stalled plans to borrow as much as $3 billion in its first local-currency Eurobonds as the government ruled out paying more than the yield on OFZs, Deputy Finance Minister Dmitry Pankin said Nov. 30. “I don’t see any surprise in the OFZ cancelation as recent auctions were not on fire,” Alexander Dotkin, a bond trader at Moscow’s Bank Zenit, said by e-mail yesterday. “Once they place an OFZ with a premium investors will likely expect it at future auctions and that’s not in the Finance Ministry’s plan.” Aborted The Finance Ministry had planned to issue bonds due June 2011 and November 2014 in the aborted auction. The 2014 notes yielded 7.23 percent yesterday, compared with 6.85 percent on their first day of trading on Sept. 28, prices on Bloomberg show. The yield on the bonds due next year touched 4.83 percent on Dec. 13, a five-month high, and dropped 10 basis points to 4.54 percent today. Policy makers canceled the second auction on Dec. 15 after selling 72 million rubles out of 9.6 billion rubles of 2013 OFZs offered in the first sale, according to data from the central bank. Investor demand fell short after the Finance Ministry offered the lowest yields relative to market rates since they began providing guidance in September. The ruble, which is managed by the central bank against a dollar-euro basket to limit swings, was little changed at 30.7077 per dollar by 11:41 a.m. in Moscow today. Non- deliverable forwards, which provide a guide to expectations of currency movements and interest-rate differentials, show the ruble weakening to 30.9575 per dollar in three months. Dollar Debt Russia’s dollar bonds due in 2020 fell, boosting the yield 2 basis points to 5.07 percent. The extra yield investors demand to hold Russian debt rather than U.S. Treasuries fell 1 basis point to 202 today, according to JPMorgan Chase & Co.’s EMBI+ indexes. The difference compares with 148 for debt of similarly rated Mexico and 186 for Brazil, which is rated two steps lower at Baa3 by Moody’s Investors Service. The yield spread on Russian bonds is 48 basis points below the average for emerging markets, the widest gap since Oct. 21, according to JPMorgan. The cost of protecting Russian debt against non-payment for five years using credit-default swaps advanced 1 basis point yesterday to 148, down from this year’s peak of 217, according to data provider CMA. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. Refinancing Rate Credit-default swaps for Russia, rated Baa1 by Moody’s, its third-lowest investment grade rating, cost 6 basis points more than contracts for Turkey, which is rated four levels lower at Ba2. Russia swaps cost as much as 40 basis points less on April 20. Russia’s refinancing rate, one of the benchmarks used by the central bank to manage inflation, will remain at a record- low 7.75 percent at the Dec. 24 review, the last in 2010, according to the median estimate of 15 economists surveyed by Bloomberg. Only one bank, UniCredit SpA, is predicting an increase this year, to 8.25 percent. The rate will rise 0.25 percentage point to 8 percent by the end of March, according to the median of 14 estimates in a separate survey. “It is clear that without a premium the OFZs planned for sale would have been uninteresting,” Olga Efremova, a fixed- income analyst at Moscow-based Nomos Bank, said by e-mail yesterday. Investors need a “sizable premium” to be lured back to OFZs, she said. Brazil, China The Finance Ministry plans to start selling zero-coupon OFZs with maturities of up to 12 months, according to a statement on its website yesterday. The notes will be sold at auction or in closed subscription, the statement said. “They believe market players will buy these short-term T- bills when the market environment is worse,” Alexander Ovchinnikov, vice president for global markets at Troika Dialog, Russia’s oldest investment bank, said by e-mail yesterday. “I expect low demand because these are like a savings instrument or a deposit and don’t belong in the official borrowing program.” Russia’s 7.75 percent refinancing rate, its 5 percent rate charged on overnight repurchase loans and the 2.5 percent deposit rate, compare with Brazil’s 10.75 percent Selic rate, and China’s 5.56 percent target. Brazil has raised its key rate three times this year and China has increased its benchmark once, on Oct. 20. Bank Rossii cut its main rates 14 times between April 2009 and May this year as it sought to revive the economy in the wake of the global financial crisis. An influx of ruble funds is expected on the market over the second half of December as the government spends any leftover budget funds before the end of the year, VTB’s Podguzov said. “They will start placing bonds more aggressively at the start of the year when there will be more ruble liquidity,” Podguzov said. To contact the reporters on this story: Emma O’Brien in Moscow at eobrien6@bloomberg.net; Denis Maternovsky in Moscow at dmaternovsky@bloomberg.net; To contact the editor responsible for this story: Gavin Serkin at gserkin@bloomberg.net.

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