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I recently spent a few days in Moscow meeting with a variety of economic and financial officials and analysts, both in the public and private sector.

Until July of this year, Russia was rosy: It was growing at an annual rate close to 8%; oil prices were peaking at $140 a barrel; the country was running a large fiscal and current account surplus; it had a war chest of $600 billion-plus of foreign reserves; and its stock market, bond markets and currency values were strong. Policy makers were thinking of turning the ruble into a major reserve currency, at least for the CIS bloc.

This economic and financial success led Russia to flex its geopolitical muscle, challenging the U.S. on a number of political and military issues and using its energy power as an instrument of foreign policy in its relations with the Eurozone and its former Soviet neighbors. The peak of this resurgence of the Russian bear came during the August war with Georgia, when Russia flaunted its military power as the U.S. looked impotent in its inability to defend an ally.

But what a difference a short time makes. Six months later, Russia is in deep economic and financial trouble.

The S&P has just announced that it has lowered Russia's foreign-currency credit rating by one notch from BBB+ to BBB. In less than six months, oil prices have fallen to under $50 a barrel (from the $140-plus peak of July). The stock market has fallen by over 60%, and on some days it has been shut down to prevent a free-fall. The current account surplus has turned into a near deficit and a sure deficit by 2009. The country has experienced a capital flight of over $100 billion and has lost about $150 billion of foreign reserves (now down to about a $450 billion level). It is facing massive external debt-financing problems as its banks financed their lending with foreign currency borrowings and its corporate firms financed massive expansion with foreign currency debt. It is now desperately trying to prevent a sharp depreciation of its currency by aggressive foreign exchange intervention. It may face a large fiscal deficit (2% of GDP) next year, and its GDP growth rate is sharply slowing down, leading the World Bank to predict a rate of only 3% in 2009--with leading local analysts predicting an actual recession (negative growth of as much as -2%) in 2009. (See the recent analysis by RGE's Rachel Ziemba for more on the risks of a hard landing in Russia.)

Given this sudden change in Russian fortunes, there are several key policy issues that the authorities need to deal with. Of course, given the external shocks (terms of trade worsening and a sudden stop of capital and credit), it was important to use the buffer of foreign reserves to avoid a bank run by providing liquidity and capital to banks--and by providing a fiscal stimulus to a country that is sharply slowing down.

But the key unresolved policy issue is what to do with the exchange rate. Until recently, Russia was on an effective basket peg (with 55% for the dollar and a 45% weight for the euro). But with oil prices now down over 60% from the peak of the summer, and with incipient current account and fiscal deficits and a likely recession in 2009, the currency is obviously overvalued. A reasonable estimate of the needed exchange-rate depreciation--with oil at about $50 a barrel in 2009--is 25%. But until recently, the authorities resisted the needed depreciation through aggressive foreign exchange intervention.

Ministry of Finance allows NWF to invest half its portfolio in domestic funds.

Until the end of October, Russia's National Wealth Fund was invested solely in high-grade foreign government debt instruments. On Oct. 21, the Ministry of Finance released new guidelines on how the $76.4 billion fund should be invested, and allowed the NWF to invest up to half of its portfolio in domestic shares and investment funds.

New management. The changes signify a fundamental shift in the fund's investment strategy and underscore the priority the Kremlin places on bolstering domestic share prices, which have fallen by over 75% since May. While it is still unclear what the exact portfolio allocation of the NWF will be, investments into Russian securities have already begun:

-At the end of October, the NWF invested some $730 million into Russian equities.

--A further $180 million were invested in Russian corporate debt securities.

--The investments were made via state-controlled Vneshekombank (VEB), which currently acts as the NWF's agent in its domestic investments.

--It has not yet been revealed which companies the NWF invested in.

VEB representatives have also announced that the NWF has a further $5.5 billion on hand to invest in Russian shares. This corresponds to some 5% of the total market capitalization of the Russian equity market, meaning the NWF is in a position to significantly affect Russian share prices.

MOSCOW, Nov 22 (Reuters) - Russia's gas firm Gazprom wwould like to avoid supply cuts to Ukraine in 2009 but will not continue deliveries without a new contract, Gazprom's spokesman Sergei Kupriyanov said on Saturday.

Russia has often threatened to cut gas supplies during pricing disputes with Ukraine and has fulfilled the threat in early 2006, briefly halting supplies to Europe, 80 percent of which go via Ukrainian territory.

Gazprom said on Thursday Ukraine must repay a $2.4 billion gas debt before new supply contracts are signed, raising fears the two sides face another battle in their gas war.

"We would like to avoid such a scenario (this time). We have time to reach an agreement before the new year but as you understand we cannot supply gas without a contract," Kupriyanov told Vesti 24 television channel.

Ukraine's state energy firm Naftogaz said its debt to RosUkrEnergo, a Russian-Ukraine intermediary gas trader, co-owned by Gazprom, amounts to only $1.27 billion.

Kupriyanov said the Ukrainian side counted only Sept-Oct debt while Gazprom included November debt as well as penalties. He denied there were major differences in the overall debt estimates.

"Everybody understands pretty well who owes to whom and how much," Kupriyanov said.

Ukraine and Russia are engaged in talks on a 2009 price for gas, currently set at $179.50 per 1,000 cubic metres. Kupriyanov said a market price for 2009 gas deliveries was $400 per 1,000 cubic metres.

GAS BURNING IN FURNACES

A memorandum signed in October by Prime Ministers Vladimir Putin and Yulia Tymoshenko sees a gradual transition to market pricing and direct supplies without intermediaries such as RosUkrEnergo.

Kupriyanov said direct supplies as well as lower gas prices for Ukraine in 2009 were only possible if other conditions set out in the memorandum, such as debt redemption in full, were met. He said Russia would not discount for the global crisis.

"If Ukraine's consumption drops, our deliveries will fall as well but it is not happening. Gas is burning in furnaces of Ukraine's economy as it had been before, therefore the crisis has nothing to do with it," Kupriyanov said.

Gazprom supplies a quarter of Europe's gas needs and sends one fifth of its total exports via Belarus with the rest going via Ukraine, giving both countries extra leverage over the firm in pricing disputes.

Kupriyanov said Gazprom's financial standing was sound, debt portfolio "healthy" with the share of short term loans only 14 percent, while a revision of the capital investment plan will not concern priority projects such as the Nord Stream pipeline. "We can talk about not receiving some of expected profit (from domestic operations). The demand is falling, warm weather in November has also played a role," Kupriyanov said.

He said the firm was in intense talks with Belarus and Moldova to switch to rouble payments. Gazprom supplied 15.32 bcm of gas to Belarus at $128 per tcm in Jan-Sept 2008 and 1.9 bcm to Moldova.

With the Russian rouble under depreciation pressure as a result of falling prices for oil, Russia's main export commodity, Russia is seeking to boost international demand for roubles from its ex-Soviet neighbours.

"The rouble is the most reliable currency. Our expenditure is also in roubles. Matching our revenues and expenses is a reasonable thing," Kupriyanov said.

He added that the transition will require changes to contracts with Belarus and Moldova. He said Russia was not yet talking about switching to roubles with Ukraine but it was "theoretically possible". (Reporting by Gleb Bryanski, Editing by Peter Blackburn)

aused by a malfunctioning fire safety system that spewed out chemicals, according to an initial investigation, officials said Sunday.

At least 21 other people were injured during Saturday's test run in the Sea of Japan, the Russian Defense Ministry said.

It was Russia's worst naval accident since the nuclear submarine Kursk sank after an onboard torpedo explosion on August 12, 2000, killing all 118 crew members.

The latest fatal accident was the result of the "accidental launch of the fire-extinguishing system" on the Pacific Fleet sub, Russian navy spokesman Capt. Igor Dygalo told reporters.

Russian news agency Interfax said a preliminary forensic investigation found that the release of Freon gas following the activation of the fire extinguishing system may have caused the fatalities.

Seventeen of the fatalities were civilian members of the shipyard crew, Interfax reported. The submarine was being field tested before it became a official part of the navy, according to a Russian Defense Ministry statement.

The statement said 208 people, including 81 soldiers were on board the submarine. In addition to the fatalities, the accident wounded 21, Russian officials said.

The accident did not damage the nuclear reactor on the submarine which later traveled back to its base on Russia's Pacific coast under its own power, Dygalo added.

The submarine returned to Bolshoi Kamen, a military shipyard and a navy base near Vladivostok, state-run Rossiya television said, according to The Associated Press.

Officials did not reveal the name of the submarine, but Russian news agencies quoted officials at the Amur Shipbuilding Factory who said the submarine was built there and is called the Nerpa.

Construction of the Nerpa, an Akula II class attack submarine, started in 1991 but due to a shortage of funding was suspended for several years, the reports said. Testing on the submarine began last month and it submerged for the first time last week.

The Kremlin is seeking to restore Russia's military power amid strained ties with the West following the war with Georgia.

But despite former President Vladimir Putin increasing military spending, Russia's military remains hampered by decrepit infrastructure and aging weapons.

The Kremlin said President Dmitry Medvedev was told about the accident immediately and ordered a thorough investigation.