Saturday, December 20, 2014

20/12/2014: Russian Crisis: Longer-Term Issues and Short-Term Risks

Earlier this week I was asked by Portuguese Expresso ( to comment on Russian crisis developments. Here is the full transcript of my comments in English:

1) Why this recent crisis in the FX market? What are the main drivers?

The main drivers of the Russian Ruble crisis are, in order of declining importance:

1) Rapid decline in oil prices since August 2014,
2) Accelerating capital outflows in Q4 2014, relative to Q2 and Q3,
3) Sanctions restricting Russian banks and companies access to the international funding markets, thus precipitating a significant rise in demand for foreign currency needed to repay hard currency debt maturing in Q4 2014 and Q1 2015, and
4) The effect of Ruble switching from a tightly managed rate to free float, triggering both speculative and algorithmic trading re-adjustments.

2) Which of the drivers of the crisis is more important: sanctions or oil?

With oil prices above USD90 per barrel, Russian companies and banks would have little difficulty funding debt redemptions coming due in Q4 and Q1 2015. However, at oil prices around USD60 per barrel, foreign exchange inflows are severely constrained, triggering a spike in demand for dollars due to restricted cash flows. This demand had to be funded by borrowing rubbles and converting these into dollars, which, in effect represents a double squeeze on the Ruble: not only demand for Rubles falls relative to Dollars, but simultaneously the supply of Rubles rises due to borrowing.

Sanctions play an important role only in so far as they underpin the demand for dollars required for redemption of maturing debt. In a sense, President Putin was correct in estimating the effect of sanctions amounting roughly to 25-30 percent of the overall crisis re-pricing of the Ruble.

3) Who are the losers and the winners of this recent crisis? Especially, in terms of the crisis impact on Russian people?

There are no winners in this crisis when it comes to either Russian citizens or the residents. Turkey and China, as well as a number of other countries, including Kazakhstan, Armenia, Belarus, Uzbekistan, Tajikistan and others are gaining through increased flows of trade and investment via-s-vis Russia. China is gaining geopolitically and economically.

In terms of losers, countries heavily reliant on remittances from the migrants residing in Russia, including some of the above mentioned CIS countries, plus Ukraine and Moldova, are feeling the pain from collapsed Ruble valuations. Ordinary people in Russia, especially those who tend to hold Ruble deposits (such as retirees), as well as people reliant on foreign (imported) medicines and those living below the poverty line, are seeing large-scale destruction of their purchasing power and savings. A small number of Russian residents have purchased homes in recent years using mortgages denominated in foreign currencies. While before the crisis these mortgages carried lower interest rates, since the devaluation, the real cost of servicing these loans rose. Many businesses lease commercial real estate based on rents expressed in foreign currency. They too will face steep increases in the cost of servicing their offices and stores. Roughly one half of Moscow's retail properties are leased using contracts in dollars.

One category of Russian population is unlikely to lose signifcantly as the result of devaluations - the super rich. While their income-generating assets are based in Russia, much of their wealth resides outside Ruble zone.

This explains why the vast majority of Russians see sanctions as a Western attack on their own well-being, rather than a pressure on oligarchs or the Government.

4) Can we talk of a syncronization between the ruble and the oil prices?  

There is a very strong correlation between Russian GDP (in levels, not growth terms) and oil prices, so it is natural to think of a strong positive correlation between Ruble and oil prices. This correlation has been reinforced by the crisis, as economic growth in Russia shows considerable structural slowdown, thus only increasing the economy's dependence on oil.
5) Does the Dutch Disease represent the main structural problem with the Russian economy?

Yes, Russian economy is a classic example of the Dutch Disease or the Curse of Oil, with major and structural over-emphasis on energy and extraction sectors as generators of exports and foreign exchange earnings. However, Russia still retains a large and relatively diversified domestic economy. In effect, imports substitution under the current sanctions and counter-sanctions regimes is driving this diversification up, while low oil prices are reducing the link between oil and economic activity in terms of investment and output.

6) What can we expect in 2015: stagflation or outright recession? 

My forecast is for a significant recession in 2015 for the Russian economy, in the region of -3 percent, with positive scenario implying a recession of roughly 1% and the downside scenario predicting a recession of ca 4.5 percent. This is based on the following considerations. Firstly, the core drivers of this week's run on the Ruble are still present and cannot be addressed in the short run. Secondly, structural slowdown in growth that started manifesting itself in 2012 and came into full view in 2013 is still present. Thirdly, absent robust recovery in Europe and facing a slowdown in growth in China, Russia is poorly positioned on the exporting side and investment side.

On inflationary side, I expect Russian CPI to run above 10 percent in Q1 2015, rising in Q2 2015 before moderating in the second half of the year. Much will depend on the quality of 2015 crop, as well as on geopolitical developments.

7) Is there a risk of a new 1998 triple crisis, coupling the FX, debt, internal default and banking?

From fundamentals point of view, there is no risk of the repeat of 1998. 1998 crisis was triggered by a combination of large debt overhang from the 1980s and 1990s, funded at ever-escalating borrowing rates, a wide fiscal and current account deficits running over a number of years, the economy undergoing huge disruptions relating to transition, and the political crisis within the ruling classes. None of the above conditions are present today. However, one cannot rule out the risk of default due to a set of reasons very distinct from the driers of the 1998 crisis. Chiefly, the risk of default arises today from the possibility of a repeated and more prolonged run on the Ruble. Added uncertainty comes courtesy of the oil prices, which are currently simply unpredictable in the medium term. If oil prices do average over 2015 around USD80/bbl as consensus forecasts in the markets suggest, then the risk of default becomes negligible for the sovereign and the majority of larger banks and companies.

8) More hikes of key interest rates ahead for the CBR? Or 'nuclear options', like capital controls, moratorium in the FX reserves outflows? Other measures from the CBR?

Over the last couple of days, Ruble enjoyed significant rebound, thus reducing the risk of Russian authorities deploying capital controls or other drastic policy measures.

However, if the crisis returns with the intensity of December 15-16th, capital controls in conjunction with a holiday on debt redemptions for sanctioned entities cannot be ruled out.

Over the medium term, the prospect of capital controls also depends on the rate of foreign exchange reserves depletions in supporting Ruble and the speed of capital outflows. In 2015, Russia is facing foreign currency debt redemptions of some USD101 billion. All but USD2 billion of this relate to banks and corporates. We need to see oil rising toward USD80 mark and Ruble stabilising at around USD50 mark for the risk of capital controls to recede significantly.

The above debt maturity is a serious challenge. If recessionary dynamics place a substantial cap on corporate revenues and banks balance sheets, we can see some isolated, but larger scale corporate defaults. Otherwise, some less significant localised defaults can take place, especially in the weaker, lower tier of Russian banks. The latter will be benign and the CBR can facilitate orderly sector restructuring.

9) With a break-even price of oil at an annual average USD107, as set in Budget 2015, is the Kremlin facing a risk of fiscal collapse?

Not in the short run.

Russian budget is expressed in Rubles-denominated price of oil. Hence, as long as Russian Ruble moves in line with the price of dollar, the budgetary pressures remain minor. For example, currently, Russian federal budget is in surplus despite the massive decline in Dollars-denominated revenues. And Russian Current Account is posting strong surpluses on foot of collapsed imports. However, over the longer term, Russian budgetary spending will have to rise to offset the effects of inflation and devaluation. When the pressure to do forces the Government to adopt some inflation-related adjustments in the budget, fiscal position will deteriorate. I do not expect this pressure to be insurmountable, however, over the next 12-24 months.

In addition, President Putin mandated the government to amend November Budget, cutting federal expenditures in real terms by 5% a year in 2015–2017. Three sectors are excluded from the cuts: defense, national security and social welfare. New targets will re-balance public sector wages from slight growth planned in previous Budget to a cut in real terms.

The longer-term issue is the ruble-oil price link up. As ruble devalues, short-term, federal budget remains balanced. But in the longer run, devaluation triggers inflationary pressures. So the challenge in the second half of 2015 will be balancing the books while inflation is expected to be running at above 10 percent mark. This is more critical than the shorter-term issues.

10) Do you expect Russia to push for an agreement on oil production cuts or a full “war” with OPEC?

OPEC is a non-homogeneous entity. Some members of OPEC are currently suffering similar fate to the Russian economy and some oil exporters outside the OPEC are feeling severe pressures as well.

It is clear that the immediate strategy for Saudi Arabia is to push for lower oil prices and higher output. This strategy is based on two considerations.

First, and foremost, Said Arabia is attempting to protect its market share in the face of the rising output of shale oil. Although shale is more expensive to extract, once production is put into place, there is significant margin that can be traded down in terms of oil prices before, over time, shale output declines. Saudi Arabia wants to weather this period and force, using lower prices, some shale production declines in the medium term.

The second, far less important consideration from the Saudi's persecutive is the effect of low oil prices on its key geopolitical challenger - Iran. The flash point here is Syria and Iran's (and Russian, to lesser extent) support for the regime there that is being opposed by the Saudis.

This leaves Russia in a weak position to bargain change vis-a-vis the OPEC. Instead of a 'war' with OPEC, Russia is adopting a response of shifting markets for its oil and gas East, toward Asia Pacific. This strategy is about the only one that is feasible in current circumstances and Russia has been pursuing it very pro-actively.

11) China is the “saviour” economy for Russia to avoid crisis?

As Russian exports and investment flows re-orient East, China is becoming a major trading and investment partner for Russia with huge play in Eastern and Southern Siberia. Geopolitically, closer links between Moscow and Beijing are of benefit to both sides, but economically, Russia is making a bet that growth slowdown in China will not reduce the space of the bilateral cooperation in trade and investment that has been developing between them.

This bet is, probably, short-term risky. China is going to run slower growth in years to come, and thus lower growth in demand for oil and gas. On the other hand, China will have to switch away from much less efficient coal in energy generation mix toward less polluting gas. The former is net negative for Russia, the latter is net positive.

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