Wednesday, December 24, 2014

24/12/2014: House of Rubles: Bulgaria's Capital on Ruble Crisis

Here is an article in Bulgarian Capital on the subject of the Russian currency crisis, with comments from myself: My original comments in English:

1. What triggered the acceleration of the rouble crisis and why the drastic raise of the interest rates didn't help?

In a currency crisis, raising interest rates usually has little effect on currency valuations because the motives for dollarisation or a switch away from the domestic currency rest outside the scope of deposits and savings.

Russian crisis has been driven by rapid collapse of oil prices and by the growing demand for dollar and euro liquidity from banks and companies forced to repay foreign borrowings due to lack of access to the foreign credit markets.

Several larger Russian firms, facing billions of dollars of debt redemptions in Q4 2014 have moved into the market in the last 10 days, buying up dollars and using ruble loans from the Central Bank to fund these purchases. In addition, new estimates that came out last week showed Central Bank of Russia witnessing accelerated rate of capital outflows suggesting that Q4 outflows will match those in Q1 and that the total volume of outflows will total $134 billion, matching 2008-2009 crisis peak. This triggered a run on the Ruble that started on Monday and continued through Tuesday. Tuesda run was further exacerbated by the dollarisation of the household deposits, with many Russian households rushing to convert Ruble savings into dollars and euros.

In a way, 10.5 percentage points hike in interest rates enacted by the Central Bank added fuel to the fire. Firstly, it signalled to the markets that capital outflows are reaching crisis proportions. Secondly, it increased the demand for loans from the households trying to secure credit before rates rise even higher, and also drove more companies and households toward conversion of their deposits into dollars.

In the short run, the interest rate hike also led to a more aggressive shorting of the ruble, especially by algorithmic trading programmes, by acting to suppress supply of dollars out of Russian deposits into ruble trades, while leaving external supply of dollars available for backing shorts unaffected. The short-term nature of such strategy was evident in the abrupt reduction in net short positions in the market.

2. What options do Russian authorities have now to deal with the situation? Will Russia need to use capital controls?

So far, Russian Central Bank spent around USD10 billion on foreign currency interventions (through the first two weeks of December). The ministry for finance further openly committed to injecting additional USD7 billion. Simultaneously, the CBR adopted measures to ease balance sheet pain for the banks. The CBR also dramatically expanded its repo operations. All of this had an effect of calming the markets down - the effect witnessed on Wednesday.

However, the underlying causes of the crisis remain unaddressed and the current reprieve can be temporary, unless the CBR and the Russian Government adopt more drastic measures. One measure that will be effective in dealing with the underlying drivers of the crisis is limited capital controls. These can reduce dollarisation of the domestic household and corporate deposits and also restrict, in part, outflows of funds abroad. However, the second problem - mounting weight of debt redemptions by sanctions-impacted banks and companies - requires a different solution. One possible solution could be freezing redemptions for entities directly covered by sanctions, allowing ill up of interest to avoid outright default. Both measures are what we can term the 'nuclear' solutions and to-date the Russian Government has balked at adopting them. However, the Government is already applying pressure on Russian companies to stop hoarding foreign currency. The Government is also diverting 10% of the Russian National Pension Fund receipts toward supporting domestic banks.

Should the crisis regain momentum, even the 'nuclear' - in economic terms - options are going to be on the table.

3. How close is Russia to a repeat of the 1998 crisis?

The 1998 crisis was very different in nature and causes, so the parallels to it are tenuous at best. In the 1998 crisis, Russian Government was carrying unsustainable levels of external debt and it was running huge deficits. The country external balance of payments was in a persistent deficit. None of these factors are present today. Russian Government fiscal surplus is in excess of 2 percent and devaluation actually improves the Federal Government position in the short term. Current account is in a surplus and even with oil going to USD50/bbl, current account position is well-supported in the short run by collapsing imports. The entirety of Russian Government debt redemptions for 2015 is just over USD2.8 billion.

On the other hand, Russian economy today is in the same structural cul de sac as in 1998. Core driver for growth - high energy and commodities prices - is gone and it is unlikely to return any time soon. Consensus forecasts suggest oil price averaging around USD80/bbl in 2015, so at the very best, Moscow can expect moderate improvement in pressures compared to current situation.

4. Is now a deep recession a certainty for Russia in 2015? And how much worse can things get?

It is most likely that the Russian economy will slip into the recession over Q4 2014 - Q2 2015. The only question is - how deep the recession can be. Based on USD60/bbl assumption for the price of oil, the Central Bank estimates that Russian economy will contract 4.5-4.7% in 2015. At USD80/bbl, the contraction is likely to be closer to 0.8-1%.

The former is a heavy toll on the economy, while the latter is relatively mild and consistent with Euro area experience in 2012-2013. And beyond that, 2016 is also promising to be a tough year. Russian economy desperately needs two things: investment for developing non-extraction sectors, modernising the capital and technological bases; and structural reforms, reducing red tape, corruption, arbitrary enforcement of laws, reducing bureaucracy and altering labour markets. It will be extremely hard to deliver investment boost in current financial conditions and in the presence of sanctions. It will be virtually impossible to deliver reforms with current power brokers' so heavily dependent on continuation of the status quo of power and wealth distribution. But, at least reforms are a function of internal will.

There are added risks to the downside of the above forecasts, however. If capital outflows remain at peak levels consistent with Q1 and Q4 2014, interest rates will have to rise even further. Meanwhile, devaluation of the ruble will require offsetting nominal increases in spending on pensions, social supports, as well as investment in imports substitution. The result will likely be even more severe recession than forecasted above.

5. Could the rouble crisis shake Putin's grip on power?

At this stage, it is very hard to imagine any significant shift in the power balance in Moscow. The reason for this is two-fold. There is no momentum for such a change in the electorate and amongst the elites. Most recent public opinion surveys show steady 80% and higher support for President Putin and similar broad approval ratings for the Government.

Economic hardship is something the Russian society endures when it is faced with geopolitical adversity. Sanctions, in a way, are reinforcing current balance of power in favour of President Putin. The Crimean Euphoria effect is now almost gone. Eastern Ukraine offers much lower support base within the Russian society, with roughly 60% of population approving Russian Government providing support for the separatists there. But the juxtaposition of Russia vis-a-vis the West is now forming the main basis for President Putin's popularity. Whether we, in the West, like it or not, Russians do feel that their interests are not being served by cooperative engagement with Nato and the West. And much of the fault for this antagonism is based in both sides actions and rhetoric.

In addition, Russia lacks viable alternative to the current power balance. Existent opposition is even more vested into nationalist rhetoric and represents more extreme positions both in economic policies terms and geopolitical outlook. Opposition currently visible outside Russia has no support base within Russia. It is a power vacuum, absent the current Presidency. And, frankly, I cannot convincingly say that external opposition offers anything other than Putinism 2.0. The head of state change is not equivalent to structural reforms and so far, democratisation rhetoric from the Western-based Russian opposition is shallow, unbacked by any serious proposals for reforms and offering no alternatives to the 'power vertical' systems put in place from ca 1995 on, from the late Yeltsin era through today.

That said, if the crisis persists beyond 2015, we are likely to see growing pressure on the President and the emergence of potential challengers. Whether they will offer any serious prospect of reforms, while providing pragmatic road map for stability and governability is another question altogether.

6. What is more likely now - the economic agony to make the wounded Russian bear even more belligerent, or to force Putin to soften his position and to seek lifting of the sanctions?

In my view, the current situation is very volatile and highly unpredictable. We can certainly hope that the crisis is going to move both Russia and the West toward reconciliation of their respective positions. We need a constructive dialogue across a range of geopolitical issues. And we need Russia to be a strong, but cooperative participant in this process. The core point here is that it takes two to tango. The West needs to moderate its position on sanctions and Nato, Russia needs to be offered a way out of the Ukrainian crisis, while Ukraine's independence and territorial integrity must be preserved. Russia, in return, must step away from brinksmanship in both Ukraine and vis-a-vis Nato. The former is a disastrous strategy that will not deliver on Russian longer-term objectives and will continue to antagonise the Ukrainian population, moving the country away from any future good will-based cooperation with Russia. The latter is a tragedy waiting to happen - close calls in fly-bys between Russian military aircraft and civilian airlines in the Baltic Sea region are the proof of this.

Can 2015 be the year when we see some positive changes in these directions? I certainly hope so. But the indications are, we will see escalation of the crisis, before we see resolution being put forward.

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