It’s no secret that a perfect storm has faced Russia and its foreign investors over the past year. A deep rouble sell-off conjured up memories of the 1998 financial crisis, just as Russia’s post-Cold War risk premia was repriced after western sanctions for the annexation of Crimea.
In the second half of 2014, the twin shock from a collapse in oil prices and sanctions savaged Russian output, crippling firms’ access to international markets and slamming the brakes on domestic consumption. Russia’s post-Cold War integration with international financial markets was in peril.
The stakes for the rouble were high. After all the risk-adjusted return from rouble investing is not just a technical matter for traders, but a benchmark for perceived political clout, since president Vladimir Putin himself has cast medium-term rouble strengthening as a sign of economic might.
But in late 2014, a sharp decline in the country’s terms of trade combined with fears over looming debt redemptions to trigger capital outflows of around $156 billion, or 8% of GDP – the highest level since the 1998 crisis. Inflation jumped. FX reserves plummeted. And the rouble crashed. A domestic financial crisis loomed.
Amid retail deposit outflows in December, fears over capital controls took centre stage.
Enter the Central Bank of Russia (CBR) under the determined stewardship of governor Elvira Nabiullina. In the teeth of domestic opposition, the CBR accelerated its move to a floating exchange-rate and imposed the regime in November to engineer a more rapid adjustment in the external balance and to stem the bleeding of FX reserves. It then raised the policy rate to 17% – including a dramatic 650 basis point hike in December – to stave off a collapse in the financial system. It expanded its FX liquidity facilities, adding new maturities and broadening the definition of eligible collateral in its FX auctions, while committing to recapitalize viable lenders, if needed.
This shock therapy worked. Bringing forward plans to abandon Russia’s failing currency band with the dollar allowed the CBR to intervene on an ad-hoc basis to stabilize financial conditions but avoided wasteful interventions. It left the market to guess the size and frequency of interventions, thereby hiking the cost of FX speculation.
Imports in the first quarter of 2015 duly declined sharply, reflecting weak domestic demand, in part, thanks to rouble depreciation, which moved the real exchange rate towards levels consistent with medium-term fundamentals.
By May 2015, this external-sector adjustment brought down consumer price inflation, and gave the central bank room to normalize rates to counter the cycle. The CBR was, in part, helped by the bottoming out of oil prices in February, while the Fed’s dovish tone in March triggered a relief rally of sorts for oversold high-beta assets, eventually lifting the rouble 40% above its winter lows.
Crucially, a banking crisis was avoided – higher deposit interest rates and rouble stabilization resulted in a spirited return of retail deposits and reduced liquidity pressures.
During the freezing of liquidity in the interbank market, the CBR stabilized the financial system with changes to its FX facilities, with banks relying primarily on FX repos to ease dollar funding pressures in the interbank market. But in March, the CBR was able to increase the cost of these FX facilities. This move to support the rouble with cheap dollar liquidity via swaps – amounting to as much as $30 billion in the first quarter, effectively replacing traditional FX interventions – was so successful that the central bank hiked rates on the FX swaps twice in April to curb the rouble’s rise. In May, the CBR suspended the one-year FX repo facility and announced a daily programme of FX purchases to guard against external risks, signalling a remarkably rapid normalization of monetary policy after December’s excitements.
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The CBR’s pro-market orthodoxy was by no means guaranteed. Markets initially viewed Nabiullina, who was appointed as governor in June 2013 after a stint as economy minister and later as economic aide to Putin, with a degree of suspicion, fearing she wouldn’t assert the CBR’s institutional autonomy. But even before the most recent crisis, Nabiullina created a bang by launching a new refinancing facility at her first policy meeting in the July of her appointment to address the divergence between money market and policy rates.
The CBR’s crisis-fighting skills win Nabiullina acclaim from foreign investors.
Paul McNamara, an emerging markets debt portfolio manager at GAM, says: “The CBR played their hand well: it stopped intervening uselessly, deployed reserves far more effectively by means of the FX repo and took the long view by tightening interest rates.”
Edward Al-Hussainy, fixed income strategist at Peridiem Global Investors, adds: “Should the CBR get credit for its policy orthodoxy over the past year? Absolutely. It tightened policy rates by 950bp to 17% between April and December 2014, and subsequently cut them to 11% by July this year. Floating the rouble was perhaps the most impressive piece of the bank’s adjustment exercise because it allowed CBR to use its FX reserve cushion for refinancing corporate debt and providing liquidity assistance to banks instead of defending the currency.”
But Russia faces a prolonged contraction as an expected recovery in oil prices has yet to materialize, sanctions are still biting, while capital flows to emerging markets are vanishing.
Al-Hussainy highlights the CBR’s litany of trade-offs. “Real rates are still high, giving CBR scope to cut further as growth decelerates this year and expectations of a recovery in 2016 decline with the price of crude. That said, I expect the bank to pause cutting further this year until rising inflation expectations are checked by contracting domestic demand. With the ministry of finance vocally pushing for further cuts, I think this will be an important first test of CBR’s commitment to its medium-term inflation target.”
Indeed. Exogenous drivers of rouble volatility – capital flows, sanctions and commodity prices – will feed into second-round inflation expectations, moderate the pace of the central bank’s cuts and test its new inflation-targeting regime. The latter challenge is particularly acute given the uncertainty over the credibility of the data to assess inflation expectations.
The CBR is also faced with the need to build up reserves without indicating to markets it is targeting a specific exchange-rate level. As analysts at Morgan Stanley explain: “The oil price decline brings to the surface the latent tension between the CBR’s external target (FX reserves) and its domestic target (inflation). If continued, FX interventions, particularly in combination with higher H2 2015 external debt payments and oil weakness, point to higher inflation from FX pass-through. This would either conflict with the ambitious inflation target, or require higher rates to hit the inflation target.”
Russia has well-known buffers. The stock of external debt as a proportion of GDP and total government debt is much lower than before 1998, while liquidity is ample. What’s more, Moscow tends to run a modest fiscal deficit and a current account surplus, while the flexible exchange rate acts as a shock absorber.
But the decline in Russian potential output in the years ahead could be more prolonged than after the 1998 crisis. The CBR under Nabiullina has given Moscow fiscal breathing room. But its anti-inflationary pro-rouble battle can only pay off if the government addresses supply-side bottlenecks and diversifies the economy away from the energy sector.