As the conflict with Kiev escalated, Monday saw a bloodbath in the Russian market with an 11% sell-off in equities, a 150 basis point hike in Russian short-term government bond yields, the rouble tumbling to an all-time low against the dollar and heavy interventions from the central bank.
Although markets rebounded from their Monday lows, amid relatively conciliatory comments by Russian president Vladimir Putin on Tuesday, and oil prices remain relatively resilient, analysts reckon Russia could fall into a mild recession in the middle of the year, citing capital outflows, higher interest rates and a reduction in investment.
Aside from the cyclical damage to the Russian economy thanks to tensions with Ukraine, structural weaknesses have been exposed.
Timothy Ash, head of emerging markets research ex-Africa at Standard Bank, and long-time Russia observer, remains the most bearish sell-side analyst about the implications of the conflict.
“It is complete tosh to think that all this aggressive action by Moscow in Crimea, and jingoism at home, and the prospect of international isolation, will have no effect on the Russian economy,” he says.
“It will have a very substantial and very negative effect, and just when the economy was already looking fragile – and it shows how worried the Russian authorities are by this emergency rate hike. It seems that Putin’s actions in Crimea and the market reaction also took the CBR [Central Bank of Russia] by surprise.”
He adds: “This [conflict] has to fundamentally change the way investors and ratings agencies view Russia. I think we will see downgrades now of Russia by the rating agencies, as they will be fearful of sanctions, capital flight and a further weakening of growth dynamics.”
He reckons the spat will trigger weakness in asset prices, reducing much-needed investment and a reduction in real GDP.
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| Russian president Vladimir Putin |
In 2008, analysts understated Russia’s vulnerability to capital flight – which in the end totalled around $130 billion – and asset price-falls, citing Russia’s low indebtedness in the public and private sector.
However, wealthy Russians with levered holdings of domestic stocks liquidated and shifted to places such as Switzerland for safety, says Emad Mostaque, strategist at Noah Capital Markets.
The worry is a repeat of this capital flight will exert a heavy toll on the real economy, although a reduction in the country’s corporate leverage and a more flexible FX regime compared with 2008 have beefed up the economy’s defences.
Says Mostaque: “I would not expect capital flight on that [2008-era] scale, but it will be tough for Russia to regain losses in the short term, even though the economy won’t take a huge hit unless there is an all-out war.”
Analysts at Morgan Stanley reckon a “security shock” hitting consumption growth (as a result of increased savings) and a fall in investment (in the face of uncertainty) could tip the economy into a mild recession this year, with the magnitude depending on the shifts in risk perceptions, monetary policy and outflows.
The principal macro defence remains Russia’s oil-driven war-chest of FX reserves at around $500 billion, but the headline figures, in a sense, flatter to deceive, testing the CBR’s backstop.
According to Dmitry Polevoy, Moscow-based analyst at ING, some $230 billion of Russia’s $500 billion of reserves comprise sovereign bonds, IMF reserves and gold, leaving a net amount of hard-currency reserves at disposal at $270 billion.
“To get a critical three-month [import] coverage, the net reserves should be at around $120 billion, ie providing the CBR with $150 billion left for FX interventions – clearly, still a sizeable volume, but not very impressive on the back of $10 billion to $12 billion it sold only on Monday.”
In other words, if Russia wanted to maintain the critical minimum of three-months import cover, the CBR could only afford 15 days of interventions of Monday’s magnitude.
Polevoy’s rare note of caution on Russia’s reserves highlights the challenges on the CBR in stabilizing FX selling pressure. He adds: “The risk of a deposit run has increased for many households and, likely, corporates’ last week levels of 35.50-36/USD already looked high, and Monday’s spike to 37/USD together with rising spreads for banks’ conversion operations in retail branches risked a blow-up scenario [before the CBR’s intervention].”
The real-economy impact of the Ukraine conflict on Russia might be limited if tensions continue to ease, but the threat of slower consumption growth as a result of increased savings, and weak investment due to political risks, underscores structural weaknesses.
In recent years, Russia has failed to embark on supply-side reforms to boost productivity and reduce the role of the state in strategic and non-strategic industries, say analysts.
Credit growth early last year exceeded 20% over some quarters while the economy struggled to grow by 2%. Analysts say Moscow can hardly afford an escalation in the conflict and any associated reduction in foreign investment as a lack of capital spending and business investment, triggered by the country’s difficult business environment, threatens Putin’s legacy.
According to the IMF, during the period 2000 to 2012, Russia had a savings-to-GDP rate similar to that of South Korea at 30%. While South Korea re-invested almost all of it, Russia’s investment rate was only about 20% of GDP, given challenges of efficiently allocating capital. With fiscal windfalls from oil used to sustain consumer spending and diminishing returns from using up Soviet-era spare capacity, Russia needs new growth drivers – fast.
To put it simply, Russia’s risk premium over other emerging markets should continue, say analysts. What’s more, though Putin has used the narrative of modern reforms to revive growth, bearish Russia analysts are quick to point out a preference for a strong centralized political economy continue to torpedo market reforms.