It was not the most productive summit in the history of mankind. President Vladimir Putin, after watching a military parade in Belgrade, Serbia, and questioning Kosovo’s independence, arrived in Milan on Friday so late that Chancellor Angela Merkel, with whom a private meeting had been scheduled, had to cool her heels for hours. Once done at 2 a.m., he headed over to his buddy’s place, persona non grata in EU politics, Silvio Berlusconi. But the Russian economy was not amused.
Russians know that the ruble is in trouble, and are not so naïve to think that their currency will start to strengthen again soon. Countless factors point in favor of further depreciation, not least the inability of Russian entities to borrow from international markets, recent marked falls in oil prices, and expectations of future US rate hikes…. Government estimates that capital flight is likely to reach between $90-120 billion this year look too conservative to us.[A]s ever with Russia, there are countless risks. What if capital flight accelerates to rates well beyond expectations to generate genuine unease about the adequacy of the CBR’s [Central Bank of Russia] reserves? What if the ruble is completely irresponsive to interest rate hikes, and simply depreciates rapidly further beyond the CBR’s comfort zone, fueling a jump in inflation into double digits? And what if companies, already unable to borrow from international markets because of sanctions, struggle to meet debt repayments? And – perhaps most obviously – what if the geopolitical situation, which is well beyond the control of the CBR, further deteriorates?
You get the point.
That’s how Daiwa Capital Markets pegged the situation about a week ago. In short, every unit of foreign currency that isn’t nailed down is being yanked out of Russia.
Now Moody’s Investors Service downgraded Russia’s sovereign debt rating to Baa2, two notches above junk. The outlook remains negative. Yet Russia still has $396 billion in foreign exchange reserves and strong balance sheet. What gives?
Moody’s cited two “key drivers”: an already weakening economy hit hard by the sanctions against state-owned banks, the defense sector, and the crucial energy sector, among others; and the erosion of foreign-exchange reserves due to low oil prices, restricted access to international capital markets, and capital flight.
Even prior to the crisis in Ukraine, the potential growth rate of the Russian economy was falling, constrained, according to the IMF, by economic rigidities such as infrastructure bottlenecks and shortfalls in labor skills and education. Additional constraints are posed by the high degree of dependence on the hydrocarbon sector…. Much needed domestic and external investment was already being undermined by the challenges posed by the Russian business climate and by Russia’s weak institutions.
The sanctions spiral is undermining the confidence of consumers as they struggle with surging inflation and high interest rates, “resulting from, among other things, the depreciating exchange rate.” And they sent domestic demand skidding in the second quarter.
Inventories and investment fell as well. The longer the sanctions drag on, “the more significant will be the damage to investors’ confidence in Russia as a source of profitable investment opportunities, leading to the loss of economic output over the medium term.” And it would curtail exploration activities in the crucial energy sector.
Low oil prices, capital flight, and restricted access for Russian borrowers to international capital markets are eroding Russia’s foreign-exchange buffers and the government’s balance sheet:
Even if trade and current account balances are temporarily strengthening due in part to the 20% fall in the exchange rate this year, the current account surplus has financed only around 60% of the $85.2 billion of capital outflows in the first nine months of this year. The Russian government and Russian-domiciled entities have been largely shut out of the international capital markets since the second quarter. This has increased their demand for onshore FX liquidity and contributed to a $60 billion decline in the Central Bank of Russia’s FX reserves to $396 billion since the end of last year, despite a current account surplus that the CBR estimates came to $52.3 billion in January-September.
And he need to supply both the public sector and the private sector with liquidity will further pressure the dwindling FX reserves:
Until now, the very high strength of the government’s balance sheet – including its large FX reserves – has sustained Russia’s credit profile notwithstanding its weak institutions, exposure to geopolitical event risk, and worsening medium-term economic prospects. However…, the recent and prospective erosion of FX buffers accentuates those other weaknesses in the government’s credit profile.
Moody’s could hit Russia with another downgrade, this one just a notch above junk, if any of these events occurred:
- Sanctions and counter-sanctions are tightened further.
- Capital flight accelerates.
- Russian companies and banks face a “more prolonged” exclusion from international capital markets.
- Commodity prices remain low for a longer period of time.
- Domestic economic growth deteriorates further.
- Institutions become even less predictable, damaging the interest of creditors.
It boils down to this: the sanctions are bad, but Russia has bigger problems. Other countries, such as Japan, are in much worse fiscal shape than Russia, and their economies may be in deeper trouble, and they may already be in a recession, but their institutions are more “robust,” and individuals and businesses don’t distrust their own government and institutions to such an extent that all-out capital flight ravages the economy and drains government resources. And unlike Russia, these countries have diversified economies that are not desperately dependent on just one vulnerable sector: oil and gas.
But the collapse in oil prices isn’t just a problem in Russia. It’s hitting the American energy boom. Theories abound why this is suddenly happening, after years of deceptive calm. Read… Toxic Mix Blows up: Oil Price Collapse & Junk Bond Insanity