Investment strategy in Russia hinges now on the outcome of the “Battle of the Ruble”. For historical and cultural reasons, any material devaluation move at the present stage of the crisis could cause mass domestic panic. Much market commentary ignores that risk and underestimates the related economic and political costs. By the same token, a devaluation lurch should not be regarded as a positive investment trigger.
A true buying opportunity in Russian debt and equity (in that order) would result from the success of the government’s present gambit of sacrificing FX reserves to buy time – at least until the end of 1Q09 – for public fears to subside and any desirable exchange rate adjustment to be effected without a damaging overshoot. The chances of success are improved by the tactics now developed to counter capital flight, while the investment case is strengthened by the new mix of tighter monetary and looser fiscal policy being forged in the crisis.
For Russia, as for several other emerging markets, the currency lies at the epicentre of the financial and economic crisis. But even as it fights the “Battle of the Ruble” – with victory defined as preventing a disorderly devaluation overshoot – the Russian government is forming a new policy framework designed to cope with the credit stop and demand slump. Success on this second (longer-term) front would consist in getting away with a mere hard landing – that is, real GDP growth slowing from the average 7 per cent seen so far this decade to an average range of 0-4 per cent in 2009-10. Failure would mean the economic pain persisting for longer than the inevitable two or three quarters and deepening into a full-blown recession.
These two battles are, of course, interrelated. A successful resolution of the currency crisis would go a long way to staving off recession. As usual with Russia, the oil price offers the simplest perspective. Just as the government’s battles would be made unwinnable were the oil price to continue its recent rate of decline for at least a couple more quarters, so a stabilisation of the oil price at somewhere close to its present level of around $50/bbl would be the best platform for a twin victory on defending the ruble and maintaining growth. But if that is a necessary condition for success, it is not a sufficient one. Unless the government also plays its policy hand well, capital flight – the main short-term threat – could continue anyway, and growth could still turn negative.
The main purpose of this note is to establish a range of perspectives on the crisis. Like the one just mentioned – namely, that there is more to this story than waiting passively to see what happens to the oil price – these perspectives go beyond the obvious.
The most obvious of all points is the uncertainty about the outcome of the government’s dual battle for the integrity of the ruble and for continued, albeit low, growth (or at least, the avoidance of a serious contraction). Amid intense pressure on the ruble, and with the global crisis already making itself felt across swathes of Russia’s real sector, the scenario of defeat is widely expected.
The mechanism of such defeat is obvious: in the face of unrelenting capital flight, FX reserves are depleted to, say, a mere three months of imports (that is, around US$100 billion), forcing the government to allow the ruble to float. The currency then crashes in the ensuing panic far below any fundamentally justified devaluation. Any such reprise of the 1998 debacle would reach into the equity market – which would need to extend its existing collapse by a further 50 per cent to match the 90 per cent peak-to-trough fall of October 1997-October 1998.
The opposite scenario – in which the government broadly achieves its goals – is not, to put it mildly, the consensus expectation at present. But at the very least, this outcome cannot be ruled out. It therefore deserves careful consideration. An additional reason for examining this scenario is that the right investment strategy in such conditions is also much less obvious than in the case of the “defeat” outcome.
A devaluation rout would drive Russia’s financial markets to their lowest trough, but this would not be an urgent buying opportunity. Much would depend on the severity of the resulting economic slump and the extent and implications of the resulting political destabilisation. It follows that the investment timeframe would not be a tight one. In particular, it would be rash to assume a mechanical repeat of Russian equities’ 200 per cent bear market bounce in 1999. Part of that bounce was a fleeting political relief rally, the equivalent of which in the present cycle has already taken place – in May 2008; and in any case, today’s global market and economic environment is incomparably worse. It is also worth recalling that even in that previous cycle, it still took three years (i.e., until October 2001) before the equity market began its historic re-rating.
By contrast, for investors engaged with the Russian market and for other investors looking around the world for the most interesting items on a fat menu of distressed opportunities, the case of Russia in the positive scenario would require more vigilance and agility. In this case, there would be more serious upside portfolio risk. We return in the conclusion of this note to the question of what would be the best investment strategy if the ruble exchange rates adjusts in an orderly fashion and only to the extent necessary to counter external shocks and if the economy overcomes the present shock to resume positive growth by the end of 2009.
For now, we consider each of these battles in turn, examining the government’s goals and methods before assessing its chances of success. We also identify signposts of impending success or failure and gauge the likely timescale in which the outcomes will become clear.
The Central Bank and government aim to avoid a major devaluation overshoot on the back of panic-driven capital flight. Instead, they are seeking to engineer in a calmer environment whatever (modest) currency depreciation may be advisable on fundamental grounds. Many commentators have doubted that this is even the right battle to be fighting. At the time of writing, all there is to show for this is the headline loss of a quarter of official FX reserves from their August 2008 peak of $598 billion.
By no means all of this loss is due to pure outflows – that is, the purchase of rubles to defend the floor of the dual USD/EUR currency basket. Almost half of the reserves contraction results from technical revaluation (in line with external exchange rate movements) and direct government refinancing of non-public external debt through the Development Bank (VEB). And at least part of the capital outflows must represent external debt service payments as opposed to pure speculation against the ruble.
For all that, straightforward capital flight has intensified along with the tumbling oil price, which reinforces devaluation expectations. In tacit acknowledgement of the terms of trade shock, the Central Bank has begun small depreciation steps, in the form of successive widening – by 1 percentage point at a time – of the permitted trading range around the dual currency peg. The obvious danger is that reserves will run out before such incremental moves have built up into a credible and orderly currency adjustment. So it is not surprising to hear wise counsel from various quarters to conserve the country’s reserves either by letting the ruble find its own level in the market or, as recommended by a Commerzbank analyst quoted in the Financial Times on 29 November, going for “a bigger downward step … [which] the market would accept”.
The pitfall of such apparently sensible advice is that it takes insufficient account of problems which, if not unique to post-Soviet transition countries like Russia, are felt in such countries with peculiar intensity. These problems boil down to confidence – that is, public distrust based on a long string of bitter experiences continuing into the recent past. One way to bring home this point is to contrast Russia’s predicament with other commodity exporting countries that are more developed. The Australian currency for example, has depreciated in response to the price shock without anyone having to worry about public panic and runs on bank deposits. Compare this with the US$7 billion of Russian FX reserves lost in a single day (11 November) when the Central Bank made its first small depreciation move, which increased market expectations of more to come.
The reality is that abandoning exchange rate management or trying to defend a new parity at some reasonable level – 15 per cent, say – below the existing one, would kindle already simmering public expectations of a repeat of the 60 percent devaluation experienced in 1998. What remained of the FX reserves would then be consumed in attempts to put out that fire.
The costs of defeat
Any doubts about the government’s determination to avoid such an outcome can be dispelled by considering the economic and political effects of a panic-driven devaluation. These may be grouped as follows:
1. Short-term economic costs, which would not be limited to defaults on foreign currency-denominated debt. The most damaging effect would be widespread bank failures, leading to even worse credit starvation and overall economic contraction. The result would be much the same, regardless of whether the bulk of the existing ruble money supply (M2) remained in the banking system in the form of foreign currency deposits or exited altogether as capital flight. In the first case, many banks would face solvency risks from currency mismatches on their balance sheet and would stop lending, while in the second case the funding base for credit would be lost. The economic pain from a devaluation overshoot would be completed by at least some inflationary effect of more expensive imports.
2. Longer-term economic damage stemming from this new blow to public confidence. In the decade since the previous debacle – and despite smaller interim setbacks, like the mid-2004 banking crisis – steady financial deepening has been achieved, and this is essential for sustained growth. The certain loss of those gains (with ruble M2 likely to halve from its present, still very modest, level of around 40 per cent of GDP) would be that much more difficult to reverse after this repeat blow.
3. Political fallout. The Putin aura would be well and truly broken. Despite the plausible scope for blaming financial and economic calamities on the US, the Russian public perception would be one of mean reversion – in the sense that the present rulers would have been revealed to be no better after all than their predecessors, the same “feet of clay”. The assurance of stability and national recovery built up under Putin’s rule, and the bedrock of his popularity, would be lost. The idea that Putin himself could benefit at the expense of his protégé Dmitry Medvedev is fanciful. Although the broader ruling establishment would maintain sufficient grip to avoid political chaos (even in 1998 the basic institutions held firm), there would be a period of marked political instability and uncertainty involving intense power struggles and negative policy fashions – such as the “proven” hazards of integration into the world economy and the desirability of ever wider state ownership and control.
Seen in this light, the Battle of the Ruble, and the related challenge of minimising the effects of the global economic shock take on an existential quality for the Putin-Medvedev administration. Much hangs, therefore, on the wisdom and effectiveness of the authorities’ strategy for stemming capital flight and averting panic.
The authorities’ tactics: Description and rationale
An assessment of their approach might start by noting the methods that for now they have chosen not to adopt. One such would have been to stop injecting liquidity into the banking system. As the chart below shows, at the outset of the currency crisis the FX reserves and sovereign funds taken together were not far short of the existing sources of outflows: total ruble money and short-term foreign debt.
But those impressive defences have been weakened by liquidity provision to banks, most of which was promptly converted into foreign currency in anticipation of devaluation. Gross liquidity injections from the Finance Ministry peaked at the equivalent of US$32 billion in October, while funding provided by the Central Bank now stands at US$44 billion. A sense of the intensity of speculation against the ruble by banks and their corporate customers can be gained by comparing those amounts with the outflow of US$13 billion, or 6 per cent, of retail deposits during October 2008, when the crisis escalated.
However, starving the banks of official liquidity injections as a way of dealing with the problem of capital flight would be like a cure that kills the patient. For liquidity denial would result in a string of bank failures, causing exactly the public panic that needs to be avoided at all costs to avert a devaluation rout.
Another option forsworn by the government is the reintroduction of capital controls, which were abolished in 2006. That very public and formal step could also trigger panic, since it would send a message that the authorities were resorting to extreme measures and must therefore be staring defeat in the face. There are other reasons for refraining from any such move. The 1990s experience of chronic and large-scale capital flight despite a web of exchange controls suggests that when the chips are down, such controls are futile. In addition, growth prospects will now hinge on effective competition for ever scarcer capital – especially continued foreign direct investment. The restoration of capital controls would be an obvious deterrent to such flows, which will be all the more valuable for financing the current account deficits to be expected at present oil price levels.
Instead, the government has a two-pronged strategy:
The clearest signal on the first point came on 11 November, when the Central Bank increased its policy rate by 1 percentage point to 12 per cent in the same breath as announcing the first small downward adjustment in the ruble’s targeted trading band. The same joint manoeuvre was repeated, clearly not for the last time, on 28 November. The tightening trend has meanwhile been applied in other ways. The ruble rates offered through the Central Bank’s currency swap window have been increased at double the pace of the policy rate, and the rates on unsecured Central Bank loans to banks rose into double figures by mid-November. The cost of the subordinated loans being provided from the National Wellbeing Fund to recapitalise banks will be changed from a fixed 7 per cent rate to a floating rate.
Even before this explicit tightening of monetary policy, actual lending rates to non-financial companies had moved into positive territory in real terms. The next section of this note returns to the longer-term implications of this important change. The main point for now is that it has become more expensive for banks to fund speculation against the ruble.
The second measure to stem capital flight is pressure on the banks and, by extension, their corporate depositors. The authorities have some formal leverage. They will make access to subordinated loans from the state and to the Central Bank’s unsecured lending window conditional on the banks showing restraint in the forex market. In addition, new legislation is planned under which the Central Bank would be permitted to post representatives in banks to monitor what use they make of government funding (which practically all important banks in the country have received in one form or another). But more effective than any of that may be the risk of unspecified repercussions for banks reckoned to be unpatriotic.
The rationale for this approach is clear. A run on retail deposits would spell defeat for the government’s efforts to prevent a disorderly devaluation. However, it would take further sharp falls in the ruble exchange rate against the dollar to trigger any such stampede by households. Restraining speculation against the ruble by banks and companies will stabilise the nominal exchange rate and slow the pace of reserves depletion, in turn allowing public fears of another 1998-style devaluation to subside over time. In any such calmer atmosphere, the Central Bank could bring about a fundamentally desirable ruble depreciation of, say, 10-15 per cent with much less danger of causing public panic and loss of control over the process. The mini-depreciation steps seen in November 2008 are evidently designed to anticipate, and therefore facilitate, any such orderly depreciation move further down the road.
The authorities’ tactics: Assessment
Will this plan work? We have our doubts about the tactic of incremental mini-depreciation steps, which risk diluting the impact and credibility of the stand against capital flight while being too small to make a positive contribution to stabilising the economy. Yet this detail will not be decisive for ultimate success or failure – which hinge respectively on a clear recovery trend in the oil price or a continued oil price decline during the next one or two quarters. Rather than assign spurious probabilities to either of those outcomes, the important point at this stage is timing.
If the government does fail, this will not happen soon. Even if FX reserves depletion continues at the average weekly rate of US$15 billion seen in October-November, it would take until March 2009 for reserves to fall close to the US$100 billion level at which, as suggested above, the game would probably be over. And if the government preferred to conserve more of its reserves, it could still continue the fight by adding some formal steps to the informal pressure against capital flight. Here again, we would expect a gradual intensification rather than capital controls being re-imposed across the board. An obvious intermediate measure would be to reintroduce compulsory conversion of a portion of export proceeds into rubles, perhaps limiting this obligation to companies in the key hydrocarbons and metals sectors.
This would buy time, which, in turn, would increase the chances of success. Since the longer the government can stay in the game, the more time is available for some visibility to emerge about oil price prospects.
The political and economic dividends of victory in the Battle of the Ruble would be less obvious than the costs of defeat. Any such success would not in itself guarantee success in the still more challenging task of cushioning the effects of the global economic downturn led by recession in the US and many other OECD countries. But averting a ruble collapse while keeping the currency competitive would be a good start.
New macroeconomic framework: Tighter money …
From the rash of emergency fire-fighting measures taken since September 2008, the outline of a new macroeconomic policy framework has emerged. This framework amounts to a reversal of the boom years in which monetary policy was very loose while fiscal policy remained relatively tight.
There is more to putting an end to negative real interest rates than deterring speculation against the ruble. This shift has longer-term importance. Part of the reason lies in the weak anti-inflationary environment that preceded the crisis. Although inflation is no longer Russia’s main and immediate economic problem, that legacy will show up in a stickier decline in CPI than in countries that have been running more orthodox monetary policies. To the chronic supply-side problems of rigid product markets and weak competition must be added the specific effect of import-led inflation, especially via food prices, even in the positive scenario of no more than limited ruble depreciation. This situation will not be helped by the vulnerability of the domestic agricultural sector to the credit squeeze. In short, the problem of stagflation will not disappear of its own accord.
There is a still more important reason for locking in the shift to positive real interest rates. This has to do with ending monetary repression. In a world of capital stringency, domestic savings need to be mobilised as efficiently as possible. Negative returns on bank deposits are the first thing to be avoided. Even before the Central Bank started raising rates in November, the foreign credit stop had already tightened monetary conditions with average two-year bank lending rates to non-financial companies rising in October to 14.3 per cent – which is about zero in real terms. Anecdotal evidence indicates that only the most creditworthy borrowers can now access funding in rubles at less than 20 per cent.
… but fiscal stimulus
Tightening domestic monetary conditions will compound the blow to demand from the foreign credit stop and global economic weakness. The government aims to cushion these blows by means of fiscal policy. Now is the time that the decision taken in 2004 to save the bulk of windfall oil tax revenues will bear fruit. As shown in the chart below, those savings are now held in the successor entities of the original stabilisation fund – the Reserve Fund and National Wellbeing Fund.
The National Wellbeing Fund has already been tapped as part of the emergency package, notably for recapitalising banks and intervening in the domestic financial markets. Looking forward to 2009, the main fiscal manoeuvre will be to draw down Rb1 trillion from the Reserve Fund. This is more than a quarter of the Fund’s existing resources.
Half of that money will finance previously planned spending at all levels of government (federal, regional and off-budget pension and social security funds), plugging the gap left by the shortfall in oil-related revenues. (It is worth mentioning here, however, that the federal budget alone could still break even at an average oil price of US$50/bbl since the proceeds of oil taxation, especially the dollar-linked crude oil export duty, will be increased by the ruble’s depreciation against the dollar.)
The other half of that Rb1 trillion Reserve Fund draw-down will finance an orthodox counter-cyclical fiscal stimulus of 1.2 per cent of 2008 GDP. The package announced on 20 November combines higher transfers (public sector wages, pensions and unemployment benefits) and tax cuts (notably a 4 percentage point reduction in the maximum rate of company profit tax to 20 per cent).
An additional stimulus can be delivered through the so-called development institutions – most of which were established and capitalised in 2007 with a total of about US$40 billion taken from the stabilisation fund. These include the government Investment Fund and the VEB, both with mandates that prioritise infrastructure projects. The drawback of capital projects as a means of economic stimulus is the long lead time involved – especially given the Russian bureaucracy’s inherent inefficiency and inexperience in managing such projects (our July 2008 note Russian infrastructure: The PPP challenge provides a detailed view of this subject). The bureaucracy’s above-average performance in rolling out emergency measures since September suggests that disbursements of state investments in infrastructure may now quicken as a result of this new sense of urgency. A more promising source of near-term disbursements is the Housing and Communal Services Reform Fund – another of the new development institutions, half of whose US$5 billion of initial capital has now been committed to acquiring finished or near-complete residential developments.
These planned acquisitions represent direct state support for the property and construction sector, which in Russia, as in most other countries, has proved especially vulnerable to the credit squeeze. But the government is planning relief for other parts of the real economy. An important focus is maintaining the previously-planned scale of the capex programmes of major state-controlled companies in the railways, electricity and oil and gas sectors (even if the nominal sums spent are lower than in existing budgets thanks to falling inflation). These giant companies’ investment activities underpin employment and wages in a wide range of domestic industrial sectors. Government support in this area has already been provided in the form of reductions in oil companies’ tax burden and the use of official FX reserves to refinance these and other companies’ external debt.
More systematic measures to support the real sector had not been announced in detail at the time of writing. But an outline government plan published on 7 November lists the favoured sectors – defence industry, machine building (including cars and agricultural machinery), homebuilding, agriculture and small business. It also enumerates some of the favoured approaches: directed lending from state banks and state guarantees and interest rate subsidies on bank loans. In addition, there has been talk of direct injections of government cash into industrial companies in the form of subordinated loans or purchases of newly issued preferred shares.
Sustainability and impact of the new fiscal-monetary framework
Of all these planned measures, interest rate subsidies deserve particular attention. They look set to be a half-way house between the tighter monetary policy necessary to combat capital flight and the negative impact of higher interest rates on growth.
From the point of view of maintaining growth, the ideal would be to win the Battle of the Ruble without the aid of higher interest rates – that is, using the FX reserves to support the exchange rate and informal pressure to stem capital flight as discussed above. In practice, the interest rate instrument will continue to be used against capital flight. While in the short term it would make sense to loosen monetary policy, there is a longer-term case for preserving the gains from the present crisis of getting interest rates into positive real territory. Even if the inflationary danger of reverting to negative real rates might seem negligible for now, the resulting monetary repression and resource misallocation would still weaken the foundation for continued growth in the much harsher global environment.
While the Central Bank will reduce its policy rate as inflation slows and the risk of a ruble panic recedes, left to its own devices it is likely to seek to lock in positive real rates. (It should be noted in passing here that the drying up of private capital inflows has improved the Central Bank’s ability to influence domestic interest rates.) However, the temptation to go for all-out monetary stimulus will increase during the coming months in line with the pain of the economic crisis – which will be reflected in ever gloomier macroeconomic data releases. As with the Battle of the Ruble, the popularity and political credibility of the Putin-Medvedev administration are at stake. Such pressures will intensify when opinion polls start showing material dips in the leaders’ public approval ratings (although there is no real sign of this at present). The political backlash potential should not be underestimated. This risk stems from the psychological effect of the abrupt stagnation (at best) of real incomes and purchasing power after a decade in which nominal dollar GDP (at market exchange rates) has risen 10 times.
This is where policies like interest rate subsidies come in. For all their intrinsic drawbacks (from favouring corruption to fostering longer-term inefficiency), such subsidies would keep the overall policy framework stable. To the extent that this framework is too austere – wih interest rates that are inappropriately high in a sharp downturn – the resulting pain could be reduced by the scope for intensifying the fiscal stimulus. Although the Reserve Fund would be exhausted by 2011 unless the oil price recovers, the government itself could resume foreign borrowing well before that. As it happens, the 7 November programme includes a first step in that direction, which is the planned issuance of infrastructure bonds by the VEB. In general, the government’s posture remains sound. Despite vigorous lobbying from industry, the previously planned schedule for domestic gas and electricity price liberalisation has been upheld (the rationale here being to support key capex programmes). Tighter competition regulation also remains on the agenda.
To sum up, if the government pulls through the present currency crisis, the new macroeconomic policy framework can support continued growth, even though that growth might prove very weak in 2009 – say 0-2 per cent for real GDP – as a result of high interest rates. Despite the resulting political pressures, the scope for fiscal stimulus in addition to the measures already announced improves the chances of this framework holding through the crisis period.
Structural reform
In contrast to the macroeconomic policy area, no change is either necessary or contemplated in the structural reform agenda. The difference now, rather, is that the domestic and global crisis puts an ever higher premium on reducing investment risks by improving the business climate (especially as regards the bureaucracy and corruption) and facilitating the financing of investment (by reform of the domestic banking system and financial markets).
Even before the crisis erupted for real in late summer, the Medvedev team had already made a reasonable start in reviving this structural reform agenda. While arrogance and complacency might return in the event of success in the Battle of the Ruble, this risk seems remote given the prospect of the serious economic pain that would in any case continue. It is economic pain (aka oil price weakness) that provides the best antidote to structural reform complacency. In any case, the ability to handle the present currency crisis is a vindication in itself of the decision to accumulate reserves and sovereign funds as insurance against future shocks – a key reformist policy that has long been attacked by influential figures in the mainstream political class such as the Mayor of Moscow, Yury Luzhkov.
One encouraging sign is the inclusion of useful structural elements in the government’s emergency fire-fighting measures adopted in September-October 2008. Particularly notable is the new legislation empowering the Deposit Insurance Agency to take effective control of troubled banks before they become definitively insolvent. The Agency will then seek to facilitate the sale of such banks to a stronger bank or, if that is no longer realistic, to arrange the orderly transfer of the bank’s retail deposits to a safer home. That pre-emptive power reflects the reality that, as with the interest rate hikes and other recent policy innovations, this step has the short-term aim of preventing public panic. But this approach also has longer-term importance in that it amounts to a Special Resolution Regime for banks and, as such, looks like the best way to take advantage of the crisis to clean up the banking system.
The global financial and economic crisis has laid bare all countries’ particular vulnerabilities. In Russia’s case, the key vulnerability stems from the country’s history of monetary confiscations, hyperinflation and – above all – the gigantic devaluation with which the financial debacle of 1998 culminated. For without this handicap, the present negative terms of trade shock – sharp as it is given the scale of the oil price fall – would not in itself have created the acute practical difficulty of adjusting the exchange rate while avoiding an overshoot or collapse. If that problem can be overcome – what is described in this note as victory in the “Battle of the Ruble” – the adjustment required for external balance is not drastic (especially against the background of the undervaluation of the ruble during the preceding years of surging oil prices).
The same conclusion may be applied to the other major vulnerability stemming from the underdevelopment of the domestic financial system, leading to an increasing reliance on foreign financing for domestic investment which (both financing and investment) has now come to an abrupt halt. Here again, the shock is a sharp one, and this sharpness will be reflected in dire macroeconomic data during the next couple of quarters. Yet this problem, too, is manageable. This is partly thanks to the same stockpile of government savings that are the key to handling the currency crisis. For these savings are also being used to refinance non-public external debt. At around 30 per cent of GDP, that debt is meaningful; but the fact that the government has the means to refinance it and that the level of the economy’s overall leverage is relatively low should spare Russia the chronic deleveraging pain in store for many other countries, both emerging and developed.
Those wider global problems will of course be transmitted to the Russian economy via commodity price weakness. This is where the new macroeconomic policy mix can help by mobilising more domestic savings through positive (almost certainly too positive) real interest rates and cushioning the shock to demand through fiscal stimulus.
That shock could yet overwhelm all defences. Russia’s present predicament, combining a currency crisis and a stun-blow to economic growth, may be likened to passing through a tunnel which, on the one hand, is dangerous and could collapse but which, on the other hand, is not too long. In fact, the light at the end of the tunnel is already visible.
Despite all the disasters of Russian financial markets in the second half of 2008 (including renewed political and corporate governance risks), and despite the wider world offering many competing claims on the attention of value investors, Russian assets will present a serious opportunity if the currency and economy emerge from that tunnel in reasonable shape. The outcome will be known by mid-2009, but clear evidence one way or the other should emerge as early as 1Q09, especially on the crucial FX front.
A positive outcome is perfectly plausible. Since such an outcome must be linked to some commodity price stabilisation, the debt and equity of Russia’s big natural resource companies – especially the state-controlled ones, which are assured minimum required financing – would lead the recovery charge. More precisely, these companies’ bonds would be the early outperformers with what at present amounts to the option value in their equity being realised in slower time.
But the best returns of all would come from the secondary effect of that commodity price stabilisation in preventing a ruble collapse. This, in turn points, to the major difference between the current cycle and the immediate post-1998 recovery, which was a story of oil output. In the recovery scenario this time around, domestic consumer demand growth, though weakened, will still exist at the outset, creating value right across the local debt and equity markets (here again, in that order). In this perspective, one thing at least would be familiar from the previous cycle of crash and recovery – namely, Russian assets overshooting their peers first on the downside and then on the upside.
The precipitate falls in official FX reserves explain the consensus – notably strong inside Russia itself – that the government will lose the Battle of the Ruble …
… but this consensus overlooks the solvency of the national balance sheet and the reality that countries which have accumulated the largest piles of FX reserves have the best chance of preserving stability. But realising that chance depends also on effective tactics to counter capital flight.
The chart below shows the equity market performance in the three years after the 1998 financial crisis. Memories of the bounce-back in 1999 have led some commentators to conclude that a sharp devaluation would allow the market to hit bottom and tee-up a strong rally …
… but that 1999 rally was powered by the removal of political uncertainties and was short-lived. The next chart shows that the equivalent politically-driven rally in the present cycle is already behind us. The key to asset price recovery lies rather in preserving the integrity of the currency as part of a wider campaign to sustain domestic demand.
The next chart provides a reminder of the astonishing growth of nominal dollar GDP (at market exchange rates) in the past decade. Even minimal ruble depreciation in the dollar entailed by success in the Battle of the Ruble would deal a blow to expectations from the reversal of the positive trend in purchasing power.
The public approval ratings of the top leadership have dipped with the onset of the crisis but have not yet been undermined.
The pressure will surely intensify. The best antidote both to economic slowdown and the linked political pressures is the scope for further fiscal stimulus, if necessary financed by new government borrowing exploiting the creditworthiness built up over years of sustained budget surpluses (see chart below).
A comparison of Russia’s leverage with a selection of other economies shows that if the shock of the foreign credit stop can be negotiated – both as regards the currency and the real economy – the country is not faced with chronic and painful deleveraging. (The chart below measures all public and non-public external and domestic debt net of official FX reserves.)
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