The Russian insulation amid global sell-off
Maxim Oreshkin, Chief Economist for Russia at VTB Capital, special to the BRICS Post.
Emerging markets scare and its pitfalls have been the most widely debated topic for the last few months.
The turmoil in the emerging market (EM) space started several months ago on the back of growing expectations that the US Federal Reserve would start tapering its $85 billion a month quantitative easing programme.
But what really were the real roots of capital outflows fr om developing financial markets?
The real cause of action in the EM space was not, of course, taper talk, but in excessive risk taking among developed market investors (which in most cases were simply trying not to miss exceptionally strong performance from indices).
Equally at fault here were relaxed local authorities, who viewed inflows as persistent and did not properly address internal risks or the possible risks associated with a sudden stop of capital inflows.
In the current environment, when most EM countries are trying to cope with volatile capital outflows and to stabilise the situation on the local bond and FX markets, Russia seems to be to a large extent protected from the negative impact from global financial market turmoil.
The reason was simple, compared with other EM countries, Russia looked more favourable: if inflows into some EMs were in the tens of billions (some countries have even seen cumulative triple-digit inflows in recent years), Russia has hardly exceeded the $30 billion threshold for the total amount of OFZs (local government bonds) held by foreign investors.
This is why, in the times of deep stress, Russia’s sovereign bond market was one of the few globally in which the firepower of local players was enough to buy out those foreigners that decided to leave the market.
As a result, the local market remained liquid even in the depths of the global sell-off.
But why didn’t Russia experience inflows of the same magnitude as other EMs, which helped it maintain stability in the current turbulent environment? I see several reasons for this.
First, unlike countries like Turkey, wh ere the central bank promised to reduce volatility on the FX market (which actually meant targeting a stable exchange rate), Russia continued to proceed toward a more flexible exchange rate regime, with minimal and even declining Central Bank interventions.
The volatile and unpredictable exchange rate certainly adds an extra level of uncertainty for investors, thus stimulating longer-term holdings over short-term. For example, the average duration of the bond holdings of foreigners on Russia’s market exceeded five years – not a typical situation among other EMs.
Second, the extremely good fiscal and external positions resulted in a tiny supply of sovereign bonds without any urgency to attract foreign money.
As a result, there was not enough supply of government bonds to be offered to foreign investors, some of whom, at some point in 2H12 and early 2013, were trying to buy out bond holdings from the local banks. Even this was not enough to build substantial bond positions compared with those in other EMs (especially as a percentage of GDP).
The understated critical role of Russia’s Central Bank
Last, but not the least, the hawkish stance of the Russian central bank helped. When all other regulators were cutting base rates to help ailing economies – and in doing so fuelling rallies on their local bond markets – Russia’s central bank(CBR), initially under Ignatiev and recently under Nabiullina, has been reluctant to engage in a monetary easing cycle, despite a sharp slowdown of growth.
The CBR thus represented a stronghold of tight monetary policy, with the 25bp increase in base rates in September of last year being the only move since September 2011. Moreover, this was combined with a tightening of liquidity conditions, which, taking into account the flaws of the local refinancing system (insufficient market collateral on the balance sheets of local banks for the use of standard refinancing facilities), resulted in a gradual but persistent tightening of monetary conditions.
However, nothing can stand too much of a good thing.
The Central Bank hawkishness though positive for the economy for some time, as it helped to avoid it being flooded with short-term foreign money and brought inflation (which was one of Russia’s key persistent problems during the last decade) to record low levels; eventually it appeared to be too much.
Internal private demand followed the path of external and government sectors and pushed the economy into a cyclical slowdown, with a widening output gap and GDP growth at just 1.2 per cent YoY in 2Q13 – the lowest since the crisis-hit 2009.
The current and future trajectory of Russian growth
Nevertheless, Russia’s growth forecast for this year at 1.7 per cent, can be easily called healthy: it is not supported either by fiscal expansion (growth in federal government spending will likely decline from 18 per cent in 2012 to just thee per cent this year), or by monetary easing (money market rates are at the highest level since crisis times while lending growth has peaked in mid of 2012 and since then decelerating).
It also means that when the Central Bank finally starts loosening monetary policy, it will orchestrate a powerful recovery, as there is clearly a cyclical factor in the recent slowdown.
We do not expect the CBR to be able to resist labour market deterioration: we believe that unemployment is likely to increase from the 5.4 per cent at the end of June to 6.2 per cent by the end of the year.
Moreover, this is to be combined with further inflation deceleration: it came as low as 6.5 per cent as of end of July vs May’s peak of 7.4 per cent.
Recent reports highlight a simultaneous decline in food inflation and, more importantly, accelerating core prices disinflation. We also expect headline CPI to come closer to five per cent in the coming months. The regulator would then be forced to launch a full-scale easing cycle – albeit this would be too late to impact the economy and inflation developments during the rest of the year.
A simultaneous slowdown of inflation and base rate cuts is the best environment for the bond market, in our view.
And when all other EMs will be heavily involved in fixing their inflation/external imbalances problems with tighter monetary policy, Russia’s bond market will start looking much more attractive.
We think this would allow the Russian bond market to reap the best results in terms of growth and inflows.
Although, overall, inflows are unlikely to be of a volume that would impress, as it will be one of the best only in comparison with weak figures from other EMs, and, of course, will be nowhere near the inflow volumes bonanza period of 2012-1Q13.