While we believe Russia’s credit quality is essentially sound and declines in the ruble and the country’s bonds have overshot their fundamental value, it is important to recognize that the risks have increased substantially recently.
Russian assets have been under pressure for several months due to the country’s involvement in the Ukrainian crisis and the consequent imposition of sanctions by the U.S. and the EU. The rapid fall in oil prices has accentuated the pressure, given the country’s dependence on oil and gas exports. The Russian ruble has lost close to half of its value against the dollar since the beginning of 2014. Russian external sovereign and corporate bonds have also performed very badly in the markets and the sell-off has spread to the local bond market as well. The Central Bank of Russia has reacted to the ruble’s weakness with an emergency 650 basis point rate hike, followed by additional measure to support the foreign exchange market.
While we continue to believe that Russia’s credit quality is essentially sound and that both the ruble and the country’s bonds have overshot their fundamental value, it is important to recognize that the risks have increased substantially in recent weeks.
Growth expectations continue to come down with lower oil prices and the Russian economy is likely to go into recession in 2015. We had been expecting growth to be just above zero. The depth of the recession will depend on oil prices and on the effect of the recent emergency rate hikes on domestic consumption, as well as the ongoing impact of sanctions. Russia’s current account will be substantially weakened by lower revenues from oil and gas exports. Imports are also likely to fall due to the recession and sanctions (both those imposed by the U.S. and the EU and the counter-sanctions on agricultural products imposed by Putin). There is a risk that the current account surplus turns into a deficit, depending on how these two factors offset each other. Russia’s capital account will remain weak as long as sanctions remain in place, as Russian corporates are repaying their existing loans without access to new financing. Capital flight — a feature of the Russian economy for the last several years — is expected to continue. These factors will continue to place pressure on foreign exchange reserves, which stood at US$416 billion at last reporting, although we estimate that only $200 billion is readily available to support the currency.
As long as the ruble’s depreciation continues to outpace the fall in oil prices, Russia’s fiscal accounts should benefit, given that a high proportion of the government’s revenues is linked to the U.S. dollar while expenditures are largely in rubles. Non-oil revenues will be hurt by slower growth, however.
The combination of sanctions and the central bank’s emergency rate hike to 17% is increasing stress on the Russian banking system and on Russian corporates. Non-performing loans in the banking system are likely to increase while corporates are facing a financing squeeze and will likely see their revenues hurt by lower domestic demand. There is a risk of downgrades to corporate credit ratings, although we believe that most large Russian corporates continue to have sound balance sheets and would be likely to receive government support if necessary, given their strategic importance. Smaller corporates are more vulnerable and some could default on their debts.
The central bank followed up its emergency rate hike — which the market found insufficient — with a series of measures to support the currency. These measures include not just the sale of U.S. dollars from reserves but also an increase in the size and frequency of foreign currency repo auctions, the provision of foreign exchange loans and a suspension of mark-to-market requirements for Russian banks. The market reacted very favorably to these measures, reversing close to half of the previous week’s currency depreciation. It remains to be seen, however, if these measures will provide more than a temporary respite. Liquidity in the ruble remains very low and bid — ask spreads are extremely high.
“Given the risks [outlined herein], our view on Russia has become more negative. Markets have, however, largely priced in a negative scenario while liquidity has dried up. We are, therefore, remaining neutral in our positioning in both U.S. dollar and local currency, while continuing to monitor the situation very closely. ”Urban A.F. Larson, Senior Product Specialist, Emerging Markets Debt, Standish Mellon Asset Management Company, LLC
There is a risk that the central bank will resort to capital controls to support the currency. We do not expect this to happen and top Russian officials have denied any intention of doing so. If capital controls were to be imposed, however, we would expect them to come first in the form of forced repatriation of U.S. dollars from Russian exporters. We think it is very unlikely that the Russian government would take measures that would prevent Russian borrowers from repaying their foreign obligations or any other measure that would further isolate Russia from the global financial markets.
We do not expect Russia to default on its sovereign or quasi-sovereign bonds. There is no reason for the country to default as payments are relatively small compared to the size of the country’s foreign exchange reserves. The risk of a downgrade to Russia’s sovereign rating has increased, however, given the deteriorating growth outlook and the stress in the financial markets. Russia is currently rated one level above junk by S&P and two levels above by Moody’s and Fitch. While we do not expect the country to lose its investment grade rating, we acknowledge that this is a possibility.
The restoration of confidence in the ruble and in Russian assets more generally depends on continued aggressive action by the central bank but also on external factors. The first of these is oil prices. We believe that for oil to stabilize the market needs to see a reduction in supply from either North American shale producers or OPEC. This may take several months to materialize and would likely lead only to a return to the US$60-70 per barrel range. This level ought to be supportive of the ruble at the current level but would not be sufficient to lead to a meaningful rebound in the currency. The second key factor would be a disengagement of Russia from Ukraine, which would lead to the removal of sanctions. We do not consider this likely and in fact the risk remains that Russia instead becomes more directly involved in the Ukrainian crisis.
Given the risks outlined above, our view on Russia has become more negative. Markets have, however, largely priced in a negative scenario while liquidity has dried up. We are, therefore, remaining neutral in our positioning in both U.S. dollar and local currency, while continuing to monitor the situation very closely.
BNY Mellon Investment Management is one of the world’s leading investment management organizations and one of the top U.S. wealth managers, encompassing BNY Mellon’s affiliated investment management firms, wealth management organization and global distribution companies. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or its various subsidiaries generally.
The information in this document is not intended to be investment advice, and it may be deemed a financial promotion in non-U.S. jurisdictions. Accordingly, where this document is used or distributed in any non-U.S. jurisdiction, the information provided is for Professional Clients only. This material is not for onward distribution to, or to be relied upon by, retail investors.
Any statements and opinions expressed in this document are as of the date of the article, are subject to change as economic and market conditions dictate, and do not necessarily represent the views of BNY Mellon or any of its affiliates. The information contained in this document has been provided as a general market commentary only and does not constitute legal, tax, accounting, other professional counsel or investment advice, is not predictive of future performance, and should not be construed as an offer to sell or a solicitation to buy any security or make an offer where otherwise unlawful. The information has been provided without taking into account the investment objective, financial situation or needs of any particular person. BNY Mellon and its affiliates are not responsible for any subsequent investment advice given based on the information supplied. This document is not investment research or a research recommendation for regulatory purposes as it does not constitute substantive research or analysis. To the extent that these materials contain statements about future performance, such statements are forward looking and are subject to a number of risks and uncertainties. Information and opinions presented in this material have been obtained or derived from sources which BNY Mellon believed to be reliable, but BNY Mellon makes no representation to its accuracy and completeness. BNY Mellon accepts no liability for loss arising from use of this material. If nothing is indicated to the contrary, all figures are unaudited.
Any indication of past performance is not a guide to future performance. The value of investments can fall as well as rise, so you may get back less than you originally invested.
This document is not intended for distribution to, or use by, any person or entity in any jurisdiction or country in which such distribution or use would be contrary to local law or regulation. This document may not be distributed or used for the purpose of offers or solicitations in any jurisdiction or in any circumstances in which such offers or solicitations are unlawful or not authorized, or where there would be, by virtue of such distribution, new or additional registration requirements. Persons into whose possession this document comes are required to inform themselves about and to observe any restrictions that apply to the distribution of this document in their jurisdiction. The investment products and services mentioned here are not insured by the FDIC (or any other state or federal agency), are not deposits of or guaranteed by any bank, and may lose value.
This document should not be published in hard copy, electronic form, via the web or in any other medium accessible to the public, unless authorized by BNY Mellon Investment Management.
This document is approved for Global distribution and is issued in the following jurisdictions by the named local entities or divisions: UK and in mainland Europe (excluding Germany): BNYMIM EMEA, BNY Mellon Centre, 160 Queen Victoria Street, London EC4V 4LA. Registered in England No. 1118580. Authorized and regulated by the Financial Conduct Authority. • Germany: Meriten Investment Management GmbH which is regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht. • Dubai, United Arab Emirates: Dubai branch of The Bank of New York Mellon, which is regulated by the Dubai Financial Services Authority. This material is intended for Professional Clients only and no other person should act up on it. • Singapore: BNY Mellon Investment Management Singapore Pte. Limited Co. Reg. 201230427E. Regulated by the Monetary Authority of Singapore. • Hong Kong: BNY Mellon Investment Management Hong Kong Limited. Regulated by the Hong Kong Securities and Futures Commission. • Japan: BNY Mellon Asset Management Japan Limited. BNY Mellon Asset Management Japan Limited is a Financial Instruments Business Operator with license no 406 (Kinsho) at the Commissioner of Kanto Local Finance Bureau and is a Member of the Investment Trusts Association, Japan and Japan Securities Investment Advisers Association. • Australia: BNY Mellon Investment Management Australia Ltd (ABN 56 102 482 815, AFS License No. 227865). Authorized and regulated by the Australian Securities & Investments Commission. • United States: BNY Mellon Investment Management. • Canada: Securities are offered through BNY Mellon Asset Management Canada Ltd., registered as a Portfolio Manager and Exempt Market Dealer in all provinces and territories of Canada, and as an Investment Fund Manager and Commodity Trading Manager in Ontario. • Brazil: this document is issued by ARX Investimentos Ltda., Av. Borges de Medeiros, 633, 4th floor, Rio de Janeiro, RJ, Brazil, CEP 22430-041. Authorized and regulated by the Brazilian Securities and Exchange Commission (CVM). The issuing entities above are BNY Mellon entities ultimately owned by The Bank of New York Mellon Corporation
BNY Mellon Cash Investment Strategies is a division of The Dreyfus Corporation. • BNY Mellon Western FMC, Insight Investment Management Limited and Meriten Investment Management GmbH do not offer services in the U.S. This presentation does not constitute an offer to sell, or a solicitation of an offer to purchase, any of the firms’ services or funds to any U.S. investor, or where otherwise unlawful. • BNY Mellon Western Fund Management Company Limited is a joint venture between BNY Mellon (49%) and China based Western Securities Company Ltd. (51%). The firm does not offer services outside of the People’s Republic of China. • BNY Mellon owns 90% of The Boston Company Asset Management, LLC and the remainder is owned by employees of the firm. • The Newton Group (“Newton”) is comprised of the following affiliated companies: Newton Investment Management Limited, Newton Capital Management Limited (NCM Ltd), Newton Capital Management LLC (NCM LLC), Newton International Investment Management Limited and Newton Fund Managers (C.I.) Limited. NCM LLC personnel are supervised persons of NCM Ltd and NCM LLC does not provide investment advice, all of which is conducted by NCM Ltd. Only NCM LLC and NCM Ltd offer services in the U.S. • BNY Mellon owns a 20% interest in Siguler Guff & Company, LP and certain related entities (including Siguler Guff Advisers LLC).