Line Break

“Cutting rates by 50 basis points here and there is not going really diminish the appeal of the ruble,” said Manik Narain, an emerging markets strategist at Standard Chartered Bank Plc in London.

“In terms of nominal interest rates Russia (at 9% as of 24 November) is still offering the highest yields in the emerging market space and in an environment where oil prices are remaining relatively well supported we think that the ruble will continue to be seen as an attractive way to position for global recovery,”

The world’s central banks are having a hard time of it these days, having just gotten through the worst banking and financial crisis in living memory they now face a growing dilema between continuing to give support to the developed economies (which are yet to recover from those early hammer blows) and the danger of creating fresh global asset price bubbles in emerging economies, asset bubbles which could easily be being fuelled by low US interest rates and a weak dollar. The latest warning in this respect comes not from Nouriel Roubini rather it emanates from Germany’s new finance minister, Wolfgang Schäuble. His comments – which were cited in last Saturday’s Financial Times – highlight official concern in Europe that the exceptional steps taken by central banks and governments to combat the crisis carry with them a series of undesireable side effects.

Such openly expressed concerns only add further weight to recent statements made in China, where only a week ago the banking regulator Liu Mingkao explicitly criticised the US Federal Reserve for indirectly fuelling the “dollar carry-trade” – a process whereby investors borrow dollars at ultra-low interest rates in the United States and the invest them in higher-yielding assets abroad.

Wolfgang Schäuble went even further, saying it would be “naive” to assume the next asset price bubble would look just like the last one. “More likely today is a scenario in which excess liquidity globally creates a new [sort of] asset market bubble.” he said, and the fact “ that low interest rate currencies such as the US dollar increasingly being used as a basis for currency carry trades should give pause for thought. If there was a sudden reversal in this business, markets would be threatened with enormous turbulence, including in foreign exchange markets.”

As I argued in my last post on the carry trade, the danger of a short term sudden reversal may be being overstated at this point, since exit from emergency life support will be at best slow and measured in the United States, while ample funding will continue to remain available in Japan, where the central bank has now formally recognised that the economy is once more back in deflation (officially it exited in 2006, and the Bank did manage to summon up a full half percentage point worth of interest rate rise before falling back towards zero again, but in reality, if we strip out the oil price impact, the sad truth is that Japan never really left deflation).

However, regardless of whether or not we are running the danger of having an overly rapid unwind effect, untold damage is in fact being done, with the structural distortions being produced by the massive “wall of liquidity” which is currently sweeping the planet being evident enough, showing up as it is in some unexpected places, like Russia for example.

Ruble Once More On The Rise

On the face of it the idea that investors who were rushing for the Russian door following the Roki tunnel incursion back in August 2008 may now be rushing back in again may seem hard to believe, particularly given the serious economic recession which followed, and in reality it isn’t quite like this, but what is clear is that a steady and significant flow of funds is now most definitely heading in Russia’s direction – even if the immediate objective is not to increase what Russia most definitely needs, namely capital investment. A brief glance at the charts for movements in the ruble vis a vis the US dollar (see below) shows immediately what has been happening. After hitting a low of $31.39 on September 2 the ruble has been steadily rising, and was at $28.65 on November 11, since which time it has been hovering, as investors vacilate waiting to see where policy and the currency go from here.

At the same time, if we look at movements in the ruble-USD over a longer period of time (2 years in the chart below) it is plain the the ruble hit bottom on 4 February 2009 at $36.22 after falling steadily from 17 July 2009 when it touched $23.25

In fact, as I say, while it is clear that Russia is on the receiving end of a steady inflow of funds, it is far from clear that these funds are of the kind she most needs at this point. Much of the money has been going into stocks, and Russian equity funds drew record amounts at the end of October, according to data provided by EPFR Global. In fact Bloomberg data show that the ruble has been the second-best performer among emerging market currencies after the Chilean peso over the past three months, gaining 8.7 percent in the period. And even foreign currency purchases from the central bank and lowering interest rates systematically to a record low (in Russian terms) has not worked. Indeed Russia’s foreign currency reserves have now risen to $441.7 billion (as of Nov. 13) compared with the low of $376.1 billion reached on March 13. Whilethe Micex Stock Index has gained 116 percent this year, making the Index the best-performing benchmark equity measure globally since January (in local currency terms), again according to Bloomberg data.

In comparison Russia’s foreign direct investment plummeted an annual by 48.1 percent, the most on record, to just $10 billion in the first nine months of the year, while overall foreign investment, including credits and flows into securities markets, was $54.7 billion, down 27.8 percent when compared with the same period a year earlier,according to Federal Statistics Service data. Other foreign investments, including loans from foreign banks and Russian companies’ foreign divisions, were down 20.9 percent in the period to $43.7 billion. The consequence of all this is that the decline in investment activity has been – as can be seen in the GDP growth components chart below – perhaps the greatest single drag on the domestic Russian economy over the past twelve months.

But, as I am stressing this earlier overall impression of Russia as a country with problems of net capital flight now no longer gives us a precise up-to-date picture because, in a reversal of the earlier pattern Russia has seen, since mid September, significant capital inflows. In this sense some of the aggregate flow data is misleading, and even while the pressure from foreign lenders to repay sindicated loans continues and Russian borrowers continue to have difficulty rolling over their debt, the aggregate capital flow data to some extent masque a change in the underlying structure of Russian external debt – here, as ever, the devil lies in the details. As Guillaume Tresca, a Paris-based emerging market strategist with Credit Agricole’s Caylon Unit, argues the mounting weight of that huge wall of liquidity sweeping the planet means that something somewhere has to give, with the consequence that the Russian authorities are now under severe pressure to accept the inevitability of short term ruble appreciation since even though they “will try to do what they can to smooth the process, it’s very hard for them to go against the flow” since current “capital inflows are massive.”

In fact a growing consensus seems to be now emerging that Russia’s central bank will find itself forced to accept a stronger ruble next year as the devastating cocktail of rising commodity prices and abundant liquidity simply prove to be too powerful a force for policy makers to counter. So while representatives of the Russian administration have repeatedly asserted that they will do all they can to cap the ruble’s advance, all may well not be enough, despite Vladimir Putin’s repeated declarations that his government won’t allow excessive appreciation in a bid to give some support to struggling exporters. The Canute like task of driving back the ocean is hardly an easy one, and, as the IMF itself recently warned, all efforts to fight the ruble’s advance may simply prove to be “unproductive.”

The problem has recently become even more complicated since, in the short term at least, letting the rouble rise also has its attractions for a Russian administration faced with simmering popular frustration with their inability to get the ongoing economic contraction fully under control. A rising ruble means slower inflation and more spending power for domestic consumers, consumers who have yet to get over the record 10.9 percent economic contraction which hit them in the second quarter. Given that the nine interest rate cuts introduced by the central bank since April have manifestly failed to unlock the credit flow to consumers as banks hold back their lending on concern borrowers can’t repay their debt (see chart below) a rising exchange rate certainly seems to be worth a second look as a way forward, since while a higher exchange rate coupled with near double digit inflation may cripple manufacturing competitiveness, it does transfer incomes directly into people’s pockets, something hard pressed politicians might see as quite beneficial.

Lending is still – as can be seen in the above chart prepared by the World Bank for its latest report – a problem, and corporate (or non-financial corporation lending) fell by 0.7 percent in September from August continuing the ongoing decline. Lending to households dropped 1.1 percent making the eighth consecutive monthly decline, with year on year levels now in negative territory, while non performing retail loans rose, climbing to 6.4 percent from 6.2 percent.

And the World Bank expect the many bank balance sheets will continue deteriorating as the share of non-performing loans increases. “In the environment of increasing credit risks, lending activities by the banks have remained limited despite improving liquidity conditions in the economy and continuing monetary loosening.” Bad debts in the banking industry may reach an average of 10 percent by the end of the year according to the Bank.

And when we look at ruble realities, as the IMF point out, efforts to stem the ongoing rise with intervention are far from being able to give the desired result. Bank Rossii bought a net $15.2 billion and 485 million euros in October, their largest foreign currency purchases since May, and went on to buy $6 billion during the first 17 days of November according to press reports citing central bank chairman, Sergey Ignatiev. Yet last week the Russian the ruble ended 0.1 percent higher at 35.0632 against the central bank’s target currency basket, its strongest level since December 23 2008. The ruble appreciated 3.4 percent in October against the dollar (for its second consecutive monthly gain) and has risen more than 1 percent so far in November. Thus the central bank has now moved on to use monetary policy to try and stem the rise, and said on October 29 that it would also use interest rates in an attempt to reduce the “attractiveness of short-term investments in Russian assets and stop the accumulation of risk”.

The recent rise follows ruble a 35 percent slump against the dollar between August last year and January, raising the cost of imports (which make up about 49 percent of the consumer goods sold in Russia) and, in theory, making Russia’s domestic industry somewhat more competitive externally. However, without a sound institutional infrastructure, and a coherent monetary policy, short term devaluation gains can easily be turned into medium term inflation, thus defeating the purpose of corrective price devaluation.

The problem is not in fact of recent making, and is a product of a steady and systematic long term mismanagement of Russia’s monetary policy which has now created a veritable Procrustean bed of problems for Russia’s economy and society. Failure to address the underlying inflation problem between 2005 and 2008 meant that large structural distrortions were accumulated in the economy, including a massive problem of commodity export dependence, a problem which effectively turned the country into a veritable disaster waiting to happen if ever there should be a protracted lull in the secular rise in energy prices. That lull has most definitely now arrived, and while Russia’s future depends in the short term – on energy prices, it is far from clear what the future holds for the energy prices themselves.

Weak global demand for oil has led to a sharp rise in excess capacity and OPEC’s spare capacity has risen to levels not seen since 2002, when prices averaged USD25/barrel with OPEC’s pricing power staying very low. Up to now oil prices have remained in the USD70/barrel range, supported by OPEC output restraint and its stated desire to have prices reach what it calls “a comfortable level” – ie near USD75/barrel – as well as by expectations of rising demand. At its September 2009 meeting, OPEC left its production quotas unchanged but indicated it would take rapid action if prices dropped sharply. OPEC production, however, continues to edge higher, with compliance to its combined cuts of 4.2 million barrels per day falling to 66 percent in September from 71 percent in August.

Thus there is evidence of OPEC strains and there is considerable uncertainty about real levels of 2010 demand, all of which makes for considerable uncertainty about prices. As can be seen in the above chart, World Bank oli price estimates (like the economic growth ones) have fluctuated from a 2010 price estimate of around $62.95 in March to the current (November) level of $75.29. While the earlier estimate may be considered to be too low, the current ones may well be too high, thus a level of $70 may not be an unrealistic forecast. It should be noted however that there are credible dissenters, and in a more or less reasoned analysis Capital Economics suggest that oil prices could well fall back again in 2010 to average somewhere around $50. If this forecast proves anywhere near correct, the Russian economy is going to be subject to major downside risks, due in particular to the difficulties posed by:

i) financing the fiscal deficit
ii) rising unemployment
iii) growing bad loans in the banking system
iv) refinancing external debt
v) the continuing high level of consumer price inflation and the difficulties this poses for monetary policy at the central bank

Added to all this, the economy will clearly not rebound as easily as many seem to foresee, adding to the risk element on all fronts.

This is an excerpt, the original full length post can be accessed here