22nd December 2014
Jan Dehn, head of research at Ashmore discusses why both sentiment towards Russia and prices of Russian assets have moved out of line with fundamentals, which is creating significant value below…
The reasons for the negative sentiment towards Russia are well-known. The Ukraine situation and sanctions have been important negatives and so has the fall in oil prices. Lately, as year-end approaches liquidity has declined significantly and ahead of us lie a few weeks of holidays during which few investors will go against the prevailing momentum in the Dollar, in commodities and in Russian assets, almost regardless of valuations. As a result prices are falling too far and price volatility has become far greater than normal. Sovereign and corporate investing is about avoiding defaults and identifying situations where prices have become seriously out of line with fundamentals, that is, where risk is incorrectly priced. Of course, if the country in question also happens to have strong fundamentals so much the better. This is the case of Russia today.”
Russia’s EMBI GD spread (that is the spread of the sovereign and quasi-sovereigns over US treasuries) is currently 620bps. This is up from 164bps in early 2013 and 360bps as recently as October. We think Russia is a significantly stronger credit than any of these countries, indeed stronger than the average EM country that today prices at 387bps over US treasuries.
We think default risk for the Russian sovereign is very low
Russian capacity and willingness to pay are both very strong. Russia’s debt to GDP ratio is around 14% and the government runs a primary surplus. FX and gold reserves stand at nearly USD 415bn. This means that:
The Russian government’s policy reaction is reassuring
The correct response to an external shock is to reduce domestic demand and to devalue the currency. This is exactly what the government has done. Unlike 2008/2009, the RUB is now a floating currency. The floating currency insulates the public finances from changes in oil prices. Of course, there is a risk that a weaker currency feeds into domestic inflation – this has already happened.
To manage this risk and to reduce domestic demand the central bank has raised rates from 5.5% in February to 17% in December. There should be no doubt about the willingness of the central bank to fulfil its mandate. The combination of higher domestic interest rates and a weaker currency will weaken growth – we expect a recession in 2015. But this is purely a cyclical adjustment, not a structural problem, so growth should bounce back thereafter. Import demand will fall next year, so external balances should improve, particularly since the currency has now overshot, moving far beyond what is justified by the fall in oil prices.
We do not think capital controls are likely to be imposed
Russia could yet impose capital controls, but this would be a last resort and not our base case. Russia understands that the world is heading in the direction of tighter financial conditions.
Russia has huge untapped resources at its disposal
The resources naturally include IMF support and loans from New Development Bank (NDB, also known as the BRICS bank), but we don’t think Russia needs to tap these sources. One interesting thing to watch is whether Russia will draw on swap lines with other EM central banks, such as its USD 25bn swap line with China. One of the ways that China is expanding the role of its currency, the Renminbi, as a global reserve currency is to activate swap lines with countries that are experiencing currency stresses. Hence, when those central banks sell Dollars, China offers to replace the Dollars with Renminbi swaps. This is an opportunistic way to increase the share of Renminbi in central bank reserve holdings the world over, and often at very good entry points.