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UNIVERSITY OF PORTSMOUTH

Russia – A Country Risk Report

BSc Economics: International Banking And Financial Management

UP704520 27/11/2016 Word count: 2000

The main objective of the Central Bank of Russia is to protect and ensure the stability of the Ruble by the way of maintaining price stability, securing the purchasing power of the Ruble on the foundation of a stable low inflation (Russia. The Kremlin. 2002). The confidence of households and businesses in the national currency is supported by the lack of change in purchasing power of the Ruble over time, encouraging both consumption and investment spending which in turn boosts economic growth.

Foreign exchange risk

Russia currently operates a floating exchange rate regime (Central Bank of Russia, 2016), signifying that the Ruble exchange rate against foreign currencies is determined by supply and demand within the foreign exchange (FX) market. Up until 2014, however, Russia had operated a managed floating exchange rate regime; with the Russian central bank allowing exchange rates to fluctuate from day to day within a range, should it fall below or rise above this range then the central bank would intervene to adjust it back. The central bank used the US dollar and Euro basket as the operational indicator of its managed exchange rate policy, meaning that the Ruble exchange rate with both the US dollar and Euro was monitored and controlled (Central Bank of Russia, 2016).

As recently as December 2014, Russia experienced a currency crisis. The official exchange rate of the USD against the RUB was set at the level of 32.6587 RUB per 1 USD as of 01/01/2014. However, the Ruble depreciated substantially to 56.2584 RUB per 1 USD by the end of the year, a 72.26% increase (Database of the Central Bank of Russia, 2016). Since the transition from a managed to a floating exchange rate regime, the Ruble has experienced extremely erratic exchange rates (See Figure 1) which, should this unstable behaviour continue, could result in the Russian Government resorting back to a managed floating regime. The volatility of the Ruble exchange rate can be explained by three primary factors: oil prices, economic sanctions and capital flight.

Russia is one of the major global suppliers of oil with a share of roughly 13% of the world market. Russia’s exports of goods and services, with 80% of the total value being represented by raw materials (namely oil and natural gas), accounts for roughly 30% of its GDP (Mironov and Petronevich, 2015). Oil prices have experienced a sharp depreciation since 2014 (See Figure 2) due to the moderate expansion of demand in main industrial countries and lower growth perspectives in emerging markets. With Russia’s economic performance being so heavily reliant upon its export industry, the depreciation of oil prices has significantly affected the countries income and therefore can be seen to have a strong negative correlation with the Ruble exchange rate (Mironov and Petronevich, 2015). From August 2015- April 2016, oil prices decreased by 32% due to expanding supply from members of the Organization of the Petroleum Exporting Countries (OPEC) attempting to gain market share and risk-off behaviour in financial markets (IMF, 2014). Forecasts of future oil prices remain uncertain. With unclear aims of many OPEC members in regards to capping oil production and intense unrest in the middle-east, oil prices could be impacted both positively and negatively (IMF, 2014). These unsettled predictions will no doubt lead to extreme precaution being made by potential investors of Russia’s oil producing organisations which could hinder its capital flows and therefore negatively impact the demand for Rubles. Nevertheless, the reverse effect could arise should low oil prices remain sustained in which case a price recovery may occur in the long term in response to high-cost producers seizing production.

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Figure 1

Source: Bloomberg

Figure 2

Source: Bloomberg

The annexation of Crimea in July 2014 was condemned by many western economies; resulting in numerous economic sanctions being enacted upon the Russian Federation. Examples include the restriction of access to Western Financial markets and services for designated Russian state-owned financial institutions, energy and defence companies, restraining the ability of these Russian enterprises to obtain funds from Western markets (Rodionov, Pshenichnikov and Zherebov, 2015). The restriction of opportunities in attracting foreign capital, including loan refinancing, has heavily affected the financial condition and investment strategies of many Russian entities. It has also meant that the Russian budget has

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Ruble Exchange Rate 21/11/2011 - 21/11/2015

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Brent Crude Oil Spot $/barrel 21/11/2011 - 21/11/2016

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been heavily burdened (See Figure 3) due to the need to support these state-owned institutions as they are unable to obtain capital elsewhere. Not only has this resulted in a negative impact upon Russia’s economic growth, it has also produced large capital outflows from Russia. The large capital outflows mean that demand for the Ruble against foreign currency has fallen, producing a weaker value of the Ruble. With the somewhat erratic behaviour of Russia in terms of foreign policy and its continued involvement in the conflict in Syria, economic sanctions against Russia are likely to be imposed regularly in the future which will again cause uncertainty as to the ability of Russian businesses to obtain investment funding and the projections of capital outflow from the economy which can seriously influence the Rubles value.

Figure 3

Source: Bloomberg

Russia has experienced large-scale capital outflows (See Figure 4) as a result of the inability of refinancing debt for private sector organisations, culminating in growth of foreign debt repayment as well as the increase of dollar deposits by Russian citizens in response to the weakening of the Ruble. This, in-turn, has led to a further depreciation of the Ruble as demand for the currency has depreciated. Additionally, the financial sanctions imposed on Russia post-Crimea have prevented western companies from investing within the country. This, combined with the inability of state-owned institutions to refinance debt, has led to large overall negative capital flows. Capital flight in Russia has also been a spill over effect from the fall in oil prices. With profit margins within the oil industry in Russia falling as a consequence of the deflation in oil prices, foreign companies have been discouraged from keeping invested capital within the country’s industry. However, despite these impacts, capital outflows have eased within the first half of 2016, and have reduced to $9.6 billion for the period January 2016- September 2016, five times less than the same date in 2015 (See Table 1). Reasons for this have been attributed to either the belief that investors no longer wish to abandon Russia in an attempt to strengthen its economy or that simply all major investments have already left the economy in the preceding years.

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Russia Budget Balance (% of GDP) 01/11/2011 - 01/06/2016

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ia B

udge

t as P

erce

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Figure 4

Source: BloombergTable 1

Time Period

Net Capital Flow Net

inflows (-)/ outflows

(+) Billions of USD

Jan-Sep 2015

48.1

Jan-Sep 2016

9.6

Source: The Central Bank of Russia

Overall, the value of the Ruble has been and still is, strikingly inconsistent. With future predictions of the exchange rate of the Ruble remaining highly uncertain it is recommendable that organisations exposed to the future value of the currency to have appropriate FX hedging strategies, such as spot contracts or dealing in the FX forward market, to help eliminate the risk of fluctuations in the value of the Ruble negatively affecting the business.

Sovereign Debt Risk

Russia has been awarded a long-term sovereign credit rating of BB+ by Standard & Poor’s Sovereign ratings agency (Trading economics, 2016). A BB+ grade signifies that there are still major current uncertainties and exposure to adverse business, financial, or economic conditions which could lead to Russia having inadequate capacity to meet its financial commitments (Standard and Poor’s, 2016). The most recent long-term credit ratings of other major credit rating agencies (See Table 2) such as Fitch and Moody’s, also place Russia on the borderline between the investment and speculative grade. A rating of BBB- from Fitch is an indication that the agency has a low current expectation of default risk with adequate payment capacity which is subject to influence from changing economic and business

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Russia Net Private Sector Capital Flow (Net inflows (-)/outflows

(+))

Date

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ons

of U

SD

conditions (Fitch, 2014). The rating of Ba1 from Moody’s simply symbolises substantial credit risk (Moody’s, 2016). These ratings most likely correspond with the vulnerability that Russia has with its dependence on the oil market and its price as a source of income for the economy. With uncertain predictions of future oil prices comes uncertainty of the amount of income the Russian economy can generate. It can, therefore, be deemed that Russia is not creditworthy and any lending or investments made through the purchase of Russia Government bonds are exposed to possible defaults depending on the future performance of the oil market. The lack of consistency in the Credit ratings awarded and outlook (See Table 2) by these agencies further emphasises the uncertainty of both the current and future sovereign risk of Russia.

Table 2Fitch S&P Moody’s

Credit Rating

BBB- BB+ Ba1

Outlook Stable Stable Negative

Source: Trading Economics

Oil, although the main determinant of Russia’s ability to generate income to meet its debt payment requirements, is not the only factor that could impact how creditworthy Russia is in the future. Extensions of economic sanctions imposed on Russia could also negatively impact its credit ratings. With the inability of selected state organisations to conduct operations within foreign markets in an attempt to obtain foreign investment and refinancing, the Russian government is forced to provide this funding themselves. With this being the case, an extension of existing sanctions could result in further increases in the Russian budget deficit which will limit the country’s ability to meet its debt obligations and increase the possibility of defaults occurring on Russian government bonds.Figure 5

Source: BloombergThe uncertainty of Russia’s ability to meet its debt obligations, both in the past and present, is also reflected in the trading of Russian sovereign credit default swaps (CDS). In the wake of

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Russia 5 Year CDS Spread 21/11/2011 - 21/11/2016

Date

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ead

USD

the announcement of economic sanctions and the oil price crisis, Russian 5-year CDS spreads escalated (See Figure 5) indicating that predictions of future credit defaults increased and as a result the perceived credit risk of Russian Federation bonds had also increased. Since then, 5-year CDS spreads have fallen and stabilised slightly (See Figure 5). Still, however, figures have not reached the levels seen pre-currency crisis which would suggest investors are, although optimistic, still precautious of the future of Russia’s economic performance.

Recent unstable perceptions of Russia’s sovereign risk is further exhibited in the price and yield of 10 year Government bonds issued by the federation. Slumps in the price and increases in the yields of the bonds during 2013 and 2014 (See Figure 6 and Figure 7) reflecting the fall in demand for Russian Government bonds and again echoing the impact that the plunge in oil prices and economic sanctions had upon the perceived sovereign risk of Russia.Figure 6

Source: Bloomberg

This analysis of the sovereign risk of Russia suggests that the country’s ability to meet its debt obligations is profoundly dependent upon the behaviour of oil markets and prices. Being a key contributor to the country’s GDP, Russia is highly exposed to the performance of oil prices and therefore any investments into the country, such as the purchase of Russian Government bonds, should take thorough consideration of the impact that potential deviations in the price will have on the risk and value of the investment. The risk of potential investments are also subject to any externalities that economic sanctions possess upon the income of the country and hence should also be taken into consideration.

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Russia 10 Years Bond Auction Average Accepted Price 01/11/2012 - 26/10/2016

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In conclusion, the past, current and future economic performance of Russia, and therefore the foreign exchange and sovereign risk of the country, can be seen to be heavily dependent on oil prices. With this being a major contributor to the country’s GDP, the fluctuation of prices in the past and uncertainty of prices in the future has, and is likely to have, significant impacts on the value of the Ruble and perceptions of the country’s sovereign risk. Additionally, other factors such as economic sanctions and capital flight have been seen to also have consequences upon the foreign exchange and sovereign risk of Russia. This being said, it is highly recommendable that organisations that have future transactions denominated in RUB to have appropriate FX hedging strategies in place, helping eliminate the risk of fluctuations in the value of the Ruble negatively affecting the business. It is also advisable that organisations wishing to invest within Russia appropriately analyse forecasts of future oil prices and other impacts on the Russian economy’s income to examine the potential influences these might have on the sovereign risk of Russia.

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Figure 7

Source: Bloomberg

Object 8

Bibliography

Russia. The Kremlin. (2002). RUSSIAN FEDERATION FEDERAL LAW On the Central Bank of the Russian Federation (Bank of Russia). Retrieved from: https://www.cbr.ru/Eng/today/

Central Bank of Russia. (2016). The bank of Russia FX policy. Retrieved from: http://www.cbr.ru/eng/dkp/?PrtId=e-r_policy

Dreger, C., Kholodilin, K. A., Ulbricht, D., & Fidrmuc, J. (2016). Between the hammer and the anvil: The impact of economic sanctions and oil prices on Russia’s ruble. Journal of Comparative Economics, 44(2), 295-308.

Mironov, V. V., & Petronevich, A. V. (2015). Discovering the signs of Dutch disease in Russia. Resources Policy, 46, 97-112.

Rodionov, D. G., Pshenichnikov, V. V., & Zherebov, E. D. (2015). Currency Crisis in Russia on the Spun of 2014 and 2015: Causes and Consequences. Procedia-Social and Behavioral Sciences, 207, 850-857.

Database of the Central Bank of Russia (2016). Foreign currency market. Retrieved from: https://www.cbr.ru/eng/currency_base/daily.aspx?date_req=01.01.2014

IMF. (2014) World economic outlook: April 2014, recovery strengthens, remains uneven. United States: International Monetary Fund (IMF).

Trading economics. (2016) Russia Credit Rating. Retrieved from: http://www.tradingeconomics.com/russia/rating

Standard and Poor’s. (2016) S&P Global Ratings Definitions. Retrieved from: http://www.spratings.com/en_US/understanding-ratings#secondPage

Fitch Ratings. (2014). Definitions of Ratings and other Forms of Opinion. Retrieved from:https://www.fitchratings.com/definitions

Moody’s. (2016). Rating Symbols and Definitions. Retrieved from: https://www.moodys.com/Pages/amr002002.aspx

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