In recent weeks, both Russia and Kazakhstan allowed major depreciation of their currencies to adjust to their new terms of trade and then attempted to repeg their currencies. These new pegs despite reflecting a 35% (Russia) and 20%+ (Kazakhstan) reflectively might not be the end of of the story as outflows and pressure on their reserves may continue to mount, causing pressure on the new ‘equilibria’ that they hope will be lasting. Russia’s depreciation has been both more gradual – including 20 or 1% moves from November to mid January before a broad widening of the trading band which they have subsequently tried to maintain by hoisting interest rates. – and more extensive (35%) whereas Kazakhstan’s has so far moved less than 20%, most of it over Feb 4. Both have faced a reversal of their terms of trade, pressure on the current account (Kazakhstan’s was in deficit again in Q4 and Russia’s shrank to a small surplus) and with oil dominating their exports even their respective 30%+ and 18% devaluations may not spell the end to the pressure given that the commodities which dominate their exports remain cheap.
Although there are many differences (Russia is a much more open, much larger, somewhat less commodity dependent economy) there are yet similarities between these countries, and clearly the Russian case influenced Kazakh authorities. The costs in terms of reserves that Russia sustained to deliver a gradual devaluation may have seemed too high especially as Kazakhstan needs its foreign currency liquidity to offset the liabilities of its banks. Instead, once it became clear that devaluation was to follow, Kazakhstan likely wanted to surprise speculators. Furthermore the Kazakh move is about the fourth in the region. In addition to Russia’s devaluation, the currencies of the Ukraine plunged sharply – and Belarus devalued by about 20% (one of the requirements of the IMF financing it received.
Both Russia and Kazakhstan have been hamstrung by the credit expansion of their private sector, including banks in the boom years. These debts outstripped the accumulated assets of the government. Furthermore, both are responding to bursting asset bubbles in property markets and much slower growth (in Russia’s case a severe contraction) in 2009 as consumption contracts and markets adjust. But lest anyone accuse us of trying to see excessive similarities, we will take these opportunity to review the outlook for both countries, with an emphasis of the credibility of their ‘new exchange rate equilibria” In both cases, we would expect further pressure on the currencies – and there may exacerbate the chain reaction of defaults given the cost of debt service and financing has increased in local currency terms. All in all, its not yet calm on the Eurasian currency front… and given the clouded economic outlook, more pressure on the regions currencies and other asset markets are likely – especially since there is increased uncertainty about where the government bailout money is going.
Russia’s economic reversal has been particularly sharp and outflows from Russia began with the fall of the oil price and accelerated through the conflict with Georgia and worries about political involvement in key Russian economic sectors (Putin’s comments on Mechel). They then accelerated as global deleveraging kicked in – and Investors in Russia had to dump stocks to raise cash (See our past note). As a result Within the space of around six months, Russia went from a reserve stock of almost $600 billion and an annual growth rate of 8% to one with less than $400 billion in reserves and a likely growth contraction in 2009 (3% according to RGE’s global outlook). Meanwhile the equity market fell sharply, property markets are tumbling, Russia’s fiscal deficit might be as large as 10% of GDP (even if it cuts spending as is rumored) and its current account surplus will shift to deficit.
The pressure on the rouble was predictable just based on the oil price but the gradual process of devaluation may have bought time for banks to pay off 2008 debts at the cost of eroding Russia’s foreign exchange liquidity. In a sense the predictability of Russia’s devaluation likely encouraged speculation, as it encouraged companies to keep funds in dollars, converting only when they needed domestic funds for tax payments (this contributed to a short-term spike in overnight interest rates back to the 20% range). Furthermore, it added to other policy uncertainty. Russian retail depositors became reluctant to hold funds in roubles and withdrew funds, adding pressure to the banks. And clearly uncertainty about the rouble and where the government bailout money was headed is exacerbating the chain of corporate defaults and non-payments set off by some of Russia’s largest corporations.
The decline in the value of the Rouble was further exacerbated by a large scale outflow of foreign investment given plummeting commodity prices and a seizure of global capital markets. Overall, in 2008 Russia experienced a net capital outflow of $129.9b with net private capital outflow reaching $130.5b in 4Q08; by far the highest ever outflows. This week, Fitch joined S&P in downgrading Russia’s sovereign debt to two notches above investment grade in response to the increasing private sector outflows Russia faced in Q408. Over $30b of Russian corporate debt was refinanced or paid off in Q4 also, with over $110b looming in 2009.
The Rouble has been pegged to a Euros and Dollar basket since 2005 after switching from a dollar peg, its euro exposure gradually increased before reaching 45% in 2007.Russia gradually adjusted the asset allocation of its reserves accordingly also. While a basket provides exposure to a diversified currency especially a country that trades in dollars for oil exports while in Euros for all other exports a basket peg is more unwieldy in times of rapid currency moves as the CBR was forced to sell both Euros and dollars to depreciate the rouble even as demand was primarily for dollar foreign exchange. In a year of sharp currency shifts in the dollar/euro, this also buffeted the rouble – and similarly the moves in the rouble of the last weeks have been cited as a reason for some of the Euro’s weakness (though interest rate expectations and the plight of weak members of the eurozone seem to be a more compelling argument.
In a bid to defend the plunging rouble, Russia used its foreign exchange reserves that have shrunk by 34% since August to under $400 bln including several weekly $20-30b drops as the central bank accelerated the pace of the ruble’s devaluation and sold more foreign currency to manage the decline. At a certain point the loss of fx reserves just becomes too high. The Central Bank Of Russia needed a more drastic step to prevent its reserves. On January 22 the Central Bank widened the trading range by about 4.1% to 41, 10 %lower than its present trading level, and declared it would be the last time for several months that the limit would be changed. Since November, the central bank lowered the trading floor in slow increments of 1%, allowing the rouble to fall a total of 22% – the bank widening implied a move of 10% more.
Despite widening the band the Rouble weakened 1.3% to 33.0558 per dollar. There is a school of thou
ght that believes the Rouble has not fallen far enough yet and might need it to fall further while there is sufficient reason to believe that investors are testing the limits of the band. This time period also marked the end of tax period which might have further fueled the decline. Given the persistently weak oil price and the uncertainty about Russia’s economic outlook, the rouble is likely to come under further pressure in the near term. The Russian government might continue to respond by hiking interest rates – it boosted them by about 1% this week, and given the re-acceleration of Russian price growth (+2.4% m/m and 13% y/y, the first y/y acceleration since August, it might also have a dampening effect on inflation. However given the uncertainty in the rouble, and the fact that interest rates remain very negative in inflation-adjusted terms and the fact that the government may be pulling back on spending and providing capital to corporates, the interest rate hike might only make it more difficult to unlock the domestic credit markets. Meanwhile the beginning of labor market slack might bring some deflationary pressures.
The Russian economy is in the midst of a very difficult year given the reduction in revenues from oil and corporate tax as well as the lack of financing for overly indebted corporates. The credit crunch is having its way with Russia’s consumption boom. Earlier this week, the Russian government suggested that it was stepping back from its offer to provide fx liquidity to corporations, limiting those who could tap VEB’s funds. In part this may be an attempt to husband Russia’s scarce resources but until the process of dispersal is clear, it adds to uncertainty. Another source of uncertainty are the rumored spending cuts. Russia’s 2009 budget was originally based on $90 a barrel oil – the current budget assumes $41, the new “worse case scenario” of the Russian government. Russia aims to make up any deficit which private sector estimates suggest could be as high as 10% of GDP with the reserve and national wealth funds. However their $220b will only go so far. Spending cuts are more likely to come from infrastructure spending rather than the consumption oriented spending previously announced. With Russia’s unemployment on the rise – wage arrears still high and Russian retail sales finally falling, supporting the unemployed, pensioners and others will be politically necessary. Already strikes have been on the increase and pressure on the government is rising – protectionist pressures are on the ascendancy with workers calling to reduce the number of foreign workers. Russia faces the challenge of trying to avoid a deterioration of its fiscal stance, and thus stop the deterioration of its ratings outlook or to spend to promote growth. Furthermore, abandoning some of the infrastructure spending further defers efforts to bring Russia’s poorer far east up to national standards and does little to offset Russia’s capacity constraints in the long-term. Compared to EM neighbors, Russia underspend in the boom times and has major infrastructure deficits.
What does this all mean for the rouble? For one – its fortunes will stay tied closely to the oil price ,and Russia may be better off allowing this move even though it will also need to deal with the fx debts outstanding. But depleting reserves to maintain an incredible parity will not help. It also means that Russia may still be some time off from real free-floating or inflation targeting. That’s a difficult switch to make now – and Russia still has a way to go before it has the pre-requisites including an independent central banks and less fragmented financial system.
Being even more reliant on oil and other commodities in its exports and revenues and the devaluation of Russia, a major trading partner, pressure has been increasing on Kazakhstan’s Tenge which has been pegged to the dollar. Kazakhstan devalued its Tenge by 18% in the face of lower oil prices, and its dwindling reserves that have fallen by $6bln since January. In practice, Kazakhstan is trying to engineer a repeg. The new corridor allows the tenge to fluctuate by 3% around a new level of 150 against the US dollar.The central bank stated that this was required to preserve current foreign exchange reserves and support the competitiveness of domestic production. However, given the fall in the price of goods that Kazakhstan exports, the fact that it frequently ran a current account deficit even in good times (on private sector borrowings and repatriation of mineral profits) , expect further pressure on the tenge.
If the scale of the move was a surprise the devaluation itself wasn’t. In fact, Kazakhstan’s devaluation has been highly anticipated for weeks. The recent appointment of Grigori Marchenko as head of the National Bank of Kazakhstan indicated that devaluation was close on the heels. The subsequent nationalization of Kazakhstan’s two largest banks (BTA and Alliance) may have facilitated the move given that the government took on their liabilities. Though the Kazakhstan warns against calling it nationalization – suggesting that it is only taking short-term stakes, referring to it as a temporary arrangement it has partly internalized the risks that the tenge’s devaluation carries for the banking sector. The share of tenge-denominated loans in the banks’ loan portfolio varies from 36% (KKB) to 60% (Halyk), while the share of BTA’s USD-denominated liabilities is 53%. In fact, the dollarization of Kazakhstan’s banking system has risen sharply since the onset of the credit crisis 18 months ago as Kazakh borrowers sought out hard currency. Yet the government’s injections of $1bn each into the capital of KKB and Halyk and the nationalization of Alliance and BTA, may make the banking sector somewhat more resilient to sharp exchange rate movements in the short-term. Yet inherent risk of the devaluation is that a speculative attack could push the currency much lower, taking a number of smaller banks into default on their foreign liabilities. Kazakhstan has one of the highest loan to deposit ratios among EMs.
Despite large saving from its oil windfall Kazakhstan seems ill equipped to bolster the fragile banking sector that borrowed heavily from cheaply available credit in the world market. They are now in a scramble to repay debts that have since accumulated and with further capital flight possible given falling oil prices the banks are looking to the government to bail them out. The government is armed with the $23.7bn National Fund for bailing out troubled banks. But the increased spending and still large needs of the banks may erode Kazakhstan’s savings quickly. Furthermore like Russia, Kazakhstan’s crisis response seems only to be centralizing and coordinating key sector which might make investors more wary.
Kazakhstan was one of few oil exporters to run a current account deficit routinely during the boom years, and this deficit will widen greatly in 2009 at the present currency levels. Given that the Russian Rouble has weakened by 35% and Russia being one of it main trading partners, the 18% decline might fall short in achieving the ambitioned competitiveness .ING has estimated that a devaluation of around 50% will be required to eliminate Kazakh’s current deficit all together.
Meanwhile, Kazakhstan is still suffering from the effect of the housing bubble that began bursting with the withdrawal of external credit in 2007. The construction sector a major contributor of GDP, has slowed sharply, and consumption has suffered from the lack of access to credit. It is for these reasons that we assume Kazakhstan will have much slower g
rowth in 2009 than in 2008 or 2007, particularly as lending channels remain impaired. It, though unlike Russia, may be able to eke out a positive rate of growth in 2009. But that assumes that Kazakhstan will be able to gradually delever its financial system and economy which may be increasingly difficult. And at current tenge rates, the pressure on Kazakh’s reserves will likely continue, limiting its ammunition to keep the growth trajectory on course.