Global Economic Woes Part 3: Russia

This is part 3 of a 3 part series about economic issues in the world’s largest economies.

Honestly, I was originally going to end this series with the United States — talking primarily about wage growth and income inequality.  However, I would be remiss by avoiding an opportunity to analyze the Russian economy at the beginning of what could become the economic story of 2015.

First, let’s remind ourselves what the ongoing sanctions to Russian financial institutions look like:

The Treasury prohibits U.S. persons and persons within the United States from “transacting in, providing financing for, or otherwise dealing in new debt of longer than 90 days maturity or new equity” for six of Russia’s largest banks.

VTB, Russia’s Second Largest Bank

Russia’s second-largest bank VTB said on Thursday its third-quarter net profit fell 98 percent year-on-year to 0.4 billion roubles ($8.57 million), compared with 18.4 billion roubles in the same period a year earlier.

The figure was below analysts’ expectations for net profit of 3 billion roubles.

Russia’s biggest state-run banks are suffering a plunge in profits, forcing some to seek government help, after the U.S. and European Union hit them with sanctions over the conflict in Ukraine and the ruble dropped the most in emerging markets.

VTB, which converted a more than 200 billion-ruble ($3.8 billion) subordinated loan from the government into preferred shares to boost capital, asked for additional state support of 250 billion rubles, Finance Minister Anton Siluanov said last week. The loan has not yet been approved and a decision will probably come by year end, Dubinin said today.

VTB’s charge for bad debts almost tripled in the third quarter to 65 billion rubles from 22.1 billion rubles a year earlier, the bank said Nov. 20.

Sberbank, Russia’s Largest Bank

Russian stocks sank the most in the world as concern grows that panicked individuals will pull deposits out of lenders including OAO Sberbank, while the plunging ruble drives up costs for importers.

Russia’s biggest lender, declined 12 percent, erasing $2.1 billion of its market value [in the RTS index], as evidence grows Russians are rushing into dollars after the ruble plunged past 70 against the U.S. currency.

“The banks are at the core of the selloff,” Anton Khmelnitski, director of EC Elbrus Capital Investments in Kiev,…“The economy is probably in recession and that will accelerate from here and there are possible risks of a deposit run.”

The RTS Index has lost almost a third of its value this month as the central bank failed to prop up the ruble with 750 basis points of rate increases and $6 billion of currency interventions.

Russia’s gross domestic product may shrink between 4.5 percent and 4.7 percent next year if oil averages $60 a barrel under a “stress scenario,” the central bank said yesterday as it raised its key interest rate to an 11-year high of 17 percent. Net capital outflows may reach $134 billion this year, more than double last year’s total.

Russia’s Central Bank, FX Repos

Russia’s central bank Wednesday said it is planning a series of one-year foreign-exchange repurchase auctions in an attempt to ensure financial stability and ease pressure on the ruble.

A need to repay foreign debt has boosted demand for dollars and euros on the Russian domestic market, which increased downside pressure on the ruble and prompted the central bank to step in.

The central bank said it will offer up to $10 billion at the first foreign currency repo auction for 12 months in mid- November. The bank will take all securities from its Lombard list, except for equities and securities issued by financial organizations, as collateral and will carry out one-year repo auctions every month.

The central bank also said [on November 5] that it is lowering rates for foreign-exchange repurchase auctions for one and four weeks to LIBOR plus 1.5 percentage point. [In October] the central bank said it was ready to provide dollars and euros at a LIBOR rate plus 2.0 percentage points for one week and at a LIBOR rate plus 2.25 percentage points for four weeks.

The central bank repo auctions with dollars and euros have so far seen limited demand due to the high rate.

My Opinion: Wow. This is like watching someone plug holes in a sinking ship. The sanctions that the West placed upon Russia, particularly to their banking sector, are certainly starting to sting now. With limited access to the U.S. dollar by banks and a flight of capital out of the country, Russia needs to seriously consider government policy changes rather than monetary policy ones. However, assuming that Putin does not change course, what is the outlook for Russia in 2015?

Possible economic depression. Consumer demand in the country will begin to wane tremendously in the next few months. Russians have already been buying as many durable goods as they can amid the plummeting currency. And with interest rates so high, Russians who don’t decide to convert the ruble to dollars will stash whatever money they absolutely don’t need into savings. Less consumer demand and higher borrowing rates will cause businesses to engage in layoffs — further depressing aggregate demand.

How can the Russian central bank respond? Interestingly, it appears that the central bank is going to drive the economy from both ends. Although they are increasing interest rates, they are also engaging in this foreign exchange repo program. However, it is yet to be seen if the repo rate they chose is appropriate for the market. If the central bank finds the appropriate repo rate then the collateral used in the repos (mostly state issued bonds – Lombard list) will see increased demand. This will place downward pressure on the interest rate for state issued bonds as banks and large companies start purchasing the bonds to use in the repurchase agreements.

Essentially, market-based credit extension will become king. But the repo market will collapse if consumer demand does not turn around and drive in the profits needed to continue rolling over the repos.

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