Russia Central Bank On Hold as Sanctions Pile Up

The Central Bank of Russia is expected to keep rates steady tomorrow. Just today, a new round of sanctions was just announced by the State Department while the EU extended existing sanctions for another six months. More are expected in the coming months and tensions with the West remain high as Russia conducts the largest military exercise since 1981 this week.

POLITICAL OUTLOOK

With all the sanctions that Russia is currently facing, we thought it would be useful to summarize them below. We note that while the situation is fluid, signs are clearly pointing to more and more sanctions ahead from a variety of avenues.

  1. The White House has authorized additional sanctions against any individual or country that interferes in the upcoming US elections. Sanctions would be imposed at the discretion of President Trump. This order appears to be an effort to derail or supplant sanctions that are being discussed in the Senate. National Security Advisor John Bolton said the White House is open to ideas and proposals from lawmakers. However, he added that since new legislation would take time to pass, the White House measures could be implemented faster.
  2. A bipartisan group of US senators will reportedly discuss the so-called “Sanctions Bill from Hell” after returning from summer recess. Loose details of the proposed bill were released last month, which includes proposals to sanction new Russian sovereign debt and banking transactions. It could also place restrictions on US involvement in Russia’s oil industry. The full text was just released this week. In setting a tough tone, the bill requires Congress to determine whether Russia “meets the criteria for designation as a state sponsor of terrorism” and to investigate “alleged war crimes and crimes against humanity attributable to [Russia].”
  3. The State Department today announced a new round of sanctions on Russia for its nerve gas attack in the UK on former Russian spy Sergei Skripal and his daughter Yulia. These are a follow-up to the August sanctions that prohibit a range of exports to Russia that have a potential national security impact. As required under the Chemical and Biological Weapons Control and Warfare Elimination Act of 1991, tougher measures were required after three months because Russia failed to prove that it is no longer using or producing chemical weapons by allowing inspections of its chemical weapons facilities.
  4. In April, the US sanctioned seven Russian oligarchs that are considered close to the Kremlin, as well as the twelve companies they own. Seventeen senior Russian government officials were also affected. The US said that round was meant to punish Russian entities for profiting from “malign activities.” These include but are not limited to Russian actions in Ukraine as well as its ongoing efforts to subvert various Western democracies.
  5. The EU today just extended its sanctions on Russia for another six months. These were first imposed after Russia annexed the Crimea, and target senior Russian officials, lawmakers, and military officers with asset freezes and travel bans. The EU also has a separate group of sanctions that target the Russian economy that will remain in place until January 2019. Those too will likely be extended.

 

A BRIEF HISTORY LESSON

Russia is holding its annual military exercises called Vostok-2018 this week. Official sources say 300,000 troops, 1000 aircraft, 36,000 combat vehicles, and up to 80 combat ships will be involved. This makes it the largest Russian military exercise since 1981 (see below). Russia’s military exercises are rotated. Every four years, they are held in the West (Zapad) and then the following year held in the East (Vostok). These exercises typically involve some sort of premise.

As the name suggests, Vostok-2018 will take place in the Far East and Siberia. The premise is not yet known. However, Russia’s Defense Ministry has billed it as a “strategic maneuver exercise” where the forces are divided into two groups that engage each other rather than fighting an imaginary opponent

Chinese and Mongolian forces will also participate for the first time in Vostok-2018. This is noteworthy, as it comes at a time when US-China and US-Russia relations are both under stress. A strong Russia-China axis would be very concerning to the US, and bears watching. China’s Ministry of National Defense noted that “The drills are aimed at consolidating and developing the China-Russia comprehensive strategic partnership of coordination, deepening pragmatic and friendly cooperation between the two armies, and further strengthening their ability to jointly deal with varied security threats, which are conducive to safeguarding regional peace and security.”

Until this year, Zapad-81 had been the largest military exercise by the Soviet Union. It was meant to be a huge show of force as the Cold War intensified with the inauguration of President Ronald Reagan that year. The exercise involved 100,000-150,000 troops from the Soviet Union and other Warsaw Pact countries. Several new weapons were tested then, including the SS-20 intermediate range ballistic missile.

The premise behind Zapad-81 was a NATO invasion of Warsaw Pact nations. The exercise included a counterattack into Germany and a preemptive use of tactical nuclear weapons against the Western forces. The message was meant not only for NATO, but for the Warsaw Pact countries as well, as dissent in Poland was growing from the Solidarity labor movement.

Due to the decline of the Soviet Union, large-scale military exercises were only held sporadically between 1981 and 2013. That year, Russia held Zapad-2013, which was meant to showcase its new and improved armed forces. While Zapad-2013 was presented as a limited exercise involving 12,000 troops in Belarus, outside observers believe that up to 90,000 took part. Typically, the Soviet Union and later Russia took pains to inflate troop numbers. Why the lowball number?

The premise behind Zapad-2013 was that “Baltic Terrorists” attacked Belarus with amphibious craft, helicopters, and aircraft and then fled into the cities, forcing the defenders into urban warfare. The exercise was troubling to the Baltic states, as various aspects of the exercise did not seem to fit into the defense-oriented premise. In hindsight, those offensive tactics are best understood knowing that the annexation of Crimea would take place the next year. Some army units that participated in Zapad-2013 went on to fight in Crimea and Donbass.

 

ECONOMIC OUTLOOK

The economy remains sluggish. GDP growth is forecast by the IMF at 1.7% in 2018 and 1.5% in 2019 vs. 1.5% in 2017. GDP rose 1.9% y/y in Q2, while monthly data so far suggest a modest acceleration in Q3. However, with widening sanctions likely to hit the economy hard, we see downside risks to these growth forecasts.

Price pressures are picking up, with CPI inflation at 3.1% y/y in August. This is the highest rate since August 2017 but remains below the 4% target. We believe that the easing cycle has ended, especially as ruble weakness continues. Recall that inflation spiked up to 17% in 2015 as Ukraine-related sanctions hit and the ruble plunged. The bank was forced into an aggressive tightening cycle because of the 2014 Ukraine crisis, hiking rates from 5.5% to 17% in less than a year. We believe a similar dynamic will be seen in the coming months.

After hiking rates to 17%, the Central Bank of Russia started the easing cycle in February 2015. There were several pauses but the policy rate was last cut to 7.25% in March. The bank had hinted that this was another pause. However, with inflation rising and pressures building on the ruble, we think the easing cycle is over and a tightening one may begin soon. We do not think markets are positioned yet for this risk.

Consensus sees no change when the central bank meets tomorrow. However, a couple of analysts see a 25 bp hike to 7.5%. We see a slight risk of a hawkish surprise tomorrow, though those risks have ebbed in light of ruble gains this week. If the central bank stands pat tomorrow, we believe the first hike is likely to be seen in Q4.

The fiscal outlook bears watching due to possible contingent liabilities stemming from the ongoing sanctions. We have seen a cyclical improvement in the budget numbers as the economy recovers with help from higher oil prices. The nominal deficit was equal to -nearly -2% of GDP in 2017, and the OECD sees the gap narrowing to -1.4% in 2018 and -1.0% in 2019. We see upside risks to these forecasts.

The external accounts remain solid. The current account surplus was 2.2% of GDP in 2017, and the IMF expects the surplus to widen to 4.5% of GDP in 2018 and 3.8% in 2019. Due to higher oil prices, export growth has been far outstripping import growth. With the oil rally back on track in recent weeks, we think export growth will remain strong in the coming months.

Foreign reserves rose to a multi-year high of $460.4 bln in August. That’s the highest since August 2014, recouping much of the sanctions-related drop from over $500 bln at the end of 2013 to around $354 bln in April 2015. Reserves cover nearly 16 months of imports and are about 4 times the stock of short-term external debt. Russia’s Net International Investment Position (NIIP) is positive and 17.5% of GDP, which is a fairly strong position.

While external vulnerabilities would appear to be low, sanctions that cut off access to global capital markets could have significant impact on corporate Russia. If a state-owned company can no longer service its debt, the government will have to assume those liabilities, thereby draining precious foreign reserves.

 

INVESTMENT OUTLOOK

The ruble continues to underperform. In 2017, RUB rose 5% vs. USD and was ahead of only the worst performers ARS (-14.5%), TRY (-7%), BRL (-2%), IDR (-1%), PHP (-0.5%), COP (+0.5%), and PEN (+4%). So far in 2018, RUB is -16% and is ahead of only the worst performers ARS (-52%), TRY (-38%), BRL (-21%), and ZAR (-16%). Our EM FX model shows the ruble to have VERY STRONG fundamentals. However, the sanctions are a game changer and so the ruble seems likely to continue underperforming.

USD/RUB has reversed lower after making a new cycle high yesterday near 70.8420. Break of the 71.05 area would set up a test of the February 2016 high near 80.63. However, with numerous sanctions in the pipeline, we think the market should start thinking about this pair eventually revisiting the January 2016 high near 85.9575. The next major retracement objectives of the big 2016-2018 drop in USD/RUB come in near 70.7570 (50%) and 74.3440 (62%).

Russian equities are outperforming this year after underperforming last year. In 2017, MSCI Russia was flat vs. 34% for MSCI EM. So far this year, MSCI Russia is -4% YTD and compares to -12% YTD for MSCI EM. This outperformance should continue, as our EM Equity model has Russia at an OVERWEIGHT position. However, the sanctions pose greater risks in the coming months.

Russian bonds have underperformed. The yield on 10-year local currency government bonds is +123 bp YTD and is ahead of only the worst EM performers Argentina (+760 bp), Turkey (+682 bp), Indonesia (+219 bp), Brazil (+211 bp), Hungary (+157 bp), and the Philippines (+129 bp). With inflation likely to rise due to RUB weakness and the central bank likely forced to eventually hike rates, we think Russian bonds will continue to underperform. This is especially true in light of the potential sanctions impact. Data show that the foreign share of Russian domestic debt fell to 27.5% in July from 34.5% in March. This will only get smaller in light of the sanctions threat.

Russia’s implied rating was steady at BBB/Baa2/BBB after rising a notch last quarter. Higher oil prices are boosting Russia’s numbers. Moody’s rating of Ba1 is lagging, but even the BBB- ratings from both S&P and Fitch are seeing some upgrade potential. However, we suspect the agencies will turn more negative on the sovereign considering the increased sanction risks. There are far too many contingent and perhaps even direct liabilities to the sovereign that might stem from the sanctions.