With DM policy gridlocked and growth moving dangerously close to recession as our base case, the only way to square the circle from a global perspective is either to expect EM growth to weaken meaningfully, or for EM policy to ease either aggressively or then at least pre-emptively (see Emerging Issues: Structural Alpha, Cyclical Beta, August 15, 2011). We have argued that more EM central banks are likely to respond to global growth risks by easing policy before 2011 ends. Some may worry right now about easing policy and exacerbating currency weakness, but delaying easing could put EM growth at risk and would require much more aggressive easing down the road.
Currency weakness: Symptom, not cause: Currency weakness is not something that needs to be addressed by policy-makers as an objective in itself. Rather, the recent weakness simply reflects a rise in the EM risk premium as investors take EM risk off the table due to: (i) a rising risk of economic and financial contagion from the DM world to EM economies; (ii) the reluctance or inability of DM policy-makers to respond convincingly to debt and growth concerns; and (iii) the reluctance of EM policy-makers to respond aggressively or pre-emptively to the risks to EM growth. While EM policy-makers can do very little about the first two concerns, they appear to have become more willing to address the third.
In doing so, they also address the risk premium that caused the sharp currency sell-off. Further currency weakness in line with monetary easing would then likely be orderly, not an indication of panic or de-risking. A reversal in currency weakness could come from aggressive monetary easing by DM economies (implying DM currency weakness and hence EM appreciation) or from an improvement in the prospects for EM growth and valuations. At the moment, there is very little appetite to use policy options aggressively to insulate growth, in which case it becomes exigent that easing be provided pre-emptively. A small but important set of EM economies are doing just that.
Easing is easier for some: Monetary easing in EM is not an open-and-shut case because global risks have to be balanced off against domestic issues. The global slowdown has complicated matters for many EM economies for at least three reasons. First, having just finished monetary tightening as part of a nine-month battle with inflation, the textbook prescription would be to keep monetary policy at its new, tighter stance and crush inflation expectations, sacrificing growth if need be. Inflation continues to be the primary concern for many EM economies including China, India, Brazil and Poland (among others), and an early reversal of policy tightening could push inflation higher. Second, the currency sell-off will likely worry many about their ability to cut policy rates (since this could exacerbate currency weakness), but is particularly a problem for the likes of Hungary (given its foreign currency loans - see FX Mortgage Plan Raises Deleveraging Risks, September 26, 2011) and Poland (given the impact of a weaker currency on debt, which is not far from the 55% ceiling that government is keen to avoid breaching - see "Poland: Election Preview - Poles to the Polls", CEEMEA Macro Monitor, September 23, 2011). Finally, some LatAm central banks continue to face robust growth and would likely have kept raising rates had it not been for the emergence of global growth risks.
Traditional channels of contagion now kicking in: EM economies are vulnerable to DM woes via three ‘channels' of contagion: (i) funding markets; (ii) traditional export and financial market links; and (iii) policy errors from DM and EM policy-makers. Our strategists have long highlighted the importance of funding markets to the EM world, whose funding needs exceed US$1 trillion over the next 12 months (see EM Profile: Channels of Financial Market Contagion - Funding Risks, August 11, 2011). Funding stress remains elevated, but not close to the levels we saw in 2008, in part because central banks have been ubiquitously aggressive in ensuring that markets stay liquid. The recent sell-off, precipitated by investors de-risking and slowing export momentum, suggests that the traditional channel is now beginning to kick in. To balance the equation, policy-makers on both sides of the economic divide need to ‘get it right', we think.
Domestic and external momentum slowing: After many fits and starts, EM monetary tightening proceeded in earnest only from the end of 2010 when export growth surged after stagnating in mid-2010. To complicate matters, oil prices soared due to political unrest in the Middle East, and inflation rose in response to this supply shock. The combination of strong domestic and external demand gave EM policy-makers the confidence to tighten policy without putting the economic recovery in jeopardy. Mostly as a result of this tightening campaign, PMIs in the EM world have consistently fallen over the last six months. Growth expectations for many economies have moderated even though current growth prints remain robust. Finally, export momentum has slowed down considerably over the last five months. Though not yet at the stagnant levels of mid-2010, the gradient of export momentum is not encouraging at all. Domestic and external conditions thus appear to be more supportive of easing.
Is EM easing a bet on global disinflation? Given that inflation has not yet turned and growth remains strong, policy rate cuts could be seen as a risky bet that global growth weakness will be disinflationary enough to push EM inflation lower. Given that monetary policy works with lags, such ‘bets' are almost an integral part of the process of running forward-looking monetary policy. Looking at EM-DM economic and policy conditions, this bet looks a lot less risky than when viewed in isolation.
We have pointed out the negative feedback loop between markets and the economy as an important recent characteristic of DM markets. Past policy mistakes and the ongoing inability or unwillingness of DM policy-makers to find a convincing policy circuit-breaker has been an important propagator of this negative feedback loop (see Global Economics: Dangerously Close to Recession, August 17, 2011). To the extent that DM policy-makers delay or disappoint in terms of their policy response, the probability of a DM recession (and hence a spillover to EM) rises. Less action on the DM policy side would then imply that EM policy-makers would have more to do. In other words, there exists a ‘strategic substitutability' between the actions of DM and EM policy-makers. It is this strategic substitutability that is likely to convince many EM central banks to look through currency weakness as a symptom rather than a constraint on policy and address the cause of the weakness, the risk of EM contagion.
‘Easy Club' - membership now open: Central banks that wish to ease will likely find it increasingly easier to do so as the ‘Easy Club' expands its membership. While the policy rate cuts by the central banks of Turkey and then Brazil raised quite a few eyebrows, easing by Russia and then Israel has become significantly less surprising. As our Israel economist, Tevfik Aksoy, has pointed out, policy decisions by the Bank of Israel have set the trend. It was the first to ease policy in 2008 and the first to tighten monetary policy in 3Q09. This time as well, it is among the first to ease policy, a decision that is unlikely to go unnoticed in policy circles.
Plenty of options: Unlike DM policy-makers, most EM policy-makers have a plethora of options - monetary and fiscal. On the monetary side, they can ease via policy rates and reserve requirements or use FX reserves to prevent disruptive changes in the exchange rate. Indeed, a large number of EM central banks globally have been active in the FX market recently. Along with better sentiment globally, this has pushed USD/EM exchange rates higher (see EM Macro Strategy Comment: And Now They're Selling, September 27, 2011. Reserve holdings withstood the shock to the currency in 2008 remarkably well and are well poised for an even better performance. Reserve requirements were used as a policy tool to address abundant liquidity in money markets by many prominent central banks including China, India, Russia, Brazil and Turkey (see Emerging Issues: QT, March 30, 2011) and these could be relaxed if liquidity conditions tighten. Finally, the broadest easing tool of rate cuts could and has been employed. Since the Bank of Israel first hiked rates in September 2009, most EM central banks have followed suit. CEEMEA economies were late in the cycle and carried on easing and then tightened policy only more recently. Given falling domestic and external demand momentum, easing will likely come via policy rates.
Fiscal options are abundant as well: While economies like India have used up a fair amount of fiscal leverage so that further fiscal easing is unlikely and probably counterproductive, most EM economies (particularly China and the rest of the AXJ region) have sufficient legroom to ease fiscal policy should they decide to keep monetary policy relatively tight to see off inflation.
In summary, EM easing appears to have gotten underway with a small but important set of policy-makers opting to provide small and pre-emptive stimulus. Given the lags of monetary policy and the risks of contagion coming from poor DM growth and policy gridlock, a bet that global risks will be disinflationary does not appear to be as risky from a global perspective. The recent sell-off in EM risky assets and currency values highlights the risk premium that investors still attach to the EM world, and rightly so. While EM growth will likely outperform DM growth by a wide margin, it should not be immune to poor DM performance. As global risks take centre stage, EM policy-makers will likely view currency weakness as a symptom and address the cause of the sell-off: risks to EM growth. The central banks of Brazil, Mexico and Israel are likely to cut policy rates this year, and more central banks could join the ‘Easy Club' before 2011 is over.
A general EM sell-off: The current fall in RUB and lack of RUB liquidity is driven, we think, by the current instability in global markets, with risk-aversion driving a switch out of EM currencies and into dollars. This is partly since we can see similar falls in the value of other EM currencies, which suggests that it is a general risk-off trade rather than a Russia-specific trade. It is also because it is difficult to pick another plausible explanation, since the Russian current account has continued to be strong, thanks to high oil prices, and there has been no obvious domestic trigger for a resumption of capital outflows.
CBR's First Priority - Providing Liquidity
RUB liquidity shortage: Domestically, the ruble liquidity shortage has resulted in short-term rates jumping above 6% and weak demand at recent OFZ auctions.
Active provision of liquidity from all sides: Following the 25bp easing in repo rates last week, the CBR has placed over RUB 600 billion in repo operations in the last five business days, the maximum in any one day or in any five-day period since 2009. The MinFin in its turn placed RUB 372 billion in 1-2-month deposit auctions this week.
We expect the liquidity shortage and short-term rates to ease, given the authorities' recent measures, which include increasing the volume of liquidity on offer at the CBR's daily repo auctions to 300 billion RUB and further MinFin deposit auctions, and the promise by Governor Ignatiev on September 27 to provide "as much liquidity as banks want". This is in stark contrast to 2008, when Russia had a tighter exchange rate regime, and rates were tightened when the RUB came under pressure to help defend the currency.
Budget to the rescue: More generally, the programmed fiscal expansion in the coming months, as the consolidated budget moves from a RUB 2 trillion surplus as of August 1 to a forecast balanced outcome for the year, will increase liquidity strongly, although the increase will be back-loaded to November and December. We illustrate the monthly accumulation of surplus up to end July as reported by the Treasury, which has been withdrawing liquidity from the economy and reducing demand, and then illustrate a path of net injections required to deliver a balanced budget for the full year, which will inject liquidity into the economy and increase demand.
Deposits - MinFin's liquidity-management tool: However, we believe that this somewhat overstates the net liquidity provision by the MinFin by year-end. The MinFin also has nearly RUB 1 trillion of deposits at commercial banks which are due to be returned to the MinFin before year-end. While the liquidity shortage continues, we expect that the MinFin will continue to place the incoming funds back on deposit at the banks. However, in late November and December, as budget spending reaches its seasonal peak and liquidity increases strongly, we expect that the MinFin will either use incoming deposits to finance spending, or retain the additional cash to avoid creating excess liquidity and fuelling inflation.
CBR's Second Priority - Reducing FX Volatility
A dramatic 15% weakening of the ruble... Following the more than 10% correction in September, the RUB - at over 32 to the USD and 37 to the BSKT - is back at the levels of mid-2009, and down.
...with no significant movement in reserves: One striking feature of the large move in RUB since end-July is the stability of reserves, which have barely fallen in headline terms by just US$1.9 billion from end-July according to the latest published data as of September 16. After accounting for the 3.7% weakening of EUR, which makes up about 40% of CBR reserves, reserves have in fact increased on our estimate by US$5.5 billion. Clearly, selling of dollars by the CBR has accelerated in the second half of September, with trading desks estimating sales of US$2 billion per day on several trading days, and the CBR announcing on September 27 that it had already sold over US$6 billion in the month. Nonetheless, the comparison with 2008 is stark. In 2008, the total movement in reserves in the six months from end-July 2008 to end-January 2009 was -US$210 billion, and the exchange rate against the dollar moved over this period by 12 RUB or 53% from 23.44 to 35.7, which implies US$17.5 billion for every RUB of depreciation. This year, reserves, after accounting for the weakening of the EUR, have fallen by a maximum of US$5 billion since end-July, while the exchange rate against the dollar has moved by nearly 5 RUB or 15% from 27.57 to 32.3, which implies just US$1 billion for every RUB of depreciation. In short, compared to 2008, depreciation is 17 times cheaper in terms of international reserves. Going forward, however, given the rule that the CBR moves the corridor by 5 kopecks for every US$600 million of intervention, each additional RUB of depreciation at the edge of the corridor would cost a heftier US$12 billion.
Current Account Not Cause of RUB Weakness
Stable US$4-7 billion monthly surplus on current account over the summer, we think: The latest monthly trade data available is July, which continued to show imports holding at around US$27 billion, the level they have been at since March, and exports at US$43 billion, down US$2-3 billion on previous months due to a 8% fall in fuel export volumes, probably due to seasonal maintenance. With the oil price holding around US$110/bbl until late September, Russia has, we expect, continued to run a strong trade surplus in August and September in the order of US$13-15 billion monthly, allowing for a tick-up in imports and some fall in gas export volumes as Gazprom export prices rise. Even after allowing for a higher US$5 billion summer deficit on the service account as a result of Russians travelling abroad for their summer holidays and a high US$4 billion on the income account as a result of strong dividend payments abroad, we still see a strong US$4-7 billion surplus on the current account in August and September. On balance, we agree with CBR Governor Ignatiev, who commented on September 27 that if oil remained at US$100/barrel, the RUB was more likely to rise than to fall.
Disconnect between RUB and the oil price: The RUB is back at parities comparable to mid-2009, when the oil price averaged US$61/bbl. A fall in oil to these levels would have immense repercussions for Russia, and would require a radical downgrade in growth forecasts (see CEEMEA Economics: Back to 2008? Contagion Risks and Policy Responses in CEEMEA, August 9, 2011 for a discussion). We base our forecasts in our base case on oil at US$103/bbl, at which level RUB looks heavily oversold. We estimate that if the capital account were in balance, then the current account at US$100/bbl would balance at an exchange rate of 31.5 RUBBSKT. We see two headwinds to a bear case correction in the oil price:
1. EM growth: EM countries are the source of oil demand growth, and as the marginal buyer of oil they are the price setters. Over the last ten years, for instance, China has accounted for 40% of oil demand growth, the BRICs for 60%, and EM for more than 100% of total oil demand growth - while DM (the OECD) has been a net drag on oil demand growth. This implies that if EM growth in general and China growth in particular remains strong - our current forecast - then oil prices would be supported, even in the face of a weak recession in DM.
2. OPEC discipline: OPEC countries now have a higher breakeven oil price, given recent increases in spending, and significant market power, given the recent decline in spare capacity. This should make them more willing and able to remove supplies and keep the market balanced if excess supply starts to push prices down radically.
Near-term strengthening of the current account from crude volume growth... First, we anticipate an October surge in fuel exports. Russian oil producers have a strong incentive to move output to October from September, since exports after implementation of the 60/66 reform of oil taxation imply ~US$4/bbl extra, which is a substantial increase, given Russian netbacks in the US$15-25/bbl range. We expect a noticeable impact, especially given that there is now some spare capacity in the pipeline system and ports. For instance, a 10% increase in crude exports would add an additional ~2 million tonnes or approximately US$1.5 billion. The historically unusual premium of Urals to Brent in the last week was another sign that Russian oils may have been holding back crude volumes this month.
...and impact of weaker RUB on imports: Second, in Russia, the feed-through from movements in the currency to changes in imports has been rapid and strong. Based on the past relationship, we calculate that a sustained 1% fall in the real value of the RUB will reduce imports growth by 3-4%Y after a month. Consequently, the 12% fall in the real RUB since end-July would, if sustained, result in import growth falling down from 34%Y in July to 8%Y starting from September-October, before moving rapidly into negative territory from then on. In fact, if the remarkable historical sensitivity of Russian imports to the exchange rate continues and the exchange rate were to hold at the current edge of the corridor (37.5 RUBBSKT) in real terms through 2012, we see the current account surplus widening from our current forecast of 2.0% to 7.6% of GDP.
Why have capital outflows picked up? As in summer 2010, the cause of the RUB weakness is capital outflows. It is not due to an increase in external debt repayments, which have been subdued over the summer, as the RUB has weakened.
The drivers of capital outflows: We see three drivers of capital outflows over the coming six months, which imply enhanced volatility and a weaker RUB than we had previously argued:
• Global risk-off: This year, international investors appear to have led the initial rush for the exits in a global risk-off trade. Global instability is clearly not over yet, and we see current risk-aversion continuing in the coming months.
• Reforms: We have argued that last year's capital outflows were driven by Russian domestic investors reacting to dismissals of key officials, which increased Russia risk for investors associated with officials, such as governors or senior police, who lost their position and authority as a result of reforms. Previously (see Russia: Dividend Outflows Slow Down Reserve Accumulation, July 8, 2011), we had argued that reform-related outflows would slow during the elections, since changes of personnel would be put on hold during the election period. However, this judgment must now be modified. United Russia is replacing half of its deputies in the Duma, and Putin has promised a "new, young, energetic management team" under Medvedev which implies changes in the current government team, some of whom may follow Kudrin into retirement, or prepare for retirement, in advance of the elections. To some extent, therefore, the reform-related driver of outflows remains intact.
• Political uncertainty: Uncertainty about terms for investment and business under the next president and government provide a general reason for capital outflow by domestic investors. The recent announcement that Putin would be the United Russia candidate for president, and that he intended to appoint Medvedev as his Prime Minister provides a high degree of certainty about the most probable composition of the government from May 2012, and reassurance about continuity of policy and political stability. However, the resignation of Finance Minister Kudrin on September 26, following a public difference with President Medvedev on the desirability of higher military spending, has highlighted concerns about the risks of higher spending and whether future policy will improve the investment climate for private business.
Structural weakness: Stepping back from the immediate crisis, we see a structural shift from capital inflows to outflows. Even excluding the exceptional 4Q08, which saw US$130 billion in outflows, since the crisis, quarterly outflows have averaged US$12 billion, or 3% of GDP annualised, compared with an average of US$5.6 billion quarterly inflows, or 2.7% of GDP, in the five years up to the crisis. Since this pattern has now been intact for three years and has persisted through the positive shock of a major increase in the oil price, we see a major policy shift as required to catalyse a shift from capital outflows to inflows, such as the formation of a new government which demonstrates a credible commitment to improving the investment climate.
Risk of a Feedback Loop
What are the risks of a negative feedback loop developing in which the slide of the RUB reduces confidence in the currency, prompting more RUB holders to buy dollars, and driving the RUB further down?
Individual hedging strategies: There are two ways in which individuals can try to hedge their FX risks - the transfer of deposits from RUB into FX and the purchase of FX on the cash market.
Up to US$15 billion in deposits at risk... In summer 2008 following the start of the RUB devaluation, households switched RUB deposits into FX deposits, and the share of deposits in FX went up from 14% in September to 34% in January 2009. To be precise, 6% of the increase was caused by devaluation and the remaining 14% by the switch of RUB deposits worth about RUB 1 trillion.
If there were a proportional reaction to the current devaluation, which has been a bit less than half the scale of the 2008 devaluation, then the share of FX deposits might go up from the current 18% to 24% of deposits, or RUB 500 billion of deposits could be switched to FX, which amounts to about US$15 billion at current exchange rates.
...and up to US$9 billion per month in cash: The other sign of loss of confidence in the RUB is the cash purchase of dollars. In 2010-11, households spent about 4% of income on FX cash purchase. In October-December 2008, this rose to 13% of total spending on average, which in the current circumstances would mean an extra RUB 300 billion FX purchases or US$9 billion per month.
Corporate deposits: Corporates' reaction was more muted in 2008. They also switched part of deposits to USD, with the share of FX deposits going up from 33% in September 2008 to 55% in January 2009. 13pp of the change in the share can be attributed to the devaluation and the remaining 9pp to the transfer of RUB deposits (about RUB 1.2 trillion). Corporates do not follow exchange rates so closely and the currency composition of deposits has been driven by other considerations. In 2011 YTD, the share of corporates' FX deposits went down from 44% of total deposits in January to 34% in June.
However, the analogy is imperfect: Clearly, a switch to FX by individuals could drive short-term pressure on reserves of up to US$40 billion, or nearly 8% of reserves. However, we think that the risk of a repeat of 2008 switching is unlikely for two reasons:
• The main driver of switching in 2008 was the (correct) perception that the exchange rate was overvalued at prevailing oil prices, and therefore RUB was at risk of a sharp devaluation. In 2011, RUB looks undervalued at prevailing oil prices, and at risk of sharp revaluation, unless you believe in a major oil price correction.
• The CBR has made a credible commitment to freeze the corridor at 37.5-32.5 for an extended period.
Central Bank Exchange Rate Regime
Sticking to the current corridor width, for now: Amid RUB weakness, First Deputy Chairman Ulyukaev said last week that the CBR would not widen the bands around the central rate in the corridor for now. Our interpretation is that the CBR is concerned that, given the fragile state of the markets, any adjustment to the exchange rate regime, such as widening the corridor, could spark additional selling of the RUB and increase volatility. However, we continue to expect a widening once markets have settled.
On September 27, the CBR announced that it had sold US$6 billion since the beginning of September. The CBR governor also added that he was satisfied with and not planning to change the current parameters of the corridor, mentioning the 5 RUB width and the upper bound of the corridor of 37.5 RUBBSKT. We set out our current understanding of the CBR corridor in Exhibit 18 in the full report.
Enhanced risk of "sudden and massive intervention": If the CBR feels that RUB volatility is being exacerbated by unjustified speculative attacks, then we see a chance that it may unpredictably intervene on a disproportionate scale to discourage future speculative attacks.
Our revised call: We see the RUB facing headwinds from capital outflows driven by global risk-aversion, reforms and political uncertainty, which will, given the lower levels of CBR intervention, keep the RUB weaker and more volatile until the new government is formed and demonstrates a commitment to improving the investment climate in 2Q12. Fundamentally, with capital flows flat next year overall, we expect the underlying strength of the current account at ~US$100/bbl to support a grind back to previous levels.
We therefore see three phases ahead:
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