EM Crisis Over? Explaining the Meltdown in Russian Financial Markets

In contradiction to the consensus outlook whom sees that EM volatility as just an aberration, well three months into the year, from China to Thailand to Ukraine to Kazakhstan, yet we see another financial market seizure: This time it is on Russia. 

The Russian Central Bank, Bank Rossii declared a 150 basis point hike in interest rate last night, from Bloomberg:

Russia raised its main interest rate the most since 1998 as the currency plunged to a record and investors pulled money from the stock market on concern that President Vladimir Putin will invade Ukraine.

The one-week auction rate, the benchmark introduced in September, was increased temporarily to 7 percent from 5.5 percent, the Bank Rossii said on its website today. The regulator also temporarily raised its other major lending rates by 150 basis points, or 1.5 percentage points.

The response has been a ghastly havoc in Russia’s financial markets

The Russian equity index the MICEX collapsed by a staggering 10.79%!!! 

The MICEX meltdown represents another wonderful example of “volatility in both directions but with a downside bias”. Months of accrued gains only to vanish in one day.

Russian bonds were also crushed! Yields of 10 year Russian bonds soared by 54 points.

Adding insult to injury has been a rout in Russia’s ruble (vis-à-vis the US dollar). The Russia's central bank, the Bank Rossii has been reported to have sold $10 billion worth of US dollar and raised interest rates. The ruble sank by a record 1.8% last night, bringing back the specter of 1998 as noted by the article.

It’s easy to blame Russia’s military involvement in Ukraine’s political quagmire as possible proximate cause, but as a bank analyst rightly commented "But today's price moves are hardly related to Ukraine exposures. What's happening today is that people are factoring in higher country risks" for Russia”

But the most important issue is; why would a 150 basis point hike spur a stampede out of Russian assets?

Well the answer all boils down a four letter word which the consensus shun at: DEBT

Political and economic uncertainty from Russia’s intervention in Ukraine signifies only a secondary cause or an aggravating circumstance acting as the release valve for what has been a seething buildup of economic and financial imbalances. 

Russia’s predicament has become evident even as early as late January when the Bank of Rossii announced “unlimited intervention” in the face of EM convulsions and a suspension of deposits from a local bank MY Bank.

Then I asked “The question is will this serve as a temporary patch or will this enough to calm Russia’s financial tantrums?” 

Well yesterday’s actions seem to have provided an answer. 

I also noted that Russia’s dilemma—contra mainstream expectation—has centered on resident capital flight. The weakness of the ruble has been a resident, and barely, a foreign instigated dynamic. And the Ukraine political impasse will only compound on this. Because not only residents will see increasing uncertainty as a factor in influencing Russia’s credit quality conditions, foreigners will likely exacerbate on this. Thus the meltdown.

From the same Blooomberg article above:

Foreign reserves fell to a three-year low of $490 billion on Feb. 7, a week after Deputy Economy Minister Andrey Klepach said that capital outflows may reach $35 billion in the first quarter, more than half of the $63 billion that left Russia in all of last year. Reserves have since risen to $493 billion.

So by raising interest rates, the Bank Rossii hopes to stanch the outflows by preempting them. Weak ruble will mean higher rates, so Bank Rossii gave it to them in one shot.

The question now is the how will the hike in interest rates affect the highly indebted entities, including Russian local governments? Will defaults become an issue? Will defaults spread or will they be constained? How will the Russian government respond to such a scenario? Bailouts? Massive inflation?

Importantly, for those in the consensus who thinks that huge foreign reserves, surpluses in current account and balance of trade should function as a talisman against the debt demon, well it appears that in Russia's case such expectations have proven to be a myth. 

A Moscow Times headline noted that Russian banks can easily absorb credit losses in Ukraine: 

Moody's estimated in a December report that the exposure to Ukraine of four Russian banks — Gazprombank, Vneshekonombank, Sberbank and VTB — was about $20 billion to $30 billion.

Another Wall Street article downplays European Bank exposure on Russian debt

Ukraine's impact on western European banks will be more limited than it would have been in the past, as direct cross-border exposures are less than half their level in 2008, said Elena Romanova, an analyst with Raiffeisen International. Prior to the financial crisis, European banks were chasing market share in what they perceived to be one of the continent's last high-growth markets. However, those banks now hold less than 20% of Ukrainian bank assets.

But such optimistic perspective appears opposite to how the financial markets responded last night.

European banks, as measured by Euro Stoxx Banks, got crushed also last night down by a terrifying 3.84%.

Add to this Germany’s major bellwether the DAX was also hammered by 3.44%.

While the above may just be a knee jerk reaction, which I think is not, they serve as a lucid paradigm of the transmission mechanism from the periphery-to-the-core phenomenon.

The end of the EM crisis? Hardly. 

All these represent a process unfolding over time. First, financial market disruption. Next, liquidity squeeze. Then, either financial crisis that leads to economic crisis or vice versa.

All these increasing incidences of emerging market turmoil signifies just an appetizer to the forthcoming global Black Swan event.