Russia’s Interventions in Crimea: The Geopolitics of Oil Prices

Global politics are a complex dynamic.

I previously noted that Russia’s response to the Ukraine’s political crisis may have been a pushback on what the former’s political leaders see as “encirclement strategy” (Russia’s government doesn’t want to see US-NATO troops on her door steps). This via indirect interventions by the US on the latter’s affair.

But there seems to be another angle: the actions of the Russian government could have been meant to keep oil prices up. As the prolific fund manager Louis-Vincent Gave of Gavekal.com sums up “when the oil price is high, Russia is strong; when the oil price is weak, Russia is weak”

Mr. Gave writes [www.gavekal.com, hat tip John Mauldin, with Mr. Gave’s permission, Thanks Louis] (bold mine, italics original):

Nineteenth century statesman Lord Palmerston famously said that “nations have no permanent friends or allies, they only have permanent interests.” As anyone who has ever opened a history book knows, Russia’s permanent interest has always been access to warm-water seaports. So perhaps we can just reduce the current showdown over Crimea to this very simple truth: there is no way Russia will ever let go of Sevastopol again. And aside from the historical importance of Crimea (Russia did fight France, England and Turkey 160 years ago to claim its stake on the Crimean peninsula), there are two potential reasons for Russia to risk everything in order to hold on to a warm seaport. Let us call the first explanation “reasoned paranoia,” the other “devilish Machiavellianism.”

Reasoned paranoia

Put yourself in Russian shoes for a brief instant: over the past two centuries, Russia has had to fight back invasions from France (led by Napoleon in 1812), an alliance including France, England and Turkey (Crimean War in the 1850s), and Germany in both world wars. Why does this matter? Because when one looks at a map of the world today, there really is only one empire that continues to gobble up territory all along its borders, insists on a common set of values with little discussion (removal of death penalty, acceptance of alternative lifestyles and multi- culturalism...), centralizes economic and political decisions away from local populations, etc. And that empire may be based in Brussels, but it is fundamentally run by Germans and Frenchmen (Belgians have a hard enough time running their own country). More importantly, that empire is coming ever closer to Russia’s borders.

Of course, the European Union’s enlargement on its own could be presented as primarily an economic enterprise, designed mainly to raise living standards in central and eastern Europe, and even to increase the potential of Russia’s neighbors as trading partners. However, this is not how most of the EU leaders themselves view the exercise; instead the EU project is defined as being first political, then economic. Worse yet in Russian eyes, the combination of the EU and NATO expansion, which is what we have broadly seen (with US recently sending fighter jets to Poland and a Baltic state) is a very different proposition, for there is nothing economic about NATO enlargement!

For Russia, how can the EU-NATO continuous eastward expansion not be seen as an unstoppable politico-military juggernaut, advancing relentlessly towards Russia’s borders and swallowing up all intervening countries, with the unique and critical exception of Russia itself? From Moscow, this eastward expansion can become hard to distinguish from previous encroachments by French and German leaders whose intentions may have been less benign than those of the present Western leaders, but whose supposedly “civilizing” missions were just as strong. Throw on top of that the debate/bashing of Russia over gay rights, the less than favorable coverage of its very expensive Olympic party, the glorification in the Western media of Pussy Riot, the confiscation of Russian assets in Cyprus ... and one can see why Russia may feel a little paranoid today when it comes to the EU. The Russians can probably relate to Joseph Heller’s line from Catch-22:“Ju st because you're paranoid doesn't mean they aren't after you.” 

Devilish Machiavellianism

Moving away from Russia’s paranoia and returning to Russia’s permanent interests, we should probably remind ourselves of the following when looking at recent developments: 1) Vladimir Putin is an ex-KGB officer and deeply nationalistic, 2) Putin is very aware of Russia’s long-term interests, 3) when the oil price is high, Russia is strong; when the oil price is weak, Russia is weak. 

It is perhaps this latter point that matters the most for, away from newspapers headlines and the daily grind of most of our readers, World War IV has already started in earnest (if we assume that the Cold War was World War III). And the reason few of us have noticed that World War IV has started is that this war pits the Sunnis against the Shias, and most of our readers are neither. Of course, the reason we should care (beyond the harrowing tales of human suffering coming in the conflicted areas), and the reason that Russia has a particular bone in this fight, is obvious enough: oil. 

Indeed, in the Sunni-Shia fight that we see today in Syria, Lebanon, Iraq and elsewhere, the Sunnis control the purse strings (thanks mostly to the Saudi and Kuwaiti oil fields) while the Shias control the population. And this is where things get potentially interesting for Russia. Indeed, a quick look at a map of the Middle East shows that a) the Saudi oil fields are sitting primarily in areas populated by the minority Shias, who have seen very little, if any, of the benefits of the exploitation of oil and b) the same can be said of Bahrain, where the population is majority Shia.

Now of course, Iran has for decades tried to infiltrate/destabilize Shia Bahrain and the Shia parts of Saudi Arabia, though so far, the Saudis (thanks in part to US military technology) have done a very decent job of holding their own backyard. But could this change over the coming years? Could the civil war currently tearing apart large sections of the Middle East get worse?

At the very least, Putin has to plan for such a possibility which, let’s face it, would very much play to Russia’s long-term interests. Indeed, a greater clash between Iran and Saudi Arabia would probably see oil rise to US$200/barrel. Europe, as well as China and Japan, would become even more dependent on Russian energy exports. In both financial terms and geo-political terms, this would be a terrific outcome for Russia.

It would be such a good outcome that the temptation to keep things going (through weapon sales) would be overwhelming. This is all the more so since the Sunnis in the Middle East have really been no friends to the Russians, financing the rebellions in Chechnya, Dagestan, etc. So having the opportunity to say “payback’s a bitch” must be tempting for Putin who, from Assad to the Iranians, is clearly throwing Russia’s lot in with the Shias. Of course, for Russia to be relevant, and hope to influence the Sunni-Shia conflict, Russia needs to have the ability to sell, and deliver weapons. And for that, one needs ships and a port. Ergo, the importance of Sevastopol, and the importance of Russia’s Syrian port (Tartus, sitting pretty much across from Cyprus).

The questions raised

The above brings us to the current Western perception of the Ukrainian crisis. Most of the people we speak to see the crisis as troublesome because it may lead to restlessness amongst the Russian minorities scattered across Eastern Europe and Central Asia, and tempt further border encroachments across a region that remains highly unstable. This is of course a perfectly valid fear, though it must be noted that, throughout history, there have been few constants to the inhabitants of the Kremlin (or of the Winter Palace before then). But nonetheless, one could count on Russia’s elite to:

a) Care deeply about maintaining access to warm-water seaports and

b) Care little for the welfare of the average Russian

So, it therefore seems likely that the fact that Russia is eager to redraw the borders around Crimea has more to do with the former than the latter. And that the Crimean incident does not mean that Putin will try and absorb Russian minorities into a “Greater Russia” wherever those minorities may be. The bigger question is that having secured Russia’s access to Sevastopol, and Tartus, will Russia use these ports to influence the Shia-Sunni conflict directly, and the oil price indirectly?

After all, with oil production in the US re-accelerating, with Iran potentially foregoing its membership in the “Axis of Evil,” with GDP growth slowing dramatically in emerging markets, with either Libya or Iraq potentially coming back on stream at some point in the future, with Japan set to restart its nukes ... the logical destination for oil prices would be to follow most other commodities and head lower. But that would not be in the Russian interest for the one lesson Putin most certainly drew from the late 1990s was that a high oil price equates to a strong Russia, and vice-versa.

And so, with President Obama attempting to redefine the US role in the region away from being the Sunnis’ protector, and mend fences with Shias, Russia may be seeing an opportunity to influence events in the Middle East more than she has done in the past. In that regard, the Crimean annexation may announce the next wave of Sunni-Shia conflict in the Middle East, and the next wave of orders for French-manufactured weapons (as the US has broadly started to disengage itself, France has been the only G8 country basically stepping up to fight in the Saudi corner ... a stance that should soon be rewarded with a €2.7bn contract for Crotale missiles produced by Thales and a €2.4bn contract for Airbus to undertake Saudi’s border surveillance). And, finally, the Crimean annexation may announce the next gap higher in oil prices.

In short, buying a straddle option position on oil makes a lot of sense. On the one hand, if the Saudis and the US want to punish Russia for its destabilizing actions, then the way to do it will be to join forces (even if Saudi-US relations are at a nadir right now) and crush the oil price. Alternatively, if the US leadership remains haphazard and continues to broadly disengage from the greater Middle East, then Russia will advance, provide weapons and intelligence to the Shias, and the unfolding Sunni- Shia war will accelerate, potentially leading to a gap higher in oil prices. One scenario is very bullish for risk assets, the other is very bearish! Investors who believe that the US State Department has the situation under control should plan for the former. Investors who fear that Putin’s Machiavellianism will carry the day should plan for the latter (e.g., buy out-of-the-money calls on oil, French defense stocks, Russian oil stocks).

My thoughts 

The above chart from Daily Reckoning which I earlier pointed out represents oil prices required to maintain welfare states of many top oil producing countries (based on 2012). This should much higher today. So if the US-Saudi consortium will punish Russia by way of forcing down oil prices then many of these oil welfare states will incur financing problems that may lead not only to bigger fiscal issues but also to another wave of internal political upheavals or “Arab Spring” 2.0. This may lead to oil supply disruptions and higher prices.

And since Saudi Arabia’s breakeven may be at $80 per bbl, then a dramatic drop in oil prices seem not to be in the interest of Saudi.

On the other hand, Mid-East wars and the risks of its escalation that will cause a spike in oil prices or an “oil shock” will likely spur more economic and political uncertainties. This should also bring forth stagflation which means soaring interest rates that may prick global debt bubbles.

And as previously noted “oil shocks” have been linked with recessions.

University of California economic professor James Hamilton argues that an “oil shock” played a substantial role in the recession of 2008. Mr. Hamilton further noted that high oil prices had been linked with 11 of the 12 post World War II recessions.

So current developments in Crimea may extrapolate to a deeper conundrum for global financial markets and world economies.

Video: 1,000 Years of Constant European Border Shifts

The Marketwatch.com writes: (ht: Gary North)

The borders of Europe have been static since the breakups of the Soviet Union, Czechoslovakia and Yugoslavia, and the reunification of Germany, but look set to shift shortly, if the Duma in Moscow ratifies the stated desire of a Crimean majority to quit Ukraine for Russia. But a broader perspective, taking into account the past 1,000 years of European history, shows that change on the continent has been a near-constant.

Watch on Loiter.co as Centennia Historical Atlas software condenses Europe’s history into a 3 ½-minute video representing the shifting borders from A.D. 1,000 through 2003: 

Video: Marc Faber: A lot of funny deals in China’s colossal bubble

Gloom Bloom & Doom publisher Dr. Marc Faber shares some very interesting insights on China and on Russia’s Putin in the following video interview with Bloomberg.

With regards to China’s deflating colossal bubble and statistical inconsistencies (transcript from Zero hedge) [bold mine]

...we had a colossal credit bubble in China and that this credit bubble is now being gradually deflated and will bring about problems in the real estate market and among some major players in the commodity markets as well. So overall, if I look at export figures from China, and they are very closely correlated to overall economic growth, then there is a huge discrepancy between what China reports and what China’s trading partners are reporting.

So if you look at the figures of China, exports are still growing. If you look at the trade figures China exports to Taiwan, so China records exports of so and so much. The Taiwan report imports from China at a much lower level. So which figures are more reliable? I think the figures of the trading partners of China are more reliable. And they would suggest that growth has slown down considerably.

Well deflating bubble and a slowing economy has not been surprising to us. 

More on the reliability of statistical data....

Governments will always publish the statistics that they wish to show irrespective whether that is in China or in other countries. Governments control basically the statistical offices, so they can show whatever they want. As Stalin said, it’s not important who votes but who counts the votes. And the government counts the statistics.

Now the kicker: A lot of funny deals in China’s trade financing…

...the fact is simply that Chinese stocks have been just about the worst performing stocks since 2006. Now analysts will dismiss that and say everything is perfect in China, but the stock market does not seem to believe everything that the government is saying about the economy. And clearly there are strength signs in the Chinese economy. In particular, as I said, we have this huge explosion of debt. Debt as a percent of GDP has increased in the last five years by more than 50 percent. Total debt is now over 215 percent of GDP, and a lot of it is trade finance that is being rolled over.

In addition to that, there are lots of funny deals. A friend of mine who analyzes China very carefully, Simon Hunt (ph), he pointed out that trade finance between one state-owned enterprise and a private company has amounted to over $5 trillion by continuing to roll over the same collateral several times. There’s lots of funny things that are happening in China. And when the whole thing unwinds it will be a disaster.

This looks like "Rehypothecation" which Investopedia.com defines as “The practice by banks and brokers of using, for their own purposes, assets that have been posted as collateral by their clients.” In other words, perhaps a lot of the trading finance debt has very little or even no collateral supporting them. 

On Putin’s action at Crimea

Mr. Putin did the right thing from his perspective. We have to look – put ourselves into his shoes. He did absolutely the right thing at the right time.

...By that I mean that there was interference by foreign powers in Ukrainian politics that were unfavorably from the perspective of Russia.

...The Crimea is strategically most important for Russia. It has practically no meaning strategically to the United States or to Europe. But for Russia it’s very important. I don’t think that Russia will move further into Ukraine unless there is serious provocation. But I doubt it will happen. But I think the wider implication is that we have now border lines. In other words, the US would intervene if a foreign power would establish bases in Haiti and in Cuba and so forth and so on, and the Chinese will react if foreign powers threaten Chinese access to resources.

Possible implications…

This is very important because the occupation or say the referendum (ph) in Crimea and Crimea moving to Russia gives essentially a signal to China that one day they can also move and seize some territory that they perceive that belongs to them.

This could also extrapolate to greater risks of real military conflicts surrounding territorial disputes. 

Have a nice day.

China’s 2nd Bond Default, EU and US imposes Sanctions on Russian Officials

China’s first bond default occurred just about 2 weeks back.

Today the Bloomberg reports a second company to declare a bond default. (hat tip zero hedge)

A closely held Chinese real estate developer with 3.5 billion yuan ($566.6 million) of debt has collapsed and its largest shareholder was detained, said government officials familiar with the matter.

Zhejiang Xingrun Real Estate Co. doesn’t have enough cash to repay creditors that include more than 15 banks, with China Construction Bank Corp. (939) holding more than 1 billion yuan of its debt, according to the officials, who asked not to be named because they weren’t authorized to discuss the matter. The company’s majority shareholder and his son, its legal representative, have been detained and face charges of illegal fundraising, the officials said.

The collapse of the company, based in the eastern town of Fenghua, adds to concern of strains in the nation’s real estate sector and comes less than two weeks after the first bond default by a Chinese company. Shanghai Chaori Solar Energy Science & Technology Co.’s inability to repay its debt may become China's own “Bear Stearns moment,” prompting investors to reassess credit risks as they did after the U.S. securities firm was rescued in 2008, Bank of America Corp. said March 5. 

The second incident in just two weeks with much more to come.

But China’s stock markets looked the other way and instead zoomed ahead. Why? Because of reports of a government stimulus (again)

From another Bloomberg report  (bold mine) 

China’s stocks rose to the highest level in a week, led by property, auto and cement companies, after the government outlined urbanization plans.

China Vanke Co. and Poly Real Estate Group Co., the nation’s biggest developers, advanced more than 1 percent, while Anhui Conch Cement Co. gained the most in a month. SAIC Motor Corp. led a rally for automakers. China will invest more than 1 trillion yuan ($163 billion) redeveloping shantytowns this year, state broadcaster China Central Television reported yesterday.

Have a debt problem? Easy, for modern day government the solution has just been to borrow and spend. Problem solved.

How many more stimulus in the face of waves of debt defaults just to boost the markets? Interesting stuff.

Now to the Ukraine political crisis.

In a referendum recently held, people from Crimea voted overwhelmingly (96%) to secede from Ukraine and join Russia. But the Western government refused to acknowledge the outcome and instead imposed sanction on Russian officials.

From Reuters:

The European Union is to impose sanctions including asset freezes and travel bans on 21 officials from Russia and Ukraine after Crimea applied to join Russia on Monday following a weekend referendum, Lithuania's foreign minister said.

Crimea's leaders declared a Soviet-style 97-percent result in favor of seceding from Ukraine in a vote condemned as illegal by Kiev and the West.

After a meeting lasting around three hours, the EU's 28 foreign ministers agreed on a list of those to be sanctioned for their part in Russia's seizure of Crimea and Sunday's referendum on joining Russia.

The US have joined the EU. From the CNBC

U.S. President Barack Obama imposed sanctions on 11 Russians and Ukrainians on Monday blamed for Russia's military incursion into Crimea, including two top aides to Russian President Vladimir Putin.

Obama's order freezes any assets in the United States and bans travel into the country of 11 people named as responsible for the Russian move into Ukraine's Crimea region.

Among those sanctioned were ousted Ukraine President Viktor Yanukovich and Putin aides Vladislav Surkov and Sergei Glazyev.

And I thought the West has been about promoting 'democracy'?

As the former US congressman Ron Paul wrote,

The Obama Administration’s policy toward Ukraine is hypocritical. The overthrow of the government in Kiev by violent street protests was called a triumph of democracy, but when the elected parliament in autonomous Crimea voted last week to hold a referendum to decide its future, President Obama condemned it as a violation of international law. What about the principle of self-determination, which is also enshrined in international law

So democracy seem as really about whose nests are being feathered.

So far, sanctions has been directed only to officials. But one thing can lead to another. The question now is how will the Russian leadership react? What if Putin and co. retaliates?  Will this not lead to an escalation? Will this not bring about greater risks of a collapse in global trade, and worse, war? 

Again Dr. Ron Paul (from the same article) echoing the great French classical liberal Frederic Bastiat

Though many mistakenly believe that sanctions are a relatively harmless way of forcing foreign countries to do what we say, we should be clear: sanctions are an act of war.

Don’t worry be happy. 

US and European stock markets seem to have discounted the above risks and appear to be relishing the moment by markedly bidding up equity assets. 

In today's central bank supported equity markets which looks like a Truman Show, Bad news is good news.

Has the Wile E. Coyote Moment Been Triggered by China and Russia?

I have been pounding on the table that the current bubble dynamics will evolve from the periphery-to-the-core sequence. Despite denials by the mainstream that there will be no contagion from the recent emerging market meltdown, I keep pointing out that changes in prices will affect people’s preferences, knowledge and economic calculation and thus eventually expressed through the allocations of resources. And the impact of such derivative actions would be to reverberate on prices, thus the slomo or gradual transition or the market’s time consuming process. Politics is just one avenue expressive of the response from the recent emerging market crisis.

I share fund manager Doug Noland opinion[1] that emerging markets, who had been last shoe to drop in the 2007-8 global crisis, has become the US crisis equivalent of the global subprime.

Here is what I wrote about the potential transmission link from Emerging Markets to Developed economies[2].

Even when the exposure would seem negligible, if the adverse impact of emerging markets to the US and developed economies won’t be offset by growth (exports, bank assets and corporate profits) in developed nations or in frontier nations, then there will be a drag on the growth of developed economies, which would hardly be inconsequential. Why? Because the feedback loop from the sizeable developed economies will magnify on the downside trajectory of emerging market growth which again will ricochet back to developed economies and so forth. Such feedback mechanism is the essence of periphery-to-core dynamics which shows how economic and financial pathologies, like biological contemporaries, operate at the margins or by stages.

I recently pointed to the ongoing slowdown in exports of major exporting nations as reinforcing signs of a significantly slowing global economy[3]. 

More importantly the biggest emerging market, the Chinese economy has been showing signs of fatigue from credit based economic inflationism. Aside from the February export collapse, recently the growth rate of Chinese retail sales (slowest pace since 2004), fixed asset investment (13-year low) and industrial production (weakest start since 2009) has fallen significantly[4].

In addition, prices of Dr. Copper have recently crashed and so with signs of renewed weakening of the Baltic Dry Index. Meanwhile the Chinese yuan continues to weaken vis-à-vis the US dollar, this should continue to put pressure on firms with US dollar indentures.

When I said that the bubble bust process will undergo first, financial market disruptions, then liquidity squeeze and lastly either we see economic crisis trigger a financial crisis or vice versa, we can see this progression in China.

From Bloomberg[5]:

Chinese steel companies, the world’s largest, helped drive a regional industry benchmark index to a seven-month low as concern builds that some mills face financial difficulty amid a government credit squeeze…

Closely-held steel mills in China are struggling to get funding at the moment and that’s led to panic selling of iron ore, according to Morgan Stanley. The nation’s top banking regulator said yesterday strict credit guidelines will be imposed on mills that were big polluters and users of energy.

The sharp reduction in the access of credit will magnify on China’s credit problems. On the other hand, amplified credit problems will mean a spreading of losses in companies and more defaults which should translate to a pronounced economic slowdown. For an economy that has been horribly distorted by both inflationism and myriad of political interventions or financial repression, I doubt if the transition to clear such existing credit excesses will be orderly. 

The Shanghai composite lost 2.6% this week but this would have been even deeper whereas not from the growing expectations by mainstream that the Chinese government will be conducting a stimulus. China’s stock market rallied as Premier Li spoke in the annual meeting of the National People’s Congress[6]. This reaction is pure Pavlovian. The mainstream has been so desperate as to fail to recognize that China’s current debt problem has been an offspring of the 2008 stimulus.

If you see in the above charts, the German Dax has broken two support levels. UK’s FTSE seems headed in Germany’s path and the Nikkei crashed 6.2% this week.

A note on Japan. I wrote that “a bet on the Nikkei is a bet on the direction of stimulus”[7]. Japan’s sales taxes is about to come online in April. I believe that this will backfire on the struggling Japanese economy also heavily distorted by interventions and inflationism. The market seems to recognize this, but has latched on to the Bank of Japan for short term panacea. This week, the Bank of Japan refused to accommodate[8] their expectations for expanded stimulus and thus the 6.2% crash. The reaction is pure Pavlovian

And out of desperation to raise wages, the Japanese government has embarked on ridiculing or putting to shame on public, companies that refuse to hike pay[9].

Such reaction reminds me of former US President Franklin D. Roosevelt’s response to the Great Depression by implementing the New Deal which forced companies to pay salaries higher than should be.

In a study by two UCLA professors Harold L. Cole and Lee E. Ohanian they discovered that artificially elevated wages then resulted to substantially higher employment[10].

President Roosevelt believed that excessive competition was responsible for the Depression by reducing prices and wages, and by extension reducing employment and demand for goods and services. So he came up with a recovery package that would be unimaginable today, allowing businesses in every industry to collude without the threat of antitrust prosecution and workers to demand salaries about 25 percent above where they ought to have been, given market forces. The economy was poised for a beautiful recovery, but that recovery was stalled by these misguided policies.

So China won’t just be the culprit to more financial tremors, expect Japan’s added role post-sales tax April.

Yet today’s pressures come from another front: the standoff by Russia and the West via the Ukraine political crisis.

The US Federal Reserve reported a record $104.5 billion plunge in US government bonds held in custody by them in favor of foreign central banks and other overseas investors. Rumors have floated that the Russian government, in fear of economic sanctions by the West, may have initiated a move out of the US Federal Reserve[11].

On the other hand, other reports say that out of the same fear of economic and financial sanctions, Russian investors have been pulling out of Western banks[12]. So aside from the impact of China, possibly part of the ongoing market liquidations may have emanated from Russians bailing out of Western markets and banks. 

So has China and Russia triggered the spreading of the Wile E. Coyote moment?

We will see.

Yet by the second quarter, Japan may play a bigger role in the unfolding saga.

So if my suspicions will hold true then we are likely to see permeation and intensification of financial market jitters and economic earthquakes on a global scale as time goes by.

It seems time to batten down the hatches.

---

[1] Doug Noland EM, Hedge Funds and Corporate Debt Credit Bubble Bulletin February 7, 2014 PrudentBear.com

[2] See Phisix: Will the Global Risk OFF Environment Intensify? February 3, 2014

[3] See EM Contagion: Based on Exports, Global Economic Growth appears to be Downshifting Fast March 12, 2014

[4] Bloomberg.com China Data Show Economy Cooling March 13, 2014

[5] Bloomberg.com China Steel Mills Slide as Credit Squeeze, Iron Ore Panic Grips March 12,2014

[6] Bloomberg.com China Stimulus Decision Looms as Investment Slows March 14, 2014

[7] See Japan’s Ticking Black Swan February 24, 2014

[8] Bloomberg.com Bank of Japan Sticks to Easing Plan as Sales-Tax Increase Looms March 11, 2014

[9] Japan Times Japan to name, shame firms that refuse to hike pay March 13, 2014

[10] UCLA Newsroom FDR's policies prolonged Depression by 7 years, UCLA economists calculate August 10, 2004

[11] Wall Street Journal Money Beat Blog Did Russia Just Move Its Treasury Holdings Offshore? March 14, 2014

[12] Financial Times Russian companies withdraw billions from west, say Moscow bankers March 14, 2014

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.

Behind Russia’s Central Bank’s “Unlimited Intervention”

With the ruble under fire, the Russian central bank mimics ECB Mario Draghi’s “Do whatever it takes” with their own “unlimited intervention” in the hope to stem the faltering currency. 

[I’ll argue below that this seems more than about the currency where the latter is only a symptom]

From Bloomberg:

Bank Rossii, which aims to let the ruble trade freely by 2015, bought the most rubles since September 2011 this week to slow the currency’s drop as central banks from Turkey to South Africa raised interest rates to prop up their currencies. The Moscow-based regulator will intervene “without quantitative limitations” until the ruble returns to the target band or the corridor is lifted to its level, it said in a statement on its website, reiterating the present framework for the currency…

The central bank has spent $29 billion since May 29 to smooth exchange-rate fluctuations, cutting its gold and forex reserves to $496.7 billion, the lowest level since 2011.

The effect of Bank Rossii’s “unlimited intervention” has been to spike ruble against the USD yesterday. The ruble has been under pressure along with most emerging markets currencies. 

The question is will this serve as a temporary patch or will this enough to calm Russia’s financial tantrums? I believe that like her peer, the Turkish central bank's who surprised with a “shock and awe” of dramatically pushing up interest rates, this will have a short term impact.

And like everywhere else, Russia’s currency woes have been manifestations of homegrown credit bubbles rather than fickle foreign money flows as consequence to zero bound rates.

Following the global crisis in 2008 Bank Rossii stepped on the interest rate pedal.

The result? Again like anywhere else, from 2008 loans to the private sector has more than doubled. 

This has been accompanied by a near doubling of M2 during the same period.

Part of that credit bubble has been due to Bank Rossii’s foreign currency reserve accumulation. [As a side note, the ruble’s weakness comes amidst a mountain of forex reserves which many mistake as a free lunch to bubbles.]

The build up in foreign exchange reserves has been reflected on the Bank Rossii’s asset growth.

So zero bound rates and Bank Rossii’s forex accumulation has prompted for a credit fueled property boom which supposedly had been one of the “hot” market for real estate in the world in 2013.

While Russia’s housing prices has not reached the pre global crisis of 2007 level (left), housing loans acquired from mostly local institutions have ballooned (middle) to record highs.

And as one would further observe, the gravitation to the real estate boom via housing loans came with declining housing loan rates (right) as charts from Global Property Guide reveal

Zero bound rates has not just been an enticement for the private sector to splurge, the real aim of zero bound rates has been to redistribute of resources from the real economy to the government and to their favored interest groups. This is known as financial repression. Zero bound rates (negative real rates) is just part of the many ways government applies financial repression.

And as proof, while Bank Rossii held rates artificially down, Russia’s local government went into a spending binge.

The Stratfor writes: (bold mine)

Most of Russia's regional governments have always had some level of debt, but resource-based export revenues have kept it mostly manageable since the 1998 crisis. However, since the 2008-2009 financial crisis, most of the regions' debt has risen by more than 100 percent -- from $35 billion in 2010 to an estimated $78 billion in 2014, and Standard & Poor's has estimated that this will rise to $103 billion in 2015. Russia's overall government debt -- the federal and regional governments combined -- is around $300 billion, or 14 percent of gross domestic product. This is small for a country as large as Russia, but the problem is that so much of the debt is concentrated in the regions, which do not have as many debt reduction tools as the federal government does.

Of the 83 regional subjects in Russia, only 20 will be able to keep a budget surplus or a moderate level of debt by 2015, according to Standard & Poor's calculations. This leaves the other 63 regions at risk of needing a federal bailout or defaulting on their debt.

Currently, the Russian regions are financing their debt via bank loans, bonds and budget credits (federal loans, for example). Each region has to get federal approval to issue bonds, because regional bonds create more market competition for the federal and business bonds. Most of the banking loans to the regions carry high interest rates and are short term (mostly between two and five years). The federal loans come with much lower rates and longer repayment schedules (mostly between five and 20 years), so naturally federal credits and loans are more attractive for the local governments, though unprofitable for the federal government. The issuance of federal credits or loans to the regions in 2013 was limited; initially, Moscow said it would issue $4.8 billion in new credits to the regions in 2013, but only issued $2.4 billion due to its own budgetary restrictions. This is one contributing factor to the dramatic local-government debt increases.

In terms of federal external currency debt one may note that Russian foreign liabilities jumped by 34% in just two years. So the devaluing ruble will magnify on the Russia’s external credit risks.

Russia’s major exports has been predominantly commodities, particularly oil, the latter accounts for 71% of total exports in 2012. This has allowed Russian government to post a surplus in both the trade balance and her current account. [note the latter graphs I will not show anymore as this post might exceed the 512k size limits, so pls just click on the links]

Despite the huge foreign reserve, current account surpluses and balance of trade account, Russia has been experiencing private capital outflows since 2008 both from the formal and likewise in the informal sector.

The informal sector has been estimated at 50-65% share of the economy where earlier I pointed out that the Russian government attempted to wage war against this sector by putting limits on cash transactions. Russia, according to Global Financial Integrity (GFI), has been the fifth largest victim of illicit capital outflow notes the RT

In my view, such outflows have partly been consequence to the economic and financial repression which has been reflected by the huge informal sector. Some in the formal and informal sector may have sought monetary refuge or safehaven from the grips of Russia’s autocratic government (e.g Cyprus, Cayman Islands). Some perhaps may have sought alternative investments abroad, and some may have been sensing trouble ahead in the Russian economy.

And symptoms of the latter can be seen via last week’s suspension of cash  withdrawals for a week by ‘My Bank’ supposedly one of Russia’s top 200 lenders by assets, according to the Zero Hedge. 

Some questions: Has this signified the continuing war against the informal economy? But if so, why limit to My Bank? Or has this been signs of a Russian bank in serious trouble? If the latter, has the problems of My Bank been large enough for the Bank Rossii to stay at the sidelines and compel My Bank to take her own measures? Will this not send signals to depositors and investors that Russia’s banking system may be in dire predicament? Could the Bank Rossi’s “unlimited intervention” have been really directed to calm the banking sector or forestall a depositor stampede/bank run?

Interesting twist of events.

In other words, instead of the mainstream’s impression that today’s emerging market rout has been led by foreign money, in Russia’s conditions, the weak ruble and the spike in bond yields 10 year Russian treasuries may have been mostly an exodus of resident money.

And this Wall Street Journal article seems to back my suspicion “High capital outflows have become a sore point in Russia in recent years, with critics saying official corruption is hampering the investment climate and driving money out of the country. The central bank considers debt redemption, dividends paid to foreign shareholders, Russian residents buying foreign currencies, and mergers and acquisitions as capital outflow.”

Bottom line:

One huge foreign reserves, and surpluses in current account and balance of trade account serve as no free pass to bubbles. Russia’s case is just one example

Two contra popular wisdom, it doesn’t take foreign money to pull the trigger for a bust to occur as in the case of Japan in the 1990. While there has hardly been a full credit bust in Russia yet, developing events seem to indicate that Russia’s credit bubble may have already reached its maximum elasticity point (in the face of rising bond yields). And the bubble bust will likely be sparked by a capital flight from resident depositors and investors.

Russia’s plight seems far from over.