Though little covered in the mainstream news, monetary events abound in Russia, clearly a large and important national economy. The era of tight monetary policy in the BRIC nation seems likely to be coming to an end. You can profit off this by going long Russian equities or by shorting the ruble. This focuses on the case for going long Russian equities and short the Russian ruble. But if the underlying thesis of this article is correct and the Central Bank of Russia takes additional steps to lower key interest rates, Russian bonds would also be likely to do well
Exotic though shorting the ruble may sound, a conventional Interactive Brokers account lets you trade the ruble/USD and the ruble/euro cross-pairs. ETFs that grant convenient exposure to the Russian equity market include the Market Vectors Russia ETF (RSX) and the SPDR S&P Russia ETF (RBL).
The Changing Face of The Russian Central Bank
For the first time in the two decades of its existence, the Russian central bank now has a mandate that includes the targeting of growth. Legislative authorities on July 5th passed legislation that tagged economic growth onto a mandate that previously only included the stabilization of price levels. According to the State Duma's website:
"The main goal of Bank Rossii's monetary policy is defending and ensuring the steadiness of the ruble by supporting price stability, including to create the conditions for balanced and steady economic growth."
In a signal that the recent change does not constitute mere cheap talk, the head of the central bank recently changed. The former head of the bank, Sergei Ignatyev, maintained tight monetary policy in an attempt to tame inflation. In this past quarter, the quarter of his exit, Russian GDP increased only 1.6% from its level a year earlier. The Russian government, however, forecasts GDP growth of 2.4% this year even though output this past fiscal quarter recently contracted. This seems to suggest that the Russian government anticipates expansionary monetary policy in an effort to stimulate growth.
The new head of the central bank, Elvira Nabiullina, has close ties to Putin's government, suggesting that she is likely to take the expansionary steps the head of state seems to want. She previously served as his chief economic aide. Unless she seemed likely to enact policies consistent with Putin's push towards higher levels of economic growth, it is unlikely that Mr. Putin would have appointed her in the first place. As a result, an expansionary tilt to Russian monetary policy seems likely to be in the future.
Inflation: A Shrinking Barrier to Easing
To Russian central bank authorities, the principal deterrent to expansionary monetary policy is the nation's history of high inflation. They maintain a 6% inflation target and inflation stands at 6.9%. But inflation has been on its way down in recent months.
In addition, Russian inflation surprises have been to the downside for the past two months. Year-over-year inflation came in at 7.4% in June, lower than the 7.7% consensus forecast. Inflation came in at 6.9% in July, defying a 7.53% consensus forecast.
Reading Between the Lines: Possible Future Easing In Spite of Inflation
The Russian central bank's language during its most recent announcement, however, raises the specter of central bank easing even if inflation remains above its target. Nabiullina drew a distinction between demand-related upwards pressure on the price levels and other sources of inflation. According to her, "the Bank of Russia estimates that this small negative output gap will continue during the course of the year, which signifies the absence of inflationary pressure from demand."
This distinction lays the logical groundwork for a rate cut in spite of inflation above the target-level. If you accept the distinction between demand-driven inflation and inflation from other sources, easing in an attempt to increase demand will not necessarily exert upward pressure on prices, but would help the central bank achieve its new goal of increasing output. So easing even with inflation above 6% would not be inconsistent with the mandate per se. Absent this distinction, easing in spite of elevated inflation would undermine its credibility. The new central bank chief's mention of the distinction therefore seems like a precursor to future easing even if the inflation target is not met.
But Nabiullina did not merely jawbone, and announced expansionary action on Friday.
Recent Unconventional Measures To Increase Credit
Though abstaining from a conventional rate cut this past Friday, the central bank took other measures to increase the availability of credit through its fractional reserve banking system. Whereas Russian banks previously could borrow from the central bank at a rate of 7.5%, under the mechanism, they can borrow against illiquid assets at a rate of 5.75% for up to a year. With inflation now at 6.9%, Russian banks now have access to central bank funds at a negative real rate of 1.15%. Notably, the bank also announced the delay of implementation of Basel III financial reforms. Both the decreased bank borrowing rate and the delay of Basel III increase the ability of Russian banks to grant loans and supply ruble-denominated credit to borrowers.
As the experiences of 2008 have painfully made clear, the fractional-reserve banking system is a vital organ of the modern economy. These changes to the Russian banking system therefore has important implications for the Russian economy, and for the assets that constitute claims on the cash flows generated by Russian economic activity. They imply a bullish case for equities and a bearish case for the ruble.
A Bullish Case for Russian Equities
An increase in the availability of credit suggests bullish backwinds for Russian GDP and bearish headwinds for the Russian national currency. The relationship between credit and GDP seems clear: an increase in the availability of credit represents an increase in ability to finance economic activity, leading to an increase in the volume of economic activity (i.e., to GDP growth). Whether or not putting on a trade based on future GDP growth is a good idea depends on what markets are pricing in, not merely GDP growth per se. Going long Russian equities is a good idea for that reason.
This is because Russian equities seem notably cheap. The SPDR S&P Russia ETF trades at a P/E of 5.43. This implies an earnings yield (E/P) of 18.43%. This valuation makes the Russian stock market the cheapest of all 21 major emerging markets tracked by Bloomberg. It is less than half of the P/E ratio of the Vanguard FTSE Emerging Markets ETF (VWO), which sits at around 12.
Granted, Russia is notoriously corrupt and difficult to do business in. You might therefore expect a political risk premium to exist in Russian equities, and for the P/E ratios of Russian equities to be lower as a result. But at 5.43 its P/E is less even than the Egypt Index ETF's (EGPT) P/E of 9, and it would seem all but impossible to imagine Russia with a higher political risk premium than Egypt. Alternatively, if you interpret national index P/E ratios as indicators of future GDP growth and ignore risk premiums, these valuations imply that Russian GDP growth will be even less than GDP growth in Egypt as it experiences historic levels of political unrest and state fragility. Given the recent and likely future efforts by Russian authority to increase credit availability, this low of an expectation of Russian GDP growth does not seem warranted.
Putting aside even the perspective of Russian equities as a play on how GDP unfolds relative to expectations and the relationship of interest rates to economic growth, the specter of a decrease in Russian interest rates paints a bullish picture for Russian equities. This is because a decrease in benchmark rates decreases the discount rate that relates future cash flows to the present. As a result, if central benchmark rates decrease, the present value of future nominal cash flows increases, and present equity prices rise (all else equal).
The exodus of funds from general emerging market and BRIC equity allocations seems like a plausible explanation for the recent beating Russian equities have taken and their low valuations at present. This would suggest that now could be a buying opportunity and that low valuations are more a market dislocation than a genuine market pricing of conditions per se.
The Bearish Case for the ruble: Credit Expansion as Currency Debasement
Economic conditions in Russia today suggest a bearish case for its national currency, the ruble.
As noted earlier, the availability of credit in Russia seems poised to increase due to the central bank's recent changes to the bank financing system. And in a fractional reserve banking system, an expansion of the size of bank balance sheets also puts downward pressure on the national currency. The abundant hype about the fractional reserve system generated in the post-2008 environment reflects this fact: that the private banks who take deposits of money from some people and give loans of money to other people, in effect, are the real "printers" of purchasing power in the economic system. An increase in the supply of anything lowers its price. Since increasing the availability of credit via the Russian banking system logically increases the amount of purchasing power in the Russian economy, as the unit of purchasing power in Russia, the ruble seems likely to decline in price relative to other currencies going forward.
You can see the relationship between credit expansion and currency weakness more clearly if you think of the issuance of a ruble-denominated loan by a Russian bank as being a short position in that currency, since whoever takes that loan must buy rubles in the future in order to pay it back. Imagine, for example, that the borrower is a Russian-U.S. dual citizen who borrows money from a bank in Moscow and then sells his borrowed rubles for U.S. dollars when he gets back to New York. To pay back that bank one day, he will have to sell U.S. dollars and buy Russian rubles. So the issuance of his loan amounted to a short sale of the ruble, and the repurchase of rubles to pay back the loan amounted to a buying of the currency to cover that short. While the dual-citizen example is a corner case, this illustrates how the downward pressure on the ruble exerted by the creation of a ruble-denominated loan is much like the downward pressure generated when somebody sells rubles in the foreign exchange market.
The Bearish Case for the ruble: Falling Interest Rates and Capital Flows
While abstaining from a rate cut right now, as noted earlier, central bank's language on its Friday announcement did suggest its increasing amenability to a future cut. Rate cuts tend to weaken currency values by decreasing the returns of interest-bearing investments denominated in those currency and sparking capital outflows. The magnitude of the devaluation triggered by a given rate cut therefore depends in large part on how much capital has been invested in interest-bearing instruments, since those capital outflows are what exert downwards pressure on the currency. It is difficult to estimate precisely how much capital would depart Russia were the central bank to cut rates.
Nevertheless, circumstances suggest that a fairly large quantity of capital currently in ruble-denominated assets would respond to a rate cut. Interest rates in much of the world are at historic lows and Russian 10-year sovereign debt yields 7.25%. And with Russian sovereign debt at less than 10% of national GDP, the risk of default seems low to minimal. Cumulatively, this suggests that investors in search of yields may have to at least some significant extent found a home in Russia. If rates fall, its appeal as a yield-haven is likely to diminish and investors are likely to sell ruble-denominated assets as a result. These capital outflows would result in downward pressure on the ruble.
The Bearish Case for the ruble: The Balance of Payments Picture
At a glance, the state of the Russian current account may seem healthy. As the chart below demonstrates, it is running a current account surplus that seems generally consistent with its five-year average.
However, it would be a mistake to conclude that Russia's balance of payments is supportive to the ruble. A more careful analysis paints a more precarious picture of Russia's national balance of payments.
Measured as a percentage of Russian GDP, the Russian current account is near the lowest level it has been in over a decade.
It is important to remember that the current account is a flow, a measure of the relationship between inflows and outflows. Russia's current account surplus does not indicate the absence of borrowing from abroad. Rather, it indicates that the nominal value the exports it sends abroad exceeds the nominal value of financial capital flowing in from abroad. And Russian exports have increased as the current account deteriorated as a percentage of GDP has deteriorated to its current level.
This increase in exports has been funded by an increasing reliance on foreign sources of funding. According to the Central Bank of Russia, the stock of debt Russians owe to foreigners increased to a record $684.4 billion this past April. An addition of +$124 billion from its level a year earlier, this represents a 22.3% increase from its level a year earlier.
Assuming at least a significant portion of the debt Russia owes foreigners are denominated in foreign currencies like U.S. dollars and euros, the repayment of this debt as it matures will put bearish pressure on the ruble. Given how low the "risk-free rates" of borrowing in U.S. dollars and in euros are in today's low-yield environment, the assumption that Russian borrowers have in borrowing in these currencies does not seem implausible. The extent of the downward pressure on ruble will depend on the extent to which the particular holders of those liabilities lack assets denominated in those liabilities. To the extent that Russian holders of external debt do face such an asset-liability denomination mismatch, they will need to sell rubles and buy those currencies to pay back their lenders. This selling generates downward pressure on the ruble relative to those currencies.
Putting It on and Wrapping It Up
It seems prudent to clarify how best to position your portfolio to create an exposure that reflects the underlying view on the future of Russian monetary policy articulated here. To clarify, that view is that circumstances in Russia suggest a future easing of Russian monetary policy (i.e., a lowering of interest rates in Russia).
Generating the ideal exposure in the currency position is more complicated than generating the ideal equity exposure. Central Bank of Russia tracks the ruble relative to a dollar-euro basket to better mimic the composition of its trade partners, to express a general view on the ruble's descent, it would seem prudent to short the ruble relative to both the euro and the U.S. dollar. If you are an American with a base currency of U.S. dollars, you can simply take the total amount of U.S. dollar exposure you wish to have for this position, divide it in half, and then convert U.S. dollar quantity into a quantity of euros to figure out how many EUR/RUB units of exposure you would want to have given your total desired U.S. dollar exposure. Shorting the ruble against both the U.S. dollar and the euro also mitigates exposures to the ongoing macroeconomic circumstances of each and creates a position with returns more driven by events in Russia than in either the U.S. or the eurozone.
Creating a long Russian equity exposure is more straightforward. You can simply go long the Market Vectors Russia ETF and the SPDR S&P Russia ETF, the two ETFs designed to reflect the general performance of the Russian stock market. However, if in today's volatile marketplace you wish to hedge out the risk of a continued decline in emerging market equities, you can accompany your long position in Russian equities with an equally sized short position in an emerging market equity index. This would result in a position with exposures to risks idiosyncratic to Russia's stock market rather than to the fate of emerging market equities in general.