Week In FX Europe - Russia: The Financial Squeeze Gets Tighter

Includes: FXE, FXF
by: Dean Popplewell

Global markets are ending the week focused on one thing: the Ukraine crisis. Politically, the situation is getting graver and the possibility of a Russian military incursion could become a reality.

The present situation is beginning to have more of a financial impact. Earlier this morning, Standard & Poor's Ratings downgraded Russia to BBB- with a negative outlook. The motherland is now in real danger of losing its investment-grade status.

"The downgrade reflects the risk we perceive of a continuation of the large financial outflows observed in the first quarter, 2014, during which the size of Russia's financial account deficit was almost twice that of the current account surplus" S&P said in a statement.

Despite Russia's debt-to-gross domestic product being moderate (12-13%), further capital outflows could potentially push Russia out of the investment elite club. The country will find it more difficult and expensive to finance its debts, especially as the west expands its sanction list. This should lead to further debt restructuring and at an obvious higher cost. This trickle-down effect will further hurt the Russian economy.

Naturally, Russian bonds yields are trading higher after the downgrade to just above junk status. The Central Bank of Russia (CBR) was expected to leave rates on hold at +7%, nonetheless bank officials deemed it necessary to hike the key policy by 50bps to +7.5%. From a Russian perspective, further aggressive rate hikes are neither welcome nor warranted given the obvious slowdown in growth. However, it may be a necessity given that the capital outflows from Russia are likely to accelerate over the coming months. The CBR may have no choice but to resort to capital controls or higher interest rates. CBR officials estimated that the net capital outflow for the first quarter at $64B to be the same as the whole of 2013.

What's interesting about the current situation is that emerging markets have not been thrown into a total tailspin. It seems that the market is clearly "distinguishing the relevant risks" and has deemed the broader market backdrop to be agreeable for the time being.

With the negative investment outlook, expect RUB assets to remain under selling pressure, which is bad for growth, bad for investment, bad for capital flows and bad for political and economic reforms. Other rating agencies are expected to follow suit.


* GBP Gross Domestic Product

* EUR German Consumer Price Index

* USD Consumer Confidence

* EUR German Unemployment Rate

* EUR Euro-Zone Consumer Price Index

* CAD Gross Domestic Product

* USD Gross Domestic Product

* USD Federal Open Market Committee Rate Decision

* USD ISM Manufacturing

* USD Change in Non-farm Payrolls

* USD Unemployment Rate