It’s no secret that a perfect storm has faced Russia and its foreign investors over the past year. A deep rouble sell-off conjured up memories of the 1998 financial crisis, just as Russia’s post-Cold War risk premia was repriced after western sanctions for the annexation of Crimea.
In the second half of 2014, the twin shock from a collapse in oil prices and sanctions savaged Russian output, crippling firms’ access to international markets and slamming the brakes on domestic consumption. Russia’s post-Cold War integration with international financial markets was in peril.
But in late 2014, a sharp decline in the country’s terms of trade combined with fears over looming debt redemptions to trigger capital outflows of around $156 billion, or 8% of GDP – the highest level since the 1998 crisis. Inflation jumped. FX reserves plummeted. And the rouble crashed. A domestic financial crisis loomed.
Amid retail deposit outflows in December, fears over capital controls took centre stage.
Enter the Central Bank of Russia (CBR) under the determined stewardship of governor Elvira Nabiullina. In the teeth of domestic opposition, the CBR accelerated its move to a floating exchange-rate and imposed the regime in November to engineer a more rapid adjustment in the external balance and to stem the bleeding of FX reserves. It then raised the policy rate to 17% – including a dramatic 650 basis point hike in December – to stave off a collapse in the financial system. It expanded its FX liquidity facilities, adding new maturities and broadening the definition of eligible collateral in its FX auctions, while committing to recapitalize viable lenders, if needed.
This shock therapy worked. Bringing forward plans to abandon Russia’s failing currency band with the dollar allowed the CBR to intervene on an ad-hoc basis to stabilize financial conditions but avoided wasteful interventions. It left the market to guess the size and frequency of interventions, thereby hiking the cost of FX speculation.
By May 2015, this external-sector adjustment brought down consumer price inflation, and gave the central bank room to normalize rates to counter the cycle. The CBR was, in part, helped by the bottoming out of oil prices in February, while the Fed’s dovish tone in March triggered a relief rally of sorts for oversold high-beta assets, eventually lifting the rouble 40% above its winter lows.
During the freezing of liquidity in the interbank market, the CBR stabilized the financial system with changes to its FX facilities, with banks relying primarily on FX repos to ease dollar funding pressures in the interbank market. But in March, the CBR was able to increase the cost of these FX facilities. This move to support the rouble with cheap dollar liquidity via swaps – amounting to as much as $30 billion in the first quarter, effectively replacing traditional FX interventions – was so successful that the central bank hiked rates on the FX swaps twice in April to curb the rouble’s rise. In May, the CBR suspended the one-year FX repo facility and announced a daily programme of FX purchases to guard against external risks, signalling a remarkably rapid normalization of monetary policy after December’s excitements.
The CBR’s crisis-fighting skills win Nabiullina acclaim from foreign investors.
Edward Al-Hussainy, fixed income strategist at Peridiem Global Investors, adds: “Should the CBR get credit for its policy orthodoxy over the past year? Absolutely. It tightened policy rates by 950bp to 17% between April and December 2014, and subsequently cut them to 11% by July this year. Floating the rouble was perhaps the most impressive piece of the bank’s adjustment exercise because it allowed CBR to use its FX reserve cushion for refinancing corporate debt and providing liquidity assistance to banks instead of defending the currency.”
Indeed. Exogenous drivers of rouble volatility – capital flows, sanctions and commodity prices – will feed into second-round inflation expectations, moderate the pace of the central bank’s cuts and test its new inflation-targeting regime. The latter challenge is particularly acute given the uncertainty over the credibility of the data to assess inflation expectations.
Russia has well-known buffers. The stock of external debt as a proportion of GDP and total government debt is much lower than before 1998, while liquidity is ample. What’s more, Moscow tends to run a modest fiscal deficit and a current account surplus, while the flexible exchange rate acts as a shock absorber.
But the decline in Russian potential output in the years ahead could be more prolonged than after the 1998 crisis. The CBR under Nabiullina has given Moscow fiscal breathing room. But its anti-inflationary pro-rouble battle can only pay off if the government addresses supply-side bottlenecks and diversifies the economy away from the energy sector.