Perfect storm brewing for the rouble

December 2, 2013

A perfect storm seems to be brewing for the Russian rouble. It has tumbled to four-year lows against a euro-dollar basket. Against the dollar, it has lost around 7 percent so far this year, faring better than many other emerging currencies. But signs are that next year will bring more turmoil.

While oil prices, the mainstay of Russia’s economy, are holding up, Russian growth is not. It is running at 1.3 percent so far this year and capital outflows continue unabated — $48 billion is estimated to have fled the country in the first nine months of 2013 compared with $55 billion in 2012. Russia’s mighty current account surplus has shrunk to barely nothing and could fall into deficit by the middle of next year, reckons Alfa Bank economist Natalia Orlova. Finally, the rouble can no longer count on the central bank for wholehearted day-to-day support. FX market interventions cost the bank $3.5 billion last month  but it also shifted the exchange-rate corridor upwards six times, indicating it is keen to move to a fully flexible currency.

Orlove also estimates that around $150 billion in overseas debt payments are due in 2014 for Russian corporates. She adds:

This is going to be an issue and given that the central bank is actively promoting inflation targeting, the market should prepare for higher rouble volatility.

There is one other major risk. Russian rouble bonds have become the must-have component of every emerging bond portfolio after Moscow made its debt eligible for processing via the major Western clearing houses Euroclear and Clearstream. As a result foreigners’ share of the Russian bond market has rocketed to over 25 percent from around 5 percent in early-2012.

Signs of rouble weakness will be a major turn-off for these bond investors. Someone who bought the market in mid-2012 when the rouble was around 29.5 will have watched with dismay as the currency has fallen steadily to 33 per dollar. Manik Narain, a strategist at UBS, notes that Russian bond holders’ problems are exacerbated by the flat yield curve which makes hedging currency exposure much more expensive than in many other markets where curves are far steeper, such as South Africa.

So an investor hedging rand exposure on his 10-year South African bond would get a net return of 2.2 percent a year after paying roughly 5.8 percent in hedging costs, Narain estimates.  In Russia, the net return after hedging would be 1.6 percent. The losses build up as the curve extends, he says:

If you are an investor in long-dated  Russian bonds and want to hedge, you don’t have a high yield to compensate for hedging costs of 7 percent a year. You are effectively not picking up any coupon and if you compare to other places where hedging-adjusted bond yields are higher, you can see those bond markets are holding up much better.

Data on Monday has provided no reason for optimism. Manufacturing, which accounts for 16 percent of the Russian economy, shrank last month, according to a closely-watched purchasing managers index.

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