Russia: The acceleration in capital outflows

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This post is a guest contribution by Jacob Nell of Morgan Stanley.

Earlier this year we looked at the reasons for and implications of Russia’s elevated level of capital outflows and developed three scenarios for 2011. In our base case, we saw capital outflows, driven by domestic factors, as moderating, as they did in June-August. But private sector capital outflows suddenly accelerated in September-October this year to a new high of US$13-14 billion per month, or about 10% of GDP. We believe that this was due to the external funding stress in Europe. We now think that an elevated level of capital outflow, driven by a mix of domestic and external drivers, is likely to persist until mid-2012. In our base case, we then see the 2H12 capital account in balance, while in our bear case, in which external funding stress continues, capital outflows continue through the year.

Since the end of the Soviet Union, Russia has fairly consistently run a current account (in fact trade) surplus, and a capital account deficit, including a private sector outflow. There was an exception in 1996-98 when low oil prices and a strengthening ruble meant Russia had no current account surplus, and heavy government borrowing through the IMF and the GKO market financed a capital account surplus which supported the ruble. There was another exception in the boom years of 2006-08 when there were strong foreign inflows of capital. Nonetheless, the pattern is clear: on average since 2000, the current account surplus has amounted to 9% of GDP, while the capital account deficit has amounted to 8% of GDP, of which on average 2.2% has been private sector capital outflows.

It is surprising in some ways that Russia is a capital exporter to EM, since Russia offers high rates of return, and a prospect of higher future rates of growth than DM economies. The higher yield suggest that there ought to be a flow of resources from capital-rich, low-growth DM to capital-poor, high-growth EM, such as Russia.

In Russia’s case we see two underlying explanations for the paradox of capital flowing out of a high yield market and to a lower yield market.

a) Investment climate: The first, as emphasised by CBR Governor Ignatiev, is that private sector capital outflows reflect the perceived riskiness of the investment climate. In addition, we see this compounded by the investor life cycle. Initially, before accumulating a significant level of assets, an investor is willing to tolerate high risk and invest in high-return Russian assets, and may in practice not have an alternative. However, once they have accumulated a significant level of wealth, they seek to protect wealth by diversification, including in particular by moving a portion of their assets to a legal jurisdiction which is perceived to provide more robust protection for property rights. Since there are now a large number of rich Russians – 101 billionaires in 2011, according to Forbes, compared to zero 20 years ago – this investor life cycle should drive net capital outflows.

b) Sovereign wealth fund: The second reason, as in the case of China, is the official capital outflow as a result of repaying debt and accumulating resources in sovereign wealth funds which invest in DM securities, typically US government paper. Note that during the crisis in 2009-10, official sector inflows through borrowing and use of Oil Fund resources provided significant support to the BoP.

New explanation needed: A poor investment climate and official outflows are not explanations for the 2010-11 acceleration in private sector capital outflows. They cannot explain the timing of the outflows. There is no clear basis for the claim that the investment climate was rapidly deteriorating. And in 2010, there were inflows from the Oil Fund, i.e., dissaving, while in 2011, the net saving in the Oil Fund has been relatively subdued. Instead, we explain the acceleration in capital outflows which took place from September 2010 as due to accelerated purchases of foreign assets by Russians, in response to reforms and political uncertainty, and the acceleration in capital outflows which took place since September 2011 as a reflection of the funding stress in Europe.

A Domestic Explanation for September 2010 – Purchase of Foreign Assets

Russians become more global, but not Russia: Over time we see a strong trend to increased capital outflows as Russia grows richer and more Russians travel, buy property, send their children to school abroad and base themselves abroad, particularly given that there is no offsetting inflow of rich foreigners into Russia. Unfortunately, the evidence for this process is largely circumstantial, and it is in fact contradicted by the migration data, which show a decline in emigration in the 2000s. The hypothesis is that large communities of Russians have emerged who live or spend extensive time in countries within easy flying distance of Russia – including the UK, Germany, Israel, Cyprus, Switzerland, the Czech Republic, Montenegro, Bulgaria, France, Italy and Spain – while retaining links and registration in Russia. This group finance their foreign life and assets out of income derived from Russia.

The dark side of capital outflows: One of the more puzzling aspects of the Russian balance of payments is the line called ‘fictitious payments’, representing what the central bank considers to be transactions designed to transfer money abroad while purporting to be payments at a market price for goods and services. It ran at 1.8% of GDP in 2010, and has averaged 2.8% of GDP over the last 10 years.

However, a long-term trend towards higher global connectivity and a long-standing practice of moving funds abroad using ‘fictitious transactions’ may be a precondition for but it cannot explain the September 2010 jump in outflows. We see two domestic drivers of these capital outflows:

(a) Reform: In the last 2-3 years, a large number of governors, senior police and military have been replaced, and now over half of United Russia deputies have been replaced, while many government ministers, given Putin’s promise for a “younger management team”, could also be replaced shortly.

(b) Uncertainty: Until the new government is formed and the policy direction has been set, there will be uncertainty about the future path of policy, and nobody to agree terms of investment with.

In our view, a key explanation for the jump in capital outflows in September 2010 was the replacement of Mayor Luzhkov of Moscow, partly because this may have been seen as an indicator that nobody was immune from reform. Secondary factors were the perspective of political uncertainty, given the impending elections, and improving liquidity as the economy recovered.

An External Explanation for September 2011 – Reduction in Foreign Liabilities

External funding market stress is driving the further acceleration in private sector capital outflows in September 2011, we think. The rise in capital outflows reflects, we think, the impact on Russia – and other EM markets – of rising funding pressure in Europe. Despite less exposure than other EM countries at high oil prices, Russia may have been disproportionally affected by outflows as a result of external funding pressure since it offers a larger, more liquid market and a liberal capital account. This external funding pressure is increasing capital outflows through various channels, we think, including:

Reduction in Russian relative yield: In terms of risk/reward, the rise in European yields while Russian OFZ yields have remained relatively flat has increased the relative attractiveness of investing in Europe.

European bank deleveraging: The requirement that European banks raise their Tier 1 capital to 9% by June 1 is driving them, we think, to sell assets, since they prefer to shrink their balance sheets than issue equity at current depressed valuations, and they will tend to prefer to sell assets in non-core markets.

Perception that more exposed to a growth slowdown: Many investors see Russia as a commodity exporter and therefore a high-beta play on global growth, growing faster when growth is high and being worse hit in a slowdown, and so may be more likely to sell Russian assets when growth prospects are downgraded.

We believe that the most significant impact has been a fall in foreign liabilities on top of the existing pattern of net purchase of foreign assets. In particular, we point to the US$19 billion 3Q11 fall in Russia’s external debt, a rollover rate of just 60%. Since the external funding stress intensified through the quarter, we suspect that the rollover rate was even lower in September. Given the external debt repayment schedule going forward, if the rollover ratio falls to 50% for the next year, as illustrated below, then 4Q external debt repayment will continue at the 3Q level, before halving in 2012, reflecting the lighter 2012 external debt repayment schedule.

Outflow of resources driving up domestic rates: More generally, we see the outflow of resources as putting pressure on domestic interest rates, which have risen by 1.5-2% since end-June, as they rise to attract funds from competing external uses. Given the continued external funding stress, and the ongoing weekly falls in reserves despite the very high oil price, we assume that the high September-October level of capital outflows at over US$10 billion per month continues to the end of the year.

On all scenarios, we think that significant capital outflow will continue through 1H12: Given the persistence of the outflows, we think that a significant event is required to trigger change. In May the new government will be formed, policy direction clarified, and cadre changes implemented, which is a potential trigger, we think, for a reduction in domestic-driven outflows, as uncertainty reduces and the current round of personnel changes are completed. European banks are due to achieve their 9% capital ratio by June 1, which is a potential trigger for a reduction in external funding pressure.

In our base case, capital outflows slow in 1H12, and the capital account switches to neutral in 2H12: Assuming progress towards resolution of the European debt crisis and a reduction in external funding stress, we see capital outflows continuing at a reduced rate through 1H12, until European banks achieve their new capital ratio, and the capital account broadly in neutral in 2H.

Implications for RUB: As set out in more detail in Russia & Ukraine Trip Notes: Divergent Responses to External Funding Pressure, November 24, 2011, we believe that the impact of the capital outflows will be to keep RUB weak and reserves on a declining path to 2H12. However, weakness and reserve loss could be offset by the strong current account at forecast high oil prices and weak import growth, restrained by the weaker RUB. With the decline in capital outflows in 2H12 and a continued strong current account, we see RUB strengthening back towards 30 to USD and reserves rebuilding to US$530-540 billion by end-2012.

Bear case risk: If external funding pressure remains strong, then capital flows could remain high, even as the impact of a global slowdown on oil prices weakens the current account, and lead to a further weakening in RUB. We see the downside risk in this scenario as capped by OPEC willingness to withdraw supply, keep the oil market balanced and support oil prices.

Source: Jacob Nell, Morgan Stanley, December 7, 2011.

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