Philip Poole, head of investment strategy at HSBC Global Asset Management, talks about the outlook for emerging equity markets and his investment strategy.
Source: Bloomberg, January 4, 2011.
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.
This post is a guest contribution by Jacob Nell of Morgan Stanley.
In 2010 the ruble did not live up to expectations: In particular, the weak 3Q10 saw a sharp slowdown in growth (from 5.2%Y in 2Q to 2.7%Y in 3Q), with unexpectedly heavy capital outflows on the balance of payments in 4Q (US$22.7 billion), which, together with a poor harvest in 2010 (37%Y fall in the grain harvest), weighed on the ruble.
Since November 2010, however, the ruble has been increasing steadily, fuelled by a rising oil price, and the consequent strong position on the current account: As of February 16, the ruble has risen against the basket to 33.95, a rise of 7% in nominal terms and 11% in real terms since the start of November. How much further could this run continue?
We still expect the ruble at 34 to the basket by end-2011: We looked at this question recently (see Will the CBR Tighten in January? January 24, 2011) when we called for a rise in the ruble to 34 to the basket by end-2011, on the basis of a forecast US$70 billion surplus on the current account, and forecast that any rise above that rate at a US$96/bbl oil price would run into increasing headwinds. This call translates into the following numbers:
At the moment, based on balance of payments fundamentals and central bank statements, we do not see a strong reason to change this call:
•· Balance of payments: Although the oil price has been slightly stronger than expected, total reserve accumulation in the year to February 4 was only US$7.6 billion, or about half of what we would have expected from the forecast US$40 billion 1Q current account surplus. This implies ongoing capital outflows offsetting the current account. There are some signs that there may be a change of investor sentiment towards Russia and a resumption of capital inflows, including the successful US$3.3 billion VTB share sale and the CBR tightening at end-January by raising reserve requirements rather than rates because of a concern about short-term capital inflows. But, the picture on investor sentiment is mixed, with three recent planned IPOs cancelled – Chelpipe, Koks and NordGold – and Barclays announcing a loss of £244 million on its Russian acquisition and exit from retail banking in Russia. The next data release on the balance of payments – 4Q10 data due on March 31 – may provide information to revise this view.
•· Central bank attitude: The CBR does not like excessive short-term volatility in the exchange rate, and is, we think, currently buying US$300-350 million per day, and will lean further against appreciation as the rate approaches the edge of the intervention bands, which Deputy Governor Ulyukaev said was 33 to 37 on February 1. Governor Ignatiev’s comment, reported by Interfax on February 10, that the CBR intends to further widen the intervention bands around the central rate, as part of the ongoing move to a more flexible exchange rate, later in the year has two implications. First, it implies that the CBR will not widen the bands in the short term, and will therefore not allow appreciation beyond 33 to the basket. Second, if the widening later in the year is by a further ruble around the central rate from 4 to 5, similar to the widening by a ruble around the central rate from 3 to 4 in October 2010, it implies that the CBR would allow appreciation up to a maximum of 32.5 to the basket by year-end.
We Forecast a Rate Rise in February
We expect a 25bp hike in the deposit rate with high conviction, a 50-100bp hike in reserve requirements and a 25bp hike in all other active policy rates (repo, refinancing) in February: Our call is that the CBR will tighten further at the policy meeting at the end of February, given rising inflation (currently 9.6% annual rate versus 6-7% target) and hawkish language (the CBR will “most likely” raise rates in February, said Governor Ignatiev on February 4). Given Ignatiev’s frequent recent references to reserve requirements as an instrument of monetary policy, the high rates of reserve requirements in Russia previously (up to 8.5%) and the current high rates in other key emerging market central banks (for instance, Turkey 6%) trying to tighten in the face of rising inflation without raising rates and provoking capital inflows, we think that the CBR will raise reserve requirements again by 1pp to 4.5% for liabilities to corporate non-residents and by a further 0.5pp to 3.5% for liabilities to residents. However, we think that the CBR will also raise rates, given inflation well above target and robust recent indicators of growth (industrial production in January up 6.7%Y, slightly above our expectations of 6.6%Y and above consensus of 6.0%Y). In addition, we believe that it is uncertain that raising reserve requirements, which might require banks to increase their reserves at the CBR by RUB 50-100 billion from the current level of around RUB 200 billion, will have an impact on monetary growth when the banks already have huge ruble liquidity of RUB 1.4 trillion at CBR correspondent accounts or on deposit at the CBR. Given the CBR’s incrementalist recent approach, we call for a 25bp hike in the deposit rate with high conviction, a 50-100bp hike in reserve requirements and a 25bp hike in all other active policy rates (repo, refinancing) in February. In our view, the Ministry of Finance is also behaving as if it expects a rate hike from the CBR in February, since despite running a budget surplus in the year to date, it has been taking advantage of high ruble liquidity and consequent low rates to increase the volume of borrowing in the domestic market.
Source: Jacob Nell, Morgan Stanley, February 18, 2011.
This post is a guest contribution by Jacob Nell of Morgan Stanley.
Food prices continue to fuel inflation in 1Q11: 2010 saw inflation of 8.8%, led by food price inflation of 12.9%. Inflation rose by 1.4% during the first two weeks of January to an annual rate of 9%, driven by further increases in food prices and in the price of regulated services, which are usually raised in January.
In addition, there are very high levels of RUB liquidity - just under RUB 1 trillion, or over 2% of GDP – held by commercial banks as deposits at the CBR, following a bigger-than-expected December spending surge, which poses an inflationary threat. We expect January inflation at 2.5%M, which will push the annual rate to 9.7%Y.
We think the hawks will prevail in January: First Deputy Governors Melikian and Ulukayev’s contrasting statements are a reminder that the costs of inflation and the pace of tightening remain controversial topics within the central bank. The pro-growth camp are cautious about raising rates because of the negative short-term effect on lending and growth, and the risk of RUB appreciation, and do not see inflation as a major threat. The orthodox camp believe that the primary task of the central bank is to deliver low and stable rates of inflation. We view the December decision to hike deposit rates by 25bp, despite the commitment given in October not to hike “in the coming months”, as a sign of growing CBR concern that inflation expectations have risen. The accelerating January inflation (particularly for highly sensitive staples such as buckwheat and potatoes), the high level of RUB liquidity and the need to establish the credibility of the move away from exchange rate targeting further strengthen the tightening case.
A Tightening Package, Not Just a Rate Hike
Tightening likely to focus on CBR deposit rather than lending rates: At the moment, reflecting the high level of RUB liquidity, banks are not borrowing in significant volumes from the CBR. The Lombard facility is practically dormant, the repo facilities are used for c.US$1.5 billion per month versus US$15 billion per day during the crisis, while banks borrow about RUB 1 billion a day overnight from the CBR at the refinancing rate on average. In comparison, the banks have nearly RUB 1 trillion on deposit at the CBR. Tightening the deposit rate will thus have a larger impact on market rates, which are currently trading at the short end below the CBR’s 2.75% overnight deposit rate. We expect the CBR to raise deposit rate in an incremental step of 25bp, as usual, but a larger move is possible.
CBR will also use reserve requirements to reduce liquidity, in our view: Given the underlying pressure for appreciation from the strong current account surplus (see below), Russia’s exchange rate sensitivity and the problem of sterilising intervention, we expect the CBR to use additional tools to constrain liquidity. Both Ignatiev and Ulukayev have mentioned the use of reserve requirements in recent public statements. Other EM central banks, including China, Turkey and Israel, have recently raised reserve requirements. Average required reserves held at the CBR are RUB 228 billion at 2.5% RRR, which implies that each 1% increase in the RRR would reduce RUB liquidity by nearly RUB 100 billion.
Pressure for RUB appreciation: We expect a US$70 billion current account surplus in 2011, driven by high oil prices (averaging over US$96/bbl in 2011). Even allowing for low gas spot prices constraining Gazprom’s ability to raise European sales, and for strong import growth, driven by rising investment and consumption, we forecast a current account surplus in 1Q11, when there is a seasonal slowdown in imports, of nearly US$40 billion, and a surplus of US$70 billion for the full year.
Current account surplus will outweigh potential capital account outflows, we think: Even if there continued to be net outflows on the capital account at the US$30 billion level of 2010, this would be outweighed by the expected US$70 billion current account surplus, and result in an accumulation of reserves of US$40 billion in 2011, and corresponding pressure for RUB appreciation.
In addition, we expect FDI and external lending to Russian corporates and banks to increase in 2011, reflecting factors such as Russia’s improving credit and growth prospects, the recent pick-up in the number of major foreign investment deals (including the US$5.4 billion Wimm-Bill-Dann acquisition by PepsiCo, and the US$7.8 billion Rosneft-BP share swap and South Kara sea exploration JV), a strong pipeline of Russian companies doing IPOs, the government’s US$30+ billion privatisation programme, and Russia’s impending WTO accession. On the CBR’s forecast, net flows on the capital account will be -US$10-+US$15 billion in 2011, an improvement of US$20-45 billion compared to 2010.
How much higher can it go? Since end-December, the RUB has appreciated by 1.5% in nominal and 2.7% in real terms versus the basket, and it now stands at 34.57 to the basket. With Russia’s strong position on the external account, and the CBR announcing that it will not intervene to maintain a particular exchange rate (see the quote below from Governor Ignatiev), we see strong pressure for further appreciation, which will run into three headwinds:
“The thing is, in previous years we had a “soft” commitment to prevent an increase in the real effective exchange rate of the ruble of more than a few percent. This commitment constrained us in achieving our inflation target. Now we no longer have such a commitment – we track neither the nominal nor the real exchange rate. The floating currency corridor is designed solely to limit sharp fluctuations in the exchange rate”. Governer Ignatiev, Kommersant, December 23, 2010
Technical: The CBR has a floating corridor at around 33-37 RUB to the basket, and has set the cost of moving the corridor at a cumulative US$650 million of intervention for every 5 kopeck shift in the corridor.
Political: As the RUB strengthens, particularly if it strengthens rapidly, political sensitivity to the exchange rate increases. However, the RUB is now trading at its highest ever level in real terms, without inciting much discussion
Economic: The IMF’s fundamental analysis suggests that the RUB would be fairly valued on a PPP basis at the level of 23.4 to the basket at end-2011.
We see the RUB appreciating up to 34 to the basket by year-end, or by a further 8.4% in real terms. We compare our year-end forecast against indicative levels at which the headwinds make appreciation increasingly unlikely. The political headwind is assumed to arise at 12% real appreciation, the technical headwind after US$40 billion accumulation of reserves and the economic headwind when the market rate is equal to the PPP rate.
Against the background of the strong external account in 1Q, it is possible that further appreciation could happen rapidly, with this week’s rate hike decision and President Medvedev’s Davos speech, which will emphasise that Russia is now open for investment, as possible triggers.
Source: Jacob Nell, Morgan Stanley, January 25, 2011.
Reflecting improved global growth, crude oil prices have increased strongly since the summer. In the paragraphs below, BCA Research argues further gains are to be expected.
“We have highlighted for some while that a rotation strategy throughout the commodity complex was likely, based on macroeconomic conditions: ‘First gold, then copper, and finally oil.’ Gold typically benefits most from aggressively anti-deflationary liquidity impulses, especially from the U.S., which bring down real interest rates and the dollar. That backdrop may be fading for now.
“Copper benefits when China is booming and/or restocking. We expect the latter, with demand exacerbated over the short-term by the launch of two ETFs (one each for copper and nickel). However, copper prices have surged since breaking above the psychological $4/pound ($8000/tonne) level and may need to consolidate recent gains.
“Finally, oil outperforms when the growth impulse broadens to the U.S. This is what appears to be currently underway: Recent economic releases suggest that the recovery is becoming more sustainable. Moreover, physical demand is starting to draw down inventories, even though several OPEC countries have been producing well above quota.”
BCA Research concludes that oil and related product prices are well positioned to benefit as firmer economic growth boosts physical demand for petroleum.
Source:BCA Research, December 16, 2010.
As an aside, while Brazil, India and China have been underperforming the U.S. stock market for almost three months, the remaining BRIC member, Russia, has been holding its own, trading solidly above its key moving averages (see price and relative charts below). The strong prices of major Russian exports products such as oil and wheat are undoubtedly helping the Russian Trading System Index and the related Market Vectors Russia ETF (RSX). Although this instrument is probably a bit toppish in the short term, it is one to put on the radar screen, especially once a downward reaction takes place.
Source: StockCharts: com
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Russia really worries me. I hope I’m wrong.
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