Falling oil prices, a plummeting currency, sanctions and the threat of capital controls in Russia are forcing investors and index providers to intensify their focus on that market.
The price of a barrel of oil has dropped sharply since the summer, and the ruble has collapsed. On Dec. 19 the exchange rate was 59.11 rubles to the dollar. A year earlier, it was 33 rubles to the dollar.
The U.S. and European Union continue to impose economic sanctions on Russia over the annexation of Crimea from Ukraine, harming the country's finance and energy sectors.
The Central Bank of Russia has already stepped up efforts to contain the potential recession-inducing impact of these factors, and is working to protect the ruble. In what economists at AXA Investment Managers said was an “emergency midnight move,” the bank raised interest rates 650 basis points last week, to 17%.
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The situation has investors, managers and index providers concerned that the country will be forced to embark on capital controls in an effort to stem outflows and protect the markets.
“I think everybody has in mind (that) capital controls are a major risk for institutional investors,” said Mathieu Negre, London-based portfolio manager, emerging markets equities, at RBC Global Asset Management Inc.
CAPITAL CONTROLS
Russian authorities have a spectrum of capital controls available to them. At the extreme end, the ability to trade in equity and fixed-income markets could be impaired.
“Then, inclusion in the [government bond index-emerging markets] global indices would be at risk, further hurting the ruble and bond yields,” Peter Eerdmans, Investec Asset Management's London-based portfolio manager on the emerging markets debt team, wrote in an emailed statement.
At the other end is the encouragement by the Kremlin for exporters to convert foreign-exchange earnings back into rubles — which Mr. Eerdmans said could become mandatory.
It is the possibility of restricting Russia's $112.2 billion MICEX index, representing the country's equity market, that has investors spooked. Russian equities already are battered. The MICEX index is up 0.93% for 2014 thru Dec. 19, with a -4.96% return in the month to date. That compared with an annual return over three years of 7.57% through Dec. 19.
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The fixed-income market is similarly struggling. The Russian Government Bond index is down 22.2% for the year through Dec. 18, with most of the losses coming in the past few weeks. The index is down 11.6% since Nov. 30.
“We have been watching the Russia situation very closely, and discussing internally, especially since the beginning of this week [Dec. 15],” said David Blitzer, managing director and chairman of the index committee at S&P Dow Jones Indices in New York.
Extreme capital controls are unlikely, as any effects would be “more damaging to Russia than to anyone else,” Mr. Blitzer said. However, it is still something index providers must consider.
Were capital controls introduced, investments in Russia would be frozen, Mr. Blitzer said.
“We would respond. We would probably take the Russia stocks out of various global and major regional indexes, and treat it as a stand-alone country ... We would do that very quickly, and I think investors would recognize this was in response to events in the market,” he said.
The issue of liquidity in the event of equity market controls also concerns officials at index provider MSCI Inc. It said in a statement last week that it was “closely monitoring” the situation and the potential restriction of the equity market, and that it would “consider preemptively replacing the local listings of all MSCI Russia index constituents with liquid depositary receipts where available to avoid a potential exclusion of the MSCI Russia index from the MSCI Emerging Markets index.”
However, Manolis Davradakis, senior emerging markets economist at AXA Investment Managers in Paris, believes any restrictions would be limited, largely because of a resulting political risk. “We are still witnessing, since 2008, massive capital outflows from Russia [by] private investors who are taking their money out of the country for various reasons,” Mr. Davradakis said.
If the central bank imposes capital controls, “then what will happen is that the capital outflows will be contained, but what may be thinner is political support” for President Vladimir Putin in the event of extreme controls, he added.
Mr. Davradakis said Russia will hike interest rates as high as possible to support the currency. When the ruble continues to fall, Russia will resort to capital controls, similar to those imposed in Malaysia after the Asia crisis in the late 1990s, he said.
“Malaysia instructed exporters that they were not to convert or export proceeds if the local currency depreciated relative to the dollar by more than 50%,” said Mr. Davradakis. “That kind of capital control worked very well. The currency depreciation of the ruble year to date is about 60%. Does that imply that capital controls are likely? Of course.”
CLOSE MONITORING
Institutional asset owners and money managers, meanwhile, have moved the issue of Russia up on their agendas.
“We have experienced a decline in the value of our holdings in Russia, but we have long-term perspective,” said a spokesman for Norges Bank Investment Management, manager of the $850 billion Government Pension Fund Global. “We stated in [the third quarter of the year] that we have not changed our holdings in Russia since spring. We have said that it is not natural to execute a countercyclical strategy based on geopolitical turmoil.”
Allocations were not disclosed.
The $145.1 billion Florida State Board of Administration has not made any relative changes to its exposure to Russia, according to a spokesman. “We continue to monitor” the situation, he said.
Cameron Brandt, director of research at EPFR Global, said Russia equity funds on Dec. 15 recorded the biggest daily institutional outflow since mid-August. Redemptions moderated Dec. 16, he said. Flows have been mixed over 2014, with EPFR's data showing the largest institutional inflow at $243.96 million for the week ended March 26, and the largest institutional outflow of $161.64 million for the week ended Jan. 29.
Sophie Baker is a reporter at sister publication Pensions & Investments.
