The Ruble Crisis: Where Oil Goes, the Ruble Follows

The present Russian ruble crisis has drawn many references in the media to the Russian sovereign debt default of 1998. But just how similar or different is the situation today? Back then, the fledgling Russian economy was heavily dependent on oil. Like today. The ruble was falling sharply. Like today. The Central Bank of Russia (CBR) was dramatically hiking interest rates to stem the tide of capital flight. Again, like today.

However, the parallels are not perfect. Back then, the Russian government was running very large fiscal deficits. Unlike today. The CBR had very low international reserves. Unlike today. And the ruble was pegged to the dollar. Also unlike today. Well, until now.

Much like the crisis of 1998, the ruble of late has been falling like a stone. In 2014, as the conflict between Russia and Ukraine escalated, the West enacted increasingly impactful sanctions. The sanctions first arose in March in response to Russian aggression and subsequent annexation of Crimea. The United States and European Union announced isolated sanctions against specific Russian and Ukrainian citizens and government officials, freezing their assets and banning travel to the sanctioning countries. Then in April 2014, Western countries imposed a second round of sanctions to further inhibit travel and business transactions, again focusing on specific Russian citizens. These early sanctions were more bark than bite as they had little impact on the overall Russian economy.

The third wave of sanctions were issued in July 2014 when the United States banned transactions with major Russian energy companies Rosneft and Novatek; two banks, Gazprombank and Vneshekonombank; as well as defense firms. The European Union took similar steps. Then in September, the United States joined with the European Union to extend sanctions to additional banks and energy and defense companies, among them Sberbank, Gazprom, Gazprom Neft, Lukoil, and Surgutneftegas. Around that time, a hodgepodge of sanctions rolled in from countries around the world ranging from travel bans to specific moratoria on trade. The escalating sanctions certainly increased risks for any person or entity transacting in Russia and likely escalated pressure on the ruble.

USD to RUB Exchange Rate

Sources: Quandl, CFA Institute.

While sanctions didn’t help Russia, falling oil prices no doubt hurt them.

When it comes to oil prices, the parallels between the Russia of 1998 and 2014–2015 are striking. In the third quarter of 1997, oil prices had peaked at about $21 per barrel (brent crude). By mid-August 1998, oil had fallen almost 50% to roughly $11 per barrel. The nascent Russian government had already been running annual budget deficits of around 9% of GDP since its inception in 1991. And Russia, then as now, derived an outsized proportion of government revenues from the oil and gas industry — more than 50% in recent years. On 14 August 1998, Boris Yeltsin, the embattled president of the new Russian Federation, called for an emergency session of parliament. To quell fears about the state of Russia’s finances, he declared, “there will be no devaluation of the ruble.” On 17 August, just three days later, Russia devalued the ruble. Thanks for the warning, Boris.

Today, oil prices plateaued at about $110 per barrel (brent crude) back in June 2014. Due to the dramatic ramp up of US shale oil production in recent years and weakening global demand, oil prices have fallen by similarly dramatic margins and are now trading below $50 per barrel. Only in today’s Russia, Vladimir Putin is at the helm. Last month, he threw his hat in the ring and declared that Russia’s current troubles “could last up to two years.” And regarding the state of Russia’s international reserves, Putin said, his government will not “thoughtlessly burn” its reserves. Phew. What a relief. I thought this might get bad. Hey . . . wait a second. In December, the CBR dramatically hiked interest rates, raising the key rate to 17%. Moreover, the CBR has stepped back into the currency markets to sell international reserves and purchase rubles. So, the CBR appears to have drawn a “soft” line in the sand to defend the ruble. Regardless of what Putin says, this is what they are doing. And we have just discovered where their pain threshold is. The ruble is now effectively pegged to the dollar.

Let’s turn our attention to international reserves. The following graph shows a comparison of international reserve levels relative to GDP both then and now.

Russian International Reserves/GDP

Sources: IMF, Russian Ministry of Finance, CFA Institute.

Clearly, today’s Russia has deeper pockets. It remains to be seen how much Russian citizens, banks, and businesses are seeking to flee rubles. Given the history of high inflation in the country, the recent sanctions by the West over the Ukraine issue, and now falling oil prices, the current ruble crisis is understandable. But what exactly is driving the departure from rubles?

A good place to start is with loans that are denominated in foreign currencies. The reason is that loans must be either repaid in full or “rolled over” as the loan approaches maturity. However, refinancing is no longer an option due to a weaker economy, capital flight, and sanctions. So, these Russian borrowers must either repay the loans in the foreign currency or default. Much of today’s ruble pressure appears to be from Russian borrowers who are repaying external debts as quickly as possible — by selling rubles and buying either dollars or euros to repay their loans. They are no doubt also motivated by a declining ruble — the longer they wait, the more expensive it becomes. In 1998, the external debt levels (i.e., debt denominated in currency other than rubles) in Russia were $188.4 billion, which translated into about 58% of GDP, according  to data I compiled from the Russian Ministry of Finance and the CBR. In contrast, external debt levels in Russia today are about $731 billion, or about 35% of GDP. So, this too is less of a burden than in 1998, but still nothing to take lightly.

Also, a first glance at Russia’s fiscal budget suggests that — until recently — Russia had its finances in order. According to the CBR, the fiscal budget ran a small deficit of 1.3% of GDP for the first three quarters of 2014 — far from the yawning 9% back in the 1990s. Russia needs brent crude prices to average about $118 per barrel for their fiscal budget to be in balance in 2014. However, oil prices have cratered — making a balanced budget a pipe dream.

Back in 1998, as oil prices plunged by a similar amount, government revenues declined by 17.5% vs. 1997. In addition, the CBR first hiked interest rates from 30% to 50% on 19 May 1998. Then, just eight days later, on 27 May, the CBR raised rates again to 150%. Today, the situation is similar, albeit less extreme, with two successive rate hikes from 8.5% to 17% in just a week. So, today’s declining oil prices and rate hikes are tearing a hole in Russia’s fiscal budget.

So, what choices does Russia have?

• Hike interest rates
• Cut spending
• Print more rubles
• Raise taxes
• Default

Hiking interest rates is a blunt tool. If investors are worried about return OF principal on their ruble-denominated investments, almost no amount of interest can compensate. Moreover, rising rates also slow economic growth (for credit fueled economies), all else equal.

Cutting spending is almost certainly in order, but it is doubtful that the Russian government can or would cut spending enough to keep the budget in balance. Few governments actually cut spending commensurate with revenues, so it remains unlikely that Russia would push to balance its budget now. Consequently, the Russian government’s need for financing is rising at precisely the moment that the willingness of investors to provide it capital is falling.

Of course, the CBR can print more rubles, but with the CBR stepping in once the ruble-US dollar exchange rate hit 60, the printing of rubles would weaken the ruble, not strengthen it. Like 1998, the CBR has effectively created a peg to the US dollar, setting Russia up for a protracted battle with the currency markets. The markets know that Russia’s international reserves are ultimately finite, so Russia can only prop up the ruble so long. How long? It’s hard to say. Through the first nine months of 2014, Russia experienced $85.3 billion in outflows. These outflows almost certainly accelerated in the fourth quarter. So, a reasonable estimate for 2014 as a whole might be $120 billion in net outflows. If net outflows hold at 2014 levels, Russia might have 3.2 years worth of reserves. Of course, more aggressive outflows, shorten the duration. And Russia recently tapped the Russian Sovereign Wealth Fund to support the ruble as well. So, this might extend Russia’s flexibility for some time, but make no mistake — this flexibility is finite.

The last option is raising taxes. And this is not at all straightforward. In the energy sector, Russia has exceptionally high tax rates, while in the consumer arena, Russia has a flat tax of 13%. In general, raising tax rates often means lower tax revenues. And with Russia’s tax revenues at 38% of GDP according to CBR and Russian Ministry of Finance figures, it would suggest that the overall tax burden is already high. At present, Russia’s tax revenues are largely dependent on the oil and gas industry where the government taxes up to 45% of revenues from each barrel of oil. It would not appear that the Russian government has much flexibility to increase tax revenues, especially in the near term.

Each of these options further inhibits the Russian economy. And Russia’s international reserves can hold out for perhaps a year or more, depending on how aggressive/tame capital flows become. But make no mistake about it, Russia has drawn a line in the sand. The ruble now has a floor of about 60 rubles to the US dollar. So, once again, Russia has pitted itself against the currency markets. Are Russia’s international reserves large enough to offset the pressures wrought by banks, corporations, and investors seeking to exit rubles? Perhaps the bigger question is: “What happens if oil falls more?” Then it is 1998 all over again. With oil at around $50, Russia has a bit of flexibility to continue the status quo. With oil at $30, market forces will win. Where oil goes, the ruble follows.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.