Hard lessons for Russia’s central bankers

“The Bank of Russia held its key rate at 10% in February, as expected, but more noteworthy were hawkish comments about the months ahead.”

Bloomberg, February 2017

When we assess the political and governance outlook for a country, the strength of domestic institutions is one of our drivers, and one of the key institutions is the central bank. Our view on the political and governance environment in Russia is unsurprisingly negative but we do have a very positive view of the Central Bank of Russia (CBR), which contributes some positive elements to Russian equities.

Russia has tended to be a high-beta emerging market, with both the equity market and the currency reacting powerfully (both up and down) to developments in the world economy and world markets. This was particularly true in the 2008-2009 crisis. As well as the Russian economy’s structural exposure to oil revenues, the crisis showed the dependence of Russian banks and corporates to short-term US dollar financing. As those financing flows reversed, the Russian economy and financial markets had a hard landing, with MSCI Russia down 74% in US dollar terms in 2008, driven by a 20% decline in the ruble. Worse, the CBR attempted an unsuccessful defense of the currency through intervention, with foreign exchange reserves falling by over US$200 billion in six months at the height of the crisis.

In the years that followed, the CBR changed its approach to managing the economy and the financial system. Key reforms included improving the financial infrastructure to make Russian domestically-denominated bonds easier for foreign investors to trade, an aggressive clean-up of the banking system, and increasing the role of domestic pension funds in domestic financial markets. The most important improvement was a move to an orthodox inflation-targeting central bank mandate under its current governor (Elvira Nabiullina).

As a second round of economic stress hit Russia in 2014-2015, with the prospect of higher US interest rates hurting capital flows to emerging markets and a decline in the oil price of a comparable size to the 2008-2009 decline, the CBR responded very differently. The ruble, floating freely, fell over 50% against the US dollar, unimpeded by intervention, and the CBR addressed the resulting rise in inflation by hiking policy interest rates from 5.5% to a peak level of 17%. This was tough medicine for the economy and equity markets, and MSCI Russia fell 49% in 2015 in US dollar terms.

However, through disciplined and sensible policies, Russia is now well-placed to benefit from the recovery in oil prices. Real wages have continued to grow, and signs so far in 2017 are that retail sales are now catching up as confidence in the recovery grows. Industrial production has also been steadily recovering since 2015.

Russia faces some very serious structural growth issues (including corruption, the rule of law, demographics, capital flight and resource dependence), but enjoys a strong cyclical outlook at present, created partly by the CBR’s embrace of orthodox policies which we feel have been overlooked by the market. We are overweight Russia in the BT Global Emerging Markets Opportunities Fund and have increased our weighting in the last few weeks.