Matein Khalid: The Crimea Crisis And Russian Equities

Global equities were hit by a spasm of risk aversion in March 2014 after China’s first onshore corporate bond default coincided with the Crimea referendum and Russian armoured division positioning on the border with eastern Ukraine.

A hard landing in China and the prospect of Western sanctions against the Kremlin (with all its attendant impact on capital flight from Russia and EU natural gas imports) triggered an immediate spasm of risk aversion on Wall Street and global markets. Gold spiked to a six month high at $1380, the Japanese yen and the Swiss franc spiked higher and investors scrambled to the safe haven of US Treasury notes and German Bunds.

It is not coincidental that the German DAX, the stock market index of Russia’s leading trading partner in Europe and Gazprom’s leading gas market, lost six per cent. The spike in the yen, in turn,has led to a 12 per cent fall in Tokyo’s Nikkei Dow index, despite the fiscal and monetary stimulus of Abenomics.

While diplomacy and realism will hopefully prevent war in Ukraine, the fact remains that Russian financial assets will remain hostage to the most serious East-West confrontation since the end of the Cold War and the end of the Soviet Union.

Even though Russia trades at only four times earnings, down 25 per cent in 2014 alone, global fund managers are not anxious to buy the shares of state-owned corporate colossi like Gazprom, Rosneft, Sberbank and VTB who are often used by the majority shareholder (the Russian state) as instruments of foreign policy.

Goldman Sachs estimates $50 billion in flight capital has fled Russia since the onset of the Ukraine crisis and the rouble has plummeted to near 37 against the US dollar. Unlike the Soviet Union, Putin’s Russia’s geopolitical intervention in Eastern Europe carries a steep domestic financial cost. Russia’s free fall, in turn, has a contagion impact on Hungary, Poland and Turkish equities, debt and currencies.

It is significant that the holdings of US Treasury debt by foreign central banks fell by $100 billion in the week the Crimea crisis escalated into a tension between Moscow and Washington.

This is clear empirical evidence that the Russian central bank has reduced its holdings in Uncle Sam debt to hedge against potential US sanctions and Japanese investors have repatriated funds home, the reason for the rise in the Japanese yen against the US dollar even though US economic data is stronger than consensus.

It is surely significant that the Eurodollar deposit market emerged in the 1960s when the Soviet Foreign Trade Bank deposited its surplus dollars in London and Paris bank to prevent Cold War asset sequesters. The sale of US Strategic Petroleum Reserve crude is also a message to Moscow about Washington’s ability to impose financial sanctions against Russia. After all, 70 per cent of Russian energy exports are headed to the EU and Russia’s $2 trillion GDP economy is dependent on oil, gas and metal revenues.

Russia’s economy did not even manage three per cent GDP growth rate in 2013 despite record crude oil prices. Apart from the risk of international sanctions, Russian banks also face the loss of $30 billion in loans to a bankrupt Ukraine and Belarus. The Russian central bank was forced to hike interest rates by 150 basis points to defend the rouble and
the Russian sovereign debt now yields almost 10 per cent in the Eurobond market.

A credit crunch is inevitable in Russia as most oligarchs and state-owned companies use shares as collateral for loans from the major state-owned banks.

The financial carnage in Russia is all the more significant since it occurs at a time of Chinese credit market distress, a rise in US Treasury bond yields as the Yellen Fed continues its monetary taper and a free fall in the world copper market. Like Mexico in 1994 or Thailand/South Korea in 1997, Russia has the potential to trigger a contagion across most emerging markets.