by Mike Azar
With the Russian currency (the ruble) plummeting and borrowing costs shooting higher, Russia is on the edge of a full-blown financial crisis. In the last three months, the ruble has lost nearly 50 percent of its value against the dollar, as the price of Brent crude oil (a key oil price benchmark) has dropped about 45 percent. The Russian economy has grown increasingly dependent on revenue from oil and natural gas extraction. It is estimated that the government budget requires an oil price around $100 per barrel to balance. Oil is currently trading at around $60 per barrel. The central bank forecasts that the country’s GDP will contract by 4.5 percent if oil prices remain at current levels.
Investors are concerned about Russia’s ability to endure a prolonged period of low oil prices and have begun to withdraw capital from that country. The resulting outflow of capital has depressed the value of the ruble and strained the country’s financial system. The Russian central bank has attempted to intervene to stem the ruble’s decline by raising interest rates (to attract investors to higher yields) and by buying rubles (by selling its foreign currency reserves) with limited success.
In this post, we explore Russia’s growing dependence on oil and natural gas and the evolving relationship between the price of oil and the value of the ruble. We also analyze the mechanisms through which a falling ruble could impose financial distress on the Russian economy, particularly the impact on Russian borrowers’ ability to service their debt obligations within the context of the existing U.S. sanctions regime. Investors would benefit by understanding the underlying factors of the current crisis in Russia. A financial crisis in that country could quickly spread to other emerging and developed economies, curtailing global economic growth and reducing investor confidence in the emerging economies.
Growing Energy Dependence
Following a period of substantial growth in crude oil and natural gas production, the Russian economy has become increasingly dependent on oil and natural gas exports. These exports make up a growing share of Russia’s total exports (approximately 70 percent) and the revenues they bring in comprise an increasing portion of total government revenue (greater than 50 percent). The Russian government derives this revenue primarily from its ownership stakes in Russian energy giants, the state-sponsored banks that fund those energy firms, and mineral extraction taxes.
Figure 1: Increased Reliance on Oil and Gas Extraction
Brent and the Ruble
Russia’s growing dependence on the crude oil and natural gas sectors has produced an important relationship between the price of Brent crude oil and the ruble-dollar exchange rate.
Figure 2: Real Brent Price and the Ruble-Dollar Exchange Rate
To measure the relationship between the price of oil and the value of the ruble, we calculate the correlation coefficient between changes in the price of Brent and changes in the value of the ruble against the dollar. The correlation coefficient measures the strength of association between two variables and has a value between -1 and 1. A value of zero suggests no relationship between the two variables.
In the analysis below, we calculate a rolling correlation, which measures the change in the correlation over time as the Russian economy has grown more dependent on revenue from oil and natural gas extraction. Further, we calculate the correlation over 1-year, 5-year, and 10-year rolling periods in order to measure the relationship between the two variables over short periods of time (1-year) and longer periods (10-year).
As indicated below, the price of Brent and the value of the ruble exhibit a strong negative correlation (correlation coefficient between -0.7 and -0.9) over both short periods and long periods of time, and this relationship has grown stronger over the last decade. A negative correlation implies that a decrease in the price of Brent is associated with a decrease in the value of the ruble against the dollar (i.e., an increase in the amount of rubles per dollar).
Figure 3: Brent-Ruble Rolling Correlation (six month rolling averages, 1995-2014)
The effect of this growing correlation is that the ruble exchange rate has become significantly more sensitive to volatile commodity prices, increasing Russia’s financial and economic vulnerability through the various economic and financial mechanisms into which the exchange rate feeds. For example, if the ruble depreciates when crude oil prices fall, domestic price inflation would increase due to the higher cost of imported goods and Russian borrowers of dollar-denominated debt may find it difficult to meet their debt service payments (which would increase in ruble terms). This post primarily focuses on the latter concern.
Growing External Debt
Over the last several years, low inflation and loose monetary policy have reduced interest rates in the U.S. for most borrowers. Russian (and other emerging market) companies have capitalized on these lower borrowing costs by issuing more dollar-denominated debt. As shown in Figure 4 below, Russia’s external debt has increased significantly since 2000 to approximately $731 billion, of which 74 percent is denominated in a foreign currency, primarily dollars.
In general, foreign currency debt is cheaper than ruble-denominated debt. However, borrowers of foreign currency debt are exposed to exchange rate fluctuations and international capital markets. The Russian economy’s vulnerability to exchange rate shocks due to the relationship between crude oil prices and the ruble-dollar exchange rate is magnified by Russia’s growing foreign currency external debt.
Figure 4: Russian External Debt
The next year and a half will be critical as a substantial quantum of dollar-denominated external debt is schedule to mature and must either be repaid or refinanced. Approximately $170 billion of external debt is scheduled to mature from December 2014 to mid-2016.
Figure 5: External Debt Maturity Profile
U.S. Sanctions and Sources of Dollar Funding
The challenges described above are amplified by the U.S. sanctions regime related to the Ukraine conflict, which has locked Russian companies out of the U.S. capital markets by prohibiting U.S. persons from transacting in certain types of debt with sanctioned Russian entities (this has discouraged international financial institutions from executing financing transactions with most Russian borrowers, whether sanctioned or not). As a result, Russian borrowers have limited sources of dollar funding with which to refinance the maturing debt. Their primary remaining source is the foreign currency reserves of the central bank, which are substantial but could quickly be exhausted if the central bank continues to intervene to support the ruble and uses its foreign currency reserves to provide financing support to Russian borrowers of foreign currency debt.
The central bank’s foreign currency reserves have already decreased substantially over the last three months. Assuming no other demands on its foreign currency reserves other than to repay Russian borrower’s maturing foreign currency debt obligation (i.e., assuming that the central bank does not intervene in the foreign exchange market to support the ruble), half of the foreign currency reserves would be used by mid-2016. Its liquid reserves would be 84 percent used. Liquid reserves are reserves that can quickly be accessed to meet near-term dollar-denominated obligations.
Figure 6: Shrinking Foreign Currency Reserves
Even if Russian borrowers are able to access dollar funding, the interest rates that investors demand may become prohibitively expensive. Interest rates on Russia’s dollar debt have already increased significantly over the last year. Russia is currently rated Baa2, BBB- and BBB by Moody’s, Standard and Poor’s and Fitch Ratings, with a negative outlook from each of the three rating agencies. A sustained period of financial or economics distress (e.g., due to low oil prices) could cause a ratings downgrade. If Russia’s credit rating is downgraded to speculative grade (the Moody’s and Standard and Poor’s ratings are just one level above speculative grade), the amount of investors who are able to invest in Russia will shrink, interest rates will rise further, the maturity of certain debt obligations may be accelerated and the ruble will depreciate.
The resulting financial distress could significantly curtail economic activity, forcing companies to lay off workers and reduce wages. With inflation already spiking recently due to the ruble’s decline, Russian citizens may find their living standards reduced.
Figure 7: Interest Rates on Russian Dollar Debt and Rising Consumer Price Inflation
Russia has few options left to avert a financial and economic crisis.
- Raise Interest Rates: On December 15, the central bank raised interest rates from 10.5 percent to 17.0 percent in an attempt to stem the ruble’s decline with limited success. By raising rates, the central bank incentivizes investors to hold ruble assets by increasing yields on these assets. However, higher interest rates also may curtail economic activity by raising borrowing costs.
- Foreign Exchange Intervention: The central bank has intervened in the foreign exchange markets to support the value of the ruble by selling foreign currency, also with limited success. The ruble’s value has continued its decline as the central bank’s foreign currency reserves have fallen by a quarter in the last three months. With a substantial amount of dollar debt coming due over the next two years, the central bank may decide to conserve its foreign currency reserves and, therefore, reduce its intervention operations.
- Capital Controls: If interest rate hikes and foreign exchange intervention do not succeed in stemming the decline of the ruble, the Russian government could implement capital controls. These include restricting the ability of investors and depositors to convert rubles into dollars, stopping foreign investors from repatriating profits out of Russia, and forcing Russian exporters to repatriate dollar export revenue and convert the proceeds into rubles. Capital controls impede the free flow of capital and increase political risks, discouraging foreign investors and harming Russia’s long-term economic prospects. Central bank officials have denied that capital controls are being considered.
- Extending Maturities: Russian borrowers could try to negotiate extensions to debt scheduled to come due to reduce near term demand for dollars. However, the restrictions imposed by the U.S. sanctions regime do extend to rollover of existing debt. As a result, this option may not provide substantial relief to Russian borrowers.
- Lifting Sanctions: If Russia’s relations with the West over Ukraine improve, sanctions could be rolled back and Russian borrowers may regain access to U.S. capital markets and dollar funding with which to refinancing maturing debt.
- Oil Price Rebound: Russia’s economy and the ruble could be saved by a rebound in crude oil prices, although depending on the volatile price of the commodity is what got Russia into this mess in the first place. A significant rebound in oil prices does not appear likely at the moment. The central bank currently forecasts a 4.5 percent decrease in GDP next year owing to a sustained period of low oil prices. The Russian economy may need to find another means of recovery.
Mike Azar is a senior associate at Greengate LLC, a project finance advisory firm, and has advised governmental lenders on large energy transactions in Russia.
 The Russian government owns 50% of Gazprom, the country’s largest natural gas producer with revenue of $124 billion in 2013, and 70% of Rosneft, the country’s largest crude oil producer, with revenue of $147 billion in 2013.
 These values measure the strength of the association between two variables. For example, a correlation coefficient of ‘1’ indicates that a one percent change in one variable is associated with a one percent change in the other variable.
 The latest central bank data is as of June 2014. The quantum of external debt issued since June 2014 is unknown although approximately $110 billion of external debt has come due during this period according to central bank figures.
 For example, a company that generates revenues in rubles but pays debt service in dollars could find its debt service payments increased (when converted into ruble terms) when the ruble depreciates against the dollar.
 Access to capital markets for certain borrowers may become limited during a crisis, preventing borrowers from refinancing maturing debt obligations at economic rates.
 Borrowers commonly refinance debt that comes due rather than simply paying it off with available cash.
 The Central Bank sells its dollar holdings in exchange for ruble thereby supporting the value of the ruble.
 According to the financial press, liquid reserves make up approximately $202 billion of the $374 billion of the Central Bank’s foreign currency reserves. The difference primarily comprises $171 billion of funds belonging to the Russian sovereign wealth funds.
 The credit rating agencies rate the creditworthiness of borrowers. Their ratings could impact the interest rate that borrowers are charged on loans and the pool of investors that are able to participate in lending.
 The objective of capital controls is to support the value of a currency by limiting investors and depositors’ ability to sell it in exchange for a foreign currency.
 Foreign investors would be discouraged from investing in Russia if they are not able to repatriate profits or if they fear that the state may pursue other measures harmful to their interests, such as expropriation and nationalization (i.e., taking investors’ assets).