Ratings agency S&P downgraded Russia’s sovereign debt on Monday for the first time in 10 years, but the move should not have come as much of a surprise to anyone. The agency had already changed its outlook for Russia on October 23.
Key to the decision is the decline of Russia’s foreign exchange reserves. In its morning note Alfa Bank says, it was always likely Russia would suffer a ratings downgrade if its reserves fell below $450bn. What’s of real interest, says the bank, is the fact S&P has kept its outlook negative’ suggesting additional ratings cuts are possible if a sharp deterioration in reserves continues. Furthermore, Alfa says:
Our final point is that the cut of the sovereign rating is likely to trigger the downgrade of Russian banks’ ratings. We believe this move may shift the market’s focus to the issue of loan quality and will therefore be negative news for the Russian equity and bonds markets.
Effectively, major distress for Russia’s beleaguered banking sector ro come.
The outlook for the rouble looks equally bleak. As RGE’s Nouriel Roubini points out in his latest article – what a difference a few months can make. Six months ago Russia was flexing its geo-political and economic muscle on the world stage, today it is in deep economic and financial trouble.
Pondering Russia’s options, Roubini says the only solution now is for the rouble to be allowed to depreciate, something that has for a while been much resisted by the Russian authorities. As he explains:
The reasons for resisting such necessary depreciation were varied: the banks and the corporate sector had massive foreign currency liabilities and a sharp movement of the currency would have led to nasty balance sheet effects and severe financial distress; the incipient bank run of retail depositors could accelerate if the currency were to fall sharply (Russian depositors were wiped out already twice in the transition period in the early 1990s and again in 1998 and they tend to be trigger happy); Putin staked part of his reputation and his view of a strong Russia on maintaining a strong rouble.
However, according to Roubini, it is now time to let go of the rouble peg (our emphasis):
The more appropriate way to regain a modicum of monetary independence and prevent a sharp increase in domestic interest rates that expectations of a rouble depreciation trigger is to let the currency peg go and flexibilize the exchange rate regime. Only after the currency has moved down enough expectations of further depreciation would quiet down. So, the right policy move would be one of a one-step large depreciation of the currency value that reduces significantly the amount of actual overvaluation of the currency
Until now, authorities have reacted by allowing only a gradual and modest depreciation – something that has only exacerbated capital flight, according to Roubini, by leading to further depreciation expectations. As he puts it, the rouble may need to fall by about 25 per cent before reaching a new equilibrium value. But there are signs that Russia may be about to change its policy. As Roubini explains:
Effectively Russia has been doing what Brazil did in 1998-99 — i.e. bailing out ex-ante its banks and corporates by allowing them to cover their forex currency exposure via purchase of a large fraction of the reserves of the central bank;. This Brazilian “ex-ante bail-out” prevented the “ex-post bail-out” that would have been necessary if banks and corporates with a massive amount of foreign currency debt had experienced a large currency depreciation before they had the time to hedge such exposure.
So now that the forex reserves of Russia have been run down enough to reduce the foreign currency exposure of the private sector the central bank can allow a faster rate of rouble depreciation without worrying about the banks and corporate going bust via the balance sheet effects of a large currency move on the value of their previous large foreign currency exposure. All these factors suggests that the Russian authorities are now ready to let the currency fall at a faster rate than it the past.