January 7, 2015

Six Risks with Russia

The consensus view is that lower oil prices will buoy global growth, moderate and contain the rate of inflation, reduce interest rates and permit central bankers to stay lower for longer.

I wanted to do a deeper dive and be more specific in assessing the risks associated with the Russian problem and the possibility of a loan default.

As I see it here are at least six identifiable risks.

Russia defaults: This is not a high probability event as, according to students of that country, Russia has $210 billion in public sector debt. This represents only about 1/10 of Russia's GDP and compares with more than $400 billion in foreign exchange reserves (though how much of this is liquid is being debated).
Russia's economic contraction adversely impacts an already moribund EU economy. In turn, this cripples global GDP: Direct trade between Russia and Europe is relatively small because Russia is not integrated into that region of the world. More risky is an economic slowdown in other energy-dependent emerging markets (some of whom might face capital outflows as oil prices descend). Such a contagion must be closely monitored.

Risks associated with Russian corporate debt and bank loans (particularly to Europe): This risk is a serious one as a levered and already-challenged European bank problem could erupt into a systemic problem and could spread to our economy and financial institutions. For now, according to the sell side, a potential Russian bank situation has been contained as bank loan exposure in Europe to Russia represents about 3-4% of their capital bases and only about 1% of total EU GDP.

Geopolitical risk: This is the big unknown as no one knows what a scared mouse (Putin) might do when faced with a bunch of cats.

The Russian Ruble is overvalued: As expressed yesterday morning, capital outflows and a run of the banks is a big risk as the recent rise in interest rates from 10.5% to 17% has failed to halt a capital exodus and to stabilize the country's currency. Capital controls may be next, but controls rarely have anything but a temporary impact.

Owners of emerging market debt and equity sell their liquid assets: This sort of domino impact must be watched closely because those markets (both debt and equity) tend to be limited liquidity.

I continue to be of the view that the drop in the price of oil may have a more ambiguous net impact on economic growth (relative to consensus).