The grim market outcome for Russia after the invasion of Ukraine

The writer is an investment director at GAM

The implosion of Russian financial markets following the invasion of Ukraine is not the first crisis to hit emerging markets. It won’t be the last either.

Ever since emerging markets were popularized as a collective asset class in the 80s and 90s, there have been events like the Asian financial crisis, the 1998 Russian debt crisis, and serial defaults. from Argentina. The magnitude of such episodes is a reminder of the risks that accompany emerging market returns. Investors are notoriously amnesiac but it will be a long time before they regain confidence in the Russian markets.

Those unlucky enough to be caught with investments in Russian assets should obviously attract limited sympathy as Ukrainian civilians are bombed. But the combination of Western sanctions on Russia in response to its aggression and Moscow’s response has severely disrupted Russian markets – including, most importantly, spiraling the ruble higher.

Index provider MSCI is removing Russian stocks from its widely followed emerging market indices and will likely record their last price as “effectively zero”. Holders of Russian ruble bonds either left their holdings marked at stale prices or depreciated them according to external debt. The endgame seems to be similar.

The removal of some Russian banks from the Swift financial messaging system grabbed the headlines, but the most powerful international action was to freeze the Russian central bank’s foreign exchange reserves. This is what caused the 25% drop in the ruble after the announcement of the sanctions, and what led to Moscow’s effective declaration of economic hostilities against foreign investors.

The central bank first ordered local investors not to bid for assets held by foreigners, then froze foreigners’ accounts, then dictated that dividends and coupons would not be paid to foreigners. Neither equity markets nor bond markets had reopened at the time of writing.

Russia might believe that it is self-sufficient in capital. After the experience of the 1998 financial crisis, the country opted for rigid budgetary discipline and posted a lasting current account surplus. Thus, the combination of capital controls and sanctions should in theory not require significant adjustment at the macroeconomic level. However, this theory is based on sanctions that do not induce major changes in behavior. It sounds optimistic.

More important is the effect on the ruble. Since the end of communism, the convertibility of the ruble was crucial to restore the national currency as a store of value.

At least part of the justification for preventing foreigners from selling Russian assets was to reduce the pool of rubles seeking to buy foreign currency. The situation is clearly perilous. Before the announcement of the sanctions, one dollar was worth 83 rubles on the market. Three days later, the foreign exchange market rate reached 122, while ordinary Russians faced much higher retail rates – where there were dollars available. Financial uncertainty leads to capital flight – the immediate cause of the 1998 collapse.

Russian authorities have boasted of the country’s low dependence on imports. It is comfortably self-sufficient in food and energy. However, Russian industry depends on Western machinery and spare parts. And Russia’s efforts to prepare for sanctions have also been heavily reliant on China.

China is unlikely to match Western sanctions. It is an avid buyer of Russian resources and Moscow is also the largest foreign holder of Chinese bonds, according to ANZ. But there would be an irony if Russia’s attack on Ukraine left it at the mercy of a wealthier and more populous neighbor.

The good news for international investors is that almost none of the factors that caused the 1998 debacle are in place. The default then set off a chain reaction that ripped through highly leveraged markets, starting with hedge fund Long Term Capital Management. There is now much less leverage applied to emerging market assets and the preparation for the Russian attack has dragged on, giving some investors time to adjust.

But what this week has illustrated is how important access to international capital markets has been for Russia. This has allowed the country to import a degree of institutional certainty – large foreign exchange reserves in reserve currencies and reliance on Western courts for dispute resolution. These are not available for a country with an arbitrary government. And the current crisis is a prime example of what can go wrong for investors braving erratic jurisdictions in search of higher returns.

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