Down via the Elevator, Up by the Stairs

I wrote a couple of posts about capital outflows from Russia.  There were a several stories about that last week.  One, from Bloomberg, says:

Capital flight from Russia is climbing as companies use record-low borrowing costs to fund the most overseas acquisitions in two years, diversifying abroad as domestic economic growth lags behind other emerging markets.

Russian companies have announced $27 billion of foreign purchases this quarter, the most since the third quarter of 2008 and triple the amount in the last three-month period, data compiled by Bloomberg show. The cost for companies to borrow in rubles is the lowest on record at an average 8.9 percent a year in October from 9.7 percent in the previous month, according to data from the central bank published on Nov. 18.

The increase in overseas investment and repayment of foreign-currency debt drove Bank Rossii to more than double its projection for 2010 capital outflows last week to $22 billion from $8.7 billion. Foreign investors put less money into Russia- focused mutual funds in the past six months than any of the other so-called BRIC nations — Brazil, India and China — as investors favored more expensive shares in faster-growing economies, EPFR Global data show.

Another, from Russia Profile adds some detail about the mechanics:

Hard-hit by the double whammy of a sudden decline in capital inflow and a recent spike in capital outflow, the Russian Finance Ministry is planning to classify some import-export operations as “money laundering.” According to information posted on its Web site last week, the Finance Ministry is seeking to amend the country’s foreign trade regulations by imposing stricter controls on some aspects of the country’s foreign trade in order to stem soaring capital flight.

The amendments being proposed by the Finance Ministry are expected to plug some loopholes in the present regulations, compel companies to repatriate export proceeds and deliver imported goods that have already been paid for through contractual agreement. If passed, companies would no longer be able to close an ongoing transaction under the pretext that its currency-transaction particulars or passports have been transferred to a foreign bank. Companies would need to supply stage-by-stage details of import-export operations to their domestic banks, and refusal to repatriate proceeds will be deemed a money-laundering offence. The Finance Ministry also wants to put in place a system of electronic confirmation of export or import transactions at customs, in an effort to combat delivery of “phony cargoes.”

The latest Central Bank figures on the country’s balance of payments show that the amount of capital which is not repatriated has soared in recent months. This is despite domestic companies borrowing heavily and taking advantage of a record-low interest rate, which stood at a yearly average of 8.9 percent in October, down from 9.7 percent in September. Last week, the Central Bank more than doubled its projection for 2010 capital outflow to $22 billion, up from $8.7 billion projected in August. The foreign assets of Russian companies have also soared, reaching $24.8 billion in the first half of the year, figures from the Central Bank show.

There seem to be several things going on here.  One is that in an effort to rejuvenate the sputtering Russian economy, the central bank is holding interest rates low.  Even though nominal rates are above nominal rates outside Russia, at the current Russian inflation rate it is possible to borrow at negative real interest rates, and invest overseas at higher rates.  Another factor is the weak Russian economy and the chronic difficulties faced by foreign investors make foreign investment inside Russia not especially attractive.

The use of export deals to export capital brings to mind schemes that were common in the 1990s.  At that time, the Russian central bank was lending money at ridiculously low interest rates, and given high inflation, the real rates on these loans were substantially negative.  The proceeds of the loans would be used to buy goods (especially raw materials often at ridiculously low official prices) that were then exported (often illegally) and the proceeds stashed overseas.

As noted above, one of the drivers of this capital outflow is low domestic interest rates.  So, right on cue, in the immediate aftermath of the flurry of stories on capital outflows, analysts are saying that an increase in Russian interest rates is inevitable, and the Russian Central Bank did not renew its pledge to keep interest rates low:

Policy makers may raise the main interest rate next quarter for the first time since 2008, lifting the benchmark a quarter point to 8 percent by the end of March, according to the median estimate of 19 economists surveyed by Bloomberg.

Ruble Gains, Stocks Fall

The ruble strengthened against the dollar, adding 0.2 percent, the most since Nov. 18, to 31.3485 per greenback at 1:33 p.m. in Moscow. The Micex Index of 30 stocks slid 0.4 percent to 1560.34.

The first increase may be announced at the bank’s next meeting in December,Vladimir Osakovsky, a Moscow-based economist at UniCredit, said in a research note today. The regulator may choose to begin tightening policy by raising reserve requirements for banks before the end of the year, said Maxim Oreshkin, chief strategist for Russia and the Commonwealth of Independent States at Credit Agricole.

. . . .

Removing the reference to keeping rates on hold from the statement is a “signal of the central bank’s sentiment shifting towards a possible change of rates in the future,” Trust Investment Bank said in a note on Nov. 26. Policy makers may raise borrowing costs as soon as in February, it said.

But the RCB faces a dilemma, because the Russian economy is stagnant:

Russia’s economy expanded in the third quarter at the weakest pace this year. Gross domestic product grew 2.7 percent from a year earlier after expanding 5.2 percent in the three months through June. The government may miss its 4 percent target for economic growth this year “by a little bit,” Economy Minister Elvira Nabiullina said on Nov. 23.

In brief, Russia is not riding the same wave as other emerging markets and other commodity exporters.  It has tried to use monetary policy to spur growth, but in a (relatively) open economy, a lot of the monetary stimulus is leaking via capital outflows.  Budgetary realities make fiscal stimulus impractical too.  All of this means that Russia’s near term economic outlook is hardly rosy, and that even though it took the hardest fall of any major economy, it is experiencing one of the weakest rebounds.

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About Craig Pirrong 238 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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