The US leveled sanctions on Russia this week, using what was regarded as the “nuclear option,” targeting Russia’s bond market. Based on both market pricing and the tenuous connection many Russians will make between financial conditions and Putin, I suspect the bomb missed the mark.
When I think about sanctions I look at them both through the eye of an investor and the prism of conversations with my 91-year old mother-in-law, Maria Alexandrovna. She grew up under Stalin, lives in Moscow and consumes a steady diet of Russian state-owned news, news that makes Fox seem like NPR. She doesn’t know what a bond market is.
US investors are now forbidden from buying Russian bonds at auction. They are still allowed to buy them on a secondary market. Primary and secondary are technical terms. In plain English, this means on the day the bond is issued, a US investor can’t buy it. But if the investor buys the bond the next day from someone who is not the Russian Ministry of Finance, it’s OK.
At a White House briefing, a person identified as a “senior administration official” said “when you remove US investors from the primary market it causes a broader chilling effect. Russia’s borrowing costs rise, you see there is capital flight, you see the currency weakens in tandem.” So the goal is to drive borrowing costs up and the ruble down, hurting the Russian economy and, presumably, weakening support for Putin.
Exchange rates are a relative price, how many rubles you get for a dollar or a euro. They are determined by supply and demand. Demand for a currency comes from exports and the attractiveness of domestic capital markets. Supply comes primarily from the central bank though credit also creates currency supply. (If you take on a mortgage you are creating dollars that were not there previously).
To accurately forecast an exchange rate, one needs to predict the relative shift in each one of these line items, which is where the complexity comes in. For instance, the US exports entertainment. What will be demand for US entertainment over the next year from foreign buyers? It’s hard to say.
People who speculate on currencies tend to realize predicting these line items with precision is impossible and instead focus on a few variables. When assessing the sanctions against these variables, the policy is facing a headwind related to market pricing and relative central bank policy.
In terms of currency supply, the US Fed is pursuing an aggressive (and for now appropriate) policy of printing to deal with Covid economic shocks. Millions are unemployed and hungry. A by-product of this is that dollars are being created at a very rapid rate. That’s why interest rates are so low.
By contrast, the central bank of Russia is tightening, or reducing the supply of rubles. They are doing this for a number of reasons but one of them is that inflation is higher in Russia than in the US, 5.7% versus 2.6%.
Regarding currency demand, when an investor buys a foreign stock or a bond, they get a package deal, both the asset and the currency in which the asset is denominated. If the underlying assets are attractive, it tends to attract capital, supporting the currency.
Russia’s economy is primarily driven by raw materials, like oil, aluminum and palladium. These prices have been rising quickly driven in part by expectations of global recovery and the Biden Administration’s infrastructure plan. This means cash flows in Russia are likely to improve going forward.
Despite a likely economic pick up, emerging market assets are trading at a discount relative to developed world assets. For instance, the yield on the S&P 500 is about 3% while the yield on the Russian stock market is around 5%. The yield on the hot stocks in the US is close to zero, meaning they are expensive.
Real (inflation adjusted) interest rates are negative in the US while they are positive in Russia. In real terms, at current prices investors are paying the US government to borrow money, which makes it hard to attract capital. By contrast, bonds in emerging market countries including Russia must pay investors to attract funds. So far, the major emerging market bond market index provider is leaving Russian bonds in their index.
Where the sanctions do succeed is in reinforcing the image of Putin’s Russia as a pariah state. While I have no clarity into Kremlin strategy, I assume their tactics in terms of election interference and other schemes are a combination of an authoritarian leader, wounded pride and a sense that they are an underdog and can’t fight fair. Russia’s GDP is less than a tenth US GDP, a pugnacious welter weight versus a heavy weight.
This pariah image, cemented following the 2014 invasion of Crimea, has likely retarded investment that would have otherwise occurred but is already priced into the bond market. In terms of the sanctions’ impact on markets, by Friday the return of Russian bonds and stocks, measured in rubles, was slightly above where it had been before the announcement.
As for Maria Alexandrovna, she believes Russia is blameless. I suspect the sanctions won’t change her mind. To me, this is a reminder that even though we confront lots of obvious problems—in this case Russian election interference—sometimes figuring out the appropriate policy response isn’t easy.