James Blake in Sydney, Australia -

Between 2008 and the first quarter of this year, Russia recorded a capital outflow of $476bn, at an average of $76bn per year, and with first quarter 2014 seeing a further $77bn outflow.  By any standard that is staggering volume of funds to depart any nation - in the same league as the roughly $500bn the US used to stave off the global financial crisis in 2008, the €500bn disbursed through IMF, EFSF, EFSM, and ESM for every crippled Eurozone sovereign bailout in the years since, and more than a year’s worth of Chinese current account surplus or US current account deficit.

The sanctions recently imposed on Russia’s banking system by the US and EU underline Russia’s capital outflow sensitivity, with treasury and banking officials both sides of the Atlantic crediting the sanctions with driving greater outflows, and Russian central bankers resigned to a full year 2014 outflow likely to extend beyond $100bn. But what that outflow actually represents and how it connects Russia with the global financial systems isn’t well understood. The widespread assumption it represents foreign investors pulling out of Russia, or Russia’s elites jumping ship or moving corruptly gained funds, isn’t entirely accurate. 

In June, JP Morgan analysts Maxim Miller and Anatoliy Shal, in research titled “Russia's capital flight and external vulnerabilities”, looked at the outflow and uncovered a few surprises. Their work, which has attracted little attention but has significant implications, partly confirmed international views about Russia’s investment climate and geopolitical exigencies driving capital outflow, but at the same time they revealed other aspects of Russia’s capital outflow and financial system, which need to be considered by investors, as well as international politicians and bankers.

Fictitious transactions – the biggest single factor in Russia’s capital outflow

Described by the Central Bank of Russia as “operations of fictitious nature” which “do not make any economic sense”, ‘Fictitious transactions’ are the biggest single component of Russia’s capital outflow, averaging $32bn each year, to reach more than $200bn since 2008. Fitting international perceptions of Russia’s capital outflow problem, this description covers a range of financial moves to launder funds across borders, including non-existent goods imports or loans extended to offshore companies never expected to be repaid.

Normally channelled through Russia’s banking system, ‘Fictitious transactions’ are visible to the Central Bank of Russia, however. They have a very high correlation with oil prices, but tend to decline at times of economic stress, and they declined significantly from late 2012 onwards as the Russian economy slowed, and the Central Bank of Russia pushed to clean up Russia’s financial system.

Russian Resident FX purchases

Resident FX purchases are the easiest component of Russia’s capital outflow to identify, invariably familiar to anyone on the streets of Moscow, and small in comparison with the overall volume. The first quarter 2014 saw an estimated $20bn converted into other currencies (mainly dollars), which surprisingly made for a total of only $22bn in the 2008 to first quarter 2014 period. This reflects a drift back into rubles since $25bn worth of FX purchases were made as Russia adjusted to the global financial crisis in late 2008, most notably with the staged ruble devaluation from October 2008 to February 2009, until volatility again drove Russian forex risk concerns at the start of this year. That certainly adds to this year’s capital outflows headline, but suggests that the volume is likely to return to Roubles over the longer term, provided tensions subside. 

Corporate outflows: FDI ‘Round Tripping’ Portfolios & trade loans

Divining corporate outflows involves coming to grips with FDI, Portfolio flows, trade loans, and non-bank financial sector balances. Teasing them out requires familiarity with the ‘Round Tripping’ of Russian corporate funds, which access offshore jurisdictions for tax minimisation purposes, as well as better property rights protections for structuring M&A deals and financing flows.

With FDI the key channel for ‘Round Tripping’ Russian funds, as much as half of Russia’s ‘inbound’ FDI is believed to originate from Russia, directly driving Russia’s negative Net FDI position. Adding to the murkiness is the 40% of total FDI flows believed to be reinvested investor earnings, and the 25% of FDI taking the form of credit lines from parent companies, as shareholders use loans to bypass earnings taxes – marking them as FDI rather than loans for balance of payment statistics. 

Navigating through this, Miller and Shal derive a net ‘greenfield’ investment figure significantly smaller than reported FDI, which has been constantly negative, and reached -$16bn in 2013, though it partly reflects increased Russian outbound FDI.  Their key point regarding FDI is that negative net real figures have little material impact, and are likely to be offset by smaller Russian outbound FDI figures too.

Portfolio flows see ample evidence of outflows from Russia-dedicated equity funds between 2011 and 2014, and the Central Bank of Russia reported portfolio inflows into Russia’s equity markets at -$9.8bn, $1.2bn and -$7.6bn in 2011, 2012 and 2013 respectively.  Russia’s international investment position showed the stock of foreign portfolio equity investments was $162bn at the end of 2012, with the current stock estimated between $120bn-140bn and further outflows considered likely, despite cheap current valuations.

Financing trade sees Russia’s foreign trade structure predisposing a negative trade loans balance, with commodity exports not generally requiring advance payment, unlike much of Russia’s imports.  The net new trade loan position was -$10bn in 2012 and -$8.7bn in 2013, with the only recent net positive position occurring in 2009, when imports collapsed (as may happen again in the wake of sanctions). Russia’s non-bank financial companies also extended $5.3bn and $4.4bn in new loans in 2012 and 2013, as well as another $3.0bn and $4.6bn in ‘other accounts receivable’.

Corporate sector external borrowing grew from $282bn to $435bn between 2008 and the end of 2013. Those raw figures are, as with FDI, clouded by related party transactions which are believed to comprise the bulk of RUB external debt, or 20-30% of total corporate debt in 2008-2013. Miller and Shal excluded all RUB obligations, except publicly traded RUB Eurobonds, to derive a ‘third party’ external corporate debt figure, which increased by $89bn between 2009 and 2013, of which $33bn was eurobond issuance and under $2bn trade loans, with the rest considered syndicated or bilateral loans. The Central Bank of Russia reports corporate maturities at $46bn in second half of 2014 and $54bn in 2015.  With the Ukraine crisis pushing a domestic focus, febrile investor confidence, and weak Russian economic growth, Russian foreign corporate debt growth is expected to slow, with Russian banks having abundant FX liquidity.

The banks - The outside role in the system

The most surprising revelation of Miller and Shal’s work is that Russia’s banks – with 60% of the system state owned – are a massive source of the outflow, and that the Russian banking system has evolved in a distinctive manner which sees it with high levels of dollarization leading to very large international asset bases, and consequently a capital outflow.

Accounting for a 2008 - first quarter 2014 net outflow of $103bn, banks rank second to ‘Fictitious transactions’ as the largest driver of Russia’s capital outflow. Representing the extent to which Russia’s banks acquired more offshore assets than internationally raised funds, these assets increased from $93bn at year end 2007 to $292bn at the end of first quarter 2014, with $170bn estimated to be relatively liquid. Currently the international assets of Russian banks, generally comprising offshore interbank accounts, loans, bonds and other securities, exceed their total external debt by $81bn.

The Central Bank of Russia, although not disclosing loan volumes to non-financial companies, recorded 'long-term loans’ at $58bn, ‘long-term deposits’ (which may include both interbank and corporate exposures) at $43bn and ‘direct capital investments’ at $13bn at the end of 2013, as well as ‘other receivables’ of $10bn.  Miller and Shal deducted these, on quality and maturity grounds, to come to a commercial banks FX reserves estimate of about $150bn.  They then added $19bn in foreign assets purchased during first quarter 2014, which they presume would be quite liquid, to arrive at a liquid foreign assets estimate of about $170bn at the end of first quarter 2014, and rightly note that the ‘outflow’ is essentially an accumulation of reserves outside the Central Bank of Russia’s balance sheet.

This, concentration of liquid foreign assets, usually overlooked in conventional analysis, represents a very distinctive X-factor, about the Russian banking system, and is particularly unusual for a nation not a major global financial centre.  It stems from the liability dollarization of Russian banks, which became embedded in Russia’s economic chaos of the 1990s but remains high to this day, with 24% of bank liabilities denominated in foreign currencies at the end of 2014, though with increased FX liabilities, while domestic FX assets have barely changed as consumer lending has become the focus.  Miller and Shal believe that banks don’t want to run a short on-balance sheet FX position, necessitating more FX assets than liabilities, with off-balance sheet hedging unlikely to appeal on a large enough scale, and that the gap between FX liabilities and domestic FX assets driving demand for foreign assets.

The official statistics treat the banks’ FX reserves accumulation as part of the capital flight. But almost no other major highly-dollarized banking system in the emerging markets holds such foreign liquid assets against its FX liabilities, and this, explained by operational and regulatory factors, but not fundamental economic reasons, makes Russian banks particularly distinctive. As a comparison, whereas Chinese banks have about 1.3% of their total assets invested internationally, the same figure for the Russian system is up to 17%.  With more than 60% of Russia’s banking sector government controlled the liquid foreign assets of Russia’s banks begin to look more like the Central Bank of Russia’s FX reserves.

The implications – for Russia and beyond

The major implication of the findings of the Miller and Shal analysis is that the Russian financial system is likely to prove more robust than had hitherto been anticipated, even in the wake of the current sanctions, if for no other reason than that the Russian government and financial regulatory authorities in Moscow have scope for significantly reducing the capital outflow – if they feel the need to. 

Certainly the behaviour of banks is subject to considerable regulatory oversight already, and the state could regulate, or provide incentives, such as risk weightings, for banks to retain greater FX assets in Russia, or reduce the motivation to move funds offshore, and the same is true for licensed asset managers.  The size and liquidity of the funds available to Russia’s banks offshore, however, suggests that the offshore nature of those assets is integral to the system, and not a threat to it.

The ‘Round tripping’ of FDI reflects doubts about Russia’s investment climate and the legal protections afforded contracting parties.  When so many corporate contracts inside Russia mandate dispute resolution in London and Stockholm rather than risk a similar approach under the Russian legal system, those in power should be noting the urge to do so and relating the resultant capital impact.     

But by far the biggest single component of the capital outflow is the role played by ‘Fictitious transactions’.  This requires the will of Russia’s regulatory authorities and lawmakers to address corruption, and the preparedness of financial authorities, in particular, to identify the leakage of capital involved and subsequently address it.  That political will to seems to have arrived in the form of Elvira Nabiullina at the Central Bank of Russia, and the number of banking licences it has revoked since mid-2012, and the corresponding reduction in ‘Fictitious transaction’ flows out of the country.

However none of this is to suggest that Russia take the capital outflow lightly.  The system and the corporate behaviours and the regulatory framework which have evolved in such a way as to promote the capital outflow, have done so in an era of major current account surpluses, almost solely on the back of oil.  Those current account surpluses have diminished from more than 10% of GDP less than 10 years ago to little more than 1% now, with the widespread expectation Russia may soon be confronting its first current account deficit in a generation. Whereas once Russia could fund massive capital outflows with larger current account surpluses, it can do so no more.  In the short term, the capital borrowings which have also played a part in funding a capital outflow are not as plausible now, and the reliance on oil as the national generator of revenues is under pressure with global prices dropping right as geopolitical concerns about Russia mount.  The Russian economy is soft, and weakening, and as has been said for more than a decade the key to economic reform and unlocking Russia’s economic potential beyond resources is investment.  If the money within Russia flows out in such volumes it provides no lead for international investors.

Finally, the significance of Russia’s capital outflow should be considered for its impact beyond Russia.  Russia’s largest trading partner, the EU, is again fending off a slide into recession, with the ECB expected to resume purchases of asset-backed securities and large-scale quantitative easing, despite the Eurozone ostensibly being the destination for considerable capital outflows from Russia.  At the same time the sanctions imposed by both the EU and Russia will aggravate weak demand on both sides, with a number of European sovereign balance sheets considerably weaker than that of Russia, and with the financial sanctions designed to limit Russian access to capital markets potentially restricting Russian capital flows to them.

Russia’s banking institutions and financial system remain poorly understood, and its links with the global financial system all too often shrouded, even by the standards of bankers.  The magnitude of Russia’s capital outflow is such that Russia, and beyond, needs to start addressing its causes and consequences, and turning it into an opportunity.