Russian OFZs are an Emerging Markets investor's safe haven

Russian OFZs are an Emerging Markets investor's safe haven
Foreign investor inflows into Russia's OFZ domestic treasury bills in April were strong enough to completely offset the devaluation effect of tumbling oil prices / bne IntelliNews
By Ben Aris in Berlin May 22, 2020

Russia has emerged as a safe haven for investors during the coronavirus (COVID-19) pandemic that has rocked capital markets around the world, according to a paper from the Institute of International Finance (IIF).

The Russian stock market sold off heavily at the end of February as the anticipation of the double whammy of an oil price shock and the impending pandemic became apparent. But while the leading dollar-denominated Russia Trading System (RTS) index remains down by a third from the start of the year, some investors are cautiously starting to cherry-pick among the blue chip names and position themselves for the inevitable recovery.

But it is Russia’s domestic bond market that is the most attractive asset and investment inflows by foreign investors were strong enough to entirely offset the devaluation pressure on the ruble from tumbling oil prices in April, according to research from Nordea bank’s Moscow-based research department.

The Russian Ministry of Finance ruble-denominated OFZ treasury bills have been a magnet for international bond traders looking for safety-plus-returns in the last few years and after a short sell-off in March they are back in fashion, as central banks everywhere slash interest rates to zero again.

“Given the scale of the current crisis, [the] YTD increase in Russia's country risk premium looks very decent compared to other EMs,” Tatiana Evdokimova tweeted, the chief economist and EM coverage expert at Nordea, along with a chart that shows the small rise in credit default swaps for leading emerging markets.


With its entire external and public debt covered dollar-for-dollar with cash, coupled with the relatively high yields Russia’s fixed income instruments pay, foreign investors have been parking their cash in this workhorse-bond for the Russian Ministry of Finance.

As bne IntelliNews reported, the Russian finance ministry broke yet another record with the placement of OFZ bonds at this week’s auctions, selling RUB170bn ($2.4bn) worth of federal bonds in three issues against a total demand of over RUB230bn ($3.2bn) this week.

April did see a mild sell-off of about RUB300bn worth of bonds, reducing the share of OFZs held by foreigners to about 31% from a peak of c.34.5% a year ago, but the market has already stabilised and investors are returning, as their choices, if they want to make some money, are limited.

Russia has taken a heavy blow from the double-headed crisis of an oil price shock and the stop-shock related to the lockdowns that went into effect on March 30.

But it is also one of the best prepared countries in the world to cope with a large shock, as it has been anticipating the imposition of new harsh sanctions by the US for more than five years, which would have also been a shock to the economy. Russian President Vladimir Putin's efforts to build a “fiscal fortress” to cope with a potential US economic attack were already complete at the start of this year, and while the US didn't follow through on threats to try to punish Russia, the country was conveniently shock-proof ready by the time the oil prices collapsed and the virus arrived in Moscow in March.

Russia’s economy won’t escape unscathed and the nominal GDP shrunk an eye-watering 28% in nominal terms (20% in real terms) in April, but the IMF predicts that there will be a rebound in the second half of this year before modest growth returns at the start of next year.

IIF initially predicted a 1% contraction this year, but recently revised its growth forecast for 2020 down further and now projects a contraction of 5.9%, with large drags from investment (-3.1pp), private consumption (-2.0pp) and net exports (-1.1pp).

Macro performance peer review

“Russian assets have performed well in recent weeks — the country is perceived as somewhat of a “safe haven” — and investors appear to be returning after the sell-off across the EM universe earlier in the year,” Elina Ribakova, deputy chief economist with the Institute of International Finance (IIF), and her colleague Benjamin Hilgenstock said in a note published on May 20.

“As we flagged in our White Paper on sanctions, Russia is well-prepared to weather external financing shocks due to substantial macro buffers, including reserves. However, growth is likely to contract sharply in 2020, and the government’s approval ratings are at 2013 lows,” Ribakova said, adding that with the US elections looming and US President Donald Trump’s total failure to cope with the pandemic Congress could well put Russian sanctions back on the table as it searches for distracting scapegoats.

Russia’s huge cash pile of c.$570bn is reassurance for investors, but so is the Kremlin’s extreme caution, which ensures that money won’t be squandered.

While other governments have rushed out anything between 5% to 20% of GDP fiscal stimulus plans, Moscow has been extremely reticent to spend anything and run down its reserves. as the Kremlin always has its eye on the next crisis – especially as the threat of new sanctions not only remains real, but would become more likely if Russia weakened itself by spending down its cash hoard.

Another factor that is appealing to investors has been several major policy changes in recent years that benefit investors. The first is the government’s decision to tap the cash in its biggest and most profitable companies not by taxing them, but by forcing them to pay dividends. While the state maintains a controlling majority in its blue chip stars, including the likes of Sberbank, Gazprom and Rosneft, all of these companies have significant minority shareholders, including foreign investors. The Ministry of Finance has been on a campaign during the last few years to force all the state-owned enterprises (SOEs) to pay out 50% of their income as dividends and despite determined resistance by some of the most powerful men in the country, MinFin had largely won the battle.

The second big change has been fact that thanks to very prudent management of the economy the Central Bank of Russia (CBR) is for the first time in a position to cut interest rates to try to stimulate growth. The CBR aggressively lopped 50bp over the prime rate to bring it down to 5.5% in April and is expected to cut again at the June meeting by up to 50bp. Despite the 19% devaluation of the ruble in March, inflation in April has fallen to zero, dragged down by the concurrent collapse in demand after everyone was locked up at home.

That stands in stark contrast to 2014, during the last oil price shock, when the central bank was forced to hike interest rates by a massive 17% to stop the currency melting down. This time round the ruble has been surprising resilient to the collapse of oil prices and lost only 19% of its value to the dollar YTD against a fall of 56% in oil prices, as bne IntelliNews reported in “Russia’s amazing levitating ruble.”

“We expect the Central Bank of Russia to cut the key rate by another 100bp to 4.5% by the end of 2020, with inflation just below the 4% target. As the ruble has stabilised around RUB70-75 per dollar, we believe that FX interventions will decline in coming weeks. Since mid-March, authorities have sold FX to the tune of RUB600bn (slightly more than $8bn),” Ribakova said.

CBR keeping its powder dry

The surprisingly strong performance of the ruble is another plus for the potential investor. In the 2014 crisis the ruble’s value collapsed from c.RUB35 to the dollar to c.RUB80 in the space of a month. This time round the currency has held up remarkably well, sliding a bit more than RUB15 to the dollar to touch on RUB80 to the dollar again, but this time round starting off from RUB62 to the dollar in February.

The CBR has been intervening in the FX market, but according to the latest research the value of the ruble has also been boosted by strong inflows into the OFZ market from foreign investors.

The CBR pumped some RUB600bn into the FX markets in April and May to hold up ruble but the latest data shows that it is already reducing its interventions as the market stabilises.

But the real surprise is that very strong inflows into the OFZ market during April have played a big role in keeping the value of the ruble up against the dollar and in the worst week completely offset the fall of oil prices to leave the month-on-month change in the ruble’s value flat. The inflows into OFZ are also more important than the brightening mood of EM investors as the epidemic starts to abate.

“Our model shows that current RUB appreciation is not driven by the EM sentiment improvement. The demand for Russian bonds helped the RUB to come around in April after corona sell-off in March. Now oil price is coming to the fore,” Grigory Zhirnov, an economist with Nordea, tweeted.

In addition to only making modest interventions in the money markets, CBR governor Elvira Nabiullina has also said the regulator will avoid engaging in quantitative easing.

The rational is the same: the CBR doesn't want to burn through its precious reserves by buying any sort of asset whatsoever. However, ever the pragmatist the central bank has started to offer long-term repos terms to help banks with their increasing maturity mismatch, according to IIF.

Bank liquidity remains good for the meantime and there is little chance of the corona-crisis sparking a financial crisis in Russia. Banks only hold about 4% of their capital as OFZs, so there is plenty of room for the Ministry of Finance to issue more and tap that liquidity pool if needed. Indeed, the budget calls for some RUB2 trillion of OFZ issuances this year (and $4bn on international capital markets) but MinFin has already said it will probably double that amount.

Russia’s modest fiscal stimulus programme will almost certainly be expanded and it is unlikely the government will tap the National Welfare Fund (NWF) for more investment capital, which currently holds RUB9 trillion of cash, or 9% of GDP. That means the obvious place to fund any extra spending will be via OFZ issuances.

“The government announced a total of 6.5% of GDP in measures. However, we only count some as direct stimulus, since these measures also include deferred tax payments, reallocation of spending and loan guarantees,” Ribakova said. “We estimate that direct stimulus measures amount to roughly RUB1.85 trillion (or 1.3% of GDP). Furthermore, we expect additional measures to be announced going forward due to the dramatic growth collapse and declining popularity of the government — possibly for a total of RUB2.5 trillion.”