Monday 6 October 2014 8:41 pm

Russia optimists are making an increasingly implausible case

A potential economic outcast is a bad place to invest money.
Russia's economy has taken a battering this year. The conflict in Ukraine and the subsequent sanctions tit-for-tat with the West has delivered an enormous blow to confidence, with some of the country’s largest companies now all but locked out of dollar debt refinancing markets. Falling commodity prices (the Brent crude benchmark has dropped by around 10 per cent since early September) have dented the profitability of some of these firms, and raised concerns over the government’s fiscal position – its reported “breakeven” price is well above $110 per barrel of oil, compared to current prices of just over $90. 
Against this backdrop, the rouble has almost relentlessly fallen, reaching an all-time low versus the dollar yesterday (see graph below), and few expect the economy to post meaningful annual growth. How, then, is it possible to argue that now might be a good time to invest? 


The Russia optimists’ central point is that the country’s stocks are currently extremely cheap – relative to Russian stocks in the past, but also compared to seemingly overstretched valuations on other global equity markets. Tucker Scott, a portfolio manager and executive vice president at US fund giant Franklin Templeton, has been a leading proponent of the idea. “With the Russian stock market trading at a discount to book value – it traded at 0.6 times book value early this year – we believe now may be a fair time to revisit investing in Russian equities,” he wrote in a blog post on 22 September. 
In some cases, he argues, Russian stocks have been so heavily discounted as a result of the Ukraine crisis that they’re no longer falling in reaction to subsequent geopolitical developments. The habit of Russian companies paying hefty dividends in recent years only sweetens the investment case. In fact, there are currently 11 stocks on the Micex index with dividend yields above 6 per cent, compared to six on the FTSE 100 and none on the Dow Jones, according data from the TopYields website yesterday. 
And relative to other emerging markets, Russia looks even more inviting. The valuation gap between Russian and emerging equities, based on forward earnings and book value, is the widest on record, according to recent data from Thomson Reuters. 


It’s a compelling argument, but one that glosses over a number of crucial moving parts. The first is currency. The rouble’s recent slide, according to Saxo Bank’s head of FX strategy John Hardy, is unlikely to let up soon, effectively ruining the value of rouble-denominated investments (and dividends). The currency’s fall is being driven by a number of factors, including wider fears of declining global liquidity, with the Fed expected to complete the wind-down of QE this month (remember the last emerging market currency meltdown as tapering kicked off?). 
And with firms locked out of dollar debt refinancing markets, many are reportedly selling the rouble on local markets in exchange for dollars – weakening the currency further. Capital flight, meanwhile, is now so acute that Vladimir Putin was yesterday forced to deny that capital controls are being considered to stem the flow. “It is difficult to discern what can relieve the pressure on the Russian rouble versus the dollar,” says Hardy, aside from detente with the West or a weakening of the dollar against all major currencies. And as long as the rouble keeps falling, it’s likely to outweigh the potential gains from “cheap” Russian markets. 


But even if foreign exchange risk is forgotten, the legacy of a decade of poor supply-side policy will continue to bite, argues Capital Economics’s Neil Shearing. “Russia is cheap for a reason,” he says. “And to an extent, the economic fallout from the Ukraine crisis is a smokescreen.” The country’s energy-led growth model seems to be running out steam, and this was evident long before the annexation of Crimea in March this year. GDP growth dropped from 3.4 per cent in 2012 to just 1.3 per cent in 2013. A long-term failure to invest and help drive productivity growth, alongside serious concerns over a corrupt administration, make it difficult to see a growth revival in the near future, says Shearing. 
Could things get substantially worse for the Russian economy? It largely depends on how the government reacts to deteriorating relations with the West. Despite Putin’s protestations that Russia will remain an “open economy”, many have doubts. Andrey Kostin, chairman and chief executive of VTB (one of Russia’s largest banks), recently said: “The basic issue now is whether the Russian leadership, under the circumstances, will switch to the model of a mobilisation economy, and introduce the old mechanism of currency control, or stay on the principle of their open market economy.” 
Prime Minister Dmitry Medvedev has explictly denied that a strategy of Soviet-style “mobilisation economics” is on the cards, arguing that the “gaps” in the country’s economy left by a sanctions war with the West could quickly be filled by a mix of domestic producers and businesses from Latin America and Asia-Pacific. Others aren’t so sure. The isolationist route – relying on domestic producers to fill the void left by declining trade with the West – would require plenty of spare capacity in the economy. But Shearing says the signs are that it is running close to full capacity, and wouldn’t be able to pick up production to meet demand. “In theory, you could choke-off imports and pursue an isolationist strategy, but that would require a degree of slack that Russia lacks,” he says. And as for the pivot to the East, Russia’s relations with nations like China relate mostly to energy, and wouldn’t involve the investment in manufacturing that Russia lacks. The likely outcome is years of stagnation, concludes Shearing. 
Some of the problems facing Russia are common to most middle-income countries. It needs to diversify its gas and oil economy and modernise by encouraging international trade and investment in other sectors. Instead, it’s in danger of turning inwards at a time when it’s most in need of foreign capital and investment.