Peter Szopo of Erste Asset Management -

Russia’s economy is under pressure, the most salient sign of this being the decline of the ruble.

The Russian currency lost nearly 26% of its value against the dollar over the past 12 months (to mid-October). To some degree, the ruble’s devaluation reflects the general strength of the US currency, which gained almost 7% over the same period on the back of the US Federal Reserve’s switch to a tightening bias and the robust economic data flow (which only suffered temporarily from seasonal effects in the first quarter). In fact, the Russian currency was already weakening at the beginning of 2013, but last year it still moved mostly in line with other emerging market (EM) currencies against the dollar. Since the beginning of 2014, however, the ruble also has decoupled from its EM peers, losing 17% relative to a GDP-weighted currency index covering 23 emerging markets (see chart 1).

Current macroeconomic imbalances alone do not explain the ruble’s slide. In 2014, Russia’s combined current account and budget surplus is expected to exceed 3% of GDP. The country is in a completely different situation compared to other ‘fragile’ economies – originally there were five, but the number seems growing – which have been characterised by a combination of massive current account and budget deficits, high debt and/or significant refinancing requirements (see chart 2; note that Ukraine and Argentina, whose currencies devalued by around 60% since May 2013, are not shown in the chart because the data points would fall off the page).

Of course, the coincidence of the ruble’s decline with the unfolding of the Ukraine crisis suggests some causality. The West’s sanctions are restricting the access of Russian banks and other entities to international capital markets as well as foreign investment in the country. A negative impact on the currency is to be expected and sanctions are certainly part of the story of why the ruble is heading south. 

However, even if US monetary policy and geopolitical factors have depressed Russia’s currency, the picture remains incomplete without taking into account the key factor driving Russia’s currency: the oil price. After trading for more than three years mostly in a stable range of $105-115 per barrel, the price of Brent dropped $30 per barrel since the end of the third quarter, and is now at the lowest level since December 2010. The ruble’s latest leg down (-20% since June 30) was clearly triggered by the collapse in crude prices (chart 3).

In an effort to untangle the various drivers of the RUB/USD-rate, we estimated a regression based on monthly returns from January 2010 to December 2013, using the parameters of the regression to forecast the theoretical forex rate changes for the first ten months of 2014. The deviation between the actual and the estimated devaluation, ie. ruble movements that are not explained by the usual fundamentals factors, are likely related to the Ukraine crisis and its fallout. As explanatory variables we used in various combinations the Brent spot price (or one-month futures), the S&P industrial metals index, VIX, the gold spot price and our own proprietary EM currency index. 

The outcome of this analysis (chart 4) suggests that based on this year’s trends in oil and industrial metal prices as well as considering the performance of EM currencies and the risk backdrop (VIX), the ruble should have devalued by about 11% year-to-date. In the first half of the year, oil was stable and industrial metals, after a moderate decline, even rebounded in the second quarter. According to the model, the ruble should trade at rate of 36.4 to the US dollar, while in fact it is trading close to 41 (mid-October), implying a devaluation of 24% – more than twice as big as what can be explained by the performance of the "usual suspects" like oil.

In other words, there is clear evidence that the ruble is overshooting. This is nothing rare in currency markets, and is usually seen as consequence of different degrees of price flexibility in the real and the financial sectors of the economy. In the ruble’s present case the excessive devaluation is more likely the result of the Ukraine crisis. The impact of sanctions and counter-sanctions, capital outflows, rumours (even if false) of more bad things to come like capital controls, and speculation about how the Russian economy will evolve over the longer term are fuelling traders and investors’ expectations. In addition, the Russian Central Bank has changed its approach and has allowed a higher degree of currency flexibility than during previous periods of turmoil.  

The flipside of the argument above is that any signs of a lasting de-escalation in Ukraine will likely trigger a rebound in the ruble. As long as sanctions stay in place – and there are strong reasons not to expect a reversal anytime soon – the ruble’s upside is limited. However, an appreciation of around 10% before year-end in response to positive signals from the geopolitical front is realistic in my view.

Of course, the usual caveat of "all other things staying equal" applies. Unfortunately, they rarely do stay equal. Arguably, the biggest uncertainty presently is oil. While crude prices seem to approach both break-even points of dollar shale-producers and fiscal break-even points of producers in the Middle East, nobody knows how much further the oil price will drop. $70 per barrel is in reach, which – in the current environment – could push the ruble easily down to 43-44 against the dollar. Thus, even seeing the ruble overshooting does not imply that the pressure will evaporate anytime soon.