An updated version of this article has been published on BNE IntelliNews
Since March 2018 the percentage of OFZ’s owned by foreigners has dropped precipitously and consistently. At its peak one year ago, non-resident share of Russian local debt was ~RUB2.35B (~USD 36M), whereas the most recent data(from Feb 1, 2019) has it at ~RUB1.70B (~USD26M). The sell-off by large institutional investors, such as Eaton Vance, Ashmore, and Morgan Stanley, has contributed to the sizable drop in foreign ownership. Many point to the increasing possibility of US sanctions targeting Russian government bonds as one of the reasons behind the foreign bearish sentiment.
A dovish Fed has fueled investment into emerging markets and Russia in particular throughout 2019, despite geopolitical uncertainty and sanction headwinds. According to Bloomberg Barclays indices, Russian ruble-denominated sovereign bonds are up 7.5% YTD while the ruble has returned 5.6% YTD. In fact, OFZ auctions on March 13 sold RUB91.44B of sovereign bonds, the largest amount issued in recent years, at a 3 year coupon of 8.02% and 10 year coupon of 8.47%. Nonetheless, foreign investment still remains low relative to recent months.
In equities, the iShares MSCI Russia ETF (ERUS) is up 9.58% in 2019, beating the iShares MSCI EM (EEM) benchmark which has returned 8.91%. Strong yearly gains are in part a recovery from an abysmal 4Q2018 for emerging markets, but it seems as if the strong performance in Russia is not merely a relief rally. High demand for Russian securities has been supported by an increasingly insulated domestic economy and a conservative fiscal structure. Further, investment has rallied behind strong crude performance, which is up 26% YTD, as well as recently implemented pension reform.
Economic growth is still weak – GDP rose 1.8% in 2018, and will likely decelerate to 1.5% in 2019 in the face of higher domestic interest rates and VAT hikes. However, Russia is not at the end of the business cycle; interest rates were raised in late 2018 for the first time since 2014 in a response to rising inflation. The CBR expects inflation to peak at 5.5% in 2019, before returning to 4% in 2020. Interest rates will likely be eased in late 2019, reestablishing the CBR’s accommodative stance. Peaking inflation and a vocally dovish central bank will likely continue to drive demand for OFZ’s in the short to medium term.
The main concern of foreign OFZ holders is that US sanctions will either limit secondary trading markets (mirroring the impact of the sanctions imposed on Venezuela in early February) or prohibit owning the bonds altogether. Just after the Venezuelan sanctions were imposed, global secondary trading of Venezuelan sovereign debt grinded to halt — the high concentration of trading within the US greatly complicated the buying and selling of Venezuelan debt on a global scale, leaving investors trapped.
Events like the one just witnessed in Venezuela and the one investors are apprehensive about vis-a-vis Russia are exogenous and unknowable. But Venezuela and Russia are not the same. Washington’s motivation behind sanctioning PDVSA and Caracas’s sovereign debt was to squeeze the oxygen out of the Maduro regime to enforce regime change. No one can reasonably expect the sanctioning of OFZ’s to lead to any major change in behavior from Moscow.
Limitations on American engagement with Russian debt will undoubtedly impact liquidity, sovereign yields, and the ruble. But the CBR’s high foreign reserves and low outstanding debt will mute the impact of possible sanctions. In fact, American OFZ holders will bear the brunt of any such penalties. Of course politically motivated ploys against Russia are possible, but the underlying cause and effect behind any such sanction simply does not add up. The bottom line, however, is that Venezuela and Russia are not facing remotely similar situations, so inducting that the Venezuelan sanctions mean that sanctions are coming to Russian OFZs is a bankrupt argument.
Losing capital and passing up on opportunities are the fundamental risks investors face. The Russian OFZ market has had a cloud of sanctions hanging over it, leading to many calling the bonds “unanalyzable.” However, the domestic economic picture, albeit slower than some had hoped for, remains fundamentally sound. Making investment decisions—whether divesting or choosing not to purchase certain securities—based on exogenous events is speculative and imprudent. Since the sanctions are unknowable and unpredictable, any decision—whether to sell, buy, hold, or not buy OFZ’s—is a bet in itself. Therefore, the potential for sanctions (or lack thereof) should not deter investors on its own.