Research Rouble risk: more about the oil price than the geopolitics

Investment General Market Conditions 13 November 2014 Rouble risk: more about the oil price than the geopolitics The Russian central bank (CBR) has allowed the rouble to float increasingly freely since 2008-09 in a widening trading range. This week the CBR allowed the rouble to float freely. We take a close look at this new regime and the impact on the rouble. We believe that, given the close relationship between the oil price and the Real Effective Exchange Rate for the rouble, the sharp fall in the oil price over the past few months has been a major factor behind the (renewed) rouble sell-off, in both real and nominal terms. The rouble has sold off heavily and the question is whether the sell-off can go even further or if we are close to a buying opportunity. We think that the rouble is getting cheaper but is not yet undervalued. Given our view that the oil price is likely to bottom in coming months and will start to recover in line with a continued pickup in global growth in 2015, we believe the rouble is likely to get increasing support from a higher oil price throughout 2015. This should help reduce the pressure on the rouble in the medium term. Our new USD/RUB forecasts are therefore 49, 51 and 51 on three-, six- and 12- month horizons, respectively. Overall, this is slightly more negative than forwards on a three- to six-month horizon and fairly neutral on a 12-month horizon. Letting it float From a market perspective, the big news out of Moscow this week is not about the renewed escalation of military fighting in eastern Ukraine but rather about Russian monetary and exchange rate policy. Hence, on Monday, the CBR under the leadership of Elvira Nabiullina effectively let the rouble float freely. The CBR has allowed the rouble to float increasingly freely since 2008-09 in a widening trading range. The Ukrainian crisis, negative emerging market sentiment and the falling oil price have put the rouble under significant weakening pressure for most of the year. Although the CBR has generally allowed for a significant weakening of the Russian currency, it has also tried to slow the rouble s descent by raising interest rates and intervening in the FX market. However, it has become increasingly clear that the cost of the defence of the rouble was not worth the fight. Therefore, on Monday, the CBR announced that it would effectively float the rouble. Here, we take a close look at the outlook for the rouble in this new regime and present our new forecasts taking the latest news and regime change into account. Chief Analyst Lars Christensen +46 8 568 805 92 larch@danskebank.dk Economist Vladimir Miklashevsky +358 10 546 7522 vlmi@danskebank.com Senior Analyst Morten Helt +45 45 12 85 18 mohel@danskebank.dk Analyst Kristoffer Lomholt +45 4513 7867 klom@danskebank.dk Analyst Stanislava Pravdová-Nielsen +45 45 12 80 71 spra@danskebank.dk Important disclosures and certifications are contained from page 8 of this report. www.danskeresearch.com

Rouble getting cheaper but not undervalued The sharp sell-off in the rouble over the past year has been attributed to the serious deterioration in the geopolitical situation in relation to the Ukrainian crisis. However, it might be useful in terms of understanding the development of the rouble to take a step back and look at more fundamental factors to understand the underlining drivers of the weakness over the past one to two years Therefore, we have estimated a relatively simple model for the Real Effective Exchange Rate (REER) for the rouble. We have tested numerous variables to explain the development in the rouble REER since 2000. However, it turns out that many variables actually explain the rouble development quite well. Unsurprisingly, the oil price has a very significant explanatory power in terms of the rouble REER. Hence, the pre-2008 appreciation of this can be explained largely by the continued rise in oil prices during this period. Similarly, the sharp REER depreciation in 2008 can be explained largely by the fall in the oil price in H2 08. Similarly, the rouble recovery in 2009 can be explained by the rising oil price. Finally, the flat lining of the rouble REER since 2010-11 has coincided with a moderate fall in the oil price in recent years. The chart below illustrates the close relationship between the REER and the oil price. Chart 1. REER vs oil price Source: Macrobond Financial, Danske Bank Markets Given the very close relationship between the oil price and the Russian REER, it is hard not to think that the sharp fall in the oil price in the past few months has been a major factor behind the (renewed) rouble sell-off in recent weeks and months, in both real and nominal terms. The other important variable in our model is what we have termed the Russian risk premium. We have measured this by the relative performance in the Russian and the US stock markets (measured in the same currency). We believe this variable overall captures changes in the markets perception of Russian risk, for example, associated with rising (geo)political uncertainty but also, for example, banking and public finance concerns. Chart 2. Predicted vs actual REER Source. Macrobond Financial, Danske Bank Markets 2 13 November 2014 www.danskeresearch.com

Chart 2 to the right shows the predicted REER compared with the actual REER. It is clear that the model fits the actual development in REER quite well. Furthermore, even though the model prediction of REER has been slightly less bearish than the actual development over the past year, predicted development in Russian REER fits the actual development fairly well and the model does not indicate that there should be any major misalignment of the rouble REER. Furthermore, we note that our REER model indicates that it is the development in the oil price rather than the Russian risk that has been a driver of the rouble REER recently. Indeed, we would argue that geopolitical risk has had little impact on the changes in the rouble REER over the past couple of months, while it was probably the key driver in the spring and early summer. Particularly given the level of the oil price, overall we can conclude that the rouble (in real terms) is trading fairly close to fair value levels. However, we note also that this is not the same as the nominal rouble remaining unchanged over time. Indeed, it follows from our analysis that higher Russian inflation than in the outside world should lead to a weaker nominal rouble rate to ensure an unchanged real exchange rate. Furthermore, higher or lower prices will change the fair value level for the rouble in both real and nominal terms. As a rule of thumb, our model indicates that a 10% fall in the oil price will weaken the rouble by 1.5% in real terms. However, the relationship between the oil price and rouble rate is not necessarily completely linear. The indication is that once the oil price falls below the USD60-80/bl range, the impact on the real effective rouble rate becomes somewhat greater. Changing the monetary transmission mechanism Until 2008, the CBR essentially operated a pegged exchange rate regime but since then it has gradually allowed for an increasingly freely floating exchange rate. However, the CBR has continued to intervene with the more or less official purpose of stabilising the swings in the rouble. The chart below illustrates this. Chart 3. USD/RUB level and level of weekly FX reserves since 2009 Source. Macrobond Financial, Danske Bank Markets 3 13 November 2014 www.danskeresearch.com

The chart shows that since 2009 there has been a fairly high correlation between the USD/RUB rate and the change in the Russian foreign currency reserve. When the rouble has strengthened (weakened), there has been a tendency for the FX currency to increase (decrease). This is a fairly strong indication that the CBR has followed a lean-againstthe-wind exchange rate policy to smoothen the movement in the rouble. However, it looks ast hough it has now given up on this policy at least that should be the case if the CBR is doing what it has announced it will do. This would also mean that it is effectively changing the monetary transmission mechanism. Hence, under a regime of a pegged rouble rate or a lean-against-the-wind exchange rate, regime changes in the oil price (the primary driver of the currency under normal circumstances) will have an impact on monetary conditions through changes to the FX reserves and therefore on the money base. However, if the rouble is allowed to float completely freely, this link would be disconnected. This effectively means that a change in the oil price would have a significantly bigger impact on the nominal exchange rate. We believe this is exactly what has happened in recent weeks. Hence, as the CBR has backed off from intervening in the FX market, the pass-through from oil prices to the FX rate has increased sharply. This also means that what could look like exchange rate overshooting is not necessarily that. In this sense, what we have seen in recent weeks is similar to what we would see during a regular currency crisis when a central bank gives up defending a fixed exchange rate. First, the impact of the currency pressure is seen in a sharp fall in the FX reserve and once the defence is given up, the currency falls but the FX reserve stabilises. For the same reason, there is no reason necessarily to expect a major rebound in the rouble just because it has sold off. If anything, that recovery might first be visible in a stabilisation of the FX reserve. This is what happened in 2008-09 after the CBR had given up defending the (harder) peg and the rouble fell sharply. The rouble only started to recover once the oil price rallied in the spring of 2009. At that time, the CBR used the opportunity to rebuild its FX reserve. Under a purely floating exchange rate regime, this would not necessarily happen again but some intervention would be likely to happen if the sentiment turned positive for the rouble. This also means that there is likely to be some asymmetry between the impact of a rising and falling oil price on the rouble. A falling oil price under the new regime would be likely to be allowed to have a fairly large and direct impact on the rouble, while a recovery in the oil price would be used by the CBR to rebuild partly its FX reserve. Recession deepens: stagflation or deflation? Economic growth in Russia has slowed further, posting 0.8% y/y growth in Q2 14 versus 0.9% y/y in Q1 14. We forecast Q3 14 to show 0.2% y/y growth in GDP. Our 2014 GDP forecast remains -0.3% y/y due to a surge in geopolitical risks, which have introduced both supply- and demand-side shocks. Yet, in October, consensus for 2014 GDP growth was at 0.3% y/y decreasing from an expectation of 2.2% in February 2014. However, the major effect of these shocks is set to be seen throughout 2015 and we expect Russia s GDP to shrink 1.8% y/y at that point. Net capital outflows slowed to USD13bn in Q3 14 versus USD23.7bn in Q2 14 (excluding banks FX operations) as the oil price fell 15% in Q3 14 and imports shrank on sanctions. We expect capital outflows to post USD120bn in 2014. 4 13 November 2014 www.danskeresearch.com

Another significant factor hitting economic growth in Russia is accelerating inflation. From 6.1% y/y in January 2014, it has jumped to 8.5% y/y in early November 2014, while the central bank s target has been 5% y/y. The escalated geopolitical situation has been the major driver of consumer price inflation over the summer of 2014 through western sanctions and Russia s countersanctions. Hence, the so-called food import ban has increased inflation expectations. However, as we expect Russia s economy to dive deeper into recession next year, we expect inflationary pressures to ease. Hence, the tightening of monetary conditions is likely to reduce significantly demand-side inflation pressures. Therefore, we are in that paradoxical situation that the Russian economy in some sense is both in a quasideflationary state (a sharp drop in aggregate demand) and in a stagflation state (higher supply-side inflation and lower potential growth in the economy). This is hardly good news for the rouble. Given the outlook for slowing inflation pressures in 2015, we now expect the Russian central bank to start cutting rates in H2 15. This would be likely to reduce the carry protection for the rouble as rates drop compared with the rest of the world. How will CBR respond to recession? Lessons from 2008-11 When the crisis hit in 2008, the Russian economy fell into a deep recession and real GDP dropped nearly 10%. However, the recovery was fairly swift and there is no doubt that the sharp rise in oil prices in 2009 to a large extent contributed to this recovery. However, we also note that what is important for the development in Russian aggregate demand is the development in the oil price measured in roubles rather than in US dollars. Hence, it was important for the recovery in the Russian economy, which started in 2009, that the increase in the oil price did not lead to a one-to-one appreciation of the rouble. So, while the rouble appreciated from the spring of 2009, it was very moderate compared with the steep increase in the oil price. In our view, this was the key driver for the recovery in Russian growth. Chart 4. Nominal GDP vs the oil price in RUB Source: Macrobond Financial, Danske Bank Markets 5 13 November 2014 www.danskeresearch.com

The lesson for today is that even if we assume that the oil price will recover in the coming year we believe it will we should not necessarily expect a similar appreciation of the rouble even if the CBR is serious about allowing the rouble to float freely. Hence, as long as growth is stagnant and the rise in inflation is seen as temporary, to support growth the CBR will have to ease monetary conditions and that would mean a less swift rouble appreciation (or even depreciation) even if the oil price were to rise in the coming one to two years. In that regard, it is also notable that the CBR effectively managed the rouble exchange rate so as to ensure rising oil prices measured in rouble until the output gap closed in 2011. Since then, the rouble has been kept more or less in a one-to-one relationship with the oil price. This has also been a contributing factor to the fairly sharp slowdown in growth, which started in 2011-12 and continues to this day. Funding risks are rising As we expect sanctions to remain in 2015, we see a deterioration in the funding situation next year. Despite the strong current account situation in previous years, we expect the current account surplus to shrink in the future, as exports are not growing due to decreasing oil production and energy prices. However, we expect imports to shrink as well. A nominally weakening rouble and sanctions are set to weigh further on imports. The environment for foreign direct investments (FDI) has clearly deteriorated this year especially for direct investments coming from western economies. Due to the challenging geopolitical environment, we expect FDI prospects to remain weak in 2015. We do not expect any growth in FDI in 2015. Russia s FX and gold reserves have dropped 16% year-to-date to under USD430bn as the central bank heavily intervened to mitigate the rouble s devaluation. As the financial sector sanctions have squeezed FX availability for Russian banks and businesses, some large corporations were promised to get access to FX from Russia s oil funds. According to the preliminary estimates on 1 October 2014, the external debt of Russian banks and other sectors was USD615bn. Of course, the debt has different maturities and many loans are being routed from offshore companies to their Russian subsidiaries. However, there are tens of billions dollars of external debt expiring in 2015 already. The situation is very challenging as the debt-to-reserves ratio is already increasing. This will be clearly negative for the rouble. Key drivers for the rouble in the coming year Above, we have made the argument that while geopolitical tension has clearly had a significantly negative impact on the rouble in 2014, the oil price and fundamentals in general have had at least as great a negative impact and maybe an even bigger one. Looking ahead, we continue to stress that we believe the key risks will be the outlook for the oil price and geopolitical tension. Both factors are obviously very difficult to forecast. However, in terms of geopolitics, overall we believe that the current geopolitical risks are mostly already reflected in the rouble rate. A further unforeseen escalation in geopolitical risks would be clearly negative for the rouble. However, such risks are best understood as black swans something we, by definition, cannot forecast in any meaningful sense (even though we can hedge against such risk see below). Therefore, overall we have assumed the status quo in terms of the Ukraine crisis and geopolitics in general in our forecast. This is not because nothing will happen but because we do not believe that such events can be forecast meaningfully. 6 13 November 2014 www.danskeresearch.com

Therefore, fundamentals take centre stage in terms of our rouble forecast and we particularly highlight the following factors. Given the present level of the oil price, the rouble is probably close to fair value in real effective terms. The Russian economy is very likely to fall into recession and, given the shocks we have already seen, we are likely to see the crisis deepen in coming quarters. This is likely to make the CBR reluctant to tighten monetary policy much further particularly taking into account that the CBR is now officially allowing the rouble to float freely. Consequently, we also believe that the CBR will be eager to avoid a renewed strengthening of the rouble in real terms, as this would keep the Russian economy stuck in recession. Remember that just because the rouble is now freely floating, it does not mean that the CBR will not take the exchange rate into account when setting overall monetary conditions for the Russian economy. Effectively, the CBR is likely to accept inflation rising up towards 10% temporarily. This also means that to keep an unchanged real effective exchange rate, the CBR will have to allow the nominal exchange to weaken enough to make up for the loss of competitiveness from higher inflation. The debt situation in Russia is becoming increasingly challenging. In that regard, it should be remembered that a too strong currency would increase public finance problems, as it would reduce the oil price measured in local currency. FX outlook for the rouble All the factors above are likely to weigh on the rouble in the coming year no matter what happens geopolitically. We expect these factors to be particularly negative on a three-six month horizon rather than a 12-month horizon. However, our view is that the oil price is likely to bottom out in the coming months and will begin to recover in line with a continued pick-up in global growth in 2015. This means the rouble is likely to get increasing support from a higher oil price throughout 2015. This should help reduce the pressures on the rouble in the medium term. Our new USD/RUB forecast is therefore 49, 51 and 51 on three-, six- and 12-month horizons. Overall, this is slightly more negative than forwards on a three-six month horizon and fairly neutral on a 12-month horizon. Table 1. RUB FX forecast Forecast Spot +1m +3m +6m +12m Exchange rates vs RUB USD/RUB 46.31 48.00 49.00 51.00 51.00 EUR/RUB 57.70 60.00 59.78 61.20 62.73 RUB/DKK 0.129 0.124 0.125 0.122 0.119 RUB/SEK 0.160 0.153 0.152 0.147 0.140 RUB/NOK 0.147 0.142 0.141 0.135 0.128 Source: Danske Bank Markets 7 13 November 2014 www.danskeresearch.com

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