Oil and Debt Hold Keys to Russia's Resurgence

Greg Saichin | 03/09/2017
Russian skyline

Summary

For years, Russia used its energy supplies to expand its influence and drive a wedge between Europe; today, Greg Saichin says Russian debt is in high demand. Both are helping the country's strive for relevance while masking certain structural weaknesses.

After the collapse of the former Soviet Union, Russia found itself searching for the right political and economic roadmap to carry it forward in a post-Soviet world. After only a short time feeling lost in the political wilderness, Russia has once again emerged as a major player on the geopolitical stage. During this transition, it again rekindled its antagonistic Cold War-era relationship with the West. Yet despite this adversarial position, Russian debt has become increasingly attractive to foreign investors looking to diversify away from a troubled European Union and other low-return regions.

Not long after the USSR’s collapse, Russia re-emerged as a major geopolitical player as Putin used Russia’s resentment toward the West to his advantage

These seemingly contradictory developments may be a head-scratcher for some, particularly those in Europe who previously held front-row seats to the USSR's demise. However, they are more easily understood when one realizes how Russia fundamentally defines its identity in opposing terms to that of the West. Capitalizing on Russia's aggrieved sense of self, President Vladimir Putin has been able to seize on the Russian people's nostalgia for a grand imperial past, in turn redirecting its old communist faith toward a new quest for global relevance.

Wielding energy as a weapon in Europe

For his part, President Putin has used the strategic principle of "divide and rule" to great effect by using energy as a weapon to drive a wedge between European countries that supported Russia and those who opposed it. Resurgent energy prices during the last decade provided the funding for this strategy, which largely focused on gaining influence through diplomatic and economic means.

Russia has wielded energy as a weapon in Europe to influence European politics, buy assets and gain disproportionate economic leverage

During Russia's economic rebound, the role of its gas in the European energy mix – through state-owned vehicles such as Gazprom – became so critical that Russia found itself capable of influencing European politics. Russia's big wallet also allowed its state-owned companies to buy energy assets in Europe, further cementing that dependency. Moreover, Europe failed to further integrate its own energy markets to diminish this Russian gas dependency, leading to "every man for himself" energy policies that, in turn, gave Russia disproportionate economic leverage in the region.

Western sanctions and 2014’s collapse in oil prices revealed structural weaknesses, but higher oil prices should help the country rebound

By the time oil prices collapsed in 2014 and the West slapped sanctions on Russia in the wake of the conflict in Ukraine, Russia was confronted by its own structural weaknesses: It was ruled by an autocratic and inefficient regime that relied upon a top-down economic model highly dependent on the energy sector. Only 14% of Russian exports in 2014 could be classified as high-value-added exports, as Russia had a high dependency on commodities, in general, and oil, in particular. Commodities accounted for approximately 86% of total exports in 2015, down from 90.3% in 2011, with this decline largely due to lower prices. According to Russian Finance Ministry officials, if prices for Urals crude blend oil remain near $50-55 per barrel, Russia's budget could collect an additional $16-24 billion in additional taxes. Higher oil prices invariably improve Russia's balance of payments, fiscal deficit and growth dynamics.

Today, Russia is a land of ambiguity for investors – a fixed-income safe haven and a region rife with highly understated volatility

A land of ambiguity for investors

Yet for investors today, Russia is both a fixed-income safe haven and a region rife with highly understated volatility. From a market perspective, this doesn't make much sense, so how could it be happening?

Part of the explanation is that Russia's willingness and ability to service and pay its debt goes hand in hand with its global superpower narrative. Despite the cathartic episode of Russia's 1998 debt restructuring – which involved disproportionate losses for holders of domestic Russian treasury bonds, known as OFZs – Russia has always strived to keep a clean record when it comes to debt service. This is reflected in its conservative macro policy framework and treasury management since the 1998 default.
From an equity perspective, however, the picture is less encouraging, as Russia's top-down model does not bode well for transparency or for checks and balances. As a result, property rights in Russia – whether justified or not – are not very sticky. In such an environment, equity prices will always carry a premium

So long as these conditions persist, Russia will remain an ambiguous destination for the investment community. This situation is likely to last for years to come, for the simple reason that nations rarely lose the idiosyncratic traits that gave rise to their nationhood in the first place. As Mr. Putin heads toward his fourth term in power, the question in many people's minds is not only what he will do next, but what comes after him. Will more Putin lead to more of the same – or to a more open, transparent Russia that is ripe for more interesting investment opportunities? One thing seems clear: Russia will not lose its deep sense of history, nor will it stop yearning for a stable and secure society.

Higher Oil Price Improves Russia's Growth Dynamics

Urals oil vs Russian GDP Sept 2012 - Sept 2016

Oil and Debt Hold Keys to Russia's Resurgence

Source: Bloomberg as at 30 Sept. 2016. Russian GDP represented by the RUDPRYOY Index, Urals oil by the FURAM1 Index. Note that Urals oil stopped pricing with Bloomberg for a period between 2013-2014; as such, prices during this period were calculated using Brent prices (CO1 Comdty) adjusted for the Ural-Brent differential.


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Expert-Image

Greg Saichin

Managing Director, CIO Global Emerging Markets Fixed Income
London
Mr. Saichin is a managing director and CIO Global Emerging Markets Fixed Income with Allianz Global Investors, which he joined in 2013. He is the head of the firm’s Emerging Markets Fixed Income team and is responsible for developing its range of strategies. Before joining the firm, Mr. Saichin worked at Pioneer Investments, where he was the head of emerging markets and leveraged finance fixed-income funds and a senior portfolio manager, responsible for emerging market debt, high-yield and multi-asset mandates. Before that, Mr. Saichin worked at Credit Lyonnais as an associate director in in the emerging-market debt group; at Deutsche bank in emerging-market debt distribution; and at Chemical Bank in European capital markets distribution. He has a B.A. in business administration from the University of Buenos Aires, Argentina, and an M.B.A. from The Wharton School, The University of Pennsylvania.

Europe Faces Critical Election 'Super Cycle'

03/09/2017
Europe Faces Critical Election 'Super Cycle'

Summary

As the Netherlands sorts out its new parliament and Article 50 looms, France and Germany are up next at the polls. Amid volatile politics, Ingo Mainert asks: Will populism and anti-Europe sentiment move the EU away from integration toward dis-integration?

As the Brexit drama plays out in the UK, 2017 is shaping up to be an election year like no other for the rest of Europe. In this “super cycle,” the Netherlands wrapped up parliamentary elections on March 15, French voters will head to the polls on April 23 and May 7, and Germany voters will have their say on September 24. In addition, early elections in Italy are still a possibility.

The PVV's defeat in the Netherlands should pave the way for pro-EU parties, preventing a "Nexit" in Europe

In the Netherlands, the euro-sceptic Party for Freedom (PVV), led by Geert Wilders, attracted a great deal of attention in the run-up to the country’s March 15 parliamentary elections. Now that the PVV has lost out to Prime Minister Mark Rutte’s center-right VVD party, we expect that the next government coalition will be pro-European Union. This should prevent the Netherlands from leaving the EU anytime soon. However, not only has Mr. Wilders already made his mark on the public debate, but the Dutch system of proportional representation means that undeniably populist issues such as the freedom of movement and the future of migration will continue to influence both the domestic political agenda and the debate over the future of Europe.

A Macron win in France would help pro-reform forces in Europe and boost hopes for a new beginning for the EU

The presidential election in France is also becoming an increasingly important and intense affair. At the time of this writing, there are three leading candidates, with the far-right Marine Le Pen gaining ground on the centre-right Francois Fillon, but with the social liberal Emmanuel Macron holding on to his favoured status. While a victory by Ms. Le Pen in the first round is possible, Mr. Macron currently appears to have the best chances in the final ballot. This would be a clear victory for pro-reform forces in Europe, and a chance for a new beginning for the European Union.

If Germany heads toward a 'red-red-green' coalition of left-leaning democrats and environmentalists, capital markets would need to take a close look

In Germany, the mood is shifting quickly at the expense of Chancellor Angela Merkel. The new candidate of the socialists – Martin Schulz, the former president of the European Parliament – has got off to a brilliant start since his nomination. He and his Social Democrats have pulled close to Mrs. Merkel's Christian Democrats, though the sustainability of his momentum remains to be seen. It is possible that Germany could eventually see a 'red-red-green' coalition of left-leaning democrats and environmentalists – a development that would need to be more strongly analysed by the capital markets in the coming months. Another interesting twist would be victories by Mr. Schulz in Germany and Mr. Macron in France, as this would increase the potential for a stronger political union for Europe.

Italy is the elephant in the room, with a lack of reforms and serious banking issues presenting critical problems

Finally, new elections in Italy are possible, yet this is the elephant in the room that few are talking about. Italy has made little to no progress on reforms, and it still suffers from serious unresolved banking issues – both critical problems that could dampen some of the enthusiasm of pro-Europe advocates.

Clearly, Europe is at a crossroads, and muddling through is no longer an option. After these elections have wrapped up, Europe will need a new vision to carry it forward, but right now it is facing a Shakespearean moment: To be, or not to be? That is indeed the question.


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