Russia Paying Dearly For Putin's Adventure

In his annual address to the nation on Thursday Russian President Vladimir Putin announced that the country’s reserve funds, usually earmarked for investment in state projects, should be used to bail out troubled Russian banks. In doing so he revealed just how grim the prospects for financial institutions have become following the rouble’s collapse. The Russian private sector appears to be on state-funded life support.

In particular, the move strongly suggests that the Russian banking system has been running out of collateral that can be used to get dollars from the central bank. Access to dollars is critical because the banks took out foreign-currency loans from investors that they have to pay back in the same currency. Current estimates suggests Russian businesses need to repay a total of $35 billion this month.

Unfortunately Russian banks face major challenges funding this at present with Western sanctions freezing them out of global capital markets on the one hand and a weakening domestic economy putting pressure on profits on the other. These issues have been compounded by a fall of around 40% in the value of the rouble since June. As it falls it becomes increasingly difficult to pay back those debts because the rouble is becoming less and less valuable, making those debts more and more expensive.

Usually it is the job of the central bank to provide emergency funding for a country’s banks. In Russia this is typically done through what are know as “currency repo auctions,” where banks offer collateral (such as high-quality bonds) in exchange for access to currency, especially dollars, that they need to meet foreign-currency obligations.

However, there has been limited use of this facility by Russian banks despite the rouble falls. The central bank had tried to explain this by saying that low demand was a consequence of there being plenty of dollar liquidity in the financial system.

Putin’s statement that the country’s reserve funds should be used instead to back its banks strongly suggests that this claim was wrong.  There was not a lack of demand, rather the banks’ collateral was insufficient to get dollars in exchange.

On Thursday the Russian central bank cut the foreign exchange repo rate, the interest rate it charges on the currency it gives to banks. The rate fell from 1.5% above the London Interbank Offered Rate (Libor) — the benchmark interest rate at which banks lend to each other — to 0.5% above Libor. A lower interest rate should make it less expensive for banks to borrow from the central bank and therefore more appealing.

The rate cut illustrates that the central bank itself is growing concerned about the ability of Russian banks to meet their debt repayments. If they fail to pay, it could trigger a wave of defaults that would further hit the fragile Russian economy, which is already expected to fall into a recession in 2015.

Yet if the problem is a shortage of collateral these measures are unlikely to be enough. Back in February, JP Morgan analysts warned of just such a scenario: around 60% of available collateral was already pledged of an  upper limit of around 75%. That top level is the point at which JPM says the stress in the banking system, in the form of increased rsk of default, may start rising rapidly.

We appear to be near that point.

Judging by today’s news, banks appear to have been forced instead to seek help from the state.

This would explain Putin’s move to divert money usually earmarked for infrastructure investment (for example, in Russia’s ageing road and rail network) into a bank bailout. Reuters quotes Putin as saying:

Using our reserves, firstly, the National Wealth Fund (NWF), I propose to … recapitalise leading domestic banks with funds offered … to use for lending to the most important projects in the real sector of economy.

The news wire reports that VTB and Gazprombank have already applied for 250 billion roubles ($4.7 billion) and up to 100 billion roubles in additional support. This would put a further dent in Russia’s reserves after the country saw total international reserves drop some $90 billion so far in 2014, mostly in failed attempts to bouy the falling rouble.

It might also open the door for non-bank companies to lobby for additional support. Oil company Rosneft requested 2 trillion roubles last month but was turned down.