While the current turmoil in Ukraine is having a sizeable impact on the most directly related financial markets, there has been no general sell-off in risk assets. The country’s sovereign Credit Default Swap (CDS) contract, which measures the cost to insure against a default, has risen this year by almost 400bps to a spread of over 1,100bps. The sovereign bond due in June 2014 is currently yielding around 44 per cent. The nation’s currency, the hryvnia, has lost around 12 per cent against the US dollar.
Ukraine is basically on the verge of bankruptcy. It requires extensive foreign aid to be able to cope with its obligations over the next few years. Repayments on foreign currency debt amount to $10 billion in 2014, according to the finance minister. Meanwhile, the central bank’s foreign currency reserves are dwindling. The EU has offered Ukraine €11 billion in loans and grants to support the economy, dependent on progress in reforms and on another deal being signed with the International Monetary Fund (IMF). For months, expectations have been growing for an agreement to be signed with the IMF. The conditions attached to the aid package would typically involve extensive structural and economic reforms. Such developments could offer hope to investors, at least in the long term.
Russia is likely to be relevant to a larger number of investors due to its relative importance. The crisis in Ukraine is having an evident impact on investor sentiment. The devaluation in the Russian ruble has attracted headlines. The currency has been one of the worst performers so far this year, losing almost 10 per cent against the US dollar. Notably, the Central Bank of the Russian Federation surprised the markets when it raised interest rates from 5.5 per cent to seven per cent in early March to preserve financial stability and combat inflation. Capital flight and rising inflation remain a risk going forward, as highlighted by Fitch Ratings last week.
In bond markets, yields on Russian government bonds have unsurprisingly risen, with spreads on US treasuries widening. The US dollar bond due 2023 currently yields around 5.2 per cent, compared to 4.6 per cent at the start of the year. The sovereign CDS has risen by around 70bps to 231bps. The government also cancelled a number of ruble bond auctions due to insufficient demand at indicated pricing. Gazprom, often considered by financial markets as a projection of Russian corporate clout (and actually owed around $2 billion by Ukraine for gas supplies), has also experienced a rise in bond yields.
Russia’s economy remains highly dependent on oil and gas. Revenues from this sector account for more than 50 per cent of the federal budget
The Russian economy, which has been relatively underperforming in recent years, will be negatively impacted by a prolonged crisis. Western sanctions and the oil and gas sector are the most obvious considerations. There are divergent views on the usefulness and on what type of sanctions, if any, could be implemented. However, whatever one’s perspective, it is relevant to note that Russia’s economy remains highly dependent on oil and gas. Revenues from this sector account for more than 50 per cent of the federal budget. The EU is the major trading partner of Russia, and the most important investor in the country.
Beyond Ukraine and Russia, contagion in financial markets from the current crisis has so far been limited. Just across the border in Poland, local currency denominated bonds have continued to rally during this period, and spreads on German sovereign debt are close to multi-month lows. With Poland viewed as an Eastern European success story, investors have not been selling indiscriminately.
With respect to the core eurozone region, there also has been very limited impact from a strictly financial or economic perspective. The president of the European Central Bank, Mario Draghi, noted last week that the “interconnections are not as important as to suggest a strong contagion from that region”. Ironically, it seems that bonds of the weaker peripheral eurozone countries have benefitted from increased inflows during the current turmoil, pushing average yields to multi-year lows in most cases. On balance, investors have generally maintained their composure so far. However, it would be imprudent to ignore this geopolitical risk, since any deterioration would have more severe consequences.
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This article is the objective and independent opinion of the author. The information contained in the article is based on public information.
Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
Karl Falzon is a credit analyst at Curmi and Partners Ltd.