CIBC’s Bipan Rai walks through the sanctions on the Central Bank of Russia and financial institutions in Russia and what they mean for the markets.
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Bipan Rai: Russia was very integrated in global trade and blocking access to Russian commodities effectively means that the supply demand imbalance that was there beforehand before the invasion now has become even more exacerbated. Hello, everyone, and welcome to yet another edition of the X Factor podcast. I’m sure most of you aware there’s been a lot of developments since our last recording, and for this episode I figured it’d be particularly important, especially for those of you that aren’t familiar with the banking sector and how certain things work. To dive a little bit into what some of the sanctions that were implemented on Russian entities entails, and I’m going to focus the episode today on the two big ones that being the G6 plus EU agreeing to bend select Russian banks from the Swift messaging platform and also the agreement to freeze the central bank of Russia’s reserves held outside of Russia, which of course includes gold and block its ability to utilise foreign exchange reserves. Otherwise, normally I would have a guest that’s a specialist in a particular area of focus for a conversation, but for today with Swift and the measures implemented against the central Bank of Russia, I’m just going to try and wing this on my own and see how things land. So first things first, let’s talk a bit about these swift sanctions. So effectively the G6 plus the EU has cut Russia off financially from the rest of the world. How has it done this? In order to really get a sense of that’s important to understand what the swift messaging service is. Basically, the Swift messaging service has been around for decades, and it’s held a near monopoly on the international payments space since. If you’re thinking of an analogy, think of Swift as Google in the search engine space. But with an even bigger market share than Google has when it comes to search engines, Swift’s primary function is to deliver secure messages that contain orders and confirmations for trade payments and foreign exchange transfers. It’s used by 11000 financial institutions and companies in over two hundred countries. Generally, message traffic is around forty two million per day, and really, what I want to emphasise when it comes to Swift is that there’s no real alternative. I mean, Russia and China have tried to set up their own versions of Swift over the past ten years, but they’ve been met with limited success, really. And the main stumbling block for any sort of alternative to these swift platform is the world’s reliance on the US dollar for use in everything from transactions to trade finance, according to some estimates. Swift has two hundred and ninety one members from Russia, and there are over 800 billion worth of flows using the platform each year involving a Russian entity. And that’s an extremely large amount of money, especially when you consider that the size of the Russian economy is actually close to one and a half trillion or just above there. So without access to the Swift platform, Russian financial institutions basically have to rely on other more crude methods of secure messaging, including emails and potentially even phones. The problem here is that most of the other counterparties outside of Russia will not partake in these sort of alternative ways of delivering information when it comes to financial transaction. Instead, Russian companies that trade outside of Russia now have limited means to convert their foreign currency back to rubles. Remember the central bank because of the other major sanction that the G6 plus EU implemented cannot utilise the reserves to help Russian companies with respect to moving foreign currencies back into Ruble. And of course, that puts downward pressure on the Ruble. And that’s particularly important given what we’ve seen since the start of this week. The Russian ruble fell by as much as 30 percent to open this week, and as a result, the central Bank of Russia had to implement measures including hiking interest rates up to 20 percent and imposing capital controls to prevent capital flow from leaving the country. Now, it’s important for me to emphasise this not all Russian financial institutions are blocked from Swift. There are select banks that are energy focussed that can still transact with foreign counterparties. Now, this was done on purpose primarily because the European Union relies heavily on Russian commodity imports, particularly natural gas and payments are usually done via the swift messaging platform. For example, Russian energy bank Gazprom Bank was excluded from the list of Russian financial institutions that were blocked. So that’s one part of the sanctions that were agreed to last Saturday. But the other angle is a bit important as well because there were significant restrictions placed on the central bank of Russia. And certainly this isn’t without precedent. We’ve seen this happen with central banks and other economies, but not for a G20 nation like Russia, especially considering the amount to which the Russian economy was integrated to global trade. This is quite an extraordinary step for the central Bank of Russia. Effectively, it cannot utilise its foreign exchange reserves. And what this means is that additional rounds of sanctions on either the oligarchs or on Putin are far more effective because it prevents them from getting their money out of the country. Now, of course, that was a key criticism for prior rounds of sanctions from years past. It also. Means that the central bank effectively can’t defend the ruble without extraordinary and painful means. And of course, I already mentioned that the central bank had hiked interest rates up to 20 percent. There is potential that they still could wrap this up even further if there is an additional round of pressure on the ruble. Secondly, of course, is the imposition of capital controls, which I’ve already mentioned. But there is a third thing that day the central Bank of Russia can still do to stem some of the pain, and that is to sell whatever gold reserves they hold in their country. But of course, they’re going to require a friendly counterparty to do that. And there are fewer and fewer of those with each passing day. But the ban on the central bank of Russia’s ability to utilise this foreign exchange reserve has also created an additional effect. Basically, it’s created some degree of U.S. dollar demand outside of Russia. How is this a case? Well, consider now that counterparties outside of Russia will not receive payments due, and that means that these creditors need to exit existing positions and try to procure as much U.S. dollars as they can. And again, generally when we have seen this in the past, the dollar has benefited from both the liquidity and its safe haven appeal. Now, this is somewhat similar to what we saw in both the early stages of the pandemic and also what we saw during the global financial crisis in 2008. There is a dollar funding squeeze, and of course, when we came in on Monday, we did see euro dollar basis widen out to similar levels that we’ve seen in years past when we had noticed some degree of funding strain. But unlike episodes past, we don’t think this episode of dollar funding pressures is going to remain persistent, and there’s a simple reason for that. Firstly, the world is flush with U.S. dollars, and that’s a direct result of the fact that the Federal Reserve has taken extraordinary measures to ensure that foreign central banks have access to dollars. That’s through two facilities. The first one is, of course, the FEMA facility, which was made permanent last year, and the second one is through central bank dollar swap lines, which did mature last at the end of December. But the Federal Reserve has indicated that it is willing to reopen the swap lines if need be to provide additional liquidity. So let’s bring it back to our world, which is foreign exchange is a few key points that I want to highlight here. Firstly, Russia was very integrated in global trade, and blocking access to Russian commodities effectively means that the supply demand imbalance that was there beforehand before the invasion now has become even more exacerbated. And we’re seeing this reflected already with the rise of several key commodities, including crude oil prices. In fact, crude oil prices have risen to levels that we haven’t seen since the financial crisis of 2008 or so. We’re seeing this in other key commodities as well, including base metals such as aluminium, nickel and, to a lesser degree, copper. We’re also seeing it in key commodity exports from the Ukraine, including wheat, which of course, is a very important input to food prices globally. But simply, there was a shortage of stuff beforehand, and now the situation looks even worse. So what does that mean for the foreign exchange space? Well, let’s start with Dollar Canada. One of the questions that I get asked often is why isn’t the CAD outperforming more, given the fact that we have seen this massive rally in oil prices? In fact, the last time that WTI was here, Dollar Canada was trading at one hundred five, which is roughly around 17 percent lower than where it is now. And there’s three key reasons for this that I’m going to mention to everyone. Firstly, it’s important to note that front end spreads have collapsed, basically, meaning that the front end of the U.S. Treasury curve has underperformed relative to the front end of the Canadian curve. And because of this, the yield advantage that wo year Canada has had over two year U.S. treasuries has narrowed significantly to the point where they’ve basically converged. Secondly, the US dollar is still strong across most of the developed market space. Now this is a very atypical environment. Generally, we don’t tend to see the U.S. dollar outperform as the same time as commodities. But these are uncertain times, and we do expect that this sort of dichotomy or the incongruent nature of the way that the US dollar is moving with commodity prices will eventually resolve. And at this point, unfortunately, it’s dependent on extraordinary things that are happening in the world right now, including the invasion and what the end game is for the invasion, of course. Thirdly, despite the pickup in oil prices, we’ve yet to see capex in the Canadian oil sands sector rise to levels that are commensurate to where oil prices are now, but this is true for the private sector in Canada in general. In fact, Bank of Canada Governor Macklem did emphasise this in a recent speech that he made with respect to private capital spending in Canada and whether or not that’s going to pick up in the period ahead. But until it does, it stands to reason that the strength of the correlation between the Canadian dollar and oil prices likely won’t be as firm as it was in years past. One other point that I’ll mention is that from a balance of payments perspective, foreign inflows to Canadian dollar assets aren’t expected to slow, so we expect this to be offset in the current account side of things by an increase in goods and services imports, especially as the economy continues to open up and as global supply chain pressures start to ease towards the second half of this year. Because of this, and despite the rally in oil prices, our bias is still for the US dollar to outperform the Canadian dollar into the second half of the year, and we are targeting a move above one point thirty four dollars Canada in H2 for other commodity currencies in the near term, we remain somewhat more constructive than we do for the Canadian dollar. First and foremost, we’re still very high on the Australian dollar for different reason, not so much related to the commodity story. Our main rationale for being constructive on the Aussie dollar is that we expect the RBA is going to pivot towards being a little bit more hawkish when it comes to inflation. One of the more underappreciated aspects about this inflationary shock is the fact that it’s macro and not idiosyncratic, and we expect that the degree of the shock will become larger in Australia in the months and quarters ahead. And that should show up in inflation expectations. In fact, it has already been showing up in Australian inflation expectations. And then the next step after that is for wages to rise, and we are expecting wages to move towards the two and a half to three percent range that the RBA has been highlighting. As for some time as being consistent with inflation being at its goals, with inflation being at its target. And as the RBA pivots, we expect markets to take profit on the extreme amount of short Aussie dollar positions that are out there and that should continue to support a move in the Aussie dollar towards the 75 percent level. So there you have it. I’m going to close this episode of The X Factor podcast. We’ll have more in the coming weeks, not just on the evolving Russia Ukraine situation, but of course, other key and topical themes that are important not just for the foreign exchange market, but also for the macroeconomic space. Thank you again, everyone for joining us, and we look forward to hosting you again sometime soon.
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