Month: January 2015

How Big is Russia’s Capital Flight Problem?

This week, the Russian Central Bank (CB) reported the capital flight figures for 2014.

According to this Bloomberg article, capital flight has amounted to USD 151.5 billion in 2014. As could be expected, the outflows were highest during Q4 where the official figure reached a whopping USD 72.9 billion – higher than for the entire 2013 (USD 61 billion). Clearly, with “capital” fleeing at this pace and an external debt load of more than USD 600 billion even those famed reserves do not help much. In other words, it will only be a matter of time before the Russian economy will be brought to its knees and the autocratic Putin regime unmasked. This seems to be the favoured narrative of the financial press and among academics in the west. Obvious, isn’t it?

Not so fast!

In this post I will address certain misconceptions with regards to Russian capital flight and will argue that there it is much lower than the official figure suggests, and the problem should be manageable. Indeed, I think that introducing capital controls, as many suggest, would be by far the dumbest idea the Russian administration could undertake, as it would only aggravate, not solve, the capital flight problem (not that I think capital controls could solve any problem anytime, anywhere).

Capital flight as a predictor of trouble ahead

Back when I started with investing in emerging markets, some fifteen years ago, I studied the topic of capital flight intensively as it was thought of to have predictive value in detecting currency crisis, especially for countries with a currency peg. And generally speaking, capital flight, like black FX markets activity, is a good indicator for an overvalued (official) FX rate and for potential trouble ahead. This is derived from a powerful economic theory called Gresham’s law. To quote from Wikipedia,

Gresham’s law is an economic principle that states: “When a government overvalues one type of money and undervalues another, the undervalued money will leave the country or disappear from circulation into hoards, while the overvalued money will flood into circulation.”[1] It is commonly stated as: “Bad money drives out good”.

And the black market exchange rates of Argentina or Venezuela, for example, have had excellent predictive value for these countries problems in recent years – certainly better than your average Nobel-Prize-winning economist.

But Russia, has no fixed exchange rate, hence we cannot resort to the black market for hints. So, we have to understand the huge USD 151.5 billion figure that the Russian central bank classifies as capital flight. And it is exactly here that I found an oddity in how the Russian central bank defines that number.

A short primer on capital flight

Capital flight, as it was defined in the classical sense, used to be monitored by looking at the errors and omissions line in the Balance of Payments (BoP), i.e. those flows that are neither captured by the current Account (CA), nor the capital and financial account (FA), nor the change in central bank reserve assets. It is a residual that is used to make the BoP actually balance. Of course, a non-zero figure in the net errors and omissions section could be due to measurement errors – these are aggregates after all. However, it is understood that a disproportionately large figure indicates a large amount of illegal activity that by definition cannot be captured by official data.

The classic example is the Mexican drug lord who sends his USD cash via some Miss Mexico/Venezuela/Colombia to Miami. This “transaction” is recorded nowhere, but since money has left the country, FX reserves are lower than they would be otherwise. As economic conditions in a country deteriorate and governments resort to capital controls, more and more otherwise honest citizens try to get their money out the same way (thereby providing drug lords additional fee income) – historically a very good indication of imminent collapse.

It is, no doubt, this picture that many pundits have in mind when they talk about USD 151.5bn fleeing Russia. Only that it is not drug lords, but oligarchs and high-ranking government bureaucrats, fearing immediate expropriation by the Kremlin, buying everything from London real estate to London football clubs. Or so the story goes.

But there are differences:

First, oligarchs buying properties abroad rarely do it secretly. After all, I regularly read about it in the newspaper. No doubt, not all transactions are reported as privacy is desired, but on average one knows quite a lot about the assets of, say, Mr. Abramovic.

Second, Russia until recently has had an annual current account surplus of about USD 56bn (that’s the CB’s estimate for 2014). This money, by definition, is available for investments in foreign assets. As a consequence, one needs to keep in mind that not every purchase of a foreign asset by an oligarch or a SOE necessarily is capital flight, but could be the natural outcome of a CA surplus. And this surplus already accounts for lavish spending in ski resorts in the Alps or at Luis Vuitton in Paris (tourism services are part of the current account and usually paid by credit card, not cash).

Third, the net errors and omissions for 2014 – that classic capital flight indicator – were a mere USD 3.4 billion. A rounding error!

Don’t get me wrong, I do not want to deny that capital flight is a problem, but I feel that the general perception about Russians buying assets abroad has led us to overestimate the phenomenon as there is the danger that we confuse CA surplus transactions with illicit flows. There are also prejudices at work. After all, one never reads about capital flight when an Arab sheik, who certainly does not have to fear expropriation at home, buys a football team, a similar CA surplus transaction.

Therefore, it is obvious that there is more to the Russian capital flight figure than meets the (superficial) eye.

So, what’s going on here?

Russian Central Bank has very unusual capital flight definition

The low errors and omission amount in combination with the high capital flight figure touted in the media, has led me to take a closer look at the matter.

A good start was this Forbes article about an EY study from two years ago which found that the “net private inflows and outflows” computation that the Russian CB uses as a capital flight proxy contains items that are perfectly legitimate capital/financial account transactions thereby overstating the Russian capital flight figure substantially. For instance, this figure includes cross border M&A flows as well as debt repayments.

In other words: when Gazprom buys a company abroad in an M&A deal the CB classifies this as capital flight. You can do that, but I doubt that most people have this in mind when they think about capital fleeing a country.

Don’t get me wrong: heightened outflows due to M&A activity can be a valuable indicator of, say, a currency’s overvaluation – and I believe the RUB was indeed overvalued for the better part of the last 4 years – but it is not capital flight in a classic sense. For most of outward M&A activity is a function of access to lending in foreign bond markets, i.e. “funny money” as well as the already mentioned CA surplus.

Further, the study’s findings were confirmed by data from the World Bank, whose capital flight estimate (USD 32bn) for the year in question (2012) is close to the EY figure (USD 40 bn.) and substantially less of the official CB figure (USD 81bn)!

That’s weird!

I have no idea as to why the CB uses this strange definition and makes the problem appear larger than it really is. I suspect the definition made sense in the communist past and has not been changed due to institutional inertia.

Now, let us have a look at the 2014 data!

Fortunately, this post on does an excellent job. So I will quote the main paragraph:

There are, however, few caveats to these figures that Western analysts of the Russian economy tend to ignore. These are:

  • USD19.8 billion of outflows in Q4 2014 were due to new liquidity supply measures by the CB of Russia which extended new currency credit lines to Russian banks. In other words, these are loans. One can assume the banks will default on these, or one can assume that they will repay these loans. In the former case, outflows will not be reversible, in the latter case they will be.
  • In Q1-Q3 2014, net outflows of capital that were accounted for by the banks’ repayment of foreign funding lines (remember the sanctions on banks came in Q2-Q3 2014) amounted to USD16.1 billion. You can call this outflow of funds or you can call it paying down debt. The former sounds ominous, the latter sounds less so – repaying debts improves balance sheets. But, hey, it wouldn’t be so apocalyptic, thus. We do not have aggregated data on this for Q4 2014 yet, but on monthly basis, same outflows for the banking sector amounted to at least USD11.8 billion. So that’s USD27.9 billion in forced banks deleveraging in 2014. Again, may be that is bad, or may be it is good. Or may be it is simply more nuanced than screaming headline numbers suggest.
  • Deleveraging – debt repayments – in the non-banking sector was even bigger. In Q4 2014 alone, planned debt redemptions amounted to USD34.8 billion. Beyond that, we have no idea if there were forced (or unplanned) redemptions.

Interesting: out of the total USD 72.9bn “capital flight” published for Q4 a substantial amount (approx. USD 45bn) was due to forced deleveraging of Russian banks and corporates. Forced, because they, no doubt, were due to the sanctions imposed in summer and certainly would not have occurred to the same extent, had refinancing been an option.

Add to this USD 45bn the USD 19.8 bn. in liquidity measures for banks during Q4 and you get a delta of some USD 8bn. which is left unexplained and probably due to the conversion of household accounts into USD.

Yes, you heard correctly: less than 8bn in Q4 2014 – the quarter where panic was highest!

If this analysis is correct, the problem is manageable. It definitively is wrong, say, to add the official capital flight figure to the external debt repayment requirements – a classic case of double counting. Unfortunately many observers seem to do just that.


It is important to understand that the official capital flight figure is not comparable to those used by other countries or, indeed, the World Bank. Although, I certainly have to dig deeper into this topic, this much seems pretty clear to me. A lot of the increase in the official figure in the second half of 2014 was due to debt repayments that could not be refinanced due to sanctions. With USD 100bn in debt repayments scheduled for 2015, I expect this figure to stay elevated. However, whether the Russian corporates and individuals will be able to manage these repayment schedules depends on their FX revenue and their profit margins – not on whether the official “capital flight” estimate slows down. As I have shown here, Lukoil should have no problem honouring its USD 1.5bn debt repayment due in 2015. It would be a big mistake, if the Russian administration freaks out because of a strangely defined macroeconomic aggregate.

(Disclosure: long RUB, Lukoil bonds as well as select Russian stocks)


Rationale behind my long position in Lukoil Bonds

One of the assets I bought during the recent Ruble-rout was the Lukoil 6.656% June 2022 USD bond. I managed to grab some at 80 cents on the Dollar which equates to a yield of slightly above 10 percent! The price has since recovered somewhat, despite the fact that the oil price has continued to fall. The market seems to fear that the low oil price combined with the fact that the company is at the sanctions list have increased the risk of default substantially.

In this article I will argue that the market’s fear is overdone and that the bonds represent an excellent risk-reward opportunity.

Lukoil’s balance sheet is a fortress

Let’s have a look at Lukoil’s most recent balance sheet (Q3 2014) in order to get a quick feel for the situation.


We can see that Lukoil had about 13bn USD in financial debt outstanding at the end of Q3 2014, the bulk of which is in USD. In a first step I compare this to the book value of USD 83bn and the market cap of about USD 34bn. Regardless of how you look at the matter, Lukoil’s leverage ratio is very low.

I think if this were a not a Russian company, we would quickly agree that this is a rock-solid balance sheet – the more than 50 percent drop in oil price notwithstanding. This can easily be seen by the fact that Exxon Mobile’s bonds of comparable duration yield about 2.5% – or 600bp less – as of this writing, despite having a higher debt load (USD 23bn) and about comparable oil reserve figures (Exxon has higher gas reserves, though). So this really seems not to be just about the oil price drop, but about the fact that Lukoil is cut off from refinancing options.

Lack of refinancing options is a problem, if you do not have enough liquidity to meet liability requirements, or if you run operating losses, otherwise it is a non-issue.

Alas, let’s have a look at Lukoil’s liquidity position.

Cash stood at USD 2.8bn, working capital was positive and a crude oil inventory stood at about USD 8.6bn. Note, that there are also about USD 1.8bn in assets classified as held for sale, the bulk of which (USD 1.2) is related to a sale of an oil field in Kazakhstan to Sinopec, the Chinese oil giant. The transaction was supposed to close until the end of 2014 subject to approval by Kazakh authorities. No news about the closing have been published so far, but, if it turns out as expected, Lukoil’s USD cash would increase to USD 4.2bn over the next few weeks.

What to make of that?

Haircutting the oil inventory by a conservative 60 percent gives us liquid assets of roughly USD 7.7bn, if you include the expected proceeds from the Sinopec deal and about 6.5 if you are sceptical that the deal will close as agreed. That means that exactly 50% of the financial debt load (also including RUB debt) is covered by highly liquid FX-assets – not that bad.

Of course, there still could be problems if all the debt would be due at once. So let’s look at the maturity profile of USD denominated bonds, i.e. its external debt. Straight from the homepage we get this overview of USD bonds outstanding.


We get a total USD debt load of USD 8bn, of which we have to mentally deduct the bond that was redeemed in November 2014 (USD 900bn) from the liquid assets above. In 2015 Lukoil has just one bond repayment of about 1.5bn in June, whereas nothing (!) is due in 2016 and just USD 500mln in 2017. To this has to be added the annual interest payment of around USD 500mln.

I will spare us the detailed calculation, but it is evident that the company is liquid enough to meet FX-bond redemptions as well as interest over the next few years with the existing liquid assets at its disposal. This leaves us with only two possibilities that Lukoil will not be able to meet its external debt load:

  1. The company will experience negative operating Cash Flows going forward due to the fall in oil prices.
  2. assets will be taken away by the Russian state, similar to what happened to Sistema leaving an empty shell.

Ad. 1.)

It is yet early days to gauge the impact of the oil price crash on the profitability of oil companies, at least for me as an outsider. In the case of Russian companies the case is further complicated by the fact that the Ruble has fallen even more than the oil price. Consequently, much depends on what percentage of costs is denominated in RUB. While it is clear that personnel costs are paid in RUB, I was surprised to read that most of capex spending is denominated in RUB as well. It seems that Russian oil companies have to rely on foreign technology (hence USD costs) for unconventional oil (arctic, shale oil…) only, whereas local service industries exist for conventional oil (something which is intuitive given that they were drilling oil during Soviet times when it is unlikely that they relied on foreign technology). Most of Lukoil’s reserves are conventional reserves which suggests that its operating margins in RUB even could have risen despite the oil crash, a view that this seekingalpha piece nicely lays out (you have to be a registered user to read the article).

So much for the short-term outlook, what about the long-term? After all, I intend to hold the bond for a few years, preferably until maturity.

Value investors know very well that in a commodity business, success in the long run is determined by low costs, as this is the only sustainable competitive advantage. How does the Russian oil industry and hence Lukoil, probably its best run company, rate on this score? The graph below has the answer (I saved the graph a few months ago and do not remember the source, sorry).


Well, I would say that Russia is pretty competitive: apart from the Gulf States, which operate in a league of its own, nobody produces at lower cost (the Opec average is dragged down by Saudi Arabia). And one has to remember that the graph was compiled before the recent RUB drop, hence it is likely that its competitive advantage has only increased.

Conclusion: Lukoil and Russian oil companies in general will make operating profits, even when most other oil producers are already highly cash flow negative (and yes, that includes the allegedly well managed Exxon mobil) – good to hear!

Ad 2.)

Obviously, investing in Russia is fraught with its own risk, notably weak property rights. This is especially true for the “strategic” oil industry. The recent expropriation of Sistema’s Bashneft serves as a memorable warning-shot. Obviously, your guess is as good as mine when it comes to predicting the Kremlin’s moves, but I do think that the Sistema expropriation has been by far Putin’s dumbest move during the standoff with the west. And I think he has realized that by arbitrarily taking away assets just because Rosneft needs more cash to pay down its debt, doesn’t help his cause as it only worsens the capital flight. I think that he has learned that lesson and that a 10 percent yield is worth the risk.


Investing at 10% in the debt of a liquid, little levered company that is among the lowest cost producers in its industry is an excellent risk/reward proposition, as it gives equity like returns without the usual corporate governance issues that come with investing in Russian stocks. The insiders have an incentive to pay the debt in time, as a debt default would only cut them off from export trade finance and highly desired FX revenues.

Currently I am thinking about increasing my position and hedging the bond with an oil future short, as the current Contango means I get paid to hedge.

This is not a recomendation – do your own research!

The Australian Dollar is going to fall a lot further

Happy New Year!

As you know, I have been short the AUD (and the CNY) for more than one year. I have written about this here and here.  The story? Australia is a China derivative and I think China is the biggest credit bubble in the history of mankind.

Now that commodity prices have fallen, the streetwise professor (a commodity expert) is likewise musing about Chinese demand – without making any predictions of course.

I will briefly repeat my opinion on this: In order to keep demand constant, credit growth has to increase exponentially, i.e. to serve existing debt including interest payments as well as to finance new demand. This is because overall demand increases have been taking place against the backdrop of rapidly increasing leverage, i.e. they were not equity financed. With increasing debt/GDP debt growth increasingly is used to serve existing debt (assumption many of these projects are not economically viable). Also credit growth gets technically more difficult to handle (environmental problems, bank liquidity…). This is why I think Chinese demand for all sorts of commodities will fall substantially over the coming years.

John Hempton of Brontecapital, one of my favorite bloggers, has come up with the best analysis of this matter so far. It is the best because it is simple, intuitive and very original. It fits on a very small sheet of paper – just as it should be.

What did he do?

He has been reading Winston Churchill’s memories and what got his attention was Churchill’s gauge of the German Reich’s iron ore demand in 1940, i.e. a phase when it was preparing for war and undertaking huge infrastructure investments (Autobahns, housing…). He estimated annual iron-ore demand at around 20mln tonnes a year.

China uses about 1.1. trillion tonnes of iron ore per year.

In other words: an economy preparing for war and undertaking massive infrastructure investments such as was Nazi-Germany needed less than 2 percent of current Chinese iron ore demand!


“Yes, but population size…” I hear you say.

The facts:

According to Wikipedia, Germany had 79.3 mln inhabitants in 1939 compared to China’s 1.367 billion today.

That’s a factor of 17x. vs a factor of 50 x in absolute iron ore demand – no, population size cannot explain this huge difference alone.


Per capita iron ore demand in China last year was 3x that of what Nazi-Germany achieved in 1940 through brutal repression, plunder (Austrian CB Reserves) and confiscation. That’s insanity x 3, so to speak.

Iron ore is Australia’s main export product and more than 30 percent of its exports are going to China. I wonder whether John Hempton is short his own currency – he should be.

The AUD is doomed, I think it is going to depreciate further from here over the next 24 months.

(Disclosure: short AUD and CNY)