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.” 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)!
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 Seekingalpha.com 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)