Russia: War, Sanctions, And Hyperinflation (Commodity:CL1:COM)

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Economy sanctions. Inscription sanctions on Russia flag.

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In 2021, Russia already was experiencing strong inflation. Now, with the effects of the war in Ukraine, that has been kicked into high gear. Hyperinflation is a term often thrown around too lightly, but under the current economic situation, hyperinflation within Russia is a reasonable concern. Hyperinflation is rare, and the situations that cause them are unique in history, but history also rhymes. Recurring factors of hyperinflation are capital production destruction, significant printing & borrowing, and net capital outflows. Russia is set up with this trifecta for monetary collapse.

Capital Production Destruction

Capital production destruction is when the overall production of the country decreases. The German Weimar Republic (Post WW1 Germany, 1918-1933) had significant hyperinflation, largely due to capital destruction. The Republic lost significant land due to the treaty of Versailles, notably the Alsace-Lorraine, and the industrial region Upper Silesia as well as others. Ultimately, the ceding of land lowered the production capacity of the Republic. Similar historic production destruction cases that resulted in hyperinflation are Yugoslavia (1992-1994), Hungary (1945-1946), Greece (1941-1945), just to name a few.

You may be saying the war is not in Russia so its production is not being reduced, the problem is the sanctions imposed by the majority of the developed world hinders production. Russia is a net exporting country, but that does not mean they do not import necessary products. One of the most notable sanctions reducing production capacity is the targeted oil refining technology sanction.

As sanctions intensify, the ability for Russia to maintain internal production will become more difficult. For example, Russia imported USD 230m in seeds in 2020, even though Russia’s capability to grow the seeds won’t have diminished, they will be unable to without the imported seeds, ultimately lowering production capability.

Oil and natural gas product sanctions have been contentious, except for Canada, no country has blocked importing. Many believed before the war the energy dependence of Europe, and particularly Germany would stop interference in Russian conflicts. But, little national-level sanctions does not mean energy exports have not been hit. Some corporations including BP p.l.c. (BP) have broken relations with Russia, in BP’s case, exiting their 20% Rosneft (OTC:OTCPK:RNFTF) stake. Additionally, many traders have stopped purchasing Russian oil, causing the largest recorded discount on Urals oil. The counterpoint to the discount is Brent crude is trading near all-time highs set in 2008, which lessens the blow to Russia. The problem is if international level sanction comes in place, Russian oil may trade at such a steep discount that the inflated Brent price may not matter.

Services are also being denied in Russia, whether due to ideals or legal restrictions. For example, accounting firms KPMG and PwC have both ceased operations in Russia due to the humanitarian violations of Russia. Netflix (NFLX) has stopped projects within Russia due to a law requiring media to display Russian Propaganda. Notably, PayPal (PYPL), Visa (V), and Mastercard (MA) have stopped some operations further harming the already fragile Russian transaction system.

Russia is imposing retaliatory sanctions, which include halting the delivery of rocket engines to the US. The issue is the Russian economy is so strained the sanctions will only result in more pain for the Russian people. At this time and most likely going forward, Russian-imposed restrictions on imports and exports will make little difference, but it is interesting to see as it shows Putin is unlikely to back down due to economic impact.

Chart showing spiking USD RUB Exchange Rate

USD RUB Exchange Rate (TradingView)

The initial sanctions have already caused the Ruble to drop from 75 RUB/USD to a low of 170 RUB/USD at the time of writing, and will most likely depreciate and become even more volatile by the time you’re reading this. The significant decline in purchasing power for the Russians who are still able to import the materials they need to produce will be required to pay a significant premium, ultimately lowering production capacity.

In summary, the Russian production system is facing death by a thousand cuts.

Labor Disruptions

Labor is considered a factor of production in economics, and the loss of labor will lower the ability to produce. Russia is facing a labor reduction due to multiple entwined factors; labor strikes, protests, military deaths, and Russians fleeing the country.

Protests are occurring in Moscow and other major cities, but have been cracked down on quickly leading to thousands of arrests.

Labor strikes will come in two forms, against poor wages which have already been seen, and as a protest against the war. Labor disruption is embedded in Russian society, a driving force to the revolution that ultimately led to the Soviet Union. The question is: Will Russians turn to mass labor strikes when they feel the effects of the war and sanctions?

“War is young men dying and old men talking”, Franklin D. Roosevelt. Russian conscription requires men aged 18-27 to serve a 12-month military service, so if a prolonged war occurs, this demographic will be absorbed by the war. Facing potential death or injury, some are fleeing the country to avoid conscription, and will most likely be unable to return any time soon. The severe loss of men during WW2 has had long-lasting implications on Russian demographics. Demographics change the labor make-up, for wartime and post-war Russia, this caused more elderly, youth, and women to work.

Even those who are not subject to the current conscription range are attempting to flee the country. Whether it be for political dissonance being struck down, negative economic outlook, or fears of a broadening war, people are leaving or looking to leave the country.

Despite being relatively small compared to the country’s population of 144 million, if the war becomes a prolonged incursion, labor disruptions will more likely than not intensify, and if civil unrest explodes, it will be a major factor.

Net Capital Outflows

Capital outflow is financial assets leaving the country. Net capital outflow includes the capital inflows which is an offsetting factor. As capital inflows decrease, the result is a lower net inflow, or in this case, a higher net outflow. Russia is facing both fewer inflows and greater outflows.

The degree of capital outflow already has the Central Bank of Russia (CBR) panicking, imposing various measures to stop the capital outflow in an attempt to stabilize the Ruble.

The Moscow Exchange was closed the week of Feb 28th and isn’t expected to open until March 9th, and when it does, foreigners will not be able to sell assets. Effectively any foreigners have had their equity frozen, and at this point, it isn’t unlikely for the assets to be seized permanently if they even have any value left that is. In addition, short sales are banned allowing more existing holders to exit positions.

Depository Receipts have plummeted in price. The issue is there are extreme doubts that any asset rights would be respected, effectively you could be buying nothing. As well with the Moscow Exchange closed, the liquidity is next to nil.

On the fixed-income side, bonds have effectively defaulted for foreigners. Russia is only willing to pay Rubles for bonds instead of the stated foreign currency. The issue for foreigners is they will be unable to sell the volatile Rubles for their desired currency, as well as being stuck within Russia with minimal investment opportunities. To make matters worse for the broader market, some credit default swaps may not trigger since some bonds do state Ruble payment can be done.

Investors will be unable to invest new funds into a market that does not respect property rights, limited liquidity if you’re even able to sell. Ultimately capital inflows from equity and fixed income investors will be drastically lower for a long time.

CBR has increased currency market operations from USD 3B to USD 5B. This is where Russia’s war chest of foreign currency comes in, the problem is half resides outside of Russia, and will not be able to control the decline.

One of the CBR’s initial controls has already failed, a ceiling was set for the USD and EUR exchange rates. The proposed rates were 90 RUB/USD and 101 RUB/EUR, which have utterly failed. So, the CBR has implemented stronger capital controls.

Companies must sell 80% of foreign revenue to CBR, in other words, 80% or greater of the nation’s foreign currency will now automatically be sold for Rubles to prop it up. As sanctions ramp up causing international trade to decrease the effect of this capital control will be lessened.

The restrictions go down to the personal level, Russians are now only allowed to export the equivalent of $10,000 of foreign currencies each month. The CBR is doing this to limit capital flight, but some Russians are using alternatives such as cryptocurrencies to flee the depreciating Ruble. Other Russians simply emptied ATMs and banks of foreign currency before the capital controls were implemented. Citizens are seeing the writing on the wall, the Ruble is dying.

In summary, capital inflows have disappeared while a flood of outflows has pushed the CBR to a panic mode.

Printing & Borrowing

Most people associate hyperinflation with money printing because it is the inevitable result of severe production destruction and capital outflow. The government needs to be able to pay for its increased wartime expenses while having a lower taxation base. The other option is to issue sovereign debt, which grants time to regain control over the currency.

The CBR pre-emptively built a war chest of foreign currency to buffer the printing and borrowing event, but due to capital restrictions, the war chest’s power was immediately diminished. Once the war chest is completely diminished, the Ruble will have no support, leading to printing and borrowing.

To attract deposits, the CBR raised interest rates to 20% from 9.5%, which were already up from 8.5% a couple of weeks prior. The 10Y bond yield is hovering around the 20% rate currently, showing some long-term support.

Russia Yield Curve as of March, 7th 2022

Russia Yield Curve March, 7th 2022 (World Government Bonds)

But, the yield curve is already inverted, a classic sign of recession, 1Y bonds are trading at a 24.5% yield. The issue with heightened rates is the economy needs to be stimulated as well, due to the decline in production capability. The CBR has an extremely difficult balancing game ahead of them.

A new issue arises when the debt matures. The first question is whether any defaults will occur, particularly against foreign-held debt. The next question is whether to roll the debt, most likely at a higher and higher rate, or print to pay off the debt. The longer the debt is rolled at a continuously heightened interest rate, the more likely a default or printing to pay will occur.

If the CBR’s hand is forced into continuous printing, hyperinflation will occur.

The Unfortunate Outcome

The longer the war and therefore the sanctions go on, the more likely hyperinflation will occur. If hyperinflation occurs, more pain will occur against the citizens of Russia who were forced into this war by Putin. Even if hyperinflation does not occur, the economic prospects of Russia are going to be severely damaged for years if not decades to come.

Setting a Position

The issue with deciding a position is you do not want to own an asset or short an asset that is under Russian jurisdiction. The market agrees with this as the MSCI Russian ETF (ERUS) which relies on American depository receipts is trading at $0.06, or -99.86% YTD, effectively worthless.

Russian-based ETFs such as (RSX) has been halted due to regulatory concerns, and are unlikely to open back up. Even ETFs where Russian equities are a portion are being reconstructed to remove Russian exposure. Bonds are seeing a similar story, being removed or discounted to near-zero when in an ETF wrapper.

Shorting the Ruble is the best and easiest way to directly capitalize on this, but make sure if you’re playing with futures that the implied interest is reasonable because, during volatile times, the rate may shoot up.

For indirect methods which are less risky, you can go long on companies and commodities that Russia exports. Oil (CL1:COM), gold (XAUUSD:CUR), copper (HG1:COM), and metallurgical coal are all significant exports of Russia. If you want an indirect equity, look for producers with no Russian exposure such as ConocoPhillips (COP) for Oil, or Teck Resources (TECK) which produces copper, metallurgical coal, as well as other commodities.



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