April 28 (Bloomberg) -- The prospect of Russia being cut to junk amid the escalating crisis with Ukraine threatens to rekindle a market selloff that last week’s surprise interest- rate increase appears powerless to prevent.
The ruble, which slid after Standard & Poor’s lowered the nation to its lowest investment grade and said more cuts may follow, closed weaker still even as Bank Rossii raised its key rate by 50 basis points. The cost of insuring against losses on government debt rose to the highest level in more than two years, and bond yields climbed to a six-week high.
While President Vladimir Putin downplayed the significance of ratings changes prior to the S&P decision, investor outflows may pick up in anticipation of the nation possibly being returned to junk, a category it escaped in 2005. Higher rates could backfire as they push up corporate funding costs and hamper the economy as the U.S. and Europe ready deeper sanctions against Russia because of its conflict Ukraine, according to Royal Bank of Scotland Group Plc.
“For investors it could mean more selling and getting out of Russian investments,” Ogeday Topcular, who oversees $300 million of assets at RAM Capital SA in Geneva, said by e-mail on April 25. “This would add a lot of pressure and create a vicious cycle for investments. The central bank is trying to put a patch on a big wound, but I don’t think it would help much.”
The premium investors demand to hold Russian dollar debt over Treasuries rose 31 basis points to 359 at the end of last week, the highest in more than two years, JPMorgan Chase & Co. indexes show. The spread averaged 232 basis points, or 2.32 percentage points, in the past 12 months.
The U.S. will impose sanctions as early as today on Russian companies and individuals close to Putin, Deputy White House National Security Adviser Tony Blinken said yesterday.
S&P’s downgrade is Russia’s first since Fitch Ratings cut the country to BBB in February 2009 after the collapse of Lehman Brothers Holdings Inc. triggered a rout in commodity prices.
The world’s biggest energy exporter was placed on review for a downgrade last month by Moody’s Investors Service, while Fitch lowered its outlook to negative. Russia’s rating may be cut again if the economic slowdown persists, S&P said last week.
Gross domestic product may expand less than 0.5 percent this year or not grow at all, according to Finance Minister Anton Siluanov. GDP grew 1.3 percent in 2013, the slowest pace in four years. Capital outflows surged to $50.6 billion in the first quarter compared with $63 billion in all of 2013.
“If the crisis with Ukraine escalates, the probability increases that Russia will lose its investment-grade status,” said Marco Ruijer, who helps oversee about $8 billion in emerging-market bonds at ING Investment Management in The Hague.
A cut to junk would “impact the Russian economy almost like a tougher sanction” as its bonds would be dropped from indexes tracked by funds and holders who can only own investment-grade securities, Ruijer said by e-mail on April 25.
The central bank raised the one-week auction rate to 7.5 percent from 7 percent, citing “higher inflation risks” in a website statement on April 25. All but one of 23 economists in a Bloomberg survey had forecast no change.
The measure follows a surprise 150 basis-point increase last month, as the central bank sought to shore up Russian assets after Putin’s incursion in Ukraine’s Crimea region triggered a sell-off in the stock market and the ruble.
The currency has lost more than 8 percent this year against the dollar, the second-worst performance among 24 emerging- market currencies tracked by Bloomberg, after Argentina’s peso.
S&P’s downgrade of Russia’s rating was expected by investors and won’t significantly change their behavior, Economy Minister Alexei Ulyukayev said April 25. The cut was “partly political” and partly based on the economic situation, he said.
Russia, which gains half of its tax revenue from oil and gas activities, has public debt amounting to 10 percent of GDP, compared with 37 percent for Brazil, also rated BBB- at S&P.
Investors routinely ignore ratings companies’ decisions. In almost half the instances, yields on government bonds fall when a rating action by Moody’s and S&P suggests they should climb, or they increase even as a change signals a decline, according to data compiled by Bloomberg on 314 upgrades, downgrades and outlook changes starting from the 1970s.
The S&P action and rate increase “could hurt the banks via higher funding costs, and therefore the bearish reaction might not be over,” Richard Segal, a strategist at Jefferies International Ltd. in London, said by e-mail on April 25.
Credit-default swaps insuring Russian debt against non- payment climbed 19 basis points to a two-year high of 284, compared with an average of 182 in the past 12 months.
The yield on Russia’s benchmark 2027 ruble bonds jumped 65 basis points last week to 9.65 percent. The ruble weakened 0.8 percent to 42.2707 against the central bank’s target basket of dollars and euros on April 25. It was trading at about 42.17 to the basket when the central bank announced the rate increase.
Putin’s seizure of Crimea last month prompted the worst standoff with the U.S. and its allies since the collapse of the Soviet Union, leaving Russian policy makers to grapple with an economy on the brink of recession and an inflation rate above the central bank’s target for the 19th month.
The U.S. and its allies have an additional list of sanctions ready and will act if there is no progress in de- escalating the crisis in Ukraine, where security forces are moving against pro-Russia separatists, U.S. President Barack Obama said on April 24 in Tokyo.
The downgrade “sours the mood in the market,” Tatiana Orlova, an economist at RBS in London, said in e-mailed comments April 25. “I am more surprised that the central bank hikes rates at the time when there is a risk of a further blow to the economy from additional sanctions.”