4 Financial Components to Improved Russian Relations

by Jim Rickards, Daily Reckoning

With the U.S. preparing to confront China and go to war with North Korea, Russia is an indispensable ally for the U.S.

There are huge implications on capital markets as these hegemonic powers continue to edge toward war.

Here’s an overview of some of the financial implications of improved relations with Russia…

1: The End of OPEC and the Rise of the Tripartite Alliance

On energy, a new producer alliance is being created to replace the old OPEC model. This new alliance will be far more powerful than OPEC ever was because it involves the three largest energy producers in the world — the U.S., Russia, and Saudi Arabia. This Tripartite Alliance is being engineered by former CEO of Exxon and Secretary of State Rex Tillerson, with support from Trump, Putin and the new Crown Prince of Saudi Arabia, Mohammad bin Salman.

This alliance is perfectly positioned to enforce both a price cap ($60 per barrel to discourage fracking) and a price floor ($40 per barrel to mitigate the revenue impact on producers). Supply cheating by outsiders, including Iran and Nigeria, can be discouraged by directing order flow to the alliance members, which denies the cheaters of any revenue.

As a result, energy will trade in the range described. Traders can profit by buying energy plays when prices are in the low 40s and selling when prices hit the mid-to-high 50s.

2: Improved U.S. Relations with Russia and Sanctions Relief

Following Russia’s annexation of Crimea and intervention in eastern Ukraine, President Obama imposed stringent economic sanctions on Russia, its major banks and corporations, and certain political figures and oligarchs. The EU joined these sanctions at the behest of the U.S. Russia responded by imposing its own sanctions on Europe and the U.S. in the form of banning certain imports.

The sanctions have been a failure. They have had no impact on Russian behavior at all. Russia still acts freely in Crimea, eastern Ukraine, and in other spheres of influence such as Syria.

This failure was predictable. Russian culture thrives on adversity. Russians understand that their culture is distinctly non-western and has its roots in Slavic ethnicity and the Eastern Orthodox religion.

The benefits to Europe from sanctions relief would amplify what is already solid growth and monetary policy normalization there. This paints a bullish picture for the euro and the ruble as trade and financial ties expand beginning in 2018.

A review of Russia’s place in the world and its prospects would not be complete without an analysis of its monetary policies and positions.

Russia’s hard currency and gold foreign exchange reserves have been on a roller coaster ride since mid-2008, just before the panic of 2008 hit full force. Reserves were $600 billion in mid-2008 before falling to $380 billion by early 2009 at the bottom of the global contraction.

Reserves then expanded to over $500 billion by mid-2011, and remained in a range between $500 billion and $545 billion until early 2014.

Russia’s reserves nosedived beginning in mid-2014 due to the global collapse of oil prices, which fell from $100 per barrel to $24 per barrel by 2016. The Russian reserve position fell to a low of $350 billion by mid-2015, about where they were at the depths of the 2008 crisis.

Reserves then began a second recovery in late 2015 and today stand at around $420 billion. This recovery is a tribute to the skill of the head of the Central Bank of Russia, Elvira Nabiuillina, who has twice been honored as the “Central Banker of the Year.”

When U.S.-led sanctions prohibited Russian multinationals, such as Gazprom and Rosneft, from refinancing dollar- and euro-denominated debt in western capital markets in 2015, those giant companies turned to Nabiullina. They requested access to Russia’s remaining hard currency reserves to pay off maturing corporate debt.

Nabiullina mostly refused their requests and insisted that the reserves were for the benefit of the Russian people and the Russian economy and were not a slush fund for corporations partially controlled by Russian oligarchs.

Nabiullina’s hard line forced the Russian energy companies to make alternative arrangements including equity sales, joint ventures, and yuan loans from China (which could be swapped for hard currency) to pay their bills. As a result, Russia’s credit was not impaired and its reserve position gradually recovered.

3: Watch Russia’s “Gold-to-GDP” Ratio

Another critical aspect of Russia’s reserve management under Nabiullina is that, even at the height of the oil-related drawdown in mid-2015, the Central Bank of Russia never sold its gold. In fact, it continued expanding its gold reserves. This meant that gold reserves as a percentage of total reserves continued to grow.

The Russian reserve position today consists of approximately 17% gold compared to only about 2.5% for China. (The U.S. has about 70% of its foreign exchange reserves in gold; a surprisingly high percentage to most observers who never hear any positive remarks about gold from U.S. Treasury or Federal Reserve officials).

More important as a measure of Russia’s gold power are gold reserves as a percentage of GDP. If we take GDP as a metric for the economy, and gold as a metric for real money, then the gold-to-GDP ratio tells us how much real money is supporting the real economy. It is the inverse of leverage through government debt.

For the United States, that ratio is 1.8%. For China the ratio is estimated at 1.5% (China’s ratio is an estimate because China is non-transparent about the amount of gold in its reserves. The actual ratio is likely in a range of 1% to 3%).

For Russia, the gold-to-GDP ratio is a whopping 5.6%, or three times the U.S. ratio. The only other economic power that comes close to Russia is the Eurozone. It consists of the 19 nations that use the euro and they collectively have just over 10,000 metric tonnes of gold.

The gold-to-GDP ratio for the Eurozone is 3.6%; not as high as Russia, but double the U.S. ratio. On the whole, Russia is the strongest gold power in the world.