Russia's move towards a flexible rouble exchange rate may well prove a boon for the struggling economy, but foreign stock and bond investors should brace for short-term losses as the currency finds a new level.
The Russian central bank this week scrapped so-called targeted interventions, bringing an end to hard currency sales of up to US$60 million ($72 million) a day and indicating that a planned shift to a fully floating rouble on January 1, 2015, is on track.
Having spent a third of its hard currency reserves to defend the rouble in 2008, Russia is clearly signalling it will take a different tack during the current market turbulence by letting the currency take the strain.
The intention to target inflation rather than the exchange rate is widely seen as positive for Russia, with a weaker rouble providing stimulus and helping to halt the steady balance of payments deterioration.
But in today's world, which looks distinctly unfriendly towards emerging markets, the move was interpreted as an invitation to sell the rouble, which fell to four-year lows against a euro-dollar basket.
The weakness may continue - risk-reversals, a measure of the relative demand for options on a currency rising and falling against the dollar, show a clear near-term skew for sharp rouble weakness .
"They are doing the right thing, but it's going to be difficult to make the change in such a turbulent market for emerging currencies. It will make people wary of rouble-denominated assets," said Luis Costa, head of CEEMEA strategy at Citi.
He noted that Russian debt was relatively resilient during the emerging markets sell-off caused by the US Federal Reserve's decision to start cutting back on its bond-buying.
That's down to Russia's relatively strong financial position but also authorities' implicit support for the rouble.
Foreign bond investors who piled into Russia following the 2013 liberalisation of the OFZ rouble bond market have largely stayed put, their portion of the market at 26 per cent at the end of November 2013, from less than 5 per cent in early 2012.
They are also mostly in the mid- to longer-dated bonds, which Costa says is most correlated with the rouble rate.
"From a foreign investor's point of view, the rouble component of holding the OFZ is now definitely negative.
The odds are you will have losses on the currency irrespective of how the bonds do," he added.
The flip side? Policy focus on inflation and transparency will benefit financial markets if it brings down volatility and encourages saving.
The economy, which Russia acknowledges will grow at just 2.5 per cent a year in the next two decades, may also get a boost.
And crucially during these turbulent times, a flexible currency may insulate the economy from 2009-style shocks.
Russia's exchange rate has long been a political totem for President Vladimir Putin, who took power a year after a default crashed the rouble and wrecked the banking system in the 1998 economic crisis.
The post-Soviet history of hyperinflation, devaluation and default in the 1990s has engendered deep-seated aversions among Russians to long-term saving and investment.
But with the country's US$2 trillion economy now stalling, the targeted exchange rate had exacerbated economic volatility, said Morgan Stanley economist Jacob Nell.
"Fixed exchange rates generally make it more difficult for policymakers to adjust to changing commodity prices, especially oil prices," Nell said.
"The move to a flexible regime opens up the prospect of a much smoother adjustment to a changing oil price."
And the rouble is by no means undervalued: against its main trade partners and adjusted for inflation, it is just off decade-highs hit last year.
The US$200 billion defence of the currency in 2008 averted a run of defaults by indebted Russian companies, but deprived the economy of a lift that could have been provided by a cheaper currency.
The economy shrank 9 per cent the next year.
"The rouble may weaken, but you can't be too short-termist, they are doing it for right reason. It's positive if they seriously target inflation," said Grant Webster, a bond fund manager at Investec Asset Management.
Webster said short-dated Russian yields were high enough at over 6 percent to compensate for currency volatility, providing a roughly 2 per cent pick up over inflation.
But most Russian bond positions are unprotected from rouble fluctuations, because of a flat bond yield curve.
That means hedging currency exposure is costlier than, say, in South Africa, where yields on short-dated bonds are much lower than on the 10- or 30-year segment.
An investor hedging exposure on his 10-year South African bond would get a net return of around 2 per cent a year after hedging costs, a similar level to what is available in Russia, says UBS analyst Manik Narain.
But in Russia, returns may diminish as the curve extends while in South Africa the reverse is true, he said, adding that bond coupons net of hedging costs are also more attractive in other markets such as Mexico and Hungary at around 3.5 per cent.
EQUITY GOOD NEWS
Equity investors are less fazed. Ed Conroy, portfolio manager at HSBC Global Asset Management says a weaker rouble would provide an earnings margin boost for the energy and metals exporters that dominate the Moscow stock market.
That upside will take the edge off the weak rouble's immediate impact on foreigners' equity portfolios.
"Then we get to the issue of at what point does it become a problem to be exposed to rouble weakness and to companies that may be highly geared to debt in dollars," Conroy said,
He noted that Russian companies' gearing level - the ratio of borrowed funds - has risen to 2.1 times from 1.3 in 2008, but attributed this to increased borrowing by solid big-name state firms such as Gazprom and Sberbank.
"(Since 2008) most companies have de-geared and others have refinanced wisely," Conroy said.
"Now is not a bad time to go for exchange rate flexibility."