4 Financial Components to Improved Russian Relations

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.

Russia is one of the five largest gold producers in the world. Currently Russian gold mining output is sold on the open market and the Russia central bank buys gold for its reserves on the open market. This stands in contrast to the situation in China, the world’s largest gold producer, where gold exports are banned, and are partly diverted to government reserves at below market prices.

However, Russia could easily flip to the China model in a financial crisis. This would rapidly increase Russian gold reserves at low cost, while drastically reducing global physical supply.

Russia and China are well-positioned to execute the greatest gold short squeeze in history. Of course, they have no interest is doing so right now because both are still buyers who favor low prices. At some point, they will flip to hoarders who favor high prices, but not yet.

Russia’s strong gold position combined with a very low amount of external debt leaves Russia in the best position to withstand economic distress without default or a funding crisis in the future. This is one reason U.S. economic sanctions have been relatively ineffective at hurting the Russian economy despite a slowdown and recent recession.

This trend in gold as a percentage of total reserves is highly revealing. It is part of a long-term effort by Russia and China (among others) to abandon the dollar-based international monetary system. They’d prefer a system less congenial to the United States and more accommodating to rising gold powers such as Russia, and rising geopolitical powers such as China.

Gold is not the only factor in the Russian plan to abandon the dollar-based system. Russia has actively promoted the ruble (RUB) as a regional reserve currency. The ruble has no prospect of becoming an international reserve currency for decades, if ever. Yet it is in wider use in bilateral trading payments in eastern Europe and central Asia where Russia is trying to reestablish local economic hegemony along the lines of the former Soviet empire.

4: Russian Relations and Blockchain Technology Will Challenge U.S. Dollar Dominance

Russia is also exploring the use of blockchain technology and crypto-currencies as a medium of exchange and as a payments platform. Recently, Putin met with Vitalik Buterin, the inventor of crypto-currency ethereum.

Buterin was born in Kolomna, Russia and was able to converse casually with Putin in their native Russian language. Here’s how Bloomberg reported the meeting on June 6, 2017:

Ethereum, the world’s largest cryptocurrency after bitcoin, has caught the attention of Vladimir Putin as a potential tool to help Russia diversity its economy beyond oil and gas…

‘The digital economy isn’t a separate industry, it’s essentially the foundation for creating brand new business models,’ Putin said at the event, discussing means to boost growth long-term after Russia ended its worst recession in two decades…

Russia’s central bank has already deployed an Ethereum-based blockchain as a pilot project to process online payments and verify customer data with lenders including Sberbank PJSC, Deputy Governor Olga Skorobogatova said at the St. Petersburg event. She didn’t rule out using Ethereum technologies for the development of a national virtual currency for Russia down the road.

Last week, Russia’s state development bank VEB agreed to start using Ethereum for some administrative functions. Steelmaker Severstal PJSC tested Ethereum’s blockchain for secure transfer of international credit letters. (Emphasis added).

Left unsaid in this report is the fact that the blockchain technology on which ethereum is based has unbreakable encryption. Its message traffic is routed through an infinite number of internet pathways that the U.S. cannot interdict. Any blockchain-based payment system offers a way to run a global payments system independent of existing systems controlled by the U.S. such as FedWire and SWIFT.

Bitcoin and ether boosters were quick to shout about the Putin-Buterin meeting as evidence of Russian support for bitcoin or ether. That’s not exactly right.

Putin’s interest is in the blockchain technology, not any particular crypto-currency. With the right technology platform, Russia could launch its own crypto-currency. This could be a digital-RUB or a jointly issued currency with China and other members of the Shanghai Cooperation Organization.

Whichever platform or direction Russia chooses, they all point in the same direction — the displacement of the dollar as a dominant transaction and reserve currency, and the creation of payments systems that the U.S. cannot sanction.

This project will continue on a gradual basis in the years ahead and then suddenly be unleashed in the equivalent a gold and digital Pearl Harbor sneak attack on the dollar.

What Does This All Add Up To?

Absent the phony scandals that have impeded the Russian–U.S. relationship for the past eight months, a substantial improvement in that relationship would have occurred already. As it is, the relationship will improve either because the scandals abate or because Trump pushes the relationship forward despite the scandals.

This is a simple matter of balance-of-power politics. With the U.S. preparing to confront China and go to war with North Korea, Russia is an indispensable ally-of-convenience for the U.S. This emerging U.S.–Russia condominium has implications far beyond China, including common interests in Syria, energy markets, and toward sanctions relief.

Notwithstanding the prospect of improved relations, Putin remains the geopolitical chess master he has always been. His long game involves the accumulation of gold, development of alternative payments systems, and ultimate demise of the dollar as the dominant global reserve currency.

It is up to the United States to defend that monetary ground. However, the likelihood of that is low because the U.S. does not even perceive the problem it’s facing, let alone the solution.

This evolving state of affairs creates enormous opportunities in the months and years ahead.

Regards,
Jim Rickards
for The Daily Reckoning