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Will The Russian Bear And The Chinese Dragon Start To Dance?

Since the start of the war (and let’s face it, it’s no longer an ‘armed conflict’, it’s a ‘war’), there has been a very interesting political fight going on between the West and Russia whereby both sides were instating ‘sanctions’ onto the other. As can be seen on the next chart, the Russian ruble has been in free fall, but as the exports have been falling off a cliff, this definitely isn’t helping the domestic economy.

Source: Yahoo Finance

To provide some protection against a falling (well, ‘crashing’ would be a better choice of words) Ruble, the Russian Central Bank has continuously sold US Dollars on the market to counter the effects of its depreciating currency. The free fall of the Russian Ruble is caused by investors who’d prefer to ‘play it safe’ which are withdrawing as much cash as they can out of the sanctioned country. To counter this effect, Russia is dumping dollars on the market to protect a targeted exchange rate.

But here’s the problem. Last week, the country dumped not less than $2B on the open market, but still couldn’t avoid a further depreciation, as the Russian Ruble still ended the week with a loss of in excess of 2%. So where do these dollars come from? Fortunately for Russia, the country still is a net exporter of oil and gas, and these contracts are still settled in US Dollars. However, as the oil price has started to nose-dive as well (the price of crude oil has decreased by 15% in less than three months time), these revenues are decreasing fast and are definitely not sufficient to meet the Central Bank’s need for Dollars to dump on the market.

This has caused a real cash drain on the Central Bank of Russia, and its estimated foreign reserves are decreasing at a very fast rate. Whereas the country had –according to the International Monetary Fund - $514B in total reserve assets in June of last year, more than 10% has just ‘evaporated’ to $457B at the last official release approximately two weeks ago. As Russia continued to dump dollars on the market, we would expect the country to have less than $450B in reserves at the next update. The situation looks even worse when you look at the amount of foreign currency reserves. In just 9 months time (the official IMF numbers are limited to July 2014), the country lost in excess of $50B in foreign currency reserves, and the outflow rate seems to be accelerating which is an alarming fact.

So, if a country’s outflow in USD is (much) larger than the inflow from oil and gas revenues, how could this shortfall be funded? The first answer is ‘by selling Dollars out of the reserves’, and this is what Russia has been doing. However, at the current outflow rate this won’t be sustainable for much longer. So what else can a country do (as ‘attracting more foreign investment’ is out of the question)? The answer is: selling off gold to raise more cash in US Dollar which would increase the liquidity.

That’s the theory, as Russia hasn’t only been dumping dollars on the market to protect the ruble, it has also increased its gold holdings. In one year time, the Russian Central Bank has added not less than 3.5 million ounces of physical gold to its reserves, for a total value of $5B. As per the latest official IMF numbers, Russia now holds 35.5 million ounces of gold. This is still less than for instance France, Germany and the USA (at least their official numbers), but it’s fascinating to see Russia is electing to INCREASE its gold position, even though it’s scrambling to get its hands on US Dollars.

The ratio of gold vs total foreign reserves at the Central Bank might perhaps clear things up. Whereas the ratio was just 7.5% in June of last year, this rapidly increased to 9.83% as of July of this year (see the next chart). Considering the stronger outflow of foreign currency in the past few weeks, we feel very comfortable to say that in excess of 10% of Russia’s reserves are held in gold, which is an increase of more than 33% in just 13 months time.

Data source: International Monetary Fund

Enter the new Russia-China energy deal whereby Russia will provide China with oil and gas. By sanctioning Russia, the Western countries have facilitated China’s attempt to get in bed with the Russians which signed a 30 year contract with an estimated value of in excess of $400B (or 1.6 trillion Russian Ruble). As we all know the Chinese are real gold-bugs, one would have to start wondering if the new Russian policy to buy more gold could be aligned with something bigger than we have been anticipating by now?

With this new energy deal, Russia and China can now be seen as relatively close allies, and it’s interesting that Russia seems to be copying China’s policy to purchase more gold. The next few months will paint a clearer picture but the Russian move to buy more gold at a moment it’s scrambling to get its hands on US Dollars is truly remarkable as it means Russia is valuing buying gold more than it is to defend its currency.

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