Capital Ideas^TM

Russia’s military aggression against Ukraine, which has become Europe’s largest ground war in generations, has impacted millions of people and triggered a large-scale humanitarian crisis as vulnerable Ukrainians take shelter or flee their homes. The intensification and spread of the conflict is deeply troubling and is having a devastating impact on those people caught in the crisis.

This article focuses on potential market and economic implications of the conflict.

Serious questions are being asked about the long-term future of Russian securities in global indices as the combination of capital controls and financial sanctions by western governments has severely impacted its accessibility and investability by international investors.

Major index providers MSCI and FTSE typically look at a number of criteria when deciding whether a market is to be included in its indices. This can range from openness to foreign ownership, ease of capital flows, efficiency of the operational framework, availability of investment instruments and stability of the market.

In Russia’s case, its scores based on the above criteria are getting weaker by the day. The Russian equity market has been hampered by negative developments that include restrictions on the sale of securities on the Moscow exchange, exclusion of Russian banks from SWIFT, closure of the Moscow Exchange, and deterioration in the convertibility of the Russian Ruble into foreign currencies.

MSCI, for example, has already implemented an index freeze on all Russian securities to manage the risk of trading and settlement disruptions as a result of difficulties for market participant to replicate indices with Russia exposure.

It has also taken swift action to remove Russian stocks from its benchmark MSCI Emerging Markets Index starting 9 March 2022 after collating feedback from the global investment community, which led to the conclusion that the Russian equity market is currently uninvestable. FTSE Russell has also announced a similar move and will be excluding Russian stocks from all its equity indices on 7 March 2022.

What are the implications?

Compared to some of the more recent index exclusions, both MSCI and FTSE Russell have acted in an extremely condensed timeline. This signals both the unprecedented nature and gravity of the Russia-Ukraine conflict. Lebanon, for example, imposed capital controls in 2019 and was deleted from the MSCI Frontier Markets only a year later. Argentina also introduced capital controls in 2019 but it took the index provider two years to remove it from the MSCI EM index.

Given that market participants now have clarity on when Russian stocks will be removed, what can they expect in terms of impact on markets? At the end of February 2022, Russian stocks have weightings of approximately 1.6%¹ in both the MSCI Emerging Markets Index and the FTSE Emerging Markets Index. Once Russian stocks are removed entirely from both indices, depending on investment objectives resulting outflows might be expected to find their way to other markets within the same indices.

Using the MSCI EM Index as a reference, the five largest markets by weight are China (31.8%), Taiwan (16.1%), India (12.4%), South Korea (12.3%) and Brazil (5.1%). Consequently, these markets are also likely to be the main beneficiaries of the potential outflows from Russia. It is a similar story for the FTSE EM Index albeit with a slightly different cast as the top five largest markets by weight are China (34.5%), Taiwan (18.2%), India (14.9%), Brazil (6.3%) and Saudi Arabia (4.5%).

Index rebalancing can pose considerable challenges for passive investors as they can only react after the underlying index. This contrasts with investment managers whose decisions are grounded in fundamental research and have the flexibility to respond quickly.

One additional technical challenge is that trading in local Russian securities was frozen on the 28^th February 2022. Meanwhile, assets with exposure to Russian securities (for example tradeable American Depositary Receipts (ADRs)) were not halted, and these prices continued downwards. As a result, losses from holding Russian securities have been amplified for ADRs. The exclusion of Russia mid-month means that this effect will not correct at the following month end as might normally be expected with transient price discrepancies. 

 

1. Data as at 28 February 2022. Source: FTSE, MSCI