For Russian President Vladimir Putin, the deadly clashes in neighboring Ukraine couldn't have come at a worse time.
The violence that threatens to topple a government propped up by his financial aid is taking investors' attention away from the Olympic games in Sochi that he sought to use as a showcase for how far Russia has come since its 1998 default. The ruble sank 1.7 percent this week, the worst rout in emerging markets, while demand for local bonds dried up, pushing benchmark yields to a record high and prompting the government to cancel its third debt auction in four weeks.
While Ukraine, with a population of 45 million, is too small to drag the world's ninth-biggest economy into crisis, the country is Russia's fourth-largest trade partner and home to a gas pipeline that state-controlled OAO Gazprom uses for more than half its European exports. What's more, Putin has pledged $15 billion in aid to pry the former Soviet republic away from a potential pact with the European Union after he oversaw spending on Sochi that soared to $43 billion from an initial $12 billion.
"The meddling with Ukraine certainly hurts Russia's image as an investment destination," David Hauner, a fixed-income and currency strategist at Bank of America Corp., said in a telephone interview from London. "It is not going to bankrupt Russia, but $15 billion can turn out to be $50 billion, and Russia will have to plug the holes for a couple years."
The tumble in Ukrainian debt prices triggered by the violence signals Russia is already suffering losses in the market value of the $3 billion of bonds it bought in the aid package's first installment.
A truce between President Viktor Yanukovych and rivals demanding snap elections proved short-lived as skirmishes broke out yesterday at the protest site in Kiev's Independence Square. Authorities reported at least 77 have died since the fighting began Feb. 18.
The EU imposed sanctions freezing assets belonging to Ukrainian government officials and sent envoys to Kiev to try to end the violence. Yanukovych interrupted the talks with EU ministers yesterday to make a phone call to Putin, whose spokesman Dmitry Peskov denied speculation the Ukrainian leader was seeking safe haven. He said crisis mediation was discussed and Russian human-rights ombudsman Vladimir Lukin was sent to Kiev.
Ukraine's benchmark dollar bonds due in 2023 are trading at about 82 cents on the dollar, down from 95 cents in mid-January, to yield 10.7 percent. The nation's debt rallied today, with the price on $1 billion of 7.95 percent notes due in June climbing to 95 cents from 93.8 cents yesterday, after the presidential administration said an accord resolving the crisis will be signed today. The securities yield 27.3 percent.
Ukraine is at risk of default after the situation "deteriorated substantially," Standard & Poor's said in an e- mailed note today. S&P cut Ukraine to CCC, eight levels below an investment rating, from CCC+ and kept its outlook negative, citing the increasing risk that Yanukovich's government will fail to service its debt.
Ukraine scrapped a planned $2 billion bond sale, according to a statement dated Feb. 20 from the Irish Stock Exchange. Russia's sovereign wealth fund invested the first $3 billion in two-year notes in December, a month after the protests began.
"Primarily the aid was driven by the political ambitions of Moscow, so that Russia could maintain influence over Ukraine," Dmitry Polevoy, chief economist for Russia and the Commonwealth of Independent States at ING Groep NV in Moscow, said in a telephone interview. The money "was meant to stabilize Ukraine's finances" and avert a default, he said.
The selloff in Russian financial assets, while less pronounced than the rout in Ukraine, has been among the worst in emerging markets.
The ruble has slumped 8.1 percent against the dollar this year, the biggest plunge after Argentina's peso among 24 emerging-market currencies tracked by Bloomberg, even as the central bank intervened in the foreign-exchange market to stem losses. Foreign reserves fell to a three-year low of $490 billion on Feb. 7, a week after Deputy Economy Minister Andrey Klepach said that capital outflows may reach $35 billion in the first quarter, more than half of the $63 billion that left the country in all of 2013.
Morgan Stanley strategists said investors may be dumping the ruble as a hedge against losses in their Ukrainian assets. They picked selling the ruble as their top emerging-market currency trade recommendation for 2014.
The government scrapped its weekly bond auction on Feb. 19, the third cancellation in less than a month, as the currency's slump cooled demand for ruble-denominated securities. Yields on bonds due 2028 dropped four basis points to 8.53 percent today after reaching a record 8.62 percent earlier this week.
The benchmark Micex stock index has fallen 1.5 percent this year, leaving the gauge trading at 5.3 times estimated earnings for the next 12 months. That's about half of the valuation investors are willing to pay for shares in the MSCI's Emerging Market Index.
"From a psychological standpoint, Ukraine's problems affect foreign investors' perception of Russia," Vladimir Bragin, head of research at Alfa Capital in Moscow, said in a telephone interview. "In their eyes, the first reaction is to sell Russia, cut risks. It's in Russia's interests that the situation stabilizes" in Ukraine.
The Finance Ministry's press service didn't immediately return phone and e-mail messages left after regular business hours seeking comment on the market declines.
Not all investors have been deterred.
Overseas demand was strong enough that Gazprom, the country's largest company, and OAO Sberbank, the biggest lender, were able to lead corporate bond sales of $2.5 billion this week. It was the busiest week for Russian issuers abroad this year, according to data compiled by Bloomberg. Investors are more comfortable buying Russian securities denominated in dollars amid the ruble selloff, said Dmitry Dudkin, head of fixed-income research at UralSib Capital in Moscow.
"Having ruble risk is quite scary now for foreign investors," Dudkin said in e-mailed comments.
The Ukraine turmoil is compounding investor concern that the economic boom that Putin, 61, helped oversee after the default is giving way to stagflation.
The International Monetary Fund last month cut its 2014 growth forecast for Russia to 2 percent from a previous 3 percent, the biggest reduction among major economies. Gross domestic product expanded 1.3 percent last year, down from an average growth rate of 7 percent in the decade following the default. Inflation has averaged 6.8 percent over the past four years, above the central bank's 5 percent target.
For Putin, the scrutiny comes at a time when he was looking to use the Olympics to highlight's Russia's world-power status.
The $43 billion the country spent to turn Sochi, a summer resort on the Black Sea, into a venue suitable for winter sports events made the games the most expensive ever. Putin attended the almost three-hour-long opening ceremony, which charted centuries of Russian history, and has been in the stands for events throughout the two weeks, including the national hockey team's loss to the U.S. on Feb. 15.
Putin was back in Moscow four days later when the team, co- favorites to win its first gold medal since the breakup of the Soviet Union two decades ago, was ousted in the quarterfinals by Finland. It was another setback in what has proven a rough week for the president.
While Putin was looking to "showcase" Russia in Sochi, the country "has underlying fundamental problems and weakness," Tim Ash, chief emerging-market economist at Standard Bank Group Ltd. said in a phone interview from London. "The perception that the meddling by Russia is destabilizing Ukraine is not particularly good for him."
--With assistance from Halia Pavliva, Elena Popina and Erik Matuszewski in New York, Lyubov Pronina in London, Ott Ummelas in Tallinn and Alex Nicholson in Moscow. Editors: David Papadopoulos, Rita Nazareth
To contact the reporters on this story: Ksenia Galouchko in Moscow at kgalouchko1bloomberg.net; Ye Xie in New York at yxie6bloomberg.net
To contact the editors responsible for this story: David Papadopoulos at papadopoulosbloomberg.net; Daniel Tilles at dtillesbloomberg.net