Russian President Dmitry Medvedev said on Tuesday he had signed a decree recognizing the Georgian rebel regions of South Ossetia and Abkhazia as independent states. In the aftermath to the diplomatic chaos this decision is causing Russia’s RTS Stock Index fell more than 6 percent to hit its lowest level since 2006 and the ruble dropped significantly.

The RTS index of 48 companies posted the biggest decline among 89 global equity measures tracked by Bloomberg today, while Russia’s currency slid to its lowest level in almost seven months against the dollar. Credit-default swaps on Russian debt climbed 7 basis points, according to CMA Datavision prices in London, as the U.K. Foreign Office “categorically” rejected President Dmitry Medvedev’s move and Italy and France expressed regret.

Medvedev’s statement today accelerated a decline sparked by a drop of more than 2 percent in crude and slumping metals prices. The dollar-denominated RTS Index fell 4.3 percent to 1,576.36 at 5:48 p.m. in Moscow, extending its third-quarter drop to 32 percent. The ruble-denominated Micex Index slumped 2.1 percent to 1,292.92, the lowest level since September 2006.

VTB Group, Russian’s second-biggest bank, plunged 3.2 percent to 6.63 kopeks, the lowest level since its initial public offering last year.

Analysts Shocked By Gazprom Plans

OAO Gazprom, the country’s biggest publicly traded company, sank for a third day today, losing 0.9 percent to 230.79 rubles. Today’s Gazprom fall follows a 2.9 percent fall last Friday after analysts said they were “shocked” by the company’s plans to raise its investment budget to more than $40 billion this year.

Russia’s natural-gas exporter has indicated it may raise its investment budget for 2008 by about 25 percent. Gazprom last month already increased the budget for 2008 by 16 percent to a record 822 billion rubles ($33.8 billion).

“We’re shocked by the magnitude of the numbers, especially given that the company revised its investment plans only a month ago,” Troika Dialog analysts Oleg Maximov, Valery Nesterov and Alex Fak wrote in a note to investors today. “This raises questions about whether the management actually intends to generate any meaningful free cash flow.”

JPMorgan Chase & Co.’s Moscow-based analysts said in a note on Friday that they “doubted” the ability of what is Russia’s biggest company to invest that amount of money efficiently. The spending signals “potential value destruction” for the stock, the bank said in the note.

Yields on Russian Credit Default Swaps Rise

Credit-default swaps on Russian government debt rose 7 basis points from Aug. 22 to 135, according to CMA Datavision prices at 12 p.m. in London. Contracts on Gazprom rose 11 basis points to 267, CMA prices show. Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements. A rise indicates a deterioration in the perception of credit quality; a decline signals the opposite.

Fitch Warns On Investor Sentiment

Rising tension with the West could damage foreign investor sentiment towards Russia, according a statement from the credit ratings agency Fitch after the announcement, although they stressed that they do not immediately see Russia’s sovereign rating coming under threat. Fitch head of emerging European sovereigns Edward Parker did however go out of his way to underline how conditions for Russian corporate and quasi-sovereign borrowers may become more difficult in the aftermath the decision to recognise Georgia’s rebel regions.

He said the fallout of the conflict may also affect sentiment towards other Central European and ex-Soviet states but that the oil and gas-rich country’s vast foreign reserves eased the risks to the Russian economy itself in the short term. Fitch rates Russia as “BBB+” with a stable outlook.

“In terms of the cost of the conflict, the impact on the economy is negligible,” Parker told Reuters in a telephone interview. “We’re not expecting to take a negative action with regards to Russia’s rating. The main potential impact on Russia is through an impact

on capital flows into the country… affecting foreign investment.”

Parker said Russian foreign exchange reserves saw a slight fall last week but that it was too soon to say if the trend would continue.”It’s still very early days to assess the impact,” he said. “Given that Russia has $580 billion in foreign exchange reserves, it has the ability to ride out weekly changes.” But he said some Russian corporate borrowers as well as quasi-sovereigns – firms seen almost indissolubly tied to the state – might face problems with foreign lenders.

“There are a significant number of corporates who are very dependent on international capital markets,” he said. “There could be an impact on the Russian banking system as well.”

Investor sentiment towards other regional economies was also being affected, he said. Ukraine is seen amongst the most exposed, with any fall in foreign direct investment potentially making it harder to cover their current account deficit. Parker said there was already some impact on investor sentiment towards the Baltic states as well as Central European countries such as Poland, which has angered Russia by agreeing to house a U.S. missile defence shield.

“We don’t see any immediate impact — it’s more a potential impact if Russia decides to take more aggressive action in due course,” Parker said. “But it is affecting investor sentiment.”

He said Fitch was keeping a close eye on other “frozen conflicts” in the region such as Moldova’s Transdniestria region – which like Abkhazia and South Ossetia is home to Russian peacekeepers – as well as in Azerbaijan and Armenia.

Some General International Comments

Carl Bildt, Foreign Minister, Sweden

“That the Russian government leadership now has chosen this route means they have chosen a policy of confrontation, not only with the rest of Europe, but also with the international community in general.” “The decision represents a Russian choice of path that will have sweeping consequences for a long time to come.” “The decision represents a breach of international law and basic principles of stability in Europe, which is as obvious as it is intentional.”

Franco Frattini, Foreign Minister, Italy

“The Balkanization of the Caucasus on an ethnic basis is a serious danger for everyone.”

British Foreign Ministry Spokesperson

“We reject this categorically and reaffirm Georgia’s sovereignty and territorial integrity.” “This is contrary to obligations that Russia has repeatedly taken on in (United Nations) Security Council resolutions.”

French Foreign Ministry Spokesperson

“We consider this a regrettable decision and I recall our attachment to the territorial integrity of Georgia.”

Uwe Halbach, Caucasus Expert, German Institute For International and Security Affairs

“There will scarcely be a neighbor of Russia’s that won’t judge this negatively.” “Russia will face accusations of breaching international law by Europe and much of the rest of the world. Hardly any other state will follow this (recognition). Russia will stand relatively alone with this step, in contrast to the recognition of Kosovo.”

“(Europe) is standing relatively helplessly … as regards an effective response to this Russian statement.”

“Russia knows that there are very different views among Europeans about sanctions, and that they have limited capacity to impose sanctions. Economic sanctions boomerang back on those who impose them, and diplomatically … you can’t break off all diplomatic contact if you still hope to exert some influence on Russia.”

Ondrej Soukup, Association For International Affairs, Prague

“We could expect it because (the regions were) de facto independent, and especially in the last two, three years, Russia has invested large money into both republics. Especially after the conflict in South Ossetia, it was just a question of time before they would recognize them officially.”

“The Russians are saying there is a Kosovo precedent, but this situation is completely different in each of the republics.”

“I don’t think (there could be a return to fighting) because basically they achieved all their goals, except maybe the removal of (Georgian President Mikheil) Saakashvili. On the other hand, his position is now quite weak.”

Vladimir Osakovsky, Economist, Unicredit Aton

“It’s likely capital outflow will continue and probably even intensify on the back of a possible escalation of the conflict and possible economic sanctions against Russia.”

“Capital outflow is likely to add to the weakening of the rouble which we have been witnessing recently.”

Erik Depoy, Strategist, Alfa-Bank

“The whirlwind crescendo of bad news seems never-ending. But the lower this market goes, the more attractive it becomes for fundamental-based investors who have a longer-term horizon.”

“We’re in a very, very thin market right now. The second half of August is the peak of the vacation season … it’s almost dysfunctional right now.”

“This is one of the worst corrections we’ve seen in a decade … it’s bigger than the one in 2004, bigger than the one in 2006.”

“Across the board the valuations speak for themselves but — and it’s a big ‘but’ — no-one wants to be the first to stick their foot back into the market.”

“It’s self-fulfilling: the fewer people buy, the worse the prices get. What you need is an indisputable catalyst for the domestic market. At this point, the only thing we can think of is some kind of announcement on the oil tax regime. That would be indisputably linked to the major part of the market, have an immediate bottom-line impact and draw some people in.”

David Aserkoff, Equity Strategist, Renaissance Capital

“If you look at the RTSI futures, they dropped about 25 points on the news Russia had recognized Abkhazia and South Ossetia. I think what investors have been hoping in the last couple of weeks is for the government to take active steps to minimize the conflict. And the recognition of these two entities is clearly a step in the wrong direction from the stock markets’ point of view.”

“This is a symptom of the poor sentiment toward Russia on the international public level, on the domestic political level, and oil prices are at a new low in recent days and weeks. It is very hard to see any positives for the Russian market at the current time.”

“However, every single stock on MICEX at this point is in the red, and well in the red. You are seeing a host of technical indicators that are telling you this market is grossly oversold. It is hard for me to see how the news gets worse unless oil dips below $105.”

Last 5 posts by Edward Hugh

• German Exports and that Looming Double Dip - March 11th, 2010
• The German Economy Is Essentially "Intact" - March 8th, 2010
• Just What Is The Real Level Of Government Debt In Europe? - February 14th, 2010
• Greek Bailout News (1) - January 31st, 2010
• My impressions of the India-US summit - January 22nd, 2010