Debt explosion flattens economic prospects

  • 31 Oct 2008
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Russia presents a fascinating case study of the effects of the financial crisis on big emerging economies and how capital markets integrate. Its paradoxes are stark: rich natural resources, vast foreign exchange reserves and state-backed companies with high cashflows versus freefalling equity markets, an overbanked financial system and plunging oil prices. Will Stirling reports.

Russia’s financial system has been poleaxed by recent events in global markets, made worse by high profile problems at home, including the protracted dispute over the ownership of oil company TNK-BP, the government’s investigation into the pricing policy of steelmaker Mechel, the invasion of South Ossetia and other parts of Georgia and the growing fear of a new cold war with the West.

The figures make grim reading. Russia’s stock market is in meltdown — on October 24 the Russian Trading System fell to 589, below 600 for the first time in five years, and the rouble denominated Micex fell 16% in the same day. Total government and corporate debt stands at $560bn, well in excess of foreign currency reserves. Oil, which has powered Russia’s economic boom that began in 2002, is down to less than $63 per barrel. The $70 a barrel mark, economists say, is a watershed, below which it is estimated that with present trade flow, Russia’s balance of trade will slip into deficit. And interbank lending in October froze, putting the necks of many small banks and brokerages on the block. Four banks have so far collapsed. Meanwhile. five year sovereign CDS blew out from nearly 500bp to 1192bp in just over four days in October.

"In Russia they are really suffering," says Michael Ganske, head of emerging markets research at Commerzbank Corporates & Markets in London. "People talk about a country that is a net foreign creditor, with the third biggest reserves in the world, but its CDS price is above 1,000bp — it’s a unique situation."

Foreign investors, domestic and international hedge funds and oligarchs have been competing in a nightmarish distressed sellers’ race to exit the Russian stockmarket as fast as possible in what has been the country’s biggest equity sell-off in its history. "In the last two months there has been a lot of negative news and technically it is a very difficult situation because a lot of investors have been very long in Russia, especially in equities, so there has been big capital outflow — perhaps $30bn over two months," says Ganske. The oligarchs alone had lost $230bn by October 19, according to reports in the Russian media.

On October 21, the finance ministry issued a decree allowing the government to invest the National Wealth Fund in Russian stocks and bonds in a move to support company valuations.

Standard & Poor’s duly lowered the sovereign’s rating outlook from stable to negative, following its decision to move Russia from positive to stable in September.

A good, hard look at the books

In some countries, an equity market capitulation and banking freeze on this scale would be catastrophic. But Russia at least has some experience of crises.

While falling — latest figures put the total at $515.7bn, down almost $15bn on the previous month — the country’s foreign reserves are still vast. Reserves have been fed by revenues from the export of oil and gas but prices are falling sharply which makes Russia’s economy extremely vulnerable.

"Russia is not in the same kind of crisis as the UK," says Leonid Slipchenko, an analyst at UralSib Capital in Moscow. "It was better prepared [with the Stabilisation Fund] and it has made more pre-emptive measures to tackle the problems than the UK and US."

That may be so. And perhaps Russia can survive a stockmarket meltdown. But its fundamental economic structure, until recently built on a surplus trade balance, is changing because of falling energy prices and this is causing concern.

"The head of the accounting office, Sergei Stepashin, said total debt, that is corporate and government debt, is $560bn," says Wolfram Schrettl, professor of economics at the Free University in Berlin. "So it is already beyond the assets of the Russian state, where I include the government and the central bank. On a net basis Russia is in debt again." Stepashin also spoke about the "uncontrolled growth" of that debt.

Russia’s fat foreign reserves, and its enviable sovereign wealth funds, valued at $157bn in January, are its safety net, ready to be deployed in times of economic difficulty. But the central bank’s reserves are falling, and rapidly, down from around $600bn at its peak in August to about $515bn in late October. Shoring up its banking system and support of the rouble are the main drivers of the fall. The fear is a falling currency will rock public confidence and send people running to withdraw deposits. So far its exchange rate protection is working and the rouble has stabilised at around Rb26-Rb27/dollar after falling from around Rb23.1 in mid-July. But cheap oil is putting more pressure on the currency.

The total debt latest figures have worried some economists, particularly at this fragile time. "The worst case is if they have to cover all the debt of the corporate sector then they are about $100bn short of the target — that totally reverses the game. Don’t forget in the worst stages of the Soviet Union the total net debt of the state was $150bn," says Schrettl.

Even with big reserves, the acceleration of debt has been eye-catching. Figures released by the central bank in April showed Russia’s aggregate foreign debt was $477.1bn. The jump to $560bn in six months alone is cause for concern.

Others are less bearish. Assessing Russia’s vulnerability to external debt, Marina Vlasenko, a senior CIS economist at Commerzbank in Moscow, says the right approach is to compare general government external debt with the reserves. "This is the main proxy — for the state’s ability to serve government debt." Government and monetary authorities had outstanding external debt of $39.4bn at July 1, versus $515.7bn reserves on October 23. So the risk for government default is immaterial in Russia, Vlasenko says. Challenging this view is the cost of insuring against default — five year sovereign CDS in Russia shot up to nearly 1,200bp over two days in October.

Banking and oil, banking on oil

Russian companies have needed to borrow dollars from Western banks in the form of syndicated loans and Eurobonds. The problem is that Western banks are no longer able to lend, at least at levels most banks and companies can afford. Russia’s solution has been to finance the companies and banks itself. This is, perhaps, why many Russians perceive the financial crisis in Russia as being the fault of the West, which they see as having severed liquidity lines mercilessly.

The country’s problems are completely integrated to the global financial crisis. But its banking sector was already extremely vulnerable to a liquidity freeze. Russia has some 1,200 banks and many small brokerages. The system was overdue consolidation, and the freeze of interbank lending that started here, as in the West, after Lehman Brothers’ collapse, has accelerated that process. Four mid-sized banks have been rescued by state companies in the past month (see banking sector chapter).

The government introduced a range of liquidity measures to stabilise the banking sector in September and October, to support bank funding and restrict the number of failures. Some analysts argue, however, that these measures have not helped second and third tier banks, which were originally not eligible for the funds. After the most recent measures were implemented, conditions have improved. "The interbank market is OK now, but we still expect small banks to collapse as they do not have access to money at all," says Slipchenko.

Analysts and economists agree that consolidation in Russian banking would be a long term, healthy consequence of the crisis. But of more pressing concern to many is the price of oil.

Energy accounts for over 50% of Russia’s exports. The price of crude oil began to drop in mid-July, its fall accelerating over the past two months to the point where, on October 28, it stood below $63, a fall of over 55% since its July 11 high. For some economists, $70 a barrel is a watershed, below which it is estimated that with present trade flow, Russia’s balance of trade will slip into deficit. Analysis by some investment banks puts the price of oil at nearer $50 a barrel by year end.

On October 24, the Organisation of Petroleum Exporting Countries announced a cut in output for 11 of its members, intended to stem the plunging price of oil. This action was swiftly dismissed on financial markets where the cost of a put option on oil costing $50 a barrel in December rose by 142% — strong evidence that the market expects oil to continue falling.

Russia is so vulnerable to the price of commodities partly because of its insatiable appetite for imported goods. This spending addiction, on full view in Moscow and major cities as fleets of Mercedes, BMWs and Porsches go past, is at threat. "Annual increases in imports have been unbelievably large, but export revenues have been higher, and growing rapidly too — not due to higher volumes of oil or gas exported but mainly higher prices," says Schrettl. "Now commodity prices are down, it has reversed. In order to control this they have to stop increasing imports. How? To control consumer spending you would have to cut down on rising incomes in Russia and no government I can imagine can do that — income tax has recently been set."

Downturn, Russian-style

A downturn is inevitable, but with 7% growth a recession is technically impossible, at least in 2009. "There won’t be a recession, as underlying growth will remain strong," says Marcus Svedburg, chief economist at East Capital in Stockholm. "The IMF forecasts average global growth at 3% next year. Russia is expected to fall from 7%-7.5% to 5.5% according to the IMF. For the past two years, domestic demand has been the primary driver in the economy — next year it will be driven more by government investment in infrastructure." As with other big economies, much of the private sector slump is expected to be offset by public sector projects, and Russia has no end of infrastructure to finance.

There is also hope that the crisis will correct bad habits picked up as a result of easy and cheap credit. "A lot of Russian businesses have expanded in recent years in a very unhealthy manner," says Sonin. "Their whole business model was based on constant growth, basing their model on the premise that the prices of their goods will always be rising — unsustainable in the long term. Now the economy will adjust to a more efficient, moderate situation."


Who wants to be the leader now?


And what of Russia’s new leadership in these dark days? The economists’ consensus view is that Dmitry Medvedev and Vladimir Putin have led competently through its most challenging period since Medvedev’s appointment as president in May.

The wide range of financial stability measures conceived and implemented during the credit crunch have certainly prevented total meltdown, although there are reservations from some about the appropriateness of certain measures. "The facility to provide direct investment in the stock market, playing against a clear downward trend, is a waste of money," says Marina Vlasenko, a senior CIS economist at Commerzbank in Moscow.

Medvedev, with his private sector background, is more strongly associated with economic policy than Putin, but both men, along with finance minister Alexei Kudrin and economic development minister Elvira Nabiullina, have had to put up a united front to tackle the crisis. Putin still has the support of the people, although the fall-out of recent events will test their loyalty.

"If you conduct a survey, then Putin and Medvedev have very high approval ratings — both of them have more than 70%," says Konstantin Sonin, a professor at the New Economic School in Moscow and columnist for Russian newspaper Vedomosti. "But people probably consider this as two separate things: 1) general trust in Putin and 2) trust on particular matters relating to their personal well-being, like protecting the currency." Putin’s will be tested on the second issue in the months ahead.

At the Krasnoyark Economic Forum in February, Medvedev spoke of a ‘hands-off’ approach to the economy, policies for private sector innovation and not directives from the state. He has also talked up the presence of fewer bureaucrats in state corporations and has implied more private sector candidates should take government office. Six months on and little has changed.

"I have seen no major items from the Krasnoyarsk forum speech [in February] that are on the current agenda or that have been implemented by the Russian government," says Sonin. "There is no new task force, no new policy appointments, no new policy proposals have arisen out of that speech."

Medvedev has no doubt had his hands full recently. But when some semblance of normality returns in Russia, he will have to do much more to avoid criticism that his economic reforms are little more than pre-presidential rhetoric.

Putin and Medvedev are safe for now, but if the financial stability measures are insufficient and many more banks go to the wall, if oil continues to fall at current rates, if the global economy does not stabilise, the leadership’s popularity might nosedive. And the need to control consumer spending while the oil price falls, through taxation or interest rate rises, is a political timebomb. "I think the financial crisis has been a test for the elite and more efficient political succession is more warranted by the economic crisis," says Sonin. "Perhaps it might happen like the Chinese way: if the party decides that the leader should go then the leader does not stay."     
  • 31 Oct 2008

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