A strange situation is emerging in CIS markets: local brokerages, usually known for talking up their own business, have started to express concern over how much local companies are borrowing externally. Meanwhile, the once-cautious foreign investors now buying Russian corporate bonds in such large numbers say everything is going fine.
As the IMF noted in its global financial report, the amount of outstanding emerging sovereign debt is decreasing. In Russia alone, it halved last year, from $105 billion at the end of 2005 to $49 billion at the end of 2006, as Russia used its stabilization fund to buy back foreign debt.
However, the amount of money flowing into emerging market debt portfolios is greater than ever, at $6.2 billion last year. This surge pushed sovereign spreads down to record lows, and made fund managers more prepared to look beyond sovereigns to the corporate sector for yields. Emerging market companies are therefore able to borrow money from abroad more easily and cheaply than ever before. Total emerging market corporate issuance was up 20% last year, to a record $125 billion. Russian and Kazakh corporate borrowing accounted for a significant portion of that growth, says the IMF.
Among leading local brokerages, Troika Dialog’s respected analysis team, led by Evgeny Gavrilenkov, published a report in April 2007, which raised concerns that outstanding Russian corporate debt had more than doubled in 2006, from $108 billion to $260 billion. The figures, Gavrilenkov says, are “quite staggering”. The economy is “getting more and more addicted to external borrowing”.
Where is the new issuance coming from? The banking sectors in both Russia and Kazakhstan are providing the bulk of new deals. Russian banking external borrowing doubled in 2006, reaching $100 billion by year-end, as banks borrowed to finance their rapidly expanding loan portfolios, which in the cases of the top banks are growing at rates of 100% a year.
Investors are being treated to the return of the “unpronounceables”, as little-known banks like Locko Bank, Credit-Europe Bank and Absolut Bank find credit easily, while more established names like Vneshtorgbank (VTB) and Sberbank are borrowing heavily in a variety of currencies and through a range of subsidiaries.
Kazakh banks have also been borrowing “like there’s no tomorrow”, in the words of one banker.
They raised $3.2 billion in the first three months of 2007 alone, compared to a mere $700 million for the whole of 2006. State-owned Russian energy companies have also been particularly strong borrowers. This is partly because the state is increasing its ownership of assets in the energy sector, as part of a new policy of the state keeping “strategic resources” under its control. This quasi-sovereign status can encourage foreign investors to lend money at lower yields.
As a result, Gazprom and Rosneft, the state’s two designated energy champions, are going on a debt-financed acquisition bonanza. The two companies’ combined foreign debt reached $56 billion in Q1 of this year, almost $10 billion more than that of the sovereign. Rosneft alone borrowed $22 billion in one spree, to buy assets from the Yukos auction.
In addition to their ambitious acquisitions, Gazprom and Rosneft also have big capex requirements for their investment programmes. Some of these will take place through subsidiaries, such as Gazprom subsidiary Nordstream, which needs to borrow several billion dollars to finance the construction of a new gas pipeline from Russia to Germany.
State pipeline monopoly Transneft also has daunting financing requirements. Just one of its projects, the eastern Siberian oil pipeline, which will take oil from Siberia to China and Japan, requires somewhere between $11 billion and $20 billion in financing, according to different analysts’ estimates. The company has reorganized its structure to make its finances more transparent and investor-friendly, and launched its first $1.3 billion Eurobond loan participation note (LPN) in March 2007. It is likely to be a regular visitor to the markets.
Russian Railways also needs to invest heavily in new infrastructure. Its CEO, Vladimir Yakunin, told President Putin in April that the company requires R30 trillion ($1 trillion) over the next 20 years or so, if the railways are not to drag down national economic growth. The company itself has not been a big borrower so far, but there are limits to the finance it can generate from IPOs of subsidiaries, which are set to raise around $4 billion over the next 18 months.
President Putin suggested to Yakunin that the company use public-private partnerships (PPPs) to raise capital. PPPs are “the great white hope of the Russian government”, as Roland Nash, chief strategist at leading investment house Renaissance Capital, puts it.
The government has put around $2.5 billion into an investment fund to support PPP projects, while billions of dollars more are set to flow from western banks. Already, BNP Paribas is set to arrange $3 billion in project financing for a new oil refinery in Tatarstan, while ABN Amro and Calyon are arranging another $2 billion for a new hydroelectric dam and aluminium smelter in central Siberia.
Borrowing risks
The first risk is a short-term one, that deals will be priced too tightly, and will then suffer in the secondary market. This is already beginning to happen. Transneft’s recent Eurobond LPN debut, for example, was described as “a disaster” by one investor. Spreads widened by as much as 25 basis points in three days when it was launched in February. Investors complained the deal had been priced too aggressively, presumably because Transneft was only too aware of the huge financing requirements it faces going forward.
A more serious long-term risk is that companies cannot service all this debt in the future. This is a particular risk for CIS banks, says the IMF. Their rapid growth in corporate and retail lending “could lead to deterioration in asset quality if banks’ credit assessment strategy becomes over-stretched. This is of some concern because capital adequacy levels are declining.”
Even state-owned champions like Gazprom and Rosneft could be at risk from exchange rate volatility, says Troika Dialog. Gavrilenkov says: “Will Russian banks and corporations such as Gazprom and Rosneft be able to service their debt and keep growing were the ruble to depreciate? We doubt it.” That said, oil and gas companies are better insulated than others against rate fluctuations, as their revenues are mostly in dollars.
This raises the question of whether the Kremlin would step in to bail out state-owned companies if they got into trouble. Renaissance Capital’s fixed-income analyst, Pavel Mamai, has his doubts. Mamai thinks that Gazprom and VTB are the most likely to enjoy state support if they encounter financial difficulties, followed by Bank of Moscow and Sberbank. He thinks AvtoVAZ, Rosneft and Gazprombank are likely to enjoy state support at the moment, but that could change in the medium term, depending on which corporate chiefs are in favour in the post-2008 Kremlin.
The other 25 or so state-owned corporate borrowers, he says, cannot be relied on for receiving state support “even in the event of a looming default”. Mamai adds: “Even if an issuer is bailed out by the state, bondholders are exposed to numerous risks. These include the state’s ability to ensure issuers remain in business despite default, creditor discrimination, and an arrogant approach towards investors.”
INVESTORS EXPOSED
Western banks have taken on large amounts of Russian corporate loan risk, but they have repackaged those loans into structured notes, and then sold them on to other investors, particularly insurance funds.
Institutional investors also have large exposure to CIS corporates. But they seem unworried as yet. Raphael Kassin, former head of emerging market debt at ABN Amro Asset Management, now at Credit Suisse Asset Management, says: “There’s a flood, but it’s a good flood. I love the state-owned companies. Liquidity is the problem, not credit quality. It’s hard to get your hands on some of this paper, so the banks need to support the liquidity.”
The Russian government is also exposed to state-owned companies’ default risk, but it does not seem too worried either. Sergei Storchak, deputy minister of finance, says: “Big monopolies like Gazprom necessarily have very big investment needs. For example, Gazprom needs money to invest in new LNG technology. Russian financial markets are still too small to meet all of these companies’ financing needs, so they must go to the international capital markets.”
But he adds: “We want them to pay attention to the manner in which they borrow, so that they are borrowing in long-term maturities, without sudden peaks in refinancing requirements.” Rosneft’s $22 billion loan package, for example, was mainly in the form of 12-month debt that will need frequent rolling over.
The corporate credit environment in Ukraine seems more of a serious immediate concern. Two mobile telephone companies, Astelit and Kyivstar, have run into trouble in recent weeks. A court injunction demanded by shareholder Alfa Group due to a dispute with co-owner TeliaSonera has prevented Kyivstar from publishing further financial data, potentially breaching its Eurobond covenant. Astelit was declared in default on two loans, one a $390 million syndicated deal from ING and Standard Bank, the other a $150 million loan from two Turkish banks, although its leading shareholders Turkcell and Ukraine’s Sistema Capital Management have agreed to a $250 million bail-out.
Moreover, the outlook has deteriorated for Naftogaz Ukraine, which last year seemed to be nearing bankruptcy as it struggled to deal with higher prices for Russian gas. It is increasingly raising debt in partnership with Gazprom, suggesting a closer reliance on the Russian firm for capital with which to buy Gazprom’s gas.
LID ON BORROWING
The IMF would like to see better regulation of the Russian and Kazakh banking sectors, and has welcomed moves by the Kazakh central bank to raise capital adequacy standards for local banks. Banking IPOs by Russian and Kazakh banks, such as Sberbank, Vneshtorgbank, Halyk Bank, ATF Bank and Alliance Bank, are also set to improve banks’ debt/equity ratio.
As for Russian energy companies, Troika’s Gavrilenkov suggests that they are victims of the Kremlin’s stabilization fund, which has improved the sovereign’s credit profile by heavily taxing energy companies, thereby pushing them to raise capital on the foreign debt markets at high interest rates. “The present structure does not make sense,” he says. So perhaps the sovereign should let energy companies keep more of their profits, in exchange for lower external borrowing.