From the October 2007 issue of Research Magazine • Subscribe!

October 1, 2007

Risky Russia

Soon after Russia's debt default and ruble devaluation in 1998, I had a talk with a money manager with expertise in emerging markets. Professionals know that emerging markets are given to huge swings and a really big wipe-out is usually a signal to pick up oversold assets.

Not in this case, he assured me: "Russia is a four-letter word as far as international investors are concerned."

Needless to say, investors' memory has proven to be "as short as a young maiden's," to use a politically incorrect Russian proverb.

Over the past two years, Russia has emerged as a favorite of investors. Its sovereign debt, which was in technical default, is now rated investment grade, or BBB+, by rating agencies. The ruble has strengthened against the euro and the U.S. dollar, and in real, or inflation-adjusted terms, it is now far stronger than it was in the 1990s, before its massive devaluation. But this time the currency is supported by a cache of central bank reserves that, at over $400 billion, is the world's third largest after China's and Japan's.

Foreign investors not only snapped up blue-chip Russian stocks, but have bought into ruble-denominated bonds. The issuance of ruble bonds, on which the Russian government defaulted to the tune of $40 billion in 1998, totaled over $30 billion in the two and a half years through mid-2007.

In August, as financial markets around the world were reeling from the deepening sub-prime mortgage crisis in the United States, the Russian market appeared better protected from turmoil. After all, Russia is a major producer of oil, gas and other commodities. It should be able to weather the crisis well and even emerge as something of a safe haven.

Dependence on OilActually, nothing could be further from the truth. On the contrary, Russia is probably an Achilles' heel of the global economy. In 1998, the Russian default nearly unsettled the global financial system, triggering a financial correction that dragged down Long Term Capital Management, the U.S. hedge fund. If jitters in global financial markets endure for a few months, and translate into slower global economic growth, Russia could once more implode -- with a major negative impact on the rest of the world.

The oil boom underway since 1999 has been especially good for Russia. Not only did crude prices increase sevenfold by mid-2007, but Russia's oil production and exports rocketed. Other commodity prices, including those of metals and timber, also increased. The inflow of petrodollars stimulated domestic demand and spurred the revival of moribund Soviet-era industrial sectors as well as the creation of new industries, especially in consumer goods and distributive trades.

However, Russia remains disproportionately dependent on oil and other commodity revenues. While the domestic economy has been growing by over 8 percent a year in recent periods, an index compiled by VTB-Europe, a U.K. unit of a Russian bank, showed that non-oil GDP growth has been gradually slowing for nine months, and now measures a much less impressive 6.3 percent.

High oil prices, meanwhile, have underpinned a borrowing spree by Russian companies in international capital markets. While the Russian government has not issued any debt under President Vladimir Putin -- apparently fearing the constraints international bondholders might impose on its freedom of action -- corporate borrowers have more than made up for the shortfall. At the end of 2006, the cumulative foreign debt of the Russian corporate sector measured around $260 billion, which is, depending on how you tally it, a quarter to a third of Russia's nominal GDP.

Debt service next year will measure $88 billion, both interest and principal due. This figure will be larger than the country's trade surplus, especially as the import bill continues to rise along with growth in domestic consumption.

In fact, the current global credit crunch could prove a blessing for the Russian economy. Analysts calculate that Russian companies planned to add another $125 billion to their foreign debt burden in 2008.

The total Russian corporate debt could still be paid off from Russia's hard currency reserves -- and a considerable sum would be left over after that. However, international financial markets have other kinds of exposure to Russia. Russian companies have been active in the London IPO market. Last year, they placed $20 billion worth of shares, and this year they were on track to raise an additional $30 billion.

Internal StrainsVTB (UK:VTBR), Russia's state-owned bank, raised $8.2 billion in May by selling a 22.5 percent stake. As of mid-August, its shares are down 20 percent from their peak, even though the Russian government remains its owner and it is, by all accounts, the most solid Russian bank.

But the Russian banking sector is fragmented, weak and non-transparent. Sberbank, the Soviet-era monopoly savings bank with braches across the country, holds a stunning 50 percent share of the national retail banking market. The rest of the sector is fragmented, comprised of some 1,200 mostly fly-by-night small fry. Over the past two years, lending has exploded. With overall lending growing by around 45 percent, consumer loans spiked 75 percent last year alone.

How this plays out in a credit crunch is anyone's guess. Add to this the murkiness associated with doing business in Russia -- exemplified by the still-unsolved murder of first deputy chairman of the central bank Andrei Kozlov a year ago -- and you have a risky situation indeed.

Wider FearsIn 1998, Russia's default had far wider repercussions in global financial markets than the country's economic weight would have suggested. Moreover, while it followed on the heels of the 1997 Asian debacle, the U.S. economy was booming and Wall Street, along with other major equity markets, was humming along.

Now, the credit crunch is spreading from the overleveraged U.S. economy, which was nearing a cyclical downturn even before the sub-prime mortgage crisis hit. Russia, meanwhile, has experienced robust growth and now vies with India to be part of the Top 10 global economies based on the size of its GDP.

The reason why Russia's default spooked world markets back then has wider political implications. Even though Russia has been off the radar screen in Washington for a while, financial markets understand that it is still, at least as far as its nuclear arsenal is concerned, very much a superpower. Economic turmoil in what is still an unsettled country could change the global political landscape radically.

Under Putin, Russia has been moving away from a free market and toward an increasingly rigid form of state capitalism. The government has re-nationalized strategically important resource industries and has built state-controlled quasi-monopolies in other sectors, as well.

An economic crisis is likely to bolster this trend. In fact, as inflationary pressures in the Russian economy picked up around mid-year, driven by higher global prices for corn and rising food prices in general, top-level legislators from the ruling pro-Putin United Russia party have started to talk darkly about prosecuting price-gougers.

Even more troubling could be social turmoil, which has accompanied economic crises in other countries, for instance in Indonesia in 1997. The collapse of communism and the disintegration of the Soviet Union came off relatively peacefully and without bloodshed. Similarly, the 1998 default triggered no street protests.

However, in the 1990s, Russia's population was still poor and traumatized by nearly eight decades of brutal communist rule. The opening up of the country was accompanied by rising hope for improvement. Now, Russia has seen nearly a decade of prosperity, which, sadly, has not trickled down in any meaningful way to the average Russian -- or made its way beyond Moscow's borders.

Even in Moscow, free-floating, barely contained anger is palpable in any sized Russian crowd. In an economic downturn, this anger could very easily gel and find a ready outlet.

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Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past four years, 2004-2007.

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