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.