￼Eternal Russia – Reboot ?April, 26 2013
In the early-2000s, we could have been asserting that the spectacular recovery from the depths of the 1998 crisis had proven that the Russian bear could walk – but, now, could she dance? Russia’s rebound had been very impressive, but it was largely attributable to broad-brush measures – fiscal probity, monetary discipline, import substitution and the end to the egregious asset stripping by the owners of the extractive industries. The question was whether Russia could build upon the momentum, modernising the economy and attacking the deeply ingrained problems of poor corporate governance, bureaucratic incompetence, corruption, short-termism, and the hunter-gatherer mentality which was the legacy of the collapse of the USSR. With little tradition of entrepreneurial activity, and limited trust in anyone not of one’s own innermost circle, as well as a substantial natural resources dependency, Russia tended to rely on very large-scale business, with a stunted SME sector.
The above problems are not unique to Russia, and one encounters at least some of them throughout the developing world. The record in has been mixed.
On the one hand, Russian agriculture has enjoyed a spectacular recovery – from the world’s largest grain importer to one of its top exporters, along with substantial restructuring of the oil and metals industries, as well as of the banking system. Unemployment has dropped to one of the lowest rates in Europe, while popular consumption is resilient, supported by a rapidly increasing supply of credit.
Despite widespread misconceptions, a major anti-corruption campaign is now underway (which has already yielded several highly-placed scalps) and we have personally witnessed a shift in business/legal practices, as court decisions are no longer systematically for sale. Moscow is finally seeing the sort of multiplication of small service businesses seen in Eastern Europe two decades ago (there are a good 30 lower/mid-market Sushi places within walking distance of our Kurskaya apartment – as opposed to zero a decade ago). After more than a decade of trying, the merged RTS/MICEX will finally allow the direct participation of those foreign investors not yet scared off by the abuse of minority shareholders.
Corporate governance remains not so much horrendous as mixed, capricious and entirely unpredictable. Investors in Russian-law traded markets are dangerously dependent upon the goodwill of the majority investors – whether private or state. Another scourge of post-Soviet Russia – short-termism and the lack of long- term capital – is largely unchanged; yes, the time-frame has shifted from a few weeks, to a few months, to perhaps a year-and-a-half, but try raising 7-year finance in Moscow… Pension reform has been repeatedly botched, savings are still channelled into real-estate or short- term government debt, while there is a severe shortage of risk-capital or non-collateralised bank lending.
Russian growth is currently hampered by the slowdown in the West – in particular, the ferrous metals and coal sectors have been badly impacted by a collapse in European demand. Finally, despite the nonsense in the press, one of the likely economic threats arises not from any lack of democracy, but from its excess: in the first decade of the millennium, the Putin government did not feel much need to buy popular support – after the appalling experiences of the 90s, the Russian public was delighted to finally enjoy some basic stability – a functioning economy and essential public services. That has now changed, as Russia is slowly moving in the direction of the European social welfare model, with an increasingly wealth citizenry having preoccupations beyond physical survival, and coming to expect far more from the State.
As regards FDI, there is a certain irony in the fact that, while investors shy away from Russia, they get dollar signs in place of their eyes when talking about China – this despite the fact that a good 90% of foreign businesses in Russia have been printing money, as opposed to only a tiny minority in China. Russia is Europe’s only high-growth automobile market, while European fast-moving consumer goods, pharmaceuticals and personal care companies are generally having a spectacular run of it. This disconnect is at least partially attributable to the pernicious and dishonest press coverage – generally discounted by businessmen with existing operations here, but which tends to frighten off would-be entrants. Despite this, Russia enjoys the second highest FDI/capita of the BRICs.
The combination of mendacious press coverage and populist Russia-bashing by Western politicians has triggered a sharp push- back from the Putin administration, taking an increasingly hard line toward what it considers to be foreign meddling, in parallel with a very real realignment towards China and the BRICs. This is a mixed blessing for investors – on the one hand, macroeconomic stability will be much enhanced by Russia’s focus on the world’s premier growth markets of Asia – on the other, it is very unlikely to promote privatisation, economic diversification or strong initiatives in favour of Western investors.
While the Russian macroeconomic profile is one of the most boringly stable of the G8, the rate of deceleration in economic growth has disappointed – we are far from the “three fives” of 2011, i.e. 5% inflation (now 6%-7%), 5% unemployment (still there) and 5% growth (now 2-3%). Indicators for sovereign debt, fiscal balances and the current account remain excellent; the banking system has improved greatly and systemic risk is lower than in the Southern European countries, with more comprehensible balance sheets (less leverage, and very limited dependence upon wholesale credit markets or government support.)
On the other hand, we find the rapid growth in consumer lending somewhat worrisome, and the entire sector is capital-constrained, with an excessive reliance upon short-term funding by the CBR. The Basel-III requirements now being introduced will further enhance safety, but at the expense of the rate of growth.
The Central Bank is confronted with the need to cut rates in order to stimulate investment, while being constrained by stubborn inflation, attributable both to the very low unemployment rate and to high capacity utilisation. Further reform of both the banking sector and the capital markets are desperately needed to fund investment, creating domestic pools of long- term money while limiting capital outflows.
The Great Russia Discount – Fact and Fiction
The “Russia Discount”, i.e. the fact that Russian assets traded at less than half of the valuations of their emerging markets peers, is both an absurdity and fully justified by recent events, depending upon which part of the market one is looking at.
Those who positioned in Russian long-dated sovereign fixed income in 1998 multiplied their money 15-20 fold (coupon reinvested) over the ensuing decade, during which Russia boasted the world’s best performing debt markets.
On the equity side, this trade worked well enough until 2007, but as repeated disappointments in terms of dividend flows, corporate governance, transparency and predictability began weigh upon the markets we gradually tempered our enthusiasm for both the equity and the local (i.e. rouble) debt markets, while remaining very bullish on corporate, subsovereign and sovereign London law bonded debt. Despite some wild price action during the 2008 global crisis, the Russian Eurobonds have performed impeccably.
Is Russia an Investible Market? Yes and No…
The fundamental misconception about the Russia Discount is that it reflects a meaningful sovereign default risk – that the supposedly parlous state of the Russian political system and the dangerously mismanaged economy mean that all Russian assets should trade at a very substantial discount – obvious nonsense!
In fact, Russia has one of the most orthodox budgetary and monetary policies in the developed world, with current account and budgetary surpluses and gradual disinflation over most of the past decade. The Central Bank has proved ready to step in with targeted actions in periods of exogenous stress (2008).
As regards commercial banking, while regulation had been somewhat lax before the 2008 crisis, it is now increasingly proactive and well conducted. The deposit insurance program has been tested and found reliable, and Russians no longer rush to their banks to withdraw their deposits at the first rumour of trouble. Taxes are very low by global standards, although social charges on labour have increased well beyond the optimal level.
There remain, of course, some very fundamental problems – a shortage of long- term capital, the absence of an active interbank market forcing banks to rely on the CBR, and a large but shrinking number of very small banks, the actual purpose of which is not usually clear; none of these factors threatens Russia with a systemic crisis imperilling sovereign solvency.
As regards political risk, we would rate it lower than in many – perhaps most – of the Eurozone countries. Issuer practices in the Eurobond market have generally been exemplary. Non-specialists are usually surprised to learn that the Russian state borrows short-term (2Y) at 1.26%, and major Russian corporates fund themselves cheaper than their European peers.
So all is well? Alas, no.
The legal protections afforded to investors in domestic Russia assets, both debt and equity, are gravely lacking. Companies can largely do as they damned well choose, at best egregiously abusing loopholes in the legislation – at worst, simply stealing the assets.
On the debt side, while Eurobond protection has been excellent, even in the wake of the 2008 global crisis (when several of the Russian commercial banks found themselves in a parlous state, yet refrained from defaulting, restructuring, or even attempted to abuse their bondholders) domestic debt restructurings are reminiscent of nothing so much as of a pack of particularly nasty dogs tearing into a garbage sack – the biggest, meanest, best-connected dogs came away with whatever the choicest morsels, while the others go hungry.
In the wake of the 2008 crisis, domestic bond markets were shambolic, with a string of defaults, the largest being the factoring company Evrokommerz, which Troika had foisted onto the market, then looked away as it was pillaged by its management – investors in the local bonds recovered precisely zero. There were numerous other such cases – perhaps less extreme but almost systematically failing to offer any equitable redistribution of assets.
The situation in the equity markets is unfortunately reminiscent of the local debt market, with occasional instances of egregious investor abuse, with shockingly little recourse available to the victims. One such case now threatens some of the largest and most experienced investment funds in Russia with substantial losses.