Standard & Poor’s rating service lowered Russian long-term sovereign credit rating outlook to negative Oct. 23 because of projections that Moscow will need to inject more credit into the faltering Russian banking sector. A credit rating indicates the agency’s estimation of a state’s ability to maintain debt payments, so in this case S&P believes that ongoing efforts to address the financial crisis could overtax the Russian government. The cut in debt rating comes as the yield on Russian government 20-year bonds has increased eight basis points (a 0.08 percent rise in yield) to 10.94 percent, indicating that the foreign appetite for Russian bonds is quickly dropping as credit becomes scarce and investors seek investments they feel are more secure. The bond yield of Russia’s largest company, natural gas behemoth Gazprom — which is also the single greatest source of Russian total external debt — has thus skyrocketed, and it now stands at almost 700 basis points above emerging sovereign debt. Meanwhile, the Russian stock exchange closed below 550 on Oct. 24, wrapping up a precipitous fall that has destroyed 80 percent of its value since May.
A comprehensive flight of investor capital is occurring in Russia for a number of reasons. This situation is placing great pressure on the Kremlin to use its capital reserves — the third largest in the world — to prop up the Russian banking sector and the main engines of the Russian economy: the energy and mineral sectors. In the short run, Moscow’s massive capital reserves will allow it to weather the global liquidity crisis and increase government control over all sectors of the economy. In the long run, however, Russia might face a dearth of capital as it drains its coffers trying to pump cash into the system, putting vital capital expenditure projects (such as improving infrastructure, improving oil and natural gas field development, and military spending) on hold to the detriment of its ability to face off with the West. The result will be an economy that has far more in common with the Soviet Union than with post-Soviet Russia — even post-Soviet Russia under Vladimir Putin. And that will affect Russia’s bid to reassert itself globally.
The Russian Golden Goose and the Liquidity Crisis
Russian state coffers contain roughly $650 billion. The money is actually divided into three different funds, with the international capital reserves accounting for the bulk ($515.7 billion as of Oct. 17) and the rest split between the National Welfare Fund and the Reserve Fund, Moscow’s long-term security blankets. The coffers have been filled with the profits from steadily rising commodity prices over the last five years, allowing Russia to amass a $50 billion budget surplus at the end of 2007 and pay off the majority of its externally held government debt.
The $650 billion figure, however, is down from $750 billion as recently as 3 months ago. This is due to the cost of the August intervention in Georgia (which cost $16.1 billion) combined with the huge number of liquidity injections (to the tune of roughly $90 billion) the state has had to make since the Sept. 16 and Oct. 6 Russian stock market crashes and in response to concerns about the stability of Russian banks.
Liquidity injections into the stock market and Russian banks were necessary because nearly $63 billion in foreign investment was pulled out of Russia immediately following the August intervention in Georgia. Foreign investors also withdrew because of a previous loss of confidence due to Russian disregard for investor rights, and because of a loss of confidence in Russian company and government bonds as the global liquidity crisis took root.
While embarrassing, the flight of foreign money from the stock market is not the Kremlin’s primary concern. The bigger problem is the collapse of confidence in Russian bonds and borrowers, the premier sources of foreign capital for funding the expensive projects of Russian energy and mineral giants.
Russian companies, as well as foreign investors looking to invest into Russia, prefer to raise capital through bonds because it does not mean taking input from foreigners on how to run their business. It also allows them to keep everything about their firms, from ownership and management structures to profits and managerial techniques, out of the public eye. Foreign bond holders only want a return at an agreed-upon date. With political risk created by the Georgian war combined with the global liquidity crisis, however, foreign investors have abandoned Russian bonds for safer investments, such as U.S. Treasury bills, elsewhere. This has left Russian companies without the ability to raise crucial capital.
Kremlin Tools to Combat the Liquidity Crisis
To inject liquidity into the system, the Kremlin first turned to the oligarchs, forcing them to inject between 10 percent and 30 percent of their total wealth into the markets and banks to shore up the financial system immediately after the Sept. 16 stock market crash. At an all-night mandatory meeting held in the Kremlin following the crash, oligarchs were ordered to plunge cash into their own faltering stocks, buy collapsing financial institutions directly, or simply fork over the cash and/or shares. Using oligarch money has the positive effect, at least from the Kremlin’s perspective, of further consolidating control over the oligarchs’ assets and decision making.
This move quickly drained the oligarchs of much of their on-hand cash, however. In the weeks since, they have largely seen their cash reserves exhausted by the combination of appeasing Kremlin demands and suffering losses from various margin calls. (In essence, they have been forced to immediately repay loans taken out to buy stock.) The only way for the oligarchs to repay these loans is to sell assets at cut-rate prices or stocks at depressed prices. So while the oligarchs are still rich in assets, they are now poor in cash, and are being forced to liquidate parts of their empires to remain liquid.
RUSAL kingpin Oleg Deripaska has been forced to ditch his Canadian auto parts venture, while Norilsk Nickel’s Vladimir Potantin is shopping around for buyers for his platinum mine in the U.S. state of Montana. Both have had to divest themselves of massive amounts of stock. In total, the 20 richest Russian oligarchs have lost personally or through their companies a combined $188.4 billion — and that figure comes only from publicly available information. While the oligarchs are still extremely wealthy, they have now been forced to give up or have lost sizable chunks of their fortunes, particularly in assets abroad. This renders them, as a tool for shoring up liquidity, a spent force for the purposes of stabilizing Russia.
This means that the Kremlin now has to pick up the slack with its own resources — namely, its $650 billion cash reserves — and that the worst of the liquidity problems are yet to come. In particular, Moscow will have to figure out how to isolate itself from the foreign liabilities accrued by its banks, both government and private, and by its energy and mineral companies.
Total Russian external debt as of June stood at $527.1 billion, of which banks — whether private or government owned — owed a whopping $228.9 billion. Domestic credit in Russia, which lacks a good system for circulation and accumulation, has always been scarce. This means Russian banks rely upon access to foreign capital to fund everything from car loans, mortgages and personal loans to Russian energy and mineral companies’ capital expenditures.
The problem with such a sizable debt is that while the ruble depreciates against the rising U.S. dollar because of Russian economic instability, capital flight and decreasing commodity prices (which act upon both the ruble and dollar simultaneously, increasing the dollar and decreasing the ruble), foreign debts made out in dollars begin to appreciate in value. Since the crisis began, the ruble has already dropped by a quarter, increasing the cost of servicing dollar-denominated debt by a like amount. The Kremlin will have to act fast to cover the debts of the banking sector, or else the debt might become unserviceable for the banks, which take in most of their revenue in rubles.
This of course assumes that the Russian consumers who took out the mortgages, car loans and personal loans will continue to service their debts, and that there will not be any significant bank run — far from a certainty given the notoriously bank-skeptical Russian populace. If the ruble continues to depreciate, Russian consumers might be unable to service their debts. This applies particularly to loans originally denominated in foreign currencies. The problem is widespread in Central Europe and the Balkans, and especially in Hungary, where foreign banks used the Swiss franc for consumer lending.
The other issue is the debt of the 14 largest Russian energy and mineral companies, which account for $142.1 billion of $185.4 billion non-bank privately held external debt. Particularly notable are the debts of Gazprom ($55 billion), Rosneft ($23 billion), RUSAL ($11.2 billion), TNK-BP ($7.5 billion), Evraz ($6.4 billion), Norilsk ($6.3 billion) and LUKoil ($6 billion). These debts are held in various dollar-, euro- and yen-denominated loans, and bonds, which are usually dollar-denominated. Unlike domestic Russian banks, which receive revenue in rubles, the energy and mineral giants will not have to contend with the problem of the appreciating dollar, because they receive their commodity-driven revenue in dollars. (All of world’s commodities are priced in dollars.) But these firms will have to contend with ever-decreasing revenue from which to service their loans as oil and minerals/metals decline in price. Oil and nickel are already down 55 percent and nearly 80 percent, respectively, from their peaks.
The Kremlin’s Choice
The Kremlin thus faces a choice between not spending its cash and risking countrywide private defaults by its banks and major companies, which would in turn trigger a complete collapse of the Russian financial system, or spending its reserves to shore up the system and severing nearly all links between Russia and the wider world. This really is not much of a choice, as the threat of further dollar appreciation against the ruble is nearly inevitable. Therefore, the Kremlin will most likely spend approximately $400 billion to buy up all of Russia’s foreign-held debt — $230 billion in bank debt and another $180 billion in various companies’ debts. (Russia lacks the option of printing currency, since the ruble is not worth much to begin with.)
Such a step would obviously drain Russia’s coffers, taking the maximum total reserves down to $250 billion. But this will have an upside. In addition to ending all outstanding foreign funding vulnerabilities, this move would make the entire Russian economy and financial system owe nearly all of its debt directly to the Kremlin. In one stroke, Russia will have recreated the financial system of the Soviet era, with all the political control that implies. (Ironically, by repaying the nearly $400 billion of its companies’ and banks’ foreign loans, the Kremlin will inadvertently also inject much-needed liquidity into Western and Japanese banks. The end result will go a long way toward recapitalizing the global banking system.)
But not all would be smooth sailing under this scenario. Russia needs massive amounts of capital to keep its long-term energy production and export industries healthy, and with energy prices weak, it simply cannot even attempt to generate the necessary funds itself. As foreign capital dries up and commodity prices fall, Russian energy companies will have no choice but to forgo capital expenditure projects that are vital for revamping Russia’s Soviet-era transportation infrastructure and increasing dwindling production in maturing oil and natural gas fields.
Russia has an excellent tool for addressing part of this problem. Unlike oil, natural gas prices do not respond to market change; fixed pipeline infrastructure combined with the difficulty of transporting the stuff gives the supplier much more pricing power. As the world’s largest exporter of natural gas and Europe’s largest supplier, Russia already has plans in the works to increase its prices to more than $500 per 1,000 cubic meters as of Jan. 1, 2009. Russia is not only certain to stick to this planned price hike despite falling global energy prices, but it also could increase the price further to buy itself some more time and income.
Despite the direness of its situation, Russia is not about to collapse. In reality, all this means is that Russia’s experience in grafting some elements of Western capitalism to the Russian political system is over. (Moscow’s bid to adopt Western economics wholesale died years ago.) Having a system where Russian firms cannot tap foreign capital markets and are instead dependent on the state is precisely how the Soviet state maintained operational and political control. It might not be central planning per se, but it is not too far off. For a number of reasons, such an economic system makes sense for a country as large and difficult to invest in privately as Russia.
But while Russia might hold together domestically, the Kremlin will need to rethink some of its broader international objectives. Increased international influence is a pricey affair, whether it means buying Ukrainian elections; shoring up Moscow’s presence in Georgia; pressuring the Baltic states; cozying up to Cuba, Nicaragua, and Venezuela; restoring its influence in the Middle East; fostering anti-ballistic missile defense social activism in the Czech Republic; or just generally increasing its intelligence activities abroad and updating its military capacity.
Ultimately, Russian stability in the post-Yeltsin era has depended on having free cash to direct where needed, when needed and in almost limitless quantities. For that, reduced access to international capital and a mere $250 billion reserve fund in an era of falling income might prove insufficient. Russia might be on the brink of a massive political consolidation into a stronger core state, but the liquidity crunch cannot help but limit its wider options. Simply put, Russia might be able to speak with a clearer voice, but its ability to project that voice has just been constrained.