Russia: The Junkiest of Junk

Streetwise Professor reports:

La Russophobe pointed me to this interesting post from the Conde Nast MarketMakers blog. The post discusses credit spreads for BRIC countries (Brazil, Russia, India, China). These credit spreads measure the creditworthiness of the sovereign debt on each of these countries. The higher the spread, the bigger the market’s estimate of a default (and/or the greater the market’s estimate of the loss conditional on default.)

You will note that as the credit crisis has exploded since late-August, all of these spreads have blown out, meaning that the market estimates that their risks of default have exploded. And surprise, surprise, surprise (cue Gomer Pyle voice), guess whose risk exploded most? Your favorite country and mine, Vlad’s paradise, that island of tranquility in troubled economic times.

In a nutshell, the market has deemed Russia the junkiest of the junky BRIC sovereign credits. And to think, this is the spread on government debt, the government that is sitting on $500 billion. Think of the market’s assessment of the credit risk of the “private” borrowers, eg Deripaska, Fridman/Alfa, Gazprom, Rosneft who are queuing up hat-in-hand to get charity from that government. Well, perhaps one reason for the wide spread is that market participants estimate that the $500 billion will be largely blown bailing out the oligarchs to keep strategic “crown jewels” out of the hands of the cursed foreigners.

Excellent MarketMaker blogger Felix Salmon expresses surprise at Russia’s poor performance relative to Brazil: “So the fact that it’s now 500bp wide of Brazil is kinda crazy. After all, they’re both mainly commodity plays, and their stock markets have both been devastated. But the credit markets show a huge distinction between the two countries which isn’t easily visible elsewhere.”

Not crazy to me, Felix. You’ve focused on just the economics (”both mainly commodity plays”) and missed the political risk angle. My conjecture is that the differential spread is the market price of political brittleness, weak institutions and property rights, corruption, and the absence of a rule of law. Now, Brazil is hardly Adam Smith’s vision of a classical liberal state, but it is miles ahead of Russia in that regard. Trying times test institutions, and times are now tough. The credit swap market is putting its money on the proposition that the current strains will overwhelm Russia’s political, legal, and economic institutions. That as a result, (a) the $500 billion plus that Russia has amassed in the seven fat years is at extremely high risk of disappearing down ratholes, leaving little behind to pay sovereign debtholders, and (b) the prospect that the gravy train is ending will spark political turmoil and infighting that threatens political stability in Russia, and sovereign debtholders hate political instability.

There are numerous stories on the web that help flesh out that story. Indeed, there are too many to mention, so I’ll just pick a few. First, this piece by Robert Skidelski in today’s FT:

Russia carries a heavy burden of political risk. This is the real economic legacy of the Putin years. Mr Putin does not understand the need for a degree of consistency between economic and foreign policy: or rather the reconciliation he has sought has been based on Russia’s energy windfall. If this has now ended, as seems likely, the key assumption of his politics – that Russia can use its energy power to boost its world power without paying much attention to the sensitivities of anyone but the Russian electorate – has been destroyed.

Russia needs to scale down its geopolitical ambition to its real weight – that of an emerging economy with only 3 per cent of the world’s gross domestic product and a quarter of America’s living standard. Also, it desperately needs to develop its human capital. The Putin era is over but Medvedev’s has not begun. This is the real Russian crisis.

(The last bit on human capital doesn’t relate to the political risk theme, but it does agree with what I’ve been arguing–not without opposition, to be fair.)

Then there’s this report describing how Russia is riding roughshod over the rights of minority foreign investors to save an oligarch (Mikhail Prokhorov) by rigging the game to allow him to escape his obligation to buy out minority investors at the price that he paid to acquire a controlling interest in power generator TGK-4. That’s not something you do when you’re thinkin’ ’bout tomorrow. If you are thinking about the future, you don’t want to do something that so damages your reputation with foreign investors. But reputation is about the future, if you are in sauve qui peut mode, it’s all about today.

One last gem, this one from the WSJ. VEB has extended a $4.5 million dollar to Rusal and Deripaska. But the rules said that the VEB assistance was limited to $2.5 billion. Rules? We don’ need no stinkin’ rules:

With the $4.5 billion Rusal loan, VEB appears to have made an exception to internal rules that limit lending of more than $2.5 billion to any one borrower. Norilsk, a major platinum producer, is considered strategic by Russian authorities. Without commenting directly on Rusal, Mr. Dmitriev said in an interview on a state-run news channel that the bank’s board — where Prime Minister Vladimir Putin is chairman — has the authority to make exceptions.

I’ll bet he does.

Both the Rusal and TGK-4 “exceptions” are only the most flagrant illustrations of the complete lack of any stable, rule-driven (and hence predictable) governance. Instead, they show that winners and losers are determined arbitrarily as a result of the exercise of influence and the exchange of political favors. They demonstrate that the system is one of personalized rule, with Putin exercising the ultimate power like the Godfather dispensing his favor on the lucky few. The Rusal exception also shows that Putin is willing to pay up to keep the “crown jewels” in Russian hands. That means that with various Russian companies owing well over $500 billion in foreign debt, there is a high risk that Russia’s reserves will be spent keeping control of these companies in Russian hands–another political decision, and one that just might be in the interest of connected people in the government. (BTW, it’s pretty sad that in the 2000s that an aluminum company is a country’s crown jewel. Think anybody in the US thinks that about Alcoa?)

In short, these episodes illustrate perfectly, Felix, why Russia trades at a 500 bp premium to freakin’ Brazil, of all places.