Bear up well

By bne IntelliNews July 2, 2012

Ben Aris in Moscow -

Russia is probably the best placed of the countries in Emerging Europe to deal with a break-up of the euro, say analysts.

The pain inflicted in the 2008 financial meltdown has squeezed out much of the debt that did so much damage last time round, while the Russian government has worked hard to rebalance its finances and is now sourcing much of its credit needs from the domestic, rather than external, capital market. Perhaps most significant of all was the Central Bank of Russia's (CBR) decision to widen the band in which the ruble can trade against the dollar, which has made the economy a lot more flexible when it comes to dealing with external shocks.

Analysts expect Russia to be one of the best performing markets in the region, thanks to a strong recovery in domestic demand, which also goes a long way in helping to cushion the Russian economy from external shocks. Still, the size of the shock matters and if Europe suffers a disorderly break-up of the euro and a series of sovereign debt defaults, the result could be messy. "At Timetric, we believe that the Russian economy can weather an orderly Greek Eurozone exit, with growth likely to be dented only in 2012. However, the economy would be subject to a deeper downturn both this year and next in the (not implausible) event of a disorderly break-up," says Stephen Rocks, an economist with new kid on the think-tank block Timetric.

Turning east

Russia's economy went from about 7% growth in the first part of 2008 to a 7% contraction in 2009 as the private sector simply seized up. With the 1998 financial crisis still fresh in everyone's minds, companies froze payments and hoarded cash, bringing the wheels of commerce to a standstill. But it was only a few heavily leveraged mega-companies that actually got into difficulties; over the last four years, most have paid off debt or at least significantly extended the maturities of their debt burden. "Levels of external debt have fallen, thus reducing its vulnerability to financial contagion from the euro-crisis. What's more, Russia's export base has diversified away from Europe and towards stronger Asian markets. Overall, we think the combination of robust credit growth and supportive fiscal policy should ensure fairly healthy growth this year, driven in large part by consumer spending," says Neil Shearing, chief emerging markets economist at Capital Economics.

And unlike 1998 when the entire top-tier of the Russian banking sector was destroyed, most of Russia's banks were in a fairly strong position before 2008, a position they have improved on since, says the CBR.

The CBR carried out bank stress tests as of January 1 based on two micro-scenarios depending on the development of the debt crisis in Europe. The pessimistic scenario found a slowdown of GDP growth to 2%, inflation at a rate of 6%, zero increase in investments, and a 1% fall of real income among the population - which would all hurt, but no more than that. Under the extreme scenario of a disorderly collapse of the Eurozone, Russia's growth would fall by 1.4%, inflation rise to 5.7%, investments to fall by 1.3% and real income of the population to decline by 2.4% - which would also not be the end of the world.

Foreign bank ownership is one of the classic channels for a crisis in one country to be transmitted to another. However, foreign banks only make up a quarter of Russia's banking sector in terms of assets (and several big names like HSBC and Barclays have left the market in the last two years). Indeed, the Russian branches of international banks were so cash rich that they sent $40bn of cash home to bolster their parents in 2011, accounting for half of all the country's capital flight.

The high levels of capital flight have caught the headlines, but another quarter, or $20bn, was simply Russian companies reinvesting profits in overseas operations. That leaves $20bn of genuine capital flight - or about the net worth of just two big oligarchs. Put another way, the share of GDP that $80bn of capital represents is a fraction of capital flight/GDP in the 1990s.

Clearly, Russian equity prices have been pummelled by the uncertainty, but as of the middle of June most of the potential pain of a meltdown looked already to have been priced in. Trading at a 50% discount to other emerging markets, Russia's stocks are close to the bottom they hit in 2009 when the price/earnings ratio of the Russian stock market fell to around 3x. As of the start of June, share prices were at a PE ratio of around 4x - the cheapest they have been for three years, so there is not much left to fall.

The one real danger for the Russian economy is a catastrophic fall in the oil price. The state's heavy spending requires an oil price of about $115 for the budget to break even, but Citibank's chief Russia strategist, Kingsmill Bond, called for the state to cut this to $80 in the middle of June to avoid a train wreck should a fresh crisis appear. Even the state forecasts oil prices to fall to an average of about $80 in the years to come.

"If [oil prices fall to $85 and stay there], the budget is likely to record a deficit of around 3.5% of GDP next year," says Capital Economic's Shearing, who has been persistently negative on Russia for years. "All told, we expect the economy to grow by 3.8% this year and 2.5% in 2013 - by no means a disaster."

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