Roland Nash of Renaissance Capital -
One financial institution that's thriving during the credit crunch is a micro-finance bank I met in Bishkek. It had its best month ever in August. But the reason for their success is rather telling. Clients had been queuing up for help to roll over their $100-500 loans that Kazakh banks had stopped refinancing. There is apparently a credit squeeze in micro-finance in Kyrgyzstan. That farmers in Osh are seeing their livelihoods threatened because credit rating agencies in the US misunderstood the concept of risk-pooling, illustrates both the awesome success of financial globalization over the past decade, and the global risk of correlated downturn.
No matter how good the economic fundamentals, there are few markets globally that are able to claim immunity from the current credit crunch. While global finance looks a less hostile environment today than it did a week ago, the imbalances generated by a decades worth of credit expansion are not unwound in a month, even one as unsettling as August. As expectations gradually improve, markets will become more susceptible to being blindsided by poor data. Despite the security provided by domestically generated economic growth, high oil prices and a relatively underdeveloped financial sector, Russia faces a number of significant liquidity-related risks in coming months, which we describe below. The economists at the Federal Reserve may have brought back the punch bowl, but if there's one thing that Russia can teach global finance, it's that the hair of the dog only postpones the hangover.
However, it is important to differentiate between two types of risk - short-term liquidity risk and longer-term economic risk. Russian equity can be impacted by liquidity risk, but the risk of US economic slowdown holds little danger for Russian equity, particularly with commodities negatively correlated to a weakening dollar. Once the market is able to become comfortable with the liquidity and can see through to the underlying fundamentals, then Russian equity should perform well. The commitment signalled by the Fed last week to provide the liquidity needed to ease the credit situation and the commitment by Finance Minister Alexei Kudrin on Friday to provide liquidity to the Russian market are together switching attention back to the fundamentals.
As this happens, Russia equity looks well positioned. While politics may still provide a short-term shock, Russia could well be set for a sharp pre-election rally in the final quarter of this year. We have recommended sitting out of the market (as far as possible) since mid-July. While risk remains, stepping back into the market to take advantage of high oil prices and better valuations seems now to be where the risk-reward balance lies.
First, the risks:
Postponed debt issuance
Despite money supply growth at an annualized rate of 53% in the first seven months of the year, and despite real interest rates that have been negative for the last couple of years, Russian entities were largely unable to raise financing since the beginning of August without paying punitive rates. So far, we estimate that at least 12 Eurobonds have been postponed and another 17 ruble bonds (see figure 1). The one entity that has insisted on refinancing in the market, Russian Standard, placed bonds at 14.5%, roughly 600 basis points (bps) higher than their bonds were trading in late June (see figure 2).
Russian banks and corporates face a difficult refinancing period in the coming months. If global credit conditions had not changed, we estimate that there would have been at least $10bn of currency denominated debt and RUB200bn of ruble paper issued before the end of the year. This, together with the overhang from August, could place significant strain on the liquidity positions of Russian business if the credit markets remain tight.
In the event of another sharp global liquidity squeeze, we would not be surprised to see Russias first significant post-1998 default, albeit of a third-tier credit - spreads of 700 bps suggest that the market is also fearful. In better times, we would view a default as the healthy development of Russias capital markets - credit differentiation in recent years has not been terrifically efficient in our view, and a default would help hone credit skills. However, in the current environment, there is a risk that any default would further spook not just the second- and third-tier credit markets, but all tradable Russian assets.
In a world where cash has been crowned, the Central Bank of Russia (CBR) is in a particularly strong position. Emerging market central banks in general are among the most liquid entities globally. Yet liquidity remains reasonably tight in the Russian market. Overnight rates are 4-6% up from 2% pre-crisis. While it is clear that the CBR has the firepower necessary to provide liquidity, the relatively tight liquidity conditions together with the potential demand highlighted above put some pressure on Russias banking sector. Although there is no obvious reason to be concerned about any individual Russian bank, the speed of growth in recent years has been so remarkable that it would be surprising if weaknesses had not developed somewhere. Any poor risk decisions or counterparty issues will be revealed by tight liquidity conditions.
On Friday, September 21, Finance Minister Alexei Kudrin announced that state development institutions would be able to invest some of their funds locally and that Russia would not be impacted by the global liquidity crunch in any serious way. This was the most reassuring official statement to date that the Russian monetary authorities are ready to step into the market to relieve any credit related difficulties. The reaction by the debt and money markets to the announcement suggests that the market agrees. The positive reaction is more evidence that liquidity risks are now dissipating.
The Achilles heal across the CIS is Kazakhstan. This year, the current account deficit will approach 6% of GDP rising to 10% next year. Foreign direct investment is actually net negative as repatriation and dividends from oil investments a decade ago outweigh current inflow. Financing, therefore, relies on international borrowing, particularly by Kazakh banks.
With access to international finance effectively closed, Kazakhstan is being forced to run down reserves to finance the current account outflow. In August, the Kazakh central bank lost $2bn, or just under 10% of its reserves. In the first half of September, another $1.3bn was lost. If capital markets reopen, Kazakhstans reputation for good monetary management should mean that financing can resume. If, however, capital markets remain closed, Kazakh monetary authorities will come under pressure to let the tenge depreciate. Given the previous access to international capital markets for Kazakh banks, any depreciation could leave the banking sector in a difficult situation.
The Kazakh monetary authorities have the best reputation in the CIS. Moreover, they face large current account surpluses in the future when Caspian hydrocarbons come on line. However, short term, Kazakhstan looks liquidity constrained. Any headline generating event in Kazakhstan would likely have spill-over consequences for Russia - particularly in an environment of increased uncertainty.
So risks still clearly remain. However, all of the risks outlined are liquidity related. On the economic side, there is little obvious cause for concern while the oil price remains supported. The risk of global economic slowdown and US recession actually holds relatively little danger for Russia, as long as it does not exacerbate the liquidity issue. The Feds easing and its apparent commitment to provide the liquidity needed to restore confidence in the credit markets mitigates the scale of the risk described above. Moreover, Kudrins statements indicate that Russias monetary authorities are also ready to provide the necessary liquidity. It is the lifting of the liquidity risk so that the market can focus on the positive fundamentals that has made us more optimistic of a pre-election rally in equities
Now, the positives:
While the equity market has done very little so far in 2007, it is a little misleading to describe Russia as one of the worse-performing markets year to date. Rather, it has been Russian oils that have been the poor performers (see figure 3). Metals and mining is up 57%, telecom has risen 38% and even financials are 18% higher.
Part of the reason for the underperformance of oils is rising costs. This issue, as has been described many times elsewhere, is long term, and can only be realistically mitigated through a more conducive tax environment. Equally, however, underperformance is also a result of the oil price failing to surprise to the upside during the first half of the year. While the level of the oil price has obviously been high, it is the earnings surprise of a higher-than-expected oil price that has tended to drive the oil sector.
Since March, the oil price has been above our initial 2007 average forecast of $60/Brent. If the oil price remains at $80 for the remainder of the year, it will have averaged $73. Next year, consensus forecast is $63. While much of the potential increase in export revenues is taxed away, domestic oil sales and oil products have a higher elasticity. Figure 4 illustrates the sensitivity.
The principal danger to the Russian equity market of a US recession and resulting global slowdown is through commodity prices. However, commodity prices are negatively correlated to a weaker dollar. So far, the dollar impact has been the more important, yet the Russian equity market has only just begun to react. The upside in Russian equity to the increased oil price has been held back by the global liquidity risk. As that dissipates, the value in the oil sector in particular should shine through.
Cheap equity market
Partly due to under performance, and partly due to high commodity prices, Russian equity has reverted to its traditional position as one of the worlds least-expensive large markets on a price/earnings basis. At a 2008 P/E of 11 (at an estimated average oil price of $63), Russian equity has the value to offer a defensive option globally (see figure 5).
It can be argued that one-year aggregated price-earnings numbers are not a particularly illuminating indicator for a commodity producer when commodity prices are high. A more accurate measurement of value is to break down the economy by sectors and compare across countries. On this basis, Russia has not compared quite so favourably in recent years. However, hydrocarbons, metals and telecoms now offer relative value. Only utilities and consumer companies look expensive (see figure 6).
Arguments can be made about whether this factor should be sitting with the positives or the negatives. Viktor Zubkov's appointment as prime minister was, to say the least, something of a surprise. His sudden appearance in public Russian politics was confirmation, if any were needed, that politics injects uncertainty into Russian markets. But perhaps as interesting as the promotion was the almost total absence of a reaction by the market. Despite speculation that the man who has presided over a trillion-dollar increase in the value of Russian equities and who has more or less absolute power over the destiny of a country with a rich tradition in volatility was to be replaced by a man about whom virtually nothing was known, the market barely budged. It would appear that equities have finally grown numb to the vagaries of Russian politics.
Nonetheless, it is our view that Zubkov will not be promoted to the presidency. Rather he, and his soon-to-be-formed government, will be the latest institutional mechanism to underpin stability between the current presidency and the next. It is quite a neat trick. Putin looks ready to solve most of the political uncertainty surrounding government and control of the natural monopolies while still in power. The next president will likely make changes. But his room for manoeuvre will be limited if most of the important personnel changes have been made while Putin remains in charge.
Whether Zubkov will become president or whether the next government will remain through to the next president, much of the uncertainty surrounding the elections should dissipate in coming days and weeks. While there may be some negative shock value to the new government, as soon as the market is able to focus through the political calendar, the positive economics should encourage new investment flows.
It is the increased optimism that the market will be able soon to see through the liquidity risks to look towards the fundamentals that persuaded us last week to become positive again on Russian equities. The equity and fixed-income markets are not immune from liquidity risk and have suffered with global markets since mid-July. Globally, liquidity risk remains. However, it appears to be dissipating to be replaced by fears over global slowdown. Unlike liquidity risk, we do no believe that global economic risk holds much danger for Russia. If the oil price remains high, then the economic risk of a global slowdown is limited for Russia. Indeed, in the event of global slowdown, Russia stands out as a safe haven and may benefit accordingly.
If we are right, then Russia could well be at the beginning of our long-anticipated pre-election rally. We began the year with a 2007 forecast for the RTS of 2500. We downgraded this to 2100 on the back of international uncertainty. With that uncertainty perhaps lifting, and with an oil price wind behind it, the RTS could yet make our original forecast.
Roland Nash is Head of Research at Renaissance Capital
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