Ben Aris, Nicholas Watson and Dominic Swire -

Central and Southeast Europe have dodged the international credit crash, but Russia could be trapped in the wreckage and is bracing itself for its own liquidity crisis in April.

The seasonal sharp liquidity squeeze in Russia that comes at the end of the first quarter of every year is going to be particularly mean this time. Liquidity is always drained out of the system by tax payments, but this time round the problems have been made far worse by the global credit crunch and new rules on VAT collection that will treble the tax bill. The Russian government has been busy amassing a pool of over $100bn of liquidity to fight any fires that break out and is confident it can cope with potential systematic problems in the financial system.

Ulyukaev warnings

Much of Russia's banking sector is still very rudimentary. At the end of every quarter, cash is drained from the system as companies pay their taxes. The effects of this ebb and flow of cash is easily seen on the stock market, as equities are one of the few investments earning real returns available to banks. The result is that at Easter every year, the RTS stock market index sells off sharply.

But this year will be worse, as new rules governing VAT payments - which makes up a third of all tax payments by itself - come into force this year. Now, companies have to pay VAT for a whole quarter in April rather than paying a bit off every month as they did in 2007, which will suck an estimated RUB400bn-600bn ($16bn-22bn) out of the system at a stroke. The Central Bank of Russia (CBR) said in February it expects demand for liquidity to peak sometime between March and April at about $16bn a day. The total liquidity of the Russian banking sector is usually somewhere between $25bn and $35bn.

In addition to the regular tax payments, the closure of the international capital markets means this year the repayment of private debt of all sorts will reach a record high of $35.9bn; a large chunk of this was due to repayments by just Rosneft ($5.7bn) and Evraz Group ($1.8bn). In a worst-case scenario, demand for cash could be pushed even higher if confidence falters. "Demand for liquidity could be pushed even higher by a possible outflow of investor money from the market and continuing turmoil within the global banking system," says Vladimir Tikhomirov, a bank analyst with UralSib.

So far this year, Russia has been holding its own, and is the only one of the BRIC (Brazil, Russia, India and China) markets to actually see inflows, albeit modest, of investment capital.

Crash test padding

The CBR already went through one hard squeeze in November 2007 when banks were asking for RUB400bn a day and the bank was forced pump in tens of billions of dollars to stave off disaster.

This time round, the state together with the CBR has built up a war chest of over $100bn of money in various forms to meet any system-wrecking liquidity crunch and plans to make RUB665bn a day available, up from the current RUB500bn limit.

The state banks are also rallying round to shore up the sector. Observers have criticised the government's policy of keeping two giant banks in the sector - Sberbank and VTB - but at times like this, being able to marshal the resources of the country's two biggest banks is an advantage.

Vnesheconombank (VEB), the state's debt agency (recently re-tasked as a domestic development bank), deposited $4.6bn of its resources into 10 banks temporarily in the middle of March. Among the recipients were Alfa Bank, Gazprombank, Russian Agriculture Bank (Rosselkhozbank) and Vozrozhdenie Bank. VEB also manages the state pension fund and has suggested placing another $3.6bn of this money in the commercial banks. "We think it expedient to convert [pension savings] free funds into deposits at commercial organizations," VEB chairman Vladimir Dmitriyev said in mid-March, without elaborating.

Other ideas on the table for boosting liquidity in March are to transfer a state fund for reforming communal services worth RUR240bn from the CBR to an asset management company that could distribute it further. Also, the Ministry of Finance is working on the auction procedure for placing a significant amount of unspent budget funds in the banking system and increasing to 30-40 the number of banks allowed to participate in this scheme.

Squeezing, biting, but not yet bleeding

No one was panicking, but by the middle of March the liquidity squeeze was already starting to bite. On March 12, the Ministry of Finance was forced to buy back some RUB21bn ($898m) of its bonds, the OFZs, in order to place new ones, as a week earlier for the first time since 2004 the ministry had to cancel an auction due to a lack of demand. Banks took up only a fifth of the new placement, or about RUB5.6bn, leaving plenty of extra cash in banks' coffers. At the same time, the CBR's bonds - the so-called "beaver" bonds - have almost completely disappeared from the market after the central bank bought back some RUB110bn of its own bonds from banks.

"In spite of injections from the finance ministry and CBR, liquidity into the Russian banking system of RUB740bn is close to the minimum sufficient level, and suggests that with the start of tax payments, banking liquidity will be once again squeezed out," says Natalia Orlova, chief economist at Alfa Bank, who thinks the government will have to come up with more ways of keeping the system flush with cash to keep it going.

The main weapon in the CBR's armoury is repurchase transactions (repos) and analysts estimate the bank can pump up to RUB1.6 trillion of liquidity in this way. Another RUB1 trillion could be transferred from treasury accounts to commercial banks, giving the CBR a total war chest of over $100bn to shore up the system.

This should be plenty. More importantly, Russian bankers, unlike their American counterparts, have growing confidence in the ability of their central bank to see them through the bumps and hairpin bends on the road ahead. The CBR has proven itself to be more than competent in managing the liquidity of the system. Having successfully avoided a train crash during Russia's mini-banking crisis in 2004 and supporting the sector during last summer's bout of the collywobbles, the CBR has nurtured a degree of confidence that it can cope with this Easter's crunch. "The liquidity situation is currently manageable," the CBR's First Deputy Chairman Alexei Ulyukaev said in March, emphasizing the bank has been preparing resources to meet demand for months. "We got the sled ready in summer, knowing that winter was coming."

Cooling off period

This crisis is largely a financial crisis and has yet to touch the real economy. Indeed, with commodities prices continuing to soar, many of Russia's biggest companies are making more money than ever, while the rest of the economy is in an investment and consumer spending virtuous cycle that is largely insulated from the international credit woes.

Lost amongst Ulyukaev's statements on the possible bank crisis in March were comments that a slowdown of the global economy could actually be a good thing; GDP growth accelerated again in 2007 to 7.8% and the CBR has identified signs that the economy is beginning to overheat. However, the impact of the international crisis on the Russian banking sector is expected to shave at least a percentage point off growth this year.

"There are several symptoms of overheating in the Russian economy associated with high consumer demand and a lack of balance between personal income growth and productivity gains," said Ulyukayev in February. "A certain amount of cooling off in the rates of economic growth and growth of banking sector assets wouldn't hurt."

The banks have been the big losers from the current brouhaha. A quarter of Russian banks reported losses in January this year, partly due to new accounting rules, but mainly because non-performing loans are rising and significant numbers of Russians have been withdrawing their money from banks, according to a CBR report.

After years of double-digit asset growth, banks saw their assets rise by only 1.4% in January from the month before. Banks have been switching out of lending and into bonds, despite bonds suffering negative real returns. Analysts at Renaissance Capital estimate the bank sector assets will grow by only 10% this year. "When banks are nervous they buy bonds, even if unprofitable. The percentage of state bonds rises because they are seen as a liquidity cushion," Gennady Melikyan, First Deputy Chairman of the Central Bank, said in March.

The crisis has also brought bond and IPO issuance to a standstill. By March, Russian companies were starting to issue bonds again, but far below the levels seen in the previous years and the domestic bond market is moving sideways. The number of corporate bonds offered on Micex halved in the first two months of 2008 to 24 compared with the same period of last year, according to Micex's director for listing, Leonid Savvinov. He said corporate bond trading volumes remained almost flat on the year in the period at RUB112bn.

However, Russia's best names have found it's still possible to raise money. While spreads on the bonds have increased dramatically, thanks to the repeated interest rate cuts by the US Federal Reserve, the cost of borrowing on the international markets has remained about the same as it was before the crisis broke last summer. "The Eurobond and syndicated loan market in Russia has slowed and those Russian institutions that are dependent on foreign borrowing have seen a big liquidity crunch. In Russia this is not a crisis but a squeeze," says Andrei Donskikh, CEO of UralSib in an exclusive interview with bne.

UralSib has raised over $1bn since the beginning of the downturn with few problems. "The overall cost of borrowing has not been affected. The spreads that banks charge have gone up, but the Libor rate has fallen and so the effective cost of money remains about the same," Donskikh says.

Elsewhere in the neighbourhood

In Central Europe, there's simply no sub-prime mortgage market to speak of. The ratio of private mortgage loans to GDP is only about 10-20% in the countries of the region, while it's about 100% in the US and about 75% in the UK. Crucially, once those loans are made, they are kept on the books by the banks that made them and not bundled and securitized as they have been in the US, which is what has caused all the problems. A recent study by the International Monetary Fund found that securitization of loans was so low in most markets of the region as to be almost impossible to measure.

"It's difficult to say on a fundamental basis how these banks are really going to be., but I can't see happening with these banks what we've seen with the US banks. I think the effects on Central and Eastern European banks are more sentiment driven than fundamental," says Gus Robertson, a senior emerging-markets fund manager with ING Investment Management.

Indeed, preliminary results from Polish banks show that the sector has a whole enjoyed record-high profitability in 2007 despite the troubles that began in the summer of 2007. Fitch Ratings notes that asset quality for the sector improved in 2007 and it expects this trend to continue in 2008, resulting in low provisioning charges. "The only possible source of higher risk costs would be a significant drop in real estate prices, which would hurt developers and customers with mortgage loans," says Artur Szeski, Fitch's analyst in Warsaw. "Nevertheless, the price correction so far has been smooth and not very severe, making a sharp market correction less likely."

With the banking sectors of the region overwhelmingly foreign owned, attention has inevitably focused on the parent banks. Yet so far it's been the Swiss banks UBS and Credit Suisse that have borne the brunt of the write-downs, but they're not the major players in the region.

Anecdotal evidence also backs up the optimistic view. While there are predictions of around 10,000 London-based banking jobs going by the end of the year, the emerging markets of Russia and Eastern Europe are looking to hire more staff. A recent survey of 32 countries by the recruitment company Manpower found that employers in places like Romania and Poland have the most optimistic hiring intentions, while the US and much of Western Europe had the weakest prospects.

The banking sector in Southeast Europe has also remained relatively insulated from the US financial crisis that has been steadily increasing in intensity since last summer. And despite the recent drama on the US markets, analysts offer the reassurance that Southeast Europe's banking sector is still well protected. On the contrary, things could be looking up.

Stefan Maxian, an analyst specializing in the region at Raiffeisen Bank in Vienna, says part of the reason for this is simply a lack of money. "Most banks in the region are, from the asset side, rather immune to [the credit crisis] simply because they have needed all their capital to fund loan growth, so there has been no temptation to invest in US paper."

Banks that could be affected, says Maxian, are those that are more reliant on wholesale funding. However, as most banks in Southeast Europe are focused on retail this is not such a problem. "You have to differentiate how a bank is structured. If a bank is able to have a big deposit base locally and a huge client network, and especially more retail-focused banks, they will be less affected because they don't have funding problems," Maxian says.

"Banks that are more reliant on wholesale funding have bigger problems. But in general in the region, you don't have the situation like in Kazakhstan, for example, where almost all banks are involved in wholesale funding and there is very, very limited deposit funding of the balance sheet," he adds.

Such a lack of development of the region's banking sector also implies potential for growth. One reason for it being such an underdeveloped market is the lack of a banking tradition existing in these countries. A recent report from Erste Bank on the banking sector in Southeast Europe said many people in the region are still prone to hoard cash rather than investing it in a bank - but this is gradually changing. "While the deposits are already at a relatively high level in countries like the Czech Republic and Croatia, in the emerging banking markets, a lot of money is still stored in piggy banks. We expect the commercial banks to continue to replace piggy banks as confidence in the banking market rises," analysts at Erste say.

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